International Business, 17th edition John D Daniels Solution Manual

International Business, 17th edition By John D. Daniels

Email: Richard@qwconsultancy.com

PART ONE BACKGROUND FOR INTERNATIONAL BUSINESS Chapter 1 Globalization and International Business OBJECTIVES 1-1 Explain why and how the study of international business (IB) is important 1-2 Understand the relationship between globalization and IB 1-3 Grasp the forces driving globalization and IB 1-4 Discuss the major criticisms of globalization 1-5 Assess the major reasons companies seek to create value by engaging in IB 1-6 Define and illustrate the different operating modes for companies to accomplish their international objectives 1-7 Recognize why national differences in companies' external environments affect how they may best improve their IB performance

CHAPTER OVERVIEW Globalization has become a major socioeconomic force and topic of debate in the twenty-first century. Chapter One examines the forces that are driving this phenomenon, as well as the oftenpassionate criticisms of the process. The chapter reviews the objectives that firms pursue when they engage in international business activities and describes the various modes of entry that may be used. It also notes the terminology that has come into existence as new types of organizations have evolved. The chapter concludes with a discussion of the conditions in a company's external environment that may affect its international operations.

CHAPTER OUTLINE OPENING CASE:

THE GLOBALIZED BUSINESS OF SPORTS [see Map 1.1]

Although not everyone agrees that the unbridled globalization of professional sports is all for the good, the process and possibilities are definitely far reaching. Today's satellite television broadcasts enable fans to watch top players and teams in nearly any sport from almost anywhere on earth. Professional teams scour the world to find and develop the most talented athletes, and players forsake home country allegiances in their pursuit of the world's highest salaries. Further, the more people that tournaments can attract through attendance and television, the more money that sponsors and advertisers are willing to pay—and the greater the likelihood that those sponsors and advertisers will have business operations that span the globe. In addition, sports and nonsports companies alike pay famous athletes and teams generous sums to endorse their products. Successful teams have opened shops both domestically and internationally to sell 1 .

souvenirs bearing their logos and may make more money on merchandise than from TV rights and sponsorships combined. Most recently, as teams and leagues have begun to seek income opportunities outside their home countries, foreign investors have acquired a U.S. baseball team; another group of foreign investors acquired controlling interest in a British soccer (football) team, and the National Football League (NFL) of the United States underwrites flag football games in Chinese schools and is playing some regular season NFL games in Europe. Map 1.1 outlines national sports in a variety of countries and can be used to discuss how culture impacts globalization.

Questions 1-1 Professional athlete A is a star. Professional athlete B is an average player. How has the globalization of professional sports affected each of these both positively and negatively?

Being a star, professional athlete A can become a target for endorsement deals from local and international companies and organizations that would use such an athlete in advertising.

They also get substantial financial contracts (salaries and bonuses) from their clubs. The endorsements and salary deals get more lucrative if professional athlete A reaches strong positive visibility in major sport events or if he/she develops a global brand such as Cristiano Ronaldo. Advertisers will pay them considerably for endorsing a product or service. However, the same athlete might be dropped if his/her performance decline or if scandals damage his/her image.

For the average player such as professional athlete B, professional sports globalization has afforded them higher salaries than before. Globalization has led to a rise in professional sports interest and viewership and, consequently, robust growth in professional athletes' salaries. At the same time, the fierce competition between athletes and the growing demands from clubs and fans have put intense pressure on athletes to perform regularly. Today's athletes have little room for mistakes. (LO1-2: Understand the relationship between globalization and IB, AACSB: Analytical Skills).

1-2 As you read the chapter, identify and show an example of each international mode of operations that is illustrated in the globalization of professional sports.

Sport is a major source of service exports and imports. Countries compete to organize major global events such as the world cup or the Olympics for many business and political reasons. Chief among them is tourism. Let's say that some American fans fly on Qatar Airlines to watch the upcoming world cup in Qatar in 2022. Their travel expenses in Qatar are service exports for Qatar and service imports for the U.S. (LO1-2: Understand the relationship between globalization and IB, AACSB: Analytical Skills).

Teaching Tips: Carefully review the PowerPoint slides for Chapter One. A good Internet source of information on globalization can be found at http://www.globalization101.org/. Finally, review the atlas provided in the text, where you will find maps of the world and its continents, as well as a country index.

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I.

THE WHY, WHAT, AND HOW OF STUDYING INTERNATIONAL BUSINESS (IB) A. Why Study IB? Nearly all organizations compete abroad, compete domestically against foreign or domestic companies with international operations, and/or use inputs from foreign suppliers. Thus, most managers should consider IB when setting their operating strategies and practices. Even if you don't anticipate direct IB activities, understanding the subject matter will likely prove useful.

Studying IB is essential because: • most organizations are either international or compete with international companies, • modes of operations may differ from those used domestically, • it helps managers to decide where to find resources and to sell, • the best way of conducting business may differ by country, • an understanding helps you make better career decisions, and • an understanding helps you decide what governmental policies to support.

B. What to Study in IB In general, an organization's international operations depend on making sense of operating environments and developing the means to achieve its objectives: 1. Operating Environment: Physical, institutional, and competitive conditions differ among countries; these differences inevitably affect the optimum ways to do business.

2. Operations of IB: Companies operating internationally engage different modes of business, such as exporting and importing.

II. THE RELATIONSHIP BETWEEN GLOBALIZATION AND IB Globalization is the widening and deepening of interdependent relationships among people from different nations. The term sometimes refers to the elimination of barriers to international movements of goods, services, capital, technology, and people that influence the integration of world economies.

A. How Does IB Fit In? IB consists of all commercial transactions (including sales, investments, and transportation) between two or more countries.

The Relation to Globalization. The global connections between supplies and markets result from the activities of international business (IB). Private companies undertake such transactions for profit; governments may undertake them either for profit or for other reasons.

III. THE FORCES DRIVING GLOBALIZATION AND IB • Globalization has been growing, although sporadically: Currently, about a quarter of world production is sold outside of its country of origin, restrictions on imports have generally been decreasing, and output from foreign-owned investments as a percentage of world production has increased.

• Globalization is less pervasive than generally thought: Only a few countries (mainly 3 .

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very small nations) either sell more than half of their production abroad or depend on foreign output for more than half their consumption. Further, the principal source of capital in almost all nations is domestic rather than international.

Globalization has economic and noneconomic dimensions: Granted, these measurements address only economic aspects of globalization. More comprehensive comparisons include noneconomic dimensions such as people-to-people contacts through travel and communications, technological interchanges, government-togovernment relationships, and acceptance and adaptation of attributes from foreign cultures such as words from other languages.

Globalization is stimulated by several interrelated factors, including: 1. Rise in and application of technology Advances in communications and transportation have significantly increased the effectiveness and efficiency of international business operations. Today, a much larger portion of the population is involved in the development of new products, than just the production of products.

2. Liberalization of cross-border trade and resource movements Over time most governments have lowered restrictions on trade and foreign investment in response to the expressed desires of their citizens and producers. The primary motives for this change include giving citizens greater consumer choice and lower prices, international competition making domestic producers more efficient, and the hope that liberalization will cause other countries to also lower trade barriers.

3. Development of services that support IB Services provided by government, banks, transportation companies, and other businesses greatly facilitate the conduct and reduce the risks of doing business internationally.

4. Growth of consumer pressures Because of innovations in transportation and communications technology, consumers are well informed about and often able to access foreign products. Thus, competitors the world over have been forced to respond to consumers' demand for increasingly higher quality and more cost-competitive offerings. Consumer pressure has also spurred companies to spend more on research and development (R&D) and to search worldwide for innovations and products they can sell to ever-moredemanding consumers.

5. Increase in global competition The pressures of increased foreign competition often persuade firms to expand internationally to gain access to foreign opportunities and to improve their overall operational flexibility and competitiveness. So-called born-global companies start out with a global focus because of their founders' international experience and because advances in communications give them a good idea of the location for global markets and supplies.

6. Changes in political situations and government policies Today, only a few countries are heavily isolated economically or do business almost entirely within a political bloc. Nevertheless, governments still deny business with others for political reasons. Also, government policies may open markets as well as close them.

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7. Expansion of cross-national cooperation Governments have increasingly entered into cross-national treaties and agreements to gain reciprocal advantages for their own firms, to jointly attack problems that one country cannot solve alone, and to deal with areas of concern that lie outside the territory of all countries.

IV. THE CRITICISMS OF GLOBALIZATION Antiglobalization forces have protested both peacefully and violently as they press for legislation and other means to stop or slow the globalization process. Issues of threats to national sovereignty, environmental stress, and growing income inequality and personal stress are addressed.

A. Threats to National Sovereignty Many citizens fear that a country's participation in multilateral agreements will diminish its sovereignty and freedom from external control and curtail its ability to act in its own best interests. In particular, people in small countries worry that dependence on larger countries for sales and/or supplies, as well as the presence of large international firms, will make them vulnerable to the demands of parties against which they are essentially powerless. In addition, people the world over are concerned that globalization will bring the homogenization of products and traditional ways of life— including language and social structure.

B. Environmental Stress Much critique of globalization revolves around the economic growth it brings. One argument is that growth in both production and international travel consumes more nonrenewable natural resources and increases environmental damage. However, other factions assert that globalization is positive for conserving natural resources and maintaining an environmentally sound planet. The positive effects of pursuing global interests may, nevertheless, conflict with national interests.

C. Growing Income Inequality and Personal Stress By various measurements, income inequality, with some notable exceptions, has been growing both among and within many countries. Although globalization has brought unprecedented opportunities for firms to profit by gaining more sales and cheaper or better supplies, critics argue that profits have gone disproportionately to the top executives rather than to the rank and file. Thus, even if the overall global gains from globalization are positive, there remains a continuing challenge to bring about the positive gains in ways that minimize costs to the losers. It is easy to think about the impacts of globalization at a macro level, but individuals are impacted very specifically, causing stress and insecurity.

POINT—COUNTERPOINT: Is Offshoring Good Strategy?

POINT: Offshoring is good because it reduces costs. Although a firm may temporarily need fewer workers in its home country, eventually domestic employment (particularly high-value jobs) will increase because of the firm's growth. In addition, offshoring not only contributes to the economic growth of less-developed countries, but it increases their need and ability to import products from developed countries and thus indirectly contributes to the growth of all nations.

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There is also a natural extension from outsourcing to offshoring. Some industries and companies have actually seen some reversal of the outsourcing trend.

COUNTERPOINT: Only a few people benefit from offshoring. Cheaper labor inputs have not resulted in cheaper prices for consumers. Further, firms that grow as a result of offshoring do so at the expense of their competitors; thus, there is no real economic growth. Displaced workers are forced to take jobs with fewer, if any, benefits and lower pay, while multinationals take advantage of their foreign workers, who are powerless. While a few countries are growing economically, world poverty levels have increased significantly in recent decades.

V. WHY COMPANIES ENGAGE IN IB When engaging in international business, a firm should consider its mission, objectives, and possible strategies. Primary operating objectives would include the following: A. Sales Expansion Pursuing international sales usually increases the potential sales and potential profits.

B. Resource Acquisition Foreign locations may give companies lower costs, new or better products and components, and additional operating knowledge.

C. Risk Reduction International operations may reduce operating risk by smoothing sales, profits, and supplies and preventing competitors from gaining advantages.

VI. IB OPERATING MODES When pursuing IB, an organization must decide on suitable modes of operations, including merchandise exports and imports, service exports and imports, and investments [see Figure 1.1.].

A. Merchandise Exports and Imports Merchandise exports and imports are tangible products—goods—that are respectively sent out of and brought into a country. Merchandise exports and imports are the most popular IB modes.

B. Service Exports and Imports Service exports and imports are international nonproduct sales and purchases. The provider and receiver of payment makes a service export; the recipient and payer makes a service import. Services constitute the fastest growth sector in international trade and take many forms, such as: 1. Tourism and Transportation. Let's say that some Australian fans take Air France to watch the Tour de France bicycle competition. Their tickets on Air France and travel expenses in France are service exports for France and service imports for Australia.

2. Service Performance. Some services, such as banking, insurance, rental, engineering, turnkey operations (construction, performed under contract, of facilities that are transferred to the owner when they are ready for operation), and management contracts (arrangements in which one firm provides personnel to perform management functions for another), net companies export earnings in the form of fees paid by a foreign client.

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3. Asset Use. Firms may receive export earnings, i.e., royalties, by allowing foreign clients to use their assets (trademarks, patents, copyrights, and other expertise).

Licensing agreements are contracts that represent a transaction in which a licensor sells the rights to the use of its intellectual property to a licensee in exchange for a fee or royalty. Franchising is a special form of licensing in which the franchisee is granted additional control over the operation in exchange for the provision of additional support and services by the franchisor.

C. Investments Dividends and interest from foreign investments are also service exports and imports because they represent the use of assets (capital). Note that foreign investment means ownership of foreign property in exchange for a financial return, such as interest and dividends, and it may take two forms: direct and portfolio.

1. Direct Investment. In foreign direct investment (FDI), sometimes referred to simply as direct investment, the investor takes a controlling interest in a foreign company. A joint venture represents a direct investment in which two or more parties share ownership of an FDI. When two or more companies share ownership of an FDI, the operation is a joint venture.

2. Portfolio Investment. A portfolio investment is a noncontrolling interest in a venture made in the form of either debt or equity. Often, firms use portfolio investment as part of their short-term financial strategy.

D. Types of International Organizations There are numerous forms of collaborative arrangements through which companies work together internationally, such as joint ventures, licensing agreements, management contracts, minority ownership, and long-term contractual arrangements. A strategic alliance is more narrowly defined to indicate that the agreement is of critical importance to the competitive viability of one or more of the partners. A multinational enterprise or MNE is a company with foreign direct investments. The term multinational corporation or company (MNC) is often used as a synonym for MNE, while the United Nations uses the term transnational company (TNC).

VII. WHY DO COMPANIES' EXTERNAL ENVIRONMENTS AFFECT HOW THEY MAY BEST OPERATE ABROAD? Smart companies develop the means to implement international strategies by examining the following conditions abroad that can affect their success: • Physical factors (such as geography or demography) • Institutional factors (such as culture, politics, law, and economy) • Competitive factors (such as the number and strength of suppliers, customers, and rival firms) A. Physical Factors Physical factors, such as geography and demography, can affect how companies produce and market products, employ personnel, and even maintain accounts.

1. Geographic Influences. The uneven distribution of resources results in different opportunities being in different parts of the world. In addition, geographic barriers affect transportation, communications, and distribution channels within a country.

Managers who are knowledgeable about geography are in a position to better determine the location, quantity, quality, and availability of the world's natural 7 .

resources and conditions.

2. Demographic Influences. Countries' populations differ in many ways, such as density, education, age distribution, and life expectancy. These differences impact IB operations, such as market demand and workforce availability.

B. Institutional Factors Institutions refer to "systems of established and prevalent social rules that structure social interactions. Language, money, law, systems of weights and measures, table manners and firms (and other organizations) are thus all institutions." We will now examine a sample of these.

1. Political Policies. A nation's political policies influence how and if IB takes place because of the influence of government leaders over the process.

2. Legal Policies. While every nation has its own body of business law, agreements between/amongst nations determine international law. Domestic business law may include regulations on home-country firms in both home and host countries regarding such matters as taxation, employment, and foreign exchange transactions.

International law—in the form of legal agreements between countries—determines how earnings are taxed by all jurisdictions. Also, the ways in which laws are enforced also affect a firm's foreign operations 3. Behavioral Factors. By studying the disciplines of anthropology, psychology, and sociology, managers can better understand the interpersonal norms of people in foreign countries and the reasons why operating procedures may need to be adjusted in foreign locales.

4. Economic Forces. Among other things, economics explains why countries exchange goods and services, why capital and people travel among countries in the course of business, and why one country's currency has a certain value compared to another. It also provides the analytical tools to determine the impact of foreign operations on home and host countries, as well as the effect of a country's economic policies and conditions upon domestic and foreign firms.

C. The Competitive Environment In addition to its physical and social environments, every globally active company operates within a competitive environment. Companies' competitive situations may differ by their relative size in different countries, the competitors they face by country, and the resources they can commit internationally. A firm's competitive strategy for products will usually involve competing on the basis of cost or differentiation. Other competitive factors are a company's size and resources compared to those of its competitors. Finally, market success, whether domestic or foreign, often depends on the strength of competition and whether it is international or local. [See Fig. 1.1] LOOKING TO THE FUTURE: Three Major Scenarios on Globalization's Future By envisioning different ways in which the future may evolve, a company can be better prepared to develop the facilities and people needed to succeed in an uncertain environment. At this time, there is much discussion about the following three viewpoints.

The first view, that further globalization is inevitable, is based largely on the premise that technical advances in transportation and communications are pervasive, that consumers demand 8 .

the best products for the best prices regardless of their country of origin, and that MNEs are so powerful they can pressure governments to further reduce restrictions on trade and investment. If this is true, then the challenge is to determine what to make of globalization with respect to the distribution of its costs and benefits.

The second view, that international business will grow primarily along regional rather than global lines, is premised on studies that show that almost all firms that consider themselves global conduct a dominant portion of the business in their home and neighboring countries. It may be possible, however, that regionalization is a transitional step on the route to globalization.

The third view, that forces opposing globalization will greatly slow its growth, is not to be dismissed. Historically, pressure groups have often been successful in obstructing policies and activities that threatened their own well-being. In addition, recent antiglobalization interests have successfully promoted a variety of causes in numerous countries that span the globe. The impact of other uncertainties also impacts the future of globalization. Some examples of these uncertainties include the impact of oil prices on global transportation, the general economic recession, and concerns about product safety. Whether institutions and people can work together to effectively manage the complexities of today's interconnected world remains to be seen.

CLOSING CASE: Carnival Cruise Lines Although sea voyages have held an aura of mystique for centuries, only in recent decades have the general masses been able to experience open seas and exotic ports of call as a purely recreational activity. Cruises, i.e., sea voyages for pleasure, offer passengers the convenience of an assigned cabin as they sail along a fixed itinerary that concludes at their original point of sea embarkation. Almost everything about the entire cruise industry is international, from the routes traveled to the use of flags of convenience to the locations of shipyards to the staffing of vessels.

By far, the largest cruise competitor is Carnival, which owns a number of different branded lines.

Because Carnival operates globally, it can treat the entire world as a source of both customers and supplies. At the same time, its widespread operations also leave Carnival vulnerable to political upheavals, health crises, economic recessions, and natural disasters. Still, in all, the future outlook both for the industry and for Carnival is bright as more people the world over choose a holiday cruise.

Questions 1-3 What specific steps has Carnival Cruise Lines taken to benefit from global social changes?

Carnival has responded to global environmental changes in a variety of ways. Because a ship is highly vulnerable to terrorist acts, Carnival has instituted very strict security measures. It has also implemented strict health and safety measures. Carnival has dealt with economic recessions by offering shorter cruises that embark closer to home and with times of economic prosperity by offering longer cruises that incorporate more exotic destinations.

It minimizes staffing costs by sourcing employees on a global basis. In addition, across its 9 .

various lines, Carnival offers a wide variety of themes, classes of service, and destinations.

(LO1-2: Understand the relationship between globalization and IB, AACSB: Analytical Skills).

1-4 What economic factors influence success of the international cruise industry? Explain how each affects such success.

The main factor is consumer spending. During economic downturns, travelers opt for cruising rather than flying partly because cruise-line fares are fixed, sparing passengers the added risk of dealing with unfavorable exchange rates. However, cruise ship profitability depends on oil prices. A spike in crude oil prices would undermine the cruise industry's earnings because fuel is one of the major cruise lines' expenses. (LO1-5: Assess the major reasons companies seek to create value by engaging in IB, AACSB: Analytical Skills).

1-5 Although most cruise line passengers are from the United States, the average number of annual vacation days taken by U.S. residents is lower than that of workers in most other high-income countries (13 days, compared to 5 weeks in France and Germany). How might the cruise lines increase sales to people outside the United States?

Given that the majority of people in the targeted income segment have yet to take a cruise, the major task confronting the cruise line industry is one of marketing. In addition to promoting the many appealing features of its various cruises and lines throughout the developed world and selected developing countries, Carnival could partner with foreign airlines and travel agents in order to get foreign vacationers to its many ports of embarkation. (LO1-6: Define and illustrate the different operating modes for companies to accomplish their international objectives, AACSB: Dynamics of a Global Economy.)

1-6 What threats exist for the future performance of the cruise-line industry and, specifically, of Carnival Cruise Lines? If you were in charge of Carnival, how would you (a) try to prevent these threats from becoming reality, and (b) deal with them if they were realized?

While the potential market for Carnival seems very attractive, port capacity could well become an issue. The deep water and the massive facilities required to dock a liner in any port are limited. In addition, there are passionate cries from environmentalists regarding the damage (pollution of the seas, disorientation of sea mammals caused by the noise of the propellers, etc.) being caused by liners both in port and at sea. Should there be a major global economic disaster or a global health pandemic, the cruise line industry will surely suffer.

To proactively deal with the possibility of a downturn, Carnival should invest heavily in research and development in order to continually minimize the environmental impact of its ships and their operation. It must also carefully develop its global cruise structure in a way that complements existing capacity—or else work with ports to provide additional capacity.

If Carnival finds that it must react to a downturn, it should always think in terms of all of its stakeholders, not just its stockholders. Of course, it will want to minimize any damage to its operations and profits. However, given the immense size of the firm, it may also be possible 10 .

for Carnival to reach out to others (such as providing liners to be used as housing for workers, as in the case of Hurricane Katrina). Carnival will be better served by a long-term rather than a short-term orientation. (LO1-4: Discuss the major criticisms of globalization, AACSB: Reflective Thinking Skills.)

Additional Exercises: The Globalization Process Exercise 1.1. Ask students to identify firms, both domestic and foreign that operate internationally. Take time to explore the extent and nature of their operations. Also, discuss a logical geographical pattern of expansion for each type of operation. Conclude the discussion by examining the list to determine if there are any particular types of firms that seem to lend themselves (or not) to global operations and strategies. Have the students explain why this might be so. (LO: 2, Learning Outcome: To understand why companies engage in international business and why international business growth has accelerated, AACSB: Dynamics of the Global Economy.)

Exercise 1.2. Ask students why they think the world's largest theme park operator, the Walt Disney Co., was motivated to establish parks in Tokyo, Paris, and Hong Kong. What particular market characteristics of each of those sites were especially attractive? Conclude the discussion by asking students if they believe that Disney should establish additional foreign parks, and if so, when, where, why, and how? (LO: 4, Learning Outcome: To become familiar with different ways in which a company can accomplish its global objectives, AACSB: Analytical Skills.)

Exercise 1.3. Divide students into small groups and ask them to explore the costs of the globalization process. What are the major issues? What companies seem to promote corporate responsibility in all aspects of their businesses? What can and/or should be done to encourage seemingly less-than-responsible businesses and governments to change their ways? (LO: 4, Learning Outcome: To become familiar with different ways in which a company can accomplish its global objectives, AACSB: Analytical Skills.)

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PART TWO COMPARATIVE ENVIRONMENTAL FRAMEWORKS Chapter 2 The Cultural Environments Facing Business OBJECTIVES 2-1 Explain why culture, especially national culture, is important in IB, but tricky to assess 2-2 Grasp the major causes of national cultural formation and change 2-3 Discuss major behavioral factors influencing countries’ business practices 2-4 Recognize the complexities of cross-cultural communications 2-5 Analyze guidelines for cultural adjustment

CHAPTER OVERVIEW When companies source, manufacture, and/or market products in foreign countries, they encounter fascinating and often challenging cultural environments. Chapter Two examines the dynamics of culture and its effect upon international business operations and strategy. Culture and business practices are ever changing and these shifting trends are incorporated in the cases and examples. While exploring the causes of cultural differences, rigidities, and changes, it focuses upon the impact of cultural traditions on business activities, as well as the mutually satisfactory reconciliation of cultural differences. The chapter concludes with a discussion of the ways in which firms can potentially maximize their effectiveness while operating in a world of complex and dynamic cultural diversities.

CHAPTER OUTLINE OPENING CASE:

SAUDI ARABIA’S DYNAMIC CULTURE [see Map 2.1.]

This case provides a striking example of the challenges presented to foreign firms by a pervasive, theocratic, national culture. It shows why companies have had mixed success in Saudi Arabia, a modern yet ancient society grounded in Islamic law, religious convictions, and behavioral traditions. In particular, the case highlights the example of the Java Lounge, a new, up-scale Jeddah restaurant that serves an affluent niche of Saudi consumers. Further, it describes ways in which a variety of foreign firms have adjusted their products, facilities, and operating strategies to meet government requirements and yet satisfy the Saudi consumer. It points out numerous paradoxes one may encounter regarding Saudi legal sanctions, purchasing patterns, and attitudes toward work. A key point to make when discussing the case is that even in this very rigid culture, things are changing. Women can now vote, hold political offices, drive automobiles, and take 1 .

physical education classes for females. The Saudi business world has also seen much change.

Consider that women own about 20 percent of all Saudi businesses.

Questions 2.1 Assume you are an MNE manager who needs to send a team to Saudi Arabia to investigate the feasibility of selling your products there. What advice should you give them to help assure that cultural problems do not impede their success?

I would begin with the idea of wastah as, according to the article, seems to be a challenging, but asset to achieve for any business headed to Saudi Arabia. As one company in the article realized, observations and engaging in small talk within restaurants or other public places, led to a clearer understanding of how to build connections or wastah. Next, depending upon the products, you may learn more about what needs to happen in regards to infrastructure. In a place where traditional gendered roles are important, sexes are separated, and religious customs strictly observed, it is important to decide what changes are needed to the day-today operations and buildings. Also, if you will send a team with women, you may need to spend additional time securing visas into the country. (LO 2-5: Analyze guidelines for cultural adjustment, AACSB: Reflective Thinking.)

2.2 Assume your company is from North America or Europe and considering the establishment of an office in Saudi Arabia. What additional operating costs might it have to assume because of the Saudi culture?

Building further than the answer in the last question, businesses coming from more Western, Christian oriented countries will need think through the transition with care. Saudi Arabia is a country where traditional gendered roles are important, sexes are separated, and religious customs strictly observed. Depending upon the employees of the building, you will need to decide if a residential compound is needed for staff and families. The offices will need separated spaces for male and female employees, including doors and meeting locations.

Travel inside and outside the country may be challenging for women of Saudi decent due to male permission expectations and needing a male companion. Also, single women of a certain age may have a challenging time traveling to Saudi Arabia due to visas. In terms of religion, a company (at least) needs to make appropriate accommodations for prayers and measures to encourage adherence (such as dimming lights and stopping work during prayers, not serving food items during the day during Ramadan, or observing Friday prayers). (LO 2-5: Analyze guidelines for cultural adjustment, AACSB: Reflective Thinking.)

TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Two.

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CULTURE’S IMPORTANCE IN IB AND TRICKINESS TO ASSESS Culture refers to the shared values, attitudes, and beliefs of a group of individuals. Often, people simultaneously belong to different groups representing different cultures and/or subcultures. Further, every business function is subject to cultural influences. Cultural 2 .

diversity means bringing together people of different backgrounds, perspectives, and experience. Thus, major problems of cultural collision are likely to occur if a firm implements practices that are less effective than intended and/or employees are unable to accept or adjust to foreign customs. Thus, it is vital that firms determine which business practices vary in a foreign country and what adjustments, if any, are necessary. At the same time, cultural diversity can be a source of competitive advantage for global firms. [see Fig. 2.1.]

Culture is an elusive topic to study, partly because people belong to multiple cultures based on their nationality, ethnicity, religion, gender, work organization, profession, age, and income level. Companies’ need to understand and be sensitive to the culture where they operate.

A. National Cultures as a Point of Reference The idea of a “nation” provides a workable definition of a “culture” because (1) similarity among people is a cause and an effect of national boundaries and (2) it is a reference people make to “we” versus “they.” National identity is perpetuated through rites, symbols, and respect for national heroes, while the preservation of national sites, documents, monuments, and museums promotes a common perception of “we.”

Despite using the nation as a cultural reference point, not everyone therein shares the same values and attitudes. In addition, nations include various subcultures, and a nation must be flexible enough to accommodate and mediate its diversity. At the same time, some people have internalized more than one culture because of having dual or multiple citizenships, parents or spouses from another country, or lived abroad at an impressionable age.

B. The People Factor As nationalities come together through projects and teams, their diverse perspectives and experiences often enable businesses to gain a deeper knowledge of how to create and deliver products and services. Cultural diversity can be a competitive advantage, but successful cultivation of diversity is difficult because individuals may interact as they do within their own cultures.

When contact among divergent cultures creates problems, the situation is known as a cultural collision. Such collision may result in a company’s implementation of practices that are less effective than intended and to its employees’ distress because of difficulty in adjusting to behaviors abroad.

C. Building Cultural Awareness Although people agree that cross-cultural differences do exist, they often disagree on their impact. Are they widespread or exceptional? Are they deep-seated or superficial?

Are they easily discerned or difficult to perceive? It is vital that managers develop an acute awareness of all those cultures in which they operate. Cultural variables include daily routines and rules, codes of social relations, language, emotive expression, and concepts of luck. In addition, not only are there differences that distinguish various cultures, there is also a good deal of variation found within cultures. No foolproof method exists for building cultural awareness. Although research on another culture can be instructive, one must assess information carefully to determine if it perpetuates unwarranted stereotypes, covers only limited segments of a country’s culture, or is 3 .

obsolete. One should also observe the behavior of those people who have garnered the kind of respect and confidence they themselves will need.

D. Shortcomings in Cultural Assessments Sometimes differences are attributed only to culture, although other factors may be influential. When China had its one-child policy, millions of families aborted female fetuses. Why? Because males could carry on a family name (cultural), help work fields in rural areas (economic), and care for parents in old age (cultural and economic).

Recently, however, China has seen a shift toward more fondness for female offspring.

Why? Urbanization requires fewer male workers on farms (economic), while rising property values (economic) have taken a toll on families’ tradition (cultural) of buying living quarters for sons before they can marry.

We should also emphasize a few common shortcomings in interpreting cultural research. First, comparing countries based upon what people say may be risky. Second, a focus on differences in terms of averages may overlook specific variations within countries. Third, current cultural attitudes may change in the future.

II. INFLUENCES ON CULTURAL FORMATION AND CHANGE A. Sources of Change Culture is transmitted in a variety of ways, but psychologists believe that children have their basic value systems firmly in place. Nonetheless, individual and societal values and customs constantly evolve in response to changing economic and social realities.

Cultural change can be brought about by choice or imposition; change that is brought about by imposition is known as cultural imperialism. The introduction of certain elements of an outside culture may be referred to as creolization, or cultural diffusion.

B. Language as Both a Diffuser and Stabilizer of Culture While a common language within a country serves as a unifying force, language diversity may undermine a firm’s ability to conduct business, to integrate workforces, and to market products on a national level. Isolation from other groups, especially because of language, tends to stabilize cultures. Because some countries see language as such an integral part of their cultures, they may regulate the inclusion of foreign words and/or mandate the use of the country’s official language for business purposes. [see Map 2.2] C. Religion as a Cultural Stabilizer Religion can be a strong shaper of values and beliefs and is a major source of both cultural imperatives and taboos. Buddhism, Christianity, Hinduism, Islam, and Judaism represent just some of the religions whose specific beliefs may affect business practices. Yet, not all nations that practice the same basic religion place identical constraints on business. In addition, violence among religious groups can damage property and disrupt business activities for both home and host country firms. [see Map 2.3.]

III. MAJOR BEHAVIORAL PRACTICES AFFECTING BUSINESS Cultural attitudes and values affect business practices—everything from decisions about what products to sell to decisions about organizing, financing, managing, and controlling operations. Some of the more important aspects of culture are mentioned below.

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A. Issues in Social Stratification Every culture ranks people. Such social stratification creates hierarchies and influences a person’s class, status, and financial rewards within that culture. Because societies value group affiliations differently, business practices differ among countries. There are many ways to classify people’s group memberships: 1. Ascribed and Acquired Membership. Those usually determined by birth are ascribed group memberships, including gender, family, age, caste, and ethnic, racial, or national origin. Acquired group memberships include those based on religion, political affiliation, educational place and achievement, and profession.

2. Ethnic and Racial Groups. Country-by-country attitudes vary toward race and ethnicity. Malaysia, for example, defines political parties and employment quotas explicitly by three ethnic groups— Malays, Chinese, and Indians. The employment quotas are primarily to upgrade the economic position of Malays because the Chinese and Indian minorities long dominated business ownership and the professions, respectively.

3. Gender-Based Groups. Strong country-specific differences exist in attitudes toward the roles of males and females in society and the workplace, as well as the types of jobs regarded as “male” or “female.” However, in some parts of the world, barriers to employment based on gender are easing. In addition, as the composition of jobs becomes less physical and more creative and/or technical, the relative demand for female employees is also increasing.

4. Age-Based Groups. Many cultures assume that age and wisdom are correlated; thus, they often have a seniority-based system of advancement. In others, there is an emphasis on youth, particularly in the realm of marketing. Often there is a mandatory retirement age in business, but not in politics. Clearly, firms must consider reference groups when deciding whom to hire and how best to promote their products.

5. Family-Based Groups. In some societies, family membership is more important than individual achievement. Where there is low trust outside the family, such as in China and southern Italy, small family-run companies are generally quite successful, but they often have difficulty expanding beyond the family. In addition, such allegiances may impede the economic development of a nation if large-scale operations are necessary to compete globally.

B. Work Motivation Employees who are motivated to work long and hard are generally more productive than those who are not. On an aggregate basis, this will have a positive effect on economic development and national competitiveness.

1. Materialism and Motivation. Countries differ in their degree of materialism. In some societies, such as Japan and the United States, people desire less leisure time than others, such as much of Europe. Sociologist Max Weber claimed that predominantly Protestant Western economies were the most economically developed because of their emphasis on hard work and investment. This view of work as a path to salvation (an outgrowth of the Reformation) is known as the “Protestant ethic.” In rural India, however, where minimal material achievement is a desirable end in itself, any added productivity will likely be taken in the form of leisure, rather than income. In still other countries, leaders stress the need for a 5 .

culture that combines material comforts with spirituality. An interesting OECD study of the trade-off between productivity and leisure points out the disparity even among high-income countries. Even with this disparity, most people in most countries see economic advancement as an important life goal.

2. Expectation of Success and Reward. Although the same tasks performed in different countries will have different probabilities of success, different rewards for success, and different consequences for failure, people will usually work harder at any task when the reward for success is greater than the consequence of failure. The greatest enthusiasm for work exists when high uncertainty of success is combined with the likelihood of a very positive reward for success and little or none for failure.

3. Performance and Achievement. The masculinity-femininity index measures attitudes toward achievement. A high-masculinity score indicates a preference for “live to work,” whereas a high-femininity score indicates a preference for “work to live.” This index may help explain national differences in behaviors.

4. Hierarchies of Needs. Maslow’s hierarchy-of-needs theory of motivation states that people will try to fulfill lower-order physiological needs before satisfying (in order) their security, affiliation, esteem, and self-actualization needs. This theory can be especially helpful for differentiating the reward preferences of employees in different countries, who may likely rank some of their higher-order needs differently. An example of these differences can be discussed using the ethnographic study comparing the US, the Dominican Republic, and Barbados.

C. Relationship Preferences Within social stratification systems, not every member of a reference group is necessarily equal. In addition, there may be strong or weak pressures for group conformity. Such national differences in norms influence both effective management styles and marketing behavior.

1. Power Distance. Power distance is a measurement of employee preferences of interaction between superiors and subordinates. With high power distance, people prefer little consultation between bosses and subordinates. They also prefer management styles that are either autocratic (ruling with unlimited authority) or paternalistic (regulating subordinate conduct by supplying their needs). With low power distance, they prefer “consultative” styles.

2. Individualism versus Collectivism. High individualism describes a preference to fulfill leisure time, build friendships, and improve skills independently of the organization. People with high individualism also prefer to receive direct monetary compensation as opposed to fringe benefits, and they prefer to engage in personal decision-making and on-the-job challenges. High collectivism, in contrast, typifies an employee’s penchant for dependence on the organization through training, satisfactory workplace conditions, and good benefits. For example, the United States is a highly individualist country, and employees socialize less with close work colleagues outside of work than employees do in more collectivist societies.

In countries with high individualism, a self-actualization opportunity is a prime motivator because employees want challenges. In those with high collectivism, fulfilling security needs is a prime motivator.

D. Risk-Taking Behavior 6 .

Nationalities differ in their attitudes toward risk-taking, i.e., how willingly people accept things the way they are and how great their need for control of their destinies.

1. Uncertainty Avoidance. Uncertainty avoidance describes a trait of being uncomfortable with ambiguity. Where this trait is strong, most employees prefer to follow set rules even if they believe that breaking them may be in the company’s best interests. They also tend to stay with current employers for a long time, preferring the certainty of present positions over the uncertainty of their future elsewhere.

2. Trust. Trust represents one’s belief in the reliability and honesty of another. Where trust is high, there tends to be a lower cost of doing business because managers devote less time to investigation and oversight and more to innovation and investment. (While Norwegians tend to exhibit a high degree of trust, Brazilians tend to be skeptical.)

3. Future Orientation. Individuals who tend to live for the present as opposed to for the future see risks in delaying gratification and investing for the future. Where future orientation is higher, workers will more likely be motivated by types of delayed compensation, such as retirement programs. (While a future orientation tends to be higher in Canada, the Netherlands, and Switzerland, it tends to be lower in Italy, Poland, and Russia.)

4. Fatalism. Fatalism represents the belief that life is predestined, that every event is inevitable, and that occurrences represent “the will of God.” Unlike those who believe strongly in self-determination and basic cause-and-effect relationships, fatalists are not likely to plan for contingencies or take responsibility for performance. Thus, they are less swayed by persuasive logic than by personal relationships.

E. Information and Task Processing People from different cultures obtain, perceive, and process information in different ways; thus, they may also reach different conclusions.

1. Perception of Cues. People perceive cues selectively. They identify things by means of their senses (sight, smell, touch, taste, and sound) and in various ways within each sense. The particular cues used will vary both for physiological and cultural reasons (e.g., differences in eye pigmentation enable some to distinguish colors better than others; the richer and more precise a language, the better one’s ability to express subtleties).

2. Obtaining Information: Low-Context versus High-Context Cultures. Language represents a culture’s primary means of communication. In a low-context culture, people rely on explicit, first-hand information that bears directly on a decision or situation; people say what they mean and mean what they say. In a high-context culture, people rely on implicit, peripheral information and infer meaning from things communicated indirectly; relationships are very important; (e.g., while the United States and most of northern Europe are considered to be low-context cultures, most countries in southern Europe are considered to be high-context cultures).

3. Information Processing. All cultures categorize, plan, and quantify, but the ordering and classification systems used often vary. To perform efficiently and work amicably in a foreign environment, you need to understand such differences in 7 .

processing systems. Further, different processing systems create challenges in sharing global data.

4. Monochronic Versus Polychronic Cultures. In monochronic cultures (e.g., northern Europeans) people prefer to work sequentially, but in polychronic cultures (e.g., southern Europeans) people are more comfortable working on multiple tasks at one time.

5. Idealism Versus Pragmatism. In some cultures, people focus first on the whole and then on the parts; similarly, some cultures will determine principles before they try to resolve small issues (idealism), whereas other cultures will focus more on details rather than principles (pragmatic).

IV. PROBLEMS IN COMMUNICATING ACROSS CULTURES Communication problems may arise when moving from one country to another, even though both countries share the same official language. Of course, problems also arise when moving from one language to another.

A. Translation of Spoken and Written Language Translating one language into another can be very difficult because (a) some words do not have a precise translation, (b) the common meaning of words is constantly evolving, (c) words may mean different things in different contexts, and (d) a slight misuse of vocabulary or word placement may change meanings substantially. Further, while jokes and laughter have universal appeal, much humor does not. Therefore, words must be chosen very carefully, because poor translations may have tragic consequences. [see Table 2.1.]

B. Silent Language Silent language incorporates the wide variety of nonverbal cues through which messages are sent—intentionally or unintentionally. Color associations, the distance between people during conversations, the perception of time and punctuality, a person’s perceived prestige, and kinesics or body language are all very significant.

Misunderstandings in any of these areas can be serious.

V. GUIDELINES FOR CULTURAL ADJUSTMENT Once a company identifies cultural differences in the foreign countries in which it operates, must it alter its customary practices? Can individuals overcome adjustment problems when working abroad?

A. Host Society Acceptance If products and operations do not run counter to deep-seated attitudes, or if the host country is willing to accept foreign customs as a trade-off for other advantages, significant adjustments may not be required.

B. Degree of Cultural Differences Cultural distance represents the degree of similarity between two societies. Countries may be relatively similar to one another because they share the same language, religion, geographical location, ethnicity, and/or level of economic development. Generally, a firm should have to make fewer adjustments when moving within a culturally similar cluster than when it moves from one distinct cultural cluster to another. Nonetheless, a manager must not assume that seemingly similar countries are more alike than they really are and be lulled into a complacency that overlooks critical subtleties.

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C. Ability to Adjust: Culture Shock Culture shock represents the trauma one experiences in a new and different culture because of having to learn to cope with a vast array of new cues and expectations.

Reverse culture shock occurs when people return home, having accepted the culture encountered abroad and discovering that things at home have changed during their absence.

D. Company and Management Orientations Whether and how a company and its managers adapt abroad depends not only on the host country culture but also on their own attitudes and behaviors. The following sections discuss three such attitudes or orientations: polycentrism, ethnocentrism, and geocentrism: 1. Polycentrism. A polycentric organization believes it should act abroad like companies there. Polycentric management may be so overwhelmed by national differences that it won’t introduce workable changes.

2. Ethnocentrism. Ethnocentrism reflects the conviction that one’s own practices are superior to those of other countries. Ethnocentric management overlooks national differences and ignores important factors, believes home-country objectives should prevail, and thinks acceptance by other cultures is easy.

3. Geocentrism. Geocentrism represents a managerial approach in which foreign operations are based on an informed knowledge of both home and host country needs, capabilities, and constraints. Geocentric management often uses business practices that are hybrids of home and foreign norms.

POINT—COUNTERPOINT: Does IB Lead to Cultural Imperialism?

POINT: Modern cultural imperialism has come about because of the technical, political, military, and economic supremacy of the developed countries in relation to the less developed countries of the world. Exposure to news and entertainment media, extensive advertising, mass distribution, and Western tourists leads periphery peoples to believe that Western lifestyles are glamorous, exciting, and desirable. As international firms take advantage of this newly created demand, they uncaringly employ practices and attitudes that further upset the local culture and self-identity that helps stabilize a nation. While rich countries may be able to prohibit investment in culturally sensitive industries, restrict the use of foreign languages, limit the screening of foreign films, etc., periphery countries lack the resources to do so.

COUNTERPOINT: Although people in many countries have adopted everything from jeans to Coca-Cola, they pick and choose products based on personal interpretations of their needs in relation to the realities of the cultures in which they live. While trade-offs are often involved, globalization provides options that otherwise would not exist. Further, evidence does not indicate that the adoption of foreign products necessarily causes a change in a country’s culture. With contact, cultural diffusion spreads in two directions. Cultures have always evolved, and what is occurring is the development of hybrid cultures, not cultural imperialism. Finally, foreign firms must adhere sufficiently to local culture lest they fail—and local competition may not be local at all.

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E. Strategies for Instituting Change Companies may need to transfer new products and/or operating methods from one country to another in order to gain a competitive advantage. To maximize the potential benefits of their foreign presence, they need to treat learning as a two-way process and transfer knowledge from home countries abroad and from host countries back home.

1. Value Systems. The more that change upsets important values, the more resistance it will encounter. Accommodation is much more likely when changes do not interfere with deep-seated customs.

2. Resistance to Too Much Change. Resistance to change may be reduced if only a few demands are made at one time; others may be phased in incrementally.

3. Participation. A proposed change should be discussed with stakeholders in advance in order to ease their fears of adverse consequences—and perhaps gain their support.

4. Reward Sharing. A company may choose to provide benefits for all the stakeholders affected by a proposed change in order to gain support for it.

5. Opinion Leadership. Characteristics of opinion leaders often vary by country. By discovering the local channels of influence, an international firm may seek the support of opinion leaders to help speed the acceptance of change.

6. Biculturals and Multiculturals as Mediators. Companies may rely on bicultural or multicultural individuals, especially those within their own ranks, to present and explain changes to stakeholders.

7. Timing. Many good business changes fail because they are ill-timed. Attitudes and needs change slowly, but a crisis may stimulate the acceptance of change.

8. Learning Abroad. The essence for undertaking transnational practices is to capitalize on diverse capabilities by transferring learning among all the countries in which a firm operates.

LOOKING TO THE FUTURE: Scenarios on the Evolvement of National Cultures Although some tangibles have become more universal, the ways in which people cooperate, solve problems, and are motivated continue to differ. Many expect that as contact across cultures becomes more widespread and as people become more flexible citizens, hybrid cultures will develop. Others believe that national cultures will be more homogenized with respect to visible expressions of culture, but that basic values will not change. A third view is that national cultures will become stronger because of feelings of nationalism. Finally, some people feel that national borders as we know them today will change to accommodate ethnic groups and other subcultures.

CLOSING CASE: International Students and International Business About 5.3 million international students attended universities outside their country of citizenship in 2017. They had a significant positive economic impact on the host countries, with financial contributions exceeding the fees they pay to universities. For instance, in the US, international students contributed to the US surplus in service trade and supported about 400,000 jobs during 10 .

2017. In the UK, they supported GBP 1 billion in tax revenues in 2014/2015. But their contributions go beyond monetary terms. International students can contribute to diplomatic connections. Academically, universities have adjusted to the influx of international students with various initiatives to meet diverse foreign student needs. Yet challenges remain particularly arduous bureaucratic and academic tasks and language difficulties. Another challenge is how to infuse international content into program curricula because many faculty members have little or no background on related topics and have time constraints in adding anything to already jampacked courses. For students, study abroad brings challenges like those experienced by expatriate managers, i.e., cultural adaptation. Given the massive growth in student mobility and the significant contribution of international students to host countries’ economies, much thought has been given to improving intercultural competence for international students. One such solution is the Process Model of Intercultural Competence (see Figure 2.3.)

Questions 2.3 Assume someone from another country asks to understand the most important cultural things about your country, how would you respond?

First, I would need to understand the differences in cultural factors, political policies/legal factors, economic forces, and geographic influences of the person to know what elements are important. For example, being from the United States, if it was a person from Canada, I may assume they know some of the basics such as language, economics, or geographic influences as they have many of the same characteristics. In this case, I may focus upon more regional differences. I might mention the importance of the Spanish language in some areas. If the person is a member of the First Nations in Canada, I may discuss the role and current situation of Native Americans in the United States. If they were coming from an urban area, I would discuss the Midwest cultural characteristics and other geographic regions. The information about the United States may change if I was talking to a student from a predominant Muslim country coming to the United States, I may discuss how the majority subscribe to Christianity, but other religions are free to practice. They may find less knowledge among Americans, however, of holidays important to Muslims. (LO: 2, Learning Outcome: Grasp the major causes of national cultural formation and change, AACSB: Reflective Thinking.)

2.4 If you are planning to visit another country as a student or tourist, what preparations can you make that will help you to understand that culture better?

No matter where you go in the world, travel should not commence until the person undertakes research. Often times, firsthand knowledge from a person from the country is the best place to start. Although the nationals of the country you wish to visit may be biased based on religion, geographic location, socioeconomic status, etc., they should be able to guide you on the basics. Depending upon the purpose of the visit, another step is to connect with your national consulate within the country or do research on internet. They often have 11 .

important information and travel alerts. In the United States, the US government produces an excellent guide about countries at https://travel.state.gov/content/travel.html. Next, there are often excellent travel guides that assist you in planning a trip and being sensitive to national cultural values of a country. Finally, if time permits, I would strongly suggest a beginner course in the language (if it is different). At least, having a contact within the country to help with translation needs may prove helpful for emergencies. (LO: 2, Learning Outcome: Grasp the major causes of national cultural formation and change, AACSB: Reflective Thinking.)

2.5 If you have visited other countries, did the experience make you think more about yourself or your home country?

Most of the time, people will both realize things they take for granted or cultural values that they did not realize were so strong when they visit a new country. For example, some people may believe religion is somewhat important to them in their home country. When you travel to a new country that does not practice the same faith, you may notice holidays that you expect (for example Christmas) are not observed, certain places of worship (a Catholic vs.

Protestant church) are not present, or religious customs may mean that you have a heightened awareness of religious values. Secondly, if the country does not speak the same language, you find out quickly how it can be difficult to get a meal, find transportation, or check into housing options. Even if people say they speak your language, often times there may be substantial differences. If you end up needing medical care, language and process to see medical professionals may vary. Another difference is just the daily aspects of life. You may not find similar types of food, restaurants, or even clothing/personal necessities as you do in your home country. (LO: 2, Learning Outcome: Grasp the major causes of national cultural formation and change, AACSB: Reflective Thinking.)

2.6 Can you think of an occasion when a student from another culture has made a contribution to student life that you valued?

I can reflect upon numerous times in which students from another culture have made a contribution and have changed the projection of my life. Interactions and cooperation with students from other countries make significant changes in stereotype ideas and interest to learn more about others. Often times, the closer the interaction and the amount of time you spend with the person influences the amount of contribution. A roommate, for example, might be more significant than a classmate. Taking the time to attend a cultural event with a friend may encourage a person to attend other cultural events and supporting others in their celebrations. Decreasing ethnocentrism is possibly the largest contribution that meeting students from other cultures can make in student life. (LO: 5, Learning Outcome: Analyze guidelines for cultural adjustment, AACSB: Reflective Thinking.)

2.7 Have you made any friends with students from other countries? Is so, describe how it happened. If not, why do you think you haven’t?

Most of my friendships across cultures comes from my natural interest to learn more about other ways of life. According to some scholars, people have a natural threshold for new or 12 .

unfamiliar situations. It often influences how likely you are to meet friends/students from other countries. Of course, there are schools with higher populations of students or urban areas with high concentrations of people from other cultures, which makes it easier because you are regularly in contact with people from other countries. However, people with a natural interest or drawn to learning more about new realities, tend to seek out friendships with people from other countries. (LO: 5, Learning Outcome: Analyze guidelines for cultural adjustment, AACSB: Reflective Thinking.)

2.8 Assume on post-graduation that you are launching a new global start-up and are seeking new partners. How might you start building your global business networks now?

Having opportunities in classes to interact and collaborate on “practice” businesses is one way to practice how partnerships may look like in the real world. In a safe space, you learn about differences in cultural values such as time, talk, and customs across cultures.

Establishing relationships in the classroom or on campus is much easier than flying into a country and starting from scratch. If you know people from major economic centers, it may allow you to discuss ideas early on to see if it is an appropriate business for the location.

(LO: 5, Learning Outcome: Analyze guidelines for cultural adjustment, AACSB: Reflective Thinking.)

Additional Exercises: Cultural Challenges Exercise 2.1. Ask students to outline the reasons why the various elements of culture (social structures and control systems, language and aesthetics, religion and other belief systems, educational systems, etc.) might increase the cost of doing business in a country. Be sure that the students illustrate their ideas with concrete examples of both cultural elements and specific countries. (LO 2-3: To discuss behavioral factors influencing countries’ business practices, AACSB: Analytical Skills.)

Exercise 2.2. Choose two to five countries that are culturally diverse. Ask students to compare the cultures of those countries and to discuss the ways in which cultural differences will affect the cost of doing business in each. Conclude the discussion by examining the ways in which business practices and ethics vary across the cultures. (LO: 1, Learning Outcome: To understand methods for learning about cultural environments, AACSB: Analytical Skills.)

Exercise 2.3 In many countries, religion has a dramatic effect on people’s attitudes, customs, and behavior. Lead students in a comparative discussion of the potential effects of the basic beliefs of the world’s major religions upon international business opportunities and operations. (LO 2-2: To analyze behavioral factors influencing countries’ business practices, AACSB: Dynamics of Global Economy.)

Exercise 2.4. Pop culture can influence the development of global preferences in a number of ways. Lead students in a discussion of the ways in which movies can affect the cultural dimensions of a society. (Select particular movies, examine various values embedded in 13 .

them, and discuss the nature of their impact upon the lifestyles of people around the world.)

(LO 2-4: To understand cultural guidelines for cultural adjustment, AACSB: Multicultural and Diversity Understanding.)

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Chapter 3 The Political and Legal Environments Facing Business OBJECTIVES 3-1 Explain how politics and laws influence business activities 3-2 Interpret the principles and practices of a political environment 3-3 Discuss the principles and practices of political freedom 3-4 Describe the idea of political risk 3-5 Interpret the principles and practices of a legal environment 3-6 Describe legal issues facing international companies 3-7 Relate the ideas of politics, law, and business

CHAPTER OVERVIEW When firms source, produce, and/or market products in foreign countries, they encounter dynamic and challenging political and legal environments. Chapter Three provides a conceptual foundation for the examination of the political and legal dimensions of international business operations. It compares major political regimes, discusses their potential influence upon the development of effective business strategies, and considers the relevance of political risk. The chapter also examines the major types of legal systems that exist today, as well as the strategic and operational concerns they pose. It concludes with a discussion of intellectual property rights and the associated challenges confronted in an age of globalization.

CHAPTER OUTLINE OPENING CASE:

CHINA: BIG OPPORTUNITIES, COMPLICATED RISKS [see Map 3.1.]

During its 30 years of communist rule, China prohibited foreign investment and restricted foreign trade. In 1978, China enacted the Law on Joint Ventures using Chinese and Foreign Investment. China’s subsequent transformation has been fueled by a landslide of foreign investments made in response to the country’s market potential, market performance, improved infrastructure, enormous resources, and strategic position. Frustrating this process, however, has been the politics of China’s elaborate bureaucracy, as well as its ill-defined legal system and pervasive corruption. Historically China has relied upon the rule of man and the belief that legal rights are derived from the power of the individual. Upon joining the WTO, China agreed to continue to reform its business environment and to move toward transparent, rules-based, enforcement-oriented standards. But the business reality is far from the WTO obligations specifically in the continued controversy over the protection of intellectual property. Coming full circle, today’s fully-owned Chinese enterprises are themselves becoming global investors, both by acquiring foreign firms and investing in foreign lands. Despite a complex political and legal

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environment, China attracts a legion of foreign investors seeking lucrative business opportunities.

Questions 3.1 What general perspective do you advocate to make sense of China’s political environment?

China’s political environment is dominantly a collectivist system. It is defined in terms of “We,” rather than “I.” In China, people’s commitment is to the “group” such as family. In other words, groups matter more than does the individual. Politically, the effectiveness, stability, and coherence of authoritarianism matter more than individual’s rights and the freedom of a democracy. (LO 3-2: Interpret the principles and practices of a political environment, AACSB: Reflective Thinking.)

3.2 How would you advise an MNE to manage the intricacies of China’s legal environment?

Navigating China’s legal environment requires studying how officials exercise and legislate policies and regulate business activity. They should also hire local lawyers with expertise in China’s legal system. MNEs can also benefit from forging partnerships with local businesses in China that have the knowledge and connections to deal with legal and political challenges. (LO 3-5: Interpret the principles and practices of a legal environment, AACSB: Reflective Thinking.)

TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Three.

I.

POLITICS, LAWS, AND OPERATING INTERNATIONALLY Politics and laws are dynamic. At different times, different parties champion different ideologies that endorse different political systems. Consequently, investing and operating internationally exposes MNEs to risks that arise from change in a country’s political system.

For a multinational enterprise to succeed in countries with different political and legal environments, its management must carefully analyze the fit between its corporate policies and the political and legal conditions of each particular nation in which it operates. [see Fig. 3.1.] [see Map 3.1.]

II. THE POLITICAL ENVIRONMENT A political system is a complete set of institutions, political organizations, and interest groups; the relationships among those institutions; and the political norms and rules that govern their activities. Thus, it integrates the various parts of a society into a viable, functioning entity. It also influences the extent to which government intervenes in business and the way in which business is conducted both domestically and internationally. The ultimate test of any political system is its ability to hold a society together.

A. Individualism It is useful to profile the similarities and differences among political systems according to the general orientation within a society about the primacy of the individual's rights and role versus that of the larger community. Individualism champions the primacy of 2 .

the individual over the group, while collectivism advocates the primacy of the group over the individual. Under an individualistic paradigm (e.g., the United States), political officials and agencies play a limited role in society. The relationship between government and business tends to be adversarial; government may intervene in the economy to deal with market defects, but generally it promotes marketplace competition. This concept that the government should not interfere in business affairs is captured in the idea of laissez-faire.

B. Collectivism Under a collectivist paradigm, the government defines economic needs and priorities, and it partners with business in major ways. The government is highly connected to and interdependent with business; the relationship is cooperative.

C. Political Ideology Applying the implications of individualism and collectivism to a political system brings us to the discussion of political ideology. A political ideology is the body of goals, theories, and aims that constitute a sociopolitical program. Although shared ideologies create bonds within and between countries, differing ideologies tend to split societies apart. better, brighter future—it specifies the means to achieve it. Figure 3.2 interprets prominent political ideologies in terms of a political spectrum. Spectrum analysis, in specifying a basic conceptual structure, guides the assessment of a complex issue—in this case, political ideology. Political freedom as the criterion encourages setting democracy as one endpoint, and totalitarianism, the other. Understanding the ideals and the means of the two endpoints, democracy and totalitarianism, helps interpret the others.

D. Democracy Democracy and individualism are intrinsically related and mutually reinforcing; individualism legitimates principles of democracy and democracy fortifies standards of individualism. Democratic government institutes personal and political rights, civil liberties, fair and free elections, and independent courts of law. Different legacies shape the performance of democracy in a nation. Table 3.1 shows that countries respond with different types of democracies. Notwithstanding variance, all advocate the authority of the many over the few.

Business Implications: In modern democracies, political and economic freedoms are increasingly interconnected. The stability and transparency of democracies support private enterprises, creating business opportunities, encouraging investments, and sustaining productive enterprises. Democracy institutes checks and balances that reduce red tape, trade barriers, rent seeking, regulatory capture, corruption, and cronyism.

E. Totalitarianism Totalitarianism subordinates the interests of the individual to that of the collective. An agent, in some form, such as an individual, a committee, an assembly, a junta, or a party, monopolizes political power and uses it to regulate many, if not all, aspects of public and private life. totalitarian government eliminates dissent through indoctrination, surveillance, propaganda, censorship, and violence.

Business Implications: Managers in totalitarian systems face radically different markets than those found in democracies. Private enterprise, when allowed, supports 3 .

the state. Political risks affect all companies, but typically target foreign investors. The state favors local companies at the expense of foreign competitors, providing them with advantageous financing, preferential tax programs, relaxed work regulations, and other benefits. The state manipulates markets for political purposes, thereby distorting resource valuations and blurring risk–return relationships.

III. The State of Freedom Since 1972 Freedom House has annually assessed the state of political freedom around the world. Freedom House identifies three types of political systems: (1) Free, (2) Partly free. and (3) Not free. Roughly 24 percent of the world population resides in partly free countries whereas 36 percent live in not free countries [see Map 3.2.].

A. The Prevalence of Political Freedom The second half of the twentieth century saw the steady diffusion of democracy worldwide. This shift signified the so-called Third Wave of Democratization, a global movement that expanded individual freedoms and civil liberties. Various forces powered past the Third Wave of Democratization: • Failure of totalitarian regimes to deliver prosperity • Improving communication technology • Economic dividends of political freedom This megatrend had huge consequences for IB. Democratic governance stabilized business environments, both at home and abroad. Growing stability encouraged MNEs to expand their investment horizon to include markets, such as China, Russia, and Eastern Europe, that had previously been off-limits given extreme political risks.

Troubling data, however, question the momentum of democracy in the twenty-first century.

B. Freedom Struggles Democracy’s advocacy of individualism, freedom, prosperity, and peace made it the most successful political idea of the 20th century. Troubling data, Freedom House reports, question its momentum in the 21st century. In 2008, its slowing momentum suggested a “democracy recession.” In 2012, data signaled democracy’s retreat worldwide. In 2015, retreat gave way to reversal and the “return of the iron fist.” In 2018, events and trends indicated a state of “democracy in crisis.” 2019 found democracy’s retreat accelerating worldwide.

Gauging the Scale of Struggle: The Texture of Democracy. The Economist Intelligence Unit (EIU) identifies four types of political systems: (1) Full democracy, (2) Flawed democracy, (3) Hybrid regime, and (4) Authoritarian regime. Specifically, the EIU evaluates the “texture of democracy” in a country in terms of the degree that its electoral process, pluralism, civil liberties, government performance, political participation, and political culture support democratic governance [see Table 3.3.] [see Map 3.3.].

The Distribution of Demography. The EIU classifies 76 countries as democracies— that is, each meets the minimum expectation of regularly running nominally fair elections. Evaluated in terms of the texture of democracy, however, many are found to be “democracies” in name only. Just 22 are full democracies. The remaining 54 are flawed democracies.

Qualifying Democracy by Demography. The distribution of political systems in terms 4 .

of demography extends the interpretation of the texture of democracy. Roughly 3.7 billion (48 percent) of the world’s population lives in some form of democracy.

