Page iInternationalBusinessCompeting in the Global Marketplace

13e

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

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INTERNATIONAL BUSINESS Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2021 by McGraw-HillEducation. All rights reserved. Printed in the United States of America. No part of this publication may be reproduced ordistributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent ofMcGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, orbroadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside theUnited States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 LWI 21 20 ISBN 978-1-260-57586-6MHID 1-260-57586-1 Cover Image: Buslik/Shutterstock All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does notindicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee theaccuracy of the information presented at these sites. mheducation.com/highered

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F o r m y c h i l d r e n , E l i z a b e t h ,C h a r l o t t e , a n d M i c h e l l e

— C h a r l e s W . L . H i l l

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about the AUTHORCharles W. L. HillUniversity of Washington Charles W. L. Hill is the Hughes M. and Katherine Blake Professor of Strategy and International Business in the FosterSchool of Business at the University of Washington. Professor Hill has taught in the Management, MBA, ExecutiveMBA, Technology Management MBA, and PhD programs at the University of Washington. During his time at theUniversity of Washington, he has received over 25 awards for teaching excellence, including the Charles E. SummerOutstanding Teaching Award.

A native of the United Kingdom, Professor Hill received his PhD from the University of Manchester, UK. Inaddition to the University of Washington, he has served on the faculties of the University of Manchester, Texas A&MUniversity, and Michigan State University.

Professor Hill has published over 50 articles in top academic journals, including the Academy of ManagementJournal, Academy of Management Review, Strategic Management Journal, and Organization Science. Professor Hill hasalso published several textbooks, including International Business (McGraw-Hill) and Global Business Today (McGraw-Hill). His work is among the most widely cited in international business and strategic management.

Professor Hill works on a private basis with a number of organizations. His clients have included Microsoft, wherehe taught in-house executive education courses for two decades. He has also consulted for a variety of other largecompanies (e.g., AT&T Wireless, Boeing, BF Goodrich, Group Health, Hexcel, Philips Healthcare, Philips MedicalSystems, Seattle City Light, Swedish Health Services, Tacoma City Light, Thompson Financial Services, WRQ, andWizards of the Coast). Additionally, Dr. Hill has served on the advisory board of several start-up companies.

For recreation, Professor Hill enjoys skiing and competitive sailing!

part one

Chapter 1

part two

Chapter 2Chapter 3Chapter 4Chapter 5

part three

Chapter 6Chapter 7Chapter 8Chapter 9

part four

Chapter 10Chapter 11Chapter 12

part five

Chapter 13Chapter 14Chapter 15

part six

Chapter 16Chapter 17Chapter 18Chapter 19Chapter 20

part seven

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brief CONTENTSIntroduction and Overview

Globalization 2

National DifferencesNational Differences in Political, Economic, and Legal Systems 38National Differences in Economic Development 62Differences in Culture 92Ethics, Corporate Social Responsibility, and Sustainability 132

The Global Trade and Investment EnvironmentInternational Trade Theory 164Government Policy and International Trade 200Foreign Direct Investment 230Regional Economic Integration 260

The Global Monetary SystemThe Foreign Exchange Market 294The International Monetary System 320The Global Capital Market 348

The Strategy and Structure of International BusinessThe Strategy of International Business 370The Organization of International Business 402Entering Developed and Emerging Markets 440

International Business FunctionsExporting, Importing, and Countertrade 470Global Production and Supply Chain Management 498Global Marketing and Business Analytics 528Global Human Resource Management 566Accounting and Finance in International Business 596

Integrative CasesGlobalization of BMW, Rolls-Royce, and the MINI 625The Decline of Zimbabwe 627Economic Development in Bangladesh 629The Swatch Group and Cultural Uniqueness 630Woolworths’ Corporate Responsibility Strategy 632The Trans Pacific Partnership (TPP) Is Dead: Long Live the CPTPP! 634Boeing and Airbus Are in a Dogfight over Illegal Subsidies 636FDI in the Indian Retail Sector 637Free Trade in Africa 639The Mexican Peso, the Japanese Yen, and Pokémon Go 641Egypt and the IMF 642Alibaba’s Record-Setting IPO 643Sony Corporation: Still a Leader Globally? 644

Organizational Architecture at P&G 646Cutco Corporation—Sharpening Your Market Entry 647Tata Motors and Exporting 649Alibaba and Global Supply Chains 650Best Buy Doing a Turnaround Again 651Sodexo: Building a Diverse Global Workforce 653Tesla, Inc.—Subsidizing Tesla Automobiles Globally 654

Glossary 656Indexes 666

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THE PROVEN CHOICE FOR INTERNATIONALBUSINESS

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

Is comprehensive, state of the art, and timely.Is theoretically sound and practically relevant.Focuses on applications of international business concepts.Tightly integrates the chapter topics throughout.Is fully integrated with results-driven technology.Takes full and integrative advantage of globalEDGE.msu.edu—the Google-ranked #1 web resource for “international business resources.”

International Business, now in its thirteenth edition, authored by Charles W. L. Hill, is a comprehensive and case-oriented version of our text that lends itself to the core course in international business for those courses thatwant a deeper focus on the global monetary system, structure of international business, international accounting, andinternational finance. We cover more and integrated cases in International Business 13e and we provide a deepertreatment of the global capital market, the organization of an international business, international accounting, andinternational finance–topics that are allocated chapters in International Business 13e but are not attended to in the shortertreatment of IB in Global Business Today 11e.

Like our shorter text, Global Business Today 11e (2019), International Business 13e focuses on being current,relevant, application rich, accessible, and student focused. Our goal has always been to cover macro and micro issuesequally and in a relevant, practical, accessible, and student focused approach. We believe that anything short of such abreadth and depth of coverage is a serious deficiency. Many of the students in these international business courses willsoon be working in global businesses, and they will be expected to understand the implications of international businessfor their organization’s strategy, structure, and functions in the context of the global marketplace. We are proud anddelighted to have put together this international business learning experience for the leaders of tomorrow.

Over the years, and through now 13 editions, Dr. Charles Hill has worked hard to adhere to these goals. Since Global Business Today 9e (2015), and InternationalBusiness 11e (2017), Charles has been guided not only by his own reading, teaching, and research but also by theinvaluable feedback he receives from professors and students around the world, from reviewers, and from the editorialstaff at McGraw-Hill Education. His thanks goes out to all of them.

COMPREHENSIVE AND UP-TO-DATETo be relevant and comprehensive, an international business package must

Explain how and why the world’s cultures, countries, and regions differ.Cover economics and politics of international trade and investment.Tackle international issues related to ethics, corporate social responsibility, and sustainability.Explain the functions and form of the global monetary system.Examine the strategies and structures of international businesses.Assess the special roles of the various functions of an international business.

Relevance and comprehensiveness also require coverage of the major theories. It has always been a goal to incorporatethe insights gleaned from recent academic scholarship into the book. Consistent with this goal, insights from thefollowing research, as a sample of theoretical streams used in the book, have been incorporated:

New trade theory and strategic trade policy.The work of Nobel Prize–winning economist Amartya Sen on economic development.Samuel Huntington’s influential thesis on the “clash of civilizations.”Growth theory of economic development championed by Paul Romer and Gene Grossman.

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Empirical work by Jeffrey Sachs and others on the relationship between international trade and economicgrowth.Michael Porter’s theory of the competitive advantage of nations.Robert Reich’s work on national competitive advantage.The work of Nobel Prize–winner Douglass North and others on national institutional structures and theprotection of property rights.The market imperfections approach to foreign direct investment that has grown out of Ronald Coase and OliverWilliamson’s work on transaction cost economics.Bartlett and Ghoshal’s research on the transnational corporation.The writings of C. K. Prahalad and Gary Hamel on core competencies, global competition, and global strategicalliances.Insights for international business strategy that can be derived from the resource-based view of the firm andcomplementary theories.Paul Samuelson’s critique of free trade theory.Conceptual and empirical work on global supply chain management—logistics, purchasing (sourcing),operations, and marketing channels.

In addition to including leading-edge theory, in light of the fast-changing nature of the international businessenvironment, we have made every effort to ensure that this product is as up-to-date as possible. A significant amount hashappened in the world since we began revisions of this book. By 2019, almost $4 trillion per day were flowing acrossnational borders. The size of such flows fueled concern about the ability of short-term speculative shifts in global capitalmarkets to destabilize the world economy.

The world continued to become more global. As you can see in Chapter 1 on Globalization, trade across countryborders has almost exponentially escalated in the last few years. Several Asian economies, most notably China and India,continued to grow their economies at a rapid rate. New multinationals continued to emerge from developing nations inaddition to the world’s established industrial powers.

Increasingly, the globalization of the world economy affected a wide range of firms of all sizes, from the very largeto the very small. We take great pride in covering international business for small- and medium-sized enterprises(SMEs), as well as larger multinational corporations. We also take great pride in covering firms from all around theworld. Some sixty SMEs and multinational corporations from all six core continents are covered in the chapters’ openingcases, closing cases, and/or Management Focus boxes.

And unfortunately, global terrorism and the attendant geopolitical risks keep emerging in various places globally,many new and inconceivable just a decade ago. These represent a threat to global economic integration and activity.Plus, with the United Kingdom opting to leave the European Union (Brexit), which has implications past 2019, theelection of President Donald Trump in the United States (who espouses views on international trade that break with thelong established consensus), and several elections around the world, the globe—in many ways—has paid more attentionto nationalistic issues over trade. These topics and many more are integrated into this text for maximum learningopportunities.

What’s New in the 13th EditionThe success of the first twelve editions of International Business was based in part on the incorporation of leading-edgeresearch into the text, the use of the up-to-date examples and statistics to illustrate global trends and enterprise strategy,and the discussion of current events within the context of the appropriate theory. Building on these strengths, our goalsfor the twelfth edition have focused on the following:

Incorporate new insights from scholarly research.Make sure the content covers all appropriate issues.Make sure the text is up-to-date with current events, statistics, and examples.Add new and insightful opening and closing cases in most chapters.

Incorporate value-added globalEDGETM features in every chapter.Connect every chapter to a focus on managerial implications.Provide 20 new integrated cases that can be used as additional cases for specific chapters but, more importantly,as learning vehicles across multiple chapters.

As part of the overall revision process, changes have been made to every chapter in the book. All statistics havebeen updated to incorporate the most recently available data. As before, we are the only text in InternationalBusiness that ensures that all material is up-to-date on virtually a daily basis. The copyright for the book is 2021 but you

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are likely using the text in 2020, 2021, or 2022–we keep it updated to each semester you use the text in your course! Weare able to do this by integrating globalEDGE features in every chapter. Specifically, the Google number-one-rankedglobaledge.msu.edu site (for “international business resources”) is used in each chapter to add value to the chaptermaterial and provide up-to-date data and information. This keeps chapter material constantly and dynamically updatedfor teachers who want to infuse globalEDGE material into the chapter topics, and it keeps students abreast of currentdevelopments in international business.

In addition to updating all statistics, figures, and maps to incorporate most recently published data, a chapter-by-chapter selection of changes for the 13th edition include the following:

Chapter 1: GlobalizationNew opening case: How the iPhone is made: Apple’s Global Production SystemUpdated statistics and figures to incorporate the most recent data on global trade flows and foreign directinvestmentDiscussion of the implications of recent political trends (Brexit and the Trump Presidency) and what this mightmean for cross border trade and investmentNew closing case: General Motors in China

Chapter 2: National Differences In Political, Economic, and Legal SystemsNew opening case: Kenya: An African LionUpdated data on corruptionNew closing case: Transformation in Saudi Arabia

Chapter 3: National Differences In Economic DevelopmentNew opening case: Poland: Eastern Europe’s Economic MiracleUpdated maps, figures, and in-text statistics to reflect most recently available dataAddition of demographic trends to the discussion of Political Economy and Economic ProgressUpdated discussion of the spread of democracy to reflect recent countertrends toward greater authoritarianism inseveral nations (e.g., Turkey)New closing case: Brazil’s Struggling Economy

Chapter 4: Differences In CultureNew opening case: Singapore: One of the World’s Most Multicultural PlacesInclusion of a discussion of patience across culturesRevised the foundation that most religions are now pro-businessNew Country Focus: Determining Your Social Class by BirthNew Country Focus: Turkey, Its Religion, and PoliticsNew closing case: China, Hong Kong, Macau, and Taiwan

Chapter 5: Ethics, Corporate Social Responsibility, and SustainabilityNew opening case: Ericsson, Sweden, and SustainabilityDeepened focus related to United Nations’ Sustainable Development GoalsCore focus on ethics as a lead-in to corporate social responsibility and sustainability issues (e.g., UN’sSustainable Development Goals).New closing case: Sustainability Initiatives at Natura, the Bodyshop, and Aesop

Chapter 6: International Trade TheoryNew opening case: A Tale of Two Nations: Ghana and South KoreaUpdated Country Focus on China and currency manipulationReference to Donal Trump’s trade policies under section on mercantilismNew closing case: Trade Wars are Good and Easy to WinUpdated balance of payments data in the Appendix to reflect 2018 data

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Chapter 7: Government Policy and International TradeNew opening case: American Steel TariffsUpdated discussion of the world trading system to reflect recent developments, including Brexit and the tradepolicies of President TrumpNew closing case: The United States and South Korea Strike a Revised Trade Deal

Chapter 8: Foreign Direct InvestmentNew opening case: Starbuck’s Foreign Direct InvestmentUpdated statistics and figures on foreign direct investment in the world economy to incorporate the most recentlyavailable dataNew Management Focus: Burberry Shifts its Entry Strategy in JapanNew closing case: Geely Goes Global

Chapter 9: Regional Economic IntegrationNew opening case: The Cost of BrexitUpdated discussion of BrexitAdded discussion of the renegotiation of NAFTA by the Trump administration and the details of the UnitedStates–Canada–Mexico Agreement (USCMA)Additional discussion of new free trade deals in AfricaClosing case: NAFTA 2.0: The USCMA

Chapter 10: The Foreign Exchange MarketNew opening case: Managing Foreign Currency Exposure at 3MUpdated data throughout the chapter to reflect currency exchange rates in 2019.New closing case: The Fluctuating Value of the Yuan Gives Chinese Business a Lesson in Foreign ExchangeRisk

Chapter 11: The International Monetary SystemNew opening case: Pakistan Takes Another IMF LoanUpdated data and discussion of the floating exchange rate regime through till 2019New Country Focus: China’s Exchange Rate RegimeNew closing case: Can Dollarization Save Venezuela?

Chapter 12: The Global Capital MarketNew opening case: Chinese IPOs in the United StatesUpdated statistics and discussion to reflect most recently available dataNew closing case: Saudi Aramco

Chapter 13: The Strategy of International BusinessNew opening case: International Strategy in the Sharing EconomyInclusion of materials on the “sharing economy” related to strategy, including a discussion of Airbnb, Uber,Lyft, and TuroNew Management Focus: IKEA’s Global StrategyNew Management Focus: Unilever’s Global OrganizationNew closing case: Red Bull, A Leader in International Strategy

Chapter 14: The Organization of International BusinessNew opening case: Bird, Lime, and Organizing GloballyIntegration of new materials on the “sharing economy” related to organizations, including a discussion of Birdand Lime

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Deeper focus on small, medium, and sharing economy organizationsNew closing case: Walmart International

Chapter 15: Entering Developed and Emerging MarketsNew opening case: Volkswagen, Toyota, and GM in ChinaNew scope of the chapter to include entering developed and emerging marketsInclusion of a discussion of less developed markets and base-of-the-pyramidNew closing case: IKEA Entering India, Finally!

Chapter 16: Exporting, Importing, and CountertradeNew opening case: Higher Education in the U.S. Is about Exporting and International Competitiveness

Revised material on globalEDGETM Diagnostic ToolsNew Management Focus: Embraer and Brazilian ImportingNew Management Focus: Exporting Desserts by a Hispanic EntrepreneurNew Management Focus: Two Men and a TruckNew closing case: Spotify and SoundCloud

Chapter 17: Global Production and Supply Chain ManagementNew opening case: Blockchain Technology and Global Supply ChainsNew material on blockchain technologyNew Management Focus: IKEA Production in ChinaNew Management Focus: Amazon’s Global Supply ChainsNew closing case: Procter & Gamble Remakes Its Global Supply Chains

Chapter 18: Global Marketing and Business AnalyticsNew chapter title to signal significant new material on Business AnalyticsNew opening case: Marketing SneakersNew section on Business AnalyticsRevised section: International Marketing ResearchInclusion of more social media topics throughoutNew Management Focus: Global Branding, Marvel Studios, and Walt Disney CompanyNew Management Focus: Burberry’s Social Media MarketingNew closing case: Fake News and Alternative Facts

Chapter 19: Global Human Resource ManagementNew opening case: Evolution of the Kraft Heinz CompanyNew section: Building a Diverse Global WorkforceNew Management Focus: AstraZeneca and Global Staffing PolicyNew closing case: Global Mobility at Shell

Chapter 20: Accounting and Finance in the International BusinessNew opening case: Pfizer, Novartis, Bayer, and GlaxoSmithKlineNew material on the U.S. corporate tax rate and implicationsNew Management Focus: Microsoft and Its Foreign Cash HoldingsNew closing case: Shoprite—Financial Success of a Food Retailer in Africa

Integrated CasesAll of the 20 integrated cases are new for International Business 13e. Many of these cases build on previous opening andclosing chapter cases that have been revised, updated, and oftentimes adopted a new angle or focus. A unique feature ofthe opening and closing cases for the chapters as well as the integrated cases at the back-end of the text is that we cover

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all continents of the world and we do so with regional or country issues and large, medium, and small companyscenarios. This makes the 60 total cases we have included in International Business 13e remarkably wealthy as alearning program.

Globalization of BMW, Rolls-Royce, and the MINIThe Decline of ZimbabweEconomic Development in BangladeshThe Swatch Group and Cultural UniquenessWoolworths’ Corporate Responsibility StrategyThe Trans Pacific Partnership (TPP) is Dead: Long Live the CTPP!Boeing and Airbus Are in a Dogfight over Illegal SubsidiesFDI in the Indian Retail SectorFree Trade in AfricaThe Mexican Peso, the Japanese Yen, and Pokemon GoEgypt and the IMFAlibaba’s Record-Setting IPOSony Corporation: Still a Leader Globally?Organizational Architecture at P&GCutco Corporation–Sharpening Your Market EntryTata Motors and ExportingAlibaba and Global Supply ChainsBest Buy Doing a Turnaround AgainSodexo: Building a Diverse Global WorkforceTesla, Inc.–Subsidizing Tesla Automobiles Globally

BEYOND UNCRITICAL PRESENTATION AND SHALLOW EXPLANATIONMany issues in international business are complex and thus necessitate considerations of pros and cons. To demonstratethis to students, we have adopted a critical approach that presents the arguments for and against economictheories, government policies, business strategies, organizational structures, and so on.

Related to this, we have attempted to explain the complexities of the many theories and phenomena unique tointernational business so the student might fully comprehend the statements of a theory or the reasons a phenomenon isthe way it is. We believe that these theories and phenomena are explained in more depth in this work than they are in thecompetition, which seem to use the rationale that a shallow explanation is little better than no explanation. Ininternational business, a little knowledge is indeed a dangerous thing.

PRACTICAL AND RICH APPLICATIONSWe have always believed that it is important to show students how the material covered in the text is relevant to theactual practice of international business. This is explicit in the later chapters of the book, which focus on the practice ofinternational business, but it is not always obvious in the first half of the book, which considers macro topics.Accordingly, at the end of each chapter in Parts Two, Three, and Four—where the focus is on the environment ofinternational business, as opposed to particular firms—there is a section titled Focus on Managerial Implications. Inthis section, the managerial implications of the material discussed in the chapter are clearly explained. Additionally, mostchapters have at least one Management Focus box. The purpose of these boxes is to illustrate the relevance of chaptermaterial for the practice of international business.

A Did You Know? feature challenges students to view the world around them through the lens of internationalbusiness (e.g., Did you know that sugar prices in the United States are much higher than sugar prices in the rest of theworld?). The author recorded short videos explaining the phenomenon.

In addition, each chapter begins with an opening case that sets the stage for the chapter and ends with a closingcase that illustrates the relevance of chapter material for the practice of international business.

To help students go a step further in expanding their application-level understanding of international business, eachchapter incorporates two globalEDGETM research tasks. The exercises dovetail with the content just covered.

INTEGRATED PROGRESSION OF TOPICS

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A weakness of many texts is that they lack a tight, integrated flow of topics from chapter to chapter. This book explainsto students in Chapter 1 how the book’s topics are related to each other. Integration has been achieved by organizing thematerial so that each chapter builds on the material of the previous ones in a logical fashion.

Part One

Chapter 1 provides an overview of the key issues to be addressed and explains the plan of the book. Globalization ofmarkets and globalization of production is the core focus.

Part TwoChapters 2 through 4 focus on country differences in political economy and culture, and Chapter 5 on ethics, corporatesocial responsibility, and sustainability issues in international business. Most international business textbooks place thismaterial at a later point, but we believe it is vital to discuss national differences first. After all, many of the central issuesin international trade and investment, the global monetary system, international business strategy and structure, andinternational business functions arise out of national differences in political economy and culture.

Part ThreeChapters 6 through 9 investigate the political economy of global trade and investment. The purpose of this part is todescribe and explain the trade and investment environment in which international business occurs.

Part FourChapters 10 and 11 describe and explain the global monetary system, laying out in detail the monetary framework inwhich international business transactions are conducted.

Part FiveIn Chapters 12 and 13, attention shifts from the environment to the firm. In other words, we move from a macro focus toa micro focus at this stage of the book. We examine strategies that firms adopt to compete effectively in the internationalbusiness environment.

Part SixIn Chapters 14 through 17, the focus narrows further to investigate business functions and related operations. Thesechap t er s expl ain how f ir ms can per f orm thei r key f uncti ons —expor ti ng, importing, and counter tr ade; gl obal produ ct i on;global supply chain management; global marketing; global research and development (R&D); human resourcemanagement—to compete and succeed in the international business environment.

Throughout the book, the relationship of new material to topics discussed in earlier chapters is pointed out to thestudents to reinforce their understanding of how the material comprises an integrated whole. We deliberatelybring a management focus to the macro chapters (Chapters 1 through 12). We also integrate macro themes incovering the micro chapters (Chapters 13 through 20).

ACCESSIBLE AND INTERESTINGThe international business arena is fascinating and exciting, and we have tried to communicate our enthusiasm for it tothe student. Learning is easier and better if the subject matter is communicated in an interesting, informative, andaccessible manner. One technique we have used to achieve this is weaving interesting anecdotes into the narrative of thetext, that is, stories that illustrate theory.

Most chapters also have a Country Focus box that provides background on the political, economic, social, orcultural aspects of countries grappling with an international business issue.

ACKNOWLEDGMENTSNumerous people deserve to be thanked for their assistance in preparing this book. First, thank you to all the people atMcGraw-Hill Education who have worked with us on this project: Peter Jurmu, Portfolio ManagerHaley Burmeister, Product DeveloperNicole Young, Senior Marketing ManagerJulia Blankenship, Marketing Coordinator

Harvey Yep, Content Project Manager (Core)Keri Johnson, Content Project Manager (Assessment)Sandy Ludovissy, Senior BuyerEgzon Shaqiri, DesignerCarrie Burger, Content Licensing Specialist Second, our thanks go to the reviewers who provided good feedback that helped shape this book: Yimai Lewis, Georgia State UniversityLong S. Le, Santa Clara UniversityClare R. Greenlaw, Jr., Southern New Hampshire University – COCERichard Ajayi, University of Central FloridaHussain Ahmad, Hofstra UniversityErica Kovacs, Indiana UniversityMarta Szabo White, Georgia State UniversityC. Jayachandran, Montclair State University, NJT.S. Gardner, UNC WilmingtonMarcel Zondag, Western Michigan UniversityMamoun Benmamoun, Saint Louis UniversityManveer Mann, Montclair State UniversityJose Luis Daniel, Saint Xavier UniversityWalter C. van Hoof, San Jose State University, San Jose, CARiikka M. Sarala, UNC GreensboroSamuel Okoroafo, University of Toledo, Toledo, OhioPamela S. Evers, University of North Carolina Wilmington A special thanks to David Closs and David Frayer for allowing us to borrow elements of the sections on Strategic Rolesfor Production Facilities; Make-or-Buy Decisions; Global Supply Chain Functions; Coordination in Global SupplyChains; and Interorganizational Relationships for Chapter 15 of this text from Tomas Hult, David Closs, and DavidFrayer (2014), Global Supply Chain Management, New York: McGraw-Hill.

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CONTENTS

part oneIntroduction and Overview

CHAPTER 1Globalization 2Opening CaseHow the iPhone Is Made: Apple’s Global Production System 3

Introduction 4

What Is Globalization? 6The Globalization of Markets 6The Globalization of Production 7

Management FocusBoeing’s Global Production System 8

The Emergence of Global Institutions 9

Drivers of Globalization 11Declining Trade and Investment Barriers 11Role of Technological Change 13

The Changing Demographics of the Global Economy 15The Changing World Output and World Trade Picture 15

Country FocusIndia’s Software Sector 17

The Changing Foreign Direct Investment Picture 17The Changing Nature of the Multinational Enterprise 19

Management FocusThe Dalian Wanda Group 20

The Changing World Order 21Global Economy of the Twenty-First Century 22

The Globalization Debate 22Antiglobalization Protests 23

Country FocusProtesting Globalization in France 24

Globalization, Jobs, and Income 24Globalization, Labor Policies, and the Environment 26Globalization and National Sovereignty 28Globalization and the World’s Poor 29

Managing in the Global Marketplace 31

Key Terms 33

Summary 33

Critical Thinking and Discussion Questions 34

Research Task 34Closing CaseGeneral Motors in China 35

Endnotes 36

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part twoNational Differences

CHAPTER 2National Differences in Political, Economic, and Legal Systems 38Opening CaseKenya: An African Lion 39

Introduction 40

Political Systems 41Collectivism and Individualism 41Democracy and Totalitarianism 43

Country FocusPutin’s Russia 44

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

Legal Systems 49Different Legal Systems 49Differences in Contract Law 50Property Rights and Corruption 51

Country FocusCorruption in Brazil 53

Management FocusDid Walmart Violate the Foreign Corrupt Practices Act? 54

The Protection of Intellectual Property 55

Management FocusStarbucks Wins Key Trademark Case in China 56

Product Safety and Product Liability 57

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

Key Terms 58

Summary 58

Critical Thinking and Discussion Questions 59

Research Task 59Closing CaseTransformation in Saudi Arabia 59

Endnotes 61

CHAPTER 3National Differences in Economic Development 62Opening CasePoland: Eastern Europe’s Economic Miracle 63

Introduction 64

Differences in Economic Development 64Map 3.1 GNI per Capita, 2018 65Map 3.2 GNI PPP per Capita, 2018 66Map 3.3 Average Annual Growth Rate in GDP (%), 2009–2018 67Broader Conceptions of Development: Amartya Sen 68Map 3.4 Human Development Index, 2017 69

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

Country FocusProperty Rights in China 72

Geography, Education, and Economic Development 72

States in Transition 74The Spread of Democracy 74Map 3.5 Freedom in the World, 2019 74The New World Order and Global Terrorism 76The Spread of Market-Based Systems 77Map 3.6 Index of Economic Freedom, 2019 79

The Nature of Economic Transformation 79Deregulation 79

Country FocusIndia’s Economic Transformation 80

Privatization 81Legal Systems 81

Implications of Changing Political Economy 82Focus on Managerial Implications: Benefits, Costs, Risks, and Overall Attractiveness of Doing Business Internationally 83

Key Terms 87

Summary 87

Critical Thinking and Discussion Questions 87

Research Task 88Closing CaseBrazil’s Struggling Economy 88

Endnotes 90

CHAPTER 4Differences in Culture 92Opening CaseSingapore: One of the World’ Most Multicultural Places 93

Introduction 94

What Is Culture? 95Values and Norms 96Culture, Society, and the Nation-State 98Determinants of Culture 99

Social Structure 99Individuals and Groups 100Social Stratification 102

Country FocusDetermining Your Social Class by Birth 103

Religious and Ethical Systems 105Map 4.1 World Religions 106Christianity 106Islam 107

Country FocusTurkey: Its Religion and Politics 110

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Hinduism 111Buddhism 112Confucianism 113

Management FocusChina and Its Guanxi 114

Language 115Spoken Language 115Unspoken Language 116

Education 116

Culture and Business 117

Cultural Change 120Focus on Managerial Implications: Cultural Literacy and Competitive Advantage 122

Key Terms 124

Summary 124

Critical Thinking and Discussion Questions 125

Research Task 126Closing CaseChina, Hong Kong, Macau, and Taiwan 126

Endnotes 128

CHAPTER 5Ethics, Corporate Social Responsibility, and Sustainability 132Opening CaseEricsson, Sweden, and Sustainability 133

Introduction 134

Ethics and International Business 135Employment Practices 136Human Rights 137

Management Focus“Emissionsgate” at Volkswagen 138

Environmental Pollution 139Corruption 140

Ethical Dilemmas 142

The Roots of Unethical Behavior 143Personal Ethics 143Decision-Making Processes 144Organizational Culture 144Unrealistic Performance Goals 145Leadership 145Societal Culture 145

Philosophical Approaches to Ethics 146Straw Men 146Utilitarian and Kantian Ethics 148Rights Theories 149Justice Theories 150

Focus on Managerial Implications: Making Ethical Decisions Internationally 151

Management FocusCorporate Social Responsibility at Stora Enso 156

Key Terms 157

Summary 158

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Critical Thinking and Discussion Questions 159

Research Task 159Closing CaseSustainability Initiatives at Natura, The Body Shop, and Aesop 160

Endnotes 161

part threeThe Global Trade and Investment Environment

CHAPTER 6International Trade Theory 164Opening CaseA Tale of Two Nations: Ghana and South Korea 165

Introduction 166

An Overview of Trade Theory 166The Benefits of Trade 167The Pattern of International Trade 168Trade Theory and Government Policy 169

Mercantilism 169Country FocusIs China Manipulating Its Currency in Pursuit of a Neo-Mercantilist Policy? 170

Absolute Advantage 170

Comparative Advantage 172The Gains from Trade 173Qualifications and Assumptions 175Extensions of the Ricardian Model 175

Country FocusMoving U.S. White-Collar Jobs Offshore 179

Heckscher–Ohlin Theory 180The Leontief Paradox 181

The Product Life-Cycle Theory 182Product Life-Cycle Theory in the Twenty-First Century 183

New Trade Theory 183Increasing Product Variety and Reducing Costs 184Economies of Scale, First-Mover Advantages, and the Pattern of Trade 184Implications of New Trade Theory 185

National Competitive Advantage: Porter’s Diamond 186Factor Endowments 187Demand Conditions 188Related and Supporting Industries 188Firm Strategy, Structure, and Rivalry 188Evaluating Porter’s Theory 189

Focus on Managerial Implications: Location, First-Mover Advantages, and Government Policy 189

Key Terms 191

Summary 191

Critical Thinking and Discussion Questions 192

Research Task 193Closing Case

“Trade Wars Are Good and Easy to Win” 193

Appendix: International Trade and the Balance of Payments 195

Endnotes 197

CHAPTER 7Government Policy and International Trade 200Opening CaseAmerican Steel Tariffs 201

Introduction 202

Instruments of Trade Policy 202Tariffs 202Subsidies 203

Country FocusAre the Chinese Illegally Subsidizing Auto Exports? 204

Import Quotas and Voluntary Export Restraints 205Export Tariffs and Bans 206Local Content Requirements 206Administrative Policies 207Antidumping Policies 207

The Case for Government Intervention 207Management FocusProtecting U.S. Magnesium 208

Political Arguments for Intervention 209Economic Arguments for Intervention 211

The Revised Case for Free Trade 213Retaliation and Trade War 213Domestic Policies 214

Development of the World Trading System 214From Smith to the Great Depression 2151947–1979: GATT, Trade Liberalization, and Economic Growth 2151980–1993: Protectionist Trends 215The Uruguay Round and the World Trade Organization 216WTO: Experience to Date 217The Future of the WTO: Unresolved Issues and the Doha Round 218

Country FocusEstimating the Gains from Trade for the United States 221

Multilateral and Bilateral Trade Agreements 222The World Trading System under Threat 222

Focus on Managerial Implications: Trade Barriers, Firm Strategy, and Policy Implications 223

Key Terms 225

Summary 225

Critical Thinking and Discussion Questions 226

Research Task 226Closing CaseThe United States and South Korea Strike a Revised Trade Deal 227

Endnotes 228

CHAPTER 8Foreign Direct Investment 230Opening CaseStarbucks’ Foreign Direct Investment 231

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Introduction 232

Foreign Direct Investment in the World Economy 232Trends in FDI 232The Direction of FDI 233The Source of FDI 234

Country FocusForeign Direct Investment in China 235

The Form of FDI: Acquisitions versus Greenfield Investments 236

Theories of Foreign Direct Investment 236Why Foreign Direct Investment? 236

Management FocusBurberry Shifts Its Entry Strategy in Japan 237

The Pattern of Foreign Direct Investment 240The Eclectic Paradigm 241

Political Ideology and Foreign Direct Investment 242The Radical View 242The Free Market View 243Pragmatic Nationalism 243Shifting Ideology 244

Benefits and Costs of FDI 244Host-Country Benefits 245Host-Country Costs 247Home-Country Benefits 248Home-Country Costs 249International Trade Theory and FDI 249

Government Policy Instruments and FDI 249Home-Country Policies 249Host-Country Policies 250International Institutions and the Liberalization of FDI 251

Focus on Managerial Implications: FDI and Government Policy 252

Key Terms 254

Summary 254

Critical Thinking and Discussion Questions 255

Research Task 256Closing CaseGeely Goes Global 256

Endnotes 257

CHAPTER 9Regional Economic Integration 260Opening CaseThe Cost of Brexit 261

Introduction 262

Levels of Economic Integration 263

The Case for Regional Integration 265The Economic Case for Integration 265The Political Case for Integration 265Impediments to Integration 266

The Case against Regional Integration 267

Regional Economic Integration in Europe 267Evolution of the European Union 267

Map 9.1 Member States of the European Union in 2019 268Political Structure of the European Union 269

Management FocusThe European Commission and Google 270

The Single European Act 271The Establishment of the Euro 272Enlargement of the European Union 275

Country FocusThe Greek Sovereign Debt Crisis 276

British Exit from the European Union (BREXIT) 277

Regional Economic Integration in the Americas 278The North American Free Trade Agreement 278Map 9.2 Economic Integration in the Americas 279The United States–Canada–Mexico Agreement (USCMA) 281The Andean Community 282Mercosur 282Central American Common Market, CAFTA, and CARICOM 283

Regional Economic Integration Elsewhere 284Association of Southeast Asian Nations 284Regional Trade Blocs in Africa 284Map 9.3 ASEAN countries 285Other Trade Agreements 286

Focus on Managerial Implications: Regional Economic Integration Threats 286

Key Terms 288

Summary 288

Critical Thinking and Discussion Questions 289

Research Task 290Closing CaseNAFTA 2.0: The USCMA 290

Endnotes 291

part fourThe Global Monetary System

CHAPTER 10The Foreign Exchange Market 294Opening CaseManaging Foreign Currency Exposure at 3M 295

Introduction 296

The Functions of the Foreign Exchange Market 297Currency Conversion 297Insuring against Foreign Exchange Risk 299

Management FocusEmbraer and the Gyrations of the Brazilian Real 301

The Nature of the Foreign Exchange Market 301

Economic Theories of Exchange Rate Determination 302Prices and Exchange Rates 303

Country FocusQuantitative Easing, Inflation, and the Value of the U.S. Dollar 307

Interest Rates and Exchange Rates 308

Page xxiInvestor Psychology and Bandwagon Effects 309Summary of Exchange Rate Theories 309

Exchange Rate Forecasting 310The Efficient Market School 310The Inefficient Market School 310Approaches to Forecasting 310

Currency Convertibility 311Focus on Managerial Implications: Foreign Exchange Rate Risk 312

Key Terms 315

Summary 315

Critical Thinking and Discussion Questions 316

Research Task 317Closing CaseThe Fluctuating Value of the Yuan Gives Chinese Businesses a Lesson in Foreign Exchange Risk 317

Endnotes 318

CHAPTER 11The International Monetary System 320Opening CasePakistan Takes Another IMF Loan 321

Introduction 322

The Gold Standard 323Mechanics of the Gold Standard 323Strength of the Gold Standard 324The Period between the Wars: 1918–1939 324

The Bretton Woods System 325The Role of the IMF 325The Role of the World Bank 326

The Collapse of the Fixed Exchange Rate System 327

The Floating Exchange Rate Regime 328The Jamaica Agreement 328Exchange Rates since 1973 328

Fixed versus Floating Exchange Rates 331The Case for Floating Exchange Rates 331The Case for Fixed Exchange Rates 332Who Is Right? 333

Exchange Rate Regimes in Practice 333Country FocusChina’s Exchange Rate Regime 334

Pegged Exchange Rates 335Currency Boards 335

Crisis Management by the IMF 336Financial Crises in the Post–Bretton Woods Era 337

Country FocusThe IMF and Iceland’s Economic Recovery 337

Evaluating the IMF’s Policy Prescriptions 338

Focus on Managerial Implications: Currency Management, Business Strategy, and Government Relations 341

Management FocusAirbus and the Euro 342

Key Terms 344

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Summary 344

Critical Thinking and Discussion Questions 345

Research Task 345Closing CaseCan Dollarization Save Venezuela? 346

Endnotes 347

CHAPTER 12The Global Capital Market 348Opening CaseChinese IPOs in the United States 349

Introduction 350

Benefits of the Global Capital Market 350The Functions of a Generic Capital Market 350Attractions of the Global Capital Market 351

Management FocusThe Industrial and Commercial Bank of China Taps the Global Capital Market 353

Growth of the Global Capital Market 355Global Capital Market Risks 357

Country FocusDid the Global Capital Markets Fail Mexico? 358

The Eurocurrency Market 359Genesis and Growth of the Market 359Attractions of the Eurocurrency Market 359Drawbacks of the Eurocurrency Market 361

The Global Bond Market 361Attractions of the Global Bond Market 362

The Global Equity Market 362

Foreign Exchange Risk and the Cost of Capital 363Focus on Managerial Implications: Growth of the Global Capital Market 364

Key Terms 364

Summary 365

Critical Thinking and Discussion Questions 365

Research Task 366Closing CaseSaudi Aramco 366

Endnotes 368

part fiveThe Strategy and Structure of International Business

CHAPTER 13The Strategy of International Business 370Opening CaseInternational Strategy in the Sharing Economy 371

Introduction 372

Strategy and the Firm 373Value Creation 374Strategic Positioning 375

Management FocusAB InBev, Beer Globally, and Creating Value 377

The Firm as a Value Chain 378

Global Expansion, Profitability, and Profit Growth 380Expanding the Market 381Location Economies 382Experience Effects 384Leveraging Subsidiary Skills 386Profitability and Profit Growth Summary 386

Cost Pressures and Pressures for Local Responsiveness 387Pressures for Cost Reductions 387

Management FocusIKEA’s Global Strategy 388

Pressures for Local Responsiveness 388

Choosing a Strategy 392Global Standardization Strategy 393Localization Strategy 393

Management FocusUnilever’s Responsiveness to Its Dutch–British Roots 394

Transnational Strategy 395International Strategy 396The Evolution of Strategy 396

Key Terms 397

Summary 397

Critical Thinking and Discussion Questions 398

Research Task 398Closing CaseRed Bull: A Leader in International Strategy 399

Endnotes 400

CHAPTER 14The Organization of International Business 402Opening CaseBird, Lime, and Organizing Globally 403

Introduction 404

Organizational Architecture 405

Organizational Structure 406Vertical Differentiation 406Horizontal Differentiation 408

Management FocusDow—(Failed) Early Global Matrix Adopter 414

Integrating Mechanisms 415

Control Systems and Incentives 420Types of Control Systems 420Incentive Systems 421Control Systems and Incentives 422

Processes 424

Organizational Culture 425

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Creating and Maintaining Organizational Culture 425Organizational Culture and Performance 427

Management FocusLincoln Electric and Culture 428

Synthesis: Strategy and Architecture 429Localization Strategy 429International Strategy 430Global Standardization Strategy 430Transnational Strategy 431Environment, Strategy, Architecture, and Performance 431

Organizational Change 432Organizational Inertia 432Implementing Organizational Change 433

Key Terms 434

Summary 435

Critical Thinking and Discussion Questions 435

Research Task 436Closing CaseWalmart International 436

Endnotes 438

CHAPTER 15Entering Developed and Emerging Markets 440Opening CaseVolkswagen, Toyota, and GM in China 441

Introduction 442

Basic Entry Decisions 443Which Foreign Markets? 443

Management FocusTesco’s International Growth Strategy 444

Timing of Entry 445Scale of Entry and Strategic Commitments 446Market Entry Summary 447

Entry Modes 448Exporting 448Turnkey Projects 449Licensing 450Franchising 451Joint Ventures 452Wholly Owned Subsidiaries 453

Selecting an Entry Mode 454Core Competencies and Entry Mode 454Pressures for Cost Reductions and Entry Mode 456

Greenfield Venture or Acquisition? 456Pros and Cons of Acquisitions 456Pros and Cons of Greenfield Ventures 458Which Choice? 459

Strategic Alliances 459Advantages of Strategic Alliances 460Disadvantages of Strategic Alliances 460

Management FocusGazprom and Global Strategic Alliances 461

Making Alliances Work 461

Key Terms 464

Summary 464

Critical Thinking and Discussion Questions 465

Research Task 465Closing CaseIKEA Entering India, Finally! 466

Endnotes 467

part sixInternational Business Functions

CHAPTER 16Exporting, Importing, and Countertrade 470Opening CaseHigher-Education Exporting and International Competitiveness 471

Introduction 472

The Promise and Pitfalls of Exporting 473Management FocusEmbraer and Brazilian Importing 476

Improving Export Performance 476International Comparisons 477Information Sources 477

Management FocusExporting Desserts by a Hispanic Entrepreneur 478

Service Providers 479Export Strategy 480

Management FocusTwo Men and a Truck 481

The globalEDGETM Exporting Tool 482

Export and Import Financing 483Lack of Trust 483Letter of Credit 485Draft 485Bill of Lading 486A Typical International Trade Transaction 486

Export Assistance 488The Export-Import Bank 488Export Credit Insurance 489

Countertrade 489The Popularity of Countertrade 490Types of Countertrade 490Pros and Cons of Countertrade 491

Key Terms 492

Summary 492

Critical Thinking and Discussion Questions 493

Research Task 493Closing Case

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Spotify and SoundCloud 494

Endnotes 495

CHAPTER 17Global Production and Supply Chain Management 498Opening CaseBlockchain Technology and Global Supply Chains 499

Introduction 500

Strategy, Production, and Supply Chain Management 501

Where to Produce 504Country Factors 504

Management FocusIKEA Production in China 505

Technological Factors 505Production Factors 508The Hidden Costs of Foreign Locations 511

Management FocusAmazon’s Global Supply Chains 512

Make-or-Buy Decisions 513

Global Supply Chain Functions 516Global Logistics 516Global Purchasing 518

Managing a Global Supply Chain 519Role of Just-in-Time Inventory 519Role of Information Technology 520Coordination in Global Supply Chains 521Interorganizational Relationships 522

Key Terms 523

Summary 523

Critical Thinking and Discussion Questions 524

Research Task 525Closing CaseProcter & Gamble Remakes Its Global Supply Chains 525

Endnotes 526

CHAPTER 18Global Marketing and Business Analytics 528Opening CaseMarketing Sneakers 529

Introduction 530

Globalization of Markets and Brands 531

Market Segmentation 533Management FocusGlobal Branding, Marvel Studios, and the Walt Disney Company 534

Business Analytics 535International Marketing Research 536

Product Attributes 540Cultural Differences 540Economic Development 541

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Product and Technical Standards 541

Distribution Strategy 542Differences between Countries 542Choosing a Distribution Strategy 544

Communication Strategy 545Management FocusBurberry’s Social Media Marketing 546

Barriers to International Communication 547Push versus Pull Strategies 548Global Advertising 549

Pricing Strategy 550Price Discrimination 550Strategic Pricing 552Regulatory Influences on Prices 553

Configuring the Marketing Mix 554

Product Development and R&D 554The Location of R&D 555Integrating R&D, Marketing, and Production 556Cross-Functional Teams 557Building Global R&D Capabilities 558

Key Terms 559

Summary 560

Critical Thinking and Discussion Questions 561

Research Task 561Closing CaseFake News and Alternative Facts 562

Endnotes 563

CHAPTER 19Global Human Resource Management 566Opening CaseEvolution of the Kraft Heinz Company 567

Introduction 568

Strategic Role of Global HRM: Managing a Global Workforce 569

Staffing Policy 570Types of Staffing Policies 571Expatriate Managers 574

Management FocusAstraZeneca and Global Staffing Policy 577

Global Mindset 578

Training and Management Development 579Training for Expatriate Managers 580Repatriation of Expatriates 580Management Development and Strategy 581

Management FocusMonsanto’s Repatriation Program 582

Performance Appraisal 582Performance Appraisal Problems 583Guidelines for Performance Appraisal 583

Compensation 583National Differences in Compensation 583

Expatriate Pay 584

Management FocusMcDonald’s Global Compensation Practices 585

Building a Diverse Global Workforce 586

International Labor Relations 588The Concerns of Organized Labor 588The Strategy of Organized Labor 589Approaches to Labor Relations 589

Key Terms 590

Summary 590

Critical Thinking and Discussion Questions 591

Research Task 591Closing CaseGlobal Mobility at Shell 592

Endnotes 593

CHAPTER 20Accounting and Finance in International Business 596Opening CasePfizer, Novartis, Bayer, and GlaxoSmithKline 597

Introduction 598

National Differences in Accounting Standards 599

International Accounting Standards 600Country FocusChinese Accounting 601

Accounting Aspects of Control Systems 602Exchange Rate Changes and Control Systems 603Transfer Pricing and Control Systems 604Separation of Subsidiary and Manager Performance 605

Financial Management: The Investment Decision 605Capital Budgeting 606Project and Parent Cash Flows 606

Management FocusBlack Sea Oil and Gas Ltd. 607

Adjusting for Political and Economic Risk 607Risk and Capital Budgeting 608

Financial Management: The Financing Decision 609

Financial Management: Global Money Management 610Minimizing Cash Balances 610Reducing Transaction Costs 611Managing the Tax Burden 612

Management FocusMicrosoft and Its Foreign Cash Holdings 614

Moving Money across Borders 614

Key Terms 618

Summary 619

Critical Thinking and Discussion Questions 620

Research Task 620Closing Case

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Shoprite: The Financial Success of a Food Retailer in Africa 621

Endnotes 622

part sevenIntegrative Cases

Globalization of BMW, Rolls-Royce, and the MINI 625The Decline of Zimbabwe 627Economic Development in Bangladesh 629The Swatch Group and Cultural Uniqueness 630Woolworths’ Corporate Responsibility Strategy 632The Trans Pacific Partnership (TPP) Is Dead: Long Live the CPTPP! 634Boeing and Airbus Are in a Dogfight over Illegal Subsidies 636FDI in the Indian Retail Sector 637Free Trade in Africa 639The Mexican Peso, the Japanese Yen, and Pokémon Go 641Egypt and the IMF 642Alibaba’s Record-Setting IPO 643Sony Corporation: Still a Leader Globally? 644Organizational Architecture at P&G 646Cutco Corporation—Sharpening Your Market Entry 647Tata Motors and Exporting 649Alibaba and Global Supply Chains 650Best Buy Doing a Turnaround Again 651Sodexo: Building a Diverse Global Workforce 653Tesla, Inc.—Subsidizing Tesla Automobiles Globally 654

Glossary 656

Indexes 666

Page 1InternationalBusinessCompeting in the Global Marketplace

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LO1-3

LO1-4

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part one Introduction and Overview

Globalization

LEARNING OBJECTIVESAfter reading this chapter, you will be able to:

Understand what is meant by the term globalization.

Recognize the main drivers of globalization.

Describe the changing nature of the global economy.Explain the main arguments in the debate over the impact of globalization.

Understand how the process of globalization is creating opportunities and challenges for management practice.

Qilai Shen/In Pictures Ltd./Corbis/Getty Images

How the iPhone Is Made: Apple’s Global Production System

OPENING CASEIn its early days, Apple usually didn’t look beyond its own backyard to manufacture its devices. A few years after Applestarted making its Macintosh computer back in 1983, Steve Jobs bragged that it was “a machine that was made in America.”As late as the early 2000s, Apple still manufactured many of its computers at the company’s iMac plant in Elk Grove, California.Jobs often said that he was as proud of the Apple’s manufacturing plants as he was of the devices themselves.

By 2004, however, Apple had largely turned to foreign manufacturing. The shift to offshore production and assembly reached itspeak with the iconic iPhone, which Apple first introduced in 2007. The iPhone contains hundreds of parts, an estimated 90 percent ofwhich are manufactured abroad. Advanced semiconductors come from Germany and Taiwan, memory from Korea and Japan, displaypanels and circuitry from Korea and Taiwan, rare metals from Africa and Asia, and the gyroscope used for tracking the iPhone’s

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orientation comes from Switzerland. Apple’s major subcontractor, the Taiwanese multinational firm, Foxconn, assembles half of allthe iPhones sold in the world today at a huge factory in China. Foxconn also has factories devoted to iPhone assembly at several otherlocations, including Brazil and India. Another Taiwanese-based company, Pegatron, also assembles iPhones for Apple at a factory inChina.

Apple still employs some 80,000 people in the United States, and it has kept important activities at home, including productdesign, software engineering, and marketing. Furthermore, Apple claims that its business supports another 450,000 jobs at U.S.-basedsuppliers. For example, the glass for the iPhone is manufactured at Corning’s U.S. plants in Kentucky, Analog Devices inMassachusetts produces chips that enable the iPhone’s touch display, and a Texas Instruments plant in Maine makes electroniccomponents that go in the iPhone. However, over 1.5 million people are involved in the engineering, building, and final assembly ofits products outside of the United States, many of them working at subcontractors like Foxconn.

When explaining its decision to assemble the iPhone in China, Apple cites a number of factors. While it is true that labor costsare lower in China, Apple executives point out that labor costs only account for a small portion of the total value of its products andare not the main driver of location decisions. Far more important, according to Apple, is the ability of its Chinese subcontractors torespond very quickly to requests from Apple to scale production up and down. In a famous illustration of this capability, back in 2007Steve Jobs demanded that a glass screen replace the plastic screen on his prototype iPhone. Jobs didn’t like the look and feel of plasticscreens, which at the time were standard in the industry, nor did he like the way they scratched easily. This last-minute change in thedesign of the iPhone put Apple’s market introduction date at risk. Apple had selected Corning to manufacture large panes ofstrengthened glass, but finding a manufacturer that could cut those panes into millions of iPhone screens wasn’t easy. Then, a bidarrived from a Chinese factory. When the Apple team visited the factory, they found that the plant’s owners were already constructinga new wing to cut the glass and were installing equipment. “This is in case you give us the contract,” the manager said. The plant alsohad a warehouse full of glass samples for Apple, and a team of engineers available to work with Apple. They had built onsitedormitories so the factory could run three shifts seven days a week to meet Apple’s demanding production schedule. The Chinesecompany got the bid.

Another critical advantage of China for Apple was that it was much easier to hire engineers there. Apple calculated that about8,700 industrial engineers were needed to oversee and guide the 200,000 assembly-line workers involved in manufacturing theoriginal iPhone. The company had estimated it would take as long as nine months to find that many engineers in the United States. InChina, it took 15 days.

Also important is the clustering together of factories in China. Many of the factories providing components for the iPhone arelocated close to Foxconn’s assembly plant. As one executive noted, “The entire supply chain is in China. You need a thousand rubbergaskets? That’s the factory next door. You need a million screws? That factory is a block away. You need a screw made a little bitdifferent? That will take three hours.”*

All this being said, there are drawbacks to outsourcing to China. Several of Apple’s subcontractors have been targeted for theirpoor working conditions. Criticisms include low pay of line workers, long hours, mandatory overtime for little or no additional pay,and poor safety records. Some former Apple executives say there is an unresolved tension within the company: Executives want toimprove working conditions within the factories of subcontractors, such as Foxconn, but that dedication falters when it conflicts withcrucial supplier relationships or the fast delivery of new products. In addition, Apple’s outsourcing decisions have been criticized byPresident Trump, who argues that the company is guilty of moving U.S. jobs overseas. While Apple disagrees with this assessment, ithas responded by increasing its investment in U.S. facilities. In 2018, for example, the company announced it would invest $30billion over five years to create 20,000 new Apple jobs in the United States. Most of these jobs, however, are expected to be insoftware development and data center operations, not manufacturing and assembly.*C. Duhigg and K. Bradsher, “How U.S. Lost Out on iPhone Work.” The New York Times, January 22, 2012.

Sources: Sam Costello, “Where Is the iPhone Made?" Lifewire, July 14, 2018; David Barboza, “How China Built iPhone City with Billions in Perks for Apple’s Partner,” TheNew York Times, December 29, 2016; Gu Huini, “Human Costs Are Built into iPad in China,” The New York Times, January 26, 2012; Chuck Jones, “Apple’s $350 Billion USContribution Was Already on the Cards,” Forbes, January 19, 2018.

IntroductionOver the past five decades, a fundamental shift has been occurring in the world economy. We have been moving awayfrom a world in which national economies were relatively self-contained entities, isolated from each other by barriers tocross-border trade and investment; by distance, time zones, and language; and by national differences in governmentregulation, culture, and business systems. We have moved toward a world in which barriers to cross-border trade andinvestment have declined; perceived distance is shrinking due to advances in transportation and telecommunicationstechnology; material culture is starting to look similar the world over; and national economies are merging into aninterdependent, integrated global economic system. The process by which this transformation is occurring is commonlyreferred to as globalization.

At the same time, recent political events have raised some questions about the inevitability of the globalizationprocess. The exit of the United Kingdom from the European Union (Brexit), the renegotiation of the North AmericanFree Trade Agreement (NAFTA) by the Trump Administration, and trade disputes between the United States and manyof its trading partners, including most notably China, have all contributed to uncertainty about the future of globalization.

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While the world seems unlikely to pull back significantly from globalization, there is no doubt that the benefits ofglobalization are more in dispute now than at any time in the last half century. This is a new reality, albeit perhaps atemporary one, but it is one the international business community will have to adjust to.

The opening case illustrates how one company, Apple, has taken advantage of globalization. Apple has created aglobal supply chain to efficiently produce its icon iPhone. While product design and software development areundertaken in California, component parts are manufactured all over the world, and the final product is assembled forApple by Foxconn in factories in China, Brazil, India, and elsewhere. In configuring the production system of the iPhonein this manner, Apple is trying to partner with the most efficient subcontractors, wherever in the world they might reside.Apple could not have configured its production system in this manner had it not been for the systematic reductions inbarriers to cross-border trade and investment that have occurred over the last half century.

At the same time, Apple has been criticized by President Trump for placing too much productive activity outside ofthe United States. Moreover, trade disputes between the United States and China have raised the possibility that Chinamay at some point not be the optimal location for assembling the iPhone. Apple has started to adjust its strategy toaccount for the potential risks here, establishing assembly operations outside of China (in India, for example), increasingits investment in the United States (in 2018, Apple announced it would invest $30 billion over five years in U.S.facilities, creating 20,000 new jobs in the process), and working with U.S.-based suppliers to help them become efficientApple partners (Apple has established a $5 billion fund to help those suppliers upgrade their capabilities). Thus, Apple istaking advantage of globalization, and simultaneously hedging against any possible pullback from the level ofglobalization that existed in 2016, which for now at least may have been a high-water mark, albeit a temporary one.

Proponents of increased global trade argue that cross-cultural engagement and trade across country borders is thefuture and that returning back to a nationalistic perspective is the past. On the other hand, the nationalistic argument restsin citizens wanting their country to be sovereign, self-sufficient as much as possible, and basically in charge of their owneconomy and country environment. We will touch on many aspects of this debate throughout this text’s 20 integratedchapters.

