INSTRUCTOR MANUAL for International Business The Challenges of Globalization 8e John Wild Kenneth Wi by StudyGuide

INSTRUCTOR MANUAL for International Business The Challenges of Globalization 8e John Wild Kenneth Wild.

CHAPTER 1 GLOBALIZATION LEARNING OBJECTIVES: 1. Identify the types of companies active in international business. 2. Explain globalization and how it affects markets and production. 3. Detail the forces that are driving globalization. 4. Outline the debate over globalization’s impact on jobs and wages. 5. Summarize the debate over income inequality. 6. Outline the debate over culture, sovereignty, and the environment. 7. Describe the global business environment and its main elements. CHAPTER OUTLINE: Introduction International Business Involves Us All Technology Makes It Possible Global Talent Makes It Happen Key Players in International Business Multinational Corporations Entrepreneurs and Small Businesses What Is Globalization? Globalization of Markets Reduces Marketing Costs Creates New Market Opportunities Levels Uneven Income Streams Local Buyers’ Needs Global Sustainability Three Markets, Three Strategies Globalization of Production Access Lower-Cost Workers Access Technical Expertise Access Production Inputs Forces Driving Globalization Falling Barriers to Trade and Investment World Trade Organization Other International Organizations Regional Trade Agreements Trade and National Output Technological Innovation E-Mail and Videoconferencing The Internet Company Intranets and Extranets Advancements in Transportation Technologies Measuring Globalization Debate Over Jobs and Wages Against Globalization Eliminates Jobs in Developed Nations

Ch 1: Globalization Lowers Wages in Developed Nations Exploits Workers in Developing Nations For Globalization Increases Wealth and Efficiency in All Nations Generates Labor Market Flexibility in Developed Nations Advances the Economies of Developing Nations Summary of the Jobs and Wages Debate Debate Over Income Inequality Inequality within Nations Inequality between Nations Global Inequality Summary of the Income Inequality Debate Debate Over Culture, Sovereignty and the Environment Globalization and Culture Globalization and National Sovereignty Globalization: Menace to Democracy? Globalization: Guardian of Democracy? Globalization and the Environment The Keys to Global Success The Global Business Environment The Road Ahead for International Business Bottom Line for Business

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 1. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION Globalization is reshaping our cultures, our political, legal, and economic systems, and affecting our standards of living. It alters the global pattern of trade and investment by expanding markets and multiplying production possibilities. A. International Business Involves Us All 1. Each of us encounters the result of international business transactions every day whether we realize it or not. 2. International business is any commercial transaction that crosses the borders of two or more nations. 3. Imports are goods and services purchased abroad and brought into a country. Exports are goods and services sold abroad and sent out of a country. B. Technology Makes It Possible 1. Technology is a remarkable facilitator of international business and change. 2. E-business (e-commerce) is the use of computer networks to purchase, sell, or exchange products; service customers; and collaborate with partners.

Ch 1: Globalization C.

Global Talent Makes It Happen 1. Development and production now regularly occur on a global basis for many goods and services. 2. Performing these globally increases firm efficiency and competitiveness.

II.

KEY PLAYERS IN INTERNATIONAL BUSINESS Large firms from developed nations once dominated, but firms from Brazil, China, and India now play a bigger role. Technological advancements allow small and midsize companies to better compete. A. Multinational Corporations A multinational corporation (MNC) has direct investments abroad in multiple countries. They generate significant jobs, investment, and tax revenue for the regions and nations they enter. 1. Profiling the largest multinationals a. Some MNCs have more employees than small nations have citizens (e.g., Walmart has 2.2 million employees globally). b. If Walmart were a country, it would rank third behind Norway in terms of economic power (Figure 1.1). B. Entrepreneurs and Small Businesses 1. They are increasingly active in international business by exporting earlier and growing faster with help from technology. 2. A born global firm is a company that adopts a global perspective and engages in international business from or near its inception. 3. Some small Internet companies reach customers solely through the Web (e.g., Vellus Products, Weekend in Italy).

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WHAT IS GLOBALIZATION? Globalization is the trend toward greater economic, cultural, political, and technological interdependence among national institutions and economies. It is marked by “denationalization,” which is not “internationalization.” A. Globalization of Markets 1. Convergence in buyer preferences in markets around the world a. Reduces marketing costs by standardizing activities b. Creates market opportunities abroad if home is small or saturated c. Levels uneven income streams for global seasonal products d. Yet companies must not overlook local buyers’ needs e. Need for global sustainability—development that meets the needs of the present without compromising the ability of future generations to meet their own needs. 2. Global Sustainability, Three Markets, Three Strategies. The world’s 7 billion people live in three types of markets, yet all require companies to act in a sustainable manner: a. Developed markets are solidly middle class and people can consume almost any product desired. A firm may use the latest technologies to develop sustainable products in a sustainable manner. b. Emerging markets are racing to catch up to rich nations and are overloading infrastructures. Resource constraints can force companies to develop sustainable production methods. c. Traditional markets have mostly rural populations for whom poverty and corruption prevail. Here, sustainability means Copyright © 2016 Pearson Education, Inc.

Ch 1: Globalization

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teaching safe farming practices, environmental stewardship, and disease awareness. Globalization of Production 1. Dispersal of production activities to locations that help a company to minimize costs or maximize quality a. Access lower-cost workers to cut overall production costs b. Access technical expertise c. Access production inputs unavailable or more costly at home

FORCES DRIVING GLOBALIZATION Forces increase competition among nations by leveling the global business playing field. A. Falling Barriers to Trade and Investment 1947 General Agreement on Tariffs and Trade (GATT) was designed to promote free trade by reducing tariffs and nontariff barriers. 1994 GATT revision (1) reduced tariffs and lowered subsidies for agricultural products; (2) defined and protected intellectual property rights; and (3) created the WTO. 1. World Trade Organization a. World Trade Organization (WTO) is the international organization that enforces the rules of international trade. b. WTO goals: (1) to help the free flow of trade, (2) help negotiate the further opening of markets, and (3) settle trade disputes. c. WTO agreements are contracts committing members to fair and open trade policies. WTO dispute settlement system is the spine of the global trading system. 2. Regional Trade Agreements a. Smaller groups of nations also are integrating their economies (e.g., NAFTA, European Union). 3. Trade and National Output a. Effect of the WTO and regional trade pacts is greater global trade and cross-border investing (Map 1.1). b. Trade growth has been faster than world output. c. Gross Domestic Product (GDP) is the value of all goods and services produced by a domestic economy over a one-year period. Gross national product (GNP) adds income from international activities. B. Technological Innovation Technology accelerates globalization by making it easier, faster, and less costly to move data, goods, and equipment around the world. 1. E-mail and videoconferencing a. Speed information flows and ease the tasks of coordination and control, which are complicated by operating across borders. b. Driving growth in videoconferencing are lower-cost bandwidth and equipment, and decreased travel for cost or safety reasons. 2. The Internet a. Helps firms sharpen forecasting, lower inventories, improve communication with suppliers, and communicate quickly and cheaply with distant managers b. Reduces the cost of reaching an international customer base, which is essential for the competitiveness of small firms 3. Company intranets and extranets

Ch 1: Globalization

Intranets are private networks of company Web sites and other information sources that allow employee access to information from distant locations. b. Extranets are computer networks that give distributors and suppliers access to a company’s database so they can place orders or restock inventories electronically and automatically. 4. Advancements in transportation technologies a. Make global shipping more efficient and dependable (e.g., GPS) Measuring Globalization 1. The KOF Swiss Economic Institute’s Globalization Index ranks nations on their economic, social, and political engagement. 2. Richest nations are the most global, with many in Europe. The United States ranked 32nd (see Table 1.1). 3. The least global nations are found in Africa, East Asia, South Asia, Latin America, and the Middle East. Low technological connectivity slows global integration.

DEBATE OVER JOBS AND WAGES A. Against Globalization 1. Eliminates jobs in developed nations as good-paying manufacturing jobs go abroad to developing countries. Low-priced goods are not worth lost jobs. 2. Lowers wages in developed nations by causing worker dislocation that gradually lowers wages. New jobs that replace lost manufacturing jobs often pay less. 3. Exploits workers in developing nations who work cheaply servicing western consumers. B. For Globalization 1. Increases wealth and efficiency in all nations because trade openness raises output. Firms grow more efficient and pass savings on to consumers. 2. Generates labor market flexibility in developed nations that allows an economy to rapidly deploy labor where demand is relatively great. 3. Advances the economies of developing nations by injecting capital that creates higher-paying jobs, which expands the middle class and raises standards of living. C. Summary: Although globalization eliminates jobs in some economic sectors, it creates jobs in other sectors. Gains in national economies are worth lost livelihoods that individuals may suffer. D. Globalization’s Impact on Labor, the Environment, and Markets 1. Labor standards a. Trade unions claim that firms continually move to nations with low labor standards, which reduces labor’s bargaining power and forces overall labor standards lower. b. But studies of developing nations’ export processing zones instead find evidence that contradicts such claims. 2. Environmental protection a. Globalization opponents say it creates a “race to the bottom” in environmental conditions and regulations: countries compete in reducing environmental protection laws.

Ch 1: Globalization b.

But evidence shows pollution-intensive U.S. firms tend to invest in countries with stricter environmental standards. Also, closed economies historically are the worst polluters. Future markets a. Protesters claim international firms pay locals the lowest possible wage and export their goods back to the home country. b. Today, firms want to build local markets in developing nations, not simply exploit workers and foment local animosity.

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DEBATE OVER INCOME INEQUALITY A. Inequality within Nations 1. Globalization critics claim that income disparity in rich nations is increasing as firms move factory jobs to poor nations. 2. Evidence is mixed, but poor people in developing nations seem to benefit from an open economy. B. Inequality between Nations 1. Globalization opponents say it is widening the gap in average incomes between rich and poor nations. 2. Looking closely at the evidence, we see that open nations are benefiting from trade whereas closed ones are not. C. Global Inequality 1. Opponents of globalization say it is widening income inequality among all people of the world. 2. Studies tend to agree that global inequality has fallen in recent decades, though they disagree on the extent of the decline. D. Summary of the Income Inequality Debate

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DEBATE OVER CULTURE, SOVEREIGNTY AND THE ENVIRONMENT A. Globalization and Culture 1. Critics say globalization homogenizes our world and lets MNCs destroy cultural diversity and wipe out small local businesses. 2. Yet globalization allows nations to: (1) specialize and trade for goods they do not produce, (2) import other peoples’ cultural goods, and (3) still protect deeper moral and cultural norms. B. Globalization and National Sovereignty 1. Globalization: menace to democracy? a. Supranational institutions with international goals and appointed officials undermine national sovereignty and democracy. b. Elected officials undercut democracy and local and regional authority with “international” agreements on citizens’ behalf. 2. Globalization: guardian of democracy? a. Globalization has helped spread democracy worldwide (e.g., more democratic nations than ever). b. Some losses of sovereignty have had positive social impacts, as in human rights, workers’ rights, and discrimination.

VIII.

THE KEYS TO GLOBAL SUCCESS A. Communicate effectively B. Know the customer C. Emphasize global awareness D. Market effectively

Ch 1: Globalization E.

Monitor the global environment

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THE GLOBAL BUSINESS ENVIRONMENT What makes international business special is that it occurs within a dynamic, integrated system that weaves together four distinct elements. A. The Global Business Environment 1. Globalization is transforming our societies and commercial activities. It also increases competition everywhere, forcing companies to be vigilant. 2. Each national business environment consists of unique cultural, political, legal, and economic characteristics. Companies must be attentive to nuances and adapt products and practices as needed. 3. The international business environment influences how business is conducted so firms must closely monitor events. 4. Context of international business management is defined by the characteristics of the national and international business environments. Managers must abide by the prevailing rules in each market in which it operates. B. The Road Ahead for International Business Part 1 (Chapter 1): Globalization Part 2 (Chapters 2–4): National Business Environments Parts 3 and 4 (Chapters 5–8 and 9–10): International Business Environment Part 5 (Chapters 11–16): International Business Management

BOTTOM LINE FOR BUSINESS A. Harnessing Globalization’s Benefits 1. The most global nations tend to have the greatest equality, robust environmental protection, inclusive political systems, lowest levels of corruption, healthiest lifestyles, and be where women have achieved the most social, educational, and economic progress. 2. The debate has opened a dialogue on how globalization can be harnessed to make its benefits exceed its costs. B. Intensified Competition 1. Continued globalization is taking companies into previously isolated markets and increasing competitive pressures worldwide. 2. As it gets easier and less costly to manage widely dispersed marketing and production activities, new opportunities and threats emerge. C. Wages and Jobs 1. Low wages are not all that draws investment by multinationals. A location must offer low-cost, adequately skilled workers in an environment with acceptable levels of social, political, and economic stability. 2. Labor mobility is increasing with globalization—depressing wages in some job categories but developing new job opportunities in others. D. The Policy Agenda 1. Rich nations could open their markets, slash agricultural subsidies, and increase development aid. Poor nations could improve their investment climates and improve social protection for the poor. 2. Rich nations could offer workers their wage insurance, subsidized health insurance if out of work, and improve education. Rich nations could help enforce labor standards, help clarify environmental agreements, and research the environmental implications of trade agreements. Copyright © 2016 Pearson Education, Inc.

Ch 1: Globalization

Quick Study Questions Quick Study 1 1.

Q: What is the value of goods and services that all nations of the world export every year? A: Goods worth $18.4 trillion and services worth 4.3 trillion.

Q: A business that has direct investments in the form of marketing or manufacturing subsidiaries abroad in multiple countries is called a what? A: A business that has direct investments abroad in multiple countries is a multinational corporation (MNC).

Q: A born global firm engages in international business from or near its inception and does what else? A: A born global firm also adopts a global perspective.

Quick Study 2 1.

Q: Globalization causes the institutions and economies of nations to become what? A: Globalization causes institutions and economies of nations to become more interdependent.

Q: What benefits might a company obtain from the globalization of markets? A: Globalization of markets refers to convergence in buyer preferences in markets around the world. Potential benefits for companies include: (1) reduced marketing costs by standardizing activities, (2) market opportunities abroad if home market is small or saturated, and (3) levels an income stream by letting international sales offset domestic sales for a company selling a global seasonal product.

Q: Sustainability is development that meets present needs without compromising what? A: Sustainability is development that meets present needs without compromising the ability of future generations to meet their own needs.

Quick Study 3 1.

Q: What global organizations have helped expand globalization? A: The 1947 GATT lowered trade barriers and made it cheaper and easier to ship goods across borders. In 1988 world merchandise trade was 20 times larger than in 1947; average tariffs dropped from 40 percent to 5 percent. A 1994 GATT revision created the WTO, which has the power to enforce international trade rules. Goals of the WTO are: (1) to help the free flow of trade, (2) help negotiate further opening of markets, and (3) settle trade disputes. WTO agreements are contracts committing members to fair and open trade policies. The WTO dispute settlement system is the spine of the global trading system. The World Bank and the International Monetary Fund have also helped expand globalization.

Q: What technological innovations are helping to propel globalization?

Ch 1: Globalization

A: E-mail and videoconferencing speed information flows and ease the tasks of coordination and control. Firms use the Web to sharpen forecasting, lower inventories, and improve communication with suppliers, and to communicate with distant managers quickly, cheaply, and efficiently. The Web also reduces the cost of reaching international customers—important for the competitiveness of small firms. Company intranets allow employees to access information from distant locations to share best practices. Extranets give distributors and suppliers access to a company’s database so they can place orders or restock inventories electronically and automatically. Transportation advancements are facilitating globalization by making shipping more efficient and dependable. 3.

Q: What nations rank high in terms of globalization? A: Belgium is an example of a nation that ranks high in terms of globalization.

Quick Study 4 1.

Q: In the debate over jobs and wages, opponents of globalization say that it does what? A: Opponents state that globalization eliminates jobs in developed nations, exploits workers in developing countries, and lowers wages in developed nations.

Q: In the debate over jobs and wages, supporters of globalization say that it does what? A: Supporters state that globalization generates labor market flexibility in developed nations and advances the economies of developing nations.

Quick Study 5 1.

Q: Evidence suggests that globalization can help developing nations boost incomes for their poorest citizens in what part of the debate over inequality? A: Inequality within nations

Q: In the debate over inequality between nations, evidence suggests that developing nations that are open to trade and investment do what? A: Evidences suggests that developing nations that are open to trade and investment grow faster than rich nations.

Q: Regarding the debate over global inequality, experts tend to agree on what? A: Experts tend to agree that inequality has fallen in recent decades.

Quick Study 6 1.

Q: People opposed to globalization say that it does what to national cultures? A: People opposed to globalization say that it homogenizes national cultures.

Q: Regarding national sovereignty, opponents of globalization say that it does what? A: Opponents say that globalization helps supranational organizations gain power, may force nations to violate the rights of local and state governments, and undercuts the democratic process and individual liberty.

Q: With regard to the physical environment, what do globalization supporters argue? A: Supporters argue that companies have invested in nations that were enacting stricter environmental rules; that few U.S. firms invest to obtain low-cost resources and then

Ch 1: Globalization export finished goods to the United States; that firms care for the environment abroad to nurture future local markets for their goods and services.

Quick Study 7 1.

Q: It helps to think about international business as four elements that occur within a what? A: It is helpful to view international business as occurring within an integrated global system consisting of four main elements: (1) Globalization is a potent force transforming our societies and commercial activities. (2) Separate national business environments, including culture and systems of politics, law, and economics. (3) The international business environment, which is where the actions of consumers, workers, companies, financial institutions, and governments from different nations converge. (4) International business management which involves all the duties of management in a domestic setting, but which are complicated by a multitude of differences.

Q: How does managing an international firm differ from managing a purely domestic business? A: International firms encounter unfamiliar societies. International managers must scan the globe for opportunities and threats. International firms may need to adapt practices or products to local conditions.

Ethical Challenge You are the CEO of a major U.S. apparel company that contracts work to garment manufacturers abroad. Employees of the contractors report 20-hour workdays, pay lower than the minimum wage, overcrowded living conditions, physically abusive supervisors, and confiscation of their passports. Contractors and government officials say local labor laws are adhered to and enforced, though abuses appear widespread. You send inspectors to the factories abroad but they uncover no labor violations. A labor-advocacy group claims that supervisors coached workers to lie to your inspectors about conditions and threatened workers with time in makeshift jails without food if they talked. 1-5 Should you implement a monitoring system to learn the truth about what is happening? 1-6 Do you help the factory improve conditions, withdraw your business, or simply do nothing? 1-7 How might your actions affect your relations with the factory owner and your ability to do business in the country? A: It’s extremely important that your company be thorough and transparent throughout the monitoring process. The monitoring process could seem more impartial by contracting an independent organization to conduct the investigation, rather than employ someone with whom the company might be suspected as having social or political connections. You could also have the report made public to all parties simultaneously to eliminate the perception of the report being adjusted. To implement and maintain rapid, sustainable improvements: monitor and verify codes of conduct regarding labor practices, disseminate information to workers explaining their rights, appeal to government agencies on effective ways to raise labor standards, explain how their reputation as being “good guys” in the labor standards arena can create a useful marketing tool and opportunities for firms and countries by differentiating themselves when competing in the apparel export market.

Ch 1: Globalization

Teaming Up Research Project. Imagine that you and several of your classmates own a company that manufactures cheap sunglasses. To lower production costs, you choose to move your factory from your developed country to a more cost-effective nation. 1-8 What elements of the national business environment might influence your decision where to move production? Are there obstacles to overcome in the international business environment? 1-9 What aspects of the globalization of production and marketing will you expect will benefit your company after the move? A: This project gets students to begin pondering the types of elements that must be considered when selecting a country for investment. At a minimum, students’ responses should consider: (1) the presence of investment barriers in the country; (2) resources needed to carry out production, as well as their availability and cost; (3) availability of modern telecommunications to facilitate communication with the home office; and (4) how the expansion might be financed. Practicing International Management Case MTV Goes Global with a Local Beat 1-16.

Q: Some people outside the United States say teens exposed to large doses of U.S. youth culture on MTV will identify less with their own societies and teens in developing countries will want Western goods they cannot afford. MTV’s response: “It’s just fun, it’s only TV,” says one executive. What do you think? Are there dangers in broadcasting U.S.-style programs and ads to developing countries? A: The debate over the impact of U.S. programming beamed to other developed and developing cultures will likely never cease. The U.S. television program The Simpsons, which depicts a rather unflattering U.S. family, is seen in more than 90 countries. Such a program is unlikely to encourage young people outside the United States to grow up to be like Homer Simpson. Generally, this program and others, such as Married with Children, the Jerry Springer Show, and Baywatch, are watched around the world for a glimpse into the humorous or darker aspects of U.S. culture. On the other hand, local programming can lose out to the U.S. programming if it is not as entertaining. In regard to desires among young people for more “Western” goods, this is a sensitive issue involving elements of economic development and materialism. It could be argued that it is not ethical to show U.S. programs that depict wealthy lifestyles in developing countries because they promote discontent in those markets and promote materialism. However, there are wealthy and poor people in every nation and, following this line of reasoning, one could argue that such programs should not be aired in the U.S. market either—incidentally, some groups do make this argument.

1-17.

Q: Digital compression technology made it possible for MTV to program over a global network. Can you think of other technological innovations that have helped companies to think globally and act locally?

Ch 1: Globalization A: Internet retailers such as Amazon make online books in English available globally. However, Amazon also has online service to accommodate those in French- and Spanishspeaking countries. This is a localized approach. The French version of Amazon can further localize its selections by offering books tailored to specific Francophone regions such as Africa and Canada, not just France. Clearly, Amazon can continue to localize by selecting other languages where significant numbers of readers are.

CHAPTER 2 CROSS-CULTURAL BUSINESS LEARNING OBJECTIVES: 1. Explain culture and the need for cultural knowledge. 2. Summarize the cultural importance of values and behavior. 3. Describe the roles of social structure and education in culture. 4. Outline how the major world religions can influence business. 5. Explain the importance of personal communication to international business. 6. Describe how firms and culture interact in the global workplace.

CHAPTER OUTLINE: Introduction What Is Culture? National Culture Subcultures Physical Environment Need for Cultural Knowledge Avoiding Ethnocentricity Developing Cultural Literacy Values and Behavior Values Attitudes Aesthetics Appropriate Behavior Manners Customs Folk or Popular Customs The Business Customs of Gift Giving Social Structure and Education Social Group Associations Family Gender Social Status Social Mobility Caste System Class System Education The “Brain Drain” Phenomenon Religion Christianity Islam Hinduism Buddhism Confucianism Judaism Shinto

Ch 2: Cross-Cultural Business

Personal Communication Spoken and Written Language Implications for Managers Language Blunders Lingua Franca Body Language Culture in the Global Workplace Perception of Time View of Work Material Culture Cultural Change Cultural Trait Cultural Diffusion When Companies Change Cultures Cultural Imperialism When Culture Changes Companies Studying Culture in the Workplace Kluckhohn-Strodtbeck Framework Case: Dimensions of Japanese Culture Hofstede Framework Bottom Line for Business

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 2. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION This chapter describes culture in the context of international business, explains how culture affects international business practices and competitiveness, and presents two methods of classifying cultures.

II.

WHAT IS CULTURE? Culture is the set of values, beliefs, rules, and institutions held by a specific group of people. Main components include: aesthetics, values and attitudes, manners and customs, social structure, religion, personal communication, education, and physical and material environments. A. National culture 1. Nation-states support and promote the concept of a national culture by building museums and monuments to preserve the legacies of important events and people. 2. Nation-states intervene to help preserve their national cultures. 3. Companies get involved in supporting culture, in part, for the public relations benefit. B. Subcultures

Ch 2: Cross-Cultural Business

III.

A subculture is a group of people who share a unique way of life within a larger, dominant culture. It can differ from the dominant culture in language, race, lifestyle, values, attitudes, and so on. 2. Companies must be mindful of subcultures when formulating business strategies (e.g., China has 50 ethnic groups). 3. Decisions regarding product design, packaging, and advertising must consider distinct cultures. 4. Subcultures also can extend beyond national borders. Physical environment—These heavily influence a culture’s development and pace of change. 1. Topography: all physical features that characterize the surface of a geographic region. Cultures isolated by impassable mountains or large bodies of water are less exposed to the cultural traits of others and change slowly. Topography impacts product needs. 2. Topography impacts personal communication (e.g., mountains and the Gobi Desert consume two-thirds of China). 3. Climate affects where people settle and directs systems of distribution (e.g., Australian desert, jungles, and coastal areas). 4. Climate plays a large role in lifestyle, clothing, and work habits, such as organizing production schedules for idled machines. Need for Cultural Knowledge 1. Avoiding ethnocentricity a. Ethnocentricity is the belief that one’s own ethnic group or culture is superior to that of others. It causes people to view other culture in terms of their own and overlook beneficial aspects of other cultures. b. Ethnocentricity can undermine business can undermine business projects when employees are insensitive to cultural nuances. 2. Developing cultural literacy a. Managers working directly in international business should develop cultural literacy—detailed knowledge about a culture that enables a person to function effectively within it. b. Cultural literacy brings a company closer to customer needs and improves competitiveness.

VALUES AND BEHAVIOR A. Values are ideas, beliefs and customs to which people are emotionally attached. They affect work ethic and desire for material possession. Some culture value leisure others hard work. B. Attitudes 1. Attitudes are positive or negative evaluations, feelings, and tendencies that individuals harbor toward objects or concepts. Learned from role models and formed within a cultural context. More flexible than values. C. Aesthetics 1. Aesthetics is what a culture considers to be in “good taste” in the arts, the imagery evoked by certain expressions, and the symbolism of colors. 2. Appropriate colors for advertising, product packaging, and even work uniforms can enhance success (e.g., Green in Islam). 3. Blunders can result from selecting inappropriate colors and symbols for advertising, product packaging, and architecture.

Ch 2: Cross-Cultural Business

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4. Music is deeply cultural and must be considered in promotions. 5. It is also an important consideration in marketing over the Internet. Appropriate Behavior—it is important to understand manners and customs to avoid mistakes abroad. In depth knowledge improves the abilities of managers. 1. Manners are appropriate ways of behaving, speaking, and dressing in a culture (e.g., conducting business during meals in the United States). 2. Customs are habits or ways of behaving in specific circumstances that are passed down through generations in a culture. Customs define appropriate habits or behaviors in specific situations. a. Folk customs are behaviors, dating back generations, practiced within a homogeneous group of people (e.g., dragon boat festival in China). b. A popular custom is behavior practiced by a heterogeneous group or by several groups (e.g., blue jeans, “burgers ’n fries”). 3. The business custom of gift giving a. Although giving token gifts to business and government associates is customary, the proper type of gift varies. b. Cultures differ in their legal and ethical rules regarding bribery. The U.S. Foreign Corrupt Practices Act prohibits companies from giving large gifts to win business favors, applies to U.S. firms operating at home and abroad.

SOCIAL STRUCTURE Social structure embodies a culture’s fundamental organization, including groups and institutions, social positions and relationships, and resource distribution. A. Social Group Associations A social group is a collection of two or more people who identify and interact with one another. Contribute to identity and self-image. 1. Family a. Nuclear family consists of immediate relatives, including parents, brothers, and sisters. Prevails in Australia, Canada, United States, and in Europe. b. Extended family includes grandparents, aunts and uncles, cousins, and relatives through marriage. More important in Asia, Middle East, North Africa, and Latin America. 2. Gender a. Gender refers to socially learned traits associated with, and expected of, men or women. Sociologists regard gender as a category—people who share some status. b. Countries vary regarding gender equality at work. B. Social Status 1. Social stratification is the process of ranking people into social layers according to family heritage, income, and occupation. 2. Top layer: royalty, government officials, and business leaders. Middle layer: scientists, medical doctors, and others with a university education. Bottom layer: manual and clerical workers with vocational training or secondary-school educations. 3. Rankings can and do change over time.

Ch 2: Cross-Cultural Business C.

Social Mobility 1. Social mobility is the ease with which individuals can move up or down a culture’s “social ladder.” 2. Caste system: people are born into a social ranking, with no opportunity for social mobility. 3. Class system: personal ability and actions decide status and mobility. Highly class-conscious cultures can offer less mobility but experience more class conflict.

EDUCATION Education passes on traditions, customs, and values. Cultures educate young people through schooling, parenting, religious teachings, and group memberships. Families and other groups provide informal instruction about customs and how to socialize with others. A. Education Level 1. Excellent basic education attracts high-wage industries that invest in training and increase productivity. Skilled, well-educated workforce attracts high-paying jobs; a poorly educated one attracts low-paying jobs. 2. Newly industrialized economies in Asia owe much of their economic development to solid education systems. B. The “Brain Drain” Phenomenon 1. Brain drain: departure of highly educated people from one profession, geographic region, or nation to another. 2. Reverse brain drain: professionals return to their homelands.

VI.

RELIGION Human values often derive from religious beliefs. Different religions take different views of work, savings, and material goods. Beliefs influence competitiveness, economic development, and business strategies. A. Christianity 1. Founded in Palestine 2,000 years ago among Jews who believed that Jesus of Nazareth was the messiah. With 2 billion followers, it is the world’s single largest religion. 2. More than 300 denominations but most are Roman Catholic, Protestant, or Eastern Orthodox. 3. Roman Catholics are to refrain from placing materialism above God and people. Protestants believe that salvation comes from faith in God and that hard work gives glory to God. 4. Christian organizations sometimes get involved in social causes that affect business policy (e.g., Ryanair, Hyundai). B. Islam 1. Founded by Muhammad in 600 A.D. in Mecca, Saudi Arabia—the holy city of Islam. World’s second largest religion with 1.3 billion adherents. Word Islam means “submission to Allah” and Muslim means “one who submits to Allah.” 2. Religion strongly affects the goods and services acceptable to Muslim consumers (e.g., alcohol, pork, interest on loans). C. Hinduism 1. Founded 4,000 years ago in present-day India, where more than 90 percent of its nearly 900 million adherents live. 2. Some say it is a way of life rather than a religion. Caste system is integral to the Hindu faith. Believe in reincarnation—rebirth of the human soul at

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the time of death. Do not eat or willfully harm living creatures as they may be reincarnated human souls. 3. Cows considered sacred animals so eating beef is not allowed (e.g., McDonald’s replaces beef with lamb). Buddhism 1. Founded 2,600 years ago in India by a Hindu prince named Siddhartha Gautama. About 380 million followers, mostly in Asia: China, Tibet, Korea, Japan, Vietnam, and Thailand. 2. Promotes a life centered on spiritual rather than worldly matters. Buddhists seek nirvana (escape from reincarnation) through charity, modesty, compassion for others, restraint from violence, and general self-control. Confucianism 1. Founded 2,500 years ago by exiled politician and philosopher Confucius. China is home to most of the 225 million followers. 2. Confucian thought ingrained in the cultures of Japan, South Korea, and nations with large numbers of ethnic Chinese, including Singapore. 3. South Korean business practice reflects Confucian thought in its rigid organizational structure and reverence for authority (e.g., Korean-style management in overseas subsidiaries). 4. For centuries, people despised merchants because earning money violated Confucian beliefs. Many Chinese moved to Indonesia, Malaysia, Singapore, and Thailand to do business. Judaism 1. Founded more than 3,000 years ago and 18 million followers. Was the first religion to teach belief in one God. Orthodox (“fully observant”) Jews make up 12 percent of Israel and constitute an increasingly important economic segment. 2. Important observances are Rosh Hashanah (the Jewish New Year), Yom Kippur (the Day of Atonement), Passover (the Exodus from Egypt), and Hanukkah (a victory over the Syrians). 3. Employers must be aware of Jewish holidays. Because Sabbath lasts from sundown on Friday to sundown on Saturday, work schedules might need adjustment. 4. Marketers must take into account foods banned among observant Jews (e.g., pork and shellfish prohibited, meat stored and served separately from milk) and “kosher” foods. Shinto 1. Means “way of the gods” and arose as the native religion of the Japanese. Teaches sincere and ethical behavior, loyalty and respect toward others, and enjoyment of life. Shinto claims about 4 million strict adherents in Japan. 2. Shinto beliefs are reflected in the workplace through lifetime employment (although this is waning today) and the traditional trust extended between firms and customers. 3. Japanese competitiveness in world markets has benefited from loyal workforces, low employee turnover, and good labor–management cooperation.

PERSONAL COMMUNICATION

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Every culture has a communication system to convey thoughts, feelings, knowledge, and information through speech, writing, and actions. A culture’s spoken and body language can help explain people’s thoughts and behaviors. A. Spoken and Written Language 1. Linguistically different segments of a population are often culturally, socially, and politically distinct. 2. Companies have made language blunders in their international business dealings. 3. A lingua franca is a third or “link” language that is understood by two parties who speak different languages. 4. Some languages are dying out, whereas some languages are growing, including Mandarin, Spanish, and English. B. Body Language 1. Communicated through unspoken cues, including hand gestures, facial expressions, physical greetings, eye contact, and the manipulation of personal space. 2. Communicates information and feelings and differs among cultures. Most is subtle and takes time to interpret. 3. Proximity is an element of body language; standing too close may invade personal space and appear aggressive. VIII.

CULTURE IN THE GLOBAL WORKPLACE A. Perceptions of Time 1. Latin American and Mediterranean cultures are casual about time; people in Japan and the United States arrive promptly for meeting and keep tight schedules. 2. Americans strive toward workplace efficiency and may leave work early if their work is done because they value individual results. Japanese look busy even when business is slow to demonstrate dedication—an attitude grounded in cohesion, loyalty and harmony B. View of Work 1. Some cultures have a strong work ethic, others stress a balanced pace in work and leisure (e.g., “Work to live, or live to work”) 2. Many European nations are trying to foster an entrepreneurial spirit to achieve the job growth realized in the United States. C. Material Culture—Includes all technology a culture uses to manufacture goods and provide services, and can measure a culture’s technological advancement. 1. A firm enters a market under one of two conditions: (1) demand for its products has developed, or (2) the market is capable of supporting its production operations. 2. Changes in material culture can change other aspects of culture. 3. Many nations display uneven levels of material culture across geography, markets, and industries. D. Cultural Change 1. Cultural trait is anything that represents a culture’s way of life including gestures, material objects, traditions, and concepts. 2. Cultural diffusion is the process whereby cultural traits spread from one culture to another. Globalization and technology are increasing the pace of cultural diffusion and change. 3. Culture can force companies to adjust business policies and practices, such as using situational management. Copyright © 2016 Pearson Education, Inc.

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Rapid cultural diffusion and increased human interaction across borders cause cultures to converge. Convergence is taking place in some market segments for some products. When Companies Change Culture 1. Cultural Imperialism is the replacement of one culture’s traditions, folk heroes, and artifacts with substitutes from another.

STUDYING CULTURE IN THE WORKPLACE People in different cultures respond differently in similar business situations. Two ways to classify cultures based on characteristics such as values, attitudes, and social structure. A. Kluckhohn–Strodtbeck Framework The Kluckhohn–Strodtbeck Framework compares cultures along six dimensions, asking the following questions: 1. Do people believe that their environment controls them, that they control the environment, or that they are part of nature? 2. Do people focus on past events, on the present, or on the future implications of their actions? 3. Are people easily controlled and not to be trusted, or can they be trusted to act freely and responsibly? 4. Do people desire accomplishments in life, carefree lives, or spiritual and contemplative lives? 5. Do people believe that individuals or groups are responsible for each person’s welfare? 6. Do people prefer to conduct most activities in private or in public? a. Dimensions of Japanese Culture: i. Japanese believe in a delicate balance between people and environment that must be maintained. ii. Japanese culture emphasizes the future. iii. Japanese culture treats people as quite trustworthy. iv. Japanese are accomplishment oriented for employers and work units. v. Japanese culture emphasizes individual responsibility to the group and group responsibility to the individual. vi. The culture of Japan tends to be public. B. Hofstede Framework The Hofstede Framework grew from a study of more than 110,000 people working in IBM subsidiaries by Dutch psychologist Geert Hofstede. He developed five dimensions for examining cultures. 1. Individualism versus Collectivism: Identifies the extent to which a culture emphasizes the individual versus the group. a. Individualist cultures value hard work, entrepreneurial risk taking, and freedom to focus on personal goals. b. Collectivist cultures feel a strong association to groups, including family and work units. The goal is to maintain group harmony and work toward collective rather than personal goals. 2. Power Distance: Identifies the degree to which a culture accepts social inequality among its people. a. Large power distance is characterized by inequality between superiors and subordinates. Organizations are hierarchical, with power derived from prestige, force, and inheritance.

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Small power distance means equality, with prestige and rewards equally shared between superiors and subordinates. Power derives from hard work and is considered more legitimate. c. Refer to Figure 2.2. Tight grouping of nations within the five clusters (plus Costa Rica): African, Asian, Central and South American, and Middle Eastern nations in Quadrant 1 (cultures with large power distance and lower individualism). Quadrants 2 and 3 include Australia and the nations of North America and Western Europe (cultures high in individualism and smaller power distance scores). Uncertainty Avoidance: Identifies the extent to which a culture avoids uncertainty and ambiguity. a. Cultures with large uncertainty avoidance value security, place faith in strong systems of rules and procedures, have lower employee turnover, formal rules for employee behavior, and more difficulty implementing change. b. Low uncertainty avoidance cultures are more open to change and new ideas. c. Refer to Figure 2.3. Quadrant 4 contains nations characterized by small uncertainty avoidance and small power distance, including Australia, Canada, Jamaica, the United States, and many Western European nations. Quadrant 2 contains many Asian, Central American, South American, and Middle Eastern nations—nations having large power distance and large uncertainty avoidance indexes. Masculinity versus Femininity: Identifies the extent to which a culture emphasizes masculinity versus femininity. a. Cultures scoring high are characterized by personal assertiveness, accumulation of wealth, and entrepreneurial drive. b. Cultures scoring low have relaxed lifestyles, with more of a concern for others than material gain. Long-Term Orientation: Indicates a society’s time perspective and an attitude of overcoming obstacles with time. It attempts to capture the differences between Eastern and Western cultures. a. Cultures scoring high (strong long-term orientation) value respect for tradition, thrift, perseverance, and a sense of personal shame. b. Cultures scoring low are characterized by individual stability and reputation, fulfilling social obligations, and reciprocation of greetings and gifts.

BOTTOM LINE FOR BUSINESS In this chapter we discussed many of the cultural differences among nations that affect international business. We saw how problems can erupt from cultural misunderstandings and learned how companies can improve their performance with cultural literacy. Localizing business policies and practices can promote success. Understanding a people’s values, beliefs, rules, and institutions makes managers more effective at their jobs.

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Quick Study Questions Quick Study 1 1.

Q: How might a subculture differ from the dominant culture? A: A subculture can differ from the dominant culture in language, race, lifestyle, values, attitudes or other characteristics.

Q: What do we call the belief that one man’s culture is superior to that of others? A: Ethnocentricity is the belief that one’s own ethnic group or culture is superior to that of others.

Q: What do we call detailed knowledge about a culture that enables a person to work happily within it? A: Cultural literacy is the detailed knowledge about a culture that enables a person to work happily within it.

Quick Study 2 1.

Q: What are examples of values? A: Ideas, beliefs, and customs to which people are emotionally attached to are called values.

Q: What type of custom might a conservative group oppose in a culture? A: Authorities in a strict religious district of Indonesia’s ACEH province banned Muslim women from wearing tight clothing, short skirts and blue jeans.

Q: The law that restricts the gift giving by U.S. firms at home and abroad is called? A: The U.S. Foreign Corrupt Practices Act prohibits companies from giving large gifts to government officials, in order to win business favors.

Quick Study 3 1.

Q: Social structure embodies a culture’s fundamental organization, including what? A: Social structure embodies a culture’s fundamental organizations; including its groups and institutions, its system of social positions and their relationships, and the process by which its resources are distributed.

Q: A person and his or her immediate relatives including parents and siblings, is called what? A: A nuclear family consists of a person’s immediate relatives, including parents, brothers and sisters.

Q: The departure of highly educated people from one profession, region, or nation to another is called what? A: The “brain drain” phenomenon refers to the departure of highly educated people from one profession, geographic region, or nation to another.

Quick Study 4

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Q: Which denomination of Christianity has a “work ethic” named after it? A: Protestants believe that salvation comes from faith in God and that hard work gives glory to God—a tenet which is widely known as the “Protestant Work Ethic.”

Q: India is home to more than 90 percent of the adherents of which religion? A: Hinduism formed around 4,000 years ago in present day India, where more than 90 percent of Hinduism’s 900 million adherents live.

Q: The Dalai Lama is the spiritual and political head of what religion? A: The Dalai Lama is the spiritual and political head of the Buddhist culture.

Quick Study 5 1.

Q: Every culture has a communication system that it uses to convey what? A: People in every culture have a communication system to convey thoughts, feelings, knowledge, and information through speech, writing, and actions.

Q: A special language understood by two parties who speak different native languages is called what? A: A lingua franca is a link language that is understood by two parties who speak different native languages. English is the lingua franca of global business, higher education, diplomacy, science, popular music, entertainment, and international travel. More than 70 nations give a special status to English (including India, Nigeria, and Singapore) and roughly one-quarter of the world’s population is fluent or competent in it.

Q: An interesting fact about body language is what? A: Body language is important because it reflects cultural communication styles through unspoken movements. It communicates through hand gestures, facial expressions, physical greetings, eye contact, and the manipulation of personal space. Like spoken language, it communicates both information and feelings and differs greatly from one culture to another. Italians, for example, animate conversations with lively hand gestures and other body motions. Japanese and Koreans, although more reserved, communicate just as much information through their own body languages; a look of the eye can carry as much or more meaning as two flailing arms.

Quick Study 6 1.

Q: People living in different cultures often have different views regarding their what? A: They have differing beliefs and behaviors that can affect activities in the workplace. Such as, different perceptions of time, view of work and change.

Q: What is an example of cultural imperialism? A: Fears of cultural imperialism still drive some French to oppose the products of the Walt Disney company and its Disneyland Paris theme park.

Q: The Kluckhohn-Strodtbeck framework does investigate whether people do what? A: The Kluckhohn-Strodtbeck Framework compares cultures along six dimensions, asking the following questions: 1. Do people believe that their environment controls them, that they control the environment, or that they are part of nature? 2. Do people focus on past events, on the present, or on the future implications of

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3. 4. 5.

their actions? Are people easily controlled and not to be trusted, or can they be trusted to act freely and responsibly? Do people desire accomplishments in life, carefree lives, or spiritual and contemplative lives? Do people believe that individuals or groups are responsible for each person’s welfare?

Q: In the Hofstede framework, the term “power distance” refers to what? A: It describes the degree of inequality between a culture’s people in different occupations.

Ethical Challenge You are the vice president of operations for a U.S.-based software firm that is exploring building a software design operation in India. Typically when international firms enter the Indian market, they quickly learn how a caste system can affect business activities. Although officially banned, the caste system still dictates everyday life for many people in India. You are confident regarding the likelihood of business success there, but you have strong misgivings about the caste system. 2-4 Do you think it will be possible to import and uphold a U.S. management style in India despite lingering effects of the caste system? 2-5 How do you think your company’s stakeholders would feel about your company simply adjusting to local management practices? A: Students must understand that understanding cultural differences is crucial to developing strong relationships. The question in this vignette poses a real dilemma for international companies operating in India. Local management practices can be very different from the company’s practices in its home country. The response by most companies is to implement the home country policies but to adapt them to the local market. This is probably best accomplished by placing as head of the Indian operation an Indian-born employee that has worked for the company in the home country who understands the corporate culture. This manager would know what policies can or cannot be implemented in the Indian subsidiary. Teaming Up Two groups of four students will debate the benefits and drawbacks of individualist versus collectivist cultures. After the first student from each side has spoken, the second will question the opponent’s arguments, looking for holes and inconsistencies. The third student will attempt to answer these arguments. The fourth student will present a summary of each side’s arguments. Finally, the class will vote on which tem has offered the more compelling argument. A: Students may want to use the content of this chapter as a guide to create the questions they will ask the interviewee. Students should include in their report a full account of the cultural elements their interview uncovers. Student teams may also enjoy comparing their findings to look for similarities and differences among companies.

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Practicing International Management Case A Tale of Two Cultures 2-14.

Q: If you worked for an international firm doing business in Asia, is there anything you would suggest to ease the tensions these cultures are experiencing? Be specific. A: This question presents students with an ethical dilemma. Some students will say that their company is in business to earn a profit and that Asian consumers are not being forced to buy Western goods—they make a conscious decision when they make a purchase. Other students will feel a sense of responsibility to those societies in which they market their products. These students will want to suggest ways to lessen tensions in those societies. Some possibilities for this include doing charity work to help people suffering economic difficulties, financially supporting and giving employees time off to do volunteer work for cultural fairs and festivals, and making counselors available in the company to help employees with their troubles.

Q: Social ills in any country are normally born from a multitude of factors. What role if any, do you think globalization is having in higher reported rates of divorce, crime, and drug abuse in Asia? A: Many students will agree that the forces of globalization are exposing people in all countries to new ways of thinking and behaving. However, many social ills are not a direct result of globalization, but of other forces causing social change. Drug use is certainly not a new problem in most countries—opium has been used across Asia for centuries. Also, many women in Asian cultures are no longer financially dependent on their spouses because of the growing employment of women in the workforce. Thus when marital problems arise, divorce can be a viable option unlike in the past. This is not a Western phenomenon being spread by globalization, but one tied to economic development and industrialization more generally.

Q: Broadly defined, Asia comprises more than 60 percent of the world’s population—a population that practices Buddhism, Confucianism, Hinduism, Islam, and numerous other religions. Do you think it is possible to carry on a valid discussion of “Asian” values? Explain? A: Clearly, there are important and significant differences between Asian societies. But some values tend to be Pan-Asian, including the extended family concept—in contrast to the nuclear family concept in Western cultures. Also, respect for community elders is deeply ingrained throughout Asia—unlike the Western emphasis on youth and vitality (most pronounced in the United States). Thus, certain cultural elements can be discussed as “Asian” just as we identify certain concepts and behaviors as “Western.” But the validity of generalizing about “Asian values” depends on the depth of the discussion. The deeper we explore Asian cultures, the more differences we uncover.

CHAPTER 3 POLITICAL ECONOMY AND ETHICS LEARNING OBJECTIVES: 1. Describe the key features of each form of political system. 2. Explain how the three types of economic systems differ. 3. Summarize the main elements of each type of legal system. 4. Outline the global legal issues facing international firms. 5. Explain the main issues of global ethics and social responsibility. CHAPTER OUTLINE: Introduction Political Systems Politics and Culture Political Participation Political Ideologies Totalitarianism Theocratic Totalitarianism Secular Totalitarianism Doing Business in Totalitarian Countries Democracy Representative Democracy Doing Business in Democracies Political Systems in Times of Change Economic Systems Centrally Planned Economy Origins of the Centrally Planned Economy Decline of Central Planning Failure to Create Economic Value Failure to Provide Incentives Failure to Achieve Rapid Growth Failure to Satisfy Consumer Needs Mixed Economy Origins of the Mixed Economy Decline of Mixed Economies Move toward Privatization Market Economy Origins of the Market Economy Laissez-Faire Economics Features of a Market Economy Government’s Role in a Market Economy Enforcing Antitrust Laws Preserving Property Rights Providing a Stable Fiscal and Monetary Environment Preserving Political Stability Economic Freedom Legal Systems Common Law

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Civil Law Theocratic Law Global Legal Issues Standardization Intellectual Property Industrial Property Copyrights Product Safety and Liability Taxation Antitrust Regulations Ethics and Social Responsibility Philosophies of Ethics and Social Responsibility CSR Issues Bribery and Corruption Labor Conditions and Human Rights Fair Trade Practices Environment Bottom Line for Business

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 3. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION This chapter considers the basic differences between political and legal systems around the world. Disputes grounded in political and legal matters affect business activities, but companies can manage the associated risks.