However, just 4.5 percent, or, about 340 million, live in a full democracy. Some 1.2 billion (17 percent) live in hybrid regimes and 2.7 billion (36 percent) reside in authoritarian regimes.

C. The Allure of Authoritarianism Countries, skeptical of the virtues of a multiparty democracy, have translated authoritarian ideologies into single-party political systems. Analogous to the engines that powered the Third Wave of Democratization, several contemporary developments promote authoritarianism. Powering expanding authoritarianism is: • robust economic performance in single-party states, • gaps between the principles and practices of democracy, • economic insecurities and growing populism, • competing interpretations of the idea of democracy Economic Problems Persistent unemployment, slow growth, higher taxes, and rising debt in many Western countries call into question the capacity of democracy to create a fairer, brighter, prosperous future.

LOOKING TO THE FUTURE: Political Ideologies and the MNEs’ Actions There is a clear link between political and economic freedom and economic growth. However, democracy does not necessarily mean stability; in fact, in a transition economy, political risk is often quite high. The emergent democracies of the 1990s, especially those of the former Soviet bloc, still wrestle with domestic unrest and security threats. Although challenges to democracy are many, terrorism stands out above all others. Some people argue that if a country is to flourish as a democracy, certain preconditions such as economic development must be present. However, others argue that democracy is the result of having political leaders who exhibit both the determination and the skills required to assure that democratization occurs. Still, others feel that indirect support may flow from Asia’s alternative conception of democracy, where economic freedom is progressing more rapidly than political freedom. China is a case in point. With a totalitarian democratic system, China has focused on economic growth in the belief that growth solves most problems. China’s success with “freedom stagnation” throws into question Western ideals of democracy. If democracy proves resilient and resourceful, then managers will face the task of adjusting their operations during periods of economic crisis, but if democracy falters, then managers will face the task of rethinking their operations in a world of increasing state control and repression.

IV. Systemic Political Risk Technically, political risk is the chance that political decisions, events, or conditions change a country’s business environment in ways that force a company to accept lower rates of return, cost it some or all of its investment, or threaten the sustainability of its operation.

A. Classifying Political Risk The following types of political risk range from the least to the most destructive. [see Figure 3.4.]

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1. Systemic Political Risk. Systemic political risks, by influencing investment and operating conditions in a nation, affect the activities of all firms.

2. Procedural Political Risk. Procedural political risk institutes impediments that constrain efficiently running activities.

3. Distributive Political Risk. Distributive political risks progressively eliminate the local property rights of foreign companies 4. Catastrophic Political Risk. Catastrophic political risk devastates the business environment for all companies POINT—COUNTERPOINT: Proactive Political Risk Management: The Superior Approach POINT—PROACTIVE POLITICAL RISK MANAGEMENT: Active political risk management reasons that if one measures the right set of discrete events, one should be able to calculate the degree of political risk in a country and estimate the likelihood that politically risky disruptions, (e.g., civil strife, terrorism, regime change, ethnic tensions, contract repudiation, financial controls) will occur. Hence, rigorous quantitative analysis and modeling should detect, measure, and predict future instances of political upheaval. Others opt to assess such risk with qualitative measures by polling a panel of country experts who possess an expert sense of the situation.

Then, likely scenarios are developed and probabilities assigned for a finite period of time.

COUNTERPOINT—PROACTIVE POLITICAL RISK MANAGEMENT: Many firms choose to treat political risk as an unpredictable hazard of international business. Given that, the strategically responsible thing to do is to find a cost-effective way to hedge the firm’s exposure.

Typically, these companies shield themselves from political risk by purchasing insurance that protects their operations from various sources of risk, including government expropriation, involuntary abandonment, or damage to assets due to political violence. Organizations that offer such insurance include the Overseas Private Investment Corporation (OPIC), Multilateral development Banks such as the World Bank and its regional counterparts, as well as private insurance firms.

V. THE LEGAL ENVIRONMENT A legal system is the mechanism for developing, stipulating, interpreting, and enforcing the laws in a formal jurisdiction. Modern legal systems have three essential components: 1. Constitutional law, which translates a country’s constitution into an open and just legal system, setting the framework for government and defining the authority and procedure of political bodies to establish laws; 2. Criminal law, which safeguards society by specifying what conduct is criminal, and prescribing punishment to those who breach those standards; and 3. Civil and commercial laws, which ensure fairness and efficiency in business transactions by stipulating private rights and specific remedies in order to regulate conduct between individuals and/or organizations.

Aspects of each component influence MNEs’ actions in a host country.

A. Types of Legal Systems. Generally, legal systems fall into one of the following categories: [see Map 3.3.]

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1. Common law. Common law is derived from judicial decisions of courts; its defining characteristic is that it emerged as precedent. Common law has AngloAmerican legacies; it prevails in, among others, Australia, Canada, England, Hong Kong, New Zealand, and the United States.

2. Civil law. Civil law is Civil law codifies core principles that serve as the primary source of law. Civil law is the most widespread type of legal system in the world; we find it in approximately 150 countries, including Azerbaijan, Chile, France, Germany, Japan, Kuwait, Mexico, Russia, Switzerland, and Thailand.

3. Theocratic law. Theocratic law applies the inspirations and instructions of religious teachings. The most prevalent theocratic system, Muslim or Islamic law, Shari’a, is based on the Qur’an (Koran), the Sunnah (decisions and sayings of the Prophet Muhammad), the writings of Islamic scholars, and the consensus of legal communities in Muslim countries. Muslim law prevails in the Middle East and North Africa. However, modernists (e.g., Turkey, Indonesia), traditionalists (e.g., Kuwait, Malaysia), and fundamentalists (e.g., Iran, Saudi Arabia) advocate different interpretations of Shari’a.

4. Customary law. Customary law is based on norms of behavior that gain legitimacy through ongoing practice. Customary law prevails in many developing countries, particularly in Africa. Few nations, notably Andorra, Guernsey, and Jersey, operate under a wholly customary legal system.

5. Mixed System. The mixed legal system results when a nation uses two or more of the preceding types; each type applies cumulatively or interactively, as well as locations where no type clearly predominates. Map 3.4 shows that one finds most mixed systems in Africa and Asia.

B. The Context of Legality Assessing the gap between principle and practice calls for assessing the context of legality in terms of the basis of rule in a nation. As seen in Map 3.5, the World Bank assesses a nation’s legal system to determine whether its basis of rule favors the law or favors the “man.” These different interpretations of legality in different nations require that managers ask, “What is the basis of rule in a country—is it the law or is it the man?”

1. The rule of law holds that no individual, from president to peon, is above laws that are clearly specified, commonly understood, and fairly enforced. Besides instituting a just political environment, the rule of law guarantees the enforceability of commercial contracts, business transactions, and the sanctity of property rights.

Companies rely on its legitimacy to validate the laws, codes, and statutes that regulate their activities.

2. The rule of man holds that the ruler, in whatever form commands authority that is above the law. In countries where the rule of man is the basis of law, acceptable marketplace behavior is unpredictable. Managers stay alert to trumped-up charges, solicitation of bribes, favoritism of local rivals, and the primacy of cronyism over competencies.

C. The Basis of Rule: Legacies and Trends From 1215 to 1776 and onward, the rule of law anchored the legal evolution of several nations, most notably Great Britain, the United States, France, and Germany. By the late twentieth century, it was the undisputed foundation of legality in westernized countries.

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History shows that as countries moved from agrarian to industrial economies, increasingly prosperous citizens called for laws to protect their increasingly vital property rights. The shift from agrarianism to industrialism in emerging economies, goes the reasoning, should see countries, such as China, Nigeria, Peru, Thailand, and Malaysia, following precedent and moving from the rule of man to the rule of law.

1. Ominous Trends. Contemporary developments complicate predictions.

Democracy’s ongoing decline has slowed the diffusion of the rule of law. Whereas the rule of law is the cornerstone of democracy, the rule of man is the cornerstone of authoritarianism. Increasing foreign investments in countries such as China with a track record of opaque governance, crony capitalism, and persistent corruption questions the absolute necessity of the rule of law.

2. Philosophical Perspectives. The forecast of the rule of law as the inevitable endstate for all nations presumes that the legal philosophies of the West apply to all.

However, the growing confidence of emerging economies increasingly questions the presumption that “the West knows best.” Today, in the realm of IB, China is the exemplar; other countries apply similar principles and practices.

D. Implications to Managers Uncertainty about the basis of rule and the goals of government throughout much of the world creates risky legal environments. Yes, operating in markets regulated by the rule of law sees the consistent application of legitimate laws. However, operating in markets regulated by the rule of man sees arbitrary regulation. Growing demands from increasingly wealthy citizens for stronger property rights, by forcing the accountability of public officials, may gradually push for the protection instituted by the rule of law.

Currently, though, as seen in fading freedom and democracy’s retreat, authoritarianism and its instrumentality, the rule of man, influence IB. VI. LEGAL ISSUES FACING INTERNATIONAL COMPANIES A. The Legality of Business Practices The legal system moderates practical aspects of business operations, including how managers start a business, enter and enforce contracts, hire and fire workers, and close a business: Starting a Business. Starting a business involves activities such as registering its name, identifying the appropriate tax classification, obtaining licenses and permits, arranging credit, and securing insurance. Some countries expedite this process, others complicate it.

Entering and Enforcing Contracts. The United Nations Convention on Contracts for the International Sale of Goods sets guidelines for negotiating and enforcing contracts.

Still, practices vary across legal systems.

Hiring and Firing. Worldwide, workplace regulation and employment law speak to how workers are hired, what they are paid, how many hours they can work, and how they are fired.

Getting Out or Going Under. In Western markets, the bankruptcy process is anchored in the English bankruptcy law of 1732, the first modern law to address this issue, and its progressive revision, beginning in 1800, by the United States. The situation differs in developing countries.

B. The Legality of Business Strategies 8 .

The legal system moderates strategic aspects of business operations, including product origin and local content, marketplace behavior, legal jurisdiction, product safety and liability, and intellectual property protection.

Product Regulation. Host governments set laws that regulate access based on the product’s country of origin—the country where it was grown, produced, or manufactured. Some countries apply this policy to product labels, under the title COOL (country-of-origin labeling), to inform consumers and support local producers. National security concerns also shape country-of-origin regulations. In addition, most host governments push MNEs to add value locally by enforcing local content regulations.

Marketplace Behavior. National laws determine permissible practices in pricing, distribution, advertising, and the promotion of products, and they vary widely from one country to another.

Product Safety and Liability Regulation. Often products must be customized in order to comply with local standards, which may be higher than those found in a firm’s home market. While product liability laws are very stringent in markets such as the United States, they are spotty, absent, and at times even arbitrary in many less developed countries.

Legal Jurisdiction. Every country specifies which law should apply and where litigation should occur when agents are involved—whether they are legal residents of the same or different countries. MNEs specify a choice-of-law clause in contracts that stipulates whose laws, when necessary, govern dispute resolution.

Intellectual Property. Intellectual property (IP)—the creative ideas, proprietary works, innovative expertise, or intangible insights, often in the form of inventions, literary and artistic works, symbols, names, images, designs, or processes, that create a competitive advantage for an individual, company, or country. The rising power of ideas in the global economy has made protecting IP a growing concern.

Currently, the individualistic perspective predominates. Transnational institutions— notably, the World Intellectual Property Organization (WIPO), along with governments and industry associations—push for stronger protection. The primary safeguard is an intellectual property right (IPR); it grants the registered owners of IP the legal authority to decide who may use its property and under what circumstances.

VII. POLITICS, LAW, AND BUSINESS Table 3.4 identifies the top-ranked and bottom-ranked countries whose political and legal policies enact, respectively, the most or least supportive business environments. The rankings highlight a key relationship: most of the top-ranked countries have a democratic political system and a common or civil law legal system anchored in the rule of law. In contrast, most bottom-ranked countries exhibit authoritarian politics and a mixed legal system anchored in the rule of man [see Table 3.4.].

CLOSING CASE: It’s a Knockoff World Worldwide, companies are plagued by piracy—the illegal imitation, copying, or counterfeiting of their intellectual property. IP theft is big business, but it is also cuts to issues of history, culture, politics, income, development, innovation, competitiveness, and prosperity. Piracy's 9 .

pervasiveness and tenacity in the face of an ever-expanding set of intellectual property rights laws, policies, and treaties raise profound questions for the software industry in particular and intellectual property rights in general. Piracy gets a huge boost from the increasing availability of counterfeit goods through Internet channels, such as P2P file-sharing sites, mail-order sites, auction sites, or the dark web. Outgunned and outfoxed, some companies surrender. The case ends with a legitimate question enquiring of the inevitability of piracy.

Questions 3-3 Would you expect piracy to thrive in a democracy or, alternatively, a totalitarian state?

Why? IP theft is booming in both democratic and totalitarian states. For instance, piracy is thriving in big, fast-growing emerging markets like China (totalitarian) and India (parliamentary democracy). Even countries with a strong democratic foundation and robust enforcement mechanisms, such as France, Japan, and the United States, report software piracy rates north of 15 percent. One might argue that the issue is not the political system but the enforcement mechanism. Yet, weak enforcement is more prevalent in countries marked by a rule of man bias and authoritarian politics. (LO 3-2: Interpret the principles and practices of a political environment, AACSB: Reflective Thinking.)

3-4 Can you envision a scenario where developers and consumers of IP develop a relationship that eliminates the profitability of piracy?

I think it is possible, especially for counterfeits that threaten global health and safety, such as fake medicine that annually kill tens of thousands. Companies should also provide incentives and loyalty programs to consumers who buy legitimate products. Poverty and affordability are also to blame for piracy. Companies need to lower their prices and give reasons to consumers to buy their legitimate products. (LO 3-2: Interpret the principles and practices of a political environment, AACSB: Reflective Thinking.)

3-5 Put yourself in the place of a poor individual in a poor country struggling to improve the quality of your life. What thoughts might shape how you interpret the legality of IPRs? Would it matter if those IPRs were held by Western MNEs? Responses and opinions may vary. I would reason to enjoy the products that the wealthy have even when I cannot afford them, and piracy provides that opportunity. Also, farmers in developing countries provided a wealth of traditional knowledge that were used by corporations in developed countries to commercialize IPR protected products. IPR can also undermine public health in poor countries as patent protection led to increase in the price of medicine (e.g., HIV medicine). As for the second question, I believe it matters because of the repercussions on poor countries—for instance, the controversies surrounding access to essential medicines such as AIDS drugs. Because Western MNEs hold the majority of IPRs for essential drugs, there was concern about poor countries' ability to provide affordable medicine and health services to their populations. (LO 3-5: Interpret the principles and 10 .

practices of a legal environment, AACSB: Reflective Thinking.)

Additional Exercises: Political and Legal Factors Exercise 3.1. Ask students to discuss the economic difficulties faced when a country changes from a totalitarian to a democratic political system. Then have students compare the political transition of a large country (e.g., Russia) to the transition of a smaller country (e.g., Hungary). Ask whether political transition has been a smoother process in one of the two countries and examine the reasons for both the differences and the similarities in the two processes. (LO 3-1: Explain how politics and laws influence business activities, AACSB: Analytical Skills.)

Exercise 3.2. Some people argue that the legal justification for ethical behavior is the only truly important justification. However, others argue that such a position is insufficient and note that everything that is unethical is not necessarily illegal. Ask students to discuss possible guidelines they might use when underdeveloped legal systems lack clear guidance with respect to business decisions. (LO 3-5: Interpret the principles and practices of a legal environment, AACSB: Analytical Skills.)

Exercise 3.3. Ask students to identify companies, both domestic and foreign, that operate internationally. Have them explore the possible sources of political risk for each of those firms, given (1) the countries in which they have a presence, and (2) the basic nature of their products and operations. (LO 3-4: Describe the idea of political risk, AACSB: Analytical Skills.)

Exercise 3.4. Lead the class in a discussion of some of the economic costs associated with the piracy and counterfeiting of intellectual property rights. Then ask students to explore the basic issue in light of the following types of legal systems: common law, civil law, and theocratic law. Is any one system better than the others for effectively dealing with the problem? Why or why not? (LO 3-6: Describe legal issues facing international companies, AACSB: Analytical Skills.)

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Chapter 4 The Economic Environments Facing Businesses OBJECTIVES 4-1 Explain the value of economic analysis 4-2 Distinguish the types of economic environments 4-3 Discuss the idea of economic freedom 4-4 Distinguish the types of economic systems 4-5 Interpret indicators of economic development, performance, and potential 4-6 Discuss elements of economic analysis 4-7 Profile approaches to integrate economic analysis

Chapter Overview When companies source, manufacture, and/or market products in foreign countries, they encounter fascinating and often challenging economic environments. Chapter Four first explores the economic environments of countries in which an MNE might want to operate by discussing the importance of economic analysis and identifying the major dimensions of that process. It then compares and contrasts key macroeconomic indicators, such as economic growth, inflation, and the surpluses and deficits reflected in the balance of payments. Finally, the chapter reviews the characteristics of the major types of economic systems, explores the principles of economic freedom, and concludes by highlighting the connection of the conceptual anchor of this chapter, economic freedom and meta-measures of the vitality of developed, developing, and emerging economies.

Chapter Outline OPENING CASE:

EMERGING ECONOMIES: COMEBACK OR COLLAPSE [see Figure 4.1]

Despite far-ranging opinions, most agree that the ongoing integration of national economies into the global market has changed economic aspects of the business environment. Some commentators see trends that indicate a flattening of the world, where others emphasize the entry of billions of people into the global marketplace from China, India, and the former Soviet countries. These developments and trends will powerfully impact one’s job, company, future, and even one’s country. The global economic meltdown impacts the business environment in many ways, including an increase in trade barriers and risk aversion. As the global economy improves, many see this as an inflection point and realize that the need to understand the economic impacts on the global business environment is more important than ever. Studies predict a shift from the rich and powerful countries of the twentieth century to many emerging economies in greater Asia. This shift can be seen as we track the global economic output [see Fig

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4.1]. All of these changes represent opportunities and threats for global players in the new economy.

Questions 4-1 Transformations such as the comeback of the emerging economies happen rarely. This amplifies their impact on our lives. Estimate how your life has changed, or will likely change, given the comeback to date and, significantly, its ongoing successes.

Responses and opinions may vary. We are in the midst of a major shift in the economic landscape: the rise of emerging economies, notably China. It has touched almost every aspect of my life, from the clothes I wear to the devices I am using at home, at work, and in school. Even our economy that we depend on and our trade policies are positively and negatively affected by the comeback of emerging economies. Emerging economies, notably China, played a crucial role in stimulating the global economy after the 2008 global financial crisis. However, the trade war with China has adversely impacted our consumers and farmers. Due to the trade, we pay higher prices for certain goods. (LO4-5: Interpret indicators of economic development, performance, and potential, AACSB: Reflective Thinking.)

4-2 Now, flip the analysis and consider what might happen if the ambitions of the emerging economies prove far too ambitious and rather than come back, they collapse. If so, what might that mean to your life?

Responses and opinions may vary. Given the significance of the emerging markets in the world economy and the slackening of western economies, the collapse of emerging economies could significantly impact my lifestyle and, likely, my job. We saw what happened in 1998 when the Asian miracle turned into a mirage or what occurred in Iceland during the 2008 global financial crisis. Both crises caused a lot of pain to people in those countries and beyond. They led to soaring unemployment and an increase in consumer prices, especially food prices. In Iceland, the 2008 global financial crisis left the country and its citizens devastated and on the verge of bankruptcy. (LO4-5: Interpret indicators of economic development, performance, and potential, AACSB: Reflective Thinking.)

Teaching Tips: Carefully review the PowerPoint slides for Chapter Four.

I.

INTERNATIONAL ECONOMIC ANALYSIS In the IB realm, cultural, political, and legal systems influence a company’s decision on where, when, and how to do business. This chapter completes our profile of the environmental domains of IB, evaluating how economic systems shape a market. Studying an economic environment helps managers make better investment choices and operating decisions. Resource constraints require managers to identify which countries in the world warrant investment as well as those they must avoid. Expanding analysis to include any number of the 217 economies in the global market quickly proves daunting. Moreover, each and every economy is fundamentally interconnected—as the COVID-19 pandemic vividly 2 .

showed. The intricacy of even the simplest economic system defies straightforward specification. Stipulating models that definitively represent an economy’s performance and potential and then work reliably in other places is challenging. Hence, managers wrestle with identifying valid perspectives and reliable measures, modeling their relationships, mapping them onto an economy, tracking key trends, and inferring their implications.

Making Choices, Navigating Challenges.

A. Making Choices, Navigating Challenges Figure 4.3 shows how managers make choices and navigate challenges—whether in their home market or in faraway places. It holds that economic conditions shape a country’s development, performance, and potential. It highlights the elements that frame assessment and emphasizes the significance of theoretical and applied analysis.

II. WHO’S WHO IN THE GLOBAL BUSINESS ENVIRONMENT In IB, the development level of a country is the single most important indicator of who’s who. It influences nearly every aspect of business, including the nature of consumer demand, organization of productive activity, attitudes toward foreign investors, regulatory transparency, sophistication of market systems, and the freedom one has to make effective and efficient business decisions. Hence, estimating the attractiveness of a country as a place to do business and, once there, making smart investment and operational decisions depends on how well managers understand its economic environment.

A. Developed Economies Developed economies generally have high-income levels, extensive industrialization, advanced technological infrastructure, and high standard of living. Developed economies steadily shift to diversified, service-oriented activities that rely on information and technology to support product and process innovation. Manufacturers in developed economies have outsourced many activities to low-cost factories in the emerging economies.

B. Developing Economies Developing economies generally have low-income levels, slight industrialization, incomplete infrastructure, and lower standards of living. Significant gaps exist in economic and social characteristics between developed and developing economies.

Some argue that developing countries have strong communities and social ties, extraordinary self-sufficiency, and admirable work ethics. Alternatively, one regularly finds higher infant mortality, shorter life expectancy, lower literacy levels, poorer public hygiene, insufficient health care, and inadequate nutrition in developing countries relative to their developed counterparts. MNEs adjust analytics anchored in the context of wealthy developed economies for the radically different markets of developing economies. Recent trends, however, refine interpretations. Notably, the Base of the Pyramid spotlights the poorest two-thirds of the economic human pyramid, a group of more than four billion people who earn a few dollars per day; most residents of developing economies qualify. Though long seen as inaccessible and unprofitable, collectively, these billions of consumers represent immense demand; some see it as the next frontier of the global economy.

C. Emerging Economies Great range marks the performance among countries precisely because different economies experience different levels of development at different rates. Some 3 .

developing economies are fast-growing, quickly industrializing countries. Some of the largest and fastest growing emerging economies include China, Mexico, Indonesia, and the Philippines. Increasingly, these countries are referred to as economies in transition, emerging markets, frontier markets, or newly industrializing countries; generally, description defaults to emerging economies. Emerging economies are experiencing accelerating growth in productivity, manufacturing, exporting, and per capita income, resulting in material improvements achieved in years, rather than decades. Their financial systems, political institutions, and market infrastructure steadily modernize.

Market liberalization promotes foreign investments and growing exports, deregulation and privatization improve business efficiency, and expanding economic freedoms encourage entrepreneurialism. Prosperity and progress support a growing middle class, whose economic aspirations fuel a revolution of rising expectations, thereby spurring society and the state to improve living standards. When one speaks of the emerging economies, many point to Brazil, Russia, India, and China (referred to as the BRICs) [see Map 4.1.]

III. ECONOMIC FREEDOM Economic freedom holds that one has the right to work, produce, consume, save, and invest in the way that one prefers. It measures the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty.

A. Measuring Economic Freedom: The Economic Freedom Index estimates economic freedom in 180 countries worldwide. In principle, this index measures the degree that a nation accepts Adam Smith’s thesis that “basic institutions that protect the liberty of individuals to pursue their own economic interests result in greater prosperity for the larger society.” The ultimate score ranges from zero (no freedom) to 100 (full freedom); hence, the higher the index for a particular nation, the higher its degree of economic freedom.

Determining factors include: property rights, freedom from corruption, fiscal freedom, government spending, labor freedom, business freedom, monetary freedom, trade freedom, investment freedom, and financial freedom. Countries ranking highest on this index tend to enjoy both the highest standards of living as well as the greatest degree of political freedom.

B. The Value of Economic Freedom Economies that implement policies that institute economic freedom enjoy a range of benefits. Economic freedom supports higher growth in the short- (5 years), medium(10 years), and long-term (20 years). Higher growth, in turn, supports higher personal income; in economically free countries, it is more than double the worldwide average and four times higher than that in mostly unfree and repressed economies. Higher growth and higher income combine to support higher living standards (see Figure 4.4).

C. The Prevalence of Economic Freedom Map 4.2 displays the Economic Freedom Index for 180 economies. North America (Canada, Mexico, and the United States) enjoys the highest levels of economic freedom, with an average score, 73.7 versus the global average, 61.6. Europe, the Middle East and North Africa, Asia and the Pacific, and Central and South America cluster around the world average at, respectively, 69.8, 61.8, 61.1, and 58.2. Sub4 .

Saharan Africa clocks in at 55.2. Worldwide, the recent growth in economic freedom has been evolutionary rather than revolutionary.

D. Economic Freedom by Type of Economic Environment Table 4.4 reports the average economic freedom score, as well as for its 12 components, by type of economic environment. The characteristics of economic freedom, controlling for the level of development, highlight the scale and scope of difference facing managers. Consistently, the developed economies devise policies that promote and protect individual choice as seen in their higher score. Richer countries typically regulate business activities less. Poorer countries typically regulate them more.

E. The Paradox of Promise Versus Prevalence Paradoxically, despite the benefits of economic freedom, just six countries out of 180 rank as a “free” economy. Map 4.2 shows that Hong Kong, Singapore, New Zealand, Switzerland, Australia, and Ireland are the only “free” economies in the world.

LOOKING TO THE FUTURE: State Capitalism: Detour or Destination?

The impressive performance in many countries with emerging and developing economies suggests that free market economics is no longer the only viable route to modernization. Many see China as the bellwether; it has used state capitalism to develop and direct the world’s fastest-growing economy that, in turn, has powered the swiftest, most extensive rise out of poverty any nation has ever seen. Throughout Asia, the Middle East, Africa, and Latin America, authoritarian governments emulate China’s model. Some dismiss state capitalism as inevitably unacceptable.

IV. TYPES OF ECONOMIC SYSTEMS An economic system is the set of structures and processes that guide the allocation of scarce resources and shapes the conduct of business activities in a nation. The spectrum of systems is anchored on one end by capitalism and on the other by communism. Free-market (capitalistic) economies are built upon the private ownership and control of the factors of production, while communism is based on state ownership of economic activity.

A. The Market Economy A market economy describes the system where individuals, rather than government, make the majority of economic decisions. Key factors include consumer sovereignty, the freedom of market entry and exit, and the determination of prices according to the laws of supply and demand. Credited to Adam Smith, the laissez-faire principle, i.e., nonintervention by government in a country’s economic activity, states that producers are driven by the profit motive, while consumers determine the relationship between price and quantity demanded. Thus, scarce resources are allocated efficiently and effectively. The high standards imposed by a market economy are based on some preconditions. Four of these preconditions indicate a basis for consistent growth: sound macroeconomic policies and solid macroeconomic background, fair and transparent political institutions, open trade, and high levels of education.

B. The Command Economy

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Also known as a centrally planned economy, a command economy is built upon the government ownership and control of the factors of production. Central planning authorities determine what products will be produced in what quantities and the prices at which they will be sold. Most often, the totalitarian aims of communism gave the highest priority to industrial investments and military spending at enormous expense to the consumer sector.

C. Mixed Economy Mixed economies fall between the extremes of a market economy and a command economy. While economic decisions are largely market driven and ownership is largely private, government nonetheless intervenes in many economic decisions. The extent and nature of such intervention may take the form of government ownership of certain factors of production, the granting of subsidies, the taxation of certain economic activities, and/or the redistribution of income and wealth.

V. ASSESSING ECONOMIC DEVELOPMENT, PERFORMANCE, AND POTENTIAL Managers use different economic measures to assess a country’s level of performance and potential. In practice, generally, managers begin an analysis by looking at the monetary value of the total flow of goods and services in the economy of a nation.

A. Monetary Measures 1. Gross National Income (GNI) measures the value of all production in the domestic economy together with the income that the country receives from other countries (in the forms of profits, interest, and dividends), less the same sorts of payments that it has made to other countries. Among monetary aggregates, GNI provides the broadest measure of economic performance.

2. Gross Domestic Product (GDP) is the total market value of goods and services produced by workers and capital within a nation’s borders; it provides the truest measure of national economic activity. Technically, GDP plus the income generated from exports, imports, and the international activities of a nation’s companies equal its GNI. See Table 4.5.

3. Gross National Product (GNP) is the total value of all final goods and services produced within a nation in a particular year.

B. Improving Economic Analytics GNI, GDP, and GNP estimate an economy’s absolute performance. Despite strengths, they can distort country comparisons. Managers improve the usefulness of economic indicators by adjusting for the (1) growth rate of the economy, (2) number of people in a country, and (3) local cost of living.

1. Rate of Economic Growth. Monetary aggregates take a static snapshot of an economy at a point in time. Hence, they do not capture its rate of change.

Interpreting present and forecasting future performance prompts considering an economy’s growth rate.

2. Population Size. Managers routinely adjust indicators by the number of people who live in a country. Adjusting GNI by population, therefore, lets managers qualify a country’s performance for its demographics. A larger population base provides the opportunity for greater productivity, but can also create additional challenges for an economy. An analyst must review the population size and determine GNI per capita to establish a true picture of a nation’s standard of living.

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3. Purchasing Power Parity. While exchange rates define the number of units of one currency that are required to purchase one unit of another currency, they do not determine what a unit of currency can buy in its home country, i.e., exchange rates do not incorporate differences in the cost of living. Purchasing power parity (PPP) represents the number of units of a country’s currency required to buy the same amount of goods and services in the domestic market that one unit of income would buy in another country. PPP is estimated by calculating the value of a universal “basket” of goods that can be purchased with one unit of a country’s currency [see Map 4.3.].

C. The Wildcard: The Shadow Economy Sometimes called the black, gray, or parallel market, or the informal economy, the shadow economy includes the extra-legal activities (e.g., driving an unlicensed taxi, street trading, or unregistered day care center) as well as well as illegal doings (e.g., prostitution, drug-slinging, illicit gambling, cigarette and alcohol smuggling, product piracy) that fall beyond official statistics. All countries experience the effects of the shadow economy; they are particularly influential in developing economies. Some countries are moving to include shadow activities when measuring production in their economy.

D. Sustainability and Stability Sustainability and stability perspectives hold that the objective of economic activity is to create an environment for people to enjoy long, healthy, and happy lives.

1. Sustainability. Green economics holds that an economy is a component of, and dependent on, the natural world. Green measures gauge economic performance in terms of the effect of current choices on long-term sustainability. Estimators of economic progress toward improving happiness includes: • Net National Product (NNP) measures the depletion of natural resources and degradation of the environment that result from making and consuming products.

• Genuine Progress Indicators (GPI) begin by applying the same accounting framework used to calculate GDP. It then adjusts for the corresponding costs of reduced environmental quality, health and hygiene, livelihood security, equity, free time, and educational attainment.

• Human Development Index (HDI). Estimating a country’s degree of human development, in terms of the physical, intellectual, and social standards that shape its overall quality of life, helps managers measure market potential. The UN translates this view into the HDI and its components: Longevity, measured by life expectancy at birth; Knowledge, measured by the adult literacy rate and the combined primary, secondary, and tertiary gross enrollment ratio; and Standard of Living, measured by GNI per capita (PPP).

2. Stability. Universal affluence, despite its appeal, is presently impossible. Rather than assessing an economy’s potential for increasing affluence, perspectives like happynomics or welfare economics encourage incorporating elements of psychology, health, security, and sociology. More fundamentally, they advocate redefining the traditional performance standards of wealth, income, or profit to reflect principles of well-being, quality of life, and life satisfaction. Estimators of economic progress toward improving happiness include: 7 .

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•

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Your Better Life Index (YBLI): Developed by the Organization for Economic Cooperation and Development (OECD), the YBLI advocates evaluating economic performance in terms of matters that people worldwide believe are important (e.g., housing, jobs, social relationships, health, security, work–family balance, education) but that fall beyond the narrow scope of monetary measures.

Gross National Wellness Index (GNWI): GNWI measures a country’s capacity to promote individual well-being in terms of mental, health, work, income, social relations, economic, retirement, political, and environmental standards.

Happy Planet Index (HPI): The HPI holds that the fundamental logic of monetary metrics is misaligned, overly emphasizing growth at all costs while downplaying its costly, destabilizing, and often destructive externalities. In the realm of the HPI, progress is defined not in terms of economic development, but through success in achieving a sustainable well-being for all.

POINT—COUNTERPOINT: Growth: Positive and Productive

POINT: Many people believe growth is not only good but that it is necessary for our continued existence as an individual, a company, and even a society. They argue that the benefits of growth include moral stability, reduction in poverty, business and government prosperity, improved potential for a peaceful and environmentally friendly world, and a very human benefit of a better and longer life.

COUNTERPOINT: Others believe that although growth has its benefits, you cannot discount the costs. These costs are short and long term and include inevitable economic inequalities, misleading benefits of growth, and the impact on sustainability and individuality. Finally, they posit that the current rate of growth is not possibly sustainable.

VI. ELEMENTS OF ECONOMIC ANALYSIS A. Integrating Economic Analysis Managers often consider meta-models to improve their understanding of the absolute and relative potential of an economic environment. Popular indices include 1. The Global Competitiveness Index (GCI). The GCI summarizes the performance and relationship among 110 variables that compose 12 so-called “pillars of competitiveness” within a nation. These pillars tap dimensions like financial market development, macroeconomic environment, technological readiness, market efficiency, and innovation.

2. The World Competitiveness Index (WCI). The World Competitiveness Project assesses a nation’s ability to set and sustain a business environment that enables enterprises to compete, prosper, and create wealth. Four factors determine a nation’s competitiveness: economic performance, government efficiency, business efficiency, and infrastructure.

3. The Global Innovation Index (GII). Rather than focus on the scale of research and development, the GII estimates a nation’s capacity to imagine ideas, leverage 8 .

them into pioneering products, and, in the process, generate knowledge, competitiveness, and wealth.

4. The Best Countries Index (BCI). The BCI sees a country’s wealth and success resulting from policies that create possibilities, the people that achieve them, and the history that anchors its outlook and orientation. The BCI evaluates 65 characteristics in terms of global perceptions that influence trade, travel, and investment that, in turn, productively shape a nation’s economy. Switzerland ranks first, followed by Japan, Canada, Germany, and the United Kingdom.

5. The Where-To-Be-Born Index (WTBBI). The WTBBI holds that how well a country provides opportunities for a healthy, safe, and prosperous life helps explain both its current and future economic environment. The WTBBI evaluates 11 indicators, such as geography, demography, quality of life, per capita income, and life expectancy.

B. Economic Freedom, Innovation, and Competitiveness Economic freedom has a strong relationship with a country’s relative competitiveness and innovation performance. Table 4.9 indicates that countries with higher degrees of economic freedom consistently show higher degrees of competitiveness and innovation. [see Table 4.9.]

CLOSING CASE: Economic Environments of the West: Problems, Puzzles, and the Fourth Industrial Revolution Today, the accelerating convergence of the physical and digital world ushers in the Fourth Industrial Revolution. This era will introduce radically different tools and techniques that require fundamentally rethinking the idea of work, productivity, and prosperity. The emergent Fourth Industrial Revolution will fundamentally alter how people work, consumers spend, companies compete, officials regulate, and markets perform. Unlike before, where these shifts unfolded over three or four generations, the West faces the unprecedented challenge of experiencing this shift in a single generation. Artificial intelligence and robots will have a significant impact on the job market, eliminating 75 million jobs worldwide by 2022. Worse still, more than half of all tasks in the workplace will be done by machines by 2025. However, more than 130 million new jobs will be created by machines in that time frame according to estimates by the World Economic Forum.

Questions 4-3 Forecast your personal future given (1) the ongoing comeback of emerging economies and then (2) the techno-transformations powered by the Fourth Industrial Revolution. Which scenario do you prefer? Why? Responses and opinions may vary. Typically, we look to the past for hints on what is in store for the future. But this time, the future is already here. Signs of the Fourth Industrial Revolution are already happening around us. From virtual reality to robots, 3D printing, self-driving cars, drones, and “Internet of things,” the Fourth Industrial Revolution is 9 .

delivering disruptive innovations that are rewriting how we live. At home, my family and I are exposed to new technologies such as smart security systems, voice assistants, and robotic vacuums that have simplified and sometimes eliminate plenty of hard manual work. AI has grown smarter, I anticipate more activities to be automated, including cooking and driving.

Growing up, I didn’t have access to these technologies, and I spent a lot of time directly interacting with family and friends. Unfortunately, these disruptive technologies weaken these bonds. They are automating several tasks that we accomplished as kids. Yes, it was hard work, but it was entertaining and enlightening for us as kids.

Practically, it is hard to predict how the ongoing comeback of emerging economies might impact me personally. It all depends on how the leaders of emerging economies exert their strength. Will they support democracy and human rights? Will they force a new world order? Will they engage in a peaceful relationship with other powers?

I prefer the techno-transformations powered by the Fourth Industrial Revolution despite its ethical and privacy challenges because it is predictable. Also, I have taken steps to develop myself and stay up-to-date with the Fourth Industrial Revolution. (LO4-6: Profile elements of economic analysis, AACSB: Analytical Skills.)

4-4 Forecast your professional future given (1) the ongoing comeback of emerging economies and then (2) the techno-transformations powered by the Fourth Industrial Revolution.

Which scenario do you prefer? Why? Responses and opinions may vary. AI applications and the rise of emerging economies will undoubtedly reshape my professional future. As an international business student, I would like to be a global analyst to help companies deal with the issues of foreign markets as well as the opportunities. Although I don’t anticipate my occupation being replaced by robots or AI, several of my daily tasks might be automated. I believe that AI could help my professional future rather than hurt it because consulting relies on big data.

I anticipate the rise of emerging economies to help my career path. Businesses are looking for people who can understand and operate successfully in emerging markets. (LO4-3: Explain the idea of economic freedom, AACSB: Analytical Skills.)

4-5 Historically, those in the West hold that economic freedom is the catalyst of prosperity.

Given the recent performance of emerging economies, do you think state capitalism might do a better job?

Responses and opinions may vary. Economic freedom allows the factors of production to move freely with constraint from the state. It brought greater prosperity to developed countries. However, economic freedom has declined in western countries over the past decade, primarily because of the severe economic and financial crisis that brought escalating protectionism and increasing regulations. In state capitalism, governments (particularly technocrats) apply sophisticated management principles to manage the economy without any ideological burden. For instance, by the end of the 1990s, China embraced market economy principles and economic liberalization to reform its economy. China’s success led some to 10 .

believe that state capitalism might do a better job to bring prosperity. I can’t entirely agree with that argument because state capitalism has also been accompanied by authoritarian governance and eroding individual and human rights. (LO4-3: Explain the idea of economic freedom, AACSB: Analytical Skills.)

4-6 In the realm of the Fourth Industrial Revolution, should governments estimate performance with monetary aggregates, like GDP, or sustainability and stability, like human development or happiness?

Responses and opinions may vary. The Fourth Industrial Revolution is expected to impact not only the economic environments but also the social, political, and ecological environments. It is, then, imperative to estimate its sustainability and stability. In other words, we need to use measures that capture, in addition to monetary costs, social and ecological costs, and impact on human conditions. (LO4-5: Interpret indicators of economic development, performance, and potential, AACSB: Analytical Skills.)

4-7 Working in the Fourth Industrial Revolution signals the increasing likelihood of working alongside ever-smarter machines. Some advice workers to complement, not compete with, AI-powered tools. How would you do so?

Responses and opinions may vary. Part of my job will likely be replaced by robots and/or AI, and the disruption is already happening. There is no other solution but for me to adjust to that reality by expanding and improving my skills, enhancing my professional development, and stay up-to-date with the latest development, challenges, opportunities, and trends in my industry (LO4-5: Interpret indicators of economic development, performance, and potential, AACSB: Analytical Skills.)

4-8 Who will likely benefit more from the Fourth Industrial Revolution: workers in developed, emerging, or developing economies? Why? Responses and opinions may vary. The Fourth Industrial Revolution will widen the gap between countries, companies, and workers. The winners will be countries, companies, and workers that have aggressively engaged with AI. Since developed countries lead the AI race, I expect workers with technological skills in developed countries to benefit the most in terms of salary and demand. At the same time, workers that do tasks that can be automated will likely be challenged by robots/AI. (LO4-5: Interpret indicators of economic development, performance, and potential, AACSB: Analytical Skills.)

Additional Exercises: Economic Factors Exercise 4.1. Select a triad economy such as Japan, the United Kingdom, France, or Germany, and select one of the BRICs (Brazil, Russia, India, and China). Then ask students 11 .

to compare the key elements of those two economic systems. Be sure they discuss the interaction between politics and economics in the two countries. (LO 4-4: Distinguish the types of economic systems, AACSB: Dynamics of the Global Economy.)

Exercise 4.2. In a day of global uncertainty, many wonder if it is necessary or even desirable to have national economies linked so closely together. Ask the students to consider what, if anything, a country can do to protect itself from the impact of negative global economic events. Then ask students to consider whether the impact of global recession on transition economies is necessarily the same as the impact on the triad countries. If not, in what ways are they different, and why? (LO 4-4: Differentiate the types of economic systems, AACSB: Dynamics of the Global Environment.)

Exercise 4.3. Many people believe that as a country’s political system changes from a more repressive to a more representative form of government, its economic system will necessarily become freer. Ask students to consider the basic logic of that idea, as well as the belief that the complete privatization of all state-owned and controlled assets is necessary for an economic transition to be successful. (LO 4-2: Distinguish the types of economic environments, AACSB: Analytical Skills.)

Exercise 4.4. Managers often study many second-order indicators of economic performance and potential, including inflation, unemployment, debt, income distribution, poverty, and the balance of payments. Ask students to consider which of these indicators may be more relevant to the assessment of an industrialized economy as compared to the assessment of an emerging economy. (LO 4-5: Interpret indicators of economic development, performance, and potential, AACSB: Analytical Skills.)

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Chapter 5 Globalization and Society OBJECTIVES 5-1 Describe the trade-offs among different stakeholders in MNE activities 5-2 Evaluate the major economic effects of MNEs on home and host countries 5-3 Explain the broad foundations of ethical behavior 5-4 Identify the cultural foundations of ethical behavior 5-5 Illustrate how ethical behavior is affected by different legal attitudes 5-6 Show how corruption and bribery affect and are affected by cultural, legal, and political forces 5-7 Summarize what the roles are of governments and companies in resolving environmental issues 5-8 Demonstrate how global labor issues need to be addressed by MNEs to their stakeholders 5-9 Restate how codes of conduct can help MNEs respond to concerns by stakeholders over responsible corporate behavior

CHAPTER OVERVIEW In this chapter, we’ll examine how globalization affects society and managers’ judgments as they interact with different laws and cultures and try to be socially responsible. The impact of MNEs on the countries where they operate is explored. The cultural and legal foundations of ethical behavior are examined, and environmental and global labor issues are highlighted. The chapter concludes with a brief discussion of the need for corporate codes of ethics.

CHAPTER OUTLINE OPENING CASE: THE GLOBAL GREENING OF GE In 2005, CEO Jeffery Immelt of GE announced a new and ambitious strategy designed to demonstrate that an ecologically conscious conglomerate could cultivate the bottom line while doing its duty toward the global environment. GE surprised both investors and industrial customers who had long seen GE as an ally in the struggle against environmental activists. The initiative, called Ecomagination, focused on several areas, including a commitment to plans to reduce greenhouse emissions, improve the energy efficiency of operations, and reduce its global use of water. With half of its markets located outside the United States, GE is already under the jurisdiction of foreign governments that are more active than the United States in addressing environmental issues. GE feels that markets exist for cleaner technology and that it can not only help the environment but also strengthen its strategic position with major profit opportunities.

The plan has been met with mixed reactions and the big question is: What happens, for example, if the markets it’s betting on don’t materialize fast enough (or at all)?

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Questions 11-1 What are the major challenges GE faces in adopting a green strategy while keeping all of its stakeholders happy?

Responses and opinions may vary. A major challenge is transforming GE corporate culture to embrace the green strategy. While GE leadership strive to create an ecologically conscious conglomerate, other units can be resistant to cultural changes due to business risks and uncertainty linked to green initiatives. Another challenge to GE’s Ecomagination strategy is the management and business turmoil within GE that risk derailing the push to remain green. (LO 5-7: Summarize what the roles are of governments and companies in resolving environmental issues, AACSB: Dynamics of the Global Economy.)

11-2 From the standpoint of environmental impact, do you think it is more important for GE to reduce its carbon footprint or to develop products that fit their Ecomagination strategy of being energy efficient?

Responses and opinions may vary. From the standpoint of environmental impact, the right thing to do is to reduce carbon footprint. However, companies should do that without irreparably harming their business. I think GE’s Ecomagination strategy aims to reduce GE’s carbon footprint, albeit at a relatively low level (a 1 percent reduction in carbon dioxide emissions from 2004 levels by 2012). GE is also committed to reducing the intensity of GHG emissions. (LO 5-7: Summarize what the roles are of governments and companies in resolving environmental issues, AACSB: Dynamics of the Global Economy.)

TEACHING TIPS: Have students visit the corporate Web site of GE (www.ge.com). The site contains additional information on the firm’s Ecomagination program.

I.

STAKEHOLDER TRADE-OFFS Doing business abroad is not easy. The greater the “distance” from one’s home country, the more complicated it is to do business. Distance can be described in many different ways, but one way to identify it is the acronym CAGE: cultural (also known as psychic distance), administrative (such as political and institutional policies), geographic, and economic.

To prosper a company must satisfy different groups of stakeholders, including shareholders, employees, customers, suppliers, and society at large. The basic idea of focusing on stakeholders more broadly is that companies can consider various socially important groups when making decisions.

II. THE ECONOMIC IMPACT OF THE MNE MNE’s activities can also affect the operating environment, such as through corruption and bribery, environmental impact (i.e., air and water pollution), and labor policies. It is hard to determine whether or not the actions of MNEs affect societal conditions. Opponents of FDI persist in trying to link MNE activities to such problems in host countries as inequitable 2 Copyright © 2022 Pearson Education, Inc

income distribution, political corruption, environmental debasement, and social deprivation.

In contrast, proponents of MNE activities tend to assume a positive link between their activities and such effects in recipient countries as higher tax revenues, increased levels of employment and exports, and greater innovation.

A. Balance-of-Payments Effects This refers to trade and capital flows that result from FDI. Under different conditions, these effects may be positive or negative, either for the host country or the home country. The formula to determine the balance-of-payments effect is simple but the data used must be estimated and are subject to assumptions. On the import side, the balanceof-payments is positive if the FDI results in a substitution for imports and negative if it results in an increase in imports. The balance-of-payments effects in terms of capital flows for FDI are usually (1) positive for the host country initially and negative for the home country and (2) negative for the host country and positive for the home country later.

B. Growth and Employment Effects In contrast to balance-of-payments effects, MNE effects on growth and employment don’t necessarily amount to zero-sum games (where gains must equal losses) between home and host countries because MNEs may use resources that were unemployed or underemployed.

III. THE FOUNDATIONS OF ETHICAL BEHAVIOR Because ethical behavior is rooted in both cultural and legal traditions that vary from one country to another, dilemmas often arise. There are multiple approaches to the analysis, including: 1. Teleological approach—decisions are based upon the consequences of the action, 2. Utilitarianism—an action is deemed right if it produces the greatest amount of good for the greater number of people, and 3. Deontological approach—moral judgments are made independent of consequences.

A. Why Do Companies Care about Ethical Behavior?

There are cultural and legal reasons for companies to behave ethically and individuals have high ethical standards. In addition, ethical behavior can help achieve a competitive advantage and avoid the perception of being irresponsible.

IV. THE CULTURAL FOUNDATIONS FOR ETHICAL BEHAVIOR A. Relativism versus Normativism Beliefs may vary because of different family and religious teachings, different laws and social pressures, different observations, experiences, and perceptions, and even different economic circumstances. Within a country, an individual’s values may differ from his/her employer’s policies, which may differ from prevalent societal norms or laws. At the international level, cultural complexity increases geometrically. While many actions elicit universal agreement on what is clearly right and wrong, others are less clear. Relativism holds that ethical truths depend upon the groups subscribing to them; thus, intervention in local issues and traditions by outsiders is clearly unethical.

On the other hand, normativism holds that there are universal standards of behavior that everyone should follow; thus, nonintervention in local violations of global standards is clearly unethical.

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B. Walking the Fine Line between Relativism and Normativism Many argue that managers the world over must exhibit ordinary decency, i.e., principles of honesty and fairness. In addition, they argue that MNEs are obligated to set good examples that can serve as the standards for responsible behavior. From a competitive standpoint, it is argued that responsible acts create strategic and financial success because they lead to trust, which in turn leads to commitment. In addition, many multilateral agreements exist that can aid in ethical decision-making; they deal primarily with employment practices, consumer and environmental protection, political activity, and human rights in the workplace. Still, no set of workable corporate guidelines is universally accepted and observed.

V. THE LEGAL FOUNDATIONS FOR ETHICAL BEHAVIOR Ethics teaches that people have a responsibility to do what is right and to avoid doing what is wrong.

A. Legal Justification: Pros and Cons The appropriateness of behavior can be measured in the sense that individuals and organizations must seek justification for their behavior, and that justification is a function of both cultural values (many of which are universal) and legal principles. However, opponents of legal justification feel that ethical behavior is not sufficient because: (i) everything that is legal is not necessarily ethical, (ii) the law is slow to develop in emerging areas of concern, (iii) the law is often based on moral concepts that cannot be separated from legal concepts, (iv) the law may need to be tested by the courts, and (v) the law is not efficient in terms of achieving ethical behavior at a minimum cost.

Nonetheless, the law does serve as a useful basis for examining ethical behavior because it embodies cultural values. Proponents of the legal-justification standard state that there are several good reasons for complying with it: (i) the law provides a basic guide for proper conduct, (ii) the law provides a clearly defined set of rules, and when followed they establish a good precedent, (iii) the law contains enforceable rules that apply to everyone, and (iv) the law reflects careful and wide-ranging discussions.

VI. CORRUPTION AND BRIBERY Bribery is one facet of corruption. The determinants of corruption include cultural, legal, and political forces. Bribery consists of payments, or promises to pay cash or something else of value, to public officials and/or other people of influence. It affects the performance of countries and companies alike. Anecdotal information indicates that in recent decades, questionable payments by MNEs to government officials have been prevalent in both industrial and developing countries.

A. Corruption with a Global Twist: Petrobras Petrobras, the Brazilian national oil company, which has resulted in the disclosure of at least $2 billion in bribes, kickbacks, and money laundering, involving payments to company executives, the ruling Brazilian Worker’s Party, and more than 50 sitting politicians and numerous companies trying to secure lucrative contracts with Petrobras.

On the international side, British Engineering group Rolls-Royce was also accused of paying bribes to secure contracts.

B. The Consequences of Corruption High levels of corruption tend to correlate with lower rates of economic growth as well 4 Copyright © 2022 Pearson Education, Inc

as lower levels of per capita income. Corruption may also erode the legitimacy of a government. Both the legal definition of a bribe and the likelihood of paying bribes abroad vary by nationality.

C. The Consequences of Corruption Efforts to slow corruption in international business practices can be seen at the global, regional, and national levels. Multilateral efforts to confront bribery include the accords established by OECD (Organization for Economic Cooperation and Development), the ICC (International Chamber of Commerce), and the UNCAC (United Nations Convention Against Corruption). The problem is that none of the conventions have the force of law behind them. The EU does not have specific anticorruption legislation, but it encourages member nations to adopt high standards and follow them. The Foreign Corrupt Practices Act (FCPA) is an example of the national approach. The FCPA outlaws bribery by U.S. firms no matter where they do business. Although the rules are not always clear, for example, some gift practices have been called into question.

Governments and industries continue to step up their anticorruption response globally.

Another major legislative effort in the United States is the Sarbanes–Oxley Act (SOX).

SOX toughened standards with regard to corporate governance, financial disclosure, and oversight of accounting and auditing practices. With its passage, the Justice Department began to use the FCPA more aggressively to combat bribery.

VII. ETHICS AND THE ENVIRONMENT Companies that extract natural resources, generate air or water waste, or manufacture products such as autos that generate pollution need to be concerned with their environmental impact. Environmental damage can occur from the extraction of resources, some of which are renewable and some of which are not, and the contamination of the environment via production processes and the use of pollution-causing products.

A. What Is “Sustainability”?

Sustainability means meeting the needs of the present without compromising the ability of future generations to meet their own needs while taking into account what is best for society and for the environment.

B. Global Warming and the Paris Agreement on Climate Change.

At the core of the United Nations Climate talks held in Paris in December 2015 is the concept that global climate change results from an increase in carbon dioxide and other gases that act like the roof of a greenhouse, trapping heat that would normally radiate into space, and thereby warming the planet. If carbon dioxide emissions are not reduced and controlled, rising temperatures could have catastrophic consequences. However, the Paris Agreement, which entered into force in November 2016, changed everything. One hundred eighty-seven countries agreed to keep the increase in the global average temperature to 2°C above pre-industrial levels and try to achieve 1.5°C. The countries also agreed to try to shoot for a target of zero net GHG emissions by the second half of the century. The United States, one of the major sources of GHG emissions, signed the agreement in 2015 by executive order of the President of the United States. However, after a new election in 2017, the United States announced it would cease all participation in the Paris Agreement.

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POINT—COUNTERPOINT: Should MNEs Accept Full Responsibility for the Unethical Behavior of Their Employees?

POINT: The German auto company, Volkswagen AG, should accept full responsibility for the unethical behavior of their employees. With such pressure to increase its market share in the United States, especially in diesel cars, and meet the stringent antipollution requirements set by the State of California, someone decided to cheat by introducing the ‘defeat” software.

Interestingly, VW also claimed that even though it was violating U.S. regulatory guidelines, it was not violating European regulatory guidelines.

COUNTERPOINT: While VW obviously must take responsibility for installing the defeat” software into some of the diesel models it is selling worldwide, it is no excuse for individuals to act unethically. Individual employees who were engaging in unethical behavior were aware of their behavior and are ultimately the ones responsible for their actions.

VIII. ETHICAL DILEMMAS OF LABOR CONDITIONS A major challenge facing MNEs today is the labor conditions of foreign workers, whether in their own offshore operations or their outsourced supply chains. They are especially critical in retail, clothing, footwear, electronics, and agriculture—industries in which MNEs typically outsource huge portions of production to independent companies abroad. Increased pressure is being placed on companies to adopt policies to protect workers as well as to disclose to shareholders the policies and their effectiveness [see Figure 5.3].

A. Sources of Concern There are several sources of concern, including forced labor, modern slavery, human trafficking, and child labor. According to the International Labor Organization (ILO), a UN institution, 218 million children between the ages of 5 and 17 are in employment .

ILO guidelines state that children who are at least 12–14 years old may be employed in “light” work that’s not harmful to their health, is less than 14 hours a week, and doesn’t interfere with school. All children under the age of 18 should be protected against the most abusive labor conditions. For MNEs, the basic challenge is negotiating a global labyrinth of business environments with different cultural, legal, and political rules than those they’re used to at home. In addition, they typically rely on local suppliers who are subject to specifically local pressures. Despite these difficulties, MNEs are not powerless when it comes to labor-related matters in overseas facilities. Frequently, MNEs operating in countries with very different labor policies succumb to the pressure to simply leave the market.

The concerns over slavery and human trafficking involve more than just child labor.

They are defined by the ILO as “all work or service which is exacted from one person under threat of a penalty and for which the person has not offered himself voluntarily.”

This tends to occur more in the supply chain for an MNE than it would directly for their own facilities abroad. It could also occur with contract manufacturers

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B. What MNEs Can and Can’t Do Frequently, MNEs operating in countries with very different labor policies succumb to the pressure to simply leave the market. Usually, this turns out to be a shortsighted decision. Others try to establish responsible policies in those same countries.

IX. CORPORATE CODES OF ETHICS: HOW SHOULD A COMPANY BEHAVE? Companies face real pressures to act responsibly, yet they don’t always act consistently. A corporate code of ethics can aid in the consistency of behavior. The United Nations Global Compact offers ten broad principles that MNEs can adopt.

A. Motivations for Corporate Responsibility Firms need to act responsibly for at least four reasons. First, unethical and/or irresponsible behavior could result in legal headaches, especially in the areas of financial mismanagement and product safety. Second, such behavior could also result in consumer action (e.g., boycotts), even though the effectiveness of such actions is unclear. Third, unethical behavior can lower employee morale. Fourth, the cost to firms of bad publicity can be enormous.

B. Developing a Code of Conduct A major component of a company’s strategy to realize ethical and socially responsible behavior across the entirety of its organization is a corporate code of conduct. External codes provide guidelines, recommendations, and rules that are issued by entities within society to enhance corporate responsibility, but they are somewhat inconsistent across organizations. Codes of conduct involve four dimensions: • Setting a global policy that must be complied with wherever the company operates, • Communicating the code to employees, suppliers, and subcontractors, • Ensuring that policies are carried out, • Reporting results to external stakeholders LOOKING TO THE FUTURE Dealing with Ethical Dilemmas in the Global Economy The more companies expand abroad, the greater the likelihood they will have hard decisions to make on how they should operate in a socially responsible manner. Most large MNEs choose to make a difference in the countries where they operate. Social media will certainly reinforce this trend as it forces socially responsible companies to be transparent.

CLOSING CASE: Anglo American PLC in South Africa: How You Make a Difference in the Fight Against HIV/AIDS??

Anglo American PLC is a diversified mining conglomerate operating worldwide with 69,000 employees who produce diamonds, precious metals (platinum), base metals (copper, nickel, zinc, and phosphates), and bulk metals (such as iron and coal). Founded in 1917 as the AngloAmerican Corp. of South Africa and now headquartered in London with mining operations worldwide. With such a huge investment in South Africa, Anglo American has been heavily affected by the HIV/AIDS epidemic. It was estimated that HIV/AIDS was adding as much as $5 to the cost of producing one ounce of gold, thereby tacking on $11 million a year to the 7 Copyright © 2022 Pearson Education, Inc

company’s production costs. In addition to losses in productivity, the company had to bear the costs entailed by high levels of absenteeism, the constant retraining of replacement workers, and burgeoning payouts in health, hospitalization, and death benefits. Having recognized the threat as far back as the early 1990s, Anglo American was one of the first companies to establish a proactive, comprehensive strategy to combat the raging effects of the disease on its workforce.

However, Anglo American has faced numerous challenges including employee compliance with the program, the spiraling costs for the program itself, pressure from various stakeholders, and the lack of active engagement from drug manufacturer. Given these problems, some have suggested that the company would be better off stopping the program rather than pouring more resources into it. There are also indications that the future may not be as bleak as it initially appeared as AIDS-related deaths had dropped by more than 51 percent since the peak in 2004.

However, the introduction and spread of COVID-19 in 2020 has added a new complexity to the challenges faced by Anglo American.

Questions 5-3. Because such a large percentage of its workforce consists of migrant workers who are more likely to acquire and spread HIV/AIDS, should Anglo adopt the policy of not hiring migrant workers? Should the South African government close the doors to migrant workers?

Migrant workers pose a special problem, not only in terms of infection rates, but also because of the widespread prevalence of the disease. This situation poses a moral dilemma for discussion. The migrant workers need employment, perhaps even more than the non-migrant workers. Discriminating against them will not solve the problems faced by Anglo American or South Africa. The problem may be lessened a bit; however, a better solution is to seek the cooperation of the South African government in increasing its budget for HIV/AIDS education, prevention, and wellness. (LO 5.2: To discuss some key issues in the social activities and consequences of globalized business, AACSB: Dynamics of the Global Economy.)

5-4. What role do pharmaceutical companies play in responding to the HIV/AIDS epidemic in South Africa? Given that HIV/AIDS drugs can be exported from India at a lower cost than from the pharmaceutical companies themselves, should Anglo just import the drugs to be used for their employees?

Pharmaceutical companies have a significant role to play in responding to the HIV/AIDS epidemic in South Africa. They should provide affordable access to AIDS drugs to poor people. Unfortunately, the relationship between the world's largest pharmaceutical companies and South Africa was conflictual. Pharmaceutical companies legally challenged the South African government’s plan to reduce the price of medicines and modify its intellectual property law to acquire generic drugs, including HIV/AIDS drugs. This leads to protests by healthcare activists against pharmaceutical companies. Anglo American PLC has already faced a lot of challenges dealing with pharmaceutical companies. It seems logical to import the HIV/AIDS drugs from India at a lower cost than from the pharmaceutical companies. (LO 5.2: To discuss some key issues in the social activities and consequences of globalized business, AACSB: Dynamics of the Global Economy.)