Globalization now has an impact on almost everything we do. For example, an American medical doctor—let’s callher Laurie—might drive to work at her pediatric office in a sports utility vehicle (SUV) that was designed in Stuttgart,Germany, and assembled in Leipzig, Germany, and Bratislava, Slovakia, by Porsche from components from partssuppliers worldwide, which in turn were fabricated from Korean steel and Malaysian rubber. Laurie may have filled hercar with gasoline at a Shell service station owned by a British-Dutch multinational company. The gasoline couldhave been made from oil pumped out of a well off the coast of Africa by a French oil company that transported itto the United States in a ship owned by a Greek shipping line. While driving to work, Laurie might talk to herstockbroker (using a hands-free, in-car speaker) on an Apple iPhone that was designed in California and assembled inChina using chip sets produced in Japan and Europe, glass made by Corning in Kentucky, and memory chips from SouthKorea. Perhaps on her way, Laurie might tell the stockbroker to purchase shares in Lenovo, a multinational Chinese PCmanufacturer whose operational headquarters is in North Carolina and whose shares are listed on the New York StockExchange.

This is the world in which we live. In many cases, we simply do not know, or perhaps even care, where a productwas designed and where it was made. Just a couple of decades ago, “Made in the USA” or “Made in Germany” hadstrong meaning and referred to something. The U.S. often stood for quality, and Germany often stood for sophisticatedengineering. Now the country of origin for a product has given way to, for example, “Made by BMW,” and the companyis the quality assurance platform, not the country. In many cases, it goes even beyond the company to the personalrelationship a customer has developed with a representative of the company, and so we focus on what has become knownas CRM (Customer Relationship Management).

Whether it is still the quality associated with the country of origin of a product, or the assurance given by a specificcompany regardless of where they manufacture their product, we live in a world where the volume of goods, services,and investments crossing national borders has expanded faster than world output for more than half a century. It is aworld in which international institutions such as the World Trade Organization and gatherings of leaders from theworld’s most powerful economies continue to work for even lower barriers to cross-border trade and investment. Thesymbols of material culture and popular culture are increasingly global, from Coca-Cola and Starbucks, to SonyPlayStation, Facebook, Netflix video streaming service, IKEA stores, and Apple iPads and iPhones. Vigorous and vocalgroups protest against globalization, which they blame for a list of ills from unemployment in developed nations toenvironmental degradation and the Westernization or Americanization of local cultures. These protesters come fromenvironmental groups, which have been around for some time, but more recently also from nationalistic groups focusedon their countries being more sovereign.

For businesses, the globalization process has many opportunities. Firms can expand their revenues by sellingaround the world and/or reduce their costs by producing in nations where key inputs, including labor, are cheap. Theglobal expansion of enterprises has been facilitated by generally favorable political and economic trends. This hasallowed businesses both large and small, from both advanced nations and developing nations, to expand internationally.

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As globalization unfolds, it is transforming industries and creating anxiety among those who believed their jobs wereprotected from foreign competition. Advances in technology, lower transportation costs, and the rise of skilled workersin developing countries imply that many services no longer need to be performed where they are delivered. As best-selling author Thomas Friedman has argued, the world is becoming “flat.”1 People living in developed nations no longerhave the playing field tilted in their favor. Increasingly, enterprising individuals based in India, China, or Brazil have thesame opportunities to better themselves as those living in Western Europe, the United States, or Canada.

In this text, we will take a close look at these issues and many more. We will explore how changes in regulationsgoverning international trade and investment, when coupled with changes in political systems and technology, havedramatically altered the competitive playing field confronting many businesses. We will discuss the resultingopportunities and threats and review the strategies that managers can pursue to exploit the opportunities and counter thethreats. We will consider whether globalization benefits or harms national economies. We will look at what economictheory has to say about the outsourcing of manufacturing and service jobs to places such as India and China and look atthe benefits and costs of outsourcing, not just to business firms and their employees but to entire economies.First, though, we need to get a better overview of the nature and process of globalization, and that is the functionof this first chapter.

What Is Globalization?

LO1-1Understand what is meant by the term globalization.As used in this text, globalization refers to the shift toward a more integrated and interdependent world economy.Globalization has several facets, including the globalization of markets and the globalization of production.

THE GLOBALIZATION OF MARKETSThe globalization of markets refers to the merging of historically distinct and separate national markets into one hugeglobal marketplace. Falling barriers to cross-border trade and investment have made it easier to sell internationally. It hasbeen argued for some time that the tastes and preferences of consumers in different nations are beginning to converge onsome global norm, thereby helping create a global market.2 Consumer products such as Citigroup credit cards, Coca-Cola soft drinks, Sony video games, McDonald’s hamburgers, Starbucks coffee, IKEA furniture, and Apple iPhones arefrequently held up as prototypical examples of this trend. The firms that produce these products are more than justbenefactors of this trend; they are also facilitators of it. By offering the same basic product worldwide, they help create aglobal market.

A company does not have to be the size of these multinational giants to facilitate, and benefit from, theglobalization of markets. In the United States, for example, according to the International Trade Administration, morethan 300,000 small and medium-sized firms with fewer than 500 employees account for 98 percent of the companies thatexport. More generally, exports from small and medium-sized companies account for 33 percent of the value of U.S.exports of manufactured goods.3 Typical of these is B&S Aircraft Alloys, a New York company whose exports accountfor 40 percent of its $8 million annual revenues.4 The situation is similar in several other nations. For example, inGermany, a staggering 98 percent of small and midsize companies have exposure to international markets, via eitherexports or international production. Since 2009, China has been the world’s largest exporter, sending more than $2trillion worth of products and services last year to the rest of the world.

global EDGE INTERNATIONAL BUSINESSRESOURCES

globalEDGE™ has been the world’s go-to site online for global business knowledge since 2001. Google typically ranks the site number1 for “international business resources” from anywhere in the world you access it. Created by a 30-member team in the InternationalBusiness Center in the Broad College of Business at Michigan State University under the supervision of Dr. Tomas Hult and Dr. TungaKiyak, globalEDGE™ is a knowledge resource that connects international business professionals worldwide to a wealth of information,insights, and learning resources on global business activities.

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The site offers the latest and most comprehensive international business and trade content for a wide range of topics. Whetherconducting extensive market research, looking to improve your international knowledge, or simply browsing, you’re sure to find whatyou need to sharpen your competitive edge in today’s rapidly changing global marketplace. The easy, convenient, and freeglobalEDGE™ website’s tagline is “Your Source for Global Business Knowledge.” Take a look at the site at globaledge.msu.edu. Wewill use globalEDGE throughout this text for exercises, information, data, and to keep every facet of the text up-to-date on a daily basis!

Despite the global prevalence of Citigroup credit cards, McDonald’s hamburgers, Starbucks coffee, and IKEAstores, for example, it is important not to push too far the view that national markets are giving way to the global market.As we shall see in later chapters, significant differences still exist among national markets along many relevantdimensions, including consumer tastes and preferences, distribution channels, culturally embedded value systems,business systems, and legal regulations. Uber, for example, the fast-growing ride-for-hire service, is finding it needs torefine its entry strategy in many foreign cities in order to take differences in the regulatory regime into account. Suchdifferences frequently require companies to customize marketing strategies, product features, and operating practices tobest match conditions in a particular country.

The most global of markets are not typically markets for consumer products—where national differences in tastesand preferences can still be important enough to act as a brake on globalization. They are markets for industrial goodsand materials that serve universal needs the world over. These include markets for commodities such as aluminum, oil,and wheat; for industrial products such as microprocessors, DRAMs (computer memory chips), and commercial jetaircraft; for computer software; and for financial assets, from U.S. Treasury bills to Eurobonds, and futures on the Nikkeiindex or the euro. That being said, it is increasingly evident that many newer high-technology consumer products, suchas Apple’s iPhone, are being successfully sold the same way the world over.

In many global markets, the same firms frequently confront each other as competitors in nation after nation. Coca-Cola’s rivalry with PepsiCo is a global one, as are the rivalries between Ford and Toyota; Boeing and Airbus; Caterpillarand Komatsu in earthmoving equipment; General Electric and Rolls-Royce in aero engines; Sony, Nintendo, andMicrosoft in video-game consoles; and Samsung and Apple in smartphones. If a firm moves into a nation not currentlyserved by its rivals, many of those rivals are sure to follow to prevent their competitor from gaining an advantage.5 Asfirms follow each other around the world, they bring with them many of the assets that served them well in other nationalmarkets—their products, operating strategies, marketing strategies, and brand names—creating some homogeneityacross markets. Thus, greater uniformity replaces diversity. In an increasing number of industries, it is no longermeaningful to talk about “the German market,” “the American market,” “the Brazilian market,” or “the Japanesemarket”; for many firms, there is only the global market.

THE GLOBALIZATION OF PRODUCTIONThe globalization of production refers to the sourcing of goods and services from locations around the globe to takeadvantage of national differences in the cost and quality of factors of production (such as labor, energy, land, andcapital). By doing this, companies hope to lower their overall cost structure or improve the quality or functionality oftheir product offering, thereby allowing them to compete more effectively. For example, Boeing has made extensive useof outsourcing to foreign suppliers. Consider Boeing’s 777 first introduced in 1995: Eight Japanese suppliers make partsfor the fuselage, doors, and wings; a supplier in Singapore makes the doors for the nose landing gear; three suppliers inItaly manufacture wing flaps; and so on.6 In total, some 30 percent of the 777, by value, is built by foreign companies.And for its most recent jet airliner, the 787, Boeing has pushed this trend even further; some 65 percent of the total valueof the aircraft is outsourced to foreign companies, 35 percent of which goes to three major Japanese companies.

Part of Boeing’s rationale for outsourcing so much production to foreign suppliers is that these suppliers are thebest in the world at their particular activity. A global web of suppliers yields a better final product, which enhances thechances of Boeing winning a greater share of total orders for aircraft than its global rival, Airbus. Boeing also outsourcessome production to foreign countries to increase the chance it will win significant orders from airlines based in thatcountry. For a more detailed look at the globalization of production at Boeing, see the accompanying ManagementFocus.

MANAGEMENT FOCUS

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Boeing’s Global Production SystemExecutives at the Boeing Corporation, America’s largest exporter, say that building a large commercial jet aircraft like the 787Dreamliner involves bringing together more than a million parts in flying formation. Half a century ago, when the early models ofBoeing’s venerable 737 and 747 jets were rolling off the company’s Seattle-area production lines, foreign suppliers accounted foronly 5 percent of those parts, on average. Boeing was vertically integrated and manufactured many of the major components thatwent into the planes. The largest parts produced by outside suppliers were the jet engines, where two of the three suppliers wereAmerican companies. The lone foreign engine manufacturer was the British company Rolls-Royce.

Fast-forward to the modern era, and things look very different. In the case of Boeing’s super-efficient 787 Dreamliner, 50outside suppliers spread around the world account for 65 percent of the value of the aircraft. Italian firm Alenia Aeronautica makesthe center fuselage and horizontal stabilizer. Kawasaki of Japan makes part of the forward fuselage and the fixed trailing edge ofthe wing. French firm Messier-Dowty makes the aircraft’s landing gear. German firm Diehl Luftahrt Elektronik supplies the maincabin lighting. Sweden’s Saab Aerostructures makes the access doors. Japanese company Jamco makes parts for the lavatories,flight deck interiors, and galleys. Mitsubishi Heavy Industries of Japan makes the wings. KAA of Korea makes the wing tips. Andso on.

Why the change? One reason is that 80 percent of Boeing’s customers are foreign airlines, and to sell into those nations, itoften helps to be giving business to those nations. The trend started in 1974 when Mitsubishi of Japan was given contracts toproduce inboard wing flaps for the 747. The Japanese reciprocated by placing big orders for Boeing jets. A second rationale was todisperse component part production to those suppliers who are the best in the world at their particular activity. Over the years, forexample, Mitsubishi has acquired considerable expertise in the manufacture of wings, so it was logical for Boeing to useMitsubishi to make the wings for the 787. Similarly, the 787 is the first commercial jet aircraft to be made almost entirely out ofcarbon fiber, so Boeing tapped Japan’s Toray Industries, a world-class expert in sturdy but light carbon-fiber composites, to supplymaterials for the fuselage. A third reason for the extensive outsourcing on the 787 was that Boeing wanted to unburden itself ofsome of the risks and costs associated with developing production facilities for the 787. By outsourcing, it pushed some of thoserisks and costs onto suppliers, who had to undertake major investments in capacity to ramp up to produce for the 787.

So what did Boeing retain for itself? Engineering design, marketing and sales, and final assembly are done at its Everett plantnorth of Seattle, all activities where Boeing maintains it is the best in the world. Of major component parts, Boeing made only thetail fin and wing to body fairing (which attaches the wings to the fuselage of the plane). Everything else was outsourced.

As the 787 moved through development, it became clear that Boeing had pushed the outsourcing paradigm too far.Coordinating a globally dispersed production system this extensive turned out to be very challenging. Parts turned up late, someparts didn’t “snap together” the way Boeing had envisioned, and several suppliers ran into engineering problems that slowed downthe entire production process. As a consequence, the date for delivery of the first jet was pushed back more than four years, andBoeing had to take millions of dollars in penalties for late deliveries. The problems at one supplier, Vought Aircraft in NorthCarolina, were so severe that Boeing ultimately agreed to acquire the company and bring its production in-house. Vought was co-owned by Alenia of Italy and made parts of the main fuselage.

There are now signs that Boeing is rethinking some of its global outsourcing policy. For its next jet, a new version of itspopular wide-bodied 777 jet, the 777X, which will use the same carbon-fiber technology as the 787, Boeing will bring wingproduction back in-house. Mitsubishi and Kawasaki of Japan produce much of the wing structure for the 787 and for the originalversion of the 777. However, recently Japan’s airlines have been placing large orders with Airbus, breaking with their traditionalallegiance to Boeing. This seems to have given Boeing an opening to bring wing production back in-house. Boeing executives alsonote that Boeing has lost much of its expertise in wing production over the last 20 years due to outsourcing, and bringing it backin-house for new carbon-fiber wings might enable Boeing to regain these important core skills and strengthen the company’scompetitive position.Sources: M. Ehrenfreund, “The Economic Reality Behind the Boeing Plane Trump Showed Off,” The Washington Post, February 17, 2017; K. Epstein and J. Crown,“Globalization Bites Boeing,” Bloomberg Businessweek, March 12, 2008; H. Mallick, “Out of Control Outsourcing Ruined Boeing’s Beautiful Dreamliner,” The Star,February 25, 2013; P. Kavilanz, “Dreamliner: Where in the World Its Parts Come From,” CNN Money, January 18, 2013; S. Dubois, “Boeing’s Dreamliner Mess: SimplyInevitable?” CNN Money, January 22, 2013; and A. Scott and T. Kelly, “Boeing’s Loss of a $9.5 Billion Deal Could Bring Jobs Back to the U.S.,” Business Insider, October14, 2013.

Early outsourcing efforts were primarily confined to manufacturing activities, such as those undertaken by Boeingand Apple. Increasingly, however, companies are taking advantage of modern communications technology, particularlythe Internet, to outsource service activities to low-cost producers in other nations. The Internet has allowed hospitals tooutsource some radiology work to India, where images from MRI scans and the like are read at night while U.S.physicians sleep; the results are ready for them in the morning. Many software companies, including Microsoft, now useIndian engineers to perform test functions on software designed in the United States. The time difference allows Indianengineers to run debugging tests on software written in the United States when U.S. engineers sleep, transmitting thecorrected code back to the United States over secure Internet connections so it is ready for U.S. engineers to work on thefollowing day. Dispersing value-creation activities in this way can compress the time and lower the costs required todevelop new software programs. Other companies, from computer makers to banks, are outsourcing customer servicefunctions, such as customer call centers, to developing nations where labor is cheaper. In another example from healthcare, workers in the Philippines transcribe American medical files (such as audio files from doctors seeking approvalfrom insurance companies for performing a procedure). Some estimates suggest the outsourcing of many administrativeprocedures in health care, such as customer service and claims processing, could reduce health care costs in America bymore than $100 billion.

Did You Know?

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Did you know that trade as a percentage of GDP for the U.S. has nearly tripled since 1960?Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation fromthe author. 

The economist Robert Reich has argued that as a consequence of the trend exemplified by companies such asBoeing, Apple, and Microsoft, in many cases it is becoming irrelevant to talk about American products, Japaneseproducts, German products, or Korean products. Increasingly, according to Reich, the outsourcing of productiveactivities to different suppliers results in the creation of products that are global in nature—that is, “global products.”7But as with the globalization of markets, companies must be careful not to push the globalization of production too far.As we will see in later chapters, substantial impediments still make it difficult for firms to achieve the optimal dispersionof their productive activities to locations around the globe. These impediments include formal and informal barriers totrade between countries, barriers to foreign direct investment, transportation costs, issues associated with economic andpolitical risk, and the sheer managerial challenge of coordinating a globally dispersed supply chain (an issue for Boeingwith the 787 Dreamliner, as discussed in the Management Focus). For example, government regulations ultimately limitthe ability of hospitals to outsource the process of interpreting MRI scans to developing nations where radiologists arecheaper.

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Nevertheless, the globalization of markets and production will probably continue. Modern firms are importantactors in this trend, their actions fostering increased globalization. These firms, however, are merely responding in anefficient manner to changing conditions in their operating environment—as well they should.

The Emergence of Global InstitutionsAs markets globalize and an increasing proportion of business activity transcends national borders, institutions areneeded to help manage, regulate, and police the global marketplace and to promote the establishment of multinationaltreaties to govern the global business system. Over the past 75 years, a number of important global institutions have beencreated to help perform these functions, including the General Agreement on Tariffs and Trade (GATT) and itssuccessor, the World Trade Organization; the International Monetary Fund and its sister institution, the World Bank; andthe United Nations. All these institutions were created by voluntary agreement between individual nation-states, and theirfunctions are enshrined in international treaties.

The World Trade Organization (WTO) (like the GATT before it) is primarily responsible for policing the worldtrading system and making sure nation-states adhere to the rules laid down in trade treaties signed by WTO memberstates. As of 2019, 164 nations that collectively accounted for 98 percent of world trade were WTO members,thereby giving the organization enormous scope and influence. The WTO is also responsible for facilitating theestablishment of additional multinational agreements among WTO member states. Over its entire history, and that of theGATT before it, the WTO has promoted the lowering of barriers to cross-border trade and investment. In doing so, theWTO has been the instrument of its member states, which have sought to create a more open global business systemunencumbered by barriers to trade and investment between countries. Without an institution such as the WTO, theglobalization of markets and production is unlikely to have proceeded as far as it has. However, as we shall see in thischapter and in Chapter 7 when we look closely at the WTO, critics charge that the organization is usurping the nationalsovereignty of individual nation-states.

The International Monetary Fund (IMF) and the World Bank were both created in 1944 by 44 nations that metat Bretton Woods, New Hampshire. The IMF was established to maintain order in the international monetary system; theWorld Bank was set up to promote economic development. In the more than seven decades since their creation, bothinstitutions have emerged as significant players in the global economy. The World Bank is the less controversial of thetwo sister institutions. It has focused on making low-interest loans to cash-strapped governments in poor nations thatwish to undertake significant infrastructure investments (such as building dams or roads).

The IMF is often seen as the lender of last resort to nation-states whose economies are in turmoil and whosecurrencies are losing value against those of other nations. During the past two decades, for example, the IMF has lentmoney to the governments of troubled states including Argentina, Indonesia, Mexico, Russia, South Korea, Thailand,

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and Turkey. More recently, the IMF took a proactive role in helping countries cope with some of the effects of the 2008–2009 global financial crisis. IMF loans come with strings attached, however; in return for loans, the IMF requires nation-states to adopt specific economic policies aimed at returning their troubled economies to stability and growth. Theserequirements have sparked controversy. Some critics charge that the IMF’s policy recommendations are ofteninappropriate; others maintain that by telling national governments what economic policies they must adopt, the IMF,like the WTO, is usurping the sovereignty of nation-states. We will look at the debate over the role of the IMF in Chapter11.

The United Nations (UN) was established October 24, 1945, by 51 countries committed to preserving peacethrough international cooperation and collective security. Today, nearly every nation in the world belongs to the UnitedNations; membership now totals 193 countries. When states become members of the United Nations, they agree to acceptthe obligations of the UN Charter, an international treaty that establishes basic principles of international relations.According to the charter, the UN has four purposes: to maintain international peace and security, to develop friendlyrelations among nations, to cooperate in solving international problems and in promoting respect for human rights, and tobe a center for harmonizing the actions of nations. Although the UN is perhaps best known for its peacekeeping role, oneof the organization’s central mandates is the promotion of higher standards of living, full employment, and conditions ofeconomic and social progress and development—all issues that are central to the creation of a vibrant global economy.As much as 70 percent of the work of the UN system is devoted to accomplishing this mandate. To do so, the UN worksclosely with other international institutions such as the World Bank. Guiding the work is the belief that eradicatingpoverty and improving the well-being of people everywhere are necessary steps in creating conditions for lasting worldpeace.8

Another institution in the news is the Group of Twenty (G20). Established in 1999, the G20 comprises the financeministers and central bank governors of the 19 largest economies in the world, plus representatives from the EuropeanUnion and the European Central Bank. Collectively, the G20 represents 90 percent of global GDP and 80 percent ofinternational global trade. Originally established to formulate a coordinated policy response to financial crises indeveloping nations, in 2008 and 2009 it became the forum through which major nations attempted to launch acoordinated policy response to the global financial crisis that started in America and then rapidly spread aroundthe world, ushering in the first serious global economic recession since 1981.

Drivers of Globalization

LO1-2Recognize the main drivers of globalization.

Two macro factors underlie the trend toward greater globalization.9 The first is the decline in barriers to the free flow ofgoods, services, and capital that has occurred in recent decades. The second factor is technological change, particularlythe dramatic developments in communication, information processing, and transportation technologies.

DECLINING TRADE AND INVESTMENT BARRIERSDuring the 1920s and 1930s, many of the world’s nation-states erected formidable barriers to international trade andforeign direct investment. International trade occurs when a firm exports goods or services to consumers in anothercountry. Foreign direct investment (FDI) occurs when a firm invests resources in business activities outside its homecountry. Many of the barriers to international trade took the form of high tariffs on imports of manufactured goods. Thetypical aim of such tariffs was to protect domestic industries from foreign competition. One consequence, however, was“beggar thy neighbor” retaliatory trade policies, with countries progressively raising trade barriers against each other.Ultimately, this depressed world demand and contributed to the Great Depression of the 1930s.

Having learned from this experience, the advanced industrial nations of the West committed themselves after WorldWar II to progressively reducing barriers to the free flow of goods, services, and capital among nations.10 This goal wasenshrined in the General Agreement on Tariffs and Trade. Under the umbrella of GATT, eight rounds of negotiationsamong member states worked to lower barriers to the free flow of goods and services. The first round of negotiationswent into effect in 1948. The most recent negotiations to be completed, known as the Uruguay Round, were finalized inDecember 1993. The Uruguay Round further reduced trade barriers; extended GATT to cover services as well asmanufactured goods; provided enhanced protection for patents, trademarks, and copyrights; and established the World

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Trade Organization to police the international trading system.11 Table 1.1 summarizes the impact of GATT agreementson average tariff rates for manufactured goods among several developed nations. As can be seen, average tariff rateshave fallen significantly since 1950 and now stand at about 2.0–3.0 percent. Comparable tariff rates in 2017 for Chinaand India were about 8 percent. This represents a sharp decline from 16.2 percent for China in 2000, and 33.6 percent forIndia in 2000. It’s also important to note that in addition to the global efforts of the GATT and WTO, trade barriers havealso been reduced by bilateral and regional agreements between two or more nations. For example, theEuropean Union has reduced trade barriers between its member states, the North American Free TradeAgreement reduced trade barriers between the United States, Mexico, and Canada, and a free trade agreement betweenthe United States and South Korea has reduced trade barriers between those two nations. In the early 1990s, there wereless than 50 such agreements in place. Today, there are around 300 such agreements.

TABLE 1.1 Average Tariff Rates on Manufactured Products as Percentage of ValueSources: The 1913–1990 data are from “Who Wants to Be a Giant?” The Economist: A Survey of the Multinationals, June 24, 1995, pp. 3–4. The 2018 data are fromthe World Development Indicators, World Bank.

Figure 1.1 charts the growth in the value of world merchandised trade and world production between 1960 and2018 (the most recent year for which data are available). The data are adjusted to take out the effect of inflation and isindexed at a value of 100 in 1960 to allow for an “apples to apples” comparison. What you can see from the chart is thatbetween 1960 and 2018 the value of the world economy (adjusted for inflation) increased 9.4 times, while the value ofinternational trade in merchandised goods increased 22.4 times. This actually underestimates the growth in trade,because trade in services has also been growing rapidly in recent decades. By 2018, the value of world trade inmerchandised goods was 19.5 trillion, while the value of trade in services was $5.8 trillion.

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FIGURE 1.1 Value of world merchandised trade and world production 1960–2019.Sources: World Bank, 2019; World Trade Organization, 2019; United Nations, 2019.

Not only has trade in goods and services been growing faster than world output for decades, so has the value offoreign direct investment, in part due to reductions in barriers limiting FDI between countries. According to UN data,some 80 percent of the more than 1,500 changes made to national laws governing foreign direct investment since 2000have created a more favorable environment. Partly due to such liberalization, the value of FDI has grown significantlyover the last 30 years. In 1990, about $244 billion in foreign investment was made by enterprises. By 2018, that figurehad increased to $1.3 trillion. As a result of sustained cross-border investment, by 2018 the sales of foreign affiliates ofmultinational corporations reached $27 trillion, almost $8 trillion more than the value of international trade in 2018, andthese affiliates employed some 76 million people.12

The fact that the volume of world trade has been growing faster than world GDP implies several things.First, more firms are doing what Boeing does with the 777 and 787: dispersing parts of their production process todifferent locations around the globe to drive down production costs and increase product quality. Second, the economiesof the world’s nation-states are becoming ever more intertwined. As trade expands, nations are becoming increasinglydependent on each other for important goods and services. Third, the world has become significantly wealthier in the lasttwo decades. The implication is that rising trade is the engine that has helped pull the global economy along.

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BCFC/Shutterstock

The globalization of markets and production and the resulting growth of world trade, foreign direct investment, andimports all imply that firms are finding their home markets under attack from foreign competitors. This is true in China,where U.S. companies such as Apple, General Motors, and Starbucks are expanding their presence. It is true in theUnited States, where Japanese automobile firms have taken market share away from General Motors and Ford over thepast three decades, and it is true in Europe, where the once-dominant Dutch company Philips has seen its market share inthe consumer electronics industry taken by Japan’s Panasonic and Sony and Korea’s Samsung and LG. The growingintegration of the world economy into a single, huge marketplace is increasing the intensity of competition in a range ofmanufacturing and service industries.

However, declining barriers to cross-border trade and investment cannot be taken for granted. As we shall see insubsequent chapters, demands for “protection” from foreign competitors are still often heard in countries around theworld, including the United States. Although a return to the restrictive trade policies of the 1920s and 1930s is unlikely,it is not clear whether the political majority in the industrialized world favors further reductions in trade barriers. Indeed,the global financial crisis of 2008–2009 and the associated drop in global output that occurred led to more calls for tradebarriers to protect jobs at home. The election of Donald Trump to the Presidency of the United States in 2017 can beseen as a continuation of this counter trend, because Trump ran on a platform advocating higher trade barriers to protectAmerican companies from unfair foreign competition. If trade barriers decline no further, this may slow the rate ofglobalization of both markets and production.

ROLE OF TECHNOLOGICAL CHANGEThe lowering of trade barriers made globalization of markets and production a theoretical possibility. Technologicalchange has made it a tangible reality. Every year that goes by comes with unique and oftentimes major advances incommunication, information processing, and transportation technology, including the explosive emergence of the“Internet of Things.”

CommunicationsPerhaps the single most important innovation since World War II has been the development of the microprocessor,which enabled the explosive growth of high-power, low-cost computing, vastly increasing the amount of informationthat can be processed by individuals and firms. The microprocessor also underlies many recent advances intelecommunications technology. Over the past 30 years, global communications have been revolutionized bydevelopments in satellite, optical fiber, wireless technologies, and of course the Internet. These technologiesrely on the microprocessor to encode, transmit, and decode the vast amount of information that flows along theseelectronic highways. The cost of microprocessors continues to fall, while their power increases (a phenomenon known asMoore’s law, which predicts that the power of microprocessor technology doubles and its cost of production falls in halfevery 18 months).13

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The InternetThe explosive growth of the Internet since 1994, when the first web browser was introduced, has revolutionizedcommunications and commerce. In 1990, fewer than 1 million users were connected to the Internet. By 1995, the figurehad risen to 50 million. By 2018, the Internet had 4 billion users, or 52 percent of the global population.14It is no surprisethat the Internet has developed into the information backbone of the global economy.

In North America alone, e-commerce retail sales were $517 billion in 2018 (up from almost nothing in 1998), whileglobal e-commerce sales reached $2.5 trillion.15 Viewed globally, the Internet has emerged as an equalizer. It rolls backsome of the constraints of location, scale, and time zones.16 The Internet makes it much easier for buyers and sellers tofind each other, wherever they may be located and whatever their size. It allows businesses, both small and large, toexpand their global presence at a lower cost than ever before. Just as important, it enables enterprises to coordinate andcontrol a globally dispersed production system in a way that was not possible 25 years ago.

Transportation TechnologyIn addition to developments in communications technology, several major innovations in transportation technology haveoccurred since the 1950s. In economic terms, the most important are probably the development of commercial jet aircraftand superfreighters and the introduction of containerization, which simplifies transshipment from one mode of transportto another. The advent of commercial jet travel, by reducing the time needed to get from one location to another, haseffectively shrunk the globe. In terms of travel time, New York is now “closer” to Tokyo than it was to Philadelphia inthe colonial days.

Containerization has revolutionized the transportation business, significantly lowering the costs of shipping goodsover long distances. Because the international shipping industry is responsible for carrying about 90 percent of thevolume of world trade in goods, this has been an extremely important development.17 Before the advent ofcontainerization, moving goods from one mode of transport to another was very labor intensive, lengthy, and costly. Itcould take days and several hundred longshore workers to unload a ship and reload goods onto trucks and trains. Withthe advent of widespread containerization in the 1970s and 1980s, the whole process can now be executed by a handfulof longshore workers in a couple of days. As a result of the efficiency gains associated with containerization,transportation costs have plummeted, making it much more economical to ship goods around the globe, thereby helpingdrive the globalization of markets and production. Between 1920 and 1990, the average ocean freight and port chargesper ton of U.S. export and import cargo fell from $95 to $29 (in 1990 dollars).18 Today, the typical cost of transporting a20-foot container from Asia to Europe carrying more than 20 tons of cargo is about the same as the economy airfare for asingle passenger on the same journey.

Implications for the Globalization of ProductionAs transportation costs associated with the globalization of production have declined, dispersal of production togeographically separate locations has become more economical. As a result of the technological innovations discussedearlier, the real costs of information processing and communication have fallen dramatically in the past two decades.These developments make it possible for a firm to create and then manage a globally dispersed production system,further facilitating the globalization of production. A worldwide communications network has become essential for manyinternational businesses. For example, Dell uses the Internet to coordinate and control a globally dispersedproduction system to such an extent that it holds only three days’ worth of inventory at its assembly locations.Dell’s Internet-based system records orders for computer equipment as they are submitted by customers via thecompany’s website and then immediately transmits the resulting orders for components to various suppliers around theworld, which have a real-time look at Dell’s order flow and can adjust their production schedules accordingly. Given thelow cost of airfreight, Dell can use air transportation to speed up the delivery of critical components to meetunanticipated demand shifts without delaying the shipment of final product to consumers. Dell has also used moderncommunications technology to outsource its customer service operations to India. When U.S. customers call Dell with aservice inquiry, they are routed to Bangalore in India, where English-speaking service personnel handle the call.

Implications for the Globalization of MarketsIn addition to the globalization of production, technological innovations have facilitated the globalization of markets.Low-cost global communications networks, including those built on top of the Internet, are helping create electronicglobal marketplaces. As noted earlier, low-cost transportation has made it more economical to ship products around theworld, thereby helping create global markets. In addition, low-cost jet travel has resulted in the mass movement ofpeople between countries. This has reduced the cultural distance between countries and is bringing about someconvergence of consumer tastes and preferences. At the same time, global communications networks and global mediaare creating a worldwide culture. U.S. television networks such as CNN and HBO are now received in many countries,Hollywood films are shown the world over, while non-U.S. news networks such as the BBC and Al Jazeera also have aglobal footprint. In any society, the media are primary conveyors of culture; as global media develop, we must expect the

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evolution of something akin to a global culture. A logical result of this evolution is the emergence of global markets forconsumer products. Clear signs of this are apparent. It is now as easy to find a McDonald’s restaurant in Tokyo as it is inNew York, to buy an iPad in Rio as it is in Berlin, and to buy Gap jeans in Paris as it is in San Francisco.

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

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The Changing Demographics of the Global Economy

LO1-3Describe the changing nature of the global economy.Hand in hand with the trend toward globalization has been a fairly dramatic change in the demographics of the globaleconomy over the past decades. Half a century ago, four facts described the demographics of the global economy. Thefirst was U.S. dominance in the world economy and world trade picture. The second was U.S. dominance in worldforeign direct investment. Related to this, the third fact was the dominance of large, multinational U.S. firms on theinternational business scene. The fourth was that roughly half the globe—the centrally planned economies of thecommunist world—was off-limits to Western international businesses. All four of these facts have changed rapidly.

THE CHANGING WORLD OUTPUT AND WORLD TRADE PICTUREIn the early 1960s, the United States was still, by far, the world’s dominant industrial power. In 1960, the United Statesaccounted for 38.3 percent of world output, measured by gross domestic product (GDP). By 2018, the United Statesaccounted for 24 percent of world output, with China now at 15.2 percent of world output and the global leader in thiscategory (see Table 1.2). The United States was not the only developed nation to see its relative standing slip. The sameoccurred to Germany, France, Italy, the United Kingdom, and Canada—these are just a few examples. All were nationsthat were among the first to industrialize globally.

TABLE 1.2 Changing Demographics of World Output and World ExportsSources: Output data from World Bank database, 2019. Trade data from WTO Statistical Database, 2019.

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Of course, the change in the U.S. position was not an absolute decline because the U.S. economy grew significantlybetween 1960 and 2018 (the economies of Germany, France, Italy, the United Kingdom, and Canada also grew duringthis time). Rather, it was a relative decline, reflecting the faster economic growth of several other economies, particularlyChina, and several other nations in Asia. For example, as can be seen from Table 1.2, from 1960 to today, China’s shareof world output increased from a trivial amount to 15.2 percent, making it the world’s second-largest economy in termsof its share in world output (the U.S. is still the largest economy overall). Other countries that markedly increased theirshare of world output included Japan, Thailand, Malaysia, Taiwan, Brazil, and South Korea.

By the end of the 1980s, the U.S.’s position as the world’s leading trading nation was being challenged. Over thepast 30 years, U.S. dominance in export markets has waned as Japan, Germany, and a number of newly industrializedcountries such as South Korea and China have taken a larger share of world exports. During the 1960s, the United Statesroutinely accounted for 20 percent of world exports of manufactured goods. But as Table 1.2 shows, the U.S. share ofworld exports of goods and services has slipped to 8.2 percent, significantly behind that of China.

As emerging economies such as Brazil, Russia, India, and China—coined the BRIC countries—continue to grow, afurther relative decline in the share of world output and world exports accounted for by the United States and other long-established developed nations seems likely. By itself, this is not bad. The relative decline of the United States reflects thegrowing economic development and industrialization of the world economy, as opposed to any absolute decline in thehealth of the U.S. economy.

Most forecasts now predict a continued rise in the share of world output accounted for by developing nations suchas China, India, Russia, Indonesia, Thailand, South Korea, Mexico, and Brazil, and a commensurate decline in the shareenjoyed by rich industrialized countries such as the United Kingdom, Germany, Japan, and the United States. Perhapsmore important, if current trends continue, the Chinese economy could be larger than that of the United States within adecade, while the economy of India could become the third largest by 2030.19

Overall, the World Bank has estimated that today’s developing nations may account for more than 60 percent ofworld economic activity by 2030, while today’s rich nations, which currently account for more than 55 percent of worldeconomic activity, may account for only about 38 percent. Forecasts are not always correct, but these suggest that a shiftin the economic geography of the world is now under way, although the magnitude of that shift is not totally evident. Forinternational businesses, the implications of this changing economic geography are clear: Many of tomorrow’s economicopportunities may be found in the developing nations of the world, and many of tomorrow’s most capable competitorswill probably also emerge from these regions. A case in point has been the dramatic expansion of India’s software sector,which is profiled in the accompanying Country Focus.

COUNTRY FOCUS

India’s Software SectorSome 30 years ago, a number of small software enterprises were established in Bangalore, India. Typical of these enterprises wasInfosys Technologies, which was started by seven Indian entrepreneurs with about $1,000 among them. Infosys now has annualrevenues of $10.2 billion and some 200,000 employees, but it is just one of more than 100 software companies clustered aroundBangalore, which has become the epicenter of India’s fast-growing information technology sector. From a standing start in themid-1980s, this sector is now generating export sales of more than $100 billion.

The growth of the Indian software sector has been based on four factors. First, the country has an abundant supply ofengineering talent. Every year, Indian universities graduate some 400,000 engineers. Second, labor costs in the Indian softwaresector have historically been low. As recently as 2008, the cost to hire an Indian graduate was roughly 12 percent of the cost ofhiring an American graduate (however, this gap is narrowing fast with pay in the sector now only 30–40 percent less than in theUnited States). Third, many Indians are fluent in English, which makes coordination between Western firms and India easier.Fourth, due to time differences, Indians can work while Americans sleep, creating unique time efficiencies and an around-the-clock work environment.

Initially, Indian software enterprises focused on the low end of the software industry, supplying basic software developmentand testing services to Western firms. But as the industry has grown in size and sophistication, Indian firms have moved up themarket. Today, the leading Indian companies compete directly with the likes of IBM and EDS for large software developmentprojects, business process outsourcing contracts, and information technology consulting services. Over the past 15 years, thesemarkets have boomed, with Indian enterprises capturing a large slice of the pie. One response of Western firms to this emergingcompetitive threat has been to invest in India to garner the same kind of economic advantages that Indian firms enjoy. IBM, forexample, has invested $2 billion in its Indian operations and now has 150,000 employees located there, more than in any othercountry. Microsoft, too, has made major investments in India, including a research and development (R&D) center in Hyderabadthat employs 4,000 people and was located there specifically to tap into talented Indian engineers who did not want to move to theUnited States.

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Sources: “Ameerpet, India’s Unofficial IT Training Hub,” The Economist, March 30, 2017; “America’s Pain, India’s Gain: Outsourcing,” The Economist, January 11, 2003, p.59; “The World Is Our Oyster,” The Economist, October 7, 2006, pp. 9–10; “IBM and Globalization: Hungry Tiger, Dancing Elephant,” The Economist, April 7, 2007, pp.67–69; P. Mishra, “New Billing Model May Hit India’s Software Exports,” Live Mint, February 14, 2013; and “India’s Outsourcing Business: On the Turn,” The Economist,January 19, 2013.

THE CHANGING FOREIGN DIRECT INVESTMENT PICTUREReflecting the dominance of the United States in the global economy, U.S. firms accounted for 66.3 percent ofworldwide foreign direct investment flows in the 1960s. British firms were second, accounting for 10.5 percent, whileJapanese firms were a distant eighth, with only 2 percent. The dominance of U.S. firms was so great that books werewritten about the economic threat posed to Europe by U.S. corporations.20 Several European governments, most notablyFrance, talked of limiting inward investment by U.S. firms.

However, as the barriers to the free flow of goods, services, and capital fell, and as other countries increased theirshares of world output, non-U.S. firms increasingly began to invest across national borders. The motivation for much ofthis foreign direct investment by non-U.S. firms was the desire to disperse production activities to optimal locations andto build a direct presence in major foreign markets. Thus, beginning in the 1970s, European and Japanese firms began toshift labor-intensive manufacturing operations from their home markets to developing nations where labor costs werelower. In addition, many Japanese firms invested in North America and Europe—often as a hedge against unfavorablecurrency movements and the possible imposition of trade barriers. For example, Toyota, the Japanese automobilecompany, rapidly increased its investment in automobile production facilities in the United States and Europe during thelate 1980s and 1990s. Toyota executives believed that an increasingly strong Japanese yen would price Japaneseautomobile exports out of foreign markets; therefore, production in the most important foreign markets, asopposed to exports from Japan, made sense. Toyota also undertook these investments to head off growing politicalpressures in the United States and Europe to restrict Japanese automobile exports into those markets.

One consequence of these developments is illustrated in Figure 1.2, which shows the change in the outward stockof foreign direct investment as a percentage of GDP for a selection of countries and the world as a whole. (The outwardstock of foreign direct investment (FDI) refers to the total cumulative value of foreign investments by firms domiciledin a nation outside of that nation's borders.) Figure 1.2 illustrates a striking increase in the outward stock of FDI overtime. For example, in 1995 the outward stock of FDI held by U.S. firms was equivalent to 13 percent of U.S. GDP; by2018, that figure was 35 percent. For the world as a whole, the outward stock of FDI increased from 12 percent to 35percent over the same time period. The clear implication is that, increasingly, firms based in a nation depend for theirrevenues and profits on investments and productive activities in other nations. We live in an increasingly interconnectedworld.

FIGURE 1.2 FDI outward stock as a percentage of GDP.Sources: OECD data 2019, World Development Indicators 2019, UNCTAD data base, 2019.

Figure 1.3 illustrates two other important trends—the sustained growth in cross-border flows of foreign direct

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investment that has occurred since 1990, and the increasing importance of developing nations as the destination offoreign direct investment. Throughout the 1990s, the amount of investment directed at both developed and developingnations increased dramatically, a trend that reflects the increasing internationalization of business corporations.A surge in foreign direct investment from 1998 to 2000 was followed by a slump from 2001 to 2004, associatedwith a slowdown in global economic activity after the collapse of the financial bubble of the late 1990s and 2000. Thegrowth of foreign direct investment resumed at “normal” levels for that time in 2005 and continued upward through2007, when it hit record levels, only to slow again in 2008 and 2009 as the global financial crisis took hold. However,throughout this period, the growth of foreign direct investment into developing nations remained robust. Amongdeveloping nations, the largest recipient has been China, which received about $250 billion in inflows last year. As weshall see later in this text, the sustained flow of foreign investment into developing nations is an important stimulus foreconomic growth in those countries, which bodes well for the future of countries such as China, Mexico, and Brazil—allleading beneficiaries of this trend.

FIGURE 1.3 FDI inflows (in millions of dollars).Source: United Nations Conference on Trade and Development, World Investment Report 2019. (Data for 2019–2020 are forecast.)

THE CHANGING NATURE OF THE MULTINATIONAL ENTERPRISEA multinational enterprise (MNE) is any business that has productive activities in two or more countries. In the last 50years, two notable trends in the demographics of the multinational enterprise have been (1) the rise of non-U.S.multinationals and (2) the growth of mini-multinationals.

Non-U.S. MultinationalsIn the 1960s, global business activity was dominated by large U.S. multinational corporations. With U.S. firmsaccounting for about two-thirds of foreign direct investment during the 1960s, one would expect most multinationals tobe U.S. enterprises. In addition, British, Dutch, and French enterprises figured prominently on lists of the world's largestmultinational enterprises. By 2003, when Forbes magazine started to compile its annual ranking of the world's top 2,000multinational enterprises, 776 of the 2,000 firms, or 38.8 percent, were U.S. enterprises. The second-largest sourcecountry was Japan with 16.6 percent of the largest multinationals. The United Kingdom accounted for another 6.6percent of the world’s largest multinationals at the time. As shown in Figure 1.4, by 2019 the U.S. share had fallen to28.8 percent, or 575 firms, and the Japanese share had declined to 11.1 percent, while Chinese enterprises had emergedto comprise 309 of the total, or 15.5 percent. There has also been a notable increase in multinationals from Taiwan, India,and South Korea.

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FIGURE 1.4 National share of the largest 2,000 multinational corporations in 2019.Source: Forbes Global 2000 in 2019.

These shifts in representation of powerful multinational corporations and their home bases can be expected tocontinue. Specifically, we expect that even more firms from developing nations will emerge as important competitors inglobal markets, further shifting the axis of the world economy away from North America and Western Europeand challenging the long dominance of companies from the so-called developed world. One such risingcompetitor, the Dalian Wanda Group, is profiled in the accompanying Management Focus.

MANAGEMENT FOCUS

The Dalian Wanda GroupThe Dalian Wanda Group is perhaps the world’s largest real estate company, but is little known outside China. Established in1988, the Dalian Wanda Group is the largest owner of five-star hotels in the world. The company’s real estate portfolio includes133 Wanda shopping malls and 84 hotels. It also has extensive holdings in the film industry, in sports companies, tourism, andchildren’s entertainment. Dalian Wanda’s stated ambition is to become a world-class multinational, a goal it may already haveachieved.

In 2012, Dalian Wanda significantly expanded its international footprint when it acquired the U.S. cinema chain AMCEntertainment Holdings for $2.6 billion. At the time, the acquisition was the largest ever of a U.S. company by a Chineseenterprise, surpassing the $1.8 billion takeover of IBM’s PC business by Lenovo in 2005. AMC is the second-largest cinemaoperator in North America, where moviegoers spend more than $10 billion a year on tickets. After the acquisition was completed,the headquarters of AMC remained in Kansas City. Dalian, however, indicated it would inject capital into AMC to upgrade itstheaters to show more IMAX and 3D movies.

In 2015, Wanda followed its AMC acquisition with the purchase of Hoyts Group, an Australian cinema operator with morethan 150 cinemas. By combining AMC movie theaters with Hoyts and its already extensive movie properties in China, DalianWanda has become the largest cinema operator in the world, with more than 500 cinemas. This puts Wanda in a strong positionwhen negotiating distribution terms with movie studios.

Wanda is also expanding its international real estate operations. In 2014, it announced it won a bid for a prime plot of land inBeverly Hills, California. Wanda plans to invest $1.2 billion to construct a mixed-use development. The company also has asizable project in Chicago, where it is investing $900 million to build the third-tallest building in the city. In addition, Wanda hasreal estate projects in Spain, Australia, and London.

Today, the Wanda Group is already among the top 400 companies in the world, with some 130,000 employees, $90 billion inassets, and about $45 billion in revenue.Sources: Keith Weir, “China’s Dalian Wanda to Acquire Australia’s Hoyts for $365.7 Million,” Reuters, June 24, 2015; Zachary Mider, “China’s Wanda to Buy AMCCinema Chain for $2.6 Billion,” Bloomberg Businessweek, May 21, 2012; and Wanda Group Corporate, www.wanda-group.com. Corporate Profile, Official Website ofWanda Group, retrieved March 2019.

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The Rise of Mini-MultinationalsAnother trend in international business has been the growth of small and medium-sized multinationals (mini-multinationals).21 When people think of international businesses, they tend to think of firms such as ExxonMobil,General Motors, Ford, Panasonic, Procter & Gamble, Sony, and Unilever—large, complex multinational corporationswith operations that span the globe. Although most international trade and investment is still conducted by large firms,many medium-sized and small businesses are becoming increasingly involved in international trade and investment. Therise of the Internet is lowering the barriers that small firms face in building international sales.

Consider Lubricating Systems Inc. of Kent, Washington. Lubricating Systems, which manufactures lubricatingfluids for machine tools, employs 25 people, and generates sales of $6.5 million. It’s hardly a large, complexmultinational, yet more than $2 million of the company’s sales are generated by exports to a score of countries, includingJapan, Israel, and the United Arab Emirates. Lubricating Systems has also set up a joint venture with a German companyto serve the European market.22

Consider also Lixi Inc., a small U.S. manufacturer of industrial X-ray equipment: More than half of Lixi’s $24.4million in revenues comes from exports to Japan.23 Or take G. W. Barth, a manufacturer of cocoa-bean roastingmachinery based in Ludwigsburg, Germany. Employing just 65 people, this small company has captured 70percent of the global market for cocoa-bean roasting machines.24 International business is conducted not just by largefirms but also by medium-sized and small enterprises.

THE CHANGING WORLD ORDERIn 1989 and 1991, a series of democratic revolutions swept the communist world. For reasons that are explored in moredetail in Chapter 3, in country after country throughout eastern Europe and eventually in the Soviet Union itself,Communist Party governments collapsed. The Soviet Union receded into history, replaced by 15 independent republics.Czechoslovakia divided itself into two states, while Yugoslavia dissolved into a bloody civil war among its fivesuccessor states.

Since then, many of the former communist nations of Europe and Asia have seemed to share a commitment todemocratic politics and free market economics. For half a century, these countries were essentially closed to Westerninternational businesses. Now, they present a host of export and investment opportunities. Three decades later, theeconomies of many of the former communist states are still relatively undeveloped, however, and their continuedcommitment to democracy and market-based economic systems cannot be taken for granted. Disturbing signs of growingunrest and totalitarian tendencies are seen in several eastern European and central Asian states, including Russia, whichhas shifted back toward greater state involvement in economic activity and authoritarian government.25 Thus, the risksinvolved in doing business in such countries are high, but so may be the returns.

In addition to these changes, quieter revolutions have been occurring in China, other countries in Southeast Asia,and Latin America. Their implications for international businesses may be just as profound as the collapse ofcommunism in eastern Europe and Russia some time ago. China suppressed its pro-democracy movement in the bloodyTiananmen Square massacre of 1989. On the other hand, China continues to move progressively toward greater freemarket reforms. If what is occurring in China continues for two more decades, China may evolve from a third-worldbusiness giant into an industrial superpower even more rapidly than Japan did. If China’s GDP per capita grows by anaverage of 6 to 7 percent, which is slower than the 8 to 10 percent growth rate achieved during the past decade, then by2030 this nation of 1.4 billion people could boast an average GDP per capita of about $23,000, roughly the same as thatof Chile or Poland today.

The potential consequences for international business are enormous. On the one hand, China represents a huge andlargely untapped market. Reflecting this, between 1983 and today, annual foreign direct investment in China increasedfrom less than $2 billion to $250 billion annually. On the other hand, China’s new firms are proving to be very capablecompetitors, and they could take global market share away from Western and Japanese enterprises (see the ManagementFocus on the Dalian Wanda Group). Thus, the changes in China are creating both opportunities and threats forestablished international businesses.

As for Latin America, both democracy and free market reforms have been evident there, too. For decades, mostLatin American countries were ruled by dictators, many of whom seemed to view Western international businesses asinstruments of imperialist domination. Accordingly, they restricted direct investment by foreign firms. In addition, thepoorly managed economies of Latin America were characterized by low growth, high debt, and hyperinflation—all ofwhich discouraged investment by international businesses. In the past two decades, much of this has changed.Throughout much of Latin America, debt and inflation are down, governments have sold state-owned enterprises toprivate investors, foreign investment is welcomed, and the region’s economies have expanded. Brazil, Mexico, and Chilehave led the way. These changes have increased the attractiveness of Latin America, both as a market for exports and asa site for foreign direct investment. At the same time, given the long history of economic mismanagement in Latin

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America, there is no guarantee that these favorable trends will continue. Indeed, Bolivia, Ecuador, and mostnotably Venezuela have seen shifts back toward greater state involvement in industry in the past few years, andforeign investment is now less welcome than it was during the 1990s. In these nations, the government has seized controlof oil and gas fields from foreign investors and has limited the rights of foreign energy companies to extract oil and gasfrom their nations. Thus, as in the case of eastern Europe, substantial opportunities are accompanied by substantial risks.

GLOBAL ECONOMY OF THE TWENTY-FIRST CENTURYThe past quarter century has seen rapid changes in the global economy. Not withstanding recent developments such asthe higher tariffs introduced by the Trump Administration in the United States, barriers to the free flow of goods,services, and capital have been coming down. As their economies advance, more nations are joining the ranks of thedeveloped world. A generation ago, South Korea and Taiwan were viewed as second-tier developing nations. Now theyboast large economies, and firms based there are major players in many global industries, from shipbuilding and steel toelectronics and chemicals. The move toward a global economy has been further strengthened by the widespread adoptionof liberal economic policies by countries that had firmly opposed them for two generations or more. In short, currenttrends indicate the world is moving toward an economic system that is more favorable for international business.

But it is always hazardous to use established trends to predict the future. The world may be moving toward a moreglobal economic system, but globalization is not inevitable. Countries may pull back from the recent commitment toliberal economic ideology if their experiences do not match their expectations. There are clear signs, for example, of aretreat from liberal economic ideology in Russia. If Russia’s hesitation were to become more permanent and widespread,the liberal vision of a more prosperous global economy based on free market principles might not occur as quickly asmany hope. Clearly, this would be a tougher world for international businesses.

Also, greater globalization brings with it risks of its own. This was starkly demonstrated in 1997 and 1998, when afinancial crisis in Thailand spread first to other East Asian nations and then to Russia and Brazil. Ultimately, the crisisthreatened to plunge the economies of the developed world, including the United States, into a recession. We explore thecauses and consequences of this and other similar global financial crises in Chapter 11. Even from a purely economicperspective, globalization is not all good. The opportunities for doing business in a global economy may be significantlyenhanced, but as we saw in 1997–1998, the risks associated with global financial contagion are also greater. Indeed,during 2008–2009, a crisis that started in the financial sector of America, where banks had been too liberal in theirlending policies to homeowners, swept around the world and plunged the global economy into its deepest recession sincethe early 1980s, illustrating once more that in an interconnected world a severe crisis in one region can affect the entireglobe. Still, as explained later in this text, firms can exploit the opportunities associated with globalization whilereducing the risks through appropriate hedging strategies. These hedging strategies may also become more and moreimportant as the world balances globalization efforts with a potential increase in nationalistic tendencies by somecountries (e.g., recently in the United States and United Kingdom).

TEST PREPUse SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBookor go to learnsmartadvantage.com for help.

The Globalization Debate

LO1-4Explain the main arguments in the debate over the impact of globalization.Is the shift toward a more integrated and interdependent global economy a good thing? Many influential economists,politicians, and business leaders seem to think so.26 They argue that falling barriers to international trade and investmentare the twin engines driving the global economy toward greater prosperity. They say increased international trade andcross-border investment will result in lower prices for goods and services. They believe that globalizationstimulates economic growth, raises the incomes of consumers, and helps create jobs in all countries thatparticipate in the global trading system. The arguments of those who support globalization are covered in detail inChapters 6, 7, and 8. As we shall see, there are good theoretical reasons for believing that declining barriers tointernational trade and investment do stimulate economic growth, create jobs, and raise income levels. Moreover, as

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described in Chapters 6, 7, and 8, empirical evidence lends support to the predictions of this theory. However, despite theexistence of a compelling body of theory and evidence, globalization has its critics.27 Some of these critics are vocal andactive, taking to the streets to demonstrate their opposition to globalization. Here, we look at the nature of protestsagainst globalization and briefly review the main themes of the debate concerning the merits of globalization. In laterchapters, we elaborate on many of these points.

ANTIGLOBALIZATION PROTESTSPopular demonstrations against globalization date back to December 1999, when more than 40,000 protesters blockedthe streets of Seattle in an attempt to shut down a World Trade Organization meeting being held in the city. Thedemonstrators were protesting against a wide range of issues, including job losses in industries under attack from foreigncompetitors, downward pressure on the wage rates of unskilled workers, environmental degradation, and the culturalimperialism of global media and multinational enterprises, which was seen as being dominated by what some protesterscalled the “culturally impoverished” interests and values of the United States. All of these ills, the demonstratorsclaimed, could be laid at the feet of globalization. The World Trade Organization was meeting to try to launch a newround of talks to cut barriers to cross-border trade and investment. As such, it was seen as a promoter of globalizationand a target for the protesters. The protests turned violent, transforming the normally placid streets of Seattle into arunning battle between “anarchists” and Seattle’s bemused and poorly prepared police department. Pictures of brick-throwing protesters and armored police wielding their batons were duly recorded by the global media, which thencirculated the images around the world. Meanwhile, the WTO meeting failed to reach an agreement, and although theprotests outside the meeting halls had little to do with that failure, the impression took hold that the demonstrators hadsucceeded in derailing the meetings.