II.

POLITICAL SYSTEMS A political system includes the structures, processes, and activities by which a nation governs itself. A. Politics and Culture 1. A nation’s political system derives from its history and culture. 2. Factors such as population, age and race composition, and per capita income influence a country’s political system. B. Political Participation 1. Participation occurs when people voice opinions, vote, and show general approval or disapproval of the system. 2. Wide participation occurs when people who are capable of influencing the political system make an effort to do so. Narrow participation occurs when few people participate. C. Political Ideologies Totalitarianism is the belief that every aspect of people’s lives must be controlled in order for a political system to be effective. Anarchism is the belief that only

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individuals and private groups should control a nation’s political activities. Pluralism is the belief that private and public groups belong in politics. 1. Totalitarianism Individuals govern without the support of the people, tightly control people’s lives, and do not tolerate opposing viewpoints. Totalitarian governments share three features: imposed authority, lack of constitutional guarantees, and restricted participation. a. Theocratic totalitarianism: political system under the control of totalitarian religious leaders. b. Secular totalitarianism: political system in which leaders rely on military and bureaucratic power. i. Communism: obtain social and economic equality only by establishing an all-powerful Communist Party and by granting the government ownership and control over all types of economic activity. ii. Socialism: obtain social and economic equality through government ownership and regulation of the means of production. iii. Tribal totalitarianism: one ethnic group imposes its will on others with whom it shares a national identity. iv. Right-wing totalitarianism: government endorses private ownership of property and a market-based economy but grants few (if any) political freedoms. Leaders strive for economic growth but oppose left-wing totalitarianism, or communism. c. Doing business in totalitarian countries: Companies need not be concerned with political opposition outside the government. It can be risky because the law is vague or nonexistent, and people in powerful government positions can interpret laws at will. 2. Democracy Democracy: Political system in which government leaders are elected directly by the wide participation of the people or their representatives. a. In representative democracies, citizens elect individuals from their groups to represent their political views. b. Representative democracies strive to provide: freedom of expression; periodic elections; full civil and property rights; minority rights; and nonpolitical bureaucracies. c. Doing business in democracies: Democracies tend to maintain stable business environments through laws protecting individual property rights. Participative democracy, property rights, and free markets encourage (not guarantee) economic growth. d. Capitalism: belief that ownership of the means of production belongs in the hands of individuals and private businesses. Political Systems in Times of Change People around the world are demanding greater participation in politics and many nations are abandoning totalitarianism. Globalization is playing a role.

ECONOMIC SYSTEMS Economic system: structure and processes a country uses to allocate its resources and conduct its commercial activities. No economy reflects a completely individual or group orientation but displays a blend of individual and group values.

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Centrally Planned Economy Land, factories, and other economic resources are owned by the government, which plans nearly all economic activity. Ultimate goal is to achieve political, social, and economic objectives through complete control of production and distribution of resources. 1. Origins of the centrally planned economy a. Group welfare is more important than individual well-being, and thus strives to achieve economic and social equality. b. Karl Marx in the 1800s argued the economy must be overthrown and replaced with an equitable “communist” system. c. By the 1970s, central planning was found in Eastern Europe, Asia, Africa, and Latin America. 2. Decline of central planning a. In the late 1980s, nations dismantled central planning in favor of market-based economics for several reasons. b. Failure to create economic value: Central planners failed to produce quality products efficiently. c. Failure to provide incentives: Government ownership limited incentives to maximize benefits from resources, which lowered economic growth and living standards. d. Failure to achieve rapid growth: Leaders realized their nations were falling quickly behind other nations. e. Failure to satisfy consumer needs: Consumers’ basic needs were not being met. Mixed Economy Land, factories, and other economic resources are more equally split between private and government ownership. Government controls economic sectors important to national security and long-term stability. Generous welfare system supports unemployed and provides health care. 1. Origins of the mixed economy a. Successful economy must be efficient and innovative, but also protect society. Goals are low unemployment, low poverty, steady economic growth, and an equitable distribution of wealth. b. Mixed economies are modernizing to be more competitive. 2. Decline of mixed economies Mixed economies are converting to market-based systems. Government ownership means less efficiency, innovation, responsibility, and accountability; higher costs; slower growth; and higher taxes and prices. a. Move toward privatization i. Selling government-owned economic resources to private companies and individuals. ii. Increases efficiency, cuts subsidies to state-owned firms, curtails appointment of managers for political reasons. Market Economy Most land, factories, and other economic resources are privately owned, either by individuals or businesses. Price mechanism determines: • Supply: Quantity of a good or service that producers are willing to provide at a specific selling price. • Demand: Quantity of a good or service that buyers are willing to purchase at a specific selling price. 1. Origins of the market economy Copyright © 2014 Pearson Education, Inc.

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Individual concerns are above group concerns. The group benefits when individuals receive incentives and rewards to act in certain ways. a. Laissez-faire economics: French for “allow them to do [without interference].” Individualism fosters democracy as well as a market economy. Features of a market economy a. Free choice: individuals have purchase options. b. Free enterprise: companies can decide what to produce and which markets to compete in. c. Price flexibility: prices rise or fall reflecting supply and demand. Government’s role in a market economy Little direct involvement, but plays four important roles: a. Enforce antitrust laws i. Goal of antitrust (antimonopoly) laws is to encourage the development of industries with as many competing businesses as the market will sustain. ii. Prevent trade-restraining monopolies and combinations that exploit consumers and constrain commerce. b. Preserve property rights i. Encourage individuals and firms to take risks such as technology investments, new product invention. ii. Legally safeguard claims to assets and future incomes they generate. c. Provide a stable fiscal and monetary environment i. Influence inflation and unemployment rates through effective fiscal and monetary policies. ii. Stability improves company forecasts and reduces risks associated with future investments. d. Preserve political stability i. Market economy depends on a stable government. ii. Helps companies avoid worrying about political risk. Economic freedom a. Connection between political freedom and economic growth is very uncertain. b. Yet greater economic freedom tends to coincide with higher living standards.

LEGAL SYSTEMS Set of laws and regulations, including the process by which laws are enacted and enforced and the ways in which courts hold parties accountable for their actions. It is influenced by cultural variables, including class barriers, religious beliefs, emphasis on individualism or conformity, and the political system. Totalitarian governments favor public ownership and enact laws limiting entrepreneurial behavior. Democracies encourage entrepreneurial activity and protect businesses with property-rights laws. A. Common Law • Tradition: Country’s legal history • Precedent: Past cases that have come before the courts • Usage: How laws are applied in specific situations 1. Originated in England in the eleventh century and adopted in its territories worldwide.

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Business contracts tend to be lengthy because they consider many contingencies and possible interpretations in case of dispute. Common law systems are flexible, taking into account particular situations and circumstances. 3. Practiced in Australia, Britain, Canada, Ireland, New Zealand, the United States, and some nations in Asia and Africa. Civil Law 1. Based on a detailed set of written rules and statutes that constitute a legal code. Can be traced to Rome in the fifth century B.C. and is the oldest and most common legal tradition. 2. Can be less adversarial than common law because it is not interpreted according to tradition, precedent, and usage. Because laws are codified and concise, parties are concerned with the explicit wording of the code; obligations, responsibilities, and privileges follow the relevant code. 3. Practiced in Cuba, Puerto Rico, Quebec, Central and South America, most of Western Europe, and parts of Asia and Africa. Theocratic Law 1. Legal tradition based on religious teachings (e.g., Islamic, Hindu, and Jewish law). 2. Islamic law is the most widely practiced theocratic legal system today. It was initially a code governing moral and ethical behavior and was later extended to commercial transactions. It restricts investments and sets guidelines for business conduct. 3. Firms operating in countries with theocratic legal systems must be sensitive to local values and beliefs. They must evaluate business activities, including hiring practices and investment policies, to ensure compliance with the law, local values, and beliefs.

GLOBAL LEGAL ISSUES Companies must adapt to dissimilar legal systems in global markets because there is no clearly defined body of international law that all nations accept. A. Standardization 1. Standardization is uniformity in interpreting and applying laws across countries, not to the standardizing of entire legal systems. 2. Treaties and agreements already exist in intellectual property rights, antitrust (antimonopoly) regulation, taxation, contract arbitration, and general matters of trade. 3. Organizations that promote standardization: the UN, OECD, and International Institute for the Unification of Private Law. B. Intellectual Property 1. Results from intellectual talent and abilities such as graphic designs, novels, computer software, machine-tool designs, and secret formulas. 2. Property rights are the legal rights to resources and any income they generate. Intellectual property can be traded, sold, and licensed in return for fees or royalty payments. a. Industrial property is often a firm’s most valuable asset. Laws protecting industrial property reward inventive and creative activity. i. Patent is a right granted to the inventor of a product or process that excludes others from making, using, or

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selling the invention. The WTO grants patents for 20 years. ii. Trademarks are words or symbols that distinguish a product and its manufacturer. Trademark protection lasts indefinitely, provided the word or symbol continues to be distinctive (e.g., Xerox). b. Copyrights give creators of original works the freedom to publish or dispose of them as they choose. i. Holder can (1) reproduce the copyrighted work, (2) derive new works from it, (3) sell or distribute it, (4) perform it, and (5) display it publicly. ii. Protected under the Berne Convention and the 1954 Universal Copyright Convention. Product Safety and Liability 1. Product liability holds manufacturers, sellers, and others, including individual company officers, responsible for damage, injury, or death caused by defective products. 2. Developed nations have the toughest product liability laws. Lessdeveloped and emerging countries have weaker laws. Taxation 1. Tax revenues needed to pay government salaries, build military capacity, and shift earnings from people with high incomes to the poor. 2. Consumption taxes: indirect taxes that help pay for consequences of using a particular product and to make imports more expensive. 3. Value added tax (VAT): levied on each party that adds value to a product throughout its production and distribution. Antitrust Regulations 1. Antitrust (antimonopoly) laws are designed to prevent companies from fixing prices, sharing markets, and gaining unfair monopoly advantages. Such laws help ensure a wide variety of products at fair prices. 2. The United States and European Union have strict antitrust regulation and are strict enforcers. In Japan, the Fair Trade Commission enforces antitrust laws, but it is often ineffective. 3. In strict antitrust countries, companies see a disadvantage against competitors whose home countries condone market sharing, whereby competitors agree to serve only designated market segments.

ETHICS AND SOCIAL RESPONSIBILITY International managers are exposed to different conceptions of ethical behavior and guidelines for socially responsible behavior. Child labor, human rights, the environment, and plant closings are the heart of debates over impact of multinationals. • Ethical Behavior: personal behavior in accordance with guidelines for good conduct or morality. No right or wrong decisions, but alternatives, each of which may be equally valid depending on one’s perspective. • Corporate Social Responsibility: practice of companies going beyond legal obligations to actively balance commitments to investors, customers, other companies, and communities. • Three layers of CSR activity: (1) company works toward a specific social cause; (2) company follows a code of conduct and operates with greater transparency; and (3) company builds social responsibility into its core operations to create value and build competitive advantage. Copyright © 2016 Pearson Education, Inc.

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Philosophies of Ethics and Social Responsibility 1. Friedman View: company’s sole responsibility is to maximize profits for its owners (or shareholders) while operating within the law. a. Example: managers would applaud a company moving pollution-generating operations from a strict country to a lax country. b. Many disagree with this argument against socially responsible activities. Today the discussion is not whether a company has CSR obligations, but how it will fulfill them. 2. Cultural Relativist View: company should adopt local ethics wherever it operates because all belief systems are determined within a cultural context. a. Sees truth, itself, as relative and argues that right and wrong are determined within a specific situation. b. “When in Rome, do as the Romans do” captures the essence of cultural relativism. 3. Righteous Moralist View: company should maintain its home-country ethics wherever it operates because the home-country’s view of ethics and responsibility is superior to others’ views. a. Example: company headquarters instructs subsidiary managers to refrain from bribing local officials and, thereby, imposes its righteous moralist view on local managers. 4. Utilitarian View: company should behave in a way that maximizes “good” outcomes and minimizes “bad” outcomes wherever it operates. a. A utilitarian manager asks the question “What outcome should I aim for?” and answers, “That which produces the best outcome for all affected parties.” b. Example: manager pays a bribe based on calculations that more people will benefit than will be harmed by the outcome. CSR Issues Business leaders realize that the future rests on healthy workforces and environments. Still, international managers face dilemmas on a daily basis. 1. Bribery and corruption a. Corruption leads to the misallocation of resources, hurts economic development, distorts public policy, and damages the integrity of “the system.” b. Enron’s failure sent a shockwave around the world. Energy trading markets were in chaos and many lost jobs worldwide. c. In 2002, Congress passed the Sarbanes-Oxley Act, which set more stringent accounting standards and reporting practices. 2. Labor conditions and human rights a. Managers must monitor behavior of themselves, employees, and business partners. b. Governments, labor unions, consumer groups, and human rights activists force apparel companies to implement codes of conduct and monitoring principles in international production. 3. Fair trade practices a. Fair trade products: involve companies working with suppliers in more equitable, meaningful, and sustainable ways.

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VIII.

TransFair USA certifies that a product embodies fair prices, fair labor conditions, direct trade, democratic community development, and environmental sustainability. Environment a. Companies pursue “green” initiatives to reduce their toll on the environment and to reduce operating costs and boost profit margins. b. Carbon footprint: environmental impact of greenhouse gases (measured in units of carbon dioxide) that results from human activity.

BOTTOM LINE FOR BUSINESS Differences in political and legal systems present both opportunities and risks for international companies. Understanding differences in culture, politics, and law is the first step for any company that hopes to manage the risks of doing business in unfamiliar environments. Managers of international companies also need to understand how global legal issues, including intellectual property, product safety, and antitrust laws, affect operations and strategy.

Quick Study Questions Quick Study 1 1.

Q: What features characterize the political ideology called pluralism? A: Pluralism is the belief that both private and public groups play important roles in a nation’ political activities. Each group (consisting of people with different ethnic racial class and lifestyle backgrounds) serves to balance power that can be gained by others. Pluralistic political systems include democracies, constitutional monarchies, and some aristocracies.

Q: Communists believe that a violent revolution is needed to seize control over resources, wish to eliminate political opposition, and do what else? A: A communist government has sweeping political and economic powers. In this type of system, private business is virtually or totally non-existent.

Q: What does a representative democracy strive to provide for its people? A: Representative democracies strive to provide some or all of the following: (1) freedom of expression, (2) periodic elections, (3) full civil and property rights, (4) minority rights, and (5) nonpolitical bureaucracies.

Q: By what other name is capitalism referred? A: Capitalism is also frequently referred to as the free market.

Quick Study 2 1.

Q: What factors contributed to the decline of centrally planned economies? A: Factors that contributed to the decline of centrally planned economies include: (1) failure to create economic value, (2) failure to provide incentives, (3) failure to achieve rapid growth, and (4) failure to satisfy customer needs.

Ch 3: Political Economy and Ethics

Q: Which economic system strives toward low unemployment, low poverty, steady economic growth, and an equitable distribution of wealth? A: The goals of a market economy are low unemployment, low poverty, steady economic growth and an equitable distribution of wealth.

Q: Laissez-faire economics calls for less government interference in commerce and what else? A: This approach not only called for less government interference, but also greater individual economic freedom.

Q: Countries with the greatest amount of freedom tend to have what? A: Countries with the greatest economic freedom tend to have the highest standard of living.

Quick Study 3 1.

Q: Which legal system decides cases by interpreting the law on the basis of tradition, precedent, and usage? A: Under common law, the justice system decides cases by interpreting the law on the basis of tradition, precedent, and usage.

Q: Which legal system is based on a detailed set of written rules and statutes that constitute a legal code? A: Civil law is a system based on a detailed set of written rules and statutes that constitute a legal code.

Q: A legal tradition based on religious teachings is called what? A: A legal tradition based on religious teaching is called theocratic law.

Quick Study 4 1.

Q: What are some examples of intellectual property rights? A: Intellectual property rights are legal rights to resources that result from intellectual abilities and any income these resources generate. Like other types of property, intellectual property can be traded, sold, and licensed in return for fees or royalty payments. Examples include: copyrights, patents, and trademarks.

Q: What are the different types of industrial property? A: Industrial property includes patents and trademarks. A patent is a right granted to the inventor of a product or process that excludes others from making, using, or selling the invention. Trademarks are words or symbols distinguishing a product and its manufacturer.

Q: Laws that hold manufacturers, sellers, individuals, and others responsible for damage, injury, or death caused by defective products are called what? A: Product liability laws hold manufacturers, sellers, and others responsible for damage, injury, or death caused by defective products. They differ greatly from one nation to another. The United States has the toughest product liability laws in the world, with Europe a close second. Awarded damages tend to be several times larger in the United States than in other developed nations. Developing and emerging countries have the

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weakest laws. Enforcement of such laws also varies from nation to nation, with highly developed countries being the strictest enforcers. Quick Study 5 1.

Q: The essence of which philosophy is captured by the expression, “When in Rome, do as the Romans do”? A: The expression captures the essence of cultural relativism. This view states that a company should adopt local ethics wherever it operates because all belief systems are determined within a cultural context.

Q: Possible consequences of corruption include what? A: Corruption is detrimental to society and business. Corruption can send resources toward inefficient uses, hurt economic development, distort public policy and damage national integrity.

Q: What are some criteria a product must meet to be Fair Trade certified? A: Fair Trade certifies that a product meets the following criteria: (1) fair prices, (2) fair labor conditions, (3) direct trade, (4) democratic community, and (5) environmental sustainability.

Q: The environmental impact of greenhouse gases that result from human activity is called what? A: Carbon footprint is the environmental impact of greenhouse gases that result from human activity.

Ethical Challenge You are the proprietor of a fledgling computer graphics company in Shanghai, China. The sophisticated business application software you need for your business normally sells for 2,900 renminbi (around $350) at computer stores in Shanghai and online. But with an income of just over $5,000 a year, you cannot afford to buy the original graphics software for your business. An associate has told you she can get you all the software you need, and more, for only $30. Yet, you have financially strapped friends who code software for the global software companies that make the very programs you need. 3-5 Do your personal circumstances make it ethical for you to purchase the pirated software? 3-6 What would you do if you were told of a new government effort to actively punish users of pirated software? 3-7 Does a software company bear any responsibility for subcontracting work to low wage markets where its finished product is unaffordable for the same coders who worked on it? A: This question forces students to consider the piracy issue from the perspective of a budding entrepreneur who cannot possibly afford the legal version of the software. One option that students often suggest is for companies to offer their products at reduced prices in markets where piracy is rampant. However, the company must be able to ensure that products are not then re-exported to other wealthier markets and sold at the official price—earning pirates a huge profit. Another is the precedent that is set for other markets—all people need to do to have companies reduce their prices would be to start an

Ch 3: Political Economy and Ethics underground market. The position most students might arrive at is for multinationals to fight piracy but to be less forceful in the poorest markets.

Teaming Up Debate Project. Two groups of four students each will debate the ethics of doing business in countries with totalitarian governments. After the first student from each side has spoken, the second student will question the opposing side’s arguments, looking for holes and inconsistencies. The third student will attempt to answer these arguments. A fourth student will present a summary of each side’s arguments. Finally, the class will vote to determine which team has offered the more compelling argument. A: Students arguing in favor of entering countries with totalitarian governments should consider the perspective of companies based in like countries, not just democratic ones. Many students will overlook the fact that many companies based in totalitarian countries do business in other like countries. Trying to view business from this perspective might challenge students not coming from such a country. For this reason, it can be interesting for international students in the class to be divided into different groups so that each group has a variety of opinions and perspectives. Likewise, students arguing against entering totalitarian countries must grapple with whether their not investing will create political change—it oftentimes does not. These students will also need to accept the fact that not investing might actually mean a lower standard of living for people in the totalitarian country and perhaps less work at home for the multinational that would undertake the investment. Practicing International Management Case

Pirates of Globalization 3-16

Q: What more do you think that the international business community could do to protect intellectual property rights? A: Student answers will vary.

3-17

Q: Are international companies simply afraid to speak out against counterfeiting in potentially lucrative emerging markets for fear of being denied access to them? A: This question gets students to consider the ramifications of cracking down on counterfeiters in lucrative markets. A policy of zero tolerance in some developing and emerging markets may invite the wrath of politicians and government bureaucrats. Officials might see multinationals with deep pockets as extremely greedy and determined to go after every petty pirate in a market. This can create a damaging backlash by local law enforcement.

3-18

Q: By using the latest technologies, people can often create prefect clones of original works. How are the Internet and the latest digital technologies influencing intellectual property laws? A: The spectacular growth of e-business conducted over the Internet will force a reevaluation of intellectual property laws. Holders of intellectual property will likely want existing laws revised to protect them from hackers that break into company

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networks and others who monitor e-mails and other Internet traffic in an effort to steal valuable data and information. 3-19

Q: Locate information on the Tiffany versus eBay lawsuit and identify each sides arguments and who prevailed. What are the implications of that lawsuit for the sale of counterfeits in online auctions? A: Tiffany’s allegation that eBay contributed directly to infringement of the Tiffany trademark due to the sale of counterfeit Tiffany jewelry is a strong warning to online auction houses. The policy of eBay has been to monitor its own site for fraud, yet that has been insufficient according to Tiffany executives. Defendant eBay was victorious in the lawsuit, though Tiffany is appealing the case. The ongoing saga can be tracked online through newspapers and search engines.

CHAPTER 4 ECONOMIC DEVELOPMENT OF NATIONS LEARNING OBJECTIVES: 1. Explain economic development and how it is measured. 2. Describe economic transition and its main obstacles. 3. Outline the various sources of political risk. 4. Explain how companies can manage political risk. 5. Describe China’s and Russia’s experience with economic transition.

CHAPTER OUTLINE: Introduction Economic Development Classifying Countries Developed Countries Newly Industrialized Countries Developing Countries National Production Uncounted Transactions Question of Growth Problem of Averages Pitfalls of Comparison Purchasing Power Parity Human Development Economic Transition Obstacles to Transition Lack of Managerial Expertise Shortage of Capital Cultural Differences Sustainability Political Risk Types of Political Risk Conflict and Violence Terrorism and Kidnapping Property Seizure Policy Changes Local Content Requirements Managing Political Risk Adaptation Information Gathering Political Influence International Relations The United Nations Emerging Markets and Economic Transition China’s Profile Chinese Patience and Guanxi China’s Challenges

Ch 4: Economic Development of Nations Russia’s Profile Russia Challenges

Bottom Line for Business

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 4. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION This chapter introduces different economic systems and their effect on international business. It explains each type of economic system, economic development, how nations are classified, and how countries implement market-based economic reforms.

II.

ECONOMIC DEVELOPMENT Economic development is a measure for gauging the economic well-being of one nation’s people as compared with that of another nation’s people. It reflects economic output (agricultural and industrial); infrastructure (power and transportation facilities); physical health and level of education; and cultural, political, legal, and economic differences. A. Classifying Countries Classifications normally based on indicators such as GNP per capita, portion of the economy devoted to agriculture, amount of exports in the form of industrial goods, and overall economic structure. 1. Developed countries a. Highly industrialized, highly efficient, and whose people enjoy a high quality of life. People receive the finest health care and benefit from the best educational systems in the world. b. Examples are Australia, Canada, Japan, New Zealand, the United States, all western European nations, and Greece. 2. Newly industrialized countries (NICs) a. Recently increased the portion of national production and exports derived from industrial operations. b. Mainly in Asia and Latin America: Hong Kong, South Korea, Singapore, Taiwan, Brazil, China, India, Malaysia, Mexico, South Africa, and Thailand. c. Combining NICs with those having potential to become a NIC forms a category called emerging markets. 3. Developing countries a. Poor infrastructure and extremely low personal income. b. Rely on one or a few sectors of production—agriculture, mineral mining, or oil drilling. They often lack resources and skills. c. Mainly in Africa, the Middle East, and the poorest nations in Eastern Europe and Asia.

Ch 4: Economic Development of Nations

III.

Often characterized by technological dualism—use of the latest technologies in some sectors of the economy coupled with the use of outdated technologies in other sectors. National Production Can classify countries by gross national product per capita, but there are problems using GNP and GDP as indicators of development. 1. Uncounted transactions a. Volunteer work, household work, illegal or underground deals, and unreported cash transactions. b. Shadow economy can be so large and prosperous that official statistics are meaningless. c. Barter is an alternative for buyers who lack hard currency to pay for imports (e.g., Pepsi-Cola in USSR). 2. Question of growth a. GNP and GDP are a snapshot of one year’s economic output, and do not indicate whether an economy is growing. 3. Problem of averages a. Per capita figures are averages. Urban areas can be more developed than rural areas and have higher per capita income. 4. Pitfalls of comparison a. To compare gross product per capita, each currency must be translated into a single currency. b. Official exchange rates do not show what the local currency can buy in its home country. Purchasing Power Parity 1. Purchasing power is the value of goods and services that can be purchased with one unit of a country’s currency. Purchasing power parity is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. 2. Using purchasing power parity to compare the wealth of nations (e.g., Swiss GDP per capita is $47,900 but only $34,700 at PPP compared to U.S. GDP at PPP of $39,700). Human Development 1. Human development index (HDI) measures extent to which a people’s needs are satisfied and the degree to which these needs are addressed equally across a nation’s entire population. Three dimensions: a long and healthy life, an education, and a decent standard of living. 2. Often disparity between wealth and HDI. 3. HDI demonstrates that high national income alone does not guarantee human progress.

ECONOMIC TRANSITION Changing a nation’s fundamental economic organization and creating new free-market institutions. Typically involves several reforms: • Stabilize the economy, reduce budget deficits, and expand credit availability. • Allow prices to reflect supply and demand. • Legalize private business, sell state-owned firms, and support property rights. • Reduce barriers to trade and investment and allow currency convertibility. A. Obstacles to Transition 1. Lack of managerial expertise

Ch 4: Economic Development of Nations a.

IV.

Central planners had little need for management skills including production, distribution, pricing, and marketing strategies; investigating consumer wants and needs and conducting research; competitively pricing products; or advertising. b. Yet the gap in education and experience between managers from the former communist nations and others has narrowed. Shortage of capital a. Transition is expensive, requiring spending to: i. Develop a telecommunications and infrastructure system, including highways, bridges, rail networks, and subways. ii. Set up financial institutions, including stock markets and a banking system. iii. Educate people in the ways of market economics. Cultural differences a. Transition causes cultural change and replaces dependence on the government with greater emphasis on individuals. b. Often cuts are in welfare, unemployment benefits, and guaranteed government jobs. Sustainability a. Economic and social policies of former communist governments in Central and Eastern Europe were disastrous for the natural environment. b. Environmental destruction is evident in increased levels of sickness and disease, which cause lower productivity in the workplace.

POLITICAL RISK Political risk is the likelihood that a government or society will undergo political changes that negatively affect local business activity. It can threaten an exporter’s market, manufacturing facilities, and the ability to repatriate profits. A. Types of Political Risk Macro risk threatens all companies regardless of industry and affects all companies equally in a country, both domestic and international. Micro risk threatens companies within a particular industry or even smaller groups. Five events can cause political risk: 1. Conflict and violence a. Local conflict discourages investment. Violence hinders manufacturing, obtaining materials and equipment, and recruiting talented personnel. b. It can arise from: (1) resentment toward the government; (2) territorial disputes; and (3) ethnic, racial, and religious disputes. 2. Terrorism and kidnapping a. Used to make political statements. Groups dissatisfied with current political or social situations try to force change through fear and destruction. b. Kidnapping and hostage-taking can fund terrorism. 3. Property seizure a. Confiscation is the forced transfer of assets from a company to the government without compensation. There is no framework for legal appeal, and compensation is far below market value.

Ch 4: Economic Development of Nations b.

Expropriation is the forced transfer of assets from a company to the government with compensation. c. Nationalization involves government takeover of an entire industry and is more common than confiscation and expropriation. It is used to: (1) protect an industry for ideological reasons, (2) save local jobs in an ailing industry, (3) control industry profits, and (4) invest in industries that private companies cannot afford. 4. Policy changes a. Result from newly empowered political parties, pressure from special interests, and civil or social unrest. b. One policy tool restricts ownership to domestic companies or limits ownership by nondomestic firms to a minority stake. c. Other policies relate to investments made across borders. 5. Local content requirements a. Specify an amount of a product to be supplied locally. Can foster local business activity and create jobs. b. Force companies to use local raw materials, procure parts from local suppliers, or employ local workers. May force a firm to take on poorly trained or excess workers, and local raw materials could increase costs or reduce quality. Managing Political Risk Companies manage political risks that threaten operations and future earnings. 1. Adaptation: Incorporate risk into business strategies, often with the help of local officials. a. Partnerships can be used to leverage expansion plans through informal arrangements or joint ventures, strategic alliances, and cross-holdings of company stock. b. Localization entails modifying operations, the product mix, or other elements to suit local tastes and culture. c. Development assistance allows an international business to assist the host country in developing distribution and communications networks and improving the quality of life for locals. d. Insurance can be used to protect companies against losses and can provide project financing. 2. Information gathering: Predict and manage political risk. Sources include employees with information and political risk agencies. a. Current employees with relevant information: people who worked in the country and have valuable contacts and knowledge. b. Agencies specializing in political-risk services: such as banks, political consultants, news publications, and risk-assessment services. 3. Political influence: Deal with local lawmakers and politicians directly or through lobbyists. a. Lobbying: policy of hiring people to represent a company’s views on political matters. b. Foreign Corrupt Practices Act forbids U.S. companies from bribing government officials or political candidates in other countries (unless a person’s life is in danger). A bribe constitutes “anything of value” and cannot be given to any “foreign

Ch 4: Economic Development of Nations

government official” empowered to make a “discretionary decision” that may be to the payer’s benefit. International Relations Favorable political relationships foster stable business environments and increase international cooperation. Stable environments require a strong legal system to resolve disputes quickly and fairly. Multilateral agreements are treaties concluded among several nations, each of which agrees to abide by treaty terms even if tensions develop. The United Nations 1. Formed after the Second World War to provide leadership in fostering peace and stability around the world. The UN and its many agencies provide food and medical supplies, educational supplies and training, and financial resources to poor member nations. 2. Receives funding from member contributions based on gross national product (GNP). Entire world is involved with the UN in some manner. 3. UN system consists of six main organs: (1) General Assembly; (2) Security Council; (3) Economic and Social Council; (4) Trusteeship Council; (5) International Court of Justice; and (6) the Secretariat. 4. Within the UN Economic and Social Council is the United Nations Conference on Trade and Development (UNCTAD). The organization has a broad mandate in international trade and economic development.

EMERGING MARKETS A. China’s profile—China’s theme is “Socialism with Chinese characteristics,” and the nation has undergone great economic reform over the past two decades. 1. Early years a. 1949: Communes planned all agricultural and industrial production and schedules. Rural families owned their homes and land and produced particular crops. b. 1979: Government reforms allowed families to grow crops they chose and sell produce at market prices. c. 1984: Township and village enterprises (TVEs) obtained materials, labor, and capital on open market and used a private distribution system. TVEs laid the groundwork for a market economy. d. Mid-1980s: Foreign companies were allowed to form joint ventures with Chinese partners. 2. Challenges ahead a. Political and social problems loom. Skirmishes between secular and Muslim Chinese, and democracy restricted. b. Unemployment, slow economic progress in rural areas, and misery of migrant workers. c. China’s one country, two systems policy must preserve order, as Taiwan is watching closely. B. Russia’s Profile Russia’s experience with communism began in 1917. For 75 years, government controlled all aspects of production and distribution, including prices of labor, capital, and products. 1. Rough transition a. In the 1980s Russia entered a new era of freedom of thought, freedom of expression, and economic restructuring.

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VI.

Except for criminals and the wealthy, people have difficulty maintaining their standard of living and buying necessities. c. Some Russians survive because they were factory managers under the old system and retained their jobs. Others have turned to the black market or organized crime. Challenges ahead a. Managers must improve skills in every facet of management practice, including financial control, research and development, employee hiring and training, marketing, and pricing. b. Political instability, especially nationalism. c. Nuclear weapons sales for cash can be lucrative, despite the clear threat to global security and Russia itself. d. Unstable investment climate causes uneasiness in Russia (e.g., arrest of Mikhail Khodorkovsky, then head of oil giant Yukos, for fraud, embezzlement, and tax evasion).

BOTTOM LINE FOR BUSINESS Ongoing market reforms in formerly centrally planned and mixed economies have a profound effect on international business. Freer markets are spurring major shifts in manufacturing activity. Lured by low wages and growing markets, international companies are forging ties in newly industrialized countries and exploring opportunities in developing nations. Global capital markets make it easier to set up factories abroad, and some newly industrialized countries produce world-class competitors of their own.

Quick Study Questions

Quick Study 1 1.

Q: An increase in the economic well-being, quality of life, and general welfare of a nation’s people is called what? A: Economic development is a measure for gauging the economic well-being of one nation’s people, as compared to that of another nation’s people.

Q: What are the drawbacks of using national production to measure economic development? A: National production provides a good estimate of a nation’s overall wealth. It provides marketers with a broad indicator of whether a nation’s people are wealthy enough to purchase their products. It also gives managers an overall indicator of whether a nation has the level of development to support production facilities. But there are problems with national production as an indicator of economic development. First, estimates for the wealth generated in the official economy can be almost meaningless for countries with large, shadow economies or those that extensively employ barter. Second, national production figures alone do not tell whether an economy is growing, static, or shrinking. Third, national averages ignore differences among different regions within a nation. Fourth, simply converting national production figures at official exchange rates does not provide any indication of the quantity of goods that money can actually buy in an economy. Finally, this indicator takes into account only the financial well-being of a people.

Ch 4: Economic Development of Nations

Q: The human development index measures what aspects of a nation’s development. A: The United Nations human development index (HDI) evaluates the extent to which a government equitably provides its people with a long and healthy life, an education, and a decent standard of living. This indicator goes beyond estimating only financial wealth and directly assesses human aspects of development.

Quick Study 2 1.

Q: What does the economic transition process involve? A: Several reform measures include: (1) stabilize the economy, reduce budget deficits, and expand credit availability; (2) allow prices to reflect supply and demand; (3) legalize private business, sell state-owned companies, and support property rights; and (4) reduce barriers to trade and investment and allow currency convertibility.

Q: What are the key obstacles for countries in transition? A: (1) A lack of managerial expertise caused by the fact that central planners formerly decided nearly every aspect of the nation’s commercial activities hampers progress today. There was little need for managers to learn management skills including how to develop production, distribution, pricing, and marketing strategies. (2) A shortage of capital presents special problems because of the high cost of economic transition. Governments of nations in transition can often afford only a portion of the required investment. These nations lack capital because of the disastrous financial management during the years of central planning. (3) Economic transition can be especially slow when a nation’s people find reform difficult for cultural reasons. In addition, importing modern management practices without tailoring them to the local culture can have serious consequences. (4) Environmental degradation caused by the headlong rush among transition economies to catch up to developed countries is leaving serious environmental damage in its wake. The direct effects of environmental destruction are evident in increased levels of sickness and disease, including asthma, blood deficiencies, and cancer—which obviously negatively impact national productivity.

Q: Transition replaces dependence on the government with greater emphasis on what? A: The process involves several key reform measures to promote economic development. These include: (1) stabilizing the economy, reducing budget deficits, and expanding credit availability; (2) allowing prices to reflect supply and demand; (3) legalizing private business, selling state owned property rights; and (4) reducing barriers to trade and investment and allowing currency convertibility.

Quick Study 3 1.

Q: How does political abroad risk affect companies? A: Terrorism aims to create fear and force change through the sudden and unpredictable destruction of life or property. Kidnapping and the taking of hostages may be used to fund a terrorist group’s activities. Each of these increases risks for international companies because expatriate executives are prime targets because their companies can afford large ransoms. Property seizure also increases the risks for international firms and can cause them to avoid investing in nations implementing such tactics. Policy changes can result from civil or social unrest or might represent the views of newly empowered political parties. They can cause managers to regard a nation’s business environment as one of a “field of moving goal posts.” Local content requirements are regulations that

Ch 4: Economic Development of Nations

require international manufacturers to use a certain amount of local resources. They foster local business activity and ease regional or national unemployment, but can also force companies to invest elsewhere if they are too confining. 2.

Q: Companies fear open violence and conflict abroad because it can threaten to do what? A: Conflict and violence can arise from people’s resentment toward their government or over territorial disputes between countries. Violent disturbances impair a company’s ability to manufacture and distribute products, obtain materials and equipment, and recruit talented personnel.

Q: What is the name given to the forced transfer of assets from a company to the government with compensation? A: Expropriation is the forced transfer of company assets with compensation.

Quick Study 4 1.

Q: How can a company incorporate political risk into its business strategies? A: (1) Adaptation involves incorporating risk into business strategies—often with the help of local officials. Companies can incorporate risk by establishing partnerships, localizing operations, offering development assistance, and obtaining insurance. (2) Information gathering involves monitoring and even trying to predict political events that could threaten local operations and future earnings. (3) Political influence involves proposing changes that positively affect their local activities, often through lobbying.

Q: What is a good source of information to help conduct accurate political risk forecasting? A: There are two sources that companies use to conduct accurate political risk forecasting. Current employees who have worked in a country long enough to gain insight into local culture and politics are often a good source of information. Second, agencies specialized in providing political risk services include banks, political consultants, news publications, and risk assessment services.

Q: What might result from unfavorable political relations among countries? A: Unfavorable political relations among countries will foster an unstable business environment, decreasing business opportunities, increasing risk, and hindering economic development.

Quick Study 5 1.

Q: During what time period did China undergo its most rigorous experience with central planning? A: China began its experiment with central planning in 1949, after the communists defeated nationalists in a long and bloody civil war.

Q: What challenges might pose a threat to China’s future economic performance? A: Political and social problems pose threats to China’s future economic performance. The nation’s leadership has poor relations with ethnic minorities and skirmishes between secular and Muslim Chinese in western provinces still occur. For the most part, political leaders restrict advanced democratic reforms. Protests sporadically arise from time to time whenever ordinary Chinese citizens grow impatient with political progress.

Ch 4: Economic Development of Nations Another potential problem is unemployment, largely the result of the collapse of state-owned industry, intensified competition, and entry of international companies into China.

Q: Over what aspects of Russia’s centrally planned economy did planners exercise control? A: Russia’s experience with Communism began in 1917. For the next 15 years, factories, distribution, and all other facets of operations, as well as the prices of labor, capital, and products were controlled by Russia’s government.

Q: What might challenge Russia’s future economic prospects? A: Political instability, especially in the form of intensified nationalist sentiment is a potential threat to progress; for example, The Russia–Georgia military confrontation and the Russian annexation of the Crimean peninsula in the Ukraine in 2014. Finally, Russia’s unstable investment climate is another concern among international business, which stems from the governments attacks on business owners who disagree with official policy and on firms that it wants to control.

Ethical Challenge You are managing director of your U.S. firm’s subsidiary in southern France. The social welfare states of Western Europe were founded in the Second World War with specific ethical considerations in mind: reduce social and economic inequality, improve living standards for the poor, and provide nearly free health care for all. Many countries in Western Europe have trimmed social welfare provisions, privatized businesses, and increased their reliance on market forces. 4-5 Do you think that the cultures of Western Europe have changed over the years and that such ethical concerns are a remnant of the past? 4-6 Do you think that free-market reforms will simply re-create the conditions that gave rise to the welfare state in the first place? 4-7 What can governments do for workers who become displaced, or perhaps obsolete, in a more open and competitive economy? A: As a manager, you must convey to your workers that there are risks involved with capitalism, yet the potential rewards are great. Ethical issues never become dated. The dilemma of the role of the state in providing for its people was argued two thousand years ago by the great philosophers of the time. The issues remain the same, only the context is different. The reason many Western European nations are cutting back on corporate welfare is because they believe market forces are more efficient at allocating resources in most situations. They are also imposing austerity programs to reduce rising government debt levels since the global recession began in 2008–2009. The extent to which these nations cut back on social-welfare benefits for individuals is difficult to estimate. However, it is highly unlikely that we will anytime soon see the kinds of conditions that existed in Europe immediately following the Second World War.

Ch 4: Economic Development of Nations

Teaming Up Debate Project. Two groups of four students each will debate the ethics of political lobbying activities in a foreign country where a company does business. After the first student from each side has spoken, the second student will question the opponent’s arguments, looking for holes and inconsistencies. The third student will attempt to answer these arguments. The fourth student will present a summary of each side’s arguments. Finally, the class will vote on which team has offered the more compelling argument. A: Students should be sure to support their arguments with ideas and topics discussed in this chapter. They should also be prepared to defend their positions, after the debate, if they are called on to give a synopsis of their position in class. It may also be useful to give students some time to do outside research to prepare for the debate. Practicing International Management Case Cuba Comes Off Its Sugar High 4-16

Q: Why do you think the Cuban government requires non-Cuban businesses to hire and pay workers only through the government? A: The Cuban government is clearly skimming off the top the difference between what it is being paid for workers and what is actually paid to workers. This allows the government to keep the people under its thumb because they continue to feel powerless with little or no voice in matters. The practice also allows the government to control where these profits go such as into the military, infrastructure, or perhaps into the private offshore bank accounts of politicians and powerful business leaders.

4-17

Q: Suppose Cuba’s government collapses and the nation embarks on a path of economic transition. How might Cuba’s experience differ from that of Russia and China? A: There are obviously a large number of possible scenarios. Students should be encouraged to be creative, yet realistic. They should recognize several important differences between these nations. First, Cuba became communist in 1959 (versus 1917 for Russia) and this might mean that the roots of communism are shallower. Second, the tie with the United States is very strong with there being a large Cuban-American population waiting for economic reform to begin in Cuba so they can invest and help their people’s development. Although there are many Russian- and Chinese-Americans, their proportion is not as great as the proportion of Cuban-Americans relative to the population of Cuba. Third, because of the difference in size between Cuba and the United States, U.S. companies will likely dominate the Cuban landscape very quickly—the scale of which could not occur in Russia or China.

4-18

Q: A U.S. law permits U.S. companies to sue firms from other nations that traffic in U.S. property nationalized by Cuba. The law also empowers the U.S. government to deny entry visas to the executives of such firms as well as their families. Why does the United States maintain such a hard line against doing business with Cuba? A: Implementation and enforcement of this law, called the Helms-Burton Law, have been repeatedly suspended by the United States in fear of reprisals from Canada and European nations. Reasons for the continued embargo are rooted in politics and foreign relations. The main political argument is rooted in continued U.S. policy against allowing a communist nation to operate freely just 90 miles from the United States (the “not in this hemisphere” argument).

Ch 4: Economic Development of Nations As far as whether it is in the best interest of the United States, there are again political and economic arguments involved. Obviously, there is no easy answer to such a question. Although U.S. companies cannot invest now, they will likely have little trouble catching up to others as soon as political and economic reforms occur. In discussing whether it is in the United States’ best interest, students might want to consider the perspective of many Cuban-Americans who themselves engage in debate over whether the embargo should continue because of the impact on ordinary citizens.

CHAPTER 5 INTERNATIONAL TRADE THEORY LEARNING OBJECTIVES: 1. 2. 3. 4. 5. 6. 7.

Describe the benefits, volume and patterns of international trade. Explain how mercantilism worked and identify its inherent flaws. Detail the theories of absolute advantage and comparative advantage. Summarize the factor proportions theory of trade. Explain the international product life cycle theory. Outline the new trade theory and the first mover advantage. Describe the national competitive advantage theory and the Porter Diamond.

CHAPTER OUTLINE: Benefits, Volume, and Patterns of International Trade Benefits of International Trade Volume of International Trade Trade and World Output International Trade Patterns Who Trades with Whom? Trade Interdependence Effect on Developing and Transition Nations Trade Dependence Dangers of Trade Dependency Theories of International Trade Mercantilism How Mercantilism Worked Trade Surpluses Government Intervention Colonialism Flaws of Mercantilism Theories of Absolute and Comparative Advantage Absolute Advantage Case: Riceland and Tealand Gains from Specialization and Trade Comparative Advantage Gains from Specialization and Trade Assumptions and Limitations Factor Proportions Theory Labor versus Land and Capital Equipment Evidence on Factor Proportions Theory: The Leontief Paradox International Product Life Cycle Stages of the Product Life Cycle Limitations of the Theory New Trade Theory First-Mover Advantage National Competitive Advantage

Ch 5: International Trade

Factor Conditions Advanced Factors Demand Conditions Related and Supporting Industries Firm Strategy, Structure, and Rivalry Government and Chance Bottom Line for Business Globalization and Trade Supporting Free Trade

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 5. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline This chapter explores international trade in goods and services, examining its benefits, volume, and patterns. It also explores the main theories of why nations trade. I.

BENEFITS, VOLUME, AND PATTERNS OF INTERNATIONAL TRADE International trade is the purchase, sale, or exchange of goods and services across national borders. One way to measure the importance of trade is to examine the volume of an economy’s trade relative to total output (see Map 5.1). A. Benefits of International Trade Creates new entrepreneurial opportunities, expands the choice of goods and services, and creates jobs. The U.S. Department of Commerce estimates that for every $1 billion increase in exports, 22,800 U.S. jobs are created. B. Volume of International Trade World merchandise exports are worth more than $14 trillion and service exports are valued at more than $4 trillion (see Table 5.1). Trade in merchandise is around 80 percent of total trade; services account for 20 percent of total trade. 1. Trade and world output Slower world economic output slows international trade; higher output spurs trade. Trade slows in a recession as people are uncertain about the future and buy less. Also, when an economy is in recession, the currency is weak, slowing imports because they are more expensive. C. International Trade Patterns Trade volume and world output provide insight into the international trade environment but do not disclose trading partners. 1. Who trades with whom? a. Trade among the world’s high-income economies accounts for roughly 60 percent of total world merchandise trade. b. Two-way trade between high-income countries and low- and middle-income nations accounts for about 34 percent of world merchandise trade.

Ch 5: International Trade

Intra-regional trade accounts for around 67 percent of Europe’s exports, 56 percent of Asia’s exports, and more than 38 percent of North America’s exports (see Table 5.2). 2. Some economists call this century the “Pacific century,” referring to the expected future growth of Asian economies and the expected shift in trade flows from the Atlantic to the Pacific Ocean. Trade Interdependence Countries lie on a scale, with total trade dependence at one end and total independence at the other. Complete independence was considered desirable from the sixteenth through eighteenth centuries, but is not desirable today. 1. Effect on developing and transition nations Developing and transition nations often depend on their developed neighbors with whom they share borders. Germany is the single most important trading partner of central and eastern European nations. Trade Dependence 2. Dangers of trade dependency If a nation experiences economic recession or political turmoil, the dependent nation can experience economic problems. Trade today is characterized by a certain degree of interdependency, which often reflects trade between a company’s subsidiaries. c.

II.

