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2 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.1 chapter Globalization McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

3 Chapter 1: GlobalizationINTRODUCTION Globalization: the trend towards a more integrated global economic system. Internet Extra: The U.S. Census Bureau contains monthly statistics on trade between the United States and its trading partners. The web site is {http://www.census.gov/foreign-trade/top}. Click on 2006, then on Total Trade, Next, click on Surplus, and then on Deficit. Who is the top trading partner for the U.S.? What is the top destination for U.S. goods? What country exports the most to the U.S.?

4 Chapter 1: GlobalizationEffects of globalization can be seen everywhere: the cars people drive the food people eat the jobs where people work the clothes people wear

5 Chapter 1: GlobalizationWHAT IS GLOBALIZATION? Globalization refers to the shift towards a more integrated and interdependent world economy.

6 Chapter 1: GlobalizationClassroom Performance System The trend away from distinct national economic units and toward one huge global market is known as Internationalization Economic integration Globalization Privatization Classroom Performance System Answer: c

7 Chapter 1: GlobalizationThe Globalization of Markets Globalization of markets: the fact that in many industries historically distinct and separate national markets are merging into one huge global marketplace in which the tastes and preferences of consumers in different nations are beginning to converge upon some global norm. Examples: Sony Playstation Citicorp credit cards Coca-Cola McDonald's hamburgers

8 Chapter 1: GlobalizationThe Globalization of Production Globalization of production: the tendency among many firms to source goods and services from different locations around the globe in an attempt to take advantage of national differences in the cost and quality of factors of production (such as land, labor, capital, and energy), thereby allowing them to compete more effectively against their rivals. Examples: Boeing Lenovo

9 Chapter 1: GlobalizationTHE EMERGENCE OF GLOBAL INSTITUTIONS Global institutions: help manage, regulate, and police the global market place promote the establishment of multinational treaties to govern the global business system

10 Chapter 1: GlobalizationExamples of Global Institutions: World Trade Organization (WTO): responsible for policing the world trading system and ensuring that nations adhere to the rules established in WTO treaties International Monetary Fund (IMF): maintains order in the international monetary system World Bank: promotes economic development United Nations (UN): maintains international peace and security, develops friendly relations among nations, cooperates in solving international problems and promotes respect for human rights, and is a center for harmonizing the actions of nations

11 Chapter 1: GlobalizationClassroom Performance System Which of the following is not an example of a global institution? The Federal Reserve The International Monetary Fund The World Bank The World Trade Organization Classroom Performance System Answer: a

12 Chapter 1: GlobalizationDRIVERS OF GLOBALIZATION Two macro factors underlie the trend toward greater globalization: Declining trade and investment barriers The role of technological change

13 Chapter 1: GlobalizationClassroom Performance System Coca-Cola, Sony Playstations, and McDonald’s hamburgers are all examples of American products Global products Industrial products National products Classroom Performance System Answer: b

14 Chapter 1: GlobalizationDeclining Trade and Investment Barriers After WWII, the industrialized countries of the West began the process of removing barriers to the free flow of goods, services, and capital between nations Under GATT, over 100 nations negotiated further decreases in tariffs and made significant progress on a number of non-tariff issues

15 Chapter 1: GlobalizationUnder the WTO, a mechanism now exists for dispute resolution and the enforcement of trade laws, and there is a push to cut tariffs on industrial goods, services, and agricultural products Removal of barriers to trade has contributed to increased international trade (the export of goods or services to consumers in another country), world output, and foreign direct investment (the investing of resources and business activities outside a firm’s home country) Internet Extra: To learn the status of current trade issues, “hot” areas of international trade, and the responsibilities of the WTO, go to {http://www.wto.org/}. Click on Current News. Review the issues that are currently at the top of the agenda for the WTO. Do they affect developed countries or developing countries? What are their implications for global trade? Go to Trade Topics. Click on Disputes Gateway. Explore the disputes currently under review. How do you think they will be resolved? Why?

16 Chapter 1: GlobalizationThe volume of world trade and investment has accelerated since the early 1980s.

17 Chapter 1: GlobalizationClassroom Performance System Which organization provides a mechanism for dispute resolution and the enforcement of trade laws? The UN The IMF The WTO The World Bank Classroom Performance System Answer: c

18 Chapter 1: GlobalizationThe Role of Technological Change The lowering of trade barriers made globalization of markets and production a theoretical possibility, technological change made it a tangible reality. Country Focus: Ecuadorian Valentine Roses Summary This feature describes Ecuador’s rose industry. In the last 20 years, Ecuador has built its rose industry from virtually nothing to a thriving industry generating $240 million in sales. Today, the industry employs tens of thousands of people at higher wages than the average Ecuadorian receives. Yet, there are concerns that in the quest for perfect flowers, the use of toxic chemicals such as pesticides may be hurting not only the environment, but also the health of the workers. Suggested Discussion Questions 1. Describe the benefits that the rose industry has brought to Ecuador. In your opinion, do the benefits outweigh the disadvantages? Why or why not? 2. Consumer groups in Europe have pushed for reforms to Ecuador’s environmental regulations for its rose industry. Other groups have encouraged trade sanctions to force Ecuadorian rose growers to be more environmentally responsible. Consider the impact these groups could have on Ecuador and workers in the rose industry if they are successful in their efforts. 3. For more information on the rose industry in Ecuador, visit {http://www.globalpolicy.org/globaliz/cultural/2003/02flowers.htm}.

19 Chapter 1: GlobalizationMicroprocessors and Telecommunications: Major advances in communications and information processing have lowered the cost of global communication and therefore the cost of coordinating and controlling a global organization The Internet and the World Wide Web: Web-based transactions have grown from virtually zero in 1994 to nearly $7 trillion in 2004 Transportation Technology: the most important developments are probably development of commercial jet aircraft and super freighters and the introduction of containerization, which greatly simplifies trans-shipment from one mode of transport to another

20 Chapter 1: GlobalizationImplications for the Globalization of Production Improvements in transportation technology have enabled firms to better respond to international customer demands

21 Chapter 1: GlobalizationImplications for the Globalization of Markets Managers today operate in an environment that offers more opportunities, but is also more complex and competitive than that of a generation ago

22 Chapter 1: GlobalizationTHE CHANGING DEMOGRAPHICS OF THE GLOBAL ECONOMY In the 1960s: the U.S. dominated the world economy and the world trade picture U.S. multinationals dominated the international business scene about half the world-- the centrally planned economies of the communist world-- was off limits to Western international business

23 Chapter 1: GlobalizationThe Changing World Output and the Changing World Trade Picture In the early 1960s, the U.S. was the world's dominant industrial power accounting for about 40.3 percent of world manufacturing output By 2005 the United States accounted for only 20.1 percent Rapid economic growth is now being experienced by countries such as China, Thailand, and Indonesia Further relative decline in the U.S. share of world output and world exports seems likely Forecasts predict a rapid rise in the share of world output accounted for by developing nations such as China, India, Indonesia, Thailand, and South Korea, and a decline in the share by industrialized countries such as Britain, Japan, and the United States

24 Chapter 1: GlobalizationThe changing picture of world output and trade can be seen in Table 1.2.

25 Chapter 1: GlobalizationThe Changing Foreign Direct Investment Picture The share of world output generated by developing countries has been steadily increasing since the 1960s The stock (total cumulative value of foreign investments) generated by rich industrial countries has been on a steady decline There has been a sustained growth in cross-border flows of foreign direct investment The flow of foreign direct investment (amounts invested across national borders each year) has been directed at developing nations especially China

26 Chapter 1: GlobalizationThe stock of FDI by the world’s six most important national sources is shown in Figure 1.2.

27 Chapter 1: GlobalizationThe sustained growth in cross-border flows of FDI and the emergence of developing nations as important destinations for FDI can be seen in Figure 1.3.

28 Chapter 1: GlobalizationClassroom Performance System Which of the following statements is true? The U.S. has been accounting for an increasing share of world trade in recent years The U.S. has been accounting for an increasing share of world foreign direct investment in recent years The U.S. has been accounting for an increasing share of world output in recent years The share of world trade accounted for by China has been increasing in recent years Classroom Performance System Answer: d

29 Chapter 1: GlobalizationThe Changing Nature of Multinational Enterprises A multinational enterprise is any business that has productive activities in two or more countries. Management Focus: China’s Lenovo Acquires IBM’s PC Operations Summary This feature explores how Lenovo, the Chinese personal computer manufacturer, is positioning itself to be a market leader in the global personal computer business. Lenovo, founded in 1984, held a 26 percent share of the Chinese market for personal computers, but wanted to become a global player. To that end, the company acquired IBM’s PC business in 2004, moved its headquarters to New York, and appointed the former head of IBM’s PC division as CEO of Lenovo. Suggested Discussion Questions 1. Explain how Lenovo has repositioned itself in the global PC market. What contributed to the company’s ability to make the transformation? What factors forced the company to change? 2. Discuss Lenovo’s decision to shift its global headquarters to New York. How important was it to appoint an American to CEO of the firm and establish English as the corporate language? 3. Lenovo’s website is {http://www.lenovo.com/us/en/}.

30 Chapter 1: GlobalizationNon-U.S. Multinationals Expect the growth of new multinational enterprises (any business that has productive activities in two or more countries) from the world's developing nations The Rise of Mini-Multinationals The number of mini-multinationals (small and medium-sized companies) is on the rise

31 Chapter 1: GlobalizationThe Changing World Order The collapse of communism in Eastern Europe represents a host of export and investment opportunities for Western businesses The economic development of China presents huge opportunities and risks, in spite of its continued Communist control Mexico and Latin America also present tremendous new opportunities both as markets and sources of materials and production

32 Chapter 1: GlobalizationThe Global Economy of the 21st Century Firms must be aware that while the more integrated global economy presents new opportunities, it also could result in political and economic disruptions that may throw plans into disarray

33 Chapter 1: GlobalizationTHE GLOBALIZATION DEBATE Is the shift toward a more integrated and interdependent global economy a good thing? Anti-globalization Protests Anti-globalization protesters now turn up at almost every major meeting of a global institution Protesters fear that globalization is forever changing the world in a negative way Country Focus: Protesting Globalization in France Summary This feature describes the anti-globalization protests going on in France. The protests, led by activist Jose Bove, started when the U.S. retaliated against EU bans on beef imports by imposing a 100% tariff on some EU products. Bove and his associates targeted McDonald’s, and also California winemaker Mondavi as symbols of their opposition to American investments. Still, despite the protests, foreign investment in France is at record highs, and ironically, so are French investments abroad. Suggested Discussion Questions 1. Consider the trade war that initiated the protests led by Bove. The EU instituted restrictions on the import of hormone treated beef because it was feared that the product might lead to health problems. The WTO stated that the restrictions were prohibited under WTO agreements and ordered the EU to lift the restrictions or face retaliatory measures. In your opinion, did the WTO act appropriately? Should a government be permitted to make decisions as to what products are or are not available to consumers? Should the WTO? What do you think would have happened if the WTO had ruled in favor of the EU? 2. Why was McDonald’s chosen as the target for anti-globalization protests? How can companies like McDonald’s protect themselves from the actions of protesters like Bove? 3. The WTO’s homepage: {www.wto.org}.

34 Chapter 1: GlobalizationGlobalization, Jobs, and Incomes Critics of globalization worry that jobs are being lost to low-wage nations Supporters of globalization 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

35 Chapter 1: GlobalizationGlobalization, Labor Policies, and the Environment Critics of globalization argue that that free trade encourages firms from advanced nations to move manufacturing facilities offshore to less developed countries with lax environmental and labor regulations Supporters of free trade point out that tougher environmental regulation and stricter labor standards go hand in hand with economic progress and that foreign investment often helps a country to raise its standards

36 Chapter 1: GlobalizationGlobalization and National Sovereignty Critics of globalization worry that economic power is shifting away from national governments and toward supranational organizations such as the World Trade Organization (WTO), the European Union (EU), and the United Nations

37 Chapter 1: GlobalizationGlobalization and the World’s Poor Critics of globalization argue that the gap between rich and poor has gotten wider and that the benefits of globalization have not been shared equally Supporters of free trade suggest that the actions of governments have made limited economic improvement in many countries

38 Chapter 1: GlobalizationMANAGING IN THE GLOBAL MARKETPLACE Managing an international business (any firm that engages in international trade or investment) is different from managing a domestic business because: countries differ managers face a greater and more complex range of problems international companies must work within the limits imposed by governmental intervention and the global trading system international transactions require converting funds and being susceptible to exchange rate changes

39 Chapter 1: GlobalizationCRITICAL DISCUSSION QUESTIONS 1. Describe the shifts in the world economy over the last 30 years. What are the implications of these shifts for international businesses based in Great Britain? North America? Hong Kong? Answer: The world economy has shifted dramatically over the past 30 years. As late as the 1960s, four stylized facts described the demographics of the global economy. The first was U.S. dominance in the world economy and world trade. The second was U.S. dominance in the world foreign direct investment picture. Related to this, the third fact was the dominance of large, multinational U.S. firms in the international business scene. The fourth was that roughly half of the globe - the centrally planned economies of the Communist world - was off-limits to Western international businesses. All of these demographic facts have changed. Although the U.S. remains the world's dominant economic power, its share of world output and world exports have declined significantly since the 1960s. This trend does not reflect trouble in the U.S. economy, but rather reflects the growing industrialization of developing countries such as China, India, Indonesia, and South Korea. This trend is also reflected in the world foreign direct investment picture. As depicted in Figure 1.2 in the textbook, the share of world output (or the stock of foreign direct investment) generated by developing countries has been on a steady increase since the 1960s, while the share of world output generated by rich industrial countries has been on a steady decline. Shifts in the world economy can also be seen through the shifting power of multinational enterprises. Since the 1960s, there have been two notable trends in the demographics of the multinational enterprise. The first has been the rise of non-U.S. multinationals, particularly Japanese multinationals. The second has been the emergence of a growing number of small and medium-sized multinationals, called mini-multinationals. The fall of Communism in Eastern Europe and the republics of the former Soviet Union have brought about the final shift in the world economy. Many of the former Communist nations of Europe and Asia seem to share a commitment to democratic politics and free market economies. Similar developments are being observed in Latin America. If these trends continue, the opportunities for international business may be enormous. The implications of these shifts are similar for North America and Britain. The United States and Britain once had the luxury of being the dominant players in the world arena, with little substantive competition from the developing nations of the world. That has changed. Today, U.S. and British manufacturers must compete with competitors from across the world to win orders. The changing demographics of the world economy favor a city like Hong Kong. Hong Kong (which is now under Chinese rule) is well located with easy access to markets in Japan, South Korea, Indonesia, and other Asian markets. Hong Kong has a vibrant labor force that can compete on par with the industrialized nations of the world. The decline in the influence of the U.S. and Britain on the global economy provides opportunities for companies in Hong Kong to aggressively pursue export markets.

40 Chapter 1: GlobalizationCRITICAL DISCUSSION QUESTIONS 2. "The study of international business is fine if you are going to work in a large multinational enterprise, but it has no relevance for individuals who are going to work in smaller firms." Evaluate this statement. Answer: People who believe in this view, and the firms that they work for, may find that they do not achieve their full potential (at best) and may ultimately fail because of their myopia. As barriers to trade decrease and state of the art technological developments take place throughout the world, new opportunities and threats exist on a worldwide basis. The rise of the mini-multinationals suggests there are global opportunities even for small firms. But staying attuned to international markets is not only important from the perspective of seeking profitable opportunities for small firms; it can also be critical for long-term competitive survival. Firms from other countries may be developing products that, if sold internationally, may wipe out small domestic competitors. Scanning international markets for the best suppliers is also important for small firms, for if a domestic competitor is able to tap into a superior supplier from a foreign country, it may be able to seriously erode a small firm's competitive position before the small firm understands the source of its competitor's competitive advantage and can take appropriate counter actions.

41 Chapter 1: GlobalizationCRITICAL DISCUSSION QUESTIONS 3. How have changes in technology contributed to the globalization of markets and of production? Would the globalization of production and markets have been possible without these technological changes? Answer: Changes in technology have contributed to the globalization of markets and of production in a very substantive manner. For instance, improvements in transportation technology have paved the way for companies like Coca-Cola, Levi Strauss, Sony and McDonalds to make their products available worldwide. Similarly, improvements in communications technology have had a major impact. The ability to negotiate across continents has been facilitated by improved communications technology, and the rapidly decreasing cost of communications has lowered the expense of coordinating and controlling a global corporation. Finally, the impact of information technology has been far reaching. Companies can now gain worldwide exposure simply by setting up a homepage on the Internet. This technology was not available just a few short years ago. The globalization of production and markets may have been possible without improvements in technology, but the pace of globalization would have been much slower. The falling cost of technology has made it affordable for many developing nations, which has been instrumental in helping these nations improve their share of world output and world exports. The inclusion of these nations, such as China, India, Thailand, and South Korea, has been instrumental in the globalization of markets and production. In addition, improvements in global transportation and communication have made it relatively easy for business executives from different countries to converse with one another. If these forms of technology, including air-travel, fax capability, , and overnight delivery of packages were not available, it would be much more difficult for businesses to conduct international trade.

42 Chapter 1: GlobalizationCRITICAL DISCUSSION QUESTIONS 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. Answer: This statement reflects a poor understanding of the unique challenges involved in international business. Managing an international business is different from managing a purely domestic business for at least four reasons. These are: (1) countries are different; (2) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business; (3) an international business must find ways to work within the limits imposed by government intervention in the international trade and investment system; and (4) international transactions involve converting money into different currencies. As a result of these differences, there are ample reasons for studying international business as a specific field of study or discipline.

43 Chapter 1: GlobalizationCRITICAL DISCUSSION QUESTIONS 5. How might the Internet and the associated World Wide Web impact international business activity and the globalization of the world economy? Answer: According to the text, the Internet and World Wide Web (WWW) promise to develop into the information background of tomorrow's global economy. This improved technology will not only make it easier for individuals and companies in different countries to conduct business with one another, but will also further decrease the cost of communications. These improvements will undoubtedly hasten the already rapid pace of globalization. Another distinct attribute of the Internet and the WWW is that they act as an equalizer between large (resource rich) and small (resource poor) firms. For instance, it does not cost any more for a small software firm to gain visibility via the WWW than it does for a large software company like Microsoft. As a result, the WWW helps small companies reach the size of audience that was previously only within the reach of large, resource rich firms.

44 Chapter 1: GlobalizationCRITICAL DISCUSSION QUESTIONS 6. If current trends continue, China may emerge as the world's largest economy by Discuss the possible implications of such a development for: The world trading system. The world monetary system. The business strategy of today's European and U.S. based global corporations. Global commodity prices. Answer: The world trading system would clearly be affected by such a development. Currently China enjoys a somewhat privileged status within the World Trade Organization as a “developing” country. Such a rise to eminence, however, would clearly force it to become a full and equal member, with all the rights and responsibilities. China would also be in a position to actively affect the terms of trade between many countries. On the monetary front, one would expect that China would have to have fully convertible and trading currency, and it could become one of the “benchmark” currencies of the world. From the perspective of Western global firms, China would represent both a huge market, and potentially the home base of some very capable competitors. Finally, commodity prices would probably fall.

45 Chapter 1: GlobalizationCRITICAL DISCUSSION QUESTIONS 7. Read the Country Focus in this chapter on the Ecuadorian rose industry, the answer the following questions: a) How has participation in the international rose trade helped Ecuador’s economy and its people? How has the rise of Ecuador as a center for rose growing benefited consumers in developed nations who purchase the roses? What do the answers to these questions tell you about the benefits of international trade? b) Why do you think that Ecuador’s rose industry only began to take of 20 years ago? Why do you think it has grown so rapidly? c) To what extent can the alleged health problems among workers in Ecuador’s rose industry be laid at the feet of consumers in the developed world and their desire for perfect Valentine’s Day roses? d) Do you think governments in the developed world should place trade sanctions on Ecuador roses if reports of health issues among Ecuadorian rose workers are verified? What else might they do to improve the situation in Ecuador? Answer: a) Ecuador is the world’s fourth largest producer of roses. In fact, roses represent the country’s fifth largest export. The industry is vital to Ecuador’s economy, creating tens of thousands of jobs, jobs that pay significantly above the country’s minimum wage. Taxes and revenues from the rose growers have also helped to pave roads, build schools, and construct sophisticated irrigation systems. For Ecuador’s consumers, the success of the industry means bigger, more vibrant flowers than were previously available. Most students will recognize that the conditions in Ecuador give the country a distinct advantage in rose growing, and that by focusing on the industry, Ecuador has been able to benefit from international trade. Consumers in other countries also benefit from Ecuador’s flower exports with better products. b) Ecuador’s rose industry began some 20 years ago, and has been expanding rapidly ever since then. Most students will probably focus advances in technology as a key to the industry’s success. Roses are a very fragile, perishable product. Modern technology enables growers to used refrigerated air transport to get the product to markets around the globe. Without that ability, the growers would be limited to the market immediately surrounding the country. c) Students will probably be divided on this issue with some students arguing that consumers are to blame for the problems, and others placing the blame on the growers. Students taking the first perspective will probably suggest that most consumers purchase their roses with little consideration for how they are grown. Rather, most consumers simply focus on their beauty and price. Students blaming the growers might argue that growers, because they feel the effect of less-than-perfect roses in the form of smaller profits, will be motivated to find ways to produce ever more perfect flowers. Certainly, the use of pesticides and other products can produce a better crop. In the end, there is probably blame on both sides. If more consumers were aware of the health problems resulting from the improper use of pesticides, they would probably demand some changes. Similarly, if pressure were put on the growers to use pesticides safely, health problems could be reduced. d) Trade sanctions are a tool that is often employed by governments that are making a statement against a specific action or actions. In the case of Ecuador, trade sanctions certainly would be an option, as would publicizing the situation so that more consumers were aware of the conditions. In the end though, it is important to consider the effect of the sanctions or other measures on people like Maria who might lose their livelihood as a result.

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47 National Differences in Political Economy2 chapter National Differences in Political Economy McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

48 Chapter 2: National Differences in Political EconomyINTRODUCTION This chapter explores how the political, economic, and legal systems of countries differ Together these systems are known as the political economy of a country

49 Chapter 2: National Differences in Political EconomyPOLITICAL SYSTEMS A political system is the system of government in a nation Political systems can be assessed according to: the degree to which they emphasize collectivism as opposed to individualism the degree to which they are democratic or totalitarian

50 Chapter 2: National Differences in Political EconomyClassroom Performance System The political, economic and legal systems of a country are called Political systems Economic systems Legal systems Political economy Classroom Performance System Answer: d

51 Chapter 2: National Differences in Political EconomyCollectivism and Individualism Collectivism refers to a system that stresses the primacy of collective goals over individual goals When collectivism is emphasized, the needs of the society as whole are generally viewed as being more important than individual freedoms

52 Chapter 2: National Differences in Political EconomySocialism Communists generally believed that collectivism could only be achieved though revolution and totalitarian dictatorship, while social democrats worked to achieve the same goals by democratic means Privatization is the movement toward free market economies by selling state-owned enterprises to private investors

53 Chapter 2: National Differences in Political EconomyIndividualism Individualism is a political philosophy that an individual should have freedom over his or her economic and political pursuits. Individualism focuses on: guaranteeing individual freedom and self-expression letting people pursue their own self-interest in order to achieve the best overall good for society

54 Chapter 2: National Differences in Political EconomyClassroom Performance System Individuals who believe socialism can be achieved only through revolutions and totalitarian dictatorship are called Social democrats Communists Individualists Representative democrats Classroom Performance System Answer: b

55 Chapter 2: National Differences in Political EconomyDemocracy and Totalitarianism Democracy is 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 opposing political parties are prohibited

56 Chapter 2: National Differences in Political EconomyDemocracy The most common form of democracy today is representative democracy, where elected representatives vote on behalf of constituents

57 Chapter 2: National Differences in Political EconomyTotalitarianism The four major forms of totalitarianism are: communist totalitarianism: advocates achieving socialism through totalitarian dictatorship theocratic totalitarianism: political power is monopolized by a party, group, or individual that governs according to religious principles tribal totalitarianism: a political party that represents the interests of a particular tribe monopolizes power right wing totalitarianism: individual economic freedom is allowed but individual political freedom is restricted in the belief that it could lead to communism

58 Chapter 2: National Differences in Political EconomyClassroom Performance System Which system emphasizes individual freedom and self-expression? Individualism Collectivism Theocratic totalitarianism Tribal totalitarianism Classroom Performance System Answer: a

59 Chapter 2: National Differences in Political EconomyECONOMIC SYSTEMS A free market system is likely in countries where individual goals are given primacy over collective goals State-owned enterprises and restricted markets are common in countries where collective goals are dominant

60 Chapter 2: National Differences in Political EconomyThree broad types of economic systems can be identified-a market economy, a command economy, and a mixed economy. Market Economy In a pure market economy the goods and services that a country produces, and the quantity in which they are produced is determined by supply and demand

61 Chapter 2: National Differences in Political EconomyCommand Economy In a pure command economy the goods and services that a country produces, the quantity in which they are produced, and the price at which they are sold are all planned by the government Mixed Economy A mixed economy includes some elements of a market economy and some elements of a command economy

62 Chapter 2: National Differences in Political EconomyClassroom Performance System Which of the following is not one of the three broad types of economic systems? Market economy Command economy Mixed economy Free economy Classroom Performance System Answer: d

63 Chapter 2: National Differences in Political EconomyLEGAL SYSTEMS The legal system of a country is the rules, or laws, that regulate behavior, along with the processes by which the laws of a country are enforced and through which redress for grievances is obtained. The legal environment of a country is important because 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 Differences in the structure of law can impact the attractiveness of a country as an investment site and/or market

64 Chapter 2: National Differences in Political EconomyDifferent Legal Systems The common law system (based on tradition, precedent, and custom) is found in most of Great Britain’s former colonies, including the United States The civil law system is based on a very detailed set of laws organized into codes and is found in over 80 countries, including Germany, France, Japan, and Russia Islamic law is the most widely practiced theocratic law system (based on religious teachings) in the modern world

65 Chapter 2: National Differences in Political EconomyDifferences in Contract Law Contract law is the body of law that governs contract enforcement 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 The United Nations Convention in Contracts for the International Sales of Goods (CIGS) 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 CIGS, a nations signals to other nations that it will treat the Convention’s rules as part of its law Country Focus: Corruption in Nigeria Summary This feature describes the corruption that has characterized Nigeria’s economy over the last 40 years. When the country initially gained its independence from Britain in 1960, expectations were high that Nigeria would become an economic heavyweight in Africa. With abundant natural resources and a large population, it seemed the stage was set for success. However, despite earnings of more than $300 billion from oil sales during the period 1970 to 2000, the country still suffered from extreme poverty, illiteracy, and high debt. Several factors have been blamed for Nigeria’s troubles including political instability and corruption. Suggested Discussion Questions 1. What is meant by corruption? Explain how a corrupt political system affects the well being of a country. 2. With its huge oil reserves and large population, Nigeria was expected to emerge as a major player in Africa. Yet today the country is extremely poor with little expectation for an economic turnaround any time in the near future. Explain how Nigeria came to be in such a sad state. 3. Clearly, Nigeria’s corrupt government has been a major factor in the country’s demise. In contrast, other countries including Finland and Canada expressly prohibit corruption. In your opinion, would Nigeria be better off following the example of countries like Finland and Canada? Why or why not?

66 Chapter 2: National Differences in Political EconomyClassroom Performance System Which type of legal system is based on a very detailed set of laws organized into codes? Contract law Civil law Common law Theocratic law Classroom Performance System Answer: b

67 Chapter 2: National Differences in Political EconomyProperty Rights and Corruption Property rights (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) are very important for the functioning of business, but can be violated by either private action or public action

68 Chapter 2: National Differences in Political EconomyPrivate Action refers to theft, piracy, blackmail, and the like by private individuals or groups Public Action and Corruption occurs when public officials extort income or resources from property holders using various legal mechanisms including excessive taxation, requiring expensive licenses or permits from property holders, or taking assets into state ownership without compensating the owners

69 Chapter 2: National Differences in Political EconomyForeign Corrupt Practices Act The Foreign Corrupt Practices Act makes it a violation of the United States’ law to bribe a foreign government official in order to obtain or maintain business over which the foreign official has authority, and requires all publicly traded countries to keep detailed records so that it is clear whether a violation of the act has occurred or not

70 Chapter 2: National Differences in Political EconomyThe Protection of Intellectual Property Intellectual property is property, such as computer software, a screenplay, or the chemical formula for a new drug, that is the product of intellectual activity Internet Extra: Focus on Intellectual Property Rights is the U.S government’s web page on intellectual property rights. The site is at {http://usinfo.state.gov/products/pubs/intelprp/}. 1. Click on Discuss Intellectual Property. List some examples of intellectual property. 2. Next, click on The Cost of Developing a New Drug. What protections do you feel should be awarded to pharmaceutical firms? Why? 3. Last, click on Taking Action. How are countries fighting intellectual property rights violations?

71 Chapter 2: National Differences in Political EconomyIntellectual Property rights include: patents -- documents giving the inventor of a new product or process exclusive rights to the manufacture, use, or sale of that invention copyrights -- exclusive legal rights of authors, composers, playwrights, artists, and publishers to publish and dispose of their work as they see fit trademarks -- designs and names, often officially registered, by which merchants or manufacturers designate and differentiate their products Internet Extra: Focus on Intellectual Property Rights is the U.S government’s web page on intellectual property rights. The site is at {http://usinfo.state.gov/products/pubs/intelprp/}. 1. Click on Discuss Intellectual Property. List some examples of intellectual property. 2. Next, click on The Cost of Developing a New Drug. What protections do you feel should be awarded to pharmaceutical firms? Why? 3. Last, click on Taking Action. How are countries fighting intellectual property rights violations?

72 Chapter 2: National Differences in Political EconomyThe protection of intellectual property rights differs greatly from country to country. The Paris Convention for the Protection of Industrial Property is an agreement signed by 96 countries to protect intellectual property rights The Trade Related Aspects of Intellectual Property Rights (TRIPS) requires WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years Management Focus: Starbucks Wins Key Trademark Case in China Summary This feature focuses on intellectual property laws in China. When Starbucks entered China in 1999, the company was quickly challenged by a look-alike competitor, Xing Ba Ke. Not only did the name Xing Ba Ke mimic the Starbucks name, but Xing Ba Ke’s stores were virtual replicas of those operated by Starbucks. In 2003, Starbucks sued Xing Ba Ke for trademark violations. In 2006, Starbucks won its case, and Xing Ba Ke was fined $62,000 and ordered to stop using its name. The case was seen as a break through of sorts, a signal that China was finally caving to pressure from other nations and the World Trade Organization to respect intellectual property rights. Today, Starbucks operates over 200 stores in China and expects the market to become second only to the U.S. Suggested Discussion Questions 1. Discuss the concept of property rights protection and why it is so important to companies. What does he court ruling against Xing Ba Ke mean for other companies that are already doing business in China, or are considering entering the market? 2. How important is the Chinese market to Starbucks? Does the presence of look-alike companies like Xing Ba Ke deter firms from entering the market? Teaching Tip: To explore Starbucks in more depth, go to the company’s web site at {http://www.starbucks.com/default.asp?cookie%5Ftest=1}. Click on “International” to explores individual country sites.

73 Chapter 2: National Differences in Political EconomyProduct Safety and Product Liability Countries have different product safety and liability laws that may require foreign companies to customize products to adhere to local standards If product standards are lower in other countries, firms must decide whether to produce products only of the highest standards even if this puts them at a competitive disadvantage relative to other producers and results in not maximizing value to shareholders, or whether they should produce products that respond to local differences, even if that means that consumers may not be assured of the same levels of safety in different countries

74 Chapter 2: National Differences in Political EconomyTHE DETERMINANTS OF ECONOMIC DEVELOPMENT Differences in Economic Development One common measure of economic development is a country’s gross national income per head of population (GNI) A purchasing power parity (PPP) adjustment allows for a more direct comparison of living standards in different countries A drawback of both GNI and PPP data is that they provide only a static picture of development

75 Chapter 2: National Differences in Political EconomyThe GNI per capita of the world’s nations in 2004 is shown in Map 2.1.

76 Chapter 2: National Differences in Political EconomyBroader Conceptions of Development: Amartya Sen Nobel Prize winning economist Amartya Sen argued that development should be assessed less by material output and more by the capabilities and opportunities that people enjoy the Human Development Index (a United Nations developed index based on life expectancy, education attainment, and whether average incomes are sufficient to meet the basic needs of life in a country) reflects Sen’s ideas and was developed to gauge a country’s economic development and likely future growth rate

77 Chapter 2: National Differences in Political EconomyPolitical Economy and Economic Progress What is the relationship between political economy and economic progress? This question has been the subject of a vigorous debate among academics and policy makers. Innovation and Entrepreneurship Are the Engines of Growth: there is broad agreement that innovation and entrepreneurship are the engines of long-run economic growth Innovation and Entrepreneurship Require a Market Economy: it has been argued that economic freedom associated with a market economy creates greater incentives for innovation and entrepreneurship than either a planned or mixed economy

78 Chapter 2: National Differences in Political EconomyInnovation and Entrepreneurship Require Strong Property Rights: strong legal protection of property rights is another requirement for a business environment conducive to innovation, entrepreneurship, and economic growth The Required Political System: it seems likely that democratic regimes are more conducive to long-term economic growth than a dictatorship, even one of the benevolent kind Economic Progress Begets Democracy: it seems evident that the subsequent economic growth leads to establishment of democratic regimes

79 Chapter 2: National Differences in Political EconomyGeography, Education, and Economic Development Geography can affect economic development Countries that invest more in the education of their young people develop faster economically

80 Chapter 2: National Differences in Political EconomySTATES IN TRANSITION Since the late 1980s, a wave of democratic revolutions has swept the world, and many of the previous totalitarian regimes collapsed There has been a move away from centrally planned and mixed economies towards free markets

81 Chapter 2: National Differences in Political EconomySpread of Democracy The spread of democracy has occurred because: many totalitarian regimes failed to deliver economic progress to the vast bulk of their population new information and communication technologies have broken down the ability of the state to control access to uncensored information in many countries the economic advances of the last quarter century have led to the emergence of increasingly prosperous middle and working classes who have pushed for democratic reforms

82 Chapter 2: National Differences in Political EconomyPolitical freedom around the world in 2005 is charted in Map 2.5.

83 Chapter 2: National Differences in Political EconomyThe New World Order and Global Terrorism The end of the Cold War and the “new world order” that followed the collapse of communism in Eastern Europe and the former Soviet Union, taken together with the collapse of many authoritarian regimes in Latin America, have given rise to intense speculation about the future shape of global geopolitics.

84 Chapter 2: National Differences in Political EconomyThe Spread of Market-Based Systems In general, command and mixed economies failed to deliver the kind of sustained economic performance that was achieved by countries adopting market-based systems Since the late 1980s there has been a transformation from centrally planned command economies to market-based economies

85 Chapter 2: National Differences in Political EconomyEconomic freedom around the world is summarized in Map 2.6.

86 Chapter 2: National Differences in Political EconomyThe Nature of Economic Transformation The shift toward a market-based economic system typically involves at least three distinct activities: deregulation privatization legal enforcement of property rights

87 Chapter 2: National Differences in Political EconomyDeregulation Deregulation involves removing restrictions on the free operation of markets Privatization Privatization transfers the ownership of state property into the hands of private investors

88 Chapter 2: National Differences in Political EconomyLegal Systems Without a legal system that protects property rights, and without the machinery to enforce that system, the incentive to engage in economic activity can be reduced substantially by private and public entities that expropriate the profits generated by the efforts of private sector entrepreneurs. Implications of Changing Political Economy Markets that were formerly off-limits to Western business are now open, however, just as the potential gains are large, so are the risks Country Focus: Building a Market Economy in India Summary This feature describes the changes in India’s political economy since the country gained independence from Britain in Until the early 1990s, India followed a mixed economy system that was characterized by a large number of state-owned enterprises, centralized planning, and subsidies. The system failed to deliver significant growth and in 1991 India’s government implemented a series of reforms designed to foster increased privatization, inward investment, and exports. While initially successful, economic reform stalled by the later 1990s, and poverty was widespread. Suggestion Discussion Questions 1. What makes India an attractive destination for foreign firms? 2. Since its reform program began in 1991, India has seen a significant turnaround in its economy. What factors might threaten this turnaround? 3.The Indian Embassy maintains a web site that provides useful information about doing business in India. The site is {http://www.indianembassy.org/newsite/Doing_business_In_India/FDI_Policy_Procedures.asp}.