Emboldened by the experience in Seattle, antiglobalization protesters have made a habit of turning up at majormeetings of global institutions. Smaller-scale protests have periodically occurred in several countries, such as France,where antiglobalization activists destroyed a McDonald’s restaurant in 1999 to protest the impoverishment of Frenchculture by American imperialism (see the accompanying Country Focus for details). While violent protests may give theantiglobalization effort a bad name, it is clear from the scale of the demonstrations that support for the cause goes beyonda core of anarchists. Large segments of the population in many countries believe that globalization has detrimentaleffects on living standards, wage rates, and the environment. Indeed, the strong support for President Donald Trump inthe 2016 U.S. election was primarily based on his repeated assertions that trade deals had exported U.S. jobs overseasand created unemployment and low wages in America.

Both theory and evidence suggest that many of these fears are exaggerated. Many protests against globalization aretapping into a general sense of loss at the passing of a world in which barriers of time and distance, and significantdifferences in economic institutions, political institutions, and the level of development of different nations produced aworld rich in the diversity of human cultures. However, while the rich citizens of the developed world may have theluxury of mourning the fact that they can now see McDonald’s restaurants and Starbucks coffeehouses on their vacationsto exotic locations such as Thailand, fewer complaints are heard from the citizens of those countries, who welcome thehigher living standards that progress brings.

COUNTRY FOCUS

Protesting Globalization in FranceIt all started one night in August 1999, but it might as well have been today. Back in 1999, 10 men under the leadership of localsheep farmer and rural activist José Bové crept into the town of Millau in central France and vandalized a McDonald’s restaurantunder construction, causing an estimated $150,000 in damage. These were no ordinary vandals, however, at least according to theirsupporters, for the “symbolic dismantling” of the McDonald’s outlet had noble aims, or so it was claimed. The attack was initiallypresented as a protest against unfair American trade policies. The European Union (EU) had banned imports of hormone-treatedbeef from the United States, primarily because of fears that it might lead to health problems (although EU scientists had concludedthere was no evidence of this). After a careful review, the World Trade Organization stated the EU ban was not allowed undertrading rules that the EU and United States were party to and that the EU would have to lift it or face retaliation. The EU refused tocomply, so the U.S. government imposed a 100 percent tariff on imports of certain EU products, including French staples such asfoie gras, mustard, and Roquefort cheese. On farms near Millau, Bové and others raised sheep whose milk was used to makeRoquefort. They felt incensed by the American tariff and decided to vent their frustrations on McDonald’s.

Bové and his compatriots were arrested and charged. About the same time in the Languedoc region of France, Californiawinemaker Robert Mondavi had reached an agreement with the mayor and council of the village of Aniane and regional

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authorities to turn 125 acres of wooded hillside belonging to the village into a vineyard. Mondavi planned to invest $7 million inthe project and hoped to produce top-quality wine that would sell in Europe and the United States for $60 a bottle. However, localenvironmentalists objected to the plan, which they claimed would destroy the area’s unique ecological heritage. José Bové,basking in sudden fame, offered his support to the opponents, and the protests started. In May 2001, the socialist mayor who hadapproved the project was defeated in local elections in which the Mondavi project had become the major issue. He was replaced bya communist, Manuel Diaz, who denounced the project as a capitalist plot designed to enrich wealthy U.S. shareholders at the costof his villagers and the environment. Following Diaz’s victory, Mondavi announced he would pull out of the project. Aspokesperson noted, “It’s a huge waste, but there are clearly personal and political interests at play here that go way beyond us.”*

So, are the French opposed to foreign investment? The experience of McDonald’s and Mondavi seems to suggest so, as doesthe associated news coverage, but look closer and a different reality seems to emerge. Today, McDonald’s has more than 1,200restaurants in France. McDonald’s employs 69,000 workers in the country. France is the most profitable market for McDonald’safter the United States. In short, 20 years after the protests, France is a major success story for McDonald’s. Moreover, France haslong been one of the most favored locations for inward foreign direct investment, receiving more than $700 billion of foreigninvestment between 2000 and 2017, which makes it one of the top destinations for foreign investment in Europe. Americancompanies have always accounted for a significant percentage of this investment. French enterprises have also been significantforeign investors; some 1,100 French multinationals have about $1.1 trillion of assets in other nations. For all of the populistopposition to globalization, French corporations and consumers appear to be embracing it.*Henley, Jon. “Grapes of Wrath Scares Off US Firm.” Guardian News & Media Limited, May 18, 2001. https://www.theguardian.com/world/2001/may/18/jonhenley.

Sources: “Behind the Bluster,” The Economist, May 26, 2001; “The French Farmers’ Anti-Global Hero,” The Economist, July 8, 2000; C. Trueheart, “France’s Golden ArchEnemy?” Toronto Star, July 1, 2000; United Nations, World Investment Report, 2014 (New York & Geneva: United Nations, 2011); and Rob Wile, “The True Story of HowMcDonald’s Conquered France,” Business Insider, August 22, 2014.

GLOBALIZATION, JOBS, AND INCOMEOne concern frequently voiced by globalization opponents is that falling barriers to international trade destroymanufacturing jobs in wealthy advanced economies such as the United States and Western Europe. Critics argue thatfalling trade barriers allow firms to move manufacturing activities to countries where wage rates are much lower.28Indeed, due to the entry of China, India, and countries from eastern Europe into the global trading system, along withglobal population growth, the pool of global labor has increased more than fivefold between 1990 and today.Other things being equal, we might conclude that this enormous expansion in the global labor force, whencoupled with expanding international trade, would have depressed wages in developed nations.

This fear is often supported by anecdotes. For example, D. L. Bartlett and J. B. Steele, two journalists for thePhiladelphia Inquirer who gained notoriety for their attacks on free trade, cite the case of Harwood Industries, a U.S.clothing manufacturer that closed its U.S. operations, where it paid workers $9 per hour, and shifted manufacturing toHonduras, where textile workers received 48 cents per hour.29 Because of moves such as this, argue Bartlett and Steele,the wage rates of poorer Americans have fallen significantly over the past quarter of a century.

In the past few years, the same fears have been applied to services, which have increasingly been outsourced tonations with lower labor costs. The popular feeling is that when corporations such as Dell, IBM, or Citigroup outsourceservice activities to lower-cost foreign suppliers—as all three have done—they are “exporting jobs” to low-wage nationsand contributing to higher unemployment and lower living standards in their home nations (in this case, the UnitedStates). Some U.S. lawmakers have responded by calling for legal barriers to job outsourcing.

Supporters of globalization reply that critics of these trends miss the essential point about free trade agreements—the benefits outweigh the costs.30 They argue that free trade will result in countries specializing in the production ofthose goods and services that they can produce most efficiently, while importing goods and services that they cannotproduce as efficiently. When a country embraces free trade, there is always some dislocation—lost textile jobs atHarwood Industries or lost call-center jobs at Dell—but the whole economy is better off as a result. According to thisview, it makes little sense for the United States to produce textiles at home when they can be produced at a lower cost inHonduras or China. Importing textiles from China leads to lower prices for clothes in the United States, which enablesconsumers to spend more of their money on other items. At the same time, the increased income generated in China fromtextile exports increases income levels in that country, which helps the Chinese purchase more products produced in theUnited States, such as pharmaceuticals from Amgen, Boeing jets, microprocessors made by Intel, Microsoft software,and Cisco routers.

The same argument can be made to support the outsourcing of services to low-wage countries. By outsourcing itscustomer service call centers to India, Dell can reduce its cost structure and thereby its prices for computers. U.S.consumers benefit from this development. As prices for computers fall, Americans can spend more of their money onother goods and services. Moreover, the increase in income levels in India allows Indians to purchase more U.S. goodsand services, which helps create jobs in the United States. In this manner, supporters of globalization argue that freetrade benefits all countries that adhere to a free-trade regime.

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If the critics of globalization are correct, three things must be shown. First, the share of national income received bylabor, as opposed to the share received by the owners of capital (e.g., stockholders and bondholders), should havedeclined in advanced nations as a result of downward pressure on wage rates. Second, even though labor’s share of theeconomic pie may have declined, this does not mean lower living standards if the size of the total pie has increasedsufficiently to offset the decline in labor’s share—in other words, if economic growth and rising living standards inadvanced economies have offset declines in labor’s share (this is the position argued by supporters of globalization).Third, the decline in labor’s share of national income must be due to moving production to low-wage countries, asopposed to improvement in production technology and productivity.

Several studies shed light on these issues.31 First, the data suggest that over the past two decades, the share of laborin national income has declined. However, detailed analysis suggests the share of national income enjoyed by skilledlabor has actually increased, suggesting that the fall in labor’s share has been due to a fall in the share taken by unskilledlabor. A study by the IMF suggested the earnings gap between workers in skilled and unskilled sectors has widened by25 percent over the past two decades.32 Another study that focused on U.S. data found that exposure tocompetition from imports led to a decline in real wages for workers who performed unskilled tasks, whilehaving no discernible impact on wages in skilled occupations. The same study found that skilled and unskilled workersin sectors where exports grew saw an increase in their real wages.33 These figures suggest that unskilled labor in sectorsthat have been exposed to more efficient foreign competition probably has seen its share of national income decline overthe past three decades.

However, this does not mean that the living standards of unskilled workers in developed nations have declined. It ispossible that economic growth in developed nations has offset the fall in the share of national income enjoyed byunskilled workers, raising their living standards. Evidence suggests that real labor compensation has expanded in mostdeveloped nations since the 1980s, including the United States. Several studies by the Organisation for Economic Co-operation and Development (OECD), whose members include the 34 richest economies in the world, conclude that whilethe gap between the poorest and richest segments of society in OECD countries has widened, in most countries realincome levels have increased for all, including the poorest segment. In one study, the OECD found that real householdincome (adjusted for inflation) increased by 1.7 percent annually among its member states. The real income level of thepoorest 10 percent of the population increased at 1.4 percent on average, while that of the richest 10 percent increased by2 percent annually (i.e., while everyone got richer, the gap between the most affluent and the poorest sectors of societywidened). The differential in growth rates was more extreme in the United States than most other countries. The studyfound that the real income of the poorest 10 percent of the population grew by just 0.5 percent a year in the UnitedStates, while that of the richest 10 percent grew by 1.9 percent annually.34

As noted earlier, globalization critics argue that the decline in unskilled wage rates is due to the migration of low-wage manufacturing jobs offshore and a corresponding reduction in demand for unskilled workers. However, supportersof globalization see a more complex picture. They maintain that the weak growth rate in real wage rates for unskilledworkers owes far more to a technology-induced shift within advanced economies away from jobs where the onlyqualification was a willingness to turn up for work every day and toward jobs that require significant education andskills. They point out that many advanced economies report a shortage of highly skilled workers and an excess supply ofunskilled workers. Thus, growing income inequality is a result of the wages for skilled workers being bid up by the labormarket and the wages for unskilled workers being discounted. In fact, evidence suggests that technological change hashad a bigger impact than globalization on the declining share of national income enjoyed by labor.35 This suggests that asolution to the problem of slow real income growth among the unskilled is to be found not in limiting free trade andglobalization but in increasing society’s investment in education to reduce the supply of unskilled workers.36

Finally, it is worth noting that the wage gap between developing and developed nations is closing as developingnations experience rapid economic growth. For example, one estimate suggests that wages in China will approachWestern levels in two decades.37 To the extent that this is the case, any migration of unskilled jobs to low-wagecountries is a temporary phenomenon representing a structural adjustment on the way to a more tightly integrated globaleconomy.

GLOBALIZATION, LABOR POLICIES, AND THE ENVIRONMENTA second source of concern is that free trade encourages firms from advanced nations to move manufacturing facilitiesto less developed countries that lack adequate regulations to protect labor and the environment from abuse by theunscrupulous.38 Globalization critics often argue that adhering to labor and environmental regulations significantlyincreases the costs of manufacturing enterprises and puts them at a competitive disadvantage in the global marketplacevis-à-vis firms based in developing nations that do not have to comply with such regulations. Firms deal withthis cost disadvantage, the theory goes, by moving their production facilities to nations that do not have suchburdensome regulations or that fail to enforce the regulations they have.

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If this were the case, we might expect free trade to lead to an increase in pollution and result in firms fromadvanced nations exploiting the labor of less developed nations.39 This argument was made by those who opposed the1994 formation of the North American Free Trade Agreement (NAFTA) among Canada, Mexico, and the United States.They painted a picture of U.S. manufacturing firms moving to Mexico so that they would be free to pollute theenvironment, employ child labor, and ignore workplace safety and health issues, all in the name of higher profits.40

Supporters of free trade and greater globalization express doubts about this scenario. They argue that tougherenvironmental regulations and stricter labor standards go hand in hand with economic progress.41 In general, as countriesget richer, they enact tougher environmental and labor regulations.42 Because free trade enables developing countries toincrease their economic growth rates and become richer, this should lead to tougher environmental and labor laws. In thisview, the critics of free trade have got it backward: Free trade does not lead to more pollution and labor exploitation; itleads to less. By creating wealth and incentives for enterprises to produce technological innovations, the free marketsystem and free trade could make it easier for the world to cope with pollution and population growth. Indeed, whilepollution levels are rising in the world’s poorer countries, they have been falling in developed nations. In the UnitedStates, for example, the concentration of carbon monoxide and sulfur dioxide pollutants in the atmosphere has decreasedby 60 percent since 1978, while lead concentrations have decreased by 98 percent—and these reductions have occurredagainst a background of sustained economic expansion.43

A number of econometric studies have found consistent evidence of a hump-shaped relationship between incomelevels and pollution levels (see Figure 1.5).44 As an economy grows and income levels rise, initially pollution levels alsorise. However, past some point, rising income levels lead to demands for greater environmental protection, and pollutionlevels then fall. A seminal study by Grossman and Krueger found that the turning point generally occurred before percapita income levels reached $8,000.45

While the hump-shaped relationship depicted in Figure 1.5 seems to hold across a wide range of pollutants—fromsulfur dioxide to lead concentrations and water quality—carbon dioxide emissions are an important exception, risingsteadily with higher-income levels. Given that carbon dioxide is a heat-trapping gas and given that there is good evidencethat increased atmospheric carbon dioxide concentrations are a cause of global warming, this should be ofserious concern. The solution to the problem, however, is probably not to roll back the trade liberalizationefforts that have fostered economic growth and globalization, and raised living standards worldwide, but to get thenations of the world to agree to policies designed to limit carbon emissions. In the view of most economists, the mosteffective way to do this would be to put a price on carbon-intensive energy generation through a carbon tax. To ensurethat this tax does not harm economic growth, economists argue that it should be revenue neutral, with increases in carbontaxes offset by reductions in income or consumption taxes.46

FIGURE 1.5 Income levels and environmental pollution.Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).

Although UN-sponsored talks have had reduction in carbon dioxide emissions as a central aim since the 1992 Earth

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Summit in Rio de Janeiro, until recently there has been little success in moving toward the ambitious goals for reducingcarbon emissions laid down in the Earth Summit and subsequent talks in Kyoto, Japan, in 1997, Copenhagen in 2009,and Paris in 2015, for example. In part, this is because the largest emitters of carbon dioxide, the United States andChina, failed to reach agreements about how to proceed. China, a country whose carbon emissions are increasing at arapid rate, has until recently shown little appetite for tighter pollution controls. As for the United States, politicaldivisions in Congress and a culture of denial have made it difficult for the country to even acknowledge, never mindmove forward with, legislation designed to tackle climate change. In late 2014, the United States and China did strike adeal under which both countries agreed to potentially significant reductions in carbon emissions. This was followed by abroadly based multilateral agreement reached in Paris in 2015 that committed the nations of the world to ambitious goalsfor reducing CO2 emissions and limiting future increases in global temperatures. However, President Donald Trumppulled the United States out of the Paris agreement in 2017. Trump, who disputes the theory and evidence that risingCO2 levels are causing climate change, argued that the Paris Accord disadvantaged the United States to the exclusivebenefits of other countries. Without the participation of the United States, it is difficult to see the world makingsignificant progress on this issue.

Many supporters of free trade point out that it is possible to tie free trade agreements to the implementation oftougher environmental and labor laws in less developed countries. NAFTA, for example, was passed only after sideagreements had been negotiated that committed Mexico to tougher enforcement of environmental protection regulations.Thus, supporters of free trade argue that factories based in Mexico are now cleaner than they would have been withoutthe passage of NAFTA.47

They also argue that business firms are not the amoral organizations that critics suggest. While there may be somerotten apples, most business enterprises are staffed by managers who are committed to behaving in an ethical manner andwould be unlikely to move production offshore just so they could pump more pollution into the atmosphere or exploitlabor. Furthermore, the relationship between pollution, labor exploitation, and production costs may not be thatsuggested by critics. In general, they argue, a well-treated labor force is productive, and it is productivity rather than basewage rates that often has the greatest influence on costs. Advocates of free trade dispute the vision of greedy managerswho shift production to low-wage countries to exploit their labor force.

GLOBALIZATION AND NATIONAL SOVEREIGNTYAnother concern voiced by critics of globalization is that today’s increasingly interdependent global economy shiftseconomic power away from national governments and toward supranational organizations such as the World TradeOrganization, the European Union, and the United Nations. As perceived by critics, unelected bureaucrats now imposepolicies on the democratically elected governments of nation-states, thereby undermining the sovereignty of those statesand limiting the nation’s ability to control its own destiny.48

The World Trade Organization is a favorite target of those who attack the headlong rush toward a globaleconomy. As noted earlier, the WTO was founded in 1995 to police the world trading system established by the GeneralAgreement on Tariffs and Trade. The WTO arbitrates trade disputes among its 164 member states. The arbitration panelcan issue a ruling instructing a member state to change trade policies that violate GATT regulations. If the violatorrefuses to comply with the ruling, the WTO allows other states to impose appropriate trade sanctions on the transgressor.As a result, according to one prominent critic, U.S. environmentalist, consumer rights advocate, and sometimepresidential candidate Ralph Nader:

Under the new system, many decisions that affect billions of people are no longer made by local or national governments butinstead, if challenged by any WTO member nation, would be deferred to a group of unelected bureaucrats sitting behind closeddoors in Geneva (which is where the headquarters of the WTO are located). The bureaucrats can decide whether or not people inCalifornia can prevent the destruction of the last virgin forests or determine if carcinogenic pesticides can be banned from theirfoods; or whether European countries have the right to ban dangerous biotech hormones in meat. . . . At risk is the very basis ofdemocracy and accountable decision making.49

I n cont rast t o Nader , many economi st s and pol itici ans mai ntai n t hat the power of supranat i onal organi zations suchas the WTO is limited to what nation-states collectively agree to grant. They argue that bodies such as the United Nationsand the WTO exist to serve the collective interests of member states, not to subvert those interests. Supporters ofsupranational organizations point out that the power of these bodies rests largely on their ability to persuade memberstates to follow a certain action. If these bodies fail to serve the collective interests of member states, those states willwithdraw their support and the supranational organization will quickly collapse. In this view, real power still resides withindividual nation-states, not supranational organizations.

GLOBALIZATION AND THE WORLD’S POORCritics of globalization argue that despite the supposed benefits associated with free trade and investment, over the past100 years or so the gap between the rich and poor nations of the world has gotten wider. In 1870, the average income per

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capita in the world’s 17 richest nations was 2.4 times that of all other countries. In 1990, the same group was 4.5 times asrich as the rest. In 2019, the 34 member states of the Organisation for Economic Co-operation and Development(OECD), which includes most of the world’s rich economies, had an average gross national income (GNI) per person ofmore than $40,000, whereas the world’s 40 least developed countries had a GNI of under $1,000 per capita—implyingthat income per capita in the world’s 34 richest nations was 40 times that in the world’s 40 poorest.50

While recent history has shown that some of the world’s poorer nations are capable of rapid periods of economicgrowth—witness the transformation that has occurred in some Southeast Asian nations such as South Korea, Thailand,and Malaysia—there appear to be strong forces for stagnation among the world’s poorest nations. A quarter of thecountries with a GDP per capita of less than $1,000 in 1960 had growth rates of less than zero, and a third had growthrates of less than 0.05 percent.51 Critics argue that if globalization is such a positive development, this divergencebetween the rich and poor should not have occurred.

Although the reasons for economic stagnation vary, several factors stand out, none of which has anything to dowith free trade or globalization.52 Many of the world’s poorest countries have suffered from totalitarian governments,economic policies that destroyed wealth rather than facilitated its creation, endemic corruption, scant protection forproperty rights, and prolonged civil war. A combination of such factors helps explain why countries such as Afghanistan,Cuba, Haiti, Iraq, Libya, Nigeria, Sudan, Syria, North Korea, and Zimbabwe have failed to improve the economic lot oftheir citizens during recent decades. A complicating factor is the rapidly expanding populations in many ofthese countries. Without a major change in government, population growth may exacerbate their problems.Promoters of free trade argue that the best way for these countries to improve their lot is to lower their barriers to freetrade and investment and to implement economic policies based on free market economics.53

Many of the world’s poorer nations are being held back by large debt burdens. Of particular concern are the 40 orso “highly indebted poorer countries” (HIPCs), which are home to some 700 million people. Among these countries, theaverage government debt burden has been as high as 85 percent of the value of the economy, as measured by grossdomestic product, and the annual costs of serving government debt have consumed 15 percent of the country’s exportearnings.54 Servicing such a heavy debt load leaves the governments of these countries with little left to invest inimportant public infrastructure projects, such as education, health care, roads, and power. The result is the HIPCs aretrapped in a cycle of poverty and debt that inhibits economic development. Free trade alone, some argue, is a necessarybut not sufficient prerequisite to help these countries bootstrap themselves out of poverty. Instead, large-scale debt reliefis needed for the world’s poorest nations to give them the opportunity to restructure their economies and start the longclimb toward prosperity. Supporters of debt relief also argue that new democratic governments in poor nations shouldnot be forced to honor debts that were incurred and mismanaged long ago by their corrupt and dictatorial predecessors.

In the late 1990s, a debt relief movement began to gain ground among the political establishment in the world’sricher nations.55 Fueled by high-profile endorsements from Irish rock star Bono (who has been a tireless andincreasingly effective advocate for debt relief), the Dalai Lama, and influential Harvard economist Jeffrey Sachs, thedebt relief movement was instrumental in persuading the United States to enact legislation in 2000 that provided $435million in debt relief for HIPCs. More important perhaps, the United States also backed an IMF plan to sell some of itsgold reserves and use the proceeds to help with debt relief. The IMF and World Bank have now picked up the banner andhave embarked on a systematic debt relief program.

For such programs to have a lasting effect, however, debt relief must be matched by wise investment in publicprojects that boost economic growth (such as education) and by the adoption of economic policies that facilitateinvestment and trade.

Economists argue that the richest nations of the world can help by reducing barriers to the importation of productsfrom the world’s poorest nations, particularly tariffs on imports of agricultural products and textiles. High-tariff barriersand other impediments to trade make it difficult for poor countries to export more of their agricultural production. TheWorld Trade Organization has estimated that if the developed nations of the world eradicated subsidies to theiragricultural producers and removed tariff barriers to trade in agriculture, this would raise global economic welfare by$128 billion, with $30 billion of that going to poor nations, many of which are highly indebted. The faster growthassociated with expanded trade in agriculture could significantly reduce the number of people living in poverty accordingto the WTO.56

Despite the large gap between rich and poor nations, there is evidence of substantial progress. According to datafrom the World Bank, the percentage of the world’s population living in poverty has declined substantially over the lastthree decades (see Figure 1.6). In 1981, 42.2 percent of the world’s population lived in extreme poverty, classified asliving on less than $1.90 a day, and 66.4 percent lived on less than $5.50 per day. By 2015, these figures were 10 percentand 46 percent, respectively. Put differently, between 1981 and 2015 the number of people living in extreme poverty fellfrom 1.9 billion to 736 million, despite the fact that the world’s population increased by around 2.5 billion over the sameperiod. The world is getting better, and many economists would argue that globalization, and the opportunities it offersto the world’s poorer nations to improve their lot, has much to do with this. On the other hand, by 2015 there were still

Page 313.4 billion people living on less than $5.50 a day, which suggests there is still a considerable way to go.

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FIGURE 1.6 Percentage of the world’s population living in poverty during 1981–2015.Source: World Bank Data Base on Poverty and Equity, World Development Indicators, 2019.

Managing in the Global Marketplace

LO1-5Understand how the process of globalization is creating opportunities and challenges for management practice.Much of this text is concerned with the challenges of managing an international business. An international business isany firm that engages in international trade or investment. A firm does not have to become a multinational enterprise,investing directly in operations in other countries, to engage in international business, although multinational enterprisesare international businesses. All a firm has to do is export or import products from other countries. As the world shiftstoward a truly integrated global economy, more firms—both large and small—are becoming international businesses.What does this shift toward a global economy mean for managers within an international business?

As their organizations increasingly engage in cross-border trade and investment, managers need to recognize thatthe task of managing an international business differs from that of managing a purely domestic business in many ways.At the most fundamental level, the differences arise from the simple fact that countries are different. Countries differ intheir cultures, political systems, economic systems, legal systems, and levels of economic development. Despite all thetalk about the emerging global village, and despite the trend toward globalization of markets and production, as we shallsee in this text, many of these differences are very profound and enduring.

Differences among countries require that an international business vary its practices country by country. Marketinga product in Brazil may require a different approach from marketing the product in Germany; managing U.S. workersmight require different skills from managing Japanese workers; maintaining close relations with a particular level of

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government may be very important in Mexico and irrelevant in Great Britain; a business strategy pursued in Canadamight not work in South Korea; and so on. Managers in an international business must not only be sensitive to thesedifferences but also adopt the appropriate policies and strategies for coping with them. Much of this text isdevoted to explaining the sources of these differences and the methods for successfully coping with them.

A further way in which international business differs from domestic business is the greater complexity of managingan international business. In addition to the problems that arise from the differences between countries, a manager in aninternational business is confronted with a range of other issues that the manager in a domestic business never confronts.The managers of an international business must decide where in the world to site production activities to minimize costsand maximize value added. They must decide whether it is ethical to adhere to the lower labor and environmentalstandards found in many less-developed nations. Then, they must decide how best to coordinate and control globallydispersed production activities (which, as we shall see later in the text, is not a trivial problem). The managers in aninternational business also must decide which foreign markets to enter and which to avoid. They must choose theappropriate mode for entering a particular foreign country. Is it best to export its product to the foreign country? Shouldthe firm allow a local company to produce its product under license in that country? Should the firm enter into a jointventure with a local firm to produce its product in that country? Or should the firm set up a wholly owned subsidiary toserve the market in that country? As we shall see, the choice of entry mode is critical because it has major implicationsfor the long-term health of the firm.

Conducting business transactions across national borders requires understanding the rules governing theinternational trading and investment system. Managers in an international business must also deal with governmentrestrictions on international trade and investment. They must find ways to work within the limits imposed by specificgovernmental interventions. As this text explains, even though many governments are nominally committed to free trade,they often intervene to regulate cross-border trade and investment. Managers within international businesses mustdevelop strategies and policies for dealing with such interventions.

Cross-border transactions also require that money be converted from the firm’s home currency into a foreigncurrency and vice versa. Because currency exchange rates vary in response to changing economic conditions, managersin an international business must develop policies for dealing with exchange rate movements. A firm that adopts thewrong policy can lose large amounts of money, whereas one that adopts the right policy can increase the profitability ofits international transactions.

In sum, managing an international business is different from managing a purely domestic business for at least fourreasons: (1) countries are different, (2) the range of problems confronted by a manager in an international business iswider and the problems themselves more complex than those confronted by a manager in a domestic business, (3) aninternational business must find ways to work within the limits imposed by government intervention in the internationaltrade and investment system, and (4) international transactions involve converting money into different currencies.

In this text, we examine all these issues in depth, paying close attention to the different strategies and policies thatmanagers pursue to deal with the various challenges created when a firm becomes an international business. Chapters 2,3, and 4 explore how countries differ from each other with regard to their political, economic, legal, and culturalinstitutions. Chapter 5 takes a detailed look at the ethical issues, corporate social responsibility, and sustainability issuesthat arise in international business. Chapters 6, 7, 8, and 9 look at the global trade and investment environment withinwhich international businesses must operate. Chapters 10, 11, and 12 review the global monetary system. These chaptersfocus on the nature of the foreign exchange market and the emerging global monetary system. Chapters 13 and 14explore the strategy, organization, and market entry choices of an international business. Chapters 15 through 20 look atthe management of various functional operations within an international business, including exporting, importing,countertrade, production, supply chain management, marketing, R&D, finance, and human resources. By the time youcomplete this text, you should have a good grasp of the issues that managers working in international business have tograpple with on a daily basis, and you should be familiar with the range of strategies and operating policies available tocompete more effectively in today’s rapidly emerging global economy.

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Key Termsglobalization, p. 6globalization of markets, p. 6globalization of production, p. 7factors of production, p. 7General Agreement on Tariffs and Trade (GATT), p. 9

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World Trade Organization (WTO), p. 9International Monetary Fund (IMF), p. 10World Bank, p. 10United Nations (UN), p. 10Group of Twenty (G20), p. 10international trade, p. 11foreign direct investment (FDI), p. 11Moore’s law, p. 14outward stock of foreign direct investment (FDI), p. 18multinational enterprise (MNE), p. 19international business, p. 31

SUMMARYThis chapter has shown how the world economy is becoming more global and has reviewed the main drivers ofglobalization, arguing that they seem to be thrusting nation-states toward a more tightly integrated global economy. Itlooked at how the nature of international business is changing in response to the changing global economy, discussedconcerns raised by rapid globalization, and reviewed implications of rapid globalization for individual managers. Thechapter made the following points:

1. Over the past three decades, we have witnessed the globalization of markets and production.2. The globalization of markets implies that national markets are merging into one huge marketplace. However,

it is important not to push this view too far.3. The globalization of production implies that firms are basing individual productive activities at the optimal

world locations for their particular activities. As a consequence, it is increasingly irrelevant to talk aboutAmerican products, Japanese products, or German products, because these are being replaced by “global”products. Or, in some cases, they are simply replaced by products made by specific companies, such as Apple,Sony, or Microsoft.

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

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

6. As a consequence of the globalization of production and markets, in the last decade, world trade has grownfaster than world output, foreign direct investment has surged, imports have penetrated more deeply into theworld’s industrial nations, and competitive pressures have increased in industry after industry.

7. The development of the microprocessor and related developments in communication and informationprocessing technology have helped firms link their worldwide operations into sophisticated informationnetworks. Jet air travel, by shrinking travel time, has also helped link the worldwide operations ofinternational businesses. These changes have enabled firms to achieve tight coordination of their worldwideoperations and to view the world as a single market.

8. In the 1960s, the U.S. economy was dominant in the world, U.S. firms accounted for most of the foreign directinvestment in the world economy, U.S. firms dominated the list of large multinationals, and roughly half theworld—the centrally planned economies of the communist world—was closed to Western businesses.

9. By the 2020s, the U.S. share of world output will have been cut in half, with major shares now beingaccounted for by European and Southeast Asian economies. The U.S. share of worldwide foreign directinvestment will have fallen by about two-thirds. U.S. multinationals will be facing competition from a largenumber of multinationals. In addition, the emergence of mini-multinationals was noted.

10. One of the most dramatic developments of the past 30 years has been the collapse of communism in easternEurope, which has created enormous opportunities for international businesses. In addition, the move towardfree market economies in China and Latin America is creating opportunities (and threats) for Westerninternational businesses.

11. The benefits and costs of the emerging global economy are being hotly debated among businesspeople,economists, and politicians. The debate focuses on the impact of globalization on jobs, wages, theenvironment, working conditions, national sovereignty, and extreme poverty in the world’s poorest nations.

12. Managing an international business is different from managing a domestic business for at least four reasons:(1) countries are different, (2) the range of problems confronted by a manager in an international business is

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wider and the problems themselves are more complex than those confronted by a manager in a domesticbusiness, (3) managers in an international business must find ways to work within the limits imposed bygovernments’ intervention in the international trade and investment system, and (4) international transactionsinvolve converting money into different currencies.

Critical Thinking and Discussion Questions

1. Describe the shifts in the world economy over the past 30 years. What are the implications of these shifts forinternational businesses based in the United Kingdom? North America? Hong Kong?

2. “The study of international business is fine if you are going to work in a large multinational enterprise, but ithas no relevance for individuals who are going to work in small firms.” Evaluate this statement.

3. How have changes in technology contributed to the globalization of markets and production? Would theglobalization of production and markets have been possible without these technological changes?

4. “Ultimately, the study of international business is no different from the study of domestic business. Thus,there is no point in having a separate course on international business.” Evaluate this statement.

5. How does the Internet affect international business activity and the globalization of the world economy?6. If current trends continue, China may be the world’s largest economy by 2035. Discuss the possible

implications of such a development fora. the world trading system.b. the world monetary system.c. the business strategy of today’s European and U.S.-based global corporations.d. global commodity prices.

7. Reread the Management Focus “Boeing’s Global Production System” and answer the following questions:a. What are t h e benef its t o Boei ng of outsour c ing manufacturing of components of the Boeing 787 to firms

based in other countries?b. What are the potential costs and risks to Boeing of outsourcing?c. In addition to foreign subcontractors and Boeing, who else benefits from Boeing’s decision to outsource

component part manufacturing assembly to other nations? Who are the potential losers?d. If Boeing’s management decided to keep all production in America, what do you think the effect would

be o n the company, i t s employees, and the communi ties that depend on it ?e. On balance, do you think that the kind of outsourcing undertaken by Boeing is a good thing or a bad thing

for the American economy? Explain your reasoning.

global EDGE research task globaledge.msu.eduUse the globalEDGE™ website (globaledge.msu.edu) to complete the following exercises:

1. As the drivers of globalization continue to pressure both the globalization of markets and the globalization ofproduction, we continue to see the impact of greater globalization on worldwide trade patterns. HSBC, a largeglobal bank, analyzes these pressures and trends to identify opportunities across markets and sectors throughits trade forecasts. Visit the HSBC Global Connections site and use the trade forecast tool to identify whichexport routes are forecast to see the greatest growth over the next 15 to 20 years. What patterns do you see?What types of countries dominate these routes?

2. You are working for a company that is considering investing in a foreign country. Investing incountries with different traditions is an important element of your company’s long-term strategic goals.Management has requested a report regarding the attractiveness of alternative countries based on the potentialreturn of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is a crucialingredient for your report. A colleague mentioned a potentially useful tool called the Foreign DirectInvestment (FDI) Confidence Index. The FDI Confidence Index is a regular survey of global executivesconducted by A.T. Kearney. Find this index and provide additional information regarding how the index isconstructed.

CLOSING CASE

General Motors in China

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In November 2018, General Motors, America’s largest home-grown automobile manufacturer, announced it would closethree assembly plants in the United States, laying off about 5,600 employees. All of these plants made passenger carsthat had fallen out of favor with U.S. consumers, who preferred to purchase sports utility vehicles and pick-up trucks.

Jvdwolf/123RF

President Donald Trump, who has made the revival of traditional U.S. manufacturing industries one of his majorgoals, quickly tweeted that he was “Very disappointed with General Motors and their CEO, Mary Barra, for closingplants in Ohio, Michigan and Maryland. Nothing being closed in Mexico & China. The U.S. saved General Motors, andthis is the THANKS we get! We are now looking at cutting all @GM subsidies including for electric cars. GeneralMotors made a big China bet years ago when they built plants there (and in Mexico)—don’t think that bet is going to payoff. I am here to protect American Workers!”* In an interview with the Wall Street Journal, Trump offered theobservation that “I think GM ought to stop making cars in China and make them here.”*Donald John Trump. Twitter, November 27, 2018. https://twitter.com/realdonaldtrump.

Trump was right that GM had made a major bet on China. GM has been operating in China since 1997 when itestablished a joint venture with SAIC Motor, a Chinese state-owned automotive design and manufacturing company.GM has a 50 percent ownership stake in the joint venture, which is known as SAIC-GM. In 2018, GM and its jointventure partner built and sold some 3.64 million vehicles in China, up from 1.2 million in 2011 and 0.4 million in 2006.By comparison, in 2018 GM sold 2.95 million vehicles in the United States. China is now the world’s largest automobilemarket. It’s been the largest market for GM since 2012. Despite the size of the Chinese market, there is still lots of roomfor growth. There are around 173 vehicles per capita in China, compared to 833 per capita in the United States.

GM sells models in China under the Chevrolet, Buick, GMC, Cadillac, Holden, Baojun, Wuling, and Jiefangbrands. GM exports almost nothing from the U.S. to China, although it does export one China-built model, the BuickEnvision, to the American market. GM says it cannot build the Buick Envision economically in the U.S., because theChinese market accounts for 80 percent of the model’s global sales.

Like many automakers, GM believes it needs factories close to its customers in order to reduce supply chain costsand design vehicles that best suit local market demands. GM also wants to be in China because the country is leading theshift away from gasoline engines toward battery-powered electric motors. Sales of electric vehicles in China are fourtimes higher than in the United States and growing faster. To foster the growth in electric vehicle production, China hasbeen providing generous subsidies to local producers (including SAIC-GM) and consumers. GM has pledged to investheavily in electric vehicles and plans to launch 20 electric models in China by 2023.

In addition, there have long been tariffs on imports of motor vehicles into China. Local production avoids these. In2018, China increased tariffs on imports of American made cars into China from 15 percent to 40 percent inretaliation for wide-ranging tariffs Trump had placed on imports of Chinese products into the United States.These tariff increases had little impact on GM, which produced all of its Chinese sales locally. However, they did impactanother American manufacturer, Tesla, which had been doing what Trump wanted GM to do: export production from theUnited States to China. Tesla’s Chinese sales fell in half in the months after the tariffs were raised. In response, Teslaslashed prices in China and stated it would accelerate plans to build production facilities there, opening a factory in 2021or 2022.Sources: Trefor Moss, “Why GM Is Likely to Keep Producing in China Despite Trump’s Pleas,” The Wall Street Journal, November 27, 2018; Anjani Trivedi, “GM Needs China morethan It Fears Trump,” Bloomberg, November 27, 2018; Wolf Richter, "GM’s Business Is Booming in China," Business Insider, December 6, 2018; Jack Perkowski, “What China’s ShiftingSubsidies Could Mean for Its Electric Vehicle Industry," Forbes, July 13, 2018.

Case Discussion Questions

1. What are the long-term prospects for the Chinese market?2. Does it make sense for GM to produce automobiles for the Chinese market in China? Why?

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3. What do you think would happen if GM tried to serve the Chinese market by exporting production from theUnited States?

4. Why do you think GM went into partnership with a state-owned company to produce automobiles in China? Whatare the possible benefits of such a venture? What might be the downside?

5. What does this case teach you about benefits and costs of import tariffs?

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Endnotes

1. Thomas L. Friedman, The World Is Flat (New York: Farrar, Straus and Giroux, 2005).2. T. Levitt, “The Globalization of Markets,” Harvard Business Review, May–June 1983, pp. 92–102.3. U.S. Department of Commerce, Internal Trade Administration, “Profile of U.S. Exporting and Importing

Companies, 2012–2013,” April 2015.4. C. M. Draffen, “Going Global: Export Market Proves Profitable for Region’s Small Businesses,” Newsday,

March 19, 2001, p. C18.5. See F. T. Knickerbocker, Oligopolistic Reaction and Multinational Enterprise (Boston: Harvard Business School

Press, 1973); R. E. Caves, “Japanese Investment in the U.S.: Lessons for the Economic Analysis of ForeignInvestment,” The World Economy 16 (1993), pp. 279–300.

6. I. Metthee, “Playing a Large Part,” Seattle Post-Intelligencer, April 9, 1994, p. 13.7. R. B. Reich, The Work of Nations (New York: Knopf, 1991).8. United Nations, “About the United Nations,” www.un.org/en/about-un.9. J. A. Frankel, “Globalization of the Economy,” National Bureau of Economic Research, working paper no. 7858,

2000.10. J. Bhagwati, Protectionism (Cambridge, MA: MIT Press, 1989).11. F. Williams, “Trade Round Like This May Never Be Seen Again,” Financial Times, April 15, 1994, p. 8.12. Data are from UNCTAD, World Investment Report 2019, United Nations, 2019.13. Moore’s law is named after Intel founder Gordon Moore.14. Data compiled from various sources and listed at www.internetworldstats.com/stats.htm.15. From www.census.gov/mrts/www/ecomm.html. See also S. Fiegerman, “Ecommerce Is Now a Trillion Dollar

Industry,” Mashable Business, February 5, 2013.16. For a counterpoint, see “Geography and the Net: Putting It in Its Place,” The Economist, August 11, 2001, pp. 18–

20.17. International Chamber of Shipping, Key Facts, www.ics-shipping.org/shipping-facts/key-facts.18. Frankel, “Globalization of the Economy.”19. Raj Kumar Ray, “India’s Economy to Become 3rd Largest, Surpass Japan, Germany by 2030,” Hindustan Times,

April 28, 2017.20. N. Hood and J. Young, The Economics of the Multinational Enterprise (New York: Longman, 1973).21. S. Chetty, “Explosive International Growth and Problems of Success Among Small and Medium Sized Firms,”

International Small Business Journal, February 2003, pp. 5–28.22. R. A. Mosbacher, “Opening Up Export Doors for Smaller Firms,” Seattle Times, July 24, 1991, p. A7.23. “Small Companies Learn How to Sell to the Japanese,” Seattle Times, March 19, 1992.24. W. J. Holstein, “Why Johann Can Export, but Johnny Can’t,” BusinessWeek, November 3, 1991.

Archived at www.businessweek.com/stories/1991-11-03/why-johann-can-export-but-johnny-cant.25. N. Buckley and A. Ostrovsky, “Back to Business—How Putin’s Allies Are Turning Russia into a Corporate

State,” Financial Times, June 19, 2006, p. 11.26. J. E. Stiglitz, Globalization and Its Discontents (New York: W. W. Norton, 2003); J. Bhagwati, In Defense of

Globalization (New York: Oxford University Press, 2004); Friedman, The World Is Flat.27. See, for example, Ravi Batra, The Myth of Free Trade (New York: Touchstone Books, 1993); William Greider,

One World, Ready or Not: The Manic Logic of Global Capitalism (New York: Simon & Schuster, 1997); D.Radrik, Has Globalization Gone Too Far? (Washington, DC: Institution for International Economics, 1997).

28. E. Goldsmith, “The Winners and the Losers,” in The Case Against the Global Economy, ed. J. Mander and E.Goldsmith (San Francisco: Sierra Club, 1996); Lou Dobbs, Exporting America (New York: Time Warner Books,2004).

29. D. L. Bartlett and J. B. Steele, “America: Who Stole the Dream,” Philadelphia Inquirer, September 9, 1996.30. For example, see Paul Krugman, Pop Internationalism (Cambridge, MA: MIT Press, 1996).31. For example, see B. Milanovic and L. Squire, “Does Tariff Liberalization Increase Wage Inequality?” National

Bureau of Economic Research, working paper no. 11046, January 2005; B. Milanovic, “Can We Discern the

Effect of Globalization on Income Distribution?” World Bank Economic Review 19 (2005), pp. 21–44. Also seethe summary in Thomas Piketty, “The Globalization of Labor,” in Capital in the Twenty First Century(Cambridge, MA: Harvard University Press, 2014).

32. See Piketty, “The Globalization of Labor.”33. A. Ebenstein, A. Harrison, M. McMillam, and S. Phillips, “Estimating the Impact of Trade and Offshoring on

American Workers Using the Current Population Survey,” Review of Economics and Statistics 67 (October 2014),pp. 581–95.

34. M. Forster and M. Pearson, “Income Distribution and Poverty in the OECD Area,” OECD Economic Studies 34(2002); OECD, “Growing Income Inequality in OECD Countries,” OECD Forum, May 2, 2011.

35. See Piketty, “The Globalization of Labor.”36. See Krugman, Pop Internationalism; D. Belman and T. M. Lee, “International Trade and the Performance of U.S.

Labor Markets,” in U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic PolicyInstitute, 1996).

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

38. E. Goldsmith, “Global Trade and the Environment,” in The Case Against the Global Economy, eds. J. Mander andE. Goldsmith (San Francisco: Sierra Club, 1996).

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

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

41. B. Lomborg, The Skeptical Environmentalist (Cambridge, UK: Cambridge University Press, 2001).42. H. Nordstrom and S. Vaughan, Trade and the Environment, World Trade Organization Special Studies No. 4

(Geneva: WTO, 1999).43. Figures are from “Freedom’s Journey: A Survey of the 20th Century. Our Durable Planet,” The Economist,

September 11, 1999, p. 30.44. For an exhaustive review of the empirical literature, see B. R. Copeland and M. Scott Taylor, “Trade, Growth and

the Environment,” Journal of Economic Literature, March 2004, pp. 7–77.45. G. M. Grossman and A. B. Krueger, “Economic Growth and the Environment,” Quarterly Journal of Economics

110 (1995), pp. 353–78.46. For an economic perspective on climate change, see William Nordhouse, The Climate Casino (Princeton, NJ:

Yale University Press, 2013).47. Krugman, Pop Internationalism.48. R. Kuttner, “Managed Trade and Economic Sovereignty,” in U.S. Trade Policy and Global Growth, ed. R. A.

Blecker (New York: Economic Policy Institute, 1996).49. Nader, Ralph, and Lori Wallach. “GATT, NAFTA, and the subversion of the Democratic Process.” U.S. Trade

Policy and Global Growth, ed. The Case Against the Global Economy. Sierra Club Books.50. Lant Pritchett, “Divergence, Big Time,” Journal of Economic Perspectives 11, no. 3 (Summer 1997), pp. 3–18.

The data are from the World Bank’s World Development Indicators, 2015.51. Lant Pritchett, “Divergence, Big Time,” Journal of Economic Perspectives 11, no. 3 (Summer 1997), pp. 3–18.

The data are from the World Bank’s World Development Indicators, 2015.52. W. Easterly, “How Did Heavily Indebted Poor Countries Become Heavily Indebted?” World Development,

October 2002, pp. 1677–96; J. Sachs, The End of Poverty (New York: Penguin Books, 2006).53. See D. Ben-David, H. Nordstrom, and L. A. Winters, Trade, Income Disparity and Poverty. World Trade

Organization Special Studies No. 5 (Geneva: WTO, 1999).54. William Easterly, “Debt Relief,” Foreign Policy, Novembe r –December 2001 , pp. 20–26.55. Jeffrey Sachs, “Sachs on Development: Helping the World’s Poorest,” The Economist, August 14, 1999, pp. 17–

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

LO2-1

LO2-2

LO2-3

LO2-4

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2

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part two National Differences

National Differences in Political, Economic, and LegalSystems

LEARNING OBJECTIVESAfter reading this chapter, you will be able to:

Understand how the political systems of countries differ.

Understand how the economic systems of countries differ.

Understand how the legal systems of countries differ.Explain the implications for management practice of national differences in political economy.

Bartosz Hadyniak/E+/Getty Images

Kenya: An African Lion

OPENING CASEThe East African nation of Kenya has emerged as one of the economic growth stories of sub-Saharan Africa. Real Gross DomesticProduct grew at 4.9 percent in 2017 and 5.9 percent in 2018. Growth for 2019 and 2020 is expected to be in the 6 percent range.Kenya is East Africa’s economic, financial, and transportation hub. Major industries include agriculture, mining, manufacturing,tourism, communications, and financial services.

When Kenya won its independence from Britain in 1963, the country embraced what was known at the time as “AfricanSocialism.” The principles of African Socialism included social development guided by a large public sector, emphasis on the Africanidentity and what it means to be African, and the avoidance of social classes within society. Practically, this meant significant public

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investment in infrastructure by state-owned companies, coupled with the encouragement of smallholder agricultural production. Thecountry also embraced a policy of import substitution, applying high tariffs to foreign manufactured goods in an attempt to fosterdomestic production.

While these policies initially produced some gains, particularly in the agricultural sector, by the early 1990s the economy wasstagnating. In 1993, Kenya embarked on a program of economic reform and liberalization that included removing price controls,lowering barriers to cross-border trade, privatizing state-owned enterprises, and the adoption of conservative fiscal and monetarymac r o-economic policies. Today, the economy of the country is primarily market-based, with relatively low barriers to cross-border tradeand investment, and a vibrant private sector.

Paralleling economic reforms there have been political reforms. Like many sub-Saharan Africa nations whose boundaries weredrawn by colonial powers, the country was left divided between multiple ethnic groups. Political parties reflected these ethnicdivides. Tension between ethnic groups often marred Kenyan politics. The largest ethnic group is the Kikuyu, who, while onlycomprising 22 percent of the population, have held a disproportionate influence over Kenyan politics since independence. Kenya waseffectively a one-party state until the early 1990s. Ethnic conflict has continued since then, often spilling over into the political arena.A new constitution introduced in 2010 has offered the promise of solving some of these long-standing problems. The constitutionplaced limits on the power of the central government, devolved political power into 47 semi-autonomous regions, and helped createan electoral framework capable of facilitating regular, free, and fair elections. These political reforms have allowed for moredemocracy, increased business confidence, and helped drive great economic growth in this nation of 50 million people.

Looking forward, one of Kenya’s great strengths is the relative youth of its population and an educated workforce. Kenya hasuniversal primary education and a respectable secondary and higher-education system. The country also has a growing urban middleclass, which will likely drive the demand for goods and services going forward. That being said, the country still faces somesignificant headwinds. On the economic front, property rights are not strong, with legal title over land often poorly established. Thismakes it difficult for Kenyans to raise money for business ventures using their land as collateral. More generally, according to theWorld Bank, Kenyans face multiple problems starting a business due to bureaucratic procedures and corruption. On average, startinga business in Kenya can take 126 days and involves seven separate procedures. By comparison, in South Korea it takes 11 days andinvolves two procedures. The World Bank ranks Kenya 61 out of 190 nations on the ease of doing business. Corruption and ethnicconflict remain persistent problems. Transparency International ranked Kenya 144 out of 180 nations on its 2018 corruption index.Terrorism is also a problem with Al-Shabab (a militant group based in neighboring Somalia that has links to Al-Qaeda), whichlaunched violent attacks in the capital of Nairobi in 2013 and 2019. Al-Shabab’s goal is to avenge Kenyan interventions in Somaliaagainst Al-Shabab. Despite these problems, however, Kenya shows promise in emerging from its post-colonial past and in becominga dynamic multi-ethnic state with a thriving economy and a more stable democracy.Sources: Leighann Spencer, “Kenya’s History of Political Violence: Colonialism, Vigilantes and Militias,” The Conversation, September 28, 2017; Amy Copley, “Figures of theWeek: Kenya’s Growth Trends and Prospects in Africa’s Lions,” Brookings, November 2, 2016; “Another Terrorist Outrage in Nairobi,” The Economist, January 16, 2019; X. N.Iraki, “Why Kenya’s Economic Prospects Look Promising,” Standard Digital, January 1, 2019.

IntroductionInternational business is much more complicated than domestic business because countries differ in many ways.Countries have different political, economic, and legal systems. They vary significantly in their level of economicdevelopment and future economic growth trajectory. Cultural practices can vary dramatically, as can the education andskill levels of the population. All these differences can and do have major implications for the practice of internationalbusiness. They have a profound impact on the benefits, costs, and risks associated with doing business in differentcountries; the way in which operations in different countries should be managed; and the strategy international firmsshould pursue in different countries. The main function of this chapter and the next two is to develop an awareness ofand appreciation for the significance of country differences in political systems, economic systems, legal systems,economic development, and societal culture. Another function of the three chapters is to describe how the political,economic, legal, and cultural systems of many of the world’s nation-states are evolving and to draw out the implicationsof these changes for the practice of international business.

This chapter focuses on how the political, economic, and legal systems of countries differ. Collectively, we refer tothese systems as constituting the political economy of a country. We use the term political economy to stress that thepolitical, economic, and legal systems of a country are interdependent; they interact with and influence each other, and indoing so, they affect the level of economic well-being. In Chapter 3, we build on the concepts discussed here to explorein detail how differences in political, economic, and legal systems influence the economic development of a nation-stateand its likely future growth trajectory. In Chapter 4, we look at differences in societal culture and at how thesedifferences influence the practice of international business. Moreover, as we will see in Chapter 4, societal culture has aninfluence on the political, economic, and legal systems in a nation and thus its level of economic well-being. We alsodiscuss how the converse may occur: how political, economic, and legal systems may also shape societal culture.

The opening case illustrates some of the issues discussed in this chapter. Following independence from Britain in1963, Kenya became a de facto one-party state that embraced socialist ideals, albeit with a distinct “African” hew. By the

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1990s, the post-independence political economy of Kenya had resulted in economic stagnation. Things started to changein the early 1990s when opposition political parties were allowed to participate in elections, and the Governmentembraced economic reforms that included the privatization of public enterprises, liberalization of cross-border trade, andthe removal of price controls. Further political reforms took place in 2010 when Kenya adopted a new constitution thatdevolved significant political power to autonomous regions, a development that many observers believe will helpmoderate ethnic tensions in the country. Helped by a young and well-educated growing urban population, sincethen the Kenyan economy has performed well and seems on track to achieve growth rates of around 6 percentper annum. The implication is that political and economic reforms have helped boost economic growth in the country,making it a more desirable location for international business. Nevertheless, risks remain for international businesses,including endemic corruption, weak property rights, smoldering ethnic tensions, and terrorism.

global EDGE GET INSIGHTS BY COUNTRY

The “Get Insights by Country” section of globalEDGE™ (globaledge.msu.edu/global-insights/by/country) is your source forinformation and statistical data for nearly every country around the world (more than 200 countries). As related to Chapter 2 of the text,globalEDGE™ has a wealth of information and data on national differences in political economy. These differences are available acrossa dozen menu categories in the country sections (e.g., economy, history, government, culture, risk). The “Executive Memos” on eachcountry page are also great for abbreviated fingertip access to current information.

Political Systems

LO2-1Understand how the political systems of countries differ.

The political system of a country shapes its economic and legal systems.1 Thus, we need to understand the nature ofdifferent political systems before discussing economic and legal systems. By political system, we mean the system ofgovernment in a nation. Political systems can be assessed according to two dimensions. The first is the degree to whichthey emphasize collectivism as opposed to individualism. The second is the degree to which they are democratic ortotalitarian. These dimensions are interrelated; systems that emphasize collectivism tend to lean toward totalitarianism,whereas those that place a high value on individualism tend to be democratic. However, a large gray area exists in themiddle. It is possible to have democratic societies that emphasize a mix of collectivism and individualism. Similarly, it ispossible to have totalitarian societies that are not collectivist.

COLLECTIVISM AND INDIVIDUALISMCollectivism refers to a political system that stresses the primacy of collective goals over individual goals.2 Whencollectivism is emphasized, the needs of society as a whole are generally viewed as being more important than individualfreedoms. In such circumstances, an individual’s right to do something may be restricted on the grounds that it runscounter to “the good of society” or to “the common good.” Advocacy of collectivism can be traced to the ancient Greekphilosopher Plato (427–347 b.c.), who, in The Republic, argued that individual rights should be sacrificed for the good ofthe majority and that property should be owned in common. Plato did not equate collectivism with equality; he believedthat society should be stratified into classes, with those best suited to rule (which for Plato, naturally, were philosophersand soldiers) administering society for the benefit of all. In modern times, the collectivist mantle has been picked up bysocialists.