THEORIES OF INTERNATIONAL TRADE It was not until the fifteenth century that people tried to explain why trade occurs. Efforts continue to refine existing trade theories and develop new ones (Figure 5.1). A. Mercantilism Nations should accumulate financial wealth, usually in the form of gold, by encouraging exports and discouraging imports. Other measures of a nation’s well-being, such as living standards or human development, are irrelevant. It was practiced from around 1500 to the late 1700s by European nations, including Britain, France, the Netherlands, Portugal, and Spain. 1. How Mercantilism Worked Trade was to benefit mother countries; colonies (in Africa, Asia, and North, South, and Central America) were exploitable resources. a. Trade surpluses Nations increased wealth through a trade surplus—when the value of a nation’s exports exceeds the value of imports. Trade deficits were to be avoided at all costs. b. Government intervention Governments intervened in international trade to maintain a trade surplus. They banned certain imports, imposed tariffs or quotas, and subsidized home-based industries to expand exports. Removal of gold and silver from the nation was outlawed. c. Colonialism Mercantilist nations acquired colonies as sources of inexpensive raw materials and markets for higher-priced finished goods. Trade among mercantilist nations and their colonies expanded wealth and created armies and navies to control colonial empires and protect shipping. 2. Flaws of Mercantilism The main problem with mercantilism is that it viewed international trade as a zero-sum game—a nation benefits only at the expense of other

Ch 5: International Trade

nations. But if all nations barricade their markets from imports and push their exports onto others, international trade would be severely restricted. Also, it kept colonial markets poor: they received little money for raw materials but were charged high prices for finished goods. Absolute Advantage Absolute advantage is the ability of a nation to produce a good more efficiently than any other nation (produce a greater output using the same, or fewer, resources). Adam Smith reasoned that international trade should not be burdened by tariffs and quotas, but should flow according to market forces. A country should produce the goods in which it holds an absolute advantage and trade with others to obtain the goods it needs but does not produce efficiently. 1. Case: Riceland and Tealand In a world of two countries (Riceland and Tealand) with two products (rice and tea) where transport costs nothing, each produces and consumes its own rice and tea. In Riceland, 1 resource unit produces a ton of rice, but 5 units are needed to produce a ton of tea. In Tealand, 6 resource units produce a ton of rice, but 3 units are needed to produce a ton of tea. Thus, Riceland has an absolute advantage in rice production and Tealand has an absolute advantage in tea production. a. Gains from specialization and trade i. Although each country now specializes and world output increases, both countries face a problem: Riceland consumes only its rice and Tealand consumes only its tea. The problem can be resolved through trade. ii. Although Tealand does not gain as much as Riceland, it gets more rice than it would without trade. Actual gains depend on the total resources of each country and the demand for each good in each country (Figure 5.2). iii. The theory of absolute advantage destroys the mercantilist idea that international trade is a zero-sum game. Because both countries gain, international trade is a positive-sum game. iv. The theory argues against restrictive trade policies and for nations to instead open their doors to trade so their people obtain more goods more cheaply in order to raise living standards. Comparative Advantage Comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other goods. Thus, trade is still beneficial even if one country is less efficient in the production of two goods, as long as it is less inefficient in the production of one of the goods. 1. Gains from Specialization and Trade a. Suppose that Riceland now holds absolute advantages in the production of both rice and tea. In Riceland, 1 resource unit produces a ton of rice but 2 are needed to produce a ton of tea. In Tealand, 6 resource units still produce a ton of rice, and 3 units are still needed to produce a ton of tea. Thus, Riceland has absolute advantages in producing both goods.

Ch 5: International Trade b.

Although Tealand has absolute disadvantages in rice and tea, it has a comparative advantage in tea; Tealand produces tea more efficiently than it produces rice. c. By specializing and trading, Tealand gets double the rice than if it produced the rice itself, and Riceland gets twice as much tea than if it produced the tea itself (Figure 5.3). 2. Assumptions and Limitations a. Assumes countries are only driven by the maximization of production and consumption. Governments get involved in trade for many reasons (e.g., concerns for workers or consumers). b. Assumes only two countries engaged in the production and consumption of two goods. In reality, more than 180 countries and countless products are produced, traded, and consumed. c. Assumes no transportation costs. In reality, transportation costs are a major expense of international trade. d. Assumes labor is the only resource for production and is mobile within each nation but cannot be transferred. Other resources are clearly needed in production and labor is becoming more mobile. e. Assumes specialization does not result in efficiency gains. In fact, specialization results in increased knowledge of a task and future improvements. Factor Proportions Theory Factor proportions theory states that countries produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply. Thus, the theory focuses on the productivity of the production process. 1. Labor versus Land and Capital Equipment a. Factor proportions theory breaks resources into two categories: (1) labor and (2) land and capital equipment. It predicts that a country will specialize in products that require labor if labor cost is low relative to land and capital costs, and vice versa. b. Factor proportions theory is conceptually appealing (e.g., Australia has much land and a small population; its exports consist of products that require much land whereas imports consist of manufactured and consumer goods). 2. Evidence on Factor Proportions Theory: The Leontief Paradox a. Theory not supported by studies that examine trade flows. b. Wassily Leontief tested whether the United States, which uses an abundance of capital equipment, exports goods requiring capitalintensive production, and imports goods requiring laborintensive production. He found U.S. exports require more laborintensive production than its imports; called the Leontief Paradox. c. One explanation is that factor proportions theory considers a country’s production factors to be homogeneous—particularly labor. But labor skills vary greatly within a country. International Product Life Cycle The international product life cycle theory states that a company will begin exporting its product and later undertake foreign direct investment as the product moves through its life cycle (a country’s export eventually becomes its import). 1. Stages of the Product Life Cycle

Ch 5: International Trade a.

In the new product stage, stage 1, high purchasing power and demand of buyers spur a company to design and introduce a new product concept (Figure 5.4). Although initially there is virtually no export market, exports increase late in the new product stage. b. In the maturing product stage, stage 2, the domestic market and markets abroad become fully aware of the existence of the product and its benefits. Demand rises and is sustained over a fairly lengthy period of time. Near the end of the maturity stage, the product generates sales in developing nations, and manufacturing is established there. c. In the standardized product stage, stage 3, competition from other companies selling similar products pressures companies to lower prices in order to maintain sales levels. An aggressive search for low-cost production bases abroad begins and the home market may begin importing. 2. Limitations of the Theory a. The United States is no longer the sole innovator of products in the world; new products spring up everywhere as the research and development activities globalize. b. Companies today design new products and make product modifications at a very quick pace. c. Companies introduce products in many markets simultaneously to recoup a product’s research and development costs before sales decline. d. The theory is challenged by the fact that more companies are operating in international markets from their inception. The Internet has made this easier particularly for small and midsize companies. Also, small companies are more often teaming up with companies in other markets to develop new products or production technologies. e. Yet the theory retains explanatory power when applied to technology-based products that are eventually mass-produced. New Trade Theory New trade theory argues: (1) there are gains to be made from specialization and increasing economies of scale; (2) companies first to market can create barriers to entry; and (3) government may play a role in assisting its home-based companies. It emphasizes productivity rather than resources. 1. First-Mover Advantage a. As specialization and output increase, companies realize economies of scale, and unit production costs decline. Then companies expand, lower prices, and force competitors to produce at a similar level of output to be competitive. b. A first-mover advantage is the economic and strategic advantage gained by being the first company to enter an industry. It creates a barrier to entry for potential rivals and may allow a country to dominate in a product. c. Some make a case for government assistance; by working together to target new industries, a government and its homebased companies can be the first mover in an industry. National Competitive Advantage

Ch 5: International Trade

National competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade. This theory attempts to explain why some nations are more competitive in certain industries. The Porter diamond (the basis of national competitiveness) consists of: (1) factor conditions; (2) demand conditions; (3) related and supporting industries; and (4) firm strategy, structure, and rivalry. 1. Factor Conditions Porter acknowledges the importance of basic factors (such as labor, natural resources, climate, and surface features) in what a country produces and exports, but adds the significance of advanced factors. a. Advanced factors include skill levels of the workforce and quality of the technological infrastructure. Account for the sustained competitive advantage that a country enjoys in a product. 2. Demand Conditions a. Sophisticated buyers in the home market are important to national competitive advantage in a product area. A sophisticated domestic market drives companies to modify existing products to include new design features and develop new products and technologies. 3. Related and Supporting Industries a. Companies in internationally competitive industries do not exist in isolation. Supporting industries provide inputs, forming clusters of related activities in the same region that reinforce productivity and competitiveness. b. Exporting clusters are those that export products or make investments to compete outside the local area and can lead to long-term prosperity. 4. Firm Strategy, Structure, and Rivalry a. Strategic decisions of firms have lasting effects on future competitiveness, but equally important is industry structure and rivalry among companies. b. The more intense the struggle to survive among domestic companies, the greater is their competitiveness. This heightened competitiveness helps them to compete against imports and against companies that might develop a production presence in the home market. 5. Government and Chance a. Government policies toward industry and export and import regulations can hurt or help competitiveness. b. Chance events also can influence national competitiveness; they can help competitiveness or threaten it. c. Porter’s theory holds promise but has just begun to be subjected to research using actual data on each of the factors involved and national competitiveness. III.

BOTTOM LINE FOR BUSINESS This chapter explores the benefits of international trade and its volume and pattern in the world today. Trade can free a nation’s entrepreneurial spirit and bring economic development. As the value and volume of trade continues to expand worldwide, new

Ch 5: International Trade theories will likely emerge to explain why countries trade and why they have advantages in producing certain products.

Quick Study Questions Quick Study 1 1.

Q: List several benefits of international trade? A: International trade provides a country’s people with a greater choice of goods and services. International trade is also important in job creation in many countries.

Q: World merchandise exports are valued at how many times the value of worldwide service exports? A: World merchandise exports are valued at more than $14 trillion, and service exports are worth more than $4 trillion. Trade in services accounts for only around 20 percent of total world trade.

Q: What portion of total world merchandise trade is accounted for by two way trade between high income economies? A: Trade among the world’s high-income economies accounts for roughly 60 percent of total world merchandise trade. Two-way trade between high-income countries and lowand middle-income nations accounts for about 34 percent of world merchandise trade. Meanwhile, merchandise trade between low income and middle income nation’s accounts for only 6 percent of world trade.

Q: What term often describes the nature of trade between a developing nation and a neighboring wealthy one? A: Trade interdependence: emerging markets that share borders with developed countries are often dependent on their wealthier neighbors.

Quick Study 2 1.

Q: What did the successful implementation of mercantilism require? A: The practice of mercantilism requires three key essentials: (1) trade surpluses, (2) active government intervention, and (3) practicing colonization.

Q: Mercantilist nations acquired colonies around the world to serve as sources of what?

A: It was a source of a nation’s economic power that in turn increased political power relative to other countries. 3.

Q: What name is given to the belief that a nation can increase its wealth only at the expense of other nations? A: Countries seen by others as trying to maintain a trade surplus and expand their national treasures at the expense of other nations are accused of practicing neo mercantilism or economic nationalism.

Quick Study 3

Ch 5: International Trade

Q: A nation that is able to produce a good more efficiently than other nations is said to have what? A: An absolute advantage is the ability of a nation to produce a good more efficiently than any other nation.

Q: What does a nation have when it is unable to produce a good more efficiently than other nations but it can produce the good more efficiently than it can any other good? A: A comparative advantage is the inability of a nation to produce a good more efficiently than other nations, but an ability to produce that good more efficiently than it does any other good. This is different from an absolute advantage in that it focuses on production efficiency within nations, not just among nations.

Q: The theories of absolute and comparative advantage say that nations benefit from trading because of the gains from what? A: Trade between two nations can still be beneficial even if one country is less efficient in the production of two goods, so long as it is less inefficient in the production of one of the goods. Even when one country is more efficient at producing both of the goods in question, both nations benefit from trade because of the gains from specialization. The country more efficient at producing both goods still gets more after specialization and trade than it would if it were to produce both goods on its own.

Quick Study 4 1.

Q: What is the name of the theory that says countries produce and export goods that require resources that are abundant and import goods that require resources in short supply? A: Factor proportions theory says countries produce and export goods that require resources that are abundant and import goods that require resources in short supply.

Q: Factor proportions theory divides a nation’s resources into what two categories? A: The theory states that a nation has two types of resources at its disposal: labor on the one hand and land and capital equipment on the other. The theory predicts that a country will specialize in products that require labor if the cost of labor is low relative to the cost of land and capital, and vice versa. The Leontief Paradox reflects the gap between the predictions using this theory and the actual trade flows in the world economy.

Quick Study 5 1.

Q: The international product life cycle theory says that a company will begin by exporting its product and later undertake “what” as the product moves through its life cycle? A: The international product life cycle theory states that a company will begin exporting its product and later undertake foreign direct investment as the product moves through its life cycle.

Q: List the three stages that a product goes through according to the international product life cycle theory. A: The international product life cycle theory states that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle. In the new product stage, high purchasing power and demand of buyers in an industrialized country spurs a company to design and introduce a new Copyright © 2016 Pearson Education, Inc.

Ch 5: International Trade product concept and production remains at home. In the maturing product stage, the domestic and markets abroad become aware of the existence of the product and its benefits. Exports rise and some production in markets abroad may begin. In the standardized product stage, competition from other companies selling similar products pressures companies to lower prices in order to maintain sales levels. An aggressive search for low-cost production bases abroad begins and the home market may even begin importing from these other markets.

Q: Whenever optimizing productivity determines where a product’s components are manufactured and where it is assembled, the resulting pattern of activities resembled that predicted by which theory? A: This pattern resembles the theory of comparative advantage in that a product’s components are made in the country that can produce them at a high level of productivity.

Quick Study 6 1.

Q: What is the main thrust of new trade theory? A: The new trade theory argues that: (1) there are gains to be had from specialization and increasing economies of scale; (2) those companies first to market can create barriers to entry; and (3) government may have a role to play in assisting its home-based companies.

Q: The economic and strategic advantage gained by being the first company to enter an industry is called what? A: A first-mover advantage is the economic and strategic advantage gained by being the first company to enter an industry.

Quick Study 7 1.

Q: The national competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to do what? A: National competitive advantage theory states that a nation’s competitiveness in an industry depends on the capacity of the industry to innovate and upgrade. An “advanced” factor is indicative of factors such as skill levels of workers and the quality of technology in a nation.

Q: The four main components of the Porter diamond are: (1) factor conditions, (2) demand conditions, (3) firm strategy, structure, and rivalry, and what else? A: The Porter diamond consists of four elements that form the basis of competitiveness, plus the roles of government and chance. Factor conditions include a nation’s basic factors (e.g., land, labor, and natural resources) and advanced factors (e.g., skills of the workforce, technological infrastructure). Today, advanced factors are increasingly important to competitiveness. Demand conditions refer to the sophistication of buyers in a market—finicky buyers help a nation to be more competitive. Related and supporting industries that spring up around a competitive industry form geographic clusters of related economic activity that reinforce productivity and competitiveness. Firm strategy, structure, and rivalry also influence competitiveness. Managers committed to producing quality products and an industry structure that intensifies firm rivalry will help improve competitiveness. Government and chance play roles in fostering the competitiveness of industries. Government policies toward industry and export and import regulations can hurt or help competitiveness. Chance events also can influence national competitiveness.

Ch 5: International Trade

Q: A group of related industries that spring up in a geographic area to support a nation’s internationally competitive industry is called a what? A: A cluster is a group of related industries that spring up in a geographic area to support a nation’s international competitive industry. Each industry in the cluster serves to reinforce the productivity, and therefore, competitiveness of every other industry within the cluster.

Ethical Challenge

You are a member of a World Trade Organization task force that is reviewing the recent banana conflict between the United States and the European Union. The European Union and the United States recently ended a nine-year battle over trade in bananas. The European Union was giving preferential treatment to banana exporters from Africa, the Caribbean, and the Pacific island nations. But the United States challenged what it saw as unfair trading practices, and the World Trade Organization agreed. Large global fruit companies such as Dole, Chiquita, and Del Monte—which alone account for nearly two-thirds of the fruit traded worldwide—supported the U.S. action. The European Union argued it was trying to support struggling economies, for which bananas make up a large portion of their income. 5-5 Should international trade be left to private enterprise only, or should governments openly manage it to benefit poorer nations? 5-6 Would you have argued on behalf of the United States or the European Union? Explain? 5-7 What are the pros and cons of each side’s arguments? A: Here is some background on the matter. The United States (backed by Mexico, Guatemala, Ecuador, and Honduras) complained about the EU policy to the WTO, which awarded victory to the plaintiffs in 1997. The EU made amendments to its banana policy, which the EU said brings the policy in line with WTO specifications. However, the United States and its backers said that the amended policy was no better than the old one. The U.S. government notified U.S. importers that they are liable for hefty tariffs on $520 million worth of European luxury goods in retaliation for European barriers on banana imports. Washington said $520 million is the sum that U.S. companies such as Chiquita and Dole lost because of the EU banana quota system. The tariffs affected a range of EU goods, from Belgian biscuits and Scottish cashmere sweaters to Italian cheese and Spanish leather goods. The British Trade Minister Brian Wilson called the U.S. action “potentially catastrophic” for the British cashmere industry concentrated in Scotland. The French Foreign Ministry also called on the United States to halt what Paris considered an illegal action by Washington. “We strongly deplore that the U.S. has once again acted unilaterally,” the ministry said in a statement. “We are asking them to show good faith and to reconsider this unacceptable decision.” The World Trade Organization ruled in April 1999 that the European Union’s banana import program violated international trade law and would have to change. Caribbean leaders reacted to the ruling with anger and concern, saying it posed a dire threat to tiny island nations that rely on bananas for their foreign exchange. The Caribbean accounts for 10 percent of the world’s banana trade. Much of the remaining 90 percent is dominated by Latin America’s so-called “dollar banana” producers. Finally, other issues that could be discussed are job creation, setting an international trade precedent, political strategy, and the environment.

Ch 5: International Trade

Teaming Up Debate Project. Two groups of four students each will debate the advantages and disadvantages of completely free international trade. After the first student from each side has spoken, the second student will question the opponent’s arguments, looking for holes and inconsistencies. The third student will attempt to answer these arguments. A fourth student will present a summary of each side’s arguments. Finally, the class will vote on which team has offered the more compelling argument. A: Students should be sure to support their arguments with aspects of the theories discussed in this chapter. They should also be prepared to defend their positions, after the debate, if they are called on to give a synopsis of their position in class. It may also be useful to give students some time to do outside research to prepare for the debate. Practicing International Management Case First in Asia and the World 5-16.

Q: As the first to set up an international air express business in 1969, DHL had the firstmover advantage over other companies. Is being a first mover as advantageous for a service company such as DHL, as it is for a manufacturing company such as Boeing? Explain. A: In theory, the principle of first-mover advantage is the same for a service firm and a manufacturer. The first-mover advantage is based on economies of scale and strategic benefits of being first. There are economies of scale in services as there are economies of scale in production and the strategic benefits of being first apply to services as well. Expedia is a prime example of this in Internet travel services.

5-17.

Q: What elements are necessary for a service company to achieve global success? A: Key to a service company’s success in markets abroad is the people that represent the company. Because services are provided and consumed simultaneously, a buyer’s impression of the provider is largely based on the experience it has during its interaction with the company. In contrast, a buyer can have an unpleasant purchase experience of a physical product but be so pleased with the product’s performance that repeat purchase is assured. Thus, the most important element or obstacle to a service firm operating internationally is the training of employees to supply the highest quality service experience as possible to buyers.

5-18.

Q: Instead of relying on local agents, DHL prides itself on having its own staff of more than 300,000 people across the globe. What are the merits and drawbacks of this international staffing approach? A: The potential problems of using this approach rest in effective training and management of employees in markets abroad. This approach can also increase the cost of providing a service, although it is believed that special employee training and oversight allows the company to provide higher quality service.

5-19.

Q: What do you think are the dangers, if any, of being a first mover? A: DHL largely overreached in its expansion throughout the United States. It underestimated its competition and faced a global recession after launching its expansion

Ch 5: International Trade

strategy. Perhaps the biggest danger of being a first mover is complacency. Companies can easily develop hubris at their rapid growth and dominance of the industry. New, more agile companies may come along and knock them off their pedestal by being more attuned to customers’ needs. Start-ups might also employ a new business model (approach to doing business in the industry) and take market share away from the leader.

CHAPTER 6 POLITICAL ECONOMY OF TRADE LEARNING OBJECTIVES: 1. Explain why governments sometimes intervene in trade. 2. Outline the instruments that governments use to promote trade. 3. Describe the instruments that governments use to restrict trade. 4. Summarize the main features of the global trading system.

CHAPTER OUTLINE: Why Do Governments Intervene in Trade? Political Motives Protect Jobs Preserve National Security National Security and Imports National Security and Exports Respond To “Unfair” Trade Gain Influence Economic Motives Protect Infant Industries Pursue Strategic Trade Policy Benefits of Strategic Trade Policy Drawbacks of Strategic Trade Policy Cultural Motives Cultural Influence of the United States Instruments of Trade Promotion Subsidies Drawbacks of Subsidies Export Financing Foreign Trade Zones Special Government Agencies Instruments of Trade Restriction Tariffs Protect Domestic Producers Generate Revenue Quotas Reason for Import Quotas Reasons for Export Quotas Voluntary Export Restraints Tariff-Quotas Embargoes Local Content Requirements Administrative Delays Currency Controls Global Trading System General Agreement on Tariffs and Trade (GATT)

Ch 6: Political Economy of Trade

Uruguay Round of Negotiations Agreement on Services Agreement on Intellectual Property Agreement on Agricultural Subsidies World Trade Organization (WTO) Dispute Settlement in the WTO Dumping and the WTO Subsidies and the WTO Doha Round of Negotiations WTO and the Environment Bottom Line for Business

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 6. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline This chapter explores business–government trade relations, considers why nations erect barriers to trade, and explores the cultural, political, and economic motives for such barriers. It also examines the instruments countries use to restrict imports and exports, and how the global trading system promotes trade. I.

WHY DO GOVERNMENTS INTERVENE IN TRADE? Free trade is the pattern of imports and exports that would result in the absence of trade barriers. Governments impose restrictions on free trade for political, economic, and cultural reasons. A. Political Motives 1. Protect jobs Short of an unpopular war, nothing will oust a government faster than high unemployment. All governments become involved when trade threatens jobs at home. 2. Preserve national security Industries essential to national security receive government-sponsored protection for both imports and exports. a. Imports Governments restrict imports to guarantee domestic supply, which preserves national security. Many countries fiercely protect their agricultural sector for national security reasons because a nation that imports its food supplies could face starvation in times of war. b. Exports Governments have national security motives for banning certain defense-related goods from export to other nations. Agencies review requests to export technologies or products that have dual uses—meaning they have both industrial and military applications.

Ch 6: Political Economy of Trade

Respond to “unfair” trade Many argue that it makes no sense for one nation to allow free trade if others do not. Governments threaten to close their ports or to impose high tariffs if another nation does not concede on a certain trade issue. 4. Gain influence Governments of the largest nations may become involved in trade to gain influence over smaller nations. The United States wishes to maintain control over Central, North, and South America and the Caribbean basin. Economic Motives 1. Protect infant industries The infant industry argument says that emerging industries need protection from international competition during development until they become competitive internationally. Protection can be removed after it gains the knowledge to become innovative, efficient, and competitive. a. Drawbacks Governments may make errors in distinguishing between industries worth protecting and those that are not. Protection can cause domestic firms to grow complacent toward innovation and limit their competitiveness and increase consumer prices. Small promising ventures today can get private funding. 2. Pursue strategic trade policy New trade theorists believe government intervention helps firms take advantage of economies of scale and enjoy first-mover advantages. Firstmover advantages result because economies of scale limit the number of companies in an industry. a. Benefits Companies earn profits if they obtain first-mover advantages and solidified market positions. The chaebol helped companies survive poor economic times because of the wide range of industries in which they competed; policies had spin-off effects on industries such as transportation. b. Drawbacks Government assistance to domestic companies caused inefficiency and high costs for South Korean and Japanese companies in the late 1990s. Government support is subject to political lobbying and special-interest groups could capture gains with no benefit for consumers. Cultural Motives Exposure to people and products of other countries slowly alters cultures. 1. Unwanted cultural influence causes great distress and can force governments to block imports. 2. Many countries have laws that protect their media programming for cultural reasons. 3. The United States is seen as a threat to national cultures because of its global strength in consumer goods, entertainment, and media. 3.

II.

INSTRUMENTS OF TRADE PROMOTION A. Subsidies A subsidy is financial assistance to domestic producers in the form of cash payments, low-interest loans, tax breaks, product price supports, or some other form intended to help domestic companies fend off international competitors.

Ch 6: Political Economy of Trade 1.

III.

Drawbacks of subsidies Some say subsidies cover costs that competitive industries should absorb, thus encouraging inefficiency and complacency. Because governments pay for subsidies with tax income, it is felt that subsidies benefit companies but harm consumers. Although subsidies provide short-term relief, the idea that subsidies are helpful in the long term is questionable. Export Financing 1. Governments promote exports by helping companies finance their export activities through loans or loan guarantees. 2. Two agencies help U.S. companies to obtain export financing: ExportImport Bank and the Overseas Private Insurance Corporation (OPIC). OPIC insures against losses due to: (1) expropriation, (2) currency inconvertibility, and (3) war, revolution, and insurrection. 3. Financing is often crucial to small businesses just beginning to export. 4. Critics say subsidizing large multinational companies at taxpayer expense is corporate welfare. Foreign Trade Zones 1. A foreign trade zone (FTZ) is a designated geographic region in which merchandise is allowed to pass through with lower customs duties (taxes) or fewer customs procedures. Goals are jobs and trade. 2. Customs duties increase production costs and the time it takes to get a product to market. Companies can reduce such costs and time by establishing a facility inside a foreign trade zone. 3. A common purpose of such zones is final product assembly. Lower customs duties are offset by the jobs created in the United States. 4. China established very large foreign trade zones to reap the benefits. 5. Mexico’s maquiladora zone: import materials from the United States without duties, process them, and re-export them to the United States, which charges duties only on the value added in Mexico. Special Government Agencies 1. Governments have special agencies responsible for promoting exports. Such agencies organize trips for trade officials and businesspeople to visit other countries and open trade offices in other countries. 3. Governments not only promote exports but also may encourage imports. 4. Although finding out about government regulations in other countries can be daunting, information access is now easier on the Web.

INSTRUMENTS OF TRADE RESTRICTION A. Tariffs 1. A tariff is a government tax levied on a product as it enters or leaves a country: (1) export tariff, (2) transit tariff, and (3) import tariff. 2. Types of import tariff: An ad valorem tariff is levied as a percentage of the stated price of an imported product. A specific tariff is levied as a specific fee for each unit (by number or weight) of an imported product. A compound tariff is calculated partly as a percentage of the stated price of an imported product, and partly as a specific fee for each unit. 3. Protect domestic producers Because import tariffs raise the cost of an imported good, domestically produced goods appear more attractive to buyers. But protection may cause domestic producers to become lax in increasing efficiency. 4. Generate revenue

Ch 6: Political Economy of Trade

Tariffs are a source of government revenue. Less-developed nations have less formal domestic economies that lack the capability to record domestic transactions accurately. Because this makes collection of sales taxes difficult, nations raise needed revenue through import and export tariffs. As countries develop, they generate a greater portion of their revenues from taxes on income, capital gains, and other economic activities. Tariffs exact a cost on countries because they lessen the gains from trade. B.

Quotas A quota is a restriction on the amount (measured in units or weight) of a good that can enter or leave a country during a certain period of time. Governments administer quota systems by granting quota licenses to other nations’ companies or governments (import quotas) and domestic producers (export quotas). 1. Reason for import quotas a. Protects domestic producers by placing a limit on the amount of goods entering the country. This helps domestic producers maintain market shares and prices by retraining competition. b. Domestic producers win because of market protection, but consumers lose because of higher prices and limited selection. Other losers include domestic producers whose production requires the import subjected to a quota; companies relying on imported intermediate goods find the final cost of their own products increase. 2. Reasons for export quotas a. A country may wish to maintain supplies in the home market. This is common for countries that export natural resources that are needed in the domestic market. b. A country may restrict supply on world markets to increase the international price. c. A voluntary export restraint (VER) is a unique version of export quota that a nation imposes on its exports, usually at the request of an importing nation. If domestic producers do not curtail production, consumers benefit from lower prices due to a greater supply. Export quotas hurt consumers in the importing nation because of reduced selection and higher prices. Export quotas might retain jobs if imports threaten to put domestic producers out of business. 3. Tariff-Quotas A tariff-quota is a lower tariff rate for a certain quantity of imports and a higher rate for quantities that exceed the quota (e.g., agricultural trade). Embargoes a. An embargo is a complete ban on trade (imports and exports) in one or more products with a particular country. It may be placed on one or a few goods or completely ban trade in all goods. It is the most restrictive nontariff trade barrier and often has political goals. b. Embargoes can be decreed by individual nations or by supranational organizations such as the UN. Local Content Requirements a. Local content requirements are laws stipulating that producers in the domestic market must supply a specified amount of a good or service.

Ch 6: Political Economy of Trade

IV.

Designed to force companies from other nations to employ local resources in their production processes—particularly labor. b. May help protect domestic producers from the price advantage of companies based in other, low-wage countries. Developing countries use them to boost industrialization. Administrative Delays a. Administrative delays are regulatory controls or bureaucratic rules designed to impair the rapid flow of imports into a country. b. Can include government actions such as requiring international air carriers to land at inconvenient airports, requiring inspections that damage the product, understaffing customs offices to cause delays, and requiring special licenses that take time to obtain. c. Objective is protectionism. Currency Controls a. Currency controls are restrictions on the convertibility of a currency into other currencies. b. Governments reduce imports by stipulating an exchange rate that is unfavorable to potential importers. Also can give exporters favorable rates to encourage exports.

GLOBAL TRADING SYSTEM World trade volume peaked in the late 1800s. U.S. Smoot-Hawley Act in 1930 shifted nation from free trade to protectionism. Smoot-Hawley, and the global trade wars it ushered in, crippled industrialized nations and helped spark the Great Depression. A. General Agreement on Tariffs and Trade (GATT) The GATT was a 1947 treaty designed to promote free trade by reducing both tariff and nontariff barriers to international trade. Success in GATT’s early years began to wane in the 1980s. 1. Uruguay Round of Negotiations The Uruguay Round made significant progress in reducing trade barriers by revising and updating GATT. a. Services The General Agreement on Trade in Services (GATS) extended the principle of nondiscrimination to cover international trade in all services. The GATS identifies four forms of services. i. Cross-border supply: Services supplied from one country to another (e.g., international phone calls). ii. Consumption abroad: Consumers or companies using a service while in another country (e.g., tourism). iii. Commercial presence: Company’s subsidiary in another country provides a service (e.g., banking operations). iv. Presence of natural persons: Individuals traveling to another country to supply a service (e.g., business consultants). b. Intellectual property i. Intellectual property refers to property that results from people’s intellectual talent and abilities and is legally protected by copyrights, patents, and trademarks. ii. Uruguay Round took a step toward getting intellectual property under control; it created the Agreement on Trade-Related Aspects of Intellectual Property (TRIPS) to standardize intellectual-property rules.

Ch 6: Political Economy of Trade c.

Agricultural subsidies i. Popular barriers to protect agricultural sectors include import quotas and subsidies paid to farmers. ii. Uruguay Round increased exposure of national agricultural sectors to market forces and increased predictability in international agricultural trade. iii. Forces countries to convert nontariff barriers to tariffs and calls for cutting of agricultural tariffs significantly. World Trade Organization The World Trade Organization (WTO) is the international organization that regulates trade among nations. Three main goals of the WTO are to: (1) help free trade; (2) negotiate opening of markets; and (3) settle trade disputes. Key component of the WTO is normal trade relations: WTO members must extend the same favorable terms of trade to all members that they extend to any single members. WTO absorbs the GATT agreements into its own agreements. 1. Dispute settlement in the WTO a. WTO’s power to settle trade disputes sets it apart from the GATT. WTO agreements are contracts among member nations that commit them to maintaining fair and open trade policies. b. When a member files a complaint, the Dispute Settlement Body of the WTO renders a decision in less than one year. Offenders must realign policies according to WTO guidelines or suffer financial penalties and perhaps trade sanctions. 2. Dumping and the WTO a. WTO gets involved in settling disputes that involve “dumping” and the granting of subsidies. Dumping occurs when a company exports a product at a price that is either lower than the price normally charged in its domestic market, or lower than the cost of production. b. Because dumping is an act by a company, not a country, the WTO cannot punish the country in which dumping is based. c. WTO allows a nation to retaliate against dumping if it proves dumping charges, calculates the damage, and can show the damage is significant. Nations retaliate by imposing an antidumping duty—an additional tariff placed on an imported product that a nation believes is being dumped on its market. 3. Subsidies and the WTO a. Governments retaliate when the competitiveness is threatened by a subsidy that another country pays domestic producers. A countervailing duty is an additional tariff placed on an imported product that a nation believes is receiving an unfair subsidy. b. WTO regulates the actions of the government that reacts to the subsidy and the one that imposes the subsidy. 4. New Round of negotiations a. Negotiations began in Doha, Qatar, in late 2001. The new round was expected to bring particular benefits for developing nations. b. Negotiations in this round are ongoing but disappointingly slow. 5. WTO and the environment a. Rapid industrialization in many developing and emerging economies has generated environmental concerns among governments and special-interest groups.

Ch 6: Political Economy of Trade b.

WTO has no separate agreement for environmental issues, but works with international agreements on the environment. But the WTO has a Committee on Trade and Environment to study the relationship between trade and the environment and to recommend changes in the WTO trade agreements. WTO also takes explicit positions on some environmental issues related to trade. It states that labeling requirements or policies cannot discriminate against the products of other WTO members. It also supports policies of the least-developed countries that require full disclosure of potentially hazardous products for reasons of public health and environmental damage.

BOTTOM LINE FOR BUSINESS Despite the theoretical benefits of trade, nations do not simply throw open their doors to free trade and force all their domestic businesses to sink or swim. This chapter has discussed reasons why national governments continue to protect all or some of their industries and how they go about it. The global trading system through the World Trade Organization tries to strike a balance between national desires for protection and international desires for free trade.

Quick Study Questions Quick Study 1 1.

Q: Free trade is the pattern of imports and exports that occurs in the what? A: It is the pattern of imports and exports that occurs in the absence of trade barriers.

Q: For what political reasons does a government intervene in trade? A: (1) Practically every government restricts imports that threaten jobs in the domestic economy. (2) Governments restrict certain imports for national security reasons because the nation must have access to a domestic supply of certain items in the event of war. Agriculture is often protected for national security because a nation importing food could face starvation in war. (3) A government often threatens to restrict imports coming from a nation that restricts its own imports. (4) The largest nations may get involved in trade to gain influence over smaller nations. For example, Japan has influence among many Asian nations because they rely on Japan for a large amount of their imports and exports. (5) Nations restrict exports containing high technology and those with “dual uses.” They also restrict imports to protect domestic sources in case of war.

Q: What are some economic reasons why a government intervenes in trade? A: One economic motive for a nation to intervene in trade is protection of young (infant) industries from competition. According to the infant industry argument, a country’s emerging industries need protection from international competition during their development phase until they become sufficiently internationally competitive. However, drawbacks of this policy include: (1) Governments may not identify industries worth protecting and those not to protect. (2) Protection from international competition can cause domestic companies to become complacent. (3) It can be political suicide to remove protection once it has been given. (4) Consumers can wind up paying more if domestic companies are protected and do not become highly competitive. (5) A main

Ch 6: Political Economy of Trade

argument of this policy is that small businesses often cannot obtain financing is less true today than in the past. Another economic motive for intervention is pursuit of a strategic trade policy. The new trade theorists believe government intervention can help companies take advantage of economies of scale and be first movers in their industries. First-mover advantages result because economies of scale limit the number of companies that an industry can sustain. Supporters of strategic trade policy argue that strategic trade policies result in increased national income. However, drawbacks of this strategy are: (1) because it fosters inefficiencies and high costs, following a strategic trade policy can be very damaging to a nation’s economy in hard times; (2) those industries with the best political connections might benefit most from such a policy; and (3) strategic trade policies can spark destructive competition and even trade wars among nations. 4.

Q: Some people see the products of what country as the greatest threat to local cultures around the world? A: Some people see the products of the United States as the greatest threat to local cultures around the world. The main cultural motive for government intervention in trade is protection of national identity. For example, France has laws that guarantee French artists a minimum amount of airtime on French radio programs and Canada is considering doing something similar. Governments also block imports of products they think might be harmful to the nation’s culture. They also restrict the importation of certain services such as media and entertainment in order to protect budding artists and others in these industries.

Quick Study 2 1.

Q: Financial assistance from a government to domestic producers is called what? A: Governments employ the use of subsidies to assist domestic companies in fending off international competitors. One drawback of subsidies is that they can cause companies to become complacent about increasing efficiency and cutting costs. This can cause companies to overuse resources—an especially difficult problem in developing and emerging countries. Because subsidies are generally funded through tax revenues earned from sales and income taxes, critics charge that they amount to corporate welfare on behalf of consumers.

Q: What are the hoped-for outcomes of a foreign trade zone? A: A foreign trade zone (FTZ) is a designated geographic region in which merchandise is allowed to pass through with lower customs duties (taxes) or fewer customs procedures. FTZs promote the most trade when they are established as low-cost assembly points for companies manufacturing products that will then be shipped out to other international markets. An example of an FTZ is the location of Japanese car plants in U.S. states that are administered by the U.S. Department of Commerce.

Q: What are some of the ways that governments provide export financing? A: Export financing can help a nation increase exports. A government can offer its companies financing to expand their export activities—financing that they would otherwise be unable to obtain. Governments can also offer to guarantee the loans of its domestic companies that will use the money to expand their exports. Such loans and loan guarantees are often crucial to the export success of small and midsize companies because they often have a far greater need for cash than large, established exporters.

Ch 6: Political Economy of Trade

Quick Study 3 1.

Q: Why might a government impose a tariff on a product? A: There are two main reasons why countries impose tariffs and they are: (1) to protect domestic producers and (2) to generate revenues.

Q: Why might a government impose a quota on a product? A: A government may impose an import quota to protect domestic producers by placing a limit on the amount of goods allowed to enter the country. This helps domestic producers maintain their market shares and prices because competitive forces are restrained.

Q: A stipulation that a portion of a product be sourced domestically is called what? A: A local content requirement is a law that stipulates a specified amount of a good or service be supplied by producers in the domestic market. It’s designed to force foreign companies to employ local resources in production processes—particularly labor.

Quick Study 4 1.

Q: The first system of multilateral agreements to promote free trade was called what? A: The GATT was designed to promote free trade by reducing both tariff and nontariff barriers to trade. The GATT was formed in 1947 and early success began to wane in the 1980s. Between 1947 and 1988, it helped to reduce average tariffs from 40 percent to 5 percent and multiply the volume of international trade by 20 times. But by the middle to late 1980s, rising nationalism worldwide and trade conflicts led to a nearly 50 percent increase in nontariff barriers to trade. Also, services (not covered by the original GATT) had become increasingly important—accounting for between 25 and 30 percent of total world trade. It was clear that a revision of the treaty was necessary, and in 1994 a new round of trade talks were concluded. A more recent round of talks, begun in 2001, has been disappointing and appears deadlocked.

Q: What are the main goals of the World Trade Organization? A: The WTO is the international organization regulating trade among nations. WTO agreements are essentially contracts among member nations that commit them to maintaining fair and open trade policies. The Dispute Settlement Body goes to work as soon as a member nation files a complaint. The rulings of the Body cannot be ignored or blocked by members. Offenders must realign their trade policies according to WTO guidelines or suffer financial penalties and perhaps trade sanctions. Dumping occurs when a company exports its product at a lower price than it normally charges in its domestic market. The WTO cannot punish the country in which the company accused of dumping is based. The WTO can rule only on the retaliatory actions of other nations. The WTO allows a country to retaliate if it can show that dumping is actually occurring, calculate the damage to its own companies, and show that the damage is significant. Finally, because countries, not companies, give subsidies, the WTO regulates and rules on the actions of both parties in a dispute over subsidies.

Q: Exporting a product at a price that is lower than that normally charged domestically or one that is lower than production costs can expose a firm to charges of what? A: Dumping is when a company exports a product at a price that is either lower than the price normally charged in its domestic market or lower than the cost of production.

Ch 6: Political Economy of Trade

Ethical Challenge The National Foreign Trade Council (NFTC), a nonprofit trade and industry group based in Washington DC, won a court battle against the state of Massachusetts. In a unanimous decision the U.S. Supreme Court sided with the NFTC and struck down a Massachusetts law that was designed to deny state contracts to any company doing business in Myanmar. The Court ruled that the Massachusetts law intruded on the federal government’s authority and was preempted by federal law regarding Myanmar. In fact, the U.S. Constitution states that “foreign policy is exclusively reserved for the federal government.” The NFTC says that it shares concern over human rights abuses in Myanmar but believes that a coordinated, multinational effort would be most effective at instilling change. 6-5 Do you think that companies should be penalized domestically based on where they do business abroad? Explain. 6-6 Do you foresee potential problems when the WTO gets involved in such political matters? 6-7 How might domestic firms react if each state were to punish firms based on its own foreign policy ideals? A: Students will likely have strong opinions on this question because of the human rights issue. Probably the biggest problem with such a policy is the cost of monitoring the activities of companies around the world and making sure that deals are not just restructured so as to hide their involvement. Even then, companies could create holding companies in offshore locations that have strict secrecy laws so that home governments would be unable to find out whether they are dealing with countries having questionable human rights records. Finally, if the WTO were to involve itself in such political issues of nations, charges of political favoritism for powerful industrialized countries would likely increase. Teaming Up Imagine that the United States slapped an antidumping duty of 30 percent on aircraft parts imported from China that it believed were being dumped in the U.S. market. Imagine that China then slapped a 35 percent countervailing duty on U.S. auto imports, saying a recent federal bailout amounts to an unfair subsidy for U.S. automakers. 6-8 What political, economic, or cultural motives do you think are behind the U.S. antidumping duty against China’s aircraft parts? A: Students can review responses to the three Quick Study 1 questions and formulate their own response to this particular situation dealing with China. 6-9

What motives do you think are behind China’s countervailing duty against U.S. autos? A: The Chinese government is retaliating because they feel that their competitiveness is being threatened.

6-10

Should countries experiencing economic difficulties be allowed to erect temporary tariff and nontariff barriers? Explain. A: International trade occurs primarily because of relative price differences among nations, which stem from differences in production costs, which in turn result from: 1. Differences in the endowments of factors of production. 2. Differences in levels of technology

Ch 6: Political Economy of Trade

3. Differences in the efficiencies with which these are utilized 4. Foreign exchange rates International trade theory states that nations will attain a higher standard of living by specializing in those goods for which they possess a comparative advantage and importing those goods for which they have a comparative disadvantage. In other words, the can benefit by exporting their strengths and importing there weaknesses. In general, trade restrictions stop this free flow of goods and will harm the nation’s welfare. So then the question that could be posed would be: “If this is true, why does every nation (i.e., China) impose trade restrictions?” Students should look at the material covered in this chapter, and then people able to formulate and present an opinion. Practicing International Management Case Down with Dumping 6-19

Q: People love finding a bargain on their favorite items while shopping. But few people would likely want those items made in the home market (and expanding employment) if it meant paying a higher price for them. Do you agree with this sentiment? Explain. A: Many people would agree with the sentiment expressed in this statement. The attitude would likely change dramatically, however, if the person were to suddenly find his or her own job threatened by a cheap import being dumped on the domestic market.

6-20

Q: Do you think that people from different cultures would respond differently to the above question? If so, identify which cultures. A: People from individual-oriented cultures would probably be more likely to agree with the statement than would people from very group-oriented cultures. For example, many Japanese would probably disagree with the statement because they would see the dumping as a threat to many people in their nation with whom they are inextricably linked and with whom they feel obligated to assist if possible.

6-21

Q: The WTO cannot punish individual companies, but can only direct the actions toward governments of countries. Why do you think the WTO was not given authority to charge individual companies with dumping? Explain. A: The task of investigating the actions of individual companies would no doubt overwhelm the resources of an organization the size of the WTO even. Investigating each company against which a complaint was brought would be very time consuming and expensive. Besides, the members of the WTO are not individual companies but the governments of nations in which companies are based. Also, if the WTO had authority to charge individual companies with offenses, charges of political favoritism would probably increase over that which already occurs at the governmental level.

CHAPTER 7 FOREIGN DIRECT INVESTMENT LEARNING OBJECTIVES: 1. Describe the worldwide pattern of foreign direct investment (FDI). 2. Summarize each theory that attempts to explain why FDI occurs. 3. Outline the important management issues in the FDI decision. 4. Explain why governments intervene in FDI. 5. Describe the policy instruments that governments use to promote and restrict FDI.

CHAPTER OUTLINE: Introduction Pattern of Foreign Direct Investment Ups and Downs of FDI Globalization Mergers and Acquisitions Worldwide Flows of FDI Theories for Foreign Direct Investment International Product Life Cycle Market Imperfections (Internalization) Trade Barriers Specialized Knowledge Eclectic Theory Market Power Management Issues and Foreign Direct Investment Control Partnership Requirements Benefits of Cooperation Purchase-or-Build Decision Production Costs Rationalized Production Mexico’s Maquiladora Cost of Research and Development Customer Knowledge Following Clients Following Rivals Why Governments Intervene in FDI Balance of Payments Current Account Capital Account Reasons for Intervention by the Host Country Control Balance of Payments Obtain Resources and Benefits Access to Technology Management Skills and Employment Reasons for Intervention by the Home Country Government Policy Instruments and FDI

Ch 7: Foreign Direct Investment

Host Countries: Promotion Financial Incentives Infrastructure Improvements Host Countries: Restriction Ownership Restrictions Performance Demands Home Countries: Promotion Home Countries: Restriction Bottom Line for Business

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 7. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION Foreign direct investment (FDI) is the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control. It differs from portfolio investment—an investment that does not involve obtaining a degree of control in a company. Most governments set the threshold for an investment to be called FDI at anywhere from 10 to 25 percent of stock ownership in a company abroad—the U.S. Commerce Department sets it at 10 percent.

II.

PATTERN OF FOREIGN DIRECT INVESTMENT A. Ups and Downs of FDI FDI inflows grew around 20 percent per year in the first half of the 1990’s and expanded about 40 percent per year in the second half of the decade, but then fell back to $1.35 trillion in 2012 due to a fragile economy and uncertain government policies. FDI inflows are expected to rise to $1.6 trillion in 2014 and $1.8 trillion in 2015 as the world emerges from recession (see Figure 7.1). 1. Globalization a. Companies got around trade barriers in the 1980s through FDI. b. Uruguay Round of GATT further cut trade barriers, letting firms produce in the most efficient locations and export to markets. Set off further FDI into newly industrialized and emerging markets. c. Globalization also lets emerging-market companies use FDI. 2. Mergers and acquisitions a. M&As and their rising values propelled long-term growth in FDI, but are falling off lately due to global credit crisis. b. Power of largest multinationals seems to multiply each year. c. Many cross-border M&A deals are done to: i. Get a foothold in a new geographic market ii. Increase a firm’s global competitiveness iii. Fill gaps in companies’ product lines in a global industry iv. Reduce costs in R&D, production, or distribution

Ch 7: Foreign Direct Investment

III.

Entrepreneurs and small businesses also engage in FDI and account for more of its growth. Worldwide Flows of FDI 1. More than 100,000 MNCs with more than 900,000 affiliates drive FDI flows. 2. In terms of share of global FDI inflows, developed countries account for about 42 percent, and developing countries account for about 52 percent. 3. The EU, United States, and Japan attract the vast amount of world FDI inflows. 4. FDI inflows to developing nations were mixed, with China attracting most in Asia and India attracting a fair amount. 5. Outflows of FDI from developing nations also on the rise.