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ADDITIONAL EXERCISES: Global and Societal Challenges Exercise 5.1. Ask students if they believe that it is better for a country to encourage (a) international trade activities or (b) inward foreign direct investment. Then have them discuss the impact of foreign direct investment upon the international trade activities of the triad nations (West Europe, Japan, Canada, and the United States) as compared to the impact upon the BRICs (Brazil, Russia, India, and China). Finally, repeat the first question regarding their general beliefs. If positions have changed, explore why. (LO 5-2: Evaluate the major economic effects of MNEs on home and host countries, AACSB: Analytical Skills.)

Exercise 5.2. Choose two to five countries that are economically diverse. Then lead the class in a comparative discussion of the impact of foreign direct investment upon those countries. What MNEs are headquartered in or have subsidiaries based in those countries?

Conclude by asking the students to discuss the societal effects of foreign direct investment upon those and possibly other countries. (LO 5-2: Evaluate the major economic effects of MNEs on home and host countries, AACSB: Analytical Skills.)

Exercise 5.3. During the late 1980s and throughout the 1990s, China was routinely cited by various governments and NGOs for human rights violations that included torture, beatings, imprisonment, and even the executions of political dissidents. At the same time, inflows of foreign direct investment into China from firms headquartered in democratic societies in West Europe, North America, and Japan were increasing at record rates. Ask the students to debate this phenomenon from an ethical perspective. Do they believe that China is a special case, and if so, why? (LO 5-4: Identify the cultural foundations of ethical behavior, AACSB: Ethical Understanding and Reasoning Ability.)

Exercise 5.4. Multinational enterprises are increasingly subject to demands from both national and local governments to implement comprehensive social programs, engage in improved labor relations, and meet increasingly rigorous environmental regulations. Ask the students to explore the strategic options they feel are available to a firm such as Newmont Mining in Indonesia that has extensive property and capital assets at risk. Suggest they consider both proactive and reactive alternatives. (LO 5-7: Summarize what the roles are of governments and companies in resolving environmental issues, AACSB: Dynamics of the Global Environment.)

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PART THREE THEORIES AND INSTITUTIONS: TRADE AND INVESTMENT Chapter 6 International Trade and Factor Mobility Theory OBJECTIVES 6-1 Understand why policymakers and managers rely on international trade and factor mobility theories to help achieve economic objectives 6-2 Illustrate the historical and current rationale for interventionist and free trade theories 6-3 Describe theories that explain national trade patterns 6-4 Explain why a country’s export capabilities are dynamic 6-5 Summarize the reasons for and major effects of international factor movements 6-6 Assess the relationship between foreign trade and international factor mobility

CHAPTER OVERVIEW This chapter will first examine theories that endorse great governmental intervention in trade movements (mercantilism and neomercantilism) versus a laissez-faire approach of no governmental intervention (free-trade theories of absolute advantage and comparative advantage). It will then look at theories to explain trade patterns (how much countries depend on trade, in what products, and with whom), including theories of country size, factor proportions, and country similarity. It will subsequently consider theories dealing with the dynamics of countries’ trade competitiveness for particular products, which include the product life cycle theory and the diamond of national competitive advantage theory. The chapter concludes with an overview of factor mobility, mainly emphasizing the mobility of human resources.

CHAPTER OUTLINE OPENING CASE: Map 6.1]

THE EVOLUTION OF TAIWAN’S INTERNATIONAL TRADE [see

Taiwan, officially the Republic of China, with a 2019 population of about 23.6 million, has successfully taken advantage of its location and used international trade to become one of the “Asian Tigers” and the world’s 21st-largest exporter. During the last half century, Taiwan transformed its economy to one that emphasizes economic liberalization, industrial products and export expansion. The most notable developments in the past two decades were the renewal and growth of Taiwan’s trade and investment with China, the upsurge of Taiwan’s outward FDI, and growing reliance on foreign contract workers.

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Questions 6-1 Using the framework in Table 6.1, explain which of the theories relate to Taiwan’s trade policy during each of the eras described in the case.

• • • •

• • •

The Japanese Occupation (1895–1945): Taiwan was under mercantilism because colonial Japan used Taiwan as a colony to produce agricultural goods for the Japanese population that moved from agriculture into the manufacturing sector.

The Period of Import Substitution (1945–1958): Taiwan’s trade policy during this period was influenced by mercantilism which advocates for import substitution to decrease its dependence on finished foreign consumer goods.

The Period of Export Expansion (1958–1969): Taiwan’s trade practices during this period falls under mercantilism as the government attempts to maximize Taiwanese export.

The Period of Import Substitution (1969–1980): Taiwan’s trade policies during this period was driven by mercantilist practices, especially domestic manufacturing, and import substitution to decrease its dependence on foreign equipment and components needed to produce finished goods.

The Period of Economic Reform and Continuous Export Expansion (1981–1989): Free trade theories powered Taiwan’s trade policies during this period. Taiwan reduced restrictions on international trade and liberalized finance and banking.

The Economic Policies in the 1990s: This period is better explained by the Product life cycle (PLC) theory because Taiwan started offshoring and outsourcing assembly to a lower wage-rate country to remain competitive.

Massive FDI And Factor Mobility (2000–Present): The PLC theory provides a better explanation of Taiwan’s trade and investment transformation during this period and in the long run. Taiwan reaches a new economic stage in which the country becomes an innovation hub and a source of outward FDI.

(LO 6-2: Illustrate the historical and current rationale for interventionist and free trade theories, AACSB: Dynamics of the Global Economy) 6-2. Map 6.1 shows that 64.9 percent of Taiwan’s exports go to only five countries/territories. Which trade theories may help to explain this concentration and why?

That Taiwan exports to only five countries/territories could be explained by countrysimilarity theory. Taiwan trade primarily with these countries because of cultural similarity (China, Hong Kong and Singapore), political relationships (the United States), and geographic distance (China, Hong Kong, Japan, and Singapore). (LO 6-2: Illustrate the historical and current rationale for interventionist and free trade theories, AACSB: Dynamics of the Global Economy) Teaching Tips: Carefully review the PowerPoint slides for Chapter Six, as well as the opening case regarding Taiwan’s international trade, which is cited throughout the chapter.

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I.

WHY DO POLICYMAKERS AND MANAGERS RELY ON INTERNATIONAL TRADE AND FACTOR MOBILITY THEORIES? Trade theory helps managers and government policymakers focus on three critical questions: What products should be imported and exported, how much should be traded, and with whom should they trade? [see Table 6.1.].

Some trade theories prescribe that governments should influence trade patterns (mercantilism and neomercantilism); others propose a laissez-faire treatment for free trade (free-trade theories of absolute advantage and comparative advantage). There are also theories that explain trade patterns (how much countries depend on trade, in what products, and with whom), including theories of country size, factor proportions, and country similarity and theories that deal with the dynamics of countries’ trade competitiveness for particular products, which include the product life cycle theory and the diamond of national competitive advantage theory.

II.

INTERVENTIONIST AND FREE TRADE THEORIES Interventionist trade theories endorse great governmental intervention in trade movements (mercantilism and neomercantilism) while free trade theories endorse laissez-faire approach of no governmental intervention (free-trade theories of absolute advantage and comparative advantage).

A. Mercantilism The concept of mercantilism served as the foundation of economic thought for nearly three hundred years (1500–1800). It purports that a country’s wealth is measured by its holdings of “treasure” (usually gold).

1. Governmental Policies. To run a trade surplus, governments restricted imports and subsidized noncompetitive production.

2. The Concept of Balance of Trade. Some mercantilist terminology has endured. For example, a favorable balance of trade (also called a trade surplus) still indicates that a country is exporting more than it imports. An unfavorable balance of trade (also known as a trade deficit) indicates the opposite. These terms are misnomers because the word favorable implies “benefit,” and the word unfavorable suggests “impairment.” Running a favorable balance of trade is not necessarily beneficial.

B. Neomercantilism.

Neomercantilism is the running of a favorable balance of trade (run an export surplus) to achieve some social or political objective.

C. Free Trade Theories Why do countries need to trade at all? Why can’t Taiwan (or any other country) be content with the goods and services it produces? Two free trade theories help answer this question: absolute advantage and comparative advantage.

1. Theory of Absolute Advantage In 1776, Adam Smith declared that a country’s well-being is its citizens’ access to goods and services rather than the mercantilists’ concept of its ownership of gold.

His theory of absolute advantage holds that different countries produce different things more efficiently than others and that consumers should not have to buy domestically produced goods when they can buy them more cheaply from abroad.

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Smith reasoned that: (i) workers become more skilled by repeating the same tasks; (ii) workers do not lose time in switching from the production of one kind of product to another; and (iii) long production runs provide greater incentives for the development of more effective working methods. Smith also asserted that countryspecific advantages can either be natural or acquired. i. Natural Advantage. A country may have a natural advantage in the production of particular products because of given climatic conditions, access to particular resources, the availability of labor, etc. Variations in natural advantages among countries help to explain where particular products can be produced most efficiently. ii. Acquired Advantage. An acquired advantage represents a distinct advantage in product or process technology that yields differentiated product offerings and/or cost-competitive homogeneous products. Technology, in particular, has created new products, displaced old products, and altered trading-partner relationships. iii. How Does Specialization Increase Output? Real income depends on the output of products as compared to the resources used to produce them. By defining the cost of production in terms of the resources needed to produce a product, the production possibilities curve shows that through the use of specialization and trade, the output of two countries will be greater, thus optimizing global efficiency. [see Fig. 6.2.]

2. Theory of Comparative Advantage In 1817 David Ricardo reasoned that there would still be gains from trade if a country specialized in the production of those things it can produce most efficiently, even if other countries can produce those same things even more efficiently. Put another way, Ricardo’s theory of comparative advantage holds that a country can maximize its own economic well-being by specializing in the production of those goods and services it can produce relatively efficiently and enhance global efficiency through its participation in (unrestricted) free trade. i. Comparative Advantage by Analogy. Would it make sense for the best physician in town, who also happens to be the most talented medical secretary, to handle all of the administrative duties of an office? No. The physician can maximize both output and income by working as a physician and employing a less skilled secretary. In the same manner, a country will gain if it concentrates its resources on the production of the goods and services it can produce most efficiently. ii. Production Possibility. A country can simultaneously have a comparative advantage and an absolute advantage in the production of a given product.

Assume that the United States is more efficient than Costa Rica in the production of both wheat and coffee; however, the U.S. has a comparative advantage in wheat production. By concentrating on the production of the product in which it has the greater advantage (wheat) and allowing Costa Rica to produce the product in which the United States is comparatively less efficient (coffee), global output can be increased, and specialization and trade will benefit both countries. [see Fig. 6.2.]

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3. Free Trade Theories: Some Assumptions and Limitations The theories of absolute and comparative advantage are based upon the economic gains from specialization, i.e., concentration on the production of a limited number of products. Each holds that specialization will maximize output and that countries will be best off by trading the output from their own specialization for the output from other countries’ specialization. However, both theories make certain assumptions that may not always be valid.

• Full Employment. Both theories (absolute and comparative advantage) assume that resources are fully employed. When countries have many unemployed or underemployed resources, they may seek to restrict imports in order to employ or use idle resources.

• Economic Efficiency. Individuals and countries often pursue objectives other than economic efficiency. Individuals may prefer activities and/or occupations that are economically less productive, and nations may choose to avoid overspecialization because of the vulnerability created by potential changes in technology and price fluctuations.

• Division of Gains. Although specialization does maximize output, it is not always clear how those gains will be divided. If one country believes that a trading partner is receiving too large a share of the benefits, it may choose to forego its relatively smaller gains in order to prevent the partner country from receiving larger gains.

• Transport Costs. If it costs more to deliver products than can be saved via specialization, then the gains from trade are negated.

• Insufficient Demand. If trade increases production by more than normally acceptable tea and wheat consumption, there still an advantage. The consumers in the two countries can gain access to sufficient output by working fewer hours, thus giving them more leisure time.

• Statics and Dynamics. Although the theories of absolute and comparative advantage consider gains at a given time (a static view), the relative conditions that surround a country’s particular advantage or disadvantage are dynamic (constantly changing). Thus, one cannot assume that future advantages will remain constant. (This idea will also be relevant to the discussion of the dynamics of the location of production and export sources.)

• Services. Although the theories of absolute and comparative advantage were developed from the perspective of trade in commodities, much of the same reasoning can be applied to trade in services.

• Production Networks. While both theories deal with the trading of one product for another, increasingly there are divisions by components and function as well as within a company’s value chain network. The firm’s value chain can include a number of countries; however, the argument for specialization still remains valid.

• Mobility. Neither the assumption that resources can move domestically from the production of one good to another at no cost, nor the assumption that resources cannot move internationally, is entirely valid. Nonetheless, domestic mobility is greater than the international mobility of resources. Clearly, the movement of resources such as capital and labor is a very real alternative to trade.

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III. THEORIES TO EXPLAIN NATIONAL TRADE PATTERNS The free trade theories demonstrate how output growth occurs through specialization and free trade; however, they do not deal with trade patterns such as how much a country trades, what products it trades, or who will be its trading partners. In this section, we discuss the theories that help explain these patterns.

A. How Much Does a Country Trade?

Apart from nontradable goods, i.e., goods and services that are impractical to export, country size helps to explain why some countries are more dependent on trade than others and why some account for larger portions of world trade than others. Nontradable goods—products and services (haircuts, retail grocery distribution, etc.) that are seldom practical to export because of high transportation costs—are produced in every country.

1. Theory of Country Size. The theory of country size holds that large countries tend to export a smaller portion of their output and import a smaller portion of their consumption. Large countries are more apt to have varied climates and a greater assortment of natural resources than smaller economies, thus making the large countries more self-sufficient. Further, given the same types of terrain and modes of transportation, the greater the distance, the higher the associated transport costs.

Thus, firms in large countries often face higher transportation costs in terms of sourcing inputs from and delivering output to distant foreign markets than do their closer foreign competitors.

2. Size of the Economy. Countries can be compared on the basis of their economic size, using indicators that include the value and share of world trade. Ten of the world’s top trading nations are high-income countries. Despite its low per capita income, China also has a large economy because of its very large population.

Together, the top ten nations account for more than one-half of all of the world’s trade. [see Map 6.2].

B. What Types of Products Does a Country Trade?

The composition of a country’s trade depends on both its natural and acquired advantages. With respect to the latter, both production and product technology can be very important.

1. Factor-Proportions Theory. Developed by Eli Heckscher and Bertil Ohlin, the factor-proportions theory holds that countries have their best trade advantage when depending on their relatively abundant production factors. The following are few observations about the factor-proportions theory: • Factor proportions theory appears logical, and a general observation gives many examples that conform to the theory.

• The factor proportions theory assumes production factors to be homogeneous, tests to substantiate the theory have been mixed.

• Factor proportions analysis becomes more complicated when the same product can be created by different methods, such as with labor versus capital intensity.

• Most new products originate in developed countries. Developing countries depend much more on the production of primary products; thus, they depend more on natural advantage.

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C. With Whom Do Countries Trade?

High-income countries trade primarily with each other, and emerging economies primarily export primary and labor-intensive products. Nonetheless, it is also true that economic and cultural similarities, political interests, and distance affect the determination of trading partners.

1. Country-Similarity Theory. The country-similarity theory says that companies create new products in response to market conditions in their home market. They then turn to markets they see as most similar to what they are accustomed, especially those markets where consumers have comparable levels of per capita income • Specialization and Acquired Advantage. In order to export, a company must provide consumers abroad with an advantage over what they could buy from their domestic producers.

• Product differentiation. Product differentiation causes countries to conduct twoway trade in seemingly similar products.

• The Effects of Cultural Similarity. Importers and exporters perceive greater ease in doing business in countries that are culturally similar to their home country, such as those that speak a common language. Likewise, historic colonial relationships explain much of the trade between specific developed and developing economies • The Effects of Political Relationships and Economic Agreements. Political relationships and economic agreements among countries may discourage or encourage trade between them.

• The Effects of Distance. Although no single factor fully explains specific pairs of trading partners, the geographic distance between two countries is important in as much as transport costs increase with distance.

IV. THE DYNAMICS OF EXPORT CAPABILITIES Both the product life cycle theory and Porter’s diamond of national advantage theory help to explain how countries develop, maintain, and possibly lose their competitive advantages.

A. Product Life Cycle (PLC) Theory Product life cycle theory states that the production location of certain manufactured products shifts as they go through their life cycle. The cycle consists of four stages: introduction, growth, maturity, and decline.

1. Product Introduction. Innovation, production, and sales occur in the domestic (innovating) country. Because the product is not yet standardized, the production process tends to be relatively labor-intensive, and innovative customers tend to accept relatively high introductory prices.

2. Growth. As demand grows, competitors enter the market. Foreign demand, competition, exports, and often-direct investment activities also begin to accelerate.

3. Maturity. Worldwide demand begins to level off, although it may be growing in some countries and declining in others. Production processes are relatively standardized and global price competition forces production site relocation to lower-cost developing countries.

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4. Decline. Market factors and cost pressures dictate that almost all production occur in developing countries. The product is then imported by the country where it was initially developed—the importing firm may or may not be the innovating firm.

Verification and Limitations of PLC Theory. Exceptions to the typical pattern of the product life cycle theory would include: products with high transport costs, products that have very short life cycles, luxury goods and services, products that require specialized labor, products that can be differentiated from direct competitors, and products for which transportation costs are relatively high.

B. The Diamond of National Competitive Advantage Introduced by Michael Porter, the diamond of national competitive advantage is a theory showing four features as important for competitive superiority: demand conditions; factor conditions; related and supporting Industries; and firm strategy, structure, and rivalry. Usually, all four conditions need to be favorable for an industry within a country to attain and maintain global supremacy. [see Fig. 6.4.]

1. Facets of the Diamond.

• Demand Conditions. The nature and level of demand in the home market lead to the establishment of production facilities to meet that demand.

• Factor Conditions. Resource availability (inputs, labor, capital, and technology) contributes to the competitiveness of both firms and countries that compete in particular industries.

• Related and Supporting Industries. The local presence of internationally competitive suppliers and other related industries contributes to both the cost effectiveness and strategic competitiveness of firms.

• Firm Strategy, Structure, and Rivalry. The creation and persistence of national competitive advantage requires leading-edge product and process technologies and business strategies.

2. Limitations of the Diamond of National Advantage Theory. The existence of the four favorable conditions may represent a necessary but insufficient condition for the development of a particular national industry. Even when abundant, resources are ultimately limited; thus, firms must make choices regarding their pursuit of existing opportunities. Further, given the ability of firms to gain market information and production inputs from abroad, the absence of favorable conditions within a country may be overcome by their existence internationally.

3. Using the Diamond for Transformation. Understanding and having the necessary conditions to be globally competitive are important, but these conditions are neither static nor purely domestic. As shown in the opening case regarding Costa Rica’s economic transformation, the Costa Rican government altered its educational system to tailor the country’s human resource development to fit the needs of targeted industries. Likewise, it developed local supplies and attracted sufficient numbers of foreign firms so that their combined presence assured a vibrant competitive environment.

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V. THE THEORY AND MAJOR EFFECTS OF FACTOR MOBILITY Over time factor conditions change in both quality and quantity. Concomitantly, the mobility of capital, technology, and people also affects the relative capabilities of countries.

Factor mobility theory focuses on why production factors move, the effects of that movement on transforming factor endowments, and the impact of international factor mobility (especially people) on world trade.

A. Why Production Factors Move 1. Capital. While capital is the most internationally mobile factor, short-term capital is the most mobile of all. Capital is primarily transferred because of differences in expected returns, although firms may also respond to government incentives.

2. People. People transfer internationally in order to work abroad, either on a temporary or a permanent basis. It may be difficult to distinguish between economic and political motives associated with international labor mobility, because poor economic conditions often accompany repressive and/or uncertain political conditions. A person who lives outside their native country is known as an expatriate.

B. Effects of Factor Movements Neither international capital nor population movements are new occurrences.

Immigrants bring human capital, thus adding to the base of a country’s skills and enabling competition in new areas. Inflows of capital to those same countries can be used to develop infrastructure and natural and other acquired advantages, thus enabling increased participation in the international trade arena.

1. What Happens When People Move? Although capital and labor are in fact different production factors, they are intertwined. Countries lose potentially productive resources when educated people leave, a situation known as brain drain, but they may in turn gain from the remittances that citizens who are working abroad send home. Countries receiving human resources may also incur the cost of social services for acculturating people into a new culture and language.

POINT—COUNTERPOINT: Should Nations Use Strategic Trade Policies?

1.

POINT: Given the importance of acquired advantage in world trade, a country must develop and maintain industries that will grow and earn sufficient revenues so that its domestic economy thrives and grows. Targeting industries has proven particularly important for emerging economies such as Costa Rica, and small countries such as Singapore. At the same time, there are numerous examples of the failure of laissez-faire trade policies in Africa— given all of their economic inadequacies, government guidance and intervention are their best hope for better results.

COUNTERPOINT: There are few circumstances where targeting will work, and even if governments are able to identify future growth industries in which their countries can likely succeed, it does not follow that firms within those industries should receive government assistance. A better policy would be to alter the conditions that affect a country’s attractiveness to firms in general, rather than specific targeted industries. This would improve 9 Copyright © 2022 Pearson Education, Inc

the investment environment for all industries without the need for government officials to choose which industries to support.

VI. THE RELATIONSHIP BETWEEN TRADE AND FACTOR MOBILITY Factor movement is an alternative to trade that may or may not be a more efficient allocation of resources.

A. Substitution. When factor proportions vary widely among countries, pressures exist for the most abundant factors to move to countries with greater scarcity. Thus, in countries where labor is relatively abundant compared to capital, workers tend to be poorly paid or unemployed; many will attempt to go to countries that enjoy full employment and offer higher wages. Likewise, capital tends to move away from countries where it is abundant to those where it is relatively scarce. In some cases, however, the inability to gain sufficient access to foreign production factors may stimulate efficient methods of domestic substitution, such as the development of alternatives for traditional production methods.

B. Complementarity. Factor mobility via foreign direct investment may in fact stimulate foreign trade because of the need for components, the parent company’s ability to sell complementary products, and the need for equipment for subsidiaries.

LOOKING TO THE FUTURE: Scenarios That May Change Trade Patterns It’s probably safe to say that trade restrictions have been diminishing, primarily because of the economic gains that countries foresee through freer trade. Yet, there are uncertainties as to whether this trend will continue. Protectionist sentiment might strengthen because of employment displacement and job shifts in developed countries. This will be further exasperated by the continued shifts of labor-intensive production to developing economies and the pressures on the developed countries to accept more immigrants. Urbanization will likely grow faster in developing than in developed countries. This could translate into higher growth in some developing countries and a larger share of world trade. We will probably see the continued trend toward a more finely tuned specialization of production among countries to take advantage of specific conditions.

Four interrelated factors are worth monitoring because they could cause product trade to become relatively less significant in the future 1. Multiple production locations 2. Flexible, small-scale production methods, especially those using robotics and digital 3. Output from and research on 3-D printers 4. Services CLOSING CASE: Ecuador: A Rosy Export Future?

Ecuador has been successful in developing markets for the export of roses. In fact, the product is one of the most important exports, behind only petroleum and bananas. This success is partially the result of a competitive labor force, as well as unique geographical advantages, including less climatic risks when compared to neighboring competitors. Producers have also cooperated with 10 Copyright © 2022 Pearson Education, Inc

competitors and purchasers to meet consumer needs. As the global market for these products expand, Ecuador will have to deal with many additional challenges and opportunities in the future.

Questions 6-3. Look back in Chapter 1 to the factors in increased globalization and explain which have influenced the growth of world trade in cut roses and why.

For several technological and economic factors, trade of cut roses is benefiting from increased globalization. First, robust, and advanced transportation and chilling technology enhance growers’ ability to reach distant markets. Second, liberalization of cross-border trade and free trade agreements have allowed cut roses to reach markets with less restrictions. Third, increase in global competition has forced cur rose growers to seek untapped markets. (LO6-4: Explain why a country’s export capabilities are dynamic, AACSB: Dynamics of the Global Economy) 6-4. Think back to the external institutional conditions (cultural, legal-political, and economic) discussed in Chapters 2 through 4 and discuss how these have affected and might affect future demands for Ecuadoran cut roses.

These forces have reduced and eliminated barriers to trade, while expanding potential markets and granted improved access to markets. These forces have also created additional opportunities and incentives for producers, while fostering international economic cooperation and development. (LO6-4: Explain why a country’s export capabilities are dynamic, AACSB: Dynamics of the Global Economy) 6-5. There are a number of ways Ecuadoran growers might increase demand for their cut roses.

Among these are (a) to try to get more consumers to move up-market by buying premium roses, (b) to promote more rose demand for a different special day (e.g., roses account for a small percentage of U.S. flower sales for Christmas/Hanukkah, Thanksgiving, and Easter/Passover), and (c) to promote sales in relatively untapped markets, such as the Middle East. Compare these and any other alternatives you can think of.

Each of the alternatives presents specific risks and opportunities. There are also a myriad of additional marketing strategies and promotions that may be used. A greater emphasis on technology and more efficiency within the distribution system, as well as the elimination of regulatory barriers to trade, could also help. (LO6-4: Explain why a country’s export capabilities are dynamic, AACSB: Dynamics of the Global Economy.)

6.6. Some counties have found success by promoting the nationality of their products, such as the Juan Valdez campaign for Colombian coffee. Discuss the viability of a national campaign to promote Ecuadorian roses abroad.

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According to the Trace Commissioner of Ecuador, the country’s year-round perfect climate and high elevation produces large-stemmed, big bulb, and colorful roses, such as purple, green, terracotta, orange, peach, and fuchsia that you cannot get from anywhere else in the world. They are the most impressive and outlast any other type of rose. FlorEcuador is also the social environmental certification which ensures that the flower farms in Ecuador treat the environment properly and their workers fairly. (LO6-4: Explain why a country’s export capabilities are dynamic, AACSB: Dynamics of the Global Economy.)

Additional Exercises: International Trade and Factor Mobility Exercise 6.1. The theories of absolute and comparative advantage and the product life cycle all contribute to the explanation of the international trade process. Select two to three different types of products and ask students to discuss the likelihood that (a) an innovating country, (b) a rapidly developing country, and (c) an emerging country would enjoy an absolute advantage, a comparative advantage, or no particular advantage as each of the products moves through the four stages of the product life cycle. Be sure they cite examples and explain their reasoning. (LO 6-1:Understand why policymakers and managers rely on international trade and factor mobility theories to help achieve economic objectives, AACSB: Dynamics of the Global Economy.)

Exercise 6.2. The factor-proportions theory and the country-similarity theory both address patterns of trade, i.e., partner nations. Ask students to compare and contrast the two theories.

In what ways are they complementary and in what ways do they differ? Then select two to five home countries of students in your class and ask the class to identify the natural and acquired advantages of those countries and to compare their various economic, cultural, and political similarities. (LO 6-1:Understand why policymakers and managers rely on international trade and factor mobility theories to help achieve economic objectives, AACSB: Analytical Skills.)

Exercise 6.3. Porter’s diamond theory deals with the competitive advantages of nations.

Select two to five countries and lead the class in a comparative analysis of the four points of the diamond, as well as the recent roles of government and chance, in those nations.

Conclude the discussion by exploring the associated competitive advantages that may accrue to foreign firms that choose to operate in each of those countries. (LO 6-4:To explain why a country’s export capabilities are dynamic, AACSB: Dynamics of the Global Economy.)

Exercise 6.4. Select two large multinational enterprises that are known to the students, one consumer-oriented (e.g., McDonald’s) and one industrial (e.g., Newmont Mining). Then ask students to discuss the concept of complementarity within the context of the operations of those two firms. What equipment, components, and/or complementary products are needed in host countries as a result of their foreign operations that may stimulate foreign trade in both the short and the long run? (LO 6-5:To understand why production factors, especially labor and capital, move internationally, AACSB: Reflective Thinking.)

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Chapter 7 Governmental Influence On Trade OBJECTIVES 7-1 Recognize the conflicting outcomes of trade protectionism 7-2 Assess governments’ economic rationales and outcome uncertainties with international trade intervention 7-3 Assess governments’ noneconomic rationales and outcome uncertainties with international trade intervention 7-4 Describe the major instruments of trade control 7-5 Understand how companies deal with import competition

CHAPTER OVERVIEW This chapter reviews the economic and noneconomic rationales for trade protectionism, the major forms of trade controls, and trade control’s effects on companies’ operating decisions.

CHAPTER OUTLINE OPENING CASE: THE U.S.-VIETNAMESE CATFISH DISPUTE [See Map 7.1.]

This case is a great example of attempts to protect a national industry against international competition. Catfish are farmed in the southern U.S. and in Vietnam. The Vietnamese production has some competitive advantages including a more conducive climate, lower governmental restrictions, and lower labor rates. So even with transportation costs, Vietnam exports catfish to the United States at low rates. The U.S. catfish growers fought back using a variety of means.

They tried to limit the use of the name “catfish” and petitioned for increased taxes on imported fish and even tried to bring into question the safety of overseas fish. The U.S. producers have not been successful in limiting imports and have even been caught up by their own efforts. A key point is that trade between nations cannot be viewed just by one industry. Vietnam is the third largest export market for U.S. beef. So, if we successfully limit the importing of catfish, will Vietnam retaliate by limiting the importing of beef?

QUESTIONS 7-1. List the advantages and disadvantages for the U.S. protection of its catfish industry.

The U.S.'s protectionist measures provide the catfish industry with opportunities to grow and compete against foreign competition. This might also boost employment in the U.S. catfish industry. Nationally, these protectionist measures would increase U.S. trade balance.

(LO7-2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention, AACSB: Analytical Skills).

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However, U.S. protection of its catfish industry might harm U.S. consumers who will have limited choices and likely pay higher prices. There is also the prospect of retaliation from foreign trade partners such as Vietnam. Also, the lack of foreign competition might undermine innovation in the U.S. catfish industry. (LO7-2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention, AACSB: Analytical Skills).

7-2. As you read through the chapter, list the protective measures (instruments) the United States has not used to protect its catfish industry. Briefly explain why each would or would not be successful.

The U.S. catfish industry lobbied for protectionism using three arguments: The appropriateness of the “catfish” label, dumping, and health arguments. The following table shows other major instruments of trade control that the U.S. has not used to protect its catfish industry Instruments of trade control

Impact

Tariff

Although the U.S. imposed antidumping taxes (tariffs) on imports of catfish from Vietnam, tariffs were not used systematically. In general, tariffs would have been successful in protecting the U.S. catfish industry and generating revenue. However, they can also lead to higher prices for U.S. consumers. Tariffs can also lead to retaliation and trade disputes.

Import Quota

Import quota would have been successful in protecting the U.S. catfish industry, but it can also lead to higher prices for domestic consumers.

Subsidies

Subsidies would be successful as they help support the catfish industry and its job market. However, subsidies might distort the catfish markets and further disadvantage Vietnam.

TEACHING TIPS: Have students visit the Web site of the WTO (https://www.wto.org/) and review the current disputes found on that site. Have students report back what they have found and discuss their opinions. Carefully review the PowerPoint slides for Chapter Six. INTRODUCTION In principle, no country permits a totally unregulated flow of goods and services across its borders. Likewise, governments may choose to enable the global competitiveness of their own domestic firms. Protectionism refers to those government restrictions and incentives that are specifically designed to help a country’s domestic firms compete with foreign competitors at home and abroad. The rationale for such policies can be economic or noneconomic in nature. Whenever governments choose to impede the flow of imports and/or 2 .

encourage the flow of exports, they simultaneously provide direct and/or indirect subsidies for their domestic firms.

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CONFLICTING OUTCOMES OF TRADE PROTECTIONISM All countries seek to influence trade and respond to their economic, social, and political objectives. Despite free-trade benefits, governments intervene in trade to attain economic, social, or political objectives. Officials enact trade policies that they reason will have the best chance to benefit their nation and its citizens—and, in some cases, their personal political longevity. Their decisions are complicated because outcomes are uncertain and affect groups of their citizens differently.

A. The Role of Stakeholders Proposals on trade regulations often spark fierce debate among people who believe they will be affected—the so-called stakeholders. Of course, those most directly affected are most apt to speak out, such as workers, owners, suppliers, and local politicians whose livelihoods depend on the actions taken. They push hardest for trade rules favorable to them. Consumers generally purchase products with little thought as to where the product was produced. Import barrier costs are often spread out so that the effect is not noticed by the consumer.

II. ECONOMIC RATIONALES FOR GOVERNMENTAL TRADE INTERVENTION AND OUTCOME UNCERTAINTIES Governmental intervention in the trade process may be either economic or noneconomic in nature. [See Table 7.1.]

A. Fighting Unemployment Probably no pressure group is more effective than the unemployed; no other group has more time and incentive to protest publicly and contact government representatives.

Import-displaced workers are often the least able to find alternative work, especially if large numbers are concentrated in small company towns where there are virtually few alternative employment opportunities 1. What’s Wrong with Full Employment as an Economic Objective? Nothing!

However, creating domestic employment by limiting imports may not fully work as expected. It may lead to retaliation by other countries, affect large and small economies differently, reduce import handling jobs, may decrease jobs in another industry, and may decrease export jobs because of lower incomes abroad. Many groups call for protectionism to increase or protect employment. However, evidence suggests that employment is better dealt with through fiscal and monetary policies.

B. Protecting “Infant Industries” The infant-industry argument holds that a government should shield an emerging industry from foreign competition by guaranteeing it a large share of the domestic market until it can compete on its own.

1. Underlying Assumptions. The infant-industry argument presumes that early operating costs within a newly producing country may be too high to compete in world markets and that sufficient cost reductions will occur over time.

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2. Risks in Designating Industries. However, production costs may never fall enough to create internationally competitive products. Inherently, there are problems. First, governments must identify those industries that have a high probability of success, and this is hard. Even if policymakers choose the right industries, some economic segment must absorb the high early cost before domestic production becomes internationally viable. This burden may fall on consumers who pay higher prices for the protected products or on taxpayers who pay for subsidies.

C. Developing an Industrial Base Since the industrial revolution, countries increasing their industrial bases grew their employment and economies more rapidly. This observation led to protectionist arguments to spur local industrialization. These arguments have been based on the following assumptions: 1. Surplus Workers. The industrialization argument purports that the development of national industrial output (and hence economic growth) should be supported, even though domestic prices may not be competitive on the world market. Surplus workers can more easily be used to increase manufacturing output than agricultural output. Shifting people out of agriculture, however, can create at least two problems: 1) when moving to urban areas they leave behind the safety net of their extended families and rely on the social services in the cities, and 2) improved agriculture practices may be a better means of achieving economic success.

2. Investment Inflows. Import restrictions encourage foreign direct investment by foreign firms that want to avoid the loss of a lucrative or potential market. FDI inflows in turn lead to increased local employment, an attractive outcome for policy makers.

3. Diversification. Price variations can wreak havoc on economies that rely on just a few commodities for job creation and export earnings. Contrary to expectations, however, unless a country’s industrial base is truly expanded, a move into manufacturing may simply shift that dependence from a reliance on the basic commodities to the downstream manufactured goods produced from them.

4. Growth in Manufactured Goods. Terms of trade refers to the quantity of imports that a given quantity of a country’s exports can buy. Many emerging nations have experienced declining terms of trade because the demand for and prices of raw materials and agricultural commodities have not risen as fast as the demand for and prices of finished goods. In addition, changes in technology have reduced the need for many raw materials. Cost savings realized from manufactured products go mainly to higher profits and wages, thus fueling the industrialization process.

5. Import Substitution and Export-Led Development. Import substitution represents an economic development strategy that relies on the stimulation of domestic production for local consumption by erecting barriers to imported goods.

If the protected industries do not become globally competitive, however, local customers will continually be penalized by high prices or higher taxes. On the other hand, export-led development encourages economic development by harnessing a country-specific advantage (e.g., low labor costs) and building a vibrant manufacturing sector through the stimulation of exports. In reality, when effectively 4 .

crafted, import substitution policies eventually lead to the possibility of export promotion as well.

D. Improving Comparative Economic Positions Countries track their own performance as compared to other nations to determine whether to impose trade restrictions as a means of improving their competitive positions. The four primary motivations for doing so are outlined below.

1. Balance-of-Trade Adjustments. The trade account (the current account) is a major part of the balance of payments for most countries. If balance-of-payments difficulties persist, a government may restrict imports and/or encourage exports in order to balance its trade account. It has two options that affect its competitive position broadly: (i) depreciate or devalue its currency, an action that makes all of its products cheaper in relation to foreign products, or (ii) rely on fiscal and monetary policy to bring about lower price increases in general than those in other countries.

2. Comparable Access or “Fairness.” The comparable access argument promotes the idea that a country’s firms are entitled to the same access to foreign markets as foreign firms have to its market. Economic theory reasons that producers operating in industries where increased production leads to economies of scale but which lack equal access to foreign competitors’ markets will struggle to become costcompetitive. However, restricting trade, even on the grounds of “fairness,” may lead to higher prices for domestic customers. There are at least two reasons for rejecting the idea of fairness. First, tit-for-tat market access can lead to restrictions that may deny one’s own consumers lower prices. And second, governments would find it impractical to negotiate and monitor separate agreements for each of the many thousands of different products and services that might be traded.

3. Import Restrictions as a Bargaining Tool. Import restrictions may be levied as a means to try to persuade other countries to lower their import barriers. The danger, however, is that each country will, in turn, retaliate by escalating its own restrictions. To successfully use restrictions as a bargaining tool requires that they be (i) believable and (ii) important to the targeted parties.

4. Export Restrictions. Export restrictions may aim either to raise or lower prices.

Countries that hold a near-monopoly of certain resources sometimes limit their international sale in an effort to raise prices abroad. However, this policy often encourages smuggling, the development of technology, or different means to produce the same product. Export controls are especially ineffective for digital products because they are so easily copied abroad. A country may also limit exports of a product that is in short supply worldwide to favor domestic consumers.

Typically, a greater supply drops domestic prices beneath foreign ones. However, favoring domestic consumers disfavors domestic producers, so they have less incentive to maintain production when prices are low.

5. Affecting Prices. Import restrictions may aim either to raise or lower prices.

• Prevention of Foreign Monopolies. There is fear that foreign producers will price their exports so artificially low that they will drive producers out of business in the importing country.

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Prevention of Dumping. The practice of pricing exports below cost, or below their home-country prices, i.e., below their “fair market value,” is known as dumping. Most countries prohibit imports of “dumped” products, but enforcement usually occurs only if the product disrupts domestic production.

Invoking the Optimum Tariff. The optimum-tariff theory claims that a foreign producer will lower its prices if the destination country places a tariff on its products. So long as the foreign producer reduces its price by any amount, some shift in revenue goes to the importing country, and the tariff is deemed an optimum one.

III. NONECONOMIC RATIONALES FOR GOVERNMENTAL TRADE INTERVENTION AND OUTCOME UNCERTAINTIES Governments may choose to intervene in the trade process for noneconomic reasons such as the maintenance of essential industries (especially defense), the promotion of acceptable practices abroad, the maintenance or extension of spheres of influence, and the preservation of national culture.

A. Maintaining Essential Industries The essential industry argument states that a government applies restrictions to protect essential domestic industries during peacetime so that the country is not dependent on foreign sources of supply during war. Protecting an inefficient industry, however, will lead to higher costs and possibly political consequences as well.

B. Promoting Acceptable Practices Abroad Groups concerned about security use national defense arguments to prevent the export, even to friendly countries, of strategic goods that might fall into the hands of potential enemies or that might be in short supply domestically. Trade controls on non-defense goods may also be used as a foreign policy weapon to try to prevent another country from meeting its political objectives. However, retaliation often renders such protectionist measures ineffective.

POINT—COUNTERPOINT: Should Governments Impose Trade Sanctions?

POINT: Many argue that although not all trade sanctions are successful, many have at least been influential in achieving their objectives. Further, when a nation breaks an international agreement and/or acts in unacceptable ways, punitive actions such as removing diplomatic recognition, boycotting events, or eliminating foreign aid or loans may be ineffective without the addition of trade sanctions.

COUNTERPOINT: Others argue against the use of sanctions on the grounds that they are ineffective. Further, even if sanctions are successful at weakening the targeted countries’ economies, the costs are borne not by government officials, but by innocent people. Finally, it appears that governments sometimes impose sanctions based on just a single issue, rather than on a country’s overall record, which is really counterproductive.

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C. Maintaining or Extending Spheres of Influence To maintain their spheres of influence, governments may give aid and credits to and encourage imports from countries that join a political alliance or vote a preferred way within international bodies. Further, trade restrictions may coerce governments to take certain political actions or punish firms whose governments do not comply.

D. Preserving National Culture Countries are partially held together though a unifying sense of cultural and national distinctiveness. To sustain this collective identity, governments may limit the presence of foreign products in certain sectors. Consumers still seek out the best products and services for the least price.

IV. MAJOR INSTRUMENTS OF TRADE CONTROL In seeking to influence exports or imports, governments’ choice of trade-control instrument is crucial because each may incite different responses from domestic and foreign groups.

One way to understand these instruments is by distinguishing between those that directly influence export or import prices and those that directly limit the amount of a good that can be traded. Let’s review these instruments.

A. Tariffs: Direct Price Influences A tariff (also called a duty) is a tax levied on a good shipped internationally. A specific duty is a tariff that is assessed on a per-unit basis; an ad valorem tariff is assessed as a percentage of the value of an item. If both a specific duty and an ad valorem tariff are assessed on the same product, it is known as a compound duty.

Tariffs collected by the exporting country are called export tariffs; if they’re collected by a country through which the goods pass, they’re transit tariffs; if they’re collected by importing countries, they’re import tariffs. Import tariffs are by far the most common.

• Import Tariffs. Unless foreign producers lower prices by the same amount (discussed earlier in the chapter), import tariffs raise the price of imported goods by taxing them, thereby giving domestically produced goods a relative price advantage. o Tariffs as Sources of Revenue. Tariffs generate government revenue, but revenue is of little importance to developed countries because collection costs usually exceed the yield. o The Effective Tariff Controversy. Raw materials (say, coffee beans) from developing countries frequently enter developed countries duty-free; however, if they are processed (say, instant coffee), developed countries then assign an import tariff. Developing countries argue that the effective tariff on the manufactured portion is higher than the published rates.

B. Nontariff Barriers: Direct Price Influences Nontariff barriers (NTBs) represent administrative regulations, policies, and procedures, i.e., quantitative and qualitative barriers that directly or indirectly impede international trade.

1. Subsidies. Subsidies consist of direct or indirect financial assistance from governments to their domestic firms to help them overcome market imperfections 7 .

and thus make them more competitive in the marketplace. Recently we have seen government intervention shoring up floundering companies and industries. One of the most popular forms of government subsidy can be seen in the agriculture industry. From the standpoint of market efficiency, subsidies are more justifiable than tariffs because they seek to overcome, rather than create, market imperfections.

However, many international frictions result from disagreements about the definition of a subsidy.

2. Tied Aid and Loans. Governments may give aid and loans to other countries but require that the recipient spend the funds in the donor country; this is known as tied aid or tied loans. In this way some donor products that might otherwise be noncompetitive may find limited international markets. However, there is growing skepticism about the value of tied aid because it can slow down the development of local suppliers in developing countries and shield suppliers in the donor countries from competition.

3. Customs Valuation. Because of the temptation to declare a low invoice price in order to pay a lower ad valorem tariff, it is sometimes difficult to determine the true value of traded products. Due to the many different products traded and the differences being minute in some cases, it is easy to misclassify a product and receive a lower tariff. First, customs officials should use the declared invoice price.

If there is none, or if the authenticity of the value is in doubt, then customs agents may assess the shipment on the basis of the value of identical (preferable) or similar (acceptable) goods arriving at about the same time. Further, because countries often impose different import barriers on products sourced from different countries, customs officials must also determine a product’s true origin.

4. Other Direct Price Influences. Other means that countries may use to affect prices include establishing special fees for consular and customs clearance and documentation, requirements that customs deposits be made in advance of shipment, and minimum price levels at which products can be sold after they receive customs clearance.

C. Nontariff Barriers: Quantity Controls Governments use a variety of nontariff barriers to directly affect the quantity of imports and exports. When the quantity of imports is limited, the resulting shift in the supply curve means that the equilibrium price will then be higher.

1. Quotas. A quota represents a numerical limit on the quantity of a product that may be imported or exported in a given period of time. (Because of the increase in the equilibrium price, quotas may increase per-unit revenues for firms that participate in the market.) Voluntary export restraints (VERs) are negotiated limitations of exports from one country to another and, as in the case of a quota, may result in higher prices to customers. An embargo represents an outright ban on imports from or exports to a particular country.

2. “Buy Local” Legislation. Buy local legislation represents laws that are intended to favor the purchase of domestically sourced products over imported products, particularly with respect to government procurement. Local content requirements, i.e., costs incurred within the local country (usually measured as a percentage of total costs), fall within this category.

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Standards and Labels. The professed purpose of standards is to protect the safety or health of the domestic population. However, countries may also devise classification, labeling, and testing standards that facilitate the sale of domestic products but obstruct the sale of foreign-sourced products.

Licensing Requirements. An import or export license requires that firms secure permission from government authorities before conducting trade transactions. Such procedures directly restrict trade when permission is denied and indirectly restrict trade because of the cost, time, and uncertainty involved in the process. A foreign exchange control requires an importer of a given product to apply to a government agency to secure the foreign currency to pay for the product.

Administrative Delays. Intentional administrative delays create uncertainty and increase the cost of carrying inventory. However, competitive pressures can motivate countries to improve inefficient administrative systems.

Reciprocal Requirements. Governments may require that foreign suppliers accept products in lieu of money. Offsets and countertrade are reciprocal requirements that are made between countries with ample access to foreign currency that want to secure jobs or technology as part of the transaction.

Restrictions on Services. Countries restrict trade in services such as transportation, insurance, advertising, consulting, and banking for reasons of essentiality, not-forprofit services, standards, and immigration.

• Essentiality. Countries consider certain services industries to be essential because they serve strategic purposes or provide social assistance to citizens.

Private companies of any sort may be prohibited, and in other cases, price controls may be imposed by the government; government-owned operations are often subsidized.

• Not-for-Profit Services. Mail, education, and hospital health services are often not-for-profit services and governments may preclude foreign firms from competing in these areas.

• Standards. Governments may limit foreign entry into particular service professions in order to assure that practitioners are qualified. Licensing standards vary by country and extend to a wide variety of occupations.

Prerequisites for taking certification examinations may be lengthy.

• Immigration. Government regulations often require that an organization, whether domestic or foreign, demonstrate that the skills needed for a particular job are not available locally before hiring a foreigner.

V. HOW COMPANIES DEAL WITH IMPORT COMPETITION When companies are threatened by import competition, they have several options, four of which stand out: (a) moving operations to a lower-cost country, (b) concentrating on market niches that attract less international competition, (c) adopting internal innovations that lead to greater efficiency or superior products, or (d) trying to get government protection. Each option entails costs and risks; therefore, different companies make different choices. Also, these methods are not realistic for every industry or company.

A. Convincing Decision-Makers. Governments cannot try to help every company that faces tough international competition. Likewise, helping one industry may hurt another.

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Thus, as a manager, you may propose or oppose a particular protectionist measure.

Inevitably, the burden falls on you and your company to convince officials that your situation warrants particular policies. A company improves the odds of success if it can ally most, if not all, domestic companies in its industry. It can lobby decision-makers and endorse the political candidates who are sympathetic to its situation.

B. Preparing for Changes in the Competitive Environment. Companies can take different approaches to deal with changes in the international competition environment.

Frequently these different approaches are based on their strategies and abilities.

LOOKING TO THE FUTURE: Dynamics and Complexity of Future World Trade Each time countries negotiate a trading agreement, new optimum production locations emerge.

Further, the international regulatory situation is in many ways becoming more complex. While some groups and firms are pushing for freer trade, others clamor for greater protection. Thus, it is likely that as barriers come down for some products in some countries, they will go up for other products in other countries. Those who see themselves as losers are not apt to accept their losses without a struggle. Support for their positions may be garnered from alliances that cross national borders, as well as within domestic countries, as economic positions continue to affect politics, and vice versa.

CLOSING CASE: Should U.S. Imports of Prescription Drugs from Canada Be Widened?

The U.S. per capita spending on both health care and pharmaceuticals is the world’s highest. On the other hand, U.S. pharmaceutical expenses have been rising faster than incomes, and the portion paid by workers has been rising faster than the portion paid by health plans. There are numerous explanations to the excessive price increases of essential drugs in the U.S. when there is little or no domestic competition. Chief among them are restrictions on U.S. pharmaceutical imports, which, basically, allowed U.S. pharmaceutical companies to set their U.S. prices and prohibited U.S. consumers from gaining access to cheaper drugs that have not received FDA approval in foreign countries such as Canada. Most assessments conclude that Canadian prescription drugs may cost 40–60 percent less at the retail level than in the United States. Another explanation is safety, namely the danger that counterfeits and illegal drugs might have on public health. Additionally, the price increase of essential drugs is defended by the need of U.S. pharmaceutical companies to recoup the development costs. U.S. pharmaceutical companies claim that they will have to greatly reduce their research budgets if they lose the ability to charge high U.S. prices in the inception phase of their new drugs. Importing from Canada (or elsewhere) will counter this ability.

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Questions 7-3. Should the United States legalize the importation of lower cost pharmaceuticals? If so, should this apply to individual consumers, pharmacies, or other entities?

Student responses to these questions can differ based on what they perceive as priority: safety or affordability. (LO7-2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention, AACSB: Analytical Skills).

7-4. If the United States were to permit importation of lower cost pharmaceuticals from abroad, should this importation apply to all foreign countries or a limited number? If a limited number, which should they be and why?

Student responses to these questions might differ based on their opinions on other countries’ mechanisms to ensure safety and efficacy of drugs. We can get some answers from the critics of current system. Many critics of the U.S. import regulations of the importation of prescription drugs claim that the nonacceptance, say from Germany or Switzerland, is misguided. In other words, restrictions shouldn’t apply for the importation of prescription of drugs from countries with the same safety and inspection standards such as the U.S. (LO7-2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention, AACSB: Analytical Skills).

7-5. If the United States were to permit importation of lower cost pharmaceuticals from Canada, what safeguards should be enacted to help assure the safety and efficacy of the imports?

I think that the U.S. should strengthen the FDA safeguards that are already in place to ensure that medicines imported to the U.S. conform with U.S. legal and regulatory requirements and meet U.S.’s standards for quality, safety, and effectiveness. Recently, the U.S. initiated the Safe Importation Action Plan to allow the import of certain lower-cost pharmaceuticals from Canada under specific health conditions. The plan aims to lower prescription drug prices for American consumers. (LO7-2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention, AACSB: Analytical Skills).

7-6. If the United States were to permit importation of lower cost pharmaceuticals from abroad, should this apply to all pharmaceuticals or just to some? If just to some, what criteria should be used?

There are different ways to categorize pharmaceuticals, such as those approved for U.S. sale versus those that are not and those that have current patented brand names versus those that are generic because they are off-patent. So, the issue is associated only with drugs that have not been approved. Generics are not a significant issue in the import question because their U.S. prices have been going down. Because of the need to balance safety and cost, the ruling should apply only to pharmaceuticals produced in countries with the same safety and inspection standards such as the U.S. (LO7-2: Assess governments’ 11 .

economic rationales and outcome uncertainties with international trade intervention, AACSB: Analytical Skills).

7-7. If pharmacies were allowed to import less costly drugs from abroad, should regulations be put into effect to pass on some/all cost savings to consumers? If so, what should they be?

Student responses to these questions can differ. Under the current system, U.S. pharmacies and health insurance companies pass on higher costs to consumers in the form of insurance costs. While the ultimate objective is to lower prescriptions’ costs, the interest of Pharmaceutical firms to recoup development costs should also be taken into consideration. (LO7-2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention, AACSB: Analytical Skills).

7-8. Consumers seldom propose the reduction of import restrictions to lower their costs. Why has this occurred for pharmaceuticals and not for other products?

I think the high and rising prescription drug costs in the U.S. are why many American consumers propose the reduction of import restrictions on certain prescription drugs from Canada. Also, pharmaceuticals are essential products and, in some cases, life-saving such as HIV/AIDS (see Closing Case, Chapter 5) and Covid-19 drugs. (LO7-2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention, AACSB: Analytical Skills).

Additional Exercises: Government Intervention In Trade Exercise 7.1. As a result of the many rounds of the General Agreement on Tariffs and Trade (GATT) and other trade negotiations, both tariff and nontariff barriers have been significantly reduced on a worldwide basis. However, given recent shifts in productive assets and employment from many industrialized countries to emerging economies such as India and China, cries for protectionist measures can be heard from many quarters. Ask students to debate the possibility that governments in industrialized countries will once again implement some form of protectionist measures in order to protect their markets and industries. Do the students expect that such measures would be in the form of tariffs or nontariff barriers? (LO7-1: To explain the rationales for governmental policies that enhance and restrict trade, AACSB: Analytical Skills).

Exercise 7.2. From a global perspective one can observe excess capacity in the steel, automobile, and commercial airline industries in both industrialized and emerging nations.

Ask students to discuss the logic of this from the standpoints of the Infant-Industry and the Industrialization Arguments. Then ask them to debate whether each of the arguments should be applied only in the case of emerging economies, or in the case of all countries. (LO7-5: Understand how companies deal with import competition, AACSB: Dynamics of the Global Economy).

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Exercise 7.3. Ask students to debate the issue of stakeholders in government trade policy, i.e., whose interests should be of paramount concern—producers, consumers, or the government. Can sanctions by a single nation against another be truly effective, or must it be a multilateral, if not a unilateral, action? (LO7-3: To describe the potential and actual effects of governmental intervention of the free flow of trade, AACSB: Analytical Skills).

Exercise 7.4. Former U.S. Secretary of State Lawrence Eagleburger claims that instead of an embargo, a more effective way to bring democracy to Cuba and other repressive nations would be to increase their exposure to the United States and other industrialized nations through trade and travel. Others claim, however, that governments that choose to violate human rights, expropriate private property, etc. must not be economically rewarded. Ask students to discuss the tension that frequently accompanies the use of economic means to achieve political ends. (LO7-4: To illustrate the business uncertainties and business opportunities created by governmental trade policies, AACSB: Dynamics of the Global Economy).

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Chapter 8 Cross-National Cooperation and Agreements OBJECTIVES 8-1 Define the three major types of international economic integration 8-2 Explain what the World Trade Organization is and how it is working to reduce trade barriers on a global basis 8-3 Summarize the major benefits of regional economic integration 8-4 Compare and contrast different regional trading groups 8-5 Describe the forces that affect the prices of commodities and their impact on commodity agreements

CHAPTER OVERVIEW Chapter Eight first introduces the forms of economic integration and examines the roles of the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO) in the expansion of world trade. It then discusses the major benefits of regional economic integration. It also examines and compares the major regional trading groups. The chapter concludes with a discussion of various commodity agreements and producer alliances, including the Organization of the Petroleum Exporting Countries (OPEC).

CHAPTER OUTLINE OPENING CASE: TOYOTA’S EUROPEAN DRIVE Toyota, the largest auto manufacturing company in the world, sells vehicles in 170 countries and regions, has 54 manufacturing companies in 28 countries and regions outside of Japan, and has R&D facilities worldwide. In Europe, Toyota has manufacturing facilities in six countries, including France where the Yaris is manufactured. It also has R&D facilities in Belgium, the U.K., Germany, and France.

So why has it taken Toyota so long to crack into the competitive European market, and why are European companies only now beginning to feel the pressure from Asian manufacturers? Many analysts have pointed to an agreement between the Japanese government and the European Community (predecessor to the European Union) in which the two negotiated a quota each year for the number of Japanese cars imported into Europe. When the quota system and other restrictions were lifted in 1999, Toyota responded by establishing a European Design and Development center in southern France and capturing distinct cost advantages by setting up additional production centers in East Europe. Toyota’s European market share and profitability began to grow steadily.

Riding on its success in Europe in the mid-2000s and its growth internationally, Toyota had ambitious goals for the future. However, the global financial crisis and the ongoing difficulties 1 .

posed by international recalls of more than 9.5 million vehicles have put a crimp in those plans.

In addition, the 2011 earthquake and tsunami in Japan severely disrupted Toyota’s supply chain.

By 2015, Toyota had only 4.2 percent of the European market, well behind market leader VW with 24.9 percent.

QUESTIONS 8-1. Why did the Europeans try to protect their auto industry from Japanese imports, and do you think this was fair to European consumers?

Responses and opinions may vary. Europeans try to protect their auto industry from Japanese imports to allow European carmakers to develop and become established without protection. French carmakers also pressured European officials to maintain the protectionist measures against Japanese imports. From my perspective, the protectionist measures were not fair to consumers because they will likely result in higher prices to consumers. (LO 8-2: Summarize the major benefits of regional economic integration, AACSB: Analytical Skills).

8-2. What has Toyota done to be more successful in Europe, and why do you think it hasn’t been more successful? What else can it do?

Instead of one size fits all, Toyota started to localize their car offerings to European markets with a customized design and marketing mix. For instance, Yaris, Toyota’s best-selling vehicle in the EU and the first to be developed within the region, was customized to the European market. Yet, Toyota has only managed to secure 5 percent of the European market because of intense competition from VW, which has a strong footprint in Europe. Also, emerging markets, including China, are becoming the new source of profitability in the car industry. Europe is becoming less attractive. To keep up with VW, Toyota should continue its push to increase its share of the European market by further adapting to market changes and consumer expectations in Europe. (LO 8-2: Summarize the major benefits of regional economic integration, AACSB: Analytical Skills).

TEACHING TIPS: A useful Web site for the opening case is https://www.toyotaeurope.com/ where students can explore the European operations of the company in greater detail. Carefully review the PowerPoint slides for Chapter Seven.

I.

FORMS OF ECONOMIC INTEGRATION Trading groups are a significant influence on the strategies of MNEs because they define the size of regional markets and the rules by which companies must operate. Economic integration is the political and economic agreements among countries that give preference to member countries in the agreement. Approaches to economic integration—political and economic agreements among countries in which preference is given to member countries— may be: • Global integration—Countries from all over the world decide to cooperate through the World Trade Organization (WTO) 2 .

• •

Bilateral integration—Two countries decide to cooperate more closely together, usually in the form of tariff reductions Regional integration—A group of countries located in the same geographic proximity decide to cooperate, as with the European Union

II. THE WORLD TRADE ORGANIZATION (WTO)—GLOBAL INTEGRATION The World Trade Organization has become the primary multilateral forum through which governments conclude trade agreements and settle associated disputes. The General Agreement on Tariffs and Trade (GATT) was established in 1947 by 23 nations as a multilateral agreement whose objective was to abolish quotas and reduce tariffs.

The fundamental principle of “trade without discrimination” was embedded in the mostfavored-nation (MFN) clause, i.e., the principle that each member nation must open its markets equally to every other member nation. Several major rounds of negotiations from 1947 to 1993 led to a wide variety of multilateral reductions in both tariff and nontariff barriers. At the conclusion of the Uruguay Round in 1994, the World Trade Organization was created in 1995 for the purpose of institutionalizing the GATT. A. What Does the WTO Do? The World Trade Organization (WTO) was founded in 1995 as a permanent world trade body for the purposes of (i) facilitating reciprocal trade negotiations and (ii) enforcing trade agreements between or among member nations. The WTO adopted the principles and agreements reached under the auspices of the GATT, but it expanded its mission to include trade in services, investment, intellectual property, sanitary measures, plant health, agriculture, textiles, and technical barriers to trade. Its 164 members collectively account for most of the world trade, and an additional 22 countries have applied for membership. The entire membership makes significant decisions by consensus. However, there are provisions for a majority vote in the event of a nondecision by member countries. Agreements then must be ratified by the governments of the member nations, which can be politically challenging.

1. Most Favored Nation. The WTO continued the MFN clause of GATT, which suggests that member countries trade without discrimination giving foreign products “national treatment.” With the following exceptions, it restricts this privilege to official members: Although the WTO restricts this privilege to official members, some exceptions are allowed, especially for developing countries or countries that are part of a regional or bilateral trading group.

2. Dispute Settlement. Under the WTO there is now a clearly defined mechanism for the settlement of disputes. Countries may bring charges of unfair trade practices to a WTO panel; accused countries may appeal; WTO rulings are binding. If an offending country fails to comply with a judgment, the rights to compensation and countervailing sanctions will follow. However, the effectiveness of this system is under serious debate, given the ambiguity and time-consuming nature of certain cases.

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III. REGIONAL ECONOMIC INTEGRATION A. Bilateral Agreements Bilateral agreements can be between two individual countries or may involve one country dealing with a group of other countries. Regional trade agreements are reciprocal pacts between two or more partners that lie somewhat between bilateral treaties and the WTO. Some of the best-known RTAs are the European Union, the U.S.-Mexico-Canada Agreement (USMCA), formerly the North American Free Trade Agreement or NAFTA; and the ASEAN (Association of Southeast Asian Nations) Free Trade Area (AFTA).

B. Geography Matters Geographic proximity is an important reason for economic integration. Geography matters for several reasons in the case of RTAs. Neighboring countries often share a common history, language, culture, and currency. Unless the countries are at war with each other, they have usually developed trading ties already. Close proximity reduces transportation costs, thereby making traded products cheaper in general. The major types of economic integration are: • Free Trade Agreements, in which all barriers to trade, i.e., tariff and nontariff barriers, are abolished among member nations, but each member determines its own external trade barriers with non-FTA countries.