SocialismModern socialists trace their intellectual roots to Karl Marx (1818–1883), although socialist thought clearly predatesMarx (elements of it can be traced to Plato). Marx argued that the few benefit at the expense of the many in a capitalistsociety where individual freedoms are not restricted. While successful capitalists accumulate considerable wealth, Marxpostulated that the wages earned by the majority of workers in a capitalist society would be forced down to subsistencelevels. He argued that capitalists expropriate for their own use the value created by workers, while paying workers onlysubsistence wages in return. According to Marx, the pay of workers does not reflect the full value of their labor. To

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correct this perceived wrong, Marx advocated state ownership of the basic means of production, distribution, andexchange (i.e., businesses). His logic was that if the state owned the means of production, the state could ensure thatworkers were fully compensated for their labor. Thus, the idea is to manage state-owned enterprise to benefit society as awhole, rather than individual capitalists.3

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

The communist version of socialism reached its high point in the late 1970s, when the majority of theworld’s population lived in communist states. The countries under Communist Party rule at that time includedthe former Soviet Union; its eastern European client nations (e.g., Poland, Czechoslovakia, Hungary); China; thesoutheast Asian nations of Cambodia, Laos, and Vietnam; various African nations (e.g., Angola and Mozambique); andthe Latin American nations of Cuba and Nicaragua. By the mid-1990s, however, communism was in retreat worldwide.The Soviet Union had collapsed and had been replaced by a collection of 15 republics, many of which were at leastnominally structured as democracies. Communism was swept out of eastern Europe by the largely bloodless revolutionsof 1989. Although China is still nominally a communist state with substantial limits to individual political freedom, inthe economic sphere, the country has moved sharply away from strict adherence to communist ideology. Old-stylecommunism, with state control over all economic activity, hangs on in only a handful of small fringe states, most notablyNorth Korea.

Social democracy also seems to have passed a high-water mark, although the ideology may prove to be moreenduring than communism. Social democracy has had perhaps its greatest influence in a number of democratic Westernnations, including Australia, Denmark, Finland, France, Germany, Great Britain, Norway, Spain, and Sweden, wheresocial democratic parties have often held political power. Other countries where social democracy has had an importantinfluence include India and Brazil. Consistent with their Marxist roots, after World War II social democratic governmentin some nations nationalized some private companies, transforming them into state-owned enterprises to be run for the“public good rather than private profit.” This trend was most marked in Great Britain where by the end of the 1970sstate-owned companies had a monopoly in the telecommunications, electricity, gas, coal, railway, and shipbuildingindustries, as well as substantial interests in the oil, airline, auto, and steel industries.

However, experience demonstrated that state ownership of the means of production ran counter to the publicinterest. In many countries, state-owned companies performed poorly. Protected from competition by their monopolyposition and guaranteed government financial support, many became increasingly inefficient. Individuals paid for theluxury of state ownership through higher prices and higher taxes. As a consequence, a number of Western democraciesvoted many social democratic parties out of office in the late 1970s and early 1980s. They were succeeded by politicalparties, such as Britain’s Conservative Party and Germany’s Christian Democratic Party, that were more committed tofree market economics. These parties sold state-owned enterprises to private investors (a process referred to asprivatization). Even where social democratic parties regained the levers of power, as in Great Britain in 1997 when theleft-leaning Labor Party won control of the government, they too were now committed to continued private ownership.

IndividualismThe opposite of collectivism, individualism refers to a philosophy that an individual should have freedom in his or hereconomic and political pursuits. In contrast to collectivism, individualism stresses that the interests of the individualshould take precedence over the interests of the state. Like collectivism, individualism can be traced to an ancient Greekphilosopher, in this case Plato’s disciple Aristotle (384–322 b.c.). In contrast to Plato, Aristotle argued that individualdiversity and private ownership are desirable. In a passage that might have been taken from a speech by contemporarypoliticians who adhere to a free market ideology, he argued that private property is more highly productive thancommunal property and will thus stimulate progress. According to Aristotle, communal property receives little care,whereas property that is owned by an individual will receive the greatest care and therefore be most productive.

Individualism was reborn as an influential political philosophy in the Protestant trading nations of England and theNetherlands during the sixteenth century. The philosophy was refined in the work of a number of British philosophers,including David Hume (1711–1776), Adam Smith (1723–1790), and John Stuart Mill (1806–1873).Individualism exercised a profound influence on those in the American colonies that sought independence fromGreat Britain. Indeed, the concept underlies the ideas expressed in the Declaration of Independence. In the twentiethcentury, several Nobel Prize–winning economists—including Milton Friedman, Friedrich von Hayek, and JamesBuchanan—championed the philosophy.

Individualism is built on two central tenets. The first is an emphasis on the importance of guaranteeing individualfreedom and self-expression. The second tenet of individualism is that the welfare of society is best served by lettingpeople pursue their own economic self-interest, as opposed to some collective body (such as government) dictating whatis in society’s best interest. Or, as Adam Smith put it in a famous passage from The Wealth of Nations, “an individual

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who intends his own gain is led by an invisible hand to promote an end that was no part of his intention. Nor is it alwaysworse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the societymore effectually than when he really intends to promote it. This author has never known much good done by those whoeffect to trade for the public good.”4

The central message of individualism, therefore, is that individual economic and political freedoms are the groundrules on which a society should be based. This puts individualism in conflict with collectivism. Collectivism asserts theprimacy of the collective over the individual; individualism asserts the opposite. This underlying ideological conflictshaped much of the recent history of the world. The Cold War, for example, was in many respects a war betweencollectivism, championed by the former Soviet Union, and individualism, championed by the United States. From thelate 1980s until about 2005, the waning of collectivism was matched by the ascendancy of individualism. Democraticideals and market economics replaced socialism and communism in many states. Since 2005, there have been some signsof a swing back toward left-leaning socialist ideas in several countries, including several Latin America nations such asVenezuela, Bolivia, and Paraguay, along with Russia (see the Country Focus for details). Also, the global financial crisisof 2008–2009 caused some reevaluation of the trends toward individualism, and it remains possible that the pendulummight tilt back the other way.

DEMOCRACY AND TOTALITARIANISMDemocracy and totalitarianism are at different ends of a political dimension. Democracy refers to a political system inwhich government is by the people, exercised either directly or through elected representatives. Totalitarianism is aform of government in which one person or political party exercises absolute control over all spheres of human life andprohibits opposing political parties. The democratic–totalitarian dimension is not independent of the individualism–collectivism dimension. Democracy and individualism go hand in hand, as do the communist version of collectivism andtotalitarianism. However, gray areas exist; it is possible to have a democratic state in which collective valuespredominate, and it is possible to have a totalitarian state that is hostile to collectivism and in which some degree ofindividualism—particularly in the economic sphere—is encouraged. For example, China and Vietnam have seen a movetoward greater individual freedom in the economic sphere, but those countries are stilled ruled by parties that have amonopoly on political power and constrain political freedom.

DemocracyThe pure form of democracy, as originally practiced by several city-states in ancient Greece, is based on a belief thatcitizens should be directly involved in decision making. In complex, advanced societies with populations in the tens orhundreds of millions, this is impractical. Most modern democratic states practice representative democracy. The UnitedStates, for example, is a constitutional republic that operates as a representative democracy. In a representativedemocracy, citizens periodically elect individuals to represent them. These elected representatives then form agovernment whose function is to make decisions on behalf of the electorate. In a representative democracy,elected representatives who fail to perform this job adequately will be voted out of office at the next election.

COUNTRY FOCUS

Putin’s RussiaThe modern Russian state was born in 1991 after the dramatic collapse of the Soviet Union. Early in the post-Soviet era, Russiaembraced ambitious policies designed to transform a communist dictatorship with a centrally planned economy into a democraticstate with a market-based economic system. The policies, however, were imperfectly implemented. Political reform left Russiawith a strong presidency that—in hindsight—had the ability to subvert the democratic process. On the economic front, theprivatization of many state-owned enterprises was done in such a way as to leave large shareholdings in the hands of the politicallyconnected, many of whom were party officials and factory managers under the old Soviet system. Corruption was also endemic,and organized crime was able to seize control of some newly privatized enterprises. In 1998, the poorly managed Russianeconomy went through a financial crisis that nearly bought the country to its knees.

Fast-forward to 2020, and Russia still is a long way from being a modern democracy with a functioning free market–basedeconomic system. On the positive side, the economy grew at a healthy clip during the early 2000s, helped in large part by highprices for oil and gas, Russia’s largest exports (in 2013 oil and gas accounted for 75 percent of all Russian exports). Between 2000and 2013, Russia’s gross domestic product (GDP) per capita more than doubled when measured by purchasing power parity. As of2018, the country boasts the world’s 12th-largest economy, just behind that of South Korea and ahead of Spain. Thanks togovernment oil revenues, public debt is also low by international standards—at just 16 percent of GDP in 2018 (in the UnitedStates, by comparison, public debt amounts to 80 percent of GDP). Indeed, Russia has run a healthy trade surplus on the back of

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strong oil and gas exports for the last decade.The Russian economy is overly dependent on commodities, particularly oil and gas. This was exposed in mid-2014 when the

price of oil started to tumble as a result of rapidly increasing supply from the United States. Between mid-2014 and early 2016, theprice of oil fell from $110 a barrel to a low of around $27 before rebounding to $50. This drove a freight train through Russia’spublic finances. Much of Russia’s oil and gas production remains in the hands of enterprises in which the state still has asignificant ownership stake. The government has a controlling ownership position in Gazprom and Rosneft, two of the country’slargest oil and gas companies. The government used the rise in oil and gas revenues between 2004 and 2014 to increase publicspending through state-led investment projects and increases in wages and pensions for government workers. While this boostedprivate consumption, there has been a dearth of private investment, and productivity growth remains low. This is particularly trueamong many state-owned enterprises that collectively still account for about half of the Russian economy. Now with lower oilprices, Russia is having to issue more debt to finance public spending.

Russian private enterprises are also hamstrung by bureaucratic red tape and endemic corruption. Transparency International,which ranks countries by the extent of corruption, ranked Russia 138 out of 180 nations in 2018. The state and state-ownedenterprises are famous for pushing work to private enterprises that are owned by political allies, which further subverts market-based processes.

On the political front, Russia is becoming less democratic with every passing year. Since 1999, Vladimir Putin has exertedincreasingly tight control over Russian politics, either as president or as prime minister. Under Putin, potential opponents havebeen sidelined, civil liberties have been progressively reduced, and the freedom of the press has been diminished. For example, inresponse to opposition protests in 2011 and 2012, the Russian government passed laws increasing its control over the Internet,dramatically raising fines for participating in “unsanctioned” street protests, and expanded the definition of treason to further limitopposition activities. Vocal opponents of the régime—from business executives who do not toe the state line to protest groups suchas the punk rock protest band Pussy Riot—have found themselves jailed on dubious charges. To make matters worse, Putin hastightened his grip on the legal system. In late 2013, Russia’s parliament, which is dominated by Putin supporters, gave thepresident more power to appoint and fire prosecutors, thereby diminishing the independence of the legal system.

Freedom House, which produces an annual ranking tracking freedom in the world, classifies Russia as “not free” and gives itvery low scores for political and civil liberties. Freedom House notes that in the March 2012 presidential elections, Putin benefitedfrom preferential treatment by state-owned media, numerous abuses of incumbency, and procedural “irregularities” during the votecount. Putin won 63.6 percent of the vote against a field of weak, hand-chosen opponents, led by Communist Party leaderGennadiy Zyuganove, with 17.2 percent of the vote. Under a Putin-inspired 2008 constitutional amendment, the term of thepresidency was expanded from four years to six. Putin was elected to another six-year term in 2018 in an election that manyobservers thought was a sham.

In 2014, Putin burnished his growing reputation for authoritarianism when he took advantage of unrest in the neighboringcountry of Ukraine to annex the Crimea region and to support armed revolt by Russian-speaking separatists in eastern Ukraine.Western powers responded to this aggression by imposing economic sanctions on Russia. Taken together with the rapid fall in oilprices, this pushed the once-booming Russian economy into a recession. Despite economic weaknesses, there is no sign thatPutin’s hold on power has been diminished; in fact, quite the opposite seems to have occurred.Sources: “Putin’s Russia: Sochi or Bust,” The Economist, February 1, 2014; “Russia’s Economy: The S Word,” The Economist, November 9, 2013; Freedom House,“Freedom in the World 2019: Russia,” www.freedomhouse.org; K. Hille, “Putin Tightens Grip on Legal System,” Financial Times, November 27, 2013; “A Fourth Term forRussia’s Perpetual President,” The Economist, March 19, 2018.

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

TotalitarianismI n a tot ali t ari an co untry, al l the constit ut ional guar ant ees on whi ch r epr es en t ati ve democr aci es ar e bui lt—an i ndividual’ sright to freedom of expression and organization, a free media, and regular elections—are denied to the citizens. In mosttotalitarian states, political repression is widespread, free and fair elections are lacking, media are heavily censored, basiccivil liberties are denied, and those who question the right of the rulers to rule find themselves imprisoned or worse.

Four major forms of totalitarianism exist in the world today. Until recently, the most widespread wascommunist totalitarianism. Communism, however, is in decline worldwide, and most of the Communist Partydictatorships have collapsed since 1989. Exceptions to this trend (so far) are China, Vietnam, Laos, North Korea, andCuba, although most of these states exhibit clear signs that the Communist Party’s monopoly on political power iseroding. In many respects, the governments of China, Vietnam, and Laos are communist in name only because thosenations have adopted wide-ranging, market-based economic reforms. They remain, however, totalitarian states that denymany basic civil liberties to their populations. On the other hand, there are signs of a swing back toward communisttotalitarian ideas in some states, such as Venezuela, where the government of the late Hugo Chávez displayed totalitariantendencies. The same is true in Russia, where the government of Vladimir Putin has become increasingly totalitarianover time (see the Country Focus).

A second form of totalitarianism might be labeled theocratic totalitarianism. Theocratic totalitarianism is found instates where political power is monopolized by a party, group, or individual that governs according to religious

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principles. The most common form of theocratic totalitarianism is based on Islam and is exemplified by states such asIran and Saudi Arabia. These states limit freedom of political and religious expression with laws based on Islamicprinciples.

A third form of totalitarianism might be referred to as tribal totalitarianism. Tribal totalitarianism hasarisen from time to time in African countries such as Zimbabwe, Tanzania, Uganda, and Kenya. The borders ofmost African states reflect the administrative boundaries drawn by the old European colonial powers rather than tribalrealities. Consequently, the typical African country contains a number of tribes (e.g., in Kenya there are more than 40tribes). Tribal totalitarianism occurs when a political party that represents the interests of a particular tribe (and notalways the majority tribe) monopolizes power. In Kenya, for example, politicians from the Kikuyu tribe have longdominated the political system (see the Opening Case).

A fourth major form of totalitarianism might be described as right-wing totalitarianism. Right-wingtotalitarianism generally permits some individual economic freedom but restricts individual political freedom, frequentlyon the grounds that it would lead to the rise of communism. A common feature of many right-wing dictatorships is anovert hostility to socialist or communist ideas. Many right-wing totalitarian governments are backed by the military, andin some cases, the government may be made up of military officers. The fascist regimes that ruled Germany and Italy inthe 1930s and 1940s were right-wing totalitarian states. Until the early 1980s, right-wing dictatorships, many of whichwere military dictatorships, were common throughout Latin America (e.g., Brazil was ruled by a military dictatorshipbetween 1964 and 1985). They were also found in several Asian countries, particularly South Korea, Taiwan, Singapore,Indonesia, and the Philippines. Since the early 1980s, however, this form of government has been in retreat. Most LatinAmerican countries are now genuine multiparty democracies. Similarly, South Korea, Taiwan, and the Philippines haveall become functioning democracies, as has Indonesia.

Pseudo-DemocraciesMany of the world’s nations are neither pure democracies nor iron-clad totalitarian states. Rather they lie between puredemocracies and complete totalitarian systems of government. They might be described as imperfect or pseudo-democracies, where authoritarian elements have captured some or much of the machinery of state and use this in anattempt to deny basic political and civil liberties. In the Russia of Vladimir Putin, for example, elections are still held,people compete through the ballot box for political office, and the independent press does not always toe the official line.However, Putin has used his position to systematically limit the political and civil liberties of opposition groups. Hiscontrol is not yet perfect, though. Voices opposing Putin are still heard in Russia, and in theory, elections are stillcontested. But in practice, it is becoming increasingly difficult to challenge a man and régime that have systematicallyextended their political, legal, and economic power over the past two decades (see the Country Focus).

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Economic Systems

LO2-2Understand how the economic systems of countries differ.It should be clear from the previous section that political ideology and economic systems are connected. In countrieswhere individual goals are given primacy over collective goals, we are more likely to find market-based economicsystems. In contrast, in countries where collective goals are given preeminence, the state may have taken control overmany enterprises; markets in such countries are likely to be restricted rather than free. We can identify three broad typesof economic systems: a market economy, a command economy, and a mixed economy.

MARKET ECONOMYIn the archetypal pure market economy, all productive activities are privately owned, as opposed to being owned by thestate. The goods and services that a country produces are not planned by anyone. Production is determined bythe interaction of supply and demand and signaled to producers through the price system. If demand for aproduct exceeds supply, prices will rise, signaling producers to produce more. If supply exceeds demand, prices will fall,

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signaling producers to produce less. In this system, consumers are sovereign. The purchasing patterns of consumers, assignaled to producers through the mechanism of the price system, determine what is produced and in what quantity.

For a market to work in this manner, supply must not be restricted. A supply restriction occurs when a single firmmonopolizes a market. In such circumstances, rather than increase output in response to increased demand, a monopolistmight restrict output and let prices rise. This allows the monopolist to take a greater profit margin on each unit it sells.Although this is good for the monopolist, it is bad for the consumer, who has to pay higher prices. It also is probably badfor the welfare of society. Because a monopolist has no competitors, it has no incentive to search for ways to lowerproduction costs. Rather, it can simply pass on cost increases to consumers in the form of higher prices. The net result isthat the monopolist is likely to become increasingly inefficient, producing high-priced, low-quality goods, and societysuffers as a consequence.

Given the dangers inherent in monopoly, one role of government in a market economy is to encourage vigorousfree and fair competition between private producers. Governments do this by banning restrictive business practicesdesigned to monopolize a market (antitrust laws serve this function in the United States and European Union). Privateownership also encourages vigorous competition and economic efficiency. Private ownership ensures that entrepreneurshave a right to the profits generated by their own efforts. This gives entrepreneurs an incentive to search for better waysof serving consumer needs. That may be through introducing new products, by developing more efficient productionprocesses, by pursuing better marketing and after-sale service, or simply through managing their businesses moreefficiently than their competitors. In turn, the constant improvement in product and process that results from such anincentive has been argued to have a major positive impact on economic growth and development.6

COMMAND ECONOMYIn a pure command economy, the government plans the goods and services that a country produces, the quantity inwhich they are produced, and the prices at which they are sold. Consistent with the collectivist ideology, the objective ofa command economy is for government to allocate resources for “the good of society.” In addition, in a pure commandeconomy, all businesses are state owned, the rationale being that the government can then direct them to makeinvestments that are in the best interests of the nation as a whole rather than in the interests of private individuals.Historically, command economies were found in communist countries where collectivist goals were given priority overindividual goals. Since the demise of communism in the late 1980s, the number of command economies has fallendramatically. Some elements of a command economy were also evident in a number of democratic nations led bysocialist-inclined governments. France and India both experimented with extensive government planning and stateownership, although government planning has fallen into disfavor in both countries.

While the objective of a command economy is to mobilize economic resources for the public good, the oppositeoften seems to have occurred. In a command economy, state-owned enterprises have little incentive to control costs andbe efficient because they cannot go out of business. Also, the abolition of private ownership means there is no incentivefor individuals to look for better ways to serve consumer needs; hence, dynamism and innovation are absent fromcommand economies. Instead of growing and becoming more prosperous, such economies tend to stagnate.

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

MIXED ECONOMYMixed economies can be found between market and command economies. In a mixed economy, certain sectors of theeconomy are left to private ownership and free market mechanisms, while other sectors have significant state ownershipand government planning. Mixed economies were once common throughout much of the developed world, although theyare becoming less so. Until the 1980s, Great Britain, France, and Sweden were mixed economies, but extensiveprivatization has reduced state ownership of businesses in all three nations. A similar trend occurred in many othercountries where there was once a large state-owned sector, such as Brazil, Italy, and India (although there are still state-owned enterprises in all of these nations). As a counterpoint, the involvement of the state in economic activity has beenon the rise again in countries such as Russia and Venezuela, where authoritarian regimes have seized control of thepolitical structure, typically by first winning power through democratic means and then subverting those same structuresto maintain their grip on power.

In mixed economies, governments also tend to take into state ownership troubled firms whose continued operationis thought to be vital to national interests. For example, in 2008 the U.S. government took an 80 percent stake in AIG tostop that financial institution from collapsing, the theory being that if AIG did collapse, it would have very seriousconsequences for the entire financial system. The U.S. government usually prefers market-oriented solutions to economicproblems, and in the AIG case, the intention was to sell the institution back to private investors as soon as possible. TheUnited States also took similar action with respect to a number of other troubled private enterprises, including Citigroupand General Motors. In all these cases, the government stake was seen as nothing more than a short-term action designedto stave off economic collapse by injecting capital into troubled enterprises in highly unusually circumstances. As soonas it was able to, the government sold these stakes. In early 2010, for example, the U.S. government sold its stake inCitigroup. The government stake in AIG was sold off in 2012, and by 2014, it had also disposed of its stake in GM.

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Legal Systems

LO2-3Understand how the legal systems of countries differ.The legal system of a country refers to the rules, or laws, that regulate behavior along with the processes by which thelaws are enforced and through which redress for grievances is obtained. The legal system of a country is of immenseimportance to international business. A country’s laws regulate business practice, define the manner in which businesstransactions are to be executed, and set down the rights and obligations of those involved in business transactions. Thelegal environments of countries differ in significant ways. As we shall see, differences in legal systems can affect theattractiveness of a country as an investment site or market.

Like the economic system of a country, the legal system is influenced by the prevailing political system (although itis also strongly influenced by historical tradition). The government of a country defines the legal framework withinwhich firms do business, and often the laws that regulate business reflect the rulers’ dominant political ideology. Forexample, collectivist-inclined totalitarian states tend to enact laws that severely restrict private enterprise, whereas thelaws enacted by governments in democratic states where individualism is the dominant political philosophy tend to bepro-private enterprise and pro-consumer.

Here, we focus on several issues that illustrate how legal systems can vary—and how such variations can affectinternational business. First, we look at some basic differences in legal systems. Next we look at contract law. Third, welook at the laws governing property rights with particular reference to patents, copyrights, and trademarks. Then wediscuss protection of intellectual property. Finally, we look at laws covering product safety and product liability.

DIFFERENT LEGAL SYSTEMSThere are three main types of legal systems—or legal traditions—in use around the world: common law, civil law, andtheocratic law.

Common LawThe common law system evolved in England over hundreds of years. It is now found in most of Great Britain’s formercolonies, including the United States. Common law is based on tradition, precedent, and custom. Tradition refers to acountry’s legal history, precedent to cases that have come before the courts in the past, and custom to the ways in whichlaws are applied in specific situations. When law courts interpret common law, they do so with regard to thesecharacteristics. This gives a common law system a degree of flexibility that other systems lack. Judges in a common lawsystem have the power to interpret the law so that it applies to the unique circumstances of an individual case. In turn,each new interpretation sets a precedent that may be followed in future cases. As new precedents arise, laws may bealtered, clarified, or amended to deal with new situations.

Civil LawA civil law system is based on a detailed set of laws organized into codes. When law courts interpret civil law, they doso with regard to these codes. More than 80 countries—including Germany, France, Japan, and Russia—operate with acivil law system. A civil law system tends to be less adversarial than a common law system because the judges rely ondetailed legal codes rather than interpreting tradition, precedent, and custom. Judges under a civil law system have lessflexibility than those under a common law system. Judges in a common law system have the power to interpret the law,whereas judges in a civil law system have the power only to apply the law.

Theocratic LawA theocratic law system is one in which the law is based on religious teachings. Islamic law is the most widelypracticed theocratic legal system in the modern world, although usage of both Hindu and Jewish law persistedinto the twentieth century. Islamic law is primarily a moral rather than a commercial law and is intended togovern all aspects of life.7 The foundation for Islamic law is the holy book of Islam, the Koran, along with the Sunnah,or decisions and sayings of the Prophet Muhammad, and the writings of Islamic scholars who have derived rules byanalogy from the principles established in the Koran and the Sunnah. Because the Koran and Sunnah are holydocuments, the basic foundations of Islamic law cannot be changed. However, in practice, Islamic jurists and scholarsare constantly debating the application of Islamic law to the modern world. In reality, many Muslim countries have legalsystems that are a blend of Islamic law and a common or civil law system.

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Although Islamic law is primarily concerned with moral behavior, it has been extended to cover certain commercialactivities. An example is the payment or receipt of interest, which is considered usury and outlawed by the Koran. To thedevout Muslim, acceptance of interest payments is seen as a grave sin; the giver and the taker are equally damned. Thisis not just a matter of theology; in several Islamic states, it has also become a matter of law. In the 1990s, for example,Pakistan’s Federal Shariat Court, the highest Islamic lawmaking body in the country, pronounced interest to be un-Islamic and therefore illegal and demanded that the government amend all financial laws accordingly. In 1999,Pakistan’s Supreme Court ruled that Islamic banking methods should be used in the country after July 1, 2001.8 By thelate 2000s, there were some 500 Islamic financial institutions in the world, and as of 2014, they collectively managedmore than $1 trillion in assets. In addition to Pakistan, Islamic financial institutions are found in many of the Gulf states,Egypt, Malaysia, and Iran.9

DIFFERENCES IN CONTRACT LAWThe difference between common law and civil law systems can be illustrated by the approach of each to contract law(remember, most theocratic legal systems also have elements of common or civil law). A contract is a document thatspecifies the conditions under which an exchange is to occur and details the rights and obligations of the partiesinvolved. Some form of contract regulates many business transactions. Contract law is the body of law that governscontract enforcement. The parties to an agreement normally resort to contract law when one party feels the other hasviolated either the letter or the spirit of an agreement.

Because common law tends to be relatively ill specified, contracts drafted under a common law framework tend tobe very detailed with all contingencies spelled out. In civil law systems, however, contracts tend to be much shorter andless specific because many of the issues are already covered in a civil code. Thus, it is more expensive to draw upcontracts in a common law jurisdiction, and resolving contract disputes can be very adversarial in common law systems.But common law systems have the advantage of greater flexibility and allow judges to interpret a contract dispute in lightof the prevailing situation. International businesses need to be sensitive to these differences; approaching a contractdispute in a state with a civil law system as if it had a common law system may backfire, and vice versa.

When contract disputes arise in international trade, there is always the question of which country’s laws to apply.To resolve this issue, a number of countries, including the United States, have ratified the United Nations Conventionon Contracts for the International Sale of Goods (CISG). The CISG establishes a uniform set of rules governingcertain aspects of the making and performance of everyday commercial contracts between sellers and buyers who havetheir places of business in different nations. By adopting the CISG, a nation signals to other adopters that it will treat theconvention’s rules as part of its law. The CISG applies automatically to all contracts for the sale of goods betweendifferent firms based in countries that have ratified the convention, unless the parties to the contract explicitly opt out.One problem with the CISG, however, is that as of 2018, only 89 nations had ratified the convention (the CISG went intoeffect in 1988).10 Some of the world’s important trading nations, including India and the United Kingdom, have notratified the CISG.

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

PROPERTY RIGHTS AND CORRUPTIONIn a legal sense, the term property refers to a resource over which an individual or business holds a legal title, that is, aresource that it owns. Resources include land, buildings, equipment, capital, mineral rights, businesses, and intellectualproperty (ideas, which are protected by patents, copyrights, and trademarks). Property rights refer to the legal rightsover the use to which a resource is put and over the use made of any income that may be derived from that resource.12Countries differ in the extent to which their legal systems define and protect property rights. Almost all countries nowhave laws on their books that protect property rights. Even China, still nominally a communist state despite its boomingmarket economy, finally enacted a law to protect the rights of private property holders in 2007 (the law gives individualsthe same legal protection for their property as the state has).13 However, in many countries these laws are not enforcedby the authorities, and property rights are violated. Property rights can be violated in two ways: through private actionand through public action.

Private ActionIn terms of violating property rights, private action refers to theft, piracy, blackmail, and the like by private individualsor groups. Although theft occurs in all countries, a weak legal system allows a much higher level of criminal action. Forexample, in the chaotic period following the collapse of communism in Russia, an outdated legal system, coupled with a

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weak police force and judicial system, offered both domestic and foreign businesses scant protection from blackmail bythe “Russian Mafia.” Successful business owners in Russia often had to pay “protection money” to the Mafia or faceviolent retribution, including bombings and assassinations (about 500 contract killings of businessmen occurred per yearin the 1990s).14

Russia is not alone in having organized crime problems (and the situation in Russia has improved since the 1990s).The Mafia has a long history in the United States (Chicago in the 1930s was similar to Moscow in the 1990s). In Japan,the local version of the Mafia, known as the yakuza, runs protection rackets, particularly in the food and entertainmentindustries.15 However, there was a big difference between the magnitude of such activity in Russia in the 1990s and itslimited impact in Japan and the United States. The difference arose because the legal enforcement apparatus, such as thepolice and court system, was weak in Russia following the collapse of communism. Many other countries from time totime have had problems similar to or even greater than those experienced by Russia.

Public Action and CorruptionPublic action to violate property rights occurs when public officials, such as politicians and government bureaucrats,extort income, resources, or the property itself from property holders. This can be done through legal mechanisms suchas levying excessive taxation, requiring expensive licenses or permits from property holders, taking assets into stateownership without compensating the owners, or redistributing assets without compensating the prior owners. It can alsobe done through illegal means, or corruption, by demanding bribes from businesses in return for the rights to operate in acountry, industry, or location.16

Corruption has been well documented in every society, from the banks of the Congo River to the palace of theDutch royal family, from Japanese politicians to Brazilian bankers, and from government officials in Zimbabwe to theNew York City Police Department. The government of the late Ferdinand Marcos in the Philippines was famous fordemanding bribes from foreign businesses wishing to set up operations in that country. The same was true ofgovernment officials in Indonesia under the rule of former President Suharto. No society is immune tocorruption. However, there are systematic differences in the extent of corruption. In some countries, the rule of lawminimizes corruption. Corruption is seen and treated as illegal, and when discovered, violators are punished by the fullforce of the law. In other countries, the rule of law is weak and corruption by bureaucrats and politicians is rife.Corruption is so endemic in some countries that politicians and bureaucrats regard it as a perk of office and openly floutlaws against corruption. This seems to have been the case in Brazil until recently; the situation there may be evolving ina more positive direction.

According to Transparency International, an independent nonprofit organization dedicated to exposing and fightingcorruption, businesses and individuals spend some $400 billion a year worldwide on bribes related to governmentprocurement contracts alone.17 Transparency International has also measured the level of corruption among publicofficials in different countries.18 As can be seen in Figure 2.1, the organization rated countries such as New Zealand andSweden as clean; it rated others, such as Russia, Zimbabwe, and Venezuela, as corrupt. Somalia ranked last out of all180 countries in the survey (the country is often described as a “failed state”).

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FIGURE 2.1 Rankings of corruption by country, 2018.Source: Constructed by the author from raw data from Transparency International, Corruption Perceptions Index 2018.

Economic evidence suggests that high levels of corruption significantly reduce the foreign direct investment, levelof international trade, and economic growth rate in a country.19 By siphoning off profits, corrupt politicians andbureaucrats reduce the returns to business investment and, hence, reduce the incentive of both domestic and foreignbusinesses to invest in that country. The lower level of investment that results hurts economic growth. Thus, we wouldexpect countries with high levels of corruption such as Indonesia, Nigeria, and Russia to have a lower rate of economicgrowth than might otherwise have been the case. A detailed example of the negative effect that corruption can have oneconomic development is given in the accompanying Country Focus, which looks at the impact of corruption oneconomic growth in Brazil.

COUNTRY FOCUS

Corruption in BrazilBrazil is the seventh-largest economy in the world with a gross domestic product of $2 trillion. The country has a democraticgovernment and an economy characterized by moderately free markets, although the country’s largest oil producer (Petrobras) andone of its top banks (Banco do Brazil) are both state owned. Many economists, however, have long felt that the country has neverquite lived up to its considerable economic potential. A major reason for this has been an endemically high level of corruption thatfavors those with political connections and discourages investment by more ethical businesses.

Transparency International, a nongovernmental organization that evaluates countries based on perceptions of how corrupt they

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are, ranked Brazil 105th out of the 180 countries it looked at in its 2018 report. The problems it identifies in Brazil include publicofficials who demand bribes in return for awarding government contracts and “influence peddling,” in which elected officials usetheir position in government to obtain favors or preferential treatment. Consistent with this, according to a study by the WorldEconomic Forum, Brazil ranks 135th out of 144 countries in the proper use of public funds.

Over the last decade, several corruption scandals have come to light that serve to emphasize Brazil’s corruption problem. In2005, a scandal known as the mensalao (the monthly payoff scandal) broke. The scandal started when a midlevel postal officialwas caught on film pocketing a modest bribe in exchange for promises to favor certain businesses in landing government contracts.Further investigation uncovered a web of influence peddling in which fat monthly payments were given to lawmakers willing toback government initiatives in National Congress. After a lengthy investigation, in late 2012 some 25 politicians and businessexecutives were found guilty of crimes that included bribery, money laundering, and corruption.

The public uproar surrounding the mensalao scandal was just starting to die down when in March 2014 another corruptionscandal captured the attention of Brazilians. This time it involved the state-owned oil company, Petrobras. Under a scheme thatseems to have been operating since 1997, construction firms wanting to do business with Petrobras agreed to pay bribes to thecompany’s executives. Many of these executives were themselves political appointees. The executives would inflate the value ofcontracts they awarded, adding a 3 percent “fee,” which was effectively a kickback. The 3 percent fee was shared among Petrobrasexecutives, construction industry executives, and politicians. The construction companies established shell companies to makepayments and launder the money. According to prosecutors investigating the case, the total value of bribes may have exceeded$3.7 billion.

Four former Petrobras officials and at least 23 construction company executives have been charged with crimes that includecorruption and money laundering. In addition, Brazil’s Supreme Court has given prosecutors the go-ahead to investigate 48 currentor former members of Congress, including the former Brazilian President Fernando Collor de Mello. The Brazilian president,Dilma Rousseff, was also tainted by the scandal. In June 2016, she was suspended from the presidency pending an impeachmenttrial. She was chair of Petrobras during the time this was occurring. She is also a member of the governing Workers’ Party, severalmembers of which seem to have been among the major beneficiaries of the kickback scandal. Although there is no evidence thatRousseff knew of the bribes or profited from them, her ability to govern effectively was severely damaged by association. Thescandal so rocked Brazil that it pushed the country close to a recession. In August 2016, Rousseff was impeached and removedfrom the presidency. Then in 2018 the former Brazilian President, Lula da Silva, was found guilty of corruption. Among thecharges against Lula were that, when President, he was given a beach-front apartment by an engineering firm in return for his helpin winning lucrative contracts for Petrobras. Lula was sentenced to 12 years in prison.

If there is a bright spot in all of this, it is that the scandals are coming to light. Backed by Supreme Court rulings and publicoutrage, corrupted politicians, government officials, and business executives are being prosecuted. In the past, that was far lesslikely to occur.Sources: Will Conners and Luciana Magalhaes, “Brazil Cracks Open Vast Bribery Scandal,” The Wall Street Journal, April 7, 2015; Marc Margolis, “In Brazil’s Trial of theCentury, Lula’s Reputation Is at Stake,” Newsweek, July 27, 2012; “The Big Oily,” The Economist, January 3, 2015; Donna Bowater, “Brazil’s Continuing CorruptionProblem,” BBC News, September 18, 2015; Simon Romero, “Dilma Rousseff Is Ousted as Brazil’s President in Impeachment Vote,” The New York Times, August 31, 2016;“Brazilian Corruption Scandals: All You Need to Know,” BBC News, April 8, 2018.

MANAGEMENT FOCUS

Did Walmart Violate the Foreign Corrupt Practices Act?In the early 2000s, Walmart wanted to build a new store in San Juan Teotihuacan, Mexico, barely a mile from ancient pyramidsthat drew tourists from around the world. The owner of the land was happy to sell to Walmart, but one thing stood in the way of adeal: the city’s new zoning laws. These prohibited commercial development in the historic area. Not to be denied, executives at theheadquarters of Walmart de Mexico found a way around the problem: They paid a $52,000 bribe to a local official to redraw thezoning area so that the property Walmart wanted to purchase was placed outside the commercial-free zone. Walmart then wentahead and built the store, despite vigorous local opposition, opening it in late 2004.

A former lawyer for Walmart de Mexico subsequently contacted Walmart executives at the company’s corporate headquartersin Bentonville, Arkansas. He told them that Walmart de Mexico routinely resorted to bribery, citing the altered zoning map as justone example. Alarmed, executives at Walmart started their own investigation. Faced with growing evidence of corruption inMexico, top Walmart executives decided to engage in damage control, rather than coming clean. Walmart’s top lawyer shipped thecase files back to Mexico and handed over responsibility for the investigation to the general council of Walmart de Mexico. Thiswas an interesting choice as the very same general council was alleged to have authorized bribes. The general council quicklyexonerated fellow Mexican executives, and the internal investigation was closed in 2006.

For several years nothing more happened; then, in April 2012, The New York Times published an article detailing bribery byWalmart. The Times cited the changed zoning map and several other examples of bribery by Walmart: for example, eight bribestotaling $341,000 enabled Walmart to build a Sam’s Club in one of Mexico City’s most densely populated neighborhoods withouta construction license, an environmental permit, an urban impact assessment, or even a traffic permit. Similarly, thanks to ninebribe payments totaling $765,000, Walmart built a vast refrigerated distribution center in an environmentally fragile flood basinnorth of Mexico City, in an area where electricity was so scarce that many smaller developers were turned away.

Walmart responded to The New York Times article by ramping up a second internal investigation into bribery that it hadinitiated in 2011. By mid-2015, there were reportedly more than 300 outside lawyers working on the investigation, and it had cost

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more than $612 million in fees. In addition, the U.S. Department of Justice and the Securities and Exchange Commission bothannounced that they had started investigations into Walmart’s practices. In November 2012, Walmart reported that its owninvestigation into violations had extended beyond Mexico to include China and India. Among other things, it was looking into theallegations by the Times that top executives at Walmart, including former CEO Lee Scott Jr., had deliberately squashed earlierinvestigations. In late 2016 people familiar with the matter stated that the federal investigation had not uncovered evidence ofwidespread bribery. In November 2017 it was reported that Walmart had settled with the Justice Department and paid a $283million fine, significantly less than had been expected.Sources: David Barstow, “Vast Mexican Bribery Case Hushed Up by Wal-Mart after Top Level Struggle,” The New York Times, April 21, 2012; Stephanie Clifford and DavidBarstow, “Wal-Mart Inquiry Reflects Alarm on Corruption,” The New York Times, November 15, 2012; Nathan Vardi, “Why Justice Department Could Hit Wal-Mart Hardover Mexican Bribery Allegations,” Forbes, April 22, 2012; Phil Wahba,“Walmart Bribery Probe by Feds Finds No Major Misconduct in Mexico,” Fortune, October 18,2015; T. Schoenberg and M. Robinson, “Wal-Mart Balks at Paying $600 Million in Bribery Case,” Bloomberg, October 6, 2016; and Sue Reisinger, “Wal-Mart Reserves$283 million to Settle Mexico FCPA Case,” Corporate Counsel, November 17, 2017.

Foreign Corrupt Practices ActIn the 1970s, the United States passed the Foreign Corrupt Practices Act (FCPA) following revelations that U.S.companies had bribed government officials in foreign countries in an attempt to win lucrative contracts. This law makesit illegal to bribe a foreign government official to obtain or maintain business over which that foreign official hasauthority, and it requires all publicly traded companies (whether or not they are involved in international trade) to keepdetailed records that would reveal whether a violation of the act has occurred. In 2012, evidence emerged that in itseagerness to expand in Mexico, Walmart may have run afoul of the FCPA (for details, see the Management Focusfeature).

In 1997, trade and finance ministers from the member states of the Organisation for Economic Co-operation and Development (OECD), an association of 34 major economies including most Western economies(but not Russia, India or China), adopted the Convention on Combating Bribery of Foreign Public Officials inInternational Business Transactions.20 The convention obliges member states to make the bribery of foreign publicofficials a criminal offense.

Did You Know?Did you know that Venezuela has dropped to one of the worst performing economies in the world?Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation fromthe author. 

Both the U.S. law and OECD convention include language that allows exceptions known as facilitating orexpediting payments (also called grease payments or speed money), the purpose of which is to expedite or to secure theperformance of a routine governmental action.21 For example, they allow small payments made to speed up the issuanceof permits or licenses, process paperwork, or just get vegetables off the dock and on their way to market. Theexplanation for this exception to general antibribery provisions is that while grease payments are, technically, bribes,they are distinguishable from (and, apparently, less offensive than) bribes used to obtain or maintain business becausethey merely facilitate performance of duties that the recipients are already obligated to perform.

THE PROTECTION OF INTELLECTUAL PROPERTYIntellectual property refers to property that is the product of intellectual activity, such as computer software, ascreenplay, a music score, or the chemical formula for a new drug. Patents, copyrights, and trademarks establishownership rights over intellectual property. A patent grants the inventor of a new product or process exclusive rights fora defined period to the manufacture, use, or sale of that invention. Copyrights are the exclusive legal rights of authors,composers, playwrights, artists, and publishers to publish and disperse their work as they see fit. Trademarks aredesigns and names, officially registered, by which merchants or manufacturers can differentiate their products (e.g.,Christian Dior clothes). In the high-technology “knowledge” economy of the twenty-first century, intellectual propertyhas become an increasingly important source of economic value for businesses. Protecting intellectual property has alsobecome increasingly problematic, particularly if it can be rendered in a digital form and then copied and distributed atvery low cost via pirated DVDs or over the Internet (e.g., computer software, music, and video recordings).22

The philosophy behind intellectual property laws is to reward the originator of a new invention, book, musicalrecord, clothes design, restaurant chain, and the like for his or her idea and effort. Such laws stimulate innovation andcreative work. They provide an incentive for people to search for novel ways of doing things, and they reward creativity.For example, consider innovation in the pharmaceutical industry. A patent will grant the inventor of a new drug a 20-year monopoly in production of that drug. This gives pharmaceutical firms an incentive to undertake the expensive,difficult, and time-consuming basic research required to generate new drugs (it can cost $1 billion in R&D and take 12

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years to get a new drug on the market). Without the guarantees provided by patents, companies would be unlikely tocommit themselves to extensive basic research.23

The protection of intellectual property rights differs greatly from country to country. Although many countries havestringent intellectual property regulations on their books, the enforcement of these regulations has often been lax. Thishas been the case even among many of the 192 countries that are now members of the World Intellectual PropertyOrganization, all of which have signed international treaties designed to protect intellectual property, including theoldest such treaty, the Paris Convention for the Protection of Industrial Property, which dates to 1883 and has beensigned by more than 170 nations. Weak enforcement encourages the piracy (theft) of intellectual property. China andThailand have often been among the worst offenders in Asia. Pirated computer software is widely available in China.Similarly, the streets of Bangkok, Thailand’s capital, are lined with stands selling pirated copies of Rolex watches, Levi’sjeans, DVDs, and computer software.

The computer software industry is an example of an industry that suffers from lax enforcement of intellectualproperty rights. A study published in 2012 suggested that violations of intellectual property rights cost personal computersoftware firms revenues equal to $63 billion a year.24 According to the study’s sponsor, the Business Software Alliance,a software industry association, some 42 percent of all software applications used in the world were pirated.One of the worst large countries was China, where the piracy rate ran at 77 percent and cost the industry morethan $9.8 billion in lost sales, up from $444 million in 1995. The piracy rate in the United States was much lower at 19percent; however, the value of sales lost was significant because of the size of the U.S. market.25

MANAGEMENT FOCUS

Starbucks Wins Key Trademark Case in ChinaStarbucks has big plans for China. It believes the fast-growing nation will become the company’s second-largest market after theUnited States. Starbucks entered the country in 1999, and by the end of 2016 it had opened more than 1,300 stores. But in China,c opycats of well -es t abl ished Wester n br ands ar e common. St arbucks f aced competit i on f r om a l ook-al i ke, Shanghai Xin g Ba KeCoffee Shop, whose stores closely matched the Starbucks format, right down to a green-and-white Xing Ba Ke circular logo thatmimics Starbucks’ ubiquitous logo. The name also mimics the standard Chinese translation for Starbucks. Xing means “star,” andBa Ke sounds like “bucks.”

In 2003, Starbucks decided to sue Xing Ba Ke in Chinese court for trademark violations. Xing Ba Ke’s general managerresponded by claiming it was just an accident that the logo and name were so similar to that of Starbucks. He claimed the right touse the logo and name because Xing Ba Ke had registered as a company in Shanghai in 1999, before Starbucks entered the city. “Ihadn’t heard of Starbucks at the time,” claimed the manager, “so how could I imitate its brand and logo?”

However, in January 2006, a Shanghai court ruled that Starbucks had precedence, in part because it had registered its Chinesename in 1998. The court stated that Xing Ba Ke’s use of the name and similar logo was “clearly malicious” and constitutedimproper competition. The court ordered Xing Ba Ke to stop using the name and to pay Starbucks $62,000 in compensation. Whilethe money involved here may be small, the precedent is not. In a country where violation of trademarks has been common, thecourts seem to be signaling a shift toward greater protection of intellectual property rights. This is perhaps not surprising becauseforeign governments and the World Trade Organization have been pushing China hard recently to start respecting intellectualproperty rights.Sources: M. Dickie, “Starbucks Wins Case against Chinese Copycat,” Financial Times, January 3, 2006, p. 1; “Starbucks: Chinese Court Backs Company over TrademarkInfringement,” The Wall Street Journal, January 2, 2006, p. A11; and “Starbucks Calls China Its Top Growth Focus,” The Wall Street Journal, February 14, 2006, p. 1.

International businesses have a number of possible responses to violations of their intellectual property. They canlobby their respective governments to push for international agreements to ensure that intellectual property rights areprotected and that the law is enforced. Partly as a result of such actions, international laws are being strengthened. As weshall see in Chapter 7, the most recent world trade agreement, signed in 1994, for the first time extends the scope of theGeneral Agreement on Tariffs and Trade to cover intellectual property. Under the new agreement, known as the Trade-Related Aspects of Intellectual Property Rights (TRIPS), as of 1995 a council of the World Trade Organization isoverseeing enforcement of much stricter intellectual property regulations. These regulations oblige WTO members togrant and enforce patents lasting at least 20 years and copyrights lasting 50 years after the death of the author. Richcountries had to comply with the rules within a year. Poor countries, in which such protection generally was muchweaker, had five years of grace, and the very poorest have 10 years.26 (For further details of the TRIPS agreement, seeChapter 7.)

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In addition to lobbying governments, firms can file lawsuits on their own behalf. For example, Starbucks won alandmark trademark copyright case in China against a copycat that signaled a change in the approach in China (see theaccompanying Management Focus for details). Firms may also choose to stay out of countries where intellectualproperty laws are lax, rather than risk having their ideas stolen by local entrepreneurs. Firms also need to be on the alertto ensure that pirated copies of their products produced in countries with weak intellectual property laws don’t turn up intheir home market or in third countries. U.S. computer software giant Microsoft, for example, discovered that piratedMicrosoft software, produced illegally in Thailand, was being sold worldwide as the real thing.

PRODUCT SAFETY AND PRODUCT LIABILITYProduct safety laws set certain safety standards to which a product must adhere. Product liability involves holding afirm and its officers responsible when a product causes injury, death, or damage. Product liability can be much greater ifa product does not conform to required safety standards. Both civil and criminal product liability laws exist. Civil lawscall for payment and monetary damages. Criminal liability laws result in fines or imprisonment. Both civil and criminalliability laws are probably more extensive in the United States than in any other country, although many other Westernnations also have comprehensive liability laws. Liability laws are typically the least extensive in less developed nations.A boom in product liability suits and awards in the United States resulted in a dramatic increase in the cost of liabilityinsurance. Many business executives argue that the high costs of liability insurance make American businesses lesscompetitive in the global marketplace.

In addition to the competitiveness issue, country differences in product safety and liability laws raise an importantethical issue for firms doing business abroad. When product safety laws are tougher in a firm’s home country than in aforeign country or when liability laws are more lax, should a firm doing business in that foreign country follow the morerelaxed local standards or should it adhere to the standards of its home country? While the ethical thing to do isundoubtedly to adhere to home-country standards, firms have been known to take advantage of lax safety and liabilitylaws to do business in a manner that would not be allowed at home.

TEST PREPUse SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBookor go to learnsmartadvantage.com for help.

FOCUS ON MANAGERIAL IMPLICATIONS

LO2-4Explain the implications for management practice of national differences in political economy.

THE MACRO ENVIRONMENT INFLUENCES MARKET ATTRACTIVENESSThe material discussed in this chapter has two broad implications for international business. First, the political,economic, and legal systems of a country raise important ethical issues that have implications for the practice ofinternational business. For example, what ethical implications are associated with doing business in totalitarian countrieswhere citizens are denied basic human rights, corruption is rampant, and bribes are necessary to gain permission to dobusiness? Is it right to operate in such a setting? A full discussion of the ethical implications of country differences inpolitical economy is reserved for Chapter 5, where we explore ethics in international business in much greater depth.

Second, the political, economic, and legal environments of a country clearly influence the attractiveness of thatcountry as a market or investment site. The benefits, costs, and risks associated with doing business in a country are afunction of that country’s political, economic, and legal systems. The overall attractiveness of a country as a market orinvestment site depends on balancing the likely long-term benefits of doing business in that country against the likelycosts and risks. Because this chapter is the first of two dealing with issues of political economy, we will delay a detaileddiscussion of how political economy impacts the benefits, costs, and risks of doing business in different nation-statesuntil the end of the next chapter, when we have a full grasp of all the relevant variables that are important for assessingbenefits, costs, and risks.

For now, other things being equal, a nation with democratic political institutions, a market-based economic system,and strong legal system that protects property rights and limits corruption is clearly more attractive as a place in which todo business than a nation that lacks democratic institutions, where economic activity is heavily regulated by the state,

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and where corruption is rampant and the rule of law is not respected. On this basis, for example, a country like Canada isa better place in which to do business than the Russia of Vladimir Putin (see the Country Focus: Putin’s Russia). Thatbeing said, the reality is often more nuanced and complex. For example, China lacks democratic institutions; corruptionis widespread; property rights are not always respected; and even though the country has embraced many market-basedeconomic reforms, there are still large numbers of state-owned enterprises—yet many Western businesses feel that theymust invest in China. They do so despite the risks because the market is large, the nation is moving toward amarket-based system, economic growth has been strong (although growth rates there have slowed downsignificantly since 2015), legal protection of property rights has been improving, and China is already the second-largesteconomy in the world and could ultimately replace the United States as the world’s largest. Thus, China is becomingincreasingly attractive as a place in which to do business, and given the future growth trajectory, significant opportunitiesmay be lost by not investing in the country. We will explore how changes in political economy affect the attractivenessof a nation as a place in which to do business in Chapter 3.

Key Termspolitical economy, p. 40political system, p. 41collectivism, p. 41socialists, p. 41communists, p. 41social democrats, p. 41privatization, p. 42individualism, p. 42democracy, p. 43totalitarianism, p. 43representative democracy, p. 43communist totalitarianism, p. 45theocratic totalitarianism, p. 45tribal totalitarianism, p. 46right-wing totalitarianism, p. 46market economy, p. 46command economy, p. 47legal system, p. 49common law, p. 49civil law system, p. 49theocratic law system, p. 49contract, p. 50contract law, p. 50United Nations Convention on Contracts for the International Sale of Goods (CISG), p. 50property rights, p. 51private action, p. 51public action, p. 51Foreign Corrupt Practices Act (FCPA), p. 54intellectual property, p. 55patent, p. 55copyrights, p. 55trademarks, p. 55World Intellectual Property Organization, p. 55Paris Convention for the Protection of Industrial Property, p. 55product safety laws, p. 57product liability, p. 57

SUMMARYThis chapter has reviewed how the political, economic, and legal systems of countries vary. The potential benefits,costs, and risks of doing business in a country are a function of its political, economic, and legal systems. The chaptermade the following points:

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Political systems can be assessed according to two dimensions: the degree to which they emphasizecollectivism as opposed to individualism and the degree to which they are democratic or totalitarian.Collectivism is an ideology that views the needs of society as being more important than the needs of theindividual. Collectivism translates into an advocacy for state intervention in economic activity and, in thecase of communism, a totalitarian dictatorship.Individualism is an ideology that is built on an emphasis of the primacy of the individual’s freedoms in thepolitical, economic, and cultural realms. Individualism translates into an advocacy for democratic ideals andfree market economics.Democracy and totalitarianism are at different ends of the political spectrum. In a representative democracy,citizens periodically elect individuals to represent them, and political freedoms are guaranteed by aconstitution. In a totalitarian state, political power is monopolized by a party, group, or individual, and basicpolitical freedoms are denied to citizens of the state.There are three broad types of economic systems: a market economy, a command economy, and a mixedeconomy. In a market economy, prices are free of controls, and private ownership is predominant. In acommand economy, prices are set by central planners, productive assets are owned by the state, and privateownership is forbidden. A mixed economy has elements of both a market economy and a commandeconomy.Differences in the structure of law between countries can have important implications for the practice ofinternational business. The degree to which property rights are protected can vary dramatically from countryto country, as can product safety and product liability legislation and the nature of contract law.

Critical Thinking and Discussion QuestionsFree market economies stimulate greater economic growth, whereas state-directed economies stifle growth.Discuss.A democratic political system is an essential condition for sustained economic progress. Discuss.What is the relationship between corruption in a country (i.e., government officials taking bribes) andeconomic growth? Is corruption always bad?You are the CEO of a company that has to choose between making a $100 million investment in Russia orPoland. Both investments promise the same long-run return, so your choice is driven by risk considerations.Assess the various risks of doing business in each of these nations. Which investment would you favor andwhy?Read the Management Focus “Did Walmart Violate the Foreign Corrupt Practices Act?” What is youropinion? If you think it did, what do you think the consequences will be for Walmart?

global EDGE research task globaledge.msu.eduUse the globalEDGE™ website (globaledge.msu.edu) to complete the following exercises:

The definition of words and political ideas can have different meanings in different contexts worldwide. Infact, the Freedom in the World survey published by Freedom House evaluates the state of political rights andcivil liberties around the world. Provide a description of this survey and a ranking (in terms of “freedom”) ofthe world’s country leaders and laggards. What factors are taken into consideration in this survey?As the chapter discusses, differences in political, economic, and legal systems have considerable impact onthe benefits, costs, and risks of doing business in various countries. The World Bank’s “Doing BusinessIndicators” measure the extent of business regulations in countries around the world. Compare Brazil, Ghana,India, New Zealand, the United States, Sweden, and Turkey in terms of how easily contracts are enforced,how property can be registered, and how investors can be protected. Identify in which area you see thegreatest variation from one country to the next.

CLOSING CASE

Transformation in Saudi ArabiaThe desert kingdom of Saudi Arabia is a rarity in the modern world, an absolute monarchy whose laws are based uponinterpretations of a religious text, the Qur’an, the holy book of Islam. Despite Saudi Arabia's adherence to an archaic

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form of government, the Saudi economy has historically performed well, primarily due to the country’s position as theworld’s largest oil exporter. In 2017, the country’s GDP per capita on a purchasing power parity basis was $54,500, notfar behind the $59,800 GDP per capita of the United States.

The oil sector accounts for around 87 percent of government revenues, 42 percent of GDP, and 90 percent of exportearnings. In times of high oil prices, the Saudi government has used oil revenues to finance a sprawling governmentapparatus and to subsidize energy prices, which are among the lowest in the world. In 2014, however, oil pricescollapsed, wiping out an annual government surplus. In 2014, the government deficit ballooned to 15 percent of GDP,and it hit 20 percent of GDP in 2016, forcing the country to issue more debt and draw down its foreign exchangereserves. Higher oil prices improved the situation in 2017 and 2018, but the crisis exposed the vulnerability of SaudiArabia to a fall in oil prices.

To compound matters, Saudi Arabia has a young population—some 70 percent of the population is under the age of30—and unemployment is high at 12 percent, a combination of factors that many see as a recipe for social unrest. Thehigh unemployment reflects the fact that while there are jobs available outside of the government sector, most of themare taken by low-paid foreign workers, who account for 80 percent of the labor force.