THEORIES OF FOREIGN DIRECT INVESTMENT A. International Product Life Cycle 1. States a company will begin by exporting its product and later undertake foreign direct investment as a product moves through its life cycle. 2. In the new product stage, a good is produced entirely in the home market. In the maturing product stage, a good is produced in the home market and in markets abroad that are large enough to warrant production facilities. In the standardized product stage, a company builds production capacity in low-cost developing nations to serve its markets around the world. 3. Yet the international product life cycle theory does not explain why companies choose FDI over other forms of market entry. B. Market Imperfections (Internalization) When an imperfection in the market makes a transaction less efficient, a company will undertake FDI to internalize the transaction and remove the imperfection. In a perfect market, prices are as low as possible and goods are easily available. Flaws in the efficient operation of an industry are market imperfections. 1. Trade barriers a. A trade barrier such as a tariff is a common market imperfection. b. Firms undertake FDI when market imperfections are present. 2. Specialized knowledge a. A unique competitive advantage may consist of specialized knowledge, technical expertise, or special marketing abilities. b. Companies charge fees for product knowledge, but when a company’s specialized knowledge is embodied in its employees, the only way to exploit an opportunity may be FDI. c. A company may undertake FDI if charging another company for access to its knowledge might create a future competitor. C. Eclectic Theory 1. States that firms undertake foreign direct investment when the features of a location combine with ownership and internalization advantages to make a location appealing for investment. When each advantage is present, a company will undertake FDI. 2. A location advantage is the advantage of locating a particular economic activity in a specific location because of the characteristics (natural or acquired) of the location.

Ch 7: Foreign Direct Investment 3.

IV.

An ownership advantage is the advantage that a company has due to its ownership of some special asset, such as a powerful brand, technical knowledge, or management ability. 4. An internalization advantage is the advantage that arises from internalizing a business activity rather than leaving it to a relatively inefficient market. Market Power 1. The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment. 2. The benefit of market power is greater profit because the firm is better able to dictate the cost of its inputs or the price of its output. 3. Companies can gain market power through vertical integration—the extension of activities into production that provide a firm’s inputs (backward integration) or absorb its output (forward integration).

MANAGEMENT ISSUES AND FOREIGN DIRECT INVESTMENT A. Control Many companies invest abroad because they wish to control activities in the local market (e.g., to ensure the selling price remains the same across markets). Yet complete ownership does not guarantee control. 1. Partnership requirements a. Many companies have strict policies regarding how much ownership they take in firms in other nations. b. Yet a nation may demand shared ownership in return for market access. Governments may use such requirements to shield workers and industries from exploitation or domination by large multinationals. 2. Benefits of cooperation a. Greater harmony exists today between governments and international companies. Developing nations and emerging markets need investment, employment, tax revenues, training, and technology transfers. b. A country with a reputation for overly restricting the operations of multinationals can see its inward investment dry up. c. Cooperation can open communication channels to maintain positive relationships in the host country. B. Purchase-or-Build Decision 1. The purchase-or-build decision of managers entails deciding whether to purchase an existing business or build a subsidiary abroad from the ground up—called a greenfield investment. 2. An acquiring firm may benefit from the goodwill the existing company has built over the years and, perhaps, brand recognition of the existing firm. The purchase of an existing business also may allow for alternative methods of financing, such as an exchange of stock ownership. 3. Factors that reduce the appeal of purchasing existing facilities are obsolete equipment, poor labor relations, and an unsuitable location. 4. Adequate facilities are sometimes unavailable and a company must go ahead with a greenfield investment. Greenfield investments have their own drawbacks—obtaining the necessary permits and financing and hiring local personnel can be difficult in some markets.

Ch 7: Foreign Direct Investment C.

Production Costs Labor regulations increase the hourly cost of production, and benefits packages and training programs add to wage costs. Although the cost of land and tax rate on profits can be lower locally, they may not remain constant. 1. Rationalized production a. Production in which components are produced where the cost of production is lowest. b. The components are brought together at one central location for assembly into the final product. c. Potential problem is that a work stoppage in one country can halt the entire production process. 2. Mexico’s maquiladora a. The 130-mile-wide strip along the U.S.–Mexican border. b. Low-wage regional economy next to a prosperous giant is a model for other regions split by wage or technology gaps. c. Ethical dilemmas arise over the wage gap between Mexico and the United States and lost U.S. union jobs to maquiladora nonunion jobs. Maquiladoras do not operate under the stringent regulations that firms in the United States do. 3. Cost of research and development a. Cost of developing subsequent stages of technology has led to cross-border alliances and acquisitions. b. One indicator of the significance of technology in foreign direct investment is the amount of R&D conducted by affiliates of parent companies in other countries. FDI in R&D appears to be spurred by supply factors such as access to high-quality scientific and technical human capital. Customer Knowledge 1. The behavior of buyers is an important issue in the decision of whether to undertake FDI. A local presence can give companies valuable knowledge of customers that is unobtainable in the home market. 2. Some countries have quality reputations in certain product categories that make it profitable to produce there. Following Clients 1. FDI puts companies near those firms they supply. “Following clients” occurs in industries in which component parts are obtained from suppliers with whom a manufacturer has a close working relationship. Following Rivals 1. FDI decisions resemble a “follow the leader” scenario in industries with a limited number of large firms. 2. Many firms believe that not making a move parallel to that of the “first mover” might result in being shut out of a lucrative market.

GOVERNMENT INTERVENTION IN FOREIGN DIRECT INVESTMENT Nations enact laws, create regulations, or construct administrative hurdles for foreign companies. A bias toward protectionism or openness is rooted in a nation’s culture, history, and politics. But FDI tends to raise output and enhance standards of living. Besides philosophical ideals, countries intervene in FDI for practical reasons. A. Balance of Payments 1. National accounting system that records all payments to entities in other countries and all receipts coming into the nation.

Ch 7: Foreign Direct Investment 2.

International transactions that result in payments (outflows) to entities in other nations are reductions in the balance of payments accounts and recorded with a minus (–) sign (see Table 7.1). 3. International transactions that result in receipts (inflows) from other nations are additions to the balance of payments accounts and recorded with a plus (+) sign. 4. Current account a. National account that records transactions involving the import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country. b. A current account surplus occurs when a country exports more goods and services and receives more income from abroad than it imports and pays abroad. c. A current account deficit occurs when a country imports more goods and services and pays more abroad than it exports and receives from abroad. 5. Capital account a. National account that records transactions involving the purchase or sale of assets. b. Financial assets such as stocks and bonds and physical assets such as investments in plants and equipment. Reasons for Intervention by the Host Country 1. Control balance of payments a. Many governments see intervention as the only way to keep their balance of payments under control. b. Host countries get a balance-of-payments boost from initial FDI flows. Local content requirements can lower imports, providing an added balance-of-payments boost. Exports from the FDI can further help the balance-of-payments position. c. When companies repatriate profits, they deplete the foreign exchange reserves of their host countries; these capital outflows decrease the balance of payments. Thus, a host nation may prohibit or restrict nondomestic firms from removing profits. d. But host countries conserve their foreign exchange reserves when international companies reinvest their earnings in local manufacturing facilities. This improves the competitiveness of local producers and boosts a host nation’s exports—improving its balance-of-payments position. 2. Obtain resources and benefits a. Access to technology Nations encourage FDI in technology because it increases productivity and competitiveness. b. Management skills and employment FDI allows talented foreign managers to train local managers in how to operate the local facilities. Some of these managers will also go on to establish their own businesses. Reasons for Intervention by the Home Country There are fewer concerns regarding the outflow of FDI among home nations because they tend to be prosperous, industrialized nations. 1. Reasons for discouraging outward FDI

Ch 7: Foreign Direct Investment

Investing in other nations sends resources out of the home country and can lessen investment at home. b. Outgoing FDI may damage a nation’s balance of payments by reducing exports otherwise sent to international markets. c. Jobs resulting from FDI outflows may replace jobs at home. Reasons for promoting outgoing FDI a. Outward FDI can increase long-run competitiveness (e.g., partnering as a learning opportunity). b. Nations may encourage FDI in industries that use obsolete technology or employ low-wage workers with few skills.

VI.

GOVERNMENT POLICY INSTRUMENTS AND FOREIGN DIRECT INVESTMENT A. Host Countries: Promotion 1. Financial incentives a. Host governments commonly offer tax incentives or low-interest loans to attract investment. b. But incentives can create bidding wars between locations vying for investment; the cost to taxpayers of snaring FDI can be more than what the actual jobs pay. 2. Infrastructure improvements a. Lasting benefits for communities surrounding the investment location can result from local infrastructure improvements— better seaports for containerized shipping, improved roads, and increased telecommunications systems. B. Host Countries: Restriction 1. Ownership restrictions a. Governments impose ownership restrictions that prohibit nondomestic companies from investing in certain industries or owning certain types of business. b. Another restriction is a requirement that nondomestic investors hold less than a 50 percent stake in local firms. Nations are eliminating such restrictions because companies can choose another location. 2. Performance demands a. Some performance demands dictate the portion of a product’s content that originates locally, stipulates the portion of output that must be exported, or requires that certain technologies be transferred to local businesses. C. Home Countries: Promotion 1. Offer insurance to cover the risks of investments abroad. 2. Grant loans to firms wishing to increase their investments abroad. 3. Offer tax breaks on profits earned abroad or negotiate special tax treaties. 4. Apply political pressure on other nations to get them to relax their restrictions on inbound investments. D. Home Countries: Restriction 1. Impose differential tax rates that charge income from earnings abroad at a higher rate than domestic earnings. 2. Impose sanctions that prohibit domestic firms from making investments in certain nations.

VII

BOTTOM LINE FOR BUSINESS

Ch 7: Foreign Direct Investment This chapter presents foreign direct investment (FDI). Like trade decisions, many factors influence a company’s decision about whether to invest in markets abroad. Depending on the philosophy of home or host nations and the impact of FDI on their economic health, a firm can be encouraged or dissuaded to invest in a nation.

Quick Study Questions Quick Study 1 1.

Q: The purchase of physical assets or significant ownership of a company abroad to gain a measure of management control is called what? A: Foreign direct investment is the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control. It differs from portfolio investment—an investment that does not involve obtaining a degree of control in a company.

Q: What are the main drivers of foreign direct investment flows? A: Three main reasons for the large increases in FDI flows over the past couple of decades are: (1) globalization, (2) mergers and acquisitions, and (3) increasing FDI on the part of entrepreneurs and small businesses.

Q: Why might a company engage in a cross-border merger or acquisition? A: Many cross border M&A deals are driven by a desire of companies to: (1) get a foothold in a new geographic market, (2) increase a firm’s global competitiveness, (3) fill gaps in companies’ product lines in a global industry, and (4) to reduce costs of research and development, production, distribution, and so forth.

Quick Study 2 1.

Q: What imperfections are relevant to the discussion of market imperfections theory? A: Market imperfections theory states that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake FDI to internalize the transaction and thereby remove the imperfection. Two important market imperfections are trade barriers and specialized knowledge, such as technical expertise of engineers or the special marketing abilities of managers. Companies can eliminate the inefficiency of trade barriers (they increase the cost of getting a product to market) by developing production facilities within the market. Sometimes the only way a company can exploit the specialized knowledge of its employees is to engage in FDI—the knowledge simply cannot be licensed to another firm. Firms also can undertake FDI when they want to lessen the risk of giving away a competitive advantage to other companies through licensing agreements.

Q: Location, ownership, and internationalization advantages combine which FDI theory? A: The eclectic theory states that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment. A location advantage is the advantage of locating a particular economic activity in a specific location because of the characteristics (natural or acquired) of that location. These advantages have historically been natural resources but can also be acquired advantages such as a productive workforce. An

Ch 7: Foreign Direct Investment

ownership advantage is the advantage that a company has due to its ownership of some special asset, such as a powerful brand, technical knowledge, or management ability. An internalization advantage is the advantage that arises from internalizing a business activity rather than leaving it to a relatively inefficient market. The theory states that when all these advantages are present, a company will undertake FDI. 3.

Q: Which FDI theory depicts a firm establishing a dominant market presence in an industry? A: The market power theory states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment. The benefit of market power is greater profit because the firm is far better able to dictate the cost of its inputs or the price of its output.

Quick Study 3 1.

Q: Where adequate facilities are not present in a market, a firm may decide to undertake what? A: Building a subsidiary abroad from the ground up is called a greenfield investment. This is pursued when adequate facilities in the local market are unavailable.

Q: A system in which a product’s components are made where cost of producing a component is lowest is called what? A: Rationalized production is when each of a good’s components is produced where the cost of producing that component is lowest. A potential problem with this production model is that a work stoppage in one country can bring the entire production process to a standstill.

Q: What do we call the situation in which a company engages in FDI because the firm it supplies has already invested abroad? A: Firms commonly engage in FDI when the firms they supply have already invested abroad. The practice of “following clients” is common in industries in which producers source component parts from suppliers with who they have close working relationships.

Quick Study 4 1.

Q: The national accounting system that records all receipts coming in to a nation and all payments to entities in other countries is called what? A: A country’s balance of payments is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation. The balance of payments helps a country monitor the flows of goods, services, income, and transfer of assets between itself and other nations.

Q: Why might a host country intervene in foreign direct investment? A: One reason host governments intervene in FDI is to control their balance of payments. (1) Countries get a balance-of-payments boost from initial FDI flow into their economies. (2) Local content requirements can lower imports, thereby providing a balance-ofpayments boost. (3) Exports generated by production resulting from FDI can help the balance-of-payments position. Another reason for intervening in FDI is to obtain resources and benefits. (1) They may want access to technology. Nations encourage the import of technology because it tends to increase the productivity and competitiveness of nations. (2) They

Ch 7: Foreign Direct Investment may want to obtain management skills and increase employment levels. By encouraging FDI, nations can allow in talented managers to train local managers in how to operate the local facilities—particularly important for former communist nations that lack skilled managers. (3) Some of these managers will go on to establish their own businesses, thereby expanding the economy and employment opportunities within the nation.

Q: Why might a home country intervene in foreign direct investment? A: There are generally fewer concerns regarding the outflow of FDI among home nations because they tend to be prosperous, industrialized nations. FDI outflows do not drastically affect the domestic economy. Nevertheless, there are reasons why home countries discourage outward FDI. (1) Investing in other nations sends resources out of the home country. (2) Outgoing FDI may ultimately damage a nation’s balance of payments by reducing exports that would otherwise be sent to international markets. (3) Jobs resulting from outgoing investments may replace jobs at home. Home countries also promote outgoing FDI. (1) They may do so because outward FDI can increase long-run competitiveness. (2) Nations may encourage FDI in industries that they have determined to be “sunset” industries.

Quick Study 5 1.

Q: What policy instruments can host countries use to promote FDI? A: Host countries promote FDI by giving tax incentives, low-interest loans, and infrastructure improvements.

Q: What policy instruments can home countries use to promote FDI? A: To promote FDI, home countries can offer insurance, low-interest loans, tax breaks, and apply political pressure.

Q: Ownership restrictions and performance demands are policy instruments used by whom to do what? A: Host nations restrict FDI through ownership restrictions and performance demands.

Q: Differential tax rates and sanctions are policy instruments used by whom to do what? A: Home countries may try to restrict FDI by using differential tax rates and performance demands.

Ethical Challenge

You are the U.S. senator deciding whether to vote yes or no on a new legislation. The potential new law places restrictions on the practice of outsourcing work to low-wage countries and is designed to protect U.S. workers’ jobs. These days it is increasingly common for companies to promise manufacturing contracts to overseas suppliers in exchange for access to that country’s market. Labor union representatives argue that these kinds of deals cost jobs as factories close and parts are made in lower cost China. They also say that the transfer of technology will breed strong competitors in other nations and thereby threaten even more jobs at home in the future. Yet, others argue that market access will translate to increased sales of products mad at home and, therefore create new jobs at home.

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Do you think companies bear an ethical burden when the contract production to factories abroad and reduce jobs at home? As senator, do you vote yes or no on the pending legislation? Explain. Depending on how you voted what policy instruments might you suggest that your government introduce? A: Students approach this issue from a variety of perspectives ranging from a total freemarket ideology to a protectionist one. Students must balance the short-term gains of new business and greater profits against the short-term loss of jobs and potential long-term loss of creating future competitors. One key issue here is whether companies are transferring cutting-edge technologies or those that are a generation or more old. Students must also consider social issues of lost jobs due to manufacturing going abroad and the strong competitors arising from transferring technologies abroad.

Teaming Up Research Project. Imagine that you work for a car manufacturer and your team is charged with evaluating the viability of a greenfield auto assembly plant in Mexico. 7-8 Q: What management issues should your team consider in making the evaluation? Explain. A: Foreign direct investment is the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control. It differs from portfolio investment—an investment that does not involve obtaining a degree of control in a company. Three main reasons for the large increases in FDI flows over the past couple of decades are: (1) globalization, (2) mergers and acquisitions, and (3) increasing FDI on the part of entrepreneurs and small businesses. 7-9

Q: For each FDI theory in this chapter, briefly describe a scenario in which the theory explains why the company investment in Mexico. A: Students should review the international product life cycle theory, market imperfections theory, eclectic theory, and then relate it after some research to the noted situation.

7-10

Q: What policy instruments can Mexico use to attract additional FDI inflows? A: Mexico can provide financial incentives, either tax incentives or low interest loans, or provide infrastructure improvements, such as improved roads or increased telecommunications systems.

Practicing International Management Case World Class in Dixieland 7-19

Q: What are the pros and cons of Mercedes’ decision to abandon the culture and some of its home country practices? A: The major advantage of the investment is potential for increased sales and market share. The major drawback is the possible dilution of the brand image that Mercedes’ has in the market place.

7-20

Q: What do you think were the chief factors involved in Mercedes’ decision to undertake FDI in the United States rather than build the M-class in Germany?

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A: Mercedes chose the United States over Germany because U.S. labor costs were lower. Alabama offered attractive tax refunds and other incentives to gain jobs that the plant would create in and around Vance, Alabama and, the company chose the U.S. market to develop an ultra-modern plant that would be a model for its future international facilities. 7-21

Q: Why do you think Mercedes decided to build the plant from the ground up in Alabama rather than buying an existing plant in, say, Detroit? List as many reasons as you can and explain your answers. A: First, Mercedes probably chose to build from the ground up because existing facilities would not supply the cutting-edge environment it wanted for its latest efforts in carmanufacturing technology, organizational design, and HRM techniques. Second, it probably chose Alabama because of the mix of economic factors, including low wages, a rural setting with a strong work ethic, and financial incentives. Third, it wanted to create a unique work setting and environment that reflected the firm’s values. .

CHAPTER 8 REGIONAL ECONOMIC INTEGRATION LEARNING OBJECTIVES: 1. Outline the levels of economic integration and its debate. 2. Describe integration in Europe and its enlargement. 3. Describe the integration in the Americas and its prospects. 4. Summarize integration in the Asia and elsewhere.

CHAPTER OUTLINE: Introduction Levels of Integration and the Debate Free Trade Area Customs Union Common Market Economic Union Political Union The Case for Regional Integration Trade Creation Greater Consensus Political Cooperation Employment Opportunities Corporate Savings The Case Against Regional Integration Trade Diversion Shifts in Employment Loss of National Sovereignty Integration in Europe European Union Early Years Single European Act Maastricht Treaty European Monetary Union Management Implications of the Euro Enlargement of the European Union Structure of the EU European Parliament Council of the EU European Commission Court of Justice Court of Auditors European Free Trade Association (EFTA) Integration in the Americas North American Free Trade Agreement (NAFTA) Local Content Requirements and Rules of Origin Effects of NAFTA Expansion of NAFTA

Ch 8: Regional Economic Integration

Central American Free Trade Area (CAFTA-DR) Andean Community (CAN) Latin American Integration Association (ALADI) Southern Common Market (MERCOSUR) Central America and the Caribbean Caribbean Community and Common Market (CARICOM) Central American Common Market (CACM) Free Trade Area of the Americas (FTAA) Integration in Asia and Elsewhere Association of Southeast Asian Nations (ASEAN) Asia Pacific Economic Cooperation (APEC) The Record of APEC Closer Economic Relations (CER) Agreement Gulf Cooperation Council (GCC) Economic Community of West African States (ECOWAS) African Union (AU) Bottom Line for Business

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 8. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION This chapter focuses on regional efforts to encourage freer trade and investment. Regional integration is defined and its benefits and drawbacks are identified. The chapter also explores several long-established trading agreements and some agreements in the earliest stages of development.

II.

LEVELS OF INTEGRATION AND THE DEBATE Regional economic integration is countries of a region cooperating to reduce or eliminate barriers to the international flow of products, people, or capital. A regional trading bloc is a group of nations in a geographic region undergoing economic integration. The goal is greater cross-border trade and investment and higher living standards. Specialization and trade allow more choice, lower prices, and increased productivity. Regional trade agreements help nations accomplish these objectives and protect intellectual property rights, the environment, or even eventual political union. There are five levels. Free trade area is the lowest extent of national integration, political union the greatest. Each level of integration incorporates the properties of those levels that precede it. A. Free Trade Area 1. Countries remove all barriers to trade among members, but each country determines its own barriers against nonmembers. 2. Policies differ greatly against nonmember countries from one country to another. Countries in a free trade area also establish a process to resolve trade disputes among members.

Ch 8: Regional Economic Integration B.

Customs Union 1. Countries remove all barriers to trade among members but erect a common trade policy against nonmembers. 2. Differs from a free trade area in that members treat all nonmembers similarly. Countries might also negotiate as a single entity with other supranational organizations such as the WTO. Common Market 1. Countries remove all barriers to trade and the movement of labor and capital among themselves, but erect a common trade policy against nonmembers. 2. Adds the free movement of important factors of production such as people and cross-border investment. It can be difficult for nations to cooperate on economic and labor policies. Economic Union 1. Countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies. 2. Requires members to harmonize their tax, monetary, and fiscal policies, create a common currency, and concede a certain amount of sovereignty to the supranational organization. Political Union 1. Countries coordinate aspects of economic and political systems. 2. Members accept a common stance on economic and political policies regarding nonmember nations. Nations are allowed a degree of freedom in setting certain political and economic policies within their territories. The Case for Regional Integration There are debates over effects on people, jobs, companies, culture, and living standards. Nations engage in specialization and trade because of the gains in output and consumption. Higher levels of trade among nations should increase specialization, efficiency, and consumption, and raise standards of living. 1. Trade creation a. Increase in trade that results from regional economic integration. b. Gives consumers and industrial buyers a wider selection of goods and services not available beforehand. c. Buyers can acquire goods and services more cheaply following the lowering of trade barriers such as tariffs. Lower costs lead to higher demand for goods because people have more money after a purchase to buy other products. 2. Greater consensus Eliminating trade barriers in smaller groups of countries may make it easier to gain consensus as opposed to working in the far larger WTO. 3. Political cooperation A group of nations can have significantly greater political weight than nations have individually. The group may have more clout in negotiating in a forum such as the WTO. Integration involving political cooperation reduces the potential for military conflict among members. 4. Employment opportunities Regional integration can expand employment by enabling people to move from country to country for work, or to earn a higher wage. 5. Corporate savings—Agreements allow companies to alter their strategies. Companies that do business throughout the region could save

Ch 8: Regional Economic Integration

III.

millions of dollars annually from the removal of import tariffs under an eventual agreement, and they could also save money from supplying entire regions from just a few regional factories. The Case Against Regional Integration 1. Trade diversion a. Diversion of trade away from nations not belonging to a trading bloc and toward member nations. Trade diversion can occur after formation of a trading bloc because of the lower tariffs charged among member nations. b. Can result in reduced trade with a more efficient nonmember nation in favor of trade with a less efficient member nation. Unless there is other internal competition, buyers will pay more due to inefficient production methods. 2. Shifts in employment a. Because trading blocs reduce or eliminate barriers to trade, the producer of a particular good or service will be decided by relative productivity. Industries requiring unskilled labor shift production to low-wage nations within a trading bloc. b. Figures on jobs lost or gained vary with the source. But job dislocation allows a nation to upgrade the economy toward higher-wage-paying industries that can increase competitiveness due to a more educated and skilled workforce. 3. Loss of national sovereignty a. Successive levels of integration require nations to surrender more sovereignty. Political union requires nations to give up a high degree of sovereignty in foreign policy. b. Because some members have delicate ties with nonmember nations whereas others have strong ties, the setting of a common foreign policy is difficult.

INTEGRATION IN EUROPE European efforts at integration began shortly after the Second World War among a small group of countries and involved a few select industries. Regional integration now encompasses practically all of Western Europe and all industries. A. European Union 1. Early Years a. Europe in 1945 faced two challenges: (1) to rebuild itself and avoid further conflict, and (2) to increase its industrial strength to stay competitive with the United States. b. Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands signed the Treaty of Paris in 1951, creating the European Coal and Steel Community to remove barriers to trade in coal, iron, steel, and scrap metal. c. Members of the European Coal and Steel Community signed the Treaty of Rome in 1957, creating the European Economic Community (EEC), which outlined a future common market. d. In 1967 the Community’s scope was broadened to include additional industries, notably atomic energy, and changed its name to the European Community. Enlargement continued and in 1994 the bloc changed its name to the European Union (EU).

Ch 8: Regional Economic Integration e.

Today the 27-member European Union has a population of about 500 million people and a GDP of around $15 trillion. f. Single European ACT (SEA) Remove remaining barriers, increase harmonization, and enhance competitiveness of EU companies. M&As swept Europe as large firms combined their understanding of European needs, capabilities, and cultures with economies of scale. g. Maastricht Treaty The 1991 Maastricht Treaty (effective in 1993): (1) created single, common currency; (2) set monetary and fiscal targets for countries taking part in monetary union; and (3) proposed eventual political union—including a common foreign and defense policy and common citizenship. European Monetary Union a. Opting out of the euro are Britain, Denmark, and Sweden. b. The euro eliminates exchange-rate risk for business deals among member nations using the euro. Transparency in prices harmonizes prices across markets. Enlargement of the European Union a. Expansion in 2004 and 2007 from 15 to 27 members today. b. Candidates for membership are Croatia, Turkey, and the Former Yugoslav Republic of Macedonia. c. New members must meet the Copenhagen Criteria. Structure of the EU a. European Parliament i. Composed of 736 members elected by popular vote within each member nation every five years. ii. Parliament acts as a consultative rather than a legislative body by debating and amending legislation proposed by the European Commission. b. Council of the EU i. The legislative body of the EU. Council members change depending on the topic under discussion (e.g., for agriculture, the Council is comprised of agriculture ministers of each member). ii. No proposed legislation becomes EU law unless the Council votes it into law. Some legislation today requires only a simple majority to win approval. c. European Commission i. The executive body of the EU whose commissioners are appointed by each country—larger nations get two commissioners, smaller countries one. ii. Drafts legislation, manages and implements policy, and monitors compliance with EU law. d. Court of Justice i. Acts as the EU court of appeals and is composed of 27 members (one from each member nation). ii. One type of case heard is when a member nation is accused of not meeting its treaty obligations. iii. Justices are required to act in the interest of the EU as a whole, not in the interest of their own countries.

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IV.

Court of Auditors i. Composed of 27 members (one from each member nation) appointed for six-year terms. ii. Duty is to audit EU accounts and implement EU budget, improve EU financial management, and report to member nations’ citizens on the use of public funds. European Free Trade Association (EFTA) 1. Some nations wanted the benefits of a free-trade area but were wary of a full common market. In 1960, they formed the European Free Trade Association (EFTA) to focus on trade in industrial goods. Today members are Iceland, Liechtenstein, Norway, and Switzerland. 2. EFTA has 12.5 million people and a combined GDP of $707 billion. 3. The EFTA and EU cooperate on the free movement of goods, persons, services, and capital. They also cooperate in other areas, including the environment, social policy, and education.

INTEGRATION IN THE AMERICAS Latin American countries began forming regional trading arrangements in the early 1960s but made substantial progress only in the 1980s and 1990s. North America is taking major steps toward economic integration. A. North American Free Trade Agreement (NAFTA) • NAFTA (January 1994) seeks to eliminate most tariffs and nontariff trade barriers on most goods originating from North America. • Calls for liberalized rules regarding government procurement practices, the granting of subsidies, and the imposition of countervailing duties. • Other provisions deal with trade in services, intellectual property rights, and standards of health, safety, and the environment. 1. Local content requirements and rules of origin a. Producers and distributors must determine if their products meet NAFTA rules to qualify for tariff-free status. The producer or distributor must also provide a NAFTA “certificate of origin” to an importer to claim an exemption from tariffs. b. Four criteria to meet NAFTA rules of origin: (1) goods wholly produced or obtained in the NAFTA region; (2) goods containing nonoriginating inputs but meeting origin rules; (3) goods produced in the NAFTA region wholly from originating materials; and (4) unassembled goods with sufficient North American regional value content. 2. Effects of NAFTA a. Trade among Canada, Mexico, and the United States has grown from $297 billion in 1993 to around $1.6 trillion. b. Mexico’s exports to the United States rose to about $230 billion, and U.S. exports to Mexico grew to more than $163 billion. c. Canada’s exports to the United States more than doubled to approximately $277 billion, and U.S. exports to Canada grew to $248 billion. d. Canada’s exports to Mexico grew more than threefold to nearly $2.7 billion. e. The agreement’s effect on employment and wages is not easy to determine. The U.S. Trade Representative Office and the AFLCIO group of unions debate NAFTA’s effect on jobs. Copyright © 2016 Pearson Education, Inc.

Ch 8: Regional Economic Integration 3.

Expansion of NAFTA a. Continued ambivalence about NAFTA delays its expansion. b. A boost would be if the U.S. Congress grants trade promotion authority to successive U.S. presidents. c. The Americas will experience further integration and North American economies could even adopt a single currency. Central American Free Trade Agreement (CAFTA-DR) 1. Established in 2006 between the United States and Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic. 2. CAFTA nations represent a U.S. export market larger than India, Indonesia, and Russia combined. And nearly 80 percent of exports from the Central American nations and the Dominican Republic already enter the United States tariff-free. 3. Central American nations have already cut average tariffs from 45 percent in 1985 to around 7 percent today. 4. Combined value of goods traded among the United States and the six CAFTA countries is around $32 billion. 5. Benefits to the United States: (1) lower tariff and nontariff barriers; (2) ensures U.S. companies are not disadvantaged by Central American nations’ trade agreements with other countries; (3) requires Central American nations and Dominican Republic to encourage competition and investment, protect intellectual property rights, and promote transparency and the rule of law; (4) supports U.S. national security interests by advancing regional integration, peace, and stability. Andean Community (CAN) 1. Formed in 1969 and today includes Bolivia, Colombia, Ecuador, and Peru. It comprises a market of around 97 million consumers and a combined GDP of about $220 billion. 2. Objectives include tariff reduction, a common external tariff, and common policies in both transportation and certain industries. 3. But each member is given exceptions in the common tariff structure for trade with nonmembers. The group has yet to create a customs union. Latin American Integration Association (ALADI) 1. Formed in 1980, called for preferential tariff agreements between pairs of members (reflecting their economic development levels). 2. ALADI did not significantly increase cross-border trade despite 24 bilateral agreements and 5 subregional pacts. Southern Common Market (MERCOSUR) 1. MERCOSUR members: Argentina, Brazil, Paraguay, Uruguay, and Venezuela (Bolivia, Chile, Colombia, Ecuador, and Peru are associate members). 2. Acts as customs union and liberalizing trade and investment—emerging as the most powerful trading bloc throughout Latin America. 3. May incorporate all of South America into a South American Free Trade Agreement and link up with NAFTA. 4. Different trade agendas, various macroeconomic policy frameworks, and economic problems of Argentina and Brazil hamper integration. Central America and the Caribbean Integration efforts here have been modest. 1. Caribbean Community and Common Market (CARICOM)

Ch 8: Regional Economic Integration

Formed in 1973. Bahamas is a member of the Community but does not belong to the Common Market. Has combined GDP of nearly $30 billion and a market of almost 6 million people. b. In 2000, CARICOM members called for the establishment of a single market, but the problem is that members trade more with nonmembers than with one another. 2. Central American Common Market (CACM) a. Intended to create a common market between Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. Progress was constrained by civil wars and wars among members. Comprises a market of 33 million and combined GDP of $120 billion. b. Not yet a customs union, but officials say goal is integration, closer political ties, and a single currency—likely the dollar. El Salvador adopted the dollar as its official currency in 2000. Free Trade Area of the Americas (FTAA) 1. Intends to create a trading bloc stretching from Alaska to Tierra del Fuego in South America. The FTAA would comprise 34 nations and 830 million consumers—with Cuba being the only Western Hemisphere nation excluded. 2. Would remove tariffs and nontariff barriers among members, but continues to face opposition from labor organizations, environmentalists, and others against globalization.

INTEGRATION IN ASIA AND ELSEWHERE A. Association of Southeast Asian Nations (ASEAN) 1. Market of 560 million consumers and a GDP of $1.1 trillion. 2. Objectives: (1) promote economic, cultural, and social development; (2) safeguard economic and political stability; and (3) serve as a forum in which differences can be resolved fairly and peacefully. 3. Adding Cambodia, Laos, and Myanmar, may help counter China’s strength and resources of cheap labor and abundant raw materials. B. Asian Pacific Economic Cooperation (APEC) 1. Comprise more than 40 percent of world trade and a GDP of more than $19 trillion. 2. Aims to strengthen the multilateral trading system and expand the global economy by simplifying and liberalizing trade and investment procedures. 3. Hopes to have completely free trade and investment throughout the region by 2020. 4. Record of APEC a. Succeeded in halving members’ tariff rates from an average of 15 to 7.5 percent. Less progress more recently. b. Is a political body as much as it is a movement toward free trade. Open dialogue and cooperation should encourage progress toward APEC goals, however slowly. c. Grants region-wide business visas without requiring multiple visas, and recommends regional recognition of national qualifications for professionals. C. Closer Economic Relations (CER) Agreement 1. Australia and New Zealand created a free trade agreement in 1966 that slashed tariffs and quotas 80 percent by 1980.

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The agreement’s success encouraged the pair to form the Closer Economic Relations (CER) Agreement in 1983 to advance free trade and further integrate their two economies. 3. The two nations totally eliminated tariffs and quotas in 1990, five years ahead of schedule. 4. Each nation allows goods (and most services) to be sold within its borders that can be legally sold in the other country. Each nation also recognizes most professionals who are registered to practice their occupation in the other country. Gulf Cooperation Council (GCC) 1. Members are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. Formed to cooperate with the increasingly powerful trading blocs in Europe. 2. Main achievements: allowing citizens to travel freely among member nations, and allowing citizens to own land, businesses, and other property in fellow member nations without the need for local partners. Economic Community of West African States (ECOWAS) 1. Intends to form a customs union and an eventual common market and monetary union among its members. The ECOWAS nations comprise a large portion of the economic activity in sub-Saharan Africa. 2. Progress on market integration is almost nonexistent, but ECOWAS has made progress in the free movement of people, construction of international roads, and development of telecommunication links. 3. Problems for ECOWAS arise because of political instability, poor governance, weak national economies, poor infrastructure, and poor economic policies. African Union (AU) 1. Group of 53 nations joined forces in 2002 to create the African Union. 2. Aims: (1) rid vestiges of colonialism and apartheid; (2) promote unity and solidarity; (3) coordinate and intensify cooperation for development; (4) safeguard members’ sovereignty and territorial integrity; (5) promote international cooperation within the United Nations. 3. But problems abound (e.g., ethnic violence in Darfur region of Sudan despite heavy AU involvement). 2.

VI.

BOTTOM LINE FOR BUSINESS This chapter describes regional integration efforts occurring today. There is much debate about the merits and demerits of regional trade agreements. Some governments and independent organizations act to counter the negative effects of integration. Although there are drawbacks to integration, governments will continue to be enticed by the potential gains from increased trade and by the desire to raise standards of living. Regional economic integration will likely continue to roll back barriers to trade among nations and among existing trading blocs of nations.

Quick Study Questions Quick Study 1

Ch 8: Regional Economic Integration

Q: What is it called when countries in a region cooperate to reduce or eliminate barriers to the international flow of products, people and capital? A: Regional economic integration is the process whereby countries in a geographic region cooperate with one another to reduce or eliminate barriers to the international flow of products, people, or capital. The ultimate goal is to raise living standards by expanding cross-border trade and investment.

Q: What are the names of the lowest and highest levels of regional economic integration? A: The first (and lowest) level of regional integration is a free trade area—economic integration whereby countries remove all barriers to trade among themselves but each country determines its own barriers against nonmembers. Each country is able to maintain whatever policy it sees fit against nonmember countries. These policies can differ widely from country to country. The second level of regional integration is a customs union—economic integration whereby countries remove all barriers to trade among themselves, but erect a common trade policy against nonmembers. What makes it different from a free trade area is that members treat all nonmembers similarly. The third level of regional integration is a common market—economic integration whereby countries remove all barriers to trade and the movement of labor and capital among themselves, but erect a common trade policy against nonmembers. Common markets integrate the elements of free trade areas and customs unions while adding the free movement of important factors of production such as people and crossborder investment. The fourth level of regional integration is an economic union—economic integration whereby countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies. Economic union requires that member countries harmonize their tax, monetary, and fiscal policies, create a common currency, and concede a certain amount of sovereignty to the supranational organization to which they belong. The fifth (and highest) level of regional integration is a political union— economic and political integration whereby countries coordinate aspects of their economic and political systems. A political union requires member nations to accept a common stance on economic and political policies regarding nonmember nations.

Q: An increase in trade between nations as a result of regional economic integration is called what? A: Trade creation is the increase in the level of trade among nations that results from regional economic integration. Trade diversion is the diversion of trade away from nations not belonging to a trading bloc and toward member nations.

Q: Trade shifting away from nations not belonging to a trading bloc and member nations is called what? A: Trade diversion is the diverting of trade away from nations not belonging to a trading bloc and toward member nations.

Quick Study 2 1.

Q: What is the name of the official single currency of the European Union? A: The Euro is the name of the official single currency of the European Union.

Ch 8: Regional Economic Integration

Q: A country may receive membership in the European Union once it meets what is called the what? A: A country can receive membership if it meets certain demands down by the EU called the Copenhagen Criteria.

Q: Why did nations belonging to the European Free Trade Association not want to join the European Union? A: Certain nations did not want to join the EU fearing destructive rivalries and a loss of national sovereignty.

Quick Study 3 1.

Q: Canada, Mexico, and the United States belong to the regional trading bloc called what? A: The three nations belonging to the North American Free Trade Agreement (NAFTA) are Canada, Mexico, and the United States.

Q: What countries belong to the regional trading bloc called CAFTA-DR? A: CAFTA-DR was established in 2006 between the United States, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic.

Q: What is the name of Latin America’s most powerful regional trading bloc? A: MERCOSUR is the most powerful trading bloc in all of Latin America. It acts as a customs union and boasts a market of more than 275 million consumers (nearly half of Latin America’s total population) and a GDP of around $3.5 trillion.

Quick Study 4 1.

Q: What are the stated aims of the Association of Southeast Asian Nations (ASEAN)? A: Main objectives of ASEAN are to: (1) promote economic, cultural, and social development in the region; (2) safeguard the region’s economic and political stability; and (3) serve as a forum in which differences can be resolved fairly and peacefully.

Q: The stated aims of which organization is not to build a trading bloc but instead to strengthen the multilateral trading system? A: The organization for Asia Pacific Economic Cooperation (APEC) includes 21 nations. Its aim is not to build another trading bloc. Its purpose is to strengthen the multilateral trading system and expand the global economy by simplifying and liberalizing trade and investment procedures among member nations.

Q: What is the name of the grouping of 53 nations across the continent of Africa? A: A group of 53 nations on the African continent joined forces in 2002 to create the African Union.

Ethical Challenge The Caribbean nations do not participate in NAFTA and CAFTA-DR. Many people in southern U.S. states complain that NAFTA and CAFTA-DR are unfair to their extended families living on the Caribbean islands. Some experts argue that the term free trade agreement is misleading. They

Ch 8: Regional Economic Integration

say these agreements are really “preferential trade agreements” that offer free trade only to members and relative protection against nonmembers. They argue that these trade agreements have cost jobs, market share, and income from apparel factories in Jamaica to sugar cane fields in Trinidad. 8-5 Given the impact on nonmembers, do you think such trade agreements are ethical? 8-6 Why do you think the Caribbean islands are not part of NAFTA or CAFT-DR? 8-7 What arguments would you make for including the Caribbean in the expansion of NAFTA or CAFTA-DR? A: One question to be addressed here is the responsibility that the United States has to its neighbors. Certainly, many Caribbean nations have strong economic and cultural ties to the United States. The “free trade” versus “preferential trade” ethical debate is nothing new. There is no practical way of ever creating a regional trading bloc that does not cause displacement of workers in other countries. However, governments must do all they can to minimize this byproduct. For example, they could establish a quota system that limits the amount of textiles allowed to pass from Mexico to Canada and the United States while guaranteeing market access for a certain amount of textiles from the Caribbean. Teaming Up Debate Project. Two groups of four students each will debate the merits of extending NAFTA to more advanced levels of economic (and political) integration. After the first student from each side has spoken, the second student will question the opponent’s arguments, looking for holes and inconsistencies. The third student will attempt to answer these arguments. A fourth student will present a summary of each side’s arguments. Finally, the class will vote to determine which team offered the more compelling argument. A: There would be many economic and political obstacles in expanding NAFTA to more advanced levels of integration and to include other countries. First, there is the problem of unequal levels of development of the three existing members’ economies. It will be quite a long time before Canada and the United States will allow Mexican workers to travel freely to their countries to find work. The disparity in wages between those countries and Mexico would literally cause a flood of workers to flee northward. Second, each subsequent country entering NAFTA would need to be given time and exceptions to ensure the smooth transitions of their economies. This would be a very long-term affair taking many years. Third, the problem that political integration faces is the fear among many countries that this would mean surrendering their national sovereignty to the United States—which through its enormous economic and political muscle could dictate what the bloc’s political position should be. One need look only at the difficulties facing political integration in the EU to see how problematic this can be. Not that it is impossible, but that it would take a very long time if it could ever be accomplished. At any rate, students should be prepared to defend their positions with conceptual information and facts from countries and companies affected by regional integration. Practicing International Management Case Global Trade Deficit in Food Safety 8-16

Q: How do you think countries with a high volume of exports to the United States, such as Mexico, would respond to stricter food-safety rules? Do you think such measures are a good way to stem the tide of food-related illnesses? Why or why not?

Ch 8: Regional Economic Integration

A: They will clearly be opposed to it. How would the U.S. government react if Mexico wanted to send its federal investigators around the United States to inspect its farming methods and safety systems? It would rightly say that the Mexican government is meddling in its domestic affairs. Education of farmers in the safe handling and shipping of agricultural products and closer inspections at U.S. borders would seem to be a better approach that would not smack of heavy-handedness and arrogance. 8-17

Q: Some people believe that free trade agreements force consumers to trade the health and safety of their families for free trade. What are the benefits and drawbacks of putting food safety regulations into regional trade pacts? A: It is probably not necessary to place food-safety regulations within the free trade agreement itself. Free trade means that goods can enter other member nations tariff-free, not inspection free. All that governments need to do is enforce the food-safety regulations on the books, or pass more stringent ones if current ones are unacceptable. It would be a far better approach than exploiting food contamination for political purposes.

8-18

Q: The lack of harmonized food-safety practices and standards is just one of the challenges faced by the food industry as it becomes more global. What other challenges face the food industry in an era of economic integration and opening markets? A: Perhaps the most important issue is whether relatively less efficient farmers will be able to compete with the large farming operations existing in developed nations. Throwing the doors to trade wide open without protection for small family-operated farms can spell disaster for the rural farming communities of relatively less developed countries.

CHAPTER 9 INTERNATIONAL FINANCIAL MARKETS LEARNING OBJECTIVES: 1. Explain the importance of the international capital market 2. Describe the main components of the international capital market. 3. Outline the functions of the foreign exchange market. 4. Explain the different types of currency quotes and exchange rates. 5. Describe the instruments and institutions of the foreign exchange market.

CHAPTER OUTLINE: Introduction Importance of the International Capital Market Purposes of National Capital Markets Role of Debt Role of Equity Purposes of the International Capital Market Expands the Money Supply for Borrowers Reduces the Cost of Money for Borrowers Reduces Risk for Lenders Forces Expanding the International Capital Market World Financial Centers Offshore Financial Centers International Capital Market Components International Bond Market Types of International Bonds Interest Rates: A Driving Force International Equity Market Spread of Privatization Economic Growth in Emerging Markets Activity of Investment Banks Advent of Cybermarkets Eurocurrency Market Appeal of the Eurocurrency Market The Foreign Exchange Market Functions of the Foreign Exchange Market Currency Conversion Currency Hedging Currency Arbitrage Interest Arbitrage Currency Speculation Currency Quotes and Rates Quoting Currencies Direct and Indirect Rate Quotes Cross Rates Spot Rates Buy and Sell Rates

Ch 9: International Financial Markets

Forward Rates Forward Contracts Swaps, Options, and Futures Currency Swaps Currency Options Currency Futures Contracts Market Instruments and Institutions Trading Centers Important Currencies Interbank Market Clearing Mechanisms Securities Exchanges Over-the-Counter Market Currency Restriction Instruments for Restricting Currencies Bottom Line for Business Appendix: Calculating Percent Change in Exchange Rates

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 9. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION This chapter explores the two interrelated systems that comprise the international financial markets, which are the international capital market and the foreign exchange market.

II.

IMPORTANCE OF THE INTERNATIONAL CAPITAL MARKET A capital market is a system that allocates financial resources in the form of debt and equity according to their most efficient uses. Its main purpose is to provide a mechanism to borrow or invest money efficiently. A. Purposes of National Capital Markets Help individuals and institutions borrow money from lenders; intermediaries exist to facilitate financial exchanges. 1. Role of debt a. Loans in which borrower repays borrowed amount (the principal) plus interest. Company debt normally takes the form of bonds—debt instruments specifying the timing of principal and interest payments. b. Holder of a bond (the lender) can force the borrower into bankruptcy if payment is not made on a timely basis. Bonds to fund investments are issued by private-sector companies and by municipal, regional, and national governments. 2. Role of equity

Ch 9: International Financial Markets a.

Equity is part ownership of a company in which the equity holder participates with other part owners in the company’s financial gains and losses. Equity normally takes the form of stock—shares of ownership in a company’s assets that give shareholders a claim on the company’s future cash flows. b. Shareholders may be rewarded with dividends or by increases in the value of their shares. They may also suffer losses through decreases in the value of their shares. Dividend payments are not guaranteed, but decided by the company’s board of directors and based on financial performance. c. Shareholders can sell one stock and buy another or liquidate exchange stock for cash. Liquidity refers to the ease with which bondholders and shareholders convert investments into cash. Purposes of the International Capital Market The international capital market is a network of individuals, companies, financial institutions, and governments that invest and borrow across national boundaries. Large international banks gather excess cash of investors and savers around the world and then channel it to global borrowers. 1. Expands the money supply for borrowers a. Companies unable to obtain funds from investors in the domestic market seek financing in the international capital market. b. Essential for firms in countries with small or developing capital markets or emerging stock markets. c. An expanded supply of money benefits small companies that might not get financing under intense competition for capital. 2. Reduces the cost of money for borrowers a. An expanded money supply reduces the cost of borrowing. The “price” reflects supply and demand. Excess funds create a buyer’s market, forcing interest rates lower. b. Projects regarded as infeasible because of low expected returns might be viable at a lower financing cost. 3. Reduces risk for lenders a. The international capital market expands the available set of lending opportunities. Investors reduce portfolio risk by spreading their money over many debt and equity instruments. b. Investing in international securities benefits investors because some economies are growing while others are in decline. Forces Expanding the International Capital Market 1. Information technology Reduces time and money needed to communicate globally. Electronic trading after close of formal exchanges facilitates fast response times. 2. Deregulation Increases competition, lowers cost of financial transactions, and opens many national markets to global investing and borrowing. Yet greater regulation flowing out of the credit crisis of 2008–2009 may curtail growth in this market. 3. Financial instruments Increased competition is creating the need to develop innovative financial instruments. Securitization is the unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and

Ch 9: International Financial Markets

III.

marketable financial instruments, or securities. Here, too, regulation of securitization may curtail growth of this market. World Financial Centers The three most important financial centers are London, New York, and Tokyo. 1. Offshore financial centers Country or territory where financial sector features few regulations and few, if any, taxes. They (1) are economically and politically stable; (2) are advanced in telecommunications; (3) offer large amounts of funding in many currencies; and (4) provide a less costly source of financing. a. Operational centers see a great deal of financial activity (e.g., London for currencies; Switzerland for investment capital). b. Booking centers are usually located on a small, island nation or territory with favorable tax or secrecy laws. Funds pass through on their way to large operational centers. Typically are offshore branches of domestic banks used to record tax and currency exchange information.