89 Chapter 2: National Differences in Political EconomyIMPLICATIONS FOR MANAGERS political, economic, and legal systems of a country raise important ethical issues that have implications for the practice of international business the political, economic, and legal environment of a country clearly influences the attractiveness of that country as a market and/or investment site

90 Chapter 2: National Differences in Political EconomyBenefits By identifying and investing early in a potential future economic stars, firms may be able to gain first mover advantages (advantages that accrue to early entrants into a market) and establish loyalty and experience in a country

91 Chapter 2: National Differences in Political EconomyCosts Political costs include the cost of paying bribes or lobbying for favorable or fair treatment Economic costs relate primarily to the sophistication of the economic system, including the infrastructure and supporting businesses It can be more costly to do business in countries with dramatically different product, workplace, and pollution standards, or where there is poor legal protection for property rights

92 Chapter 2: National Differences in Political EconomyRisks Political risk is the likelihood that political forces will cause drastic changes in a country's business environment that adversely affects the profit and other goals of a business enterprise Economic risk is the likelihood that economic mismanagement will cause drastic changes in a country's business environment that adversely affects the profit and other goals of a business enterprise Legal risk is the likelihood that a trading partner will opportunistically break a contract or expropriate property rights

93 Chapter 2: National Differences in Political EconomyOverall Attractiveness The overall attractiveness of a country as a potential market and/or investment site for an international business depends on balancing the benefits, costs, and risks associated with doing business in that country. Internet Extra: The U.S. State Department produces a series of annual "Country Reports“. The site is {http://www.state.gov/travelandbusiness/}. 1. Click on Doing Business in International Markets. Discuss the ways the State Department helps American companies doing business in other countries. 2. Next, click on More Business Information and then on Investment Climate Statements. Compare the investment climate in several countries. Where would you invest? Which countries would you avoid?

94 Chapter 2: National Differences in Political EconomyClassroom Performance System Which type of risk involves the likelihood that a trading partner will opportunistically break a contract or expropriate intellectual property rights? Contract risk Economic risk Legal risk Political risk Classroom Performance System Answer: c

95 Chapter 2: National Differences in Political EconomyCRITICAL THINKING QUESTIONS 1. Free market economies stimulate greater economic growth, whereas state-directed economies stifle growth! Discuss. Answer: In a market economy, private individuals and corporations are allowed to own property and other assets. This right of ownership provides a powerful incentive for people to work hard, introduce new products, develop better advertising campaigns, invent new products, etc., all in the hopes of accumulating additional personal capital and wealth. In turn, the constant search on the part of individuals and corporation to accumulate wealth enriches the entire economy and creates economic growth. In contrast, in a command economy, private individuals and corporations are not allowed to own substantial quantities of property and other assets. The objective of a command economy is for everyone to work for “the good of the society.” Although this sounds like a noble ideal, a system that asks individuals to work for the good of society rather than allowing individuals to build personal wealth does not provide a great incentive for people to invent new products, develop better advertising campaigns, find ways to be more efficient, etc. As a result, command economies typically generate less innovation and are less efficient than market economies.

96 Chapter 2: National Differences in Political EconomyCRITICAL THINKING QUESTIONS 2. A democratic political system is an essential condition for sustained economic progress. Discuss. Answer: This question has no clear-cut answer. In the West, we tend to argue that democracy is good for economic progress. This argument is largely predicted upon the idea that innovation is the engine of economic growth, and a democratic political system encourages rather than stifles innovation. However, there are examples of totalitarian regimes that have fostered a market economy and strong property rights protection and experienced rapid economic growth. The examples include four of the fastest growing economies of the past 30 years – South Korea, Taiwan, Singapore, and Hong Kong – all of which have grown faster than Western economies. However, while it is possible to argue that democracy is not a necessary precondition for the establishment of a free market economy, it seems evident that subsequent economic growth leads to establishment of democratic regimes. Several of the fastest-growing Asian economies have recently adopted more democratic governments.

97 Chapter 2: National Differences in Political EconomyCRITICAL THINKING QUESTIONS 3. What is the relationship between corruption (i.e., bribe taking by government officials) in a country and economic growth? Is corruption always bad? Answer: Economic evidence suggests that high levels of corruption significantly reduce the economic growth rate in a country. By siphoning off profits, corrupt politicians and bureaucrats reduce the returns to business investment, and hence, reduce the incentive that both domestic and foreign businesses have to invest in that country. The lower level of investment that results has a negative impact on economic growth. However, while most students will probably agree that corruption is bad, some may point out that the U.S., despite its Foreign Corrupt Practices Act, does allow “grease payments” to expedite or secure the performance of a routine governmental action. According to Congress, “grease payments” while technically bribes are not being used to obtain or maintain business, but rather are simply made to facilitate performance of duties that the recipients are already obligated to perform.

98 Chapter 2: National Differences in Political EconomyCRITICAL THINKING QUESTIONS 4. The Nobel prize-winning economist Amartya Sen argues that the concept of development should be broadened to include more than just economic development. What other factors does Sen think should be included in an assessment of development? How might adoption of Sen’s views influence government policy? Do you think Sen is correct that development is about more than just economic development? Explain. Answer: Sen has argued that development be assessed less by material output measures such as GNP per capita, and more by the capabilities and opportunities that people enjoy. Sen suggests that development be seen as a process of expanding real freedoms that people experience, and as such, that development requires the removal of major impediments to freedom. Governments influenced by Sen might ensure that basic health care and education programs are available especially for women. Many students will agree with Sen and the notion that development is not just an economic process, but a political one too, and that to succeed citizens must be given a voice in the important decisions made for the country.

99 Chapter 2: National Differences in Political EconomyCRITICAL THINKING QUESTIONS 5. You are the CEO of a company that has to choose between making a $100 million investment in either Russia or the Czech Republic. Both investments promise the same long-run return, so your choice of which investment to make is driven by considerations of risk. Assess the various risks of doing business in each of these nations. Which investment would you favor and why? Answer: When assessing the risks of investment, one should consider the political, economic, and legal risks of doing business in either Russia or the Czech Republic. At this time (Fall 2002), the risk in Russia would probably be considered higher than the risk in the Czech Republic. The Czech Republic has just been accepted as a future member of the EU, and as such gains the benefits and stability offered by the EU. Russia, by contrast, is still many years away from even being in a position to be considered by the EU for membership. Depending upon when you are using the book, this situation could be different. (You also may want to substitute other countries into this question depending on current events and the countries with which you feel your students will be most familiar.)

100 Chapter 2: National Differences in Political EconomyCRITICAL THINKING QUESTIONS 6. Read the Country Focus on India in this chapter and answer the following questions: a. What kind of economic system did India operate during ? What kind of system is it moving towards today? What are the impediments to completing this transformation? b. How might widespread public ownership of businesses and extensive government regulations have impacted (i) the efficiency of state and private businesses, and (ii) the rate of new business formation in India during the 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 to generate growth in other sectors of the Indian economy? e. Given what is now occurring in the Indian economy, do you think that the country represents an attractive target for inward investment by foreign multinationals selling consumer products? Why? Answer: a. 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. In 1991, India’s government embarked on an ambitious economic reform program. Much of the industrial licensing system was dismantled, and several areas once closed to the private sector were opened. In addition, investment by foreign companies was welcomed, and plans to start privatizing state-owned businesses were announced. India has posted impressive gains since 1991, however there are still impediments to further transformation. Attempts to reduce import tariffs have been stalled by political opposition from employers, employees, and politicians. Moreover, the privatization program has been slowed thanks to actions taken by the Supreme Court. Finally, extreme poverty continues to plague the country. b. The mixed economy that developed in India after 1947 was characterized by a large number of state-owned enterprises, centralized planning, and subsidies. This system not only constrained the growth of the private sector, but it also consequently limited the effects of competition that typically promote efficiency and productivity in a free market system. The system even limited the actions of private companies, requiring them to get government approval for routine business activities. Production quotas and high import tariffs also stunted the development of a healthy private sector, as did restrictive labor laws that made it difficult to fire employees. Foreign exchange restrictions, limitations on foreign investment, controls on land use, and managed prices further exacerbated the situation. It would appear that India’s rate of economic growth was negatively affected during this time frame. By 1994, India’s economy was still smaller than Belgium’s despite having a large population. Both GDP and literacy rates were very low, and some 40 percent of the population lived in poverty. c. In 1991, India’s government embarked on an ambitious economic reform program. So far, the response to the program has been impressive. The economy expanded at an annual rate of about 6.3 percent from 1994 to Foreign investment is up from $150 million in 1990 to $6 billion in Certain sectors of the economy including information technology and pharmaceuticals have done particularly well. Still, problems persist. Actions taken by the government continue to limit efficiency gains for private companies and the country’s high rate of poverty is still a major problem. d. India’s gains in information technology and pharmaceuticals are impressive. The country has emerged as a vibrant global center for software development, and India’s pharmaceutical companies have taken a strong global position by selling low cost generic versions of drugs that have come of patent in the developed world. As these industries continue to prosper, other sectors of the economy should also see the benefit of spillover effects. e. Foreign investment is up in India. In fact, foreign investment rose from $150 million in 1990 to $6 billion in However, whether India is an attractive destination for foreign multinationals selling consumer products remains to be seen. Certainly, the large population will serve to attract some companies, but the fact that some 40 percent of the population is living in abject poverty will scare other companies away. Moreover, it is still not easy to run a company in India thanks to laws limiting everything from who can be fired to who can which products.

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102 Differences in Culture3 chapter Differences in Culture McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

103 Chapter 3: Differences in CultureINTRODUCTION Operating a successful international business requires cross-cultural literacy (an understanding of how cultural differences across and within nations can affect the way in which business is practiced). A relationship may exist between culture and the costs of doing business in a country or region.

104 Chapter 3: Differences in CultureWHAT IS CULTURE? The fundamental building blocks of culture are values (abstract ideas about what a group believes to be good, right, and desirable) and norms (the social rules and guidelines that prescribe appropriate behavior in particular situations). The term society refers to a group of people who share a common set of values and norms.

105 Chapter 3: Differences in CultureValue and Norms Values provide the context within which a society’s norms are established and justified and form the bedrock of a culture Norms are the social rules that govern the actions of people toward one another and can be further subdivided into folkways (the routine conventions of everyday life) and mores (norms that are seen as central to the functioning of a society and to its social life)

106 Chapter 3: Differences in CultureCulture, Society, and the Nation-State A society can be defined as a group of people that share a common set of values and norms; that is, a group bound together by a common culture The Determinants of Culture The values and norms of a culture are the evolutionary product of a number of factors at work in a society

107 Chapter 3: Differences in CultureThe determinants of culture are shown in Figure 1.3.

108 Chapter 3: Differences in CultureClassroom Performance System Abstract ideas about what a society believes to be good right and desirable are called Attitudes Norms Values Mores Classroom Performance System Answer: c

109 Chapter 3: Differences in CultureSOCIAL STRUCTURE A society's social structure is its basic social organization. Two dimensions to consider: the degree to which the basic unit of social organization is the individual, as opposed to the group the degree to which a society is stratified into classes or castes

110 Chapter 3: Differences in CultureIndividuals and Groups The Individual A focus on the individual, and individual achievement is common in many Western societies This contributes to the dynamism of the US economy, but can lead to a lack of company loyalty and failure to gain company specific knowledge, competition between individuals in a company rather than team building, and a limit on people's ability to develop a strong network of contacts within a firm

111 Chapter 3: Differences in CultureThe Group In many Asian societies, the group is the primary unit of social organization. This may discourage job switching between firms, encourage lifetime employment systems, and lead to cooperation in solving business problems, but might also suppress individual creativity and initiative

112 Chapter 3: Differences in CultureSocial Stratification All societies are stratified on a hierarchical basis into social categories, or social strata Social Mobility Social mobility is the extent to which individuals can move out of the strata into which they are born A caste system is a closed system of stratification in which social position is determined by the family into which a person is born, and change in that position is usually not possible during an individual's lifetime A class system is a form of open social stratification in which the position a person has by birth can be changed through his or her achievement or luck

113 Chapter 3: Differences in CultureSignificance In cultures where there is a great deal of consciousness over the class of others, the way individuals from different classes work together (i.e. management and labor) may be very prescribed and strained in some cultures (i.e. Britain), or have almost no significance in others (i.e. Japan) Class consciousness is a condition where people tend to perceive themselves in terms of their class background, and this shapes their relationships with others

114 Chapter 3: Differences in CultureClassroom Performance System The extent to which an individual can move out of the social strata into which they are born is called Social stratification Class mobility Social mobility Caste system Classroom Performance System Answer: c

115 Chapter 3: Differences in CultureRELIGIOUS AND ETHICAL SYSTEMS Religion is a system of shared beliefs and rituals that are concerned with the realm of the sacred. The religions with the greatest following are Christianity, Islam, Hinduism, and Buddhism. Confucianism influences behavior and shapes culture in many parts of Asia. Ethical systems are a set of moral principles, or values, that are used to guide and shape behavior. The ethical practices of individuals within a culture are often closely intertwined with their religion.

116 Chapter 3: Differences in CultureMap 3.1 shows dominant religions across the world.

117 Chapter 3: Differences in CultureChristianity Christianity is the largest religion and is common throughout Europe, the Americas, and other countries settled by Europeans Economic Implications of Christianity: The Protestant Work Ethic At the turn of the century Weber suggested that it was the Protestant work ethic (focus on hard work, wealth creation, and frugality) that was the driving force of capitalism

118 Chapter 3: Differences in CultureIslam Islam extends the underlying roots of Christianity to an all-embracing way of life that governs one's being. Islamic Fundamentalism In the West, Islamic fundamentalism is associated in the media with militants, terrorists, and violent upheavals. However, the vast majority of Muslims point out that Islam teaches peace, justice, and tolerance. Fundamentalists have gained political power in many Muslim countries, and have tried to make Islamic law the law of the land. Economic Implications of Islam In Islam, people do not own property, but only act as stewards for God and thus must take care of that which they have been entrusted with. While Islam is supportive of business, the way business is practiced is prescribed. Country Focus: Islamic Banking in Pakistan Summary This feature focuses on changes in the Pakistani banking system as the country adopts Islamic banking methods. Because Islamic banks cannot pay or charge interest, they must find an alternate means of making money. Currently, Pakistan’s banks are experimenting with two different Islamic banking methods, the mudarabah (a contract similar to a profit-sharing scheme), and the murabaha (a contract that involves a mark-up that is paid directly to the bank). Suggested Discussion Questions 1. Describe the basic difference between Islamic banking and conventional Western banking. Compare and contrast the two Islamic banking methods that are being considered by Pakistan’s banks. Which method is more likely to be adopted? Explain your answer. 2. Discuss the transition process from conventional Western banking to the Islamic system. What challenges should banks be prepared for?

119 Chapter 3: Differences in CultureHinduism Hinduism, practiced primarily on the Indian sub-continent, focuses on the importance of achieving spiritual growth and development, which may require material and physical self-denial Economic Implications of Hinduism Since Hindus are valued by their spiritual rather than material achievements, there is not the same work ethic or focus on entrepreneurship found in some other religions Promotion and adding new responsibilities may not be the goal of an employee, or may be infeasible due to the employee's caste Management Focus: McDonald’s and Hindu Culture Summary This feature describes the unique challenges faced by McDonald’s in India. The cow is considered sacred in India’s Hindu culture prompting McDonald’s to alter its menu to offer mutton and chicken alternatives to its traditional beef burgers. However, the company recently made news when it was discovered that its French fries were cooked in oil that contained beef extract. Suggested Discussion Questions 1. How did McDonald’s change its product line to meet the needs of the Indian market? Does the Indian version of McDonald’s still maintain the company’s identity? 2. Did McDonald’s handle the revelation that its French fries contained beef extract well? What would you have done differently?

120 Chapter 3: Differences in CultureBuddhism Buddhists stress spiritual growth and the afterlife, rather than achievement while in this world Buddhism, practiced mainly in South East Asia, does not support the caste system, however, so individuals do have some mobility and can work with individuals from different classes

121 Chapter 3: Differences in CultureConfucianism Confucianism, practiced mainly in China, teaches the importance of attaining personal salvation through right action The need for high moral and ethical conduct and loyalty to others is central in Confucianism Economic Implications of Confucianism Three key teachings of Confucianism - loyalty, reciprocal obligations, and honesty - may all lead to a lowering of the cost of doing business in Confucian societies

122 Chapter 3: Differences in CultureClassroom Performance System The religion with the largest following in the world is Christianity Islam Hinduism Buddhism Classroom Performance System Answer: a

123 Chapter 3: Differences in CultureLANGUAGE Language, both spoken and unspoken, is one of the defining characteristics of culture. Spoken Language While English is the language of international business, knowledge of the local language is beneficial, and in some cases, critical for business success Unspoken Language Unspoken language such as facial expressions and hand gestures can be important for communication. However, because these can have different interpretations in different cultures, misunderstandings are common

124 Chapter 3: Differences in CultureEDUCATION Formal education is the medium through which individuals learn many of the language, conceptual, and mathematical skills that are indispensable in a modern society. The knowledge base, training, and educational opportunities available to a country's citizens can also give it a competitive advantage in the market and make it a more or less attractive place for expanding business.

125 Chapter 3: Differences in CultureCULTURE AND THE WORKPLACE How does a society's culture impact on the values found in the workplace?

126 Chapter 3: Differences in CultureGeert Hofstede isolated four dimensions that he claimed summarized different cultures: Power Distance is focused on how a society deals with the fact that people are unequal in physical and intellectual capabilities Individualism Versus Collectivism is focused on the relationship between the individual and his or her fellows Uncertainty Avoidance measures the extent to which different cultures socialize their members into accepting ambiguous situations and tolerating ambiguity Masculinity Versus Femininity looks at the relationship between gender and work roles

127 Chapter 3: Differences in CultureThe results of Hofstede’s study are shown in Table 3.1.

128 Chapter 3: Differences in CultureClassroom Performance System Which of Hofstede’s dimensions measures the extent to which different cultures socialize their members into accepting ambiguous situations and tolerating uncertainty? Individualism versus collectivism Uncertainty avoidance Masculinity versus femininity Power distance Classroom Performance System Answer: b

129 Chapter 3: Differences in CultureCULTURAL CHANGE Culture evolves over time, although changes in value systems can be slow and painful for a society. Social turmoil is an inevitable outcome of cultural change. As countries become economically stronger, cultural change is particularly common.

130 Chapter 3: Differences in CultureIMPLICATIONS FOR MANAGERS Cross-Cultural Literacy Individuals and firms must develop cross-cultural literacy International businesses that are ill informed about the practices of another culture are unlikely to succeed in that culture Individuals must also beware of ethnocentric behavior, or a belief in the superiority of one's own culture Management Focus: Cross-Cultural Illiteracy Summary This feature describes the debacle resulting from the publication of a print ad depicting a helicopter hovering above a mosque with soldiers being lowered to the roof and a tag line stating “It descends from the heavens, ironically it unleashes hell…Consider it a gift from above.” The ad was commissioned by the aircraft makers, Boeing and Bell Helicopter, and originally was published in the Armed Forces Journal. The ad was seen as conveying the message that the war on terror was really a war on Islam. The two companies withdrew the ad immediately, but not before it was also printed in the National Journal. The two companies publicly apologized for the ad. Suggested Discussion Questions 1. What message was the ad trying to convey? How was the ad interpreted? 2. What lesson can companies learn from the Boeing and Bell Helicopter incident? How can companies prevent similar misunderstandings?

131 Chapter 3: Differences in CultureCulture and Competitive Advantage For international companies, the connection between culture and competitive advantage is important because: the connection suggests which countries are likely to produce the most viable competitors the connection between culture and competitive advantage has important implications for the choice of countries in which to locate production facilities and do business Internet Extra: To learn more about international business etiquette, go to {http://www.cyborlink.com}. Choose a country, then find three fun facts about your country. Compare these to those in other countries. What are some areas where cultural misunderstandings could occur? How does Hofstede assess your country? Based on what you’ve read, do you agree?

132 Chapter 3: Differences in CultureCRITICAL THINKING QUESTIONS 1. Outline why the culture of a country influences the costs of doing business in that country. Illustrate your answer with examples. Answer: Since in a sense the entire chapter is about this question, there can be numerous reasons and examples of how culture influences the costs of doing business. Several are highlighted in the following sentences, but there could be numerous others. When there are simply different norms between how individuals from different countries interact, the costs of doing business rise as people grapple with unfamiliar ways of doing business. For example, while in the US we may get down to business first, and then get to know each other socially later, in many South American countries it is important develop a good social relationship before trying to discuss business issues. Different class structures and social mobility also raise the costs of doing business, for if there are inhibitions against working with people from different classes, then the efficiency with which information can flow may be limited and the cost of running a business increased. A country's religion can also affect the costs of business, as religious values can affect attitudes towards work, entrepreneurship, honesty, fairness, and social responsibility. In Hindu societies where the pursuit of material well-being can be viewed as making spiritual well being less likely, worker productivity may be lower than in nations with other religious beliefs. Finally, a country's education system can have important implications for the costs of business. In countries where workers receive excellent training and are highly literate, the need for specific worker training programs are decreased and the hiring of additional employees is facilitated.

133 Chapter 3: Differences in CultureCRITICAL THINKING QUESTIONS 2. Do you think business practices in an Islamic country are likely to differ from business practices in the United States? If so, how? Answer: A number of aspects of the cultural differences between an Islamic country and the USA will cause business practices to differ. The role women can take, appropriate etiquette (including simple things like not passing papers with the left hand), holidays, and wining and dining all differ from in the USA. But beyond these, the underlying philosophy and role of business differs from in the USA. Since Muslims are stewards of property for God, rather than owners, they are more likely to use their resources carefully and may be less likely to give up or sell something to a person who may not practice the same stewardship. The importance of fairness to all parties in relations means that over-aggressiveness in self-interest may not be well received, and breaking an agreement, even if technically/legally permissible may be viewed as very inappropriate. Finally, the prohibitions on interest payments in some Islamic countries means that the wording of the terms of an agreement must be done carefully so that "fair profits" are not construed as being "interest payments."

134 Chapter 3: Differences in CultureCRITICAL THINKING QUESTIONS 3. What are the implications for international business of differences in the dominant religion of a country? Answer: Differences in the dominant religion of a country affect relationships, attitudes toward business, and overall economic development. Firstly, differences in religion require inter-cultural sensitivity. This sensitivity requires things like simply knowing the religious holidays, accepting that some unexpected things may happen "because of Allah's will," or understanding how interpersonal relationships may be different between "believers" and "non-believers." (Hence non-believers may be treated differently.) Secondly, religious beliefs can significantly affect a countries attitude toward business, work, and entrepreneurship. In one country successfully beating a competitor may be considered a great achievement while in another it may be thought of as showing a lack of compassion and disruptive to the society and persons involved, both attitudes that may be derived from underlying religious beliefs. Likewise, hard work may be either rewarded positively or viewed as something of secondary importance to spiritual peace and harmony. Thirdly, different dominant religions may affect the overall competitiveness and potential for economic growth of a nation, and hence attractiveness of a country for international business.

135 Chapter 3: Differences in CultureCRITICAL THINKING QUESTIONS 4. Choose two countries that appear to be culturally diverse. Compare the culture of those countries and then indicate how cultural differences influence the costs of doing business in each country the likely future economic development of that country business practices business ethics Answer: Responses to this question will obviously vary based on the countries chosen by the students, and their knowledge of the countries. Hopefully the student can present some information on the dimensions of culture including values, norms, social structure, religion, language, and education of the countries and also describe the key differences and similarities of the countries along these dimensions. Relating the differences between the countries along these dimensions to differences in the costs of doing business, the potential for economic development, and business practices would fully answer the question. (While it may be more difficult for students to come up with really good examples relative to business practices, the costs and prospects for economic development should be quite feasible.)

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137 Ethics in International Business4 chapter Ethics in International Business McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

138 Chapter 4: Ethics in International BusinessINTRODUCTION 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 business people. Ethical strategy is a strategy, or course of action, that does not violate these accepted principles. Internet Extra: Consumers International {http://www.consumersinternational.org/}is an organization dedicated to protecting the rights of consumers worldwide. In doing so, it promotes ethical behavior on the part of companies. Go to the site and click on one of the organization’s current efforts. What are the issues that are being raised? How do they affect companies? Do you agree with the organization’s position? Why or why not?

139 Chapter 4: Ethics in International BusinessETHICAL ISSUES IN INTERNATIONAL BUSINESS The most common ethical issues in business involve employment practices, human rights, environmental regulations, corruption, and the moral obligation of multinational companies.

140 Chapter 4: Ethics in International BusinessEmployment Practices When work conditions in a host nation are clearly inferior to those in a multinational’s home nation, companies must decide which standards should be applied, those of the home nation, those of the host nation, or something in between

141 Chapter 4: Ethics in International BusinessHuman Rights Basic human rights taken for granted in the developed world such as freedom of association, freedom of speech, freedom of assembly, freedom of movement, and so on, are by no means universally accepted

142 Chapter 4: Ethics in International BusinessEnvironmental Pollution When environmental regulations in host nations are far inferior to those in the home nation, ethical issues arise The tragedy of the commons occurs when a resource held in common by all, but owned by no one, is overused by individuals resulting in its degradation Management Focus: Unocal in Myanmar Summary This feature explores Unocal’s actions in Myanmar. Unocal, an American, oil and gas enterprise, formed a joint venture with a French company to build a pipeline from Myanmar to Thailand. Unocal made that investment as a number of other American companies were exiting the country in protest of the local government’s policy of brutally suppressing internal dissent. Suggested Discussion Questions 1. Why did Unocal’s investment become so controversial? Did Unocal behave in an ethical manner? 2. A 1996 law suit against Unocal was dismissed on the grounds that the Unocal could not be held liable for the actions of a foreign government against its own people, although the judge noted that the company was aware of what was going on in the country. Discuss the difference between acting in an ethical manner and acting according to the law.

143 Chapter 4: Ethics in International BusinessClassroom Performance System Multinational companies are concerned with ethics is all of the following areas except Employment practices Human rights Environmental regulations Trade regulations Classroom Performance System Answer: d

144 Chapter 4: Ethics in International BusinessCorruption In the United States, the Foreign Corrupt Practices Act outlawed the practice of paying bribes to foreign government officials in order to gain business The Organization for Economic Cooperation and Development (OECD) adopted a Convention on Combating Bribery of Foreign Public Officials in International Business Transactions in 1997 which obliges member states to make the bribery of foreign public officials a criminal offense

145 Chapter 4: Ethics in International BusinessSome economists suggest that the practice of giving bribes might be the price that must be paid to do a greater good These economists believe 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 actually enhance welfare Other economists have argued that corruption reduces the returns on business investment and leads to low economic growth

146 Chapter 4: Ethics in International BusinessMoral Obligations The concept of social responsibility refers to the idea that business people should take the social consequences of economic actions into account when making business decisions, and that there should be a presumption in favor of decisions that have both good economic and good social consequences In its purest form, social responsibility can be supported for its own sake simply because it is the right way for a business to behave Advocates of this approach argue that businesses need to recognize their noblesse oblige (honorable and benevolent behavior that is the responsibility of successful companies) and give something back to the societies that have made their success possible Management Focus: News Corp in China Summary This feature explores the entry of News Corp’s, one of the largest media conglomerates in the world, entry into the Chinese market. According to critics, Robert Murdoch, head of News Corp, gained preferential access to the Chinese media market by systematically suppressing media content that was critical of China and publishing material designed to ingratiate the company with China’s leaders. Suggested Discussion Questions 1. Consider the allegations against Robert Murdoch. Did he behave in an ethical manner if he suppressed media content that was critical of China? 2. Newspapers and news programs are frequently criticized for giving biased reports of events. What standards should these organizations hold to? Did News Corp hold to these standards?

147 Chapter 4: Ethics in International BusinessETHICAL DILEMMAS Ethical dilemmas are situations in which none of the available alternatives seems ethically acceptable.

148 Chapter 4: Ethics in International BusinessTHE ROOTS OF UNETHICAL BEHAVIOR Personal Ethics Business ethics reflect personal ethics (the generally accepted principles of right and wrong governing the conduct of individuals) Expatriates may face pressure to violate their personal ethics because they are away from their ordinary social context and supporting culture, and they are psychologically and geographically distant from the parent company

149 Chapter 4: Ethics in International BusinessDecision Making Processes Studies show that business people may behave unethically because they fail to ask the relevant question—is this decision or action ethical?

150 Chapter 4: Ethics in International BusinessOrganization Culture In firms with an organization culture (the values and norms that are shared among employees of an organization) that does not emphasize business culture, unethical behavior may exist

151 Chapter 4: Ethics in International BusinessUnrealistic Performance Expectations Pressure from the parent company to meet performance goals that are unrealistic, and can only be attained by cutting corners or acting in an unethical manner can cause unethical behavior Leadership If leaders are not acting ethically, other employees may not act ethically Management Focus: Pfizer’s Drug Testing Strategy in Nigeria Summary This feature raises questions as to whether pharmaceutical giant, Pfizer, acted ethically when testing a new drug. In 1996, Pfizer, was seeking FDA approval for a new antibiotic. The company lacked the necessary test results to have the drug approved for children. The company saw an opportunity to quickly test the drug when an outbreak of bacterial meningitis hit a town in Nigeria. In 2003, two dozen Nigerian families sued Pfizer arguing that their children either died or were injured as a result of the drug testing. They allege that Pfizer did not take the appropriate steps to properly test the drug, and that the company acted in an unethical manner. Suggested Discussion Questions 1. Was Pfizer irresponsible when it tested its experimental drug in Nigeria? How could the company have acted more ethically? 2. Pfizer saw the bacterial meningitis outbreak in Nigeria as a means of quickly getting a large pool of sick children to test its new antibiotic on. Consider the dilemma facing pharmaceutical companies. In order to get FDA approval to introduce their new drugs, numerous studies must demonstrate the efficacy of the drugs, studies that, as the Pfizer example demonstrates, can be difficult to complete. Would you have been tempted to follow Pfizer’s strategy? If you waited, and completed the testing in the United States, what might be the effect on your company’s bottom line? Would you be acting in the best interests of your stakeholder by waiting, or by testing in Nigeria?

152 Chapter 4: Ethics in International BusinessThe causes of unethical behavior are shown in Figure 4.1.

153 Chapter 4: Ethics in International BusinessClassroom Performance System Which of the following does not contribute to unethical behavior by managers? Unrealistic performance goals Leadership Organizational culture Restrictions on bribes Classroom Performance System Answer: d

154 Chapter 4: Ethics in International BusinessPHILOSOPHICAL APPROACHES TO ETHICS Straw Men Straw men approaches to business ethics are approaches that are raised by business ethics scholars primarily for the purpose of demonstrating that they offer inappropriate guidelines for ethical decision making in a multinational enterprise. Four such approaches are the Friedman doctrine, cultural relativism, the righteous moralist, and the naïve immoralist.

155 Chapter 4: Ethics in International BusinessThe Friedman Doctrine Economist’s Milton Friedman’s position is that the only social responsibility of business is to increase profits, so long as the company stays within the rules of law Cultural Relativism Cultural relativism is the belief that ethics are culturally determined and that firms should adopt the ethics of the cultures in which they operate, or in other words, “when in Rome, do as the Romans do”

156 Chapter 4: Ethics in International BusinessThe Righteous Moralist The righteous moralist approach claims that a multinational’s home country standards of ethics are the appropriate ones for companies to follow in foreign countries The Naïve Immoralist The naïve 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

157 Chapter 4: Ethics in International BusinessUtilitarian and Kantian Ethics Utilitarian approaches to ethics hold that the moral worth of actions or practices is determined by their consequences An action is judged to be desirable if it leads to the best possible balance of good consequences over bad consequences

158 Chapter 4: Ethics in International BusinessProblems with the approach is measuring the benefits, costs, and risks of a course of action, and the fact that philosophy fails to consider justice Kantian ethics are based on the philosophy of Immanuel Kant who argued that people should be treated as ends and never purely as means to the ends of others

159 Chapter 4: Ethics in International BusinessRights Theories Rights theories recognize that human beings have fundamental rights and privileges that transcend national boundaries and culture Moral theorists argue that fundamental human rights form the basis for the moral compass that managers should navigate by when making decisions that have an ethical component The idea that some fundamental rights transcend national borders and cultures was the underlying motivation for the UN’s Universal Declaration of Human Rights (specifies the basic principles that should always be adhered to irrespective of the culture in which one is doing business)

160 Chapter 4: Ethics in International BusinessJustice Theories Justice theories focus on the attainment of a just distribution of economic goods and services A just distribution is one that is considered fair and equitable

161 Chapter 4: Ethics in International BusinessOne theory of justice was set forth by John Rawls who argued that all economic goods and services should be distributed equally except when an unequal distribution would work to everyone’s advantage Impartiality is guaranteed by the veil of ignorance (everyone is imagined to be ignorant of all his or her particular characteristics) where people would agree that each person is permitted the maximum amount of basic liberty compatible with a similar liberty for others, and that once equal basic liberty is assured, inequality in basic goods social goods are to be allowed only if they benefit everyone Rawls formulates the difference principle, which is that inequalities are justified if they benefit the position of the least advantaged person

162 Chapter 4: Ethics in International BusinessClassroom Performance System Which philosophy claims that a company’s home-country standards of ethics are the appropriate ones to follow in foreign countries? Cultural relativism Righteous moralist Friedman doctrine Naïve immoralist Classroom Performance System Answer: b

163 Chapter 4: Ethics in International BusinessIMPLICATIONS FOR MANAGERS Firms that ensure ethical issues are considered in business decisions: favor hiring and promoting people with a well grounded sense of personal ethics build an organizational culture that places a high value on ethical behavior makes sure that leaders within the business not only articulate the rhetoric of ethical behavior, but also act in manner that is consistent with that rhetoric put decision making processes in place that require people to consider the ethical dimension of business decisions develop moral courage

164 Chapter 4: Ethics in International BusinessHiring and Promotion Businesses should strive to identify and hire people with a strong sense of personal ethics Prospective employees should find out as much as they can about the ethical climate in an organization

165 Chapter 4: Ethics in International BusinessOrganization Culture and Leadership Businesses need to build an organization culture that places a high value on ethical behavior: the business must explicitly articulate values that place a strong emphasis on ethical behavior, perhaps using a code of ethics (a formal statement of the ethical priorities a business adheres to) leaders in the business should give life and meaning to the code of ethics by repeatedly emphasizing their importance, and then acting on them the business should put in place a system of incentives and rewards that recognize people who engage in ethical behavior and sanction those who do not

166 Chapter 4: Ethics in International BusinessDecision Making Processes A moral compass can help determine whether a decision is ethical. If a manager can answer “yes” to the following questions, the decision is ethically acceptable. does my decision fall within the accepted values of standards that typically apply in the organizational environment? am I willing to see the decision communicated to all stakeholders affected by it? would the people with whom I have significant personal relationships approve of the decision?

167 Chapter 4: Ethics in International BusinessA five step process can also help managers think through ethical problems: business people should identify which stakeholders (the individuals or groups who have an interest, stake, or claim in the actions and overall performance of a company) a decision would affect and in what ways Internal stakeholders are people who work for or who own the business such as employees, the board of directors, and stockholders. External stakeholders are the individuals or groups who have some claim on a firm such as customers, suppliers, and unions.

168 Chapter 4: Ethics in International BusinessThen, managers need to determine whether a proposed decision would violate the fundamental rights of any stakeholders Next, managers need to establish moral intent (the business must resolve to place moral concerns ahead of other concerns in cases where either the fundamental rights of stakeholders or key moral principles have been violated) The company should then engage in ethical behavior Finally, the business must audit its decisions, reviewing them to make sure that they were consistent with ethical principles

169 Chapter 4: Ethics in International BusinessEthics Officers To ensure ethical behavior in a business, a number of firms now have ethics officers Moral Courage It is important to recognize that employees in an international business may need significant moral courage

170 Chapter 4: Ethics in International BusinessClassroom Performance System A company’s formal statement of ethical priorities is called its Mission statement Code of ethics Code of values Organizational culture Classroom Performance System Answer: b

171 Chapter 4: Ethics in International BusinessSummary of Managerial Actions In the end, there are clearly things that an international business should do, and there are things that an international business should not do, but there are also actions that present managers with true dilemmas

172 Chapter 4: Ethics in International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 1. Review the Management Focus on testing drugs in the developing world and discuss the following questions: (a) Did Pfizer behave unethically by rushing to take advantage of an epidemic in Nigeria in order to test an experimental drug on sick children? Should the company have proceeded more carefully? (b) Is it ethical to test an experimental drug on children in emergency settings in the developing world where the overall standard of health care is much lower than in the developed world, and where proper protocols might not be followed? Answer: Some students might argue that Pfizer was between a rock and a hard place. The company needed to test its drug on children prior to getting FDA approval, yet the company could not find enough sick children to properly test the drug. Most students will probably agree that the company acted irresponsibly with its testing in Nigeria, and that the company should have proceeded more carefully, but some students may also suggest that had the drug proved to be extremely successful in treating bacterial meningitis, Pfizer might have been seen as a hero, despite its questionable ethics.

173 Chapter 4: Ethics in International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 2. 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, 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? Answer: This question, illustrating a potentially very real ethical dilemma facing managers working in foreign subsidiaries, is designed to stimulate class discussion. Students should recognize that neither alternative—violating the company’s position on child labor, nor putting the child out on the streets—seems acceptable. In the end, many students may agree that allowing the child to continue to work in the factory is the lesser of the two evils.