• Customs Unions, in which all barriers to trade, i.e., tariff and nontariff barriers, are abolished among member nations and common external barriers are levied against non-member countries.

• Common Market. Beyond the reduction of tariffs and nontariff barriers, countries can enhance their cooperation in a variety of other ways. Adding free mobility of production factors to a customs union results in a common market.

C. The Effects of Integration Regional economic integration can affect member countries in social, cultural, political, and economic ways. Initially, however, our focus is on its economic rationale.

1. Static and Dynamic Effects. Static effects represent the shifting of resources from inefficient to efficient firms as trade barriers fall. Dynamic effects represent the gains from overall market growth, the expansion of production, the realization of greater economies of scale and scope, and the increasingly competitive nature of the market. Static effects may develop when either of two conditions occurs: • Trade Creation. Trade creation occurs when production shifts from less efficient domestic producers to more efficient regional producers for reasons of absolute or comparative advantage.

• Trade Diversion. Trade diversion Trade diversion—trade shifts to countries in the group at the expense of trade with countries not in the group.

Dynamic effects of integration occur when trade barriers come down and markets grow. Because of that growth, companies can increase their production, which will result in lower costs per unit—a phenomenon we call economies of scale. Another important effect of an RTA is greater efficiency due to increased competition.

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IV. MAJOR REGIONAL TRADING GROUPS Trading groups can be organized by type and/or location. Firms are interested in regional trading groups because they can serve as potential markets, sources of raw materials, and production locations.

A. The European Union The European Union (EU) represents the most advanced regional trade and investment group in the world today.

1. Predecessors. The EU evolved from the European Economic Community (EEC) to the European Community (EC) to the European Union (EU). [Key milestones are summarized in Table 8.2.] European Free Trade Association (EFTA) is an FTA involving Iceland, Liechtenstein, Norway, and Switzerland, with close ties to the EU. All but Switzerland are part of the European Economic Area, which provides them access to the “four freedoms” of the EU: the free movement of goods, services, persons, and capital. However, it does not include other areas of cooperation, such as a customs union and monetary union.

2. Organizational Structure. Detailed information on the history, structure, and function of the EU is available on its extensive Web site. [see Map 8.1.]

• Key Governing Bodies o The European Commission provides political leadership, drafts laws, and runs the various daily programs of the EU. o The Council of the European Union, or European Summit, is composed of the heads of state of each member country. o The three major responsibilities of the European Parliament are legislative power, control over the budget, and supervision of executive decisions. o The European Court of Justice ensures consistent interpretation and application of EU treaties.

3. Antitrust Investigations. The EU has been very aggressive in enforcing antitrust laws in a variety of areas, including high-tech companies like Microsoft and Google on charges that they were harming competitors because of their dominant market positions, Apple and Amazon on suspicion that they were receiving unfair tax advantages from Ireland and Luxembourg respectively, and Facebook on allegations that it was violating privacy policies.

4. Monetary Union: The Euro. The Treaty of Maastricht, signed in 1992, sought to foster both political and monetary union within the EU. While the move toward a common currency has partially eliminated different currencies as a barrier to trade, not all members have adopted the euro. As of 2020, 19 of the 27 EU members had adopted the euro, also known as the euro zone. Others are preparing to do so as well, while only Denmark and the United Kingdom (now no longer a member of the EU) have opted out of the common currency. Other European countries also use the euro, even though they are not EU members.

5. The Schengen Area. To facilitate the free flow of people from country to country within the EU, the Schengen Agreement was signed in 1990 with gradual implementation allowing citizens to cross-internal borders without having to go through border checks. The agreement also does away with border checks. Only a 5 .

few member countries, including the UK, have not signed on, but several non-EU states, including all members of EFTA, have signed on.

6. Migration: A Threat to Schengen. Migration and terrorism are threatening the open borders that are at the heart of the Schengen Agreement.

7. Expansion. One of the EU’s major challenges is expansion. Official candidates for future membership currently include Albania, Montenegro, North Macedonia, Serbia, and Turkey.

8. Bilateral Agreements. In addition to reducing trade barriers for member countries, the EU has signed numerous bilateral free trade agreements with other countries outside the region.

9. The Transatlantic Trade and Investment Partnership (T-TIP). One of the more intriguing potential agreements involves the United States and the EU. Even though tariffs between the two superpowers are already low (the United States and the EU have the world’s largest trading relationship and account for nearly half of the world’s economic output), the new agreement would eliminate the remaining tariffs, boost trade between the regions, and aid in harmonizing product standards between them. In 2019, the EU declared that T-TIP was obsolete and no longer relevant, even though the EU and United States were continuing to try to resolve trade issues.

10. How to do Business with the EU: Implications for Corporate Strategy. Doing business in the EU can influence corporate strategy, especially for outside MNEs, in three ways.

• First, they must determine their production site location(s) on the basis of total costs that include labor, transportation, and other strategic factors.

• Second, foreign firms must decide upon an entry strategy, i.e., new investments, expanding existing investments, or joint ventures and mergers.

• Third, firms must be sensitive to essential national differences, particularly in areas such as economic growth rates and cultural traditions. In addition, the trade-offs between the advantages of pan-European strategies and more localized strategies must be continually examined.

B. The U.S.-Mexico-Canada Agreement (USMCA) Effective as of January 1, 1994, the North American Free Trade Agreement (NAFTA) incorporates Canada, Mexico, and the United States into a regional trade bloc of countries of quite different sizes and sources of national wealth. In 2020, the USMCA replaces the NAFTA agreement. The USMCA changed some of the features of NAFTA and added others.

1. Why NAFTA? As Table 8.1 indicates, NAFTA is a powerful trading bloc with a combined population and GDP greater than the 27-member EU. Unlike the EU, NAFTA was a free trade agreement in goods and services rather than a customs union or a common market, and there is no common currency. That has continued with USMCA. However, USMCA extends far beyond reductions in tariff and nontariff barriers to include provisions for digital trade, financial services, investment, intellectual property, labor, the environment, and a strong dispute resolution mechanism. USMCA has provided both static and dynamic effects.

Canada and the U.S. benefit from the lower-cost agricultural products from Mexico 6 .

and U.S. producers benefit from the growing Mexican market. USMCA is also a good example of trade diversion in which Canadian and U.S. companies have shifted some production facilities to Mexico from Asia due to the benefits of the trade agreement.

2. Rules of Origin and Regional Content. Two important components of USMCA are rules of origin and regional content.

• Rules of origin: Goods and services must originate in North America to get access to lower tariffs.

• Regional content: This is the percentage of value that must be from North America for the product to be considered North American in terms of country of origin. Regional content under USMCA was raised from 62.5 percent under NAFTA to 75 percent or autos.

3. Labor and Enforcement Provisions. All the three countries had to agree to accept ILO labor practices, and workers had to be represented at collective bargaining agreements. To ensure that the labor mandates were followed, an inspection and arbitration process was established that includes representatives of all three countries. A major challenge to NAFTA that will continue to be an issue with USMCA is immigration. The bigger issue is the flood of immigrants from Central America due to crime, poverty, and those seeking asylum from their home countries. This is not dissimilar to the refugee situation in the European Union.

4. Rationalization of Production. One of the predictions made when NAFTA was signed was that companies would look at it as one big regional market, allowing them to rationalize production, products, financing, and the like. That has largely happened in a number of industries, especially in automotive products and electronics. NAFTA’s rules of origin have forced European and Asian automakers to bring in parts suppliers and set up assembly operations in Mexico. It will be interesting to monitor investment and cross border supply chains as affected by the new regional content and Labor Value Content rules in USMCA. 5. Mexico as a Consumer Market. An additional benefit is that Canadian and U.S. companies have realized that Mexico is a consumer market rather than just a production location.

C. Regional Economic Integration in the Americas There are six major regional economic groups in the Americas, divided into Central American and South American [see Maps 8.2 and 8.3], Central America (excluding Mexico) has the Caribbean Community (CARICOM), the Central American Common Market (CACM), and the Central American Free Trade Agreement (CAFTA-DR)— which includes the members of CACM but also Honduras and the Dominican Republic, along with the United States. The two major groups in South America are the Andean Community (CAN) and the Southern Common Market (Mercosur). The Andean Community is a customs union, whereas Mercosur is set up to be a common market.

The major reason for these different collaborative groups was market size. This economic cooperation is intended to enlarge the potential market size so that Latin American companies could achieve economies of scale and be more competitive worldwide.

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1. CARICOM: Benchmarking the EU Model. The Caribbean Community is working hard to establish an EU-style form of collaboration, one that would mirror the EU, but on a smaller scale.

2. MERCOSUR. Mercosur is a customs union among Argentina, Brazil, Paraguay, and Uruguay. Mercosur is significant because of its size: a population of 251 million and a GDP of $2.9 trillion. It generates 75 percent of South America’s GDP, making it the third-largest trading bloc in the world in terms of GDP after the EU and NAFTA 3. Pacific Alliance. Created in 2012, it has four member states bordering with pacific: Mexico, Colombia, Peru, and Chile. They have a combined GDP of $1.8 trillion, second only to MERCOSUR 4. Andean Community (CAN). Started in 1969, CAN is the second most important regional group in South America but has not been successful in achieving its original goals.

D. Regional Economic Integration in Asia Regional economic integration has not been as successful in Asia as in the EU or the NAFTA region because most Asian countries have relied on U.S. and European markets for their exports.

1. Association of Southeast Asian Nations (ASEAN). The Association of Southeast Asian Nations (ASEAN) was first organized in 1967. [see Map 8.4.] On January 1, 1993, it officially formed the ASEAN Free Trade Area (AFTA) for the purpose of cutting tariffs on interzonal trade to a maximum of 5% by 2008. By 2018, most products traded among the AFTA countries were subject to duties from 0 to 5 percent, so AFTA has been successful in its objectives.

2. Asia-Pacific Economic Cooperation (APEC). The Asia-Pacific Economic Cooperation (APEC) community was founded in 1989 to promote multilateral economic cooperation in trade and investment in the Pacific Rim. It is comprised of 21 countries that border the Pacific on both the east and the west. It is a large and powerful organization that is focused on a wide range of activities related to trade and investment, security, energy, sustainability, anticorruption, and transparency, among other things. However, it is not an RTA as defined by the WTO and does not show up on that list of RTAs. The sheer size of APEC is what sets it apart: 59 percent of global GDP and 49 percent of world trade.

3. Trans-Pacific Partnership (TPP). The TPP was initiated by the United States to spur economic growth and create jobs, and it involves Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, the United States, and Vietnam. The formation of the initiative was announced in 2011, the agreement was concluded in October 2015 and signed by the trade ministers in February 2016.

However, the U.S. government pulled out of the TPP for political reasons, and it looked as if it were dead. In spite of that, Japan and the remaining 10 members of TPP moved forward and created the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, also known as CPTP, TPP11, or TPP-11. TPP-11 is moving forward with the same structure as the original agreement, and additional countries are looking to join.

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E. Regional Economic Integration in Africa Africa is truly the new frontier, with 49 countries in sub-Saharan Africa, and 54 in total.

The estimated population of sub-Saharan Africa was 1.078 billion people in early 2019, growing at 2.7 percent annually. The UN keeps revising its estimates of population growth in Africa, but the latest estimates are that sub-Saharan Africa’s population will double to 2.5 billion in 2050, up from 1.2 billion people in 2015, with Nigeria having a population of 400 million, up from around 200 million in 2019. Initially, trade was dependent on former colonial powers, and then the United States became Africa’s largest trading partner. Most recently, however, China has surpassed the United States as the major trade partner with African countries, especially as they have increased investments in oil and minerals [see Map 8.5.].

POINT—COUNTERPOINT: Is Regional Economic Integration a Good Idea?

POINT: Regional free trade agreement among a small group of countries is easy to establish and monitor, unlike the broader agreements of the WTO. It provides a larger market area, which will increase economies of scale and open up investment opportunities. Countries are willing to give up sovereignty in order to receive the economic benefits of being part of a larger community.

COUNTERPOINT: The proponents of regional integration are governments, and they invest so much political capital in negotiating and signing agreements that they get trapped and can never get out. Also, a dominant economic power, such as the United States can impose its will on smaller trade partners such as those in CAFTA-DR. As free trade agreements progress to a customs union to more extensive integration, national sovereignty becomes gradually more compromised. It is not uncommon to overstate the benefits and understate the shortcomings. The British found that out in 2016 as Brexit was approved by 52 percent to 48 percent, with 17 million Britons voting to leave the EU. The EU now has 27 instead of 28 members.

F.

The United Nations and Other NGOs 1. The United Nations. The UN was established in 1945 to promote international peace and security and to help with global issues such as economic development, antiterrorism, and humanitarian relief. There are 193 member states in the UN General Assembly, including 15 that compose the Security Council. The UN Conference on Trade and Development (UNCTAD) was established to tackle problems of the developing world concerning trade issues.

2. Non-Government Organizations (NGOs) Nongovernmental, nonprofit voluntary organizations are all lumped under the category of NGOs: private institutions that are independent of any government.

V. COMMODITY AGREEMENTS A commodity agreement is designed to stabilize the price and supply of a primary commodity such as petroleum, natural gas, copper, coffee, cocoa, tea, or sugar because both long-term trends and short-term fluctuations in their prices have important consequences for the world economy.

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A. Commodities and the World Economy On the demand side, commodity markets play an important role in industrial countries, transmitting business cycle disturbances to the rest of the economy and affecting the rate of growth of prices. On the supply side, primary products account for about half of developing countries’ export earnings.

B. Consumers and Producers For many years, countries tried to band together as product alliances or joint producers to help stabilize commodity prices. However, these efforts, with the exception of OPEC, have not been very successful.

C. The Organization of Petroleum Exporting Countries (OPEC) The Organization of Petroleum Exporting Countries (OPEC) is a group of 13 oilproducing countries that have significant control over supply and band together to control output and price. Its members include Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Several of the largest oil-producing countries, including the United States, Russia, and China, are not members of OPEC. In 2019, the United States became the largest oil producer in the world, followed by Saudi Arabia, and for the first time since 1953 became a net oil and gas exporter.

1. Price Controls and Politics. OPEC controls prices by establishing production quotas on member countries. Politics play an important role in OPEC deliberations as countries with larger populations are tempted to exceed their quotas to generate more revenue.

2. Output and Exports. OPEC has 81.9 percent of the world’s crude oil reserves, with the Middle East containing 65.3 percent of OPEC’s total reserves. Therefore, OPEC can have a strong influence on the oil market, especially if it decides to reduce or increase its level of production.

3. The Downside of High Prices. Keeping prices high has a downside for OPEC. Competition from non-OPEC countries rises because the revenues accruing to the competitors are higher. High prices also attract competition from nonconventional oil, (such as oil shale, oil sands, and biofuels, and nuclear energy.

LOOKING TO THE FUTURE: Will the WTO Overcome Bilateral and Regional Integration Efforts?

Although the objective of the WTO is to reduce barriers to trade in goods, services, and investment, regional groups do that and more. Regional economic integration deals with the specific problems facing member countries, while the WTO concerns itself with trade issues facing the world as a whole. As a result, regional integration, which is more flexible, may help the WTO achieve its objectives as the process leads to the liberalization of issues not covered by the WTO. Regional economic integration can also serve to lock in trade liberalization across developing countries. No trade agreement is easy or perfect. The WTO has serious challenges due to its size. Regional agreements like USMCA, the EU, ASEAN,, and others have many different challenges as well.

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CLOSING CASE: Walmart Goes South Because of its sheer size and volume purchases, as well as its unique distribution system, Walmart has been able to reduce its prices so successfully that in 2001, it became the largest company in the world. Mexico’s first Sam’s Club, a subsidiary of Walmart, opened in 1991 in Mexico City. Mexico’s retail sector has greatly benefited from the increasing trade liberalization under NAFTA, as well as the improvements to its transportation infrastructure encouraged by NAFTA. In addition, NAFTA improved opportunities for foreign investment in Mexico. One of the country’s largest retail chains, Comercial Mexicana S.A. (Comerci), has found it increasingly difficult to remain competitive since Walmart’s aggressive entry into its market. Walmart’s strong operating presence and low prices since the lifting of tariffs under NAFTA have put such strong competitive pressures on Comerci that it must now decide whether its participation with the recently formed purchasing consortium, Sinergia, will be sufficient for its survival.

Questions 8-3. How much of Walmart’s success is due to NAFTA, and how much is due to Walmart’s inherent competitive strategy? In other words, could any other U.S. retailer have the same success in Mexico post-NAFTA, or is Walmart a special case?

Responses and opinions may vary. Walmart’s success is primarily due to its inherent competitive and localized strategy and successful entry mode. NAFTA/USMCA has strengthened that strategy and allows Walmart to fend off fierce competition from local retailers and international chains such as Carrefour and Costco. Although Walmart is a special case, there is still room for other retailers such as Costco to take advantage of Mexico’s tremendous potential. However, they have to design the right strategy to thwart Walmart’s formidable pricing and distribution strategy. (LO 8-2: Summarize the major benefits of regional economic integration, AACSB: Analytical Skills).

8-4. What can local Mexican retailers do to compete against Walmart?

Comerci has attempted to lower its prices, but for many items, it simply lacks the negotiating power with its suppliers to get prices as low as Walmart’s. Walmart uses its sheer size and volume of purchases to negotiate prices to rock-bottom levels that are not available to smaller competitors. Comerci can challenge that by joining force with one of Mexico’s top retailers. Comerci can also emulate the success of some retailers in the U.S. that managed to remain competitive despite competition from Walmart. Another extreme solution is to position itself in a different segment of the market. (LO 8-2: Summarize the major benefits of regional economic integration, AACSB: Analytical Skills).

8-5. How do you think the passage of USMCA will impact Walmart’s strategy in Mexico?

Responses and opinions may vary. There are only a few differences between USMCA and NAFTA, and they are not expected to impact retailers significantly. The only exception is 11 .

labor cost in Mexico, which is expected to rise under USMCA. Yet, Walmart and many other retailers supported the adoption of USMCA. (LO 8-2: Summarize the major benefits of regional economic integration, AACSB: Analytical Skills).

ADDITIONAL EXERCISES: The Economic Integration Process Exercise 8.1. In 1998 the World Trade Organization issued a ruling in which it stated that the U.S. was wrong to prohibit shrimp imports from countries that failed to protect sea turtles from entrapment in the nets of shrimp boats. The basic position of the WTO was that while environmental considerations are important, the primary aim of international trade agreements is the promotion of economic development through unfettered free trade. Ask students to debate the position of the WTO in decoupling trade and environmental policy.

(LO 8-1: To identify the major characteristics and challenges of the World Trade Organization, AACSB: Dynamics of the Global Economy.)

Exercise 8.2. Ask students to compare the foreign market entry strategies of exporting, licensing, and foreign direct investment in (a) a free trade area, (b) a customs union, and (c) a common market. What barriers and incentives do they expect to encounter? (Be sure students assume the perspective of a firm located outside of the regional bloc.) (LO 8-4: To define different forms of regional economic integration, AACSB: Analytical Skills.)

Exercise 8.3. Prior to the breakup of the U.S.S.R., COMECON (also known as the Council for Mutual Economic Assistance [CMEA]) held the Soviet bloc together economically. It represented a trade association that existed to help fulfill the output goals of the central planning authorities of Russia and its satellite nations. Ask students to discuss the reasons they believe that COMECON disintegrated in a post-Soviet environment. (LO 8-5: To compare and contrast different regional trading groups, AACSB: Dynamics of the Global Economy) Exercise 8.4. Ask students to consider the major geographic areas of the world: Europe, Asia (including Oceania), Africa, South America, and North America. Then have them speculate about the extent to which they expect regional economic integration to progress in each of those areas: (a) in 10 years, and (b) in 25 years. Finally, ask them to discuss the extent to which they expect global economic integration to progress during the next 25 years. Which organization(s) do they expect will play a major role in that process? (LO 8-5: To compare and contrast different regional trading groups, AACSB: Analytical Skills.)

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PART FOUR WORLD FINANCIAL ENVIRONMENT Chapter 9 Global Foreign-Exchange Markets OBJECTIVES 9-1 Define what foreign exchange is and who the major players are in the foreign-exchange market 9-2 Summarize the major characteristics of the foreign-exchange market 9-3 Compare and contrast spot, forward, options, and futures markets 9-4 Explain some of the major aspects of the foreign-exchange markets 9-5 Show how companies use foreign exchange to facilitate international trade

CHAPTER OVERVIEW The foreign-exchange market consists of all those players who buy and sell foreign-exchange instruments for business, speculative, or personal purposes. Primarily, foreign exchange is used to settle international trade, licensing, and investment transactions. Chapter Nine explains in detail basic concepts (such as rates, instruments, and convertibility) and explores the major characteristics of the foreign-exchange markets. The chapter includes a discussion of the foreignexchange trading process that focuses on both the over-the-counter and the exchange-traded markets, i.e., banks, securities exchanges, electronic brokerages, and the respective roles they play.

CHAPTER OUTLINE OPENING CASE:

Going Down to the Wire in the Money-Transfer Market

This case describes Western Union’s international money transfer services and the increasing competition the company is facing from a variety of sources. Western Union has been particularly successful in attracting business from Mexican emigrants in the United States who send part of their paycheck home to support their families. Financial institutions such as banks have pressured Western Union to use better exchange rates. This new onslaught of competition by banks has forced Western Union to cut its fees and offer new services, including a home delivery service, where money is delivered directly to the recipient’s door. Western Union is also moving into countries such as China and India to boost its market share. The increased 1 .

competition has driven down remittance fees around the world. Western Union has also developed other delivery mechanisms, including online and mobile delivery.

Questions 9-1. The United Emirates, of which Dubai is a member, is one of the Gulf Cooperation Council members. How does it compare with the other GCC countries in terms of total population and the nonimmigrant population as a percentage of total population? How important do you think migration and therefore capital remittances are for each of the countries in the GCC? Apart from Saudi Arabia, all GCC countries have a relatively small native population.

Consequently, they heavily rely on migrant workers. According to the International Labor Organization, the GCC is among the highest in the world in terms of migrant population as a percentage of the overall population. The migrant workers constitute around 90 percent of the population in Qatar and the UAE and over 50 percent in Kuwait, Bahrain, Oman, and Saudi Arabia. With expanding economies in the past three decades and limited domestic labor endowment, the region has sought foreign labor to support economic growth.

However, the trend is decelerating recently because of the economic slowdown in the region. Nevertheless, the region, especially UAE, remains a significant source of remittances. (LO 9- 1: Define what foreign exchange is and who the major players are in the foreign-exchange market, AASCB: Analytical Skills.)

9-2. What forces are likely to have the greatest influence on Western Union’s business in the future?

Responses and opinions may vary. The shift to digital, mobile, and cryptocurrencies would greatly influence Western Union’s business in the future. In fact, digital transformation has already brought new competitors such as TransferWise, and WorldRemit that have forced Western Union to reduce transfer fees and revise its strategy. (LO 9- 1: Define what foreign exchange is and who the major players are in the foreign-exchange market, AASCB: Analytical Skills.)

TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Eight and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures, tables, and maps in the text.

Students can check currency prices by visiting the Web site http://finance.yahoo.com.

I.

WHAT IS FOREIGN EXCHANGE AND WHO ARE THE MAJOR PLAYERS IN THE MARKET? Foreign exchange (FX) is money denominated in the currency of another nation or group of nations, i.e., it is a financial instrument issued by countries other than one’s own. An exchange rate is the price of one currency expressed in terms of another, i.e., the number of 2 .

units of one currency needed to buy a unit of another.

The foreign-exchange market is made up of several players. The Bank of International Settlements (BIS), a Swiss-based central banking institution, divides the market into three major players: reporting dealers, other financial institutions, and non-financial institutions.

Reporting dealers are also known as money center banks and include large banks such as Deutsche Bank and HSBC. Other financial institutions include commercial banks other than money center banks (local and regional banks), hedge funds, pension funds, money market funds, currency funds, mutual funds, and specialized foreign-exchange trading companies.

Non-financial customers include governments and companies.

II. ASPECTS OF THE FOREIGN-EXCHANGE MARKET A. How to Trade Foreign Exchange The foreign-exchange market is comprised of two major segments the over-the-counter market (OTC) and the exchange-traded market. The OTC market includes commercial banks, investment banks, and other financial institutions—this is where most foreignexchange activity occurs. The exchange-traded market includes certain securities exchanges the CME Group, NASDAQ, and Intercontinental Exchange (ICE), where certain types of foreign-exchange instruments, such as futures and options, are traded.

B. Global OTC Foreign-Exchange Instruments The phrase “global OTC foreign-exchange instruments” refers to spot transactions, outright forwards, FX swaps, currency swaps, currency options, and other foreignexchange products. FX swaps remain the dominant category of instruments with 47 percent of the market, closely followed by spot transactions with 33 percent. Outright forwards represent 14 percent, and options, currency swaps, and other transactions are only 6 percent of the market. These instruments are all traded in the markets mentioned above.

• Spot transactions involve the exchange of currency “on the spot,” or technically, transactions that are settled within two business days after the date of agreement to trade. The spot rate is the exchange rate quoted for transactions that require the immediate delivery of foreign currency, i.e., within two business days.

• Outright forward transactions involve the exchange of currencies beyond two days following the date of agreement at a set rate known as the forward rate. The forward transaction will be settled at the forward rate no matter what the actual spot rate is at the time of settlement.

• In an FX swap (a simultaneous spot and forward transaction), one currency is swapped for another on one date and then swapped back on a future date. In fact, the same currency is bought and sold simultaneously, but delivery occurs at two different times.

• Currency swaps deal with interest-bearing financial instruments (such as bonds) and involve the exchange of principal and interest payments.

• An option is a foreign-exchange instrument that guarantees the purchaser the right (but does not impose an obligation) to buy or sell a certain amount of foreign currency at a set exchange rate within a specified amount of time.

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A futures contract is a foreign-exchange instrument that specifies an exchange rate, an amount, and a maturity date in advance of the exchange of the currencies, i.e., it is an agreement to buy or sell a particular currency at a particular price on a particular future date.

C. Size, Composition, and Location of the Foreign-Exchange Market The BIS estimated in its 2019 survey of global foreign-exchange activity that daily foreign-exchange turnover was $6.6 trillion, an increase of 33 percent from the 2016 survey.

1. Using the U.S. Dollar on the Foreign-Exchange Market. The U.S. dollar is the most important currency on the foreign-exchange market; in the latest BIS Survey, it was one side (buy or sell) of 88.3 percent of all foreign currency transactions worldwide, as Table 9.1. Although the dollar, euro, yen, and pound sterling are the most widely traded currencies, the Chinese yuan is steadily growing in importance.

There are five major reasons why the dollar is so widely traded: 1. It’s an investment currency in many capital markets.

2. It’s a reserve currency held by many central banks.

3. It’s a transaction currency in many international commodity markets.

4. It’s an invoice currency in many contracts.

5. It’s an intervention currency employed by monetary authorities in market operations to influence their own exchange rates.

2. Frequently Traded Currency Pairs. The dollar, the most traded currency in the world, is part of four of the top eight currency pairs: the dollar/euro and the dollar/yen are the top two. Because of the importance of the U.S. dollar in foreign exchange trade, the exchange rate between two currencies other than the dollar—for example, the exchange rate between the euro and the Brazilian real—is known as a cross rate.

The euro is in two of the top ten currency pairs: against the dollar and the British pound. However, the euro is also important for other currencies in the EU that are not part of the monetary union as well as non-EU countries in Europe, such as Turkey.

D. Foreign-Exchange Trades and Time Zones.

If the U.S. dollar is the most widely traded currency in the world, why is London so important as a trading center? There are two major reasons. First, London, which is close to the major capital markets in Europe, is a strong international financial center where many domestic and foreign financial institutions operate. Thus, its geographic location relative to significant global economic activity is key [see Figure 9.1]. Second, London is positioned in a unique way because of its time zone [see Map 9.1].

III. MAJOR FOREIGN-EXCHANGE MARKETS A. The Spot Market The spot market is for foreign-exchange transactions that occur within two business days. Rates are quoted by foreign-exchange dealers. The bid (buy) rate is the price at which the dealer is willing to buy foreign currency; the offer (sell) rate is the price at 4 .

which the dealer is willing to sell foreign currency. The difference between the bid and offer rates is the dealer’s profit margin: • Bid—the rate at which traders buy foreign exchange • Offer—the rate at which traders sell foreign exchange • Spread—the difference between bid and offer rates Exchanges can be quoted in American terms, i.e., a direct quote that gives the value in dollars of a unit of foreign currency, or European terms, i.e., an indirect quote that gives the value in foreign currency of one U.S. dollar. The base currency, or the denominator, is the quoted, underlying, or fixed currency; the terms currency is the numerator. Most large newspapers quote exchange rates daily, listing both spot and forward rates. The spot rates listed are usually the selling rates for interbank transactions (transactions between banks) of $1 million or more.

• American terms, or direct quote—the number of dollars per unit of foreign currency • European terms, or indirect quote—the number of units of foreign currency per dollar B. Forwards The forward rate is the rate quoted for transactions that call for delivery after two business days. A forward contract is entered into whereby the customer agrees to buy (or sell) over the counter a specified amount of a specific currency at a specified price on a specific date in the future.

1. Forward Discounts and Premiums. The difference between the spot and forward rates is either the forward discount (the forward rate, i.e., the future delivery price, is lower than the spot rate) or the forward premium (the forward rate is higher than the spot rate).

C. Options An option is a foreign-exchange instrument that guarantees the right, but does not impose an obligation, to buy or sell a foreign currency within a certain time period or on a specific date at a specific exchange rate (called the strike price). The writer of the option will charge a fee, known as the premium. An option is more flexible, but also more expensive, than a forward contract.

D. Futures A foreign currency future resembles a forward contract because it specifies an exchange rate sometime in advance of the actual exchange of the currency. However, a future is traded on an exchange, not OTC. While a forward contract is tailored to the amount and time frame the customer needs, futures contracts have preset amounts and maturity dates. The futures contract is less valuable to a firm than a forward contract, but it may be useful for small transactions or speculation.

IV. THE FOREIGN-EXCHANGE TRADING PROCESS When a firm needs foreign exchange, it typically goes to its commercial bank. If the bank is large enough, it may have its own foreign-exchange traders. A smaller bank, dealing either on its own account or for a client, can trade foreign exchange directly with another bank or 5 .

through a foreign exchange broker, who matches the best bid and offer quotes of interbank traders. The foreign-exchange trading process can be seen in Figure 9.3.

A. Banks and Exchanges At one time, only big money center banks could deal directly in foreign exchange.

Now, with the advent of electronic trading, smaller regional banks can hook up to Reuters or Bloomberg and deal directly in the interbank market. In spite of these developments, the greatest volume of foreign-exchange activity still takes place with the big money center banks.

1. Top Foreign-Exchange Dealers. The top banks in the interbank market are chosen because of their location, expertise in major and specific currencies, and ability to deal in different financial instruments. Based on these criteria, the major banks that deal in foreign exchange worldwide in the 2019 Euromoney survey are JPMorgan, Deutsche Bank, Citi, XTX Markets, and UBS. B. Top Exchanges for Trading Foreign Exchange Major exchanges that deal in foreign currency derivatives are the CME Group, NASDAQ, and NYSE:ICE (Intercontinental Exchange).

1. CME Group. The Chicago Mercantile Exchange (CME) offers futures and options contracts in numerous foreign currencies. CME uses three electronic trading platforms to trade different commodities, including currencies: CME Globex, DME Direct, and CME Clearport.

2. NASDAQ. In 2008, The Philadelphia Stock Exchange merged with NASDAQ OMX, and in 2014, the name was changed to NASDAQ. It trades options in seven currencies—the Australian dollar, the British pound, the Canadian dollar, the euro, the Swiss franc, the New Zealand dollar, and the Japanese yen.

3. NYSE:ICE. In 2013, Intercontinental Exchange (ICE) purchased NYSE Euronext, forming NYSE:ICE. The combined company is a giant in futures and options. ICE Futures US offers cross-trades in a number of currencies through ICE’s futures contracts on key currency pairs traded in the interbank market through an electronic trading platform.

V. HOW COMPANIES USE FOREIGN EXCHANGE Companies enter the foreign-exchange market to facilitate their regular business transactions and/or to speculate.

A. Cash Flow Aspects of Imports and Exports When a company must move money to pay for purchases or receives money for sales, it has an option on the documents it can use, the currency of denomination, and the degree of protection it can ask for.

1. Commercial Bills of Exchange. In order for these transactions to take place, a number of documents are needed, including a draft and a letter of credit. A draft (or commercial bill of exchange) is an instrument in which one party directs another to make a payment. If the exporter demands payment to be made immediately, the draft is called a sight draft. If the payment is to be made later, it is called a time draft.

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2. Letters of Credit. With a bill of exchange, it is always possible the importer will not be able to make the payment to the exporter. A letter of credit (L/C) obligates the buyer’s bank to honor the draft. There are still risks with an L/C. It must adhere to all the conditions in the document in order to be valid. A letter of credit may also be confirmed by another bank and is called a confirmed letter of credit.

B. Other Financial Flows Companies also deal in foreign exchange for other transactions, such as the receipt or payment of dividends or the receipt or payment of loans and interest.

1. Speculation. Sometimes companies deal in foreign exchange for profit.

Speculation involves buying (or selling) a currency based on the expectation it will gain (or lose) in strength against other currencies. Although speculation offers the chance to profit, it also contains an element of risk.

2. Arbitrage. Profit-seekers may engage in arbitrage, i.e., they may purchase foreign currency on one market for immediate resale on another market (in a different country) in order to profit from a price discrepancy. Interest arbitrage involves investing in debt instruments (such as bonds) in different countries in order to maximize profits by capturing interest-rate and exchange-rate differentials.

POINT—COUNTERPOINT: Is it OK to Speculate on Currency?

POINT: Currency speculation is not illegal, nor is it necessarily bad. Speculators are merely trying to make a profit by trading based on market trends. Currency speculation allows investors to diversify their portfolios from traditional stocks and bonds, which are themselves, forms of speculative investment.

COUNTERPOINT: There are plenty of opportunities for a trader, whether in foreign exchange or securities, to make money illegally or contrary to company policy. Nicholas Leeson, a 28year-old trader for British bank Barings PLC was chief dealer for the bank in Singapore. Leeson had no checks and balances on his trading and made big bets on stock index futures assuming that the Tokyo stock market would rise. After the January 17, 1995, earthquake in Kobe, Japanese stocks plunged and Leeson had to come up with cash to cover the margin call. With lax internal controls, Leeson was able to make numerous questionable and illegal transactions to illicitly generate the cash needed to cover his positions. These actions resulted in huge losses in excess of $1 billion for Barings, putting the company into bankruptcy. Since the collapse of Barings, measures have been put into place in banks to prohibit such consequences, yet the occurrence of and potential for negative outcomes from rogue trading continue to exist. Another recent example, Jerome Kerviel of the French bank Societe Generale shows the ongoing risk for banks to lose significant amounts of money.

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LOOKING TO THE FUTURE: Where Are Foreign-Exchange Markets Headed?

The speed at which transactions are processed and information is transmitted globally will continue to lead to greater efficiencies and more opportunities in foreign-exchange markets.

Companies’ costs of trading foreign exchange should come down and they should gain faster access to more currencies. Government exchange restrictions should diminish as currency markets are liberalized. The big change in the future will be the increasing usage of the yuan in global transactions, especially for countries that trade with China. The yuan can only be successful as a major player in the global foreign-exchange market as it becomes more accepted as a reserve currency that countries have confidence in. As the yuan increases in importance, it will be interesting to see how much Singapore and Hong Kong will increase in importance, and whether or not Shanghai will increase in importance. In 2009, the Bitcoin was launched, ushering in the world of cryptocurrencies, also known as virtual or digital currencies. Although other virtual currencies, such as Ethereum, have been launched, Bitcoin is still the number one virtual currency—but Ethereum is gaining ground. Facebook, Inc., is launching a digital currency, known as Libra and JP Morgan announced in 2019 that it would be creating its own cryptocurrency.

CLOSING CASE: Do Yuan to Buy Some Renminbi?

On November 30, 2015, the International Monetary Fund announced that the Chinese yuan, also known as the renminbi (RMB or “people’s currency”), would finally join the U.S. dollar, the euro, the British pound, and the yen in the basket of reserve currencies also known as SDRs or Special Drawing Rights. The yuan is the official currency of China.

Yuan has been historically fixed and controlled by the Chinese government. As China becomes a greater global exporter and economic powerhouse, critics are claiming that the currency is being undervalued and manipulated to protect domestic markets. Domestic and international pressures have forced the Chinese government to review the status of its currency. Given these pressures, China took an historic step on July 21, 2005, and de-linked the yuan from its decade-old peg to the U.S. dollar in favor of a currency basket.

As China moved closer to the yuan being accepted as a global currency in late 2015, it allowed the yuan to appreciate against a basket of currencies by more than 30 percent, and by 10 percent alone from mid-2014 to mid-2015.

Questions 9-3. Why is it important for the Chinese yuan to become a major world currency? What are the risks for China?

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China is now a leader in international world trade, a major exporter, and currently holds the largest foreign exchange reserve in the world. The nation has one of the highest GDPs in the world, and is increasing its economic power. The sheer size, volume, and magnitude of China’s economic activity may also be arguments for the yuan to become a major world currency. Yet, there are risks associated with being a world currency. China will lose control over its ability to manage its economy and control its capital flows. It will also have to be more transparent in its financial dealings. Also, to be accepted as a global currency, it will need legal, political, and institutional reforms that will inspire confidence of foreign investors. Is it China ready to do that? (LO 9- 1: Define what foreign exchange is and who the major players are in the foreign-exchange market, AASCB: Analytical Skills.)

9-4. What role do foreign banks like HSBC and electronic platforms like Thomson Reuters and ICAP play in helping the yuan move closer to becoming a global currency?

These entities have the ability to create platforms and markets to stimulate and expedite currency trading. Consequently, these entities can increase the circulation of the yuan.

Further, these actors will be instrumental in allowing the yuan to be exchanged in a floating exchange system against the world’s other leading currencies. (LO 9- 1: Define what foreign exchange is and who the major players are in the foreign-exchange market, AASCB: Analytical Skills.)

9-5. Why is the yuan being used more widely in global business transactions? Do you think it will ever replace the dollar or the euro? Why or why not?

Responses and opinions may vary. The yuan is being used more widely in global business transactions because of China’s growing economic might in the global economy and its moves in recent years to deregulate its financial markets. I think there is a possibility that the yuan would outdo the euro first under certain economic and financial conditions, especially economic and monetary stability, global acceptance, and euro decline. In addition, the eurozone has been going through severe crises in the past few years, which relatively undermined consumer and investors’ confidence in the euro. (LO 9- 1: Define what foreign exchange is and who the major players are in the foreign-exchange market, AASCB: Analytical Skills.)

ADDITIONAL EXERCISES: The Foreign-Exchange Market Exercise 9.1. Some students will have had experience with foreign currency conversion.

Ask them to describe the differences they have encountered in rates quoted at the airport, in hotels and banks, and on the street. Then ask students to describe their experiences using credit cards and ATM cards in particular foreign countries. How were the transactions reported on their statements? Were they charged processing fees? (LO 9-3: To describe how the foreign-exchange market works, AACSB: Reflective Thinking.)

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Exercise 9.2. Take copies of the most recent editions of The Wall Street Journal and the Financial Times to class. Explain to students where to find foreign-exchange rates, forward rates, cross rates, commodity prices, etc. Select the home countries of various students in your class. Use the forward rates to engage the students in a discussion as to which currencies appear to be stronger. Explore the possible underlying reasons for a given currency’s strength or weakness. (LO 9-1: To learn the fundamentals of foreign exchange, AACSB: Analytical Skills.)

Exercise 9.3. More than 150 currencies exist today. Some countries share a common currency (e.g., those that participate in the euro), while certain countries peg their currencies to others (e.g., Chile’s currency is pegged to the U.S. dollar). Many nations, however, maintain their own independent currencies. Ask students to debate the potential for additional regional currencies such as the euro. If they support the concept, should those currencies necessarily be tied to regional economic blocs? (LO 9-2: To identify the major characteristics of the foreign-exchange market and how governments control the flow of currencies across national borders, AACSB: Communication Abilities.)

Exercise 9.4. Have the students assume the role of CFO of a mid-sized U.S. company that exports to Europe. The company has received a contract to supply components to a European manufacturer with an agreed-upon sales price of €4 million due in 90 days. Should the CFO do anything to hedge against possible fluctuations in the dollar/euro exchange rate?

If so, what? If not, why not? (LO 9-5: To understand why companies deal in foreign exchange, AACSB: Analytical Skills.)

Exercise 9.5. Go to a trading Web site like www.forex-markets.com or an information site like finance.yahoo.com/currency and demonstrate the charting, conversion calculators, and other research and information tools available for foreign exchange. (LO 9-1: To learn the fundamentals of foreign exchange, AACSB: Use of Information Technology.)

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Chapter 10 The Determination of Exchange Rates OBJECTIVES 10-1 Describe the International Monetary Fund and its role in exchange rate markets 10-2 Discuss the major exchange-rate arrangements that countries use 10-3 Identify the major determinants of exchange rates 10-4 Show how managers try to forecast exchange-rate movements 10-5 Examine how exchange-rate movements influence business decisions

CHAPTER OVERVIEW From a managerial point of view, it is critical to understand how exchange-rate movements influence business decisions and operations. Chapter Ten first describes the International Monetary Fund and the role it plays in exchange-rate determination. Next, the chapter examines the various types of exchange-rate regimes countries may choose, as well as the role central banks play in the currency valuation process. It then presents the theories of purchasing power parity, the Fisher Effect, and the International Fisher Effect and discusses their contributions to the explanation of exchange-rate movements. The chapter concludes with a brief examination of the potential effects of exchange-rate fluctuations on business operations.

CHAPTER OUTLINE OPENING CASE:

Venezuela’s Rapidly Changing Currency [see Map 9.1]

In 2015, when inflation in the developing countries was 5.7 percent, inflation in Venezuela was 159.1 percent, the highest in the world by far. The rapid rise in inflation resulted in the precipitous drop of the Venezuelan bolívar fuerte (known at the VEF). The key to the Venezuelan economy is oil. Hugo Chavez, the president of Venezuela from 1999–2013, implemented a program of nationalism, known as chavismo, that led to huge budget deficits and extensive external borrowing. Under Chavez, the VEF was locked onto the U.S. dollar at a fixed rate known as a conventional peg, and it was not allowed to freely float. Under his successor, as the oil prices plunged, Venezuela experienced severe shortages in everything from pharmaceuticals and medical supplies to toilet paper to diapers, which led to the creation of a thriving black market. In 2016, three years after Chavez died, the government allowed the VEF to float against the dollar but was managed by the government and not freely floating.

Unfortunately, this also resulted in a black market for the currency. Riots at the end of April 2016 due to power and water cuts and shortages in food and medical imports led to petitions to recall President Maduro. The Crisis in Venezuela had raised the question on whether 1 .

dollarization is the Solution. In Latin America, both El Salvador and Ecuador dropped their currencies in favor of the dollar. After dollarization, Salvadoran companies and the government gained access to cheaper interest rates because the move eliminated, or at least reduced, the risk of devaluation, thereby infusing more confidence in foreign banks to lend to the country.

Questions 10-1.Do you think Venezuela should drop its currency, the VEF, and adopt the U.S. dollar? Why or why not?

Responses and opinions may vary. Although dollarization has pros and cons, I think Venezuela would be better off dropping its currency, the VEF, and adopt the U.S. dollar.

There are many similarities between Venezuela’s current economic conditions and Ecuador’s case in the late 1990s. Ecuador chose to dollarize in 2000. The decision helped bring macroeconomic stability, slow hyperinflation, and resolve the economic crisis in Ecuador. In fact, since the dollarization and for a few years, Ecuador outperformed many Latin American countries in economic growth. (LO 10-3: To identify the major determinants of exchange rates, AACSB: Analytical thinking.)

10-2. If Venezuela does not replace the VEF with the dollar, what do you think will happen to the Venezuelan economy, inflation, and the exchange rate?

Responses and opinions may vary. I think the outcome depends on what the Venezuelan government would do to solve the economic crisis. It also depends on the global oil market because Venezuela’s economy is heavily dependent on oil. In the worst-case scenario, the economy will shrink dangerously even further, inflation would persist, and the bolivar’s value would plummet. (LO 10-3: To identify the major determinants of exchange rates, AACSB: Analytical thinking.)

TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Ten and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures, tables, and maps in the text.

Current foreign currency values and other related information can be found on the Web site http://finance.yahoo.com. Have students visit the site and report back on its usefulness.

INTRODUCTION An exchange rate represents the number of units of one currency needed to acquire one unit of another currency. Managers must understand how governments set exchange rates and what causes them to change so they can make decisions that anticipate and take those changes into account.

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THE INTERNATIONAL MONETARY FUND In 1944, the major allied governments met in Bretton Woods, NH, to discuss post-war economic needs. One of the results was the establishment of the International Monetary Fund (IMF) on December 27, 1945. The IMF began financial operations on March 1, 1947.

A. Origin and Objectives Twenty-nine countries initially signed the IMF agreement, and there were 189 member countries as of January 1, 2020. The fundamental mission of the IMF is to: • Foster global monetary cooperation, • Secure financial stability, • Facilitate international trade, • Promote high employment and sustainable economic growth, and • Reduce poverty around the world.

1. Bretton Woods and the Principle of Par Value. The Bretton Woods Agreement established a system of fixed exchange rates under which each IMF member country set a par value (benchmark) for its currency based on gold and the U.S. dollar. Par values were later done away with when the IMF moved toward greater exchange-rate flexibility.

B. The IMF Today 1. The Quota System. When a country joins the IMF, it contributes a certain sum of money, called a quota, relating to its national income, monetary reserves, trade balance, and other economic indicators. The quota then becomes part of a pool of money the IMF can draw on to lend to member countries. At the end of 2010, the total quota held by the IMF was SDR 476.8 billion (U.S. $750 billion). It also forms the basis for the voting power of each country, as well as the allocation of its special drawing rights.

2. Special Drawing Rights (SDRs). To help increase international reserves, the IMF created a special drawing right (SDR), an international reserve asset designed to supplement members’ existing reserves of gold and foreign exchange. The SDR is used as the IMF’s unit of account (the unit in which the IMF keeps its records) and for IMF transactions and operations. The value of the SDR is based on the weighted average of four currencies. Since October 1, 2016, the value of the SDR has been based on five currencies. The currencies and their weights are: 42 percent for the U.S. dollar, 31 percent for the euro, 11 percent for the Chinese renminbi, 8 percent for the Japanese yen, and 8 percent for the British pound. The weight of the dollar remained the same at the time the renminbi was added, but the weights of the other three currencies fell to make room for the renminbi.

C. The Role of the IMF in Global Financial Crises An important responsibility of the IMF is to monitor and assess vulnerabilities of the economic and financial policies of member countries in relation to domestic and global stability. Where necessary, the IMF can provide precautionary credit lines to countries that are in distress. These loans are short-term emergency assistance loans, and in order to receive a loan, a country has to ensure that it will follow sound fiscal and monetary policies as determined jointly with the IMF staff.

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D. Evolution to Floating Exchange Rate The IMF’s original system was one of fixed exchange rates; the U.S. dollar remained constant with respect to the value of gold and other currencies operated within narrow bands of value relative to the dollar.

1. The Smithsonian Agreement. Following President Nixon’s suspension of the dollar’s convertibility to gold in 1971, the international monetary system was restructured via the Smithsonian Agreement, which permitted an 8% devaluation of the U.S. dollar, a revaluation of other currencies, and a widening of the exchange-rate flexibility bands.

2. The Jamaica Agreement. These measures proved insufficient; however, and in 1976 the Jamaica Agreement eliminated the use of par values by abandoning gold as a reserve asset and permitting greater exchange-rate flexibility.

II. EXCHANGE-RATE ARRANGEMENTS [see Table 10.1] The IMF surveillance and consultation programs are designed to monitor the exchange-rate policies of member nations to be sure they act openly and responsibly with respect to their exchange-rate policies. Member countries are permitted to select and maintain their exchange-rate regimes, but they must communicate those choices to the IMF. The formal decision of a country to adopt a particular exchange-rate mechanism is called a de jure system. In addition, the IMF surveillance program determines the de facto or actual exchange rate system that a country uses.

A. Three Choices: Hard Peg, Soft Peg, or Floating Arrangement The IMF classifies currencies into one of three broad categories, moving from the least to the most flexible.

B. Hard Peg There are two possibilities for countries that adopt a hard peg: dollarization or currency board.

1. Dollarization is the use of the dollar with no domestic legal tender.

2. Some nations use the dollar in addition to creating domestic legal tender. Currency boards may issue domestic currency anchored to a foreign currency.

C. Soft Peg There are many different kinds of soft pegs, but the most common is a conventional fixed-peg arrangement in which a country pegs its currency to another currency or basket of currencies and allows exchange rates to vary plus or minus 1 percent from that value.

D. Floating Floating exchange-rate regimes include floating and freely floating.

1. Floating currencies change according to market forces but may be subject to market intervention.

2. Free-floating currencies are subject to intervention only in exceptional circumstances.

E. The Euro The euro is the currency of the European Monetary System (EMS).

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The creation of the euro had its roots in the European Monetary System (EMS), begun in 1979. The EMS was set up as a means of creating exchange-rate stability within the European Community. Members’ currencies were linked through a parity grid. As the fluctuations in exchange rates narrowed, the EMS was replaced with the Exchange Rate Mechanism (ERM). In 1999, the European Monetary Union (EMU) came into being, creating the euro as the common currency of all EMU member nations. The euro is administered by the European Central Bank (ECB). Having a common currency eliminates exchange rate risk among member nations and greatly reduces the cost of cross-border transactions. Despite these advantages, three of the original 15 members of the European Union have opted not to join the eurozone. New applicants to the eurozone must meet the following criteria to be accepted to the EMU: • Annual government deficit must not exceed 3 percent of GDP. • Total outstanding government debt must not exceed 60 percent of GDP. • Rate of inflation must remain within 1.5 percent of the three best performing EU countries.

• Average nominal long-term interest rate must be within 2 percent of the average rate in the three countries with the lowest inflation rates.

• Exchange rate stability must be maintained, meaning that for at least two years, the country concerned has kept within the “normal” fluctuation margins of the European Exchange Rate Mechanism.

As of February 29, 2020, 19 members of the EU were officially in the Eurozone, one had opted out (Denmark), and 7 were still preparing to join the Eurozone. The euro is administered by the European Central Bank (ECB). The ECB has been responsible for setting monetary policy and managing the exchange-rate system for all of Europe since January 1, 1999 The Euro and the Global Financial Crisis. During the financial crisis of 2008, the euro fell because investors were pulling money out of stocks and putting it into safe-haven currencies such as the Japanese yen and the U.S. dollar. When the stock markets recovered, the dollar fell in value and the euro rose. However, the weakness in European economies, especially countries like Greece, Italy, and Spain, forced the ECB to use monetary stimulus to attempt to boost economic growth. The hardest hit has been Greece.

POINT—COUNTERPOINT: Should Africa Develop a Common Currency?

POINT: The success of the euro shows the benefits that a common currency can bring to close geographical and economic partner countries. Africa, with deep economic and political problems, stands to benefit greatly from a common currency. Such a move would hasten economic integration leading to an increase in market size, greater economies of scale, increased trade, and lower transaction costs. The foundation for a common currency already exists in three regional monetary unions and five existing regional economic communities. By combining into 5 .

one large African economic union, these groups could form a Central Bank and establish a common monetary policy, forcing institutions in each African nation to improve and insulating monetary policy from political pressures.

COUNTERPOINT: There is no way that the countries of Africa will ever establish a common currency, due to a flawed and inadequate institutional framework. Political pressures in many African countries are too intense to allow the separation of monetary policy from political expediency. Countries in the region will be very reluctant, or completely unwilling, to give up monetary sovereignty. Transportation problems within Africa also make it much more difficult to transfer goods within the region than it is in Europe. The establishment of the euro in the EU took years of work despite a very favorable political climate, strong institutional framework, and very cooperative relations among member states. None of these factors exist in Africa, making the task of developing a common currency nearly unimaginable. Further strengthening and expansion of the existing regional monetary unions is the only viable path toward a single African currency in the long-term future.

III. DETERMINING EXCHANGE RATES Exchange-rate regimes are either fixed or floating, with fixed rates varying in terms of just how fixed they are and floating rates varying with respect to just how much they are allowed to float.

A. Nonintervention: Currency in a Floating-Rate World Floating-rate regimes are those whose currencies respond to the conditions of supply and demand. Technically, an independent floating currency is one that floats freely, unhampered by any form of government intervention. Equilibrium exchange rates are achieved when supply equals demand [see Fig 10.1].

B. Intervention: Currency in a Fixed-Rate or Managed Floating-Rate World In a managed fixed exchange-rate system, a nation’s central bank intervenes in the foreign-exchange market in order to influence the currency’s relative price. To buy foreign currencies, it must have sufficient reserves on hand. When economic policies and market intervention don’t work, a country may be forced to either revalue or devalue its currency.

1. The Role of Central Banks Each country has a central bank responsible for the policies affecting the value of its currency. The central bank in the United States is the Federal Reserve System, i.e., the Fed, a system of 12 regional banks. The New York Fed, representing both the Fed and the U.S. Treasury, is responsible for intervening in foreign-exchange markets to achieve dollar exchange-rate policy objectives. The New York Fed also acts as the primary contact with other foreign central banks. In the European Union, the European Central Bank coordinates the activities of each member country’s central bank, such as the Bundesbank in Germany, to establish a common monetary policy in Europe, much as the Fed does in the United States.

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a. Central Bank Reserve Assets. Central bank reserve assets are kept in three forms: foreign-exchange reserves, IMF-related assets , and gold. Central banks are primarily concerned with liquidity, in order to ensure they have the cash and flexibility needed to protect their countries’ currencies. b. How Central Banks Intervene in the Market. A central bank can intervene in currency markets in several ways. The U.S. Fed, for example, can use foreign currencies to buy dollars when the dollar is weak, or sell dollars for foreign currency when the dollar is strong. Central banks may coordinate actions with other central banks, make policy statements to influence markets, and intervene to reverse, resist, or support a market trend. c. Different Attitudes to Intervention. Government policies change over time, depending on economic conditions and the attitude of the prevailing administration concerning intervention in the foreign-exchange market. d. Challenges with Intervention. In general, it is very difficult, if not impossible, for intervention to have a lasting effect on the value of a currency.

Given the daily volume of foreign-exchange transactions, no one government can move the market unless its movements can change market psychology C. Black Markets The less flexible a country’s exchange-rate system, the more likely there will be a black market, i.e., a foreign-exchange market that lies outside the official market.

Black markets are underground markets where prices are based on supply and demand; the adoption of floating rates eliminates the need for their existence.

D. Foreign Exchange Convertibility and Controls Some countries with fixed exchange rates control access to their currencies. Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts.

1. Hard and Soft Currencies. Hard currencies are currencies that are usually fully convertible and strong or relatively stable in value in comparison with other currencies. Soft (weak) currencies are not fully convertible and tend to be the currencies of developing nations. Most countries today have nonresident, or external, convertibility, meaning that foreigners can convert their currency into the local currency and can convert back into their currency as well. Most countries today have nonresident (or external) convertibility, meaning that foreigners can convert their currency into the local currency and back.

2. Controlling Convertibility. Governments sometimes place restrictions on currencies such as licenses that are required of importers and exporters that fix exchange rates at an official price. Some countries employ multiple exchange rates, where different exchange rates are set for different types of transactions, and others use advance import deposits, which require a deposit with the central bank for as long as one year interest-free. Governments may also limit the amount of exchange through quality controls, which limit the amount of foreign currency that can be used in a specific transaction.

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E.

Exchange Rates and Purchasing Power Parity 1. Purchasing Power Parity (PPP). The PPP exchange rate is the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country 2. The “Big Mac Index.” An illustration of the PPP theory is the “Big Mac index” of currencies used by The Economist each year. Since 1986, the British periodical The Economist has used the price of a Big Mac to estimate the exchange rate between the dollar and another currency. The Big Mac index, also known as “McParity,” has both supporters and detractors.

F. Exchange Rates and Interest Rates Although inflation is the most important long-run influence on exchange rates, interest rates are also important.

1. The Fisher Effect. The Fisher Effect is the theory that the nominal interest rate in a country (r, the actual monetary interest rate earned on an investment) is determined by the real interest rate (R, the nominal rate less inflation) and the inflation rate (i) as follows: (1 + r) = (1 + R)(1 + i) or r = (1 + R)(1 + i) - 1 2. The International Fisher Effect. The International Fisher Effect implies the currency of the country with the lower interest rate will strengthen in the future.

G. Other Factors in Exchange-Rate Determination 1. Confidence: Flight to Risk Versus Flight to Safety. Various other factors can affect currency values. One not to be dismissed lightly is confidence: In times of turmoil, people prefer to hold currencies that are considered safe. On the other hand, sometimes the appetite for risk (which implies greater returns) is more important than safety.

IV. FORECASTING EXCHANGE-RATE MOVEMENTS Managers must be able to formulate at least a general idea of the timing, magnitude, and direction of exchange-rate movements.

A. Fundamental and Technical Forecasting While fundamental forecasting uses trends regarding fundamental economic variables to predict future exchange rates, technical forecasting uses past trends in exchange-rate movements to spot future trends.

1. Dealing with Biases. Smart managers develop their own exchange-rate forecasts and then use the fundamental and technical forecasts of outside experts to corroborate their analyses.

2. Timing, Direction, and Magnitude. Forecasting includes predicting the timing, direction, and magnitude of exchange-rate movements. For countries whose currencies are not freely floating, the timing is often a political decision, and not so easy to predict. Predicting the direction is easier than predicting the magnitude. The problem with attempting to predict the value of a freely floating currency is that you never really know what will happen to its value.

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B. Fundamental Factors to Monitor When forecasting exchange-rate movements, key variables to monitor include: • Institutional Setting • Fundamental Analyses • Confidence Factors • Circumstances • Technical Analyses V. BUSINESS IMPLICATIONS OF EXCHANGE-RATE CHANGES Exchange-rate fluctuations can affect all areas of a company’s operations.

A. Marketing Decisions Exchange-rate changes can affect demand for a firm’s products, both at home and abroad. For instance, the strengthening of a country’s currency could create price competitiveness problems for exporters; on the other hand, importers would favor that situation.

B. Production Decisions Firms may choose to locate production operations in a country whose currency is weak because initial investment there is relatively inexpensive; it could also be a good base for exporting the firm’s output. Exchange-rate differentials contribute to this situation across industrialized nations, as well from industrialized to developing nations.

C. Financial Decisions Exchange rates can influence the sourcing of financial resources, the cross-border remittance of funds, and the reporting of financial results.

LOOKING TO THE FUTURE: Changes in the Relative Strength of Global Currencies Although the U.S. dollar is the main reserve asset used by central banks, the Chinese RMB is gaining steam. However, the three key determinants of the reserve status of a currency are size, stability, and liquidity. The RMB suffers in all three areas: size (although the Chinese economy is formidable), stability, and liquidity. The financial institutions in China are still very weak, even though they are improving. Although the RMB became part of the SDR basket in 2016 and thus eligible to be a reserve asset, it has been struggling. In addition, the RMB is not a freely floating currency.

The euro is a strong currency and represents the second-largest amount of allocated reserves behind the dollar. The major challenge of the euro is that its member countries are fragmented with numerous internal problems, such as Greek debt. In addition, Britain, one of the strongest countries in the EU, never adopted the Euro, and left the EU in 2020.

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CLOSING CASE: Welcome to the World of Sony— Unless the Falling Yen Rises (or Falls) Again This case reviews the impact of the yen on Japan’s Sony. In Sony’s early years (1946-1970), they had the luxury of operating with a weak yen. They also received support from the government and expanded rapidly. This era was followed by the first Endaka (“high yen”). This period (1970-1993) saw the yen very strong against the dollar due to a weak U.S. economy, the Persian Gulf War, a rise in interest rates in Japan, and lack of agreement on the condition of the yen among the G8. A second Endaka hit in1995. Japanese companies were having trouble remaining competitive and cut costs to do so. The Japanese economy was in recession and the Bank of Japan dropped interest rates, which reduced the value of the yen. Although Sony continued to innovate during these decades, competition from Korean companies, like Samsung and LG, heated up. During the economic crisis, the yen became a safe-haven currency. Sony continues to be geographically diversified and take advantage of production outside of Japan.

With the strong yen, Sony’s financial statements were negatively impacted and competition continued. Sony has lots of strengths but continues to face challenges. There seems to be a reversal of fortunes with the election of Prime Minister Shinzo Abe in 2012. The yen had fallen by more than 20 percent since Abe took office helping Sony doubled its annual profit estimates due partly to the falling yen. Now we are in 2020 where the yen reversed years of weakness against the dollar but finally stabilized in a range of ¥105 – ¥115 per dollar. The strong yen was hurting Sony’s financial statements.