INTERNATIONAL CAPITAL MARKET COMPONENTS A. International Bond Market Consists of all bonds sold by issuing companies, governments, and other organizations outside their own countries. Buyers include medium- to large-size banks, pension funds, mutual funds, and governments. 1. Types of international bonds a. Eurobond Issued outside the country in whose currency it is denominated (e.g., issued in Venezuela in U.S. dollars, and sold in Britain, France, and Germany). It accounts for 75 to 80 percent of all international bonds. Absence of regulation reduces the cost of issuing a bond but increases its risk. b. Foreign bond Sold outside borrower’s country and denominated in currency of country in which it is sold (e.g., yen-denominated bond issued by German carmaker BMW in Japan’s bond market). It accounts for 20 to 25 percent of all international bonds. Issuers must meet certain regulatory requirements and disclose details about company activities, owners, and upper management. 2. Interest rates: a driving force a. Borrowers from newly industrialized and developing countries borrow money from nations where interest rates are lower. b. Investors in developed countries buy bonds in newly industrialized and developing nations to obtain a higher return. c. Many emerging countries see the need to develop their own national markets. Volatility in currency market hurts projects that earn funds in those currencies and pay debts in dollars. B. International Equity Market Consists of all stocks bought and sold outside the issuer’s home country. Companies and governments issue equity and buyers include other companies, banks, mutual funds, pension funds, and individuals. 1. Spread of privatization a. A single privatization often places billions of dollars of new equity on stock markets.

Ch 9: International Financial Markets

IV.

Increased privatization in Europe is expanding worldwide equity. European Union integration has made investors willing to invest in stocks from other European nations. 2. Economic growth in emerging markets a. Growth in newly industrialized and developing countries contributes to growth in the international equity market. b. Because of a limited supply of funds in emerging economies, the international equity market is a major source of funding. 3. Activity of investment banks a. Global banks facilitate the sale of stock worldwide by bringing together sellers and large potential buyers. b. Becoming more common than listing a company’s shares on another country’s stock exchange. 4. Advent of cybermarkets a. Stock markets consisting of online global trading activities that allow listing of stocks worldwide for electronic 24-hour trading. Eurocurrency Market 1. All the world’s currencies banked outside their countries of origin are Eurocurrency and trade on the Eurocurrency market (e.g., Eurodollars, Europounds). It involves large transactions by the largest companies, banks, and governments. 2. Four sources of deposits: a. Governments with excess funds from prolonged trade surplus b. Commercial banks with excess currency c. International companies with excess cash d. Extremely wealthy individuals 3. Eurocurrency market is valued at around $6 trillion, with London accounting for about 20 percent of all deposits. 4. Appeal of the Eurocurrency market a. Complete absence of regulation lowers costs. Banks charge borrowers less and pay investors more but still earn profit. b. Low transaction costs because transactions are large. c. Interbank interest rates are interest rates that the world’s largest banks charge one another for loans. London Interbank Offer Rate (LIBOR) is the interest rate charged by London banks to other large banks borrowing Eurocurrency. London Interbank Bid Rate (LIBID) is the interest rate offered by London banks to large investors for Eurocurrency deposits. 5. Downside of Eurocurrency market is greater risk due to a lack of government regulation. Still, Eurocurrency transactions are fairly safe because of the size of the banks involved.

THE FOREIGN EXCHANGE MARKET Market in which currencies are bought and sold and in which currency prices are determined. Exchange rates reflect the size of the transaction, the trader conducting it, general economic conditions, and sometimes, government mandate. If the British pound is quoted in U.S. dollars at $1.5054, the bank may bid $1.5052 to buy British pounds and offer to sell them at $1.5056. The difference is the bidask spread; banks buy low and sell high, earning profits from the bid-ask spread. A. Functions of the Foreign Exchange Market 1. Currency conversion

Ch 9: International Financial Markets

Companies use the foreign exchange market to convert currencies. Currency hedging Insuring against potential losses that result from adverse changes in exchange rates. Companies use it to: (1) lessen the risk of international transfers; and (2) reduce exposure in transactions where a time lag exists between billing and receipt of payment. Currency arbitrage Instantaneous purchase and sale of a currency in different markets for profit. Common among experienced foreign exchange traders, large investors, and firms in arbitrage business. a. Interest arbitrage is the profit-motivated purchase and sale of interest-paying securities denominated in different currencies. Companies use interest arbitrage to find higher interest rates abroad in government treasury bills, corporate and government bonds, and even bank deposits. Currency speculation Purchase or sale of a currency with the expectation that its value will change and generate a profit. Much riskier than arbitrage because the value, or price, of currencies is quite volatile.

CURRENCY QUOTES AND RATES A. Quoting Currencies Two components to every quoted exchange rate: the quoted currency and the base currency. In (¥/$), the yen is the quoted currency, the dollar is the base currency. The quoted currency is always the numerator, and the base currency is always the denominator. 1. Direct and indirect rate quotes a. In ¥ 90/$, the yen is the quoted currency; this is called a direct quote on the yen and an indirect quote on the dollar. b. In $0.0111/¥, the dollar is the quoted currency; this is called a direct quote on the dollar and an indirect quote on the yen. c. This formula derives a direct quote from an indirect quote: Direct Quote = ____1_____ Indirect Quote And, for deriving an indirect quote from a direct quote, use: Indirect Quote = ____1____ Direct Quote 2.

Cross rates Used when no access to the exchange rate between two nation’s currencies, but have exchange rates for each nation’s currency with that of a third nation. Cross rates can be calculated using either currency’s indirect or direct exchange rates with another currency. Spot Rates Exchange rate that requires delivery of a traded currency within two business days. The spot market helps companies to: • Convert income from sales abroad into the home-country currency. • Convert funds into the currency of an international supplier. Copyright © 2016 Pearson Education, Inc.

Ch 9: International Financial Markets

•

Convert funds into the currency of a country in which it will invest. Buy and sell rates The spot rate is available only to banks and foreign exchange brokers. Small businesspeople exchanging currencies at their local bank receive a buy rate (the bank’s rate to buy a currency) and an ask rate (the bank’s rate to sell a currency). For example, if a bank quotes you an exchange rate between dollars and euros of $1.268/78 per euro (€), it will buy dollars at $1.268/€ and sell them at peso $1.278/€. Forward Rates Exchange rate at which two parties agree to exchange currencies on a specified future date. Represent traders’ and bankers’ expectations of a currency’s future spot rate. Used to insure against unfavorable changes in exchange rates. 1. Forward contract a. Requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate. Belong to a family of financial instruments known as derivatives. b. Commonly signed for 30, 90, and 180 days into the future, but customized contracts are also possible. Swaps, Options, and Futures Three other types of currency instruments are used in the forward market. 1. Currency swap Simultaneous purchase and sale of foreign exchange for two different dates. Used to reduce exchange-rate risk and lock in a future exchange rate. Can be viewed as a complex forward contract. 2. Currency option Right, or option, to exchange a specific amount of a currency on a specific date at a specific rate. Used to hedge against exchange-rate risk or obtain foreign currency at a favorable rate. 3. Currency futures contract Contract requiring the exchange of a specific amount of currency on a specific date at a specific exchange rate, with all conditions fixed and not adjustable. 1.

VI.

MARKET INSTRUMENTS AND INSTITUTIONS Electronic network of foreign exchange traders, currency trading banks, and investment firms among major financial centers. Single-day trading volume on the foreign exchange market (currency swaps and spot and forward contracts) is $4 trillion. A. Trading Centers The United Kingdom, United States, and Japan account for half of all global currency trading. London dominates the foreign exchange market for historic and geographic reasons. B. Important Currencies A vehicle currency is used as an intermediary to convert funds between two other currencies. Currencies most often involved in currency transactions are the U.S. dollar, British pound, Japanese yen, and European Union euro. C. Interbank Market Market where the world’s largest banks exchange currencies at spot and forward rates. Banks act as agents for clients and turn to foreign exchange brokers, who can obtain seldom traded currencies. 1. Clearing mechanisms aggregate currencies that one bank owes another and then carry out that transaction.

Ch 9: International Financial Markets

2. D.

VII.

Today, clearing is a mostly digital, computerized affair, whereas in the past it meant physically delivering currencies from one bank to another. Securities Exchanges Specialize in currency futures and options transactions. Securities brokers facilitate currency transactions on securities exchanges. Transactions on securities exchanges are much smaller than those in the interbank market and vary with each currency. Over-the-Counter (OTC) Market Consists of a global computer network of foreign exchange traders and other market participants, but with no central trading location. Major players in the OTC market are large financial institutions and investment banks. The OTC market has grown because of several benefits: 1. Businesspeople search for the institution that provides the best (lowest) price for transactions. 2. It offers greater opportunities for designing customized transactions. Currency Restriction A convertible (hard) currency is one that trades freely in the foreign exchange market, with its price determined by the forces of supply and demand. But some countries do not permit the free convertibility of their currencies. Goals of currency restriction include: 1. Preserve nation’s hard currencies to repay debts owed to other nations. 2. Preserve hard currencies to pay for imports and finance trade deficits. 3. Protect a currency from speculators. 4. Keep individuals and businesses from investing in other nations. Instruments for Restricting Currencies 1. Nation’s central bank must perform all foreign exchange transactions. 2. Government controls amount of foreign currency leaving the country by requiring importers to obtain import licenses. 3. Implement systems of multiple exchange rates that specify higher rates on the imports of certain goods or on the imports from certain nations. 4. Issue import deposit requirements that require businesses to deposit certain percentages of their foreign exchange holdings in special accounts before being granted import licenses. 5. Issue quantity restrictions that limit the amount of foreign currency that individuals can take out of the country when traveling abroad. 6. Countertrade a. The exchange of goods or services between two parties without the use of money. International companies can circumvent currency convertibility restrictions and yet conduct business.

BOTTOM LINE FOR BUSINESS Key components of international financial markets are the international bond, equity, and Eurocurrency markets. Continued growth in the international capital market is expected. It is crucial that managers understand the fundamentals of exchange rates and how the foreign exchange market is structured. The next chapter covers how market forces (including interest rates and inflation) affect exchange rates. We explore the roles of government and international institutions in managing movements in exchange rates.

Ch 9: International Financial Markets

APPENDIX: Calculating Percent Change in Exchange Rates 1. Exchange rate risk can jeopardize profits from current and future international transactions. Managers minimize this risk by tracking percent changes in exchange rates. 2. Take Pn as the exchange rate at the end of a period (a currency’s new price), and Po as the exchange rate at the beginning of that period (a currency’s old price). Percent change in the value of the currency is calculated with the following formula: Percent change (%) = Pn – Po x 100 Po 3.

Suppose on February 1, the exchange rate between the Norwegian krone (NOK) and the U.S. dollar was NOK 5/$. On March 1, the exchange rate stood at NOK 4/$. What is the change in the value of the base currency—the dollar? Percent change (%) = 4 – 5 x 100 = –20% 5

Quick Study Questions Quick Study 1 1.

Q: What is the purpose of the international capital market? A: First, it expands the money supply for borrowers. Companies unable to obtain funds from investors in the domestic market can seek financing in the international capital market. The option of going outside the home nation is particularly important to firms in countries with small or developing capital markets of their own, particularly those with emerging stock markets. Second, it reduces the cost of money for borrowers. The “price” of money is determined by supply and demand—if its supply increases, price (in the form of interest rates) falls. Thus, excess supply creates a buyer’s market, forcing down interest rates and the cost of borrowing. Third, it reduces risk for lenders. The international capital market expands the available set of lending opportunities. Investors enjoy a greater set of opportunities from which to choose. They can thus reduce overall portfolio risk by spreading their money over a greater number of debt and equity instruments. Investing in international securities also benefits investors because some economies grow while others decline.

Q: Unbundling and repacking hard-to-trade financial assets into more marketable financial instruments is called what? A: Securitization is the unbundling and repacking of hard to trade financial assets into more liquid, negotiable, and marketable financial securities.

Q: What is the characteristic of an offshore financial center? A: An offshore financial center is a country or territory whose financial sector features very few regulations and few, if any, taxes. Offshore financial centers offer large amounts

Ch 9: International Financial Markets

of funding in many currencies and are a cheap source of financing for multinationals. They tend to be characterized by economic and political stability and typically have excellent telecommunications infrastructures. Some offshore centers are located on small, island nations or territories with favorable tax or secrecy laws. Quick Study 2 1.

Q: What type of financial instrument is traded in the international bond market? A: The international bond market is the market consisting of all bonds sold by issuing companies, governments, or other organizations outside their own countries. The international bond market is growing at about 10 percent per year. The most important factor fueling the growth in the international bond market was the low interest rates (the cost of borrowing money). Low interest rates in developed nations meant low rates of return for investors in government and corporate bonds. Thus, investors turned to bonds issued by entities in developing and emerging markets where higher returns reflected their greater risk. Low interest rates in developed markets and high rates in developing and emerging markets caused growth in the international bond market.

Q: The market of all stocks bought and sold outside the issuer’s home country is called what? A: The international equity market consists of all stocks bought and sold outside the issuer’s home country. Stock exchanges listing the greatest number of companies from outside their own borders are Frankfurt, London, and New York.

Q: What does the Eurocurrency market consist of? A: All the world’s currencies that are banked outside their countries of origin are referred to as Eurocurrency and traded on the Eurocurrency market. For example, U.S. dollars deposited in Tokyo’s Sumitomo Bank are called Eurodollars, and British pounds deposited in New York’s Chase Manhattan are called Europounds. Deposits of Eurocurrency originate from governments with excess funds, commercial banks with excess currency, international companies with excess cash, and wealthy individuals. Because the world’s largest financial institutions operate in the Eurocurrency market, individual transactions are worth very large sums of money. This allows the banks to lower transaction costs and charge one another what are called interbank interest rates—interest rates that the world’s largest banks charge one another for loans. The London Interbank Offer Rate (LIBOR) is the interest rate charged by London banks to other large banks borrowing Eurocurrency. The London Interbank Bid Rate (LIBID) is the interest rate offered by London banks to large investors for Eurocurrency deposits. The main appeal of the Eurocurrency market is the complete absence of regulation—allowing it to operate at lower cost than traditional banking. This means that banks can charge borrowers less, pay investors more, and still earn healthy profits.

Quick Study 3 1.

Q: What is the market in which currencies are bought and sold and their prices determined? A: To exchange one currency for another in international transactions, companies rely on a mechanism called the foreign exchange market, a market in which currencies are bought and sold and their prices determined.

Ch 9: International Financial Markets

Q: Insuring against potential losses that may result from adverse changes in exchange rates is called what? A: The practice of insuring against potential losses that result from adverse changes in exchange rates is called currency hedging.

Q: What do we call the instantaneous purchase and sale of a currency in different markets to make a profit? A: Currency arbitrage is the instantaneous purchase and sale of a currency in different markets to make a profit.

Quick Study 4 1.

Q: The numerator in a quoted exchange rate, or the currency with which another currency is to be purchased is called what? A: When you designate any exchange rate, the quoted currency is always the numerator, and the base currency is the denominator.

Q: What is the name given to the risk of adverse changes in exchange rates? A: Exchange rate risk is the risk of adverse changes in exchange rates.

Q: What do we call an exchange rate requiring delivery of a traded currency within two business days? A: A spot rate is the exchange rate that requires delivery of the traded currency within two business days. The spot rate is available only to banks and foreign exchange brokers because their trades are worth many millions of dollars. The spot market assists companies in: • Converting income from sales abroad into the home-country currency. • Converting funds into the currency of an international supplier. • Converting funds into the currency of a country in which it will invest.

Q: What instruments are used in the forward market? A: A forward contract is a contract in which two parties agree to exchange currencies on a specified future date. Forward rates are helpful to a company that knows it will need a certain amount of currency on a certain future date. Companies often use the forward market to insure against unfavorable changes in exchange rates. In addition, a currency swap is the simultaneous purchase and sale of foreign exchange for two different dates. A currency option is a right, or option, to exchange a specified amount of a currency on a specified date at a specified rate. A currency futures contract is a contract requiring the exchange of a specified amount of currency on a specified date at a specified exchange rate, with all conditions fixed and not adjustable.

Quick Study 5 1.

Q: Where does more than half of all global currency trading take place? A: The world’s main foreign exchange trading centers are located in the United Kingdom (London), the United States (New York), and Japan (Tokyo)—together accounting for slightly more than one-half of all global currency trading. London dominates the foreign exchange market for historic and geographic reasons. The U.S. dollar, the British pound, the Japanese yen, and the European euro are the currencies most used in the foreign exchange market.

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Q: A currency used as an intermediary to convert funds between two other currencies is called what? A: A vehicle currency is used as an intermediary to convert funds between two other currencies.

Q: What is another name for a freely convertible currency? A: A hard currency is another name for a freely convertible currency, one that is accepted by both residents and no residents of the country for payment of goods and services.

Q: Why do governments sometimes engage in currency restrictions? A: Reasons nations restrict currency conversion: 1. Preserve a country’s reserve of hard currencies with which to repay debts owned to other nations. 2. Preserve hard currencies to pay for imports and finance trade deficits. 3. Protect a currency from speculators. 4. Keep resident individuals and businesses from investing in other nations. Policies nations use to restrict currency conversion: 1. Require all foreign exchange transactions to go through the nation’s central bank. 2. Require importers to obtain import licenses—allowing governments to control the amount of foreign currency leaving the country. 3. Implement systems of multiple exchange rates that specify higher rates on the imports of certain goods or on the imports from certain nations. 4. Issue import deposit requirements that require businesses to deposit certain percentages of their foreign exchange holdings in special accounts before being granted import licenses. 5. Issue quantity restrictions that limit the amount of foreign currency that individuals can take out of the country when traveling abroad.

Ethical Challenge The goal of government regulation of financial-services industries is to maintain the integrity and stability of financial systems, thereby protecting both depositors and investors. Regulations include prohibitions against insider trading, against lending by management to itself or to closely related entities (called “self-dealing”), and against other transactions in which there is a conflict of interest. In less than two decades, deregulation transformed the world’s financial markets. It drove competition and growth in financial sectors and boosted the economies of developed and emerging countries alike. It also helped bring the international financial system to the brink of a complete collapse. Although it is also true that intervention in financial markets by government officials helped fuel the financial bubble that eventually burst. 9-5 Q: What do you see as the “dark side” of deregulation, in terms of business ethics? A: The dark side of deregulation is the potential for the occurrence of those very things that are mentioned in the question itself. However, deregulation does not mean the total dismantling of all regulations, but a reduction in those that are overly burdensome and that create market inefficiencies. Countries retain the most important regulatory aspects of their legal systems and continue to support their agencies responsible for oversight of financial services industries. The “colluding producers” argument may apply today to the recent surge in merger and acquisition activity. However, as long as regulators scrutinize proposed mergers and acquisitions for anticompetitive consequences, it is likely that the trend toward greater concentration will continue in many industries.

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Q: Do you think the recent increase in regulation is effective in helping prevent another global financial meltdown? A: This is a good opportunity to discuss extraterritoriality. On the one hand, should the U.S. government have the right to control and legislate U.S. business activity abroad? And on the other hand, should U.S. firms be allowed to exploit a loophole and avoid paying their fair share of taxes? Students supporting the use of an OFC to avoid taxation in national markets must explain why it is okay for some (usually large) companies to evade national taxation but not others (usually small companies with fewer resources). They must also justify letting a company using an OFC off the hook in terms of contributing to the national infrastructure, health care, education, and general welfare of the people of that nation. Students supporting a clampdown on the OFC system must explain why it is unethical to use an OFC to shelter income and avoid regulations.

9-7

Q: Do you think the warning of Adam Smith, one of the first philosophers of capitalism against the dangers of “colluding producers,” applies to the financial-services sector today? A: Countries retain the most important regulatory aspects of their legal systems and continue to support their agencies responsible for oversight of financial services industries. The “colluding producers” argument may apply today to the recent surge in merger and acquisition activity. However, as long as regulators scrutinize proposed mergers and acquisitions for anticompetitive consequences, it is likely that the trend toward greater concentration will continue in many industries.

Teaming Up Research Project. Suppose your team works for a firm that has $10 million in excess cash to invest for one month. Your team’s task is to invest this money in the foreign exchange market to earn a profit—holding dollars is not an option. Select the currencies you wish to buy at today’s spot rate, but do not buy less than $2.5 million of any single currency. Track the spot rate for each of your currencies over the next month in the business press. On the last day of the month, exchange your currencies at the day’s spot rate. Calculate your team’s gain or loss over the onemonth period. (Your instructor will determine whether, and how often, currencies may be traded throughout the month.) A: This project is excellent for instructors who want their students to acquire a better grasp of the foreign exchange market and the reasons for currency fluctuations. Students should be asked to research each of the currencies they purchase and pass these reasons on to the instructor at the time of their initial purchase. Students should also follow the business press to learn the reasons for daily fluctuations in the value of each currency. Practicing International Management Case Should We Cry for Argentina? 9-16

Q: Argentina’s peso was linked to the U.S. dollar through a currency board for ten years before it was cut loose. Why did Argentina peg its currency to the dollar in the first place? A: Students can consult business and financial Web sites to update the situation and get background information on the peso’s link to the dollar. The peso–dollar link contributed

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to Argentina’s problems. For 10 years the Argentine peso was fixed at parity to the dollar through a currency board. Argentina initially pegged the peso to the dollar to reduce inflation. Early on, the currency board worked and stabilized the peso and eliminated the inflation problem. But the peg caused problems after Brazil devalued its currency, raising the relative price of Argentina’s goods on global markets. 9-17

Q: Companies encounter many difficulties in adapting their strategies to deal with the effects of a currency crisis that becomes an economic crash. How did local and international companies adapt to the business environment at the height of Argentina’s crisis? A: The Argentine units of U.S. companies, which collect revenues in pesos, had a difficult time repaying dollar-denominated debts as the peso’s value fell. Parent firms did not rescue their ailing subsidiaries in Argentina because most were independent entities. AES Corp., of Arlington, VA reported that most of its Argentine businesses were in default on their project-financing arrangements but that AES was not required to support the potential cash flow or debt service obligations of the businesses. Local companies blamed their defaults on the need to get authorization from the central bank to send money abroad. Stiff restrictions on foreign-currency exchange forced importers to wait several months or more while the government authorized payments in dollars. Companies also struggled with new rules that raised taxes on exporters and other cash-rich firms to help the government pay for social services. Local firms also had a hard time obtaining funds to pay their debts to foreign suppliers. (Students could be asked to research the experiences of several Argentine companies to learn how they endured the economic crisis, loss of markets abroad, and so on.)

9-18

Q: What has been the impact on the savings and purchasing power of ordinary citizens? A: Strapped for cash, the government seized the savings accounts of its citizens and restricted how much they could withdraw at a time. When street protesters turned violent, they beat up several politicians and attacked dozens of banks. Many citizens have lost everything because of the value of the currency and chose to leave Argentina. For example, the World Jewish Congress financially assisted Argentine Jews to relocate to Israel. Students should locate recent articles in the business press for reports on how international aid is perceived by the Argentines themselves (paying attention to the people’s differing economic status) and the international community. There will no doubt be disparity in their views.

CHAPTER 10 INTERNATIONAL MONETARY SYSTEM LEARNING OBJECTIVES: 1. Describe the importance of exchange rates to business activities. 2. Outline the factors that help determine exchange rates. 3. Explain attempts to construct a system of fixed exchange rates. 4. Describe efforts to create a system of floating exchange rates CHAPTER OUTLINE: Introduction IMPORTANCE OF EXCHANGE RATES Desire for Stability and Predictability Forecasting Exchange Rates Efficient Market View Inefficient Market View Forecasting Techniques Fundamental Analysis Technical Analysis Difficulties of Forecasting

What Factors Determine Exchange Rates? Law of One Price McCurrency Purchasing Power Parity Role of Inflation Impact of Money-Supply Decisions Impact of Unemployment and Interest Rates How Exchange Rates Adjust to Inflation Role of Interest Rates Fisher Effect Evaluating PPP Impact of Added Costs Impact of Trade Barriers Impact of Business Confidence and Psychology FIXED EXCHANGE RATE SYSTEMS Early Years: The Gold Standard Par Value Advantages of the Gold Standard Collapse of the Gold Standard Bretton Woods Agreement Fixed Exchange Rates Built-In Flexibility World Bank International Monetary Fund Special Drawing Right (SDR)

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Collapse of the Bretton Woods Agreement Smithsonian Agreement Final Days SYSTEM OF FLOATING EXCHANGE RATES Jamaica Agreement Later Accords Today’s Exchange-Rate Arrangements Pegged Exchange-Rate Arrangement Currency Board European Monetary System How the System Worked Recent Financial Crises Developing Nations’ Debt Crisis Mexico’s Peso Crisis Southeast Asia’s Currency Crisis Russia’s Ruble Crisis Argentina’s Peso Crisis Future of the International Monetary System Bottom Line for Business

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 10. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline 1.

INTRODUCTION This chapter explores factors that determine exchange rates and various international attempts to manage them. It also presents different methods of forecasting exchange rates, and the functioning of the international monetary system.

IMPORTANCE OF EXCHANGE RATES Exchange rates affect demand for products. When a country’s currency is weak, the price of its exports declines, making the exports more appealing on world markets. Devaluation is the intentional lowering of the value of a currency by the nation’s government. Gives domestic producers an edge on world markets, but also reduces citizens’ buying power. Revaluation is the intentional raising of the value of a nation’s currency. Increases the price of exports and reduces the price of imports. Exchange rates affect profits earned abroad when repatriated by the parent company into the home currency. Translating subsidiary earnings from a weak host country currency into a strong home currency reduces earnings, and vice versa. A.

Desire for Stability and Predictability 1. Stability makes for accurate financial planning and cash flow forecasts.

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Predictability reduces odds that a company will be caught off-guard by unexpected rate changes. Reduces the need for costly insurance (currency hedging) against possible adverse exchange rates.

FORECASTING EXCHANGE RATES A.

Efficient Market View 1. In an efficient market, prices of financial instruments quickly reflect new public information made available to traders. The efficient market view says prices of financial instruments reflect all publicly available information at any given time. 2. Forward exchange rates are accurate forecasts of future rates, and reflect market expectations about the future values of two currencies. 3. Forward exchange rates are the best possible predictors of exchange rates and worthless to seek out information that may affect future rates.

Inefficient Market View 1. The inefficient market view says prices of financial instruments do not reflect all publicly available information. Proponents believe that companies can search for information to improve forecasting. 2. This view is more compelling considering private information (e.g., if a currency trader holds privileged information, the trader can act on this information to make a profit).

Forecasting Techniques 1. Fundamental Analysis Fundamental analysis employs statistical models based on fundamental economic indicators to forecast exchange rates. Economic variables in these models include inflation, interest rates, the money supply, tax rates, government spending, the nation’s balance-of-payments situation, and government intervention in foreign exchange markets. 2. Technical Analysis Technical analysis employs past trends in currency prices and other factors to forecast exchange rates. Using statistical models and past data trends, analysts estimate the conditions prevailing during changes in exchange rates and estimate the timing, magnitude, and direction of future changes.

Difficulties of Forecasting Beyond problems with data used, failings can be traced to human error (e.g., people might miscalculate the importance of certain economic events, placing too much emphasis on some elements and ignoring others).

WHAT FACTORS DETERMINE EXCHANGE RATES? To understand what determines rates, must know: (1) the law of one price and (2) purchasing power parity. Each tells the level at which an exchange rate should be. A.

Law of One Price

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Exchange rates do not guarantee or stabilize the buying power of a currency; purchasing power fluctuates. Law of one price says an identical product must have an identical price in all countries when expressed in the same currency. Product must be identical in quality or content and be entirely produced within each country. If price were not identical in each country, an arbitrage opportunity would arise. Traders would buy in the low-priced market and sell in the high-priced market; buying drives up the price in one market and drives down the price in the other. The Economist publishes its “Big Mac Index” using the law of one price to determine the exchange rate between the U.S. dollar and other currencies. Fair predictor of the “direction” rates should move.

Purchasing Power Parity PPP is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. Tells how much of currency “A” a person in nation “A” needs to buy the same amount of products that someone in nation “B” can buy with currency “B.” • Considers price levels in adjusting the relative values of the two currencies. • Economic forces will push a market exchange rate toward that calculated by PPP or an arbitrage opportunity arises. • Holds for internationally traded products not restricted by trade barriers and entailing few or no transportation costs. 1. Role of Inflation Inflation erodes purchasing power. If money is injected into an economy not producing greater output, a greater amount of money is spent on a static amount of products. Demand soon outstrips supply and prices rise. a. Impact of Money-Supply Decisions i. Governments manage the supply of and demand for currency with policies that influence the money supply. ii. Monetary policy refers to activities that directly affect a nation’s interest rates or money supply. Governments buy or sell government securities on the open market to influence the money supply. iii. Fiscal policy involves using taxes and government spending to influence the money supply indirectly. Governments can increase or lower taxes, or increase or decrease government spending. b. Impact of Unemployment and Interest Rates i. Threat of a company moving abroad for lower wages holds down wages at home. Companies then need not raise prices to pay higher wages, lowering inflationary pressures. ii. Low unemployment puts upward pressure on wages. To maintain profit margins with higher labor costs, producers pass the cost of higher wages on to consumers in higher prices, causing inflationary pressure. iii. Low interest rates encourage consumers and businesses to borrow and spend, causing inflationary pressure. c. How Exchange Rates Adjust to Inflation Copyright © 2016 Pearson Education, Inc.

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Exchange rates adjust to different rates of inflation across countries, which is necessary to maintain purchasing power parity between nations. ii. For example, if inflation in Mexico is higher than in the United States, the exchange rate adjusts to reflect that a dollar will buy more pesos due to higher inflation in Mexico. iii. U.S. goods become more expensive for Mexican firms, and Mexican goods become cheaper for U.S. companies. Role of Interest Rates The interest rate a bank quotes a borrower is the nominal interest rate. a. Fisher Effect i. The Fisher effect is the principle that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation over a specific period. ii. The real rate of interest should be the same in all countries because of arbitrage. iii. The international Fisher effect is the principle that a difference in nominal interest rates supported by two countries’ currencies will cause an equal but opposite change in their spot exchange rates. iv. Because real interest rates are theoretically equal across countries, any difference in interest rates in two countries is due to inflation. Evaluating PPP PPP is better at predicting long-term exchange rates than short-term rates. Short-term forecasts, however, are most beneficial to managers. a. Impact of Added Costs PPP assumes no transportation costs, and thus overstates the threat of arbitrage. The presence of transport costs can allow unequal prices between markets to persist, causing PPP to fail. b. Impact of Trade Barriers PPP assumes no trade barriers. But a high tariff or outright ban on a product can impair price leveling, causing PPP to fail to predict exchange rates accurately. c. Impact of Business Confidence and Psychology PPP overlooks business confidence and human psychology. Yet nations try to maintain confidence of investors, businesspeople, and consumers in their economies and currencies.

FIXED EXCHANGE RATE SYSTEMS

Early Years: The Gold Standard Gold was internationally accepted for paying for goods and services. Pros: its limited supply caused high demand and it can be traded, stored, and melted into coins or bars making a good medium of exchange. Cons: its weight made transport expensive, and if a ship sank, the gold was lost.

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Ch 10: International Monetary System Gold standard was an international monetary system in which nations linked the value of their paper currencies to a specific value of gold. The gold standard operated from the early 1700s until 1939. 1. Par Value a. The value of a currency expressed in terms of gold. All nations fixing their currencies to gold also indirectly linked their currencies to one another. Thus, the gold standard was a fixed exchange rate system—one in which the exchange rate for converting one currency into another is fixed by international governmental agreement. b. The U.S. dollar was fixed at $20.67/oz of gold, the British pound at £4.2474/oz.; exchange rate was $4.87/£ ($20.67 ÷ £4.2474). 2. Advantages of the Gold Standard a. Reduced the risk in exchange rates because it locked exchange rates between currencies. Fixed exchange rates reduced the risks and costs of trade and grew as a result. b. Imposed strict monetary policies that required nations to convert paper currency into gold if demanded by holders of the currency. This forced nations to keep adequate gold reserves on hand. A nation could not let paper currency grow faster than the value of its gold reserves, which controlled inflation. c. Helped correct a nation’s trade imbalance. i. If a nation imports more than it exports, gold flowed out to pay for imports. The government must decrease the supply of paper currency in the domestic economy because it could not have paper currency in excess of gold reserves. As the money supply falls, so do prices of goods and services because fewer dollars are chasing the same supply of goods and services. Falling prices make its exports cheaper on world markets and exports rise until the nation’s international trade is in balance. ii. In the case of a trade surplus, the inflow of gold supports an increase in the supply of paper currency. This increases the demand for and cost of goods and services; exports fall in reaction to their higher prices until trade is in balance. 3. Collapse of the Gold Standard a. Gold standard was violated when nations in the First World War financed the war by printing paper currency. This caused rapid inflation and caused nations to abandon the gold standard. b. Britain returned to the gold standard in the early 1930s at the same par value that existed before the war. The United States returned to the gold standard at a new, lower par value that reflected the inflation of previous years. c. The U.S. decision in 1934 to devalue its currency and Britain’s decision not to do so lowered the price of U.S. exports and increased the price of British goods imported. It now took $8.24 to buy a pound ($35.00 ÷ £4.2474). d. Countries retaliated against one another through “competitive devaluations” to improve their own trade balances. Faith in the

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gold standard vanished, as it was no longer an accurate indicator of a currency’s true value. B.

Bretton Woods Agreement 1944 accord among nations to create a new international monetary system based on the value of the U.S. dollar. Designed to balance strict discipline of the gold standard with flexibility to manage temporary domestic monetary difficulties. 1. Fixed Exchange Rates a. Incorporated fixed exchange rates by tying the value of the U.S. dollar directly to gold, and the value of other currencies to the value of the dollar. b. Fixed U.S. dollar par value at $35/oz of gold; other currencies had par values against the U.S. dollar, not gold. c. Members were to keep their currencies from deviating more than 1.0 percent above or below their par values. Extended the right to exchange gold for dollars only to national governments. 2. Built-In Flexibility a. Allowed devaluation only in extreme circumstances called fundamental disequilibrium—when a trade deficit causes a permanent negative shift in the balance of payments. b. Devaluation in such situations was to reflect a permanent economic change in a country, not temporary misalignments. 3. World Bank Created the World Bank (IBRD) to fund national economic development. a. World Bank’s immediate purpose was to finance European reconstruction after the Second World War. It later shifted its focus to the general financial needs of developing countries. b. World Bank finances economic development projects in Africa, South America, and Southeast Asia, and offers funds to countries unable to obtain capital for projects considered too risky. It often undertakes projects to develop transportation networks, power facilities, and agricultural and educational programs. 4. International Monetary Fund IMF was created to regulate fixed exchange rates and enforce the rules of the international monetary system. Purposes of the IMF are to: a. Promote international monetary cooperation. b. Facilitate expansion and balanced growth of international trade. c. Promote exchange stability with orderly exchange arrangements, and avoid competitive exchange devaluation. d. Make resources temporarily available to members. e. Shorten the duration and lessen the degree of disequilibrium in the international balance of payments of member nations. 5. Collapse of the Bretton Woods Agreement Bretton Woods faltered in the 1960s because of U.S. trade and budget deficits. Nations holding U.S. dollars doubted the U.S. government had gold reserves to redeem all its currency held outside the United States. Demand for gold in exchange for dollars caused a large global sell-off of dollars. a. Smithsonian Agreement In 1971, the U.S. government held less than one-fourth of the amount of gold needed to redeem all U.S. dollars in circulation.

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The Smithsonian Agreement was to restructure and strengthen the international monetary system: (1) lowered the value of the dollar in terms of gold to $38/oz. of gold, (2) required that other countries increase the value of their currencies against the dollar, and (3) increased the 1 percent floatation band to 2.25 percent. Final Days Many nations abandoned the system in 1972 and 1973, and currency values floated freely against the dollar.

C. SYSTEM OF FLOATING EXCHANGE RATES The new system of floating exchange rates was to be a temporary solution. Instead of the emergence of a new international monetary system, there emerged several efforts to manage exchange rates. 1. Jamaica Agreement IMF accord (1976) formalized the present system of floating exchange rates. Three main provisions included: (1) endorsement of a managed float system of exchange rates; (2) elimination of gold as the primary reserve asset of the IMF; and (3) expansion of the IMF to act as a “lender of last resort” for nations with balance-of-payments difficulties. 2. Later Accords Between 1980 and 1985 the U.S. dollar rose against other currencies, pushing up prices of U.S. exports and adding to a U.S. trade deficit. a. The Plaza Accord (1985) was an agreement among the largest industrialized economies known as the G5 (Britain, France, Germany, Japan, and the United States) to act together in forcing down the value of the U.S. dollar. b. The Louvre Accord (1987) was an agreement among the G7 nations (the G5 plus Italy and Canada) that affirmed the dollar was appropriately valued and that they would intervene in currency markets to maintain its current market value. D.

Today’s Exchange-Rate Arrangements Remains a managed float system, but some nations maintain more stable exchange rates by tying their currencies to other currencies 1. Pegged Exchange-Rate Arrangement a. Pegged exchange-rate arrangements “peg” a country’s currency to a more stable and widely used currency in international trade. b. Many small countries peg their currencies to the dollar, euro, the special drawing right of the IMF, or other individual currency. Others peg their currencies to “baskets” of currencies. 2. Currency Board a. A currency board is a monetary regime based on a commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. The government is legally bound to hold an amount of foreign currency equal to the amount of domestic currency; this helps cap inflation. b. The currency board’s survival depends on sound budget policies.

European Monetary System

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Europe looked for a system that could stabilize currencies and reduce exchangerate risk. In 1979, they created the European monetary system (EMS) to stabilize exchange rates. It was ended in 1999 when the EU adopted a single currency. 1. How the System Worked a. The exchange rate mechanism (ERM) limited fluctuations of EU member currencies within a trading range (or target zone). b. The EMS was successful; currency realignments were infrequent and inflation was controlled. Problems arose in 1992 and the EMS was revised in 1993 to allow currencies to fluctuate in a wider band from the midpoint of the target zone. c. ERM II introduced in 1999 to link the euro to the currencies of nations applying for membership in the EU. F.

Recent Financial Crises Despite nations’ best efforts to head off financial crises within the international monetary system, the world has seen several wrenching crises. 1. Developing Nations’ Debt Crisis a. By the early 1980s, developing countries (especially in Latin America) had amassed huge debts payable to large international commercial banks, the IMF, and the World Bank. To prevent a meltdown of the entire financial system, international agencies revised repayment schedules. b. In 1989, the Brady Plan called for large-scale reduction of poor nations’ debt, exchange of high-interest loans for low-interest loans, and debt instruments tradable on world financial markets. 2. Mexico’s Peso Crisis a. Rebellion and political assassination shook investors’ faith in Mexico’s financial system in 1993–1994. Mexico’s government responded slowly to the flight of portfolio investment capital. b. In late 1994, the Mexican peso was devalued, forcing a large loss of purchasing power on ordinary Mexican people. The IMF and private commercial banks in the United States provided about $50 billion in loans to shore up Mexico’s economy. c. Mexico repaid the loans ahead of schedule and once again has a sizable reserve of foreign exchange. 3. Southeast Asia’s Currency Crisis a. On July 11, 1997, the speculators sold off Thailand’s baht on world currency markets; the baht plunged and every other economy in the region was in a slump. b. The shock waves of Asia’s crisis could be felt throughout the global economy. Indonesia, South Korea, and Thailand needed IMF and World Bank funding. As incentives to begin economic restructuring, IMF loan packages came with strings attached. c. Crisis likely caused by a combination of: (1) Asian style capitalism (lax regulation, loans to friends and relatives, lack of financial transparency); (2) currency speculators and panicking investors; and (3) persistent current account deficits. 4. Russia’s Ruble Crisis a. Russia’s problems in the 1990s included: (1) spillover from the Southeast Asia crisis; (2) depressed oil prices; (3) falling hard currency reserves; (4) unworkable tax system; and (4) inflation.

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In 1996 as currency traders dumped the ruble, the Russian government attempted to defend the ruble on currency markets. The government received a $10 billion aid package from the IMF and promised to reduce debt, collect taxes, cease printing sums of currency, and peg its currency to the dollar. c. Things improved for a while, but then in mid-1998 the government found itself once again trying to defend the ruble. By late 1998, the IMF had lent Russia more than $22 billion. Argentina’s Peso Crisis a. By late 2001, Argentina had been in recession for nearly 4 years. Argentina’s goods remained expensive because its currency was linked to a strong U.S. dollar through a currency board. b. The country finally defaulted on its $155 billion of public debt in early 2002, the largest default by any country ever. c. The government scrapped its currency board that linked the peso to the U.S. dollar and the peso quickly lost about 70 percent of its value on currency markets. d. Argentina has in many respects recovered. It has registered growth of around 9 percent a year and unemployment around 8 percent in 2008, down from a high of 25 percent in 2002. e. Argentina’s plan of boosting wages, imposing price controls, keeping the peso low, and increasing public spending seems to be working. Growth was expected to be around 4 percent to 5 percent but inflation was at 9 percent a year and reducing purchasing power. f. As of 2012, another economic collapse was unlikely although Argentina was experiencing 26 percent inflation.

Future of the International Monetary System 1. Recurring crises are raising calls for a new system designed to meet the challenges of a global economy. 2. Revision of the IMF and its policy prescriptions are likely; transparency on the part of the IMF is being increased to instill greater accountability. The IMF is increasing its surveillance of members’ macroeconomic policies and abilities in the area of financial sector analysis. 3. Ways must be found to integrate international financial markets to manage risks. The private sector must become involved in the prevention and resolution of financial crises.

BOTTOM LINE FOR BUSINESS Recent financial crises underscore the need for managers to fully understand the complexities of the international financial system. Chapters 9 and 10 discuss the international financial markets and international monetary system. Understanding this material improves managers’ knowledge of financial risks in international business. But this knowledge must be paired with vigilance of financial market conditions to manage businesses in the global economy effectively.

Quick Study Questions

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Quick Study 1 1.

Q: For a country with a currency that is weakening (valued low relative to other countries), what will happen to the price of its exports and the price of its imports? A: Devaluation lowers the price of a country’s exports on world markets and increases the price of imports because the country’s currency is now worth less on world markets. Q: Unfavorable movements in exchange rates can be costly for business, so managers prefer that exchange rates be what?. A: Stable exchange rates improve the accuracy of financial planning, including cash flow forecasts. Predictable exchange rates reduce the likelihood that companies will be caught off-guard by sudden and unexpected rate changes. This reduces the need for costly insurance (usually by currency hedging) against possible adverse movements in exchange rates. Q: The view that prices of financial instruments reflect all publicly available information at any given time is called what? A: The efficient market view states that prices of financial instruments reflect all publicly available information at any given time.

Quick Study 2 1.

Q: The principle that an identical item must have an identical price in all countries when price is expressed in a common currency is called what? A: The law of one price is a principle that an identical product must have an identical price in all countries when expressed in the same currency. This product must be identical in quality and content and be entirely produced within each country. If the price is not identical in each country, an arbitrage opportunity would arise—an opportunity to buy a product at a specific price in one country and sell it at a higher price in another country. The law of one price holds because if people were to attempt arbitrage, the greater demand for the product in the lower-priced market would increase its price there and the greater supply in the higher-priced market would lower its price there. The limitations of the law of one price are several. First, the law of one price requires that the products must be identical in quality and content in each country, and must be entirely produced within each particular country. This is very hard to accomplish in today’s global economy except for most raw materials, fruits and vegetables, and the like. The Big Mac index comes close to an ideal but it has its own limitations. Second, the products must be “tradable” in the sense that it is practical to buy the product in one country and sell it in another to take advantage of an arbitrage opportunity. For example, the Big Mac index fails in this regard. Third, using a single product to determine what a nation’s exchange rate should be is far too simplistic a method. Probably every economy is far too complex to have its exchange rate determined by a single product.

Q: A unique aspect of purchasing power parity in the context of exchange rates is that it is only useful when applied to what? A: Purchasing power parity is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries. It tells us how much of currency “A” that a person in country “A” needs in order to buy the same amount of products that a person in country “B” can buy with currency “B.” Purchasing power parity holds for internationally traded products that are not restricted by trade barriers and that entail few or no transportation costs.

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Q: What is the impact on purchasing power when growing demand for products outstrips a stagnant supply? A: As growing demand for products outstrips stagnant supply, prices will rise and devour any increase in the amount of money the consumers have to spend.

Q: What factors influence the power of purchasing power parity to accurately predict exchange rates? A: There are limitations to the PPP concept. First, purchasing power parity is better at predicting long-term exchange rates than short-term rates. Unfortunately, short-term forecasts are often more beneficial to managers. Second, although PPP assumes a world of no transportation costs, this is clearly unrealistic. If adding transportation costs to the cost of a product makes the product equally or more expensive in the otherwise cheaper market, trade will not occur. Thus, because of the absence of an arbitrage opportunity after transaction costs, no leveling of prices between the two markets will occur. Third, although PPP assumes no trade barriers, we know this to be false in reality. Trade might not occur if a high tariff on an import increases the cost of the product significantly. Of course, the same is true if importing the product is made illegal. Fourth, PPP overlooks business confidence and human psychology. The confidence of businesspeople and consumers impacts the value of a nation’s currency. Confidence in a nation’s economic outlook encourages companies to invest and consumers to increase their spending. Currency traders can also influence the exchange rate of a nation’s currency. If traders believe a currency is overvalued, they can sell the currency on currency markets— thereby causing its value to fall and the exchange rate to adjust accordingly.

Quick Study 3 1.

Q: The gold standard is an example of what type of international monetary system? A: In the earliest days of international trade, gold was the internationally accepted currency for payments of goods and services. The gold standard was an international monetary system in which nations linked the value of their paper currencies to specific values of gold. The value of a currency expressed in terms of gold is called its par value. Because each nation fixed its currency to gold, it also indirectly linked its own currency to those of other nations. Thus, the gold standard was called a fixed exchange rate system—one in which the exchange rate for converting one currency into another is fixed by international governmental agreement.

Q: What are the main advantages of the gold standard? A: There are three main advantages associated with an international monetary system based on the gold standard. First, because the gold standard maintained highly fixed exchange rates between currencies, it drastically reduced exchange-rate risk. Second, because the gold standard requires governments to convert paper currency into gold if demanded by holders of the currency, governments must always have adequate gold reserves on hand to pay them. Thus, a government cannot allow the volume of its paper currency to grow faster than its gold reserves. This created an effective tool in helping nations control inflation. Third, the gold standard also helped nations to correct trade imbalances. Suppose a nation is importing more than it is exporting. As gold flows out to pay for imports, the government must decrease the supply of paper currency in the domestic economy because it cannot have paper currency in excess of gold reserves. As the money supply falls, so do prices of goods and services in the country because demand is falling while supply is unchanged. The falling prices of the country’s goods make its

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exports cheaper on world markets. Exports rise until the nation’s international trade is once again in balance. The fundamental principle of the gold standard was violated when nations involved in the First World War needed to finance their enormous war expenses by printing additional paper currency. This caused rapid inflation for these nations and caused them to abandon the gold standard altogether. Britain returned to the gold standard in the early 1930s at the same par value that existed before the war. However, the United States returned to the gold standard at a new, lower par value that reflected the inflation of previous years. The decision by the United States to devalue its currency and Britain’s decision not to do so lowered the price of U.S. exports on world markets and increased the price of British (and other nations’) goods imported into the United States. Countries retaliated against one another through “competitive devaluations” to improve their own trade balances. Faith in the gold standard vanished, as it no longer indicated a currency’s true value.