174 Chapter 4: Ethics in International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 3. Drawing upon John Rawls’ concept, the veil of ignorance, develop an ethical code that will (a) guide the decisions of a large oil multinational towards environmental protection, and (b) influence the policies of a clothing company to outsource its manufacturing process? Answer: According to John Rawls, a decision is just and ethical if people would allow for it when designing a social system under a veil of ignorance. Rawls’ veil of ignorance is a conceptual tool that can contribute towards the moral compass that managers can use to help them navigate through difficult ethical dilemmas. This question can produce some interesting responses particularly in a class with a diverse group of nationalities.

175 Chapter 4: Ethics in International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 4. Under what conditions is it ethically defensible to outsource production to producers in the developing world who have much lower labor costs when such actions also involve laying off long term employees in the firm’s home country? Answer: This question is likely to stimulate some lively discussion, particularly if students have personally felt the impact of this practice. Many American companies are outsourcing not only blue collar work, but white collar positions to the developing world. Students are facing a tenuous job market where positions that they may have sought when they began their college degrees are being “shipped abroad.” Some students will argue that companies have to do what is best for all stakeholders, and if that means taking advantage of cheaper labor costs elsewhere, then that is the appropriate strategy. Others however, will probably argue that companies owe a social debt to their home countries, and that loyalty from long term employees should be rewarded.

176 Chapter 4: Ethics in International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 5. Are facilitating payments ethical? Answer: Students will probably be divided on this question, and a lively debate should ensue. Certainly, the notion of when in Rome, do as the Romans do. However, those taking this perspective should recognize that it may be difficult to draw the line on exactly what is acceptable under this guise, and when bribery goes too far.

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178 International Trade Theory5 chapter International Trade Theory McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

179 Chapter 5: International Trade TheoryINTRODUCTION In this chapter: theories that explain why it is beneficial for a country to engage in international trade are presented the pattern of international trade that is observed in the world economy are explained Teaching Tip: It is often worth asking students before discussing the theories why countries trade the products they do. They will frequently – with a little prompting hit upon many of the ideas presented in this chapter and consequently relate better to the various theories that are discussed.

180 Chapter 5: International Trade TheoryAN OVERVIEW OF TRADE THEORY Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country.

181 Chapter 5: International Trade TheoryThe Benefits of Trade The theories of Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself International trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, and import products that can be produced more efficiently in other countries

182 Chapter 5: International Trade TheoryThe Pattern of International Trade Some patterns of trade are fairly easy to explain - it is obvious why Saudi Arabia exports oil, Ghana exports cocoa, and Brazil exports coffee But, why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Japan export automobiles, consumer electronics, and machine tools?

183 Chapter 5: International Trade TheoryTrade Theory and Government Policy Trade theories lack agreement in their recommendations for government policy. Mercantilism makes a crude case for government involvement in promoting exports and limiting imports The theories of Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade New trade theory and Porter’s theory of national competitive advantage justify limited and selective government intervention to support the development of certain export-oriented industries

184 Chapter 5: International Trade TheoryMERCANTILISM Mercantilism, which emerged in England in the mid-16th century, asserted that it is in a country’s best interest to maintain a trade surplus, to export more than it imports. Mercantilism advocated government intervention to achieve a surplus in the balance of trade It viewed trade as a zero-sum game, one in which a gain by one country results in a loss by another As an economic philosophy, mercantilism is problematic and not valid, yet many political views today have the goal of boosting exports while limiting imports by seeking only selective liberalization of trade Country Focus: Is China a Neo-Mercantilist Nation? Summary This feature analyzes claims that China is a neo-mercantilist nation. Exports are largely responsible for China’s recent rapid economic growth. The country, capitalizing on its cheap labor force, has been focused on converting raw materials into products that are exported to developing countries like the United States. In 2005, China’s trade surplus was a record $121 billion, and its holdings of foreign exchange reserves were over $800 billion. Suggested Discussion Questions 1. Are the claims that China is following a neo-mercantilist policy valid? Why or why not? 2. What incentive does China have to open its markets to foreign products? Why might China resist such a move? 3. Is there evidence that China is pursuing an import substitution policy? How would this type of policy benefit the country?

185 Chapter 5: International Trade TheoryABSOLUTE ADVANTAGE In 1776, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game and argued that countries differ in their ability to produce goods efficiently, and that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

186 Chapter 5: International Trade TheoryAssume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa. In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice So, 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 the two extremes

187 Chapter 5: International Trade TheoryIn South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice So, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between Ghana has an absolute advantage in the production of cocoa South Korea has an absolute advantage in the production of rice

188 Chapter 5: International Trade TheoryWithout trade: Ghana would produce 10 tons of cocoa and 5 tons of rice South Korea would produce 10 tons of rice and 2.5 tons of cocoa If each country specializes in the product in which it has an absolute advantage and trades for the other product: Ghana would produce 20 tons of cocoa South Korea would produce 20 tons of rice

189 Chapter 5: International Trade TheoryGhana could trade 6 tons of cocoa to South Korea for 6 tons of rice After trade: Ghana would have 14 tons of cocoa left, and 6 tons of rice South Korea would have 14 tons of rice left and 6 tons of cocoa Both countries gained from trade.

190 Chapter 5: International Trade TheoryThe theory of absolute advantage is illustrated in Table 5.2.

191 Chapter 5: International Trade TheoryCOMPARATIVE ADVANTAGE In 1817, 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 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

192 Chapter 5: International Trade TheoryAssume: Ghana is more efficient in the production of both cocoa and rice In Ghana, it takes 10 resources to produce one tone of cocoa, and 13 1/3 resources to produce one ton of rice So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two

193 Chapter 5: International Trade TheoryIn South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice So, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two If each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries will gain.

194 Chapter 5: International Trade TheoryWith trade: Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice Ghana will still have 11 tons of cocoa, and 4 additional tons of rice South Korea still has 6 tons of rice and 4 tons of cocoa

195 Chapter 5: International Trade TheoryThe theory of comparative advantage is illustrated in Table 5.2.

196 Chapter 5: International Trade TheoryClassroom Performance System Which theory did not suggest that there could be gains from specialization and trade? Mercantilism Absolute advantage Comparative advantage Heckscher-Ohlin theory Classroom Performance System Answer: a

197 Chapter 5: International Trade TheoryThe Gains from Trade The theory of comparative advantage argues that trade is a positive sum gain in which all gain. It provides a strong rationale for encouraging free trade. Qualifications and Assumptions The simple example of comparative advantage makes a number of assumptions: only two countries and two goods; zero transportation costs; similar prices and values; resources are mobile between goods within countries, but not across countries; constant returns to scale; fixed stocks of resources; and no effects on income distribution within countries

198 Chapter 5: International Trade TheorySimple Extensions of the Ricardian Model Immobile Resources Resources do not always move freely from one economic activity to another Dynamic Effects and Economic Growth Trade might increase a country's stock of resources as increased supplies become available from abroad Free trade might increase the efficiency of resource utilization, and free up resources for other uses

199 Chapter 5: International Trade TheoryThe Samuelson Critique Samuelson argues that the ability to offshore services jobs that were traditionally not internationally mobile may have the effect of a mass inward migration into the United States, where wages would then fall Country Focus: Moving U.S. White Collar Jobs Offshore Summary This feature goes to the heart of a debate that has been played out many times over the past half century—the transference of jobs from the United States to lower-wage countries. The difference now however, is that rather than blue-collar jobs being transferred, the new trend is for white-collar jobs to move, jobs associated with the knowledge-based economy. Suggested Discussion Questions 1. Will the United States suffer from the loss of highly skilled and high paying jobs? What does the transference of white-collar jobs mean to the average American? 2. What does the transference of white-collar jobs mean to recipient countries such as India and the Philippines? 3. Why do American companies transfer white-collar jobs to countries like India and the Philippines?

200 Chapter 5: International Trade TheoryEvidence for the Link between Trade and Growth Studies exploring the relationship between trade and economic growth suggest that countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade

201 Chapter 5: International Trade TheoryHECKSCHER-OHLIN THEORY Heckscher and Ohlin argued that comparative advantage arises from differences in national factor endowments The Heckscher-Ohlin theory predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce

202 Chapter 5: International Trade TheoryThe Leontief Paradox In 1953, Wassily Leontief postulated that since the U.S. was relatively abundant in capital compared to other nations, the U.S. would be an exporter of capital intensive goods and an importer of labor-intensive goods. However, he found that U.S. exports were less capital intensive than U.S. imports Since this result was at variance with the predictions of the theory, it has become known as the Leontief Paradox

203 Chapter 5: International Trade TheoryClassroom Performance System Which theory viewed trade as a zero sum game? Mercantilism Absolute advantage Comparative advantage Heckscher-Ohlin theory Classroom Performance System Answer: a

204 Chapter 5: International Trade TheoryTHE PRODUCT LIFE CYCLE THEORY In the mid-1960s, Raymond Vernon proposed the product life-cycle theory that suggested that as products mature both the location of sales and the optimal production location will change affecting the flow and direction of trade. Early in the life cycle of a typical new product, while demand is starting to grow in the U.S., demand in other advanced countries is limited to high-income groups, and so it is not worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the U.S. to those countries

205 Chapter 5: International Trade TheoryOver time, demand for the new product starts to grow in other advanced countries making it worthwhile for foreign producers to begin producing for their home markets U.S. firms might also set up production facilities in those advanced countries where demand is growing limiting the exports from the U.S. As the market in the U.S. and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon

206 Chapter 5: International Trade TheoryProducers based in advanced countries where labor costs are lower than the United States might now be able to export to the U.S. If cost pressures become intense, developing countries begin to acquire a production advantage over advanced countries The United States switches from being an exporter of the product to an importer of the product as production becomes more concentrated in lower-cost foreign locations

207 Chapter 5: International Trade TheoryFigure 5.3 shows the dynamic gains that arise from free trade.

208 Chapter 5: International Trade TheoryEvaluating the Product Life Cycle Theory While the product life cycle theory accurately explains what has happened for products like photocopiers and a number of other high technology products developed in the US in the 1960s and 1970s, the increasing globalization and integration of the world economy has made this theory less valid in today's world.

209 Chapter 5: International Trade TheoryNEW TRADE THEORY New trade theory suggests that because of economies of scale (unit cost reductions associated with a large scale of output) and increasing returns to specialization, in some industries there are likely to be only a few profitable firms Firms with first mover advantages (the economic and strategic advantages that accrue to many entrants into an industry) will develop economies of scale and create barriers to entry for other firms

210 Chapter 5: International Trade TheoryIncreasing Product Variety and Reducing Costs A 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

211 Chapter 5: International Trade TheoryEconomies of Scale, First Mover Advantages, and the Pattern of Trade The pattern of trade we observe in the world economy may be the result of first mover advantages and economies of scale

212 Chapter 5: International Trade TheoryImplications of New Trade Theory New trade theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology, and 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 While this is at variance with the Heckscher-Ohlin theory, it does not contradict comparative advantage theory, but instead identifies a source of comparative advantage An extension of the theory is the implication that governments should consider strategic trade policies that nurture and protect firms and industries where first mover advantages and economies of scale are important

213 Chapter 5: International Trade TheoryNATIONAL COMPETITIVE ADVANTAGE: PORTER’S DIAMOND Porter’s 1990 study tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage: Factor Endowments A nation's position in factors of production can lead to competitive advantage These factors can be either basic (natural resources, climate, location) or advanced (skilled labor, infrastructure, technological know-how)

214 Chapter 5: International Trade TheoryDemand Conditions The nature of home demand for the industry’s product or service influences the development of capabilities Sophisticated and demanding customers pressure firms to be competitive Relating and Supporting Industries The presence supplier industries and related industries that are internationally competitive can spill over and contribute to other industries Successful industries tend to be grouped in clusters in countries - having world class manufacturers of semi-conductor processing equipment can lead to (and be a result of having) a competitive semi-conductor industry

215 Chapter 5: International Trade TheoryPorter’s Diamond of competitive advantage is shown in Figure 5.5.

216 Chapter 5: International Trade TheoryClassroom Performance System Economies of scale and first mover advantages are central to which theory of trade Porter’s diamond of competitive advantage New trade theory Vernon’s product life cycle Comparative advantage Classroom Performance System Answer: b

217 Chapter 5: International Trade TheoryFirm Strategy, Structure, and Rivalry The conditions in the nation governing how companies are created, organized, and managed, and the nature of domestic rivalry impacts firm competitiveness Management Focus: The Rise of Finland’s Nokia Summary This feature is about the growth of the cellular telephone equipment industry, and more specifically, about the rise in competitiveness of Nokia, a Finnish cellular telephone company. The feature explains the reasons that Nokia was particularly well positioned to take advantage of the growth of the global cellular telephone industry. Suggested Discussion Questions 1. Using the New Trade Theory and Porter’s theory of National Competitive Advantage, describe why Nokia emerged as a leading competitor in the global cellular telephone equipment industry. 2. Explain why the cellular telephone industry caught on in Finland and the other Scandinavian countries faster than the rest of the world. 3. Why didn’t the development of the cellular telephone equipment industry take place in Mexico or another Central or South American country rather than Finland, Sweden, and the United States? Base your answer of the international trade theories described in this chapter.

218 Chapter 5: International Trade TheoryEvaluating Porter’s Theory Government policy can affect demand through product standards, influence rivalry through regulation and antitrust laws, and impact the availability of highly educated workers and advanced transportation infrastructure . The four attributes, government policy, and chance work as a reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage Management Focus: The Rise of Finland’s Nokia Summary This feature is about the growth of the cellular telephone equipment industry, and more specifically, about the rise in competitiveness of Nokia, a Finnish cellular telephone company. The feature explains the reasons that Nokia was particularly well positioned to take advantage of the growth of the global cellular telephone industry. Suggested Discussion Questions 1. Using the New Trade Theory and Porter’s theory of National Competitive Advantage, describe why Nokia emerged as a leading competitor in the global cellular telephone equipment industry. 2. Explain why the cellular telephone industry caught on in Finland and the other Scandinavian countries faster than the rest of the world. 3. Why didn’t the development of the cellular telephone equipment industry take place in Mexico or another Central or South American country rather than Finland, Sweden, and the United States? Base your answer of the international trade theories described in this chapter.

219 Chapter 5: International Trade TheoryFOCUS ON MANAGERIAL IMPLICATIONS There are at least three main implications for international businesses: location implications, first-mover implications, and policy implications. Location One way in which the material discussed in this chapter matters to an international business is the link between the theories and a firm’s decision about where to locate its productive activities It makes sense for a firm to disperse its various productive activities to those countries where they can be performed most efficiently

220 Chapter 5: International Trade TheoryFirst Mover Advantages Being a first mover can have important competitive implications, especially if there are economies of scale and the global industry will only support a few competitors

221 Chapter 5: International Trade TheoryGovernment Policy Government policies with respect to free trade or protecting domestic industries can significantly impact global competitiveness Businesses should work to encourage governmental policies that support free trade Internet Extra: To learn more about government policy towards international trade, and how it might affect companies go to Electronic Embassy {http://www.embassy.org}. The site provides links to all of the foreign embassies located in Washington D.C. Go to the site and click on Embassies. Select the country you are interested, for example Japan. Then click on the URL for the Japanese embassy. To learn more about Japan’s policies on trade, click on Japan’s Foreign Policy. Consider the information and what it means for managers as they make their decisions on where to export, where to produce, and so on.

222 Chapter 5: International Trade TheoryClassroom Performance System Porter’s Diamond is made up of all of the following except Factor endowments Related and supporting industries Firm strategy, structure, and rivalry Supply conditions Classroom Performance System Answer: d

223 Chapter 5: International Trade TheoryCRITICAL THINKING AND DISCUSSION QUESTIONS 1. “Mercantilism is a bankrupt theory that has no place in the modern world.” Discuss. Answer: Mercantilism, in its purest sense, is a bankrupt theory that has no place in the modern world. The principle tenant of mercantilism is that a country should maintain a trade surplus, even if that means that imports are limited by government intervention. This policy is bankrupt for at least two reasons. First, it is inconsistent with the general notion of globalization, which is becoming more and more prevalent in the world. A policy of mercantilism will anger potential trade partners because it will exclude their goods from free access to the mercantilist country’s markets. Eventually, a country will find it difficult to export if it imposes oppressive quotas and tariffs on its imports. Second, mercantilism is bankrupt because it hurts the consumers in the mercantilist country. By denying its consumers access to either “cheaper” goods from other countries or more “sophisticated” goods from other countries, the mercantilist country’s ordinary consumers suffer.

224 Chapter 5: International Trade TheoryCRITICAL THINKING AND DISCUSSION QUESTIONS 2. Is free trade fair? Discuss! Answer: This question is designed to stimulate class discussion. Trade theory tells suggests that specialization and free trade benefits all countries. However, a case can be made in some situations for imposing trade barriers. For example, if a developing country is trying to establish an industry, trade barriers may be needed in the short term until the industry can become competitive. While it could be argued that another country could make the product more efficiently already, is it fair to limit a country’s ability to develop its industrial base?

225 Chapter 5: International Trade TheoryCRITICAL THINKING AND DISCUSSION QUESTIONS 3. Unions in developed nations often oppose imports from low-wage countries and advocate trade barriers to protect jobs from what they often characterize as “unfair” import competition. Is such competition “unfair?” Do you think that this argument is in the best interests of the unions the people they represent the country as a whole Answer: The theory of comparative advantage suggests that a country should specialize in producing those goods that it can produce most efficiently, while buying goods that it can produce relatively less efficiently from other countries. Furthermore, the theory suggests that opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. Therefore, it would follow that if low-wage countries can make certain products more efficiently than high wage countries, the low wage countries should produce and export those products. While trade barriers may protect workers and companies, they are a short-term fix at best. Moreover, by protecting industries, the government is not encouraging companies to become more efficient. Instead, they are promoting inefficiency. Consumers lose out because they have higher prices and less choice.

226 Chapter 5: International Trade TheoryCRITICAL THINKING AND DISCUSSION QUESTIONS 4. What are the potential costs of adopting a free trade regime? Do you think governments should do anything to reduce these costs? What? Answer: Students will probably be divided on this question, and a lively debate should ensue. For example, certainly, students will probably recognize that by adopting a free trade regime, jobs will be lost in some industries, however they may not agree on exactly what should be done about the jobs losses. Some students might suggest that the government provide retraining programs while others may argue that people lose their jobs everyday and don’t get government assistance to find new ones.

227 Chapter 5: International Trade TheoryCRITICAL THINKING AND DISCUSSION QUESTIONS 5. Reread the country focus feature on outsourcing service jobs. Is there is a difference between the transference of high paying white collar jobs, such as computer programming and accounting, to developing nations, and low paying blue collar jobs? If so, what is the difference, and should government do anything to stop the flow of white- collar jobs out of the country to countries like India? Answer: This question is likely to generate a lively debate. Many students will suggest that the outward flow of white-collar jobs is indeed a serious issue, one that should be the focus of government attention. Students taking this perspective are likely to suggest that white-collar jobs are more important to the nation’s future, and that they should remain at home. Other students however, may argue that companies cannot afford to pay the higher wages commanded by white-collar jobs and still remain profitable. Therefore, the argument might be that by taking these jobs outside the country, the company is able to remain viable, and keep other people employed.

228 Chapter 5: International Trade TheoryCRITICAL THINKING AND DISCUSSION QUESTIONS 6. 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 a particular industry. What kind of policies would you recommend that the government adopt? Are these policies at variance with the basic free trade philosophy? Answer: Porter’s theory of national competitive advantage argues that four broad attributes of a nation shape the environment in which local firms compete, and that these attributes promote or impede the creation of competitive advantage. These attributes are: factor endowments, demand conditions, related and supporting industries, and firm strategy, structure, and rivalry. Porter goes on to argue that firms are most likely to succeed in industries in which the diamond (which are the four attributes collectively) is favorable. Porter adds two factors to the list of attributes described above: chance and government policy. The New Trade theory addresses a separate issue. This theory argues that due to the presence of substantial scale economies, world demand will support only a few firms in many industries. Underpinning this argument is the notion of first-mover advantages, which are the economic and strategic advantages that accrue to early entrants into an industry. One could argue that when the attributes of a nation are conductive to the production of a product, and when the manufacturers of that product have experienced some “chance” events that have provided them first-mover advantages, the governmental policies of that nation should promote the building of national competitive advantage in that particular area. This could be accomplished through government R&D grants, policies that favor the industry in capital markets, policies towards education, the creation of a favorable regulatory atmosphere, tax abatements, and the like. Ask your students whether they think this policy is at variance with the basic free trade philosophy. One could argue that it is, because the government intervention is creating the basis for comparative advantage. Conversely, one could argue that if a country establishes a comparative advantage in a particular area that is based on a unique set of attributes (such as Swiss production of watches), world output will be favorably impacted by letting that country pursue its area of comparative advantage.

229 Chapter 5: International Trade TheoryCRITICAL THINKING AND DISCUSSION QUESTIONS 7. The world’s poorest countries are at a competitive disadvantage in every sector of their economies. They have little to export. They have no capital; their land is of poor quality; they often have too many people given available work opportunities; and they are poorly educated. Free trade cannot possibly be in the interests of such nations! Discuss. Answer: This is a difficult question. Certainly, most students will recognize that these countries are in dire straights and need assistance from richer countries. Most students will probably be sympathetic to their cause and suggest various aid programs including education and monetary support to help the countries develop. However, others may be more cautious and promote the notion that assistance would have to come in an organized form with multiple nations working together. The question is an interesting one that should provide students with an eye-opening experience.

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231 The Political Economy of International Trade6 chapter The Political Economy of International Trade McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

232 Chapter 6: The Political Economy of International TradeINTRODUCTION Free trade refers to a situation where a government does not attempt to restrict what its citizens can buy from another country or what they can sell to another country. While many nations are nominally committed to free trade, they tend to intervene in international trade to protect the interests of politically important groups.

233 Chapter 6: The Political Economy of International TradeINSTRUMENTS OF TRADE POLICY There are seven main instruments of trade policy: Tariffs Subsidies Import quotas Voluntary export restraints Local content requirements Antidumping policies Administrative policies

234 Chapter 6: The Political Economy of International TradeTariffs A tariff is a tax levied on imports that effectively raises the cost of imported products relative to domestic products. Specific tariffs are levied as a fixed charge for each unit of a good imported Ad valorem tariffs are levied as a proportion of the value of the imported good Tariffs increase government revenues, provide protection to domestic producers against foreign competitors by increasing the cost of imported foreign goods, and force consumers to pay more for certain imports So, tariffs are unambiguously pro-producer and anti-consumer, and tariffs reduce the overall efficiency of the world economy

235 Chapter 6: The Political Economy of International TradeClassroom Performance System A tariff levied as a fixed charge for each unit of a good imported is a(n) Fixed tariff Specific tariff Ad valorem tariff Transit tariff Classroom Performance System Answer: a

236 Chapter 6: The Political Economy of International TradeSubsidies A subsidy is a government payment to a domestic producer. Subsidies help domestic producers in two ways: they help them compete against low-cost foreign imports they help them gain export markets Consumers typically absorb the costs of subsidies. Country Focus: Subsidized Wheat Production in Japan Summary This feature explores the subsidies Japan continues to pay its wheat farmers. Tens of thousands Japanese farmers continue to grow wheat despite the fact the wheat grown in North America, Argentina, and Australia is far cheaper and of superior quality. The Japanese farmers stay in business thanks to the hefty subsidies paid by the Japanese government. As a result, wheat prices in Japan are substantially higher than they would be if a free market were allowed to operate. Suggested Discussion Questions 1. Who are the winners and who are the losers from Japanese wheat subsidies? 2. Why does Japan continue to subsidize its wheat farmers when cheaper wheat is readily available in international markets?

237 Chapter 6: The Political Economy of International TradeImport Quotas and Voluntary Export Restraints An import quota is a direct restriction on the quantity of some good that may be imported into a country. tariff rate quotas are a hybrid of a quota and a tariff where a lower tariff is applied to imports within the quota than to those over the quota voluntary export restraints are quotas on trade imposed by the exporting country, typically at the request of the importing country’s government a quota rent is the extra profit that producers make when supply is artificially limited by an import quota import quotas and voluntary export restraints benefit domestic producers by limiting import competition, but they raise the prices of imported goods

238 Chapter 6: The Political Economy of International TradeLocal Content Requirements A local content requirement demands that some specific fraction of a good be produced domestically. local content requirements benefit domestic producers, but consumers face higher prices Administrative Policies Administrative trade polices are bureaucratic rules that are designed to make it difficult for imports to enter a country. these polices hurt consumers by denying access to possibly superior foreign products

239 Chapter 6: The Political Economy of International TradeAntidumping Policies Dumping is defined as selling goods in a foreign market below their costs of production, or as selling goods in a foreign market at below their “fair” market value. Dumping is viewed as a method by which firms unload excess production in foreign markets Some dumping may be predatory behavior, with producers using substantial profits from their home markets to subsidize prices in a foreign market with a view to driving indigenous competitors out of that market, and later raising prices and earning substantial profits Antidumping polices (or countervailing duties) are designed to punish foreign firms that engage in dumping and protect domestic producers from “unfair” foreign competition Management Focus: U.S. Magnesium Seeks Protection Summary This feature explores the dumping charged levied by U.S. Magnesium against Chinese and Russian producers. According to U.S. Magnesium, the sole American producer of magnesium, Russian and Chinese producers were selling magnesium significantly below market value in an effort to drive U.S. Magnesium out of business. The company failed a complaint with the International Trade Commission (ITC) which ultimately ruled in favor of U.S. Magnesium. Suggested Discussion Questions 1. What is dumping? Were Chinese and Russian producers guilty of dumping? How did U.S. Magnesium justify its claims against Russian and Chinese producers? 2. What does the ITC’s ruling mean for American consumers of magnesium? In your opinion, was the ruling fair?

240 Chapter 6: The Political Economy of International TradeClassroom Performance System A quota on trade imposed from the exporting country’s side is a(n) Voluntary export restraint Quota rent Local content requirement Administrative trade policy Classroom Performance System Answer: a

241 Chapter 6: The Political Economy of International TradeTHE CASE FOR GOVERNMENT INTERVENTION There are two types of arguments for government intervention: political and economic. Political arguments are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers) Economic arguments are typically concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers)

242 Chapter 6: The Political Economy of International TradePolitical Arguments for Intervention Political arguments for government intervention include: protecting jobs protecting industries deemed important for national security retaliating to unfair foreign competition protecting consumers from “dangerous” products furthering the goals of foreign policy protecting the human rights of individuals in exporting countries

243 Chapter 6: The Political Economy of International TradeProtecting Jobs and Industries The most common political reason for trade restrictions is protecting jobs and industries Usually this results from political pressures by unions or industries that are "threatened" by more efficient foreign producers, and have more political clout than the consumers that will eventually pay the costs

244 Chapter 6: The Political Economy of International TradeNational Security Protecting industries such as aerospace or electronics because they are important for national security is another argument for trade restrictions Retaliation When governments take, or threaten to take, specific actions, other countries may remove trade barriers, however, if threatened governments don’t back down, tensions can escalate and new trade barriers may be enacted

245 Chapter 6: The Political Economy of International TradeProtecting Consumers Consumer protection can also be an argument for restricting imports Furthering Foreign Policy Objectives Trade policy can be used to support foreign policy objectives Preferential trade terms can be granted to countries that a government wants to build strong relations with Trade policy can also been used to punish rogue states that do not abide by international laws or norms (the U.S. has done this with Libya, Iran, Iraq, North Korea, and Cuba) However, it might cause other countries to undermine unilateral trade sanctions Two acts, the Helms-Burton Act and the D’Amato Act, have been passed to protect American companies from such actions

246 Chapter 6: The Political Economy of International TradeProtecting Human Rights Governments sometimes use trade policy to improve the human rights policies of trading partners Unless a large number of countries choose to take such action, however, it is unlikely to prove successful Some critics have argued that the best way to change the internal human rights of a country is to engage it in international trade The decision to grant China MFN status in 1999 was based on this philosophy

247 Chapter 6: The Political Economy of International TradeEconomic Arguments for Intervention The Infant Industry Argument The infant industry argument suggests that an industry should be protected until it can develop and be viable and competitive internationally. The infant industry argument has been accepted as a justification for temporary trade restrictions under the WTO However, it can be difficult to gauge when an industry has grown up Critics argue that if a country has the potential to develop a viable competitive position its firms should be capable of raising necessary funds without additional support from the government

248 Chapter 6: The Political Economy of International TradeStrategic Trade Policy Strategic trade policy suggests that in cases where there may be important first mover advantages, governments can help firms from their countries attain these advantages. Strategic trade policy also suggests that governments can help firms overcome barriers to entry into industries where foreign firms have an initial advantage Country Focus: Trade in Hormone-Treated Beef Summary This feature describes the trade battle between the U.S. and EU over beef from cattle that have been given growth hormones. It outlines the basic issues that led to the dispute, and shows how the World Trade Organization has treated the case. Suggested Discussion Questions 1. Why is the EU so concerned about beef from cattle that have been given growth hormones? 2. Why did the WTO rule against the EU?

249 Chapter 6: The Political Economy of International TradeClassroom Performance System Which argument for government intervention suggests that an industry should be protected until it can develop and be viable and competitive internationally? Strategic trade policy National security Retaliation Infant industry Classroom Performance System Answer: d

250 Chapter 6: The Political Economy of International TradeTHE REVISED CASE FOR FREE TRADE Two situations where restrictions on trade may be inappropriate: retaliation and politics. Retaliation and Trade War Krugman argues that strategic trade policies aimed at establishing domestic firms in a dominant position in a global industry are beggar-thy-neighbor policies that boost national income at the expense of other countries A country that attempts to use such policies will probably provoke retaliation.

251 Chapter 6: The Political Economy of International TradeDomestic Politics Since special interest groups can influence governments, Krugman argues that strategic trade policy is almost certain to be captured by special interest groups within an economy, who will distort it to their own ends

252 Chapter 6: The Political Economy of International TradeDEVELOPMENT OF THE GLOBAL TRADING SYSTEM From Smith to the Great Depression Up until the Great Depression of the 1930s, most countries had some degree of protectionism In 1930, the U.S. enacted the Smoot-Hawley tariff, which created significant import tariffs on foreign goods Other nations took similar steps and as the depression deepened, world trade fell further

253 Chapter 6: The Political Economy of International Trade: GATT, Trade Liberalization, and Economic Growth After WWII, the U.S. and other nations realized the value of freer trade, and established the General Agreement on Tariffs and Trade (GATT) The approach of GATT (a multilateral agreement to liberalize trade) was to gradually eliminate barriers to trade

254 Chapter 6: The Political Economy of International Trade: Protectionist Trends During the 1980s and early 1990s, the world trading system was strained Japan’s economic strength and huge trade surplus stressed what had been more equal trading patterns, and Japan’s perceived protectionist (neo-mercantilist) policies created intense political pressures in other countries Persistent trade deficits by the U.S., the world’s largest economy, caused significant economic problems for some industries and political problems for the government Many countries found that although limited by GATT from utilizing tariffs, there were many other more subtle forms of intervention that had the same effects and did not technically violate GATT (e.g. VERs)

255 Chapter 6: The Political Economy of International TradeThe Uruguay Round and the World Trade Organization In 1986, GATT members began new negotiations to reduce tariffs-- the Uruguay Round. The talks focused on several areas: Services and Intellectual Property Going beyond manufactured goods to address trade issues related to services and intellectual property, and agriculture The World Trade Organization By establishing the WTO, it was hoped that enforcement mechanisms would make the WTO a more effective policeman of the global trade rules The WTO encompassed GATT along with two sisters organizations, the General Agreement on Trade in Services (GATS) and the Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPS)

256 Chapter 6: The Political Economy of International TradeWTO: Experience to Date Since its establishment, the WTO has emerged as an effective advocate and facilitator of future trade deals, particularly in such areas as services WTO as Global Police So far, the WTO’s policing and enforcement mechanisms are having a positive effect. In general, countries have adopted WTO recommendations for trade disputes Internet Extra: The WTO site {http://www.wto.org} provides a wealth of information on current trade issues. Go to the site, and click on Trade Topics. Browse down the menu to explore the current situation at the Doha Round, the status of talks on electronic commerce, or the WTO’s current efforts regarding trade and the environment.

257 Chapter 6: The Political Economy of International TradeExpanding Trade Agreements In 1997, 68 countries that account for more than 90% of world telecommunications revenues pledged to open their markets to foreign competition and to abide by common rules for fair competition in telecommunications Similarly, 102 countries pledged to open to varying degrees their banking, securities, and insurance sectors to foreign competition Like the telecommunications deal, the agreement covers not just cross-border trade, but also foreign direct investment

258 Chapter 6: The Political Economy of International TradeThe WTO in Seattle: A Watershed? The 1999 meeting of the WTO in Seattle was important not only for what happened between the member countries, but also for what occurred outside the building Inside, members failed to agree on how to work toward the reduction of barriers to cross-border trade in agricultural products and cross-border trade and investment in services Outside, the WTO became a magnet for various groups protesting free trade

259 Chapter 6: The Political Economy of International TradeThe Future: Unresolved Issues and the Doha Round Three issues on the current agenda of the WTO are the rise of anti-dumping policies, the high level of protectionism in agriculture, and the lack of strong protection for intellectual property rights in many nations, and continued high tariffs on nonagricultural goods and services in many nations

260 Chapter 6: The Political Economy of International TradeAnti-Dumping Actions The WTO is encouraging members to strengthen the regulations governing the imposition of antidumping duties Protectionism in Agriculture The WTO is concerned with the high level of tariffs and subsidies in the agricultural sector of many economies

261 Chapter 6: The Political Economy of International TradeProtecting Intellectual Property Because members believe that the protection of intellectual property rights is an essential element of the international trading system, TRIPS obliges WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years The WTO would like to bring down tariff rates on nonagricultural goods and services, and reduce the scope for the selective use of high tariff rates

262 Chapter 6: The Political Economy of International TradeA New Round of Talks: Doha In late 2001, the WTO launched a new round of talks at Doha, Qatar The agenda includes cutting tariffs on industrial goods and services, phasing out subsidies to agricultural producers, reducing barriers to cross-border investment, and limiting the use of anti-dumping laws Country Focus: Estimating the Gains from Trade for America Summary This feature explores the results of a study by the Institute for International Economics. The study, which estimated the gains to the American economy from free trade, found that America’s GDP was more than 7 percent higher as a result of reductions in trade barriers than it would have been if the barriers remained. The study also estimated that if tariffs were reduced to zero, significant gains would still result. Suggested Discussion Questions 1. What does the Institute for International Economics suggest about the benefits of free trade? 2. According to the Institute for International Economics study, a move toward free trade would cause disruption in employment. Is it still worth pursuing free trade if it means that some people lose their jobs?

263 Chapter 6: The Political Economy of International TradeClassroom Performance System The main issues on the table at the Doha Round include all of the following except Anti-dumping policies Protectionism in agriculture Intellectual property rights Infant industry protection Classroom Performance System Answer: d

264 Chapter 6: The Political Economy of International TradeIMPLICATIONS FOR MANAGERS Trade Barriers and Firm Strategy Trade barriers raise the cost of exporting products to a country Voluntary export restraints (VERs) may limit a firm’s ability to serve a country from locations outside that country To conform to local content requirements, a firm may have to locate more production activities in a given market than it would otherwise All of these can raise the firm’s costs above the level that could be achieved in a world without trade barriers

265 Chapter 6: The Political Economy of International TradePolicy Implications International firms have an incentive to lobby for free trade, and keep protectionist pressures from causing them to have to change strategies While there may be short run benefits to having governmental protection in some situations, in the long run these can backfire and other governments can retaliate

266 Chapter 6: The Political Economy of International TradeCRITICAL THINKING AND DISCUSSION QUESTIONS 1. Do you think the U.S. government should consider human rights when granting preferential trading rights to countries? What are the arguments for and against taking such a position? Answer: China is frequently cited as a violator of human rights, and can form the basis for a discussion of this question. While the answer to the first question clearly is a matter of personal opinion, in stating their opinions, students should consider the following points. Trade with the U.S. is very important to China, as China views the U.S. as an important market. The U.S. is also an important source of certain products. Thus, the U.S. has some leverage with trade when trying to influence China’s human rights policies. For this policy to have much effect, however, other nations important to China must adopt similar policies. Otherwise China will simply choose to work with other countries, and U.S. consumers and producers may be more negatively impact than the Chinese. Another concern with tying MFN status to human rights is that denying MFN may make the human rights situation worse rather than better. By engaging in trade, the income levels in China will increase, and with greater wealth the people will be able to demand and receive better treatment.

267 Chapter 6: The Political Economy of International TradeCRITICAL THINKING AND DISCUSSION QUESTIONS 2. Whose interests should be the paramount concern of government trade policy - the interests of producers (businesses and their employees) or those of consumers? Answer: The long run interests of consumers should be the primary concern of governments. Unfortunately consumers, each of whom may be negatively impacted by only a few dollars, are less motivated and effective lobbyists than a few producers that have a great deal at stake. While in some instances it could be argued that domestic consumers will be better off if world-class domestic producers are nurtured and allowed to gain first mover advantages in international markets, it is doubtful that the government will be better than international capital markets at "picking winners", and will more likely pick the firms with the greatest political clout. While employees may well lose jobs if there are more efficient foreign competitors, some would argue that this is just the nature of competition, and that the role of government should be to help these employees get jobs where they can be efficiently employed rather than to protect them from reality in inefficient firms.