Questions 10-3. Why do you think it is important for Sony to manufacture more products in the United States and Europe and to also buy more from suppliers in other countries in Asia?

By manufacturing more products in the United States and Europe, Sony can reduce exposure to a strong yen. Also, a strong yen means that imports would be cheaper. In this case, it would be beneficial for Sony to buy more from suppliers in other countries in Asia where parts are cheaper and where Sony can invoice its purchases in dollars. (LO 10-3: Learning Outcome: To identify the major determinants of exchange rates, AACSB: Analytical thinking.)

10-4. What are the major forces that affected the Japanese yen over the years? What factors do you think are important to monitor as you try to forecast what will happen to the value of the yen in the future?

The world economy, particularly the U.S. economy, impacts the strength or weakness of the yen. The period between 1970 and 1993 saw the yen very strong against the dollar due to a 10 .

weak U.S. economy, the Persian Gulf War, a rise in interest rates in Japan and lack of agreement on the condition of the yen among the G8. Also, internal fears of inflation and government intervention have a direct impact on the value of the yen. Initially, during the economic crisis, the yen became a safe-haven currency which benefited the exchange against the euro. Investors also left the emerging markets and returned to Japan, giving strength to the yen. Economic recovery is still very slow and many did not see improvement until the second half of 2010. The yen had fallen by more than 20 percent since Abe took office in 2012 giving exporters like Sony, Toyota, and Panasonic the opportunity to expand their sales abroad. The yen is still one of the major currencies globally and will remain so in the foreseeable future. (LO 10-3: Learning Outcome: To identify the major determinants of exchange rates, AACSB: Analytical thinking.)

ADDITIONAL EXERCISES: Exchange-Rate Determination Exercise 10.1. In the early 1990s, the Canadian and U.S. dollars were close to par. At the end of June 2003, the Canadian dollar was worth about U.S. $0.7374. By March 2006, the Canadian dollar was worth about U.S. $.8635. Ask students to discuss the reasons they believe the Canadian dollar lost so much ground against its American counterpart between 1990 and 2003. Be sure they raise factors such as the implementation of the North American Free Trade Agreement and the separatist movement in Quebec. Now, ask them why the Canadian dollar strengthened against the U.S. dollar from 2003 to 2006. Finally, note the importance of U.S. trade to the Canadian economy and ask students if they think Canada should consider “Americanizing” (pegging) its dollar to its neighbor’s. Why or why not?

(LO 10-2: To discuss the major exchange-rate arrangements that countries use, AACSB: Dynamics of the Global Economy) Exercise 10.2. Use the IMF International Financial Statistics to identify countries that use the SDR as a basis for the value of their currencies and those that use the euro. Then engage the students in a discussion as to why certain countries have chosen to use the SDR while others have chosen the euro. In what ways are the SDR and the euro similar? In what ways are they different? (LO 10-1: Describe the International Monetary Fund and its role in exchange rate markets, AACSB: Multicultural and Diversity Understanding.)

Exercise 10.3. Historically, the International Monetary Fund has prescribed strict monetary policies and reduced government spending for developing countries that sought aid in dealing with currency crises. Ask students to debate the wisdom of the IMF’s approach. Do they believe it was effective? Then ask the students to suggest ways in which the IMF might change its approach in the future. Be sure they consider the implications of their suggestions for international businesses. (LO 10-1: Describe the International Monetary Fund and its role in exchange rate markets, AACSB: Multicultural and Diversity Understanding.)

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Exercise 10.4. Have students look up Big Mac prices. Which is the most expensive country in which to buy a Big Mac? Which is the least expensive? What factors other than currency overvaluation or undervaluation might contribute to these differences? Based on the theory of purchasing-power parity, what is likely to happen to these currencies against the dollar in the next few years? (LO 10-6: To explain how exchange-rate movements influence business decisions, AACSB: Dynamics of the Global Economy.)

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Chapter 11 Global Capital Markets OBJECTIVES 11-1 Describe the finance function of an MNE in a global context 11-2 Define leverage and how it affects the choice of capital structure 11-3 Explain the different ways to access capital internationally 11-4 Summarize how foreign source income is taxed 11-5 Analyze how offshore financial centers provide financing opportunities for MNEs

CHAPTER OVERVIEW Firms that invest and operate abroad access both debt and equity capital in large global markets as well as in local markets. Chapter Eleven highlights the external sources of funds available to MNEs, as well as the internal sources that come from interfirm linkages. It first explores global debt markets, global equity markets, and offshore financial centers. Then the types of foreignexchange risk and the hedging strategies associated with foreign-exchange risk management are discussed. The chapter concludes with a discussion of international capital budgeting decisions and tax issues facing MNEs.

CHAPTER OUTLINE OPENING CASE:

TAX WARS: PFIZER VERSUS THE U.S. GOVERNMENT

In 2014, Pfizer, the U.S.-based pharmaceutical company, and Allergan, the pharma headquartered in Ireland, planned to merge and move Pfizer corporate headquarters to Dublin, Ireland. From a competitive perspective, Pfizer needed to expand its portfolio of new drugs.

From another perspective, if the merger went through and Pfizer was able to move its corporate headquarters to Ireland, it stood to significantly reduce its corporate tax liability and therefore free up more cash for its equity shareholders and for reinvestment into the development of new drugs. Not only was Pfizer interested in the tax benefits from the inversion, but it also had over $74 billion in profits kept overseas that would be subject to U.S. tax if brought back to the United States.

A merger between Pfizer and Allergan would probably not have been an issue for U.S. regulators from a competitive standpoint. However, the issue for the Treasury Department is not a loss of competition; it’s a loss of tax revenues. The fight against inversions was taken up by the U.S. Treasury, not Congress. The problem with Congress is that the Democrats and Republicans couldn’t agree on comprehensive tax reform, so there wasn’t much incentive to take on one isolated issue. In 2016, the Treasury Department slammed the door shut on certain tax inversions, or at least made it more difficult for them, in a series of regulations aimed directly at Pfizer. Soon afterward, Pfizer and Allergan followed up with their own announcement that the 1 .

merger would no longer make sense. In 2017, the U.S. tax system has changed following the passage of the Tax Cuts and Jobs Act (TCJA). The changes reduce the incentives for corporate tax inversions.

Questions 11-1. In the case of Allergan and Pfizer, there are two sovereign powers in play: Ireland and the United States. Why was Ireland interested in letting the inversion take place, and why was the U.S. government against the inversion? Is the decision by the United States a direct affront to the sovereignty of Ireland?

FDI has been a cornerstone of Ireland’s economic performance over the past decade contributing to growth and employment. Consequently, Ireland continues to provide incentives to attract FDI. Chief among those incentives is the low corporate tax rate. On the other hand, the U.S. government opposition to inversion comes from of loss of tax revenue and the risk to employments if the trend continues. It should be noted however that there are members of Congress who are not opposed to inversion and put the blame, instead, on U.S. tax system. Others argue, however, that inversion is unethical since U.S. companies enjoyed all the benefits of the United States and should accordingly pay the taxes. As noted by the U.S. Treasury Secretary leading the fight against tax inversions, “These firms involved in these transactions still expect to benefit from their business location in the United States, with our protection of intellectual property rights, our support of research and development, our investment climate and our infrastructure, as funded by various levels of government.

But these firms are attempting to avoid paying taxes here, notwithstanding the benefits they gain from being located in the United States.”

Regarding sovereignty, students’ responses can vary. It is, however, common in international trade for countries whose economies are adversely affected by the economic measures by another country to intervene or retaliate. (LO11-4: Summarize how foreign source income is taxed, AACSB: Analytical thinking.)

11-2. In what ways are tax inversions beneficial to both the United States and the host country of the inversion?

By merging with foreign firms and incorporating abroad to reduce their tax liability, American companies free up more cash for reinvestments, which might benefit both the U.S. and the host country of the inversion. For instance, Burger King has proven its prediction that growth, not just taxes, was the foundation of the merger with Tim Hortons. 3G Partners, which owns Burger King, is now expanding its new Tim Hortons business in the United States, creating more American jobs as well as creating more wealth for Tim Hortons. In addition, U.S. corporate tax rate put U.S. firms at a competitive disadvantage vis-à-vis firms headquartered in other countries with lower tax rate. Tax inversions would then allow U.S. companies to be competitive in the global marketplace. (LO11-4: Summarize how foreign source income is taxed, AACSB: Analytical thinking.)

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Teaching Tips: Review the PowerPoint slides for Chapter Eleven and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the map, tables, and figures in the text.

INTRODUCTION MNEs access both local and global capital markets in order to finance their operational and expansion activities. This chapter examines external sources of debt and equity capital available to companies operating abroad as well as internal sources of funds that arise from intercompany links. Additional topics explored include international dimensions of the capital investment decision, global cash management, foreign-exchange risk-management strategies, and international tax issues.

I.

THE FINANCE FUNCTION The finance function in the firm focuses on cash flows, both short term and long term. Cash flow management is divided into four major areas: (i) capital structure, (ii) capital budgeting, (iii) long-term financing, and (iv) working capital management.

A. The Role of the CFO [see Figure 10.1] It is the responsibility of an organization’s chief financial officer (CFO) to acquire (generate) and allocate (invest) financial resources among activities and projects.

1. The CFO’s Global Perspective. The CFO’s job becomes increasingly complex in the global environment because of factors such as foreign-exchange risk, currency flows and restrictions, political risk, differing tax rates, and laws and regulations regarding access to capital.

II. CAPITAL STRUCTURE Capital structure is the mix between long-term debt and equity.

A. Leveraging with Debt Financing The degree to which a firm funds the growth of business by debt is known as leverage.

The amount of leverage used varies from country to country, and country-specific factors are a more important determinant of a company’s capital structure than any other factor because companies tend to follow the financing trends in their own country and their particular industry within their country. Leveraging is often perceived as the most cost-effective route to capitalization.

1. When Is Leveraging Not the Best Option? Leveraging may not be the best approach in all countries for two reasons. First, excessive reliance on long-term debt increases financial risks and thus requires a higher rate of return for investors.

Second, foreign subsidiaries of an MNE may have limited access to local capital markets.

B. Factors Affecting the Choice of Capital Structure A company’s choice of capital structure depends on tax rates, degree of development of local equity markets, and creditor rights within its country and in other countries.

1. Debt and Exchange Rates. The global financial crisis of 2007–2009 highlighted foreign exchange risk. Leading up to the crisis, many Asian companies borrowed in dollars at relatively low-interest rates. But when the dollar rose in value, the 3 .

companies couldn’t generate enough cash to convert into dollars to pay off their debts.

2. Regulatory Risk. A second factor that affects local borrowing is regulatory risk.

Regulatory reform has complicated access to debt financing. The Basel Committee on Global Banking Supervision has set standards for stronger capital positions and increased liquidity. The most recent agreement is called Basel III; it is designed to strengthen regulation, supervision, and risk management of the banking sector.

III. GLOBAL DEBT MARKETS A. Eurocurrencies and the Eurocurrency Market A Eurocurrency is any currency banked outside its country of origin, but it is primarily dollars banked outside the United States. The Eurodollar market is the most significant Eurocurrency market. A Eurodollar is a deposit in U.S. dollars in a bank outside the United States. Dollars held by foreigners on deposit in the United States are not Eurodollars, but dollars held at branches of U.S. or other banks outside the United States are.

1. Major Sources of Eurocurrencies. There are four major sources of Eurocurrencies: foreign governments or individuals who want to hold dollars outside the U.S., MNEs that have excessive cash, European banks with excessive currency, and countries with large balance-of-trade surpluses.

2. Characteristics of the Eurocurrency Market. The Eurocurrency market is a wholesale (companies and other institutions) rather than a retail market (individuals), so transactions are very large . The Eurocurrency market is both short- and medium-term. Short-term borrowing is composed of maturities less than one year. Anything from one to five years is considered a Eurocredit, which may be a loan, a line of credit, or another form of medium- and long-term credit. This would include syndication, in which several banks pool resources to extend credit to a borrower and spread the risk.

3. Interest Rates in the Eurocurrency Market. A major attraction of the Eurocurrency market is the difference in interest rates compared with those in the domestic market. The global financial crisis forced central banks all over the world to drop interest rates to stimulate economic growth. a. London Inter-Bank Offered Rate (LIBOR). This is the deposit rate that applies to an inter-bank loan within London. ICE Libor is an interest rate on five different currencies for seven different maturities, the most common of which is the three-month Eurodollar rate.

B. International Bonds Many companies have active bond markets available to domestic and foreign investors.

1. Types of International Bonds a. Foreign Bonds. A bond sold outside the country of the borrower but denominated in the currency of the country of issue. b. Eurobonds. A bond issue sold in a currency other than that of the country of origin. c. Global Bond. A Eurobond which is issued in several locations at the same time.

2. What’s So Attractive about the International Bond Market?

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The international bond market is a desirable place to borrow money. For one thing, it allows a company to diversify its funding sources from the local banks and the domestic bond market and borrow in maturities that might not be available in the domestic markets. It also tends to be less expensive than local bond markets and attracts investors from around the world.

C. Global Equity Markets Another source of financing is equity securities, whereby an investor takes an ownership position in return for shares of stock and possible capital appreciation and/or dividends. One way a company can easily and inexpensively get access to capital is through private placement. In addition, the company can issue stock on one or more foreign exchanges. Sovereign Wealth Funds (SWF) are also an important source of capital. An SWF is a state-owned investment fund that generates resources from a variety of places, including revenues from the exports of natural resources, such as oil.

1. The Size of Global Stock Markets. The total market capitalization of the world’s 83 stock exchanges is $92.6 trillion in January 2020, up from 79.6 trillion in January 2019. Map 11.1 identifies the 10 largest stock markets in the highincome countries and top-10 largest stock markets in emerging countries in terms of domestic market capitalization in January 2020.

2. Political and Economic Forces and Trends in Global Stock Market. To understand trends in stock markets, it is important to understand trends in political and economic forces worldwide and that forces in countries or regions often vary.

During the past few years, global markets have been in turmoil, and that will continue to be the case. Major sources of influence on global stock markets are oil prices, weakness in the global economy, weakness in the Chinese economy, and interest rates.

3. The Rise of the Euroequity Market. Euroequities are shares listed on stock exchanges in countries other than the home country of the issuing company. a. The Trend toward Delisting. The trend of listing on more than one exchange began to reverse somewhat as more and more companies reduced the number of exchanges on which their stocks were listed. Investors are finding that the best price for stocks is usually in the home market of the company in which they are investing. b. American Depositary Receipt. Most foreign companies that list on U.S. stock exchanges do so through American Depositary Receipts (ADR), which are financial documents that represent specified number of shares in the foreign company.

IV. TAXATION OF FOREIGN-SOURCE INCOME Taxes can profoundly affect profitability and cash flow, especially in international business.

Taxation has a strong impact on several choices, including: • Location of operations • Choice of operating form (export/import, licensing, overseas investment) • Legal form of the enterprise (branch or subsidiary) • Possible facilities in tax haven countries to raise capital and manage cash • Method of financing (internal or external sourcing, debt or equity) 5 .

• Capital budgeting decisions • Method of setting transfer prices A. International Tax Practices 1. Differences in Tax Practices. Countries differ in terms of the types of taxes they have (income versus excise), the tax rates applied to income, the determination of taxable income, and the treatment of foreign-source income.

2. Differences in Types of Taxes. Two major types of taxes are income taxes and excise taxes.

3. Differences in Generally Accepted Accounting Principles (GAAP). Variations among countries in GAAP can lead to differences in the determination of taxable income.

4. Differences in Tax Rates. Corporate tax rates differ from country to country.

5. Two Approaches to Corporate Taxation a. Separate Entity Approach. In the separate entity approach, governments tax each taxable entity when it earns income . b. Integrated System Approach. An integrated system tries to avoid double taxation of corporate income through tax credits or split tax rates.

6. Differences in Taxing Foreign-Source Income. Taxation of foreign-source income also depends on the country where the parent company is domiciled. Sometimes, countries tax MNEs on their worldwide income and give them credits for foreign corporate income taxes paid. This is referred to as the “worldwide method.” More commonly, countries now tax MNEs only on their domestic income, which is referred to as the “territorial system.” The 2017 Tax Cuts and Jobs Act in the United States switched the method of taxing U.S. multinationals from the worldwide system to the territorial system.

B. Taxing Branches and Subsidiaries To illustrate the complexities of taxing foreign-source income, it is useful to examine how U.S.-based companies tax earnings from a foreign branch and a foreign subsidiary.

1. The Foreign Branch. Since a foreign branch is an extension of the parent company, any foreign branch income (or loss) is directly included in the parent’s taxable income.

2. The Foreign Subsidiary. A foreign corporation is an independent legal entity set up in a country according to the laws of incorporation of that country. When an MNE purchases or establishes such an entity, it is called a subsidiary. Subsidiary income is either taxable to the parent or tax deferred (not taxed until it is submitted as a dividend to the parent). The tax status of a subsidiary depends on whether the subsidiary is a controlled foreign corporation (CFC) and whether the income is active or passive.

3. The Controlled Foreign Corporation. In a CFC, U.S. shareholders hold more than 50% of the voting stock. A U.S. shareholder is any U.S. person or company that holds 10 percent or more of the CFC’s voting stock. Any foreign subsidiary is considered a CFC for tax purposes. A joint venture company abroad may not be considered a CFC if the U.S. MNE does not own more than 50% of the stock in the joint venture. a. Active versus Passive Income. Active income is derived from the direct 6 .

conduct of a trade or business. Passive, or subpart F income, comes from sources other than those connected with the direct conduct of a trade or business (generally in tax haven countries). Subpart F income includes holding company income, sales income, and service income. The 2017 tax reform in the United States makes an effort to expand the taxation of passive income. b. Determining a Foreign Affiliate’s Income. Figure 11.2 illustrates how the tax status of a foreign affiliate’s income is determined.

C. Transfer Prices Transfer pricing applies to transactions between related entities and is not usually an arm’s length price (price between two unrelated entities). The assumption is that an arm’s-length price is more likely than a transfer price to reflect the market accurately.

1. Transfer Prices and Taxation. Companies establish arbitrary transfer prices primarily because of differences in taxation between countries. The OECD, however, is very concerned about the way companies manipulate transfer prices in order to minimize tax liability and has set transfer pricing guidelines to eliminate this manipulation.

D. Double Taxation and Tax Credit In the United States, the IRS allows a tax credit for corporate income tax for tax that U.S. companies pay to another country in order to avoid double taxation. A tax credit is a dollar-for-dollar reduction of tax liability and must coincide with the recognition of income.

1. Tax Treaties: Eliminating Double Taxation. The purpose of tax treaties is to prevent double taxation or to provide remedies when it occurs. When agreeing to a treaty, countries generally grant reciprocal reduction on dividend withholding and exempt royalties, and sometimes interest payments, from any withholding tax.

E. Dodging Taxes Some countries provide tax incentives to attract investment, and these incentives can help MNEs lower their overall tax liability. One advantage that MNEs have is that it may be hard for a country to figure out its own tax policy, but it is almost impossible for countries to come up with one global tax policy that everyone can agree on. As a result, companies do the best they can to exploit the differences.

V. OFFSHORE FINANCING AND OFFSHORE FINANCIAL CENTERS Companies can raise debt or equity funds in their domestic market or offshore. Offshore financing is the provision of financial services by banks and other agents to nonresidents of a country.

A. What’s an OFC? Offshore financial centers (OFC) are cities or countries that provide large amounts of funds in currencies other than their own and are used as locations in which to raise and accumulate cash.

1. Characteristics of OFCs. Generally, OFCs provide a more flexible and less expensive source of funding for MNEs and exhibit one or more of the following characteristics: • A large foreign-currency (Eurocurrency) market for deposits and loans • A market that functions as a large net supplier of funds to the world financial markets 7 .

•

A market that functions as an intermediary or pass-through for international loan funds • Economic and political stability • An efficient and experienced financial community • Good communications and supportive services • An official regulatory climate that is favorable to the financial industry 2. Operational versus Booking Centers. Centers are either operational centers, with extensive banking activities involving short-term financial transactions (e.g., London), or booking centers, in which little actual banking activity takes place but in which transactions are recorded to take advantage of secrecy laws and/or low or no tax rates (e.g., the Cayman Islands).

3. OFCs as “Tax Havens.” A major concern with OFCs is the tax avoidance dimension of their activities. The Organization for Economic Cooperation and Development (OECD) has been working closely with the major OFCs to ensure that they are engaged in legal activity. The OECD is trying to reduce harmful tax practices through improved translation and disclosure. Putting the spotlight on countries seems to be the best approach.

POINT-COUNTERPOINT: Should Offshore Financial Centers and Aggressive Tax Practices Be Eliminated?

POINT: OFCs operate in a shroud of secrecy that allows companies to engage in illegal and unethical behavior. Enron, one of the largest bankruptcies in corporate history, created hundreds of subsidiaries in tax havens and used them to pass off corporate debts, losses, and executive compensation. Parmalat used a similar strategy, establishing shell companies in the Caribbean to capture cash through fake invoices and credits. Terrorists and drug dealers also use OFCs to launder money.

COUNTERPOINT: Despite examples of corporate malfeasance, OFCs serve useful and ethical purposes. They allow subsidiaries to take advantage of lower borrowing costs and tax rates— activities that are not illegal. More and more countries are taxing offshore earnings, making it harder for companies to avoid paying taxes. The key is to improve transparency and reporting so that illegal activities can be curtailed.

LOOKING TO THE FUTURE The Growth of Capital Markets and the Drive by Governments to Reform Corporate Taxes Global capital markets are in disarray largely because of unstable macroeconomic forces and political instability. Despite these conditions, companies are scouring the world in search of cheap capital. The stock and bond markets will be increasingly important as banks deal with their own financial problems and increased regulations to protect against default. Investments in emerging markets will continue to be a flight to risk. China is in deep trouble and will continue to be so for several years because of mountains of debt and weak economic growth. The competition for global capital will be fierce 8 .

as companies are forced to shift funding from banks that are under great financial stress to issuing stocks and bonds as a way to grow and expand. Another source of cash to MNEs will continue to be tax minimization schemes. However, the OECD countries are working hard to close tax loopholes used by MNEs as they expand abroad. The OECD, IMF, and EU will help countries narrow their tax differences and crack down on the illegal transfer of money for illegal purposes.

CLOSING CASE: Open Sesame: Alibaba Isn’t Poor Anymore Alibaba is China’s largest e-commerce company and likely the largest in the world. Incorporated in 1999, Alibaba decided to go public in 2014. The company raised $25 billion, making it one of the world’s largest IPO in history at the time. Before the IPO, the company relied on capital from external sources, notably Japan’s SoftBank and Yahoo. As a result of the IPO, SoftBank’s $20 million investment ballooned to a value of $58 billion at the time of the IPO, and Yahoo received more than $9.5 billion for the sale of 140.4 million shares. Alibaba recognized that an IPO would force the company to deal with outside shareholders and alter the organization’s ownership structure. So, the company chose to list on the NYSE, which allows dual-class structures. This provision gives Jack Ma (the founder) and his management team the ability to retain majority voting power despite having a minority position. Also, listing on exchanges in the United States was particularly appealing.

QUESTIONS 11-3. Do you agree with the decision to list an IPO, or should Alibaba have borrowed more money, possibly floating a Eurobond in London or elsewhere?

Responses and opinions may vary. I totally agree with Alibaba decision to list an IPO. First, the company had already raised capital from external sources, notably Japan’s SoftBank and Yahoo. Second, the timing was perfect for an IPO. Stock prices were relatively high, and Alibaba was thriving. Third, the IPO gave Alibaba exposure to a broad pool of investors from around the world. (LO11-3: Explain the different ways to access capital internationally, AACSB: Analytical thinking.)

11-4. What do you feel are the best justifications for Alibaba to issue the IPO in New York? Are there any downsides to their decision to list in New York?

Alibaba can argue that the decision to base the IPO in the NYSE is strongly justified.

Importantly, NYSE allows dual-class structures, which gives Jack Ma (the founder) and his management team the ability to retain majority voting power despite having a minority position. The NYSE also provides other benefits, such as access to a large pool of investors in the U.S. market, which includes not only U.S. investors but also many foreign investors from around the world. Also, the NYSE allows Alibaba to align itself with financial markets in advanced countries (LO11-3: Explain the different ways to access capital internationally, 9 .

AACSB: Analytical thinking.)

11-5. What is the impact to existing shareholders of diluting Alibaba’s ownership, and is this a model that other companies can be expected to follow?

In general, existing shareholders might not welcome share dilution because it reduces their ownership of the company. However, in the case of Alibaba, which has a proven track record in e-commerce, the dilution is worth it since the extra capital might boost revenue.

This model might not work for other companies because there is no guarantee the additional capital would lead to an increase in profit margin. (LO11-3: Explain the different ways to access capital internationally, AACSB: Analytical thinking.)

11-6. What do you think Alibaba’s future is in the United States?

Responses and opinions may vary. A large IPO does not necessarily guarantee success.

Alibaba struggled to duplicate its Chinese success in the U.S. Despite its massive IPO in the NYSE, Alibaba is still not a well known e-commerce platform in the U.S. Amazon rules the U.S.’s e-commerce market, and this is unlikely to change, at least, in the short term. Alibaba still has a lot of growth potential and might come back to compete with Amazon and eBay in the U.S. market. (LO11-3: Explain the different ways to access capital internationally, AACSB: Analytical thinking.)

Additional Exercises: Global Capital Markets Exercise 11.1. When using capital budgeting techniques to evaluate a potential foreign project, a firm needs to recognize the specific political and economic risks (including foreign-exchange risk) arising from that foreign location. Ask students to compare the advantages of (i) using a higher discount rate and (ii) forecasting lower cash flows to evaluate such projects. (LO11-1: To describe the financial function and how it fits in the MNE’s organizational structure, AACSB: Analytical Skills.)

Exercise 11.2. Typically, the cost of capital is lower in the global capital market than in domestic capital markets. Other things being equal, firms will likely prefer to finance their investments by borrowing from the global capital market. However, such borrowing may be restricted by host-country regulations or demands. Ask the students to discuss the point at which firms should consider using the global equity markets to finance foreign investments and operations in lieu of the global debt markets. Are firms likely to encounter restrictions in the equity markets as well? What are the effects of such restrictions likely to be on a firm’s investment and operating decisions? (LO11-2: To show how companies can acquire outside funds for normal operations and expansion, including offshore debt and equity funds, AACSB: Dynamics of the Global Economy.)

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PART FIVE GLOBAL STRATEGY, STRUCTURE, AND IMPLEMENTATION Chapter 12 The Strategy of International Business OBJECTIVES 12-1 Explain the idea of strategy in the MNE 12-2 Profile how executives make strategy 12-3 Analyze resources, capabilities, and competencies 12-4 Assess approaches to create value 12-5 Diagram the features and functions of the value chain 12-6 Compare global integration and local responsiveness 12-7 Distinguish the types of strategies used by MNEs

CHAPTER OVERVIEW Chapter Twelve presents tools and concepts used in analyzing and formulating an international business strategy. First, the role of strategy in international business is examined. Next, value chain analysis is used to identify the internal capabilities of the firm that can be leveraged to create competitive advantage. The dilemma of choosing between two imperatives: standardizing products and processes or localization is also discussed. Finally, a typology of strategic alternatives including international, localization, global, and transnational strategies is presented.

CHAPTER OUTLINE OPENING CASE:

Zara’s Disruptive Vision: Data-Driven Fast-Fashion [see Fig 12.1 and Map 12.1.]

Zara, a large clothing retailer headquartered in northwest Spain, has used an innovative strategy to power its global expansion. The first Zara shop opened its doors in 1975 in La Coruña. Today, there are more than 2,000 outlets and, on average, a new one opens every day. Now, in 2016, from its humble beginnings, there are more than 2,000 Zara storefronts strategically located in leading cities spanning 88 countries. Zara’s vision of data-driven fast-fashion anchors its strategy to integrate cutting-edge systems; state-of-the-art information technology; efficient, scale-driven production; astonishing logistics; and alluring distribution that designs, makes, moves, and sells sophisticated, yet affordable, apparel. Zara, in starting and sustaining the data-driven fast-fashion revolution, translates its vision into a practical strategy through a range of ingenious choices in acquiring resources, developing capabilities, and creating competencies. Separately and collectively, these anchor Zara’s competitiveness. Presently, no other apparel company comes 1 .

close to designing, making, moving, and selling fashion as speedily as Zara. Its success leaves rivals with less time to figure out how to better configure and coordinate their operations. Some stay in the game, such as H&M, while others fall further behind, notably Gap.

Questions 12-1. Evaluate how Zara translates its “Give customers what they want, get it to them faster than anyone else” into its day-today operations?

Zara translates its mission statement with the strategy of fast fashion and the concept of right fashion. Using data-driven strategy and distinctive supply chain, Zara strive to swiftly deliver the latest, greatest fashion that excite customers and meet their demands. Zara has developed world-class resources in each step of its value chain, from conception to distribution. Zara’s designers and trend spotters rely on data from various sources to design the “right fashion”. Then the company makes most of it. Although Zara has little use for advertising or promotion, it transformed its meticulously selected stores into grassroots marketing agents. The company also put its faith in positive word of mouth. (LO12-1: To evaluate industry structure, firm strategy, and value creation, AACSB: Analytical Skills.)

12-2. Assess the difficulty a competitor, such as Gap, faces trying to re-create the resources, capabilities, and core competencies that define Zara.

Zara is disrupting the fashion industry, and competition is struggling to adapt. Competition is grappling with delivering the latest fashion fast and efficiently while also keeping their stores relevant. To re-create the resources, capabilities, and core competencies that define Zara, competitors would have to reshape their value chain, which is not an easy task. Zara has raised the stakes, and the status quo will not cut it in the fashion industry anymore. To keep up with Zara and recover its losses, hard-hit competitors such as Gap must adapt quickly to the new reality with data and customer-centric strategy and innovation and a focus on their competitive advantages. Gap can learn not just from Zara but also from H&M, which has managed to stay in the game. (LO12-1: To evaluate industry structure, firm strategy, and value creation, AACSB: Analytical Skills.)

TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Twelve, as well as the opening case regarding Zara, which is cited throughout the chapter.

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STRATEGY IN THE MNE Superior performance requires managers to plan for the opportunities and threats in the global business environment. The scale and scope of opportunities and, inevitably, threats spanning 217 markets can overwhelm analysis. The job of the strategist is identifying the implications of these situations to which products to make, where to make them, where to sell them, how to compete, and, all the while, earn a profit. In principle, strategy is an integrated and coordinated set of commitments and actions that reflect the company’s present situation, identifies the direction it should go, and determines how it will get there [see Fig 12.1] 2 .

A. Getting Started: Vision and Mission Strategy starts with a vision and a mission. Vision is the idealization of what an MNE firm wants to be. It expresses, in broad terms, its ultimate goal. The MNE’s mission defines its business, its objectives, and its approach to achieving them. Table 12.1 profiles the vision and mission statements of various MNEs. 1. Rhetoric to Reality. Translating the lofty rhetoric of an MNE’s vision and mission into relevant programs and realistic performance standards, one can imagine, is tough. Increasing the challenge for the typical MNE is the fact that its vision and mission statements must work in many businesses run by many different people operating in many different environments.

B. Moving Onward: Strategic Planning Strategic planning is a comprehensive process that determines how the firm can best achieve its vision and mission. Managers use various frameworks to organize strategic planning. Most frameworks follow a similar logic and share common steps, typically cycling through some variation of the following sequence: (1) identify potential product markets and assess each for opportunities and threats; (2) assess the preferences of targeted customer segments; (3) analyze internal strengths and weaknesses relative to customers’ expectations and competitors’ competencies; (4) formulate a strategy; (5) set clear and compelling objectives; (6) formalize programs, policies, and tactics; (7) acquire resources, create capabilities, and develop competencies; and (8) monitor thresholds and adjust standards given change in performance, rivals, or markets.

II. MAKING SENSE TO MAKE STRATEGY The complexity of the global business environment can easily overtax strategic planning.

Preempting analysis paralysis spurs managers to integrate sensemaking perspectives into strategic planning. Sensemaking involves studying shifting markets, competitors’ initiatives, and changing consumer behaviors in order to determine how economics, politics, culture, trade, and industry influence the company’s plans. Managers apply a range of sensemaking perspectives. Currently, one commonly sees variations of the Industrial Organization and the Resource-Based Views.

A. Industrial Organization (IO) The industrial organization (IO) outlook sets the external environment as the primary determinant of an MNE’s strategic plan. The IO model holds that markets tend toward perfect competition. Strategic planning processes anchored in the IO sensemaking perspective assess how an industry’s structural characteristics shape competitive dynamics that, in turn, determine the profitability of different choices B. Resource Based View (RBV) In reality, some industries are, and persistently remain, far from perfectly competitive.

In these settings, proprietary advantages, high entry barriers, or oligopolistic dynamics, for instance, produce market imperfections. These sorts of situations spotlight an alternative sensemaking perspective. That is, manager’s insight in terms of acquiring resources, organizing capabilities, and developing competencies, rather than the structure of the industry, fundamentally shapes strategic success. This view, generally referred to as Great by Choice, highlights the power of bright managers and their keen sense of devising a strategy that is difficult, if not impossible, to copy.

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III. THE ROLE OF RESOURCES, CAPABILITIES, AND COMPETENCIES The IO Model and the Great by Choice outlooks both speak to the importance of resources, capabilities, and competencies in supporting a strategy that creates competitive advantages.

Resources are inputs into an MNE production process. A capability is the capacity for resources to perform an activity in an integrated manner [see Table 12.3 and Table 12.4].

Managers bundle resources and capabilities to create a core competency.

Just as bright managers combine resources into capabilities, they also convert resources and capabilities into competencies. Difficult to define precisely, competencies are the unique, inimitable knowledge, skill, or ability that, in synthesizing links between resources and capabilities, sets and sustains an MNE’s competitiveness.

IV. THE QUEST TO CREATE VALUE Value measures a firm’s capability of selling what it makes for more than the costs incurred in making it. We follow convention and define value in economic terms, specifying it as the difference between the cost of making a product and the price that customers are willing to pay for it. In broad terms, an MNE can create value by perfecting processes and products in order to do things more efficiently than others, thereby making products for lower costs than can competitors (the strategy of cost leadership). Alternatively, MNE can create value by doing something no one else can do, and do it effectively, thereby making products for which consumers pay a premium price (the strategy of differentiation). In some situations, an MNE insightfully combines the two approaches (the strategy of integrated cost leadership/differentiation).

A. The Cost Leadership Strategy The cost leadership strategy aims to make a product at a given level of quality for a cost below those of competitors.

1. Risk of the Cost Leadership Strategy. The cost leadership strategy has several risks, including (1) disruptive technologies change efficiency standards; (2) customer’s needs change; and (3) cheaper, and better products from rivals.

B. The Differentiation Strategy The differentiation strategy champions developing products that customers value and that rivals find hard, if not impossible, to match or copy. Products are differentiated on a variety of tangible and intangible dimensions.

1. Risk of the Differentiation Strategy. The differentiation strategy has several risks, including (1) customers’ expectations change; (2) customers no longer see sufficient value to justify the price premium; (3) a rival introduces a newer, cooler, higher-performing alternative.

C. The Integrated Cost Leadership/Differentiation Strategy The differentiation strategy calls for continual innovation, whereas cost leadership champions sustainable efficiency. The integrated cost leadership/differentiation strategy aims to do both. The integrated cost leadership/differentiation strategy provides customers with relatively lower-cost products that also have differentiated features.

1. Risks of the Integrated Cost Leadership/Differentiation Strategy. The key threat to the integrated cost leadership/differentiation strategy is getting “caught in the middle,” falling short of optimizing production or sufficiently differentiating.

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POINT—COUNTERPOINT: Is Strategic Planning Productive?

POINT: Indeed, in today complex global business environment, strategic planning is necessary.

Strategic planning pushes managers to break free of day-to-day routines, look toward the horizon, and ask and answer big questions. Strategic planning improves the flexibility to change as markets change. Strategic planning, by enforcing rigorous, disciplined, systematic decisionmaking, makes expanding into familiar markets or venturing into different territories manageable.

COUNTERPOINT: In actuality, the shifting dynamics of the global marketplace present overwhelming challenges that suggest strategic planning is arguably ineffective. Managers’ best intentions to map the future, many continually run into the problem that the future famously does not cooperate with pre-set visions, missions, and plans. Notwithstanding best intentions, strategic planning falls prey to deficiencies and delusions.

V. ORGANIZING VALUE CREATION: THE VALUE CHAIN Just as strategic planning helps managers develop their strategy; value chain analysis helps them assess how activities create value. Value-chain analysis helps managers understand the potential and performance of resources and capabilities, thereby clarifying cost structures and value creation. The value chain is the set of linked activities the company performs to design, make, market, distribute, and support a product. A value chain disaggregates a firm into (1) primary activities that design, make, sell, and deliver the product; and (2) support activities that implement the primary activities. Figure 12.2 maps the activities that comprise the value chain. Figure 12.3 profiles their characteristics.

A. Configuring the Value Chain How an MNE distributes value activities around the world is the matter of configuration—essentially, the task of deciding which activity to do where. Besides the option to sell in the 217 markets that compose the global business environment, the MNE has the option to install operations in each. The option to go anywhere to do anything pushes an MNE to configure its value chain to exploit location advantages.

Locating primary and support activities operations in productive places optimizes the MNE’s competitive positioning. In theory, configuration ranges from concentrated (the MNE performs all value chain activities in one location) to dispersed (the MNE performs different value-chain activities in different locations).

1. Economies of Scale. Selling globally, rather than only locally, superbly positions an MNE to achieve economies of scale. Specifically, an MNE captures economies of scale in terms of size, output, or scale of operation.

2. The Risks of Configuration Choices. Configuration decisions face the risks of unpredictable market change. Disruptions, such as a regime change, material shortages, labor unrest, or currency instability, can quickly convert an efficient location into a costly one.

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LOOKING TO THE FUTURE Digits, Widgets, and Changing Location Advantages Revolutionary developments in digitalization, robots, and 3-D printers have given MNE cost effective solutions to configure value activities. By integrating these disruptive technologies into the value chain, MNEs can optimize location advantages and shape where and how MNEs do what. The traditional determinants of factory locations are slowly becoming secondary to digitization and robotics. We already see how digitization and robotics are pushing MNE to bring back manufacturing activities that had been moved to low-cost labor locations and, in the process, expanding the notions of locations.

VI. GLOBAL INTEGRATION VERSUS LOCAL RESPONSIVENESS Competing in the global marketplace puts an MNE on the horns of a dilemma: should it single-mindedly standardize products and processes and resolutely exploit location effects to maximize the efficiency gains of global integration? Or, should it adapt products and processes to the unique situations in each market in order to maximize the effectiveness benefits of local responsiveness? As we see in Table 12.6, significant motivations endorse each imperative.

A. The Potential for Standardization The convergence of national markets, standardization of business, and efficiency imperatives push MNEs to integrate activities.

B. The Context of Consumer Behavior Differences in local consumers’ preferences endure due to cultural redisposition, historical legacy, and latent nationalism. Responding to local customers’ preferences requires customizing products and processes. Adaptation reduces the efficiencies of standardization, thereby aggravating the liability of foreignness, inflating operational costs, and reducing value creation.

C. The Agenda of Institutional Agents Aspects of standardization endorse global integration whereas the issue of divergent consumer behaviors endorses local responsiveness. A third factor, institutional agents and their policy agendas, can, at different times, support either scenario. Various transnational institutions, such as the IMF, WTO, and World Bank, build an increasingly seamless global business environment. On the other hand, institutional agents, particularly host governments, often strongly encourage, if not compel, local responsiveness.

D. Global Integration and Local Responsiveness: Mapping their Interaction Operating internationally calls for configuring and coordinating operations in ways that reconcile the competing demands of global integration and local responsiveness. The Integration-Responsiveness (IR) Grid provides a straightforward framework to organize analysis (see Figure 12.4). Procedurally, it positions an industry in the quadrant that represents its sensitivity to the dual imperatives. As such, it provides executives a framework to interpret the challenge. The IR Grid helps managers map their strategic options given prevailing pressures for standardization and adaptation in their particular industry 6 .

VII. INTERNATIONAL CORPORATE-LEVEL STRATEGIES Corporate-level strategy determines the actions an MNE takes to gain a competitive advantage by selecting and managing its business across a group of nations. A corporatelevel strategy (1) articulates how managers plan to reconcile global integration and local responsiveness in ways that support the MNE’s vision and mission, (2) stipulates how managers will integrate the MNE’s various parts into a strategic whole, and (3) specifies the decision-making role the headquarters and subsidiaries take doing so. The international, localization, global standardization, and transnational strategies anchor contemporary interpretation. Table 12.8 profiles the principles and practices of each archetype.

A. The International Strategy The international strategy emphasizes the transfer of core competencies from the domestic operation to foreign subsidiaries. It allows for limited local customization.

Examples of companies using this strategy include Airbus, Apple, and Google.

1. Advantages. The international strategy works well when an MNE’s products or processes speak to a universal customer preference.

2. Limitations. Headquarters’ confidence in the superior competitiveness of its competencies discourages local adaptation. Initially, this outlook does not carry high risks. But, as an MNE expands its global operations, a one-way view of the world may miss opportunities or misread threats in foreign markets. Moreover, the international strategy sustains strong performance as long as foreign rivals scramble futilely.

B. The Localization Strategy The localization strategy encourages decentralized decision-making so that local subsidiaries can adjust value activities to local circumstances.

1. Advantages. The localization strategy superbly speaks to the unique features of consumer preferences, market situations, and environmental context found in a national market. It drives MNEs to customize products and processes. The localization strategy gives the MNE’s local units a distinctive advantage against incountry competitors who lack the benefits provided by the parent company.

2. Limitations. The localization strategy, by encouraging operational overlap, increases overhead expenses.

C. Global Strategy A global strategy requires worldwide consistency and standardization in order to be effective. Firms that choose the global strategy face strong pressures for cost reductions but weak pressure for local responsiveness. Operationally, MNEs that adopt a global strategy usually are or aim to become the low-cost player in their industry. This generally requires global-scale production facilities in a few low-cost locations.

1. Advantages. The transnational strategy reconciles global integration and local responsiveness in ways that leverage the MNE’s core competency throughout worldwide operations.

2. Limitations. The transnational strategy is difficult to implement in practice, given the challenges of complicated agendas, high costs, and cognitive limits.

D. Transnational Strategy The transnational strategy targets the efficiency of global integration, the effectiveness of local responsiveness, and the systematic diffusion of innovations.

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1. Advantages. The global strategy exploits economies of scale, learning effects, and location economies in order to translate the MNE’s resources and capabilities into core competences that support cost leadership worldwide.

2. Limitations. The cost sensitivity of the global strategy leaves MNEs little latitude to customize processes or products to local conditions; each change reduces efficiency. Hence, an MNE’s success is a function of the validity of the ‘one type product fits all customers’ needs worldwide’ thesis.

CLOSING CASE: The Multinational Enterprise of the Future: Leading Scenarios Evolving workflows, technology platforms, and market dynamics intensify globalization trends.

MNEs respond in kind, rethinking visions, clarifying missions, adjusting strategies, and reconfiguring value chains to compete in the brave new world. Now, like the Internet, the globally integrated enterprise designs its strategy, configures its activities, and coordinates its processes to connect everything and everywhere.

In the future, goes this scenario, world-class operational efficiency will no longer determine an MNE’s competitive advantage. Nor will an MNE build superior competitiveness from unique features of its home country or, for that matter, from a set of national subsidiaries. Rather, victory will go to those who move from designing multinational operations to synthesizing metanational competencies.

The future frontier for the MNE is set by the matter of size, say others. The average size is falling—many of the 80,000 plus firms that operate internationally employ fewer than 250 people. This anomaly signals the era of so-called “micro-multinationals”: nimble, small firms that are born global, operating internationally from day one.

Advocates of regionalization endorse the awkward term “Glorecalization” as the next step in the evolution of the MNE. Glorecalization, a portmanteau of Globalization-RegionalizationLocalization, champions a global vision and customized local tactics through a value chain configured to exploit location economies within a regional market. Essentially, rather than “think global, act local,” the glorecalized MNE opts to “go global, think regionally, act local.”

Another emerging organizational form is the digi-corp, a form unimaginable a generation ago but is increasingly a reality today. The digi-corp does not organize products, consumers, or markets to reflect or respect the geography set by quaint lines on a map. Instead, the digital connectivity of the Internet, not national borders, defines its operational boundaries.

Indisputably, calling the MNE of the future is more speculation than stipulation. No matter the standard that ultimately emerges, we expect it will showcase the historic markers of companies that are built to last: a down-to-earth, pragmatic, committed-to-excellence framework run by bright people who articulate an insightful vision, practical mission, and clever strategy that changes the game.

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Questions 12-3. You have a choice to work for a globally integrated enterprise, a metanational, a glorecalized MNE, a micro-multinational, or a digi-corp. Which would you choose? Why? Responses and opinions may vary. There is no single “best” enterprise. Each form of MNE has some advantages and disadvantages. However, I do prefer digi-corps because of their adaptability to changing environments. They develop competencies that help them react in real time to changes in customers, markets, and environments. (LO12-1: Explain the idea of strategy in the MNE, AACSB: Reflective Thinking (Able to understand oneself in the context of society.))

12-4. Looking out over the next decade, estimate the likely standards of how an MNE will create value. In your opinion, which form of MNE is best designed for this scenario? Why? Responses and opinions may vary. The “globally integrated enterprise” is the future, and it is one that puts investments, people, and work anywhere in the world based on the right cost, right skills, and the right business environment with work flowing to the places where it will be done most efficiently and to the highest quality. (LO12-1:Explain the idea of strategy in the MNE, AACSB: Reflective Thinking (Able to understand oneself in the context of society.)

12-5. The MNE of the future, in whatever form it takes, will face pressures for global integration along with those clamoring for local responsiveness. In your opinion, which form will best reconcile that challenge?

Responses and opinions may vary. The “globally integrated enterprise” is designed to reconcile that challenge. It can balance global integration with local responsiveness by configuring its activities, coordinating its processes, and allocating its resources efficiently to appeal to both local and cost pressures. (LO12-1:Explain the idea of strategy in the MNE, AACSB: Reflective Thinking (Able to understand oneself in the context of society.)

Additional Exercises: The Strategy of International Business Exercise 12.1. Have the students perform a value chain analysis on Zara. Which of Zara’s value chain activities create the most value for the company? What are Zara’s core competencies? (LO12-5: To profile the types of strategies MNEs use, AACSB: Analytical Skills.)

Exercise 12.2. Ask the students to use the five fundamental forces model to analyze one of the industries listed in the integration-responsiveness grid (Fig. 12.6). Does the pressure for local responsiveness and/or global integration impact the five forces in the industry they 9 .

selected? (LO12-3: Analyze resources, capabilities, and competencies, AACSB: Analytical Skills.)

Exercise 12.3. Have the students refer to the Fortune Global 500 (http://money.cnn.com/magazines/fortune/global500/). Categorize each of the top five global firms in terms of strategy types (Fig. 12.5). Ask the students to specify what information they would need to make an informed judgment on strategy type for any given company. Have them identify sources of that information. (LO12-1: To evaluate industry structure, firm strategy, and value creation, AACSB: Analytical Skills.)

Exercise 12.4. Select two large multinational enterprises that are known to the students, one consumer-oriented (e.g., Toyota) and one industrial (e.g., BASF). Then ask students to discuss the pressures for local responsiveness and global integration faced by each firm.

Which experiences the greater pull toward local responsiveness? Why? Which faces a greater need for global standardization? Why? (LO12-5: To profile the types of strategies MNEs use, AACSB: Dynamics of the Global Economy.)

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Chapter 13 Country Evaluation and Selection OBJECTIVES 13-1 Elaborate on the significance of location in IB operations 13-2 Illustrate why comparing countries through scanning is important and how it connects to final location choices 13-3 Discern major opportunity and risk variables and how to prioritize and relate them when deciding whether and where to expand abroad 13-4 Summarize the sources and shortcomings of comparative country information 13-5 Explain alternative considerations and means for companies to allocate resources among countries 13-6 Recognize why companies make noncomparative decisions when choosing where to operate abroad

CHAPTER OVERVIEW The country evaluation and selection process determines the geographical opportunities that firms choose to pursue. Chapter Thirteen first discusses the challenges of marketing and production site location. It goes on to carefully examine the process by describing the choice and weighting of variables used for opportunity and risk analysis as well as the inherent problems associated with data collection and analysis. The chapter then introduces the use of grids and matrices for country comparison purposes, discusses resource allocation possibilities, and concludes by noting the different factors considered as part of start-up, acquisition, and expansion decisions.

CHAPTER OUTLINE OPENING CASE:

BURGER KING® [see Fig 13.1]

Burger King is the world’s largest flame-broiled fast-food hamburger chain. Beginning in the early 1960s the company expanded internationally to the Bahamas and Puerto Rico. Then it entered Europe, Asia, and Latin America in the 1970s. Some of its international moves turned out to be highly successful, and a few did not. In seeking new places to enter, Burger King looks most favorably at countries with large populations (especially young people), high consumption of beef, availability of capital to franchisees for growth, a safe pro-business environment, growth in shopping centers, and availability of a potential franchisee with experience and resources.

Recently its model has been to grant franchise rights by pairing a private equity firm with an experienced restaurant operator in a joint venture (JV). In some cases, Burger King has become the third party in the JV without committing capital to it. The possibilities in the BRIC countries are too great to ignore. Burger King opened its first Brazilian and Chinese restaurants in 2004.

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While Burger King has had success in both these countries, it has been able to expand much faster in the former due largely to its recognition advantage in Brazil. Burger King’s recent growth in its U.S. and Canada region has lagged its growth elsewhere. Burger King is planning unprecedented expansion. The fact that some of its competitors have expanded abroad much more than Burger King may indicate that it has untapped international potential.

Questions 13-1. Discuss the risks that an international restaurant company such as Burger King would have by operating abroad rather than just domestically.

Internationally, MNEs have to deal with national differences between countries in terms of economic, cultural, legal and political environments. These differences may impact profitability if not managed properly. For instance, in India, Burger King has done an extensive market research to develop a vegetarian menu in response to local demand. Also, rules and regulations may hinder operations. In China, Burger King was forced to adjust to Chinese laws requiring firms to form a JV with a Chinese firm or own and operate two or more stores for at least a year before starting franchise operations. There are also financial and currency risks for companies such as Burger King that conduct transactions in multiple currencies. (LO 13-6: Recognize why companies make noncomparative decisions when choosing where to operate abroad, AACSB: Multicultural and Diversity Understanding).

13-2. How has Burger King’s headquarters location influenced its international expansion? Has this location strengthened or weakened its global competitive position?

With its overwhelming Hispanic influence and prevalence of Spanish language, Miami is nicknamed “the capital of Latin America.” The Latin American influence has attracted corporations targeting the affluent Hispanic population in Miami and the improving markets of Central and South America. Hence, having a headquarter and a strong presence in Miami has allowed Burger King to build brand loyalty with the Hispanic community. This has made it easy for Burger King to expand to Latin America. Burger King has also targeted emerging markets namely China, Russia, India, and Brazil because of their large population and growth potential. (LO 13-6: Recognize why companies make noncomparative decisions when choosing where to operate abroad, AACSB: Multicultural and Diversity Understanding).

TEACHING TIPS: Review the PowerPoint slides for Chapter Thirteen and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, review the figures and tables in the text.

I.

THE IMPORTANCE OF LOCATION The adage that “location, location, and location” are the three most important factors for business success rings true for IB. The world has a bit more than 200 countries, each offering distinct opportunities and risks. Because companies have limited resources, they must be careful in choosing among countries when making the following decisions: (1) the 2 .

location of sales, production, and administrative and auxiliary services, such as R&D, (2) the sequence for entering different countries and (3) the portion of resources and efforts to allocate to each country where they operate.

II. COMPARING COUNTRIES THROUGH SCANNING Managers use scanning techniques to examine and compare countries on broad indicators of opportunities and risks.

A. Why Is Scanning Important?

Scanning is like seeding widely and then weeding out; it is useful insofar as a company might otherwise consider too few or too many possibilities. However, comparison among countries is not always practical.

B. Scanning Versus Detailed Analysis 1. Step 1: Scanning. Through the use of scanning, decision makers can perform a detailed analysis of a manageable number of geographic locations. Managers can usually complete the scanning process without having to incur the expense of visiting foreign countries. Instead, they rely on analyzing information found on the Internet and other publicly available sources, as well as communicating with people familiar with the foreign countries they are interested in.

2. Step 2: Detailed Analysis. Once managers narrow their consideration to the most promising countries, they need to compare the feasibility and desirability of each.

The more time and money companies invest in examining an alternative, the more likely they are to accept it regardless of its merits—a phenomenon known as escalation of commitment. Companies should be careful about taking forced actions based on peer and/or media pressure and should instead carefully weigh important variables when comparing countries of interest.

III. OPPORTUNITY AND RISK VARIABLES Managers should consider country conditions that could significantly affect success or failure. These conditions should reveal both opportunities and risks.

A. Opportunities: Sales Expansion Sales expansion is probably the single most important motive for international business.

It is often difficult to estimate sales potential in a new market, and managers may have to rely on sales of similar or complementary goods, or use economic or demographic data to estimate market potential.

1. Examining Economic and Demographic Variables. Some primary considerations when examining economic and demographic variables include: • Obsolescence and leapfrogging of products • Demand for necessities versus discretionary products • Substitution • Income inequality • Cultural factors and taste • Existence of trading blocs B. Opportunities: Resource Acquisition When undertaking IB to secure resources (e.g., labor, raw materials, knowledge), 3 .

companies are limited to those locales that likely have what they want, such as securing petroleum only where there are prospective reserves.

1. Cost Considerations. Total cost is made up of numerous sub-costs that need to be considered. Many of these are industry or company specific, which must be examined in the detailed onsite visitations. Several costs that apply to a large cross section of companies are outlined below. a. Labor. Labor compensation remains an important cost for most organizations.

In the scanning process, factors such as labor market size, labor compensation, minimum wages, customary and required fringe benefits, and unemployment rates can be used for comparison. When companies move into emerging economies because of labor cost differences alone, their advantages may be short-lived. Competitors often follow leaders into low-wage areas, there is little first-mover advantage for low-labor-cost production migration, and the costs can rise quickly because of pressure on wage or exchange rates. b. Infrastructure. Poor internal infrastructure and social services may easily negate cost differences in labor rates. In many developing countries, infrastructure is both poor and unreliable, which adds to companies’ cost of operating. c. External Connections. The need to integrate operations among countries influences location decisions d. Governmental Incentives and Disincentives. Countries often compete to attract investors, offering incentives such as lower taxes, training of employees, loan guarantees, low-interest loans, exemptions on import duties, and subsidized energy and transportation costs. There may also be disincentives such as taxes, labor conditions, and environmental compliance. Government corruption may also be present and represent a disincentive.

C. Risks Is it ever rational for a firm to invest in a country with high economic and political risk ratings? Such questions must be carefully weighed when making international capitalinvestment decisions.

1. Factors to Consider in Analyzing Risk There are a number of factors to consider when analyzing risk: • Companies and their managers differ in their perceptions of what is risky • One company’s risk may be another’s opportunity • Companies may reduce their risks by means other than avoiding locations • There are trade-offs among risks • Risks may occur for suppliers and within suppliers’ supply chains 2. Political Risk Political risk reflects the expectation the political climate in a given country will change in such a way that a firm’s operating position will deteriorate. It relates to changes in political leaders’ opinions and policies, civil disorder, and animosity between a home and host country. When evaluating political risk, decision makers refer to past patterns in a given country, expert opinions, and country analysts. They also look for economic and social conditions that could lead to political instability, 4 .

but there is no consensus as to what constitutes dangerous instability or how it can be predicted. a. Analyzing Past Patterns. Predicting risk based on past patterns can be problematic in that situations change. Also, the overall situation in a country may mask political risks with the country. b. Evaluating Opinions. Managers should study the statements made by political leaders and access political polls to attempt to determine the likelihood of a candidate gaining political office. Managers should visit short-listed countries for a cross-section of opinions. Analysts and commercial political risk assessment services can also be used. c. Examining Social and Economic Conditions. Countries’ social and economic conditions may lead to unrest if large sectors of the population have unmet needs. Frustrated groups may disrupt business and destroy property. Foreign leaders may place blame on foreign companies.

3. Foreign Exchange Risk Companies may be affected by either changes in exchange rates or ability to move funds out of a country. a. Exchange Rate Changes. Changing exchange rates may be a benefit or a disadvantage, depending upon the direction of the change and if the firm is seeking to sell or acquire resources. If the U.S. dollar depreciates it makes American products abroad; however, it will cost firms more to acquire foreign resources. b. Immobility of Funds. When a company exports to or invests in a foreign country, it prefers international mobility of its sales receipts, earnings, and capital there. Without the mobility, many firms either forgo operations or expect a higher rate of return there than elsewhere.

4. Natural Disaster Risk Natural disasters and debilitating diseases upset operations and are spread unevenly around the world. Each year, hundreds of millions of people are exposed to risks from earthquakes, cyclones, flooding, drought, volcanic eruptions, rising ocean levels, mudslides, and tornados. These disasters upset markets, infrastructure, and production and create havoc with global supplies. Also, the incapacitating effects of disease and pandemics such Covid-19 have an impact on several facets of international business operations.

5. Competitive Risk The comparison of likely success among countries is largely contingent on competitors’ actions. Four competitive factors that should be considered when comparing countries are discussed below. a. Compatibility for Companies’ Operations. Companies are highly attracted to countries that are located nearby, share the same language, and have market conditions similar to those in their home countries. For example, marketing programs in one country often result in product awareness elsewhere, particularly in an adjacent country, an occurrence known as a spillover effect.

For example, U.S. television ads regularly reach Canadians, making it easier for U.S. firms to do business there.

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b. Diversification of Locations. Operating in economically diverse countries whose business cycles are not highly interrelated may enable companies to smooth their sales and profits, which, in turn, is an advantage in raising funds. c. Following Competitors or Customers. Companies may also reduce risk by avoiding overcrowded markets, or conversely, they may purposely crowd a market to prevent competitors from gaining advantages therein that they can use to improve their competitive positions elsewhere, a situation known as oligopolistic reaction. Firms may also seek “clusters” of competitors (also known as agglomeration) that attract multiple suppliers, customers, and highly trained personnel in order to gain access to new products, technologies, and markets. One example of this would be the computer firms clustered in California’s Silicon Valley. d. Heading Off or Avoiding Competition. A company may try to reduce competitive risk by either getting a strong foothold in markets before competitors do or by avoiding strong competitors altogether. A company’s innovative advantage may be short lived. When pursuing a strategy known as imitation lag, a firm moves first to those countries most likely to adapt and catch up to the advantage. In some instances firms may seek those countries where they are least likely to confront significant competition; in others, they may gain advantages by moving into countries where competitors are already present. By being the first major competitor in a market, companies can more easily gain the best partners, best locations, and best suppliers—a strategy to gain first-mover advantage.

D. Analyzing and Relating the Opportunity and Risk Variables Two common tools for analyzing information collected via scanning are grids and matrices.

1. Grids [see Table 13.1] A grid can be used to make country comparisons according to a wide variety of relevant factors, such as ownership rules, potential returns, and perceived risk.

Variables can be ranked and weighted according to specific criteria that reflect a firm’s situation and objectives. Although useful for establishing minimum scores and for ranking countries, grids often obscure interrelationships among countries.

2. Matrices [see Fig 13.3] One matrix frequently used when doing country comparisons is the opportunity-risk matrix. When using this matrix, the manager plots a country according to the perceived value of the opportunity the country offers, on the one hand, and the expected level of risk associated with operating in that country on the other. Factors that are good indicators of risk and opportunity and the weight assigned to each must be identified and assigned by the firm. Once scores are determined for each country being considered, they can be plotted and reviewed from a comparative perspective. A useful application of this technique is to develop both present and future scores for countries (e.g., five years hence) because a significant shift in a score in the future could have serious implications with respect to the country selection process.

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IV. SOURCES AND SHORTCOMINGS OF COMPARATIVE COUNTRY INFORMATION Firms perform research to reduce uncertainties in their decision processes and to assess their operating performance. The costs of data collection should always be weighed against the probable payoffs in terms of revenue gains or cost savings.

A. Some Problems with Research Results and Data Numerous countries have agreed to standards for collecting and publishing various categories of national data. However, the lack, obsolescence, and inaccuracy of data on other countries can make research difficult and expensive to undertake.

1. Inaccuracy Six basic reasons why reported information may be inaccurate: a. Governmental resources may limit accurate data collection b. Governments must depend on estimates and revisions c. Governments may omit or purposely publish misleading information d. Respondents may give false information to data collectors e. Official data may include only legal and reported market activities f. Questionable methodology may be used 2. Noncomparability Comparability problems result from definitional differences across countries (e.g., family categories, literacy levels, accounting rules), differences in base years, distortions in foreign currency conversions, the measurement of investment flows, the presence of black market activities, etc.

B. External Sources of Information Apart from the Internet, the most costly sources are marketing research and consulting companies, but the advantage is that they can target more closely what companies want.