Q: What is the name of the international monetary system that formed in 1944 following the demise of the gold standard? A: The Bretton Woods agreement was an accord among nations to create a new international monetary system based on the value of the U.S. Dollar.

Quick Study 4 1.

Q: An exchange rate system in which currencies float against one another with governments intervening to stabilize currencies at target rates is called what? A: A managed float system is one in which currencies float against one another, with governments intervening to stabilize their currencies at particular target exchange rates.

Q: What do we call the arrangement whereby a nation lets its currency float within a margin around the value of another more stable currency? A: A free float system is an arrangement whereby a nation lets its currency float within a margin around the value of another more stable currency.

Q: A currency board is a monetary regime based on an explicit commitment to exchange domestic currency for what? A: The currency board is a monetary regime based on an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.

Teaming Up 1.

Q: Suppose you and several classmates are a marketing team assembled by your Brazilbased firm to estimate demand in the U.S. market for its newly developed product. The market research firm you hired requires $150,000 to perform a thorough study. But your group is informed that the total research budget for the year is 3 million Brazilian real and that no more than 20 percent of the budget can be spent on any one project. (3a.) If the current exchange rate is 5 real/$, will you have the market study conducted? Why or why not? (3b.) If the exchange rate changes to 3 real/$, will you have the study conducted? Why or why not?

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Ch 10: International Monetary System (3c.) At what exchange rate do you change your decision from rejecting the proposed research project to accepting the project? A: (3a.) The answer is no. Converting real into dollars at an exchange rate of 5 real/$, we arrive at $600,000 (3,000,000/5 real/$ = $600,000). The research project costing $150,000 is 25 percent of the total research budget of $600,000 ($150,000/$600,000 = 0.25). This exceeds the cutoff figure of 20 percent for the cost of any single research project. (3b.) The answer is yes. Converting real into dollars at an exchange rate of 3 real/$, we arrive at $1,000,000 (3,000,000 real/3 real/$ = $1,000,000). The research project costing $150,000 is 15 percent of the total research budget of $1,000,000 ($150,000/$1,000,000 = 0.15). This is below the cutoff figure of 20 percent for the cost of any single research project. (3c.) The threshold exchange rate at which the project decision changes from “accept” to “reject” is 4 real/$. We can set up the problem as an equation which is .20x = $150,000. (The .20x is the 20 percent cutoff figure and the $150,000 is the cost of the project.) Solving the equation and dividing $150,000 by 0.20 gives us a figure of $750,000—the total research budget stated in dollars. Then, dividing the research budget stated in real (3 million real) by that stated in dollars ($750,000), we arrive at a real/$ exchange rate of 4 real/$.

Ethical Challenges 1.

Q: You are the chair of an IMF task force. Your job is to reevaluate the policy of bailing out national governments that suffer losses in the private sector. Current policy is to enlist the governments of industrialized countries in bailing out emerging nations in the midst of financial crises. Taxpayers in industrial countries typically foot the bill for IMF activities, with total loans running into the many billions of dollars. Recent examples are the bailouts of Mexico, Indonesia, and Thailand. Some critics call this system a kind of “remnant socialism” that rescues financial institutions and investors from their own mistakes with money from taxpayers. For instance, the financial crisis in Thailand was largely a private-sector affair. Thai banks and insurance companies were heavily in debt and the central bank had recklessly pledged its foreign exchange reserves to shore up the currency. As chair of the task force, what is your position on this dilemma? Do you believe that the current system socializes losses (the government bails them out) and privatizes profits? Explain exactly who benefits from such bailouts. What is an alternative to an IMF bailout? A: Students might look at the recent events in the U.S. financial system meltdown for ideas on this topic. They may research articles around the time of the Southeast Asian crisis to understand who benefits and loses when losses are socialized—the argument that private financial institutions earn healthy returns when times are good and taxpayers do not share in these gains (though stockholders in these companies do). The question is why should taxpayers bear losses when these institutions make bad investments? The companies may be more cautious if they know taxpayers would not bail them out. This may be a good question to pose as a debate between classmates playing the roles of proponents of private financial institutions on one side, and taxpayers on the other.

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Practicing International Management Case Banking on Forgiveness 1.

This item can be assigned as a Discussion Question in MyManagementLab. Student responses will vary. Q: The World Bank and the IMF had once argued that the leniency of

debt forgiveness would make it more difficult for the lenders themselves to borrow cheaply on the world’s capital markets. If you were a World Bank donor, would you support the HIPC Debt Initiative or argue against it? Explain your answer. A: This question could set up a debate between groups arguing for and against debt relief. Students arguing for debt relief must explain the benefits (humanitarian, economic, etc.) that debt forgiveness is expected to have for the debtors and lenders. Students arguing against debt forgiveness must explain the harm to the institutional lenders and lending countries from the debt forgiveness and explain why debtor nations would be better off mired in crippling debt that denies their people basic health care and education.

Q: In negotiating the HIPC Debt Initiative, the World Bank and the IMF worked closely together. At one point, however, the plan came to a standstill when the two organizations produced different figures for Uganda’s coffee exports, with the IMF giving a more optimistic forecast and so arguing against the need for debt relief. In your opinion, is there any benefit to these organizations working together? Explain. Which organization do you think should play a greater role in aiding economic development? Why? A: Students should be encouraged to visit the Web sites of the International Monetary Fund and World Bank and gather other printed documents they publish in order to gain a fuller understanding of these organizations’ activities before answering this question.

CHAPTER 11 INTERNATIONAL STRATEGY AND ORGANIZATION LEARNING OBJECTIVES: 1. Explain the company analysis techniques that precede strategy selection. 2. Describe the various strategies that companies use to reach their goals. 3. Outline the key issues behind the selection of organizational structure. 4. Describe the various international organizational structures and types of work teams.

CHAPTER OUTLINE: Introduction Company Analysis Company Mission and Goals Types of Mission Statements Core Competency and Value-Creation Unique Abilities of Companies Value-Chain Analysis Primary Activities Support Activities National and International Business Environments Strategy Formulation Two International Strategies Multinational Strategy Global Strategy Corporate-Level Strategies Growth Strategy Retrenchment Strategy Stability Strategy Combination Strategy Business-Level Strategies Low-Cost Leadership Strategy Differentiation Strategy Focus Strategy Department-Level Strategies Primary and Support Activities Issues of Organizational Structure Centralization versus Decentralization When to Centralize When to Decentralize Participative Management and Accountability Coordination and Flexibility Structure and Coordination Structure and Flexibility Types of Organizational Structure International Division Structure International Area Structure Global Product Structure

Ch 11: International Strategy and Organization

Global Matrix Structure Work Teams Self-Managed Teams Cross-Functional Teams Global Teams A Final Word

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 11. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION Planning is the process of identifying and selecting an organization’s objectives and deciding how the organization will achieve those objectives. Strategy is the set of planned actions taken by managers to meet company objectives. Developing an effective strategy requires a clear definition of objectives (or goals) and a plan to achieve them. An analysis of capabilities and strengths identifies what a company does better than the competition. Assessing the competitive environment, the national, and the international business environments are part of the analysis. A well-defined strategy coordinates divisions and departments to reach companywide goals effectively and efficiently. A clear, appropriate strategy focuses on the activities performed best to avoid mediocre performance or total failure.

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COMPANY ANALYSIS Firms must determine what products to produce, where to produce them, and where and how to market them. Whether a site for operations or potential market, each international location has a rich mixture of cultural, political, legal, and economic traditions and processes. All these factors add to the complexity of planning and strategy. A. Company Mission and Goals Mission statement: written statement of why a company exists and what it plans to accomplish (e.g., supply the highest level of service in a market segment). 1. Types of mission statements a. Mission statements often describe how a company’s operations affect stakeholders—all parties, ranging from suppliers and employees to stockholders and consumers, affected by a company’s activities. b. The mission statement of an international business depends on the type of business, the stakeholders, and the most important aspect of the business for goal achievement. Companies must be sensitive to the needs of stakeholders in different nations. c. Stockholders’ needs for financial returns must be balanced against the public interest in countries where production is located. d. Managers must define global objectives. High-level objectives are stated in general terms, “to be the largest global company in

Ch 11: International Strategy and Organization

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each industry in which we compete.” Business-unit objectives are more specific, “to mass produce a zero-pollution-emissions automobile by 2020.” Department-level objectives often carry numerical performance targets, “to increase global market share by 5 percent in each of the next three years.” Core Competency and Value-Creation Before managers formulate strategies, they analyze the company, industry, and the national business environment(s). They should examine industries and nations targeted for potential future entry. Analysis helps managers discover core competency and abilities, and the activities that create customer value. 1. Unique abilities of companies a. Core competency: an ability of a company that competitors find extremely difficult or impossible to equal. Refers to multiple skills coordinated to form a single technological outcome. b. Skills are learned through on-the-job training and personal experience, whereas core competencies develop over a long period and are difficult to teach. 2. Value-chain analysis Value-chain analysis is the process of dividing a company’s activities into primary and support activities and identifying those that create value for customers. Primary activities include inbound and outbound logistics, manufacturing, marketing and sales, and customer service. Support activities include firm infrastructure, human resource management, technology development, and procurement. Each activity is a source of strength or weakness for a company. a. Primary activities When analyzing primary activities, managers look for areas in which the company can increase customer value. b. Support activities Support activities assist in performing primary activities. A sophisticated infrastructure improves internal communication and supports organizational culture and each primary activity. 3. National and international business environments a. National differences in language, religious beliefs, customs, traditions, and climate complicate strategy formulation. b. Manufacturing processes must sometimes be adapted to the supply of local workers, local customs, traditions, and practices. c. Differences in political and legal systems complicate international strategies. d. Different national economies complicate strategy formulation.

STRATEGY FORMULATION Strengths and capabilities of international companies and environmental forces play a role in strategy. A. Two International Strategies 1. Multinational strategy a. Adapts products and marketing strategies in each national market to suit local preferences. b. Benefit: monitor buyer preferences in each local market and respond quickly and effectively to new buyer preferences.

Ch 11: International Strategy and Organization

Drawback: cannot exploit scale economies in product development, manufacturing, or marketing. c. Not suited to industries in which price competitiveness is a key to success. 2. Global strategy a. Offers the same products using the same marketing strategy in all markets. b. Firms take advantage of scale and location economies by producing entire inventories or components in a few optimal locations. They perform product R&D in one or a few locations and design promotional campaigns and advertising strategies at headquarters. c. Benefit: cost savings from standardized products and marketing; lessons learned in a market are shared. d. Drawback: yet a firm employing this strategy may overlook differences in buyer preferences. Only simple modifications in features. Competitors can step in and satisfy unmet local needs creating a niche market. Corporate-Level Strategies Companies in more than one business must formulate a corporate-level strategy by identifying the markets and industries in which to operate. Overall objectives for different business units are developed and the role of each unit in reaching those objectives is determined. 1. Growth strategy a. A growth strategy is designed to increase the scale or scope of a corporation’s operations. Scale refers to the size of a corporation’s activities; scope to the kinds of activities it performs. b. Organic growth relies on internally generated growth. c. Other methods of growth are mergers and acquisitions, joint ventures, and strategic alliances. Partners in pursuing these include competitors, suppliers, and buyers; firms join competitors to reduce competition, expand product lines, or expand geographically. 2. Retrenchment strategy a. Reduces the scale or scope of a corporation’s businesses. Corporations cut back the scale of operations when economic conditions worsen or competition increases by closing factories with unused capacity and laying-off employees. Corporations reduce the scope of activities by selling unprofitable business units. 3. Stability strategy a. Guards against change and used to avoid either growth or retrenchment. b. Corporations have met objectives, are satisfied with accomplishments, and see no opportunities or threats. 4. Combination strategy a. Mixes growth, retrenchment, and stability strategies across a corporation’s business units. b. Common because rarely do international corporations follow identical strategies in each business unit.

Ch 11: International Strategy and Organization C.

Business-Level Strategies A company may need only one strategy for its one line of business or others may need many strategies. Key to an effective business-level strategy is a general competitive strategy in the marketplace. 1. Low-cost leadership strategy a. Exploits economies of scale to have the lowest cost structure of any competitor in an industry. b. Companies contain administrative costs and the costs of its various primary activities, including marketing, advertising, and distribution. c. Low-cost leadership based on efficient production in large quantities guards against attack by competitors because of the large start-up costs. d. A negative aspect of the low-cost leadership strategy is low customer loyalty—buyers will purchase from the low-cost leader if everything else is equal. A low-cost leadership strategy works best with mass-marketed products aimed at price-sensitive buyers. 2. Differentiation strategy a. Company designs products to be perceived as unique. b. Tends to force a company into a lower-market-share position because it involves the perception of exclusivity or meeting the needs of a certain group. c. Companies develop loyal customer bases to offset smaller market shares and higher costs of producing and marketing a unique product. d. Products can be differentiated on the basis of quality, brand image, and product design. Special features differentiate goods and services in the minds of consumers. Manufacturers combine differentiation factors in formulating their strategies. 3. Focus strategy a. Company focuses on the needs of a narrowly defined market segment by being the low-cost leader, by differentiating its product, or both. b. Competition forces more products to be distinguished by price, quality, or design. Greater product range leads to refinement of market segments. c. Some firms serve the needs of one ethnic or racial group, whereas others focus on a single geographic area. Department-Level Strategies Reaching corporate- and business-level objectives depends on effective departmental strategies that focus on activities that transform resources into products. Department-level strategies rely on capabilities—primary and support activities that create value for customers. 1. Primary and support activities a. Each department creates customer value through lower costs or differentiated products. b. For primary activities, manufacturing strategies cut production costs and improve product quality; marketing strategies promote differences in products; and efficient logistics result in cost savings.

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Support activities create customer value (e.g., R&D identifies market segments with unsatisfied needs and designs products to meet them).

ISSUES OF ORGANIZATIONAL STRUCTURE Organizational structure is the way in which a company divides its activities among separate units and coordinates activities among those units. An appropriate organizational structure for a firm’s strategic plans will help it achieve its goals. A. Centralization versus Decentralization Centralized decision making occurs at a high level in one location such as headquarters. Decentralized decision making occurs at lower levels, such as in international subsidiaries. Managers cannot get involved in every hiring decision or task assignment, but overall corporate strategy cannot be delegated to subsidiaries because only top management has the appropriate perspective. Companies rarely centralize or decentralize all decision making, but seek the approach that creates the greatest efficiency and effectiveness. International companies may centralize decision making in certain geographic markets, but decentralize it in others. 1. When to centralize a. Centralization helps coordinate international subsidiaries; important when one subsidiary’s output is another’s input. b. Companies maintain strong central control over financial resources by channeling all subsidiary profits back to the parent for redistribution to subsidiaries. c. Other companies centrally design policies, procedures, and standards to stimulate a single global organizational culture. 2. When to decentralize a. Decentralized decision making is beneficial when fast changing business environments require local responsiveness. b. Because subsidiary managers are in contact with local culture, politics, laws, and economies, decentralized decisions result in products suited to the needs and preferences of local buyers. c. Delayed response and misinterpreted events result in lost orders, stalled production, and weakened competitiveness. d. Participative management and accountability i. Decentralization fosters participative management practices. Employee morale is higher if subsidiary managers and subordinates are involved in decisions. ii. If delegated to subsidiaries, decisions about production, promotion, distribution, and pricing can generate greater commitment from managers and workers. iii. Decentralization improves personal accountability. When local managers are rewarded (or punished) for their decisions, they invest more effort in making and executing them. B. Coordination and Flexibility Key questions: What is the most efficient way to link divisions? Who should coordinate the divisions? How should the company process and deliver information? How should it use corrective measures? 1. Structure and coordination

Ch 11: International Strategy and Organization

Companies need structure to define responsibility and chains of command—lines of authority that run from top management to each employee and specify internal reporting relationships. b. Companies need structures to bind areas requiring cooperation, such as linking R&D and manufacturing to avoid product designs that complicate manufacturing. Structure and flexibility a. Organizational structure is not permanent, but is modified to suit changes within a company and in its external environment. b. Changes in strategy and in the business environment force modifications in organizational structure; some countries are characterized by rapidly shifting business environments.

TYPES OF ORGANIZATIONAL STRUCTURE Four organizational structures are common for most international companies. A. International Division Structure 1. An international division with its own manager keeps domestic and international activities separate. A general manager for each nation in which a company operates then controls product manufacturing and marketing within that market. 2. Concentrates international expertise in one division where the manager becomes a specialist in foreign exchange, exporting, and so on. Firm reduces costs, increases efficiency, and prevents international activities from disrupting home operations. 3. Potential problems with this structure are: (1) poor coordination between the international division and the rest of the company can hurt performance; and (2) destructive rivalries may arise between different country managers within the division. B. International Area Structure 1. Organizes a company’s global operations into countries or regions. The more countries in which a company operates, the greater the likelihood it will organize into regions, not countries. 2. Each geographic division operates as a self-contained unit, with decision making decentralized to country or regional managers. 3. Useful structure when there are vast cultural, political, or economic differences among nations or regions. 4. By controlling activities in their environments, general managers become experts on the unique needs of their buyers. But because units act independently, resources may overlap, and cross-fertilization of knowledge across units can be limited. C. Global Product Structure 1. Divides worldwide operations according to a company’s product areas. Suitable when a firm has a diverse set of products. 2. Because the primary focus is on the product, domestic and international managers for each product division must coordinate their activities so they do not conflict. D. Global Matrix Structure 1. Splits the chain of command between product and area divisions. Each manager reports to two bosses—the president of the product division and the president of the geographic area.

Ch 11: International Strategy and Organization 2.

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Brings together geographic area managers and product area managers in joint decision making. 3. Bringing specialists together creates a team-type organization. Increases local responsiveness, reduces costs, coordinates worldwide operations, and can increase coordination while improving agility and local responsiveness. 4. Two major shortcomings: (1) The matrix form can be quite cumbersome as the need for complex coordination tends to make decision making time consuming and slows the reaction time. (2) Individual responsibility and accountability are blurred in the matrix organization structure; because of shared responsibility, managers may attribute poor performance to the other manager. Work Teams Work teams can be useful in improving responsiveness by cutting across functional boundaries (between production and marketing) that slow decision making in an organization. Work teams coordinate their efforts to arrive at solutions and implement corrective action. 1. Self-managed teams a. Employees from a single department accept responsibilities of former supervisors. In production settings, self-managed teams reduce the need for direct supervisors and increase productivity, product quality, customer satisfaction, employee morale, and company loyalty. b. Quality-improvement teams are the most common type of selfmanaged team in many manufacturing companies because they reduce production waste and cut costs. c. Cultural differences can cause resistance to the concept of selfmanagement and the use of teams. Experts suggest that international managers use caution when implementing them. d. Certain cultures are less individualistic and more collectivist; some harbor greater respect for differences in status. In cultures in which people are hard working, teams will be productive if given greater autonomy. 2. Cross-functional teams a. Composed of employees who work at similar levels in different functional departments. Such teams can help improve interdepartmental coordination and help boost product quality. b. Break down interdepartmental barriers and reorganize operations around processes, not functional departments. 3. Global teams a. Group of top managers from both headquarters and subsidiaries who meet to develop solutions to company-wide problems. b. Large distances between team members, lengthy travel times to meetings, and the inconvenience of working across several time zones can hamper global teams.

A FINAL WORD Managers have the important and complicated task of formulating international strategies at the levels of the corporation, business unit, and department. International managers must identify the company’s mission and goals. Managers often analyze the company’s operations by performing a value-chain analysis. This process lets managers identify and

Ch 11: International Strategy and Organization

implement strategies suited to a company’s unique capabilities. The strategies managers select then determine a firm’s organizational structure. Business environments can affect managers’ strategy and structure decisions, including whether to alter their products (standardization or adaptation), where to locate facilities (centralized or decentralized production), and what type of decision making to implement (centralized or decentralized decision making). Quick Study Questions Quick Study 1 1.

Q: A written statement of why a company exists and what it plans to accomplish is called a what? A. Most companies have a general purpose for why they exist that they express in a mission statement—a written statement of why a company exists and what it plans to accomplish.

Q: A special ability of a company that competitors find extremely difficult or impossible to equal is called a what? A: A core competency is a special company ability that competitors find extremely difficult or impossible to equal. It is not a skill. Individuals possess skills such as the ability to hit 70 home runs in professional baseball. A core competency refers to multiple skills that are coordinated to form a single technological outcome. Core competencies develop over long periods of time and are difficult to teach or transfer.

Q: Value-chain analysis involves separating a company’s activities into what two categories of activities? A: Value-chain analysis is the process of dividing a company’s activities into primary and support activities and identifying those that create value for customers. Primary activities include inbound and outbound logistics, manufacturing (or operations), marketing and sales, and customer service. Support activities include firm infrastructure, human resource management, technology development, and procurement. Each primary and support activity is a source of strength or weakness for a company.

Quick Study 2 1.

Q: What strategy involves adapting products and their marketing strategies to national markets to suit local preferences? A: A multinational (multidomestic) strategy is a strategy of adapting products and their marketing strategies in each national market to suit local preferences. The main benefit of a multinational strategy is that it allows companies to closely monitor buyer preferences in each local market and respond quickly and effectively as new buyer preferences emerge. The main drawback of a multinational strategy is that it does not allow companies to exploit scale economies in product development, manufacturing, or marketing.

Q: What is the benefit of using a global strategy? A: A global strategy is a strategy of offering the same products using the same marketing strategy in all national markets. The main benefit of a global strategy is its cost savings

Ch 11: International Strategy and Organization due to product and marketing standardization. The main problem with a global strategy is that it may cause a company to overlook important differences in buyer preferences from one market to another.

Q: Deciding on a general competitive strategy in the marketplace is the key to developing what? A: The key to developing an effective business-level strategy is deciding on a general competitive strategy in the marketplace.

Quick Study 3 1.

Q: How a company divides its activities among separate units and coordinates activities among units is called what? A: Organizational structure is the way in which a company divides its activities among separate units and coordinates activities among those units. If a company’s organizational structure is appropriate for its strategic plans, it will be more effective in working toward its goals.

Q: What type of decision making helps coordinate the operations of international subsidiaries? A: A vital issue for top managers is determining the degree to which decision making in the organization will be centralized or decentralized. Centralized decision making is the degree to which decision making is centralized at a high level in one location such as headquarters. Decentralized decision making is the degree to which decisions are made at lower levels, such as in international subsidiaries.

Q: What is the benefit of decentralized decision making in an organization? A: Decentralized decision making is beneficial when fast changing national business environments put a premium on local responsiveness.

Quick Study 4 1.

Q: What type of organizational structure tends to concentrate all international expertise in one division? A: An international division structure separates domestic from international business activities by creating a separate international division with its own manager.

Q: An organizational structure that divides worldwide operations according to a firm’s product areas is called what? A: A global product structure divides worldwide operations according to a company’s product areas. The global product structure is suitable for companies offering diverse sets of products or services.

Q: What do we call a group of employees who work at similar levels in different departments? A: A cross-functional team is one that is composed of employees who work at similar levels in different functional departments. Such teams can improve coordination among departments, improve product quality, and help companies in reorganizing themselves around processes.

Ch 11: International Strategy and Organization

Ethical Challenge You are the CEO of a multinational corporation that operates in more than 100 nations worldwide. Recent changes in the global economy are redrawing many geographical and political borders. The growing interdependence of socially, politically, economically, and legally diverse countries is causing firms to revise operating policies and strategies. You are personally involved in developing a code of ethics for your firm that reflects today’s legal and moral atmosphere. You want your firm’s code to be effective across all markets in which it operates. 11-5 Given the complexity of the issues involved, what sort of policy do you think is appropriate for a firm involved in dissimilar nations? 11-6 Do you think that it is possible to create a uniform code of ethics that is applicable to any business operating in any culture? What issues should such a code address? A: Many CEOs wrestle with the idea of adapting their firm’s code of ethics to local laws and customs around the world. Clearly, such global codes of conduct do exist. However, students should try to think of situations in which such a code could be challenging to implement. Although such codes look nice in the company’s annual report, the real difficulties lie on the front lines in international markets when they are implemented (to varying degrees of success). Teaming Up Two groups of four students each will debate the merits of adopting either a multinational or global strategy (each side will advocate one strategy). After the first student from each side has spoken, the second student will question the opposing side’s arguments, looking for holes and inconsistencies. The third student will attempt to answer these arguments. The fourth student will present a summary of each side’s arguments. Finally, the class will vote to determine which team has offered the more compelling argument. A: Students should be sure to support their arguments with features of each of the two types of strategies discussed in this chapter. They should also be prepared to defend their positions, after the debate, if they are called on to give a synopsis of their position in class. It may also be useful to give students some time to do outside research to prepare for the debate. Practicing International Management Case IKEA’s Global Strategy 11-9

Q: When company founder Kamprad decided to expand into China his decision was not based on market research but, rather, on his own intuition. How well is IKEA doing in China? Did Kamprad’s decision pay off? A: So far IKEA’s stores in Beijing and Shanghai are performing well. IKEA changed some elements of its global strategy in culturally diverse China. In China, the company balances the implementation of its global policies and the need for greater localization. IKEA has improved its responsiveness to the needs of the China market regarding its corporate culture, structure, and strategy.

11-10 Q: Relying on topics covered in this chapter, would you classify IKEA’s approach as one of standardization or adaptation in markets around the world? Explain.

Ch 11: International Strategy and Organization A: IKEA has standardized its brand image and main marketing concept worldwide. It has only adapted its facilities in terms of size to suit the U.S. market. The approach certainly seems to be working well for IKEA.

CHAPTER 12 ANALYZING INTERNATIONAL OPPORTUNITIES LEARNING OBJECTIVES: 1. Explain the importance of examining basic appeal and national factors. 2. Describe how companies measure and select a market or site. 3. Identify the main sources of secondary market research data. 4. Describe common methods used to conduct primary market research. CHAPTER OUTLINE: Introduction Basic Appeal and National Factors Step 1: Identify Basic Appeal Determining Basic Demand Determining Availability of Resources Step 2: Assess the National Business Environment Cultural Forces Political and Legal Forces Government Regulation Government Bureaucracy Political Stability Economic and Financial Forces Other Forces Cost of Transporting Materials and Goods Country Image Measure and Select the Market or Site Step 3: Measure Market or Site Potential Measuring Market Potential Industrialized Markets Emerging Markets Measuring Site Potential Step 4: Select the Market or Site Field Trips Competitor Analysis Secondary Market Research International Organizations Government Agencies Industry and Trade Associations Service Organizations Internet Problems with Secondary Research Availability of Data Comparability of Data Primary Market Research Trade Shows and Trade Missions Interviews and Focus Groups Surveys Environmental Scanning

Ch 12: Analyzing International Opportunities

Problems with Primary Research A Final Word

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 12. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION Technological advances in communication and transportation open national markets around the globe. Managers screen and analyze locations as potential markets and as potential sites for operations. The attraction to distant markets and the integrated nature of location decisions demand that location decisions be made in a systematic manner.

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BASIC APPEAL AND NATIONAL FACTORS Managers try to keep search costs low yet examine every potential market or location when screening potential markets and sites. The screening process has four steps. A Step 1: Identify Basic Appeal For a potential market, this entails determining basic product demand. For a potential site, this involves determining the availability of resources required. 1. Determining basic demand Must explore the suitability of a nation’s climate, and whether there are bans on a product (e.g., alcohol in Islamic nations). 2. Determining availability of rResources a. Raw materials for manufacturing must be local or imported. Imports may face tariffs, quotas, or other trade barriers. b. Companies making labor-intensive products often relocate to low-wage countries. c. Financing can send production abroad if it is not available at home or when interest rates are high at home. d. Markets and sites not meeting requirements are dropped. B. Step 2: Assess the National Business Environment Managers must understand differences in cultures, politics, laws, and economies and incorporate that understanding into market and site selection decisions. 1. Cultural forces a. Countries differ in language, attitudes toward business, religious beliefs, traditions, and customs. Cultural elements can influence what kinds of products are sold and how. b. Culture affects site-selection decisions; companies sometimes locate production in the local market when changes must be made to a product’s physical features for cultural reasons. c. The local work ethic, education, and level of managerial skills affect site-selection decisions. 2. Political and legal forces a. Government regulation

Ch 12: Analyzing International Opportunities i.

Nations differ in their attitudes toward trade and investment based on culture, history, and current events. A nation’s attitude is reflected in the quantity and types of restrictions it places on imports. ii. Can quickly eliminate a market or site from further consideration. They create investment barriers to ensure domestic control of a company or industry by imposing investment rules on business ownership. iii. Restrict international companies from freely removing profits, forcing them to hold cash in the host country or to reinvest it in new projects there. iv. Impose strict environmental regulations such as pollution-control devices or close monitoring of nearby air, water, and soil quality. v. Extend investment rules to bar international companies from competing in certain sectors of the economy. b. Government bureaucracy i. Lean and smoothly operating bureaucracy can encourage investment whereas an inefficient, cumbersome, or corrupt one can discourage it. ii. Companies will endure an inefficient bureaucracy if the benefits outweigh the cost of inefficiencies. c. Political stability i. Companies must monitor political events that threaten operations and future earnings. Political risk can threaten activities of any international business activity. ii. Key to political risk is unforeseen political change: if a company cannot estimate the future political environment with accuracy, political risk is increased. iii. Companies can obtain political risk information from political-risk agencies, international relations scholars, political and union leaders, reporters, bankers, and so on. Economic and financial forces a. Poor fiscal and monetary policies can increase inflation and budget deficits, weaken a currency, lower productivity levels, and slow innovation. These reduce investor confidence and cause companies to scale back or cancel proposed investments. b. Currency and liquidity issues: a volatile currency complicates the prediction of future earnings in the home-country currency. c. Managers can obtain information about economic and financial conditions from international agencies. Other forces A country’s image and the cost of transporting materials and goods are important in assessing a nation’s business environment. a. Cost of transporting materials and goods i. Can affect where manufacturing facilities are located. ii. Logistics is managing the physical flow of products from point of origin as raw materials to end users as finished products. Logistics wed production to delivery. b. Country image

Ch 12: Analyzing International Opportunities i. ii. iii. iv.

III.

Embodies all facets of a nation’s business environment and affects the selection of sites for any activity. Affects product image because products are stamped with labels identifying country of origin or assembly. Country image can be good for certain products but unfavorable for others. Country image can also change over time.

MEASURE AND SELECT THE MARKET OR SITE A. Step 3: Measure Market or Site Potential Despite local demand for a product or availability of resources, consumers might not be ready or able to buy a product or certain sites may be unable to supply the resources needed. 1. Measuring market potential Level of economic development affects the products sold, how they are sold, and their features. Different levels of economic development require varying approaches to researching market potential. a. Industrialized markets i. Great deal of information on market potential is available about industrialized countries. ii. Information in a typical industry analysis: • Names, production volumes, and market shares of largest competitors • Volume of exports and imports of the product • Structure of wholesale and retail distribution networks • Market background, including population, social trends, and marketing approaches used • Total expenditure on product (and similar products) • Retail sales volume and market prices of product • Future market outlook and potential opportunities iii. These reports provide a quick overview of the size and structure of a nation’s market for a product. iv. One way to forecast market demand is to determine a product’s income elasticity—sensitivity of demand for a product relative to a change in income. Calculated by dividing a percentage change in the quantity of a product demanded by a percentage change in income. v. Income-elastic product: demand increases in a greater proportion to increase in income. These are discretionary purchases such as video games, jewelry, and so on. vi. Income-inelastic product: demand increases less relative to increase in income. These are considered essential and include food, utilities, beverages, and so on. b. Emerging markets i. Companies often face a lack of information. Data on market size or potential may be unavailable.

Ch 12: Analyzing International Opportunities ii.

Can rank locations using a market-potential indicator if company is considering exporting: • Market size: snapshot of market size at the moment. • Market growth rate: Identify large (but shrinking) markets and small (but expanding) markets. • Market intensity: Estimate a market’s wealth or buying power (both individuals and businesses). • Market consumption capacity: Estimate a market’s spending capacity. • Commercial infrastructure: Assess channels of distribution and communication. • Economic freedom: Estimate extent that freemarket principles predominate. • Market receptivity: Estimate market “openness.” • Country risk: Estimate risk of doing business, including political, economic, and financial risks. iii. After analyzing each factor, the importance of each to demand for a product is determined; then potential locations are ranked according to their market appeal. 2. Measuring site potential a. Managers must assess the quality of resources they will employ locally. For many companies, the most important resource will be labor and management. b. Wages are lower if labor is abundant, relatively less skilled (though perhaps well-educated), or both. Yet, training local managers requires a substantial investment of time and money. c. Companies must assess the productivity of local labor and managers; low wages may reflect low productivity levels. d. Managers should examine local infrastructure, including roads, bridges, airports, seaports, and telecommunications systems; each can impact efficiency. Step 4: Select the Market or Site This involves intensive efforts of assessing remaining potential markets and sites. Managers visit each location to confirm earlier expectations and perform a competitor analysis. Managers evaluate each potential location’s contribution to cash flows by undertaking a financial evaluation. 1. Field trips Trips to each remaining site let managers experience the culture, observe the workforce, or make personal contact with potential new customers and distributors. 2. Competitor analysis Intensely competitive markets put downward pressure on the prices firms charge their customers. Intensely competitive sites for production and R&D activities increase the costs of doing business. Competitor analysis should address the following: a. Number of competitors in each market (domestic and international)

Ch 12: Analyzing International Opportunities b. c. d. e. f. g. h. i.

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Market share of each competitor Whether each competitor’s product appeals to a small market segment or has mass appeal Whether each competitor focuses on high quality or low price Whether competitors tightly control channels of distribution Customer loyalty commanded by competitors Potential threat from substitute products Potential entry of new competitors into the market Competitors’ control of production inputs (labor, capital, raw materials, etc.)

SECONDARY MARKET RESEARCH Market research is the collection and analysis of information in order to assist managers in making informed decisions. It applies to the assessment of markets and sites. International market research provides information on business environments: cultural practices, politics, regulations, the economy, a market’s potential size, buyer behavior, logistics, and distribution. It is helpful in designing a marketing strategy and understanding buyer preferences and attitudes. Market research informs managers about employment levels, wage rates, and local infrastructure before committing to the new location. It supplies timely and relevant market information to anticipate market shifts, changes in current regulations, and the potential entry of new competitors. Secondary market research is obtaining information that already exists within the company or that is obtainable from outside sources. Secondary data can estimate market demand for a product or form a general impression of a business environment. Its appeal is that it is relatively inexpensive. A. International Organizations 1. International organizations are excellent sources of free and inexpensive information about product demand. 2. These include the United Nations, the International Trade Center, the World Bank, IMF, and the Asian Development Bank. B. Government Agencies 1. Commerce departments and international trade agencies data: import and export regulations, quality standards, and market size. 2. Visiting embassies and attending social functions are excellent for making contact with potential business partners. Seek sources with an objective view of a potential location. 3. Central Intelligence Agency (CIA) World Factbook: useful throughout the market- or site-screening process because of its facts on each nation’s business environment. 4. Trade Information Center (TIC) provides product standards and advice for U.S. companies in individual markets; information includes trade laws, trade shows, export counseling, import tariffs, and customs procedures. 5. National agencies abroad promoting trade and investment. 6. Trade-data libraries of governments (e.g., JETRO in Japan). C. Industry and Trade Associations 1. Associations of firms within an industry or trade often publish newsletters (and Web sites) to keep members abreast of market happenings and opportunities in their particular industry.

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2. D.

Sometimes commission specialized studies of their industries and offer them to members at subsidized prices. Service Organizations 1. International service organizations in banking, insurance, management consulting, and accounting offer information on cultural, regulatory, and financial conditions. 2. Newsletters cover trends in population growth, consumer spending, purchase behavior, media, and advertising. Internet 1. Leading online information provider is LEXIS-NEXIS: a database of full-text news reports from around the world. It provides profiles of executives and products, and information on financial conditions, marketing strategies, and public relations. 2. The Internet is an inexpensive means to conduct secondary research considering the high cost of other research tools. Problems with Secondary Research Unique circumstances present difficulties that force adjustments in conducting market research in different nations. Companies must be aware of such obstacles to ensure their research data is reliable. 1. Availability of data a. Most industrialized markets have secondary data on product markets. In many emerging and developing countries, previously gathered information can be difficult to obtain; even when market data is available, its reliability is questionable. b. Government-collected information in emerging markets is often stated in the most favorable light and thus suspect. c. Large international research agencies are entering these markets, providing a source of higher-quality information. 2. Comparability of data a. Data obtained from other countries must be interpreted with great caution. Terms such as poverty, consumption, and literacy can differ greatly from one country to another. b. Different ways governments measure data affects comparability among nations. Misinterpreting data can sabotage the best marketing plans and production strategies.

PRIMARY MARKET RESEARCH Primary market research is the process of collecting and analyzing original data and applying the results to current research needs. Primary research helps complete the broad picture supplied by secondary data. A. Trade Shows and Trade Missions 1. Trade show is an exhibition at which members of an industry or group of industries showcase their latest products, see what rivals are doing, and learn about recent trends and opportunities. 2. Trade mission is an international trip by government officials and businesspeople organized by agencies of national or provincial governments to explore business opportunities. 3. Trade missions appealing for small- and medium-size firms: (1) visible support of home-country government officials gives them clout in the host country, and (2) cost-effective because they often include several national markets across a region.

Ch 12: Analyzing International Opportunities B.

E. VI.

Interviews and Focus Groups 1. These techniques can uncover potential or current buyers’ emotions, attitudes, and general impressions of a company or its product. Interviewing customers in other countries is difficult and getting unbiased and reliable results is challenging. 2. Focus group: unstructured but in-depth interview of a small group of individuals (8 to 12 people) by a moderator to learn attitudes about a company or its product. Uncovers negative perceptions among buyers to correct marketing strategies. 3. Because subtle differences in verbal and body language could go unnoticed, focus group interviews work best when moderators are natives of the countries in which the interview is held. 4. A consumer panel is research in which people record, in personal diaries, information on their attitudes, behaviors, or purchasing habits. This can be useful when people in a focus group might agree with others in the group—as in group-oriented cultures. Surveys 1. Research in which an interviewer has current or potential buyers answer written or verbal questions to obtain facts, opinions, or attitudes. Can gather a vast amount of data in a single sweep. 2. Survey methods must be adapted to local markets. Written surveys are impractical in countries with high illiteracy rates although verbal responses can be obtained. Environmental Scanning a. Ongoing process of gathering, analyzing, and dispensing information for tactical or strategic purposes. Entails obtaining factual and subjective information on the business environments in which a company is operating or considering entering. b. Contributes to well-informed decisions and effective strategies by helping develop contingency plans in a volatile environment. Problems with Primary Research

A FINAL WORD In competitive global business, companies should follow a systematic screening process that incorporates high-quality research methods. This chapter provides a systematic way to screen potential locations as new markets or sites for business operations. Yet this is only the first step in “going international.” The next step involves actually accomplishing the task of entering selected markets and establishing operations abroad. Later chapters cover entry modes available to companies, acquiring resources needed to carry out activities, and managing sometimes far-flung international business operations.

Quick Study Questions Quick Study 1 1.

Q: What is the first step in the screening process for potential markets and sites? A: The first step in identifying potential markets is to assess the basic demand for a product. Similarly, the first step in selecting a site for a facility to undertake production, R&D, or some other activity is to explore the availability of the resources required. In

Ch 12: Analyzing International Opportunities

other words, the first step in searching for potential markets mean finding out whether there is a basic demand for the company’s product. 2.

Q: What forces should a company research when assessing a nation’s business environment? A: Cultural differences in language, attitudes toward business, religious beliefs, traditions, and customs can influence what products are sold and how they are sold. Companies sometimes locate production in the local market when significant changes must be made to a product’s physical features for cultural reasons. Cultural elements such as work ethic, educational attainment, or the level of managerial skills of the local people also affect site-location decisions. Nations differ in their attitudes toward trade and investment from other countries. Governments can create barriers to investment, for example, by placing restrictions on the percent ownership foreign companies can have in domestic firms or by forcing the formation of joint ventures with local firms. Governments can bar foreign companies from competing in certain sectors of the economy. They can restrict companies from freely removing capital from the host nation. This can force companies to hold cash in the country or invest in new investment projects there. Governments can impose strict environmental regulations that can significantly increase production costs. They can require that companies divulge certain information—such as India’s demand for CocaCola’s secret recipe. A clean and smoothly operating bureaucracy can encourage investment whereas an inefficient, cumbersome, or corrupt one can discourage it. Political risk can threaten the activities of any type of international business activity. Companies must analyze a nation’s economic policies before selecting a new market or site. Poor fiscal and monetary policies can cause high rates of inflation, increasing budget deficits, a depreciating currency, falling productivity levels, and flagging innovation. Such conditions can lessen investor confidence and cause companies to scale back or cancel proposed investment projects. Volatile currency exchange rates can make it difficult to calculate the amount of funds needed for an investment, and increase the uncertainty of how much money can be obtained in liquidation situations.

Q: Evaluating a product from a certain country as superior to similar products from other countries is an example of what force at work? A: Country image embodies every facet of a nation’s business environment, it is highly relevant to the selection of sites for production, R&D, or any other activity. Country image affects the location of manufacturing or assembly operations because products must typically be stamped with labels identifying where they were made or assembled such as “Made in China.” Products in relatively more developed countries tend to be evaluated more positively than those from relatively less developed nations. Country image can be good for certain products but unfavorable for others. Country image can also change over time. Although “Made in India” once applied only to textiles and sporting goods, it now has a respectable image for quality software and services.

Quick Study 2 1.

Q: The sensitivity of demand for a product relative to changes in income is called what? A: Income elasticity is the sensitivity of demand for a product relative to changes in income and is one way of forecasting market demand. It is calculated by dividing the percent change in the quantity of a product demanded by a percent change in income. A coefficient of greater than 1.0 conveys an income-elastic product: one for which demand increases in a greater proportion to growth in income. The concept helps managers

Ch 12: Analyzing International Opportunities forecast future demand for products under certain economic conditions. It allows them to work up demand figures under several different scenarios of economic conditions. This allows companies to supplement all the current data collected in earlier screening stages with actual forecasts of potential demand for their products.

Q: What variable is commonly included in a market potential indicator? A: The main variables commonly included in market-potential analysis are: market size, market growth rate, market intensity, market consumption capacity, commercial infrastructure, economic freedom, market receptivity, and country risk. Its usefulness lies in the fact that hard data on market size (which is readily available in industrialized markets) is often unavailable in emerging markets. The market-potential indicator is one way for companies to rank different markets in terms of their appeal. However, it should be noted that this indicator is only useful for companies considering exporting to markets.

Q: How important is it for top managers to pay a visit to a market or site before making a final decision? A: The final step in the screening process represents the most intensive efforts of assessing remaining potential markets and sites—typically less than a dozen, sometimes just one or two. At this stage of the screening process, managers often want to take trips to each remaining site. The trip gives managers an opportunity to experience the culture, observe in action the workforce that they might soon employ, or make personal contact with potential new customers and distributors. There are also competitive issues managers should analyze in the final step of screening. Some of these are the number of competitors and their market shares, the customer segment of each competitor and the loyalty of their customers, potential new entrants, and competitors’ control over key inputs. Intensely competitive markets typically put downward pressure on the prices that firms can charge their customers. An intensely competitive site can also increase the cost of doing business at that location. Lower prices and higher costs due to competitive forces must be balanced against the potential benefits offered by each market and site under consideration.

Quick Study 3 1.

Q: Obtaining information that already exists within or outside the company is called what? A: The process of obtaining information that already exists within the company or that can be obtained from outside sources is called secondary market research.

Q: What are possible sources of secondary research data? A: The main sources of secondary research data include international organizations, government agencies, industry and trade associations, service organizations, and the Internet and World Wide Web.

Q: What are potential problems that can arise with the use of secondary research data? A: Availability of data: In the most industrialized markets, much secondary data already exists on various product markets. However, in many emerging and developing countries, previously gathered information of high quality can be difficult to obtain. Even when market data is available, its reliability can be questionable. Government-collected information in emerging markets is often stated in the most favorable light—and therefore somewhat suspect. However, large international research agencies are entering these markets, thereby providing a source of higher-quality information.

Ch 12: Analyzing International Opportunities

Comparability of data: Data obtained from other countries must be interpreted with great caution. Terms such as poverty, consumption, and literacy can differ greatly from one country to another. The different ways governments measure data also affects comparability among nations. Misinterpreting data because one does not know how it was compiled can sabotage even the best marketing plans and production strategies. Cultural differences: Marketers conducting research in unfamiliar markets must pay attention to the ways that cultural variables influence information. Perhaps the most important variable is language. For example, even the use of interpreters can complicate matters as they may unintentionally place more or less emphasis on a certain point they are translating by the words they choose or their voice inflections. High illiteracy rates can force researchers to conduct time-consuming verbal surveys with potential customers. Hiring local research agencies (or international ones with local affiliations) is a good avenue when a company runs into cultural obstacles to research. Quick Study 4 1.

Q: Collecting and analyzing original data and applying the results to current research needs is called what? A: Primary market research is the process of collecting and analyzing original data and applying the results to current research needs. It helps complete the broad picture supplied by secondary data. Primary research differs from secondary research in that a company (or an outside agency on behalf of the company) gathers it for the first time.

Q: A trade show is the same thing as what? A: A trade show is an exhibition at which members of an industry or group of industries showcase their latest products, see what rivals are doing, and learn about recent trends and opportunities.

Q: A firm researching a very unfamiliar but potentially very profitable market might be best to do what? A: Companies that have little experience in an unfamiliar market often hire local agencies to perform some or all of their market research.

Ethical Challenge You are executive director of Qualitative Research Consultants Association (QRCA), an organization designed to assist market research practitioners. As part of their membership agreement, QRCA members agree to abide by a nine-point code of ethics that forbids practices such as discriminating in respondent recruitment and offering kickbacks or other favors in exchange for business. The code also calls for research to be conducted for legitimate research purposes, and not as a front for product promotion. 12-5 Why do you think the QRCA and other market research organizations create such codes? 12-6 Do you believe they are helpful in reducing unethical research practices? 12-7 As QRCA director, what other areas of marketing research do you believe should be covered by ethical codes of conduct? A: Clearly, such codes are designed to provide researchers with ethical guidelines of conduct. The question of whether they help reduce unethical behavior is a tricky one. Many students will likely respond that the code at least becomes part of the subconscious and therefore will guide researchers toward ethical conduct. However, researchers can

Ch 12: Analyzing International Opportunities just easily recall the code, make an evaluation, disregard the code, and go ahead with the opportunistic behavior. As far as new areas for inclusion in the code, certainly there are many online research techniques that must be incorporated into a newly updated code. Data privacy issues, such as medical and financial scenarios, have been brought before the U.S. Congress and laws passed that deal with online snooping and “cookies.”