268 Chapter 6: The Political Economy of International TradeCRITICAL THINKING AND DISCUSSION QUESTIONS 3. Given the arguments relating to the new trade theory and strategic trade policy, what kind of trade policy should business be pressuring government to adopt? Answer: According to the textbook, businesses should urge governments to target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those technologies. Government should provide export subsidies until the domestic firms have established first mover advantages in the world market. Government support may also be justified if it can help domestic firms overcome the first-mover advantages enjoyed by foreign competitors and emerge as viable competitors in the world market. In this case, a combination of home market protection and export-promoting subsidies may be called for.

269 Chapter 6: The Political Economy of International TradeCRITICAL THINKING AND DISCUSSION QUESTIONS 4. You are an employee of an U.S. firm that produces personal computers in Thailand and then exports them to the U.S. and other countries for sale. The personal computers were originally produced in Thailand to take advantage of relatively low labor costs and a skilled workforce. Other possible locations considered at that time were Malaysia and Hong Kong. The U.S. government decides to impose punitive 100 percent ad valorem tariffs on imports of computers from Thailand to punish the country for administrative trade barriers that restrict U.S. exports to Thailand. How should your firm respond? What does this tell you about the use of targeted trade barriers? Answer: As long as the manufacturing requirements haven't changed significantly, looking at Malaysia or Hong Kong again for production would appear obvious. By the U.S. government introducing a specific ad valorem tariff on Thai computer imports, it would be easy to get around these by looking at other locations. Hence such targeted trade barriers can often be easily circumvented without having to locate production facilities in an expensive country like the U.S.

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271 Foreign Direct Investment7 chapter Foreign Direct Investment McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

272 Chapter 7: Foreign Direct InvestmentINTRODUCTION Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market in a foreign country. Once a firm undertakes FDI it becomes a multinational enterprise. FDI takes on two main forms: A greenfield investment (the establishment of a wholly new operation in a foreign country) Acquisition or merging with an existing firm in the foreign country FDI is not foreign portfolio investment (investment by individuals, firms, or public bodies in foreign financial instruments)

273 Chapter 7: Foreign Direct InvestmentClassroom Performance System A company that establishes a new operation in a foreign country has made An acquisition A merger A greenfield investment A joint venture Classroom Performance System Answer: c

274 Chapter 7: Foreign Direct InvestmentFOREIGN DIRECT INVESTMENT IN THE WORLD ECONOMY The flow of FDI refers to the amount of FDI undertaken over a given time period The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time Outflows of FDI are the flows of FDI out of a country Inflows of FDI are the flows of FDI into a country Internet Extra: Each year, Fortune magazine publishes a list of the 500 largest global corporations in the world. Go to the magazine’s web site {http://money.cnn.com/magazines/fortune/global500/2006} and explore the list. Which country has the most companies on the list? Which region of the world is most represented? Are there any new entrants? Are certain industries better represented than others? What conclusions can you draw from your findings? Are there other meaningful trends to consider?

275 Chapter 7: Foreign Direct InvestmentTrends in FDI Over the past 20 years there has been a marked increase in both the flow and stock of FDI in the world economy. FDI has grown more rapidly than world trade and world output because: firms still fear the threat of protectionism the general shift toward democratic political institutions and free market economies has encouraged FDI the globalization of the world economy is having a positive impact on the volume of FDI as firms undertake FDI to ensure they have a significant presence in many regions of the world

276 Chapter 7: Foreign Direct InvestmentFDI Outflows from 1982 to 2005 are shown in Figure 7.1.

277 Chapter 7: Foreign Direct InvestmentThe Direction of FDI Historically, most FDI has been directed at the developed nations of the world, with the United States being a favorite target FDI inflows have remained high during the early 2000s for the United States, and also for the European Union South, East, and Southeast Asia, and particularly China, are now seeing an increase of FDI inflows Latin America is also emerging as an important region for FDI

278 Chapter 7: Foreign Direct InvestmentFDI Flows by Region are shown in Figure 7.2.

279 Chapter 7: Foreign Direct InvestmentGross fixed capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and the like All else being equal, the greater the capital investment in an economy, the more favorable its future prospects are likely to be So, FDI can be seen as an important source of capital investment and a determinant of the future growth rate of an economy Country Focus: Foreign Direct Investment in China Summary This feature explores investment opportunities in China. In the late 1970s, China opened its doors to foreign investors. By the mid 2000s, China attracted $60 billion of FDI annually. China’s large population is a magnet for many companies and because high tariffs make it difficult to export to the Chinese market, firms frequently turn to foreign direct investment. However, many companies have found it difficult to conduct business in China, and in recent years investment rates have slowed. In response, the Chinese government, hoping to continue to attract foreign companies has established a number of incentives for would-be investors. The following questions can be used in a discussion. 1. Consider the challenges involved with investing in China. How does China’s political position and economic situation affect its ability to attract foreign direct investment? 2. Discuss China’s efforts to encourage investment in its underdeveloped areas. What effect will investment have on these areas? How can firms prepare for the unique challenges of operating in these areas?

280 Chapter 7: Foreign Direct InvestmentThe Source of Foreign Direct Investment For most of the period after World War II, the U.S. was by far the largest source country for FDI Other important source countries were the United Kingdom, the Netherlands, France, Germany, and Japan

281 Chapter 7: Foreign Direct InvestmentThe Form of FDI: Acquisitions versus Greenfield Investments The majority of cross-border investment is in the form of mergers and acquisitions rather than greenfield investments. Firms prefer to acquire existing assets because: mergers and acquisitions are quicker to execute than greenfield investments it is easier and perhaps less risky for a firm to acquire desired assets than build them from the ground up firms believe that they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills

282 Chapter 7: Foreign Direct InvestmentThe Shift to Services Over the last 20 years, there has been a shift away from FDI in extractive industries and manufacturing, and towards services. The shift to services is being driven by: the general move in many developed countries toward services the fact that many services need to be produced where they are consumed a liberalization of policies governing FDI in services the rise of Internet-based global telecommunications networks that have allowed some service enterprises to relocate some of their value creation activities to different nations to take advantage of favorable factor costs

283 Chapter 7: Foreign Direct InvestmentClassroom Performance System Which of the following statements is true? Over the years, there has been a marked decrease in the stock and flow of FDI Over the years, there has been a marked increase in the stock and flow of FDI Over the years, there has been a marked decrease in the stock and an increase in the flow of FDI Over the years, there has been a marked increase in the stock and an decrease in the flow of FDI Classroom Performance System Answer: b

284 Chapter 7: Foreign Direct InvestmentTHEORIES OF FOREIGN DIRECT INVESTMENT Why Foreign Direct Investment? Why do firms prefer FDI to either exporting (producing goods at home and then shipping them to the receiving country for sale) or licensing (granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit that the foreign entity sells)?

285 Chapter 7: Foreign Direct InvestmentLimitations of Exporting The viability of an exporting strategy can be constrained by transportation costs and trade barriers Foreign direct investment may be undertaken as a response to actual or threatened trade barriers such as import tariffs or quotas

286 Chapter 7: Foreign Direct InvestmentLimitations of Licensing Internalization theory suggests that licensing has three major drawbacks as a strategy for exploiting foreign market opportunities: licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability a problem arises with licensing when the firm’s competitive advantage is based not so much on its products as on the management, marketing, and manufacturing capabilities that produce those products

287 Chapter 7: Foreign Direct InvestmentAdvantages of Foreign Direct Investment A firm will favor FDI over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive A firm will favor FDI over licensing when it wishes to maintain control over its technological know-how, or over its operations and business strategy, or when the firm’s capabilities are simply not amenable to licensing

288 Chapter 7: Foreign Direct InvestmentThe Pattern of Foreign Direct Investment Firms in the same industry often undertake foreign direct investment around the same time and tend to direct their investment activities towards certain locations.

289 Chapter 7: Foreign Direct InvestmentStrategic Behavior Knickerbocker looked at the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms) and suggested that FDI flows are a reflection of strategic rivalry between firms in the global marketplace The theory can be extended to embrace the concept of multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries)

290 Chapter 7: Foreign Direct InvestmentThe Product Life Cycle Vernon’s view is that firms undertake FDI at particular stages in the life cycle of a product they have pioneered Firms invest in other advanced countries when local demand in those countries grows large enough to support local production, and then shift production to low-cost developing countries when product standardization and market saturation give rise to price competition and cost pressures Vernon fails to explain why it is profitable for firms to undertake FDI rather than continuing to export from home base, or licensing a foreign firm

291 Chapter 7: Foreign Direct InvestmentThe Eclectic Paradigm John Dunning’s eclectic paradigm argues that in addition to the various factors discussed earlier, location-specific advantages (that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets) and externalities (knowledge spillovers that occur when companies in the same industry locate in the same area) must also be considered when explaining both the rationale for and the direction of foreign direct investment.

292 Chapter 7: Foreign Direct InvestmentClassroom Performance System Advantages that arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets are First mover advantages Location advantages Externalities Proprietary advantages Classroom Performance System Answer: b

293 Chapter 7: Foreign Direct InvestmentPOLITICAL IDEOLOGY AND FOREIGN DIRECT INVESTMENT Ideology toward FDI has ranges from a radical stance that is hostile to all FDI to the non-interventionist principle of free market economies. Between these two extremes is an approach that might be called pragmatic nationalism.

294 Chapter 7: Foreign Direct InvestmentThe Radical View Supporters of the radical view, which traces its roots to Marxist political and economic theory, argue that the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries.

295 Chapter 7: Foreign Direct InvestmentThis position lacked support by the end of the 1980s because of: the collapse of communism in Eastern Europe the poor economic performance of those countries that followed the policy a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth the strong economic performance of developing countries that embraced capitalism rather than ideology

296 Chapter 7: Foreign Direct InvestmentThe Free Market View The free market view argues that international production should be distributed among countries according to the theory of comparative advantage The free market view has been embraced by a number of advanced and developing nations, including the United States, Britain, Chile, and Hong Kong

297 Chapter 7: Foreign Direct InvestmentPragmatic Nationalism The pragmatic nationalist view is that FDI has both benefits, such as inflows of capital, technology, skills and jobs, and costs, such as repatriation of profits to the home country and a negative balance of payments effect According to this view, FDI should be allowed only if the benefits outweigh the costs Shifting Ideology In recent years, there has been a strong shift toward the free market stance creating a surge in FDI Management Focus: DP World and the United States Summary This feature explores the reaction to the bid by DP World, a Dubai-based ports operator, to acquire P&O, a British firm that runs a network of global marine terminals. An acquisition of P&O would give DP World management of six U.S. ports. While the Bush administration claimed the acquisition posed no threat to national security, several prominent U.S. Senators raised concerns about the acquisition. Ultimately, DP World pulled out of the deal, but stated that it would look for alternative ways to enter the U.S. market. The following questions can be used in a discussion. Suggested Discussion Questions 1. Do you agree with the senators who raised concerns about the DP World deal? Why or why not? Would your response be different if DP World were a British firm? 2. DP World has vowed to enter the U.S. market in some other way. Why is the U.S. market so important to DP World? What do you think the response of the government might be to another attempt by DP World?

298 Chapter 7: Foreign Direct InvestmentBENEFITS AND COSTS OF FDI Host Country Benefits The main benefits of inward FDI for a host country are: the resource transfer effect the employment effect the balance of payments effect effects on competition and economic growth

299 Chapter 7: Foreign Direct InvestmentResource-Transfer Effects FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available Employment Effects FDI can bring jobs to a host country that would otherwise not be created there

300 Chapter 7: Foreign Direct InvestmentBalance-of-Payments Effects A country’s balance-of-payments account is a record of a country’s payments to and receipts from other countries. The current account is a record of a country’s export and import of goods and services Governments typically prefer to see a current account surplus than a deficit

301 Chapter 7: Foreign Direct InvestmentFDI can help a country to achieve a current account surplus: if the FDI is a substitute for imports of goods and services if the MNE uses a foreign subsidiary to export goods and services to other countries

302 Chapter 7: Foreign Direct InvestmentEffect on Competition and Economic Growth FDI in the form of greenfield investment increases the level of competition in a market, driving down prices and improving the welfare of consumers Increased competition can lead to increased productivity growth, product and process innovation, and greater economic growth

303 Chapter 7: Foreign Direct InvestmentClassroom Performance System Benefits of FDI include all of the following except The resource transfer effect The employment effect The balance of payments effect National sovereignty and autonomy Classroom Performance System Answer: d

304 Chapter 7: Foreign Direct InvestmentHost Country Costs There are three main costs of inward FDI: the possible adverse effects of FDI on competition within the host nation adverse effects on the balance of payments the perceived loss of national sovereignty and autonomy

305 Chapter 7: Foreign Direct InvestmentAdverse Effects on Competition Host governments worry that the subsidiaries of foreign MNEs operating in their country may have greater economic power than indigenous competitors because they may be part of a larger international organization

306 Chapter 7: Foreign Direct InvestmentAdverse Effects on the Balance of Payments There are two possible adverse effects of FDI on a host country’s balance-of-payments: with the initial capital inflows that come with FDI must be the subsequent outflow of capital as the foreign subsidiary repatriates earnings to its parent country when a foreign subsidiary imports a substantial number of its inputs from abroad, there is a debit on the current account of the host country’s balance of payments

307 Chapter 7: Foreign Direct InvestmentNational Sovereignty and Autonomy Many host governments worry that FDI is accompanied by some loss of economic independence The concern is that key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control

308 Chapter 7: Foreign Direct InvestmentHome Country Benefits The benefits of FDI to the home country include: the effect on the capital account of the home country’s balance of payments from the inward flow of foreign earnings the employment effects that arise from outward FDI the gains from learning valuable skills from foreign markets that can subsequently be transferred back to the home country

309 Chapter 7: Foreign Direct InvestmentHome Country Costs The most important concerns center around the balance-of-payments and employment effects of outward FDI International Trade Theory and FDI International trade theory suggests that home country concerns about the negative economic effects of offshore production (FDI undertaken to serve the home market) may not be valid

310 Chapter 7: Foreign Direct InvestmentGOVERNMENT POLICY INSTRUMENTS AND FDI Home Country Policies Home countries can both encourage and restrict FDI by local firms.

311 Chapter 7: Foreign Direct InvestmentEncouraging Outward FDI Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time

312 Chapter 7: Foreign Direct InvestmentHost Country Policies Host countries adopt policies designed both to restrict and to encourage inward FDI.

313 Chapter 7: Foreign Direct InvestmentEncouraging Inward FDI Governments offer incentives to foreign firms to invest in their countries Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI, and to capture FDI away from other potential host countries

314 Chapter 7: Foreign Direct InvestmentRestricting Inward FDI The most common controls to restrict FDI are ownership restraints and performance requirements. The rationale underlying ownership restraints is twofold: first, foreign firms are often excluded from certain sectors on the grounds of national security or competition second, ownership restraints seem to be based on a belief that local owners can help to maximize the resource transfer and employment benefits of FDI for the host country

315 Chapter 7: Foreign Direct InvestmentInternational Institutions and the Liberalization of FDI Until recently there has been no consistent involvement by multinational institutions in the governing of FDI The formation of the World Trade Organization in 1995 is changing this

316 Chapter 7: Foreign Direct InvestmentIMPLICATIONS FOR MANAGERS The Theory of FDI The location-specific advantages argument associated with John Dunning help explain the direction of FDI Government Policy A host government’s attitude toward FDI is an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment Internet Extra: The World Bank is a great place to start researching a country as a potential destination for FDI. Go to the World Bank site {http://rru.worldbank.org/Themes/ForeignDirectInvestment}and click on Business Environment, then on Foreign Direct Investment. Compare and contrast several countries on various factors to determine the relative merits of countries as host nations for investment.

317 Chapter 7: Foreign Direct InvestmentCRITICAL THINKING AND DISCUSSION QUESTIONS 1. In 2004, inward FDI accounted for some 24 percent of gross capital formation in Ireland, but only 0.6 percent in Japan. What do you think explains this difference in FDI inflows into the two countries? Answer: Gross capital formation summarizes the total amount of capital invested in factories, stores, office buildings, and so on. When capital investment is high, a country has more favorable growth prospects. The difference between the rates of gross capital formation in Ireland and Japan would indicate that FDI is an important source of investment capital and economic growth in Ireland, but not in Japan. There are several reasons for this. Companies may perceive that Ireland is more attractive as a destination for their investments, or that it is easier to establish operation in Ireland than in Japan. Investors may be cautious about Japan because of its reputation for burdensome regulations.

318 Chapter 7: Foreign Direct InvestmentCRITICAL THINKING AND DISCUSSION QUESTIONS 2. Compare and contrast these explanations of horizontal FDI: the market imperfections approach, Vernon’s product life cycle theory, and Knickerbocker’s theory of FDI. Which theory do you think offers the best explanation of the historical pattern of horizontal FDI? Why? Answer: Internalization theory seeks to explain why firms often prefer foreign direct investment to licensing as a strategy for entering foreign markets. According to internationalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities: licensing may result in a firm giving away proprietary technology, licensing does not permit a firm to maintain tight control over its activities, and licensing is not appropriate when a firm’s competitive advantage is based not so much on its products as on the management, marketing, and manufacturing capabilities that produce those products. Vernon’s product life cycle theory argues that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production. They subsequently shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs. Finally, Knickerbocker’s theory of FDI suggests that firms follow their domestic competitors overseas. This theory had been developed with regard to oligopolistic industries. Imitative behavior can take many forms in an oligopoly, including FDI. The second part of this question is designed to stimulate classroom discussion and/or force students to think through these theories and select the one that they feel provides the best explanation for the historic pattern of FDI.

319 Chapter 7: Foreign Direct InvestmentCRITICAL THINKING AND DISCUSSION QUESTIONS 3. Read the opening case on Starbucks, then answer the following questions: Initially Starbucks expanded internationally by licensing its format to foreign operators. It soon became disenchanted with this strategy. Why? Why do you think Starbucks has now elected to expand internationally primarily through local joint ventures, to whom it licenses its format, as opposed to a pure licensing strategy? What are the advantages of a joint venture entry mode for Starbucks over entering through wholly owned subsidiaries? On occasion, Starbucks has chosen a wholly owned subsidiary to control its foreign expansion (e.g. in Britain and Thailand). Why? Which theory of FDI best explains the international expansion strategy adopted by Starbucks? Answer: Starbucks began its international expansion in Japan where it licensed its formula to a joint venture formed with a local company. Starbucks feared that a pure licensing agreement would not provide it with the control it felt was necessary to successfully replicate the look, feel, and experience of an American Starbucks. To help ensure continuity between its American stores, and its Japanese locations, Starbucks transferred American employees to the Japanese stores to help train workers in the Starbucks way. Using joint ventures has allowed Starbucks to share the cost and risk of developing its foreign markets. While a wholly owned subsidiary would give Starbucks complete control, it also implies that Starbucks would incur all of the cost and risk involved. In Britain, Starbucks did acquire an existing coffee chain that was modeled after Starbucks. Because the chain was already successful, some of the risk that would normally be associated with introducing a new concept to a foreign market was eliminated. Starbucks also shifted to a wholly owned operation in Thailand after its joint venture there experienced difficulty raising capital for further expansion. By acquiring the joint venture, Starbucks was able to gain control over the process. Internalization theory suggests that when licensing is difficult, foreign direct investment is appropriate. Starbucks seems to have followed this philosophy.

320 Chapter 7: Foreign Direct InvestmentCRITICAL THINKING AND DISCUSSION QUESTIONS 4. Compare and contrast these explanations of vertical FDI: the strategic behavior approach and the market imperfections approach. Which theory do you think offers the better explanation of the historical pattern of vertical FDI? Why? Answer: The strategic behavior approach suggests that FDI flows reflect strategic rivalry between firms in the global marketplace. According to the theory, firms in oligopolistic industries will be motivated to respond to competitor actions with similar actions of their own. Studies show that in the 1950s and 60s, American firms in oligopolistic industries imitated each other’s FDI. Similarly, FDI undertaken by Japanese firms in the 1980s was imitative. The market imperfections theory tries to explain why the first firm in an oligopoly chooses investment over exporting or licensing. Many economists prefer this approach because it addressed the question of whether FDI is more efficient than exporting or licensing for international expansion.

321 Chapter 7: Foreign Direct InvestmentCRITICAL THINKING AND DISCUSSION QUESTIONS 5. You are the international manager of a US business that has just invented a revolutionary new personal computer that can perform the same functions as PCs, but costs only half as much to manufacture. Your CEO has asked you to decide how to expand into the European Union market. Your options are to export from the United States to license a European firm to manufacture and market the computer in Europe 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. Answer: In considering expansion into the European Union, three options will be considered: FDI, licensing, and export. With export, assuming there are no trade barriers, the key considerations would likely be transport costs and localization. While transport costs may be quite low for a relatively light and high value product like a computer, localization can present some difficulties. Power requirements, keyboards, and preferences in model all vary from country to country. It may be difficult to fully address these localization issues from the United States, but not entirely infeasible. Since there are many computer manufacturers and distributors in Europe, there are likely to be a number of potential licensees. But by signing up licensees, valuable technological information may have to be disclosed, and the competitive advantage lost if the licensees use or disseminate this information. FDI (setting up a wholly owned subsidiary) is clearly the most costly and time consuming approach, but the one that best guarantees that critical knowledge will not be disseminated and that localization can be done effectively. Given the fast pace of change in the personal computer industry, it is difficult to say how long this revolutionary new computer will retain its competitive advantage. If the firm can protect its advantage for a period of time, FDI may pay off and help assure that no technological know-how is lost. If, however, other firms can copy or develop even superior products relatively easily, than licensing, while speeding up knowledge dissemination, may also allow the firm to get the quickest large scale entry into Europe and make as much as it can before the advantage is lost.

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323 Regional Economic Integration8 chapter Regional Economic Integration McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

324 Chapter 8: Regional Economic IntegrationINTRODUCTION Regional economic integration refers to agreements between countries in a geographic region to reduce tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other. While regional trade agreements are designed to promote free trade, there is some concern that the world is moving toward a situation in which a number of regional trade blocks compete against each other.

325 Chapter 8: Regional Economic IntegrationLEVELS OF ECONOMIC INTEGRATION There are five levels of economic integration. In a free trade area all barriers to the trade of goods and services among member countries are removed, but members determine their own trade policies with regard to nonmembers Examples of free trade areas include the European Free Trade Association (between Norway, Iceland, Liechtenstein, and Switzerland), and the North American Free Trade Agreement (between the U.S., Canada, and Mexico)

326 Chapter 8: Regional Economic IntegrationThe different levels of economic integration are shown in Figure 8.1.

327 Chapter 8: Regional Economic IntegrationThe customs union is one step further along the road to full economic and political integration, and eliminates trade barriers between member countries and adopts a common external trade policy The Andean Pact (between Bolivia, Columbia, Ecuador and Peru) is an example of a customs union

328 Chapter 8: Regional Economic IntegrationThe common market has no barriers to trade between member countries, a common external trade policy, and the free movement of the factors of production MERCOSUR (between Brazil, Argentina, Paraguay, and Uruguay) is aiming for common market status

329 Chapter 8: Regional Economic IntegrationAn economic union involves the free flow of products and factors of production between members, the adoption of a common external trade policy, and in addition, a common currency, harmonization of the member countries’ tax rates, and a common monetary and fiscal policy The European Union (EU) is an economic union, although an imperfect one since not all members of the EU have adopted the euro, and differences in tax rates across countries still remain

330 Chapter 8: Regional Economic IntegrationIn a political union, independent states are combined into a single union The EU is headed toward at least partial political union, and the United States is an example of even closer political union

331 Chapter 8: Regional Economic IntegrationClassroom Performance System In a _______, all barriers to the free flow of goods and services between member countries are removed, and a common policy toward nonmembers is established. Free trade area Customs union Common market Economic union Classroom Performance System Answer: b

332 Chapter 8: Regional Economic IntegrationClassroom Performance System The European Union is an example of a(n) Free trade area Customs union Common market Economic union Classroom Performance System Answer: d

333 Chapter 8: Regional Economic IntegrationTHE CASE FOR REGIONAL INTEGRATION The Economic Case for Integration Regional economic integration is an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under international agreements such as the WTO

334 Chapter 8: Regional Economic IntegrationThe Political Case for Integration The political case for integration has two main points: by linking countries together, making them more dependent on each other, and forming a structure where they regularly have to interact, the likelihood of violent conflict and war will decrease by linking countries together, they have greater clout and are politically much stronger in dealing with other nations

335 Chapter 8: Regional Economic IntegrationImpediments to Integration There are two main impediments to integration: while a nation as a whole may benefit from a regional free trade agreement, certain groups may lose concerns over the loss of national sovereignty

336 Chapter 8: Regional Economic IntegrationTHE CASE AGAINST REGIONAL INTEGRATION Regional economic integration only makes sense when the amount of trade it creates exceeds the amount it diverts Trade creation occurs when low cost producers within the free trade area replace high cost domestic producers Trade diversion occurs when higher cost suppliers within the free trade area replace lower cost external suppliers

337 Chapter 8: Regional Economic IntegrationREGIONAL ECONOMIC INTEGRATION IN EUROPE Evolution of the European Union The EU is the result of: the devastation of two world wars on Western Europe and the desire for a lasting peace the desire by the European nations to hold their own on the world’s political and economic stage

338 Chapter 8: Regional Economic IntegrationThe evolution of the European Union is shown in Map 8.1.

339 Chapter 8: Regional Economic IntegrationThe forerunner of the EU was the European Coal and Steel Community, which had the goal of removing barriers to trade in coal, iron, steel, and scrap metal formed in 1951 The European Economic Community was formed in 1957 at the Treaty of Rome with the goal of becoming a common market

340 Chapter 8: Regional Economic IntegrationPolitical Structure of the European Union The five main institutions of the EU are: the European Council (resolves major policy issues and sets policy directions) the European Commission (responsible for implementing aspects of EU law and monitoring member states to ensure they are complying with EU laws) the Council of the European Parliament (the ultimate controlling authority within the EU) the European Parliament (debates legislation proposed by the commission and forwarded to it by the council) the Court of Justice (the supreme appeals court for EU law) Management Focus: The European Commission and Media Industry Mergers Summary This feature explores the efforts of the European Commission to influence the strategies of media companies as they joined forces in Europe. The European Commission, concerned that proposed joint ventures and mergers between companies would negatively affect competition within the industry, demanded that some companies alter their plans to work together, and indeed abandon relationships all together. Discussion of the feature can begin with the following questions. 1. Why did Timer-Warner and EMI agree to drop their proposed joint venture? How did the European Commission convince AOL and Time Warner to change their strategy? 2. In your opinion, were the actions of the European Commission reasonable? Why or why not? Do you feel that the governing bodies of one nation should have the power to restrict the actions of foreign companies?

341 Chapter 8: Regional Economic IntegrationThe Single European Act The Single European Act, adopted by the EU member nations in 1987, committed the EC countries to work toward establishment of a single market by December 31, 1992 The Stimulus for the Single European Act The Single European Act was born out of frustration among EC members that the community was not living up to its promise

342 Chapter 8: Regional Economic IntegrationThe Objectives of the Act frontier controls to remove all frontier controls between EC countries mutual recognition of standards to apply the principle of “mutual recognition,” which is that a standard developed in one EC country should be accepted in another, provided it meets basic requirements in such matters as health and safety public procurement to open procurement to non-national suppliers

343 Chapter 8: Regional Economic Integrationfinancial services to lift barriers to competition in the retail banking and insurance businesses exchange controls to remove all restrictions on foreign exchange transactions between members by the end of 1992 freight transport to abolish restrictions on sabotage, the right of foreign truckers to pick up and deliver goods within another member’s borders, by the end of 1992 supply-side effects should lower the costs of doing business in the EC, but the single-market program is also expected to have more complicated supply-side effects

344 Chapter 8: Regional Economic IntegrationImpact The Single European Act provided the impetus for the restructuring of substantial sections of European industry allowing for faster economic growth than would otherwise have been the case

345 Chapter 8: Regional Economic IntegrationThe Establishment of the Euro The Treaty of Maastricht, signed in 1991, committed the EU to adopt a single currency, the euro, by January 1, 1999 The euro is used by 12 of the 25 member states By adopting the euro, the EU has created the second largest currency zone in the world after that of the U.S. dollar For now, three EU countries, Britain, Denmark and Sweden, are opting out of the euro-zone Euro notes and coins were issued on January 1st, 2002 (in the interim, national currencies circulated, and were worth a defined amount of euros) Country Focus: Creating a Single European Market in Financial Services Summary This feature explores the European Union’s progress towards creating a single financial market. The quest, started in 1999, was to have been completed by 2005, however, progress has been slowed by various factors related to the member countries’ tradition of operating autonomously. So, while 41 measures designed to create a single market are in place, how to enforce the rules is still to be determined. In fact, some experts believe that it will be at least another decade before the benefits of the new rules become apparent. Discussion of this feature can begin with the following questions. 1. What are the benefits of creating a single financial market in the European Union for companies? Does it make sense for consumers? 2. What are the impediments to creating a single financial market in the European Union? What does the potential for this type of market mean for countries like Great Britain that have not joined the euro-zone?

346 Chapter 8: Regional Economic IntegrationBenefits of Euro Businesses and individuals should realize significant savings from having to handle one currency, rather than many The adoption of a common currency will make it easier to compare prices across Europe

347 Chapter 8: Regional Economic IntegrationFaced with lower prices European producers will be forced to look for ways to reduce their production costs in order to maintain their profit margins The introduction of a common currency should give a strong boost to the development of highly liquid pan-European capital market The development of a pan-European euro denominated capital market will increase the range of investment options open both to individuals and institutions

348 Chapter 8: Regional Economic IntegrationCosts of Euro A drawback of a single currency is that national authorities lose control over the monetary policy The Maastricht treaty called for the establishment of an independent European central bank (ECB) with a clear mandate to manage monetary policy so as to ensure price stability Internet Extra: More information about the euro is available at the European Union site {http://ec.europa.eu/economy_finance/euro/our_currency_en.htm}. Go to the site and click on Frequently Asked Questions to see numerous topics about the euro. Then click on Benefits of the euro to see why member countries have made the transition to the euro. Finally click on Use in the World to see which countries have adopted the euro and how it fits into the international monetary system.

349 Chapter 8: Regional Economic IntegrationThe ECB sets interest rates and determines monetary policy across the euro-zone Another drawback of the Euro is that the EU is not an optimal currency area (an area where similarities in the underlying structure if economic activities make it feasible to adopt a single currency and use a single exchange rate as an instrument of macro-economic policy)

350 Chapter 8: Regional Economic IntegrationThe Early Experience Since its establishment January 1, 1999, the euro has had a volatile trading history with the U.S. dollar Initially, the euro fell in value relative to the dollar, but strengthened to a five year high of $1.33 in March 2005

351 Chapter 8: Regional Economic IntegrationEnlargement of the European Union Many countries, particularly from Eastern Europe, have applied for membership in the EU Ten countries joined on May 1, 2004 expanding the EU to 25 states, with population of 450 million people, and a single continental economy with a GDP of €11 trillion Internet Extra: To extend the discussion of the European Union, and explore its historical role and current activities in the global economy, go to {http://europa.eu.int/index-en.htm}. Click on Activities and peruse the menu of options under What the European Union does by Subject to find topics pertaining to your discussion. To learn more about its political structure, click on Institutions and then on the individual parts of the EU’s governing systems.

352 Chapter 8: Regional Economic IntegrationClassroom Performance System The ultimate decision making body of the European Union is the Council of the European Union European Parliament Court of Justice European Commission Classroom Performance System Answer: a

353 Chapter 8: Regional Economic IntegrationREGIONAL ECONOMIC INTEGRATION IN THE AMERICAS Regional economic integration is on the rise in the Americas.

354 Chapter 8: Regional Economic IntegrationRegional economic integration in the Americas is shown in Map 8.2.

355 Chapter 8: Regional Economic IntegrationThe North American Free Trade Agreement (NAFTA) NAFTA’s Contents The free trade agreement between the United States, Canada, and Mexico became law January 1, 1994 NAFTA abolished tariffs on 99 percent of the goods traded between Mexico, Canada, and the United States, removed most barriers on the cross-border flow of services, protects intellectual property rights, removes most restrictions on FDI between the three member countries, allows each country to apply its own environmental standards, provided such standards have a scientific base, establishes two commissions to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored

356 Chapter 8: Regional Economic IntegrationThe Case for NAFTA Proponents of NAFTA have argued that it will provide economic gains to all countries: Mexico will benefit from increased jobs as low cost production moves south, and will attain more rapid economic growth as a result The U.S. and Canada will benefit from the access to a large and increasingly prosperous market and from the lower prices for consumers from goods produced in Mexico In addition, U.S. and Canadian firms with production sites in Mexico will be more competitive on world markets

357 Chapter 8: Regional Economic IntegrationThe Case against NAFTA Opponents of NAFTA argued: that jobs would be lost and wage levels would decline in the U.S. and Canada Mexican workers would emigrate north pollution would increase due to Mexico's more lax standards Mexico would lose its sovereignty

358 Chapter 8: Regional Economic IntegrationNAFTA: The Results so Far Studies of NAFTA’s early impact suggest that both advocates and detractors may have been guilty of exaggeration The agreement has helped to create the background for increased political stability in Mexico

359 Chapter 8: Regional Economic IntegrationEnlargement Several other Latin American countries have indicated their desire to eventually join NAFTA Currently both Canada and the U.S. are adopting a wait and see attitude with regard to most countries

360 Chapter 8: Regional Economic IntegrationClassroom Performance System Studies show that after its first decade, There was a small net gain of jobs in the U.S. Exports from the U.S. failed to grow NAFTA’s overall impact has been significant The U.S., Canada, and Mexico all experienced a decrease in productivity Classroom Performance System Answer: a

361 Chapter 8: Regional Economic IntegrationThe Andean Community The Andean Pact, originally formed in 1969, was based on the EU model By the mid-1980s, the Andean Pact had more or less failed In the late 1980s, Latin American governments began to adopt free market economic policies In 1990, the Andean Pact was re-launched, and now operates as a customs union In 2003, it signed an agreement with MERCOSUR to restart negotiations towards the creation of a free trade area

362 Chapter 8: Regional Economic IntegrationMERCOSUR MERCOSUR originated in 1988 as a free trade pact between Brazil and Argentina In 1990, it was expanded to include Paraguay and Uruguay MERCOSUR has been making progress on reducing trade barriers between member states Given some fairly high tariffs for goods from other countries, it appears that in some industries, MERCOSUR is diverting trade rather than creating trade, and local firms are investing in industries that are not competitive on a worldwide basis

363 Chapter 8: Regional Economic IntegrationCentral American Common Market and CARICOM There are two other trade pacts in the Americas: the Central American Trade Market CARICOM Neither has made much progress yet.

364 Chapter 8: Regional Economic IntegrationFree Trade of the Americas Talks began in April 1998 to establish a FTAA (Free Trade of The Americas) by 2005 If the FTAA is established, it will have major implications for cross-border trade and investment flows within the hemisphere The FTAA would create a free trade area of nearly 800 million people

365 Chapter 8: Regional Economic IntegrationREGIONAL ECONOMIC INTEGRATION ELSEWHERE Association of Southeast Asian Nations Formed in 1967, ASEAN currently includes Brunei, Indonesia, Malaysia, the Philippines, Singapore, Thailand, and, most recently, Vietnam, Myanmar, Laos, and Cambodia The basic objectives of ASEAN are to foster freer trade between member countries and to achieve some cooperation in their industrial policies In 2003, an ASEAN Free trade Area (AFTA) between the six original members of ASEAN came into full effect with a goal of reducing import tariffs among the older members to zero by 2010, and for newer members by 2015

366 Chapter 8: Regional Economic IntegrationAsian Pacific Economic Cooperation (APEC) APEC currently has 21 members including the United States, Japan, and China The stated aim of APEC is to increase multilateral cooperation in view of the economic rise of the Pacific nations and the growing interdependence within the region

367 Chapter 8: Regional Economic IntegrationRegional Trade Blocs in Africa There are nine trade blocs on the African continent, however progress toward the establishment of meaningful trade blocs has been slow

368 Chapter 8: Regional Economic IntegrationIMPLICATIONS FOR MANAGERS Opportunities Markets that were formerly protected from foreign competition are opened The free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes, makes it possible for firms to realize potentially enormous cost economies by centralizing production in those locations where the mix of factor costs and skills is optimal

369 Chapter 8: Regional Economic IntegrationThreats The business environment becomes competitive For non-EU and/or non-North American firms, challenges arise from the likely long-term improvements in the competitive position of many European and North American companies

370 Chapter 8: Regional Economic IntegrationThere is a risk of being shut out of the single market by the creation of a “trade fortress” Firms may be limited in their ability to pursue the strategy of their choice in the EU as the EU continues to increase its role in competition policy and intervene and impose conditions on companies proposing mergers and acquisitions

371 Chapter 8: Regional Economic IntegrationCRITICAL THINKING AND DISCUSSION QUESTIONS 1. NAFTA has produced significant net benefits for the Canadian, Mexican, and U.S. economy. Discuss. Answer: The proponents argue that NAFTA should be viewed as an opportunity to create an enlarged and a more productive base for the U.S., Canada, and Mexico. As low-income jobs move from Canada and the United States to Mexico, the Mexican economy should be strengthened giving Mexico the ability to purchase higher-cost American products. The net effect of the lower income jobs moving to Mexico and Mexico increasing its imports of high quality American goods should be positive for the American economy. In addition, the international competitiveness of United States and Canadian firms that move production to Mexico to take advantage of lower labor costs will be enhanced, enabling them to better compete with Asian and European rivals.