Some of the major Internet sources are prepared by service companies, government agencies, international organizations, and trade associations. In any case, it is wise to know how sources generate their information and, in the case of those offering advice (e.g., a risk-assessment company), what their past success rates have been.

C. Internally Generated Data When firms have to conduct studies in foreign countries, they may find traditional data gathering and analytical methods do not reveal critical insights. In that case, a researcher must be extremely imaginative and observant. In some instances, useful information may be found by analyzing indirect or complementary indicators.

POINT—COUNTERPOINT: Should Companies Operate in and Send Employees to Violent Areas?

POINT: Where there’s risk, there are usually rewards. Companies need to take risks, as they have in the past, to develop markets. Violence is only one of many risks and should not be looked at in isolation. Risks from activities such as terrorism are the same whether you are in London, Madrid, Caracas, or New York. All areas have their risks, and many countries traditionally viewed as risky may actually be less risky than the United States or England. Some industries, such as petroleum, have to operate in violent areas because that is where the resources 7 .

are. MNEs should operate anywhere there are opportunities, and develop plans to manage and react to risks as effectively as possible.

COUNTERPOINT: MNEs should not make investments in violent areas because it puts MNE personnel at risk. MNEs are visible and therefore vulnerable to attack by anti-globalization groups, kidnappers, and groups opposed to foreigners, as well as others. It is unethical to put employees in excessively dangerous situations. Employees who will take dangerous assignments are usually either difficult to control, excessively naïve, or addicted to the thrill of danger. Any country subject to extreme violence is not the kind of country to do business in.

V. ALLOCATING RESOURCES AMONG LOCATIONS We now examine three complementary strategies for international expansion: alternative gradual commitments, geographic diversification versus concentration, and reinvestment A. Alternative Gradual Commitments Companies favor operations in countries similar to their home country. Nevertheless, there are alternative means of risk-minimization expansion patterns that can be undertaken as seen in Fig 13.7. A company does not necessarily move at the same speed along each axis. A slow movement along one axis may free up resources that allow faster expansion along another.

B. Geographic Diversification versus Concentration A firm may take different paths en route to gaining a sizable presence in most countries. At one end of the spectrum is a diversification strategy, whereby a firm moves rapidly into many foreign countries and then gradually builds its presence in each. At the other end of the spectrum is a concentration strategy, whereby a firm moves into a limited number of countries and develops a strong competitive position there before moving into others. There are, of course, hybrids of the two strategies—for example, moving rapidly to most markets but increasing commitment in only a few.

The following are the reasons for using one strategy versus the other: • Need for Rapid Growth in Country • Competitive Lead Time • Need for Product, Communication, and Distribution Adaptation • Program Control Requirements C. Reinvestment and Harvesting Once a firm makes an initial investment, it will then need to decide whether to continue investing in that operation or to harvest the earnings (and possibly divest the assets) and use them elsewhere.

1. Reinvestment Decisions. Reinvestment refers to the use of retained earnings to replace depreciated assets or to add to a firm’s existing stock of capital. Aside from competitive factors, a company may need several years of almost total reinvestment (and often allocation of additional funds) in order to realize its objectives at a given location.

2. Harvesting. Harvesting (also known as divesting) refers to the reduction in the amount of an investment; a firm may choose to simply harvest the earnings of an 8 .

operation or divest the assets there as well. If an operation no longer fits a company’s overall strategy, or if better opportunities exist elsewhere, it must determine how to exit that operation. When selling or closing facilities, firms must consider possible government performance contracts as well as potential adverse publicity, plus the possible difficulty in re-establishing operations in that country in the future.

VI. NONCOMPARATIVE DECISION-MAKING One might expect companies to maintain a storehouse of ranked foreign operating proposals, undertaking the best, second best, etc. until they could make no further commitments, but this is usually not the case. They make go-no-go decisions by examining one opportunity at a time and pursuing it if it meets some threshold criteria.

LOOKING TO THE FUTURE: Conditions That May Cause Prime Locations to Change Demographers expect a slowing in the growth of global population, with some countries experiencing declining populations, particularly in developed, and the most robust growth in developing economies, particularly those in sub-Saharan Africa. Given the importance of population size for sales potential, these changes, if they materialize, will be profound. Further, because the world’s population will continue to age and people will pursue education for more years, the share of what we now consider the working-age population should fall for developed countries and increase in many developing ones. As a result, the growth in per capita GDP should be higher in today’s developing economies than in today’s developed countries unless we redefine working age. If these demographic changes occur, they will affect the location of both markets and labor forces. An intriguing possibility is the near-officeless headquarters for international companies as technology allow people to communicate without traveling as much.

Concomitantly, another view is that elite in leading Western societies is increasingly using its capability to delay and block new technologies. If successful, their efforts will result in the emergence of different countries at the forefront of technological development and acceptance.

CLOSING CASE: Amazon.com This case explores the location and pattern for Amazon’s international expansion. Amazon’s first foreign subsidiaries came in April 1998 in the United Kingdom. Today, Amazon operates 17 localized online storefronts, as shown in Map 13.2. Although it had been shipping to more than 150 countries from its U.S. website, Amazon’s international expansion has been relatively slow and not aggressive. Amazon developed an approach to country selection that relies on three selection criteria: population, size of the economy, and density of internet use. These criteria took Amazon to Japan, Germany, France, and the United Kingdom. Japan, Germany, and the United Kingdom accounts for 66 percent of its $72.7 billion in international sales in 2018.

Despite this, analysts do not necessarily regard Amazon as successful in Europe and Japan.

Amazon entered China using the same business model it implemented in Europe. But the 9 .

company failed to compete with Alibaba or gain any meaningful share of the market. Ultimately Amazon chose to shut down its Chinese e-commerce business. In India, Amazon pursue a more localized approach in order to get closer to the consumer, but the company faces competition from Walmart and Alibaba. While Amazon’s future growth is tied to international expansion, its success internationally depends on the selection of countries and foreign entry strategies.

Questions 13-3. What advantages and disadvantages would Amazon likely have when compared with domestic e-commerce websites where it operates?

Amazon's most significant competitive advantages in host markets experience in ecommerce, financial resources, the vast range of products (often at competitive prices), innovation, and reliability. However, Amazon is at a disadvantage in foreign markets because of national differences in economic, cultural, legal, and political environments.

They add risk factors that might offset the advantages. For instance, Amazon could not compete with domestic challengers in China. Also, its business strategy was poorly executed and did not adapt to Chinese consumer behavior and preferences. (LO 13-5: Explain alternative considerations and means for companies to allocate resources among countries, AACSB: Analytic Skills).

13-4. Evaluate the reasons for following a geographic concentration versus a diversification strategy as they apply to large e-commerce retailers such as Amazon In global e-commerce, companies must tailor their products and operating methods for each country they enter. For instance, in India, Amazon used a localized approach to get closer to the consumer. However, this strategy comes with extra costs. Hence, many e-commerce retailers follow a concentration strategy to minimize the costs of entering multiple countries simultaneously. (LO 13-5: Explain alternative considerations and means for companies to allocate resources among countries, AACSB: Analytic Skills).

13-5. Do you think Amazon should enter Russia?

Answers will vary, but perhaps Amazon should enter the Russian e-commerce market for the following reasons. First, although e-commerce in Russia has lagged behind that of other emerging economies, the market has considerable growth potential and a large population.

Second, Amazon should follow competitors to prevent them from gaining advantages there that they can use to improve their positions elsewhere. Third, Amazon has a strong presence in Europe, and entry into Russia could provide integration possibilities within the continent (LO 13-5: Explain alternative considerations and means for companies to allocate resources among countries, AACSB: Analytic Skills).

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ADDITIONAL EXERCISES: Country Evaluation and Selection Exercise 13.1. As the phenomenon of economic integration progresses, the process of country selection takes on new dimensions. Ask students to compare and contrast the opportunities and risks associated with establishing operations in the European Union to those in the USMCA region. Would such investments be primarily resource- or marketseeking? Be sure students explain and give examples to support their ideas. (LO: 1, Learning Outcome: To grasp company strategies for sequencing the penetration of companies, AACSB: Analytical Skills.)

Exercise 13.2. Ask students to compare the costs and benefits of investing in an industrialized economy to the costs and benefits of investing in a developing economy from the standpoint of an MNE. Then ask the students to debate the idea that MNEs have a responsibility to work toward developing global efficiency, i.e., that economic considerations should be weighted more heavily than other factors in the country selection process. (LO 13-2: Elaborate on the significance of location in IB operations, AACSB: Analytic Skills .)

Exercise 13.3. During the 1970s, a number of MNEs such as Coca-Cola and IBM made decisions to abandon operations in certain developing countries and not to enter others because of government restrictions. Ask the students to discuss the likelihood that MNEs will face such decisions in the future, given the progress of the WTO and movements toward economic integration in many parts of the world. Do the students foresee other factors that might cause more divestments in the future? (LO 13-5: Explain alternative considerations and means for companies to allocate resources among countries, AACSB: Analytic Skills .)

Exercise 13.4. Have the students use the simplified grid to compare countries for market penetration (Table 13.2) to compare South Africa, Ireland, and Argentina for a possible investment. Encourage them to use outside data sources such as www.doingbusiness.org/en/doingbusiness, www.worldbank.org, and www.nationmaster.com/ to gather information and make meaningful comparisons. Which of these three countries would be most suitable for investment? Why? (LO 13-6: Recognize why companies make noncomparative decisions when choosing where to operate abroad , AACSB: Analytical Skills.)

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Chapter 14 Export and Import OBJECTIVES 14-1 Explain the principles and practices of exporting 14-2 Distinguish the motivations and methods of exporting 14-3 Understand the startup and expansion of exporting 14-4 Explain the principles and practices of importing 14-5 Distinguish the motivations and methods of importing 14-6 Describe the problems and pitfalls that challenge international traders 14-7 Identify the resources and assistance that help international traders 14-8 Define the standards of an export plan 14-9 Distinguish the principles and practices of countertrade

CHAPTER OVERVIEW The first part of Chapter Fourteen is devoted to an examination of export and import strategies.

Next, the roles of a wide variety of third-party intermediaries are discussed. The chapter concludes with a discussion of the major issues related to export financing, including the use of countertrade as a form of payment mechanism.

CHAPTER OUTLINE OPENING CASE:

SPINCENT: THE DECISION TO EXPORT

SpinCent is a small Pennsylvania exporter of laboratory and industrial centrifuges. The company was initially a passive exporter. However, a struggling U.S. economy provided the incentive for the company to focus on international markets. The Asia market became a prime target for the organization. Management looked to develop long-term beneficial relationships with a distribution network in the region. The company did its homework and spent time in the region identifying market potential, competition, price points, and recruiting a sales force. The company discovered that exporting to the region provided more opportunities than risks. They now do a steady stream of business overseas, experiencing low-cost/high-reward endeavor. Successful planning and a commitment to goals are advocated by the organization.

Questions 14-1. Identify two challenges that SpinCent overcame in developing its export activity. Describe how it overcame them.

The first challenge is the CEO’s doubt about exporting and his unease about the trade-off between opportunities and risks. SpinCent’s CEO overcame this challenge by getting more 1 .

info about the Asian market from various sources, namely the U.S. Commercial Service’s Export Assistance Center. The second challenge was finding a long-term partner who could develop, make, and service consumers in their respective territories. SpinCent overcame this challenge by doing on-the-ground research in Asia. The company also tapped the Commercial Services’ Gold Key program, which helps SMEs enlist Commercial Services agents. (LO 14-7: Identify the resources and assistance that help international traders, AACSB: Analytical thinking.)

14-2. Based on its Asian experiences, map a sequence to guide SpinCent’s export expansion to sub-Saharan Africa.

Responses and opinions may vary. I think SpinCent should use the same market research strategy that they used in Asia to get a better sense of the opportunities and risks in subSaharan Africa. The company should take advantage of government agencies’ resources and data and plan on-the-ground research in sub-Saharan Africa. If the company concludes that exporting is the correct entry strategy, they need to seek Commercial Services representatives to find long-term and reliable local/regional partners. (LO 14-7: Identify the resources and assistance that help international traders, AACSB: Analytical thinking.)

TEACHING TIPS: A good source of additional information on exporting is www.export.gov.

Students can find an abundance of resources useful to the practical aspects of exporting, and the availability of governmental help to exporters at this site. Review the PowerPoint slides for Chapter Fourteen and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures and tables in the text.

INTRODUCTION Export and import are, by far, the most common modes of international business. The scale and scope of firms that trade steadily increases. The popularity of export and import follows from their key advantages. Both are straightforward, low-cost, and quick means to engage foreign markets. Both impose minimum business risk and require relatively low resource commitment. Moreover, whether large or small, international trade helps companies improve productivity, increase profits, and diversify risk.

I. EXPORTING: PRINCIPLES AND PRACTICES A. Exporting Exporting is the sale of goods or services produced by a firm based in one country to customers that reside in another country. Service exports occur across a range of industry sectors. However, the sometimes hazy standards of a service make it a bit tougher to define what qualifies as an export. Technically, a service need not physically leave a country to qualify as an export. Rather, it need only earn foreign currency.

B. Who Are Exporters?

Types of exporters include (1) non-exporter, (2) sporadic exporter, and (3) regular exporter: 1. Sporadic Exporter. This type of company takes a passive approach to assessing international trade options. It fills an unsolicited order from the occasional foreign 2 .

buyer, but prefers to focus on the domestic market.

2. Regular Exporter. The company that aggressively pursues exports sales as a productive, profitable, strategic activity is a regular exporter. It’s experienced with the technicalities of international trade. Regular exporters look to international markets for growth, invest resources to expand export operations, and proactively respond to export signals.

3. Non-Exporter. This type is generally disinterested in international trade and, for any number of reasons, has little to no familiarity with exporting.

C. The Matter of Advantages 1. Ownership advantages are the firm’s specific assets, international experience, and the ability to develop either low-cost or differentiated products within the context of its value chain.

2. Location advantages refer to the combination of sales opportunity and investment risk that creates favorable locations in foreign markets.

3. Internalization advantages are the benefits of retaining a core competency within the company and threading it through the value chain rather than opting to license, outsource, or sell it. In general, companies that have low levels of ownership advantages either do not enter foreign markets or, if they do, they enter through low-risk modes.

D. Characteristics of Exporters While the largest companies are routinely the largest exporters from their countries, smaller firms play an important part in overall export activity. In the United States, the 500 biggest firms accounted for nearly 60 percent of total export value, the 250 biggest accounted for more than half, the 100 biggest contributed just under one-third, and the top 20 accounted for a fifth. Nevertheless, many see great export potential in small and medium-sized enterprises (SMEs)—those firms that, by definition, have fewer than 500 employees. In the United States, for example, SMEs are 97 percent of all exporters and importers and generate a third of the total trade value; moreover, 91,860 of the companies that exported in 2016 did not export in 2015. This situation is found worldwide as approximately two-thirds of exporters and importers report fewer than 20 employees. So, while big companies are the biggest exporters, many SMEs are active exporters, and many anticipate expanding activity expanding activity. A firm’s characteristics moderate its export activity. Size matters, but often management commitment, productivity, innovativeness, and cost structure matter more.

II. EXPORTING: MOTIVATION AND METHODS Study of export scenarios identifies many motivators. Ultimately, the export decision centers on improving profitability, boosting productivity, and achieving diversification.

A. Profitability Exporting opens opportunities to increase profits. Often, companies sell their products for higher prices abroad than at home. Foreign markets may lack competitive alternatives. Or, they may be in different stages of the product’s life cycle.

B. Productivity Exporting helps companies improve productivity, creating options to use scarce resources, such as capital and labor, more efficiently. Productivity is often linked to 3 .

increasing economies of scale; exploiting capacity or spreading costs over more customers improves efficiency. Hence, selling more products to more people in more markets drives productivity gains.

C. Diversification Exporting diversifies activities, thereby fortifying a firm’s adaptability to business cycles and disruptive innovations.

III. EXPORT: STARTUP AND EXPANSION Research studies how, when, and why a company initiates and develops exporting. Two views of export shape interpretation: the deliberate, sequential dynamic of incremental internationalization and the instant internationalization of the born global.

A. Incremental Internationalization This view, developed in the 1970s, sees physical distance, cultural ties, and market circumstances fundamentally shaping how a company approaches and engages export.

Specifically, export activity follows a sequential process that leads a company to sell initially from its home market to geographically and psychologically proximate countries. From there, it methodically expands, systematically exporting to more dissimilar and distant countries. Progressively gaining experience in successfully dealing with increasingly dissimilar markets encourages managers to expand their international horizon.

B. The Born-Global Phenomenon The international entrepreneurship literature reports that that some firms initiate exporting as a born global (also known as an “instant international,” micronational, or “international new venture”). Rather than methodically engaging a sequence of increasingly dissimilar foreign markets, born-globals step onto the world stage immediately upon their founding or soon after. They regard their home as just one of many opportunities in the world.

C. The Influence of Time and Place Neither the incremental-international nor born-global perspective definitively represents how companies initiate and increase exporting. Company practices confirm that each credibly interprets elements of the export process. Trade data suggest an increasing interaction between the incremental-international and born-global perspectives.

D. The Wildcard of Serendipity Exporters are often proactive decision-makers. Sometimes, however, serendipity— making fortunate discoveries by accident—initiates export activity.

E. Approaches to Exporting Generally, the ease of exporting reflects how a company chooses to serve foreign customers. As we now see, there are several options: 1. Direct Exporting. Exporting directly involves independent representatives, distributors, or retailers outside of the exporter’s home country.

2. Indirect Exporting. Indirect exports are products sold to an intermediary in the home market, which then exports those products to other countries.

3. Passively Filling Orders from Domestic Buyers Who Then Export the Product.

In this mode, a company supplies inputs to other firms who then use that as a component in making a product that they then export.

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F. Which Approach When?

Several factors shape an SME’s preferred approach to export, notably its mix of ownership, location, and internalization advantages. The four approaches to exporting are not mutually exclusive; company and market circumstances moderate whether managers opt to apply one or a mix. Technology influences the relative merits of the various export approaches. The Internet makes direct exporting increasingly efficient and effective by providing immediate, low-cost means that lets regular exporters, particularly born-globals, easily access more markets.

POINT-COUNTERPOINT: Exporting E-waste: A Just Solution POINT: E-waste—trash composed of computers, monitors, electronics, game consoles, hard drives, television, smartphones, and other items—inexorably increases as the Information Age rolls on. The world trashes hundreds of millions of electronic components, generating millions of tons of e-waste. While some is recycled locally, most gets exported. A substantial proportion of e-waste export goes to depots and dumps in developing countries in Africa and Asia where the disposal costs are low. Exporting e-waste is an efficient solution to an escalating problem. Ewaste exports shipped to developing countries help create jobs, improve the local standard of living and spurs local development. Certainly, callous companies dump useless, toxic e-waste around the world. And, yes, some of it pollutes landfills, poisons waterways, and fouls the air.

Overall, though, exporting e-waste works for citizens, consumers, companies, and countries.

COUNTERPOINT: Hazardous waste export has generated serious health and environmental risks in countries that are ill-equipped to process it and lack the regulatory codes or disposal infrastructure to safeguard against common dangers. Environmentalists advocate tougher standards to monitor, control, and certify cross-border shipments. Many endorse stronger enforcement of the Basel Convention, that regulates the generation, management, movements, and disposal of hazardous waste. As of 2020, 187 states and the European Union had ratified.

The United States signed it in 1990, but has not ratified it, thereby not legally bound by its terms.

IV. IMPORTING: PRINCIPLES AND PRACTICES Importing is the purchase of a good or service by a buyer in Country X—the importer— from a seller in Country Y—the exporter. Effectively, importing is the reverse of exporting.

The import of services has subtle characteristics. The standard to keep in mind is that the import of a service consists of any transaction that (1) does not result in ownership, and (2) is rendered by nonresidents to residents.

A. Characteristics of Importers Wide-ranging research has assessed the characteristics of exporters; for various reasons, however, importers receive less attention. Still, data indicate that importers are also likely to be exporters, and that these firms account for the bulk of the world’s exports and imports. On fundamental points, the characteristics of exporters apply to importers.

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V. IMPORTING: MOTIVATION AND METHODS Several reasons motivate importing: (1) Specialization of labor, (2) Global rivalry, (3) Local unavailability, (4) Diversification, and (5) Top management’s outlook.

A. Import Drivers 1. Specialization of Labor. The specialization of labor is a powerful force to improve productivity. It benefits the import potential and performance of SMEs and large firms.

2. Input Optimization. Companies import goods from foreign suppliers in order to lower costs. This is imperative in industries where competitive rivalry imposes persistent cost pressures 3. Local Unavailability. The WTO identifies the expanded scope of choice as the chief benefit of import. Importing lets local markets improve the variety of their offerings, providing consumers with products that are either unavailable locally or that can serve as competitive substitutes to local options.

4. Diversification. Importers, like exporters, diversify by tapping international markets to develop options. Diversification through importing lets companies find higher-quality, lower-cost products and services, thereby making it less vulnerable to the dictates of a local supplier or business cycle.

B. Type of Importers 1. Optimizers. This type of importer uses foreign sourcing to optimize, in terms of price or quality, the inputs fed into its supply chain.

2. Opportunistic. This type of importer looks for products around the world that it can import and profitably sell to local citizens.

3. Arbitrageurs. In theory, a good sold in one market should sell for the same price in another. In practice, the price of the same product can vary significantly from country to country due to market imperfections that result from government regulations, trade inefficiencies, political risks, and other factors. These imperfections, by creating supply gaps, create the basis for import arbitrage.

VI. IMPORTING AND EXPORTING: PROBLEMS AND PITFALLS Companies identify many problems that complicate international trade. The types, characteristics, and impact of trade barriers vary considerably. Regular, as well as sporadic, exporters struggle with various barriers. Let’s take a look at persistent concerns. [see Table 14.1].

A. Operations Management Navigating language and culture, preferences for local goods/services, distribution channels, logistics expenses, product adaptation pressures, different service norms B. Strategic Management Top management commitment, IB expertise, staff flexibility, lower profitability, difficulty developing sales, finding trustworthy partners, IPR protection.

C. Financial Management Difficulty receiving/processing payments, different taxation regimes, obtaining trade credits, funding working capital, currency fluctuations, and exchange controls. SMEs regularly rate financial constraints as the most daunting barrier to trading internationally.

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D. Government Regulation The success of the WTO, the transnational organization whose mission is to expand international trade, has made it easier worldwide. Still, government regulations, in terms of standards, security, and protection, confound exporters and importers. such as home and foreign trade regulations, complex tariffs schedules, non-tariff barriers, inadequate public support programs, and buy national codes.

E. Trade Documentation A battery of documentation is still required for international trade: Custom procedures, homeland security regulations, export-import forms, permit and licensing arrangements, fees and charges [see Table 14.2].

VII. IMPORTING AND EXPORTING : RESOURCES AND ASSISTANCE Many firms find themselves in situations where assistance can meaningfully influence the productivity and profitability of their international activities. They can enlist aid from various public or private agents.

A. Public Agencies In the United States, as in most countries, public agencies help firms initiate and develop exports and imports.

1. Agents and Services. In the United States, SMEs can start at the nearest Commercial Service office, the trade promotion arm of the U.S. Department of Commerce’s International Trade Administration. U.S. government agencies provide information and share advice on the practicalities and technicalities of exporting.

B. Private Agents Companies routinely enlist private agents to help navigate international trade.

Prominent types include export intermediaries, freight forwarders, customs brokers, World Trade Centers, and international banks.

1. Export Management Companies. An export management company (EMC) is a firm that either acts as a manufacturer’s agent or buys merchandise from manufacturers for international distribution. EMCs generally operate on a contractual basis, provide exclusive representation in a well-defined foreign territory and act as the export arm of a manufacturer. Often, export management companies are small and specialize according to product, function, and/or market area.

2. Export Trading Companies. An export trading company (ETC) is somewhat like an export management company, but its primary purpose in becoming involved in international trade as an independent broker is to match domestic exporters to foreign customers. Export trading companies that are based in the United States may be exempt from antitrust provisions to allow them to penetrate foreign markets by collaborating with other U.S. firms. The primary difference between ETCs and EMCs is that ETCs tend to operate on the basis of demand rather than supply.

3. Freight Forwarders. A freight forwarder is a foreign trade specialist who deals in the movement of goods from producer to customer, and is the largest export intermediary in terms of value and weight of products managed. Even export management companies may use the specialized services of foreign freight forwarders.

4. Third-Party Logistics (3PLs). These entities work with manufacturers, shippers, and retailers to mitigate the problems associated with logistics in international trade.

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5. Customs Brokers. Customs reflect a country’s import and export procedures and restrictions. The primary duties of a customs agency are the assessment and collection of all duties, taxes, and fees on imported products, the enforcement of customs and related laws, and the administration of certain navigation laws and treaties.

6. The Costs and Constraints of Private Agents. Besides payments, hiring a trade intermediary requires an exporter relinquish some, or even considerable, decisionmaking control regarding shipping, buyer segments, price policies, quality of promotion materials, delivery schedules, or customer service. Longer terms, supportive governments, fading language barriers, improving communications and connections, harmonizing finance practices, and efficient electronic exchange steadily diminish the appeal of fee-based trade agents.

VIII. RECONCILING OPPORTUNITY AND CHALLENGE: AN EXPORT PLAN Going international imposes many demands that, collectively, influence resource allocation, executive effectiveness, operational flexibility, and financial stability. Successful exporters, citing the notion that “companies don’t plan to fail, they fail to plan,” indicate that developing an export plan manages these demands. An export plan defines a company’s intent to leverage resources and manage constraints in initiating and developing export activity. An export plan prioritizes markets, formalizes top management buy-in, organizes trade activities, and forecasts market scenarios. Traders stress-test an export plan by consulting trade specialists along with public and private agents.

LOOKING TO THE FUTURE: Technology Transforms International Trade Advances in transportation and communications systems steadily facilitate export growth and make it easier for companies to reach international markets. The Internet helps individuals engage each other easily and quickly. Online filing of cargo manifests, customs documents, and transit forms expedites shipments. Improving technologies create online, software, and logistics platforms that blur the distinction between the big, global giant and the small, neighborhood start-up. A burst of business software in the past few years has “created a total revolution in what small businesses are able to accomplish overseas.” Companies use innovative programs to manage overseas factories with tools that once were reserved for big MNEs. Improving logistics help SMEs move products more cheaply and easily to more places. High-tech, low-cost shipping services rob big firms of a long-running advantage. Now, the no-name, one-person exporter down the street from you, because of its big-name shipping partners spanning the globe, has many of the same logistics capabilities commanded by a large MNE, but at a fraction of the cost.

Improving online, software, market, and logistics platforms, by improving the technology of buying and selling, levels the playing field of international trade.

X. COUNTERTRADE Companies and countries often use countertrade to build mutually beneficial relationships.

Countertrade is an umbrella term for several sorts of trade, such as barter or offset, in which the seller accepts goods or services, rather than currency or credit, as payment.

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A. Costs Countertrade is an inefficient way of doing business. Companies prefer straightforward cash or credit to settle a transaction. Negotiating “payment” is not the only hurdle.

Goods may be of poor quality, packaged unattractively, or difficult to sell and service.

Consequently, countertrade deals are prone to price, financing, and quality problems.

Ultimately, countertrade and its variations threaten free market forces with indirect protectionism and price-fixing.

B. Benefits Companies and countries in tough binds use it to generate jobs, preserve foreignexchange holdings, and develop trade relationships. Countertrade helps countries reduce their need to borrow working capital and gives them access to companies’ technological skills and marketing expertise. Companies also benefit; they can resolve bad debts, repatriate blocked funds, or develop customer relationships. Accepting countertrade signals a seller’s good faith and flexibility, often positioning it to gain preferential market access in the future.

CLOSING CASE: Alibaba: Redefining Export Pathways, Platforms, and Performance Performance Electronic commerce is changing the way companies around the world do business. The Internet has opened up a whole new era of business opportunities, making virtual information on any product from virtually any market accessible readily and inexpensively. The web has given SMEs cost-effective means to go global. Spearheading this transformation are e-commerce giants such as Alibaba. The Chinese behemoth is the world’s largest online business-to-business marketplace. It reaches Internet users in more than 240 countries and territories and connects tens of millions of merchants to more than two billion consumers. From its beginning, in 1999, Alibaba built an e-commerce platform that provided all the necessary resources, digital infrastructure services, and logistics that SMEs would need to succeed in global business. Yet, challenges remain, particularly the issue of trust and transparency. Alibaba has put several measures to police its platform and prevent fraudulent activities.

Questions 14-3. Do you think most international trade might eventually take place through websites like Alibaba.com? How might that influence your interest in importing and exporting?

Responses and opinions may vary. Indeed, the Coronavirus pandemic has proven that point.

The lockdowns and stay-at-home orders have led to a spike in e-commerce sales and heightened online shopping. E-commerce giants such as Amazon and Alibaba have seen increased traffic to their e-commerce sites, and their revenues from online sales skyrocketed.

Given these trends, it is very reasonable to speculate that this would eventually become the new normal. I believe most trade between SMEs would occur in the virtual sphere. It is thrilling to see SMEs and even microenterprises begin to use e-commerce platforms such as eBay, Alibaba, and Amazon to engage in international trade and compete with the big players. (LO: 3, Learning Outcome: To identify the problems and pitfalls that challenge 9 .

international traders, AACSB: Dynamics of the Global Economy). (LO 14-7: Identify the resources and assistance that help international traders, AACSB: Analytical thinking.)

14-4. Identify a product you would like to import. Visit www.alibaba.com, go to the advanced search field, and enter it. Select required criteria and click on “Search.” Review the list of companies that qualify. Find a suitable seller. Analyze this process for ease and usefulness.

Responses and opinions may vary. (LO: 2, Learning Outcome: To introduce the idea importing and profile its elements, AACSB: Use of Information Technology). (LO 14-7: Identify the resources and assistance that help international traders, AACSB: Analytical thinking.)

14-5. Provide three recommendations that you would offer an SME, based on the opportunities and limitations of Alibaba, as it considers exporting or importing.

Responses and opinions may vary. Many SMEs from around the globe use Alibaba’s ecosystem to export and import. Alibaba has simplified the process to make export and import straightforward and easy. First, I would urge SMEs to take advantage of Alibaba’s platform to expand their business beyond the home market. The global pandemic has wreaked havoc on SMEs, and international e-commerce via Alibaba or Amazon provides a lifeline to keep them afloat. Second, despite the simplicity of engaging in export and import via Alibaba, SMEs must craft the proper export and import strategy to succeed. For instance, they need to make sure their products are appropriate for the target market from marketing and legal perspectives. They need to choose the proper supplier. Third, while Alibaba is generally safe, SMEs must still be cautious about scams and frauds. For instance, they need to check whether the supplier is legit or a scammer. Fortunately, Alibaba provides tools to rate and judge company profiles. (LO 14-7: Identify the resources and assistance that help international traders, AACSB: Analytical thinking.)

14-6. How transparent do sites like Alibaba.com make import-export transactions? To what degree would you worry about fraud? What safeguards would you seek?

Responses and opinions may vary. Alibaba is generally safe. The company put several features to increase transparency and reduce the risk of fraud. One of those tools is The Company Profile which provides information about companies and some verification icons that help determine the suppliers’ legitimacy and trustworthiness, such as the Gold Supplier icon. I do worry about fraud and scams, and I was a victim of one on eBay. Luckily I used PayPal, which has a Purchase Protection that covers buyers. So, when doing business on any e-commerce platform, I look at similar safeguards to protect my transactions. (LO: 1, To introduce the idea of exporting and profile its elements, AACSB: Analytical Skills). (LO 147: Identify the resources and assistance that help international traders, AACSB: Analytical thinking.)

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ADDITIONAL EXERCISES: Export and Import Strategies Exercise 14.1. Research has shown that although the largest firms in the world also tend to be the world’s largest exporters, export intensity is not positively correlated with the size of a firm. Begin a discussion by asking students to explore the reasons for this. Then, ask students to discuss the levels of export intensity they would expect to find with respect to a variety of industries. Be sure they explain their reasoning and compare differences across industries. (LO 14-1: Explain the principles and practices of exporting, AACSB: Analytical Skills.)

Exercise 14.2. A major barrier to international trade activities is the issue of trust. Even when importers and exporters are known to each other, there is a high degree of risk associated with international trade transactions, i.e., exporters want to be sure they’ll be paid and importers want to be sure they receive the full value of an order. Ask students to discuss the reasons letters of credit and the various forms of a draft help both importers and exporters overcome this challenge. Under what conditions might each instrument be preferred? (LO 14-3: Understand the startup and expansion of exporting , AACSB: Dynamics of the Global Economy.)

Exercise 14.3. Ask each student (or team of students) to choose a product to import to the United States from a foreign country market. Are there regulations regarding their chosen product that they would have to be aware of before importing? Have them look up the tariff for the product. Tariffs can be found on the United States International Trade Commission Web site (www.usitc.gov). (LO 14-2: Distinguish the motivations and methods of exporting, AACSB: Dynamics of the Global Economy.)

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Chapter 15 Direct Investment and Collaborative Strategies OBJECTIVES 15-1 Comprehend why export and import may not suffice for companies’ achievement of IB objectives 15-2 Explain why and how companies make wholly owned foreign direct investments 15-3 Ascertain why companies collaborate in international markets 15-4 Compare and contrast forms of and considerations for selecting an international collaborative arrangement 15-5 Grasp major reasons why IB collaborative arrangements fail or succeed

CHAPTER OVERVIEW Although most companies operating internationally would prefer exporting to other market entry modes, there are circumstances in which exporting may not be feasible. In these cases, companies may engage in direct investment in other countries, or enter markets through various collaborative strategies such as joint ventures and alliances. Collaborative strategies allow firms to spread both assets and risk across countries by entering into contractual agreements with a variety of potential partners. Chapter Fifteen first discusses reasons for not exporting and then explores the motives that drive firms to engage in noncollaborative and collaborative arrangements, as well as the various types of possible arrangements, including foreign direct investment, licensing, franchising, joint ventures, and equity alliances. It goes on to explore the various problems that may arise in FDI and collaborative ventures and concludes with a discussion of the various methods for managing these evolving arrangements.

CHAPTER OUTLINE OPENING CASE:

MELIÁ HOTELS INTERNATIONAL

Meliá Hotels International is a Spanish hotel chain founded by Gabriel Escarré in 1956.

Although Meliá has 43 percent of its hotels in Spain, international operations has been growing more rapidly. Some international expansion has come from acquisitions. Having acquired experience and expertise within Spain, the firm’s first start-up abroad was a joint venture for the Meliá Bali in Indonesia. Soon after, the company focused on Latin America and eventually on other areas such as Cuba, China, Africa, and the Middle East. Meliá has made and continues to use various operating modes: leasing, franchise, management contracts, and ownership (FDI).

Most of Meliá’s early international growth resulted from acquisitions. In 2018, more than two thirds of Meliá’s new operations were via management contracts, followed by leasing and franchise agreements.

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Questions 15-1. Explain the advantages for Meliá to own its hotels versus managing them for other organizations.

The main advantage of hotel ownership is control of the business’s value chain. While management contracts are popular in the hospitality industry, there is a risk of a breach of contract similar to what happened to Barceló in China. Barceló reached an agreement in 2000 with a Chinese state-owned company to manage the Shanghai International Convention Center & Hotel. However, the owners unilaterally terminated the contract even though Barceló brought the hotel back into profitability within six months.

15-2. Discuss the advantages and risks for Meliá in its non-equity joint venture with Jin Jiang.

The partnership between Shanghai Jin Jiang International Hotel Group and Meliá is a winwin for both companies. It gives Meliá access to the lucrative Chinese hospitality market and to new knowledge and expertise from China’s largest hotel chain. Similarly, the partnership gives Jin Jiang access to Europe. However, the partnership might carry some risks. Jin Jiang can gain access to Meliá ‘s critical and core services and could become a formidable competitor. (LO 15-2: To comprehend why and how companies make foreign direct investments, AACSB: Analytical Skills) Teaching Tips: Review the PowerPoint slides for Chapter Fifteen and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, review the figures in the text.

INTRODUCTION Companies must choose an international operating mode to fulfill their objectives and carry out their strategies. When forming objectives and implementing strategies in a variety of country environments, firms must either handle international business operations on their own or collaborate with other companies. Although exporting is usually the preferred alternative since it allows firms to produce in their home countries, participating in some markets may require using a variety of other equity and nonequity arrangements. These can range from wholly owned operations to partially owned subsidiaries, joint ventures, equity alliances, licensing, franchising, management contracts, and turnkey operations.

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WHY EXPORT AND IMPORT MAY NOT SUFFICE Companies may find more advantages to locating production in foreign countries than export to them. The advantages occur under six conditions: • When production abroad is cheaper than at home • When transportation costs are too high for moving goods or services internationally • When companies lack domestic capacity • When products and services need to be altered substantially to gain sufficient consumer demand abroad • When governments inhibit the import of foreign products • When buyers prefer products originating from a particular country [see Fig 15.2] 2 .

A. When It’s Cheaper to Produce Abroad Competition requires companies to control their costs and to choose production locations with costs in mind.

B. When Transportation Costs Too Much Some products and services become impractical to export after the cost of transportation are added to production costs. In general, the farther the target market is from the home country, the higher the transportation costs. Also, the higher transportation costs are relative to production costs, the more difficult it is to be competitive through exporting.

Some services are impossible to export and require establishing operations in the target country.

C. When Domestic Capacity Isn’t Enough As long as a company has excess capacity, it can service foreign markets and price on the basis of variable rather than full costs. When demand exceeds capacity, however, new facilities are needed and are often located nearer to the end consumers in other countries.

D. When Products and Services Need Altering Special requirements for products in some markets may require additional investments that are often better made in the country the company intends to sell to. The more that products must be altered for foreign markets, the more likely production will shift to those foreign markets.

E. When Trade Restrictions Hinder Imports Although import barriers have been on the decline, some significant tariffs continue to exist. In these situations, avoiding barriers through production in the target country must be weighed against other considerations such as the market size of the country and the scale of technology used in production. When barriers fall within a group of countries, companies may be attracted to make direct investments to serve the entire region since the expanded market may justify scale economies.

F. When Country of Origin Becomes an Issue Consumers may prefer goods produced in their own country to imports because of nationalistic feelings. For some products, consumers may prefer imported goods from specific countries due to a perception that those products are superior. Other considerations like the availability of service and replacement parts for imported products, or adoption of just-in-time manufacturing systems may influence production locations.

II. WHY AND HOW DO COMPANIES MAKE WHOLLY OWNED FDI Two forms of foreign direct investment (FDI) that do not involve collaboration are wholly owned operations and partially owned operations with the remainder widely held.

A. Reasons for Wholly Owned Foreign Direct Investment To qualify as a foreign direct investment, the investor must have control. This can be established with a small percentage of the holdings if ownership is widely dispersed.

The more ownership a company has, the greater its control over the management decisions of the operation. There are four primary explanations for companies to make a wholly owned FDI: market failure, internalization theory, appropriability theory, and freedom to pursue global objectives, appropriability theory, and freedom to pursue global objectives.

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1. Market Failure. The failure of the market to connect firms as collaborators will entice a company to enter with wholly owned operations only if it perceives having operating advantages to overcome its liability of foreignness.

2. Internalization. Control through self-handling of operations is known as internalization. Transactions cost theory holds that companies should organize operations internally when the costs of doing so are lower than contracting with another party to handle it for them. Internalization may result in lower costs because: • Different operating units with the same company likely share a common culture, which expedites communications • The company can use its own managers, who understand and are committed to carrying out its objectives • The company can avoid protracted negotiations with another company on such matters as how each will be compensated for contributions • The company can avoid possible problems with enforcing an agreement 3. Appropriability. Appropriability theory is the idea that companies want to deny rivals and potential rivals access to resources such as capital, patents, trademarks, and management know-how that might be captured through collaborative agreements.

4. Freedom to Pursue a Global Strategy. When a company has a wholly owned foreign operation, it may more easily have that operation participate in a global strategy. Furthermore, the fact that most countries have laws to protect minority shareholders’ interest means that sharing of ownership may restrict a company from implementing a global strategy.

B. Acquisition versus Greenfield FDI usually involves international capital movement, but could also involve the transfer of other assets, such as managers or cost control systems. Companies can either acquire an interest in an existing company or construct new facilities, known as a greenfield investment.

1. Acquisition. Companies may acquire existing operations in order to avoid adding further capacity to the market, to avoid start-up problems, obtain easier financing, and get an immediate cash flow rather than tying up funds during construction. A company may also save time, reduce costs, and reduce risks by buying an existing company.

2. Making Greenfield Investments. Companies may choose to build if no suitable company is available for acquisition, if the acquisition is likely to lead to carry-over problems, and if the acquisition is harder to finance. In addition, local governments may prevent acquisitions because they want more competitors in the market and fear foreign domination.

3. Leasing. This is much like an acquisition, but one that forgoes the need to invest.

III. WHY COMPANIES COLLABORATE Each participant in a collaborative arrangement has its own basic objectives for operating internationally as well as its own motives for collaborating with a partner. [see Fig 15.3]

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A. General Motives for Collaborative Arrangements Companies collaborate with other firms in either their domestic or foreign operations in order to spread and reduce costs, to specialize in particular competencies, to avoid or counter competition, to secure vertical and/or horizontal linkages, and to learn from other companies.

1. To Spread and Reduce Costs. When the volume of business is small, or one partner has excess capacity, it may be less expensive to collaborate with another firm. Companies should periodically reappraise the question of internal versus external handling of their operations.

2. To Specialize in Competencies. The resource-based view of the firm holds that each firm has a unique combination of competencies. Thus, a firm can maximize its performance by concentrating on those activities that best fit its competencies and relying on partners to supply other products, services, or support activities.

3. To Avoid or Counter Competition. When markets are not large enough for numerous competitors, or when firms need to confront a market leader, they may band together in ways to avoid competing with one another or combine resources to increase their market presence.

4. To Secure Vertical and Horizontal Links. If a firm lacks the competence and/or resources to own and manage all of the activities of the value-added chain, a collaborative arrangement may yield greater vertical access and control. At the horizontal level, economies of scope in distribution, a better smoothing of sales and earnings through diversification, and an ability to pursue projects too large for any single firm can all be realized through collaboration.

5. To Gain Knowledge. Many firms pursue collaborative arrangements in order to learn about their partners’ technology, operating methods, or home markets and thus broaden their own competencies and competitiveness over time.

B. International Motives for Collaborative Arrangements Companies collaborate with other firms in their foreign operations in order to gain location-specific assets, overcome legal constraints, diversify geographically, and minimize their exposure in high-risk environments.

1. To Gain Location-Specific Assets. Cultural, political, competitive, and economic differences among countries create challenges for companies that operate abroad.

To overcome such barriers and gain access to location-specific assets (e.g., distribution access or a competent workforce), firms may pursue collaborative arrangements with local companies.

2. To Overcome Governmental Constraints. Countries may prohibit or limit the participation of foreign firms in certain industries, or discriminate against foreign firms via tax rates and profit repatriation. Firms may be able to overcome such barriers via collaboration with a local partner. It is also helpful to have a collaborative relationship with a local firm to protect assets. Some countries provide protection only if intellectual property is exploited locally within a specified time period. Local partners can monitor the illegal usage of the firm’s intellectual property.

3. To Diversify Geographically. By operating in a variety of countries, a firm can smooth its sales and earnings; collaborative arrangements may also offer a faster 5 .

initial means of entering multiple markets or establishing multiple sources of supply.

4. To Minimize Risk Exposure. The higher the risk managers perceive with respect to a foreign operation, the greater their desire to form a collaborative arrangement.

IV. FORMS OF AND CHOICE OF COLLABORATIVE ARRANGEMENTS A. Some Considerations in Choosing a Form 1. Trade-offs and Limitations. Operating modes for foreign operations differ in the amount of resources a company commits and the proportion of the resources it locates abroad. In this respect, there are trade-offs. Furthermore, a company may be limited in entering a market with its preferred operating mode.

2. What’s the Purpose? Alliance Types. Alliances vary by objective and by place in the value chain. These variances have led to terms that describe different types.

Scale alliances aim to provide efficiency for partners by pooling similar operations such as airlines have done by combining their lounges. In a link alliance, firms use their partners’ complementary resources to expand into a new business. A vertical alliance connects firms in different links of their value chains, such as a food franchiser with a franchisee. A horizontal alliance, such as the Mexican joint venture between Mercedes and Infiniti, enables each partner to extend its product offerings (in this case, a new compact car) on the same level of the value chain.

Coopetition, such as the Mercedes-Infiniti example, refers to collaboration while competing.

3. Prior Company Expansion. Companies’ experience and assets in a foreign country influence their choices of operating mode when introducing new products or businesses.

4. Compensation. Collaboration also implies sharing revenues and knowledge. How to divide revenue is not clear-cut because many variables influence the outcome.

Factors such as government mandates, partners’ perception of risk, and competitive constraints are all important in the agreement.

POINT-COUNTERPOINT: Should Countries Limit Foreign Control of Key Industries?

POINT: Countries should limit foreign control of key industries in order to protect their economic and security interests, especially in key industries such as transportation, mass media, and energy. History has shown that home governments have used powerful foreign companies to influence policies in the countries where they operate, and that foreign companies have used their home governments as instruments to improve their interests in a country. Whenever a company is controlled from abroad, decisions about that company can be made abroad, possibly to the detriment of the host country.

COUNTERPOINT: Decisions made by foreign companies are not likely to be much different than decisions made by local companies. MNEs staff their foreign subsidiaries mainly with nationals of the countries where they operate, and make decisions based on a good deal of local advice. Their decisions have to adhere to local laws and consider the views of suppliers and customers. Protection of certain industries from foreign control could reduce competitiveness in 6 .

those industries and harm, rather than help, the local people. Those who argue for limits are relying on the outdated dependencia theory, which holds that emerging economies have practically no power in their dealings with MNEs. More recent bargaining school theory states that the terms for a foreign investor’s operations depend on how much the investor and host country need the other’s assets. Countries and foreign companies need each other, and both will lose if limitations are placed on foreign control.

A. Licensing Under a licensing agreement, a firm (the licensor) grants rights to intangible property to another company (the licensee) to use in a specified geographic area for a specified period of time; in exchange, the licensee ordinarily pays a royalty to the licensor. Such rights may be exclusive or nonexclusive. Usually, the licensor is obliged to furnish technical information and assistance, while the licensee is obliged to exploit the rights effectively and pay compensation to the licensor. Intangible property may be classified as: • Patents, inventions, formulas, processes, designs, patterns • Copyrights for literary, musical, or artistic compositions • Trademarks, trade names, brand names • Franchises, licenses, contracts • Methods, programs, procedures, systems 1. Major Motives for Licensing. Licensing often has an economic motive, such as the desire for faster start-up, lower costs, or access to additional resources (e.g., technology). For the licensor, the risks and costs of a given venture are lessened; for the licensee, costs are less than if it had to develop a product or process on its own. Cross-licensing represents the situation in which companies in various countries exchange technology rather than compete with each other with every product in every market.

2. Payment Considerations. The amount and type of payment for licensing arrangements may vary. Each contract tends to be negotiated on its own merits; the bargaining range is based on dual expectations. Both agreement-specific and environment-specific factors may affect the value of a license. Companies commonly negotiate a “front-end” payment to cover transfer costs when technology is involved. In addition, they usually charge fees based on actual usage. Licensors of technology do this because it usually takes more than simply transferring explicit knowledge, such as through reports. The move requires the transfer of tacit knowledge as well, such as engineering.

3. Licensing to Subsidiaries. Many licenses are given to firms owned in part or in whole by the licensor. From a legal standpoint, subsidiaries are separate companies; thus, a license may be required in order to transfer intangible property.

B. Franchising Franchising represents a specialized form of licensing in which the franchisor not only sells an independent franchisee the use of the intangible property essential to the franchisee’s business, but also operationally assists the business on a continuing basis.

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In a sense, the two partners act like a vertically integrated firm because they are interdependent and each produces a part of the product that ultimately reaches the customer.

1. Franchise Organization. A franchisor may penetrate a foreign country by dealing directly with its foreign franchisees, or by setting up a master franchise and giving that organization the right to open outlets on its own or to develop subfranchises in the country or region.

2. Operational Modifications. Franchise success is derived from three factors: product standardization, effective cost control, and high identification through promotion. Nonetheless, franchisors face a classic dilemma: the more they standardize on a global basis, the lower the potential for product acceptance in a given country; the more they permit adaptation to local conditions, the less the franchisor can offer the franchisee, the higher the costs and the less the control by the franchisor.

C. Management Contracts A management contract represents an arrangement in which one firm provides management personnel to perform general or specialized functions to another firm for a fee. A firm usually pursues such contracts when it believes a partner can manage certain operations more efficiently and effectively than it can itself.

D. Turnkey Operations Turnkey operations represent a type of collaborative arrangement in which one firm contracts with another to build complete, ready-to-operate facilities. Usually, suppliers of turnkey facilities are industrial-equipment and construction companies; projects may cost billions of dollars; customers most often are government agencies or large MNEs. 1. Contracting to Scale. One characteristic that sets the turnkey business apart from most other international business operations is size of the contract.

2. Making Contacts. The nature of the business requires executives with top-level contacts abroad.

3. Marshaling Resources. Many turnkey operations are in remote areas and necessitate massive housing construction and the importation of personnel.

E. Joint Ventures (JVs) Although usually thought of as 50/50 companies, JVs may nonetheless involve more than two companies and ones in which a partner owns more than 50 percent. When more than two organizations participate, the venture is sometimes called a consortium.

JVs may also involve a partner owning over 50 percent, such as ANA’s ownership of 67 percent in Air Asia Japan. [see Figure 15.4].

1. Possible Combinations. Examples of combinations of JV partnerships include: • Two companies from the same country joining together in a foreign market (e.g., NEC and Mitsubishi [Japan] in the United Kingdom) • A foreign company joining with a local company (e.g., Barrick [Canada] and Zijin Mining Group in China) • Companies from two or more countries establishing a joint venture in a third country (e.g., Mercedes-Benz [Germany] and Nissan [Japan] in Mexico) • A private company and a local government forming a joint venture, or mixed venture (e.g., Mitsubishi [Japan] with the government-owned Exportadora de Sal in Mexico) 8 .

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A private company joining a government-owned company in a third country (e.g., BP Amoco [private British-U.S.] and Eni [government-owned Italian] in Egypt) F. Equity Alliances An equity alliance represents a collaborative arrangement in which at least one of the collaborating firms takes an ownership position (usually a minority) in the other(s). The purpose of an equity alliance is to solidify a collaborating contract, thus making it more difficult to break.

V. WHY COLLABORATIVE ARRANGEMENTS FAIL OR SUCCEED All collaborative arrangement parties must be satisfied with performance; otherwise, the arrangement may fail.

A. Reasons for Failure The major strains on collaborative arrangements are due to five factors: • Relative importance to partners • Divergent objectives • Control problems • Comparative contributions and appropriations • Differences in culture 1. Relative Importance. One partner may give more attention to the collaboration than the other—often because of a difference in size. An active partner will blame the less active partner for its lack of attention, while the less active partner will blame the other for poor decisions.

2. Divergent Objectives. Although firms may enter into collaborative arrangements with complementary capabilities and objectives, their views regarding such things as reinvestment vs. profit repatriation and desirable performance standards may evolve quite differently over time.

3. Questions of Control. When no single party has control of a collaborative arrangement, the venture may lack direction; if one party dominates, it must still consider the interests of the other. By sharing assets with another firm, a company may lose some control over the extent and/or quality of the assets’ use. Further, even when control is ceded to one of the partners, both may be held responsible for problems.

4. Comparative Contributions and Appropriations. One partner’s ability to contribute technology, capital, and other assets may diminish (at least on a relative basis) over time. Further, in almost all collaborations the danger exists that one partner will use the other’s contributed assets, or take more than its fair share from the operation, thus enabling it to become a direct competitor. Such weaknesses may cause a drag on a venture and even lead to the dissolution of the agreement.

5. Culture Clashes. Differences in both national and corporate cultures may cause problems with collaborative arrangements, especially joint ventures. a. Differences in Country Cultures. Firms differ by nationality in terms of how they evaluate the success of an operation (e.g., profitability, strategic market position, and/or social objectives). Nonetheless, joint ventures from culturally distant countries tend to survive at least as well as those between partners from similar cultures.

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b. Differences in Corporate Cultures. In addition to national culture, differences in corporate culture may create problems for joint ventures. For example, some firms may have an entrepreneurial culture and others are risk averse.

Compatibility of corporate cultures is important to the success of joint venture projects.

B. Helping Collaborative Operations Succeed Aside from awareness of and adjustment to the pitfalls we have discussed, the following considerations help assure success when choosing among and managing operating forms: • Fitting modes to country differences • Finding and evaluating partners • Negotiating agreements: The question of secrecy • Controlling through contracts and trust • Evaluating continually • Adjusting the internal organization 1. Fitting Modes to Country Differences. A company should ordinarily commit more of its IB resources to those markets that are most attractive and fit best with its strategies and competence. The choice of operating mode directly affects this resource allocation inasmuch as different modes commit different levels of resources and different portions of those resources abroad. Figure 15.5 illustrates a matrix relating country attractiveness, a company’s competitive strength per country, and operating forms.

2. Finding and Evaluating Potential Partners. Partner pairing should depend on mutual assessment of each other’s resources, motivation, and compatibility.

3. Negotiating the Arrangement. The Question of Secrecy. Numerous collaborative arrangements involve technology transfers. Because the value of many technologies would diminish if they were widely used or understood, technology owners have historically insisted on including contract provisions whereby recipients will not divulge such information.

4. Controlling Through Contracts and Trust. Although both trust and contracts have control limitations, there are provisions that should be included in any collaborative agreement.

5. Evaluating Continually. Contracting with a capable and compatible partner is necessary but insufficient to ensure success. A company must continually assess partners’ performance and periodically assess the need for change in the type of collaboration.

6. Adjusting Within the Internal Organization. As companies change operating modes, they encounter pressures necessitating organizational adjustments. These include organizational application of what they have learned and the need to alter group and individual evaluations as operating forms change. a. Learning and Its Applications. Evidence suggests that companies’ collaborative performance improves with experience. However, improvement is most associated with similar types of collaborations, such as applying what a firm has learned from JV operations in one country to JVs in another country.

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b. Pressures from Switching Collaborative Modes. Changes in operating mode, such as from exporting to foreign production to serve a market, cause some individuals to gain and others to lose responsibilities.

LOOKING TO THE FUTURE: Growth in Project Size and Complexity More than a half-century ago, John Kenneth Galbraith postulates that because the cost of development is often so high, it can only be carried out with firms of considerable size.

Galbraith’s conclusion overlooks several factors. Although firms can become ever larger through mergers and acquisitions, collaborative arrangements are likely to be increasingly important in the future as governments opt to restrict such activities because of antitrust concerns. At the same time, companies might not be able to internalize the breadth of technology necessary to solve these big problems. Also, most product development is much more modest than required to unravel the gigantic projects. Collaborative arrangements will bring forth both opportunities and problems as firms move simultaneously into new countries and to new types of contractual arrangements with new partners. The more partners in a given alliance, the more strained the decision-making and control processes will likely be.

CLOSING CASE: The Oneworld Airline Alliance [see Map 15.2] The airline industry is almost unique in that its need to form collaborative arrangements has been important almost from the start of international air travel because of cost, regulatory, and competitive factors. In recent years, this need has accelerated because of airlines’ difficult profit performance. No single airline has the capacity to serve the whole world, yet passengers want to travel the whole world with a seamless experience. Thus, airlines have increasingly worked together to provide more seamless experiences for passengers and to cut costs. Several notable regulatory changes have occurred in recent years. First, the U.S. domestic market has been deregulated. Once deregulation was instituted, many U.S. airlines were competitively forced out of business. Second, similar deregulation within Europe influenced the demise of some airlines.

The high cost of maintenance and reservations systems and the need to spread costs have led to cooperation involving multiple airlines from multiple countries in the form of JVs and alliances such as the oneworld Alliance which comprises 15 airlines. These alliances allow for considerable cooperation, such as code-sharing; however, antitrust regulations (unless given immunity) prohibit their members from coordinating routes, schedules, and prices.

Questions 15-3. Companies within the oneworld, Star, and Sky Team alliances have also engaged in major mergers and acquisitions (M&A): American and US Air (oneworld), Delta and Northwest (Sky Team), and Continental and United (Star). What are the advantages and disadvantages of M&A versus non-equity alliances in this industry?

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M&A can help airlines reduce costs (urgently needed during economic and financial crisis), reach a broader customer base, and access new routes. For the consumer, M&A could result in improved services. However, the M&A might lead to reduction in competition, higher fares, and a lower number of flights. Also, M&A can be difficult to implement due to government regulations, labor issues, and technical challenges such as the combination of accrued frequent flyer passenger points. On the other hand, non-equity alliances involves less resource commitment. It also allows airlines to maintain a level of autonomy and independence. (LO 15-5: Grasp major reasons why IB collaborative arrangements fail or succeed, AACSB: Analytical Skills) 15-4. Some airlines, such as Southwest, have survived as niche players without extensive international connections. Can they continue this strategy?

Southwest is one of the very few airlines that are consistently profitable. There are several reasons for this profitability and their model has been widely copied by other low-fare carriers, particularly in Europe. Recently Southwest has announced some codeshare agreements with WestJet of Canada and Volaris of Mexico. The implementation of these agreements has yet to be completed. This does show that even a niche player like Southwest recognizes the benefits of alliances. (LO 15-2: Explain why and how companies make wholly owned foreign direct investments, AACSB: Analytical Skills.)

15-5. Why should an airline not be able to establish service anywhere in the world simply by demonstrating that it can and will comply with the local labor and business laws of the host country?

If it were only that easy to expand, but governments continue to limit expansion and it isn’t necessarily about labor or business laws. Airlines are a protected industry because they play a role in national security. The U.S. uses commercial carriers to transport troops. With the increased terrorist attacks, like the 2009 Christmas Day attempt, countries are worried about protecting their airspace. Protectionism also plays a role. Domestic airlines fly the lucrative internal routes and the continued health of domestic airlines is a priority for governments.

(LO 15-3: Ascertain why companies collaborate in international markets, AACSB: Analytical Skills.)

15-6. The U.S. law limiting foreign ownership of U.S. airlines to no more than 25 percent of voting shares was enacted in 1938. Is this law an anachronism, or are there valid reasons for having it today?

Responses and opinions may vary. Although foreign ownership might benefit the consumer, public opinion, national pride and security fears (since 9/11) have given more legitimacy to U.S. law limiting foreign ownership. In fact, security concerns will likely continue to reinforce foreign ownership restrictions. (LO 15-5: Grasp major reasons why IB collaborative arrangements fail or succeed, AACSB: Analytical Skills)

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15-7. Many airlines have sometimes been no more than marginally profitable. Is this such a vital industry that governments should intervene to guarantee survival? If so, how?

Industry bailouts have been prevalent in 2008 and 2009, from financial institutions to the auto industry. Post 9/11, President Bush signed into law the Air Transportation Safety and Stabilization Act that compensated airlines for mandatory grounding of flights. This was a one-time bailout based on extraordinary circumstances. The question is, should the government bail out the industry due to underlying profitability concerns? Individual airlines have been allowed to fail and consolidation has occurred in the airline industry without government intervention. An underlying economic pressure is the price of fuel and Southwest’s hedging programs have allowed it to be profitable when others have been in the red. Now that the economy is showing some signs of recovery, the political pressure has increased for less government intervention in the economy. Does the government value this industry? Absolutely, for the many reasons outlined in the case. Will it be necessary for them to intervene at the industry level? Time will tell. (LO 15-5: Grasp why IB collaborative arrangements fail or succeed, AACSB: Analytical Skills.)

Additional Exercises: Collaborative Strategies Exercise 15.1. Ask the students to identify several foreign-owned companies with operations in their local area. Are these companies viewed as good corporate citizens and contributors to the local community? Do they employ mostly local people or do they have a large number of expatriates? How do the wages paid by these companies compare to those of other companies in the same industry? (LO 15-1: To clarify why companies may need to use modes other than exporting to operate effectively in international business, AACSB: Multicultural and Diversity Understanding.)

Exercise 15.2. Assume that a company near you wanted to expand into foreign markets.

What issues should that company explore before deciding whether to export or to engage in foreign direct investment? (LO 15-2: To comprehend why and how companies make foreign direct investments, AACSB: Analytical Skills.)

Exercise 15.3. Ask students to name companies, both domestic and foreign, that operate internationally. Then ask them to discuss the potential types of collaborative arrangements they feel would be appropriate for the various firms. Conclude the discussion by examining the list of firms and asking students if there are particular industries that seem to lend themselves to particular types of collaborative arrangements more readily than others. Be sure the students discuss why this might be so. (LO 15-4: To define the major types of collaborative arrangements, AACSB: Dynamics of the Global Economy.)

Exercise 15.4. Identify the various home countries of students in your class. Then lead the class in a discussion of the likely types of collaborative arrangements foreign firms might pursue in those countries. Be sure students cite the various economic, political, and cultural factors that would influence decisions regarding viable collaborative strategies. (LO 15-5: Grasp major reasons why IB collaborative arrangements fail or succeed, AACSB: Analytical Skills) 13 .