Following the death of his brother, in January 2015 Salman bin Abd al-Aziz Al Saud became King. Breaking withtradition, the aging King quickly devolved substantial power to his son, crown prince Muhammad bin Salman(commonly known as “MBS”). The young crown prince articulated a different vision for Saudi Arabia. Knownas Vision 2030, this calls for reducing the kingdom’s dependence on oil revenues, privatizing the state-owned oilcompany Saudi Aramco, cutting energy and water subsidies, growing the private sector, investing $500 billion in a newcity called NEOM that will serve as a hub for private and foreign investment, and introducing a value-added tax in orderto close the government deficit. At the same time, the crown prince is seeking to loosen the stifling moral codes that havelimited cultural life and to promote a “moderate Islam open to the world and all religions.”

Not surprisingly, this vision has met with resistance, particularly from members of the sprawling royal family andconservative clergy who have benefited from the status quo. To counter this, the crown prince consolidated his power,removing members of the royal family that disagreed with him and putting his allies in positions of power. Thisculminated in an unprecedented shake-up in November 2017 when scores of people, including some of the mostpowerful princes in the kingdom, were arrested in a massive anticorruption sweep and jailed in, of all places, Riyadh’sopulent Ritz Carlton.

Whether this power grab will help the crown prince achieve his goals for Saudi Arabia remains to be seen. Thegovernment has had to backtrack on plans to reduce subsidies after strong resistance from the population, but it didintroduce a 5 percent value-added tax in January 2018.

Plans for the privatization of Saudi Aramco are under way, and the government budget deficit has been cut in halfsince 2015—although stronger oil prices have had a lot to do with that. Some of the stricter laws have also been relaxed.Women are now allowed to drive, and some banned cultural entertainments once seen as decadent, including going to thecinema, are now allowed. In the long run though, transforming the Saudi economy will require growth in the non-oilprivate sector, and that is a challenging task.

Moreover, a scandal surrounding the murder of Washington Post journalist Jamal Khoshoggi by Saudi operatives inTurkey in October 2018 has at the very least potentially weakened the power of the crown prince. Khoshoggi, a Saudicitizen and U.S. resident, was a critic of the Saudi regime. Although the Saudi government has claimed that his killingwas the result of a rogue operation gone wrong, few believe that narrative. Many critics suspect that Muhammad binSalman was aware of plans to arrest Khoshoggi. Indeed, there is growing evidence that, back in 2017, MBS authorized asecret campaign to silence dissenters, which included the surveillance, kidnapping, detention, and torture of Saudicitizens. Khoshoggi was just the highest-profile case in that operation. In the wake of Khoshoggi’s murder, some foreigninvestors have reconsidered their ties with the kingdom, and there is little doubt that the fallout from the scandal hasmade it more difficult for the Saudis to attract foreign investment.

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Bandar Algaloud/Saudi Kingdom Council/Handout/Anadolu Agency/Getty Images

Sources: Asa Fitch, “Saudi Arabia Plans Record Spending in New Budget,” The Wall Street Journal, December 19, 2017; Brittany De Lea, “Saudi Citizens Plagued by New Taxes, HighUnemployment after Oil Price Collapse,” Fox Business, October 26, 2017; “Saudi Arabia’s Unprecedented Shake-up,” The Economist, November 5, 2017; Mark Mazzetti and BenHubbard, “It Wasn’t Just Khashoggi: A Saudi Prince’s Brutal Drive to Crush Dissent,” The New York Times, March 17, 2019.

Case Discussion QuestionsWhat long-term economic and political problems does Saudi Arabia face?How might the reforms proposed by Muhammad bin Salman potentially address these problems? Who will gainfrom these reforms? Who might object and push back against them?Current plans for Saudi Aramco call for the state-owned oil company to be privatized. An initial public offering(IPO) is tentatively scheduled for 2021. What are the potential benefits to Saudi Arabia of privatizing SaudiAramco? Is there a downside?Is it morally correct for international businesses to invest in a country that denies basic rights to women?Is it morally correct for international businesses to invest in an autocratic country where the current leader hasbeen implicated in ordering the murder of one of his critics?

Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education

Endnotes

1. As we shall see, there is not a strict one-to-one correspondence between political systems and economic systems.A. O. Hirschman, “The On-and-Off Again Connection between Political and Economic Progress,” AmericanEconomic Review 84, no. 2 (1994), pp. 343–48.

2. For a discussion of the roots of collectivism and individualism, see H. W. Spiegel, The Growth of EconomicThought (Durham, NC: Duke University Press, 1991). A discussion of collectivism and individualism can befound in M. Friedman and R. Friedman, Free to Choose (London: Penguin Books, 1980).

3. For a classic summary of the tenets of Marxism, see A. Giddens, Capitalism and Modern Social Theory(Cambridge, UK: Cambridge University Press, 1971).

4. Smith, Adam. The Wealth of Nations. The Modern Library. Random House, Inc., 1937.5. R. Wesson, Modern Government—Democracy and Authoritarianism, 2nd ed. (Englewood Cliffs, NJ: Prentice

Hall, 1990).6. For a detailed but accessible elaboration of this argument, see Friedman and Friedman, Free to Choose. Also see

P. M. Romer, “The Origins of Endogenous Growth,” Journal of Economic Perspectives 8, no. 1 (1994), pp. 2–32.7. T. W. Lippman, Understanding Islam (New York: Meridian Books, 1995).8. “Islam’s Interest,” The Economist, January 18, 1992, pp. 33–34.9. M. El Qorchi, “Islamic Finance Gears Up,” Finance and Development, December 2005, pp. 46–50; S. Timewell,

“Islamic Finance—Virtual Concept to Critical Mass,” The Banker, March 1, 2008, pp. 10–16; Lydia Yueh,“Islamic Finance Growing Fast, But Can It Be More Than a Niche Market?” BBC News, April 14, 2014.

10. This information can be found on the UN’s treaty website atwww.uncitral.org/uncitral/en/uncitral_texts/sale_goods/1980CISG.html.

11. International Court of Arbitration, www.iccwbo.org/index_court.asp.12. D. North, Institutions, Institutional Change, and Economic Performance (Cambridge, UK: Cambridge University

Press, 1991).

13. “China’s Next Revolution,” The Economist, March 10, 2007, p. 9.14. P. Klebnikov, “Russia’s Robber Barons,” Forbes, November 21, 1994, pp. 74–84; C. Mellow, “Russia: Making

Cash from Chaos,” Fortune, April 17, 1995, pp. 145–51; “Mr. Tatum Checks Out,” The Economist, November 9,1996, p. 78.

15. K. van Wolferen, The Enigma of Japanese Power (New York: Vintage Books, 1990), pp. 100–105.16. P. Bardhan, “Corruption and Development: A Review of the Issues,” Journal of Economic Literature, September

1997, pp. 1320–46.17. Transparency International, “Global Corruption Report, 2014,” www.transparency.org, 2014.18. Transparency International, Corruption Perceptions Index 2016, www.transparency.org.19. J. Coolidge and S. Rose Ackerman, “High Level Rent Seeking and Corruption in African Regimes,” World Bank

policy research working paper no. 1780, June 1997; K. Murphy, A. Shleifer, and R. Vishny, “Why Is Rent-Seeking So Costly to Growth?” AEA Papers and Proceedings, May 1993, pp. 409–14; M. Habib and L.Zurawicki, “Corruption and Foreign Direct Investment,” Journal of International Business Studies 33 (2002), pp.291–307; J. E. Anderson and D. Marcouiller, “Insecurity and the Pattern of International Trade,” Review ofEconomics and Statistics 84 (2002), pp. 342–52; T. S. Aidt, “Economic Analysis of Corruption: A Survey,” TheEconomic Journal 113 (November 2003), pp. 632–53; D. A. Houston, “Can Corruption Ever Improve anEconomy?” Cato Institute 27 (2007), pp. 325–43; S. Rose Ackerman and B.J. Palifka, Corruption andGovernment, 2nd ed. (Cambridge, UK: Cambridge University Press, 2016).

20. Details can be found at www.oecd.org/corruption/oecdantibriberyconvention.htm.21. D. Stackhouse and K. Ungar, “The Foreign Corrupt Practices Act: Bribery, Corruption, Record Keeping and

More,” Indiana Lawyer, April 21, 1993.22. For an interesting discussion of strategies for dealing with the low cost of copying and distributing digital

information, see the chapter on rights management in C. Shapiro and H. R. Varian, Information Rules (Boston:Harvard Business School Press, 1999). Also see C. W. L. Hill, “Digital Piracy,” Asian Pacific Journal ofManagement, 2007, pp. 9–25.

23. Douglass North has argued that the correct specification of intellectual property rights is one factor that lowers thecost of doing business and, thereby, stimulates economic growth and development. See North, Institutions,Institutional Change, and Economic Performance.

24. Business Software Alliance, “Ninth Annual BSA Global Software Piracy Study,” May 2012, www.bsa.org.25. Business Software Alliance, “Ninth Annual BSA Global Software Piracy Study,” May 2012, www.bsa.org.26. “Trade Tripwires,” The Economist, August 27, 1994, p. 61.

LO3-1

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part two National Differences

National Differences in Economic Development

LEARNING OBJECTIVESAfter reading this chapter, you will be able to:

Explain what determines the level of economic development of a nation.

Identify the macropolitical and macroeconomic changes occurring worldwide.

Describe how transition economies are moving toward market-based systems.Explain the implications for management practice of national difference in political economy.

Andrzej Fryda/Shutterstock

Poland: Eastern Europe’s Economic Miracle

OPENING CASEAs the great financial crisis of 2008 and 2009 unfolded, countries across Europe were hit hard. A notable exception was Poland,whose economy grew by 1.5 percent during 2009, while every other economy in the European Union contracted, as did the UnitedStates’. Poland’s impressive economic performance continued after the crisis. Between 2010 and 2018, Poland’s growth rateaveraged 3.5 percent per annum, the best in Europe. This country of 38 million now has the largest economy among the post-Communist states of Eastern Europe. How did Poland achieve this?

In 1989, Poland elected its first democratic government after more than four decades of Communist rule. The Governmentmoved quickly to shift the economy away from the centrally planned Soviet model it had been operating under since 1945. Polandembraced market-based economic policies and quickly implemented them through a “shock therapy” program. The country openedits markets to international trade and foreign investment, privatized many state-owned businesses, and made it much easier forentrepreneurs to start their own businesses. In 2004, the country joined the European Union and subsequently adopted the euro,

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giving it easy access to the large consumer markets of Western Europe. All this helped transform Poland into an export powerhouse.Exports now account for 54 percent of GDP, compared to 34 percent in 2004. By way of comparison, exports account for 30 percentof GDP in the United Kingdom, and just 12 percent in the United States. Poland’s exports include machinery and transportationequipment, intermediate manufactured goods, furniture, hardwood products, food, and casual clothing. As a consequence of thesechanges, between 1989 and 2018 Poland recorded the highest sustained growth in the region. Living standards, measured by GDP percapita at purchasing power parity increased 2.7 times, compared to 1.7 times in the neighboring Czech Republic.

Poland’s government has also been fiscally conservative, keeping public debt in check, not allowing it to expand during therecession as many other countries did. This led to investor confidence in the country. Consequently, there was no large outflow offunds during the 2008–2009 economic turmoil. This stands in stark contrast to what happened in the Baltic states, where investorspulled money out of those economies during 2008 and 2009, driving their currencies down, raising the cost of government debt, andprecipitating a full-blown economic crisis that required the IMF and EU to step in with financial assistance.

A tight monetary squeeze in the early 2000s, which was designed to curb inflation and ease Poland’s entry into the EuropeanUnion, headed off the asset price bubble, particularly surging home prices that hurt so many other economies around the world.Ironically, the Polish government had been criticized for its tight monetary policy earlier in the decade, but in 2008 and 2009 it servedthe country well. Post 2009, the Government has continued to adhere to a fairly conservative management of the economy. In 2018,the Government deficit as a percentage of GDP was 1.6 percent, safely below the 3 percent European Union requirement for membersof the euro zone. As of 2018, economic growth remains strong, inflation is low at under 2 percent, and the unemployment rate of 3.7percent is the lowest since 1989.

None of this is to say that Poland is a model state. Looking forward, the country faces several significant economic challenges.First, the work force is aging. Poland faces a shortage of labor in the coming years. For Poland to continue to expand economically, itneeds more immigration. Despite some anti-immigration sentiment in the country, the Polish government has been issuingsubstantially more work permits to immigrants, the majority of whom have come from the Ukraine. Second, the Government recentlylowered the retirement age (which exacerbates the labor shortage) and raised social security payments, moves which could createfiscal problems down the road. Third, despite substantial privatization after 1990, Poland still has a mixed economy with severalmajor state-owned enterprises. The government controls the two largest banks, the biggest insurer, and two defense groups, as well asimportant energy, mining, and petrochemical companies. Political constraints and ongoing interference mean that these enterprisesare not always as well managed as they might be and begs the question of whether further privatization is warranted.Sources: Daniel Tilles, “Poland’s Anti-Immigration Government Is Overseeing one of Europe’s Biggest Waves of Immigration,” Notes From Poland, October 3, 2018; J.Rostowski, “The Secret of Poland’s Success,” The Wall Street Journal, February 1, 2010, p. 15; “Not Like the Neighbors,” The Economist, April 25, 2009, p. 55; “Ahead ofElections, Poland’s Ruling Party Offers Huge Handouts,” The Economist, February 28, 2019; “Poland’s State Owned Giants Cope with Unprecedented Turnover,” TheEconomist, November 29, 2018; World Bank, World Development Indicators Online, Accessed March 22, 2019.

IntroductionIn Chapter 2, we described how countries differ with regard to their political systems, economic systems, and legalsystems. In this chapter, we build on this material to explain how these differences influence the level of economicdevelopment of a nation and, thus, how attractive it is as a place for doing business. We also look at how economic,political, and legal systems are changing around the world and what the implications of this are for the future rate ofeconomic development of nations and regions. The past three decades have seen a general move toward more democraticforms of government, market-based economic reforms, and adoption of legal systems that better enforce property rights.Taken together, these trends have helped foster greater economic development around the world and have created a morefavorable environment for international business. In the final section of this chapter, we pull all this material together toexplore how differences in political, economic, and legal institutions affect the benefits, costs, and risks of doingbusiness in different nations.

The opening case, which looks at the performance of the Polish economy since 1990, highlights some of theseissues. Over the last 30 years Poland has had one of the best performing economies in Europe. This achievement was dueto a number of positive factors, including the adoption of a democratic political system, market-based economic reforms,privatization of state-owned enterprises, the reduction of barriers to private enterprise formation, and pro-trade policies,including joining the World Trade Organization and the European Union. As a consequence of these changes, todayPoland has a dynamic export-led economy that has substantially raised real living standards for its population. However,Poland now faces labor shortages, which could constrain its economic growth going forward. To continue to grow, itmay have to expand its labor force through higher immigration. In recognition of this, its government has recently issuedmore work permits to immigrants from its troubled neighbor, the Ukraine.

Differences in Economic Development

LO3-1Explain what determines the level of economic development of a nation.Different countries have dramatically different levels of economic development. One common measure of economicdevelopment is a country’s gross national income (GNI) per head of population. GNI is regarded as a yardstick for theeconomic activity of a country; it measures the total annual income received by residents of a nation. Map 3.1summarizes the GNI per capita of the world’s nations in 2018. As can be seen, countries such as Japan, Sweden,Switzerland, the United States, and Australia are among the richest on this measure, whereas the large developingcountries of China and India are significantly poorer. Japan, for example, had a 2018 GNI per capita of $41,340, butChina achieved only $9,470 and India just $2,020.1

MAP 3.1 GNI per capita, 2018.

GNI per person figures can be misleading because they don’t consider differences in the cost of living. Forexample, although the 2018 GNI per capita of Switzerland at $83,580 exceeded that of the United States by a widemargin, the higher cost of living in Switzerland meant that U.S. citizens could actually afford almost as many goods andservices as the average Swiss citizen. To account for differences in the cost of living, one can adjust GNI per capita bypurchasing power. Referred to as a purchasing power parity (PPP) adjustment, it allows a more direct comparison ofliving standards in different countries. The base for the adjustment is the cost of living in the United States. The PPP fordifferent countries is then adjusted (up or down) depending on whether the cost of living is lower or higher than in theUnited States. For example, in 2018 the GNI per capita for China was $9,470 but the PPP per capita was $18,140,suggesting that the cost of living was lower in China and that $9,470 in China would buy as much as $18,140 in theUnited States. Table 3.1 gives the GNI per capita measured at PPP in 2018 for a selection of countries, along with theirGNI per capita, their average annual growth rate in gross domestic product (GDP) from 2009 to 2018, and the overallsize of their economy (measured by GDP). Map 3.2 summarizes the GNI PPP per capita in 2018 for the nations of the

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world.

TABLE 3.1 Economic Data for Select CountriesS o u r c e: Wor l d D e velopment Indicators Online, 2018.

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MAP 3.2 GNI PPP per capita, 2018.

As can be seen, there are striking differences in the standards of living among countries. Table 3.1 suggests theaverage Indian citizen can afford to consume only about 12 percent of the goods and services consumed by the averageU.S. citizen on a PPP basis. Given this, we might conclude that despite having a population of 1.2 billion, India isunlikely to be a very lucrative market for the consumer products produced by many Western international businesses.However, this would be incorrect because India has a fairly wealthy middle class of close to 250 million people, despiteits large number of poor citizens. In absolute terms, the Indian economy now rivals that of Russia.

Did You Know?Did you know that by 2050 India may be the second largest economy in the world and Indonesia the fourth?Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation fromthe authors.

To complicate matters, in many countries the “official” figures do not tell the entire story. Large amounts ofeconomic activity may be in the form of unrecorded cash transactions or barter agreements. People engage in suchtransactions to avoid paying taxes, and although the share of total economic activity accounted for by such transactionsmay be small in developed economies such as the United States, in some countries (India being an example), they arereportedly very significant. Known as the black economy or shadow economy, estimates suggest that in India it has beenas high as 50 percent of GDP, which implies that the Indian economy may be half as big again as the figuresreported in Table 3.1. Estimates produced by the European Union suggest that the shadow economy accountedfor between 10 and 12 percent of GDP in the United Kingdom and France but 21 percent in Italy and as much as 23percent in Greece.2

The GNI and PPP data give a static picture of development. They tell us, for example, that China is poorer than theUnited States, but they do not tell us if China is closing the gap. To assess this, we have to look at the economic growthrates achieved by countries. Table 3.1 gives the rate of growth in gross domestic product (GDP) per capita achieved by anumber of countries between 2009 and 2018. Map 3.3 summarizes the annual average percentage growth rate in GDPfrom 2009 to 2018. Although countries such as China and India are currently relatively poor, their economies are already

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large in absolute terms and growing far more rapidly than those of many advanced nations. They are already hugemarkets for the products of international businesses. In 2010, China overtook Japan to become the second-largesteconomy in the world after the United States. Indeed, if both China and the United States maintain their currenteconomic growth rates, China will become the world’s largest economy sometime during the next decade. On currenttrends, India too will be among the largest economies in the world. Given that potential, many internationalbusinesses are trying to establish a strong presence in these markets.

MAP 3.3 Average annual growth rate in GDP (%), 2009–2018.

global EDGE COUNTRY COMPARATOR

The “Country Comparator” tool on globalEDGE™ (globaledge.msu.edu/comparator) includes data from as early as 1960 to the mostrecent year. Using this tool, it is easy to compare countries across a variety of macro variables to better understand the economic changesoccurring in countries. As related to Chapter 3, the globalEDGE™ Country Comparator tool is an effective way to statistically get anoverview of the political economy and economic development by country worldwide. Comparisons of up to 20 countries at a time can bemade in table format. Sometimes we talk about the BRIC countries when referring to Brazil, Russia, India, and China—in essence, webroadly classify them as “superstar” emerging markets, but are they really that similar? Using the Country Comparator tool onglobalEDGE, we find that the GDP adjusted for purchasing power parity is by far the greatest in Russia. Where do you think Brazil,India, and China fall on the GDP PPP scale?

BROADER CONCEPTIONS OF DEVELOPMENT: AMARTYA SENThe Nobel Prize–winning economist Amartya Sen has argued that development should be assessed less by materialoutput measures such as GNI per capita and more by the capabilities and opportunities that people enjoy.3 According toSen, development should be seen as a process of expanding the real freedoms that people experience. Hence,development requires the removal of major impediments to freedom: poverty as well as tyranny, poor economic

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opportunities as well as systematic social deprivation, and neglect of public facilities as well as the intolerance ofrepressive states. In Sen’s view, development is not just an economic process but a political one too, and to succeedrequires the “democratization” of political communities to give citizens a voice in the important decisions made for thecommunity. This perspective leads Sen to emphasize basic health care, especially for children, and basic education,especially for women. Not only are these factors desirable for their instrumental value in helping achieve higher incomelevels, but they are also beneficial in their own right. People cannot develop their capabilities if they are chronically ill orwoefully ignorant.

Sen’s influential thesis has been picked up by the United Nations, which has developed the Human DevelopmentIndex (HDI) to measure the quality of human life in different nations. The HDI is based on three measures: lifeexpectancy at birth (a function of health care); educational attainment (measured by a combination of the adult literacyrate and enrollment in primary, secondary, and tertiary education); and whether average incomes, based on PPPestimates, are sufficient to meet the basic needs of life in a country (adequate food, shelter, and health care). As such, theHDI comes much closer to Sen’s conception of how development should be measured than narrow economic measuressuch as GNI per capita—although Sen’s thesis suggests that political freedoms should also be included in the index, andthey are not. The HDI is scaled from 0 to 1. Countries scoring less than 0.5 are classified as having low humandevelopment (the quality of life is poor), those scoring from 0.5 to 0.8 are classified as having medium humandevelopment, and those that score above 0.8 are classified as having high human development. Map 3.4 summarizes theHDI scores for 2017, the most recent year for which data are available.

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MAP 3.4 Human Development Index, 2017.

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Political Economy and Economic ProgressIt is often argued that a country’s economic development is a function of its economic and political systems. What thenis the nature of the relationship between political economy and economic progress? Despite the long debate over thisquestion among academics and policymakers, it is not possible to give an unambiguous answer. However, it is possibleto untangle the main threads of the arguments and make a few generalizations as to the nature of the relationship betweenpolitical economy and economic progress.

INNOVATION AND ENTREPRENEURSHIP ARE THE ENGINES OF GROWTHThere is substantial agreement among economists that innovation and entrepreneurial activity are the engines of long-runeconomic growth.4 Those who make this argument define innovation broadly to include not just new products, but alsonew processes, new organizations, new management practices, and new strategies. Thus, Uber’s strategy of letting ridershail a cab using a smartphone application can be seen as an innovation because it was the first company to pursue thisstrategy in its industry. Similarly, the development of mass-market online retailing by Amazon.com can be seen as aninnovation. Innovation and entrepreneurial activity help increase economic activity by creating new products andmarkets that did not previously exist. Moreover, innovations in production and business processes lead to anincrease in the productivity of labor and capital, which further boosts economic growth rates.5

Innovation is also seen as the product of entrepreneurial activity. Often, entrepreneurs first commercializeinnovative new products and processes, and entrepreneurial activity provides much of the dynamism in an economy. Forexample, the U.S. economy has benefited greatly from a high level of entrepreneurial activity, which has resulted inrapid innovation in products and process. Firms such as Apple, Google, Facebook, Amazon, Dell, Microsoft, Oracle, andUber were all founded by entrepreneurial individuals to exploit new technology. All these firms created significanteconomic value and boosted productivity by helping commercialize innovations in products and processes. Thus, we canconclude that if a country’s economy is to sustain long-run economic growth, the business environment must beconducive to the consistent production of product and process innovations and to entrepreneurial activity.

INNOVATION AND ENTREPRENEURSHIP REQUIRE A MARKET ECONOMYThis leads logically to a further question: What is required for the business environment of a country to be conducive toinnovation and entrepreneurial activity? Those who have considered this issue highlight the advantages of a marketeconomy.6 It has been argued that the economic freedom associated with a market economy creates greater incentivesfor innovation and entrepreneurship than either a planned or a mixed economy. In a market economy, any individual whohas an innovative idea is free to try to make money out of that idea by starting a business (by engaging in entrepreneurialactivity). Similarly, existing businesses are free to improve their operations through innovation. To the extent that theyare successful, both individual entrepreneurs and established businesses can reap rewards in the form of high profits.Thus, market economies contain enormous incentives to develop innovations.

In a planned economy, the state owns all means of production. Consequently, entrepreneurial individuals have feweconomic incentives to develop valuable new innovations because it is the state, rather than the individual, that capturesmost of the gains. The lack of economic freedom and incentives for innovation was probably a main factor in theeconomic stagnation of many former communist states and led ultimately to their collapse at the end of the 1980s.Similar stagnation occurred in many mixed economies in those sectors where the state had a monopoly (such as coalmining and telecommunications in Great Britain). This stagnation provided the impetus for the widespread privatizationof state-owned enterprises that we witnessed in many mixed economies during the mid-1980s and that is still going ontoday (privatization refers to the process of selling state-owned enterprises to private investors; see Chapter 2 for details).

A study of 102 countries over a 20-year period provided evidence of a strong relationship between economicfreedom (as provided by a market economy) and economic growth.7 The study found that the more economic freedom acountry had between 1975 and 1995, the more economic growth it achieved and the richer its citizens became. The sixcountries that had persistently high ratings of economic freedom from 1975 to 1995 (Hong Kong, Switzerland,Singapore, the United States, Canada, and Germany) were also all in the top 10 in terms of economic growth rates. Incontrast, no country with persistently low economic freedom achieved a respectable growth rate. In the 16 countries forwhich the index of economic freedom declined the most during 1975 to 1995, gross domestic product fell at an annualrate of 0.6 percent. Other studies have reached broadly similar conclusions.

INNOVATION AND ENTREPRENEURSHIP REQUIRE STRONG PROPERTY

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RIGHTSStrong legal protection of property rights is another requirement for a business environment to be conducive toinnovation, entrepreneurial activity, and hence economic growth.8 Both individuals and businesses must be given theopportunity to profit from innovative ideas. Without strong property rights protection, businesses and individuals run therisk that the profits from their innovative efforts will be expropriated, either by criminal elements or by the state. Thestate can expropriate the profits from innovation through legal means, such as excessive taxation, or through illegalmeans, such as demands from state bureaucrats for kickbacks in return for granting an individual or firm a license to dobusiness in a certain area (i.e., corruption). According to the Nobel Prize–winning economist Douglass North,throughout history many governments have displayed a tendency to engage in such behavior.9 Inadequatelyenforced property rights reduce the incentives for innovation and entrepreneurial activity—because the profits from suchacti vi t y are “st olen”—and hence r educe t he r ate of economic gr owth.

The influential Peruvian development economist Hernando de Soto has argued that much of the developing worldwill fail to reap the benefits of capitalism until property rights are better defined and protected.10 De Soto’s argumentsare interesting because he says the key problem is not the risk of expropriation but the chronic inability of propertyowners to establish legal title to the property they own. As an example of the scale of the problem, he cites the situationin Haiti, where individuals must take 176 steps over 19 years to own land legally. Because most property in poorcountries is informally “owned,” the absence of legal proof of ownership means that property holders cannot converttheir assets into capital, which could then be used to finance business ventures. Banks will not lend money to the poor tostart businesses because the poor possess no proof that they own property, such as farmland, that can be used ascollateral for a loan. By de Soto’s calculations, the total value of real estate held by the poor in third-world and formercommunist states amounted to more than $9.3 trillion in 2000. If those assets could be converted into capital, the resultcould be an economic revolution that would allow the poor to bootstrap their way out of poverty. Interestingly enough,the Chinese seem to have taken de Soto’s arguments to heart. Despite still being nominally a communist country, inOctober 2007 the government passed a law that gave private property owners the same rights as the state, whichsignificantly improved the rights of urban and rural landowners to the land that they use (see the accompanying CountryFocus).

THE REQUIRED POLITICAL SYSTEMMuch debate surrounds which kind of political system best achieves a functioning market economy with strongprotection for property rights.11 People in the West tend to associate a representative democracy with a market economicsystem, strong property rights protection, and economic progress. Building on this, we tend to argue that democracy isgood for growth. However, some totalitarian regimes have fostered a market economy and strong property rightsprotection and have experienced rapid economic growth. Five of the fastest-growing economies of the past 40 years—China, South Korea, Taiwan, Singapore, and Hong Kong—had one thing in common at the start of their economicgrowth: undemocratic governments. At the same time, countries with stable democratic governments, such as India,experienced sluggish economic growth for long periods. In 1992, Lee Kuan Yew, Singapore’s leader for many years,told an audience, “I do not believe that democracy necessarily leads to development. I believe that a country needs todevelop discipline more than democracy. The exuberance of democracy leads to undisciplined and disorderly conductwhich is inimical to development.”12

However, those who argue for the value of a totalitarian regime miss an important point: If dictators made countriesrich, then much of Africa, Asia, and Latin America should have been growing rapidly during 1960 to 1990, and this wasnot the case. Only a totalitarian regime that is committed to a market system and strong protection of property rights iscapable of promoting economic growth. Also, there is no guarantee that a dictatorship will continue to pursue suchprogressive policies. Dictators are rarely benevolent. Many are tempted to use the apparatus of the state to further theirown private ends, violating property rights and stalling economic growth. Given this, it seems likely that democraticregimes are far more conducive to long-term economic growth than are dictatorships, even benevolent ones. Only in awell-functioning, mature democracy are property rights truly secure.13 Nor should we forget Amartya Sen’s argumentsreviewed earlier. Totalitarian states, by limiting human freedom, also suppress human development and therefore aredetrimental to progress.

ECONOMIC PROGRESS BEGETS DEMOCRACYWhile it is possible to argue that democracy is not a necessary precondition for a market economy in which propertyrights are protected, subsequent economic growth often leads to establishment of a democratic regime. Severalof the fastest-growing Asian economies adopted more democratic governments during the past three decades,including South Korea and Taiwan. Thus, although democracy may not always be the cause of initial economic progress,

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it seems to be one consequence of that progress.

COUNTRY FOCUS

Property Rights in ChinaOn October 1, 2007, a new property law took effect in China, granting rural and urban landholders far more secure property rights.The law was a much-needed response to how China’s economy has changed over the past 30 years as it transitions from a centrallyplanned system to a more dynamic market-based economy where two-thirds of economic activity is in the hands of privateenterprises.

Although all land in China still technically belongs to the state—an ideological necessity in a country where the governmentstill claims to be guided by Marxism—urban landholders had been granted 40- to 70-year leases to use the land, while ruralfarmers had 30-year leases. However, the lack of legal title meant that landholders were at the whim of the state. Large-scaleappropriation of rural land for housing and factory construction had rendered millions of farmers landless. Many were given littleor no compensation, and they drifted to the cities where they added to a growing underclass. In both urban and rural areas,property and land disputes had become a leading cause of social unrest. According to government sources, in 2006 there wereabout 23,000 “mass incidents” of social unrest in China, many related to disputes over property rights.

The 2007 law, which was 14 years in gestation due to a rearguard action fought by left-wing Communist Party activists whoobjected to it on ideological grounds, gives urban and rural land users the right to automatic renewal of their leases after theexpiration of the 30- to 70-year terms. In addition, the law requires that land users be fairly compensated if the land is required forother purposes, and it gives individuals the same legal protection for their property as the state. Taken together with a 2004 changein China’s constitution, which stated that private property “was not to be encroached upon,” the new law significantly strengthensproperty rights in China.

Nevertheless, the law has its limitations; most notably, it still falls short of giving peasants marketable ownership rights to theland they farm. If they could sell their land, tens of millions of underemployed farmers might find more productive workelsewhere. Those who stayed could acquire bigger landholdings that could be used more efficiently. Also, farmers might be able touse their landholdings as security against which they could borrow funds for investments to boost productivity.

Recognizing such limitations, in 2016 the ruling Communist Party released a set of guidelines for further shoring up propertyrights protection, including better legal enforcement of property rights. There is no doubt that additional protection is needed.Chinese firms and residents have continued to suffer under poor property protections, facing eviction to make way for newdevelopments and facing fierce competition as patents and copyrights are repeatedly violated. Whether these new guidelines willimprove matters, however, remains to be seen.Sources: “China’s Next Revolution—Property Rights in China,” The Economist, March 10, 2007, p. 11; “Caught between the Right and Left,” The Economist, March 10,2007, pp. 25–27; Z. Keliang and L. Ping, “Rural Land Rights under the PRC Property Law,” China Law and Practice, November 2007, pp. 10–15; and Sara Hsu, “China IsFinally Improving Property Rights Protection,” Forbes, November 30, 2016.

A strong belief that economic progress leads to adoption of a democratic regime underlies the fairly permissiveattitude that many Western governments have adopted toward human rights violations in China. Although China has atotalitarian government in which human rights are violated, many Western countries have been hesitant to criticize thecountry too much for fear that this might hamper the country’s march toward a free market system. The belief is thatonce China has a free market system, greater individual freedoms and democracy will follow. Whether this optimisticvision comes to pass remains to be seen.

GEOGRAPHY, EDUCATION, DEMOGRAPHICS, AND ECONOMICDEVELOPMENTWhile a country’s political and economic systems are probably the big engine driving its rate of economic development,other factors are also important. One that has received attention is geography.14 But the belief that geographycan influence economic policy, and hence economic growth rates, goes back to Adam Smith. The influentialeconomist Jeffrey Sachs argues that

throughout history, coastal states, with their long engagements in international trade, have been more supportive of marketinstitutions than landlocked states, which have tended to organize themselves as hierarchical (and often militarised) societies.Mountainous states, as a result of physical isolation, have often neglected market-based trade. Temperate climes have generallysupported higher densities of population and thus a more extensive division of labour than tropical regions.15

Sachs’s point is that by virtue of favorable geography, certain societies are more likely to engage in trade thanothers and are thus more likely to be open to and develop market-based economic systems, which in turn promotes fastereconomic growth. He also argues that, irrespective of the economic and political institutions a country adopts, adverse

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geographic conditions—such as the high rate of disease, poor soils, and hostile climate that afflict many tropicalcountries—can have a negative impact on development. Together with colleagues at Harvard’s Institute for InternationalDevelopment, Sachs tested for the impact of geography on a country’s economic growth rate between 1965 and 1990. Hefound that landlocked countries grew more slowly than coastal economies and that being entirely landlocked reduced acountry’s growth rate by roughly 0.7 percent per year. He also found that tropical countries grew 1.3 percent moreslowly each year than countries in the temperate zone.

Education emerges as another important determinant of economic development (a point that Amartya Senemphasizes). The general assertion is that nations that invest more in education will have higher growth rates because aneducated population is a more productive population. Anecdotal comparisons suggest this is true. In 1960, Pakistanis andSouth Koreans were on equal footing economically. However, just 30 percent of Pakistani children were enrolled inprimary schools, while 94 percent of South Koreans were. By the mid-1980s, South Korea’s GNP per person was threetimes that of Pakistan.16 A survey of 14 statistical studies that looked at the relationship between a country’s investmentin education and its subsequent growth rates concluded investment in education did have a positive and statisticallysignificant impact on a country’s rate of economic growth.17 Similarly, the work by Sachs discussed earlier suggests thatinvestments in education help explain why some countries in Southeast Asia, such as Indonesia, Malaysia, andSingapore, have been able to overcome the disadvantages associated with their tropical geography and grow far morerapidly than tropical nations in Africa and Latin America.

Economists also argue that demographic forces are an important determinant of a country’s economic growth rate.Assuming a country has institutions in place that promote entrepreneurship and innovation, a country with a young andgrowing population has greater growth potential than one with an aging stagnant population.18 A growing populationincreases the supply of labor. Younger workers also tend to consume more than older retirees, which boosts demand forgoods and services. Moreover, an aging population implies that fewer workers are supporting more retirees, which canstress government finances. In the 1970s and 1980s, Japan had one of the most dynamic economies in the world, but lowbirthrates and an aging population have held back economic growth since the turn of the century. More generally, goingforward, low birthrates and an aging population could potentially cause labor shortages and slower economic growth in anumber of other major economies, including China, Germany, and the United States. One way around this is forcountries with an aging population to permit higher immigration. For example, as we saw in the opening case, Polandhas allowed for increased immigration from the Ukraine, largely as a strategy for coping with labor shortages due to anaging population. But immigration can bring political problems and is resisted in a number of countries (Japan, forexample, has tight restrictions on immigration despite predictions that the population could fall by 30 percent over thenext 40 years due to a very low birthrate).

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States in Transition

LO3-2Identify the macropolitical and macroeconomic changes occurring worldwide.The political economy of many of the world’s nation-states has changed radically since the late 1980s. Three trends havebeen evident. First, during the late 1980s and early 1990s, a wave of democratic revolutions swept the world. Totalitariangovernments fell and were replaced by democratically elected governments that were typically more committed to freemarket capitalism than their predecessors had been. Second, over the same period, there has been a move away fromcentrally planned and mixed economies and toward a more free market economic model. Third, and counter to the twoprior trends, since 2005 there has been a shift back toward greater authoritarianism in some nations, and there are somesigns that certain nations may be retreating from the free market model, particularly in the area of international tradewhere protectionism is on the rise again.

THE SPREAD OF DEMOCRACYOne notable development of the last 30 years has been the spread of democratic political institutions (and, by extension,

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the decline of totalitarianism). Map 3.5 reports on the extent of totalitarianism in the world as determined by FreedomHouse.19 This map charts political freedom in 2019, grouping countries into three broad groupings: free, partlyfree, and not free. In “free” countries, citizens enjoy a high degree of political and civil freedoms. “Partly free”countries are characterized by some restrictions on political rights and civil liberties, often in the context of corruption,weak rule of law, ethnic strife, or civil war. In “not free” countries, the political process is tightly controlled and basicfreedoms are denied.

MAP 3.5 Freedom in the world, 2019.

Freedom House classified some 86 countries as free in 2019, accounting for about 44 percent of the world’snations. These countries respect a broad range of political rights. Another 59 countries, accounting for 30 percent of theworld’s nations, were classified as partly free, while 51 countries representing approximately 26 percent of the world’snations were classified as not free.

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

Many of the newer democracies are to be found in eastern Europe and Latin America, although there also havebeen notable gains in Africa during this time, including South Africa and Nigeria. Entrants into the ranks of the world’sdemocracies during the last 30 years include Mexico, which held its first fully free and fair presidential election in 2000after free and fair parliamentary and state elections in 1997 and 1998; Senegal, where free and fair presidential electionsled to a peaceful transfer of power; and Nigeria, where in 2015 for the first time the opposition won an election and therewas a peaceful transfer of power.

Three main reasons account for the spread of democracy.20 First, many totalitarian regimes failed to delivereconomic progress to the vast bulk of their populations. The collapse of communism in eastern Europe, for example, wasprecipitated by the growing gulf between the vibrant and wealthy economies of the West and the stagnant economies ofthe communist East. In looking for alternatives to the socialist model, the populations of these countries could not havefailed to notice that most of the world’s strongest economies were governed by representative democracies. Today, theeconomic success of many of the newer democracies—such as Poland and the Czech Republic in the former communistbloc, the Philippines and Taiwan in Asia, and Chile in Latin America—has strengthened the case for democracy as a keycomponent of successful economic advancement.

Second, new information and communication technologies—including satellite television, desktop publishing, and,most important, the Internet and associated social media—have reduced a state’s ability to control access to uncensoredinformation. These technologies have created new conduits for the spread of democratic ideals and information from freesocieties. Today, the Internet is allowing democratic ideals to penetrate closed societies as never before.21 Young peoplewho utilized Facebook and Twitter to reach large numbers of people very quickly and coordinate their actions organizedthe demonstrations in 2011 that led to the overthrow of the Egyptian government.

Third, in many countries, economic advances have led to the emergence of increasingly prosperous middle andworking classes that have pushed for democratic reforms. This was certainly a factor in the democratic transformation ofSouth Korea. Entrepreneurs and other business leaders, eager to protect their property rights and ensure the dispassionateenforcement of contracts, are another force pressing for more accountable and open government.

Although democratic institutions became more widespread following the democratic revolutions of the late 1980s,Freedom House notes that, since 2005, there has been a drift back toward more authoritarian modes of government inmany nations. Between 1988 and 2005 the share of countries ranked “not free” dropped from 37 percent to 23 percent,and the share of countries ranked as “free” increased from 36 percent to 46 percent. However, from 2005 through to2019, the share of “not free” countries rose to 26 percent, while the share of countries ranked as “free” dropped to 44percent. Some 23 countries have suffered a negative status change since 2005. Many of these countries hadbenefited from the wave of democracy that swept around the world in 1988–1990, but have since backtrackedtoward a more authoritarian status. In general, in these nations, elections have been compromised, civil libertiesincluding freedom of expression and association have been restricted, the independent press has been attacked orsuppressed, and opposition political parties have been restricted.

Consider Turkey, where Recep Tayyip Erdogan was elected president in 2014. Erdogan used a failed coup attemptin 2016 to tighten his control over the country and consolidate power in the presidency. Opposition politicians have beenarrested and imprisoned, often on dubious charges. There have been frequent arrests and convictions of journalists andsocial media users who were critical of the government. There has also been a sharp rise in the number of people chargedunder a century-old archaic law that makes it a crime to “insult the president.” The number of prosecutions for this“crime” increased from almost nothing to over 6,000 in 2017. In 2017, Erdogan called and won a referendum onamending the constitution that extended the power of the President, allowing him to appoint judges and cabinetmembers, form and regulate ministries, draft budgets, and appoint or remove civil servants, mostly without parliamentaryapproval. Erdogan won the referendum by a narrow margin: 51.4 percent to 48.6 percent. He can now run for three moreterms. While it is true that this extended power was given to Erdogan in a democratic referendum, critics argue thatTurkey has now moved toward “one-man rule,” and that the Turks have in essence voted away their democracy by anarrow margin, allowing the ruling majority to entrench its position and marginalize any opposition. Freedom Housenow ranks Turkey as “not free.”

As in Turkey, authoritarianism has been gaining ground in several other countries where political and civil libertiesh ave be en pr ogr ess ivel y l i mi t ed i n r ecent year s, i ncl udi ng Russia, Ukrai ne, Indonesia, Ecuador , and Venezuela. Anincreasingly autocratic Russia annexed the Crimea region from the Ukraine in 2014 and has actively supported pro-Russi an r ebels in eastern Ukraine. Li bya, wh ere t her e was hop e t hat a democr acy might be est abl i shed, appears t o haveslipped into anarchy. In Egypt, after a brief flirtation with democracy, the military stepped in, removing the governmentof Mohamed Morsi, after Morsi and his political movement, the Muslim Brotherhood, exhibited its own authoritariant endenc i es. The mi lit ary – backed government, howe ver , has al so acted i n an aut horit ar ian manner, e f fecti vely rever sing

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much of the progress that occurred after the revolution of 2011. Of note, Freedom House also expressed concerns thatu nder the l eadershi p of Donal d Tr ump, Amer i ca has stepped back fr om i ts tr adi t i o na l role of pr omot i ng democracy andhuman rights around the world, a development that it views with some alarm, because pressure from the United Stateshas historically helped to spread democratic ideals.22

THE NEW WORLD ORDER AND GLOBAL TERRORISMThe end of the Cold War and the “new world order” that followed the collapse of communism in eastern Europe and theformer Soviet Union, taken together with the demise of many authoritarian regimes in Latin America, gave rise tointense speculation about the future shape of global geopolitics. In an influential book, 25 years ago author FrancisFukuyama argued, “We may be witnessing . . . the end of history as such: that is, the end point of mankind’s ideologicalevolution and the universalization of Western liberal democracy as the final form of human government.”23 Fukuyamawent on to argue that the war of ideas may be at an end and that liberal democracy has triumphed.

Many questioned Fukuyama’s vision of a more harmonious world dominated by a universal civilizationcharacterized by democratic regimes and free market capitalism. In a controversial book, the late influential politicalscientist Samuel Huntington argued there is no “universal” civilization based on widespread acceptance of Westernliberal democratic ideals.24 Huntington maintained that while many societies may be modernizing—they are adoptingthe material paraphernalia of the modern world, from automobiles and Facebook to Coca-Cola and smartphones—they are not becoming more Western. On the contrary, Huntington theorized that modernization in non-Western societies can result in a retreat toward the traditional, such as the resurgence of Islam in many traditionallyMuslim societies. He wrote,

The Islamic resurgence is both a product of and an effort to come to grips with modernization. Its underlying causes are thosegenerally responsible for indigenization trends in non-Western societies: urbanization, social mobilization, higher levels ofliteracy and education, intensified communication and media consumption, and expanded interaction with Western and othercultures. These developments undermine traditional village and clan ties and create alienation and an identity crisis. Islamistsymbols, commitments, and beliefs meet these psychological needs, and Islamist welfare organizations, the social, cultural, andeconomic needs of Muslims caught in the process of modernization. Muslims feel a need to return to Islamic ideas, practices, andinstitutions to provide the compass and the motor of modernization.25

Thus, the rise of Islamic fundamentalism is portrayed as a response to the alienation produced by modernization.In contrast to Fukuyama, Huntington envisioned a world split into different civilizations, each of which has its own

value systems and ideology. Huntington predicted conflict between the West and Islam and between the West and China.While some commentators originally dismissed Huntington’s thesis, in the aftermath of the terrorist attacks on the UnitedStates on September 11, 2001, Huntington’s views received new attention. The dramatic rise of the Islamic State (ISIS)in war-torn Syria and neighboring Iraq during 2014–2015 drew further attention to Huntington’s thesis, as has thegrowing penchant for ISIS to engage in terrorist acts outside the Middle East, as in Paris in 2015.

If Huntington’s views are even partly correct, they have important implications for international business. Theysuggest many countries may be difficult places in which to do business, either because they are shot through with violentconflicts or because they are part of a civilization that is in conflict with an enterprise’s home country. Huntington’sviews are speculative and controversial. More likely than his predictions coming to pass is the evolution of a globalpolitical system that is positioned somewhere between Fukuyama’s universal global civilization based on liberaldemocratic ideals and Huntington’s vision of a fractured world. That would still be a world, however, in whichgeopolitical forces limit the ability of business enterprises to operate in certain foreign countries.

As for terrorism, in Huntington’s thesis, global terrorism is a product of the tension between civilizations and theclash of value systems and ideology. The terror attacks undertaken by al-Qaeda and ISIS are consistent with this view.Others point to terrorism’s roots in long-standing conflicts that seem to defy political resolution—the Palestinian,Kashmir, and Northern Ireland conflicts being obvious examples. It is also true that much of the terrorism perpetrated byal-Qaeda affiliates in Iraq during the 2000s and more recently by ISIS in Iraq and Syria can be understood in part as astruggle between radicalized Sunni and Shia factions within Islam. Moreover, a substantial amount of terrorist activity insome parts of the world, such as Colombia, has been interwoven with the illegal drug trade. As former U.S. Secretary ofState Colin Powell has maintained, terrorism represents one of the major threats to world peace and economic progress inthe twenty-first century.26

THE SPREAD OF MARKET-BASED SYSTEMSParalleling the spread of democracy since the 1980s has been the transformation from centrally planned commandeconomies to market-based economies. More than 30 countries that were in the former Soviet Union or the easternEuropean communist bloc have changed their economic systems. A complete list of countries where change is nowoccurring also would include Asian states such as China and Vietnam, as well as African countries such asAngola, Ethiopia, and Mozambique.27 There has been a similar shift away from a mixed economy. Many states

in Asia, Latin America, and Western Europe have sold state-owned businesses to private investors (privatization) andderegulated their economies to promote greater competition.

ISIS fighters are a visible symbol of the rise of global terrorism in the post Cold War world.Medyan Dairieh/ZUMA Press, Inc./Alamy Stock Photo

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

Map 3.6, based on data from the Heritage Foundation, a politically conservative U.S. research foundation, givessome idea of the degree to which the world has shifted toward market-based economic systems. The HeritageFoundation’s index of economic freedom is based on 10 indicators, including the extent to which the governmentintervenes in the economy, trade policy, the degree to which property rights are protected, foreign investmentregulations, taxation rules, freedom from corruption, and labor freedom. A country can score between 100 (freest) and 0(least free) on each of these indicators. The higher a country’s average score across all 10 indicators, the more closely itseconomy represents the pure market model.

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MAP 3.6 Index of economic freedom, 2019.Source: “Interactive Heat Map.” The Heritage Foundation, 2019. www.heritage.org/index/heatmap.

According to the 2019 index, which is summarized in Map 3.6, the world’s freest economies are (in rank order)Hong Kong, Singapore, New Zealand, Switzerland, Australia, Ireland, United Kingdom, Canada, and the United ArabEmirates. The United States was ranked 12, Germany came in at 24, Japan at 30, Mexico at 66, France at 71, Russia at98, China at 100, India at 129, and Brazil at 150. The economies of Zimbabwe, Venezuela, Cuba, and North Korea are tobe found at the bottom of the rankings.28

Economic freedom does not necessarily equate with political freedom, as detailed in Map 3.6. For example, the twotop states in the Heritage Foundation index, Hong Kong and Singapore, cannot be classified as politically free. HongKong was reabsorbed into communist China in 1997, and the first thing Beijing did was shut down Hong Kong’s freelyelected legislature. Singapore is ranked as only partly free on Freedom House’s index of political freedom, due topractices such as widespread press censorship.

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The Nature of Economic Transformation

LO3-3Describe how transition economies are moving toward market-based systems.The shift toward a market-based economic system often entails a number of steps: deregulation, privatization, andcreation of a legal system to safeguard property rights.29

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DEREGULATIONDeregulation involves removing legal restrictions to the free play of markets, the establishment of private enterprises,and the manner in which private enterprises operate. Before the collapse of communism, the governments in mostcommand economies exercised tight control over prices and output, setting both through detailed state planning. Theyalso prohibited private enterprises from operating in most sectors of the economy, severely restricted direct investmentby foreign enterprises, and limited international trade. Deregulation in these cases involved removing price controls,thereby allowing prices to be set by the interplay between demand and supply; abolishing laws regulating theestablishment and operation of private enterprises; and relaxing or removing restrictions on direct investment by foreignenterprises and international trade.

In mixed economies, the role of the state was more limited; but here, too, in certain sectors the state set prices,owned businesses, limited private enterprise, restricted investment by foreigners, and restricted international trade. Forthese countries, deregulation has involved the same kind of initiatives that we have seen in former command economies,although the transformation has been easier because these countries often had a vibrant private sector. India is anexample of a country that has substantially deregulated its economy over the past two decades (see the upcomingCountry Focus).

COUNTRY FOCUS

India’s Economic TransformationAfter gaining independence from Britain in 1947, India adopted a democratic system of government. The economic system thatdeveloped in India after 1947 was a mixed economy characterized by a large number of state-owned enterprises, centralizedplanning, and subsidies. This system constrained the growth of the private sector. Private companies could expand only withgovernment permission. It could take years to get permission to diversify into a new product. Much of heavy industry, such asauto, chemical, and steel production, was reserved for state-owned enterprises. Production quotas and high tariffs on imports alsostunted the development of a healthy private sector, as did labor laws that made it difficult to fire employees.

By the early 1990s, it was clear this system was incapable of delivering the kind of economic progress that many SoutheastAsian nations had started to enjoy. In 1994, India’s economy was still smaller than Belgium’s, despite having a population of 950million. Its GDP per capita was a paltry $310, less than half the population could read, only 6 million had access to telephones, andonly 14 percent had access to clean sanitation; the World Bank estimated that some 40 percent of the world’s desperately poorlived in India, and only 2.3 percent of the population had an annual household income in excess of $2,484.

The lack of progress led the government to embark on an ambitious economic reform program. Starting in 1991, much of theindustrial licensing system was dismantled. Several areas once closed to the private sector were opened, including electricitygeneration, parts of the oil industry, steelmaking, air transport, and some areas of the telecommunications industry. Investment byforeign enterprises, formerly allowed only grudgingly and subject to arbitrary ceilings, was suddenly welcomed. Approval wasmade automatic for foreign equity stakes of up to 51 percent in an Indian enterprise, and 100 percent foreign ownership wasallowed under certain circumstances. Raw materials and many industrial goods could be freely imported, and the maximum tariffthat could be levied on imports was reduced from 400 percent to 65 percent. The top income tax rate was also reduced, andcorporate tax fell from 57.5 percent to 46 percent in 1994, and then to 35 percent in 1997. The government also announced plans tostart privatizing India’s state-owned businesses, some 40 percent of which were losing money in the early 1990s.

Judged by some measures, the response to these economic reforms has been impressive. The Indian economy expanded at anannual rate of about 7 percent from 1997 to 2017. Foreign investment, a key indicator of how attractive foreign companies thoughtthe Indian economy was, jumped from $150 million in 1991 to over $40 billion in 2017. In the information technology sector,India has emerged as a vibrant global center for software development with sales of $150 billion and exports of $117 billion in2017, up from sales of just $150 million in 1990. In pharmaceuticals, too, Indian companies are emerging as credible players in theglobal marketplace, primarily by selling low-cost, generic versions of drugs that have come off patent in the developed world.

However, the country still has a long way to go. Attempts to further reduce import tariffs have been stalled by politicalopposition from employers, employees, and politicians who fear that if barriers come down, a flood of inexpensive Chineseproducts will enter India. The privatization program continues to hit speed bumps—the latest in September 2003 when the IndianSupreme Court ruled that the government could not privatize two state-owned oil companies without explicit approval from theparliament. State-owned firms still account for 38 percent of national output in the nonfarm sector, yet India’s private firms are 30to 40 percent more productive than state-owned enterprises. There has also been strong resistance to reforming many of India’slaws that make it difficult for private business to operate efficiently. For example, labor laws make it almost impossible for firmswith more than 100 employees to fire workers, creating a disincentive for entrepreneurs to increase their enterprises beyond 100employees. Other laws mandate that certain products can be manufactured only by small companies, effectively making itimpossible for companies in these industries to attain the scale required to compete internationally.Sources: “India’s Breakthrough Budget?” The Economist, March 3, 2001; “America’s Pain, India’s Gain,” The Economist, January 11, 2003, p. 57; Joanna Slater, “In OnceSocialist India, Privatizations Are Becoming More Like Routine Matters,” The Wall Street Journal, July 5, 2002, p. A8; “India’s Economy: Ready to Roll Again?” TheEconomist, September 20, 2003, pp. 39–40; Joanna Slater, “Indian Pirates Turned Partners,” The Wall Street Journal, November 13, 2003, p. A14; “The Next Wave: India,”The Economist, December 17, 2005, p. 67; M. Dell, “The Digital Sector Can Make Poor Nations Prosper,” Financial Times, May 4, 2006, p. 17; “What’s Holding IndiaBack,” The Economist, March 8, 2008, p. 11; “Battling the Babu Raj,” The Economist, March 8, 2008, pp. 29–31; Rishi Lyengar, “India Tops Foreign Investment Rankings

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Ahead of U.S. and China,” Time, October 11, 2015; and “FDI in India,” Indian Brand Equity Foundation, March 2018.