372 Chapter 8: Regional Economic IntegrationCRITICAL THINKING AND DISCUSSION QUESTIONS 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? Answer: The economic case for regional integration is straightforward. As we saw in Chapter 5, unrestricted free trade allows countries to specialize in the production of goods and services that they can produce most efficiently. If this happens as the result of economic integration within a geographic region, the net effect is greater prosperity for the nations of the region. From a more philosophical perspective, regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under international agreements such as the WTO. The political case for integration is also compelling. Linking neighboring economies and making them increasingly dependent on each other creates incentives for political cooperation between neighboring states. Also, the potential for violent conflict between the states is reduced. In addition, by grouping their economies together, the countries can enhance their political weight in the world. Despite the strong economic and political arguments for integration, it has never been easy to achieve (on a meaningful level). There are two main reasons for this. First, although economic integration benefits the majority, it has its costs. While a set of nations as a whole may benefit significantly from a regional free trade agreement, certain groups may loose. The second impediment to integration arises from concerns over national sovereignty.

373 Chapter 8: Regional Economic IntegrationCRITICAL THINKING AND DISCUSSION QUESTIONS 3. What effect is creation of a single market and a single currency within the EU likely to have on competition within the EU? Why? Answer: If the EU is successful in establishing a single market and currency, member countries can expect significant gains from the free flow of trade and investment. This will result from the ability of the countries within the EU to specialize in the production of the product that they manufacture the most efficiently, and the freedom to trade those products with other EU countries without being encumbered by tariffs and other trade barriers. In terms of competition, the competition between European firms will increase. Some of the most inefficient firms may go out of business because they will no longer be protected from other European companies by high tariffs, quotas, or administrative trade barriers. Companies from those countries that have not adopted the euro may find that their costs are higher as they deal with currency exchanges.

374 Chapter 8: Regional Economic IntegrationCRITICAL THINKING AND DISCUSSION QUESTIONS 4. Do you think it is correct for the European Commission to restrict mergers between American companies that do business in Europe? (For example, the European Commission vetoed the proposed merger between WorldCom and Sprint, both U.S. companies, and it carefully reviewed the merger between AOL and TimeWarner, again both U.S. companies.) Answer: This question deals with the delicate issue of just how far a country can extend the reach of its law, and should set the stage for a good debate. While some students will argue that the European Commission is overstepping its boundaries by restricting mergers between American companies doing business in Europe, other students will recognize that the U.S. might act in a similar fashion if American firms were being threatened by foreign companies seeking to merge and operate in the U.S. market.

375 Chapter 8: Regional Economic IntegrationCRITICAL THINKING AND DISCUSSION QUESTIONS 5. How should a U.S. business firm that currently only exports to ASEAN countries respond to the creation of a single market in this regional grouping? Answer: A U.S. business firm that is currently only exporting to ASEAN markets should seriously consider opening a facility somewhere within the region, as the economics of a common market suggest that outsiders can be at a disadvantage to insiders. The opening of borders within a common market has the potential to increase the size of the market for the firm. Of course it is possible, after careful consideration, that exporting may still be the most appropriate means of serving the market in some situations.

376 Chapter 8: Regional Economic IntegrationCRITICAL THINKING AND DISCUSSION QUESTIONS 6. How should a firm that has self-sufficient production facilities to 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? Answer: The creation of the single market means that it may no longer be efficient to operate separate duplicative production facilities in each country. Instead, the facilities should either be linked so that each specializes in the production of only certain items, or several sites should be closed down and production consolidated into the most efficient locations. Existing differences between countries as well as the need to be located near important customers may limit a firm’s ability to fully consolidate or relocate production facilities for production cost reasons. Minimizing production costs are only one of many objectives of firms, as location of production near R&D facilities can be critical for new product development and future economic success. Thus what is most important in location decisions is long run economic success, not just cost minimization.

377 Chapter 8: Regional Economic IntegrationCRITICAL THINKING AND DISCUSSION QUESTIONS 7. After a promising start, in the last few years, MERCOSUR, the major Latin American trade agreement, has faltered and made little progress since What problems are hurting MERCOSUR? What can be done to solve these problems? Answer: MERCOSUR originated in 1988 as a free trade pact between Brazil and Argentina. The pact was expanded in 1990 to include Paraguay and Uruguay with goal of becoming a full free trade area by 1994, and a common market sometime after. While initially considered a success, critics began to question whether the trade diversion effects of MERCOSUR outweighed it trade creation effects. Then, in 1998 member states slipped into a recession and in 1999, Brazil’s financial crisis led to a significant devaluation of its currency creating further turmoil. Finally, in 2001, Argentina beset by economic stresses asked that the customs union be temporarily suspended, effectively ending MERCOSUR’s quest to become a fully functioning customs union. However, in 2003, Brazil’s new president announced his support for a revitalized and expanded MERCOSUR that would be modeled after the EU. Students can check the current status of the agreement online {http://www.sice.oas.org/trade/mrcsr/mrcsrtoc.asp /}.

378 Chapter 8: Regional Economic IntegrationCRITICAL THINKING AND DISCUSSION QUESTIONS 8. Would the establishment of a Free Trade Area of the Americas (FTAA) in 2005 be good for the two most advanced economies of the hemisphere, the United States and Canada? How might the establishment of the FTAA impact the strategy of North American firms? Answer: In 1994, a Free Trade of the Americas (FTAA) was proposed. If the agreement comes about, it would effectively create a free trade area of nearly 800 million people responsible for more than $12 trillion in GDP in However, the U.S., while initially a strong advocate of the agreement, has lessened its support for the FTAA recently. The question of whether the agreement is good for the U.S. and Canada will likely produce a lively debate among students.

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380 The Foreign Exchange Market9 chapter The Foreign Exchange Market McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

381 Chapter 9: The Foreign Exchange MarketINTRODUCTION This chapter: explains how the foreign exchange market works examines the forces that determine exchange rates discusses the degree to which it is possible to predict exchange rate movements maps the implications for international business of exchange rate movements and the foreign exchange market

382 Chapter 9: The Foreign Exchange MarketT he foreign exchange market is a market for converting the currency of one country into that of another country The exchange rate is the rate at which one currency is converted into another

383 Chapter 9: The Foreign Exchange MarketTHE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET The foreign exchange market serves two main functions: to convert the currency of one country into the currency of another to provide some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates)

384 Chapter 9: The Foreign Exchange MarketClassroom Performance System The rate at which one currency is converted into another is the Exchange rate Cross rate Conversion rate Foreign exchange market Classroom Performance System Answer: a

385 Chapter 9: The Foreign Exchange MarketCurrency Conversion International businesses use foreign exchange markets when: the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies they must pay a foreign company for its products or services in its country’s currency they have spare cash that they wish to invest for short terms in money markets they are involved in currency speculation (the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates) Internet Extra: To see real time currency conversions, go to XE.com {http://www.xe.com}. Click on Quick Currency converter, and enter the currencies you want to convert.

386 Chapter 9: The Foreign Exchange MarketInsuring Against Foreign Exchange Risk The foreign exchange market can be used to provide insurance to protect against foreign exchange risk (the possible adverse consequences of unpredictable changes in exchange rates) 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

387 Chapter 9: The Foreign Exchange MarketForward Exchange Rates A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future A forward exchange rate occurs when two parties agree to exchange currency and execute the deal at some specific date in the future Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

388 Chapter 9: The Foreign Exchange MarketCurrency 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 businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk Management Focus: South African Airlines’ Disastrous Currency Hedge Summary This feature examines how the failure to fully insure against foreign exchange rate risk can have severe negative consequences for a firm. In 2002, South African Airlines entered into forward contracts to protect itself against a drop in the South African rand relative to the dollar. The rand had been weak against the dollar for several years and South African Airlines felt this trend was likely to continue. The company ran into trouble when the rand appreciated by almost 30 percent relative to the dollar in 2002 and early Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. What type of exposure was South African Airlines facing in 2002? Why do you think the company failed to adequately protect itself? 2. How should South African Airlines have hedged its foreign exchange exposure? What can other companies learn from the experiences of South African Airlines?

389 Chapter 9: The Foreign Exchange MarketClassroom Performance System The rate at which a foreign exchange dealer converts one currency into another currency on a particular day is the Currency swap rate Forward rate Specific rate Spot rate Classroom Performance System Answer: d

390 Chapter 9: The Foreign Exchange MarketTHE NATURE OF THE FOREIGN EXCHANGE MARKET The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. Two significant features of the market are: it never sleeps high-speed computer linkages between trading centers around the globe have effectively created a single market

391 Chapter 9: The Foreign Exchange MarketIf exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage (the process of buying a currency low and selling it high), and the gap would close The US dollar is often used as a vehicle currency to facilitate the exchange of other currencies Internet Extra: Companies can anticipate how currencies might move by following various economic and political indicators. To explore the effect of these indicators on exchange rates, go to {http://www.fxcmtr.com/education/what-moves-rates.html?engine=exchangerate+rostext2+text&CMP=SFS SF7AAM&keyword=01t031}. Examine the effect of factors such as interest rates and geo-political tensions on exchange rates. What happens to a currency’s value of exchange rates or exports rise, or there is a threat of terrorism? What factors should companies track to better predict what might happen to a currency’s value?

392 Chapter 9: The Foreign Exchange MarketECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION Exchange rates are determined by the demand and supply for different currencies. Three factors impact future exchange rate movements: a country’s price inflation a country’s interest rate market psychology

393 Chapter 9: The Foreign Exchange MarketPrices and Exchange Rates The Law of One Price The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

394 Chapter 9: The Foreign Exchange MarketPurchasing Power Parity PPP theory argues that given relatively efficient markets (markets in which few impediments to international trade and investment exist) the price of a “basket of goods” should be roughly equivalent in each country

395 Chapter 9: The Foreign Exchange MarketMoney Supply and Price Inflation A positive relationship between the inflation rate and the level of money supply exists When the growth in the money supply is greater than the growth in output, inflation will occur PPP suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run

396 Chapter 9: The Foreign Exchange MarketEmpirical Tests of PPP Theory Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes

397 Chapter 9: The Foreign Exchange MarketInterest Rates and Exchange Rates Interest rates also affect exchange rates. The Fisher Effect states that for any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between two countries In other words: (S1 - S2) / S2 x 100 = i $ - i ¥ where i $ and i ¥ are the respective nominal interest rates in two countries (in this case the US 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.

398 Chapter 9: The Foreign Exchange MarketThe International Fisher Effect suggests that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries

399 Chapter 9: The Foreign Exchange MarketInvestor Psychology and Bandwagon Effects Exchange rates can also be affected by investor psychology. The bandwagon effect occurs when expectations on the part of traders can turn into self-fulfilling prophecies, and traders can join the bandwagon and move exchange rates based on group expectations Governmental intervention can prevent the bandwagon from starting, but is not always effective Country Focus: Why Did the Korean Won Collapse? Summary This feature describes South Korea’s 1997 financial crisis. In the space of a few months Korea saw its economy and currency move from prosperity to critical lows. Much of the blame for Korea’s financial collapse can be placed with the country’s chaebol (large industrial conglomerates) that had built up massive debts as they invested in new factories. Speculators, concerned about the chaebol’s ability to repay their debts, began to withdraw money from the Korean Stock and Bond markets fueling a depreciation in the Korean Won. Despite government efforts to halt the fall in the currency, the won fell some 67% relative to the dollar. Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. Discuss investor psychology and bandwagon effects and their role in accelerating Korea’s difficulties. 2. As a CEO of an American company, what or how does Korea’s situation affect your operations? 3. In your opinion, did the Korean government take the right steps to ease the crisis? Explain your response.

400 Chapter 9: The Foreign Exchange MarketSummary Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates So, international businesses should pay attention to countries’ differing monetary growth, inflation, and interest rates

401 Chapter 9: The Foreign Exchange MarketClassroom Performance System All of the following impact future exchange rate movements except A country’s price inflation A country’s interest rate A country’s arbitrage opportunities Market psychology Classroom Performance System Answer: c

402 Chapter 9: The Foreign Exchange MarketEXCHANGE RATE FORECASTING Is it worthwhile for a company to invest in exchange rate forecasting services to aid decision-making? Two schools of thought address this issue: the efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting services

403 Chapter 9: The Foreign Exchange MarketThe Efficient Market School An efficient market is one in which prices reflect all available information Most empirical tests seem to confirm the efficient market hypothesis suggesting that companies should not waste their money on forecasting services

404 Chapter 9: The Foreign Exchange MarketThe Inefficient Market School An inefficient market is one in which prices do not reflect all available information So, in an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates and it may be worthwhile for international businesses to invest in forecasting services

405 Chapter 9: The Foreign Exchange MarketApproaches to Forecasting Fundamental Analysis Forecasters that use fundamental analysis to predict exchange rates draw upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information

406 Chapter 9: The Foreign Exchange MarketTechnical Analysis Forecasters that use technical analysis typically chart trends, and believe that past trends and waves are reasonable predictors of future trends and waves

407 Chapter 9: The Foreign Exchange MarketCURRENCY CONVERTIBILITY Convertibility and Government Policy A currency is freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency A currency is externally convertible when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

408 Chapter 9: The Foreign Exchange MarketFree convertibility is the norm in the world today, although many countries impose some restrictions on the amount of money that can be converted The main reason to limit convertibility is to preserve foreign exchange reserves and prevent capital flight (when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency). When a country’s currency is nonconvertible, firms may turn to countertrade (barter like agreements by which goods and services can be traded for other goods and services) to facilitate international trade

409 Chapter 9: The Foreign Exchange MarketIMPLICATIONS FOR MANAGERS It is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Transaction Exposure Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

410 Chapter 9: The Foreign Exchange MarketTranslation Exposure Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company Management Focus: Translation Exposure at Baxter International Summary This feature describes impact of changing exchange rates for Baxter International, a U.S. producer of medical products. In 2000, Baxter’s CEO predicted that the company would hit earnings and sales targets for 2000, and grow revenues and earning in However, just three months later the company reported that growth would be slower than previously anticipated due to the continuing weakness of the euro against the U.S. dollar. About 27 percent of the company’s earnings came from European sources and the weak euro meant that its revenues would decline significantly. Suggested Discussion Questions 1. Consider the experience of Baxter International in Explain which type(s) of foreign exchange exposure the company faced. How could the company protect itself from the exposure? 2. Why didn’t Baxter International hedge its exposure to the falling euro? 3. As an investor, how do you feel about Baxter’s response to the declining euro? Did the company make the right decisions? How would you have acted differently?

411 Chapter 9: The Foreign Exchange MarketEconomic 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-term effect of changes in exchange rates on future prices, sales, and costs Management Focus: Translation Exposure at Baxter International Summary This feature describes impact of changing exchange rates for Baxter International, a U.S. producer of medical products. In 2000, Baxter’s CEO predicted that the company would hit earnings and sales targets for 2000, and grow revenues and earning in However, just three months later the company reported that growth would be slower than previously anticipated due to the continuing weakness of the euro against the U.S. dollar. About 27 percent of the company’s earnings came from European sources and the weak euro meant that its revenues would decline significantly. Suggested Discussion Questions 1. Consider the experience of Baxter International in Explain which type(s) of foreign exchange exposure the company faced. How could the company protect itself from the exposure? 2. Why didn’t Baxter International hedge its exposure to the falling euro? 3. As an investor, how do you feel about Baxter’s response to the declining euro? Did the company make the right decisions? How would you have acted differently?

412 Chapter 9: The Foreign Exchange MarketReducing Translation and Transaction Exposure Firms can minimize their foreign exchange exposure by: buying forward and using swaps leading and lagging payables and receivables (paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements)

413 Chapter 9: The Foreign Exchange MarketA lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Lead and lag strategies can be difficult to implement.

414 Chapter 9: The Foreign Exchange MarketReducing Economic Exposure The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates Reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce

415 Chapter 9: The Foreign Exchange MarketClassroom Performance System The extent to which income from individual transactions is affected by fluctuations in foreign exchange values is Translation exposure Accounting exposure Transaction exposure Economic exposure Classroom Performance System Answer: c

416 Chapter 9: The Foreign Exchange MarketOther Steps for Managing Foreign Exchange Risk To manage foreign exchange risk: central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand firms should attempt to forecast future exchange rates firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position firms should produce monthly foreign exchange exposure reports

417 Chapter 9: The Foreign Exchange MarketCRITICAL THINKING AND DISCUSSION QUESTIONS 1. The interest rate on South Korean government securities with one-year maturity is 4 percent and the expected inflation rate for the coming year is 2 percent. The US interest rate on government securities with one-year maturity is 7 percent and the expected rate of inflation is 5 percent. The current spot exchange rate for Korea won is $1 = W Forecast the spot exchange rate one year from today. Explain the logic of your answer. Answer: From the Fisher effect, we know that the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book: (S1 - S2)/S2 x 100 = i$ - iWon and substituting 7 for i$, 4 for iWon, and 1200 for S1, yields a value for S2 of $1=W1165.

418 Chapter 9: The Foreign Exchange MarketCRITICAL THINKING AND DISCUSSION QUESTIONS 2. Two countries, Britain and the US produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound. (a) According to PPP theory, what should the $/£ spot exchange rate be? (b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65 in Britain. What should be the one year forward $/£ exchange rate? (c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10 percent, what would you expect current interest rate to be in Britain? Answer: (a) According to PPP, the $/£ rate should be 2.80/3.70, or .76$/£. (b) According to PPP, the $/£ one year forward exchange rate should be 3.10/4.65, or .67$/£. (c) Since the dollar is appreciating relative to the pound, and given the relationship of the international fisher effect, the British must have higher interest rates than the US. Using the formula (S1 - S2)/S2 x 100 = i£ - i$ we can solve the equation for i£, with S1=.76, S2=.67, I$ = 10, yielding a value of 23.4% for the British interest rates.

419 Chapter 9: The Foreign Exchange MarketCRITICAL THINKING AND DISCUSSION QUESTIONS 3. 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% per annum. What should you do? Answer: The simplest solution would be to just wait until December, take the ¥400,000 and convert it at the spot rate at that time, which you assume will be $1=¥100. In this case you would have $4,000 in mid-December. If the current 180 day forward rate is lower than 100¥/$, then it would be preferable since it both locks in the rate at a better level and reduces risk. If the rate is above ¥100/$, then whether you choose to lock in the forward rate or wait and see what the spot does will depend upon your risk aversion. There is a third possibility also. You could borrow money from a bank that you will pay back with the ¥400,000 you will receive (400,000/1.03 = ¥388,350 borrowed), convert this today to US$ (388,350/130 = $2,987), and then invest these dollars in a US account. For this to be preferable to the simplest solution, you would have to be able to make a lot of interest (4, ,987 = $1,013), which would turn out to be an annual rate of 51% ((1,013/4000) * 2). If, however, you could lock in these interest rates, then this method would also reduce any exchange rate risk. What you should do depends upon the interest rates available, the forward rates available, how large a risk you are willing to take, and how certain you feel that the spot rate in December will be ¥100 = $1.

420 Chapter 9: The Foreign Exchange MarketCRITICAL THINKING AND DISCUSSION QUESTIONS 4. You are CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take? Answer: This question deals with the risk faced by businesses related to changes in exchange rates. If the peso depreciates as expected peso relative to the dollar, the dollar value of the company’s Mexican subsidiary would decrease substantially. This would then reduce the total dollar value of the firm’s equity reported in its consolidated balance sheet, raising the apparent leverage of the firm, which could increase the firm’s cost of borrowing and limit its access to the capital market. Most students will suggest that the company explore the use of forward contracts and swaps to protect itself from the currency movement for individual transactions. In addition, the company may want to engage in a lead strategy and collect its foreign receivables early.

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422 The International Monetary System10 chapter The International Monetary System McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

423 Chapter 10: The International Monetary SystemINTRODUCTION The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates. When the foreign exchange market determines the relative value of a currency, a floating system exists When the value of a currency is fixed to a reference country and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate, a pegged exchange rate system exists

424 Chapter 10: The International Monetary SystemA dirty float occurs when the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency Countries that adopt a fixed exchange rate system fix their currencies against each other Prior to the introduction of the euro, some European Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

425 Chapter 10: The International Monetary SystemClassroom Performance System When the foreign exchange market determines the relative value of a currency, a ________ exchange rate system exists. Fixed Floating Pegged Market Classroom Performance System Answer: b

426 Chapter 10: The International Monetary SystemTHE GOLD STANDARD The origin of the gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value. Mechanics of the Gold Standard The practice of pegging currencies to gold and guaranteeing convertibility is known as the gold standard Under the gold standard one U.S. dollar was defined as equivalent to grains of "fine (pure) gold The exchange rate between currencies was based on the gold par value (the amount of a currency needed to purchase one ounce of gold)

427 Chapter 10: The International Monetary SystemThe Strength of the Gold Standard The great strength of the gold standard was that it contained a powerful mechanism for simultaneously achieving balance-of-trade equilibrium (when the income a country’s residents earn from its exports is equal to the money its residents pay for imports) by all countries

428 Chapter 10: The International Monetary SystemThe Period Between the Wars, The gold standard worked fairly well from the 1870s until the start of World War I, Then, in an effort to encourage exports and domestic employment, countries started regularly devaluing their currencies People lost confidence in the system and started to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility

429 Chapter 10: The International Monetary SystemTHE BRETTON WOODS SYSTEM In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. The goal was to build an enduring economic order that would facilitate postwar economic growth. The agreement established two multinational institutions: the International Monetary Fund (IMF) to maintain order in the international monetary system the World Bank to promote general economic development

430 Chapter 10: The International Monetary SystemUnder the new system: the US dollar was the only currency to be convertible to gold, and other currencies would set their exchange rates relative to the dollar devaluations were not to be used for competitive purposes a country could not devalue its currency by more than 10% without IMF approval

431 Chapter 10: The International Monetary SystemThe Role of the IMF The IMF was responsible for executing the main goal of the Bretton Woods agreement, avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility. Internet Extra: The IMF has an interactive web page designed especially for students. Go to {http://www.imf.org}. Click on For Students, then click on EconEd Online. Several interactive activities are available to help students learn more about the IMF and its activities. For example, to see how the IMF evaluates a country, click on The IMF in Action. This interactive exercise allows students to pick an online team to help analyze a member country’s economy.

432 Chapter 10: The International Monetary SystemDiscipline A fixed exchange rate regime imposes discipline in two ways: the need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment a fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation

433 Chapter 10: The International Monetary SystemFlexibility Although monetary discipline was a central objective of the agreement, it was recognized that a rigid policy of fixed exchange rates would be too inflexible The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment

434 Chapter 10: The International Monetary SystemThe Role of the World Bank The official name of the World Bank is the International Bank for Reconstruction and Development (IBRD). 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. a second scheme is overseen by the International Development Agency, an arm of the bank created in 1960 IDA loans go only to the poorest countries

435 Chapter 10: The International Monetary SystemClassroom Performance System The gold standard was a ______ exchange rate system. Fixed Floating Pegged Market Classroom Performance System Answer: b

436 Chapter 10: The International Monetary SystemTHE COLLAPSE OF THE FIXED EXCHANGE RATE SYSTEM U.S. macroeconomic policy decisions from 1965 to 1968 led to the collapse of the exchange rate system established in Bretton Woods. Under Johnson, the U.S. financed huge increases in welfare programs and the Vietnam War by increasing its money supply, leading to significant inflation Speculation that the dollar would have to be devalued relative to most other currencies, as well as underlying economics and some forceful threats by the U.S., forced other countries to increase the value of their currencies relative to the dollar However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point

437 Chapter 10: The International Monetary SystemTHE FLOATING EXCHANGE RATE REGIME The floating exchange rate regime that followed the collapse of Bretton Woods was formalized in January 1976 in Jamaica. The Jamaica Agreement The purpose of the Jamaica meeting was to revise the IMF's Articles of Agreement to reflect the new reality of floating exchange rates. Under the Jamaican agreement: floating rates were declared acceptable gold was abandoned as a reserve asset total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion

438 Chapter 10: The International Monetary SystemExchange Rates since 1973 Since 1973, exchange rates have become more volatile and less predictable in part because of: The oil crisis in 1971 The loss of confidence in the dollar that followed the rise of U.S. inflation in 1977 and 1978 The oil crisis of 1979 The unexpected rise in the dollar between 1980 and 1985 The partial collapse of the European Monetary System in 1992 The 1997 Asian currency crisis

439 Chapter 10: The International Monetary SystemFIXED VERSUS FLOATING EXCHANGE RATES Disappointment with floating rates in recent years has led to renewed debate about the merits of a fixed exchange rate system. The Case for Floating Exchange Rates The case for floating exchange rates has two main elements: monetary policy autonomy automatic trade balance adjustments

440 Chapter 10: The International Monetary SystemClassroom Performance System Floating exchange rates were deemed acceptable under The Bretton Woods Agreement The Gold Standard The Jamaica Agreement The Louvre Accord Classroom Performance System Answer: c

441 Chapter 10: The International Monetary SystemMonetary Policy Autonomy Advocates of a floating exchange rate regime argue that removal of the obligation to maintain exchange rate parity restores monetary control to a government 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

442 Chapter 10: The International Monetary SystemTrade Balance Adjustments Under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime

443 Chapter 10: The International Monetary SystemThe Case for Fixed Exchange Rates The case for fixed exchange rates rests on arguments about monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates. Monetary Discipline The need to maintain a fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates

444 Chapter 10: The International Monetary SystemSpeculation Critics of a floating exchange rate regime also argue that speculation can cause exchange rate fluctuations Uncertainty Speculation adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes Trade Balance Adjustments Advocates of floating exchange rates argue that floating rates help adjust trade imbalances

445 Chapter 10: The International Monetary SystemWho is Right? There is no real agreement as to which system is better We know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work A different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment

446 Chapter 10: The International Monetary SystemEXCHANGE RATE REGIMES IN PRACTICE 19% of IMF members follow a free float policy 26% of IMF members follow a managed float system 22% of IMF members have no legal tender of their own the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

447 Chapter 10: The International Monetary SystemThe exchange rate policies of IMF members are shown in Figure 10.2.

448 Chapter 10: The International Monetary SystemClassroom Performance System The most common exchange rate policy among IMF members today is the Free float Managed float Fixed peg Adjustable peg Classroom Performance System Answer: b

449 Chapter 10: The International Monetary SystemPegged Exchange Rates Under a pegged exchange rate regime a country will peg the value of its currency to that of another major currency Pegged exchange rates are popular among the world’s smaller nations There is some evidence that adopting a pegged exchange rate regime does moderate inflationary pressures in a country

450 Chapter 10: The International Monetary SystemCurrency Boards A country that introduces 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% of the domestic currency issued

451 Chapter 10: The International Monetary SystemCRISIS MANAGEMENT BY THE IMF Many of the original reasons for the IMF's existence have disappeared The IMF has redefined its mission, and now focuses on lending money to countries experiencing financial crises

452 Chapter 10: The International Monetary SystemFinancial Crisis in the Post Bretton Woods Era A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates

453 Chapter 10: The International Monetary SystemA banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt.

454 Chapter 10: The International Monetary SystemMexican Currency Crisis of 1995 The Mexican currency crisis of 1995 was a result of high Mexican debts, and a pegged exchange rate that did not allow for a natural adjustment of prices In order to keep Mexico from defaulting on its debt, a $50 billion aid package was created

455 Chapter 10: The International Monetary SystemThe Asian Crisis The causes of the financial crisis that erupted across Southeast Asia during the fall of 1997 were sown in the previous decade when these countries were experiencing unprecedented growth. The Investment Boom Huge increases in exports helped fuel a boom in commercial and residential property, industrial assets, and infrastructure Often the investments were made on the basis of projections about future demand conditions that were unrealistic and significant excess capacity emerged

456 Chapter 10: The International Monetary SystemExcess Capacity Investments made on the basis of unrealistic projections about future demand conditions created significant excess capacity The Debt Bomb These investments were often supported by dollar-based debts. When inflation and increasing imports put pressure on the currencies, the resulting devaluations led to default on dollar denominated debts Expanding Imports By the mid 1990s, imports were expanding across the region

457 Chapter 10: The International Monetary SystemThe Crisis By mid-1997, it became clear that several key Thai financial institutions were on the verge of default Foreign exchange dealers and hedge funds started to speculate against the Baht, selling it short After struggling to defend the peg, the Thai government abandoned its defense and announced that the Baht would float freely against the dollar

458 Chapter 10: The International Monetary SystemWith its foreign exchange rates depleted, Thailand lacked the foreign currency needed to finance its international trade and service debt commitments, and was in desperate need of the capital the IMF could provide Following the devaluation of the Baht, speculation caused other Asian currencies including the Malaysian Ringgit, the Indonesian Rupaih and the Singapore Dollar to fall These devaluations were mainly driven by similar factors to those that underlay the earlier devaluation of the Baht--excess investment, high borrowings, much of it in dollar denominated debt, and a deteriorating balance of payments position

459 Chapter 10: The International Monetary SystemEvaluating the IMF’s Policy Prescription By 2005, the IMF was committing loans to some 59 countries that were struggling with economic and currency crises All IMF loan packages come with conditions attached, generally a combination of tight macroeconomic policy and tight monetary policy

460 Chapter 10: The International Monetary SystemInappropriate Policies The IMF has been criticized for having a “one-size-fits-all” approach to macroeconomic policy that is inappropriate for many countries Moral Hazard The IMF has also been criticized for exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong)

461 Chapter 10: The International Monetary SystemLack 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 Observations As with many debates about international economics, it is not clear who is right Country Focus: Turkey’s and the IMF Summary This feature explores Turkey’s 18th IMF program. In May 2001, the IMF agreed to lend $8 billion to Turkey to help stabilize its economy and halt a sharp slide in the value of its currency. While initially the Turkish government resisted IMF mandates on economic policy, in 2003, the government passed an austerity budget. By 2005, significant progress had been made and today, the country appears to be on track for recovery, with lower inflation rates, an increase in privatization, and a budget surplus. The following questions can be helpful in directing the discussion: Suggested Discussion Questions 1. What led to Turkey’s financial crisis? What goals did the IMF establish as part of the loan agreement? 2. What are the challenges for a government to deal with a currency crisis like the one that Turkey experienced? 3. Was the IMF successful in Turkey?

462 Chapter 10: The International Monetary SystemIMPLICATIONS FOR MANAGERS Currency Management Companies must recognize that the current system is a managed float system in which government intervention can help drive the foreign exchange market Under the present system, speculative buying and selling of currencies can create volatile movements in exchange rates

463 Chapter 10: The International Monetary SystemBusiness Strategy Exchange rate movements are difficult to predict, yet their movement can have a major impact on the competitive position of businesses One response to the uncertainty that arises from a floating exchange rate regime is to build strategic flexibility Management Focus: Airbus and the Euro Summary This feature describes how Airbus is protecting itself from exchange rate fluctuations. French aircraft maker Airbus prices its planes in dollars. However, because over half the company’s costs are in euros, the company has the potential to see significant fluctuations in its earnings if it does not hedge its foreign exchange exposure. The following questions can help in the discussion of the feature: Suggested Discussion Questions 1. What type of foreign exchange exposure does Airbus face? How can Airbus protect itself from its exposure to changing exchange rates? How does the company’s switch to more U.S. suppliers help the company? 2. Airbus has asked its European based suppliers to start pricing in U.S. dollars. What does Airbus hope to gain by this request? What does it mean for suppliers?

464 Chapter 10: The International Monetary SystemCorporate-Government Relations As major players in the international trade and investment environment, businesses can influence government policy towards the international monetary system

465 Chapter 10: The International Monetary SystemCRITICAL THINKING AND DISCUSSION QUESTIONS 1. Why did the gold standard collapse? Is there a case for returning to some type of gold standard? What is it? Answer: 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 their massive military expenditures by printing money. This resulted in inflation, and by the war's end in 1918, price levels were higher everywhere. Several countries returned to the gold standard after World War I. However, the period that ensued saw so many countries devalue their currencies that it became impossible to be certain how much gold a currency could buy. Instead of holding onto another country's currency, people often tried to exchange it into gold immediately, least the country devalue its currency in the intervening period. This put pressure on the gold reserves of various countries, forcing them to suspend gold convertibility. As a result, by the start of World War II, the gold standard was dead. The great strength of the gold standard was that it contained a powerful mechanism for simultaneously achieving balance-of-trade equilibrium by all countries, as explained in the example provided on pages of the textbook. This strength is the basis for reconsidering the gold standard as a basis for international monetary policy.

466 Chapter 10: The International Monetary SystemCRITICAL THINKING AND DISCUSSION QUESTIONS 2. What opportunities might IMF lending policies to developing nations create for international businesses? What threats might they create? Answer: The IMF lending policies require the recipient countries to implement governmental reforms to stabilize monetary policy and encourage economic growth. One of the principal ways for a developing nation to spur economic growth is to solicit foreign direct investment and to provide a hospitable environment for the foreign investors. These characteristics of IMF lending policies work to the advantage of international businesses that are looking for investment opportunities in developing countries.

467 Chapter 10: The International Monetary SystemCRITICAL THINKING AND DISCUSSION QUESTIONS 3. Do you think the standard IMF policy prescriptions of tight monetary policy and reduced government spending are always appropriate for developing nations experiencing a currency crisis? How might the IMF change its approach? What would the implications be for international businesses? Answer: Critics argue that the tight macroeconomic policies imposed by the IMF in the recent Asian crisis are not well suited to countries that are suffering not from excessive government spending and inflation, but from a private-sector debt crisis with inflationary undertones. Anti-inflationary monetary policies and reductions in government spending usually result in a sharp contraction of demand, at least in the short run. In the longer term, the policies can promote economic growth and expansion of demand, which creates opportunities for international business.

468 Chapter 10: The International Monetary SystemCRITICAL THINKING AND DISCUSSION QUESTIONS 4. Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most important criteria in a choice between the systems? Which system is the more desirable for an international business? Answer: The case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and the lack of connection between the trade balance and exchange rates. In terms of monetary discipline, the need to maintain fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates. In terms of speculation, a fixed exchange rate regime precludes the possibility of speculation. In terms of uncertainty, a fixed rate regime introduces a degree of certainty in the international monetary system by reducing volatility in exchange rates. Finally, in terms of trade balance adjustments, critics question the closeness of the link between the exchange rate and the trade balance. The case for floating exchange rates has two main elements: monetary policy autonomy and automatic trade balance adjustments. In terms of the former, it is argued that a floating exchange rate regime gives countries monetary policy autonomy. Under a fixed rate 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. In terms of the later, under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation. Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country’s currency in the foreign exchange markets will lead to depreciation in its exchange rate. An exchange rate depreciation should correct the trade deficit by making the country’s exports cheaper and its imports more expensive. It is a matter of personal opinion in regard to which system is better for an international business. We do know, however, that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work. Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment.

469 Chapter 10: The International Monetary SystemCRITICAL THINKING AND DISCUSSION QUESTIONS 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? Answer: In theory, a fixed exchange rate system similar to the ERM of the European Monetary System should impose monetary discipline, remove uncertainty, limit speculation, and promote trade and investment among member countries. Therefore, for international businesses, such a system should be positive, and the three countries should see increased trade and investment.

470 Chapter 10: The International Monetary SystemCRITICAL THINKING AND DISCUSSION QUESTIONS 6. Reread the Opening Case, then answer the following questions: a) Why do you think the Chinese government originally pegged the value of the Yuan against the U.S. dollar? What were the benefits of doing this for China? What were the costs? b) Over the last decade, many foreign firms have invested in China and used their Chinese factories to produce goods for export. If the Yuan is allowed to float freely against the U.S. dollar on the foreign exchange markets and appreciates in value, how might this affect the fortunes of those enterprises? c) How might a decision to let the Yuan float freely affect future foreign direct investment flows into China? d) Under what circumstances might a decision to let the Yuan freely destabilize the Chinese economy? What might be the global implications of this be? e) Do you think the U.S. government should push the Chinese to let the Yuan float freely? Why? f) What do you think the Chinese government should do? Let the Yuan float, maintain the peg, or change the peg in some way? Answer: China’s decision to peg its currency to the U.S. dollar provided for a more stable currency for China, the Yuan moved in lockstep with the value of the dollar, a currency that would be far more stable than the Yuan. However, the decision led to a situation that was not popular with the U.S. or other developed nations, as, over the next decade, the Yuan became undervalued by as much as 40 percent. This trend allowed China to increase its exports dramatically, while at the same time making it more difficult for foreign exporters to sell their products to China. Foreign companies manufacturing in China were able to capitalize on the undervalued Yuan, and reap the benefits of “cheap” exports. Recently, after years of rapid economic growth stimulated by exports, and amassing a stockpile of dollars valued at more than $700 billion, China faced significant pressure for currency revaluation. China’s decision to abandon its peg will probably result in some slowdown in its exports, however, some American politicians believe that China needs to reduce its control over the Yuan even further. But, China must be careful how quickly it moves, a sudden shift in its policy could scare investors off. At the moment, China is an attractive investment destination, however a stronger, and a less stable Yuan could change that.