Teaming Up As a team, select an emerging market that interests you. Start by compiling fundamental country data and then do additional research following the steps in this chapter. Flesh out the nature of the market opportunity offered by this country or its suitability as a manufacturing site. Next, select a company that is pursuing opportunities in the country. Determine whether the company’s activities are consistent with the market or site potential as your team researched it. A: This may be a good time to get students working on their Market Entry Strategy Project. This exercise gets students to learn more about a country, and to generate interest in countries other than their own. The project focuses on important aspects of each country and the process can begin to develop teamwork in the course. Practicing International Management Case Vietnam’s Emerging Market Potential 12-10 Q: What do you think western countries can do to help improve the political climate in Vietnam? A: Governments in the West can probably best help improve the business climate in Vietnam by developing closer ties with the government. They can provide aid for infrastructure improvements and help the government to streamline the bureaucracy. However, beyond this, Vietnam itself and its people must want to become more open to investment from Western companies. Without a change in the mindset of the nation’s government and its people, Vietnam is not likely to experience rapid progress. 12-11 Q: What problems might a company encounter while conducting market research in Vietnam? A: Students should review the problems covered in this chapter and consult the business press for stories about the cultural, political, legal, economic, and financial obstacles companies face when researching the market of Vietnam. 12-12 Q: Reflecting on your perception of products labeled, “Made in Vietnam.” Does the type of product affect your perception? Explain. A: As discussed in this chapter, certain low-cost products will be unlikely to have any negative connotation if labeled “Made in Vietnam.” However, high-priced luxury or technical products would likely suffer from such a label. However, as Vietnam develops economically over time, any negativity of such a label on sophisticated goods would be expected to decline.

CHAPTER 13 SELECTING AND MANAGING ENTRY MODES LEARNING OBJECTIVES: 1. Describe how companies use exporting, importing, and countertrade. 2. Explain the various methods of export/import financing. 3. Describe the different contractual entry modes. 4. Describe the various kinds of investment entry modes. 5. Outline key strategic factors in selecting an entry mode.

CHAPTER OUTLINE: Introduction Exporting, Importing, and Countertrade Why Companies Export Developing an Export Strategy: A Four-Step Model Step 1: Identify a Potential Market Step 2: Match Needs to Abilities Step 3: Initiate Meetings Step 4: Commit Resources Degree of Export Involvement Direct Exporting Sales Representatives Distributors Indirect Exporting Agents Export Management Companies Export Trading Companies Avoiding Export and Import Blunders Countertrade Types of Countertrade Export/Import Financing Advance Payment Documentary Collection Letter of Credit Open Account Contractual Entry Modes Licensing Advantages of Licensing Disadvantages of Licensing Franchising Advantages of Franchising Disadvantages of Franchising Management Contracts Advantages of Management Contracts Disadvantages of Management Contracts Turnkey Projects Advantages of Turnkey Projects

Ch 13: Selecting and Managing Entry Modes

Disadvantages of Turnkey Projects Investment Entry Modes Wholly Owned Subsidiaries Advantages of Wholly Owned Subsidiaries Disadvantages of Wholly Owned Subsidiaries Joint Ventures Joint Venture Configurations Forward Integration Joint Venture Backward Integration Joint Venture Buyback Joint Venture Multistage Joint Venture Advantages of Joint Ventures Disadvantages of Joint Ventures Strategic Alliances Advantages of Strategic Alliances Disadvantages of Strategic Alliances Strategic Factors in Selecting an Entry Mode Selecting Partners for Cooperation Cultural Environment Political and Legal Environments Market Size Production and Shipping Costs International Experience A Final Word

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 13. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION An entry mode is the institutional arrangement by which a firm gets its products, technologies, human skills, or other resources into a market. Companies seek entry to new marketplaces for manufacturing or selling products. Entry mode selection depends on market experience, level of control desired, and market size.

II.

EXPORTING, IMPORTING, AND COUNTERTRADE The most common method of buying and selling goods internationally is exporting and importing. Companies use countertrade when exporting and importing products when using currencies is not an option. A. Why Companies Export 1. Expand total sales when the domestic market is saturated. 2. Diversify sales to level off cash flow, making it easier to coordinate payments to creditors with receipts from customers.

Ch 13: Selecting and Managing Entry Modes 3.

Owners and managers with little or no knowledge of how to conduct business in other cultures, use exporting as a low-cost, low-risk way of gaining valuable international experience. Developing an Export Strategy: A Four-Step Model A logical approach to exporting is to research and analyze international opportunities and develop a coherent export strategy. A firm with such a strategy pursues export markets rather than waiting for orders to arrive. 1. Step 1: Identify a potential market a. To identify clearly whether demand exists in a target market, market research should be performed and results interpreted. b. Novice exporters should focus on one or a few markets that are culturally understood. c. A new exporter should seek advice on regulations, exporting in general and to a target market in particular. 2. Step 2: Match needs to abilities a. Assess a company’s ability to satisfy market needs. 3. Step 3: Initiate meetings a. Early meetings with potential distributors, buyers, and others. Initial contact should focus on building trust and cooperation. b. Later meetings can estimate potential success of an agreement. c. In the most advanced stage, negotiations take place and details of agreements are finalized. 4. Step 4: Commit resources a. After all the meetings and negotiations, it is time to put the company’s human, financial, and physical resources to work. b. The objectives of the export program must be clearly stated and should extend out at least 3 to 5 years. c. As companies expand activities, they discover the need for an export department or division. Degree of Export Involvement Some companies use intermediaries to get their products in a market abroad. Other companies perform all of their export activities themselves, with an infrastructure that bridges the gap between the two markets. 1. Direct exporting Company sells directly to buyers in a target market. Need not sell directly to end-users; can rely on local representatives or distributors. a. Sales representatives represent their own company’s products, not those of other companies. Promote products by attending trade fairs and making personal visits to local retailers and wholesalers. Do not take title to the merchandise. b. Distributors take ownership of merchandise when it enters their country, accept risks associated with local sales, and sell to retailers, wholesalers, or end users through their own channels of distribution. This reduces an exporter’s risk and its control. 2. Indirect exporting Company sells to intermediaries who resell to buyers in a target market. The choice of intermediary depends on the ratio of international sales to total sales, available resources, and the growth rate of the target market. a. Agents

Ch 13: Selecting and Managing Entry Modes i.

Individuals or organizations that represent one or more indirect exporters in a target market. Compensated with commissions on sales. ii. Represent several indirect exporters and might focus their promotional efforts on the products of the company paying the highest commission. b. Export management companies i. EMC exports on behalf of indirect exporters, operating contractually, either as an agent or as a distributor. ii. Provides services on a retainer basis: gather market information, formulate promotional strategies, perform promotional duties, research customer credit, arrange shipping, and coordinate export documents. iii. Advantage: deep understanding of the cultural, political, legal, and economic conditions of target market. Disadvantage: breadth and depth of an EMC’s service hinders exporter’s international skills development. iv. After the EMC contract expires, a company can go at it alone in exporting its products. c. Export trading companies i. ETC provides services in addition to those directly related to clients’ exporting activities: import, export, and countertrade services, distribution channels, storage facilities, trade and investment projects, and manufacturing. ii. Concept met limited success in the United States; remain small and are dwarfed by Asian counterparts. iii. Governments, financial institutions, and companies have closer working relationships in Asia. The U.S. regulatory environment is wary of such arrangements, and the lines between companies and industries are clearly drawn. Avoiding Export and Import Blunders 1. Companies new to exporting often make errors; many fail to conduct adequate market research and obtain adequate export advice. 2. Companies can hire a freight forwarder—a specialist in such exportrelated activities as customs clearing, tariff schedules, and shipping and insurance fees. Can pack shipments for export and take responsibility for getting a shipment from the port of export to the port of import. Countertrade Selling goods or services that are paid for, in whole or part, with other goods or services. Developing and emerging markets often rely on countertrade to import goods due to lack of hard currency. Formerly communist countries in Eastern and Central Europe use countertrade as well as nations in Africa, Asia, and the Middle East. Requires an extensive network of international contacts, but smaller companies can take advantage of its benefits. 1. Types of countertrade a. Barter: Exchange of goods or services directly for other goods or services without the use of money. b. Counterpurchase: Sale of goods or services to a country by a company that promises to make a future purchase of a country’s product.

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III.

Offset: Agreement that a company will offset a hard-currency sale to a nation by making a hard-currency purchase of an unspecified product from that nation in the future. d. Switch trading: One company sells to another its obligation to make a purchase in a given country. e. Buyback: Export of industrial equipment in return for products produced by that equipment. Countertrade can provide access to markets otherwise off-limits because of a lack of hard currency. But typically involves commodity and agricultural products such as oil, wheat, or corn—products whose prices on world markets fluctuate. Problems arise when the price of a product declines between the barter time and the selling time; fluctuating prices generate the same type of risk as in currency markets. Managers might hedge this risk on commodity futures markets as they hedge against currency fluctuations in currency markets.

EXPORT/IMPORT FINANCING International trade poses risks for both exporters and importers. Exporters risk not receiving payment after delivery, whereas importers fear that delivery might not occur once payment is made. Export and import financing methods: A. Advance Payment 1. Importer pays for merchandise before it is shipped. Used when two parties are unfamiliar with each other, the transaction is small, or the buyer has a poor credit rating. 2. Prior payment eliminates the risk of nonpayment, but creates the complementary risk of nonshipment—importers might pay for goods but not receive them. B. Documentary Collection 1. Bank acts as an intermediary without accepting financial risk. Used in ongoing business relationships between two parties. 2. A draft (bill of exchange) is a document ordering an importer to pay an exporter a specified sum of money at a specified time. A bill of lading is a contract between an exporter and a shipper that specifies merchandise destination and shipping costs. 3. After receiving the appropriate documents from the exporter, the exporter’s bank sends the documents to the importer’s bank. 4. Documentary collection reduces the risk of nonshipment because the packing list details the contents of the shipment, and the bill of lading is proof that the merchandise was shipped. The risk of nonpayment is increased because the importer does not pay until he receives the necessary documents. C. Letter of Credit 1. Importer’s bank issues a document stating that the bank will pay the exporter when the exporter fulfills the terms of the document. 2. Used when an importer’s credit rating is questionable, when the exporter needs it to obtain financing, and when a market’s regulations require it. 3. Banks issue letters of credit after an importer has deposited a sum equal to the value of the imported merchandise. The bank pays the exporter, but the deposit protects the bank if the importer fails to pay for the merchandise.

Ch 13: Selecting and Managing Entry Modes 4.

IV.

Several types of letters of credit: a. An irrevocable letter of credit allows the bank issuing the letter to modify its terms only after obtaining the approval of both exporter and importer. b. A revocable letter of credit can be modified by the issuing bank without obtaining approval from either the exporter or the importer. c. A confirmed letter of credit is guaranteed by both the exporter’s bank in the country of export and the importer’s bank in the country of import. 5. Letter of credit reduces the risk of nonshipment because of proof of shipment before payment. 6. Although risk of nonpayment is increased, this is more secure because the importer’s bank accepts nonpayment risk when it pays the exporter’s bank. Open Account 1. Exporter ships merchandise and later bills the importer. 2. Used for sales between two subsidiaries within an international company and when the parties are familiar with each other. 3. Reduces risk of nonshipment for importer but increases the risk of nonpayment for exporter.

CONTRACTUAL ENTRY MODES Some products simply cannot be traded in open markets because they are intangible. Companies can use a variety of contracts to market highly specialized assets and skills in international markets. A. Licensing 1. Contractual entry mode in which a company owning intangible property (the licensor) grants another firm (the licensee) the right to use that property for a specified period of time. 2. Licensors receive royalty payments based on a percentage of revenue generated by the property. Commonly licensed intangible property includes patents, copyrights, special formulas and designs, trademarks, and brand names. 3. Licensing often involves granting companies the right to use process technologies inherent to production. 4. Cross-licensing occurs when companies employ licensing agreements to swap intangible property (e.g., Fujitsu and Texas Instruments use crosslicensing to use each other’s technology, saving R&D costs). 5. Advantages a. Finance international expansion. b. Less risky method of international expansion. c. Can reduce likelihood of product appearing on black market. d. Licensees can upgrade existing production technologies. 6. Disadvantages a. Can restrict a licensor’s future activities. b. Might reduce the global consistency of the quality and marketing of a product. c. Might amount to “lending” strategically important property to future competitors. B. Franchising

Ch 13: Selecting and Managing Entry Modes 1.

Contractual entry mode in which one company (the franchiser) supplies another (the franchisee) with intangible property and assistance over an extended period of time. Franchisers typically receive compensation as flat fees, royalty payments, or both. 2. The brand name or trademark of a company is normally the single most important item desired by the franchisee. 3. Franchising differs from licensing in three ways: a. Gives greater control over sale of a product in a target market. b. Although licensing is fairly common in manufacturing industries, franchising is primarily used in the service sector. c. Although licensing normally involves a one-time transfer of property, franchising requires ongoing assistance from the franchiser. 4. Companies based in the United States dominate the world of international franchising. Franchising is growing in the EU with the single currency and a unified set of franchise laws. In Eastern Europe, expansion suffers from a lack of capital, high interest rates and taxes, bureaucracy, restrictive laws, and corruption. 5. Advantages a. Low-cost, low-risk mode of entry into new markets. b. Allows for rapid geographic expansion. c. Uses cultural knowledge and know-how of local managers. 6. Disadvantages a. Cumbersome to manage many franchisees in several nations. b. Franchisees can experience a loss of organizational flexibility in franchising agreements. Management Contracts 1. One company supplies another with managerial expertise for a specific period of time. The supplier of expertise is compensated with either a lump-sum payment or a fee based on sales. 2. Used to transfer two types of knowledge: (1) specialized knowledge of technical managers and (2) business-management skills. 3. Advantages a. Exploit an international opportunity but risk few physical assets. b. Nation can award contract to operate and upgrade public utilities when a nation is short of investment financing. c. Help nations develop skills of local workers and managers. 4. Disadvantages a. Places the lives of managers in danger in developing or emerging nations undergoing political or social turmoil. b. Suppliers of expertise may nurture a formidable new competitor in the local market. Turnkey Projects 1. Designing, constructing, and testing a production facility for a client. Are often large-scale and often involve government agencies. 2. Transfer special process technologies or production-facility designs to a client (e.g., power plants, telecommunications, petrochemical facilities). 3. Advantages a. Firm specializes in core competency to exploit opportunities. b. Governments can obtain designs for infrastructure from the world’s leading companies.

Ch 13: Selecting and Managing Entry Modes 4.

Disadvantages a. Company may be awarded a project for political reasons rather than for technological know-how. b. Can create future competitors.

INVESTMENT ENTRY MODES Investment entry modes entail the direct investment in plant and equipment in a country coupled with ongoing involvement in the local operation. A. Wholly Owned Subsidiaries 1. Facility entirely owned and controlled by a single parent company. Can establish by purchasing an existing company or by forming a new company from the ground up. 2. Whether an international subsidiary is purchased or newly created depends on its operations; for high-tech products, a company may build new facilities because state-of-the-art operations are hard to locate. 3. Major drawback of “greenfield” is the time it takes to construct new facilities, hire and train employees, and launch production. 4. Advantages a. Managers have complete control over day-to-day operations in the target market and over access to valuable technologies, processes, and other intangible properties within the subsidiary. b. Firm can coordinate activities of its national subsidiaries. 5. Disadvantages a. Expensive, so difficult for small- and medium-size firms. b. Requires substantial resources so risk exposure is high. B. Joint Ventures Separate company is created and jointly owned by two or more independent entities to achieve an objective. 1. Joint venture configurations a. Forward integration joint venture Parties invest together in downstream business activities. b. Backward integration joint venture Parties invest together in upstream business activities. c. Buyback joint venture Input provided by, and output absorbed by, each partner. d. Multistage joint venture One partner integrates downstream, and the other, upstream. 2. Advantages a. Can reduce risk. b. Penetrate international markets that are otherwise off-limits. c. Access another company’s international distribution network. d. Defensiveness: local government or government-controlled company gives authorities a direct stake in venture’s success. 3. Disadvantages a. Can result in conflict between partners. b. Loss of control over a joint venture’s operations can also result when the local government is a partner in the joint venture. C. Strategic Alliances 1. Two or more entities cooperate (but do not form a separate company) to achieve the strategic goals of each.

Ch 13: Selecting and Managing Entry Modes 2. 3. 4.

VI.

Like joint ventures, can be formed for short or long periods, depending on the goals of the participants. Can be established between a company and its suppliers, its buyers, and even competitors; sometimes each partner purchases the other’s stock. Advantages of strategic alliances a. Share the cost of an international investment project. b. Tap into competitors’ specific strengths. c. Similar reasons as for entering into joint ventures. Disadvantages of strategic alliances a. Can create a future local or even global competitor. b. Conflict can arise and eventually undermine cooperation.

STRATEGIC FACTORS IN SELECTING AN ENTRY MODE Because entering a new market requires an investment of time and money, and because of the strategic implications of the entry mode, selection must be done carefully. A. Selecting Partners for Cooperation 1. Each partner must be firmly committed to the stated goals of the cooperative arrangement. Detailing duties and contributions of each party through prior negotiations helps ensure continued cooperation. 2. Although the importance of locating a trustworthy partner seems obvious, cooperation should be approached with caution. 3. Each party’s managers must be comfortable working with people of other cultures and traveling to (perhaps even living in) other cultures. 4. A suitable partner must have something valuable to offer. Managers must evaluate the benefits of a potential international cooperative arrangement as they would any other investment opportunity. B. Cultural Environment 1. Culture can differ greatly, and managers can feel less confident in their ability to manage operations in the host country. 2. Company may avoid investment entry modes in favor of exporting or a contractual mode; cultural similarity encourages manager confidence and thus the likelihood of investment. 3. Importance of cultural differences diminishes when managers are knowledgeable about the culture of the target market. C. Political and Legal Environment 1. Political instability in a target market increases the risk exposure of assets. Significant political differences and instability cause companies to avoid large investments in favor of entry modes that shelter assets. 2. Target market’s legal system influences the choice of entry mode: certain import regulations such as high tariffs or low quota limits can encourage investment. 3. Company producing locally avoids tariffs that increase product cost; it does not have to worry about making it into the market below quota. 4. Governments may enact laws that ban certain types of investment. D. Market Size 1. Size of a potential market influences choice of entry mode. Rising incomes encourage investment entry because a firm can prepare for growing demand and better understand the target market. 2. Growing demand in China is attracting investment in joint ventures, strategic alliances, and wholly owned subsidiaries. Investors believing a market will remain small may prefer exporting or contractual entry.

Ch 13: Selecting and Managing Entry Modes E.

VII.

Production and Shipping Costs 1. By helping to control total costs, low-cost production and shipping can give a company an advantage. 2. Setting up production in a market is desirable when the total cost of production is lower than at home. Low-cost local production might encourage contractual entry through licensing or franchising. 3. Companies producing products with high shipping costs prefer local production; exporting is feasible when products have low shipping costs. International Experience 1. As companies gain international experience, they select entry modes that require deeper involvement. This also means that they must accept greater risk in return for greater control over operations and strategy. 2. They initially explore the advantages of licensing, franchising, management contracts, and turnkey projects. 3. Once they become comfortable in a market, joint ventures, strategic alliances, and wholly owned subsidiaries become viable options. 4. Advances in technology and transportation allow small companies to undertake entry modes requiring more commitment to the local market.

A FINAL WORD This chapter explains important factors in selecting entry modes and key aspects in their management. It details the circumstances in which each entry mode is most appropriate and the advantages and disadvantages that each provides. The choice of which entry mode(s) to use in entering international markets should match a company’s international strategy. Some companies want entry modes that give them tight control over activities abroad because they are pursuing a global strategy. Another company might not require an entry mode with central control because it is pursuing a multinational strategy. The entry mode must also be chosen to align well with an organization’s structure.

Quick Study Questions Quick Study 1 1.

Q: What are the four steps, in order, involved in creating an export strategy? A: Companies should not simply respond to international requests for their products, but develop a detailed export strategy. First, they should identify a potential market. In order to identify clearly whether demand exists in a particular target market, market research should be performed and results interpreted. Second, they should match the needs of the market to their abilities to satisfy the needs of the market. Third, they should initiate meetings. Early meetings with potential distributors, buyers, and others are a must. Initial contact should focus on building trust and a cooperative climate among all parties. Beyond building trust, successive meetings are designed to estimate the potential success of any agreement if interest is shown on both sides. Fourth, they must be willing to commit the resources needed to get the job done. After all the meetings, negotiations, and contract signings, it is time to put the company’s human, financial, and physical resources to work.

Q: When a company sells its products to intermediaries who then resell to buyers in a target market it is call what?

Ch 13: Selecting and Managing Entry Modes

A: Indirect exporting occurs when a company sells its products to intermediaries who then resell to buyers in a target market. Indirect exporters can use several different types of intermediaries including agents, export management companies, and export trading companies. 3.

Q: What is the name of a specific type of countertrade? A: Countertrade is the practice of selling goods or services that are paid for, in whole or part, with other goods or services. Countertrade can provide access to markets that are otherwise off-limits because of a lack of hard currency. 1. Barter is the exchange of goods or services directly for other goods or services without the use of money. 2. Counterpurchase is the sale of goods and services to a country by a company that promises to make a future purchase of a specific product from that country. 3. Offset is an agreement that a company will offset a hard-currency sale to a nation by making a hard-currency purchase of an unspecified product from that nation in the future. 4. Switch trading is countertrade whereby one company sells to another its obligation to make a purchase in a given country. 5. Buyback is the export of industrial equipment in return for products produced by that equipment.

Quick Study 2 1.

Q: Export/import financing that presents the most risk for exporters is called what? A: Open account is export and import financing in which an exporter ships merchandise and later bills the importer for its value. Open account reduces the risk of nonshipment that the importer faces under the advance payment method. However, it increases the risk of nonpayment for exporters.

Q: Export/import financing in which a bank acts as an intermediary without financial risk is called what? A: Documentary collection is export and import financing in which a bank acts as an intermediary without accepting financial risk. This method is common when there is an ongoing business relationship between two parties.

Q: Export/import financing in which the importer’s bank issues a document stating that the exporter will get paid when it fulfills the terms of the document is called what? A: A letter of credit is export/import financing in which the importer’s bank issues a document stating that the bank will pay the exporter when the exporter fulfills the terms of the document.

Quick Study 3 1.

Q: What is the name of a specific type of contractual entry mode? A: A company can use a variety of contractual modes, such as, licensing, franchising, management contracts, and turnkey projects to market highly specialized assets and skills in markets beyond its national borders.

Q: What is it called when companies use agreements to exchange intangible property?

Ch 13: Selecting and Managing Entry Modes A: Licensing is a contractual entry mode in which a company owning intangible property (the licensor) grants another firm (the licensee) the right to use that property for a specified period of time.

Q: A disadvantage of both management contracts and turnkey projects is what? A: A disadvantage of both management contracts and turnkey projects is that a future competitor may be created.

Quick Study 4 1.

Q: What is the name of a specific type of investment entry mode? A: There are three common forms of investment entry modes: wholly owned subsidiary, joint ventures, and strategic alliances

Q: A wholly owned subsidiary is a facility owned and controlled by what? A: A wholly owned subsidiary is a facility entirely owned and controlled by a single parent company.

Q: What is the name of a specific type of joint venture? A: A joint venture is a separate company that is created and jointly owned by two or more independent entities to achieve a common business objective. In the forward integration joint venture, the parties choose to invest together in downstream business activities. In the backward integration joint venture, the parties choose to invest together in upstream business activities. In the buyback joint venture, its input is provided by and output is absorbed by each of its partners. In the multistage joint venture, one partner integrates into downstream activities and one partner integrates into upstream activities.

Q: A strategic alliance is similar to a joint venture except for that it doesn’t involve what? A: A strategic alliance is similar to a joint venture except for that it doesn’t involve the formation of a separate firm.

Quick Study 5 1.

Q: When selecting a partner for cooperation it is important to remember what? A: Every partner must be firmly committed to the goals of the venture or agreement. Trust is also important, so that often firms naturally prefer to partner with firms that they have had a favorable experience in the past, Finally, in an international arrangement, each party’s managers must also be comfortable working with people of other cultures and with traveling to (even perhaps living in) other cultures, and a suitable partner must have something valuable to offer the company.

Q: What factors may discourage an investment entry mode? A: The factors to be considered are the cultural environment, the political and legal environment, market size, production and shipping costs, and the firms level of international experience.

Q: What factors may encourage an investment entry mode? A: Just as the factors listed to discourage investment, in turn they could also serve to encourage investment entry modes.

Ch 13: Selecting and Managing Entry Modes

Ethical Challenge You are chief operating officer of a U.S.-based telecommunications firm considering a joint venture inside China with a Chinese firm. The consultant you hired to help you through the negotiations has just informed you that ethical concerns can arise when international companies consider a cooperative form of market entry (such as a joint venture) with a local partner in any market. This is especially true when each partner contributes personnel to the venture because cultural perspectives cause people to see ethical dilemmas differently. This is of special concern to you because the venture had planned to employ people from both China and the United States. In light of this recent information, you are reassessing your entry mode options. 13-5 Do you think your two companies can establish a set of ethical principles before commencing operations that will guide a potential joint venture? 13-6 What ethical issues might arise in conjunction with other entry modes discussed in this chapter? 13-7 Is there a company that succeeded under circumstances that are similar to those that your firm faces? A: There are many differences between the U.S. and Chinese cultures that can add to the complexity of a joint venture agreement. The differences in saving face, low versus high context culture, and individualism between U.S. and Chinese workers should be considered when developing any cooperative policies. These differences can lead to ethical misconceptions due to different behavioral expectations. Further, up-front and frank discussions of potentially damaging ethical issues can help avoid potentially disastrous results based in ethical dilemmas. Better late than never if the formation has already taken place. Teaming Up Negotiation Project. This project is designed to introduce you to the complexity of negotiations and to help develop your negotiating skills. Background: A Western European automobile manufacturer is considering entering markets in Southeast Asia. The company wants to construct an assembly plant outside Ho Chi Min City, Vietnam, to assemble its lower-priced cars. Major components would come from manufacturing plants in Brazil, Poland, and China. The cars would then be sold in emerging markets throughout Southeast Asia and the Indian subcontinent. Managers are hoping to strike a $100 million joint venture deal with Vietnam’s government. The company would supply technology and management for the venture, and the government would contribute a minority share of financing to the venture. The company considers the government’s main contributions to be providing tax breaks (and other financial incentives) and a stable business environment in which to operate. Financial capital is flowing into Vietnam at a fair pace. The currency is strong, and inflation remains low. As with other nations in the region, investors are generally wary of the nation’s stability. The new auto assembly plant would boost the local economy, reduce unemployment, and increase local wages. But some local politicians fear the company might be interested only in exploiting the country’s relatively low-cost labor. Activity: Break into an equal number of negotiating teams of three or four persons. Half the teams are to represent the company and the other half the government. As a group, meet for 15 minutes to develop the team’s opening position and negotiating strategy. Meet with a team from

Ch 13: Selecting and Managing Entry Modes

the other side and undertake 20 minutes of negotiations. After the negotiating session, spend 15 minutes comparing the progress of your negotiations with that of the other pairs of teams. A: This exercise can teach students to evaluate investment projects not only from the standpoint of companies, but also from the perspective of governments. If taken very seriously, the students will also be able to judge their abilities as international negotiators. Practicing International Management Case Telecom Ventures Unite the World 13-10 Q: What strengths did AT&T bring to its joint venture with Unisource? A: AT&T offered a globally recognized brand name and a presence in practically every major market worldwide except Latin America. AT&T also had significant experience in developing international relationships as well as the firm’s association with WorldPartners. 13-11 Q: Can you think of any potential complications that could arise in the AT&T–Unisource joint venture? A: Perhaps the greatest potential danger is the potential for complications caused by the fact that there are so many partners involved in the venture. Not only can there be conflicts over the direction and goals of the venture, but also partners exiting and entering can cause a loss of strategic focus and intent. Just as things begin going well, one partner may leave or another one may join with different motivations. 13-12 Q: Assess the formation of Global One, Unisource, and other partnerships in this case. Which strategic factors might have influenced the entry mode choices that these firms made? A: Students should be sure to cover at least the main points listed near the end of the chapter. They should also be encouraged to present other factors that they consider potentially important. Specifically, cultural, legal, regulatory, and technological competencies in each scenario should be assessed and evaluated.

CHAPTER 14 DEVELOPING AND MARKETING PRODUCTS LEARNING OBJECTIVES: 1. Describe the factors to consider in developing international product strategies. 2. Outline the international promotional strategies and methods available to firms. 3. Explain the factors to consider when designing international distribution strategies. 4. Describe the two main international pricing strategies and factors to consider.

CHAPTER OUTLINE: Introduction Developing Product Strategies Laws and Regulations Cultural Differences Brand and Product Names Selecting International Brand and Product Names National Image Counterfeit Goods and Black Markets Shortened Product Life Cycles Creating Promotional Strategies Push and Pull Strategies International Advertising Standardizing or Adapting Advertisements Case: The Elusive Euro-Consumer Blending Product and Promotional Strategies Communicating Promotional Messages Product/Communications Extension (Dual Extension) Product Extension/Communications Adaptation Product Adaptation/Communications Extension Product/Communications Adaptation (Dual Adaptation) Product Invention Designing Distribution Strategies Designing Distribution Channels Degree of Exposure Channel Length and Cost Influence of Product Characteristics Special Distribution Problems Lack of Market Understanding Theft and Corruption Developing Pricing Strategies Worldwide Pricing Dual Pricing Factors That Affect Pricing Decisions Transfer Prices Arm’s Length Pricing Price Controls Dumping

A Final Word

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 14. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION Globalization affects international business activities, industries, and products differently. Some companies market an identical product worldwide, whereas others must adjust marketing strategies across national markets.

II.

DEVELOPING PRODUCT STRATEGIES A. Laws and Regulations 1. Companies must adapt their products to satisfy laws and regulations in a target market. 2. The fact that many developing countries have fewer consumer-protection laws creates an ethical issue; lower levels of education and experience mean that consumers need protection. 3. Many governments impose fewer regulations to hold down production costs and consumer prices. B. Cultural Differences 1. Companies sometimes must adapt their products to suit local buyers’ preferences rooted in culture. 2. Not all companies modify products but find a different cultural need that it satisfies. C. Brand and Product Names 1. Brand name is the name of one or more items in a product line that identifies the source or character of the items. Consumers assign products a certain value based on experiences with a brand. 2. Brand names help consumers select, recommend, or reject products; they also function as legal property that owners can protect from competitors. 3. A consistent worldwide brand image is important as more consumers and businesspeople travel internationally. 4. Companies must review its brand image and update it if needed. 5. Selecting international brand and product names a. Products in international markets need carefully selected names whether standardized or localized. b. Company and product names are made up of morphemes—semantic elements, or language building blocks. c. Brand names seldom offend people in international markets, but product names do. D. National Image 1. Value customers obtain from a product is influenced by the image of the country in which it is designed, manufactured, or assembled. 2. Image can be positive for some products but negative for others.

Because it affects buyers’ perceptions of quality and reliability, national image is an important element of product policy. 4. National image can and does change over time. Counterfeit Goods and Black Markets 1. Counterfeit goods are imitation products passed off as legitimate trademarks, patents, or copyrighted works. 2. Counterfeit brand name consumer goods, such as watches, perfumes, clothing, movies, music, and computer software are sold to consumers on the black market. 3. Topping the list for counterfeits: China, India, Russia, Thailand, and Turkey. Counterfeiting is worth tens of billions globally each year. 4. Counterfeit goods can damage buyers’ images of a brand when the counterfeits are of inferior quality to the original. Buyers who purchase a brand expect a level of craftsmanship and satisfaction; when the product fails to deliver on expectations, the buyer is dissatisfied and the company’s reputation is tarnished. Shortened Product Life Cycles 1. Companies traditionally managed to extend a product’s life by introducing it into different markets consecutively; products were first in industrialized countries and later in developing markets. 2. Advances in telecommunications have alerted consumers around the world to the latest product introductions; consumers in developing and emerging markets demand the latest products. 3. Companies now undertake new product development at a rapid pace and shorten product life cycles. 3.

III.

CREATING PROMOTIONAL STRATEGIES Efforts by companies to reach distribution channels and target customers through communications such as personal selling, advertising, public relations, and direct marketing are called its promotion mix. A. Push and Pull Strategies 1. Pull strategy: Create buyer demand that will encourage channel members to stock a company’s product. Buyer demand is generated in order to “pull” products through distribution channels to end-users. 2. Push strategy: Pressure channel members to carry a product and promote it to final users. Manufacturers of products sold in department and grocery stores often use a push strategy. 3. The strategy to use depends on the type of distribution system, access to mass media, and the type of product. a. Distribution system: Implementing a push strategy is difficult when channel members wield a great deal of power relative to that of producers. It can be ineffective when distribution channels are lengthy. It might be easier to use a pull strategy. b. Access to mass media: Developing and emerging markets have fewer forms of mass media, making it difficult to increase consumer awareness and generate product demand. Many consumers cannot afford cable or satellite television, or glossy magazines, so advertisers use billboards and radio. c. Type of product: A pull strategy is appropriate when buyers display brand loyalty; brand-loyal buyers know what they want before they buy it. Push strategies are appropriate for inexpensive consumer goods for

buyers who are not brand loyal; low brand loyalty means that a buyer purchases one of the brands carried by the retailer. International Advertising International advertising differs from domestic advertising. Cultural similarities mean that ads are only slightly modified in different nations. Cultural differences may mean that entirely new ads must be created. 1. Standardizing or adapting advertisements a. Most advertising in any one nation is produced solely for that domestic audience. Companies that advertise in multiple markets must determine the aspects of the advertising campaign that can be standardized and those that cannot. b. To pursue a global marketing strategy, a company tries to get the most for its advertising expenditure. An increasingly popular method is marketing over the World Wide Web. Companies that use direct marketing (such as telemarketing or leaflets through the mail) have had mixed results with Web ads. c. Companies reach a global audience by sponsoring global sporting events, such as the Olympics, World Cup Soccer, and Formula One automobile racing. 2. Case: The Elusive Euro-Consumer a. The integration of EU nations causes marketers to think they can standardize advertising to appeal to the Euro-consumer. b. Advertising agencies have tried a pan-European advertising approach only to fail due to national differences; Europe’s many languages create translation issues for marketers. c. Successful pan-European ads contain visuals, few words, and a focus on the product. Blending Product and Promotional Policies When companies extend marketing to international markets, they develop communication strategies that blend product and promotional policies. A company’s communication strategy for a market considers the nature of the product and the promotion mix. There are five product/promotional methods. 1. Communicating promotional messages a. Marketing communication is the process of sending promotional messages about products to target markets. b. Marketing internationally often means translating promotional messages from one language to another. Marketers must also be knowledgeable of cultural nuances that affect how buyers interpret a promotional message. c. Laws that govern promotion in another country can force changes in marketing communication. d. Marketing communication is typically considered a circular process (Figure 14.1): i. The company with an idea to communicate is the source. ii. The idea is encoded (translated into images, words, and symbols) into a promotional message. iii. The promotional message is sent to the audience (potential buyers) through various media—radio, television, newspapers, magazines, billboards, and direct mailings. The audience receives the message, decodes the message, and interprets its meaning.

iv.

Information in the form of feedback (purchase or nonpurchase) flows to the source of the message. v. The decoding process can be disrupted by the presence of noise—anything that disrupts the audience’s ability to receive and interpret the promotional message. Language barriers between the company and potential buyers create noise if a company’s promotional message is incorrectly translated into the local language. Product/communications extension (dual extension) a. Extends the same home-market product and marketing promotion into target markets. Under certain conditions, it can be the simplest and most profitable strategy. b. May grow more popular as the information age ties the world together. Best suited for companies that use a global strategy; upscale personal items with global brand names. c. Useful to companies who are low-cost leaders in their industries; one product and one promotional message keep costs down. Product extension/communications adaptation a. Extends the same product into new target markets, but alters its promotion. Communications require adaptation because the product satisfies a different need, serves a different function, or appeals to a different type of buyer. b. Contains costs because the product does not undergo any alterations; developing new promotional campaigns is expensive. c. Low economic development can demand that communications be adapted to local conditions. In developing countries, television and radio coverage are limited and the Web is years behind; marketers use door-todoor personal selling and regional product shows or fairs. Product adaptation/communications extension a. Requires a company to adapt its product to the international market yet retain the original marketing communication. b. Company may adapt its product for reasons such as legal requirements in the local market. Governments can require certain local materials, labor, or other resources in local production process; if the same materials are not available locally, the product may be modified. c. Can be costly, especially if a company invests in production facilities to remain close to changing buyer preferences. It can be successful if a firm sells a differentiated product and charges a higher price to offset production costs. Product/communications adaptation (dual adaptation) a. Adapts a product and its marketing communication to suit the target market. The product itself is adapted to match the needs or preferences of local buyers. The promotional message is adapted to explain how the product meets those needs and preferences. b. High cost means few companies employ this strategy; it can be implemented successfully if a large and profitable market segment exists. Product invention a. Requires that an entirely new product be developed for the target market. Product invention is necessary when many differences exist between the domestic and target markets.

b. c. IV.

One reason for invention is that local buyers cannot afford a product because of low purchasing power. Product inventions can arise due to lack of infrastructure.

DESIGNING DISTRIBUTION STRATEGIES Planning, implementing, and controlling the physical flow of a product from its point of origin to its point of consumption is called distribution. The physical path that a product follows on its way to customers is called a distribution channel. Companies along this channel that work together in delivering products to customers are called channel members or intermediaries. Manufacturers of goods are not the only producers who need distribution channels; service providers such as consulting companies, health-care organizations, and news services need distribution. Companies develop their international distribution strategies based on two related decisions: (1) how to get the goods into a country and (2) how to distribute goods within a country. A. Designing Distribution Channels When managers establish distribution policies, they consider the market exposure needed and the cost of distribution. 1. Degree of exposure a. Exclusive channel: Manufacturer grants the right to sell its product to one or a limited number of resellers. Gives control over sales to channel members such as wholesalers and retailers; this helps constrain distributors from selling competing brands. b. An exclusive channel creates a barrier that makes it difficult or impossible for outsiders to penetrate the channel. c. Intensive channel: Producer grants the right to sell its product to many resellers. Provides convenience because of the many outlets through which a product is sold. It does not create strong barriers to channel entry, nor provide control over reseller decisions such as what competing brands to sell. d. Obstacle for small companies that choose intensive channels is gaining shelf space. This is exacerbated by the increasing global trend toward retailers developing their own private label brands—brands created by retailers themselves. 2. Channel length and cost a. Channel length refers to the number of intermediaries between the producer and the buyer. b. Zero-level channel (called direct marketing): producers sell directly to final buyers. c. One-level channel: One intermediary between producer and buyer. Two intermediaries make up a two-level channel, and so on. d. The more intermediaries, the more costly it becomes because each one adds a fee for services. B. Influence of Product Characteristics 1. Value density: Value of a product relative to its weight and volume; an important variable in formulating distribution policies. 2. As a rule, the lower a product’s value density, the more localized the distribution system. Commodities have low value-density ratios—value is low relative to their cost of shipping.

Products with high value-density ratios include emeralds, semiconductors, and premium perfumes. Because the cost of transporting these products is small relative to their values, they can be processed or manufactured and then shipped. Special Distribution Problems A country’s distribution system develops over time and reflects its unique cultural, political, legal, and economic traditions. The distribution system of each nation has its own unique pros and cons. 1. Lack of marketing understanding This can create frustration and financial loss for companies. 2. Theft and corruption This can present major obstacles to distribution.

DEVELOPING PRICING STRATEGIES The pricing policy must match a company’s overall international strategy. A. Worldwide Pricing 1. Establishes one selling price for all international markets. 2. Difficult to achieve for four reasons: a. Production costs differ from one nation to another. b. Producing in just one location cannot guarantee the same selling price in international markets because of the different cost of reaching different markets. c. Purchasing power of local buyers must be considered. d. Fluctuating currency values can affect a product’s price abroad. B. Dual Pricing 1. Product has a different selling price (typically higher) in export markets than it has in the home market. 2. When a product has a higher selling price in the target market than it does in the home market, it is called price escalation, which results from exporting costs and currency fluctuations. 3. Product’s export price may be lower than the price in the home market. 4. Some companies decide that domestic sales are to cover expenses for R&D, administration, and overhead; exports cover only additional costs associated with exporting and selling in a target market (e.g., tariffs). 5. To apply dual pricing in international marketing, a company must keep domestic and international buyers separate. If a company cannot keep its buyers separate, they could undermine the policy through arbitrage—buying products at lower prices and reselling them at higher prices. C. Factors That Affect Pricing Decisions Several key factors affect pricing decisions. 1. Transfer prices a. Price of products between a company and a subsidiary. b. Companies enjoyed freedom in setting transfer prices; subsidiaries in countries with high taxes charged a low price for outputs to subsidiaries. The subsidiary lowered the parent company’s taxes by reducing profits in the high-tax country. c. Large firms used transfer pricing to manage their global taxes and become more price-competitive. 2. Arm’s length pricing a. Free-market price that unrelated parties charge one another. b. Although companies had great latitude in assigning transfer prices, many governments are assigning them arm’s length prices to clamp down on

VI.

tax evasion. There is also pressure on companies to be good corporate citizens in target markets. c. Developing and emerging markets are hurt by lost revenue when international companies manipulate prices to reduce tariffs and corporate taxes. Need revenue for schools, hospitals, and infrastructure. These, in turn, benefit companies by improving the productivity and efficiency of the local business environment. Price controls a. Upper or lower limits placed on the prices within a country. b. Upper-limit price controls provide price stability in an inflationary economy (when prices are rising). Companies that want to raise prices must apply to government authorities. c. Lower-limit price controls prohibit the lowering of prices below a certain level. d. Governments impose lower-limit prices to help local companies compete against the less expensive imports of international companies or to ward off price wars. Dumping a. Price of a good is lower in export markets than in the domestic market. b. Accusations of dumping are often made against foreign competitors when inexpensive imports flood a domestic market. c. Although charges of dumping normally result from deliberate efforts to undercut the prices of competitors in the domestic market, changes in exchange rates can cause unintentional dumping. d. Antidumping tariffs punish producers in the offending nation by increasing the price of their products.

A FINAL WORD Despite the academic debate over globalization and the extent to which companies should standardize their international marketing activities, many companies continue to adapt to local conditions. Sometimes this takes the form of only slightly modifying promotional campaigns and at other times it can require the creation of an entirely new product. The causes of alterations in promotional aspects of marketing strategy can be cultural, such as language differences. They can also be legal such as requirements to produce locally so as to help ease local unemployment. Some companies benefit from standardization and centralized production obtained by selling one product worldwide.

Quick Study Questions Quick Study 1 1.

Q: Deciding whether to keep a marketing strategy the same or modify it a broad is also known as what? A: This dilemma is referred to as the standardization versus adaptation decision. U.S. researcher Theodore Levitt argued that because the world is becoming standardized and homogeneous, companies should market the same products in the same way in all countries. Technology, he claimed, causes needs and preferences to converge throughout the world. Others say that standardization is just one of many strategies to enter the international marketplace successfully. They argue that standardization is not always the best strategy and advise smaller companies to adapt to local cultures while exploiting their unique images to gain local market share. Globalization is transforming the way some products are marketed internationally. Some companies implement a global strategy that uses similar promotional messages and themes to market the same product around the world. Those companies can reduce production and marketing costs by standardizing the physical features of their products and marketing strategies. Others find that their products require physical changes to suit the tastes of consumers abroad. Consumers in different national markets demand products that reflect their tastes: cultural, political, legal, and economic environments affect consumer preferences and industrial buyers worldwide. Certain products do appeal to practically all cultures. Product standardization is more likely when nations share the same level of economic development.

Q: What factors influence a country’s international product strategy? A: Many factors influence a company’s product policies. First, laws and regulations of the target market can force product alteration. Cultural differences between the home and host markets can force adaptations in products to suit local buyers’ product preferences. National image of the country in which a product is designed, manufactured, or assembled can have a strong influence on the value that customers obtain from a product. It affects buyers’ perceptions of quality and reliability. Counterfeit goods can damage buyers’ images of a brand because counterfeits are often of inferior quality to the original product. Companies historically entered international markets on a sequential basis and could therefore greatly extend their products’ life cycles. But new product development at an increasingly rapid pace is shortening the life cycles of products.

Q: What product characteristic is more likely than others to offend people in another country? A: Whether they are standardized or adapted locally, products in international markets need carefully selected brand names. Brand names seldom offend people in international markets, but brand names can be highly offensive if they are not researched and selected.

Quick Study 2 1.

Q: A strategy that pressures channel members to carry and promoted a product is called what? A: A push strategy is a promotional strategy designed to pressure channel members to carry a product and promote it to final users.

Q: Firms that standardize international advertising often control campaigns from where? A: Firms that standardize their advertising tend to control campaigns from the home office.

Q: The process of sending promotional messages about products to target markets is called what? A: The process of sending promotional messages about products to target markets is called marketing communication. Communicating the benefits of a product can be more difficult in international business than domestic business for at least several reasons. Marketing internationally usually means translating promotional messages from one language into another. Marketers must also be knowledgeable of many cultural nuances that can affect how buyers interpret a promotional message. A nation’s laws that govern the promotion of products in another country can also force changes in marketing communication.

Quick Study 3 1.

Q: What type of channel grants the right to sell a product to many resellers? A: An intensive channel is one in which a producer grants the right to sell its product to many resellers.

Q: In terms of channel length, direct marketing is known as what? A: Direct marketing is referred to as a zero-length channel because the producers sell directly to final buyers

Q: A product with a low value density tends to have a distribution system that is more what? A: The value of a product relative to its weight and volume is called its value density. Value density is an important variable in formulating distribution policies. As a rule, the lower a product’s value density, the more localized the distribution system.

Quick Study 4 1.

Q: What makes worldwide pricing difficult to achieve? A: A pricing policy in which one selling price is established for all international markets is called worldwide price. This is very difficult to achieve for the following reasons: First, keeping products costs the same is not possible for a company that has production bases within each market that it serves. As a result, selling prices will reflect the different costs of production. Second, a company that produces in just one location cannot guarantee that selling prices will be the same in every target market. The cost of exporting could be different in each country. Third, the purchasing power of local buyers must be taken into account. A lower price might be applied so that buyers could afford the product and the company can gain market share. Finally, currency fluctuations need to be considered. When the value of the currency in a country where production takes place rises against a target market’s currency, the product will become more expensive in the target market.

Q: To apply dual pricing successfully, how must a firm treat its domestic and international buyers? A: Worldwide pricing sets one selling price for all international markets. Dual pricing is a pricing policy in which a product has a different selling price (typically higher) in export markets than it has in the home market. It is typically the result of price escalation resulting from exporting costs and currency fluctuations.

Q: Parent firms and subsidiaries often transfer products among themselves as a price called what? A: A transfer price is the price charged for products transferred between a company and its subsidiaries.

Ethical Challenge You are a lawyer working with the International Court of Justice in The Hague in the Netherlands. Your task is to review a recent decision by a U.S. judge regarding extraterritoriality. The case: French survivors of the Holocaust sued Yahoo USA because French citizens were purchasing Nazi memorabilia on Yahoo’s U.S. website. The lawsuit also charged Yahoo USA with hosting the websites of anti-Semitic groups. Although both these actions are illegal according to French law, they are permitted in the United States because of U.S. legislation protecting free speech. Because Yahoo’s French website did not violate French law, the U.S. federal judge hearing the case threw it out. The judge ruled that French law does not have the right to dictate the behavior of U.S. firms operating inside the United States. Today, the Internet can make it difficult to determine where jurisdictions begin and end. 14-5 If you had been the U.S. judge in this case, would you have ruled similarly? Explain. 14-6 What factors most influenced your decision? 14-7 Do you know of any Internet controls that companies or governments can use to stop such cases from occurring in the future? A: There are a number of ways to view this dilemma. From the U.S. perspective, French law does not have jurisdiction over the operations of U.S. firms within their own country. Although with the Internet it does become a challenge at times to determine the exact area of operations of a Web site. Thus, from the French perspective it could be argued that because French citizens can access Yahoo.com (as opposed to Yahoo.fr in France), their laws apply. The Yahoo! managerial perspective must be considered as well. Is this negative publicity worth the marginal income for Yahoo!? Finally, the individuals who accessed the Nazi Web sites as well as the creators of these sites and sellers of memorabilia should be factored in to a final decision.