Exercise 15.5. While offering desirable advantages, licensing agreements also limit the amount of control a licensor can exercise over a foreign production process. Engage the students in a discussion of the type of firm that would most likely be willing to allow a licensee to use its established brand name and the type of firm that would not be willing to do so. Explore the reasons for each position as well as the reasons a licensee would be willing to accept a license that did not include rights to the use of the associated brand name.

(LO 15-4: To define the major types of collaborative arrangements, AACSB: Dynamics of the Global Economy.)

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Chapter 16 The Organization of International Business OBJECTIVES 16-1 Discuss the idea of an organization 16-2 Interpret classical organization structures 16-3 Interpret neoclassical organization structures 16-4 Differentiate the systems used to coordinate international activities 16-5 Differentiate the systems used to control international activities 16-6 Explain the principle and practices of organizational culture

CHAPTER OVERVIEW Structuring an organization is a complex task made even more complex when the organization spans national boundaries. Chapter Sixteen examines the ways in which firms group their operations in order to implement their strategies and control processes, as well as the role of organizational culture. The chapter begins with a discussion of the principles of organization and then explores the dynamics of various organizational structures. It considers the trade-offs between centralizing and decentralizing the decision-making process and discusses the various mechanisms that can be used to help ensure control measures are in fact implemented. The chapter concludes with an examination of organization in special situations such as acquisitions and shared ownership as well as the role of legal structures.

CHAPTER OUTLINE OPENING CASE:

ORGANIZING GLOBAL OPERATIONS: THE “GORE WAY”

Since 1958, W. L. Gore & Associates have built a global reputation as “the world’s most innovative company.” Notwithstanding its discoveries, many contend that Gore’s supreme invention is setting and sustaining a stunningly effective global organization. Gore’s locations in China, France, Germany, Italy, Korea, Sweden, and the UK have been named one of the respective nation’s best workplaces. Globally, Gore gains accolades. Assessment centered on issues of mutual trust, esprit de corps and camaraderie, and supportiveness of the work environment. Gore, headquartered in Newark, Delaware, is one of the 200 largest privately held companies in the United States; it had more than $3 billion in sales in 2016. Since its establishment, the company founder, Bill Gore, puts into play then, and still today, far-reaching management ideas on organization, enterprise, accountability, and authority. Or, in company shorthand, the “Gore Way.” He installed a flat organization whereby everyone could freely talk with anyone else, no matter their role or rank. Everyone was and, to this day, is an “Associate.”

Liberated from a rigid bureaucracy, Associates make decisions based on knowledge and initiative rather than seniority and titles. Continuing growth, fueled by expanding 1 .

internationalization, has led Gore to formalize some elements of its organization. Going forward, Associates look to meld the Gore Way with the transformational connection, communication, and collaboration technologies unleashed by the Internet.

Questions 16-1. The World Economic Forum, noting that the world of work is changing, emphasizes the importance of complex problem-solving, critical thinking, creativity, and dealing with ambiguity to effective executive performance. Estimate how these skills would support your performance as an Associate at W. L. Gore.

According to the article, the conditions at W. L. Gore warrant an employee who can work as a team member. As they look to expand their markets abroad, they acknowledge the climate may change. So far, their global operations have been able to operate in a “niche.”

Associates will need to balance the “niche”-like environment while building global teams.

This will undoubtedly bring ambiguity. Critical thinking in how to the Gore philosophy may look when it is another country (LO 16-6: Explain the principle and practices of organizational culture, AACSB: Analytical Skills.)

16-2. Identify two reasons that encourage you to work for W. L. Gore. Then, identify two that discourage you. Based on these, what would you decide to do?

One of the most important aspects is how the current employees feel about the company.

The awards of the company, Best Places to Work and World’s Best Multinational Workplaces, may illustrate how the employees feel about the workplace. I also like the way the teams are tightknit and are reminded to consider the colleagues and company (communication) in their work. In many way the close team and communication across individual talent drives a community environment, but it can also slow down the global reach of the company. Also, the “family” owned business, may cause challenges in the future between family members. (LO 16-6: Explain the principle and practices of organizational culture, AACSB: Analytical Skills.)

Teaching Tips: Review the PowerPoint slides for Chapter Sixteen and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures in the text. In addition, have students visit the Web site of J&J, http://www.jnj.com, where they will find a link for “Our Company.” This Web page provides greater information on the company’s values and credo. Have students report back what they have found.

INTRODUCTION Designing an organization that adeptly runs activities worldwide, all the while ingeniously reconciling the competing pressures for global integration and local differentiation, is an enduring challenge for MNEs. The idea of an organization refers to the activities that managers engage to build the structure, systems, and culture needed to implement a strategy within the general context of the external environment (see Figure 16.1).

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THE IDEA OF AN ORGANIZATION An MNE’s organization reflects its market circumstances, strategic choice, value chain configuration, administrative legacy, and executive preferences.

II. CLASSICAL ORGANIZATION STRUCTURES The formal arrangement of roles, responsibilities, and relationships in the MNE represents its organization structure. Managers configure the elements of the company’s workflow to stipulate the lines of authority and communication, assign rights and duties, and set connections between units. These decisions often spell the difference between success and failure. Designing an organization typically begins by determining the ideal structure for arranging individuals and units to implement the MNEs strategy—indeed, a long-running thesis in management theory holds that “structure follows strategy”. Making sense of the strategy-structure situation forces a cascade of decisions. Many managers begin by resolving (1) the degree of vertical differentiation (deciding who has what authority to make which decision) and (2) the degree of horizontal differentiation (the task of specifying which people in which units do which jobs).

A. Vertical Differentiation No matter the mix of markets, products, or ambitions, MNEs face competing calls for global integration and local responsiveness. They key question is who has the authority to make what decision. If the plan is to make those issues headquarters’ call, then managers must build an organization that supports that outlook. Conversely, if the plan is to have those calls made by local subsidiaries, then, again, managers must build an organization to support that outlook. More formally, managers reconcile this tension by vertically differentiating the company’s structure in terms of the centralization (how high up) versus the decentralization (how low down) of decision-making [see Table 16.1].

1. Structure Follows Strategy. The choice of centralization versus decentralization is not an either-or proposition. Some activities spur centralized decision-making.

Likewise, other activities encourage decentralized decision-making.

2. Technology, Balance, and Globality. Technology increasingly alters the calculus of who should have the authority to make which decision. The Internet, for example, progressively makes it easier for executives at headquarters as well as subsidiaries to track global conditions and local performance in real time.

Consequently, MNEs fine-tune decision-making for growing globality in which “business flows in every direction.

B. Horizontal Differentiation Vertically speaking, MNEs run from top (the CEO) to the bottom (the entry-level worker). Horizontally speaking, MNEs run sideways from function to function, such as research to production to marketing to finance. Horizontal differentiation involves assigning specific tasks to specific people in specific functions. Horizontally differentiating on the basis of business activity anchors the functional structure; doing so on the basis of product or geography installs a divisional structure, and doing so on the basis of a combination results in a matrix or mixed structure. The long-running use of these formats by MNEs designates them as classical structures.

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C. The Functional Structure The functional structure, as depicted in Figure 16.2, organizes the company’s operations by business functions (i.e., production people work with production people, marketing people work with marketing people, finance people work with finance people). Each group’s responsibility for its function worldwide sets precise roles and relationships.

1. Drawbacks. Horizontally differentiating people and processes by business function constrains the development of cross-functional knowledge-generating and decisionmaking relationships. Consequently, coordinating different functional units, in response to a market disruption or strategic change, is difficult.

D. Divisional Structures The divisional structure follows from executives’ choice to organize work in terms of the products they make, services they provide, or the places they sell. That is, the MNE can organize in terms of product (e.g., medical devices, pharmaceutical processing, consumer products, industrial components, and aerospace electronics for a consumer products firm), services (e.g., retail, commercial, investing, and asset management for a bank), or markets (e.g., North America, Europe, Africa, and Asia for a geographically diversified company).

1. International Division. An MNE prefers this format when its international activities represent a small share of its total activity. It charges a separate, standalone operating unit with responsibility for overseas activities [see Figure 16.3]. a. Drawbacks. Disaggregating an MNE into domestic-international divisions can fan “us versus them” tensions, thereby blocking cross-division connections.

Conflict between domestic and international units obstructs sharing competencies, leveraging best practices, and exploiting experience effects.

2. Worldwide Product Division. Product divisions are very popular among international companies today because most companies’ businesses involve a variety of diverse products. This structure is well suited for a global strategy and enhances a company’s ability to sell or spin off certain product lines. [see Figure 16.4]. a. Drawbacks. The autonomy of each product division means that different subsidiaries from different product divisions within the same foreign country often report to different executives at headquarters. Unless safeguarded, coordination problems create inefficiencies.

3. Worldwide Area Division. An MNE uses geographic divisions when its sales are not dominated by a single country or region. Typically, its activities are evenly distributed across multiple markets. In this scenario, an MNE horizontally differentiates activities by geography, whereby Division Alpha is responsible for region/country A, Division Beta takes region/country B, and so on. [see Figure 16.5]. a. Drawbacks. Conducting similar organizational activities in several places increases administrative inefficiency.

4. The Matrix Structure A global matrix structure horizontally differentiates the MNE along two dimensions; as shown in Figure 16.6, those dimensions are geography and product.

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Interlacing different types of divisions integrates units that are sensitive to competing pressures. Requiring managers from both divisions to negotiate mutually agreeable plans, goes the reasoning, infuses both perspectives into decision-making, thereby more effectively reconciling integration and responsiveness pressures. Organizing the workflow in an organization encourages instituting a matrix structure. a. Drawbacks. In principle, the global matrix structure promotes cross-divisional communication and multifunctional collaboration. In practice, organizational politics fans competition for resources and rewards. Unchecked, gamesmanship threatens collaboration, thereby short circuiting the knowledge-generating and decision-making relationships that were the original promise of the matrix.

Conducting similar organizational activities in several places increases administrative inefficiency. A matrix structure also institutes a dual hierarchy that runs afoul of the unity-of-command principle. This notion holds that an unbroken chain of command should flow through the levels of the hierarchy, beginning with the CEO down to the entry-level employee. Giving one worker two bosses, by blurring lines of responsibility, creates conflicting lines of command and nebulous accountability 5. The Mixed Structure Firms seldom if ever get all of their activities to neatly correspond to a single organizational structure. A mixed structure combines various functional, area, and product dimensions, particularly with respect to foreign operations, due to legacies, executive preferences, and other circumstances.

III. NEOCLASSICAL STRUCTURES Some MNEs adopt neoclassical structures to organize different approaches to horizontal and vertical differentiation that broaden relationships, expand communication, and promote collaboration. In absolute terms, neoclassical formats serve the same purpose as do their classical counterparts. They stipulate how an MNE organizes its workplace, utilizes resources, administers systems, and specifies authority, rights, and responsibilities.

However, neoclassical structures do so in ways that differ radically, notably moving from organizing the boundaries that define a hierarchy to achieving the boundarylessness that marks a heterarchy.

A. The Challenge of Boundaries In practical terms, boundaries are (1) vertical divisions that separate employees into specific slots, each marked by explicit superior-subordinate roles, in the hierarchy and (2) horizontal divisions that follow from having specific employees do specific jobs in specific units. In a classical structure, vertically and horizontally differentiating the workflow leads to specifying precise rules, responsibilities, and relationships—each, in turn, institutes a boundary.

B. The Quest of Boundarylessness In practical terms, boundaries are (1) vertical divisions that separate employees into specific slots, each marked by explicit superior-subordinate roles, in the hierarchy and (2) horizontal divisions that follow from having specific employees do specific jobs in specific units. In a classical structure, vertically and horizontally differentiating the 5 .

workflow leads to specifying precise rules, responsibilities, and relationships—each, in turn, institutes a boundary.

C. The Network Structure The network structure, a leading neoclassical format, arranges roles, relationships, and responsibilities in a patterned flow of activity that allocates people and resources to decentralized projects. [see Fig 16.7]. The network structure minimizes rules and regulations processes in order to preempt potential boundaries.

1. Networks Aren’t New. The network structure is not unprecedented. Japanese MNEs have long used the so-called keiretsu format, an integrated collective of nominally independent companies in which each owns a share of the others.

Keiretsus rely on long-term personal relationships among the companies’ executives.

D. The Virtual Structure A virtual structure uses technologies to connect otherwise detached entities (from employees to entire enterprises).

E. Neoclassical Structures: Practical Problems Like its classical counterparts, neoclassical structures have limits. Networks are intrinsically dynamic structures, spurring adaptive reconfiguration, responsive coordination, and real-time control. Organizing something that continually evolves poses problems.

POINT—COUNTERPOINT: The Hierarchical Structure: The Superior Format POINT: Proponents of hierarchy argue that this format is the enduring foundation for how managers across the world determine the optimal degree of work specialization. Since the early twentieth century, hierarchical structures have provided a powerful framework that has guided the international expansions of thousands of companies. The absolute clarity of hierarchy enables companies to develop sophisticated planning and control systems. Supporters of a hierarchy system of organization recognize that technological and other changes require some adaptation in structure, but not the discarding of the basic principles.

COUNTERPOINT: In contrast, some argue that a new organizational form helps companies identify and exploit opportunities ahead of their competitors. Often, hierarchy organizes information flows in ways that work against integrating all the pieces. Hyperarchy can unleash the intrinsic motivation of employees and increase innovation. The hyperarchy structure also provides a format that remedies the intrinsic limitations of the hierarchy as well as positions a company to better deal with the emerging environment of globalization. Changes in the environment have ushered in a need for organizational change. In our view, the neoclassical heterarchy, not the classical hierarchy, meets the challenge of changing market situations, shifting technological frontiers, and radical workflow resets. _____________________________________________

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IV. COORDINATION SYSTEMS Systems are the framework of processes and procedures used to ensure that an organization can fulfill all tasks required to achieve its objectives. MNEs use several coordination systems to synchronize, integrate, and regulate value activities across the units of its organization.

A. Coordination by Standardization Companies with widely dispersed operations often standardize the ways that employees do their jobs and deal with customers. Standardization sets universal rules and procedures that apply worldwide and enforces consistency in performance of activities in geographically dispersed units. Rules and regulations about how employees interact, also called formalization, aims to reduce workplace uncertainty and simplify the exchange of ideas and resources. Standardization is undermined when frequent exceptions to rules are made, and is best suited for strategies that champion constancy and predictability in stable industries.

1. Challenges. Differences in industry conduct and host-government attitudes complicate coordination by standardization. Market circumstances, strategic goals, or workflow patterns often prevent specifying universal policies and procedures. Too, often they do not fit every situation in every unit in every country.

B. Coordination by Plan This type of coordination requires interdependent units to meet common deadlines and objectives. MNEs following a multidomestic strategy may opt to establish objectives and schedules that give interdependent units greater discretion in developing coordination systems.

1. Challenges. Notwithstanding a plan’s brilliance, the unexpected is ever-present.

Market disruptions, government regulations, mergers and acquisitions, to name just a few, cause big changes. Cultural differences routinely pose complications. Absent rules regulating relationships, cultural divergence increases the time, expense, and errors in cross-national exchange.

C. Coordination by Mutual Adjustment Coordination by mutual adjustment requires managers to interact with counterparts to enable flexible coordination mechanisms, largely informally. MNEs that opt to encourage mutual adjustment also adopt a formal structure and install standardization and planning systems, but they see great value in engaging an adaptable approach to coordination that involves creating more opportunity and incentive for parties to work with one another. Mutual adjustment can be a very effective coordination tool when an MNE faces new problems that cannot be defined with customary rules or procedures.

Coordination by mutual adjustment taps various methods.

1. Challenges. Coordination by mutual adjustment imposes tough demands, especially as globalizing markets press companies to support customers through traditional methods as well as virtual formats. The MNE opting for coordination via mutual adjustment must facilitate collaboration among associates in different parts of the world.

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V. Control Systems Every MNE must regulate what its employees can and cannot do in order to avoid spinning out of control. Control systems must ensure that people are doing what they are supposed to do and not doing what they are not supposed to do.

A. Bureaucratic control emphasizes organizational authority and relies on rules and regulations.

B. Market control uses external market mechanisms to set standards that regulate performance.

C. Clan control uses shared values and ideals to moderate employee behavior.

D. Control Methods Effective control requires objective mechanisms. Presently, MNEs support their control system with the following sorts of tools.

1. Reports. Decisions on how to allocate capital, personnel, and technology continue without interruption, so reports must be timely, accurate, and informative. The global diffusion of standardized software packages, often in the form of enterprise resource planning platforms, from SAP, Oracle, IBM, Microsoft, and Red Hat, organize many report systems. Standardizing the format worldwide, by leveraging corporate management’s familiarity, improves the real-time performance of reporting controls. Also, reports that share the same format ease comparing the performance of different units.

2. Visiting Subsidiaries. Face-to-face meetings, formal budget reviews, and planning seminars fortify responsibility and accountability. Old-school subsidiary visits, awash with strategizing and socializing, promote communication between headquarters and local managers. Increasingly, technologies expand managers’ options. Teleconference innovations, supported by wikis, social networking, and web-based collaboration services, help MNEs reduce travel, save time, boost productivity, and tighten controls.

3. Information Systems. Technology platforms, by expediting information exchange, provide useful control tools. MNEs use enterprise resource planning to monitor activities, such as product planning, parts purchasing, maintaining inventories, customer service, and order fulfillment.

E. Which Control System When?

Generally, as structure follows strategy, so too does control. MNEs following a global strategy prefer market controls, given that they can apply standard, objective benchmarks to evaluate performance in any market. Alternatively, transnational companies find value in clan control; the necessity of open exchange among geographically diffuse workers encourages control based on common values and norms. In any scenario, managers adjust their control system for the contingencies posed by the competing pressures of global integration and local responsiveness.

VI. ORGANIZATION CULTURE Organizational culture refers to the ideologies, symbols, and core values that employees, no matter their location in the MNE’s worldwide operations, regard as legitimate.

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A. A Key Piece of the Performance Puzzle Analyses and anecdotes of corporate performance indicate that building a resourceful organization is a challenging balancing act: an MNE must find ways to inspire employees worldwide to develop and apply new ideas but ensure that they implement them in ways that fit the MNE’s vision and mission.

1. Sophisticated Strategy, Sophisticated Culture. Expanding to increasingly diverse markets with increasingly diverse workplace norms calls for boosting the flexibility and versatility of an organization.

2. Culture is Key. Managing sophisticated resources, capabilities, and competencies escalate demands on MNEs’ structure and systems. There are low odds of successfully meeting those demands without a supportive organizational culture.

B. The Power of Common Cause An effective organizational culture stimulates people to identify with the company’s vision, do their jobs well, and collaborate with others while lessening the need to regulate their behaviors with elaborate structures and systems. Its capacity to power individual performance beyond that motivated by monetary incentives puts the onus on executives to build a company that people do not want to merely work for, but aspire to belong to.

C. Developing an Organizational Culture The overlapping practices of cultural exemplars, notably Gore, J&J, Google, Infosys, and Toyota, highlight the importance of hiring, rewarding, and promoting people who support the MNE’s vision and then, “walk the talk” implementing its mission. Leading through example, they promote socialization processes and communication practices that diffuse as well as fortify the idealized values and norms. Rather than relying on chance encounters among employees to develop common cause, MNEs proactively set and sustain their idealized organizational culture with fascinating methods.

1. Setting the System. Overcoming hurdles calls for arranging closer contact among managers from different countries to unify values. Cross-national teams are a prevalent tool.

2. Sustaining the System. Ad hoc approaches effectively set the standards of an organization’s culture. Sustaining that calls for instituting outlooks and systems.

Instead of letting the organization’s culture emerge naturally, many managers do as they do with structure and systems: purposefully and proactively develop the system of shared values that supports the MNE’s vision and mission.

LOOKING TO THE FUTURE: Changing Times, Changing Skills, and Changing Organizations The Internet is radically redefining how organization should be structured. Just as novel strategies called for innovative organizations in the early 1900s, the ongoing procession of stunningly powerful technologies will reset the workplace of the future. Already, advanced analytics, automation, and artificial intelligence are radically shaping the ways and means through which workers work and leaders lead. Digitization requires a drastic review of organizational structure, coordination, control, and culture. It also calls for the improvement of 9 .

specific competencies, namely complex problem-solving, critical thinking, creativity, people management, emotional intelligence, judgment and decision-making, and cognitive flexibility.

CLOSING CASE Building a Magical Organization at Johnson & Johnson Headquartered in New Brunswick, New Jersey, Johnson & Johnson (J&J) J&J has more than 134,000 workers that staff some 260 operating units in 60 countries. Nearly 60 percent of its $85 billion in sales occurs outside the United States and is transacted in more than 175 countries.

Some, though, believe the intricacy of the company’s organization, in terms of its decentralized structure, sophisticated coordination and control systems, and Credo-based culture, anchors its superior performance. Decentralized management is the heart of J&J’s organization. It allows each of its 275 units to operate with substantial autonomy. J&J’s successful decentralization structure attracted talented, bright, and motivated people.

Decentralization enables J&J to respond to local needs but slows the global diffusion of products and programs. Preserving the magic of decentralization, given the contest between local autonomy and global integration, spurs tightening coordination and control systems. Pressures to integrate operations due to market trends, competitors’ moves, and shifting technologies push J&J to centralize some activities.

Separating J&J from the pack is the primacy of its organizational culture, as embodied in “Our Credo.” This one-page ethical code of conduct states how J&J fulfills its responsibilities. J&J’s long list of accomplishments, earned by developing, adjusting, and improving its structure, systems, and culture, has built an organization that confidently leverages bright ideas, no matter if global executives or local subsidiary leaders champion them.

Questions 16-3. Profile the perspective that you think best explains how J&J makes its structure, systems, and culture work ?

It appears that J&J’s decentralized style has connected the large corporation to its community. Community provides feedback and the structure of the organization to respond in a community-based way. This means that abroad and domestically, they understand the needs of the unique community. (LO 16-6: Explain the principle and practices of organizational culture, AACSB: Analytical Skills.)

16-4. Given the choice, would you rather work in J&J’s corporate headquarters in New Jersey, United States, or, alternatively, in a local subsidiary in an overseas market? Why? .

New Jersey. The reason is related to its connection to its community. I would need to develop a stronger relationship with a community. This may be hard for an expatriate to do. In addition, you would need to understand the culture of medicine within the country, while responding to the profit goals of the company. This may be challenging 10 .

for a new expatriate to accomplish. (LO 16-6: Explain the principle and practices of organizational culture, AACSB: Analytical Skills.)

16-5. The World Economic Forum emphasizes the importance of complex problem-solving, critical thinking, and creativity to effective executive performance. Estimate how these skills would make you an outstanding performer if you were working for J&J? The diversity of the products created by J&J would alone require creative individual.

Also, as we saw with COVID, a complex worldwide pandemic meant all medical related organization needing to respond in a quick and complex way. J&J was on the forefront of supplying medical products and an immunization for COVID-19. The medical world can be unpredictable and requires critical thinking in complex problemsolving. The nature of the company and the importance to the community requires all of the skills emphasized by World Economic Forum. (LO 16-6: Explain the principle and practices of organizational culture, AACSB: Analytical Skills.)

Additional Exercises: The Organization of International Business Exercise 16.1. A recent trend among MNEs is to replace expatriates in foreign subsidiaries with local managers. Ask students to debate the implications of that policy from the standpoints of (a) the development and implementation of global strategies, (b) the control of foreign subsidiaries, and (c) the development of managers with significant international experience and expertise. Does it mean decision making will necessarily be decentralized?

(LO 16-5: Profile the role and characteristics of organizational culture, AACSB: Multicultural and Diversity Understanding.)

Exercise 16.2. Ask the students to compare the apparent corporate cultures of three MNEs. Then ask them to propose and defend specific types of organizational structures for each of the firms, given the nature and extent of their operations. Would decision making be centralized or decentralized? (LO 16-5: Profile the role and characteristics of organizational culture, AACSB: Multicultural and Diversity Understanding.)

Exercise 16.3. Historically, many foreign firms that competed in the European marketplace established an extensive network of highly autonomous local subsidiaries. However, as Europe has evolved into a single market via the EU, those same firms have often been frustrated in their efforts to shift from a multidomestic to a regional (European) strategy.

Ask students to discuss the reasons for this and to suggest mechanisms firms might use to accomplish the shift. Finally, have the students compare the strategic advantages of a longestablished multidomestic-type organization to a newly established regionally oriented firm.

(LO 16-2: Describe the features of classical structures, AACSB: Analytical Skills.)

Exercise 16.4. Ask students if they would be more comfortable working in a hierarchy or hyperarchy. Divide students into smaller groups having students of both preferences. Have the students discuss the pros and cons of each organizational mechanism and develop a list of circumstances in which hierarchy is preferable and another list of conditions in which 11 .

hyperarchy is preferable. (LO 16-3: Describe the features of neoclassical structures, AACSB: Communication Ability.)

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PART SIX MANAGING INTERNATIONAL OPERATIONS Chapter 17 Marketing Globally OBJECTIVES 17-1 Classify international marketing strategies in terms of marketing orientations, segmentation, and targeting 17-2 Discuss the pros and cons of country adaptation versus global standardization of products 17-3 Describe pricing complexities when selling in foreign markets 17-4 Recognize the pros and cons of using uniform promotional marketing practices among countries 17-5 Explain the different branding strategies companies may employ internationally 17-6 Discern major practices and complications of international distribution 17-7 Illustrate how gap analysis can help in managing the international marketing mix

CHAPTER OVERVIEW Marketing is a social and managerial process through which individuals and organizations satisfy their needs and objectives via the exchange process. Chapter Seventeen begins by examining the ways in which marketing managers analyze country market potential in order to develop effective international marketing mix strategies. It reviews the adaptation vs. standardization debate and also considers the rationale for selecting nationally responsive vs. globally integrated marketing strategies. The chapter discusses each of the marketing mix variables from an international perspective and concludes with a note about international e-commerce.

CHAPTER OUTLINE OPENING CASE:

TOMMY HILFIGER

The Tommy Hilfiger brand has been very successful since its introduction in 1988. The brand became an almost overnight success with creative advertising that created a mental association of the name with other designer brands. International sales account for approximately half of all sales and the company is seeking ways to harmonize its American and European operations and designs. But markets differ and Tommy Hilfiger recognizes some of the issues. European operations are more expensive, and prices are higher in Europe than in the United States due to the need for more design changes in Europe, and the fragmentation of the European wholesale and retail system. In the United States, the retail market is more concentrated and produces 1 .

greater efficiencies that can be passed on to consumers. Also, in some cases, European consumers were demanding higher-quality materials be used for the clothing. Price differentials between Europe and the United States can bring about a few difficulties such as gray market activity and image problems.

QUESTIONS 17-1 The chapter explains five international marketing orientations. Which one applies most to Tommy Hilfiger? Explain why.

The strategic marketing orientation indicates a firm is committed to continually serving foreign target markets and to making incremental product adaptations to satisfy local customers. Similar marketing principles apply in domestic and foreign markets; however, country differences may cause companies to apply these principles differently abroad, such as offering product variations to correspond with local preferences. (LO 17-2: Discuss the pros and cons of country adaptation versus global standardization of products, AACSB: Analytical Skills.)

17-2 The chapter explains five elements in the marketing mix (product, pricing, promotion, branding, and distribution). In which of these have Tommy Hilfiger’s operating practices been the most standardized globally? Explain why this has been possible and desirable.

Hilfiger’s promotion and branding strategies have been the most standardized globally. This was necessary as a way to convince stores to stock the products and to convince customers to want it. Because of this approach, Tommy Hilfiger has become a global brand with strong recognition and a distribution network in over 90 countries and more than 1000 retail stores throughout North America, Europe, Central and South America, and Asia Pacific. (LO 17-2: Discuss the pros and cons of country adaptation versus global standardization of products, AACSB: Analytical Skills.)

Teaching Tips: Review the PowerPoint slides for Chapter Seventeen and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures and tables in the text.

I.

INTERNATIONAL MARKETING STRATEGIES: ORIENTATIONS, SEGMENTATION, AND TARGETING Although marketing principles are global, companies need to apply them differently abroad.

A. Marketing Orientations The international applications of five common product policies are highlighted below: 1. Production Orientation. A production orientation indicates a firm is more concerned about production variables such as efficiency, quality, and/or capacity than it is about marketing. Firms assume customers want lower prices and/or higher quality. Such an approach is still used internationally for selling commodities, for passive exports, and for serving foreign-market segments that resemble domestic markets.

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2. Sales Orientation. A sales orientation indicates a firm assumes global customers are reasonably similar and it can, therefore, sell abroad the same product it sells at home. A firm will be aided in this approach when there is also a spillover of product information from one country to another.

3. Customer Orientation. A customer orientation indicates a firm is sensitive to customer needs, i.e., it thinks in terms of identifying and serving the needs of the customer. Given a particular country market, what products are needed?

4. Strategic Marketing Orientation. A strategic marketing orientation indicates a firm is committed to continuously serving foreign target markets and to making incremental product adaptations to satisfy local customers. It draws upon elements of the production, sales, and customer orientations, as appropriate.

5. Societal Marketing Orientation. The societal marketing orientation indicates a firm recognizes it must conduct its activities in a way that preserves or enhances the well-being of all its stakeholders, i.e., as it serves the needs of its customers it must also address the environmental, health, social, and work-related problems that may arise when producing or marketing its products abroad.

B. Segmenting and Targeting Markets Market size is not only a function of population in a given country, but is more specifically related to how many people are likely to consume a particular product. The most common way of identifying market segments within a country is through demographic factors such as income, age, gender, ethnicity, and religion.

Internationally, segmentation and targeting may take place at a global or country level 1. By Global Segment. A company may identify some segments globally, such as segments based primarily on income. Thus each country may have some people within the same segment.

2. By Country. A company may choose to segment its market by selecting a single country to enter. There is little opportunity of gaining economies through standardization with this approach.

3. Mixing the Marketing Mix. A company may hold one or more elements of its marketing functions—prices, promotion, branding, and distribution— constant while altering the others.

4. Mass Markets versus Niche Markets. Companies must decide when introducing their products abroad to enter it with a mass market or niche market strategy.

Because the percentage of people that fall into any segment may vary substantially among countries, a niche market in one country may be a mass market in another.

II. PRODUCT POLICIES: COUNTRY ADAPTATION VERSUS GLOBAL STANDARDIZATION Although adopting marketing orientations that involve product adaptations for foreign markets is often costly, many companies continue to make product alterations for foreign markets for a variety of compelling reasons.

A. Why Firms Adapt Products The primary reasons behind the tendency of firms to alter their products to meet local conditions are legal, cultural, and/or economic in nature.

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1. Legal Considerations. Explicit product-related legal requirements vary widely by country but are usually meant to protect customers, the environment, or both. a. Labeling Requirements. One of the more cumbersome product alterations for companies is adjusting to different laws on labeling. b. Environmental-Protection Regulations. Some countries prohibit certain types of containers, others restrict the volume of packaging materials, and there are sometimes mandates on container reusability. c. Indirect Legal Considerations. Marketing managers must also watch for indirect legal requirements such as higher taxes on heavy automobiles that may shift demand to lighter ones. d. Issues of Standardization. A recurring issue is the need to arrive at international product standards and eliminate some of the wasteful product requirements for alterations among countries.

2. Cultural Considerations. Cultural factors affecting product demand may or may not be easily discerned. While religious beliefs may offer clear guidelines regarding product acceptability, other factors such as color, design, and artistic preferences may be much more subtle.

3. Economic Considerations. Levels of income, differences in income distribution, and the extent and condition of available infrastructure can all affect demand for a particular product. Often, price-reducing alterations are required if a firm wishes to participate in a particular country market. Poor infrastructure may also require alterations, as companies must deal with rough terrain, etc.

B. Alteration Costs Usually, firms will choose to standardize basic components while altering critical enduse characteristics. Certain alterations (such as packaging and color options) may be inexpensive to make, yet they can have an important effect on demand.

C. The Product Line: Extent and Mix Although most companies produce multiple products, it is doubtful that all of these products could generate sufficient sales in a given foreign market to justify the cost of penetrating that market.

1. Sales and Cost Considerations. When making product line decisions, managers must consider the cost and effect on sales of offering just one or a few products internationally as opposed to an entire family of products. Whereas narrowing a product line allows for the concentration of effort and resources, the broadening of a product line may lead to distribution economies.

III. INTERNATIONAL PRICING COMPLEXITIES Price represents the value asked for a product. In the long run, price must be low enough to generate sufficient demand but high enough to yield a profit to the firm.

A. Potential Obstacles in International Pricing The complexities of pricing are exacerbated in the international arena.

1. Government Intervention. Every country has laws that either directly or indirectly affect prices at the consumer level. Price controls may set either maximum or minimum prices for designated products. The WTO permits a government to establish restrictions against any imports that enter the country at a price below the 4 .

price charged to customers in the exporting country (dumping). However, a firm may charge different prices in different countries because of competitive and demand factors (e.g., a firm may choose to exclude fixed costs in the price calculation of products exported to developing countries in order to be price competitive in those markets.)

2. Market Diversity. Country variations lead to many ways of segmenting the market for a particular product. Consumers in some countries simply like certain products more and are willing to pay more for them.

3. Export Price Escalation. If standard markups occur within distribution channels, lengthening the channels or adding expenses somewhere in the system will further raise the price to the consumer by more than incremental transport and duty costs— a situation known as export price escalation. Common reasons for price escalation in export sales are tariffs and the often-greater distance to the market. To compete in export markets, a firm may have to sell its products to intermediaries at a reduced price in order to lessen the amount of price escalation [see Fig 17.2].

4. Fluctuations in Currency Value. Pricing in the case of highly volatile currencies can be extremely difficult, especially under conditions of high inflation. Pricing decisions must assure the company of sufficient funds to replenish inventory. This may result in the need for frequent price adjustments. Further, currency fluctuations also affect pricing decisions for any product that faces foreign competition; when a currency is strong, producers may have to accept a lower profit margin if they wish to be price competitive. a. The Gray Market. The gray market, or product diversion, is the selling and handling of goods through unofficial distributors, thus enabling the unofficial ones to import cheaper supplies from abroad to compete against official ones.

5. Fixed versus Variable Pricing. MNEs often negotiate export prices, while small companies frequently give price concessions too quickly. This limits small companies’ ability to negotiate on a range of marketing factors that affect their costs such as: • Discounts for quantity or repeat orders • Deadlines that increase production or transportation costs • Credit and payment terms • Service • Supply of promotional materials • Training of sales personnel or customers a. Supplier Relations. Dominant retailers with substantial clout may get suppliers to offer them lower prices, which in turn will enable them to compete as the lowest-cost retailer. However, such clout may not exist in new foreign markets. In addition, many industrial buyers are claiming large price reductions through Internet purchases.

IV. SHOULD PROMOTION DIFFER AMONG COUNTRIES? Promotion consists of the messages intended to help sell a product or service. The types and direction of messages and the method of presentation may be extremely diverse, depending on the company, product, and country of operation.

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A. The Push-Pull Mix Promotion strategies may be categorized as push (which uses direct selling techniques) or pull (which relies on mass media). Most firms use a combination of both.

1. Factors in Push-Pull Decisions. Factors that will determine the mix of push and pull strategies include the type of distribution system, the cost and availability of media, customer attitudes toward sources of information, and the relative price of the product as compared to disposable income. Push is more likely when selfservice is not predominant, advertising is restricted, and product price is a high portion of income.

B. Some Problems in International Promotion Because of diverse national environments, promotional problems are varied. In many countries regulations pose an even greater barrier. In emerging economies, MNEs usually have to use more push strategies for mass consumer products.

1. Advertising Standardization: Pro and Con. Advertising represents any paid form of media (nonpersonal) presentation. Although savings from the standardization of advertising are not as great as those from product standardization, they can nonetheless be substantial. However, in addition to reducing costs, standardized advertising may also improve the quality of advertising at the local level, prevent the confusion associated with different national messages and images and speed the entry of products into new country markets. Standardization usually implies using the same agency globally. The issue of standardization in advertising raises problems in a few other areas—namely, translation, legality, and message needs. a. Translation. When a media transmission spans multiple countries, there is no opportunity to translate a message into other local languages. When messages are translated, numerous difficulties can be encountered with both language (content and meaning) and images. b. Legality. What is deemed to be legal advertising in one country may, in fact, be illegal elsewhere. Differences result mainly from varying national views on consumer protection, competitive protection, standards of morality, and nationalism. c. Message Needs. An advertising theme may not be appropriate everywhere because of national differences in how well consumers know a product, how they perceive it, who makes the purchasing decision, and what features are most important.

2. The Internet. The growth in products’ online availability through the Internet creates new promotional and distributional opportunities and challenges. a. Opportunities. There are certainly many e-commerce success stories. These include promotion for direct sales as well as information to pre-sell and inform shoppers where they may buy the products. b. Problems. Global Internet sales are not without glitches. A company that wants to reach global markets may need to supplement its Internet sales with other means of promotion and distribution, which can be very expensive.

Further, a switch to Internet sales may risk upsetting existing distributors and, if unsuccessful, make future sales more difficult.

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V. INTERNATIONAL BRANDING STRATEGIES A brand is a name, term, sign, symbol, and/or design that is intended to identify a product or product line and differentiate it in the marketplace. A trademark is a brand, or a part of a brand, that is granted legal protection because it is capable of exclusive appropriation. It protects the seller’s exclusive rights to use the brand name and/or brand mark.

A. Global Brand versus Local Brands In addition to the same branding decisions that every producer has to make, international marketers must make a decision about whether to adopt a worldwide brand or to brand products for a variety of local markets.

1. Advantages of Global Brands. A global image assists in the marketing to international travelers and creates an international identity as a global player.

2. Some Problems with Global Brands. A number of problems are inherent in using global brands a. Language. Both the translation and pronunciation of brand names pose potential problems in many markets. Often the problems are obvious, but other times they are quite subtle, yet critical. In addition, brand symbols (shapes and colors) are culturally sensitive in many societies. b. Brand Acquisition. When an MNE acquires a (foreign) firm, it automatically acquires its brands. In some instances those brands will be maintained; in others they will be folded into a larger brand in order to capture economies of scale and to promote regional/global brand recognition. c. Country-of-Origin Image. Firms must determine whether to promote a local or foreign image for their products. The products of some countries may be perceived as being particularly desirable and of higher quality than products from other countries. A firm may be able to enhance its competitive advantage by effectively exploiting this perception. d. Locational Origin of Names. One ongoing international legal debate concerns product names associated with location. The EU protects the names of many European products based on location names, such as Roquefort and Feta cheeses, Parma ham, and Chianti wine. It has also pushed for protection against the foreign use of regulated names associated with wines, such as clos, chateau, tawny, noble, ruby, and vintage. e. Generic and Near-Generic Names. While firms want their brand names to become household words, they do not want those names to become so common they are considered to be generic (e.g., Kleenex and Xerox). Generic names may either stimulate or frustrate the sales of the firm from whom the name was expropriated.

POINT—COUNTERPOINT: Should Home Governments Regulate Their Companies’ Marketing in Developing Countries?

POINT: International companies sell products in developing countries for which there are restrictions in their home countries. Often, the regulations in developing countries are lax, and the consumers may not be able to make good decisions due to poor education and low incomes.

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If home governments don’t regulate to protect consumers in developing countries, no one will. In addition to selling potentially harmful products, many MNEs also neglect to develop new products that consumers in developing countries actually need. Further regulation may help to improve the situation for consumers in developing countries.

COUNTERPOINT: Instead of regulating companies, efforts should be focused on improving education and living standards in less developed countries. Even if developed countries limited their own companies from selling certain harmful products, companies from developing countries would likely continue to sell those same products. Again, education of individuals, rather than government intervention, is the only effective long-term solution to consumer protection.

VI. DISTRIBUTION PRACTICES AND COMPLICATIONS Distribution refers to the physical and legal path that products follow from the point of production to the point of consumption. In many instances, geographic barriers and poor transportation infrastructure and facilities will divide a country into very distinct viable and non-viable markets.

A. Deciding Whether to Standardize Distribution is often the marketing mix variable that firms find the most difficult to standardize. This is because each country has its own national distribution system that is historically intertwined with its cultural, economic, and legal environments. Other factors that influence the ways in which consumer products are distributed within a given country include people’s attitudes toward entrepreneurship, the ability to pay retail workers, restrictions on the size of stores and their hours of operation, the financial ability to carry large inventories, and the efficacy of the national postal system.

B. Internalization or Not? Should companies handle their own distribution? Or should they contract other companies to do it for them?

1. Sales Volume and Cost. When sales volume is low, it is usually more cost effective for a firm to contract with an external distributor. On the other hand, distribution may be handled internally when sales volume is high, when the firm has sufficient human, capital, and financial resources, when after-sales service is extensive and complex, when customers are global, and when a firm can otherwise enhance its competitive advantage.

2. Factors Favoring Internalization. Circumstances conducive to internalization include not only high sales volume but also the following factors: • When a product has the characteristic of high price, high technology, or the need for complex after-sales servicing (such as aircraft), the company will probably have to deal directly with the buyer, but may simultaneously use a distributor to identify sales leads.

• When the company deals with global customers, especially business-tobusiness, sales may go directly to the global customer.

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When the company’s main competitive advantage is its distribution methods, it may control distribution abroad, such as Avon’s direct selling through independent representatives.

C. Distribution Partnership If a company wishes to collaborate with a distributor abroad, it can usually compare several potential companies. While trying to find the best distributors, it must also convince them to handle its products.

1. Which Distributors Are Best Qualified? The choice of international distributor depends on the same criteria as for domestic options. These criteria include the distributor’s financial strength, its good connections, the extent of its other business commitments, its current status (e.g., personnel, facilities, and equipment), and its reputation as an honest performer.

2. Promoting to Potential Distributors. Companies must evaluate potential distributors, but distributors must choose which companies and products to represent and emphasize. In some cases, distributors are tied into exclusive arrangements with manufacturers that impede new competitive entries.

D. Distribution Challenges and Opportunities 1. How Reliable Is After-Sales Service? The more complex and expensive a product, the more important that after-sales service will be. When after-sales service is critical, firms may need to invest in service centers, which, can in turn, become important sources of revenues and profits.

2. Hidden Costs and Gains in Distribution. Several factors often contribute to country differences in distribution costs: a. Infrastructure Conditions. Where roads and warehousing facilities are in bad condition, getting goods to consumers quickly, cheaply, and with minimum damage or loss is problematic. b. Levels in the Distribution System. Where there are multitiered wholesalers that sell to each other before the product reaches the retail level, each intermediary adds a markup and prices escalate. c. Retail Inefficiencies. Where low labor costs and owners’ distrust of nonfamily members cause counter- rather than self-service merchandise examination, there is less productivity in serving customers. In addition, many retailers (mainly in developing economies) lack equipment that improves the efficiency of handling customers and reports, such as electronic scanners and payment systems linked to inventory-control records and to credit card companies. d. Inventory Stock-Outs. Costs rise where governments restrict the ability of some retailers from using more productive distribution practices.

VII. GAP ANALYSIS: A TOOL FOR HELPING TO MANAGE THE INTERNATIONAL MARKETING MIX Although every element in the marketing mix is important, the relative importance of one versus another may vary from place to place and over time. Thus management must monitor and adjust its marketing programs accordingly. Once a company is operating in a country and estimates that country’s market potential, it must calculate how well it is doing there. One tool that can be used to accomplish this is gap analysis—a method for 9 .

estimating potential sales by identifying market segments a company is not serving adequately [see Fig 17.3]. The difference between total market potential and a company’s sales is due to several types of gaps: • Usage—collectively, all competitors sell less than the market potential • Product line—the company lacks some product variations • Distribution—the company misses coverage by geography or type of outlet • Competitive—competitors’ sales are not explained by product-line and distribution gaps A. Usage Gaps Gaps may exist in a country’s usage of the product. Marketing campaigns may be developed to attempt to persuade consumers in those countries to use more of the product.

B. Product Line Gaps Gaps that develop due to the lack of a wide line of products sold by the company.

C. Distribution and Competitive Gaps A company’s products may be sold in too few places, creating a gap in distribution.

There also may be competitive gaps—sales by competitors that cannot be explained by differences between product lines and distribution. That is, competitors are selling more because of their prices, advertising campaigns, goodwill, or any of a host of other factors.

D. Aggregating Countries’ Programs Although gap analysis prioritizes elements in the marketing mix within countries, it is also possible to use the tool by aggregating needs among countries.

LOOKING TO THE FUTURE: How Might International Market Segmentation Evolve?

There are, of course, many global trends that may affect future international marketing than we can possibly highlight (e.g., aging population, growing obesity, increasing use of social media), thus the following discussion highlights only one key demographic and one key psychographic area. Most projections indicate the disparities between the “haves” and the “have-nots” of the world will continue to grow throughout the foreseeable future, both within and across countries.

To serve the “haves,” firms will offer luxury products to customer niches that cut across national boundaries. At the other extreme, companies will have numerous opportunities to develop lowcost, standardized products designed to fit the needs of the “have-nots.” Thus, companies will have conflicting opportunities: develop luxury to serve the haves and cut costs to serve the havenots. Despite the growing proportions of haves and have-nots, demographers project that the actual numbers of people moving out of poverty levels and into middle-income levels will increase. Attitudinal differences also affect demand in general as well as for particular types of products and services. There are three types of personality traits that affect how potential consumers react. The traits are materialism, cosmopolitanism, and consumer ethnocentrism.

The traits are not mutually exclusive but the portion of people who are influenced by one or another varies by country. How these factors evolve will likely have a profound influence on the future of international marketing.

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CLOSING CASE: Grameen Danone Foods in Bangladesh Bangladesh has millions of impoverished persons, a high illiteracy rate, poor infrastructure, high unemployment, and a high incidence of infectious disease. Nevertheless, The Grameen Foundation from Bangladesh, and Groupe Danone from France, has created a joint venture social business to assist some of the most needy citizens and consumers in the world. A social business operates differently than traditional NGO’s, corporations, or not-for-profits. The organization utilized each venture partner’s respective strength in micro-banking/finance and the delivery of food products to provide much needed products. The venture provides a socially responsible approach to assist those in need. Aside from the favorable publicity, the venture may also be a good long-term strategy for the French corporation. Today’s impoverished may be a viable market for future sales as economic, social, and health conditions in the country improve. The venture required the organizations to make all of the classic strategic marketing decisions, including branding, pricing, promotion, distribution, etc. Thus far, the joint venture appears to be operating successfully. Inspired by this new model of collaboration, other major MNEs are establishing social businesses with the Grameen Foundation. Despite the publicity and promise of these high-profile collaborative ventures, however, Danone will need to evaluate how brand recognition and goodwill at the BoP can be harnessed for sales farther up the pyramid in order to expand to more affluent market segments.

QUESTIONS 17-3. What advantages might Danone receive from the Grameen Danone joint venture?

Prior to the joint venture, Danone aimed most of its products at higher-end consumers. The demand for these products has been maturing in wealthier countries, which have been Danone’s traditional markets. The joint venture offer several potential economic advantages. First, it enables them to enter poorer countries learn about customers and ways of operating in less developed countries. Second, Danone’s products are all healthful and sanitary which gives the company favorable publicity with consumers who are moving upward economically. Third, being perceived as socially responsible may improve business performance in various ways and gives the company free positive publicity globally (LO 17-1: To understand a variety of international product policies and their appropriate circumstances, AACSB: Analytical Skills).

17-4. How much do you think Danone’s decision to set up a social business was motivated by wanting to be socially responsible versus believing the move would help its performance?

Does the answer to this make any difference?

Responses and opinions may vary. There are several arguments that support Danone’s decision as being motivated by a sense of social responsibility. The country did not have operations in Bangladesh; therefore it took extra effort and risk to become involved in the project. Further, the size and global nature of the organization makes it obvious that the company could have invested profits in other regions or endeavors that would have 11 .

provided a greater return on income. The company must answer to shareholders. The true motivations of the organization are important when making ethical considerations and analysis, but those impoverished citizens that may benefit from the joint venture may be less concerned with intentions and more concerned with the actions. (LO 17-5: Explain the different branding strategies companies may employ internationally, AACSB: Analytical Skills.)

17-5. If Danone were to add products to sell to the BoP, which of its products would be the best candidates? Why? Responses and opinions may vary. Considering the high levels of need and poverty in the region, those products that would seem most essential to health and survival would probably be seen as the most advantageous. Non-essentials may appear to be more of an attempt at exploitation. A focus on essential products strengthens the argument for social responsibility and would promote the best result for the health and sociological problems that are so prevalent in the country. (LO 17-1: To understand a variety of international product policies and their appropriate circumstances, AACSB: Dynamics of a Global Economy) 17-6. Since the establishment of the Grameen Danone Foods social business, the number of social businesses worldwide has grown so much that there is now an annual global summit in Wolfsburg, Germany. Are there types of companies that might not be good candidates to establish social businesses? If so, what are they and why?

Responses and opinions may vary. Any type of product or business that may be objectionable in terms of morality, a violation of the socially acceptable norms and standards of society, the creation health risks, or that would result in a form of consumer exploitation would not be a good candidate to establish a social business. However, that does not mean that such an organization could not play a role in a different capacity, such as donating funds or resources to other projects. (LO 17-4: Recognize the pros and cons of using uniform promotional marketing practices among countries, AACSB: Analytical Skills.)

17-7. Can you think of any other MNEs that can collaborate successfully with the Grameen Foundation and help solve specific problems in Bangladesh? How can they do this?

Responses and opinions may vary. Grameen Intel Social Business Ltd. was founded in 2011 to create software applications on handheld computing devices that address such social problems as low agricultural output and lack of prenatal care. BASF Grameen Ltd. was formed to develop long-lasting insecticide-impregnated nets to fight the spread of malaria. (LO 17-1: Classify international marketing strategies in terms of marketing orientations, segmentation, and targeting, AACSB: Analytical Skills.)

17-8. Initially, Grameen Danone Foods JV was expected to make a profit by 2012. Although no official numbers are published, it seems that they had not reached that point by 2018.

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Should Danone continue to invest in this JV? If so, what can be done to improve the financial outlook of the JV going forward?

Responses and opinions may vary. Danone should continue to invest in this JV because serving the BoP will help foster a positive long-term relationship between consumers and the organization. It is also a good step in creating a culture of social responsibility within the company. Discontinuing the JV might also send a negative message about the real intent of the company and reinforce the allegations of exploitation of consumers in poor countries. To improve the financial outlook of the JV going forward, the company needs to formulate a long-term strategy and diversify its clientele and its services to offsets losses.

(LO 17-7: Illustrate how gap analysis can help in managing the international marketing mix, AACSB: Analytical Skills.)

ADDITIONAL EXERCISES: INTERNATIONAL MARKETING Exercise 17.1. While many firms have moved to develop globally standardized products, others have moved toward more product differentiation across countries. Ask students to discuss the types of products for which they would expect to see more global standardization, and those for which they would expect to see more local differentiation. Be sure they consider both goods and services. (LO 17-2: Discuss the pros and cons of country adaptation versus global standardization of products, AACSB: Dynamics of the Global Economy.)

Exercise 17.2. A number of advertising agencies have expanded their operations to the global level so they can offer their services on a worldwide basis. Ask students to discuss the reasons an MNE might prefer to work with a single global advertising agency rather than a series of local or regional agencies. Then ask students to explore the challenges advertising agencies face when they choose to offer worldwide services. (LO 17-3: To appreciate the pricing complexities when selling in foreign markets, AACSB: Analytical Skills.)

Exercise 17.3. When a firm is confronted with excess capacity but its national currency is relatively weak, it may choose to export to markets with relatively stronger currencies. Ask students to discuss the logic and wisdom of basing a long-term international marketing strategy on foreign currency swings. What would a firm have to do to effectively position itself to maximize such “opportunities”? (LO 17-3: To appreciate the pricing complexities when selling in foreign markets, AACSB: Dynamics of the Global Economy.)

Exercise 17.4. Ask students to identify a popular local product that is not widely available in other countries. Have the students pick a country and develop a marketing plan for the product in that country. What alterations might have to be made to the product or its packaging for it to succeed in the target country? How should they distribute the product?

What about pricing? Is there a large potential market for the product in the target country?

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Why or why not? (LO 17-4: Recognize the pros and cons of using uniform promotional marketing practices among countries, AACSB: Dynamics of the Global Economy.)

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Chapter 18 Global Operations and Supply-Chain Management OBJECTIVES 18-1 Define what is meant by global supply-chain management 18-2 Describe the different facets of global operations strategies 18-3 Show how global sourcing is an important aspect of global supply-chain and operations management 18-4 Explain how information technology is used in global operations and supply-chain management 18-5 Summarize how quality management is important in global operations and supply chain management

CHAPTER OVERVIEW Important objectives shared by the global operations and supply chain functions are to simultaneously lower costs and increase quality by eliminating defects from both processes. In the chapter, we will discuss the international dimensions of the global supply chain, focusing on the upstream processes of the purchasing function and supplier networks; operations strategy; the role of information technology in global supply-chain management; and quality management as it affects operations

CHAPTER OUTLINE OPENING CASE:

APPLE’S GLOBAL SUPPLY CHAIN

This case describes how Apple Inc., an American multinational corporation headquartered in Cupertino, California, that designs, develops, and sells consumer electronics, computer software, and personal computers developed its global manufacturing and distribution systems.

Questions 18-1. Although Apple’s inbound logistics began with Apple controlling the assembly of its computers, it shifted to having suppliers acquire raw materials with contract manufacturers handling most of the production and assembly of final products. Why did they do this, and what are the major challenges Apple faces?

Apple used to manufacture its own components but switched to having them manufactured by a small number of contract manufacturers, primarily in Asia, like Foxconn. In fact, Apple outsourced the entire production process to Foxconn. The shift was not driven solely by the desire to reduce cost, but also by the prospect of shortening lead times in its supply chain.

By consolidating suppliers of components and manufacturers in cheap labor locations, 1 .

Apple was able to reduce cost and lead time. The major challenges that Apple faces are labor issues in suppliers’ factories and the risk of interruption since the company depends on only a few contract manufacturers. For instance, Apple’s dependence on Foxconn has been exposed because of the disruption in the company’s supply chain due to Covid-19 and the trade war between the U.S. and China. (LO 18-1: To describe the different dimensions of a global manufacturing strategy, AACSB: Analytical Skills).

18-2. Foxconn, a major contract manufacturer for Apple, is by far the largest ODM/EMS (original design manufacturer/Electronics Manufacturing Services) company in the world, dwarfing U.S.-based Flextronics, which is the major manufacturer and assembler of Samsung phones. In 2013, Foxconn was contemplating opening operations in the United States. In what way could this be a challenge for Apple Inc.?

Foxconn’s likely expansion into the U.S. could become a challenge to Apple in terms of labor cost as they are still cheaper in countries such as China and Vietnam. However, the move might cut down the shipping costs and lead time for Apple when serving U.S. customers. (LO 18-2: To examine the elements of global supply-chain management, AACSB: Dynamics of the Global Economy) Teaching Tips: Review the PowerPoint slides for Chapter Eighteen and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures in the text.

I.

Global Supply-Chain Management Most companies agree that effective supply-chain management is one of their most important tools in reducing costs and boosting revenue.

A. What Is Supply Chain Management?

As illustrated in Figure 18.1, the supply chain is the network that links together the different aspects of the value chain, from sourcing and procurement to conversion through operations to the final consumer. Supply-chain management refers to activities in the value chain that occur outside the company, whereas operations management (also known as logistics management) refers to internal activities. Suppliers can be part of the company’s organizational structure, such as in a vertically integrated company, or they can be independent of it.

II. GLOBAL SUPPLY-CHAIN AND OPERATIONS MANAGEMENT STRATEGIES Recall Apple’s change in manufacturing strategy over time. Issues of location-specific advantage, firm-specific assets, and internalization all played a part in the changing strategy.

A. Operations Management Strategy One piece in the supply-chain strategy for both manufacturing and services is operations: the conversion of inputs into outputs. The success of a global operations strategy depends on four key factors: compatibility, configuration, coordination, and control.

1. Compatibility. Compatibility refers to the degree of consistency between a firm’s foreign investment decisions and the company’s competitive strategy.

• Efficiency/cost—reduction of operational costs 2 .

•

Dependability—degree of trust in a company’s products, its delivery, and its price promises • Quality—performance reliability, good service, speed of delivery, and dependable product maintenance • Innovation—ability to develop new products and ideas • Flexibility—ability of the production process to make a variety of products and adjust the volume of output 2. Manufacturing Configuration. MNEs must consider three basic configurations in establishing a global manufacturing strategy: • Centralized Manufacturing. Centralized manufacturing in one country.

• Regional Manufacturing. Manufacturing facilities in specific regions to service those regions.

• Multidomestic Manufacturing. As MNEs expand markets internationally, they may be forced to manufacture products in individual markets where they can be closer to consumers and meet individual needs. This is consistent with a multi-domestic strategy as discussed in Chapter 12 3. Offshoring, Nearshoring, and Onshoring • Offshore manufacturing—any investment that takes place in a country other than the home country.

• Nearshoring implies moving the supply chain closer to the home market, such as Mexico for U.S. firms or Prague for German firms.

• Reshoring or onshoring means bringing back production to the home country from offshore locations.

4. Coordination and Control. Coordination represents the linking or integrating of participants all along the global supply chain into a unified system. Control embraces systems, such as organizational structure and performance measurement, which are designed to help ensure strategies are implemented, monitored, and revised, when appropriate.

III. GLOBAL SOURCING Global sourcing is the first step in the process of materials management, which includes obtaining a supply of inputs used in the production process, inventory management, and transportation between suppliers, manufacturers, and customers. The term sourcing is used in a variety of ways. Outsourcing, for instance, refers to a situation in which one company externalizes a process or function to another company. Another way to look at outsourcing is supply chaining “which is a method of collaborating horizontally among suppliers, retailers, and customers to create value.” Supply chaining is slightly different from traditional outsourcing, which focuses more on a business process, but far more extensive and complicated since it relates more directly to the final product sold to customers. Apple’s use of Foxconn as a contract manufacturer for products such as the iPhone is technically supply chaining.

A. Why Global Sourcing?

Companies pursue global sourcing strategies for a number of reasons: • To reduce costs through cheaper labor, laxer work rules, and lower land and facilities costs • To improve quality 3 .

• • •

To increase exposure to worldwide technology To improve the delivery-of-supplies process To strengthen the reliability of supply by supplementing domestic suppliers with foreign ones • To gain access to materials that are only available abroad, possibly because of technical specifications or product capabilities • To establish a presence in a foreign market • To satisfy offset requirements • To react to competitors’ offshore sourcing practices B. Major Sourcing Configurations 1. Vertical Integration. The company owns the entire supplier network, or at least a significant part of it.

2. Industrial Clusters. Buyers and suppliers locate in close proximity to facilitate doing business. a. Keiretsus. Japanese Keiretsus are groups of independent companies that work together to manage the flow of goods and services along the entire value chain.

C. The Make-or-Buy Decision In determining whether to make or buy, MNEs should focus on making those parts and performing those processes critical to a product and in which they have a distinctive advantage. Other things can potentially be outsourced.

POINT-COUNTERPOINT: Should Firms Outsource Innovation?

POINT: Yes, firms should outsource innovation to effectively position themselves in the highly competitive high-tech and electronics industries. Suppliers’ capabilities continue to grow, making them important sources of innovation that can be incorporated into final products.

Outsourcing R&D can result in tremendous cost savings and can greatly speed the R&D process.

COUNTERPOINT: Companies that outsource any R&D risk losing control of core technologies.

Outsourcing turns intellectual property into a commodity rather than a source of sustainable competitive advantage. Outsourcing R&D risks losing important technology to current competitors, and also presents the possibility of having suppliers and other partners turn into future competitors. A company without R&D is merely a marketing front that has little identifiable intrinsic value. Outsourcing of manufacturing is potentially harmful to competitiveness, but the outsourcing of innovation could be disastrous to a company’s future fortunes.

D. Supplier Relations When an MNE decides to outsource rather than integrate vertically, it must determine the nature and extent of its involvement with suppliers.

E. Conflict Minerals

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Conflict minerals are certain minerals that come from warring areas, principally the eastern provinces of the Democratic Republic of the Congo, that generate revenues to fund conflicts F. The Purchasing Function Global progression in the purchasing function includes four phases: 1. Domestic purchasing only 2. Foreign buying based on need 3. Foreign buying as a part of procurement strategy 4. Integration of global procurement strategy The last phase is reached when a firm realizes the benefits from the integration and coordination of purchasing on a global basis. At this point, the MNE may once again be faced with the centralization vs. decentralization dilemma.

IV. INFORMATION TECHNOLOGY AND GLOBAL SUPPLY CHAIN MANAGEMENT A comprehensive supply-chain strategy is most effective with a strong commitment to information technology (IT), which aids in quick and efficient production, proficient inventory management, effective supplier communication, and customer satisfaction A. Electronic Data Interchange (EDI) Electronic data interchange (EDI) refers to the electronic movement of money and information via computers and telecommunications equipment in a way that effectively links suppliers, customers, and third-party intermediaries, and ultimately enhances customer value.