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472 The Strategy of International Business11 chapter The Strategy of International Business McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

473 Chapter 11: The Strategy of International BusinessINTRODUCTION In this chapter, we focus on the firm itself and, in particular, on the actions managers can take to compete more effectively as an international business.

474 Chapter 11: The Strategy of International BusinessSTRATEGY AND THE FIRM A firm’s strategy can be defined as the actions that managers take to attain the goals of the firm. Profitability can be defined as the rate of return the firm makes on its invested capital. Profit growth is the percentage increase in net profits over time.

475 Chapter 11: The Strategy of International BusinessValue Creation The more value customers place on the firm’s products, the higher the price the firm can charge for those products The value created by a firm is measured by the difference between V (the price that the firm can charge for that product given competitive pressures) and C (the costs of producing that product)

476 Chapter 11: The Strategy of International BusinessFirms can increase their profits: by adding value to a product so that customers are willing to pay more for it by lowering the costs There are two basic strategies for improving a firm’s profitability: a differentiation strategy a low cost strategy

477 Chapter 11: The Strategy of International BusinessStrategic Positioning A central tenet of the basic strategy paradigm is that in order to maximize its long run return on invested capital, a firm must: Pick a position on the efficiency frontier that is viable in the sense that there is enough demand to support that choice Configure its internal operations so that they support that position Make sure that the firm has the right organization structure in place to execute its strategy

478 Chapter 11: The Strategy of International BusinessOperations: The Firm as a Value Chain The firm can be thought of a value chain composed of a series of distinct value creation activities, including production, marketing, materials management, R&D, human resources, information systems, and the firm infrastructure These value creation activities can be categorized as primary activities and support activities

479 Chapter 11: The Strategy of International BusinessPrimary Activities The primary activities of a firm have to do with creating the product, marketing and delivering the product to buyers, and providing support and after-sale service to the buyers of the product Support Activities Support activities provide the inputs that allow the primary activities of production and marketing to occur

480 Chapter 11: The Strategy of International BusinessClassroom Performance System All of the following are examples of primary activities except Logistics Marketing and sales Customer service Production Classroom Performance System Answer: a

481 Chapter 11: The Strategy of International BusinessOrganization: The Implementation of Strategy The term organization architecture can be used to refer to the totality of a firm’s organization, including formal organizational structure, control systems and incentives, organizational culture, processes, and people.

482 Chapter 11: The Strategy of International BusinessOrganizational structure refers to: the formal division of the organization into subunits the location of decision-making responsibilities within that structure the establishment of integrating mechanisms to coordinate the activities of subunits including cross functional teams and or pan-regional committees

483 Chapter 11: The Strategy of International BusinessControls are the metrics used to measure the performance of subunits and make judgments about how well managers are running those subunits Incentives are the devices used to reward appropriate managerial behavior Processes are the manner in which decisions are made and work is performed within the organization Organizational culture is the norms and value systems that are shared among the employees of an organization By people we mean not just the employees of the organization, but also the strategy used to recruit, compensate, and retain those individuals and the type of people that they are in terms of their skills, values, and orientation

484 Chapter 11: The Strategy of International BusinessIn Sum: Strategic Fit In sum, for a firm to attain superior performance and earn a high return on capital, its strategy must make sense given market conditions.

485 Chapter 11: The Strategy of International BusinessGLOBAL EXPANSION, PROFITABILITY, AND PROFIT GROWTH Firms that operate internationally are able to: Expand the market for their domestic product offerings by selling those products in international markets Realize location economies by dispersing individual value creation activities to locations around the globe where they can be performed most efficiently and effectively Realize greater cost economies from experience effects by serving an expanded global market from a central location, thereby reducing the costs of value creation Earn a greater return by leveraging any valuable skills developed in foreign operations and transferring them to other entities within the firm’s global network of operations

486 Chapter 11: The Strategy of International BusinessExpanding 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 The success of firms that expand in this manner is based not only on the goods or services they sell, but also on their core competencies (skills within the firm that competitors cannot easily match or imitate) Core competencies enable the firm to reduce the costs of value creation and/or to create perceived value in such a way that premium pricing is possible

487 Chapter 11: The Strategy of International BusinessLocation Economies Firms can benefit by basing each value creation activity 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 as strategy can realize location economies (the economies that arise from performing a value creation activity in the optimal location for that activity, wherever in the world that might be)

488 Chapter 11: The Strategy of International BusinessLocating a value creation activity in the optimal location for that activity can have one of two effects: It can lower the costs of value creation and help the firm to achieve a low cost position It can enable a firm to differentiate its product offering from the offerings of competitors

489 Chapter 11: The Strategy of International BusinessCreating a Global Web By taking advantage of location economies in different parts of the world, multinational firms create a global web of value creation activities Under this strategy, different stages of the value chain are dispersed to those locations around the globe where perceived value is maximized or where the costs of value creation are minimized

490 Chapter 11: The Strategy of International BusinessSome Caveats Introducing transportation costs and trade barriers complicates this picture Political risks must be assessed when making location decisions

491 Chapter 11: The Strategy of International BusinessExperience Effects The experience curve refers to the systematic reductions in production costs that have been observed to occur over the life of a product Learning Effects Learning effects are cost savings that come from learning by doing So, when labor productivity increases, individuals learn the most efficient ways to perform particular tasks, and management learns how to manage the new operation more efficiently

492 Chapter 11: The Strategy of International BusinessEconomies of Scale Economies of scale refers to the reductions in unit cost achieved by producing a large volume of a product. Sources of economies of scale include: the ability to spread fixed costs over a large volume the ability of large firms to employ increasingly specialized equipment or personnel

493 Chapter 11: The Strategy of International BusinessStrategic Significance Moving down the experience curve allows a firm to reduce its cost of creating value Serving a global market from a single location is consistent with moving down the experience curve and establishing a low-cost position

494 Chapter 11: The Strategy of International BusinessLeveraging Subsidiary Skills Managers must recognize that valuable skills that could be applied elsewhere in the firm can arise anywhere within the firm’s global network (not just at the corporate center) Managers must also establish an incentive system that encourages local employees to acquire new skills Summary Managers need to keep in mind the complex relationship between profitability and profit growth when making strategic decisions about pricing

495 Chapter 11: The Strategy of International BusinessClassroom Performance System When different stages of a value chain are dispersed to those locations around the world where value added is maximized or where the costs of value creation are minimized, _____ is (are) created. Experience effects Learning effects Economies of scale A global web Classroom Performance System Answer: d

496 Chapter 11: The Strategy of International BusinessCOST PRESSURES AND PRESSURES FOR LOCAL RESPONSIVENESS Firms that compete in the global marketplace typically face two types of competitive pressures: pressures for cost reductions pressures to be locally responsive These pressures place conflicting demands on the firm.

497 Chapter 11: The Strategy of International BusinessPressures for cost reductions and pressures to be locally responsive are shown in Figure 11.8.

498 Chapter 11: The Strategy of International BusinessPressures for Cost Reductions Pressures for cost reductions are greatest: in industries producing commodity type products that fill universal needs (needs that exist when the tastes and preferences of consumers in different nations are similar if not identical) where price is the main competitive weapon when major competitors are based in low cost locations where there is persistent excess capacity where consumers are powerful and face low switching costs

499 Chapter 11: The Strategy of International BusinessFirms facing pressures for cost reductions: must try to lower the costs of value creation by mass-producing a standard product at the optimal locations worldwide

500 Chapter 11: The Strategy of International BusinessPressures for Local Responsiveness Pressures for local responsiveness arise from: differences in consumer tastes and preferences differences in traditional practices and infrastructure differences in distribution channels host government demands

501 Chapter 11: The Strategy of International BusinessDifferences in Consumer Tastes and Preferences Strong pressures for local responsiveness emerge when consumer tastes and preferences differ significantly between countries Differences in Infrastructure and Traditional Practices Pressures for local responsiveness emerge when there are differences in infrastructure and/or traditional practices between countries

502 Chapter 11: The Strategy of International BusinessDifferences in Distribution Channels A firm's marketing strategies may have to be responsive to differences in distribution channels between countries Host Government Demands Economic and political demands imposed by host country governments may necessitate a degree of local responsiveness

503 Chapter 11: The Strategy of International BusinessClassroom Performance System Pressures for local responsiveness come from all of the following except Excess capacity Host government demands Differences in consumer tastes and preferences Differences in distribution channels Classroom Performance System Answer: a

504 Chapter 11: The Strategy of International BusinessCHOOSING A STRATEGY Firms use four basic strategies to compete in the international environment: global standardization localization transnational international Internet Extra: Cadbury Schweppes has changed its strategy over the years to respond to shifting market and competitive conditions. Go to the company’s web site {http://www.cadburyschweppes.com/EN/} to further explore this and to see real examples of the different strategic approaches outlined in this chapter. Click on Investor Centre, then on Our Business and Values. From this point, you can explore why the company is in its various products lines and what it expects to achieve (click on Origins and Portfolio Development), where the company is today, and why (click on The Business Today), the company’s structure and organization (click on structure and organization), and where the company wants to go in the future (click on 2007 goals and priorities).

505 Chapter 11: The Strategy of International BusinessGlobal Standardization Strategy A global standardization strategy focuses on increasing profitability and profit growth by reaping the cost reductions that come from economies of scale, learning effects, and location economies The strategic goal is to pursue a low-cost strategy on a global scale This strategy makes sense when there are strong pressures for cost reductions and demands for local responsiveness are minimal

506 Chapter 11: The Strategy of International BusinessLocalization Strategy A localization strategy focuses on increasing profitability by customizing the firm’s goods or services so that they provide a good match to tastes and preferences in different national markets Localization is most appropriate when there are substantial differences across nations with regard to consumer tastes and preferences, and where cost pressures are not too intense

507 Chapter 11: The Strategy of International BusinessTransnational Strategy A transnational strategy tries to simultaneously: achieve low costs through location economies, economies of scale, and learning effects differentiate the product offering across geographic markets to account for local differences foster a multidirectional flow of skills between different subsidiaries in the firm’s global network of operations A transnational strategy makes sense when cost pressures are intense, and simultaneously, so are pressures for local responsiveness.

508 Chapter 11: The Strategy of International BusinessInternational Strategy An international strategy involves taking products first produced for the domestic market and then selling them internationally with only minimal local customization When there are low cost pressures and low pressures for local responsiveness, an international strategy is appropriate

509 Chapter 11: The Strategy of International BusinessThe Evolution of Strategy An international strategy may not be viable in the long term To survive, firms may need to shift to a global standardization strategy or a transnational strategy in advance of competitors Similarly, localization may give a firm a competitive edge, but if the firm is simultaneously facing aggressive competitors, the company will also have to reduce its cost structures, and the only way to do that may be to shift toward a transnational strategy Management Focus: The Evolution of Strategy at Procter & Gamble Summary This feature explores the evolution of Procter & Gamble’s global strategy. In 1915, Procter & Gamble opened its first foreign operation in Canada. In the 1950s and 1960s, Procter & Gamble expanded into Western Europe, and then, in the 1970s, into Japan and other parts of Asia. Throughout this expansion, the company maintained all product development at its Cincinnati, Ohio headquarters, while each subsidiary took on the responsibility for manufacturing, marketing, and distributing the products. Procter & Gamble shifted its strategy in the 1990s, closing several foreign locations and moving to a more regional approach to global markets. More recently, the company implemented a business unit approach whereby different units are entirely responsible for generated profits for a product group. Discussion of this feature can begin with the following questions. Suggested Discussion Questions 1. Discuss the evolution of Procter & Gamble’s strategy. Do you think Procter & Gamble was reactive or proactive in its approach to strategy in the late 1990s and early 2000s? 2. What factors have forced Procter & Gamble to change its strategy? As a competitor to Procter & Gamble, what can you learn from the company’s experiences? 3. How would you characterize Procter & Gamble’s current strategy? What challenges do you foresee with the new strategy?

510 Chapter 11: The Strategy of International BusinessClassroom Performance System When pressures are high for local responsiveness, but low for cost reductions, a _______ makes sense. Global standardization strategy International strategy Transnational strategy Localization strategy Classroom Performance System Answer: d

511 Chapter 11: The Strategy of International BusinessSTRATEGIC ALLIANCES Strategic alliances refer to cooperative agreements between potential or actual competitors

512 Chapter 11: The Strategy of International BusinessThe Advantages of Strategic Alliances Strategic alliances: facilitate entry into a foreign market allow firms to share the fixed costs (and associated risks) of developing new products or processes bring together complementary skills and assets that neither partner could easily develop on its own Management Focus: Cisco and Fujitsu Summary This feature examines Cisco Systems’ joint venture with Fujitsu. Cisco, the world’s largest manufacturer of Internet routers, entered the alliance in 2004 in an effort to jointly develop the next generation of high end routers for sales in Japan. Cisco believes that the Japanese market will be important, and wants to expand its presence there. Fujitsu wanted the routers so that it can offer end-to-end communications solutions to its customers. Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. What did Cisco hope to gain by forming an alliance with Fujitsu? What risks are involved for Cisco with this alliance? How can Cisco limit those risks? 2. What did Fujitsu bring to the alliance? Why was it important for Cisco to have a Japanese presence? What were the advantages of the alliance for Fujitsu? 3. What does the alliance between Cisco and Fujitsu mean to other competitors in the router market?

513 Chapter 11: The Strategy of International BusinessThe Disadvantages of Strategic Alliances Strategic alliances can give competitors low-cost routes to new technology and markets, but unless a firm is careful, it can give away more than it receives Management Focus: Cisco and Fujitsu Summary This feature examines Cisco Systems’ joint venture with Fujitsu. Cisco, the world’s largest manufacturer of Internet routers, entered the alliance in 2004 in an effort to jointly develop the next generation of high end routers for sales in Japan. Cisco believes that the Japanese market will be important, and wants to expand its presence there. Fujitsu wanted the routers so that it can offer end-to-end communications solutions to its customers. Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. What did Cisco hope to gain by forming an alliance with Fujitsu? What risks are involved for Cisco with this alliance? How can Cisco limit those risks? 2. What did Fujitsu bring to the alliance? Why was it important for Cisco to have a Japanese presence? What were the advantages of the alliance for Fujitsu? 3. What does the alliance between Cisco and Fujitsu mean to other competitors in the router market?

514 Chapter 11: The Strategy of International BusinessMaking Alliances Work The success of an alliance seems to be a function of three main factors: partner selection alliance structure the manner in which the alliance is managed

515 Chapter 11: The Strategy of International BusinessPartner Selection A good partner has three principal characteristics: a good partner helps the firm achieve its strategic goals and has the capabilities the firm lacks and that it values a good partner shares the firm’s vision for the purpose of the alliance a good partner is unlikely to try to opportunistically exploit the alliance for its own ends: that it, to expropriate the firm’s technological know-how while giving away little in return

516 Chapter 11: The Strategy of International BusinessAlliance Structure Alliances can be designed to make it difficult to transfer technology not meant to be transferred Contractual safeguards can be written into an alliance agreement to guard against the risk of opportunism by a partner Both parties can agree in advance to swap skills and technologies to ensure a chance for equitable gain The risk of opportunism by an alliance partner can be reduced if the firm extracts a significant credible commitment from its partner in advance

517 Chapter 11: The Strategy of International BusinessManaging the Alliance Successfully managing an alliance requires managers from both companies to build interpersonal relationships A major determinant of how much a company gains from an alliance is its ability to learn from its alliance partners

518 Chapter 11: The Strategy of International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 1. In a world of zero transportation costs, no trade barriers, and non-trivial differences between nations with regard to factor endowments, firms must expand internationally if they are to survive. Discuss. Answer: Given differences in countries with respect to factor endowments, the theory of comparative advantage suggests that different activities should take place in the countries that can perform them most efficiently. If there are also no barriers or costs to trade, then it is likely that a lot of industries will be based out of the countries that provide the best set of factor endowments. For a firm that is located in a sub-optimal location, it will either have to expand internationally or switch to a different industry where the factor endowments are in its favor. For firms already located in the countries with the most favorable factor endowments for their industry, however, there may not be a need to expand internationally. Firstly, the firm may be content to simply focus on the domestic market. But if the firm does want to expand internationally, it may be able to do so via licensing or exporting, and need not necessarily undertake FDI. Thus, not only in theory, but also in practice many firms are able to survive quite well without having to expand internationally.

519 Chapter 11: The Strategy of International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 2. Plot the position of the following firms on Figure Procter & Gamble, IBM, Nokia, Coca-Cola, Dow Chemical, US Steel, and McDonald's. In each case justify your answer. Answer: Procter & Gamble would be located in the middle right-hand portion of the graph. This is a position of high pressures for local responsiveness and moderate pressures for cost reductions. P&G sells personal and home care products, which do face pressures for local responsiveness. Although these products are not commodities, there are many competitors in P&G industries, which implies a moderate degree of cost pressures. IBM would be in the upper middle portion of the graph. This is a position of moderate pressure for local responsiveness and high pressure for cost reductions. There is a moderate amount of pressure for local responsiveness for IBM products, due to language differences and differing voltage requirements for electronic products across countries. IBM is in a very competitive industry, and cost pressures are high. Nokia manufactures wireless handsets and infrastructures such as switches. Nokia, because it must customize its product offering according to the technical standards prevailing in a given country would be in the lower right hand side of the graph. Coca-Cola is a commodity type product, and it would be located in the upper left-hand portion of the graph. This is a position of low pressures for local responsiveness and high pressures for cost reductions. Dow Chemical and U.S. Steel would both be located in the upper left-hand portion of the graph. Both Dow and U.S. Steel sell products that are commodity-like by nature. As a result, cost pressures would be high and local responsiveness pressures would be low for these products. Finally, McDonalds would be located in the middle left-hand portion of the graph. Pressures for local responsiveness would be low, and cost reduction pressures would be moderate. McDonalds sells a semi commodity-like product, but not to the same degree as Dow Chemical of U.S. Steel.

520 Chapter 11: The Strategy of International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 3. Re-Read the Management Focus box on Procter & Gamble and then answer the following questions: a) What strategy was Procter & Gamble pursuing when it first entered foreign markets in the period up until the 1980s? b) Why do you think this strategy became less viable in the 1990s? c) What strategy does Procter & Gamble appear to be moving toward? What are the benefits of this strategy? What are the potential risks associated with it? Answer: Procter & Gamble initially expanded internationally when it entered Canada in However, even after expanding into Western Europe and Asia in the 1960s and 1970s, the company sill maintained all product development at its headquarters location in Cincinnati, Ohio. Subsidiary units were responsible for manufacturing, marketing, and distributing the products in their local markets. However, by the 1990s several factors caused Procter & Gamble to reconsider its international strategy. Barriers to low-cost trade were falling rapidly worldwide, and fragmented national markets were merging into larger regional or global markets. In addition, the retailers through which the company distributed its products were growing larger and more global, and were demanding price discounts from Procter & Gamble. The company now appears to be moving towards a transnational strategy in which there are seven self-contained business units, each responsible for the complete generation of profits from its products, and for manufacturing, marketing, and development. A transnational strategy is complex, and the company will have to balance the demands of responding to local market needs for its consumer products, while at the same time reaching its cost savings goals.

521 Chapter 11: The Strategy of International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 4. What do you see as the main organizational problems that are likely to be associated with the implementation of a transnational strategy? Answer: Simultaneously trying to achieve cost efficiencies, global learning, and local responsiveness places difficult and contradictory demands on an organization. Managing these conflicting demands requires the setting of control and motivational policies for people and organizations that force balancing of these demands at multiple levels within firms. The organizational challenges involve managing these inherent conflicts to resolutions that serve the best interests of the firm overall.

522 Chapter 11: The Strategy of International BusinessCRITICAL THINKING AND DISCUSSION QUESTIONS 5. Reread the Management Focus box on the alliance between Cisco and Fujitsu. What are the benefits to Cisco and Fujitsu respectively of the alliance? What are the risks to Cisco? How can Cisco mitigate those risks? Answer: The Cisco-Fujitsu venture was important to both companies as they develop the next generation of routers. The firms will be able to pool their R&D efforts, share complementary technology, and get products to market more quickly. The two companies also believe that the combination of Cisco’s technology together with Fujitsu’s production expertise will enable them to produce more reliable products. In addition, the alliance provides Cisco with access to the Japanese market, a market that it believes will be important in the future, and a more complete product line for Fujitsu. Cisco will have to ensure that it puts proper safeguards in place as it shares its technology with Fujitsu, or risk creating a competitor.

523

524 Entering Foreign Markets12 chapter Entering Foreign Markets McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

525 Chapter 12: Entering Foreign MarketsINTRODUCTION A firm expanding internationally must decide: which markets to enter when to enter them and on what scale how to enter them (the choice of entry mode)

526 Chapter 12: Entering Foreign MarketsThere are several options including: exporting licensing or franchising to host country firms setting up a joint venture with a host country firm setting up a wholly owned subsidiary in the host country to serve that market

527 Chapter 12: Entering Foreign MarketsThe advantages and disadvantages associated with each entry mode is determined by: transport costs and trade barriers political and economic risks firm strategy While it may make sense for some firms to serve a market by exporting, other firms might set up a wholly owned subsidiary, or utilize some other entry mode.

528 Chapter 12: Entering Foreign MarketsBASIC ENTRY DECISIONS There are three basic decisions that a firm contemplating foreign expansion must make: which markets to enter when to enter those markets on what scale

529 Chapter 12: Entering Foreign MarketsWhich Foreign Markets? The choice between different foreign markets is based on an assessment of their long run profit potential. Typically, the most favorable markets are those that are politically stable developed and developing nations that have free market systems, and where there is not a dramatic upsurge in either inflation rates, or private sector debt Those that are less desirable are politically unstable developing nations that operate with a mixed or command economy, or developing nations where speculative financial bubbles have led to excess borrowing Firms are more likely to be successful if they offer a product that has not been widely available in a market and that satisfies an unmet need

530 Chapter 12: Entering Foreign MarketsTiming of Entry With regard to the timing of entry, we say that entry is early when an international business enters a foreign market before other foreign firms, and late when it enters after other international businesses have already established themselves in the market

531 Chapter 12: Entering Foreign MarketsThe advantages associated with entering a market early are called first mover advantages, and include: the ability to pre-empt rivals and capture demand by establishing a strong brand name the ability to build up sales volume in that country and ride down the experience curve ahead of rivals and gain a cost advantage over later entrants the ability to create switching costs that tie customers into their products or services making it difficult for later entrants to win business

532 Chapter 12: Entering Foreign MarketsDisadvantages associated with entering a foreign market before other international businesses are referred to as first mover disadvantages and include: Pioneering costs (costs that an early entrant has to bear that a later entrant can avoid)

533 Chapter 12: Entering Foreign MarketsPioneering costs arise when a business system in a foreign country is so different from that in a firm’s home market that the enterprise has to devote considerable time, effort and expense to learning the rules of the game, and include: the costs of business failure if the firm, due to its ignorance of the foreign environment, makes some major mistakes the costs of promoting and establishing a product offering, including the cost of educating the customers

534 Chapter 12: Entering Foreign MarketsSummary It is important to realize that there are no “right” decisions here, just decisions that are associated with different levels of risk and reward Management Focus: The Jollibee Phenomenon—A Philippine Multinational Summary This feature describes the remarkable success story of Jollibee. Jollibee, a fast food chain from the Philippines, not only stood its ground when McDonald’s invaded its market in 1981, but also managed to find the weaknesses in the larger company’s global strategy and capitalize on them. Jollibee, unlike McDonald’s, tailored its menu to the local market. The company was able to build on this localization strategy as it expanded into neighboring Asian countries and the Middle East. Today, Jollibee has even managed to find success in the U.S. market where it is being hailed as a strong niche player. Suggested Discussion Questions 1. How would Christopher Bartlett and Sumantra Ghoshal view Jollibee’s performance to date? 2. A key difference between McDonald’s global strategy and that of Jollibee is that McDonald’s sees its path to success as offering a fairly standardized menu everywhere whereas Jollibee views localization as its ticket to success. In your opinion, would Jollibee have achieved its current position in the market if the company had standardized its menu like McDonald’s?

535 Chapter 12: Entering Foreign MarketsScale of Entry and Strategic Commitments The consequences of entering a market on a significant scale are associated with the value of the resulting strategic commitments (decisions that have a long term impact and are difficult to reverse) Deciding to enter a foreign market on a significant scale is a major strategic commitment that changes the competitive playing field Small-scale entry has the advantage of allowing a firm to learn about a foreign market while simultaneously limiting the firm’s exposure to that market Management Focus: International Expansion at ING Group Summary This feature describes ING Group’s rapid expansion into the U.S. ING, the third largest bank in the Netherlands, primarily expands through acquisitions. The company is seeking to be one of the top 10 financial services firms in the world. Discussion of the feature can revolve around the following questions: Suggested Discussion Questions 1. What makes ING’s strategy in its quest to become one of the top 10 financial services firms in the world so successful? What does ING’s entry into the U.S. market mean for competitors? 2. How did ING approach the U.S. market? How did the company signal its commitment to the U.S. market? What effect will this commitment have for ING?

536 Chapter 12: Entering Foreign MarketsClassroom Performance System The time and effort in learning the rules of a new market, failure due to ignorance, and the liability of being a foreigner are all examples of First mover advantages Strategic commitments Pioneering costs Market entry costs Classroom Performance System Answer: c

537 Chapter 12: Entering Foreign MarketsENTRY MODES These are six different ways to enter a foreign market. Exporting Most manufacturing firms begin their global expansion as exporters and only later switch to another mode for servicing a foreign market Internet Extra: Developing an export plan is a first step for any company that is preparing to expand internationally via exports. The Business Link offers a great site where companies can get started on the process. Go to the site {http://www.cbsc.org/alberta/tbl.cfm?fn=export}, and click on 10 Steps to Successful Exporting. One of the key elements in a successful strategy is the export plan. Click on Export Plan, and download the file Writing an Export Plan. To better understand the process for companies, go through the plan and sketch out your own business plan.

538 Chapter 12: Entering Foreign MarketsAdvantages Exporting avoids the substantial cost of establishing manufacturing operations in the host country Exporting may also help a firm achieve experience curve location economies

539 Chapter 12: Entering Foreign MarketsDisadvantages There may be lower-cost locations for manufacturing abroad High transport costs can make exporting uneconomical Tariff barriers can make exporting uneconomical Agents in a foreign country may not act in exporter’s best interest

540 Chapter 12: Entering Foreign MarketsTurnkey Projects In a turnkey project, the contractor agrees to handle every detail of the project for a foreign client, including the training of operating personnel At completion of the contract, the foreign client is handed the "key" to a plant that is ready for full operation

541 Chapter 12: Entering Foreign MarketsAdvantages Turnkey projects are a way of earning great economic returns from the know-how required to assemble and run a technologically complex process Turnkey projects make sense in a country where the political and economic environment is such that a longer-term investment might expose the firm to unacceptable political and/or economic risk

542 Chapter 12: Entering Foreign MarketsDisadvantages By definition, the firm that enters into a turnkey deal will have no long-term interest in the foreign country The firm that enters into a turnkey project may create a competitor If the firm's process technology is a source of competitive advantage, then selling this technology through a turnkey project is also selling competitive advantage to potential and/or actual competitors

543 Chapter 12: Entering Foreign MarketsLicensing A licensing agreement is an arrangement whereby a licensor grants the rights to intangible property to another entity (the licensee) for a specified time period, and in return, the licensor receives a royalty fee from the licensee Intangible property includes patents, inventions, formulas, processes, designs, copyrights, and trademarks

544 Chapter 12: Entering Foreign MarketsAdvantages The firm does not have to bear the development costs and risks associated with opening a foreign market The firm avoids barriers to investment It allows a firm with intangible property that might have business applications, but which doesn’t want to develop those applications itself, to capitalize on market opportunities

545 Chapter 12: Entering Foreign MarketsDisadvantages The firm doesn’t have the tight control over manufacturing, marketing, and strategy that is required for realizing experience curve and location economies Licensing limits a firm’s ability to coordinate strategic moves across countries by using profits earned in one country to support competitive attacks in another There is the potential for loss of proprietary (or intangible) technology or property One way of reducing this risk is through the use of cross-licensing agreements where a firm might license intangible property to a foreign partner, but requests that the foreign partner license some of its valuable know-how to the firm in addition to a royalty payment

546 Chapter 12: Entering Foreign MarketsFranchising Franchising is basically a specialized form of licensing in which the franchisor not only sells intangible property to the franchisee, but also insists that the franchisee agree to abide by strict rules as to how it does business

547 Chapter 12: Entering Foreign MarketsAdvantages The firm avoids many costs and risks of opening up a foreign market

548 Chapter 12: Entering Foreign MarketsDisadvantages Franchising may inhibit the firm's ability to take profits out of one country to support competitive attacks in another The geographic distance of the firm from its foreign franchisees can make poor quality difficult for the franchisor to detect

549 Chapter 12: Entering Foreign MarketsJoint Ventures A joint venture is the establishment of a firm that is jointly owned by two or more otherwise independent firms

550 Chapter 12: Entering Foreign MarketsAdvantages A firm can benefit from a local partner's knowledge of the host country's competitive conditions, culture, language, political systems, and business systems The costs and risks of opening a foreign market are shared with the partner Political considerations may make joint ventures the only feasible entry mode

551 Chapter 12: Entering Foreign MarketsDisadvantages A firm risks giving control of its technology to its partner The firm may not have the tight control over subsidiaries that it might need to realize experience curve or location economies Shared ownership can lead to conflicts and battles for control if goals and objectives differ or change over time

552 Chapter 12: Entering Foreign MarketsWholly Owned Subsidiaries In a wholly owned subsidiary, the firm owns 100 percent of the stock. Establishing a wholly owned subsidiary in a foreign market can be done two ways: the firm can set up a new operation in that country the firm can acquire an established firm

553 Chapter 12: Entering Foreign MarketsAdvantages A wholly owned subsidiary reduces the risk of losing control over core competencies A wholly owned subsidiary gives a firm the tight control over operations in different countries that is necessary for engaging in global strategic coordination (i.e., using profits from one country to support competitive attacks in another) A wholly owned subsidiary maybe required if a firm is trying to realize location and experience curve economies

554 Chapter 12: Entering Foreign MarketsDisadvantage Firms bear the full costs and risks of setting up overseas operations

555 Chapter 12: Entering Foreign MarketsClassroom Performance System Most firms begin their foreign expansion with Exporting Joint ventures Licensing or franchising Wholly owned subsidiaries Classroom Performance System Answer: a

556 Chapter 12: Entering Foreign MarketsSELECTING AN ENTRY MODE The optimal choice of entry mode involves trade-offs. Core Competencies and Entry Mode The optimal entry mode depends to some degree on the nature of a firm’s core competencies

557 Chapter 12: Entering Foreign MarketsThe advantages and disadvantages of the various entry modes are shown in Table 12.1.

558 Chapter 12: Entering Foreign MarketsTechnological Know-How A firm with a competitive advantage based on proprietary technological know-how should avoid licensing and joint venture arrangements in order to minimize the risk of losing control over the technology If a firm believes its technological advantage is only transitory, or the firm can establish its technology as the dominant design in the industry, then licensing may be appropriate even if it does involve the loss of know-how

559 Chapter 12: Entering Foreign MarketsManagement Know-How The competitive advantage of many service firms is based upon management know-how The risk of losing control over the management skills to franchisees or joint venture partners is not high, and the benefits from getting greater use of brand names is significant

560 Chapter 12: Entering Foreign MarketsPressures for Cost Reductions and Entry Mode The greater the pressures for cost reductions, the more likely a firm will want to pursue some combination of exporting and wholly owned subsidiaries This will allow it to achieve location and scale economies as well as retain some degree of control over its worldwide product manufacturing and distribution

561 Chapter 12: Entering Foreign MarketsClassroom Performance System A firm that wants the ability to engage in global strategic coordination should choose Franchising Joint ventures Licensing Wholly owned subsidiaries Classroom Performance System Answer: d

562 Chapter 12: Entering Foreign MarketsGREENFIELD VENTURE OR ACQUISITION? Should a firm establish a wholly owned subsidiary in a country by building a subsidiary from the ground up (greenfield strategy), or should it acquire an established enterprise in the target market (acquisition strategy)?

563 Chapter 12: Entering Foreign MarketsPros and Cons of Acquisition Benefits of Acquisitions Acquisitions have three major points in their favor: they are quick to execute acquisitions enable firms to preempt their competitors managers may believe acquisitions are less risky than green-field ventures

564 Chapter 12: Entering Foreign MarketsWhy Do Acquisitions Fail? Acquisitions fail for several reasons: the acquiring firms often overpay for the assets of the acquired firm there may be a clash between the cultures of the acquiring and acquired firm attempts to realize synergies by integrating the operations of the acquired and acquiring entities often run into roadblocks and take much longer than forecast there is inadequate pre-acquisition screening

565 Chapter 12: Entering Foreign MarketsReducing the Risks of Failure Problems can minimized: through careful screening of the firm to be acquired by moving rapidly once the firm is acquired to implement an integration plan

566 Chapter 12: Entering Foreign MarketsPros and Cons of Greenfield Ventures The main advantage of a greenfield venture is that it gives the firm a greater ability to build the kind of subsidiary company that it wants However, greenfield ventures are slower to establish Greenfield ventures are also risky

567 Chapter 12: Entering Foreign MarketsClassroom Performance System Which of the following is not an advantage of acquisitions as compared to greenfield investments? They are quicker to execute Attempts to realize synergies by integrating the operations of the acquired entities can be challenging and take time They enable firms to preempt their competitors They may be less risky Classroom Performance System Answer: b

568 Chapter 12: Entering Foreign MarketsCRITICAL THINKING AND DISCUSSION QUESTIONS 1. Review the Management Focus on ING. ING chose to enter the U.S. financial services market via acquisitions rather than greenfield ventures. What do you think are the advantages to ING of doing this? What might the drawbacks be? Does this strategy make sense? Why? Answer: Most students will probably agree that ING’s strategy of acquiring firms with a strong local presence makes sense. The company maintains the local management team and products, yet sells its own ING products as well. This strategy allows the company to act locally, while building a global name.

569 Chapter 12: Entering Foreign MarketsCRITICAL THINKING AND DISCUSSION QUESTIONS 2. Licensing propriety technology to foreign competitors is the best way to give up a firm's competitive advantage. Discuss. Answer: The statement is basically correct - licensing proprietary technology to foreign competitors does significantly increase the risk of losing the technology. Therefore licensing should generally be avoided in these situations. Yet licensing still may be a good choice in some instances. When a licensing arrangement can be structured in such a way as to reduce the risks of a firm's technological know-how being expropriated by licensees, then licensing may be appropriate. A further example is when a firm perceives its technological advantage as being only transitory, and it considers rapid imitation of its core technology by competitors to be likely. In such a case, the firm might want to license its technology as rapidly as possible to foreign firms in order to gain global acceptance for its technology before imitation occurs. Such a strategy has some advantages. By licensing its technology to competitors, the firm may deter them from developing their own, possibly superior, technology. And by licensing its technology the firm may be able to establish its technology as the dominant design in the industry. In turn, this may ensure a steady stream of royalty payments. Such situations apart, however, the attractions of licensing are probably outweighed by the risks of losing control over technology, and licensing should be avoided

570 Chapter 12: Entering Foreign MarketsCRITICAL THINKING AND DISCUSSION QUESTIONS 3. Discuss how the need for control over foreign operations varies with firms’ strategies and core competencies. What are the implications for the choice of entry mode? Answer: If a firm’s competitive advantage (its core competence) is based on control over proprietary technological know-how, licensing and joint venture arrangements should be avoided if possible so that the risk of losing control over that technology is minimized. For firms with a competitive advantage based on management know-how, the risk of losing control over the management skills to franchisees or joint venture partners is not that great. Consequently, many service firms favor a combination of franchising and subsidiaries to control the franchises within particular countries or regions. The subsidiaries may be wholly owned or joint ventures, but most service firms have found that joint ventures with local partners work best for controlling subsidiaries.