PRIVATIZATIONHand in hand with deregulation has come a sharp increase in privatization. Privatization, as discussed in Chapter 2,transfers the ownership of state property into the hands of private individuals, frequently by the sale of state assetsthrough an auction.30 Privatization is seen as a way to stimulate gains in economic efficiency by giving new privateowners a powerful incentive—the reward of greater profits—to search for increases in productivity, to enter newmarkets, and to exit losing ones.31

The privatization movement started in Great Britain in the early 1980s when then–Prime Minister MargaretThatcher started to sell state-owned assets such as the British telephone company, British Telecom (BT). In a pattern thathas been repeated around the world, this sale was linked with the deregulation of the British telecommunicationsindustry. By allowing other firms to compete head to head with BT, deregulation ensured that privatization did notsimply replace a state-owned monopoly with a private monopoly. Since the 1980s, privatization has become a worldwidephenomenon. More than 8,000 acts of privatization were completed around the world between 1995 and 1999.32 Someof the most dramatic privatization programs occurred in the economies of the former Soviet Union and its easternEuropean satellite states. In the Czech Republic, for example, three-quarters of all state-owned enterprises wereprivatized between 1989 and 1996, helping push the share of gross domestic product accounted for by the private sectorup from 11 percent in 1989 to 60 percent in 1995.33

Privatization is still ongoing today. For example, in 2017 the Brazilian government announced the privatization of astate-owned electric company, airports, highways, ports, and the lottery (see the opening case). In Saudi Arabia, thegovernment has plans to privatize the state-owned oil company, Saudi Aramco. Conversely, in China the privatization ofinefficient state-owned enterprises has slowed down somewhat as the state pursues a “mixed ownership” strategy.34

Despite this three-decade trend, large amounts of economic activity are still in the hands of state-owned enterprisesin many nations. In China, for example, state-owned companies still dominate the banking, energy, telecommunications,health care, and technology sectors. Overall, they account for about 40 percent of the country’s GDP. The World Bankcautioned China that unless it reformed these sectors—liberalizing them and privatizing many state-owned enterprises—the country runs the risk of experiencing a serious economic crisis.35

As privatization has proceeded, it has become clear that simply selling state-owned assets to private investors is notenough to guarantee economic growth. Studies of privatization have shown that the process often fails to deliverpredicted benefits if the newly privatized firms continue to receive subsidies from the state and if they are protected fromforeign competition by barriers to international trade and foreign direct investment.36 In such cases, the newly privatizedfirms are sheltered from competition and continue acting like state monopolies. When these circumstances prevail, thenewly privatized entities often have little incentive to restructure their operations to become more efficient. Forprivatization to work, it must also be accompanied by a more general deregulation and opening of the economy. Thus,when Brazil decided to privatize the state-owned telephone monopoly, Telebrás Brazil, the government also split thecompany into four independent units that were to compete with each other and removed barriers to foreign directinvestment in telecommunications services. This action ensured that the newly privatized entities would face significantcompetition and thus would have to improve their operating efficiency to survive.

LEGAL SYSTEMSAs noted in Chapter 2, a well-functioning market economy requires laws protecting private property rights and providingmechanisms for contract enforcement. Without a legal system that protects property rights and without the machinery toenforce that system, the incentive to engage in economic activity can be reduced substantially by private and publicentities, including organized crime, that expropriate the profits generated by the efforts of private-sectorentrepreneurs. For example, when communism collapsed in eastern Europe, many countries lacked the legalstructure required to protect property rights, all property having been held by the state. Although many nations havemade big strides toward instituting the required system, it may be years before the legal system is functioning assmoothly as it does in the West. For example, in most eastern European nations, the title to urban and agriculturalproperty is often uncertain because of incomplete and inaccurate records, multiple pledges on the same property, andunsettled claims resulting from demands for restitution from owners in the pre-communist era. Also, although mostcountries have improved their commercial codes, institutional weaknesses still undermine contract enforcement. Courtcapacity is often inadequate, and procedures for resolving contract disputes out of court are often lacking or poorlydeveloped.37 Nevertheless, progress is being made. In 2004, for example, China amended its constitution to state that“private property was not to be encroached upon,” and in 2007 it enacted a new law on property rights that gave property

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holders many of the same protections as those enjoyed by the state (see the Country Focus “Property Rights inChina”).38

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Implications of Changing Political EconomyThe global changes in political and economic systems discussed earlier have several implications for internationalbusiness. The long-standing ideological conflict between collectivism and individualism that defined the twentiethcentury is less in evidence today. The West won the Cold War, and Western ideology is more widespread. Althoughcommand economies remain and totalitarian dictatorships can still be found around the world, and although there hasbeen some retreat from democratic institutions, the world remains a more democratic place, with a much greateradherence to a market-based economic system than was the case prior to 1988.

For nearly 50 years, half of the world was off-limits to Western businesses. Since the late 1980s, much of that haschanged. Many of the national markets of eastern Europe, Latin America, Africa, and Asia may still be underdeveloped,but they are potentially enormous. With a population of more than 1.3 billion, the Chinese market alone is potentiallybigger than that of the United States, the European Union, and Japan combined. Similarly, India, with about 1.2 billionpeople, is a potentially huge market. Latin America has another 600 million potential consumers. It is unlikely thatChina, India, Vietnam, or any of the other states now moving toward a market system will attain the living standards ofthe West soon. Nevertheless, the upside potential is so large that companies need to consider investing there. Forexample, if China and the United States continue to grow at the rates they did from 1996 through 2018, China willsurpass the United States to become the world’s largest national economy within the next two decades.

Just as the potential gains are large, so are the risks. There is no guarantee that democracy will thrive in many of theworld’s newer democratic states, particularly if these states have to grapple with severe economic setbacks.Authoritarianism is on the rise again and totalitarian dictatorships could return, although they are unlikely to be of thecommunist variety. Though the bipolar world of the Cold War era has vanished, it may be replaced by a multipolar worlddominated by a number of civilizations. In such a world, much of the economic promise inherent in the global shifttoward market-based economic systems may stall in the face of conflicts between civilizations. While the long-termpotential for economic gain from investment in the world’s new market economies is large, the risks associated with anysuch investment are also substantial. It would be foolish to ignore these. The financial system in China, for example, isnot transparent, and many suspect that Chinese banks hold a high proportion of nonperforming loans on their books. Iftrue, these bad debts could trigger a significant financial crisis during the next decade in China, which woulddramatically lower growth rates.

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FOCUS ON MANAGERIAL IMPLICATIONS

LO3-4Explain the implications for management practice of national difference in political economy.

BENEFITS, COSTS, RISKS, AND OVERALL ATTRACTIVENESS OF DOINGBUSINESS INTERNATIONALLYAs noted in Chapter 2, the political, economic, and legal environments of a country clearly influence the attractiveness of

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that country as a market or investment site. In this chapter, we argued that countries with democratic regimes, market-based economic policies, and strong protection of property rights are more likely to attain high and sustained economicgrowth rates and are thus a more attractive location for international business. It follows that the benefits, costs, and risksassociated with doing business in a country are a function of that country’s political, economic, and legal systems. Theoverall attractiveness of a country as a market or investment site depends on balancing the likely long-term benefits ofdoing business in that country against the likely costs and risks. Here, we consider the determinants of benefits, costs,and risks.

BenefitsIn the most general sense, the long-run monetary benefits of doing business in a country are a function of the size of themarket, the present wealth (purchasing power) of consumers in that market, and the likely future wealth of consumers.While some markets are very large when measured by number of consumers (e.g., India), relatively low living standardsmay imply limited purchasing power and, therefore, a relatively small market when measured in economic terms.International businesses need to be aware of this distinction, but they also need to keep in mind the likely futureprospects of a country. In 1960, South Korea was viewed as just another impoverished third-world nation. By 2017, ithad the world’s 11th-largest economy. International firms that recognized South Korea’s potential in 1960 and began todo business in that country may have reaped greater benefits than those that wrote off South Korea.

By identifying and investing early in a potential future economic star, international firms may build brand loyaltyand gain experience in that country’s business practices. These will pay back substantial dividends if that countryachieves sustained high economic growth rates. In contrast, late entrants may find that they lack the brand loyalty andexperience necessary to achieve a significant presence in the market. In the language of business strategy, early entrantsinto potential future economic stars may be able to reap substantial first-mover advantages, while late entrants may fallvictim to late-mover disadvantages.39 (First-mover advantages are the advantages that accrue to early entrants into amarket. Late-mover disadvantages are the handicaps that late entrants might suffer.) This kind of reasoning has beendriving significant inward investment into China, which may become the world’s largest economy by 2030 if it continuesgrowing at current rates (China is already the world’s second-largest national economy). For more than two decades,China has been the largest recipient of foreign direct investment in the developing world as international businesses—including General Motors, Volkswagen, Coca-Cola, and Unilever—try to establish a sustainable advantage in this nation.

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

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Coca-Cola has been in China for about 40 years, and about 140 million servings of the company’sproducts are enjoyed daily in China.Testing/Shutterstock

CostsA number of political, economic, and legal factors determine the costs of doing business in a country. With regard topolitical factors, a company may be pushed to pay off politically powerful entities in a country before the governmentallows it to do business there. The need to pay what are essentially bribes is greater in closed totalitarian states than inopen democrati c s ociet i es wher e p ol it i ci ans ar e h el d account able by the el ectorate (although t his is not a hard- and-fastdistinction). Whether a company should actually pay bribes in return for market access should be determined on the basisof the legal and ethical implications of such action. We discuss this consideration in Chapter 5, when we look closely atthe issue of business ethics.

With regard to economic factors, one of the most important variables is the sophistication of a country’s economy.It may be more costly to do business in relatively primitive or undeveloped economies because of the lack ofinfrastructure and supporting businesses. At the extreme, an international firm may have to provide its own infrastructureand supporting business, which obviously raises costs. When McDonald’s decided to open its first restaurant in Moscow,it found that to serve food and drink indistinguishable from that served in McDonald’s restaurants elsewhere, it had tovertically integrate backward to supply its own needs. The quality of Russian-grown potatoes and meat was too poor.Thus, to protect the quality of its product, McDonald’s set up its own dairy farms, cattle ranches, vegetable plots, andfood-processing plants within Russia. This raised the cost of doing business in Russia, relative to the cost in moresophisticated economies where high-quality inputs could be purchased on the open market.

As for legal factors, it can be more costly to do business in a country where local laws and regulations set strictstandards with regard to product safety, safety in the workplace, environmental pollution, and the like (because adheringto such regulations is costly). It can also be more costly to do business in a country like the United States, where theabsence of a cap on damage awards has meant spiraling liability insurance rates. It can be more costly to dobusiness in a country that lacks well-established laws for regulating business practice (as is the case in many ofthe former communist nations). In the absence of a well-developed body of business contract law, international firmsmay find no satisfactory way to resolve contract disputes and, consequently, routinely face large losses from contractviolations. Similarly, local laws that fail to adequately protect intellectual property can lead to the theft of aninternational business’s intellectual property and lost income.

RisksAs with costs, the risks of doing business in a country are determined by a number of political, economic, and legalfactors. Political risk has been defined as the likelihood that political forces will cause drastic changes in a country’s

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business environment that adversely affect the profit and other goals of a business enterprise.40 So defined, political risktends to be greater in countries experiencing social unrest and disorder or in countries where the underlying nature of asociety increases the likelihood of social unrest. Social unrest typically finds expression in strikes, demonstrations,terrorism, and violent conflict. Such unrest is more likely to be found in countries that contain more than one ethnicnationality, in countries where competing ideologies are battling for political control, in countries where economicmismanagement has created high inflation and falling living standards, or in countries that straddle the “fault lines”between civilizations.

Social unrest can result in abrupt changes in government and government policy or, in some cases, in protractedcivil strife. Such strife tends to have negative economic implications for the profit goals of business enterprises. Forexample, in the aftermath of the 1979 Islamic revolution in Iran, the Iranian assets of numerous U.S. companies wereseized by the new Iranian government without compensation. Similarly, the violent disintegration of the Yugoslavianfederation into warring states, including Bosnia, Croatia, and Serbia, precipitated a collapse in the local economies and inthe profitability of investments in those countries.

More generally, a change in political regime can result in the enactment of laws that are less favorable tointernational business. In Venezuela, for example, the populist socialist politician Hugo Chávez held power from 1998until his death in 2013. Chávez declared himself to be a “Fidelista,” a follower of Cuba’s Fidel Castro. He pledged toimprove the lot of the poor in Venezuela through government intervention in private business and frequently railedagainst American imperialism, all of which is of concern to Western enterprises doing business in the country. Amongother actions, he increased the royalties that foreign oil companies operating in Venezuela had to pay the governmentfrom 1 to 30 percent of sales.

Other risks may arise from a country’s mismanagement of its economy. An economic risk can be defined as thelikelihood that economic mismanagement will cause drastic changes in a country’s business environment that hurt theprofit and other goals of a particular business enterprise. Economic risks are not independent of political risk. Economicmismanagement may give rise to significant social unrest and, hence, political risk. Nevertheless, economic risks areworth emphasizing as a separate category because there is not always a one-to-one relationship between economicmismanagement and social unrest. One visible indicator of economic mismanagement tends to be a country’s inflationrate. Another is the level of business and government debt in the country.

The collapse in oil prices that occurred in 2014–2015 exposed economic mismanagement and increased economicrisk in a number countries that had been overly dependent upon oil revenues to finance profligate government spending.In countries such as Russia, Saudi Arabia, and Venezuela, high oil prices had enabled national governments to spendlavishly on social programs and public sector infrastructure. As oil prices collapsed, these countries saw governmentrevenues tumble. Budget deficits began to climb sharply, their currencies fell on foreign exchange markets, priceinflation began to accelerate as the price of imports rose, and their economies started to contract, increasingunemployment and creating the potential for social disruption. None of this was good for those countries, nor did itbenefit foreign business that had invested in those economies.

On the legal front, risks arise when a country’s legal system fails to provide adequate safeguards in thecase of contract violations or to protect property rights. When legal safeguards are weak, firms are more likely to breakcontracts or steal intellectual property if they perceive it as being in their interests to do so. Thus, a legal risk can bedefined as the likelihood that a trading partner will opportunistically break a contract or expropriate property rights.When legal risks in a country are high, an international business might hesitate entering into a long-term contract orjoint-venture agreement with a firm in that country. For example, in the 1970s when the Indian government passed a lawrequiring all foreign investors to enter into joint ventures with Indian companies, U.S. companies such as IBM and Coca-Cola closed their investments in India. They believed that the Indian legal system did not provide adequate protection ofintellectual property rights, creating the very real danger that their Indian partners might expropriate the intellectualproperty of the American companies—which for IBM and Coca-Cola amounted to the core of their competitiveadvantage.

Overall Attractiveness

The overall attractiveness of a country as a potential market or investment site for an international business depends onbalancing the benefits, costs, and risks associated with doing business in that country (see Figure 3.1). Generally, thecosts and risks associated with doing business in a foreign country are typically lower in economically advanced andpolitically stable democratic nations and greater in less developed and politically unstable nations. The calculus iscomplicated, however, because the potential long-run benefits are dependent not only on a nation’s current stage ofeconomic development or political stability but also on likely future economic growth rates. Economic growth appears tobe a function of a free market system and a country’s capacity for growth (which may be greater in less developednations). This leads us to conclude that, other things being equal, the benefit–cost–risk trade-off is likely to be mostfavorable in politically stable developed and developing nations that have free market systems and no dramatic upsurge

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in either inflation rates or private-sector debt. It is likely to be least favorable in politically unstable developing nationsthat operate with a mixed or command economy or in developing nations where speculative financial bubbles have led toexcess borrowing.

FIGURE 3.1 Country attractiveness.

Key Termsgross national income (GNI), p. 64purchasing power parity (PPP), p. 64Human Development Index (HDI), p. 68innovation, p. 69entrepreneurs, p. 70deregulation, p. 79first-mover advantages, p. 83late-mover disadvantages, p. 83political risk, p. 85economic risk, p. 85legal risk, p. 86

SUMMARYThis chapter reviewed how the political, economic, and legal systems of countries vary. The potential benefits, costs,and risks of doing business in a country are a function of its political, economic, and legal systems. The chapter madethe following points:

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

2. Many countries are now in a state of transition. There is a marked shift away from totalitarian governmentsand command or mixed economic systems and toward democratic political institutions and free market

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economic systems.3. The attractiveness of a country as a market and/or investment site depends on balancing the likely long-run

benefits of doing business in that country against the likely costs and risks.4. The benefits of doing business in a country are a function of the size of the market (population), its present

wealth (purchasing power), and its future growth prospects. By investing early in countries that are currentlypoor but are nevertheless growing rapidly, firms can gain first-mover advantages that will pay back substantialdividends in the future.

5. The costs of doing business in a country tend to be greater where political payoffs are required to gain marketaccess, where supporting infrastructure is lacking or underdeveloped, and where adhering to local laws andregulations is costly.

6. The risks of doing business in a country tend to be greater in countries that are politically unstable, subject toeconomic mismanagement, and lacking a legal system to provide adequate safeguards in the case of contractor property rights violations.

Critical Thinking and Discussion Questions

1. What is the relationship among property rights, corruption, and economic progress? How important areanticorruption efforts in the effort to improve a country’s level of economic development?

2. You are a senior manager in a U.S. automobile company considering investing in production facilities inChina, Russia, or Germany. These facilities will serve local market demand. Evaluate the benefits, costs, andrisks associated with doing business in each nation. Which country seems the most attractive target for foreigndirect investment? Why?

3. Reread the Country Focus “India’s Economic Transformation” and answer the following questions.a. What kind of economic system did India operate under during 1947–1990? What kind of system is it

moving toward today? What are the impediments to completing this transformation?b. How might widespread public ownership of businesses and extensive government regulations have

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

c. How would privatization, deregulation, and the removal of barriers to foreign direct investment affect theefficiency of business, new business formation, and the rate of economic growth in India during the post-1990 period?

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

e. Given what is now occurring in the Indian economy, do you think the country represents an attractivetarget for inward investment by foreign multinationals selling consumer products? Why?

global EDGE research task globaledge.msu.eduUse the globalEDGE™ website (globaledge.msu.edu) to complete the following exercises:

1. Increased instability in the global marketplace can introduce unanticipated risks in a company’s dailytransactions. Your company must evaluate these commercial transaction risks for its foreign operations inArgentina, China, Egypt, Poland, and South Africa. A risk analyst at your firm said you could evaluate boththe political and commercial risk of these countries simultaneously. Provide a commercial transaction riskoverview of all five countries for top management. In your evaluation, indicate possible corrective measuresin the countries with considerably high political and/or commercial risk.

2. Managers at your firm are very concerned about the influence of terrorism on its long-term strategy. Tocounter this issue, the CEO has indicated you must identify the countries where terrorism threats and politicalrisk are minimal. This will provide the basis for the development of future company facilities, which need tobe built in all major continents in the world. Include recommendations on which countries in each continentwould serve as a good candidate for your company to further analyze.

CLOSING CASE

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Brazil’s Struggling EconomyBetween 2000 and 2012, Brazil had one of the fastest-growing economies in the world, expanding by over 5 percent peryear. In 2012, the Brazilian economy temporarily surpassed that of the United Kingdom, making it the world’s sixth-largest economy. Brazil’s economic gains were partly due to booming international demand for commodities and highcommodity prices. Brazil is a major exporter of coffee, soybeans, and iron ore. The country also benefited from strongdomestic demand, cheap credit in international markets, inflows of foreign capital, tame inflation (important in a countrywi t h a his t o r y of hyperi nf l ation), and moder atel y conservative macro-economi c policies . Si nce 2012, h owever , Br azilhas been beset by a deep economic malaise. Economic growth decelerated in 2013. The economy entered into a seriousrecession in 2014. Economic activity contracted by over 3.5 percent in both 2015 and 2016 before growing by a sluggish0.7 percent in 2017 and just 1.1 percent in 2018.

Brazil’s economic problems were partly due to weaker demand for exports and a fall in global commodity prices. In2010, exports grew 11.6 percent, but that growth stalled in 2012, and in 2014 exports contracted by 1 percent.However, the country has other deep structural problems that led to a fall in domestic demand. Under theleadership of President Dilma Rousseff and her left-of-center Workers’ Party, between 2011 and 2014 the governmentspent extravagantly on higher pensions and unproductive tax breaks for favored industries. When the economicslowdown hit, unemployment surged to over 12 percent and tax revenues slumped. As a result of higher outlays andlower tax revenues, the fiscal deficit swelled from 2 percent of GDP in 2010 to 10 percent in 2015. This pushed up totalgovernment debt to 70 percent of GDP and required higher interest rates to sell government bonds, which were seen asincreasingly risky. The government also raised interest rates to keep inflation in check, which historically has been aproblem in Brazil. Because of high interest rates, the cost of servicing government debt expanded to 7 percent of GDP—and, of course, higher interest rates, by raising borrowing costs for consumers and businesses, further depressedeconomic activity.

Paulo Vilela/Shutterstock

Given high interest rates, the only way for the government to get the fiscal deficit under control is to cut spendingand raise taxes. This has not been easy to do. A central problem in Brazil is the country’s pension obligations. Thepension system entitles Brazilians to retire, on average, at just 54. Pension obligations already account for 13 percent ofGDP. Without reform, that figure could balloon to 25 percent by mid-century as the population ages.

In addition, tariff barriers protecting inefficient local enterprises from foreign competition, labor laws, andburdensome tax laws have long been seen as a drag on the Brazilian economy. A typical manufacturing firm spends2,600 hours a year complying with the country’s complex tax code; the Latin American average is 356 hours. Labor lawsmake it expensive to fire even incompetent workers. And protection from international competition has resulted inmanufacturing productivity that is low by international standards. To compound matters, the country has been beset by amassive corruption scandal that has reached into the highest levels of government. This resulted in the impeachment ofRousseff in 2016 and further damaged confidence in the economy (see the Country Focus “Corruption in Brazil” inChapter 2).

In 2016, Michel Temer replaced Rousseff as President. He made a promising start to reforming the economy. Hefroze public spending in real terms for the next 20 years. He also overhauled the country’s labor laws, making it mucheasier to fire unproductive workers. Inflation moderated significantly, and a rise in commodity prices helped increaseexports. This allowed the central bank to reduce interest rates to 6.75 percent (they were as high as 12 percent), furtherboosting economic growth. There was also a rash of privatizations—including that of the leading electric utility,Eletrobras—as the government sought to raise capital by selling state assets and tried to increase the efficiency of theeconomy. What remains is to fix the country’s pension problems. This would require raising the retirement age

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significantly. Temer ran up against strong resistance. His initial proposals failed to garner enough votes in the Braziliancongress to change the law on pensions.

In October 2018, Brazil held elections. Temer’s left wing Worker’s Party lost the election. The victor, JairBolsonaro of the right-wing Social Liberal Party, ran on a law-and-order ticket, promising to fix Brazil’s high crime rate.He also stated he would make necessary reforms to the country’s pension system.Sources: Denise Chrispim Marin, “Brazil’s Half Glass Economy,” Global Finance, October 3, 2017; “Michel Temer Is Trying to Fix Brazil’s Pension Systems,” The Economist, February15, 2018; “Will Brazil’s Future Arrive?” The Economist, August 17, 2017; “Brazil’s Fall,” The Economist, January 2, 2016; Jeffrey T. Lewis, “Brazil Posted Lackluster Economic Growthin 2018,” The Wall Street Journal, February 28, 2019.

Case Discussion Questions

1. Brazil was seen as one of the world’sf ast est-growing developing economies in the 2000–2010 period. What were the foundations of this success?

2. Why did Brazil’s economic growth falter after 2012? How much of the damage was self-inflicted, and how muchwas due to factors outside of the country’s control?

3. What do you think of Temer’s economic reforms? Were they on the right track?4. What policies do you think Brazil should adopt going forward to reignite economic growth? How easy would it

be to implement these policies in Brazil?

Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education

Endnotes

1. World Bank, World Development Indicators Online, 2019.2. Brindusa Mihaela Tudose and Raluca Irina Clipa, “An Analysis of the Shadow Economy in EU Countries,” CES

Working Papers,” Volume 111, Issue 2, pp. 303–312, 2018.www.ceswp.uaic.ro/articles/CESWP2016_VIII2_TUD.pdf.

3. A. Sen, Development as Freedom (New York: Knopf, 1999).4. G. M. Grossman and E. Helpman, “Endogenous Innovation in the Theory of Growth,” Journal of Economic

Perspectives 8, no. 1 (1994), pp. 23–44; P. M. Romer, “The Origins of Endogenous Growth,” Journal ofEconomic Perspectives 8, no. 1 (1994), pp. 2–22.

5. W. W. Lewis, The Power of Productivity (Chicago: University of Chicago Press, 2004).6. F. A. Hayek, The Fatal Conceit: Errors of Socialism (Chicago: University of Chicago Press, 1989).7. J. Gwartney, R. Lawson, and W. Block, Economic Freedom of the World: 1975–1995 (London: Institute of

Economic Affairs, 1996); C. Doucouliagos and M. Ali Ulubasoglu, “Economic Freedom and Economic Growth:Does Specification Make a Difference?” European Journal of Political Economy 22 (March 2006), pp. 60–81.

8. D. North, Institutions, Institutional Change, and Economic Performance (Cambridge, UK: Cambridge UniversityPress, 1991). See also K. M. Murphy, A. Shleifer, and R. Vishney, “Why Is Rent Seeking So Costly to Growth?,”American Economic Review 83, no. 2 (1993), pp. 409–14; K. E. Maskus, “Intellectual Property Rights in theGlobal Economy,” Institute for International Economics, 2000.

9. North, Institutions, Institutional Change and Economic Performance.10. H. de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New

York: Basic Books, 2000).11. A. O. Hirschman, “The On-and-Off Again Connection between Political and Economic Progress,” American

Economic Review 84, no. 2 (1994), pp. 343–48; A. Przeworski and F. Limongi, “Political Regimes and EconomicGrowth,” Journal of Economic Perspectives 7, no. 3 (1993), pp. 51–59.

12. Hirschman, Albert O. ‘’The On-and-off Again Connection between Political and Economic Progress.’’ TheAmerican Economic Review 84, no. 2, Papers and Proceedings of the Hundred and Sixth Annual Meeting of theAmerican Economic Association (May, 1994): 343–48. https://www.jstor.org/stable/2117856?seq=1#page_scan_tab_contents.

13. For details of this argument, see M. Olson, “Dictatorship, Democracy, and Development,” American PoliticalScience Review, September 1993.

14. For example, see Jared Diamond’s Pulitzer Prize–winning book Guns, Germs, and Steel (New York: Norton,1997). Also see J. Sachs, “Nature, Nurture and Growth,” The Economist, June 14, 1997, pp. 19–22; J. Sachs, TheEnd of Poverty (New York: Penguin Books, 2005).

15. Sachs, Jeffrey. “Nature, Nurture and Growth.” The Economist, June 12, 1997.https://www.economist.com/special/1997/06/12/nature-nurture-and-growth.

16. “What Can the Rest of the World Learn from the Classrooms of Asia?” The Economist, September 21, 1996, p.

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24.17. J. Fagerberg, “Technology and International Differences in Growth Rates,” Journal of Economic Literature 32

(September 1994), pp. 1147–75.18. D. Baker, J. B. Delong and P. R. Krugman, “Asset Returns and Economic Growth,” Brookings Papers on

Economic Activity, 2005, 289–330; G. S. Becker, E. L. Laeser, and K. M. Murphy, “Population and EconomicGrowth,” American Economic Review, 89(2) pp. 214–228.

19. See The Freedom House Survey Team, “Freedom in the World 2018,” and associated materials,www.freedomhouse.org.

20. Freedom House, “Democracies Century: A Survey of Political Change in the Twentieth Century, 1999,”www.freedomhouse.org.

21. L. Conners, “Freedom to Connect,” Wired, August 1997, pp. 105–6.22. Diego Cupolo, “Turks Have Voted Away Their Democracy,” The Atlantic, June 25, 2018; “Turkey: End

Prosecutions for ‘Insulting the President,’” Human Rights Watch, October 17, 2018.23. Fukuyama, Francis. “The End of History?” The National Interest (Summer 1989).

https://history.msu.edu/hst203/files/2011/02/Fukuyama-The-End-of-History.pdf.24. S. P. Huntington, The Clash of Civilizations and the Remaking of World Order (New York: Simon & Schuster,

1996).25. Huntington, Samuel. The Clash of Civilizations And the Remaking of World Order. New York: Simon &

Schuster, 2011.26. U.S. National Counterterrorism Center, Reports on Incidents of Terrorism, 2005, April 11, 2006.27. S. Fischer, R. Sahay, and C. A. Vegh, “Stabilization and the Growth in Transition Economies: The Early

Experience,” Journal of Economic Perspectives 10 (Spring 1996), pp. 45–66.28. M. Miles et al., 2018 Index of Economic Freedom (Washington, DC: Heritage Foundation, 2018).29. International Monetary Fund, World Economic Outlook: Focus on Transition Economies (Geneva: IMF, October

2000). “Transition Economies, an IMF Perspective on Progress and Prospects,” IMF, November 3, 2000.30. J. C. Brada, “Privatization Is Transition—Is It?” Journal of Economic Perspectives, Spring 1996, pp. 67–

86.31. See S. Zahra et al., “Privatization and Entrepreneurial Transformation,” Academy of Management Review 3, no.

25 (2000), pp. 509–24.32. N. Brune, G. Garrett, and B. Kogut, “The International Monetary Fund and the Global Spread of Privatization,”

IMF Staff Papers 51, no. 2 (2003), pp. 195–219.33. Fischer et al., “Stabilization and Growth in Transition Economies.”34. Shannon Sims, “Brazil’s Privatization Push,” US News and World Reports, October 11, 2017; Jane Cai, “Forget

Privatization, Xi Has Other Big Plans for Bloated State Firms,” South China Morning Post, September 6, 2017.35. “China 2030,” World Bank, 2012.36. J. Sachs, C. Zinnes, and Y. Eilat, “The Gains from Privatization in Transition Economies: Is Change of

Ownership Enough?” CAER discussion paper no. 63 (Cambridge, MA: Harvard Institute for InternationalDevelopment, 2000).

37. M. S. Borish and M. Noel, “Private Sector Development in the Visegrad Countries,” World Bank, March 1997.38. “Caught between Right and Left,” The Economist, March 8, 2007.39. For a discussion of first-mover advantages, see M. Liberman and D. Montgomery, “First-Mover Advantages,”

Strategic Management Journal 9 (Summer Special Issue, 1988), pp. 41–58.40. S. H. Robock, “Political Risk: Identification and Assessment,” Columbia Journal of World Business, July–August

1971, pp. 6–20.

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4

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part two National Differences

Differences in Culture

LEARNING OBJECTIVESAfter reading this chapter, you will be able to:

Explain what is meant by the culture of a society.

Identify the forces that lead to differences in social culture.

Identify the business and economic implications of differences in culture.Recognize how differences in social culture influence values in business.

Demonstrate an appreciation for the economic and business implications of cultural change.

George Hammerstein/Corbis/Glow Images

Singapore: One of the World’s Most Multicultural Places

OPENING CASESingapore (www.gov.sg) has a population of roughly 5.7 million people, with 100 percent of its citizens living in urban areas due toits city-state infrastructure. (Athens in Greece, and Rome in Italy, began as city-states, also.) A city-state is often defined as asovereign state, basically a type of small independent country that usually consists of a single city and smaller peripheral dependentterritories. Singapore and Vatican City (the Holy See) are considered the most well-known city-states in the world today. As forVatican City, it is a city-state surrounded by Rome in Italy, and is of course the headquarters of the Roman Catholic Church, wherethe Pope resides.

Singapore is in Southeastern Asia, and is an island city between southern Malaysia and Indonesia. The climate is tropical withtwo distinct monsoon seasons: Northeastern monsoon (December to March) and Southwestern monsoon (June to September). Despite

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its small size, Singapore ranks 14th globally in exporting, 16th in importing, and has a positive trade balance that places the country9th in the world on the export-to-import ratio. Among corporations and global travelers, Singapore is favored for many reasons, suchas low corruption, global connectedness, ease of doing business, global competitiveness, innovation, opportunities, economicfreedom, networked readiness, and reasonable taxes. Some of the negatives include environmental performance, freedom of the press,and political leadership.

One of the most fascinating characteristics of Singapore is its unique multicultural makeup. Not only is it a city-state, it is alsovery young compared to other places that have become equally multicultural and successful in the global marketplace. It was onlyabout half a century ago that Singapore gained independence from Malaysia (on August 9, 1965). The tiny island nation is proud ofthe diverse cultures and religions that meld in relative harmony within its borders. While the majority of Singapore’s residents are ofChinese origin, other prominent ethnic groups include Malays, Indians, and Eurasians. People from the United States and Canada arealso represented, but in smaller numbers. To be culturally inclusive and in an effort to ensure that communication remains smoothamong its citizens, Singapore boasts four official languages: English, Malay, Mandarin, and Tamil.

Singapore is a costly destination for tourists, and many of its residents pay hefty sums to live there. Nevertheless, Singapore’smelting-pot culture makes the country unique and a bridge between various parts of the world. Companies and people engage withSingapore for these cultural and business reasons. So, how costly is Singapore for multinational corporations? The benefits mustoutweigh the costs, given the myriad companies in Singapore. Indeed, several cost-based indices exist to rank countries in the world,and these indices provide a picture of how costly, or inexpensive, Singapore is for people and businesses. For example, the Index ofEconomic Freedom (developed by The Heritage Foundation) focuses on assessing the fundamental right of every human to controlhis or her own labor and property. Singapore is ranked number 2 on the IEF, meaning the country is very accommodating.

Another index that shows Singapore’s cost to companies is The Paying Taxes Indicator. This index, generated byPricewaterhouseCoopers (PwC) and The World Bank, investigates and compares tax regimes across economies worldwide. Again,Singapore scores high, ranking number 7 in the world. This means Singapore’s government welcomes and facilitates multinationalcorporations doing business in the city-state. Because Singapore is small, many companies benefit from the robust infrastructure of itscentralized government, as well as its pervasive accommodations for foreign businesses. In the end, businesses thrive in Singapore,even if tourists and citizens find the country costly. (Singapore is usually ranked as one of the most expensive cities to live in.)

For its part, the Singapore Board of Tourism stresses that “Singapore is where cultures, religions, and even passions meet!” Theidea is that Singapore’s strength in diversity is why people and companies should engage with their city-state. Billed as one of themost harmonious and plural nations on the planet, its ethnic communities are vibrant and diverse, its religions co-exist in harmony, itsvaried peoples celebrate as one, and as a result of it all, its citizens’ passions come alive.Sources: Marcelina Morfin, “The 10 Most Multicultural Cities in the World,” April 16, 2018; Karen Gilchrist, “Singapore Named the World’s Most Expensive City,” CNBC,March 14, 2018; Amir Yusof, “Principles for Budget 2019 Reflect the Singapore way,” Channel NewsAsia, February 28, 2019; “Singapore on globalEDGE,”globaledge.msu.edu/countries/singapore, March 1, 2019.

IntroductionIn Chapters 2 and 3, we saw how national differences in political, economic, and legal systems influence the benefits,costs, and risks associated with doing business in various countries of the world. In this chapter, we explore howdifferences in culture—both across and within countries—can have an effect on a company’s international businessstrategies. This includes a focus on the development and implementation of international business strategies for all typesof companies—from small to medium to large companies. Large multinational corporations often become the focus intextbooks, but culture affects every size and type of organization.

Several themes run through this chapter. The first is that business success in many, if not most, countries requirescross-cultural literacy. By cross-cultural literacy we mean understanding how cultural differences across and withincountries can have an effect on the way business is practiced. It is sometimes easy to forget how different cultures acrossthe globe really are even today.1 Beneath the veneer of globalization, deep cultural differences often remain that canhave a marked effect on a number of issues in a company’s value chain. These differences are also what create acommon bond—a value system—among people in a country, in essence a reason for the country to exist. Culturallybased value systems can also reside in families, companies, and world regions. Sometimes even industries have distinctvalue systems.2

Numerous values and norms reside in these cultural systems. Some affect international business, some do not, andwith some it is hard to tell if they affect international strategy and implementation. For example, Sweden has been foundto be the country where people tend to be most patient among the 195 countries in the world (followed by theNetherlands and the United States). A team of researchers concluded, “Populations of European ancestry tend to be morepatient than the world mean. Indeed, all of the 10 most patient countries in the world are either located in the neo-European, English-speaking world, or else in Western Europe, with the Scandinavian countries exhibiting particularlyhigh levels of patience.”3 The country where people tend to be least patient is Nicaragua (followed by Rwanda andGeorgia). Patience, risk aversion, reciprocity, altruism, and trust are all culture-related factors that make each countryunique.

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The opening case shows that Singapore is unique in its multicultural blend of people’s backgrounds andcharacteristics. Contrary to cultural differences that often separate people and create friction, Singaporeans value theirmulticultural makeup and draw strength from it. Not only is Singapore a city-state, it is also very young compared toother places that have become equally multicultural and economically successful. Singapore gained independence fromMalaysia in 1965, and since then the tiny island nation has proudly nurtured diverse cultures and religions that melttogether in harmony. The majority of Singapore’s residents are of Chinese origin. Other prominent groups includeMalays, Indians, and Eurasians (Americans and Canadians are also represented, but in smaller numbers). To be culturallyinclusive, Singapore boasts four official languages: English, Malay, Mandarin, and Tamil. Perhaps we can go as far assaying that, as one of the most multicultural places in the world, Singapore creates a unique cultural homogeneity out ofits diverse existence.

Skipping ahead to the end of this chapter, the closing case on China, Hong Kong, Macau, and Taiwan highlightssome of the traditional deep cultural differences that can exist. However, this occurs in a region that many believeconsists of nations and areas with a very similar cultural background—i.e., Greater China. Instead, what we find is thatthroughout the colonial era, Hong Kong’s citizens developed a distinct “Hong Kong identity” that seeks to be recognizedas a unique culturally based “national identity.” Meanwhile, the Taiwanese culture, a blend of Confucian Han Chineseand Taiwanese aboriginal cultures, is often at odds with mainland China. On the positive side, Macau has had a betterexperience with mainland China due to the economic difficulties that preceded the handover of Macau from Portugal toChina in 1999. China came in as a helping hand economically at the right time, resulting in a much betterpartnership between China and Macau than between China and Hong Kong and Taiwan, respectively. Macau isalso being positioned as a key diplomatic player in China’s relations with Portuguese-speaking countries.

While some observers around the world may simply refer to the Greater China Region as “Chinese,” the deeplyingrained cultural values of the region’s separate entities are very different from each other as a practical matter.Consequently, cultural differences affect doing business in the region differently. This includes the various cost factors atplay. As such, another theme we develop in this chapter is that a relationship exists between culture and the cost of doingbusiness in a country or region. Different countries will be either more or less supportive of the market-based mode ofproduction and sales to customers (i.e., where supply and demand set the prices for products and services).

For example, cultural factors were the triggers that lowered the costs of doing business in Japan and helped explainJapan’s rapid ascent as an industrialized and competitive nation in the world about half a century ago.4 Cultural factorscan also trigger rising costs in doing business. Historically, class divisions were an important aspect of the Britishculture, and for a long time, firms operating in the United Kingdom found it difficult to achieve cooperation betweenmanagement and labor. Class divisions led to a high level of industrial disputes in the UK during the same period thatJapan was developing into a global force. This mismatch hurt the United Kingdom but opened up doors for Japan. It alsoraised the costs of doing business in Britain relative to the costs in countries such as Germany, Japan, Norway, Sweden,and Switzerland, where class conflict was historically less prevalent. Cultural foundations in many ways are also behindthe last decade of nationalistic movements around the world (e.g., France, Germany, United Kingdom, United States),often resulting in higher tariffs and overall international trade costs across country borders.

The examples of Japan and the United Kingdom bring us to another theme we explore in this chapter: Culture is notstatic. Culture is rooted in the values and norms we have as people, and those are generally tied to doing something overa period of time. Think about it. If you do the same thing over and over, it becomes a habit, and then you almost take itfor granted. But sometimes you break the habit and start something new or change how you do certain things. Culture isvery much the same. Culture can and does evolve, although the rate at which cultures change is a subject of dispute.(From a personal vantage point, how easy or often do we change habits?) Generally, culture evolves as certain behaviorsof people become ingrained and coded into people’s values and norms. A cultural mindset develops that is consistentwith people’s behavior over time. Then, at some point again in the future, things may happen that cause people’sbehavior to once more change, and so culture continues to evolve.

You likely realize that your own personal cultural values and norms are hard to change. The same goes for theculture of a society, which evolves when large population segments in a country or region adopt values based oncommon ways of behaving. Societal changes are usually very slow moving. Importantly, multinational corporationsoperating across national cultures typically have unique values and norms as well. Consequently, many individuals havecertain values and norms in their personal lives, possibly a (slightly) different set of vales and norms at work, and yet adifferent way of behaving in society. This is not to say that there are not overlaps, but many people also act differently ineach context based on values and norms that pertain to a specific context.

What Is Culture?

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LO4-1Explain what is meant by the culture of a society.People have a hard time agreeing on a simple definition of culture. This makes it difficult to be strategic about what typeof culture can be created in small, medium, and large companies operating in some portion of the world’s 195 countries.Because culture as a system of values and norms resides in multiple layers of society (people, families, companies,industries, countries, and world regions), we also have to take into account these important layers of culture and howthey interact with each other.

If we go back to the 1870s, anthropologist Edward Tylor defined culture as “that complex whole whichincludes knowledge, belief, art, morals, law, custom, and other capabilities acquired by man as a member of society.”5Since then, thousands of definitions have been argued over and defended by diverse experts from many cultures—inother words, culture actually affects how different people define culture itself!

Look around your college or university. Do you think the students can collectively define culture in a universallyacceptable way that fits all geographic areas represented by the students or even among a smaller group of your friends?The answer is probably maybe, but after a few tries. However, we will make it easier by focusing on culture as it relatesto international business (instead of everything related to culture).

To start, Florence Kluckhohn and Fred Strodtbeck’s values orientation theory of culture states that all definitions ofculture must answer a limited number of universal problems, that the value-based solutions are limited in number anduniversally known, and that different cultures have different preferences among them.6 Following their work, otherprominent specialists have supported the idea of a universal set of human values serving as the basis for culture; seeMilton Rokeach’s work on “the nature of human values” and Shalom Schwartz’s work on the “theory of basic humanvalues.”7Rokeach and Schwartz are prominent culture experts who have had a significant influence on theorists,including Geert Hofstede.

Also supportive of a finite set of human values, Geert Hofstede, a Dutch expert on cross-cultural differences andinternational management, defined culture as “the collective programming of the mind which distinguishes the membersof one human group from another.”8 Hofstede’s work is by far the most used culture research in business over the lasthalf a century, and this textbook relies on his scientific approach to understand how, when, and why culture has animpact on multinational corporations. At the basic level, culture includes systems of values, and values are among thebuilding blocks of culture.9 Another complementary definition of culture comes from sociologists Zvi Namenwirth andRobert Weber, who see culture as a system of ideas and argue that these ideas constitute a design for living.10

Discussion in this textbook subscribes to culture as conceptualized by Hofstede and influenced by the team ofNamenwirth and Weber. As such, culture is a system of values and norms that are shared among a group of people andthat when taken together constitute a design for living. Values are ideas about what a group believes to be good, right,and desirable. Put differently, values are shared assumptions about how things ought to be.11 Norms are the social rulesand guidelines that prescribe appropriate behavior in particular situations. Society refers to a group of people sharing acommon set of values and norms. While a society may be equivalent to a country, some countries have several societiesor subcultures, and some societies embrace more than one country. For example, the Scandinavian countries ofDenmark, Finland, Iceland, Norway, and Sweden are often viewed as culturally being one society. The implication isthat if one Scandinavian country’s people like a product from a company, there is a very good chance customers from theother Scandinavian countries will as well.

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Geert Hofstede, often viewed as the top expert on cross-cultural differences in international business,presents his work in Istanbul, Turkey, at the Academy of International Business conference.Academy of International Business (AIB)

VALUES AND NORMSValues form the bedrock of a culture. Values provide the context within which a society’s norms are established andjustified. They may include a society’s attitudes toward such concepts as individual freedom, democracy, truth, justice,honesty, loyalty, social obligations, collective responsibility, women, love, sex, marriage, and so on. Values are not justabstract concepts; they are invested with considerable emotional significance. People argue, fight, and even die overvalues, such as freedom. Freedom and security are often the core reasons the political leadership in manydeveloped nations (e.g., United States) uses when justifying their country engaging in various parts of the world.Values are also reflected in the economic systems of a society. For example, as we saw in Chapter 2, democratic freemarket capitalism is a reflection of a philosophical value system that emphasizes individual freedom.12

Norms are the social rules that govern people’s actions toward one another. These norms can be subdivided intotwo major categories: folkways and mores. Both of these norm-related categories were coined in 1906 by WilliamGraham Sumner, an American sociologist, and they are still applicable and embedded in our societies. Folkways are theroutine conventions of everyday life. Generally, folkways are actions of little moral significance. Rather, they are socialconventions that deal with things like appropriate dress code, good social manners, eating with the correct utensils,neighborly behavior, and so on. Although folkways define the way people are expected to behave, violations of them arenot normally a serious matter. People who violate folkways may be thought of as eccentric or ill-mannered, but they arenot usually considered to be evil or bad. In many countries, foreigners may initially be excused for violating folkways.However, traveling managers are increasingly expected to know about specific dress codes, social and professionalmanners, eating with the correct utensils, and business etiquette. The evolution of norms now demands that businesspartners at least try to behave according to the folkways in the country in which they are doing business.

A good example of a folkway is people’s attitude toward time. People are very aware of what time it is, the passageof time, and the importance of time in the United States and northern European cultures such as Germany, Netherlands,and the Scandinavian countries (Denmark, Finland, Iceland, Norway, and Sweden). In these cultures, business people arevery conscious about scheduling their time and are quickly irritated when time is wasted because a business associate islate for a meeting or if they are kept waiting for any reason. Time is really money in the minds of these business people.

The opposite of the time-conscious Americans, Germans, Dutch, and Scandinavians, business people in manyArabic, Latin, and African cultures view time as more elastic. Keeping to a schedule is viewed as less important thanbuilding a relationship or finishing an interaction with people. For example, an American businessperson might feelslighted if he or she is kept waiting for 30 minutes outside the office of a Latin American executive before a meeting.However, the Latin American person may simply be completing an interaction with another associate and view theinformation gathered from this as more important than sticking to a rigid schedule. The Latin American executiveintends no disrespect, but due to a mutual misunderstanding about the importance of time, the American may see thingsdifferently. Similarly, Saudi Arabian attitudes toward time have been shaped by their nomadic Bedouin heritage, inwhich precise time played no real role and arriving somewhere “tomorrow” might mean next week. Like LatinAmericans, many Saudis are unlikely to understand Westerners’ obsession with precise times and schedules.

Folkways also include rituals and symbolic behavior. Rituals and symbols are the most visible manifestations of aculture and constitute the outward expression of deeper values. For example, upon meeting a foreign business executive,a Japanese executive will hold his business card in both hands and bow while presenting the card to the foreigner.13 Thisritual behavior is loaded with deep cultural symbolism. The card specifies the rank of the Japanese executive, which is avery important piece of information in a hierarchical society such as Japan. The bow is a sign of respect, and the deeperthe angle of the bow, the greater the reverence one person shows for the other. The person receiving the card is expectedto examine it carefully (Japanese often have business cards with Japanese printed on one side and English printed on theother), which is a way of returning respect and acknowledging the card giver’s position in the hierarchy. The foreigner isalso expected to bow when taking the card and to return the greeting by presenting the Japanese executive with his or herown card, similarly bowing in the process. To not do so and to fail to read the card that he or she has been given, insteadcasually placing it in a jacket, pocket, or purse, violates this important folkway and is considered rude.

Mores refer to norms that are more widely observed, have greater moral significance than folkways, andare central to the functioning of a society and to its social life. Violating mores can bring serious retribution, ill will, andthe collapse of any business deal. Mores are often so important that they have been enacted into law. Mores, to useextreme examples, include laws against theft, adultery, incest, and cannibalism. All advanced societies have laws againsttheft and cannibalism, among other things, but in modern times not necessarily adultery. Many mores (and laws) differacross cultures. In the United States, for example, drinking alcohol is widely accepted, whereas in Saudi Arabia theconsumption of alcohol is viewed as violating important social mores and is punishable by imprisonment (as some

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Western citizens working in Saudi Arabia have discovered to their dismay). That said, countries like Saudi Arabia andthe United Arab Emirates are becoming more tolerant of Westerners behaving like Westerners in their countries—suchas when their Western comrades drink alcohol, as long as they do not flaunt it. Over time, mores may be implementeddifferently depending on where you are and who you are, and it pays to know the difference.

CULTURE, SOCIETY, AND THE NATION-STATEWe have defined a society as a group of people who share a common set of values and norms; that is, people who arebound together by a common culture. There is not a strict one-to-one correspondence between a society and a nation-state. Nation-states are political creations. While nation-states are often studied for their “national identity,” “nationalcharacter,” and even “competitive advantage of nations,” in reality they may contain a single culture or severalsubcultures.14 The French nation can be thought of as the political embodiment of French culture. However, the nationof Canada has a French culture too, and at least three core cultures—an Anglo culture, a French-speaking “Quebecois”culture, and a Native American culture. Similarly, many of the 54 African nations have important cultural differencesamong tribal groups, as horrifically exhibited in the early 1990s when Rwanda dissolved into a bloody civil war betweentwo tribes, the Tutsis and Hutus. Africa is not alone in this regard. India, for example, is composed of many distinctcultural groups with their own rich history and traditions (e.g., Andhras, Gonds, Gujaratis, Marathas, Oriya, Rajputs,Tamils).

Cultures can also embrace several nations, as with the Scandinavian countries of Denmark, Finland, Iceland,Norway, and Sweden. These Scandinavian nations trace their cultural values and norms back centuries, and this culturalmindset still resides in most Scandinavians. Next time you meet some Scandinavians, see if you can pick out whichcountry they are from! There is also a strong case for considering Islamic society a culture that is shared by citizens ofmany different nations in the Middle East, Asia, and Africa. Of course, there are nuances to the Islamic world—thosewho adhere to various degrees, or different elements, of Islam. As you will recall from Chapter 3, this view of expansivecultures that embrace several nations underpins Samuel Huntington’s view of a world that is fragmented into differentcivilizations, including Western, Islamic, and Sinic (Chinese) cultures.15 In fact, many international business scholarsmake the culture argument as a way of saying that companies should not target countries in a multinational strategicapproach today, but instead focus on dividing up the world’s 195 countries into like-minded business regions.

To complicate things further, as we mentioned earlier, it is also possible to talk about culture at different levelswithin a country. It is reasonable to talk about “American society” and “American culture,” but there are several societieswithin America, each with its own culture. For example, in the United States, one can talk about African Americanculture, Cajun culture, Chinese American culture, Hispanic culture, Indian culture, Irish American culture, Southernculture, and many more cultural groups. In some way, this means that the relationship between culture and country isoften ambiguous. Even if a country can be characterized as having a single homogeneous culture, often that nationalculture is a mosaic of subcultures (e.g., Singapore). To honor these cultural nuances, business people need to beaware of the delicate issues that pertain to folkways, and they also need to make sure not to violate mores in thecountry or culture in which they intend to do business. Increased globalization has meant an increased number ofbusiness relationships across countries and cultures, but not necessarily an increased cultural understanding to go with it.Culture is a complex phenomenon with multiple dimensions and multiple levels always worthy of study.16

DETERMINANTS OF CULTURE

LO4-2Identify the forces that lead to differences in social culture.The values and norms of a culture do not emerge fully formed. As we have explained, values and norms evolve overtime in response to a number of factors, including prevailing political and economic philosophies, the social structure ofa society, and the dominant religion, language, and education (see Figure 4.1). Ultimately, a culture forms when people’sbehaviors—as a result of these various influences—become ingrained in people’s daily activities, patterns, and ways ofdoing things.

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FIGURE 4.1 Determinants of culture.

We discussed political and economic philosophies in Chapter 2. Such philosophies clearly influence the valuesystems of a society. For example, the values found in communist North Korea toward freedom, justice, and individualachievement are clearly different from the opposite values found in Sweden, precisely because each society operatesaccording to different political and economic philosophies. In the next sections of this chapter, we discuss the influenceof social structure, religion, language, and education. The chain of causation runs both ways. While factors such as socialstructure and religion clearly influence the values and norms of a society, the values and norms of a society can influencesocial structure and religion. That means that people’s behaviors can lead to culture evolving, and the existing culturealso affects how people behave.

TEST PREPUse SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBookor go to learnsmartadvantage.com for help.

Social StructureA society’s social structure refers to its basic social organization. It indicates how a society is organized in terms of thevalues, norms, and relationships that are part of its fabric. How society operates and how people, groups, and companiestreat each other both emerge from, and are determinants of, the behaviors of individuals in that specific society.

Two dimensions are particularly important when explaining differences across social structures (although manydimensions exist beyond these two). The first is the degree to which the basic unit of a social organization is theindividual, as opposed to the group, or even company for which a person works. In general, Western societiestend to emphasize the importance of the individual, whereas groups tend to figure much larger in many non-Western societies. The second dimension is the degree to which a society is stratified into classes or castes. Somesocieties are characterized by a relatively high degree of social stratification and relatively low mobility between strata(India). Other societies are characterized by a low degree of social stratification and high mobility between strata (UnitedStates).

INDIVIDUALS AND GROUPSA group is an association of two or more individuals who have a shared sense of identity and who interact with eachother in structured ways on the basis of a common set of expectations about each other’s behavior.17 Human social life is

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group life. Individuals are involved in families, work groups, social groups, recreational groups, and potentially myriadother groups. Social media have expanded the boundaries of what is included in group life and placed an added emphasison extended social groups. Social media has unique possibilities that affect both individuals within a social group and thegroup itself. For example, consumers are significantly more likely to buy from the brands they follow on Instagram,Twitter, Facebook, or LinkedIn, or that they get exposed to via Snapchat, due to group influences. However, whilegroups are found in all societies, some societies differ according to the degree to which the group is viewed as theprimary means of social organization.18 In some societies, individual attributes and achievements are viewed as beingmore important than group membership; in others, the reverse is true.

The Individual

LO4-3Identify the business and economic implications of differences in culture.In Chapter 2, we discussed individualism as a political philosophy. However, individualism is more than just an abstractpolitical philosophy. In many societies, the individual is the basic building block of social organization. This is reflectednot just in the political and economic organization of society but also in the way people perceive themselves and relate toeach other in social and business settings. The value systems of many Western societies, for example, emphasizeindividual achievement. The social standing of individuals is not so much a function of whom they work for as of theirindividual performance in whatever work setting they choose. More and more, individuals are regarded as “independentcontractors” even though they belong to and work for a company. These individuals build their personal brands byutilizing the knowledge, skills, and experience they have, which often translates to increased salaries and promotions oranother company seeking their employment, if they believe the company can benefit from that person’s capabilities. Inscience, the label “star scientist” has become synonymous with these individual high-producers of innovative productsbased on their knowledge, skills, and experience.19

The emphasis on individual performance has both potential beneficial and harmful aspects. In the United States, theemphasis on individual performance finds expression in an admiration of rugged individualism, entrepreneurship, andinnovation. One benefit of this is the high level of entrepreneurial activity in the United States, in Europe, and throughoutmany of the so-called developed nations. Over time, entrepreneurial individuals in the United States have created lots ofnew products and new ways of doing business (personal computers, photocopiers, computer software, biotechnology,supermarkets, discount retail stores, social media). One can argue that the dynamism of the U.S. economy owes much tothe philosophy of individualism. Highly individualistic societies are often synonymous with those capable of constantlyinnovating by having a flowing stream of creative ideas for new products and services.

Individualism also finds expression in a high degree of managerial mobility between companies, as our “personalbrand” example illustrated earlier, and this is not always a good thing. Although moving from company to company maybe good for individual managers who are trying to build impressive résumés and increase their salaries, it is notnecessarily a good thing for companies. The lack of loyalty and commitment to a company and the tendency to move onfor a better offer can result in managers who have good general skills but lack the knowledge, experience, andnetwork of contacts that come from years of working for the same company. An effective manager draws oncompany-specific experience, knowledge, and a network of contacts to find solutions to current problems, andcompanies may suffer if their managers lack these attributes. One positive aspect of high managerial mobility, however,is that executives are exposed to different ways of doing business. The ability to compare business practices helpsexecutives identify how good practices and techniques developed in one firm might be profitably applied to other firms.

The GroupIn contrast to the Western emphasis on the individual, the group is the primary unit of social organization in many othersocieties. For example, in Japan, the social status of an individual has traditionally been determined as much by thestanding of the group to which he or she belongs as by his or her individual performance.20 In traditional Japanesesociety, the group was the family or village to which an individual belonged. Today, the group has frequently come to beassociated with the work team or business organization. In a now-classic study of Japanese society, Nakane noted howthis expresses itself in everyday life:

When a Japanese faces the outside (confronts another person) and affixes some position to himself socially he is inclined to giveprecedence to institution over kind of occupation. Rather than saying, “I am a typesetter” or “I am a filing clerk,” he is likely tosay, “I am from B Publishing Group” or “I belong to S company.”21

Nakane goes on to observe that the primacy of the group often evolves into a deeply emotional attachment in whichidentification with the group becomes very important in a person’s life. For example, as a student, you will often identifyyourself as going to a specific university or, soon enough, as a graduate of that university—and the latter identification as

1.2.3.4.