B. Enterprise Resource Planning/Material Requirements Planning The next wave of technology affecting the global supply chain was the implementation of IT packages known as enterprise resource planning (ERP). ERP refers to the use of software to link information flows from different parts of a business and from different parts of the world. An extension of ERP is material requirements planning (MRP), a computerized information system that addresses complex inventory situations and calculates the demand for parts from the production schedules of the companies that use the parts.

C. Radio Frequency ID (RFID) Radio frequency ID (RFID) is a system that labels products with an electronic tag that stores and transmits information regarding the product’s origin, destination, and quantity.

D. E-Commerce E-Commerce refers to the use of the Internet to link suppliers with firms and firms with customers.

1. Extranets and Blockchains. Companies with web-based systems usually establish an extranet for suppliers—a linkage to its information system via the Internet—so they can organize production and delivery of parts. Plugged into a company’s customer database, the suppliers can keep track of changes in demand; plugged into the ordering process, they can track the progress of their orders from factory to doorstep. A future development in global supply chain management is the potential of utilizing blockchain technology, which is best known because of cryptocurrencies.

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2. “The Digital Divide.” While many networks can, in fact, be managed via the Internet, others (especially those in developing countries) cannot because of the lack of available, leading-edge technology.

V. QUALITY Quality refers to meeting or exceeding the expectations of the customer. More specifically, it incorporates conformance to specifications, value enhancement, fitness for use, after-sales support, and psychological impressions (image).

A. Zero Defects Acceptable quality level (AQL) is a premise that allows for a tolerable (negotiable) level of defects that can be corrected through repair and service warranties. Zero defects describe the refusal to tolerate defects of any kind.

B. Lean Manufacturing and Total Quality Management (TQM) Total quality management (TQM) is a process that stresses three principles: customer satisfaction, continuous improvement, and employee involvement. The goal of TQM is to eliminate all defects. The goal is to eliminate all defects. TQM often focuses on benchmarking world-class standards, product and service design, process design, and purchasing.

1. Risks in Foreign Sourcing. Foreign sourcing can create big risks for companies that use lean manufacturing and JIT because interruptions in the supply line can cause havoc.

2. The Kanban System. A kanban system facilitates JIT by using cards to control the flow of production through a factory.

C. Six Sigma Six Sigma is a highly focused quality-control system designed to scrutinize a firm’s entire production system and eliminate defects, slash product cycle time, and cut costs across the board.

D. Quality Standards There are three different levels of quality standards: general, industry-specific, and company specific.

1. General-Level Standards. The International Organization for Standardization (ISO) was created to facilitate the international coordination and unification of industrial standards. It partners with the IEC (International Electrotechnical Commission), the International Telecommunications Union, and the World Trade Organization, and represents a network of standard setters in 158 countries around the world. a. ISO 9000 and ISO 14000. ISO 9000 is a set of universal standards initially designed to harmonize technical standards within the EU that are now accepted worldwide; it is applied uniformly to companies in any industry and of any size in order to promote quality at every level of an organization. Rather than judging the quality of a product, ISO 9000 evaluates the management of the manufacturing process according to standards in 20 domains, from purchasing to design to training. ISO 14000 is concerned with environmental management and what the company does to improve its environmental performance.

2. Industry-Specific Standards. Industry-specific standards represent the qualityrelated requirements expected of suppliers.

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3. Company-Specific Standards. Individual companies also set their own standards for suppliers to meet if they are going to continue to supply them.

LOOKING TO THE FUTURE: Uncertainty and the Global Supply Chain As firms have outsourced more of their operations and supply lines have grown longer, greater risk has arisen that something will disrupt that supply. With the threat of a terrorist attack or global political events disrupting the supply chain, some companies have sought multiple sources to reduce this uncertainty. Some firms have also created scenario-building schemes in the event of a disruption. Looking at “what-if” scenarios is probably a necessary procedure in an uncertain world.

CLOSING CASE Nokero: Lighting the World Nokero is a born-global social enterprise that markets solar light bulbs to over 120 countries. The organization was started by Steve Katsaros, an inventor and entrepreneur. Upon receiving a patent for his bulb technology, he received start-up capital from investors in Hong Kong and China. The company maintains the goal of delivering environmentally friendly solar products that are affordable to those most in need. The product was designed to reduce the use of kerosene and diesel in regions that have shortages of electricity. Nokero has engaged corporations, governments, international agencies, and NGOs on collaborative social programs related to environmental sustainability, renewable energy, poverty alleviation, and disaster and relief projects. The company has benefited from dozens of favorable stories in print media, TV networks, and social media around the world. Consequently, demand for the product has increased significantly. The organizational headquarters are located in Denver, Colorado, but the sole supplier of the company’s product is located in China. Sales are driven through direct, Webbased sales and through licensed distributors around the world. Katsaros understands that the success of Nokero’s business hinges on its ability to address critical supply-chain issues and some operational issues related to supply-chain management. dispersed.

QUESTIONS 18-3 What manufacturing strategy should Nokero pursue? Should it continue to supply all of its light bulb orders from a single factory location in China? What impact could uncontrollable issues such as COVID-19 have on Nokero’s sourcing strategy?

Relying on a single factory location is risky because of the prospect of interruption to the company’s supply chain due to natural disasters or trade disputes. For instance, several companies that depended on a few suppliers in China experienced delayed supplies and, in 7 .

some cases, a complete halt because of the U.S.-China trade war and the Covid-19 pandemic. Hence, Nokero should be prepared to deal with these worst-case scenarios. One solution is to consider a second or third supplier that will support its major supplier partner in China. (LO 18-2: Examine the elements of global supply chain management, AACSB: Analytical Skills) 18-4 In terms of distribution networks, should Nokero maintain fulfillment warehouses in Africa, Asia, and Latin America? How should Nokero address the last mile issue of accessing people in the most remote locations?

Yes, they should maintain the fulfillment warehouses; however, they need to address and resolve the issue of updated international pricing of shipping charges. With reference to the last mile issue, Nokero has identified that it is beneficial to educate users about the product attributes and usage. Nokero has decided to partner with companies that have a strong reach and connection with customers in remote locations, even hiring local employees to help with communication and distribution of products. (LO 18-2, Describe the different facets of global operations strategies, AACSB: Analytical Skills.)

Additional Exercises: Global Operations and Supply Chain Management Exercise 18.1. The total cost concept is a major concern in global operations and supply chain management. Strategic reorder points and economic order quantities must be determined. The tradeoffs between (i) customer service and cost minimization and (ii) control and flexibility must be considered. Contractual linkages with the participants in the system must be negotiated and honored. Ask students to discuss the challenges a firm faces in establishing its global manufacturing and supply chain network given the dynamics of today’s competitive environment. Use examples of firms in different types of industries as a basis for the discussion. (LO 18-2: To examine the elements of global supply-chain management, AACSB: Dynamics of the Global Economy.)

Exercise 18.2. A firm is considering whether to make a component in-house or to outsource it to an independent foreign supplier. Manufacturing the part in-house will require an investment in specialized assets; quality control and the protection of intellectual property rights are major concerns. The most efficient and reliable suppliers are located in countries whose currencies many foreign exchange analysts expect will appreciate in the next decade; likewise, wage rates in those countries are expected to rise. Ask students to discuss the pros and cons of manufacturing the component in-house as opposed to outsourcing it. Should the firm consider foreign direct investment as one of its options? Explain. (LO 18-1: To describe the different dimensions of a global manufacturing strategy, AACSB: Analytical Skills.)

Exercise 18.3. The value-to-weight ratio is very important with respect to manufacturing site location decisions because of its influence on transportation costs. Other things being equal, products with a high value-to-weight ratio are good candidates for exporting, while those with low value-to-weight ratios should be manufactured in multiple locations close to major markets to minimize transportation costs. For example, many electronic components 8 .

have high value-to-weight ratios—although they are expensive, they are very small and weigh very little. Even when shipped halfway around the world, transportation accounts for a very small percentage of the total delivered cost. Given that, ask students to consider why low value but heavy products such as petroleum and refined sugar are shipped such great distances. Why are products such as automobiles, which are bulky and can be so easily damaged, also shipped great distances, rather than being manufactured locally? (LO 18-4: To illustrate how supplier networks function, AACSB: Analytical Skills.)

Exercise 18.4. Have students assume the role of top management at a major global electronics company that is developing a wireless device capable of on-demand music and video downloads from anywhere on the globe. What criteria should the company use to make a decision on where to manufacture the device and whether to outsource the manufacturing or control it internally? (LO 18-6: Discuss how to establish successful transportation networks as part of the global supply chain, AACSB: Analytical Skills.)

Exercise 18.5. India and China are both very large emerging markets that are becoming increasingly important in many MNEs’ global supply chains. What are the advantages and disadvantages of sourcing from China as opposed to India? What types of products or services are best suited for sourcing from India versus China? Why? (LO 18-6: Discuss how to establish successful transportation networks as part of the global supply chain, AACSB: Dynamics of the Global Economy.)

Exercise 18.6. Have half the students assume the role of a large MNE and half the class assume the role of a small potential supplier. What are the major concerns of the MNE as it evaluates the smaller firm as a potential supplier? What concerns does the small firm have as it attempts to develop a relationship with the MNE? Break students up into small groups to discuss the issues. (LO 18-4: To illustrate how supplier networks function, AACSB: Analytical Skills.)

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Chapter 19 International Accounting And Finance Issues OBJECTIVES 19-1 Explain the crossroads of accounting and finance 19-2 Identify the major factors affecting the development of accounting objectives, standards, and practices 19-3 Describe international accounting standards and the process of global convergence 19-4 Demonstrate how companies account for foreign-currency transactions 19-5 Determine how companies can translate foreign-currency financial statements 19-6 List some of the key international finance functions 19-7 Show how companies protect against foreign-exchange risk

CHAPTER OVERVIEW The international accounting and taxation functions comprise great challenges for today’s global business managers. Chapter Nineteen presents the key accounting and taxation issues confronting firms that do business abroad. First, the chapter examines the ways in which national accounting systems differ and how today’s global capital markets force countries to consider the harmonization of their accounting and reporting standards. It then explores a number of unique issues MNEs face, such as the valuation and translation of transactions and assets that are denominated in foreign currencies. The chapter concludes with an examination of the impact of transfer pricing on business unit performance evaluation and an explanation of the balanced scorecard approach to performance evaluation.

CHAPTER OUTLINE OPENING CASE:

GPS CAPITAL MARKETS: IN THE MARKET FOR AN EFFECTIVE HEDGING STRATEGY?

Founded in 2002, GPS Capital Markets, Inc. became a leading brokerage firm in the corporate foreign exchange business. The first choice for most companies when it comes to foreign exchange is to use their commercial bank with which they already have a good relationship. GPS was able to overcome that by relying on three key competitive advantages: lower transaction costs, 100 percent transparency, and customizing solutions to satisfy customer needs. Thomson Reuters and Bloomberg play an important role in the business of GPS, with their powerful analytical tools, market information, real-time pricing, and a trading platform. When the global economic crisis hit in 2008, many companies flocked to it to handle their foreign-exchange transactions, which caused a large spike in activity. GPS developed proprietary software called FXpert to help its clients monitor foreign-exchange flows and determine how to save money on transactions. In addition to technical expertise, GPS has developed a solid marketing strategy, continuing to focus on SMEs while expanding its client base by setting up business centers in 1 .

Los Angeles, Phoenix, Dallas, Atlanta, Charlotte, Waltham (Massachusetts), London, Sydney, and Melbourne. Entering London has opened up significant opportunities for GPS in the UK and the rest of Europe.

Questions 19-1. What is the unique market niche for GPS, and what does it have to offer compared to larger banks and other financial institutions?

The unique market niche for GPS consists of SMEs and clients with significant foreign exchange needs. GPS’s competitive advantages resides in lower transaction costs, customizing solutions to satisfy customer needs, transparency and importantly customer relationships (LO 19-6: Explain how offshore financial centers are used to raise funds and manage cash flows, AACSB: Dynamics of the Global Economy) 19-2. What do you think are the major obstacles to success for GPS in Europe and Australia?

The major obstacles in both Europe and Australia are the regulatory environments in which GPS operates. Also, from a sales point of view, GPS managers need to make sure they understand what CFOs and treasurers need to know about the firm and what it has to offer.

(LO 19-6: Explain how offshore financial centers are used to raise funds and manage cash flows, AACSB: Dynamics of the Global Economy) Teaching Tips: Have students visit the Web site of the International Accounting Standards Board (IASB) at www.iasb.org for the latest developments in international accounting and convergence. Review the PowerPoint slides for Chapter Nineteen and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the map, figures, and tables in the text.

I.

THE CROSSROADS OF ACCOUNTING AND FINANCE The accounting and finance functions are closely related, with each relying on the other to fulfill its responsibilities. The CFO relies on the controller, or chief accountant, to provide the right information for making decisions, while the internal audit staff ensures that corporate policies and procedures are followed. The internal auditors, the controller, and the CFO work closely with the external auditor to try to safeguard the assets of the business.

The actual and potential flow of assets across national boundaries complicates the finance and accounting functions. So MNEs must learn to cope with differing inflation rates, exchange-rate changes, currency controls, expropriation risks, customs duties, tax rates and methods of determining taxable income, levels of sophistication of local accounting personnel, and local as well as home country reporting requirements.

A. What Are the Responsibilities of the Controller?

A company’s controller collects and analyzes data for internal and external users. The role of the controller has expanded beyond the traditional roles of management accounting and now involves strategic issues.

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B. Differences in Financial Statements Internationally Accounting origins and traditions are as individual as the languages of the nations that produce them. As a result, financial statements in different countries appear different from each other both in form (format) and in content (substance).

C. Differences in the Content of Financial Information.

Because MNEs must adjust to different accounting systems on a worldwide basis, the international accounting function becomes increasingly complex and costly. Providers of financial information for the broader investing community need to consider the following three factors: (i) language, (ii) currency, (iii) Underlying GAAP on which the statements are based.

1. Language Differences. English tends to be the first choice of companies choosing to raise capital abroad. Many companies provide their financial statements in different languages.

2. Currency Differences. Companies around the world prepare their financial statements in different currencies.

3. Underlying Accounting Standards. A major hurdle in raising capital in different countries is dealing with widely varying accounting and disclosure requirements.

II. FACTORS AFFECTING ACCOUNTING OBJECTIVES, STANDARDS, AND PRACTICES Figure 19.1 identifies some of the factors affecting the development of accounting standards and practices both domestically and internationally. As we will discuss in more detail below, cultural issues cut across all countries and strongly influence the development of accounting.

The regulatory environment, including legal and tax systems, is very influential, especially in countries with weak stock markets. However, the regulatory environment is also influential on stock markets. Certain international factors also have weight, such as former colonial influence, foreign investment, and the influence of regional economic agreements, such as the EU. A. Cultural Differences in Accounting Culture influences both measurement practices (how firms value assets) and disclosure practices (how and what information firms provide and discuss). 1. The SecrecyTransparency/Optimism-Conservatism Matrix [see Figure 19.2]. From an accounting standpoint, secrecy and transparency refer to the degree to which corporations disclose information to the public. Optimism and conservatism refer to the degree of caution that companies exhibit in valuing assets and recognizing income. The more conservative countries tend to understate assets and income, whereas optimistic countries tend to be more liberal in their recognition of income.

III. International Standards and Global Convergence A. Mutual Recognition versus Reconciliation Major approaches to dealing with accounting and reporting differences: (1) mutual recognition, (2) reconciliation to local GAAP, and (3) issue financial statements according to IFRS and (4) convergence to a common set of accounting standards.

Despite the many differences in accounting standards and practices around the world, a number of forces are leading to convergence: 3 .

• •

A movement to provide information compatible with the needs of investors The global integration of capital markets, which means easier and faster access to investment opportunities around the world and, therefore, the need for more comparable financial data • The need of MNEs to raise capital outside their home-country capital markets while generating as few different financial statements as possible • Regional political and economic harmonization, such as the efforts of the EU, which affect accounting as well as trade and investment issues • Pressure from MNEs for more uniform standards to allow greater ease and reduced costs in general reporting in each country B. The First Steps in Establishing IFRS The International Accounting Standards Committee (IASC) has worked toward harmonizing accounting standards by issuing a set of International Accounting Standards (IAS). The key turning point in the significance of the IAS standards came in 1995 when the International Organization of Securities Commissions (IOSCO) announced it would endorse IASC core standards if a set were developed that both organizations could agree upon. In May 2000, the IASC completed a core set of standards acceptable to IOSCO, and securities market regulators began the process of convincing their standard setters to adopt these standards, called International Financial Reporting Standards (IFRS).

C. The International Accounting Standards Board In March 2001, the IASC reorganized into the International Accounting Standards Committee Foundation (now called the IFRS Foundation) and the International Accounting Standards Board (IASB).

1. International Financial Reporting Standards (IFRS). When the IASB was organized, all of the old International Accounting Standards were adopted, and the board began to issue new standards called International Financial Reporting Standards (IFRS). As of 2020, 144 out of a total of 166 countries and jurisdictions require the use of IFRS for domestic listed companies in their capital markets.

2. The Relationship between the FASB and the IASB. The U.S. Financial Accounting Standards Board (FASB) and IASB have been working closely to achieve a convergence of accounting standards. The FASB and IASB also decided to adopt a process of convergence of accounting standards. Standard setting in the U.S. depends on the cooperation of the SEC. Convergence is complicated because it is both technical in terms of the quality of the standards as well as political.

3. The European Response to Convergence. The convergence process has been very unsettling for some Europeans. Differences in opinions exist on how IFRS should be applied and how the rules should be enforced.

Point-Counterpoint: Should U.S. Companies Be Allowed to Use IFRS? POINT: Investors, as well as creditors and other users, need reliable, comparable financial statement information to make well-informed decisions on a global basis. The two standards– U.S. GAAP and IFRS–are becoming more alike and allowing U.S. companies to use IFRS would make the U.S. more a part of the global economy, its companies could also raise more capital 4 .

because investors in countries that use it would be more familiar and able to keep up with the single international set of standards.

U.S. investors would also benefit. They would become more familiar with the international standards and would feel more apt to invest in international companies. Many U.S. firms with international operations use IFRS abroad, so allowing IFRS to be used for U.S. reporting would reduce the costs of accounting for and reporting information to users. In addition, U.S. companies that acquire foreign companies that use IFRS would find it easier to use IFRS for all operations rather than have to convert the results of their acquired companies from IFRS to U.S. GAAP for reporting purposes.

COUNTERPOINT: The U.S. economy is the largest economy in the world and thus needs the most stringent financial reporting standards in the world. The U.S. system has historically used the most reliable standards in the world. Allowing U.S. companies to use IFRS would impose tremendous costs on the nation’s economy. The differences between IFRS and U.S. GAAP, though growing more insignificant, still exist. The standards are not directly comparable, which could mean trouble for investors who may have difficulty seeing the differences. In addition, sovereignty, even over accounting, is not something the U.S. government would give up to an international organization over which it has some influence but not control.

IV. TRANSACTIONS IN FOREIGN CURRENCIES In addition to minimizing or eliminating foreign-exchange risk, firms must concern themselves with the proper recording and subsequent accounting of transactions resulting from the purchase or sale of products and the borrowing or lending of foreign currency.

A. Recording Transactions When accounting for assets, liabilities, revenues and expenses, foreign-currency receivables and payables result in gains and losses whenever the relevant exchange rate changes. Such transaction gains and losses must be included on the income statement in the accounting period in which they arise.

B. Correct Procedures for U.S. Companies The FASB requires that U.S. companies report foreign currency transactions at the original spot exchange rate and that subsequent gains and losses on foreign-currency receivables or payables be put on the income statement. The same procedure must be followed according to IFRS. V. TRANSLATING FOREIGN-CURRENCY FINANCIAL STATEMENTS An MNE must eventually develop one set of financial statements in its home-country currency. Translation involves the process of restating foreign-currency financial statements, and consolidation is the process of combining the translated financial statements of a parent and its subsidiaries into a single set. In the United States, translation is a two-step process: first, statements are recast according to U.S. GAAPs; then all foreign currency amounts are translated into U.S. dollars.

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A. Translation Methods FASB No. 52 and IAS 21 are alike in that they require MNEs to translate their foreigncurrency financial statements into the currency of the parent’s country. The two standards yield the same result.

1. Two Methods: Current-Rate and Temporal. The method the firm chooses depends on the functional currency of the foreign operation, which is the currency of the primary economic environment in which the entity operates. If the functional currency is that of the local operating environment, the firm must use the currentrate method, which provides that all assets and liabilities be translated at the current exchange rate (the spot exchange rate on the balance sheet date). All income statement items are translated at the average exchange rate, and owner’s equity is translated at the rates in effect when the firm issued capital stock and accumulated retained earnings. If the functional currency is the parent’s currency, then the firm must use the temporal method, which provides that only monetary assets such as cash, marketable securities and receivables and liabilities be translated at the current exchange rate. Inventory and property, plant, and equipment are all translated at the historical exchange rates in effect when the assets were acquired. In general, income statement accounts are translated at the average exchange rate, but cost of goods sold and depreciation expenses are reported at the appropriate historical exchange rates (not an average for the period). a. The Translation Process. Tables 19.1 and 19.2 show a balance sheet and income statement developed under both approaches to compare the differences in translation methods. b. Disclosing Foreign-Exchange Gains and Losses. Under the current-rate method of translating foreign-currency financial statements, the gain or loss is called an accumulated translation adjustment and is recognized in owners’ equity. Under the temporal method, the gain or loss is taken directly to the income statement, thus affecting earnings per share.

VI. INTERNATIONAL FINANCIAL ISSUES A. Capital Budgeting in a Global Context Capital budgeting is the process whereby MNEs determine which projects and countries will receive capital investment funds.

1. Methods of Capital Budgeting a. Payback Period. One method uses a payback period—the number of years required to recover the initial investment made. b. Net Present Value. Another method is to determine the net present value (NPV) of a project, which is a function of the annual free cash flow in a period, the required rate of return or cost of capital, the initial outlay of cash, and the project’s expected life. c. Internal Rate of Return. A third approach is to compute the internal rate of return—the rate that equates the present value of future cash flows with the present value of the initial investment.

2. Complications in Capital Budgeting Several aspects of capital budgeting are unique to foreign project assessment: • Parent cash flows must be distinguished from project cash flows 6 .

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Remittance of funds to the parent (such as dividends, interest on loans, and payment of intra-company receivables and payables) is affected by differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in how financial markets and institutions function • Differing rates of inflation • Unanticipated exchange-rate changes • Political risk in the target market • The terminal value of the project is difficult to estimate because potential purchasers from host, home, or third countries may have widely divergent views on the project’s value.

Because of these complications, it is very difficult to estimate future cash flows.

There are two ways to deal with these variations: 1) determine several different cash flow scenarios and 2) adjust the hurdle rate, which is minimum required rate of return the project must achieve for it to receive capital.

B. Internal Sources of Funds Funds refer to working capital, i.e., the difference between current assets and current liabilities. Internal sources of funds include loans, investment through equity capital, interfirm receivables and payables, and dividends.

C. Cash Flows and the MNE Interfirm financial links become extremely important as MNEs grow in size and complexity. Funds can flow from parent to subsidiary, subsidiary to parent, and/or subsidiary to subsidiary. Goods, services, and funds all can move within an MNE, thus creating receivables and payables. Entities may choose to pay quickly (a leading strategy) or to defer payment (a lagging strategy). Transfer pricing can be used to adjust the size of a payment. In addition, firms can generate cash from normal operations.

Whatever the means, international cash management is complicated by differing inflation rates, fluctuating exchange rates, and distinct national and regional bloc policies regarding the flow of funds.

D. Global Cash Management Global cash management strategy focuses on the flow of money to serve specific operating objectives. Effective cash management hinges on the following questions: • What are the local and corporate system needs for cash?

• How can the cash be withdrawn from subsidiaries and centralized?

• Once the cash has been centralized, what should be done with it?

Cash budgets and forecasts are essential in assessing a firm’s cash needs. Cash may be transferred within a firm via dividends, royalties, management fees, and the repayment of principal and interest on loans.

1. Multilateral Netting. Multilateral netting is the process of coordinating cash inflows and outflows among subsidiaries so that only net cash is transferred, reducing transaction costs. Multilateral netting allows subsidiaries to transfer net intercompany flows to a clearing account, which disburses cash to net receivers.

Netting requires sophisticated software and good banking relationships in different countries. [See Figure 19.6 and Table 19.3]

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VII. FOREIGN-EXCHANGE RISK MANAGEMENT As illustrated earlier, global cash-management strategy focuses on the flow of money for specific operating objectives. Another important objective of an MNEs financial strategy is to protect against the foreign-exchange risks of investing abroad. Strategies to protect against such risks may include the internal movement of funds, as well as the use of foreignexchange instruments such as options and forward contracts.

A. Types of Exposure The three types of foreign-exchange exposure include translation exposure, transaction exposure, and economic exposure.

1. Translation Exposure. Translation exposure reflects the foreign-exchange risk that occurs because a parent company must translate foreign-currency financial statements into the reporting currency of the parent, i.e., the value of the exposed asset or liability changes as the exchange rate changes.

2. Transaction Exposure. Transaction exposure reflects the foreign-exchange risk that arises because a firm has outstanding accounts receivable or payable that are denominated in a foreign currency, i.e., the receivable or payable changes in value as the relevant exchange rate changes.

3. Economic (or Operating) Exposure. Economic or operational exposure arises from effects of exchange-rate changes on future cash flows, the sourcing of parts and components, the location of investments, and the competitive position of the company in different markets.

B. Exposure-Management Strategy Management must do a number of things if it wishes to protect assets from exchangerate risk.

1. Define and Measure Exposure. An MNE must forecast the degree of exposure in each major currency in which it operates and adopt appropriate hedging strategies for each. A key aspect of measuring exposure is forecasting exchange rates, where the major concerns are the direction, magnitude, and timing of exchange-rate fluctuations.

2. Organize and Implement a Reporting System. Once the company has decided how to define and measure exposure and estimate future exchange rates, it must create a reporting system that will assist in protecting it against risk. To achieve this goal, substantial participation from foreign operations must be combined with effective central control.

3. Formulate Hedging Strategies. A firm can hedge its position by adopting operational and/or financial strategies, each with cost/benefit and operational implications. a. Operational Hedging Strategies. Firms may choose to balance local assets with local debt by borrowing funds locally, because that helps avoid the foreignexchange risk associated with borrowing in a foreign currency. They may also choose to take advantage of leads and lags for interfirm payments. b. Leads and Lags. A lead strategy means collecting foreign-currency receivables before they are due when the currency is expected to weaken or paying foreigncurrency payables before they are due when a currency is expected to strengthen. A lag strategy means delaying collection of foreign-currency receivables if the currency is expected to strengthen or delaying payment of 8 .

foreign-currency payables when the currency is expected to weaken. However, such strategies may not be useful for the movement of large blocks of funds, and they may also be subject to government restrictions. c. Using Derivatives to Hedge Foreign-Exchange Risk. A firm can also hedge exposure through forward contracts and options, which establish fixed exchange rates for future transactions and currency options, i.e., derivatives, which assure access to a foreign currency at a fixed exchange rate for a specific period of time. A foreign-currency option is more flexible than a forward contract because it gives the purchaser the right, but does not impose the obligation, to buy or sell a certain amount of foreign currency at a set exchange rate within a specified amount of time.

LOOKING TO THE FUTURE: The Impact of Global Economic Forces on Accounting and Finance The future of accounting is complicated. It is clear that more jurisdictions use IFRS than U.S. GAAP for external financial reporting. However, the United States is no closer to allowing IFRS to be used for U.S. companies listing on U.S. stock exchanges. A major reason is that GAAP is far more comprehensive than IFRS, both in depth and breadth. Also, it responds more to the background, needs, and regulatory requirements of U.S. capital markets than do IFRS. From a financial point of view, fluctuations in the foreign exchange markets will continue to wreak havoc.

CLOSING CASE H&M: The Challenges of Global Expansion and the Move to Adopt International Financial Reporting Standards This case explores the accounting standards of Hennes & Mauritz AB (also known as H&M), the Swedish MNE that is a trend setter in the latest fashion trends, with the goal of giving customers unbeatable value by offering fashion and quality at the best price. H&M must comply with the accounting standards of its home country, Sweden, as well as the accounting standards of the European Union. The case traces the changes H&M makes in its reporting standards over the past few years. Prior to the move to IFRS in 2006, H&M reported its results in compliance with Swedish GAAP. In this case H&M is dealing with multiple reporting issues and questions of compliance.

QUESTIONS 19-3. If an investor wants to compare the financial results of The Gap, Inditex, and H&M, what difference does it make that their financial statements are prepared according to different GAAP? Would you expect there to be a big difference between U.S. GAAP as used by The Gap and IFRS as used by H&M and Inditex?

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It does make a difference to know which GAAP is used because it might have an impact on the financial statements. Because Swedish GAAP, in recent years, has been adapted to IFRS to a high degree, I expect a big difference between U.S. GAAP as used by The Gap and IFRS as used by H&M and Inditex. (LO 19-1: To examine the major factors influencing the development of accounting practices in different countries, AACSB: Analytical Skills).

19-4. What type of IFRS did H&M decide to disclose in its financial statements in 2005? In 2015?

H&M converted to IFRS in 2005. Prior to the move to IFRS, H&M reported its financial results in compliance with Swedish GAAP —a bit of a mixture between Anglo-American accounting, which is driven by the capital markets, and Germanic accounting, which is driven by bank financing and taxation. In its 2015 annual report, H&M states that its consolidated accounts have been prepared in accordance with IFRS issued by the IASB and the interpretations provided by the IFRS Interpretations Committee. In addition, the IFRS that is used for its parent company reports are only those approved by the EU. (LO 19-3: Describe international accounting standards and the process of global convergence, AACSB: Reflective Thinking).

Additional Exercises: Multinational Accounting Exercise 19.1. Ask the students to find the financial statements of a company headquartered in Europe and one headquartered in the United States. Are these statements comparable?

What are the major differences in accounting standards that one might want to be aware of when trying to compare the financial results as reported by these two companies? (LO 19-1: To examine the major factors influencing the development of accounting practices in different countries, AACSB: Analytical Skills.)

Exercise 19.2. Have students look at Coca-Cola’s most recent financial statements. What impact do currency fluctuations have on Coca-Cola’s business results? Are there any notes in the financial statements that explain the handling and/or impact of currency fluctuations on reported results? (LO 19-3: To explain how companies account for foreign-currency transactions and translate foreign-currency financial statements, AACSB: Dynamics of the Global Economy.)

Exercise 19.3. Many transition economies such as China, Russia, and the former Soviet satellite nations have not only different accounting standards from those found in West Europe, North America, and Japan, but their accounting systems are seriously underdeveloped, given the dynamics of today’s global business environment. Ask the students to discuss the logic of those countries adopting the International Accounting Standards as the basis of their national business accounting systems. (LO 19-2: To examine the global convergence of accounting standards, AACSB: Multicultural and Diversity Understanding.)

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Chapter 20 International Human Resource Management OBJECTIVES 20-1 Describe international human resource management 20-2 Distinguish the perspective of the expatriate 20-3 Differentiate the staffing frameworks used by MNEs 20-4 Describe expatriate selection 20-5 Appraise expatriate preparation 20-6 Profile expatriate compensation 20-7 Explain expatriate repatriation 20-8 Describe expatriate failure

CHAPTER OVERVIEW Firms the world over agree on the importance of qualified personnel to achieve their foreign growth and operational objectives. Chapter Twenty broadly deals with two primary human resource concerns. The management discussion begins with an overview of specific international management qualifications and characteristics; it then explores the advantages of transferring and promoting home country vs. expatriate vs. third-country managers, plus the associated issues of compensation and repatriation. The chapter concludes with an exploration of expatriate failure.

CHAPTER OUTLINE OPENING CASE:

GLOBALIZING YOUR CAREER

Today’s global companies are increasingly looking for managers who are comfortable on the world stage. International companies use expatriate managers to varying degrees, some extensively and some sparingly. Many companies develop their managers for years before assigning the manager to an overseas position. Laying the foundation for a possible career in international business is hard work, and the experience of actually working internationally can be even harder. Managers in foreign assignments are usually given much broader responsibilities than they have experienced in their home country. After completing an international assignment, repatriation to the home country presents major challenges as well. Despite the challenges of international careers, more and more CEOs assert that international experience is an essential feature of a high-performance career.

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Questions 20-1. Identify three compelling reasons to pursue an expatriate assignment.

Some people believe that an expatriate assignment will give them a larger leadership position with expanded opportunities. As the expatriate assignment brings on broader leadership opportunities, it also develops creativity and adeptness to problem think in new ways. It also can mean gaining knowledge about differences between people and markets.

(LO 20-4: Describe expatriate selection, AACSB: Analytical Skills.)

20-2. Identity three key qualifications of a successful expatriate .

A successful expatriate needs to have the ability to understand the location, requiring cultural intelligence and specific skill set needed for the specific market. They need to be ready to collaborate with the local population and staff. They need to be willing and able to navigate challenging, even unsafe, environments. A successful expatriate feels confident on the global stage, but also keeps contacts within the professional world back home. (LO 20-4: Describe expatriate selection, AACSB: Analytical Skills.)

Teaching Tips: Review the PowerPoint slides for Chapter Twenty and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures and tables in the text.

I.

INTERNATIONAL HUMAN RESOURCE MANAGEMENT International Human Resource Management (IHRM) is an umbrella term that refers to overseeing all things related to managing employees in the MNE. IHRM organizes people within the MNE, developing policies and systems that improve individual productivity and collective performance. Unconditionally, IHRM is more difficult for the MNE than for its uninational counterpart. Besides dealing with situations in the home market, IHRM adjusts policies and systems for differing political, cultural, legal, and economic circumstances. This chapter evaluate IHRM from the perspective that the successful MNE staffs its operations with skilled executives that are mission-led and principle-driven to leverage its strengths and managing its weaknesses, all the while reconciling the competing pressures of global integration and local responsiveness. This perspective emphasizes that IHRM activities perform best when managers link them to the MNE’s strategy (see Figure 20.2).

A. The Strategic Role of IHRM Anecdotes suggest and research confirms a powerful relationship between HRM processes, management productivity, and strategic performance. International HRM can be a source of creating superior value and competitive advantages. Superior human resources can sustain high productivity, competitive advantage, and value creation for the international company. The relationship between superior HRM and high productivity, competitive advantage, and shareholder value confirms its importance and has transformed HRM. HRM is now a driver of company strategy and has a direct mission: to staff the right person in the right job in the right place for the right salary.

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1. A Case in Point: GE’s Evolution. Beginning in the 1980s, GE focused on globalizing its markets and materials sourcing. At each step along the way to its current transnational strategy, GE rethought its HRM philosophy to make sure it had the human capital to achieve its strategy.

B. IHRM’s Mission GE’s success, like that of many other MNEs profiled throughout this chapter, highlights IHRM’s mission: find, staff, compensate, and retain executives with the qualifications needed to support and sustain the MNE’s strategy. Done well, IHRM supports higher productivity, stronger competitiveness, and improving profitability. Done poorly, people problems undermine firm performance and diminish careers.

II. The Perspectives of the Expatriate A. Who’s Who? Classifying a foreign assignment, in terms of the executive’s relative nationality, uses a range of terms, including • expatriate, • home-country national, • inpatriate, • parent-country national, • third-country national, • transpatriate, • repatriate, There are various types of expatriates. A home-country national, also known as a parent-country national, is a citizen of the country where the firm is headquartered (i.e., a Brazilian national sent to the Argentinean subsidiary of their Brazilian MNE). A third country national is a citizen of neither the home, nor the host country (i.e., an Indonesian national running the German subsidiary of their Singaporean company). If the Indonesian executive is transferred to the MNE’s Singapore headquarters, they are then an inpatriate. A transpatriate works an ongoing series of international assignments, plans never to return to headquarters, and often identifies with neither a corporate nor a national “home.” Lastly, a repatriate is an expatriate returning to the home market from the foreign assignment.

B. Trends in Expatriate Assignment.

Demand for expatriates escalates worldwide. MNEs of all types struggle to staff subsidiaries. Shortages of talented executives, in light of flexible logistics and shifting markets, change the characteristics of the international assignment. The notion of “a few years” increasingly gives way to a few months, a few weeks, or even a few days.

So-called commuter assignments post an expatriate for a short span. In extreme cases, it comprises the workweek, with the expat returning home for the weekend— weekend—say, shuttling between Vienna and London. Increasingly, commuter assignments give rise to so-called flexpatriates, executives who run the commuter cycle for a longer span as they work “frequent flyer assignments”.

1. The Young, the Old, and the Restless. Traditionally, an international assignment was seen as a midcareer opportunity for development. Now companies are looking to older and younger employees who are more mobile. Younger employees are 3 .

given an early opportunity for international experience. More females are also seeking expatriate placements. Increasingly, one sees individuals who relocate on their own initiative and motivation to work abroad —these are commonly referred to a self-initiated expatriate (SIEs).

2. Expanding Scope of Women. Females currently comprise about 20% of all expatriates.

3. Growing Scope of Third Country National. The changing workplace of globalization elevates the role of third country nationals, who often have the particular outlook and versatile competencies needed to run organizations in diverse locations. Short-term assignments boost the logistical appeal of third-country nationals.

4. Reverse Expatriates. The rising importance of emerging markets refines our evolving ideas of expatriates. Historically, MNEs recruited executives in richer countries and assigned them to units in developing countries. Now, talented executives from emerging economies—so-called reverse-expats—are sent straight to richer countries to speed their development. They spend anywhere from a few weeks to a year in an operational unit before eventually returning home—where they often replace a traditionally defined, and usually higher-paid, expatriate.

C. The Economics of Expatriates.

Economic pressures and cost concerns spur companies to emphasize frequent business travel in lieu of a longer-term international assignment. Cost pressures encourage localization, whereby an expatriate retains the foreign assignment but accepts the status of a local hire and, correspondingly, a lower host-location salary.

D. The Enduring Constant.

Evolving trends in the global marketplace drive evolving ideas on staffing international operations. Still, there is an enduring constant: Running the hundreds of thousands of subsidiaries throughout the world requires a mix of talented, enterprising locals, parentcountry execs, and third-country expatriates.

III. Staffing Frameworks in the MNE IHRM professionals apply staffing frameworks (a conceptual structure that helps solve complex issues) to organize expatriate policies and systems. Research emphasizes the ethnocentric, polycentric, and geocentric staffing frameworks.

A. The Ethnocentric Framework Ethnocentrism occurs when one group places itself at the top of a supposed hierarchy of relevant groups. Hence, the ethnocentric framework signifies the belief that the management principles and business practices used by headquarters are superior to those used in other countries.

1. Advantages. Staffing overseas slots with parent-country executives has strategic, skills, and socialization advantages. a. Strategic Advantages. Headquarters prefers entrusting control of the company’s “crown jewels” to those who will best protect them: namely, trustworthy colleagues from the home country.

2. Transfer Advantages. Regulating the transfer of its core competencies is vital when they are difficult to articulate, specify, or standardize. An ethnocentric 4 .

framework offsets this problem by posting a home-country manager with technical knowledge and direct experience to local slots. a. Socialization Advantages. Expats from the home office, besides diffusing technical expertise and insight, also help socialize locals to the company’s global outlook.

3. Limitations. This approach can, however, lead some difficulties. a. Workplace Tensions. Ethnocentric staffing policies demotivate local workers.

Unless an expatriate transfers unique skills, local employees may resent someone they see as no more, perhaps less, qualified than themselves. b. Legal-Political Tensions. An ethnocentric staffing policy can prove legally difficult and politically impractical. Employment law in countries worldwide regulates, sometimes lightly, sometimes strictly, the use of expatriates in place of locals. c. Misreads and Misfits. Tensions Force-fitting foreign operations to mimic the standards of the home office risks pounding square pegs into circular slots.

Certainly, an MNE can make its foreign operations mirror the outward appearance of its home-country headquarters. Assigning home-office executives to foreign operations, however, does not automatically create a successful “mini-me” subsidiary. Consequently, an ethnocentric framework can prove detrimental, posting executives who misread markets and methods.

B. The Polycentric Framework The polycentric staffing framework looks to host-country nationals to manage local subsidiaries.

1. Advantages. Staffing foreign operations with locals has strategic, economic, and political advantages a. Strategic Advantages. Proponents of polycentrism reason that local managers are stronger performers given their keener understanding of local customers, markets, and institutions. b. Economic Advantages. Using host-country managers boosts local motivation and morale. Still, likely costs include gaps with global operations due to problems of accountability and allegiance. c. Political Advantages. Understandably, host governments prefer polycentric approaches. They see local managers as better citizens and stakeholders than expatriates, far more likely to champion national interests over global objectives. Activist officials often require the MNE hire locals, such as licensing requirements that prohibit expatriate accountants and lawyers or visa regulations that put a hard cap on the number of foreigners who can staff a local subsidiary. The polycentric framework neutralizes these impediments.

2. Limitations. A polycentric approach, by effectively decentralizing authority to local subsidiaries, fans organizational tensions on several counts. a. Autonomy Tensions. Installing local executives in decision-making roles and growing resource independence from the parent could turn the local subsidiary into a quasi-autonomous unit. Unchecked, an MNE risks devolving into a federation of loosely connected, largely autonomous national operations that pay little mind to headquarters. Dilemmas over allegiance emerge when host 5 .

country managers are loyal to local colleagues instead of their home-country bosses. b. Motivation and Mobility Tensions. Locals have scant opportunities to work outside their home country, effectively imposing a glass ceiling on their professional mobility. Consequently, local managers may see little incentive to study multinational business practices or identify ways to improve crossnational integration. The resulting single-country focus can isolate national subsidiaries as well as push enterprising executives, ambitious to work abroad, to quit.

C. The Regiocentric Staffing Framework.

The regiocentric staffing framework fills expat slots with executives that have the corresponding regional outlook and orientation and typically reside in the region.

1. Advantages. Staffing intra-regional units with “regio-pats” has strategic and proximity advantages a. Strategic Advantages. Staffing expat slots within a region by folks who reside in the region develops cohesive, coherent interpretations of business activities and market situations and. b. Proximity Advantages. Managing human resources within a geographically proximate region supports all sorts of operational advantages. Flexpats, commuters, and gig-pats are compellingly practical options given the ease of traveling among neighboring countries. Other benefits follow from linguistic, cognitive, and cultural intersections; ultimately, goes the reasoning, improved communication improves collaboration that improves decision-making.

2. Limitations. The focused domain of a regional operation can intensify organizational and interpersonal social dynamics. Unchecked, ordinary complications can escalate into charged complexities. a. Position and Power. Disaggregating the operations into regional zones directs regional units to focuses outlooks and orientations on regional matters at the expense of global integration. b. Legacies. The rationale that folks that reside in a region share outlooks and orientations is appealing, but not necessarily realistic. Differing cultural, social, political, and legal moderators among nations within a region similarly challenge the effectiveness of the regio-pat.

D. The Geocentric Staffing Framework The geocentric staffing framework posts the most qualified executives, regardless of nationality, to expatriate slots.

1. Advantages. The geocentric framework develops executives whose global mindset enables them to easily and effectively navigate cultures and countries a. Strategic Advantages. Geocentricity, and its advocacy of a global mindset, develops expats that command key competencies. They understand and interpret what is going on in a global situation, they decipher verbal and nonverbal messages and signals from people of different outlooks, and their flexibility helps them deal appropriately with different situations. They effectively implement global and, especially, transnational strategies, finding 6 .

ways to exploit learning opportunities, transfer knowledge, and promote collaboration 2. Limitations. A geocentric framework is tough to develop and costly to sustain.

Professional and logistic tension complicate its effectiveness. a. Professional Tensions. Difficulty plagues expat development given the need for executives to retain a sense of identity in the face of increasing diversity.

Working with groups marked by cultural diversity takes on a different vibe than with groups composed of people of similar ethnicities and nationalities. b. Logistics Tensions. The geocentric framework imposes costly logistics.

Exposing executives to different ideas in diverse places, given the quest to improve their global mindset, is expensive.

E. Which Framework When?

Each of the three staffing approaches has its merits and drawbacks. [see Table 20.1].

IV. EXPATRIATE SELECTION Screening executives to find those with the greatest inclination and highest potential for a foreign assignment is the process of expatriate selection (see Figure 20.4). Today, IHRM applies operational, cultural, and personality measures, commensurate with the prevailing staffing framework, to identify candidates. These screens, applied through objective evaluations and in-depth personal interviews, assess candidates on several dimensions.

Anecdotes and analysis emphasize the following.

A. Technical Competence Technical competence (usually indicated by past performance) is a significant determinant of success in foreign assignments. The foreign subsidiary manager must understand both the technical necessities of a position and also how to adapt to foreign conditions, such as scaled-down plant and equipment, varying productivity standards and less efficient national infrastructure.

B. Self-Orientation An expatriate assignment is marked by ambiguity, uncertainty, and risk. Thrust into challenging situations, an expat’s effectiveness depends upon developing new knowledge, skills, and abilities. Facing ambiguities, one must organize interpretation and fortify decision-making.

C. Others-Orientation Orientation, both self and others, help expats (1) manage ambiguity, uncertainty and risk, (2) resolve physical, emotional and social stress, (3) support effective communication, and (3) enhances interpersonal interactions.

D. Resourcefulness Resourcefulness refers to a person’s potential for (1) self-maintenance situational flexibility, (2) interpreting the immediate environment, and (3) developing productive workplace relationships.

E. Global Mindset Increasingly a precondition as well as an outcome of expatriate success, a global mindset reflects awareness of differences across countries coupled with a capacity to divine overlapping principles. A global mindset helps successful expatriates see not a barren landscape, but a cornucopia of choices upon entering foreign markets.

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V. EXPATRIATE PREPARATION AND SUPPORT Ideally, IHRIM begins preparing an executive for an international assignment long before she is slated to go. Too, IHRIM does not stop once she begins her new job; support systems carry on to optimize her performance. Conventionally, IHRM focused on fitting an expat’s technical know-how with the position’s requirements. Figure 20.5 identifies leading concerns of expatriates ahead of moving to their foreign assignment. These concerns show that improving cultural sensitivities and interpersonal skills improves the odds of successful adjustment and, by extension, a successful assignment. IHRM translate this imperative into a two-stage program: preparation prior to departure, and then, once in-country, ongoing development: A. Pre-Departure Preparation Programs Expatriate preparation programs aim to transfer specific information about the host country as well as improve the executive’s cultural sensitivity. preparing expats often requires helping them recognize gaps in their global mindset. Realization helps immunize them to culture shock—a soon-after-arrival dissatisfaction with the host society that can deteriorate into homesickness, irritability, arrogance, and disdain.

B. In-Country Development Programs In-country development efforts, often through mentorship programs, virtual meetings, and executive coaching, support the expatriate. Increasingly, MNEs use CD-based or web-based development programs, given that the expatriate can tap resources anywhere, anytime during an assignment. Their economical convenience provides incountry reinforcement tools that can span the assignment.

C. Family Matters Increasingly, expatriate preparation and support activities include the spouse and family members. An emerging trend is including families in predeparture preparation, particularly destination familiarization and cultural orientation programs.

POINT-COUNTERPOINT: English: Destined to be the Global Language?

POINT: English is quickly becoming the lingua franca of the world. English is being taught as the second language in a number of schools throughout the world. Nearly a quarter of the world’s population speaks some English, and English speakers account for 40 percent of the world’s output. The prevalence of English on the Internet makes it possible to conduct business all over the world in one language, and translation software makes learning a foreign language less useful. Many managers report that foreign language skills rank low relative to other skills needed to work abroad.

COUNTERPOINT: There are many reasons for learning a foreign language. Surveys report that managers who learn foreign languages make better innovative contributions to their organizations. Learning the local language can build rapport with local employees and sends an important message. Cross-cultural literacy can also keep one from being excluded from important business networks and chatting with local officials and colleagues. Learning a foreign language is also a personally enriching experience for anyone going abroad. Finally, foreign 8 .

language competency may be needed as Americans increasingly face strong competitors who are bilingual or multilingual.

VI. EXPATRIATE COMPENSATION Compensation plays a decisive role in attracting, motivating, and retaining expatriates.

Setting effective compensation systems that fairly reward executives here, there, and everywhere requires IHRM deal with a range of issues regarding differing pay levels, benefits, tax programs, and prerequisites.

A. Types of Compensation Plans The most common approach to expatriate pay is the balance sheet approach, which aims to develop a salary structure that equalizes purchasing power across countries so expatriates have the same standard of living in their foreign assignment as they had at home. There are three common methods of implementing the balance sheet compensation plan.

1. Home-Based Method. The home-based method sets compensation based on the salary of a comparable job in the expatriate’s home city.

2. Headquarters-Based Method. The headquarters-based method sets salary in terms of the salary of a comparable job in the city where the MNE has its headquarters.

3. Host-Based Method. Sometimes called destination pricing, going rate, or localization, this method bases expatriate compensation on the prevailing pay scales in the foreign locale.

4. Global Market Method. The global market approach views an international assignment as a continuous but an irregular activity. It recognizes that an expatriate, in the context of a commuter or flex assignment, irregularly works for different durations in the same or, sometimes, different countries. Implementing this approach requires designing flexible systems and sophisticated performance tracking that, in spite of logistical complications, keeps the expat whole.

B. Compensation Components Commonly, expatriates negotiate their base salary, foreign-service premium, various allowances, fringe benefits, tax differentials, and benefits [see Table 20.2]. Each dimension can significantly influence the total compensation. The changing economics of expatriate assignments moderates compensation schemes. In particular, the mandate to contain costs pushes IHRM to review the link between aspects of selecting and classifying expatriates with compensation standards. Key points include: 1. Assignment Type. The growing use of commuters and flexpatriates alters the compensation calculus. Short-term assignments typically do not trigger a change in pay or benefits, but add a per diem to regular pay.

2. Supply Dynamics. Many international assignments have “gone from being special and unique, with piles of money thrown at them, to being an everyday part of the company.” Foreign service premiums, likewise, have been phased out by many.

3. Qualifying Locations. Increasing globalization, by diffusing life-style standards, steadily reduces the number of hardship destinations. Certainly, some qualify on the basis of difficult climate, housing, crime, health care, or pollution conditions; expats 9 .

assigned to such posts receive a hardship differential of between 10 and 35 percent of their salary. Still, IHRM reports decreasing hardship allowances for locales that are far more hospitable than they once were.

C. Compensation Complications Setting compensation in evolving organizations that use several types of expatriates expands the parameters of analysis. IHRM, for instance, regularly resolves complications of the following sort. a. Changing Standards. The evolving dynamics of globalization require IHRM finetune compensation methods. MNEs struggle to equalize pay for the same type of job that is done by different people in different countries. b. Consistency Concerns. Legal, cultural, and regulatory differences require tailoring performance-based pay by country and region. c. Strategic Concerns. An MNE applying an ethnocentric framework may have few expatriates today, but expanding internationalization complicates administering compensation packages run on a case-by-case basis. An MNEs applying a geocentric framework, alternatively, has expats of multiple nationalities that are moving from high- to low- or from low- to high-cost locations creates anomalies and exceptions. IHRM must determine if all managers who perform the same job, but in different locations, receive the same compensation VII. EXPATRIATE REPATRIATION Repatriation is the process of returning the expatriate to his or her home country-working environment and is a process fraught with difficulties.

A. Repatriation Challenges 1. Career Progression. The principal cause of repatriation frustrations is finding the right job for the returning executive.

2. Changes in Personal Finances. Most expatriates enjoy a rich lifestyle and returning home with fewer benefits and perks may be difficult.

3. Personal Readjustment. Expatriates may experience reverse culture shock when returning home. They may find that they have to relearn things they took for granted.

B. Managing Repatriation Effective human resource practices for soothing re-entry include placement in jobs that build on foreign experiences, a reorientation program, and a corporate mentor who looks after expatriates’ interests while they’re abroad. The principal cause of repatriation frustrations is finding the right job for someone to return to. IHRM notes the importance of effective repatriation. Most have formal repatriation policies, organize workshops, and link return strategies to career management. IHRM studies and solves repatriation complications precisely because the greater the difficulties that repatriates confront, the greater the difficulty in convincing others to accept international assignments.

VIII. EXPATRIATE FAILURE Expatriate failure, narrowly defined, is a manager’s premature return home due to poor operational performance. Broadly defined, it is the breakdown of IHRM’s expatriate 10 .

management systems. In the 1980s, performance problems brought nearly a third of American expatriates assigned to advanced countries home early; the failure rate was twice that for those posted to less-hospitable countries. Today, approximately 5 percent of expats fail to complete their assignment . Leading causes include quitting to work elsewhere, family concerns, spouse/partner dissatisfaction, inadequate job performance, organizational restructuring, and internal transfer [see Figure 20.6].

A. The Costs of Failure Expatriate failure is operationally costly, professionally detrimental, and personally stressful. The average cost of an expatriate failure can be as high as three times the annual domestic salary plus the cost of relocation.

B. The Wildcard Some folks, despite best intentions, do not adjust well to working abroad. In theory, an ideal expatriate’s technical qualification, self-confidence, resourcefulness, and global mindset make her effective anywhere and everywhere. Displacement can lead to nostalgia, culture shock, and depression. Notwithstanding the glamour and rewards, the expatriate lifestyle moves some far beyond their comfort zone. Then, no matter the degree of preparation, a sought-after adventure devolves into a depressing exile.

LOOKING TO THE FUTURE: I’m Going Where? The Changing Geography of International Assignments In the past, expatriates found their assignments in the premier business centers of Europe, North America, and Japan. The rising importance of emerging economies in fast expanding Asia and Africa is the driving force behind Western MNEs relocating a large share of operations in these regions. As sales, growth, labor, and executive opportunity migrate from the west to faster growing emerging economies, you can expect a change in the geography of expatriate assignments and activities. Data already confirms the trend is underway: China, Vietnam, the United Arab Emirates, Hong Kong, Thailand, Czechia, Qatar, India, and Singapore are leading destinations for expats. Not far behind are Thailand, Malaysia, Oman, Estonia, Kenya, and Nigeria.

CLOSING CASE: Tel-Comm-Tek: Selecting the Managing Director of its Indian Subsidiary Tel-Comm-Tek (TCT) manufactures a variety of small office equipment such as copying machines, dictation units, laser printers, and paper shredders. The company is headquartered in the U.S., but has an Indian subsidiary. Mark Hopkins, the managing director of TCT’s Indian subsidiary, has just resigned and needs to be replaced. Six candidates have been identified as possibilities to fill the position. Due to plans for the construction of a factory in Bengaluru, the new director will need to have manufacturing experience as well as the ability to function effectively in other aspects of the position.

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QUESTIONS 20-3. Identify the key advantage of each of the six candidates. Identify each candidate’s key limitation. Then, rank-order the candidates, from most to least qualified, for the position of Managing Director of TCT India.

The first thing I did was to look at the location of Bengaluru. India is a very diverse country in regard to regional characteristics and even dialects. Some areas are predominantly Muslim and other areas are Hindu. Hindi and English are the main languages used in official business.

Rank Candidates Pro 1 Saumitra Saumitra is already in India. His job Chakraborty performance has been positive. He also has several connections and speaks the language of the region 2 Atasi Das Speaks Hindi and English; Does not need to move a family to a new location requiring additional transitional needs.

2

Ravi Desai

3

Julan Bukit Seng

4

Brett Harrison

Con He is a younger candidate, and it does indicate that he lacks line experience

While she has Indian ancestry and parents as first-generation immigrants from India, her family is from the Northern states which means her relationship with Bengaluru may be limited.

He is already based in India, requiring We have not learned as less transitional time. He already has much about his abilities to had experience as an expatriate, so he manage a new market. He may be open to a new role within the will also need to relocate country. his family. Compared to others, he is rather young As a native to the region of South Asia, One limitation is that he he would be familiar with some Asian carries a pretty large role cultural traditions. He travels on a in the region. He may see regular basis already. While he does not the step as shift downward speak Hindi, he speaks English and as he is over the entire Tamil, which is also spoken in country of Malaysia Bengaluru.

Has been with the company for 21 He will need to move a years and has already proven success in family (including a teenage the Asia area with the company. daughter). Sometimes, it is fine to visit a country, but moving to a country with a family brings new challenges for the 12 .

5

Tom Wallace

He may be up to considering a new position because his position will be eliminated soon. He is close to retirement, but as his position will be eliminated, he may consider this role to complete his time to retirement. His overall commitment to the job has been remarkable.

employee. Currently, he is in the Asian market, but has limited experience in India.

He does not have much expat experience and his family may have a hard transition to the region.

(LO 20-4: Describe expatriate selection, AACSB: Analytical Skills.)

20-4.What operational and personal challenges might the person you recommend encounter if named managing director?

Operational: Beginning a new location, having a “complete” understanding of operations, establishing connections Personally: Transition to a new place, relocating family, travel time needed to return/visit family or home country, differences in celebrations or cultural places. Developing a new support system for a person or family in the region.

(LO 20-4: Describe expatriate selection, AACSB: Analytical Skills.)

20-5. What steps would you recommend your preferred candidate take to manage those challenges?

Candidates Saumitra Chakraborty Atasi Das Ravi Desai Julan Bukit Seng Brett Harrison

Steps Provide staff assistance from headquarters.

Provide technical training and development at headquarters.

Offer advanced work with local management.

Offer advanced work with local management.

Offer orientation and language training.

Provide training visits to similar operations elsewhere.

Offer special commuting arrangements so his wife can maintain her career.

Offer fixed-term assignment.

Provide assistance in selecting and settling the children into schools.

Tom Wallace

Offer orientation and language training for Wallace and his wife.

Provide training visits to similar operations elsewhere.

Offer extra encouragement so Wallace feels valued.

(LO 20-4: Describe expatriate selection, AACSB: Analytical Skills.) .

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20-6. Imagine TCT applied a polycentric staffing framework. Would that change your ranking of the candidates? Who now would be your preferred candidate?

As a Polycentric operation respects local environment and hires locally, the pick of Saumitra Chakraborty would support the advantages of the model. One of the pick number twos, Ravi Desai, is located within India, so he probably would inch out ahead of Atashi. The rest of the picks would say at the same ranking. The only challenges of Saumitra and Ravi, is that they would be responsible to responding to the differences between home/host countries. As far as we know, they have not spent time at the main headquarters of TCT. (LO 20-3: Differentiate the staffing frameworks used by MNEs, AACSB: Analytical Skills.)

20-7 Imagine TCT applied an ethnocentric staffing framework. Would that change your ranking of the candidates? Who now would be your preferred candidate?

Yes, it would. Tom Wallace has an extensive history within the headquarter company. With an ethnocentric framework, you would only focus on transmitting the goals of the headquarter, so having regional experience would not necessarily be a plus. In this case, Atashi would move ahead of Saumitra and Ravi as well due to her experience in the United States. (LO 20-4: Describe expatriate selection, AACSB: Analytical Skills.)

20-8 Imagine TCT applied a regiocentric staffing framework. Would that change your ranking of the candidates? Who now would be your preferred candidate?

I think if it would change to a regiocentric staffing framework, the focus would be more on a larger regional, rather than the immediate country. This may mean that regional placed employees such as Brett Harrison and Jalan Bukit Seng may be a good choice as they have experience in the region of South Asia. (LO 20-4: Describe expatriate selection, AACSB: Analytical Skills.)

Additional Exercises: Human Resource Management Exercise 20.1. Ask students to discuss the human resource implications for an MNE that pursues (a) a multidomestic strategy, (b) a global strategy, and (c) a transnational strategy.

Then ask them to follow that discussion by examining the relationship among the human resource function and the sourcing/manufacturing and the marketing functions of MNEs that pursue each of those strategies. (LO 20-1: To discuss the importance of human resource management, AACSB: Dynamics of the Global Economy.)

Exercise 20.2. Research suggests many expatriate employees encounter problems that limit both their effectiveness in foreign assignments and their contributions to the firm once they return home. Ask students to discuss the primary causes and consequences of these problems. What can a firm do to reduce the occurrence of such problems? (LO 20-2: To explain the types of expatriates, AACSB: Analytical Skills.)

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Exercise 20.3. A key issue in international labor relations is the degree to which organized labor can limit a firm’s ability to pursue a global or a transnational strategy. Ask students to identify MNEs whose operations reflect each of those management strategies. Then ask them to discuss the ways in which organized labor can possibly affect (or has affected) their pursuit of those strategies. What, if anything, can MNEs do to counter those efforts? (LO 20-3: To profile the staffing frameworks used by MNEs, AACSB: Dynamics of the Global Economy.)

Exercise 20.4. Have the students pick a country other than their home country in which they would like to work. What challenges do they think they would face working in that country?

Would they feel that learning another language would be a prerequisite for working there?

What type of compensation package would they expect? (LO 20-4: To assess how MNEs select, prepare, compensate, and retain managers, AACSB: Analytical Skills.)

Exercise 20.5. Divide the class into two groups, one representing the management of a large MNE and the other representing workers at one of the company’s plants in Chile. Tell the students representing Chilean workers that they are unhappy with their current compensation and working conditions. Have the two sides discuss the situation and come to an understanding of the challenges and likely negotiating positions on both sides. (LO 20-1: To discuss the importance of human resource management, AACSB: Communication Abilities.)

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