571 Chapter 12: Entering Foreign MarketsCRITICAL THINKING AND DISCUSSION QUESTIONS 4. A small Canadian firm that has developed some valuable new medical products using its unique biotechnology know-how is trying to decide how best to serve the European Community market. Its choices are given below. The cost of investment in manufacturing facilities will be a major one for the Canadian firm, but it is not outside its reach. If these are the firm’s only options, which one would you advise it to choose? Why? Manufacture the product at home and let foreign sales agents handle marketing. Manufacture the products at home but set up a wholly owned subsidiary in Europe to handle marketing. Enter into a strategic alliance with a large European pharmaceutical firm. The product would be manufactured in Europe by a 50/50 joint venture, and marketed by the European firm. Answer: If there were no significant barriers to exporting, then option (iii) would seem unnecessarily risky and expensive. After all, the transportation costs required to ship drugs are small relative to the value of the product. Both options (i) and (ii) would expose the firm to less risk of technological loss, and would allow the firm to maintain much tighter control over the quality and costs of the drug. The only other reason to consider option (iii) would be if an existing pharmaceutical firm could also give it much better access to the market and potentially access to its products and technology, and that this same firm would insist on the 50/50 manufacturing joint venture rather than agreeing to be a foreign sales agent. The choice between (i) and (ii) boils down to a question of which way will be the most effective in attacking the market. If a foreign sales agent can be found that is already quite familiar with the market and who will agree to aggressively market the product, the agent may be able to increase market share more quickly than a wholly owned marketing subsidiary that will take some time to get going. On the other hand, in the long run the firm will learn a great deal more about the market and will likely earn greater profits if sets up its own sales force.

572

573 Exporting, Importing, and Countertrade13 chapter Exporting, Importing, and Countertrade McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

574 Chapter 13: Exporting, Importing, and CountertradeINTRODUCTION Both large and small firms stand to benefit from exporting The volume of export activity in the world economy is increasing as exporting has become easier The decline in trade barriers under the WTO along with regional economic agreements such as the European Union and the North American Free Trade Agreement have increased export opportunities Firms wishing to export must identify export opportunities, avoid a host of unanticipated problems that are often associated with doing business in a foreign market, become familiar with the mechanics of export and import financing , learn where to get financing and export credit insurance, and learn how to deal with foreign exchange risk Internet Extra: Exporting is often the first step in a company’s international expansion. Some companies may feel that while opportunities for exporting exist, they are not ready to begin the process themselves. Export. Gov {http://www.export.gov/exportbasics/exp_ asp} offers a site where companies can explore their export readiness. Go to the site and click on Are You Export Ready. This will bring you to an online quiz where you can see some of the questions a firm should answer prior to beginning the export process. Take the quiz using either an imaginary company as your basis, or a company that you are familiar with. What do your results tell you? How might you help your company be a successful exporter?

575 Chapter 13: Exporting, Importing, and CountertradeTHE PROMISE AND PITFALLS OF EXPORTING The potential benefits from exporting can be great--the rest of the world is a much larger market than the domestic market Larger firms may be proactive in seeking out new export opportunities, but many smaller firms are reactive and only pursue international opportunities when the customer calls or knocks on the door Many novice exporters have run into significant problems when first trying to do business abroad, souring them on following up on subsequent opportunities

576 Chapter 13: Exporting, Importing, and CountertradeCommon pitfalls include: poor market analysis poor understanding of competitive conditions lack of customization for local markets, poor distribution arrangements, bad promotional campaigns a general underestimation of the differences and expertise required for foreign market penetration The tremendous paperwork and formalities that must be dealt with can be also be overwhelming for exporters.

577 Chapter 13: Exporting, Importing, and CountertradeIMPROVING EXPORT PERFORMANCE An International Comparison One big impediment to exporting is the simple lack of knowledge of the opportunities available The way to overcome ignorance is to collect information Both Germany and Japan have developed extensive institutional structures or promoting exports Japanese exporters can also take advantage of the knowledge and contacts of sogo shosha, the country’s great trading houses

578 Chapter 13: Exporting, Importing, and CountertradeInformation Sources The most comprehensive source of information for U.S. firms to increase their awareness of export opportunities is the U.S. Department of Commerce

579 Chapter 13: Exporting, Importing, and CountertradeUtilizing Export Management Companies Export management companies are export specialists that act as the export marketing department or international department for client firms. EMCs normally accept two types of export assignments: they start exporting operations for a firm with the understanding that the firm will take over operations after they are well established they start services with the understanding that the EMC will have continuing responsibility for selling the firm’s products The advantage of EMCs is that they are experienced specialists who can help the neophyte exporter identify opportunities and avoid common pitfalls However, there is a large variation in the quality of EMCs, so a careful review of a number of companies should be conducted Management Focus: Exporting with a Little Government Help Summary This feature describes the challenges faced by small firms as they seek to expand their sales through exports. The case notes that there are a number of agencies, institutions, and export management companies that provide assistance to small exporters. The following questions can be helpful in directing the discussion. Suggested Discussion Questions 1. Foreign market expansion can be a daunting prospect, especially for a small company with no international experience. Discuss how Novi, Inc became such a success story in such a short time. What lessons can other companies learn from Novi’s experiences? 2. As a small business owner facing saturated domestic markets, how would you approach foreign markets? Develop a strategic plan outlining how you would research markets, get your product to potential customers, handle the financing side of the business, and grow your sales. Include information on what resources are available to help with this process.

580 Chapter 13: Exporting, Importing, and CountertradeExport Strategy Firms can reduce the risks associated with exporting if they are careful about their choice of exporting strategy. It helps to hire an EMC, or at least an experienced export consultant, to help with the identification of opportunities and navigate through the tangled web of paperwork and regulations so often involved in exporting It often makes sense to initially focus on one, or a few, markets It may make sense to enter a foreign market on a fairly small scale in order to reduce the costs of any subsequent failures Management Focus: Exporting Strategy at 3M Summary This feature explores the Minnesota Mining and Manufacturing Company’s (3M) export strategy. 3M generates more than half its revenues from outside the U.S. The company often uses exports to establish an initial presence in a foreign market, only building foreign production facilities once sales volume rises to a level where local production is justified. Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. Discuss why 3M initially enters on a small scale. How does the firm’s strategy fit with the philosophy that exporting is not an end in itself, but merely a step on the road toward establishment of foreign production? 2. Explain the three principles that make 3M so successful. Why was it important for 3M to hire local personnel?

581 Chapter 13: Exporting, Importing, and CountertradeThe exporter needs to recognize the time and managerial commitment involved in building export sales, and should hire additional personnel to oversee this activity In many countries it is important to devote a lot of attention to building strong and enduring relationships with local distributors and customers It is important to hire local personnel to help the firm establish itself in a foreign market It is important for the exporter to keep the option of local production in mind Management Focus: Red Spot Paint Varnish Summary This feature focuses on Red Spot paint Varnish, a company that produces paints for plastic components used in automobiles. The company relies on foreign markets for some 15-25% of its annual revenue. Generating its foreign sales has not been an easy task according to one employee. The company has found it difficult to hire managers with appropriate international experience and has also struggled with pressures to achieve quick results. The following questions provide a starting point for discussion of this feature. Suggested Discussion Questions 1. How has the Internet made it easier for companies to not only get export assistance but also to find the experienced talent necessary to build an international staff? How has Red Spot Paint been able to capitalize on foreign market opportunities while similar competitors have not? 2. In an era of “time is money,” how can the trusting relationships that are so often critical to the success of a foreign venture be achieved? How important was the establishment of trust between Red Spot Paint and its local distributors and customers to the success of the company?

582 Chapter 13: Exporting, Importing, and CountertradeEXPORT AND IMPORT FINANCING Mechanisms for financing exports and imports have evolved over the centuries in response to a problem that can be particularly acute in international trade: the lack of trust that exists when one must put faith in a stranger.

583 Chapter 13: Exporting, Importing, and CountertradeLack of Trust Firms engaged in international trade have to trust someone who may be very difficult to track down if they default on an obligation Due to the lack of trust, each party to an international transaction has a different set of preferences regarding the configuration of the transaction The problems arising from a lack of trust between exporters and importers can be solved by using a third party who is trusted by both - normally a reputable bank

584 Chapter 13: Exporting, Importing, and CountertradeLetter of Credit A letter of credit is issued by a bank at the request of an importer and states the bank will pay a specified sum of money to a beneficiary, normally the exporter, on presentation of particular, specified documents

585 Chapter 13: Exporting, Importing, and CountertradeDraft A draft, also called a bill of exchange, is the instrument normally used in international commerce for payment A draft is simply an order written by an exporter instructing an importer, or an importer's agent, to pay a specified amount of money at a specified time A sight draft is payable on presentation to the drawee while a time draft allows for a delay in payment - normally 30, 60, 90, or 120 days

586 Chapter 13: Exporting, Importing, and CountertradeBill of Lading The bill of lading is issued to the exporter by the common carrier transporting the merchandise. It serves three purposes: it is a receipt it is a contract it is a document of title

587 Chapter 13: Exporting, Importing, and CountertradeClassroom Performance System An order written by an exporter instructing an importer to pay a specified amount of money at a specified time is A letter of credit A draft A bill of lading A confirmed letter of credit Classroom Performance System Answer: b

588 Chapter 13: Exporting, Importing, and CountertradeA Typical International Transaction The entire process for conducting an export transaction is summarized in Figure 13.4.

589 Chapter 13: Exporting, Importing, and CountertradeClassroom Performance System A bill of lading serves all of the following purposes except It is a receipt It is a contract It is a document of title It is a form of payment Classroom Performance System Answer: d

590 Chapter 13: Exporting, Importing, and CountertradeEXPORT ASSISTANCE Prospective U.S. exporters can draw on two forms of government-backed assistance to help their export programs: they can get financing aid from the Export-Import Bank they can get export credit insurance from the Foreign Credit Insurance Association

591 Chapter 13: Exporting, Importing, and CountertradeExport-Import Bank The Export-Import Bank (Eximbank) is an independent agency of the U.S. government Its mission is to provide financing aid that will facilitate exports, imports, and the exchange of commodities between the U.S. and other countries Export Credit Insurance In the U.S., export credit insurance is provided by the Foreign Credit Insurance Association (FICA) FICA provides coverage against commercial risks and political risks

592 Chapter 13: Exporting, Importing, and CountertradeCountertrade is an alternative means of structuring an international sale when conventional means of payment are difficult, costly, or nonexistent Countertrade refers to a range of barterlike agreements that facilitate the trade of goods and services for other goods and services when they cannot be traded for money

593 Chapter 13: Exporting, Importing, and CountertradeThe Incidence of Countertrade Countertrade arose in the 1960s as a way for the Soviet Union and the Communist states of Eastern Europe, whose currencies were generally nonconvertible, to purchase imports During the 1980s, the technique grew in popularity among many developing nations that lacked the foreign exchange reserves required to purchase necessary imports There was a notable increase in the volume of countertrade after the Asian financial crisis of 1997

594 Chapter 13: Exporting, Importing, and CountertradeTypes of Countertrade Countertrade can be categorized into five distinct types of trading arrangements: barter counterpurchase offset switch trading compensation or buyback

595 Chapter 13: Exporting, Importing, and CountertradeBarter Barter is a direct exchange of goods and/or services between two parties without a cash transaction Barter is the most restrictive countertrade arrangement It is used primarily for one-time-only deals in transactions with trading partners who are not creditworthy or trustworthy Counterpurchase Counterpurchase is a reciprocal buying agreement It occurs when a firm agrees to purchase a certain amount of materials back from a country to which a sale is made

596 Chapter 13: Exporting, Importing, and CountertradeOffset Offset is similar to counterpurchase insofar as one party agrees to purchase goods and services with a specified percentage of the proceeds from the original sale The difference is that this party can fulfill the obligation with any firm in the country to which the sale is being made

597 Chapter 13: Exporting, Importing, and CountertradeSwitch Trading Switch trading refers to the use of a specialized third-party trading house in a countertrade arrangement When a firm enters a counterpurchase or offset agreement with a country, it often ends up with what are called counterpurchase credits, which can be used to purchase goods from that country Switch trading occurs when a third-party trading house buys the firm’s counterpurchase credits and sells them to another firm that can better use them

598 Chapter 13: Exporting, Importing, and CountertradeCompensation or Buybacks A buyback occurs when a firm builds a plant in a country—or supplies technology, equipment, training, or other services to the country—and agrees to take a certain percentage of the plant’s output as a partial payment for the contract

599 Chapter 13: Exporting, Importing, and CountertradeClassroom Performance System The use of a specialized third-party trading house in a countertrade arrangement is called Buyback Offset Counterpurchase Switch trading Classroom Performance System Answer: d

600 Chapter 13: Exporting, Importing, and CountertradeThe Pros and Cons of Countertrade Countertrade’s main advantage is that it can give a firm a way to finance an export deal when other means are not available If a firm is unwilling to enter a countertrade agreement, it may lose an export opportunity to a competitor that is willing to make a countertrade agreement A countertrade arrangement may be required by the government of a country to which a firm is exporting goods or services

601 Chapter 13: Exporting, Importing, and CountertradeThe drawbacks of countertrade are substantial: countertrade contracts may involve the exchange of unusable or poor-quality goods that the firm cannot dispose of profitably countertrade is most attractive to large, diverse multinational enterprises that can use their worldwide network of contacts to dispose of goods acquired in countertrading

602 Chapter 13: Exporting, Importing, and CountertradeClassroom Performance System Which of the following is not an advantage of countertrade? It may involve the exchange of unusable or poor-quality goods that the firm cannot dispose of profitably It can give a firm a way to finance an export deal when other means are not available It can be a strategic marketing weapon It can give a firm an advantage over firms that are unwilling to engage in countertrade arrangements Classroom Performance System Answer: a

603 Chapter 13: Exporting, Importing, and CountertradeCRITICAL THINKING AND DISCUSSION QUESTIONS 1. A firm based in Washington State wants to export a shipload of finished lumber to the Philippines. The would-be importer cannot get sufficient credit from domestic sources to pay for the shipment but insists that the finished lumber can be quickly resold in the Philippines for a profit. Outline the steps the exporter should take to effect this export to the Philippines. Answer: The exporter should recommend to the importer that the importer apply to Eximbank for a loan. Eximbank has a direct lending operation under which it lends dollars to foreign borrowers for use in purchasing U.S. exports. The foreign borrowers use the loans to pay U.S. suppliers and repay the loan to Eximbank with interest.

604 Chapter 13: Exporting, Importing, and CountertradeCRITICAL THINKING AND DISCUSSION QUESTIONS 2. You are the assistant to the CEO of a small textile firm that manufactures high-quality, premium-priced, stylish clothing. The CEO has decided to see what the opportunities are for exporting and has asked you for advice as to the steps the company should take. What advice would you give the CEO? Answer: This question is designed to stimulate classroom discussion and/or to encourage your students to “think” about the export process in completing a written answer for this question. There are a number of approaches that can be pursued in answering this question. The first step might be to tap into some of the government information sources that are available, free of charge, to see if international markets are available for the company’s product. There are also a number of resources on the Internet, mentioned throughout the text that can assist companies in learning about the foreign market potential of their products. Another approach would be to contact an export management company for assistance. While this approach may involve some cost, it may be the fastest way to get “up and running” in regard to initiating an export program.

605 Chapter 13: Exporting, Importing, and CountertradeCRITICAL THINKING AND DISCUSSION QUESTIONS 3. An alternative to using a letter of credit is export credit insurance. What are the advantages and disadvantages of using export credit insurance rather than a letter of credit for exporting (a) a luxury yacht from California to Canada, and (b) machine tools from New York to the Ukraine? Answer: Exporters prefer to get letters of credit from importers. However, when the importer is in a strong bargaining position and able to play competing suppliers off against each other, an exporter may have to forgo a letter of credit. The lack of a letter of credit exposes the exporter to the risk that the foreign importer will default on payment. The exporter can insure against this possibility by buying export credit insurance. Students may suggest that in the case of the luxury yacht, should the importer fail to make payment, the clearly defined laws of Canada would make it easier to go after the importer than would be the case with the machine tools in the Ukraine, and that therefore a letter of credit is less important for the yacht exporter. On the other hand, students may note that there is probably more competition in machine tools as compared to luxury yachts and that the exporter of machine tools may lose the sale if the exporter insists on a letter of credit.

606 Chapter 13: Exporting, Importing, and CountertradeCRITICAL THINKING AND DISCUSSION QUESTIONS 4. How do you explain the popularity of countertrade? Under what scenarios might its popularity increase still further by the year 2010? Under what scenarios might its popularity decline? Answer: This question requires students to speculate on the future state of global trade. As trade between developing and developed countries, and trade among developing countries continues to grow, many students will predict that the popularity of countertrade will increase by the year Some students may predict a decline in the popularity of countertrade by 2010 as countries from the former Soviet Union and Eastern European Communist bloc either become members of the EU an adopt the fully convertible euro as their currency, or develop their own fully convertible currency.

607 Chapter 13: Exporting, Importing, and CountertradeCRITICAL THINKING AND DISCUSSION QUESTIONS 5. How might a company make strategic use of countertrade schemes as a marketing weapon to generate export sales revenues? What are the risks associated with pursuing such a strategy? Answer: Counterrtrade is an alternative means of structuring an international sale when conventional means of payment are difficult, costly, or nonexistent. The governments of developing countries sometimes insist on a certain amount of countertrade. Thus, if a firm is unwilling to enter a countertrade agreement, it may lose an export opportunity to a competitor that is willing to make a countertrade agreement. Companies that are willing to entertain countertrade as a means of financing, will have an advantage over those firms that prefer traditional forms of financing. Firms engaging in countertrade must be willing to invest in an in-house trading department dedicated to arranging and managing countertrade deals, and must be aware of the quality of the products received in countertrade deals.

608

609 Global Production, Outsourcing, and Logistics14 chapter Global Production, Outsourcing, and Logistics McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

610 Chapter 14: Global Production, Outsourcing, and LogisticsINTRODUCTION Where in the world should productive activities be located? What should be the long-term strategic role of foreign production sites? Should the firm own foreign production activities, or is it better to outsource those activities to independent vendors? How should a globally dispersed supply chain be managed, and what is the role of Internet-based information technology in the management of global logistics? Should the firm manage global logistics itself, or should it outsource the management to enterprises that specialize in this activity?

611 Chapter 14: Global Production, Outsourcing, and LogisticsSTRATEGY, PRODUCTION, AND LOGISTICS How can production and logistics be conducted internationally to: lower the costs of value creation add value by better serving customer needs Production refers to activities involved in creating a product. Logistics refers to the procurement and physical transmission of material through the supply chain, from suppliers to customers.

612 Chapter 14: Global Production, Outsourcing, and LogisticsThe objectives of the production and logistics function are to lower costs and increase product quality by eliminating defective products from both the supply chain and the manufacturing process These two objectives are interrelated

613 Chapter 14: Global Production, Outsourcing, and LogisticsThere are three ways in which improved quality control reduces costs: productivity increases because time is not wasted manufacturing poor quality products that cannot be sold increased product quality means lower re-work and scrap costs greater product quality means lower warranty and re-work costs

614 Chapter 14: Global Production, Outsourcing, and LogisticsThe main management technique that companies are utilizing to boost their product quality is the Six Sigma program which aims to reduce defects, boost productivity, eliminate waste, and cut costs throughout a company Six Sigma, a direct descendant of total quality management (TQM), has a goal of improving product quality Some countries have also promoted specific quality guidelines The European Union requires that the quality of a firm’s manufacturing processes and products be certified under a quality standard known as ISO 9000 before the firm is allowed access to the European marketplace

615 Chapter 14: Global Production, Outsourcing, and LogisticsTwo other objectives are important for international companies: production and logistics functions must be able to accommodate demands for local responsiveness production and logistics must be able to respond quickly to shifts in customer demand

616 Chapter 14: Global Production, Outsourcing, and LogisticsWHERE TO PRODUCE There are three factors that should be when making a location decision: country factors technological factors product factors Internet Extra: The World Factbook offers very detailed guides on countries and is a great starting place to explore the relative merits of different countries as investment destinations. Create a fictitious product and market. Then go to the site {https://www.cia.gov/cia/publications/factbook/index.html}. Click on the countries you are interested in exploring. Then identify various relevant factors such as government or transportation. Develop a ranking system to help you identify the best location to produce your product.

617 Chapter 14: Global Production, Outsourcing, and LogisticsCountry Factors Country factors suggest that a firm should locate it various manufacturing activities in those locations where economic, political, and cultural conditions, including relative factor costs, are most conducive to the performance of that activity Regulations affecting FDI and trade can significantly affect the appropriateness of specific countries, as can expectations about future exchange rate changes Management Focus: Philips in China Summary This feature describes Philips NV’s operations in China. Philips, the Dutch consumer electronics, lighting, semiconductor, and medical equipment conglomerate, has been operating factories in China since By 2002, the company had invested $2.5 billion in China and operated 23 factories there. Initially, Philips believed that it would sell a large portion of its output to the local Chinese market. However, the company quickly discovered that the low wages that make China such an attractive production location also meant that the market for its products was smaller than anticipated. Philips’ solution was to export most of its output to the United States and elsewhere. Suggested Discussion Questions 1. What makes China such an attractive production location for Philips? Are there other locations that share the same characteristics? 2. Philips wants to eventually turn China into a global supply base from which its products will be exported around the world. Consider the advantages and disadvantages of this strategy.

618 Chapter 14: Global Production, Outsourcing, and LogisticsTechnological Factors The type of technology a firm uses in its manufacturing can affect location decisions. Three characteristics of a manufacturing technology are of interest: the level of fixed costs its minimum efficient scale its flexibility

619 Chapter 14: Global Production, Outsourcing, and LogisticsFixed Costs In some cases the fixed costs of setting up a manufacturing plant are so high that a firm must serve the world market from a single location or from a very few locations

620 Chapter 14: Global Production, Outsourcing, and LogisticsMinimum Efficient Scale The larger the minimum efficient scale (the level of output at which most plant-level scale economies are exhausted) of a plant, the more likely centralized production in a single location or a limited number of locations makes sense

621 Chapter 14: Global Production, Outsourcing, and LogisticsFlexible Manufacturing and Mass Customization The term flexible manufacturing technology or lean production covers a range of manufacturing technologies that are designed to: reduce set up times for complex equipment increase the utilization of individual machines through better scheduling improve quality control at all stages of the manufacturing process

622 Chapter 14: Global Production, Outsourcing, and LogisticsFlexible manufacturing technologies allow a company to produce a wide variety of end products at a unit cost that at one time could only be achieved through the mass production of a standardized output Mass customization implies that a firm may be able to customize its product range to suit the needs of different customer groups without bearing a cost penalty

623 Chapter 14: Global Production, Outsourcing, and LogisticsFlexible machine cells (grouping of various types of machinery, a common materials handler, and a centralized cell controller) are another common flexible manufacturing technology Adopting flexible manufacturing technologies can help improve the competitive position of firms by allowing the firm to customize products to different national markets in accordance with demands for local responsiveness

624 Chapter 14: Global Production, Outsourcing, and LogisticsSummary Concentrating production at a few choice locations makes sense when: fixed costs are substantial the minimum efficient scale of production is high flexible manufacturing technologies are available Concentrating production at a few choice locations is not as compelling when: both fixed costs and the minimum efficient scale of production are relatively low appropriate flexible manufacturing technologies are not available

625 Chapter 14: Global Production, Outsourcing, and LogisticsProduct Factors Two product factors impact location decisions: the product's value-to-weight ratio If the value-to-weight ratio is high, it is practical to produce the product in a single location and export it to other parts of the world. If the value-to-weight ratio is low, there is greater pressure to manufacture the product in multiple locations across the world.

626 Chapter 14: Global Production, Outsourcing, and Logisticswhether the product serves universal needs (needs that are the same everywhere) Since there are few national differences in consumer taste and preference for such products, the need for local responsiveness is reduced, increasing the attractiveness of concentrating manufacturing in a central location.

627 Chapter 14: Global Production, Outsourcing, and LogisticsLocating Production Facilities There are two basic strategies for locating manufacturing facilities: concentrating them in the optimal location and serving the world market from there decentralizing them in various regional or national locations that are close to major markets

628 Chapter 14: Global Production, Outsourcing, and LogisticsThe appropriate strategic choice is determined by various country, technological, and product factors.

629 Chapter 14: Global Production, Outsourcing, and LogisticsClassroom Performance System Decentralized production will be favored when There are substantial differences in political economy Fixed costs are high The product’s value-to-weight ratio is high Exchange rates are volatile Classroom Performance System Answer: d

630 Chapter 14: Global Production, Outsourcing, and LogisticsClassroom Performance System Firms will prefer concentrated production when Minimum efficient scale is high Location externalities are not important The product does not serve universal needs There are few trade barriers Classroom Performance System Answer: a

631 Chapter 14: Global Production, Outsourcing, and LogisticsTHE STRATEGIC ROLE OF FOREIGN FACTORIES The strategic role of foreign factories and the strategic advantage of a particular location can change over time. A factory initially established to make a standard product to serve a local market, or to take advantage of low cost inputs, can evolve into a facility with advanced design capabilities As governmental regulations change and/or countries upgrade their factors of production the strategic advantage of a particular location can change

632 Chapter 14: Global Production, Outsourcing, and LogisticsAs the strategic role of a factory is upgraded and a firm develops centers of excellence in different locations worldwide, it supports the development of a transnational strategy A major aspect of a transnational strategy is a belief in global learning, or the idea that valuable knowledge does not reside just in a firm’s domestic operations, it may also be found in its foreign subsidiaries Management Focus: Hewlett Packard in Singapore Summary This feature explores the strategic decision making involved in establishing Hewlett Packard’s Singapore plant. The company initially used the plans as a low cost location to manufacture electronic components. Later, entire products were produced in Singapore, Later still, the Singapore plant was involved not only in production but also product design. Today, the plant is an important part of Hewlett Packard’s global network responsible for manufacturing and also product development and design. The following questions can provide the basis for the discussion of this feature. Suggested Discussion Questions 1) What factors were important in Hewlett Packard’s initial decision to open a plant in Singapore? How did these factors contribute to the decision to increase responsibilities at the Singapore plant? 2) Today, the Singapore plant is considered to be a “lead plant” for Hewlett Packard. How can the company help the plant continue to be a key component in Hewlett Packard’s global network?

633 Chapter 14: Global Production, Outsourcing, and LogisticsOUTSOURCING PRODUCTION: MAKE-OR-BUY DECISIONS Should an international business make or buy the component parts to go into their final product? Make-or-buy decisions are important factors in many firms' manufacturing strategies

634 Chapter 14: Global Production, Outsourcing, and LogisticsThe Advantages of Make Vertical integration (making component parts in-house): is associated with lower costs facilitates investments in highly specialized assets protects proprietary technology facilitates the scheduling of adjacent processes

635 Chapter 14: Global Production, Outsourcing, and LogisticsLowering Costs If the firm is more efficient at that a production activity than any other enterprise, it may pay a firm to continue manufacturing a product or component part in-house

636 Chapter 14: Global Production, Outsourcing, and LogisticsFacilitating Specialized Investments Internal production makes sense when substantial investments in specialized assets (assets whose value is contingent upon a particular relationship persisting) are required to manufacture a component

637 Chapter 14: Global Production, Outsourcing, and LogisticsClassroom Performance System Which of the following is not one of the key factors that influence the decision of where to produce? Country factors Competitors factors Technological factors Product factors Classroom Performance System Answer: b

638 Chapter 14: Global Production, Outsourcing, and LogisticsProtecting Proprietary Product Technology A firm might prefer to make component parts that contain proprietary technology in-house in order to maintain control over the technology Improving Scheduling The weakest argument for vertical integration is that the resulting production cost savings make planning, coordination, and scheduling of adjacent processes easier Management Focus: Outsourcing at the Boeing Company Summary This feature focuses on the process of generating "make-or-buy" decisions at Boeing. The Boeing Company is the world's largest manufacturer of commercial jet aircraft with a 60 percent share of the global market. Due to decreasing demand for its aircraft and cost constraints on the part of its buyers, Boeing has been forced to find ways to become more price competitive. One strategy that Boeing has utilized is outsourcing. The feature describes Boeing's outsourcing criteria, which involves making a determination whether it is better for Boeing to "make" or "buy" a particular component part. For Boeing this is serious business. On the one hand, Boeing does not want to take unnecessary strategic risks and become too dependent on outside suppliers for critical component parts. On the other hand, Boeing can outsource certain component parts and realize a substantial cost saving. The feature illustrates the nature of this dilemma at Boeing. Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. Describe Boeing's criteria for determining whether a component part should be "outsourced" or whether it should be manufactured in-house. Are Boeing’s criteria appropriate? Why or why not? 2. What could go wrong with Boeing's strategy of outsourcing? Has Boeing taken the necessary precautions? Are there any hazards in the company's strategy? 3. In the future do you believe that Boeing will be doing more or less outsourcing? Justify your answer.

639 Chapter 14: Global Production, Outsourcing, and LogisticsThe Advantages of Buy Buying component parts from independent suppliers: gives the firm greater flexibility helps drive down the firm's cost structure helps the firm to capture orders from international customers

640 Chapter 14: Global Production, Outsourcing, and LogisticsStrategic Flexibility The greatest advantage of buying component parts from independent suppliers is that the firm can maintain its flexibility, switching orders between suppliers as circumstances dictate This is particularly important when changes in exchange rates and trade barriers might alter the attractiveness of various supply sources over time

641 Chapter 14: Global Production, Outsourcing, and LogisticsLower Costs Firms that buy components from independent suppliers can avoid: the challenges involved with coordinating and controlling the additional subunits that are associated with vertical integration the lack of incentive associated with internal suppliers the difficulties with setting appropriate transfer prices

642 Chapter 14: Global Production, Outsourcing, and LogisticsOffsets Outsourcing can help firms capture more orders from suppliers’ countries Trade-Offs The benefits of manufacturing components in-house are greatest when: highly specialized assets are involved when vertical integration is necessary for protecting proprietary technology when the firm is more efficient than external suppliers at performing a particular activity.

643 Chapter 14: Global Production, Outsourcing, and LogisticsStrategic Alliances with Suppliers Firms have tried to capture some of the benefits of vertical integration, without encountering the associated organizational problems, by entering into long-term strategic alliances with key suppliers While such alliances can help the firm to capture the benefits associated with vertical integration firms may find their strategic flexibility limited by commitments to alliance partners

644 Chapter 14: Global Production, Outsourcing, and LogisticsClassroom Performance System Buying from independent suppliers offers all of the following advantages except It gives the firm greater flexibility It helps drive down the firm's cost structure It protects proprietary property It helps the firm to capture orders from international customers Classroom Performance System Answer: c

645 Chapter 14: Global Production, Outsourcing, and LogisticsMANAGING A GLOBAL SUPPLY CHAIN Logistics encompasses the activities necessary to get materials to a manufacturing facility, through the manufacturing process, and out through a distribution system to the end user. The logistics function is complicated in an international business by factors such as distance, time, exchange rates, and customs barriers Efficient logistics can have a major impact upon a firm's bottom line

646 Chapter 14: Global Production, Outsourcing, and LogisticsThe Power of Just-in-Time (JIT) The basic philosophy behind JIT systems is to economize on inventory holding costs by having materials arrive at a manufacturing plant just in time to enter the production process, and not before. JIT systems generate major cost savings from reduced warehousing and inventory holding costs JIT systems can help the firm to spot defective parts and take them out of the manufacturing process and boost product quality

647 Chapter 14: Global Production, Outsourcing, and LogisticsThe Role of Information Technology and the Internet Web-based information systems play a crucial role in materials management. EDI: facilitates the tracking of inputs allows the firm to optimize its production schedule allows the firm and its suppliers to communicate in real time eliminates the flow of paperwork between a firm and its suppliers

648 Chapter 14: Global Production, Outsourcing, and LogisticsCRITICAL THINKING AND DISCUSSION QUESTIONS 1. An electronics firm is considering how best to supply the world market for microprocessors used in consumer and industrial electronic products. A manufacturing plant cost approximately $500 million to construct and requires a highly skilled work force. The total value of the world market for this product over the next 10 years is estimated to be between $10 and $15 billion. The tariffs prevailing in this industry are currently low. What kind of manufacturing strategy do you think the firm should adopt - concentrated or decentralized? What kind of location(s) should the firm favor for its plant(s)? Answer: The firm should pursue a concentrated manufacturing because (1) the tariffs prevailing in the industry are low, (2) the cost of building a plant to produce the microprocessors is high, and (3) the product's value-to-weight ratio is high. All of these factors favor a concentrated vs. a decentralized manufacturing strategy. In terms of location, the company should consider three factors: country factors, technology factors, and product factors. First, in terms of country factors, the firm should locate its plant in a country that has a highly skilled pool of workers available. That criterion probably limits the firm to developed nations. Second, in terms of technology factors, the firm is compelled to limit the number of its manufacturing facilities because of the high cost of constructing a plant. Third, in terms of product factors, the firm can manufacturer its product in a central location due to the relatively high value-weight ratio and the universal appeal of the product.

649 Chapter 14: Global Production, Outsourcing, and LogisticsCRITICAL THINKING AND DISCUSSION QUESTIONS 2. A chemical firm is considering how best to supply the world market for sulfuric acid. A manufacturing plant costs approximately $20 million to construct and requires a moderately skilled work force. The total value of the world market for this product over the new 10 years is estimated to be between $20 and $30 billion. The tariffs prevailing in this industry are moderate. Should the firm favor concentrated manufacturing or decentralized manufacturing? What kind of location(s) should the firm seek for its plant(s)? Answer: This question is a tougher call than the scenario depicted in Question #1. The firm should probably pursue a limited decentralized manufacturing strategy (meaning that the firm should not set up a plant in every country that it sells to, but should set up plants in several "regions" of the world). This strategy makes sense because (1) The tariffs prevailing in the industry are moderate (rather than low), (2) the cost of constructing a facility is relatively modest ($20 million), and (3) only a moderately skilled work force is needed (which is probably available in many low-cost regions of the world). The firm should select its location based on country factors, technology factors and product factors. In terms of country factors, the firm should find locations where semi-skilled labor is inexpensive. In terms of technology factors, the firm is not constrained by a high fixed costs associated with its product, so technology is not a pervasive issue. Finally, product factors favor the firm locating in several locations throughout the world. The company's product has a low value-weight ratio, making it unattractive to produce the product in a central location and export it across the world.

650 Chapter 14: Global Production, Outsourcing, and LogisticsCRITICAL THINKING AND DISCUSSION QUESTIONS 3. A firm must decide whether to make a component part in-house or to contract it out to an independent supplier. Manufacturing the part requires a nonrecoverable investment in specialized assets. The most efficient suppliers are located in countries with currencies that many foreign exchange analysts expect to appreciate substantially over the next decade. What are the pros and cons of (a) manufacturing the component in-house and (b) outsourcing manufacture to an independent supplier? Which option would you recommend? Why? Answer: Manufacturing in-house would reduce the risk of currency appreciation and rising costs from independent suppliers. Specialized asset investment would make firm dependent on specific suppliers, however, technological know-how would be protected, and improved scheduling would be available. Out-sourcing would be beneficial if the product using the component fails in the market because the supplier will bear the cost of the non-recoverable investment, and flexibility in case a better component can be designed or bought would be preserved. Outsourcing would also lower organizational and coordination costs. Based on what we know, manufacturing in house may be slightly preferred, but other information could tip the decision the other way.

651 Chapter 14: Global Production, Outsourcing, and LogisticsCRITICAL THINKING AND DISCUSSION QUESTIONS 4. Explain how an efficient materials management function can help an international business compete more effectively in the global marketplace. Answer: Given the complexity involved in coordination of material and product flows in a multinational enterprise (purchases, currency exchange, inbound and outbound transportation, production, inventory, communication, expediting, tariffs and duties), a materials management function can help to assure that these flows take place in the most efficient manner possible. A related advantage is that by having a materials management function, a firm may obtain improved information about the costs of different transport alternatives, and choose to reconfigure some of its flows to better take advantage of these costs. By being better able to utilize just in time techniques, the cost of production can be lowered while the quality is increased. The materials management function can also help an international business to develop information technology systems that allow it to better track the flow of goods throughout the firm.

652

653 Global Marketing and R&D15 chapter Global Marketing and R&D McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

654 Chapter 15: Global Marketing and R&DINTRODUCTION The marketing mix (the choices the firm offers to its targeted market) is comprised of: product attributes distribution strategy communication strategy pricing strategy Firms try to perform marketing and R&D activities so they will reduce the costs of value creation and add value by better serving customer needs. However, firms are constrained by the need to reduce costs, while at the same time be responsive to local conditions.

655 Chapter 15: Global Marketing and R&DClassroom Performance System The marketing mix involves all of the following elements except Product attributes Communication strategy Distribution strategy Production strategy Classroom Performance System Answer: d

656 Chapter 15: Global Marketing and R&DTHE GLOBALIZATION OF MARKETS AND BRANDS Theodore Levitt argued that world markets were becoming increasingly similar making it unnecessary to localize the marketing mix Levitt’s theory has become a lightening rod in the debate about globalization Internet Extra: Cadbury Schweppes operates in many countries around the world. The company sells some products in virtually the same way in some markets, but sells entirely different products that fill a similar need in other markets. Go the company’s site {http://www.cadburyschweppes.com/EN}. Click on Our Brands. Pick a couple of products and see where they are sold. What conclusions can you draw from your findings? For example, are the countries all former British colonies that may have similar cultural preferences? Next, to see when new brands were developed or acquired, and to see how the company has changed some product names, go to Brand History. Finally, click on Brand Websites. Pick a brand. Then go to a couple of countries and explore the sites for the brand. For example, compare the site for Cadbury in the U.S. to Cadbury in the U.K. How are the sites the same? How are they different? Is the product line the same in both countries? How about packaging? What do your findings imply about pressures to be locally responsive?