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an alumnus is something you will carry with you for life. In many cases, we also extend that group thinking beyond acompany, organization, or university. For example, we talk about being part of a university-related conference—forexample, “I’m going to Michigan State University, and we are part of the Big Ten Conference.” Or, “I’m going to theUniversity of Washington, and we are part of the Pac-12 Conference.”

At the country level, one central value of Japanese culture is the importance attached to group membership. Thismay have beneficial implications for business firms. Strong identification with the group is argued to create pressures formutual self-help and collective action. If the worth of an individual is closely linked to the achievements of the group, asNakane maintains is the case in Japan, this creates a strong incentive for individual members of the group to worktogether for the common good. Some argue that the success of Japanese companies in the global economy has beenbased partly on their ability to achieve close cooperation between individuals within a company and between companies.This has found expression in the widespread diffusion of self-managing work teams within Japanese organizations; theclose cooperation among different functions within Japanese companies (e.g., among manufacturing, marketing, andR&D); and the cooperation between a company and its suppliers on issues such as design, quality control, and inventoryreduction.22 In all these cases, cooperation is driven by the need to improve the performance of the group.

The primacy of the value of group identification also discourages managers and other workers from moving fromone company to another. Lifetime employment in a particular company was long the norm in certain sectors of theJapanese economy (estimates suggest that between 20 and 40 percent of all Japanese employees have formal or informallifetime employment guarantees), albeit those norms have changed significantly in recent decades, with much moremovement being seen between companies. Over the years, managers and workers build up knowledge, experience, and anetwork of interpersonal business contacts. All these things can help managers perform their jobs more effectively andachieve cooperation with others.

However, the primacy of the group is not always beneficial. Just as U.S. society is characterized by agreat deal of entrepreneurship, reflecting the primacy of values associated with individualism, some argue that Japanesesociety is characterized by a corresponding lack of entrepreneurship. Although the long-run consequences are unclear,one implication is that the United States could continue to create more new industries than Japan and continue to be moresuccessful at pioneering radically new products and new ways of doing business. By most estimates, the United Stateshas led the world in innovation for some time, especially radically new products and services, and the country’sindividualism is a strong contributor to this innovative mindset. At the same time, some group-oriented countries, such asJapan, do very well in innovation also, especially non-radical “normal” innovations, according to the GE GlobalInnovation Barometer.23 This is an indication that multiple paths to being innovative exist in both individualistic andgroup-oriented cultures, drawing from the uniqueness of the particular culture and what core competencies are reflectedin the culture.24 Some argue that individualistic societies are great at creating innovative ideas while collectivist, orgroup-oriented, societies are better at the implementation of those ideas (taking the idea to the market).

SOCIAL STRATIFICATION

LO4-2Identify the forces that lead to differences in social culture.All societies are stratified on a hierarchical basis into social categories—that is, into social strata. These strata aretypically defined on the basis of socioeconomic characteristics such as family background, occupation, and income.Individuals are born into a particular stratum. They become a member of the social category to which their parentsbelong. Individuals born into a stratum toward the top of the social hierarchy tend to have better life chances than thoseborn into a stratum toward the bottom of the hierarchy. They are likely to have better education, health, standard ofliving, and work opportunities. Although all societies are stratified to some degree, they differ in two related ways. First,they differ from each other with regard to the degree of mobility between social strata. Second, they differ with regard tothe significance attached to social strata in business contexts. Overall, social stratification is based on four basicprinciples:25

Social stratification is a trait of society, not a reflection of individual differences.Social stratification carries over a generation to the next generation.Social stratification is generally universal but variable.Social stratification involves not just inequality but also beliefs.

Social MobilityThe term social mobility refers to the extent to which individuals can move out of the strata into which they are born.

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Social mobility varies significantly from society to society. The most rigid system of stratification is a caste system. Acaste system is a closed system of stratification in which social position is determined by the family into which a personis born, and change in that position is usually not possible during an individual’s lifetime. Often, a caste position carrieswith it a specific occupation. Members of one caste might be shoemakers, members of another might be butchers, and soon. These occupations are embedded in the caste and passed down through the family to succeeding generations.Although the number of societies with caste systems diminished rapidly during the twentieth century, one partialexample still remains. India has four main castes and several thousand subcastes. Even though the caste system wasofficially abolished in 1949, two years after India became independent, it is still a force in rural Indian society whereoccupation and marital opportunities are still partly related to caste (for more details, see the accompanying CountryFocus on the caste system in India today, “Determining Your Social Class by Birth”).26

A class system is a less rigid form of social stratification in which social mobility is possible. It is a form of openstratification in which the position a person has by birth can be changed through his or her own achievements or luck.Individuals born into a class at the bottom of the hierarchy can work their way up; conversely, individuals borninto a class at the top of the hierarchy can slip down.

COUNTRY FOCUS

Determining Your Social Class by BirthModern India is a country of dramatic contrasts. The country’s information technology (IT) sector is among the most vibrant in theworld, with companies such as Tata Consultancy Services, Cognizant Technology Solutions, Infosys, and Wipro as powerfulglobal players. Cognizant is an interesting company in that it was founded as a technology arm of Dun & Bradstreet (USA), but itis typically considered an Indian IT company because a majority of its employees are based in India. In fact, many IT companieslocate or operate in India because of its strong IT knowledge, human capital, and culture.

Traditionally, India has had one of the strongest caste systems in the world. Somewhat sadly, as a British author, this castesystem still exists today even though it was officially abolished in 1949, and many Indians actually prefer it this way! At the core,the caste system has no legality in India, and discrimination against lower castes is illegal. India has also enacted numerous newlaws and social initiatives to protect and improve living conditions of lower castes in the country.

Prior to 1949, India’s caste system was definitely an impediment to social mobility, and some say it remains difficult to moveacross castes. But the stranglehold on people’s socioeconomic conditions is becoming a fading memory among the educated, urbanmiddle-class Indians who make up the majority of employees in the high-tech economy. Unfortunately, the same is not true inrural India, where some 64 percent of the nation’s population still resides. In the rural part of the country, the caste remains apervasive influence.

For example, a young female engineer at Infosys, who grew up in a small rural village and is a dalit (sometimes called a“scheduled caste”), recounts how she never entered the house of a Brahmin, India’s elite priestly caste, even though half of hervillage were Brahmins. And when a dalit was hired to cook at the school in her native village, Brahmins withdrew their childrenfrom the school. The engineer herself is the beneficiary of a charitable training scheme developed by Infosys. Her caste, making upabout 16 percent of the country (or around 212 million people), is among the poorest in India, with some 91 percent making lessthan $100 a month.

To try to correct this historical inequality, politicians have talked for years about extending the employment quota system toprivate enterprises. The government has told private companies to hire more dalits and members of tribal communities and havebeen warned that “strong measures” will be taken if companies do not comply. Private employers are resisting attempts to imposequotas, arguing with some justification that people who are guaranteed a job by a quota system are unlikely to work very hard.

At the same time, progressive employers realize they need to do something to correct the inequalities, and unless India tapsinto the lower castes, it may not be able to find the employees required to staff rapidly growing high-technology enterprises. As aconsequence, the Confederation of Indian Industry implemented a package of dalit-friendly measures, including scholarships forbright lower-caste children. Building on this, Infosys is leading the way among high-tech enterprises. The company providesspecial training to low-caste engineering graduates who have failed to get a job in industry after graduation. While the trainingdoes not promise employment, so far almost all graduates who completed the seven-month training program have been hired byInfosys and other enterprises. Positively, Infosys programs are a privatized version of the education offered in India to try to breakdown India’s caste system.Sources: Mari Marcel Thekaekara, “India’s Caste System Is Alive and Kicking—and Maiming and Killing,” The Guardian, August 15, 2016; Noah Feldman, “India’s HighCourt Favors Nationalism over Democracy,” Bloomberg View, January 8, 2017; “Why Some of India’s Castes Demand to Be Reclassified,” The Economist, February 16,2016.

While many societies have class systems, social mobility within a class system also varies from society to society.For example, some sociologists have argued that the United Kingdom has a more rigid class structure than certain other

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Western societies, such as the United States.27 Historically, British society was divided into three main classes: the upperclass, which was made up of individuals whose families for generations had wealth, prestige, and occasionallypower; the middle class, whose members were involved in professional, managerial, and clerical occupations;and the working class, whose members earned their living from manual occupations. The middle class was furthersubdivided into the upper-middle class, whose members were involved in important managerial occupations and theprestigious professions (lawyers, accountants, doctors), and the lower-middle class, whose members were involved inclerical work (bank tellers) and the less prestigious professions (school teachers).

The British class system exhibited significant divergence between the life chances of members of different classes.The upper and upper-middle classes typically sent their children to a select group of private schools, where they wouldnot mix with lower-class children and where they picked up many of the speech accents and social norms that markedthem as being from the higher strata of society. These same private schools also had close ties with the most prestigiousuniversities, such as Oxford and Cambridge. Until fairly recently, Oxford and Cambridge guaranteed a certain number ofplaces for the graduates of these private schools. Having been to a prestigious university, the offspring of the upper andupper-middle classes then had an excellent chance of being offered a prestigious job in companies, banks, brokeragefirms, and law firms run by members of the upper and upper-middle classes.

Modern British society is now rapidly leaving behind this class structure and moving toward more of a classlesssociety. However, sociologists continue to dispute this finding. For example, one study reported that state schools in theLondon Borough (suburb) of Islington, which now has a population of 230,000, had only 79 candidates for university,while one prestigious private school alone, Eton, sent more than that number to Oxford and Cambridge.28 This,according to the study’s authors, implies that “money still begets money.” They argue that a good school means a gooduniversity, a good university means a good job, and merit has only a limited chance of elbowing its way into this tightcircle. In another survey, a sociologist noted that class differentials in educational achievement have changedsurprisingly little over the last few decades in many societies, despite assumptions to the contrary.29

Another society for which class divisions have historically been of some importance has been China, where therehas been a long-standing difference between the life chances of the rural peasantry and urban dwellers. Ironically, thishistoric division was strengthened during the high point of communist rule because of a rigid system of householdregistration that restricted most Chinese to the place of their birth for their lifetime. Bound to collective farming, peasantswere cut off from many urban privileges—compulsory education, quality schools, health care, public housing, evenvarieties of food, to name only a few—and they largely lived in poverty. Social mobility was very limited. This systemcrumbled following the reforms of a few decades ago, and as a consequence, migrant peasant laborers have flooded intoChina’s cities looking for work. Sociologists now hypothesize that a new class system is emerging in China based less onthe rural–urban divide and more on urban occupation.30

The class system in the United States is less pronounced than in India, the United Kingdom, and China and mobilityis greater. Like the UK, the United States has its own upper, middle, and working classes. However, class membership isdetermined to a much greater degree by individual economic achievements, as opposed to background and schooling.Thus, an individual can, by his or her own economic achievement, move smoothly from the working class to the upperclass in a lifetime. Successful individuals from humble origins are highly respected in American society. Part of theadmiration comes from entrepreneurs in the United States who have done exceedingly well creating and marketing theirproducts, services, and ideas (e.g., Andrew Carnegie, Henry Ford, Oprah Winfrey, Bill Gates, and Larry Page).

Significance

LO4-3Identify the business and economic implications of differences in culture.From a business perspective, the stratification of a society is significant if it affects the operations of companies. InAmerican society, the high degree of social mobility and the extreme emphasis on individualism limit the impact of classbackground on business operations. The same is true in Japan, where most of the population perceives itself to be middleclass. In a country such as the United Kingdom or India, however, the relative lack of class mobility and thedifferences between classes have resulted in the emergence of class consciousness. Class consciousness refersto a condition by which people tend to perceive themselves in terms of their class background, and this shapes theirrelationships with members of other classes.

This has been played out in British society in the traditional hostility between upper-middle-class managers andtheir working-class employees. Mutual antagonism and lack of respect historically made it difficult to achievecooperation between management and labor in many British companies and resulted in a relatively high level ofindustrial disputes. However, the past two decades have seen a dramatic reduction in industrial disputes, which bolsters

the arguments of those who claim that the country is moving toward a classless society. Interestingly, some argue that theUnited Kingdom leaving the European Union (“Brexit”) has become a class-related negotiation and outcome that maytake the Brits decades to solve effectively. Also, as noted earlier, class consciousness may be reemerging in urban China,and may ultimately prove significant in the country.

Overall, an antagonistic relationship between management and labor classes, and the resulting lack of cooperationand high level of industrial disruption, tends to raise the costs of production in countries characterized by significantclass divisions. This can make it more difficult for companies based in such countries to establish a competitiveadvantage in the global economy. China has seen a slowdown in its economy, Britain is engulfed in Brexit repercussions,the United States faces nationalistic tendencies, and India still practices a caste system that limits mobility. These are nothistorical artifacts; they are here and now and companies need to strategically plan accordingly.

TEST PREPUse SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBookor go to learnsmartadvantage.com for help.

Religious and Ethical Systems

LO4-2Identify the forces that lead to differences in social culture.Religion may be defined as a system of shared beliefs and rituals that are concerned with the realm of the sacred.31 Anethical system refers to a set of moral principles, or values, that are used to guide and shape behavior.32 Most of theworld’s ethical systems are the product of religions. Thus, we can talk about Christian ethics and Islamic ethics.However, there is a major exception to the principle that ethical systems are grounded in religion. Confucianism andConfucian ethics influence behavior and shape culture in parts of Asia, yet it is incorrect to characterize Confucianism asa religion.

The relationship among religion, ethics, and society is subtle and complex. Of the thousands of religions in theworld today, four dominate in terms of numbers of adherents: Christianity with roughly 2.20 billion adherents, Islamwith around 1.60 billion adherents, Hinduism with 1.10 billion adherents (primarily in India), and Buddhism with about535 million adherents (see Map 4.1). Although many other religions have an important influence in certain parts of themodern world (e.g., Shintoism in Japan, with roughly 40 million followers, and Judaism, which has 18 million adherentsand accounts for 75 percent of the population of Israel), their numbers pale in comparison with these dominant religions.We review these four religions, along with Confucianism, focusing on their potential business implications.

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MAP 4.1 World religions.Source: “Map 14,” in Allen, John L., and Sutton, Christopher J., Student Atlas of World Politics, 10th ed. New York, NY: McGraw-Hill Companies, Inc., 2013.

Some scholars have theorized that the most important business implications of religion center on the extent towhich different religions shape attitudes toward work and entrepreneurship and the degree to which religious ethicsaffect the costs of doing business. However, it is hazardous to make sweeping generalizations about the nature of therelationship among religion, ethical systems, and business practice. Nations with Catholic, Protestant, Muslim, Hindu,and Buddhist majorities all show evidence of entrepreneurial activity and economic growth in various ways.

Interestingly, research by economists Robert Barro and Rachel McCleary suggest that strong religious beliefs,particularly beliefs in heaven, hell, and an afterlife, have a positive impact on economic growth rates, irrespective of theparticular religion in question.33 Barro and McCleary looked at religious beliefs and economic growth rates in 59countries. Their conclusion was that higher religious beliefs stimulate economic growth because they helpsustain aspects of individual behavior that lead to higher productivity. At the same time, other professionalssuggest such economic growth is a function of sound economic policy and not necessarily religions or religious ethics.

CHRISTIANITYChristianity is the most widely practiced religion in the world, with some 2.20 billion followers. The vast majority ofChristians live in Europe and the Americas, although their numbers are growing rapidly in Africa. Christianity grew outof Judaism. Like Judaism, it is a monotheistic religion (monotheism is the belief in one God). A religious division in theeleventh century led to the establishment of two major Christian organizations: the Roman Catholic Church and theOrthodox Church. Today, the Roman Catholic Church accounts for more than half of all Christians, most of whom arefound in southern Europe and Latin America. The Orthodox Church, while less influential, is still of major importance inseveral countries (especially Greece and Russia). In the sixteenth century, the Reformation led to a further split withRome; the result was Protestantism. The nonconformist nature of Protestantism has facilitated the emergence ofnumerous denominations under the Protestant umbrella (Baptist, Methodist, Calvinist, and so on).

Economic Implications of Christianity

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LO4-3Identify the business and economic implications of differences in culture.Several sociologists have argued that, of the main branches of Christianity—Catholic, Orthodox, and Protestant—thelatter has the most important economic implications. In 1904, prominent German sociologist Max Weber made aconnection between Protestant ethics and “the spirit of capitalism” that has since become legendary.34 Weber noted thatcapitalism emerged in Western Europe, where

business leaders and owners of capital, as well as the higher grades of skilled labor, and even more the higher technically andcommercially trained personnel of modern enterprises, are overwhelmingly Protestant.35

Weber theorized that there was a relationship between Protestantism and the emergence of capitalism. He arguedthat Protestant ethics emphasizes the importance of hard work and wealth creation (for the glory of God) and frugality(abstinence from worldly pleasures). According to Weber, this kind of value system was needed to facilitate thedevelopment of capitalism. Protestants worked hard and systematically to accumulate wealth. Their ascetic beliefssuggested that rather than consuming the wealth by indulging in worldly pleasures, they should invest it in the expansionof capitalist enterprises. Thus, the combination of hard work and the accumulation of capital, which could be used tofinance investment and expansion, paved the way for the development of capitalism in Western Europe and subsequentlyin the United States. In contrast, Weber argued that the Catholic promise of salvation in the next world, rather than thisworld, did not foster the same kind of work ethic.

Protestantism also may have encouraged capitalism’s development in another way. By breaking away from thehierarchical domination of religious and social life that characterized the Catholic Church for much of its history,Protestantism gave individuals more freedom to develop their own relationship with God. The right to freedom of formof worship was central to the nonconformist nature of early Protestantism. This emphasis on individual religious freedommay have paved the way for the subsequent emphasis on individual economic and political freedoms and thedevelopment of individualism as an economic and political philosophy. As we saw in Chapter 2, such a philosophyforms the bedrock on which entrepreneurial free market capitalism is based. Building on this, some scholars claim thereis a connection between individualism, as inspired by Protestantism, and the extent of entrepreneurial activity in anation.36 Again, we must be careful not to generalize too much from this historical sociological view. While nations witha strong Protestant tradition such as Britain, Germany, and the United States were early leaders in the IndustrialRevolution, nations with Catholic or Orthodox majorities show significant and sustained entrepreneurial activity andeconomic growth in the modern world.

ISLAM

LO4-2Identify the forces that lead to differences in social culture.With about 1.60 billion adherents, Islam is the second largest of the world’s major religions. Islam dates to 610 a.d. whenthe Prophet Muhammad began spreading the word, although the Muslim calendar begins in 622 a.d. when, to escapegrowing opposition, Muhammad left Mecca for the oasis settlement of Yathrib, later known as Medina. Adherents ofIslam are referred to as Muslims. Muslims constitute a majority in more than 40 countries and inhabit a nearlycontiguous stretch of land from the northwest coast of Africa, through the Middle East, to China and Malaysia in the FarEast.

Islam has roots in both Judaism and Christianity (Islam views Jesus Christ as one of God’s prophets). LikeChristianity and Judaism, Islam is a monotheistic religion. The central principle of Islam is that there is but the one trueomnipotent God (Allah). Islam requires unconditional acceptance of the uniqueness, power, and authority of God and theunderstanding that the objective of life is to fulfill the dictates of His will in the hope of admission to paradise.According to Islam, worldly gain and temporal power are an illusion. Those who pursue riches on earth may gain them,but those who forgo worldly ambitions to seek the favor of Allah may gain the greater treasure: entry intoparadise. Other major principles of Islam include (1) honoring and respecting parents, (2) respecting the rightsof others, (3) being generous but not a squanderer, (4) avoiding killing except for justifiable causes, (5) not committingadultery, (6) dealing justly and equitably with others, (7) being of pure heart and mind, (8) safeguarding the possessionsof orphans, and (9) being humble and unpretentious.37 Parallels exist with central principles of Judaism and Christianity.

Islam is an all-embracing way of life governing the totality of a Muslim’s being.38 As God’s surrogate in this

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world, a Muslim is not a totally free agent, but is circumscribed by religious principles—by a code of conduct forinterpersonal relations—in social and economic activities. Religion is paramount in all areas of life. A Muslim lives in asocial structure that is shaped by Islamic values and norms of moral conduct. The ritual of everyday life in a Muslimcountry is striking to a Western visitor. Among other things, orthodox Muslim ritual requires prayer five times a day(business meetings may be put on hold while the Muslim participants engage in their daily prayer ritual), demands thatwomen should be dressed in a certain manner, and forbids the consumption of pork and alcohol.

Islamic FundamentalismThe past three decades, in particular, have witnessed the growth of a social movement often referred to as Islamicfundamentalism.39 In the West, Islamic fundamentalism is associated with militants, terrorists, and violent upheavals,such as the bloody conflict in Algeria, the killing of foreign tourists in Egypt, and the September 11, 2001, attacks on theWorld Trade Center and Pentagon in the United States. For most, this characterization is misleading. Just as Christianfundamentalists are motivated by deeply held religious values that are firmly rooted in their faith, so are Islamicfundamentalists.

A small minority of radical “fundamentalists” who have hijacked the religion to further their own political andviolent ends perpetrate the violence that the Western media associates with Islamic fundamentalism. Radical Islamicfundamentalists exist in various forms today, but the most notorious is probably ISIS—an acronym for Islamic State ofIraq and Syria. Now, the violence associated with radical Islamic fundamentalists can be seen across other religions aswell. Some Christian “fundamentalists” have incited their own political engagement and violence. The vast majority ofMuslims point out that Islam teaches peace, justice, and tolerance, not violence and intolerance. In fact, the foundation isthat Islam explicitly repudiates the violence that a radical minority practices.

The rise of Islamic fundamentalism has no one cause. In part, it is a response to the social pressures created intraditional Islamic societies by the move toward modernization and by the influence of Western ideas, such as liberaldemocracy; materialism; equal rights for women; and attitudes toward sex, marriage, and alcohol. In many Muslimcountries, modernization has been accompanied by a growing gap between a rich urban minority and an impoverishedurban and rural majority. For the impoverished majority, modernization has offered little in the way of tangible economicprogress, while threatening the traditional value system. Thus, for a Muslim who cherishes his or her traditions and feelsthat their identity is jeopardized by the encroachment of Western values, Islamic fundamentalism is a cultural anchor.

Fundamentalists demand a commitment to strict religious beliefs and rituals. The result has been a marked increasein the use of symbolic gestures that confirm Islamic values. In areas where fundamentalism is strong, women haveresumed wearing floor-length, long-sleeved dresses and covering their hair; religious studies have increased inuniversities; the publication of religious tracts has increased; and public religious orations have risen.40 Also, thesentiments of some fundamentalist groups are often anti-Western. Rightly or wrongly, Western influence is blamed for arange of social ills, and many fundamentalists’ actions are directed against Western governments, culturalsymbols, businesses, and individuals.

In several Muslim countries, fundamentalists have gained political power and have used this to try to make Islamiclaw the law of the land (as set down in the Koran, the bible of Islam). There are grounds for this in Islamic doctrine.Islam makes no distinction between church and state. It is not just a religion; Islam is also the source of law, a guide tostatecraft, and an arbiter of social behavior. Muslims believe that every human endeavor is within the purview of theirfaith—and this includes political activity—because the only purpose of any activity is to do God’s will.41 Muslimfundamentalists have been most successful in Iran, where a fundamentalist party has held power since 1979, but theyalso have had an influence in many other countries, such as Afghanistan, Algeria, Egypt, Pakistan, Saudi Arabia, andSudan.

Economic Implications of Islam

LO4-3Identify the business and economic implications of differences in culture.

The Koran establishes some explicit economic principles, many of which are pro-free enterprise.42 The Koran speaksapprovingly of free enterprise and earning profit through trade and commerce (the Prophet Muhammad himself was oncea trader). The protection of the right to private property is also embedded within Islam, although Islam asserts that allproperty is a favor from Allah (God), who created and so owns everything. Those who hold property are regarded astrustees rather than owners. As trustees, they are entitled to receive profits from the property but are admonished to use itin a righteous, socially beneficial, and prudent manner. This reflects Islam’s concern with social justice. Islam is criticalof those who earn profit through the exploitation of others. In the Islamic view, humans are part of a collective in whichthe wealthy have obligations to help the disadvantaged. In Muslim countries, it is fine to earn a profit, so long as that

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profit is justly earned and not based on the exploitation of others. It also helps if those making profits undertakecharitable acts to help the poor. Furthermore, Islam stresses the importance of living up to contractual obligations,keeping one’s word, and abstaining from deception. For a closer look at how Islam, capitalism, and globalization cancoexist, see the accompanying Country Focus on the region around Kayseri in central Turkey.

Given the Islamic proclivity to favor market-based systems, Muslim countries are likely to be receptive tointernational businesses as long as those businesses behave in a manner that is consistent with Islamic ethics, customs,and business practices. But, in Islamic countries where fundamentalism is on the rise, general hostility toward Western-owned businesses is also likely to increase. When foreigners are involved in predominantly Muslim countries, oneunique economic principle of Islam can come into play. Islam prohibits the payment or receipt of interest, which isconsidered illegal. This is not just a matter of theology; in several Islamic states, it is also a matter of law. The Koranclearly condemns interest, which is called riba in Arabic, as exploitative and unjust. For many years, banks operating inIslamic countries conveniently ignored this condemnation, but starting in the 1970s with the establishment of an Islamicbank in Egypt, Islamic banks opened in predominantly Muslim countries. Now there are hundreds of Islamic banks inmore than 50 countries with assets of around $1.6 trillion; plus more than $1 trillion is managed by mutual funds thatadhere to Islamic principles.43 Even conventional banks are entering the market: both Citigroup and HSBC, two of theworld’s largest financial institutions, now offer Islamic financial services. While only Iran and Sudan enforce Islamicbanking conventions, in an increasing number of countries customers can choose between conventional banks andIslamic banks.

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

COUNTRY FOCUS

Turkey, Its Religion, and PoliticsFor years now, Turkey has been lobbying the European Union to allow it to join the free trade bloc as a member state. Even asgrumblings take place in some EU countries about leaving (e.g., Brexit), Turkey is all in to join if it can. If the EU says yes, it willbe the first Muslim state in the European Union. But this is unlikely to happen any time soon; after all, it has been half a century inthe making!

Many critics in the EU worry that Islam and Western-style capitalism do not mix well and that, as a consequence, allowingTurkey into the EU would be a mistake. However, a close look at what is going on in Turkey suggests this view may be misplaced.Consider the area around the city of Kayseri in central Turkey. Many dismiss this poor, largely agricultural region of Turkey as anon-European backwater, far removed from the secular bustle of Istanbul. It is a region where traditional Islamic values hold sway.And yet it is a region that has produced so many thriving Muslim enterprises that it is sometimes called the “Anatolian Tiger.”Businesses based here include large food manufacturers, textile companies, furniture manufacturers, and engineering enterprises,many of which export a substantial percentage of their production.

Local business leaders attribute the success of companies in the region to an entrepreneurial spirit that they say is part ofIslam. They point out that the Prophet Muhammad, who was himself a trader, preached merchant honor and commanded that 90percent of a Muslim’s life be devoted to work in order to put food on the table. Outside observers have gone further, arguing thatwhat is occurring around Kayseri is an example of Islamic Calvinism, a fusion of traditional Islamic values and the work ethicoften associated with Protestantism in general and Calvinism in particular.

However, not everyone agrees that Islam is the driving force behind the region’s success. Saffet Arslan, the managing directorof Ipek, the largest furniture producer in the region (which exports to more than 30 countries), says another force is at work:globalization! According to Arslan, over the past three decades, local Muslims who once eschewed making money in favor offocusing on religion are now making business a priority. They see the Western world, and Western capitalism, as a model, notIslam, and because of globalization and the opportunities associated with it, they want to become successful.

If there is a weakness in the Islamic model of business that is emerging in places such as Kayseri, some say it can be found intraditional attitudes toward the role of women in the workplace and the low level of female employment in the region. Accordingto a report by the European Stability Initiative, the same group that holds up the Kayseri region as an example of IslamicCalvinism, the low participation of women in the local workforce is the Achilles’ heel of the economy and may stymie theattempts of the region to catch up with the countries of the European Union.Sources: Marc Champion, “Turkey’s President Is Close to Getting What He’s Always Wanted,” Bloomberg BusinessWeek, February 8, 2017; “Dress in a Muslim Country:Turkey Covers Up,” The Economist, January 26, 2017; “Turkey’s Future Forward to the Past: Can Turkey’s Past Glories Be Revived by Its Grandiose Islamist President?”The Economist, January 3, 2015.

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A mudarabah contract is similar to a profit-sharing scheme. Under mudarabah, when an Islamic bank lends moneyto a business, rather than charging interest, it takes a share in the profits that are derived from the investment. Similarly,when a business (or individual) deposits money at an Islamic bank, the deposit is treated as an equity in whatever activitythe bank uses the capital for to invest. Thus, the depositor receives a share in the profit from the bank’s investment (asopposed to interest payments) according to an agreed-upon ratio. Some Muslims claim this is a more efficient systemthan the Western banking system because it encourages both long-term savings and long-term investment. However,there is no hard evidence of this, and many believe that a mudarabah system is less efficient than a conventional Westernbanking system.

Glow Images

global EDGE CULTURE ON GLOBALEDGE

The “Culture” section of globalEDGE™ (globaledge.msu.edu/global-resources/culture) offers a variety of sources, information, and dataon culture and international business. In addition, the “Insights by Country” section (globaledge.msu.edu/global-insights/by/country),with coverage of more than 200 countries and territories, has culture coverage (e.g., what to do and not do when visiting a country). Inthis chapter, we cover a lot of material on culture, and Geert Hofstede’s research has been the most influential on culture and business forabout half a century. globalEDGE™ has “The Hofstede Centre” as one of its cultural reference sources. This reference focuses onHofstede’s research on cultural dimensions, including scores for countries, regions, charts, and graphs. Are you interested in the scoresfor a country that we do not illustrate in Table 4.1? If so, check out “The Hofstede Centre” and its “Culture Compass,” and see what thescores are for your favored country.

TABLE 4.1 Work-Related Values for 15 Selected CountriesSource: Hofstede Insights; www.hofstede-insights.com/product/compare-countries, Accessed March 7, 2019.

The second Islamic banking method, the murabaha contract, is the most widely used among the world’s Islamicbanks, primarily because it is the easiest to implement. In a murabaha contract, when a firm wishes to purchasesomething using a loan—let’s say a piece of equipment that costs $1,000—the firm tells the bank after having negotiatedthe price with the equipment manufacturer. The bank then buys the equipment for $1,000, and the borrower buys it backfrom the bank at some later date for, say, $1,100, a price that includes a $100 markup for the bank. A cynic might pointout that such a markup is functionally equivalent to an interest payment, and it is the similarity between this method andconventional banking that makes it so much easier to adopt.

HINDUISM

LO4-2Identify the forces that lead to differences in social culture.Hinduism has approximately 1.10 billion adherents, most of them on the Indian subcontinent. Hinduism began in theIndus Valley in India more than 4,000 years ago, making it the world’s oldest major religion. Unlike Christianity andIslam, its founding is not linked to a particular person. Nor does it have an officially sanctioned sacred book such as theBible or the Koran. Hindus believe that a moral force in society requires the acceptance of certain responsibilities, calleddharma. Hindus believe in reincarnation, or rebirth into a different body, after death. Hindus also believe in karma, thespiritual progression of each person’s soul. A person’s karma is affected by the way he or she lives. The moral state of anindividual’s karma determines the challenges he or she will face in the next life. By perfecting the soul in each new life,Hindus believe that an individual can eventually achieve nirvana, a state of complete spiritual perfection that rendersreincarnation no longer necessary. Many Hindus believe that the way to achieve nirvana is to lead a severe asceticlifestyle of material and physical self-denial, devoting life to a spiritual rather than material quest.

Economic Implications of Hinduism

LO4-3Identify the business and economic implications of differences in culture.

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Max Weber, famous for expounding on the Protestant work ethic, also argued that the ascetic principles embedded inHinduism do not encourage the kind of entrepreneurial activity in pursuit of wealth creation that we find inProtestantism.45 According to Weber, traditional Hindu values emphasize that individuals should be judged not by theirmaterial achievements but by their spiritual achievements. Hindus perceive the pursuit of material well-being as makingthe attainment of nirvana more difficult. Given the emphasis on an ascetic lifestyle, Weber thought that devout Hinduswould be less likely to engage in entrepreneurial activity than devout Protestants.

Mahatma Gandhi, the famous Indian nationalist and spiritual leader, was certainly the embodiment ofHindu asceticism. It has been argued that the values of Hindu asceticism and self-reliance that Gandhi advocated had anegative impact on the economic development of post-independence India.46 But we must be careful not to read toomuch into Weber’s rather old arguments. Modern India is a very dynamic entrepreneurial society, and millions ofhardworking entrepreneurs form the economic backbone of the country’s rapidly growing economy, especially in theinformation technology sector.47

Historically, Hinduism also supported India’s caste system. The concept of mobility between castes within anindividual’s lifetime makes no sense to traditional Hindus. Hindus see mobility between castes as something that isachieved through spiritual progression and reincarnation. An individual can be reborn into a higher caste in his or hernext life if he or she achieves spiritual development in this life. Although the caste system has been abolished in India, asdiscussed earlier in the chapter, it still casts a long shadow over Indian life.

BUDDHISM

LO4-2Identify the forces that lead to differences in social culture.Buddhism, with some 535 million adherents, was founded in the sixth century b.c. by Siddhartha Gautama in what is nowNepal. Siddhartha renounced his wealth to pursue an ascetic lifestyle and spiritual perfection. His adherents claimed heachieved nirvana but decided to remain on earth to teach his followers how they, too, could achieve this state of spiritualenlightenment. Siddhartha became known as the Buddha (which means “the awakened one”). Today, most Buddhists arefound in Central and Southeast Asia, China, Korea, and Japan. According to Buddhism, suffering originates in people’sdesires for pleasure. Cessation of suffering can be achieved by following a path for transformation. Siddhartha offeredthe Noble Eightfold Path as a route for transformation. This emphasizes right seeing, thinking, speech, action, living,effort, mindfulness, and meditation. Unlike Hinduism, Buddhism does not support the caste system. Nor does Buddhismadvocate the kind of extreme ascetic behavior that is encouraged by Hinduism. Nevertheless, like Hindus, Buddhistsstress the afterlife and spiritual achievement rather than involvement in this world.

Economic Implications of Buddhism

LO4-3Identify the business and economic implications of differences in culture.The emphasis on wealth creation that is embedded in Protestantism is historically not found in Buddhism. Thus, inBuddhist societies, we do not see the same kind of cultural stress on entrepreneurial behavior that Weber claimed couldbe found in the Protestant West. But unlike Hinduism, the lack of support for the caste system and extreme asceticbehavior suggests that a Buddhist society may represent a more fertile ground for entrepreneurial activity than a Hinduculture. In effect, innovative ideas and entrepreneurial activities may take hold throughout society independent of whichcaste a person may belong to, but again, each culture is uniquely oriented toward its own types of entrepreneurialbehavior.

In Buddhism, societies were historically more deeply rooted to their local place in the natural world.48 This meansthat economies were more localized, with relations between people and also between culture and nature being relativelyunmediated. In the modern economy, complex technologies and large-scale social institutions have led to a separationbetween people and also between people and the natural world. Plus, as the economy grows, it is difficult to understandand appreciate the potential effects people have on the natural world. Both of these separations are antithetical to theBuddha’s teachings.

Interestingly, recent trends actually bring in the “Zen” orientation from Buddhism into business in the Westernworld.49 Now there are some 700 trademarks containing the word Zen in the United States alone, according to the U.S.

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Patent and Trademark Office. “In business, ‘Zen’ is often a synonym for ordinary nothingness,” blogged NancyFriedman, a corporate copywriter who consults with businesses on naming and branding. She said that “Zencan be combined with mail to describe ‘an incoming e-mail message with no message or attachments.’ Zenspin is a verb meaning ‘to tell a story without saying anything at all.’ And to zen a computing problem means to figure itout in an intuitive flash—perhaps while you’re plugged into the earphones of your ZEN system available fromCreative.”50

CONFUCIANISM

LO4-2Identify the forces that lead to differences in social culture.Confucianism was founded in the fifth century b.c. by K’ung-Fu-tzu, more generally known as Confucius. For more than2,000 years until the 1949 communist revolution, Confucianism was the official ethical system of China. Whileobservance of Confucian ethics has been weakened in China since 1949, many people still follow the teachings ofConfucius, principally in China, Korea, and Japan. Confucianism teaches the importance of attaining personal salvationthrough right action. Although not a religion, Confucian ideology has become deeply embedded in the culture of thesecountries over centuries and has an impact on the lives of many millions more.51 Confucianism is built around acomprehensive ethical code that sets down guidelines for relationships with others. High moral and ethical conduct andloyalty to others are central to Confucianism. Unlike religions, Confucianism is not concerned with the supernatural andhas little to say about the concept of a supreme being or an afterlife.

Economic Implications of Confucianism

LO4-3Identify the business and economic implications of differences in culture.Some scholars maintain that Confucianism may have economic implications as profound as those Weber argued werefound in Protestantism, although they are of a different nature.52 Their basic thesis is that the influence of Confucianethics on the culture of China, Japan, South Korea, and Taiwan, by lowering the costs of doing business in thosecountries, may help explain their economic success. In this regard, three values central to the Confucian system of ethicsare of particular interest: loyalty, reciprocal obligations, and honesty in dealings with others.

In Confucian thought, loyalty to one’s superiors is regarded as a sacred duty—an absolute obligation. Inorganizations based in Confucian cultures, the loyalty that binds employees to the heads of their organization can reducethe conflict between management and labor that we find in more class-conscious societies. Cooperation betweenmanagement and labor can be achieved at a lower cost in a culture where the virtue of loyalty is emphasized in the valuesystems. However, in a Confucian culture, loyalty to one’s superiors, such as a worker’s loyalty to management, is notblind loyalty.

The concept of reciprocal obligations is also important. Confucian ethics stresses that superiors are obliged toreward the loyalty of their subordinates by bestowing blessings on them. If these “blessings” are not forthcoming, thenneither will be the loyalty. This Confucian ethic is central to the Chinese concept of guanxi, which refers to relationshipnetworks supported by reciprocal obligations.53 Guanxi means relationships, although in business settings it can bebetter understood as connections. Today, Chinese will often cultivate a guanxiwang, or “relationship network,” for help.Reciprocal obligations are the glue that holds such networks together. If those obligations are not met—if favors doneare not paid back or reciprocated—the reputation of the transgressor is tarnished, and the person will be less able to drawon his or her guanxiwang for help in the future. Thus, the implicit threat of social sanctions is often sufficient to ensurethat favors are repaid, obligations are met, and relationships are honored. In a society that lacks a rule-based legaltradition, and thus legal ways of redressing wrongs such as violations of business agreements, guanxi is an importantmechanism for building long-term relationships and getting business done in China. For an example of the importance ofguanxi, read the accompanying Management Focus on China.

A third concept found in Confucian ethics is the importance attached to honesty. Confucian thinkers emphasize thatalthough dishonest behavior may yield short-term benefits for the transgressor, dishonesty does not pay in thelong run. The importance attached to honesty has major economic implications. When companies can trusteach other not to break contractual obligations, the costs of doing business are lowered. Expensive lawyers are notneeded to resolve contract disputes. In a Confucian society, people may be less hesitant to commit substantial resources

Page 115to cooperative ventures than in a society where honesty is less pervasive. When companies adhere to Confucian ethics,they can trust each other not to violate the terms of cooperative agreements. Thus, the costs of achievingcooperation between companies may be lower in societies such as Japan relative to societies where trust is lesspervasive.

MANAGEMENT FOCUS

China and Its GuanxiA few years ago, DMG emerged as one of China’s fastest-growing advertising agencies with a client list that includes Unilever,Sony, Nabisco, Audi, Volkswagen, China Mobile, and dozens of other Chinese brands. Dan Mintz, the company’s founder, saidthat the success of DMG was connected strongly to what the Chinese call guanxi.

Guanxi means relationships or business connections. The concept has its roots in the Confucian philosophy of valuing socialhierarchy and reciprocal obligations. Confucian ideology has a 2,000-year-old history in China. Confucianism stresses theimportance of relationships, both within the family and between a master and the servant. Confucian ideology also teaches thatpeople are not created equal. In Confucian thought, loyalty and obligations to one’s superiors (or to family) are regarded as asacred duty, but at the same time, this loyalty has its price. Social superiors are obligated to reward the loyalty of their socialinferiors by bestowing “blessings” upon them; thus, the obligations are reciprocal. Chinese will often cultivate a guanxiwang, or“relationship network,” for help. There is a tacit acknowledgment that if you have the right guanxi, legal rules can be broken, or atleast bent.

Mintz, who is fluent in Mandarin, cultivated his guanxiwang by going into business with two young Chinese who hadconnections, Bing Wu and Peter Xiao. Wu, who works on the production side of the business, was a former national gymnasticschampion, which translates into prestige and access to business and government officials. Xiao comes from a military family withmajor political connections. Together, these three have been able to open doors that long-established Western advertising agenciescould not. They have done it in large part by leveraging the contacts of Wu and Xiao and by backing up their connections withwhat the Chinese call Shi li, the ability to do good work.

A case in point was DMG’s campaign for Volkswagen, which helped the German company become ubiquitous in China. Theads used traditional Chinese characters, which had been banned by Chairman Mao during the cultural revolution in favor ofsimplified versions. To get permission to use the characters in film and print ads—a first in modern China—the trio had to draw onhigh-level government contacts in Beijing. They won over officials by arguing that the old characters should be thought of not as“characters” but as art. Later, they shot TV spots for the ad on Shanghai’s famous Bund, a congested boulevard that runs along thewaterfront of the old city. Drawing again on government contacts, they were able to shut down the Bund to make the shoot. DMGhas also filmed inside Beijing’s Forbidden City, even though it is against the law to do so. Using his contacts, Mintz persuaded thegovernment to lift the law for 24 hours. As Mintz has noted, “We don’t stop when we come across regulations. There arerestrictions everywhere you go. You have to know how get around them and get things done.”*

Today, DMG Entertainment has expanded into being a Chinese-based production and distribution company. While it began asan advertising agency, the company started distributing non-Chinese movies in the Chinese market in the late 2000s (e.g., IronMan 3, the sixth-highest-grossing film of all time in China) as well as producing Chinese films, the first being Founding of aRepublic, a movie that marked the 60th anniversary of the People’s Republic of China. In these activities, DMG is also enjoyingguanxi in the country. Variety reported that DMG benefited from “strong connections” with Chinese government officials and thestate-run China Film Group Corporation.*Graser, Marc, “Featured Player,” Variety, October 18, 2004.

Sources: Rob Cain, “Chinese Studio DMG Emerges as Bidder for Major Stake in Paramount Pictures,” Media and Entertainment, March 15, 2016; Ali Jaafar, “China’s DMGInks Deal with Hasbro to Launch First ‘Transformers’ Live Action Attraction,” Deadline Hollywood, January 16, 2016; A. Busch, “China’s DMG and Valiant EntertainmentPartner to Expand Superhero Universe,” Deadline Hollywood, March 12, 2015; C. Coonan, “DMG’s Dan Mintz: Hollywood’s Man in China,” Variety, June 5, 2013; andSimon Montlake, “Hollywood’s Mr China: Dan Mintz, DMG,” Forbes, August 29, 2012.

For example, it has been argued that the close ties between the automobile companies and their component partssuppliers in Japan are facilitated by a combination of trust and reciprocal obligations. These close ties allow the autocompanies and their suppliers to work together on a range of issues, including inventory reduction, quality control, anddesign. The competitive advantage of Japanese auto companies such as Toyota may in part be explained by suchfactors.54 Similarly, the combination of trust and reciprocal obligations is central to the workings and persistence ofguanxi networks in China.

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LanguageOne obvious way in which many countries differ is the language used by the population. By language, we mean both thespoken and the unspoken means of communication. Language is also one of the defining characteristics of a culture.Oftentimes, learning a language entails learning the culture and vice versa. Some would even argue that a person cannotget entrenched in a culture without knowing its dominant language.

SPOKEN LANGUAGELanguage does far more than just enable people to communicate with each other. The nature of a language alsostructures the way we perceive the world. The language of a society can direct the attention of its members to certainfeatures of the world rather than others. The classic illustration of this phenomenon is that whereas the English languagehas but one word for snow, the language of the Inuit (Eskimos) lacks a general term for it. Instead, distinguishingdifferent forms of snow is so important in the lives of the Inuit that they have 24 words that describe different types ofsnow (e.g., powder snow, falling snow, wet snow, drifting snow).55

Because language shapes the way people perceive the world, it also helps define culture. Countries with more thanone language often have more than one culture. Canada has an English-speaking culture and a French-speaking culture.Tensions between the two can run quite high, with a substantial proportion of the French-speaking minority demandingindependence from a Canada “dominated by English speakers.” The same phenomenon can be observed in many othercountries. Belgium is divided into Flemish and French speakers, and tensions between the two groups exist. In Spain, aBasque-speaking minority with its own distinctive culture has been agitating for independence from the Spanish-speaking majority for decades. On the Mediterranean island of Cyprus, the culturally diverse Greek- and Turkish-speaking populations of the island continually engage in some level of conflict. The island is now partitioned into twoparts as a consequence. While it does not necessarily follow that language differences create differences in culture and,therefore, separatist pressures (witness the harmony in Switzerland, where four languages are spoken), there certainlyseems to be a tendency in this direction.56

Mandarin (Chinese) is the mother tongue of the largest number of people, followed by English and Hindi, which isspoken mainly in India. However, the most widely spoken language in the world is English, followed by French,Spanish, and Mandarin (many people speak English as a second language). English is increasingly becoming thelanguage of international business, as it has been in much of the developed world for years. When Japanese and Germanbusinesspeople get together to do business, it is almost certain they will communicate in English. However, thoughEnglish is widely used, learning the local language yields considerable advantages. Most people prefer to converse intheir own language, and being able to speak the local language can build rapport and goodwill. Internationalbusinesses that do not understand the local language often make blunders through improper translation, takelonger to negotiate business deals, or may lose a potential deal altogether.

For example, some time ago, the Sunbeam Corporation used the English words for its “Mist-Stick” mist-producinghair-curling iron when it entered the German market, only to discover after an expensive advertising campaign that mistmeans excrement in German. General Motors was troubled by the lack of enthusiasm among Puerto Rican dealers for itsChevrolet Nova. When literally translated into Spanish, nova means star. However, when spoken it sounds like “no va,”which in Spanish means “it doesn’t go.” General Motors changed the name of the car to Caribe.57 Ford made a similarand somewhat embarrassing mistake in Brazil. The Ford Pinto may well have been a good car, but the Brazilians wantedno part of a car called “pinto,” which is slang for tiny male genitals in Brazil. Even the world’s largest furnituremanufacturer, IKEA from Sweden, ran into branding issues when it named a plant pot “Jättebra” (which means great orsuperbly good in Swedish). Unfortunately, Jättebra resembles the Thai slang word for sex. Pepsi’s slogan “come alivewith the Pepsi Generation” did not quite work in China. People in China took it to mean “bring your ancestors back fromthe grave.”

UNSPOKEN LANGUAGE

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Identify the forces that lead to differences in social culture.Unspoken language refers to nonverbal communication. We all communicate with each other by a host of nonverbalcues. The raising of eyebrows, for example, is a sign of recognition in most cultures, while a smile is a sign of joy. Manynonverbal cues, however, are culturally bound. A failure to understand the nonverbal cues of another culture can lead toa communication failure. For example, making a circle with the thumb and the forefinger is a friendly gesture in theUnited States, but it is a vulgar sexual invitation in Greece and Turkey. Similarly, while most Americans and Europeansuse the thumbs-up gesture to indicate that “it’s all right,” in Greece the gesture is obscene.

Another aspect of nonverbal communication is personal space, which is the comfortable amount of distancebetween you and someone you are talking with. In the United States, the customary distance apart in a businessdiscussion is five to eight feet. In Latin America, it is three to five feet. Consequently, many North Americansunconsciously feel that Latin Americans are invading their personal space and can be seen backing away from themduring a conversation. Indeed, the American may feel that the Latin is being aggressive and pushy. In turn, the LatinAmerican may interpret such backing away as aloofness. The result can be a regrettable lack of rapport between twobusinesspeople from different cultures.

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Education

LO4-2Identify the forces that lead to differences in social culture.Formal education plays a key role in a society, and it is usually the medium through which individuals learn many of thelanguages, knowledge, and skills that are indispensable in a modern society. Formal education supplements the family’srole in socializing the young into the values and norms of a society. Values and norms are taught both directly andindirectly. Schools generally teach basic facts about the social and political nature of a society. They also focus on thefundamental obligations of citizenship. In addition, cultural norms are taught indirectly at school. Respect for others,obedience to authority, honesty, neatness, being on time, and so on are all part of the “hidden curriculum” of schools.The use of a grading system teaches children the value of personal achievement and competition.58

From an international business perspective, one important aspect of education is its role as a determinant of nationalcompetitive advantage.59 The availability of a pool of skilled and knowledgeable workers is a major determinant of thelikely economic success of a country. In analyzing the competitive success of Japan, for example, Harvard BusinessSchool Professor Michael Porter notes that after the last World War, Japan had almost nothing except for apool of skilled and educated human resources:

With a long tradition of respect for education that borders on reverence, Japan possessed a large pool of literate, educated, andincreasingly skilled human resources. . . . Japan has benefited from a large pool of trained engineers. Japanese universitiesgraduate many more engineers per capita than in the United States. . . . A first-rate primary and secondary education system inJapan operates based on high standards and emphasizes math and science. Primary and secondary education is highlycompetitive. . . . Japanese education provides most students all over Japan with a sound education for later education and training.A Japanese high school graduate knows as much about math as most American college graduates.60

Porter’s point is that Japan’s excellent education system is an important factor explaining the country’s postwareconomic success. Not only is a good education system a determinant of national competitive advantage, but it is also animportant factor guiding the location choices of international businesses. The trend to outsource information technologyjobs to India, for example, is partly due to the presence of significant numbers of trained engineers in India, which in turnis a result of the Indian education system. By the same token, it would make little sense to base production facilities thatrequire highly skilled labor in a country where the education system was so poor that a skilled labor pool was notavailable, no matter how attractive the country might seem regarding other dimensions, such as cost.

The general education level of a country is also a good index of the kind of products that might sell in a country,and of the type of promotional materials that should be used. As an example, a country where more than 50 percent ofthe population is illiterate is unlikely to be a good market for popular books. But perhaps more importantly, promotionalmaterials containing written descriptions of mass-marketed products are unlikely to have an effect in a country where

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half of the population cannot read. It is far better to use pictorial promotions in such circumstances.

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Culture and Business

LO4-4Recognize how differences in social culture influence values in business.Of considerable importance for a multinational corporation, or any company—small, medium, or large—with operationsin different countries, is how a society’s culture affects the values found in the workplace. Management processes andpractices may need to vary according to culturally determined work-related values. For example, if the cultures of Braziland the United Kingdom or the United States and Sweden result in different work-related values, a company withoperations in the different countries should vary its management processes and practices to account for these differences.

The most famous study of how culture relates to values in the workplace was undertaken by Geert Hofstede.61 Aspart of his job as a psychologist working for IBM, Hofstede collected data on employee attitudes and values for morethan 116,000 individuals. Respondents were matched on occupation, age, and gender. The data enabled him to comparedimensions of culture across 50 countries. Hofstede initially isolated four dimensions that he claimed summarized thedifferent cultures62—power distance, uncertainty avoidance, individualism versus collectivism, and masculinity versusfemininity—and then, later on, he added a fifth dimension inspired by Confucianism that he called long-term versusshort-term orientation.63

The fifth dimension was added as a function of the data obtained via the Chinese Value Survey (CVS), aninstrument developed by Michael Harris Bond based on discussions with Hofstede.64 Bond used input from “Easternminds,” as Hofstede called it, to develop the Chinese Value Survey. Bond also references Chinese scholars as helpinghim create the values that exemplify this new long-term versus short-term orientation. In his original research, Bondcalled the fifth dimension “Confucian work dynamism,” but Hofstede said that in practical terms, the dimension refers toa long-term versus short-term orientation.

Hofstede’s power distance dimension focused on how a society deals with the fact that people areunequal in physical and intellectual capabilities. According to Hofstede, high power distance cultures were found incountries that let inequalities grow over time into inequalities of power and wealth. Low power distance cultures werefound in societies that tried to play down such inequalities as much as possible.

The individualism versus collectivism dimension focused on the relationship between the individual and his or herfellows. In individualistic societies, the ties between individuals were loose, and individual achievement and freedomwere highly valued. In societies where collectivism was emphasized, the ties between individuals were tight. In suchsocieties, people were born into collectives, such as extended families, and everyone was supposed to look after theinterest of his or her collective.

Hofstede’s uncertainty avoidance dimension measured the extent to which different cultures socialized theirmembers into accepting ambiguous situations and tolerating uncertainty. Members of high uncertainty avoidancecultures placed a premium on job security, career patterns, retirement benefits, and so on. They also had a strong need forrules and regulations; the manager was expected to issue clear instructions, and subordinates’ initiatives were tightlycontrolled. Lower uncertainty cultures are characterized by both a readiness to take risks and less emotional resistance tochange.

Hofstede’s masculinity versus femininity dimension looked at the relationship between gender and work roles. Inmasculine cultures, gender roles were differentiated, and traditional “masculine values,” such as achievement andeffective exercise of power, determined cultural ideals. In feminine cultures, gender roles were less distinguished, andlittle differentiation was made between men and women in the same job.

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

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Hofstede created an index score for each of these five dimensions that ranged from 0 to 100 (with 100 being a highscore).65 By using IBM, Hofstede was able to hold company influences as a constant across cultures. Thus, anydifferences across the country cultures would by design be due to differences in the countries’ cultures and not thecompany’s culture. He averaged the scores for all employees from a given country to create the index score for eachdimension.

A strong movement is under way to add a sixth dimension to Hofstede’s work. Geert Hofstede, working withMichael Minkov’s analysis of the World Values Survey, added a promising new dimension called indulgence versusrestraint (IND) in 2010.66 On January 17, 2011, Hofstede delivered a webinar for SIETAR Europe called “New Softwareof the Mind” to introduce the third edition of Cultures and Organizations, in which the results of Minkov’s analysis wereincluded to support this sixth dimension. In addition, in a keynote delivered at the annual meeting of the Academy ofInternational Business (http://aib.msu.edu) in Istanbul, Turkey, on July 6, 2013, Hofstede again presented results andtheoretical rationale to support the indulgence versus restraint dimension. Indulgence refers to a society that allowsrelatively free gratification of basic and natural human drives related to enjoying life and having fun. Restraint refers to asociety that suppresses gratification of needs and regulates it by means of strict social norms. Despite years in themaking, strong support exists for the original four dimensions of Hofstede’s work, and many agree on the fifthdimension as well, but a number of scholars remain skeptical about the latest sixth addition.

Table 4.1 summarizes data for 15 selected countries for the five established dimensions of individualism versuscollectivism, power distance, uncertainty avoidance, masculinity versus femininity, and long-term versus short-termorientation (the Hofstede data were collected for 50 countries and the Bond data were collected for 23 countries;numerous other researchers have also added to the country samples). Western nations such as the United States, Canada,and United Kingdom score high on the individualism scale and low on the power distance scale. Latin American andAsian countries emphasize collectivism over individualism and score high on the power distance scale. Table 4.1 alsoreveals that Japan’s culture has strong uncertainty avoidance and high masculinity. This characterization fitsthe standard stereotype of Japan as a country that is male dominant and where uncertainty avoidance exhibitsitself in the institution of lifetime employment. Sweden and Denmark stand out as countries that have both lowuncertainty avoidance and low masculinity (high emphasis on “feminine” values).

Hofstede’s results are interesting for what they tell us in a very general way about differences among cultures.Many of Hofstede’s findings are consistent with standard stereotypes about cultural differences. For example, manypeople believe Americans are more individualistic and egalitarian than the Japanese (they have a lower power distance),who in turn are more individualistic and egalitarian than Mexicans. Similarly, many might agree that Latin countriesplace a higher emphasis on masculine value—they are machismo cultures—than the Scandinavian countries of Denmarkand Sweden. As might be expected, East Asian countries such as Japan and Thailand scored high on long-termorientation, while nations such as the United States and Canada scored low.