Teaming Up Products often service different needs, appeal to different buyers, or are perceived differently in different markets. Consider a good or service that is sold in your country and another using different marketing strategies in each. One of the countries must be the countries home market. 14-8 In the home market, was the product’s initial introduction a new innovation or an extension of an existing product? 14-9 From the product’s home market, which one of the five product and promotion methods was used in the other market? 14-10 What factors likely explain why the company selected that particular method? A: Students might need to do some further research into the company’s business activities before answering this question fully. Practicing International Management Case Psychology of Global Marketing 14-13 Q: If you were Stephan Loerke, of the World Federation of Advertisers, how would you argue for the EU to enact more strict advertising laws?

A: Students should recognize the highly political debate that will arise within the EU. Some may feel that it is foolish to enact new laws if they cannot be enforced. Sweden cannot currently control the broadcasts of other nations that are accessed by satellite. If members of the EU could agree on “voluntary” limits just the way that members agreed to institute the euro or accept certain standards for products, then the problem could be controlled. However, agreement on advertising in the EU would be difficult. 14-14 Q: Do you personally agree with the case you made above? A: Students responses will vary based on their own personal value system. 14-15 Q: Thinking of a specific product sold in industrialized nations, do you think it could create more than it satisfies needs if it were marketed in a developing country? A: Ads can indeed create wants. The cell phone is a good example. Before cell phones were available, the landline telephone sufficed. In developing countries, there are fewer telephones per person, but telephone access was generally possible. Now, it seems that every young person around the world wants a cell phone with all the bells and whistles and personalized, designer outer shells. The ethical issue is whether companies are creating wants in some countries that should instead be focusing on the more basic needs of young people, such as education and health.

CHAPTER 15 MANAGING INTERNATIONAL OPERATIONS LEARNING OBJECTIVES: 1. Describe the elements to consider when formulating production strategies. 2. Outline the issues to consider when acquiring physical resources. 3. Identify the key production matters that concern managers. 4. Explain the potential ways to finance business operations. CHAPTER OUTLINE: Introduction Production Strategy Capacity Planning Facilities Location Planning Location Economies Centralization versus Decentralization Process Planning Standardization versus Adaptation Facilities Layout Planning Acquiring Physical Resources Make-or-Buy Decision Reasons to Make Lower Costs Greater Control Reasons to Buy Lower Risk Greater Flexibility Market Power Barriers to Buying Raw Materials Fixed Assets Key Production Concerns Quality Improvement Efforts Total Quality Management ISO 9000 Shipping and Inventory Costs Reinvestment versus Divestment Financing Business Operations Borrowing Issuing Equity Issuing American Depository Receipts Advantages of ADRs Venture Capital Emerging Stock Markets Internal Funding Internal Equity, Debt, and Fees Revenue from Operations Capital Structure

Ch 15: Managing International Operations

A Final Word

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 15. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION Essential to success in international markets are production strategies, including the decision to centralize or decentralize production and standardize or adapt production to national markets.

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PRODUCTION STRATEGY Careful planning of production helps companies cut costs to become low-cost leaders and to design new products or product features necessary for a differentiation strategy. A. Capacity Planning 1. Assessing a company’s ability to produce enough output to satisfy market demand. 2. If capacity now used is greater than the expected market demand, production must be scaled back. 3. Countries have different laws regulating the ability of employers to eliminate jobs; depending on the country, a firm may or may not need to give advance notice of layoffs or plant closings. 4. If market demand is growing, managers must determine in which facilities to expand production or whether additional facilities are needed to expand capacity. 5. Capacity planning is also extremely important for service companies. B. Facilities Location Planning 1. Selecting a location for production facilities. 2. Key environmental factors in planning include the cost and availability of labor and management, raw materials, component parts, and energy. Other factors include political stability, the extent of regulation and bureaucracy, economic development, and the local culture, including beliefs about work and important traditions. 3. Reducing production costs through lower wages is often essential to keep products at competitive prices, especially when labor accounts for a large portion of total production. Lower wages must be balanced against worker productivity, which is lower in developing and emerging nations. 4. Service companies must locate near their customers and consider customers’ needs when locating facilities. 5. Supply issues are important in location planning; the greater the distance between production facilities and target markets, the longer it takes for customers to receive shipments. 6. Marketing managers must compensate for delays by maintaining larger inventories in target markets—adding to storage and insurance costs.

Ch 15: Managing International Operations 7.

Shipping costs are greater when production is conducted far from target markets. Transportation costs are a driving force behind the globalization of the steel industry. 8. Location economies a. Economic benefits derived from locating production activities in optimal locations. b. Companies undertake business activities in a location or obtain products and services from companies located there. c. The key fact is that each production activity generates more value in a particular location than could be generated elsewhere. The productivity of a location is heavily influenced by labor and capital. 9. Centralization versus decentralization a. Centralized production refers to the concentration of production facilities in one location. Decentralized production spreads facilities over several locations and could mean one facility for each business environment. b. Companies often centralize production facilities in pursuit of low-cost strategies and to take advantage of economies of scale. c. Transportation costs and the physical landscape affect the centralization versus decentralization decision. d. Because they typically sell undifferentiated products in all markets, low-cost competitors do not need to locate near their markets to respond to changes in buyer preferences. They choose locations with the lowest combined production and transportation costs. e. Firms must balance the cost of getting inputs into production and getting products to market. f. Companies with differentiated products find decentralized production the better option; locating separate facilities near different markets, they remain close to customers and respond to buyer preferences. g. When R&D and manufacturing must cooperate for differentiation, they tend to be located in the same place, although today technology allows for separate locations. Process Planning 1. Deciding the process a company will use to create its product. 2. Low-cost strategies require large-scale production because producers want the cost savings of economies of scale. 3. Differentiation strategies demand extra value by offering something unique, such as superior quality, added features, or special brand images. 4. Availability and cost of labor in the local market is crucial to process planning; if labor in the host country is cheap, a company opts for less technology and more labor-intensive methods in production. 5. Standardization versus adaptation a. Production processes must be standardized or adapted for different markets. b. Large production batches reduce the cost of producing each unit, offsetting the higher initial investment in automation; costs are further reduced as employees repeat the process and learn.

Ch 15: Managing International Operations c.

III.

Differentiation demands decentralized facilities to improve local responsiveness; these facilities produce for a national or regional market and tend to be smaller. Eliminates economies of scale and increases per-unit production costs. R&D costs are higher for products with special product designs, styles, and features. Facilities Layout Planning 1. Deciding the spatial arrangement of production processes within production facilities. 2. Facility layout depends on the type of production process, which depends on a company’s business-level strategy.

ACQUIRING PHYSICAL RESOURCES International companies must acquire physical resources to begin operations. They must decide whether to make or buy the components for production processes. What will be the sources of any required raw materials? Will the company acquire facilities and production equipment or build its own? A. Make-or-Buy Decision Deciding whether to make a component or buy it from another company. 1. Reasons to make Vertical integration is the process by which a company extends its control over additional stages of production—either inputs or outputs. When a company makes a product, it engages in “upstream” activities: Production activities that precede current business operations. a. Lower costs i. The company decides to make the products rather than buy them in order to reduce total costs. ii. Companies use in-house production when it costs less than buying on the open market. iii. Small companies are less likely to make rather than buy, except if the company possesses technology or another competitive advantage. b. Greater control i. Making rather than buying can give managers greater control over raw materials, product design, and the production process itself—all of which are important factors in product quality. ii. Companies often undertake in-house production when persuading a supplier to make special modifications to a product on their behalf is difficult. iii. Companies keep greater control over product design and features if they manufacture components themselves. iv. Companies also make rather than buy when buying requires providing key technology. 2. Reasons to buy a. Outsourcing is the practice of buying from another company a good or service that is not central to a company’s competitive advantage. Outsourcing results from continuous specialization and technological advancement. b. By outsourcing, a company reduces vertical integration and its overall amount of specialized skills and knowledge.

Ch 15: Managing International Operations c. d. e.

“Stealth manufacturing” calls for outsourcing the assembly of computers plus shipping to distributors and other intermediaries. Outsourcing is catching on in the pharmaceutical industry. Lower risk i. Social unrest or open conflict can threaten physical facilities, equipment, and employee safety. ii. Eliminate the exposure of assets to political risk by refusing to invest in plants and equipment abroad; it can purchase products from international suppliers. iii. Eliminates the need to purchase expensive insurance coverage needed in an unstable country. But does not completely shield the buyer from disruptions; political instability can cause delays in receiving needed parts. Greater flexibility i. Making in-house products that require huge investment in equipment and buildings often reduces flexibility. ii. Companies that buy products from one or more outside suppliers retain or gain flexibility. Added flexibility is key in a change of attitude toward outsourcing. iii. Maintaining flexibility is important when the national business environments of suppliers are volatile. Buying from several suppliers or establishing production facilities in several countries allows outsourcing from one location if instability erupts in another. iv. Volatility in exchange rates can increase or decrease the cost of importing; by buying from multiple suppliers in several countries, a company maintains the flexibility to change sources and reduce risk. v. Companies maintain operational flexibility by not investing in production facilities; it can then alter its product line very quickly. vi. A company has financial flexibility if its capital is not locked up in plants and equipment; it uses excess capital to pursue opportunities. Market power i. Companies can gain power in their relationships with suppliers by becoming important customers. ii. Sometimes a supplier becomes a hostage to one customer when the supplier depends on a company with its production capacity; if the buyer outsources elsewhere, the supplier has few other customers. iii. This situation gives the buyer significant control in dictating quality improvements, forcing cost reductions, and making special modifications. Barriers to buying i. Companies sometimes face obstacles when purchasing products from international suppliers. ii. The government of the buyer’s country may impose import tariffs to improve the balance of trade. iii. The services provided by intermediaries increase the cost of buying abroad.

Ch 15: Managing International Operations B.

IV.

Raw Materials 1. The twin issues of quality and quantity drive many decisions about raw material acquisition. 2. Some industries and companies rely almost exclusively on the quantity of locally available raw materials. 3. Raw material quality has a huge influence on the quality of a company’s end product. Fixed Assets 1. Fixed assets are company assets such as production facilities, inventory warehouses, retail outlets, and production and office equipment. 2. Companies can (1) acquire or modify existing factories, or (2) build new facilities—called a greenfield investment. 3. Considering either option involves many individuals, such as production managers, site-acquisition experts, legal staff, and public relations staff. 4. Local infrastructure must support proposed on-site business operations.

KEY PRODUCTION CONCERNS How manufacturing operation companies maximize quality and minimize shipping and inventory costs, and important reinvestment versus divestment decisions. A. Quality Improvement Efforts 1. Companies strive toward quality improvement for two reasons: costs and customer value. 2. Quality products keep production costs low by reducing waste in valuable outputs, reducing the cost of retrieving defective products, and reducing disposal costs due to defective products. 3. Some minimum level of acceptable quality is an aspect of every product today. A company that combines a low-cost position with a high-quality product can gain a competitive advantage. 4. Improving quality is important for service providers; quality is complex because a service is created and consumed at the same time. The interaction between an employee who delivers a service and the buyer is part of service quality. 5. Activities conducted prior to service delivery are also important. 6. Total quality management a. Emphasis on continuous quality improvement to meet or exceed customer expectations. It places responsibility on each individual to focus on the quality of output. b. By continuously improving quality, a company differentiates itself from rivals and attracts loyal customers. 7. ISO 9000 a. The International Standards Organization (ISO) 9000 is an international certification that companies receive when they meet the highest quality standards in their industries. b. To become certified, companies must demonstrate the reliability and soundness of all business processes affecting the quality of their products. B. Shipping and Inventory Costs 1. Shipping costs can have a dramatic effect on the cost of getting materials and components to the location of production facilities.

Ch 15: Managing International Operations

Shipping costs are affected by a nation’s business environment, such as its level of economic development, including the condition of seaports, airports, roads, and rail networks. 3. Because storing inventory is costly, companies adopt just-in-time (JIT) manufacturing—in which inventory is kept to a minimum and inputs to production arrive exactly as needed. 4. JIT drastically reduces the costs of large inventories and reduces wasteful expenses because defective materials and components are spotted quickly during production. Reinvestment versus Divestment 1. Managers need to decide whether to invest further in operations abroad or to reduce or divest international operations. 2. Companies continue investing in markets requiring long payback periods if the outlook is good. 3. Companies reinvest when a market is experiencing rapid growth. Investing in expanding markets is attractive because potential customers may not yet be loyal to the products of any one company or brand. 4. Companies scale back their international investments when it is apparent that profitability will take longer than expected. 5. Problems in the political, social, or economic sphere can force companies either to reduce investment or eliminate operations altogether. 6. Companies invest in operations offering the best return on investment; this means reducing investments or divesting operations in profitable markets to invest in more profitable opportunities elsewhere. 2.

FINANCING BUSINESS OPERATIONS Companies need financial resources to pay for operating expenses and investment projects. They must buy raw materials and component products for manufacturing and assembly activities. They need capital for expanding production capacity or entering new geographic markets and financing to pay for training and development, to compensate workers and managers, and to advertise. A. Borrowing 1. International companies (like domestic companies) try to get the lowest interest rates possible on borrowed funds. 2. Difficulties include exchange-rate risk, restrictions on currency convertibility, and restrictions on the international flow of capital. 3. Borrowing locally can be advantageous, especially when the value of the local currency has fallen against that of the home country. But companies are not always able to borrow funds locally; they are forced to seek international sources of capital. 4. A back-to-back loan is a loan in which a parent company deposits money with a host-country bank, which then lends it to a subsidiary located in the host country. B. Issuing Equity The international equity market consists of all stocks bought and sold outside the home country of the issuing company. This helps firms to access investors with funds unavailable domestically. Yet getting shares listed on another country’s stock exchange can be a complex process. Complying with all the rules and regulations governing a stock exchange costs time and money. 1. Issuing American Depository Receipts

Ch 15: Managing International Operations a.

To maximize international exposure, non-U.S. companies list themselves on U.S. stock exchanges. A non-U.S. company can list shares in the United States by issuing American Depository Receipts (ADRs)—certificates that trade in the United States and represent a specific number of shares in a non-U.S. company. b. International companies also use Global Depository Receipts (GDRs), which are similar to ADRs but are listed and traded in London and Luxembourg. c. Advantages of ADRs: Buyers pay no currency-conversion fees, and there are no minimum purchase requirements. Also, companies offer ADRs in the United States to appeal to mutual funds because U.S. investment laws limit the amount that a mutual fund can invest in companies not registered on U.S. exchanges. 2. Venture capital a. Venture capital is financing obtained from investors who believe that the borrower will experience rapid growth and receive equity (part ownership) in return. b. Venture capitalists invest in new risky ventures because they can generate large returns on investment. c. The venture capital industry has become global. 3. Emerging stock markets a. Companies in countries with emerging stock markets face two problems. First, emerging stock markets are often volatile. i. Investments can be either hot money—money that can be quickly withdrawn in a crisis—or patient money— investment in factories, equipment, and land that cannot be withdrawn easily. ii. Large and sudden sell-offs of equity are signs of market volatility that characterize emerging stock markets. Large sell-offs occur because of uncertainty regarding the nation’s future economic growth. b. Second is the issue of poor market regulation. i. Large local companies can wield influence over their domestic stock markets; if domestic shareholders dominate such exchanges, international investors may hesitate to enter. ii. The problem lies in regulation that favors insiders over international investors. Internal Funding Ongoing business activities and new investments can also be financed internally with funds supplied by the parent company or its international subsidiaries. 1. Internal equity, debt, and fees a. Time is needed for new subsidiaries to become financially independent; so, parent companies finance operations. b. Subsidiaries often obtain capital by issuing equity solely to the parent, which benefits from an appreciating share price. c. Parent companies lend money to subsidiaries during the start-up phase and for new investments; subsidiaries with excess cash lend money to parent or sister companies when they need capital. 2. Revenue from operations

Ch 15: Managing International Operations

VI.

Revenue is earned from the sale of goods and services; this source of capital is the lifeblood of international companies and their subsidiaries. b. For long-term success, a company must generate sufficient revenue to sustain day-to-day operations; outside financing is required only to expand operations or to survive lean periods. c. A transfer price is the price charged for a good or service transferred between a company and a subsidiary. Companies set subsidiaries’ transfer prices high or low according to their own goals (e.g., to minimize taxes in a high taxation country). Capital Structure 1. A company’s capital structure is the mix of equity, debt, and internally generated funds that it uses to finance its activities. 2. Firms try to strike the right balance among financing methods in order to minimize the cost of capital and risk. 3. Debt requires periodic interest payments to creditors such as banks and bondholders. If the company defaults on interest payments, creditors can sue the company or force it into bankruptcy; preferred stock equity holders can force bankruptcy because of default. 4. Companies prefer not to carry so much debt in relation to equity that it increases its risk of insolvency. 5. Debt appeals to companies because interest payments are deducted from taxable earnings—lowering the taxes a firm must pay. 6. National restrictions can influence the choice of capital structure. Restrictions include limits on international capital flows, the cost of local versus international financing, access to international financial markets, and currency exchange controls. 7. Choice of capital structure for subsidiaries is highly complex.

A FINAL WORD Whether an international company’s production activity involves manufacturing a product or providing a service, it must acquire many resources before beginning operations. It needs to resolve such issues as where it will get raw materials or components, how much production capacity it needs, whether to construct or buy new facilities, the size of service centers, and where it will get financing. The answers to these questions are complex and interrelated.

Quick Study Questions Quick Study 1 1.

Q: Assessing a firm’s ability to produce enough output to satisfy demand is called what? A: Capacity planning is the process of assessing a company’s ability to produce enough output to satisfy market demand. If capacity is inadequate to fulfill forecasted demand, capacity must be expanded, and vice-versa. This affects production strategy.

Q: Location economies can arise from the optimal execution of what? A: Location economies are economic benefits derived from locating production activities in optimal locations. Location economies can involve practically any business activity

Ch 15: Managing International Operations that companies in a particular location do very well, including performing research and development or providing financial services. The key point is that each production activity generates more value in a particular location than could be generated anywhere else.

Q: What typically determines the process that a firm uses to create its product? A: Process planning is deciding the process that a company will use to create its product. Availability and cost of labor in the local market is crucial to process planning. An important production issue in strategic planning is deciding whether the production process will be standardized for all markets or adapted to manufacture products modified for different markets. Low-cost leadership typically dictates automated, standardized production in large batches. Differentiation often requires smaller batches and much product tailoring or adaptation.

Quick Study 2 1.

Q: Vertical integration is the process by which a company extends its control over what? A: Vertical integration is the extension of company activities into stages of production that provide a firm’s inputs or absorb its outputs. Vertical integration can influence the make-or-buy decision through its advantages of lower production costs, allowing greater control over production, making product modifications without persuading a supplier, and keeping key technology in-house.

Q: Why might a company make a product in-house rather than buy it? A: Companies often decide to make a product rather than buy it in order to reduce total costs. In general, companies will undertake in-house production when they can produce for less cost than they can buy on the open market. Also, making rather than buying can give managers greater control over raw materials, product design, and the production process itself—all of which are important factors in product quality. Companies often undertake in-house production when persuading a supplier to make special modifications to a product on their behalf is difficult. Companies also make rather than buy when buying from a supplier requires providing them with a key technology.

Q: Why might a firm buy a product rather than make it in-house? A: Outsourcing is the practice of buying from another company a good or service that is not central to a company’s competitive advantage. One reason why a company may buy rather than make a product is to lower risk. Political risk is quite high in certain markets. Sometimes the government of an intensely nationalistic nation might decide to expropriate or nationalize industries without concern for the interest of an international company. Although companies can shield themselves from such risks by outsourcing, international outsourcing can result in longer delivery times that can increase the probability that products will be delayed in transport. Another reason to buy is to gain flexibility. Making an in-house product that requires large investments in equipment and buildings often reduces flexibility. Companies that buy products from one or more outside suppliers retain or gain flexibility. Finally, companies can gain a great deal of power in their relationships with suppliers simply by becoming important customers.

Quick Study 3 1.

Q: Why might a company strive for quality improvement?

Ch 15: Managing International Operations

A: Companies strive toward quality improvement for two reasons. First, quality products help keep production costs low because they reduce waste in valuable outputs, reduce the cost of retrieving defective products from buyers, and reduce disposal costs due to defective products. Second, some minimum level of acceptable quality is an aspect of every product today. 2.

Q: The international certification that a company gets when it meets the highest quality standards in the industry is called what? A: The International Standards Organization (ISO) 9000 is an international certification that companies get when they meet the highest quality standards in their industries. To become certified, companies must demonstrate the reliability and soundness of all business processes affecting the quality of their products.

Q: Under what conditions might a company reinvest earnings in its operations? A: If new and potentially profitable opportunities present themselves in the market, managers might decide to expand operations. In general, the reinvestment decision is based on four conditions. 1. Companies must decide whether to continue investing in markets requiring long payback periods. 2. Firms must decide whether increasing local investment is necessary merely to maintain market share and its competitive position. 3. Companies usually decide to reinvest when a market is experiencing rapid growth. 4. Companies may try to reduce international competition by investing in the home markets of international competitors. All companies have a limited supply of resources at their disposal to invest in current operations or new endeavors. There are three reasons why companies decide either to scale back or to eliminate operations abroad. 1. Companies scale back their international investments when it becomes apparent that making operations profitable will take longer than expected. 2. Problems in the political, social, or economic sphere can force companies either to reduce investment or eliminate operations altogether. 3. Companies invest in those operations offering the best return on their investments. That policy often means reducing investments or divesting operations in some markets even though they may be profitable, in order to invest in more profitable opportunities elsewhere.

Quick Study 4 1.

Q: In general, through what source do companies obtain financial resources? A: Companies can obtain financial resources through one of three resources: (1) borrowing (debt), (2) issuing equity (stock ownership), or (3) internal financing.

Q: A common way for non-U.S. companies to access U.S. capital markets is to issue what? A: Companies issue stock outside the home country primarily to access pools of investors with funds that are unavailable domestically. A non-U.S. company can list shares directly in the United States by issuing American Depository Receipts (ADRs)—certificates that trade in the United States and represent a specific number of shares in a non-U.S. company. There are three main advantages of ADRs. First, investors who buy ADRs pay no currency-conversion fees. Second, there are no minimum purchase requirements for

Ch 15: Managing International Operations ADRs, as there sometimes are for shares of a company’s stock. Third, companies offer ADRs in the United States to appeal to mutual funds. Investment laws in the United States limit the amount of money that a mutual fund can invest in the shares of companies not registered on U.S. exchanges.

Q: A firm’s mix of equity, debt, and internally generated funds that it uses to finance its activities is called what? A: A company’s capital structure is the mix of equity, debt, and internally generated funds that it uses to finance its activities. Firms try to strike the right balance among financing methods in order to minimize the cost of capital and their risk.

Ethical Challenges

You are special assistant to the governor of a southeastern U.S. state in which unemployment (especially in rural areas) is well above the national average. After nearly three years in office and elected on a pledge to attract industry and create jobs, the governor is concerned. Because he respects your moral stance on issues, the governor has come seeking your insights. A European automobile maker has just told the governor that your state is on its short list of potential sites for a new manufacturing facility. The facility is expected to employ about 1,500 people, with plenty of spillover effects on the wider economy. The governor informs you the European automaker expects significant incentives and concessions. The governor would like to offer some $300 million in tax breaks and subsidies in an effort to bring the new plant to the state. 15-5 What plan of action do you advise the governor to take? 15-6 Would the outlay be an appropriate use of taxpayer money? Explain. 15-7 Would you feel comfortable defending your advice if it were to become public? Explain. A: A similar scenario actually occurred in Alabama when Mercedes signed a deal to open its new state-of-the-art manufacturing facility. Taxpayer money often fosters economic development packages in large and small communities throughout the United States. Many jobs are subsequently created as a result of the influx of new businesses. It can be a proper use of taxpayer money based on the rationale that a new facility brings new jobs plus increased activity for the local real estate market, retail businesses, health care providers, and the local educational facilities. Teaming Up

Financing Project. Suppose you and several classmates are a team assembled by the chief financial officer of a consumer-goods company based in Mexico. Your company wishes to expand internationally but lacks the necessary financial capital. Your team’s task is to research the options. 15-8 What financing options do you think are available to your company? 15-9 Considering the prevailing situation in the Mexican and international capital markets, why is each option feasible? 15-10 Why are certain options off limits, given prevailing market conditions? A: Students should be sure to consider the current financial and economic conditions prevailing in Mexico at the present time. Options for financing can rapidly change

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depending on financial and economic conditions. Students should supply several financing options under different scenarios for the Mexican economy. Practicing International Management Case Toyota’s Strategy for Production Efficiency 15-13 Q: Chrysler engineers helped Toyota develop its Sienna minivan. In return, Toyota provided input on automobile production techniques to Chrysler. Why do you think Chrysler was willing to share its minivan know-how with a key competitor? A: Clearly, Chrysler felt that obtaining insight into Toyota’s production techniques outweighed the costs of giving Toyota engineering designs on a model that (as normally is the case) will be redesigned a few years down the road. However, insight into Toyota’s methods could give Chrysler a huge advantage over its domestic rivals. 15-14 Q: Considering financial, marketing, and human resource management issues, what other benefits do you think Toyota obtains from its production system? A: Toyota must feel it can outdo the competition. Based on its past performance of gaining a cost advantage in its other products, Toyota might also gain a cost advantage in minivans and put a great deal of pressure on Chrysler.

CHAPTER 16 HIRING AND MANAGING EMPLOYEES LEARNING OBJECTIVES: 1. Explain the three types of staffing policies that companies use. 2. Describe the key human resource recruitment and selection issues. 3. Summarize the main training and development programs that firms use. 4. Explain how companies compensate managers and workers. 5. Describe the importance of labor–management relations.

CHAPTER OUTLINE: Introduction International Staffing Policies Ethnocentric Staffing Advantages of Ethnocentric Staffing Disadvantages of Ethnocentric Staffing Polycentric Staffing Advantages and Disadvantages of Polycentric Staffing Geocentric Staffing Advantages and Disadvantages of Geocentric Staffing Recruiting and Selecting Human Resources Human Resource Planning Recruiting Human Resources Current Employees Recent College Graduates Local Managerial Talent Nonmanagerial Workers Selecting Human Resources Culture Shock Reverse Culture Shock Dealing with Reverse Culture Shock Training and Development Methods of Cultural Training Environmental Briefings and Cultural Orientations Cultural Assimilation and Sensitivity Training Language Training Field Experience Compiling a Cultural Profile Nonmanagerial Worker Training Employee Compensation Managerial Employees Bonus and Tax Incentives Cultural and Social Contributors to Cost Nonmanagerial Workers Labor–Management Relations Importance of Labor Unions International Labor Movements

Ch 16: Hiring and Managing Employees

A Final Word

A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 16. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material. Lecture Outline I.

INTRODUCTION Human resource management (HRM) is the process of staffing a company and ensuring that employees are as productive as possible. It requires managers to be effective in recruiting, selecting, training, developing, evaluating, and compensating employees and in forming good relations. International HRM differs considerably from HRM in a domestic setting because of differences in national business environments. There is the issue of expatriates—citizens of one country who are living and working in another; many issues arise when expatriate employees have job assignments that last several years. Culture is central to the discussion of how international companies manage their employees. Training and development programs and recruitment and selection practices must often be tailored to local practices.

II.

INTERNATIONAL STAFFING POLICIES Staffing policy is the means by which a company staffs its offices; staffing policy is influenced by international involvement. The main approaches to the staffing of international operations are ethnocentric, polycentric, and geocentric. Companies often blend different staffing policies. A. Ethnocentric Staffing Individuals from the home country manage operations abroad. Appeals to companies that want control over decision making in offices abroad and that formulate policies designed to work in every country of operations. Firms pursue this policy only for top managerial posts in their international operations because at lower levels, it is impractical. 1. Advantages of ethnocentric staffing a. Locally qualified people are not always available. In developing and newly industrialized countries, there is often a shortage of qualified personnel—resulting in a highly competitive local labor market. b. Companies use ethnocentric staffing to re-create operations in the image of home-country operations. c. Expatriate managers infuse branch offices with the corporate culture; important to shared values in each international office implementing global strategies. The image of home-office operations can ease the transfer of special know-how. d. Some firms feel managers sent from the home country will look out for the company’s interests more than host-country natives.

Ch 16: Hiring and Managing Employees e.

III.

Companies that operate in highly nationalistic markets and those worried about industrial espionage use an ethnocentric approach. 2. Disadvantages of ethnocentric staffing a. Relocating managers from the home country is expensive. Bonuses for relocating, plus relocation expenses for families, increase the cost of a manager. Cultural differences and long periods away from relatives and friends contribute to the failure of international assignments. b. Can create barriers for the host-country office. Home-country managers in the host country encourage a “foreign” image of the business; lower-level employees feel that managers do not understand their needs. Expatriate managers may not overcome cultural barriers or understand the needs of their local employees or their local customers. Polycentric Staffing Individuals from the host country manage operations abroad. 1. Well-suited to companies that want to grant autonomy in decision making. But this policy does not mean that host-country managers are left to run operations any way they see fit. 2. Large international companies conduct extensive training programs in which host-country managers visit home offices for extended periods to be exposed to the company’s culture and business practices. 3. Advantages and disadvantages of polycentric staffing: a. Places managerial responsibility in the hands of people familiar with the local business environment. b. Managers with deep cultural understanding of the local market can be an enormous advantage. c. They need not overcome cultural barriers created by being an outsider, and they have a better feel for the needs of employees, customers, and suppliers. d. Eliminates the high cost of relocating expatriate managers and families. e. But with natives of each country managing, a company becomes a collection of national businesses. f. For a firm following a global strategy, a lack of integration, knowledge sharing, and a common image may negatively affect performance. Geocentric Staffing Best-qualified individuals, regardless of nationality, manage operations abroad. The local manager is from the host country, from the home country, or from a third country, depending on specific needs. Reserved for top-level managers. 1. Advantages and disadvantages of geocentric staffing: a. Develops global managers who adjust to any business environment and to cultural differences. b. Useful for companies trying to break down nationalistic barriers among managers in an office or between different offices. c. The main drawback is cost. The high demand for people with special skills and their short supply have inflated salaries.

RECRUITING AND SELECTING HUMAN RESOURCES

Ch 16: Hiring and Managing Employees Companies try to recruit and select qualified managers and nonmanagerial workers well suited to their tasks and responsibilities. How does a company recruit and select the best available individuals? A. Human Resource Planning 1. Forecasting both a company’s human resources needs and supply. 2. Phase one: take inventory of a company’s current human resources. Data is collected on employees, including education, job skills, previous jobs, language skills, and experience living abroad. 3. Phase two: estimate future HR needs to decide whether to hire employees or to subcontract production to other producers. a. This decision can raise ethical questions. Subcontracting work to low-wage nations and allegations of workplace abuse cause many firms to establish codes of conduct and step up efforts to ensure compliance. 4. Phase three: managers develop a plan for recruiting and selecting people to fill vacant and anticipated new positions. 5. A firm must make plans for reducing its workforce—a process called decruitment—when HR levels are greater than anticipated. B. Recruiting Human Resources Identifying and attracting qualified applicants for vacant positions. 1. Current employees a. Likely candidates within the company are those managers who were involved in previous stages of an international project. b. These individuals may have important contacts in the host country and have been exposed to its culture. 2. Recent college graduates a. Companies also recruit from among recent college graduates who have come from other countries to attend college in the firm’s home country. b. This is a common practice among U.S. companies; new hires receive general and specialized training and receive positions in their native countries. They learn about the organization’s culture and how it conducts business. c. Most important is their familiarity with the culture of the target market, including its customs, traditions, and language. 3. Local managerial talent a. Hiring local managers is common when cultural understanding is a key job requirement. b. Hiring local managers with government contacts may speed the approval process for local operations. c. Governments may force a company to recruit local managers to develop its own managerial talent. d. Governments may restrict the number of international managers that can work in the host country. 4. Nonmanagerial workers a. Companies recruit locally for nonmanagerial positions if there is little need for specialized skills or training. b. A specialist from the home country is brought in to train people chosen for more demanding positions.

Ch 16: Hiring and Managing Employees c.

Firms turn to the local labor market when governments restrict the number of workers allowed into the host country; such efforts reduce unemployment among the local population. d. Countries sometimes permit the importation of nonmanagerial workers. Selecting Human Resources 1. Screening and hiring the best-qualified applicants with the greatest performance potential. 2. For international assignments, it is essential to measure a person’s ability to bridge cultural differences. 3. Expatriate managers must adapt to a new way of life in the host country and work with others from different cultural backgrounds. 4. Culturally sensitive managers increase the likelihood that a company will achieve its business goals. 5. Recruiters assess cultural sensitivity by asking candidates questions about their receptiveness to new ways of doing things and questions about racial and ethnic issues. They can employ global aptitude tests. 6. The cultural sensitivity of each family member going to the host country needs assessment; the inability of a family member or spouse to adapt is the most common reason for the expatriate failure. Culture Shock 1. Culture shock is a psychological process that affects people living abroad, characterized by homesickness, irritability, confusion, aggravation, and depression. 2. A person experiencing it has trouble adjusting to the new environment in which they find themselves. 3. Expatriate failure—the early return by an employee from an international assignment because of inadequate job performance—often results from cultural stress. 4. The higher cost of expatriate failure is convincing many companies to invest in cultural-training programs for employees sent abroad. Reverse Culture Shock 1. Reverse culture shock is the psychological process of re-adapting to one’s home culture. 2. Values and behavior that once seemed so natural now seem strange, and returning managers find that either no position or a “standby” position awaits them in the home office. 3. Companies often do not take full advantage of the cross-cultural abilities of managers who have spent valuable years abroad. 4. Expatriates who successfully adapt to new cultures often leave their companies within a year of returning home because of difficulty blending back into the company culture. 5. Spouses and children often have difficulty leaving the adopted culture and returning home. 6. Dealing with reverse culture shock a. Home-culture reorientation programs and career-counseling sessions for returning managers and their families can be highly effective. b. The employer might bring the family home for a short stay before the return to prepare for reverse culture shock.

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IV.

Good career development programs help companies retain valuable managers. Ideally, a career development plan is created before an employee goes abroad. Mentors can be assigned to returning managers; mentor becomes a confidant so the expatriate manager can discuss problems about work, family, and readjustment to the home culture.

TRAINING AND DEVELOPMENT After recruitment and selection, a company identifies the skills and knowledge needed to perform duties. Employees lacking the necessary skills or knowledge go into training or development programs. Companies realize the need for in-depth training and development programs if they want maximum productivity from managers abroad. A. Methods of Cultural Training 1. The extent of a company’s international involvement demands a corresponding level of cultural knowledge from employees. 2. Companies that are highly international need employees with language fluency and in-depth experience in other countries; small companies or those new to global business begin with basic cultural training. 3. Companies use many methods to prepare managers for international assignments. The goal of most programs is to create informed, openminded, and flexible managers with a level of cultural training appropriate to the duties required of them. 4. Environmental briefing and cultural orientations a. Environmental (area) briefings include information on local housing, health care, transportation, schools, and climate. b. Cultural orientations offer insight into social, political, legal, and economic institutions. 5. Cultural assimilation and sensitivity training a. Cultural assimilation teaches the culture’s values, attitudes, manners, and customs. b. Guerilla linguistics, which involves learning some phrases in the local language, is used at this stage. c. Also useful at this stage is role-playing: the trainee responds to a situation and is evaluated by a team of judges. d. Sensitivity training teaches people to be considerate and understanding of other peoples’ feelings and emotions. 6. Language training a. This level of training gets a trainee “into the mind” of local people—to learn more about why people behave as they do. b. This is perhaps the most critical part of cultural training for longterm assignments. c. A survey of top executives found that foreign-language skills topped the list of skills needed for a competitive edge. 7. Field experience a. Field experience means visiting the culture, walking the streets of its cities and villages, and becoming absorbed by it for a short period of time. b. The trainee enjoys the unique cultural traits and feels the stresses inherent in living in the culture. B. Compiling a Cultural Profile

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Cultural profiles can be quite helpful in deciding whether to accept an international assignment. Sources for constructing a cultural profile include: 1. CultureGrams: This guide can be found in the reference section of many libraries. Updates make this a timely source of information. 2. Country Studies Area Handbooks: This series explains how politics, economics, society, and national security issues are related and shaped by culture in more than 70 countries. 3. Background Notes: These notes contain relevant factual information on human rights and related issues. Published by the U.S. State Department, they take a U.S. perspective. 4. Information can also be obtained by contacting the embassies of other countries and by locating people with firsthand knowledge and specific books and films. Nonmanagerial Worker Training 1. Nonmanagerial workers have training and development needs, especially in developing and newly industrialized countries where people have not completed primary school. 2. Even when well educated, workers may lack industry experience. 3. The need for basic-skills training grows as companies explore opportunities in emerging markets. 4. In some countries, students who are unable or unwilling to enter college can enter programs paid for by the government and private industry and undergo extensive training for cutting-edge technologies (e.g., Japan and Germany lead the world in vocational training and apprenticeship programs for nonmanagerial workers).

EMPLOYEE COMPENSATION Goal should be to attract and retain the best and brightest employees and reward them for their performance. Because a country’s compensation practices are rooted in its culture, legal, and economic systems, determining compensation is complicated. A. Managerial Employees 1. Compensation packages must reflect the cost of living, which includes the cost of groceries, dining out, clothing, housing, schooling, heath care, transportation, and utilities. 2. It costs more to live in some countries, and within a country the cost of living varies from large cities to rural towns. 3. Managers who relocate to lower cost-of-living countries are paid the same amount that they were receiving at the home office; otherwise, they would be penalized for accepting an international job. 4. Companies cover other costs incurred by expatriate managers such as high-quality local education. 5. Bonus and tax incentives a. Companies commonly offer inducements for international postings; the most common is a financial bonus. b. Hardship pay involves bonuses for an unstable country or one with a very low standard of living. c. The U.S. government permits citizens working abroad to exclude “foreign-earned income” from their taxable income in the United States. 6. Cultural and social contributors to cost a. Culture is a key to the compensation of expatriate managers.

Ch 16: Hiring and Managing Employees b.

VI.

Some nations offer more paid holidays, free medical care, and plans for taking seriously ill expatriates and family members home or to nearby countries. c. Companies that hire managers in the local market might encounter additional costs engendered by social attitudes (e.g., paid maternity leave). d. Host-country managers receive the same pay as managers who work for local companies but receive special perks. Nonmanagerial Workers Two main factors influence the wages of nonmanagerial workers. 1. First, their compensation is strongly influenced by increased cross-border business investment. 2. Employers can relocate fairly easily to nations where wages are lower. But workers at home must accept lower wages or see jobs lost. 3. This may create a trend toward greater equality in workers’ pay worldwide. An equalizing effect may encourage improvement in workers’ lives in some countries at the expense of those in others. 4. But freedom to relocate differs from country to country; some countries allow firms to move with little notice, others impose restrictions. 5. Second, labor is more mobile than ever before. 6. Although labor laws in Europe are more stringent than in the United States, EU countries are abolishing the requirement that workers from one EU nation obtain visas to work in another (e.g., if workers in Spain have no work or the pay is inadequate, they can move to another EU country).

LABOR–MANAGEMENT RELATIONS When management and workers realize they depend on each other, the company is better prepared to meet its goals and surmount unexpected obstacles. Giving workers a greater stake in the company—through profit-sharing plans—can increase morale and generate commitment to improved quality and customer service. Because relations between laborers and managers are human relations, they are rooted in culture and are affected by political movements. To control operations, large companies make high-level labor decisions at home; but lower-level decisions are typically left to managers in each country. Localizing management decisions contributes to better labor–management relations because local managers may handle local matters more effectively. A. Importance of Labor Unions 1. The strength of labor unions where a company has operations affects performance and the selection of a location. 2. Developing and emerging markets in Asia are popular for international companies, and some Asian governments appeal to companies by promising to keep labor unions in check. 3. Developed nations are attractive if a cooperative atmosphere exists between company management and labor unions. 4. Labor unions are stronger in France and Germany although union membership in Germany has fallen. 5. Under codetermination, German workers enjoy a direct say in the strategies and policies of their employers. 6. International labor movements

Ch 16: Hiring and Managing Employees a.

Unions around the globe try to improve the treatment of workers and reduce incidents of child labor. It is difficult for a union in one nation to support its counterpart abroad. Events abroad are difficult to comprehend, and workers compete for jobs at multinational companies. Labor unions in one country might offer concessions to attract the jobs created by a new production facility; in this way, unions in different nations compete against one another. Some argue that this phenomenon creates downward pressure on wages and union power worldwide.

VII.

A FINAL WORD This chapter concludes our survey of international business. We studied how firms, ranging from small- and medium-size businesses to large global companies, hire and manage their most important resource—their employees. We hope we piqued your interest in the goings-on of the global marketplace and in the activities of international companies of all types and sizes.

Quick Study Questions Quick Study 1 1.

Q: A firm that staffs its operations abroad with home-country nationals uses a staffing policy called? A: In ethnocentric staffing, operations outside the home country are managed by individuals from the home country. This policy tends to appeal to companies that want to maintain tight controls over the decision making of branch offices abroad.

Q: Polycentric staffing is when a company staffs its operations with people from where? A: In polycentric staffing, operations outside the home country are managed by individuals from the host country. This policy does not mean that host-country managers are left to run operations in any way they see fit. Large international companies usually conduct extensive training programs in which host-country managers visit home offices for extended periods.

Q: Geocentric staffing is typically reserved for whom? A: In geocentric staffing, operations outside the home country are managed by the best qualified individuals, regardless of nationality. This policy is reserved for top level managers.

Quick Study 2 1.

Q: The process of forecasting a company’s human resource needs and supply is called what? A: Human resource planning is important in order for the firm to forecast its human resource needs and supply. The process involves three stages: (1) taking an inventory of the company’s human resources; (2) estimating the company’s future needs for human resources; and (3) developing a plan for recruiting and selecting human resources.

Ch 16: Hiring and Managing Employees

Q: When recruiting employees, from where can employers attract qualified applicants? A: Companies recruit their employees internally or through external sources. Likely candidates within the company (current employees) are those managers who were involved in previous stages of an international project. Companies also recruit from among recent college graduates who have come from other countries to attend college in the firm’s home country. Hiring local managerial talent is common when cultural understanding is a key job requirement. In some cases, a government forces a company to recruit local managers so that the nation can develop its own internal pool of managerial talent. Companies typically recruit locally for nonmanagerial workers because there is often little need for highly specialized skills or training.

Q: Culture shock is a psychological process that affects people who live where? A: Culture shock is a psychological process that affects people living abroad and is characterized by homesickness, irritability, confusion, aggravation, and depression. It is important in the selection of international managers because it is often the cause of managers failing in their international assignment and returning home. This can be extremely expensive for companies.

Quick Study 3 1.

Q: What constitutes the most basic level of cultural training? A: For managers, the goal is often to create informed, open-minded, and flexible employees with cultural training appropriate to their duties. Environmental briefings typically include information on local housing, health care, transportation, schools, and climate. Cultural orientations offer insight into social, political, legal, and economic institutions. Cultural assimilation teaches the culture’s values, attitudes, manners, and customs. Sensitivity training teaches people to be considerate and understanding of other peoples’ feelings and emotions. In-depth language training gets a trainee “into the mind” of local people to learn why people behave as they do. Field experience means visiting the culture, and becoming absorbed by it for a short period of time. Nonmanagers also have a need for training and development, especially in developing countries where basic educational opportunities are limited and industrial experience may be new. In many countries, national governments cooperate with businesses to train nonmanagerial workers. Japan and Germany lead the world in vocational training and apprenticeship programs for nonmanagerial workers.

Q: What type of training is said to get one “into the mind” of the local people? A: Language training is the type that is used to get the trainee “into the mind” of local people. The trainee learns more about why local people behave as they do.

Quick Study 4 1.

Q: A manager who goes to work in an unstable country might receive a bonus called what? A: Hardship pay is the term used for bonuses given to managers who are asked to go into a particularly unstable country or one with a very low standard of living.

Q: Some factors that contribute to the compensation of expatriate managers include what? A: Compensation for managerial employees must reflect the cost of living in that country. Culture plays an important role in the compensation of expatriate managers. For example,

Ch 16: Hiring and Managing Employees

many countries offer free medical care to everyone living and working there. Companies that hire managers in the local market might encounter additional costs engendered by social attitudes. In some countries, employers are expected to provide free or subsidized housing. Two main factors influence the wages of nonmanagerial workers. First, their compensation is strongly influenced by increased cross-border business investment. Second, because labor is more mobile today than ever before, wages are affected. Quick Study 5 1.

Q: Because labor–management relations are human relations they are rooted in what? A: Labor–management relations are the positive or negative condition of relations between company management and its workers. Positive relations between labor and management can give a firm a competitive advantage. Because labor–management relations are human relations, they are rooted in culture and are often influenced by political movements in a market.

Q: German workers have a direct say in the strategies and policies of their employers under a plan called what? A: Under a plan called codetermination, German workers enjoy a direct say in the strategies and policies of their employers. This plan allows labor representatives to participate in high level company meetings by actually voting on proposed actions.

Ethical Challenge You are an expatriate manager at a manufacturing facility in Asia on your first assignment abroad. You are aware of increasing concern among your employees (mostly young women) about wages that barely permit them to live at subsistence level. The plant is not unionized, and you know that your superiors in your home country are not particularly supportive of efforts to organize workers. In fact, despite the calm demeanor when the subject of unions is raised, you believe that upper management in the home country could react severely if workers unionized. Headquarters would likely shift production elsewhere, close the plant, and transfer you elsewhere. 16-5 Can you propose anything that might improve conditions for workers that would also get the approval of upper management? 16-6 If you attempted what you proposed above but then failed, would you encourage workers to unionize? Explain. A: As manager of the manufacturing facility, headquarters could be asked for things other than salary that could improve the standards of living for the workers. A donation to a local charity that helps out poor families is one option. Another is to give local schools and hospitals grant money for needed repairs or equipment. Another option is to provide health check-ups free of charge for the workers and their immediate families. Anything that could be helpful in terms of raising living standards yet would not jeopardize the jobs of employees is probably the best avenue to follow.

Ch 16: Hiring and Managing Employees

Teaming Up Suppose you and several of your classmates are a team assembled by your employer to decide whether to begin personality testing all employees. A British firm found that the top three reasons people quit or underperform are rooted in personality rather than skill, knowledge, or qualification. Personality testing in the workplace is widespread in Australia, Europe, and the United States, but is catching on in Asia. 16-7 What personality traits might help explain poor performance? Explain. 16-8 Could the reason why Asian societies have not used such testing in the past be rooted in culture? Explain. 16-9 What advantages might global aptitude tests offer firms doing business globally? A: Students will likely need to do research (in the library or on the Internet) to answer this question adequately. Practicing International Management Case Expatriation or Discrimination? 16-12 Q: In addition to those mentioned in the case, what are some other advantages associated with the hiring of local managers in emerging markets? A: Local managers have intimate knowledge of the local culture and how the local business community functions. This can help a company get farther ahead than it might possibly have been able to do with an expatriate in charge. 16-13 Q: What steps should a company take to ensure that, if taken to court, it can demonstrate that staffing cuts have not been discriminatory? A: It should do exactly as Ricoh had done in the case. It must have documentation and hard evidence of poor performance in job-related activities. These cannot be simply “trumped-up charges” but must be made honestly and ethically in the best interests of the company’s performance.