657 Chapter 15: Global Marketing and R&DThe current consensus is that although the world is moving towards global markets, the continuing persistence of cultural and economic differences among nations acts as a major brake on any trend toward global consumer tastes and preferences In addition, trade barriers and differences in product and technical standards also constrain a firm's ability to sell a standardized product to a global market Internet Extra: Cadbury Schweppes operates in many countries around the world. The company sells some products in virtually the same way in some markets, but sells entirely different products that fill a similar need in other markets. Go the company’s site {http://www.cadburyschweppes.com/EN}. Click on Our Brands. Pick a couple of products and see where they are sold. What conclusions can you draw from your findings? For example, are the countries all former British colonies that may have similar cultural preferences? Next, to see when new brands were developed or acquired, and to see how the company has changed some product names, go to Brand History. Finally, click on Brand Websites. Pick a brand. Then go to a couple of countries and explore the sites for the brand. For example, compare the site for Cadbury in the U.S. to Cadbury in the U.K. How are the sites the same? How are they different? Is the product line the same in both countries? How about packaging? What do your findings imply about pressures to be locally responsive?

658 Chapter 15: Global Marketing and R&DMARKET SEGMENTATION Market segmentation involves identifying distinct groups of consumers whose purchasing behavior differs from others in important ways. Management Focus: Marketing to Black Brazil Summary This feature explores how companies are marketing to Brazil’s black population. Although Brazil is home to a sizable racial minority, to date companies have essentially ignored the market segment. Now however, companies are beginning to target the group using products and promotions specifically developed for the market. Suggested Discussion Questions 1. Describe the differences between the black population in the U.S. and the black population in Brazil. What are the implications of these differences for the culture as a whole? 2. How has Unilever targeted the black population in Brazil? How does the company’s strategy in Brazil differ from its strategy in other countries? What does your response tell you about Unilever’s overall global marketing strategy?

659 Chapter 15: Global Marketing and R&DFirms must adjust their marketing mix from segment to segment Firms also need to consider the existence of segments that transcend national borders and understand differences across countries in the structure of segments Segments that transcend national borders include consumers with compelling similarities that lead to similarities in purchasing behavior Where there are no such similarities, firms must customize the product, the packaging, or the way in which the product is marketed in order to maximize performance in the market Global market segments are more likely to exist in industrial products than in consumer products Management Focus: Marketing to Black Brazil Summary This feature explores how companies are marketing to Brazil’s black population. Although Brazil is home to a sizable racial minority, to date companies have essentially ignored the market segment. Now however, companies are beginning to target the group using products and promotions specifically developed for the market. Suggested Discussion Questions 1. Describe the differences between the black population in the U.S. and the black population in Brazil. What are the implications of these differences for the culture as a whole? 2. How has Unilever targeted the black population in Brazil? How does the company’s strategy in Brazil differ from its strategy in other countries? What does your response tell you about Unilever’s overall global marketing strategy?

660 Chapter 15: Global Marketing and R&DPRODUCT ATTRIBUTES Products sell well when their attributes match consumer needs If consumer needs were the same everywhere, a firm could sell the same product worldwide But, consumer needs do vary from country to country depending on culture and the level of economic development Internet Extra: Food products firms and fast food restaurants are examples of companies that standardize some elements of the marketing mix, and customize others. For example, Kraft sells its products in several markets around the world. In some markets, Kraft sells virtually identical products, in others, products have been adapted to meet local needs. Go to the web site {http://www.kraft.com/default.aspx}. Click on Brands. Pick a few products and look at how they are sold in other markets. Are product names the same? What differences do you see in product packaging? Are there differences in the products themselves? What do your answers tell you about Kraft’s international marketing strategy?

661 Chapter 15: Global Marketing and R&DCultural Differences Countries differ along a range of cultural dimensions including: tradition social structure language religion education Among these dimensions, there is evidence of the trends Levitt identified.

662 Chapter 15: Global Marketing and R&DEconomic Development A country’s level of economic development has important marketing implications. Firms based in highly developed countries tend to build a lot of extra performance attributes into their products Consumers in less developed nations tend to prefer more basic products

663 Chapter 15: Global Marketing and R&DProduct and Technical Standards National differences in product and technological standards force firms to customize the marketing mix

664 Chapter 15: Global Marketing and R&DDISTRIBUTION STRATEGY A firm’s distribution strategy (the means it chooses for delivering the product to the consumer ) is a critical element of the marketing mix If the firm manufacturers its product in the particular country, it can sell directly to the consumer, to the retailer, or to the wholesaler The same options are available to a firm that manufactures outside the country

665 Chapter 15: Global Marketing and R&DA typical distribution system consists of a channel that includes a wholesale distributor and a retailer.

666 Chapter 15: Global Marketing and R&DDifferences between Countries Retail Concentration In some countries the retail system is very concentrated, while in other countries it is fragmented In a concentrated system, a few retailers supply most of the market In a fragmented system there are many retailers, no one of which has a major share of the market

667 Chapter 15: Global Marketing and R&DChannel Length Channel length refers to the number of intermediaries between the producer and the consumer When the producer sells directly to the consumer, the channel is very short When the producer sells through an import agent, a wholesaler, and a retailer, a long channel exists

668 Chapter 15: Global Marketing and R&DChannel Exclusivity An exclusive distribution channel is one that is difficult for outsiders to access Japan's system is an example of a very exclusive system

669 Chapter 15: Global Marketing and R&DChannel Quality Channel quality refers to the expertise, competencies, and skills of established retailers in a nation, and their ability to sell and support the products of international businesses. The quality of retailers is good in most developed countries, but is variable at best in emerging markets and less developed countries

670 Chapter 15: Global Marketing and R&DChoosing a Distribution Strategy The choice of distribution strategy determines which channel the firm will use to reach potential consumers Since each intermediary in a channel adds its own markup to the products, there is generally a critical link between channel length and the firm's profit margin A long channel can be beneficial because it economizes on selling costs when the retail sector is very fragmented

671 Chapter 15: Global Marketing and R&DClassroom Performance System Which of the following is not one of the three main differences between distribution systems? Retail concentration Product attributes Channel length Channel exclusivity Classroom Performance System Answer: b

672 Chapter 15: Global Marketing and R&DCOMMUNICATION STRATEGY Communicating product attributes to prospective customers is a critical element in the marketing mix and is partly determined the channel choice. Communication channels available to a firm include direct selling sales promotion direct marketing advertising

673 Chapter 15: Global Marketing and R&DBarriers to International Communication International communication occurs whenever a firm uses a marketing message to sell its products in another country. The effectiveness of a firm's international communication can be jeopardized by: cultural barriers source and country of origin effects noise levels Lecture Note: The class can be stimulated to think of some positive and negative source effects (German autos vs. German wine, Italian cuisine vs. British cuisine). Management Focus: Overcoming Cultural Barriers to Selling Tampons Summary This feature examines Procter & Gamble’s (P&G) efforts to bring tampons to the world. After purchasing Tambrands in 1997, P&G found that marketing strategies that were successful in the U.S. failed to generate sales in many other parts of the world. P&G, in an effort to reach new customers, has developed a new marketing strategy that is based on direct selling and relationship marketing. The strategy is currently being tested in Mexico, and if successful, will be implemented in other South Americas n markets. Suggested Discussion Questions 1. How has culture affected P&G’s efforts to sell tampons around the world? 2. P&G has resorted to direct selling and relationship marketing to sell tampons. In your opinion, would these methods work in the U.S.? Why or why not?

674 Chapter 15: Global Marketing and R&DPush versus Pull Strategies The main choice with regard to communication strategy is between a push strategy (emphasizes personnel selling) and a pull strategy (emphasizes mass media advertising). The choice between the strategies depends upon: product type and consumer sophistication channel length media availability

675 Chapter 15: Global Marketing and R&DProduct Type and Consumer Sophistication Firms in consumer goods industries that are trying to sell to a large segment of the market tend to prefer a pull strategy Firms that sell industrial products or other complex products favor a push strategy

676 Chapter 15: Global Marketing and R&DChannel Length Using direct selling to push a product through many layers of a distribution channel can be very expensive A firm may try to pull its product through the channels by using mass advertising to create consumer demand

677 Chapter 15: Global Marketing and R&DMedia Availability A pull strategy relies on access to advertising media A push strategy is more attractive when there is limited access to mass media

678 Chapter 15: Global Marketing and R&DThe Push-Pull Mix Push strategies tend to be emphasized: for industrial products and/or complex new products when distribution channels are short when few print or electronic media are available

679 Chapter 15: Global Marketing and R&DPull strategies tend to be emphasized: for consumer goods products when distribution channels are long when sufficient print and electronic media are available to carry the marketing message Management Focus: Unilever—Selling to India’s Poor Summary This feature explores Unilever’s innovative global marketing strategy. Unilever maintains a substantial presence in many of the world’s poorer nations where low-income levels, unsophisticated consumers, illiteracy, a fragmented retail distribution system, and unpaved roads make marketing difficult. Still, the company has managed to succeed thanks to its efforts to customize its marketing strategy to the local market. Suggested Discussion Questions 1. Discuss the effects of India’s culture on each of the components of Unilever’s marketing strategy. What can Unilever learn from its experiences in India? 2. Is Unilever’s strategy in India a push strategy or a pull strategy? Explain.

680 Chapter 15: Global Marketing and R&DGlobal Advertising Should a firm standardize its advertising worldwide?

681 Chapter 15: Global Marketing and R&DFor Standardized Advertising Standardized advertising makes sense when: it has significant economic advantages creative talent is scarce and one large effort to develop a campaign will be more successful than numerous smaller efforts brand names are global

682 Chapter 15: Global Marketing and R&DClassroom Performance System A push strategy works best in all of the following situations except For industrial products When distribution channels are short When sufficient print and electronic media are available to carry the marketing message For complex new products Classroom Performance System Answer: c

683 Chapter 15: Global Marketing and R&DAgainst Standardized Advertising Standardized advertising is not appropriate when: cultural differences among nations are significant country differences in advertising regulations may block the implementation of standardized advertising

684 Chapter 15: Global Marketing and R&DDealing with Country Differences Some firms have been trying tactics to capture the benefits of global standardization while responding to individual cultural and legal environments

685 Chapter 15: Global Marketing and R&DPRICING STRATEGY How should a firm price its product or service in foreign markets?

686 Chapter 15: Global Marketing and R&DPrice Discrimination A firm can maximize profits by using price discrimination (charging consumers in different countries different prices for the same product) For price discrimination to work the firm must be able to keep national markets separate and different price elasticities of demand must exist in different countries

687 Chapter 15: Global Marketing and R&DThe price elasticity of demand is a measure of the responsiveness of demand for a product to changes in price. Demand is elastic when a small change in price produces a large change in demand Demand is inelastic when a large change in price produces only a small change in demand

688 Chapter 15: Global Marketing and R&DThe elasticity of demand is determined by a number of factors including: income level competitive conditions In general price elasticities tend to be greater in countries with lower income levels and greater numbers of competitors.

689 Chapter 15: Global Marketing and R&DStrategic Pricing Strategic pricing has three aspects: predatory pricing multi-point pricing experience curve pricing

690 Chapter 15: Global Marketing and R&DPredatory Pricing Predatory pricing involves using the profit gained in one market to support aggressive pricing designed to drive competitors out, in another market

691 Chapter 15: Global Marketing and R&DMulti-point Pricing Strategy Multi-point pricing refers to the fact that a firm’s pricing strategy in one market may have an impact on a rival’s pricing strategy in another market Aggressive pricing in one market may elicit a competitive response from a rival in another critical market For managers, it is important to centrally monitor pricing decisions around the world

692 Chapter 15: Global Marketing and R&DExperience Curve Pricing Firms pursuing an experience curve pricing strategy on an international scale price low worldwide in an attempt to build global sales volume as rapidly as possible, even if this means taking large losses initially A firm using experience curve pricing believes that several years in the future, when it has moved down the experience curve, it will be making substantial profits and have a cost advantage over its less aggressive competitors

693 Chapter 15: Global Marketing and R&DRegulatory Influences on Prices The use of either price discrimination or strategic pricing may be limited by national or international regulations

694 Chapter 15: Global Marketing and R&DAntidumping Regulations Dumping occurs whenever a firm sells a product for a price that is less than the cost of producing it Antidumping rules set a floor under export prices and limit firms’ ability to pursue strategic pricing

695 Chapter 15: Global Marketing and R&DCompetition Policy Most industrialized nations have regulations designed to promote competition and restrict monopoly practices These regulations can be used to limit the prices that a firm can charge

696 Chapter 15: Global Marketing and R&DCONFIGURING THE MARKETING MIX Standardization versus customization is not an all or nothing concept Most firms standardize some things and customize others Management Focus: Castrol Oil in Vietnam Summary This feature focuses on the strategies and experience of Castrol Oil in marketing its GTX brand of motor oil around the world. Castrol Oil is the lubricants division of the British chemical, oil, and gas concern Burmah Castrol. Castrol Oil’s GTX brand of motor oil is marketed as a premium brand. The feature focuses on the company’s entries into the lubricants markets in Thailand and Vietnam . Castrol has a unique strategy of appealing to consumers who drive motorcycles, in hopes of developing brand loyalty and retaining these customers as their countries develop to the point where cars are more common. This strategy worked well in Thailand, and is currently under way in Vietnam . Suggested Discussion Questions 1. In underdeveloped countries like Thailand and Vietnam , the conventional forms of media that we are accustomed to, like radio and television, are often absent. This problem is particularly pronounced in Vietnam . Describe how Castrol Oil overcame this challenge. Does the company’s approach seem prudent to you? Explain your answer. 2. Would you describe Castrol Oil’s communications strategy in Vietnam as a push or a pull strategy? Explain your answer. 3. Castrol Oil emphasizes a premium pricing strategy. What elements of the company’s communications and distributions strategies support this premium pricing strategy?

697 Chapter 15: Global Marketing and R&DClassroom Performance System When a firm uses a pricing strategy aimed at giving a company a competitive advantage over its rivals, the firm is engaging in Predatory pricing Multipoint pricing Experience curve pricing Strategic pricing Classroom Performance System Answer: d

698 Chapter 15: Global Marketing and R&DNEW PRODUCT DEVELOPMENT The Location of R&D New product ideas come from the interactions of scientific research, demand conditions, and competitive conditions.

699 Chapter 15: Global Marketing and R&DThe rate of new-product development is greater in countries where: more money is spent on basic and applied research and development demand is strong consumers are affluent competition is intense

700 Chapter 15: Global Marketing and R&DIntegrating R&D, Marketing, and Production Commercialization of new technologies in international firms may require different versions of a new product to be produced for different countries New product development efforts should be closely coordinated with the marketing, production, and materials management functions This integration will ensure that customer needs are met and that the company performs all its value creation activities efficiently

701 Chapter 15: Global Marketing and R&DCross-Functional Teams Cross-functional integration is facilitated by cross-functional product development teams Effective cross functional teams should: be led by a heavyweight project manager with status in the organization have members from all the critical functional areas have members located together have clear goals have an effective conflict resolution process

702 Chapter 15: Global Marketing and R&DBuilding Global R&D Capabilities R&D and marketing need to be integrated to adequately commercialize new technologies This may require R&D centers in North America, Asia, and Europe that are closely linked by formal and informal integrating mechanisms with marketing operations in each country in their regions, and with the various manufacturing facilities

703 Chapter 15: Global Marketing and R&DCRITICAL THINKING AND DISCUSSION QUESTIONS 1. Imagine you are the marketing manager for a US manufacturer of disposable diapers. Your firm is considering entering the Brazilian market. Your CEO believes the advertising message that has been effective in the United States will suffice in Brazil. Outline some possible objections to this. Your CEO also believes that the pricing decisions in Brazil can be delegated to local managers. Why might she be wrong? Answer: While babies’ behinds serve the same function in all cultures, and the product's technical standards may be similar, sensitivity to bodily functions does vary across cultures. Thus the advertising message may need to be changed for different attitudes towards what is appropriate advertising. Likewise, where it might be progressive to show an ad with a male changing a diaper in some countries, in other countries this message could be lost or misinterpreted. Another consideration would be the noise level created by the advertising message of competitor's products, which may well be different in Brazil. While local demand and price elasticity decisions should play an important role in Brazil, pricing should not be left solely to the discretion of the local managers. Since this is a global business, your firm will likely be competing in Brazil with some of the same competitors as elsewhere. Thus pricing decisions in one country can have an impact on pricing and competition in other markets. Similarly, your firm may want to position and price the brand similarly across different South American countries.

704 Chapter 15: Global Marketing and R&DCRITICAL THINKING AND DISCUSSION QUESTIONS 2. Within 20 years we will have seen the emergence of enormous global markets for standardized consumer products. Do you agree with this statement? Justify your answer. Answer: One could either choose to agree or disagree, while the best answer would likely hedge it somewhere in the middle. There clearly already are enormous global markets already for products like Coke and Levis, while it is questionable whether there will ever be a global consumer market for Norwegian lutefisk. More global consumer markets will likely emerge, but there will continue to be national distinctions for many products.

705 Chapter 15: Global Marketing and R&DCRITICAL THINKING AND DISCUSSION QUESTIONS 3. You are the marketing manager of a food products company that is considering entering the Indian market. The retail system in India tends to be very fragmented. Also, retailers and wholesalers tend to have long-term ties with Indian food companies, which makes access to distribution channels difficult. What distribution strategy would you advise the company to pursue? Why? Answer: The firm should sell to either wholesalers or import agents. Because the retail system in India is very fragmented, it would be very expensive for the firm to make contact with each individual retailer. As a result, it would be more economical for the firm to sell to wholesalers or import agents. Import agents may have long-term relationships with wholesalers, retailers, and/or other import agents. Similarly, wholesalers may have long-standing relationships with retailers and, therefore, be better able to persuade them to carry the firm’s product than the firm itself would.

706 Chapter 15: Global Marketing and R&DCRITICAL THINKING AND DISCUSSION QUESTIONS 4. Price discrimination in indistinguishable from dumping. Discuss the accuracy of this statement? Answer: In some specific instances this statement is correct, but as a general rule it is not. When a firm is pricing lower in a foreign country than it is in its domestic market, it can be difficult to distinguish dumping from price discrimination unless it is clear that the firm is selling at below cost in the foreign market. Yet when costs are reasonably well known and all prices are above these, or if the firm is pricing lower in its domestic market than in foreign markets, it can reasonably concluded that price discrimination rather than dumping is occurring.

707 Chapter 15: Global Marketing and R&DCRITICAL THINKING AND DISCUSSION QUESTIONS 5. You work for a company that designs and manufactures personal computers. Your company’s R&D center is in North Dakota. The computers are manufactured under contract in Taiwan. Marketing strategy is delegated to the heads of three regional groups: a North American group (based in Chicago), a European group (based in Paris), and an Asian group (based in Singapore). Each regional group develops the marketing approach within its region. In order of importance, the largest markets for your products are North America, Germany, Britain, China, and Australia. Your company is experiencing problems in its product development and commercialization process. Products are late to market, the manufacturing quality is poor, and costs are higher than projected, and market acceptance of new products is less than hoped for. What might be the source of these problems? How would you fix them? Answer: The dispersion of activities makes sense - products are produced in the lowest cost location and marketed by people familiar with local conditions. (The R&D in North Dakota must be a historical fluke.) Yet this makes the coordination task extremely complex, and information required for successful commercialization is likely not being effectively communicated among all the appropriate people. Greater cross-functional integration in the new product development process should help to improve product development and commercialization.

708

709 Global Human Resource Management16 chapter Global Human Resource Management McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

710 Chapter 16: Global Human Resource ManagementINTRODUCTION Human resource management (HRM) refers to the activities an organization carries out to utilize its human resources effectively. These activities include: determining the firm's human resource strategy staffing performance evaluation management development compensation labor relations

711 Chapter 16: Global Human Resource ManagementHRM is more complex in an international business because of differences between countries in labor markets, culture, legal systems, economic systems, and so on The HRM function must also deal with a host of issues related to expatriate managers (citizens of one country working abroad)

712 Chapter 16: Global Human Resource ManagementTHE STRATEGIC ROLE OF INTERNATIONAL HRM Success in international business requires that HRM policies be congruent with the firm’s strategy

713 Chapter 16: Global Human Resource ManagementSTAFFING POLICY Staffing policy is concerned with the selection of employees who have the skills required to perform a particular job. Types of Staffing Polices Research has identified three main approaches to staffing policy within international businesses: the ethnocentric approach the polycentric approach the geocentric approach

714 Chapter 16: Global Human Resource ManagementThe Ethnocentric Approach An ethnocentric approach to staffing policy is one in which key management positions in an international business are filled by parent-country nationals The policy makes most sense for firms pursuing an international strategy

715 Chapter 16: Global Human Resource ManagementFirms pursue an ethnocentric staffing policy for three reasons: the firm believes there is a lack of qualified individuals in the host country to fill senior management positions the firm sees an ethnocentric staffing policy as the best way to maintain a unified corporate culture the firm believes the best way to create value by transferring core competencies to a foreign operation is to transfer parent country nationals who have knowledge of that competency to the foreign operation

716 Chapter 16: Global Human Resource Managementthe ethnocentric staffing policy is now on the wane in most international businesses There are two reasons for this: an ethnocentric staffing policy limits advancement opportunities for host country nationals an ethnocentric policy can lead to "cultural myopia"

717 Chapter 16: Global Human Resource ManagementThe Polycentric Approach A polycentric staffing policy is one in which host country nationals are recruited to manage subsidiaries in their own country, while parent country nationals occupy the key positions at corporate headquarters While this approach minimizes the dangers of cultural myopia, it also helps create a gap between home and host country operations The policy is best suited to firms pursuing a localization strategy

718 Chapter 16: Global Human Resource ManagementThere are two advantages to the polycentric approach: the firm is less likely to suffer from cultural myopia this staffing approach may be less expensive to implement than an ethnocentric policy

719 Chapter 16: Global Human Resource ManagementThere are two disadvantages to the polycentric approach: host country nationals have limited opportunities to gain experience outside their own country and thus cannot progress beyond senior positions in their own subsidiaries. a gap can form between host country managers and parent country managers

720 Chapter 16: Global Human Resource ManagementThe Geocentric Approach A geocentric staffing policy is one in which the best people are sought for key jobs throughout the organization, regardless of nationality This approach is consistent with building a strong unifying culture and informal management network It makes sense for firms pursuing either a global or transnational strategy Immigration policies of national governments may limit the ability of a firm to pursue this policy

721 Chapter 16: Global Human Resource ManagementThe advantages of a geocentric approach to staffing include: enabling the firm to make the best use of its human resources building a cadre of international executives who feel at home working in a number of different cultures The disadvantages of geocentric approach include: difficulties with immigration laws costs associated with implementing the strategy

722 Chapter 16: Global Human Resource ManagementCLASSROOM PERFORMANCE SYSTEM A _______ approach to staffing makes sense when a firm wants to pursue a transnational strategy. Ethnocentric Geocentric Polycentric Transcentric Classroom Performance System Answer: b

723 Chapter 16: Global Human Resource ManagementThe advantages and disadvantages of each of the three main approaches to staffing policy are summarized in Table 16.1

724 Chapter 16: Global Human Resource ManagementClassroom Performance System A staffing approach in which all key management positions are filled by parent-country nationals is called An ethnocentric staffing policy A geocentric staffing policy A polycentric staffing policy A transcentric staffing policy Classroom Performance System Answer: a

725 Chapter 16: Global Human Resource ManagementExpatriate Managers Expatriate failure is the premature return of an expatriate manager to his or her home country.

726 Chapter 16: Global Human Resource ManagementExpatriate Failure Rates Studies show the main reasons for expatriate failure for Western firms are: the inability of an expatriate's spouse to adapt to a foreign culture the inability of the employee to adjust other family-related reasons the manager’s personal or emotional maturity the inability to cope with larger overseas responsibilities Management Focus: Managing Expatriates at Royal Dutch/Shell Summary This feature examines how Royal Dutch/Shell, a global petroleum company employing over 100,000 people manages its expatriates. The international mobility of its workforce is an important part of Shell’s overall philosophy. However, in the early 1990’s, the company found that it was having an increasingly difficult time recruiting personnel for foreign postings. Suggested Discussion Questions 1. Shell’s commitment to the success of its foreign assignments is demonstrated by its efforts to uncover expatriate concerns. Discuss the results of Shell’s survey to its present and past expatriates and families. How do these results compare to the results of other studies exploring expatriate failure? 2. Shell has implemented several changes to its expatriate program including providing education assistance to families with children, and establishing a Spouse Employment Center to help locate employment opportunities. In your opinion, will these programs “solve” Shell’s problems, or is there still more to be done?

727 Chapter 16: Global Human Resource ManagementFor European firms, only one reason was found to consistently explain expatriate failure: the inability of the manager’s spouse to adjust to a new environment

728 Chapter 16: Global Human Resource ManagementFor Japanese firms, the reasons for failure, were: the inability to cope with larger overseas responsibility difficulties with the new environment personal or emotional problems a lack of technical competence the inability of spouse to adjust

729 Chapter 16: Global Human Resource ManagementClassroom Performance System Studies show the most common reason for expatriate failure is The manager’s inability to adjust The manager’s emotional or personal maturity The inability of the spouse to adjust The manager’s lack of technical competence Classroom Performance System Answer: c

730 Chapter 16: Global Human Resource ManagementExpatriate Selection Expatriate failure rates can be reduced through improved selection procedures. Mendenhall and Oddou identified four dimensions that predict expatriate success: self-orientation others-orientation perceptual ability cultural toughness

731 Chapter 16: Global Human Resource ManagementSelf-orientation attributes strengthen the expatriate's self-esteem, self-confidence, and mental well-being Others orientation refers to how the attributes of this dimension enhance the expatriate’s ability to interact effectively with host-country nationals Perceptual ability refers to the ability to understand why people of other countries behave the way they do Cultural toughness refers to the fact that how well an expatriate adjusts to a particular posting tends to be related to the country of assignment

732 Chapter 16: Global Human Resource ManagementClassroom Performance System Dimensions that help predict success in a foreign positing include all of the following except Others-orientation Cultural toughness Perceptual ability Technical expertise Classroom Performance System Answer: d

733 Chapter 16: Global Human Resource ManagementTRAINING AND MANAGEMENT DEVELOPMENT Training begins where selection ends and it focuses upon preparing the manager for a specific job Management development is concerned with developing the skills of the manager over his or her career with the firm Internet Extra: Preparing managers for foreign assignments can help to improve their chances for success. To see how well you understand the ways of doing business in other countries, go to Kwintessential Language and Cultural Specialists’ web page {http://www.kwintessential.co.uk/cultural-services/articles/expat-cultural-training.html}. Click on Online Test: How Culturally Active Are You. From here, you can choose several online quizzes to test your knowledge of business etiquette in a number of countries. Take a few quizzes. Try to pick countries that you are not familiar with. What did you learn? What mistakes might you have made without preparing for a new business environment? Be sure to explore some of the Intercultural components at the bottom of the list of quizzes. Look at negotiations in India for example, or see where two countries stack up on Hofstede’s four dimensions of culture.

734 Chapter 16: Global Human Resource ManagementTraining for Expatriate Managers Cultural training, language training, and practical training have all been shown to reduce expatriate failure Yet, according to one study only about 30 percent of managers sent on one- to five-year expatriate assignments received training before their departure

735 Chapter 16: Global Human Resource ManagementCultural Training Cultural training seeks to foster an appreciation for the host country's culture Language Training An exclusive reliance on English diminishes an expatriate manager's ability to interact with host country nationals

736 Chapter 16: Global Human Resource ManagementPractical Training Practical training helps the expatriate manager and her family ease themselves into day-to-day life in the host country

737 Chapter 16: Global Human Resource ManagementRepatriation of Expatriates A critically important issue in the training and development of expatriate managers is to prepare them for reentry into their home country organization The HRM function needs to develop good program for re-integrating expatriates back into work life within their home country organization once their foreign assignment is over, and for utilizing the knowledge they acquired while abroad

738 Chapter 16: Global Human Resource ManagementManagement Development and Strategy Management development programs increase the overall skill levels of managers through a mix of ongoing management education and rotations of managers through jobs within the firm to give them varied experiences Management development is often used as a strategic tool to build a strong unifying culture and informal management network, both of which are supportive of a transnational and global strategy Management Focus: Monsanto's Repatriation Program Summary This feature describes Monsanto’s repatriation program for its expatriate managers. The program is very sophisticated, and is designed to provide a supportive environment for the company’s managers who are returning from overseas assignments. The feature describes the details of the repatriation program, which is a model program for the repatriation of expatriate managers. Suggested Discussion Questions 1. How does Monsanto’s repatriation program provide an incentive for high-potential managers to accept overseas assignments? 2. According to the feature, after they return home, Monsanto’s expatriate managers are given the opportunity to showcase their experience to their peers, subordinates, and superiors, in special information exchange. Why is this important? What function does this serve in the repatriation process? 3. How does Monsanto’s repatriation program help an expatriate manager adjust his personal life to returning home? Is this an important component of a firm’s repatriation program?

739 Chapter 16: Global Human Resource ManagementPERFORMANCE APPRAISAL Performance Appraisal Problems In most cases, two groups evaluate the performance of expatriate managers - host nation managers and home office managers - and both are subject to unintentional bias Home country managers tend to rely on hard data when evaluating expatriates Host country managers can be biased towards their own frame of reference

740 Chapter 16: Global Human Resource ManagementGuidelines for Performance Appraisal To reduce bias in performance appraisal: Most expatriates believe more weight should be given to an on-site manager's appraisal than to an off-site manager's appraisal A former expatriate who has served in the same location could be involved in the appraisal process to help reduce bias. When the policy is for foreign on-site mangers to write performance evaluations, home office managers should probably be consulted before an on-site manager completes a formal termination evaluation

741 Chapter 16: Global Human Resource ManagementCOMPENSATION National Differences in Compensation Should firms pay executives in different countries according to the prevailing standards in each country, or should it equalize pay on a global basis?

742 Chapter 16: Global Human Resource ManagementExpatriate Pay The most common approach to expatriate pay is the balance sheet approach This approach equalizes purchasing power across countries so employees can enjoy the same standard in their foreign positing that they enjoyed at home

743 Chapter 16: Global Human Resource ManagementThe components of the typical expatriate compensation package are: base salary a foreign service premium allowances of various types tax differentials benefits

744 Chapter 16: Global Human Resource ManagementBase Salary An expatriate’s base salary is normally in the same range as the base salary for a similar position in the home country. Foreign Service Premium A foreign service premium is extra pay the expatriate receives for working outside his or her country of origin It is offered as an inducement to accept foreign postings

745 Chapter 16: Global Human Resource ManagementAllowances Four types of allowances are often included in an expatriate’s compensation package: hardship allowances housing allowances cost-of-living allowances education allowances

746 Chapter 16: Global Human Resource ManagementTaxation Unless a host country has a reciprocal tax treaty with the expatriate’s home country, the expatriate may have to pay income tax to both the home country and the host-country governments When a reciprocal tax treaty is not in force, the firm typically pays the expatriate’s income tax in the host country Benefits Many firms also ensure that their expatriates receive the same level of medical and pension benefits abroad that they received at home.

747 Chapter 16: Global Human Resource ManagementINTERNATIONAL LABOR RELATIONS A key issue in international labor relations is the degree to which organized labor is able to limit the choices available to an international business A firm's ability to pursue a transnational or global strategy can be significantly constrained by the actions of labor unions

748 Chapter 16: Global Human Resource ManagementThe Concerns of Organized Labor A principal concern of organized labor is that the multinational can counter union bargaining power by threatening to move production to another country Another concern is that multinationals will try to import and impose unfamiliar labor practices from other countries

749 Chapter 16: Global Human Resource ManagementThe Strategy of Organized Labor Organized labor has responded to the increased bargaining power of multinational corporations by: trying to set-up their own international organizations lobbying for national legislation to restrict multinationals trying to achieve regulations of multinationals through international organization such as the United Nations

750 Chapter 16: Global Human Resource ManagementApproaches to Labor Relations Traditionally labor relations have been decentralized to individual subsidiaries within multinationals Now there is a trend towards greater centralization to enhance the bargaining power of the multinational vis-à-vis organized labor There is a growing realization that the way in which work is organized within a plant can be a major source of competitive advantage

751 Chapter 16: Global Human Resource ManagementClassroom Performance System Labor has responded to the increased bargaining power of multinationals by doing all of the following except Establishing global unions Trying to set-up their own international organizations Lobbying for national legislation to restrict multinationals Trying to achieve regulations of multinationals through international organization such as the United Nations Classroom Performance System Answer: a

752 Chapter 16: Global Human Resource ManagementCRITICAL THINKING AND DISCUSSION QUESTIONS 1. What are the main advantages and disadvantages of the ethnocentric, polycentric, and geocentric approaches to staffing policy? When is each approach appropriate? Answer: The answer to this question is contained in Table 16.1 in the text. An ethnocentric staffing policy is one in which key management positions are filled by parent country nationals. The advantages of the ethnocentric approach are: (1) Overcomes lack of qualified managers in host country, (2) Unified culture, and (3) Helps transfer core competencies. The disadvantages of the ethnocentric approach are: (1) Produces resentment in host country, and (2) Can lead to cultural myopia. An ethnocentric approach is typically appropriate for firms utilizing an international strategy. A polycentric staffing policy requires host country nationals to be recruited to manage subsidiaries, while parent country nations occupy key positions at corporate headquarters. The advantages of the polycentric approach are: (1) Alleviates cultural myopia, and (2) It is inexpensive to implement. The disadvantages of the polycentric approach are: (1) Limits career mobility, and (2) Isolates headquarters from foreign subsidiaries. A polycentric approach is typically appropriate for firms utilizing a localization strategy. A geocentric staffing policy seeks the best people for key jobs throughout the organization, regardless of nationality. The advantages of a geocentric approach are: (1) Uses human resources efficiently, (2) Helps build strong culture and informal management network. The disadvantages of the geocentric staffing policy are: (1) National immigration policies may limit implementation, and (3) It is expensive to implement. A geocentric approach is typically appropriate for firms unitizing a global or transnational strategy.

753 Chapter 16: Global Human Resource ManagementCRITICAL THINKING AND DISCUSSION QUESTIONS 2. Research suggests that many expatriate employees encounter problems that limit both their effectiveness in a foreign posting and their contribution to the company when they return home. What are the main causes and consequences of these problems, and how might a firm reduce the occurrence of such problems? Answer: The primary causes of expatriate problems are the inability of the spouse to adjust, inability of the employee to adjust, other family problems, personal/emotional maturity, and an inability to cope with the larger overseas responsibilities. The consequences of such problems are that an employee can be ineffective or detrimental overseas, and/or may return prematurely before the assigned job tasks are completed. A firm can reduce the occurrence of expatiate problems by developing an effective selection process, training, and repatriation program. The most successful expatriates seem to be those who have high self-esteem and self-confidence, get along well with others, are willing to attempt to communicate in a foreign language, and can empathize with people of other cultures. An expatriate training program should include cultural, language, and practical training. Cultural training seeks to foster an appreciation of the host country's culture so that the expatriate behaves accordingly. Language training involves training in local language both from a business and personal perspective. Practical training is aimed at assisting the expatriate manager and her family to ease themselves into day-to-day life in the host country. The sooner a day-to-day routine is established, the better the prospects are that the expatriate and family will adapt successfully. Before leaving, however, specific plans and procedures should be in place for the repatriation of the employee.

754 Chapter 16: Global Human Resource ManagementCRITICAL THINKING AND DISCUSSION QUESTIONS 3. What is the link between an international business's strategy and its human resource management policies, particularly with regard to the use of expatriate employees and their pay scale? Answer: In firms pursuing a localization strategy, a polycentric staffing approach is most common and there are relatively few expatriates or the associated pay issues. Expatriates are more common in firms with international strategies, and an ethnocentric staffing approach is utilized. In this situation the pay is often based on home country levels, with adjustments as required for differing living costs and taxes as outlined by the balance sheet approach. Firms pursuing global standardization or transnational strategies most often use a geocentric approach to staffing, where the best individuals (regardless of nationality) are chosen fill positions in any country. Here the pay issues for expatiates can become particularly complex, as allowance must be made for home country norms, host country costs and expectations, and global norms across the company.

755 Chapter 16: Global Human Resource ManagementCRITICAL THINKING AND DISCUSSION QUESTIONS 4. In what ways can organized labor constrain the strategic choices of an international business? How can an international business limit these constraints? Answer: Organized labor can significantly constrain the choices firms make with respect to location. International firms (or domestic ones for that matter) often choose to locate new facilities in places where there is relative labor peace and harmonious working relations. Labor can also raise objections and threaten disruptive behavior if a firm decides to move some activities to other locations - which in some cases only reinforces the need for relocating the activities. Organized labor has also attempted to (i) set-up their own international organizations, (ii) lobby for national legislation to restrict multinationals, and (iii) achieve regulation of multinationals through international organization such as the United Nations. However, none of these broader efforts have been that successful. International businesses have the advantage of being able to provide or take away jobs, and in today's labor market that gives them considerable power. As a condition of opening or expanding a facility, firms can negotiate favorable conditions with local unions and force unions to compete against each other for the gains in membership.