However, we should be careful about reading too much into Hofstede’s research. It has been criticized on a numberof points.67 First, Hofstede assumes there is a one-to-one correspondence between culture and the nation-state, but as wediscussed earlier, many countries have more than one culture. Second, Hofstede’s research may have been culturallybound. The research team was composed of Europeans and Americans. The questions they asked of IBM employees—and their analysis of the answers—may have been shaped by their own cultural biases and concerns. The later addition ofthe long-term versus short-term dimension illustrates this point. Third, Hofstede’s informants worked not only within asingle industry, the computer industry, but also within one company, IBM. At the time, IBM was renowned for its ownstrong corporate culture and employee selection procedures, making it possible that the employees’ values were differentin important respects from the values of the cultures from which those employees came, as we also pointed out earlier.

Still, Hofstede’s work is the leading research the world has seen on culture. It represents a great startingpoint for managers trying to figure out how cultures differ and what that might mean for managementpractices. Also, several other scholars have found strong evidence that differences in culture affect values and practicesin the workplace, and Hofstede’s basic results have been replicated using more diverse samples of individuals indifferent settings.68 Nevertheless, managers should use the results with caution. One reason for caution is the plethora ofnew cultural values surveys and data points that are starting to become important additions to Hofstede’s work. Twoadditional cultural values frameworks that have been examined and have been related to work and business issues are theGlobal Leadership and Organizational Behavior Effectiveness instrument and the World Values Survey.

The Global Leadership and Organizational Behavior Effectiveness (GLOBE) instrument is designed to address thenotion that a leader’s effectiveness is contextual.69 It is embedded in the societal and organizational values and norms ofthe people being led. The initial GLOBE findings from 62 societies involving 17,300 middle managers from 951organizations build on findings by Hofstede and other culture researchers. The GLOBE research established nine culturaldimensions: power distance, uncertainty avoidance, humane orientation, institutional collectivism, in-group collectivism,assertiveness, gender egalitarianism, future orientation, and performance orientation.

The World Values Survey (WVS) is a research project spanning more than 100 countries that explores people’s

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values and norms, how they change over time, and what impact they have in society and on business.70 The WVSincludes dimensions for support for democracy; tolerance of foreigners and ethnic minorities; support for genderequality; the role of religion and changing levels of religiosity; the impact of globalization; attitudes toward theenvironment, work, family, politics, national identity, culture, diversity, and insecurity; and subjective well-being.

As a reminder, culture is just one of many factors that might influence the economic success of a nation. Whileculture’s importance should not be ignored, neither should it be overstated. The Hofstede framework is the mostsignificant and studied framework of culture as it relates to work values and business that we have ever seen. But someof the newer culture frameworks (e.g., GLOBE, WVS) are also becoming popular in the literature, and they havepotential to complement and perhaps even supplant Hofstede’s work with additional validation and connection to work-related values, business, and marketplace issues. At the same time, the factors discussed in Chapters 2 and 3—economic,political, and legal systems—are probably more important than culture in explaining differential economic growth ratesover time.

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Cultural Change

LO4-5Demonstrate an appreciation for the economic and business implications of cultural change.An important point we want to make in this chapter on culture is that culture is not a constant; it evolves overtime.71 Changes in value systems can be slow and painful for a society. Change, however, does occur and can often bequite profound. At the beginning of the 1960s, the idea that women might hold senior management positions in majorcorporations was not widely accepted. Today, of course, it is a natural and welcomed reality, and most people in theUnited States could not fathom it any other way. For example, in 2012 Virginia Rometty became the CEO of IBM; MaryBarra became the CEO of General Motors in 2014; and Corie Barry became the CEO of Best Buy in 2019—allcompanies with more than $40 billion in annual sales (GM $147B, IBM $80B, and Best Buy $40B). GM’s Mary Barrahas been named to the Time 100, and Forbes named her one of the World’s 100 Most Powerful Women. As anotherexample, 24 of the CEO positions at S&P 500 companies were held by women in 2019; obviously still a largediscrepancy compared with the opportunities for men, but an improvement from decades earlier, and one that is likely tocontinue to improve. In mainstream American society, no one any longer questions the development or capability ofwomen in the business world, and it is amazing to think the country once did.

For another illustration of cultural change, consider Japan. Some business professionals argue that a cultural shifthas been occurring in Japan, with a move toward greater individualism.72 The Japanese office worker, or “salaryperson,” is characterized as being loyal to his or her boss and the organization to the point of giving up evenings,weekends, and vacations to serve the organization. However, a new generation of office workers may not fit this model.An individual from the new generation is likely to be more direct than the traditional Japanese. This new-generationperson acts more like a Westerner, a gaijin. He or she does not live for the company and will move on if he or she gets anoffer of a better job or has to work too much overtime.73

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Leila Navidi/Minneapolis Star Tribune/ZUMA Wire/Alamy Stock Photo

Several studies have suggested that economic advancement and globalization may be important factors in societalchange.74 There is evidence that economic progress is accompanied by a shift in values away from collectivism andtoward individualism.75 As Japan has become richer, the cultural emphasis on collectivism has declined and greaterindividualism is being witnessed. One reason for this shift may be that richer societies exhibit less need for social andmaterial support built on collectives, whether the collective is the extended family or the company. People are better ableto take care of their own needs. As a result, the importance attached to collectivism declines, while greater economicfreedoms lead to an increase in opportunities for expressing individualism.

The culture of societies may also change as they become richer because economic progress affects a number ofother factors, which in turn influence culture. For example, increased urbanization and improvements in the quality andavailability of education are both a function of economic progress, and both can lead to declining emphasis on thetraditional values associated with poor rural societies. The World Values Survey, which we mentioned earlier, hasdocumented how values change. The study linked these changes in values to changes in a country’s level of economicdevelopment.76 As countries get richer, a shift occurs away from “traditional values” linked to religion, family, andcountry, and toward “secular-rational” values. Traditionalists say religion is important in their lives. They have a strongsense of national pride; they also think that children should be taught to obey and that the first duty of a child is to makehis or her parents proud.

The merging or convergence of cultures can also be traced to the world today being more globalized than ever.Advances in transportation and communication, technology, and international trade have set the tone for globalcorporations (e.g., Disney, Microsoft, Google) to be part of bringing diverse cultures together into a form ofhomogeneity we have not seen before.77 There are endless examples of global companies helping to foster a ubiquitous,social-media-driven youth culture. Plus, with countries around the world climbing the ladder of economic progress, someargue that the conditions for less cultural variation have been created. There may be a slow but steady convergenceoccurring across different cultures toward some universally accepted values and norms. This is known as theconvergence hypothesis, and such convergence at least is happening at younger ages of the population. Older people stillappear culturally different, however—their world remains spiky and is not yet flat!78

At the same time, we should not ignore important countertrends, such as the shift toward Islamic fundamentalism inseveral countries; the continual separatist movement in Quebec, Canada; ethnic strains and separatist movements inRussia; nationalist movements in the United Kingdom (Brexit); and the election of a populist, nationally oriented DonaldTrump as the 45th president of the United States. Such countertrends are a reaction to the pressures for culturalconvergence. In an increasingly modern and materialistic world, some societies are trying to reemphasize their culturalroots and uniqueness. It is also important to note that while some elements of culture change quite rapidly—particularlythe use of material symbols—other elements change slowly. Thus, just because people the world over wear jeans, eat at McDonald’s, use smartphones,watch their national version of American Idol, and drive Ford cars to work, we should not assume they have also adoptedAmerican (or Western) values. Often they have not.79 Thus, a distinction must be made between the visible materialaspects of culture and its deep structure, particularly its core social values and norms. The deep structure changes onlyslowly, and differences are often far more persistent.

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FOCUS ON MANAGERIAL IMPLICATIONSCULTURAL LITERACY AND COMPETITIVE ADVANTAGEInternational business is different from national business because countries and societies are different. Societies differbecause their cultures vary. Their cultures vary because of differences in social structure, religion, language, education,economic philosophy, and political philosophy. Three important implications for international business flow from thesedifferences. The first is the need to develop cross-cultural literacy. There is a need not only to appreciate that culturaldifferences exist but also to appreciate what such differences mean for international business. A second implicationcenters on the connection between culture and national competitive advantage. A third implication looks at the

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connection between culture and ethics in decision making. In this section, we explore the first two of these issues indepth. The connection between culture and ethics is explored in Chapter 5.

Cross-Cultural LiteracyOne of the biggest dangers confronting a company that goes abroad for the first time is the danger of being ill-informed.International businesses that are ill-informed about another culture are likely to fail. Doing business in different culturesrequires adaptation to conform to the value systems and norms of that culture. Adaptation can embrace all aspects of aninternational firm’s operations in a foreign country. The way in which deals are negotiated, appropriate incentive paysystems for salespeople, the structure of the organization, name of a product, tenor of relations between management andlabor, the manner in which the product is promoted, and so on, are all sensitive to cultural differences. What works inone culture might not work in another.

To combat the danger of being ill-informed, international businesses should consider employing local citizens tohelp them do business in a particular culture. They must also ensure that home-country executives are well-versedenough to understand how differences in culture affect the practice of business. Transferring executives globally atregular intervals to expose them to different cultures will help build a cadre of knowledgeable executives. Aninternational business must also be constantly on guard against the dangers of ethnocentric behavior. Ethnocentrism is abelief in the superiority of one’s own ethnic group or culture. Hand in hand with ethnocentrism goes a disregard orcontempt for the culture of other countries. Unfortunately, ethnocentrism is all too prevalent; many Americans are guiltyof it, as are many French people, Japanese people, British people, and so on.

Anthropologist Edward T. Hall has described how Americans, who tend to be informal in nature, react strongly tobeing corrected or reprimanded in public.80 This can cause problems in Germany, where a cultural tendency towardcorrecting strangers can shock and offend most Americans. For their part, Germans can be a bit taken aback by thetendency of Americans to call people by their first name. This is uncomfortable enough among executives of the samerank, but it can be seen as insulting when a junior American executive addresses a more senior German manager by hisor her first name without having been invited to do so. Hall concludes it can take a long time to get on a first-name basiswith a German; if you rush the process, you will be perceived as over friendly and rude—and that may not be good forbusiness.

Hall also notes that cultural differences in attitude to time can cause myriad problems. He notes that in the UnitedStates, giving a person a deadline is a way of increasing the urgency or relative importance of a task. However, in theMiddle East, giving a deadline can have exactly the opposite effect. The American who insists an Arab businessassociate make his mind up in a hurry is likely to be perceived as overly demanding and exerting undue pressure. Theresult may be exactly the opposite, with the Arab going slow as a reaction to the American’s rudeness. The Americanmay believe that an Arab associate is being rude if he shows up late to a meeting because he met a friend in the street andstopped to talk. The American, of course, is very concerned about time and scheduling. But for the Arab,finishing the discussion with a friend is more important than adhering to a strict schedule. Indeed, the Arabmay be puzzled as to why the American attaches so much importance to time and schedule.

Culture and Competitive Advantage

One theme that surfaces in this chapter is the relationship between culture and national competitive advantage.81 Putsimply, the value systems and norms of a country influence the costs of doing business in that country. The costs ofdoing business in a country influence the ability of firms to establish a competitive advantage. We have seen howattitudes toward cooperation between management and labor, toward work, and toward the payment of interest areinfluenced by social structure and religion. It can be argued that the class-based conflict between workers andmanagement in class-conscious societies raises the costs of doing business. Similarly, some sociologists have argued thatthe ascetic “other-worldly” ethics of Hinduism may not be as supportive of capitalism as the ethics embedded inProtestantism and Confucianism. Islamic laws banning interest payments may raise the costs of doing business byconstraining a country’s banking system.

Some scholars have argued that the culture of modern Japan lowers the costs of doing business relative to the costsin most Western nations. Japan’s emphasis on group affiliation, loyalty, reciprocal obligations, honesty, and education allboost the competitiveness of Japanese companies—at least that is the argument. The emphasis on group affiliation andloyalty encourages individuals to identify strongly with the companies in which they work. This tends to foster an ethicof hard work and cooperation between management and labor “for the good of the company.” In addition, the availabilityof a pool of highly skilled labor, particularly engineers, has helped Japanese enterprises develop cost-reducing processinnovations that have boosted their productivity.82 Thus, cultural factors may help explain the success enjoyed by manyJapanese businesses. Most notably, it has been argued that the rise of Japan as an economic power during the second halfof the twentieth century may be in part attributed to the economic consequences of its culture.83

It also has been argued that the Japanese culture is less supportive of entrepreneurial activity than, say, Americansociety. In many ways, entrepreneurial activity is a product of an individualistic mindset, not a classic characteristic of

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the Japanese. This may explain why American enterprises, rather than Japanese corporations, dominate industries whereentrepreneurship and innovation are highly valued, such as computer software and biotechnology. Of course, exceptionsto this generalization exist. Masayoshi Son recognized the potential of software far faster than any of Japan’s corporategiants. He set up his company, Softbank, in 1981, and over the past 40 years has built it into Japan’s top softwaredistributor. Similarly, entrepreneurial individuals established major Japanese companies such as Sony and Matsushita.

For international business, the connection between culture and competitive advantage is important for two reasons.First, the connection suggests which countries are likely to produce the most viable competitors. For example, we mightargue that U.S. enterprises are likely to see continued growth in aggressive, cost-efficient competitors from those PacificRim nations where a combination of free-market economics, Confucian ideology, group-oriented social structures, andadvanced education systems can all be found (e.g., South Korea, Taiwan, Japan, and, increasingly, China). Second, theconnection between culture and competitive advantage has important implications for the choice of countries in which tolocate production facilities and do business.

Consider a hypothetical case where a company has to choose between two countries, A and B, for locating aproduction facility. Both countries are characterized by low labor costs and good access to world markets. Both countriesare of roughly the same size (in terms of population), and both are at a similar stage of economic development. Incountry A, the education system is underdeveloped, the society is characterized by a marked stratificationbetween the upper and lower classes, and there are six major linguistic groups. In country B, the educationsystem is well developed, social stratification is lacking, group identification is valued by the culture, and there is onlyone linguistic group. Which country makes the best investment site?

Country B probably does. In country A, the conflict between management and labor, and between differentlanguage groups, can be expected to lead to social and industrial disruption, thereby raising the costs of doing business.84The lack of a good education system also can be expected to work against the attainment of business goals. The samekind of comparison could be made for an international business trying to decide where to push its products, country A orB. Again, country B would be the logical choice because cultural factors suggest that in the long run, country B is thenation most likely to achieve the greatest level of economic growth.

But as important as culture is to people, companies, and society, it is probably less important than economic,political, and legal systems in explaining differential economic growth between nations. Cultural differences aresignificant, but we should not overemphasize their importance in the economic sphere. For example, earlier we notedthat Max Weber argued that the ascetic principles embedded in Hinduism do not encourage entrepreneurial activity.While this is an interesting thesis, recent years have seen an increase in entrepreneurial activity in India, particularly inthe information technology sector, where India is an important global player. The ascetic principles of Hinduism andcaste-based social stratification have apparently not held back entrepreneurial activity in this sector.

Key Termscross-cultural literacy, p. 94culture, p. 96values, p. 96norms, p. 96society, p. 96folkways, p. 97mores, p. 98social structure, p. 99group, p. 100social strata, p. 102social mobility, p. 102caste system, p. 102class system, p. 102class consciousness, p. 105religion, p. 105ethical system, p. 105power distance, p. 118individualism versus collectivism, p. 118uncertainty avoidance, p. 118masculinity versus femininity, p. 118long-term versus short-term orientation, p. 118ethnocentrism, p. 122

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SUMMARYThis chapter has looked at the nature of culture and discussed a number of implications for business practice. Thechapter made the following points:

1. Culture is a complex phenomenon that includes knowledge, beliefs, art, morals, law, customs, and othercapabilities acquired by people as members of society.

2. Values and norms are the central components of a culture. Values are abstract ideals about what a societybelieves to be good, right, and desirable. Norms are social rules and guidelines that prescribe appropriatebehavior in particular situations.

3. Values and norms are influenced by political forces, economic philosophy, social structure, religion, language,and education. And, the value systems and norms of a country can affect the costs of doing business in thatcountry.

4. The social structure of society refers to its basic social organization. Two main dimensions alongwhich social structures differ are the individual–group dimension and the stratification dimension.

5. In some societies, the individual is the basic building block of a social organization. These societies emphasizeindividual achievements above all else. In other societies, the group is the basic building block of the socialorganization. These societies emphasize group membership and group achievements above all else.

6. Virtually all societies are stratified into different classes. Class-conscious societies are characterized by lowsocial mobility and a high degree of stratification. Less class-conscious societies are characterized by highsocial mobility and a low degree of stratification.

7. Religion may be defined as a system of shared beliefs and rituals that is concerned with the realm of thesacred. Ethical systems refer to a set of moral principles, or values, that are used to guide and shape behavior.The world’s major religions are Christianity, Islam, Hinduism, and Buddhism. The value systems of differentreligious and ethical systems have different implications for business practice.

8. Language is one defining characteristic of a culture. It has both spoken and unspoken dimensions. In countrieswith more than one spoken language, we tend to find more than one culture.

9. Formal education is the medium through which individuals learn knowledge and skills as well as becomesocialized into the values and norms of a society. Education plays a role in the determination of nationalcompetitive advantage.

10. Geert Hofstede studied how culture relates to values in the workplace. He isolated five dimensions thatsummarized different cultures: power distance, uncertainty avoidance, individualism versus collectivism,masculinity versus femininity, and long-term versus short-term orientation.

11. Culture is not a constant; it evolves, albeit often slowly. Economic progress and globalization are twoimportant engines of cultural change.

12. One danger confronting a company that goes abroad is being ill-informed. To develop cross-cultural literacy,companies operating globally should consider employing host-country nationals, build a cadre ofcosmopolitan executives, and guard against the dangers of ethnocentric behavior.

Critical Thinking and Discussion Questions

1. Discuss why the culture of a country might influence the costs of doing business in that country. Illustrateyour answer with country and company examples.

2. Do you think that business practices in an Islamic country are likely to differ from business practices in aChristian country? If so, how? If not, why?

3. Choose two countries that appear to be culturally diverse (e.g., Sweden and Colombia). Compare the culturesof those countries, and then indicate how cultural differences influence (a) the costs of doing business in eachcountry, (b) the likely future economic development of each country, and (c) differences in business practices.

4. Reread the Country Focus “Turkey, Its Religion, and Politics.” Then answer the following questions:a. Can you see anything in the values and norms of Islam that is hostile to business? Explain.b. What does the experience of the region around Kayseri teach about the relationship between Islam and

business?c. What are the implications of Islamic values toward business for the participation of a country such as

Turkey in the global economy or becoming a member of the European Union?5. Reread the Management Focus “China and Its Guanxi” and answer the following questions:

a. Why do you think it is so important to cultivate guanxi and guanxiwang in China?

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b. What does the experience of DMG tell us about the way things work in China? What would likely happento a business that obeyed all the rules and regulations, rather than trying to find a way around them likeDan Mintz?

c. What ethical issues might arise when drawing on guanxiwang to get things done in China? What does thissuggest about the limits of using guanxiwang for a Western business committed to high ethical standards?

global EDGE research task globaledge.msu.eduUse the globalEDGE™ website (globaledge.msu.edu) to complete the following exercises:

1. You are preparing for a business trip to Brazil, where you will need to interact extensively with localprofessionals. As a result, you want to collect information about the local culture and business practices priorto your departure. A colleague from Latin America recommends that you visit the Brazil page on globalEDGEand read through the country insights and data available. Prepare a short description of the most strikingcultural characteristics that may affect business interactions in this country.

2. Typically, cultural factors drive the differences in business etiquette encountered during international businesstravel. In fact, Middle Eastern cultures exhibit significant differences in business etiquette when compared toWestern cultures. Prior to leaving for your first business trip to the region, a colleague informed you thatglobalEDGE can help you (as can a globalEDGE-promoted guide titled Business Etiquette around the World).Identify five tips regarding business etiquette in the Middle Eastern country of your choice (e.g., Turkey).

CLOSING CASE

China, Hong Kong, Macau, and TaiwanToday, a lot of discussion centers on how much economic power, political influence, and international competitivenessthe People’s Republic of China (PRC) has achieved in the international marketplace in just a few decades. Culturally,such power in the international marketplace also begs the questions of how much influence China is likely to havemoving forward, and what this means for China’s influence culturally around the world. So far, other powerful countriesin the world have focused on China’s economic influence, but what about the country’s influence on culture?

China, along with India, Brazil, and Russia, form the so-called BRIC countries (an acronym formulated using theirinitial letters), which have been viewed as the business engines of tomorrow (especially China and India), based on theirimmense economic potential. The BRICs, which cover a quarter of the world’s landmass and contain 40 percent of itspopulation, had a combined GDP of $20 trillion in 2001. Today, these increasingly market-oriented economies boast aGDP of $37 trillion (or 22 percent of global GDP), a figure forecast to reach $120 trillion by 2050. Together, theycontrol more than 43 percent of the world’s currency reserves ($4 trillion) and 20 percent of its trade. Is it too simplisticand naïve to think that the BRIC countries–especially China and Russia–only have a focus on economic power? Clearly,Russia has engaged in at least some political activities that have had tremendous global effects (e.g., election meddling).And what about China? Many reports and investigations suggest the country is likewise engaged in political meddling.Does that affect culture around the world also?

The BRIC countries’ economic size and population were the simplistic starting point to group them as powerfulmarketplaces—to export products to, and to buy products from. These datapoints led former Goldman Sachs chiefeconomist Jim O’Neill to first coin the acronym BRIC to highlight the immense collective economic potential of thesefour emerging markets. However, despite many countries’ and companies’ enthusiasm for increased global interactionand economic exchange with the BRIC economies, especially China and India, many have found that cultural differenceshinder their ability to conduct business in these countries. Not only is the culture different between each BRIC countryand most of the globe’s remaining 191 countries, but the business and societal cultures within the BRIC countries arealso vastly different from each other.

Plus, the outlook for the BRICs may not be as positive as we have been led to believe anyway. For example, thestructural transformation of China (the main driver of the BRICs) from an export-driven economy to one relying more ondomestic consumption, has added some woes. The likelihood is that the trend of annual increases of exports to Chinafrom much of the developed world will also slow down. We will see trade increases, nevertheless, just not assignificantly as in the past decade. China is a gigantic market that we must pay attention to, of course. China isbeginning to also influence the world’s culture outwardly. Economics still drive China’s global operations, albeit with aneye toward also influencing the international marketplace in such a way that it favors China—both in its home marketand abroad.

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For example, China is still trying to implement the “one country, two systems” approach—a constitutional principleformulated by Deng Xiaoping—which involves how to merge mainland China with Hong Kong and Macau. With XiJinping president of China for the foreseeable future as a function of his de facto lifetime appointment when term limitswere removed in 2018, China’s political infrastructure is unlikely to change much. Consequently, China’s culture athome and how it handles business issues abroad is unlikely to change much as well. Beyond Hong Kong and Macau,Taiwan presents an even bigger ongoing structural, legal, and cultural challenge for China. While Hong Kong and Macaumostly fall in line within China’s basic parameters, Taiwan does not.

Hong Kong, a business port located off the southeast coast of China in eastern Asia, traces its history to the OldStone Age, and really became entrenched in today’s infrastructure with its inclusion into the Chinese empire during theQin dynasty (221–206 b.c.). However, Hong Kong was a self-governing British colony from 1841 to 1997, at which timeit became a Special Administrative Region (SAR) of the People’s Republic of China (on July 1, 1997), pursuant to the1984 Sino-British Joint Declaration. Throughout this colonial era, Hong Kong’s citizens developed a distinctive “HongKong identity.” To this day, the cultural differences between mainland China and Hong Kong are often pronounced, andwhenever mainland China tries to assert its influence, their relationship becomes more contentious. The sentiment inHong Kong is that it needs to be recognized as having a unique culture and a “national identity.” Hong Kong is often, inmany ways, at odds with mainland China in this way, and periodic clashes flare.

Prior to 1999, Macau was a Portuguese colony, that became an overseas province under Portuguese administrationfrom 1887 to 1999. Macau was both the first and last European colony in China. Just before its return to China in 1999,Macau experienced a number of economic difficulties. Its biggest revenue items—gaming and tourism—decreaseddrastically in 1993, followed by the collapse of the property market in 1994, and then the economic crisis in 1997 thataffected much of Asia. By the time 1999 came around for a handover from Portugal to China, most locals welcomed thechange because of deteriorating public order, rising crime rates, and widespread corruption that had infiltrated the cultureduring the last years of the Portuguese-Macau government. Today, Macau is being positioned as a key diplomatic playerin China’s relations with Portuguese-speaking countries.

Taiwan, officially named the Republic of China (ROC), is an island nation (Island of Taiwan, formerly Formosa). Itis the most populous country, with the largest economy, that is not a member of the United Nations. Taiwan was cededby the Qing dynasty to Japan in 1895 after the Sino-Japanese War. The Republic of China was established in 1912 afterthe fall of the Qing dynasty, while Taiwan was under Japanese rule. However, China has consistently claimedsovereignty over Taiwan and asserted that the Republic of China (ROC) is no longer in legitimate existence. Under itsOne-China Policy, China even refuses to engage in diplomatic relations with any country that recognizes Taiwan. In thissemi-independent state, Taiwan has experienced solid economic growth and industrialization, creating a stable industrialeconomy. The culture blends Confucianist Han Chinese and Taiwanese aboriginal influences.

When mainland China, Hong Kong, Macau, and Taiwan are combined, we often talk about the larger entity“Greater China” or the “Greater China Region.” Obviously, there is no legal entity or sovereignty associated with this“greater region,” except in business/economic development terms. Some argue that the “region” can be seen as beingculturally homogeneous, but such arguments do not hold up well given the clashes between mainland China on one handand Hong Kong and Taiwan on the other. Interestingly, Macau has been more positive about its relationship with China,perhaps due to experiencing serious financial difficulties immediately prior to the 1999 handover from Portugal (thesefinancial difficulties were essentially solved by China).

Overall, given the strained relationships between China and its close cultural neighbors, the phrase “sinophoneworld” (“Chinese-speaking world”) is often used instead of Greater China to incorporate mainland China, Hong Kong,Macau, and Taiwan. The “sinophone world” may look like a culturally homogenous region, but is far from it.Sources: Tomas Hult, “The U.S. Shouldn’t Fret over Cheaper Yuan,” Time, August 14, 2015; Tomas Hult, “Why the Fed Is No Longer the Center of the Financial Universe,” Fortune,September 17, 2015; Tomas Hult, “Does the Global Stock Market Sell-Off Signal the BRIC Age Is Already Over?” The Conversation, August 28, 2015; Tomas Hult, “U.S. Shouldn’t Fretover Cheaper Yuan: China’s Growing Middle Class Will Keep Buying ‘Made In America,’” The Conversation, August 13, 2015; Tomas Hult, “The BRIC Countries,” globalEDGEBusiness Review, 3 (4), 2009; Mark Esposito, Amit Kapoor, and Deepti Mathur, “What Is the State of the BRICS Economies?” World Economic Forum, April 19, 2016.

Case Discussion Questions

1. When Goldman Sachs chief economist Jim O’Neill coined the acronym BRIC in 2001 to refer to Brazil, Russia,India, and China, the focus was to highlight the immense collective economic potential of these countries. Sincethat time, China and Russia have influenced the international marketplace in political ways as well. How do youthink these four countries—or a subset of them—will likely influence the world’s cultures in the next 10 years?

2. Anyone who has been to Hong Kong typically says it is different from mainland China, more like Singapore,albeit with a strong connection to China. Do you think Hong Kong will become more like China in the next fewyears, or will China leverage Hong Kong as an asset to engage more capitalistically in the internationalmarketplace instead?

3. Macau was under Portuguese influence until 1999, which is not that long ago. Many in Macau welcomed theChinese takeover so that the area could be better taken care of (e.g., infrastructure, economy). But being part of

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the Portuguese administration from 1887 to 1999 clearly has imbued their cultural values and beliefs in themindset of Macau’s citizens. How are these values and beliefs likely to influence the Macau–China relationship inthe years to come?

4. Taiwan maintains diplomatic relations with some 76 member states of the United Nations (19 in an officialcapacity and 57 in an unofficial capacity). The nation’s culture is a blend of Confucianist Han Chinese andTaiwanese aboriginal influences. How would you handle the link between China and Taiwan—culturally,economically, and politically?

Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education

Endnotes

1. D. Barry, Exporters! The Wit and Wisdom of Small Businesspeople Who Sell Globally (Washington, DC:International Trade Administration, U.S. Department of Commerce, 2013); T. Hult, D. Ketchen, D. Griffith, C.Finnegan, T. Padron-Gonzalez, F. Harmancioglu, Y. Huang, M. Talay, and S. Cavusgil, “Data Equivalence inCross-Cultural International Business Research: Assessment and Guidelines,” Journal of International BusinessStudies, 2008, pp. 1027–44; S. Ronen and O. Shenkar, “Mapping World Cultures: Cluster Formation, Sources,and Implications,” Journal of International Business Studies, 2013, pp. 867–97.

2. This is a point made effectively by K. Leung, R. S. Bhagat, N. R. Buchan, M. Erez, and C. B. Gibson, “Cultureand International Business: Recent Advances and Their Implications for Future Research,” Journal ofInternational Business Studies, 2005, pp. 357–78. Several research articles and books also support the notion thatsignificant cultural differences still exist in the world; for example, T. Hult, D. Closs, and D. Frayer, GlobalSupply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage(New York: McGraw-Hill, 2014).

3. Falk, Armin, Anke Becker, Thomas Dohmen, and Benjamin Enke, “Global Evidence on Economic Preferences,”Quarterly Journal of Economics 133, no. 4 (November 2018): 1645–692.

4. See R. Dore, Taking Japan Seriously (Stanford, CA: Stanford University Press, 1987).5. Tylor, Edward Burnett. Primitive Culture: Researches Into the

Development of Mythology, Philosophy, Religion, Art, and Custom, Vol. 1. London: John Murray, 1871.

6. F. Kluckhohn and F. Strodtbeck, Variations in Value Orientations (Evanston, IL: Row, Peterson, 1961); C.Kluckhohn, “Values and Value Orientations in the Theory of Action,” in T. Parsons and E. A. Shils (Eds.),Toward a General Theory of Action (Cambridge, MA: Harvard University Press, 1951).

7. M. Rokeach, The Nature of Human Values (New York: Free Press, 1973); S. Schwartz, “Universals in theContent and Structure of Values: Theory and Empirical Tests in 20 Countries,” in M. Zanna (Ed.), Advances inExperimental Social Psychology, vol. 25 (New York: Academic Press, 1992), pp. 1–65.

8. G. Hofstede, Culture’s Consequences: International Differences in Work-Related Values (Thousand Oaks CA:Sage, 1984), p. 21.

9. G. Hofstede, Culture’s Consequences: International Differences in Work-Related Values (Thousand Oaks, CA:Sage, 1984), p. 21.

10. J. Z. Namenwirth and R. B. Weber, Dynamics of Culture (Boston: Allen & Unwin, 1987), p. 8.11. R. Mead, International Management: Cross-Cultural Dimensions (Oxford: Blackwell Business, 1994),

p. 7.12. G. Hofstede, Culture’s Consequences: Comparing Values, Beliefs, Behaviors, Institutions and Organizations

Across Nations (Thousand Oaks, CA: Sage, 2001).13. E. T. Hall and M. R. Hall, Hidden Differences: Doing Business with the Japanese (New York: Doubleday, 1987).14. B. Keillor and T. Hult, “A Five-Country Study of National Identity: Implications for International Marketing

Research and Practice,” International Marketing Review, 1999, pp. 65–82; T. Clark, “International Marketing andNational Character: A Review and Proposal for an Integrative Theory,” Journal of Marketing, 1990, pp. 66–79;M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990).

15. S. P. Huntington, The Clash of Civilizations (New York: Simon & Schuster, 1996).16. F. Vijver, D. Hemert, and Y. Poortinga, Multilevel Analysis of Individuals and Cultures (New York: Taylor &

Francis, 2010).17. M. Thompson, R. Ellis, and A. Wildavsky, Cultural Theory (Boulder, CO: Westview Press, 1990).18. M. Douglas, In the Active Voice (London: Routledge, 1982), pp. 183–254.19. L. Zucker and M. Darby, “Star-Scientist Linkages to Firms in APEC and European Countries: Indicators of

Regional Institutional Differences Affecting Competitive Advantage,” International Journal of Biotechnology,1999, pp. 119–31.

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20. C. Nakane, Japanese Society (Berkeley: University of California Press, 1970).21. Nakane, Chie. Japanese Society. University of California Press, 1972.22. For details, see M. Aoki, Information, Incentives, and Bargaining in the Japanese Economy (Cambridge, UK:

Cambridge University Press, 1988); M. L. Dertouzos, R. K. Lester, and R. M. Solow, Made in America(Cambridge, MA: MIT Press, 1989).

23. Global Innovation Barometer 2018 is a product by Ideas Lab and is supported by General Electric (GE). The GEGlobal Innovation Barometer explores how business leaders around the world view innovation and how thoseperceptions are influencing business strategies in an increasingly complex and globalized environment. It is thelargest global survey of business executives dedicated to innovation. GE is now surveying more than 3,000executives in 25 countries, www.ge.com/reports/innovation-barometer-2018.

24. P. Skarynski and R. Gibson, Innovation to the Core: A Blueprint for Transforming the Way Your CompanyInnovates (Boston, MA: Harvard Business School Press, 2008); L. Edvinsson and M. Malone, IntellectualCapital: Realizing Your Company’s True Value by Finding Its Hidden Brainpower (New York: Harper Collins,1997); T. Davenport and L. Prusak, Working Knowledge: How Organizations Manage What They Know (Boston,MA: Harvard Business School Press, 1998).

25. G. Macionis and L. John, Sociology (Toronto, Ontario: Pearson Canada, Inc., 2010), pp. 224–25.26. E. Luce, The Strange Rise of Modern India (Boston: Little, Brown, 2006); D. Pick and K. Dayaram, “Modernity

and Tradition in the Global Era: The Re-invention of Caste in India,” International Journal of Sociology andSocial Policy, 2006, pp. 284–301.

27. For an excellent historical treatment of the evolution of the English class system, see E. P. Thompson, TheMaking of the English Working Class (London: Vintage Books, 1966). See also R. Miliband, The State inCapitalist Society (New York: Basic Books, 1969), especially Chapter 2. For more recent studies of class inBritish societies, see Stephen Brook, Class: Knowing Your Place in Modern Britain (London: Victor Gollancz,1997); A. Adonis and S. Pollard, A Class Act: The Myth of Britain’s Classless Society (London: HamishHamilton, 1997); J. Gerteis and M. Savage, “The Salience of Class in Britain and America: A ComparativeAnalysis,” British Journal of Sociology, June 1998.

28. Adonis and Pollard, A Class Act.29. J. H. Goldthorpe, “Class Analysis and the Reorientation of Class Theory: The Case of Persisting Differentials in

Education Attainment,” British Journal of Sociology, 2010, pp. 311–35.30. Y. Bian, “Chinese Social Stratification and Social Mobility,” Annual Review of Sociology 28 (2002), pp. 91–117.31. N. Goodman, An Introduction to Sociology (New York: HarperCollins, 1991).32. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics: Ethical Decision Making and Cases (Mason, OH:

Cengage Learning, 2012).33. R. J. Barro and R. McCleary, “Religion and Economic Growth across Countries,” American Sociological Review,

October 2003, pp. 760–82; R. McCleary and R. J. Barro, “Religion and Economy,” Journal of EconomicPerspectives, Spring 2006, pp. 49–72.

34. M. Weber, The Protestant Ethic and the Spirit of Capitalism (New York: Scribner’s, 1958, original 1904–1905).For an excellent review of Weber’s work, see A. Giddens, Capitalism and Modern Social Theory (Cambridge,UK: Cambridge University Press, 1971).

35. Weber, Max. The Protestant Ethic and the Spirit of Capitalism. Routledge: Taylor & Francis, 1930.36. A. S. Thomas and S. L. Mueller, “The Case for Comparative Entrepreneurship,” Journal of International

Business Studies 31, no. 2 (2000), pp. 287–302; S. A. Shane, “Why Do Some Societies Invent More thanOthers?” Journal of Business Venturing 7 (1992), pp. 29–46.

37. See S. M. Abbasi, K. W. Hollman, and J. H. Murrey, “Islamic Economics: Foundations and Practices,”International Journal of Social Economics 16, no. 5 (1990), pp. 5–17; R. H. Dekmejian, Islam in Revolution:Fundamentalism in the Arab World (Syracuse, NY: Syracuse University Press, 1995).

38. T. W. Lippman, Understanding Islam (New York: Meridian Books, 1995).39. Dekmejian, Islam in Revolution.40. M. K. Nydell, Understanding Arabs (Yarmouth, ME: Intercultural Press, 1987).41. Lippman, Understanding Islam.42. The material in this section is based largely on Abbasi et al., “Islamic Economics.”43. “Sharia Calling,” The Economist, November 12, 2010; N. Popper, “Islamic Banks, Stuffed with Cash,

Explore Partnerships in West,” The New York Times, December 26, 2013.44. “Forced Devotion,” The Economist, February 17, 2001, pp. 76–77.45. For details of Weber’s work and views, see Giddens, Capitalism and Modern Social Theory.46. See, for example, the views expressed in “A Survey of India: The Tiger Steps Out,” The Economist, January 21,

1995.47. “High-Tech Entrepreneurs Flock to India,” PBS News Hour, February 9, 2014, www.pbs.org/newshour/bb/high-

tech-entrepreneurs-flock-india, accessed March 7, 2014.48. H. Norberg-Hodge, “Buddhism in the Global Economy,” International Society for Ecology and Culture,

www.localfutures.org/publications/online-articles/buddhism-in-the-global-economy, accessed March 7,2014.

49. P. Clark, “Zen and the Art of Startup Naming,” Bloomberg Businessweek, August 30, 2013,www.businessweek.com/articles/2013-08-30/zen-and-the-art-of-startup-naming, accessed March 7, 2014.

50. Clark, Patrick. “Zen and the Art of Startup Naming.” Bloomberg Businessweek, October 9, 2013.51. Hofstede, Culture’s Consequences.52. See Dore, Taking Japan Seriously; C. W. L. Hill, “Transaction Cost Economizing as a Source of Comparative

Advantage: The Case of Japan,” Organization Science 6 (1995).53. C. C. Chen, Y. R. Chen, and K. Xin, “Guanxi Practices and Trust in Management,” Organization Science 15, no.

2 (March–April 2004), pp. 200–10.54. See Aoki, Information, Incentives, and Bargaining; J. P. Womack, D. T. Jones, and D. Roos, The Machine That

Changed the World (New York: Rawson Associates, 1990).55. This hypothesis dates back to two anthropologists, Edward Sapir and Benjamin Lee Whorf. See E. Sapir, “The

Status of Linguistics as a Science,” Language 5 (1929), pp. 207–14; B. L. Whorf, Language, Thought, andReality (Cambridge, MA: MIT Press, 1956).

56. The tendency has been documented empirically. See A. Annett, “Social Fractionalization, Political Instability, andthe Size of Government,” IMF Staff Papers 48 (2001), pp. 561–92.

57. D. A. Ricks, Big Business Blunders: Mistakes in Multinational Marketing (Homewood, IL: Dow Jones–Irwin,1983).

58. Goodman, An Introduction to Sociology.59. Porter, The Competitive Advantage of Nations.60. Porter, Michael E. Competitive Advantage of Nations: Creating and Sustaining Superior Performance. Simon and

Schuster, 2011.61. G. Hofstede, “The Cultural Relativity of Organizational Practices and Theories,” Journal of International

Business Studies, Fall 1983, pp. 75–89; G. Hofstede, Cultures and Organizations: Software of the Mind (NewYork: McGraw-Hill USA, 1997); Hofstede, Culture’s Consequences.

62. Hofstede, “The Cultural Relativity of Organizational Practices and Theories”; Hofstede, Cultures andOrganizations.

63. Hofstede, Culture’s Consequences.64. G. Hofstede and M. Bond, “Hofstede’s Culture Dimensions: An Independent Validation Using Rokeach’s Value

Survey,” Journal of Cross-Cultural Psychology 15 (December 1984), pp. 417–33.65. The factor scores for the long-term versus short-term orientation, using Bond’s survey, were brought into a 0–100

range by a linear transformation (LTO = 50 × F + 50, in which F is the factor score). However, the data for Chinacame in after Hofstede and Bond had standardized the scale, and they put China outside the range at LTO = 118(which indicates a very strong long-term orientation).

66. G. Hofstede, G. J. Hofstede, and M. Minkov, Cultures and Organizations: Software of the Mind, 3d ed. (NewYork: McGraw-Hill, 2010).

67. For a more detailed critique, see Mead, International Management, pp. 73–75.68. For example, see W. J. Bigoness and G. L. Blakely, “A Cross-National Study of Managerial Values,” Journal of

International Business Studies, December 1996, p. 739; D. H. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Cheng, “The Impact of National Culture and Economic Ideology on Managerial Work Values,” Journal ofInternational Business Studies 28, no. 1 (1997), pp. 177–208; P. B. Smith, M. F. Peterson, and Z. Ming Wang,“The Manager as a Mediator of Alternative Meanings,” Journal of International Business Studies 27, no. 1(1996), pp. 115–37; L. Tang and P. E. Koves, “A Framework to Update Hofstede’s Cultural Value Indices,”Journal of International Business Studies 39 (2008), pp. 1045–63.

69. R. House, P. Hanges, M. Javidan, P. Dorfman, and V. Gupta, Culture, Leadership, and Organizations: TheGLOBE Study of 62 Societies (Thousand Oaks, CA: Sage, 2004); J. Chhokar, F. Brodbeck, and R. House, Cultureand Leadership across the World: The GLOBE Book of In-Depth Studies of 25 Societies (New York: Routledge,2012).

70. R. Inglehart, Modernization and Postmodernization: Cultural, Economic, and Political Change in 43 Societies(Princeton, NJ: Princeton University Press, 1997). Information and data on the World Values Survey can be foundat www.worldvaluessurvey.org.

71. For evidence of this, see R. Inglehart, “Globalization and Postmodern Values,” The Washington Quarterly,Winter 2000, pp. 215–28.

72. Mead, International Management, chap. 17.73. “Free, Young, and Japanese,” The Economist, December 21, 1991.

Page 13174. Namenwirth and Weber, Dynamics of Culture; Inglehart, “Globalization and Postmodern Values.”75. G. Hofstede, “National Cultures in Four Dimensions,” International Studies of Management and

Organization 13, no. 1 (1983), pp. 46–74; Tang and Koves, “A Framework to Update Hofstede’sCultural Value Indices.”

76. See Inglehart, “Globalization and Postmodern Values.” For updates, seewww.isr.umich.edu/cps/project_wvs.html.

77. Hofstede, “National Cultures in Four Dimensions.”78. D. A. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Chung, “The Impact of National Culture and Economic

Ideology on Managerial Work Values,” Journal of International Business Studies, 2007, pp. 1–19.79. See Leung et al., “Culture and International Business.”80. Hall and Hall, Understanding Cultural Differences.81. Porter, The Competitive Advantage of Nations.82. See Aoki, Information, Incentives, and Bargaining; Dertouzos et al., Made in America; Porter, The Competitive

Advantage of Nations, pp. 395–97.83. See Dore, Taking Japan Seriously; Hill, “Transaction Cost Economizing as a Source of Comparative Advantage.”84. For empirical work supporting such a view, see Annett, “Social Fractionalization, Political Instability, and the

Size of Government.”

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part two National Differences

Ethics, Corporate Social Responsibility, and Sustainability

LEARNING OBJECTIVESAfter reading this chapter, you will be able to:

Understand the ethical, corporate social responsibility, and sustainability issues faced by international businesses.

Recognize an ethical, corporate social responsibility, and/or sustainability dilemma.

Identify the causes of unethical behavior by managers as they relate to business, corporate social responsibility, orsustainability.

Describe the different philosophical approaches to business ethics that apply globally.

Explain how global managers can incorporate ethical considerations into their decision making in general, as well as corporatesocial responsibility and sustainability initiatives.

Atmosphere1/123RF

Ericsson, Sweden, and Sustainability

OPENING CASEAccording to Toronto, Canada-based Corporate Knights, which ranks the Top 100 Most Sustainable Corporations, Swedish-basedEricsson is ranked number 21 in the world for its sustainability efforts. That makes Ericsson, headquartered in Sweden, the top-ranked multinational corporation for its sustainability efforts, in a country that is ranked at the top on the United Nations’ SustainableDevelopment Goals (SDG Index). It says a lot to be the best on sustainability in the country that is itself the best among the world’snations when it comes to sustainability. The SDG Index includes 156 of the 195 countries in the world (all countries with reliable dataon the 17 SDG dimensions), while the index by Corporate Knights is based on analyses of some 7,500 corporations with annual

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revenues in excess of $1 billion.Perhaps it is only logical that Ericsson (ericsson.com) would place high in both the world ranking and in Sweden. Ericsson has

integrated the United Nations’ SDGs as part of its framework for how to describe and measure the company’s impact on society. Theview of Ericsson is that the Information and Communication Technologies (ICT) that are the core of Ericsson’s products and servicesin the global marketplace can help achieve all 17 SDGs. By applying Ericsson’s technology and expertise, the thought is that thecompany has made a positive impact and supported those SDGs ratified by 193 UN-member nations in 2015. Specifically, ICT incombination with a well-integrated corporate sustainability strategy can help tackle a range of global challenges. This thinking is howEricsson works with technological advancements to continue being a responsible and relevant driver of positive change on society.

Sweden (Sweden.se) has benefited from Ericsson’s sustainability influence and efforts. The country is consistently rankednumber one in the world regarding sustainability, according to the SDG Index. Sweden is a country of 10 million, with thousands ofcoastal islands and inland lakes, along with vast boreal forests and glaciated mountains. It is very protective of its environment, andits government and corporations spend a great deal of time protecting that environment. For example, more than half of the energyused in Sweden comes from renewable energy sources. Also, Americans release about four times as much carbon dioxide (CO₂) intothe atmosphere as the average Swede.

Sweden is also a data-rich country, reporting on almost every aspect of each citizen’s daily life. Somewhat uniquely, in Sweden,which is overflowing with technological advancement, thousands of people have also had microchips inserted into their hands. Thechips are designed to speed up people’s daily routines and make their lives more convenient, by accessing their homes, offices, gyms,and so on by simply swiping their hands against digital readers. The chips are designed to provide access to almost anything digitalreaders will allow, including data collection on sustainability efforts. Such sophisticated data collection permeates Swedish society.For example, Ericsson has reported on sustainability performance for over 25 years, evolving with the times from environmentaldisclosure to the broader “triple bottom line” approach (i.e., environmental, social, and economic development) and, more recently, tothe responsible business practices that Ericsson has adopted.

For the country, Sweden is focused on a sustainability agenda called Climate Roadmap, a direct operationalization of Roadmap2050, which is an initiative of the European Union (www.roadmap2050.eu): “The mission of (the) Roadmap 2050 project is toprovide a practical, independent and objective analysis of pathways to achieve a low-carbon economy in Europe, in line with theenergy security, environmental and economic goals of the European Union. The Roadmap 2050 project is an initiative of theEuropean Climate Foundation (ECF).”* To support this initiative, Sweden passed a new climate law that became effective in 2018,which committed the country to reach carbon neutrality by 2045. Guided by a Climate Policy Council, the law also sets out how thegoals are to be achieved. The climate action plan must be evaluated on an annual basis to reach intermediary emission reductiontargets for 2030 and 2040.

Another unique aspect of Sweden’s sustainability effort is the country’s recycling “revolution.” Swedes recycle 99 percent oftheir household waste. Weine Wiqvist, CEO of the Swedish Waste Management and Recycling Association (Avfall Sverige), stillthinks the country and its citizens can do more, however. He argues that about half of all household waste is burned, meaning it isturned into energy. Wiqvist explains that if the country could instead reuse the materials, the result would be less energy being used tocreate a new product than burning the waste for energy. “We are trying to ‘move up the refuse ladder,’ as we say, from burning tomaterial recycling by promoting recycling and working with authorities,”** he says. Despite the high ratio of burning waste toreusing it, the positive for Sweden is that waste in landfills is not an issue in the country anymore. All waste is used in some form.

Likewise, when the United Nations launched the SDGs in 2015, Ericsson was there, leading the industry. With expertise in ICTand a sustainability strategy incorporated into the Ericsson’s business, the company has a strong platform for making decisiveadvances. In fact, Ericsson is one of the few organizations in the world that has directly connected each of the 17 SDGs to specificissues that pertain to the company, and especially the ICT industry that Ericsson operates in. For example, SDG goal 11 is focused onsustainable cities and communities. In this area, Ericsson states that “ICT can reduce administration costs and improveaccess to key areas such as health care, education and banking, and provide a platform for inclusion.”***

*Roadmap 2050. Roadmap.

**Avfall Sverige/Swedish Institute.

***”Global Goals SDG 11,” Ericsson, 2019, https://www.ericsson.com/en/about-us/sustainability-and-corporate-responsibility/sustainable-development-goals/goal-11.

Sources: Susanne Arvidsson, “Lessons from Sweden in Sustainable Business,” The Conversation, December 11, 2017; Maddy Savage, “The Swedish Wasteland That Is Now aSustainability Star,” BBC News, October 3, 201; Klas Ericson, Martin Bauer, and Andreas Scheibenpflug, “How Sweden Lays the Foundation for Sustainable Manufacturing,”Business Sweden, February 19, 2019; Ben Wilde, “How Sweden Became the World’s Most Sustainable Country: Top 5 Reasons,” Adec Innovations, January 12, 2016; “EnergyUse in Sweden,” Sweden.se, February 19, 2019; Dominic Hogg, “The Dark Truth Behind Sweden’s Revolutionary Recycling Schemes,” The Independent, December 13, 2016;“Sweden Turns Goal to Reach Carbon Neutrality in 2045 Into Law,” Climate Policy Observer, June 16, 2017.

IntroductionEthics, corporate social responsibility, and sustainability are intertwined issues facing companies, industries, countries,and regional societies worldwide. These “social” issues arise frequently in international business, often because businesspractices and regulations differ from nation to nation. With regard to lead pollution, for example, what is allowed inMexico is outlawed in the United States. The tricky part is also that what is ethical, socially responsible, or sustainable

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often is not a legal obligation that companies and countries face.Instead, “doing good” is often a self-correcting measure that companies or industries place on themselves and

countries adopt as a business model (it may be a legal issue within one country but seldom carries universally to all othercountries in the world). Ultimately, differences in “sustainable” practices can create dilemmas for businesses.Understanding the nature of these dilemmas and deciding the course of action to pursue when confronted with them is acentral theme in this chapter. We blend a lot of business ethics with corporate social responsibility and sustainabilityissues to capture a global understanding of the issues around the world.

global EDGE ONLINE COURSE MODULES

globalEDGE™ has a series of interactive “online course modules”—free educational learning opportunities for business people, policyofficials, and students. These modules focus on issues that are important to international business. Each module includes a wealth ofcontent, a case study or anecdotes, glossary of terms, questions to consider, and a list of references. See more atglobaledge.msu.edu/reference-desk/online-course-modules. The combination of the textbook and the globalEDGE™ online coursemodules serves as an excellent resource that you can use to prepare for NASBITE’s Certified Global Business Professional Credential.Achieving the industry-leading CGBP credential ensures that employees are able to practice global business at the professional level—including ethics, corporate social responsibility, and sustainability—required in today’s competitive global environment. View thequestions in the modules as a test of your readiness to achieve the CGBP credential.

These are not easy issues to capture, understand, or even buy into at all times. For example, we know that some toymanufacturers have been violating safety regulations for decades, and many companies will likewise continue to do so inthe future across all product and industry categories. For the toy industry specifically, time will tell, assumingwe can track the ingredients in the materials being used to make toys. What we do know is that about a third ofthe toys that are exported out of China are often tainted with heavy metals above the norm. Unfortunately, it is not illegalto use lead, for example, in plastics at this time. It is an ethical issue and perhaps also a sustainability issue—and usuallya voluntary one—that some companies tackle and others choose to sidestep. The obvious reason some companies takeshortcuts is simple math or capitalism—the large size of market opportunities in the toy industry. A basic question thenis: Can it be considered unethical to manufacture toys that include heavy metals that are bad for children to ingest andcome in contact with when using the toys in their proper way? What about corporate social responsibility among acountry’s companies or the companies’ sustainable business practices?

The sustainability dynamics between a country and a company is illustrated in the opening case on Ericsson andSweden. Since the ratification by 193 countries in September 2015 of the United Nations’ Sustainable DevelopmentGoals (SDGs), Sweden has performed the best of all countries on the 17 SDGs and accompanying 169 measures.Meanwhile, Ericsson ranked number 21 in the world in the Top 100 Most Sustainable Corporations, and is the top-ranked company in Sweden on incorporating sustainability into its strategies. Basically, Sweden provides a superbinfrastructure and resources for companies like Ericsson to implement sustainability practices. This is a huge differencecompared to China and its many toy companies, which operate in less than ideal situations, polluting the environmentand also using heavy metals like lead—which are forbidden in the Unites States and many other countries—to producetoys for the international marketplace.

The core starting point for this chapter is ethics. Ethics serves as the foundation for what people do or do not do,and ultimately ethical behavior of employees results in corporate social responsibility and sustainability practicesengaged in by the company. Companies’ involvement in corporate social responsibility practices and sustainabilityinitiatives can be traced to the ethical foundation of its employees and other stakeholders, such as customers,shareholders, suppliers, regulators, and communities.1 Ethics refers to accepted principles of right or wrong that governthe conduct of a person, the members of a profession, or the actions of an organization. Business ethics are the acceptedprinciples of right and wrong governing the conduct of businesspeople, and an ethical strategy is a strategy, or course ofaction, that does not violate these accepted principles.

Broadly, as a start, we look at how ethical issues should be incorporated into decision making in an internationalbusiness. We also review the reasons for poor ethical decision making and discuss different philosophical approaches tobusiness ethics. Then, using the ethical decision-making process as our platform, we present a series of illustrations viatwo Management Focus boxes related to Volkswagen and Stora Enso. The chapter closes by reviewing the differentprocesses that managers can adopt to make sure that ethical considerations are incorporated into decision making ininternational business and how these decisions filter into corporate social responsibility and sustainability efforts.

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Ethics and International Business

LO5-1Understand the ethical, corporate social responsibility, and sustainability issues faced by international businessesMany of the ethical issues in international business are rooted in differences in political systems, laws,economic development, and culture across countries. What is considered normal practice in one nation may beconsidered unethical in another. Also, what is illegal in one country may even be normal ethical business practice inanother. There are significant reasons why countries and these country-level differences exist—otherwise, we could justhave a one-world mentality, as China does with its “One-China Policy” (i.e., a policy stating there is only one country ofChina, despite the fact there are two governments with China in its name: the People’s Republic of China, what iscommonly referred to as China; and the Republic of China, which is commonly referred to as Taiwan). The One-ChinaPolicy has not been universally adopted around the world and, likewise, a one-world policy is unlikely to happen.Consequently, we will have differences in political systems, laws, economic development, and culture across the globe’s195 countries.

The unique complexities of legal and ethical differences, in particular, make it incredibly difficult to come up withglobal standards for ethics, corporate social responsibility, and sustainability. As we discussed in the opening case onEricsson and Sweden, the United Nations did have its 193-member nations ratify the Sustainable Development Goals in2015, but they are far from being achieved (although the goal is set to be met by 2030). Instead, managers inmultinational corporations need to be particularly sensitive to these systematic country-level differences when they dobusiness throughout the world. Many businesspeople try to advocate or even enforce their home country view oncompanies in other countries without much thinking about the implications for the relationship. In the internationalbusiness setting, the most common ethical issues involve employment practices, human rights, environmentalregulations, corruption, and the moral obligation of multinational corporations. We will discuss each.

EMPLOYMENT PRACTICESWhen work conditions in another country (host nation) are inferior to those in a multinational corporation’s home nation,which standards should be applied? Those of the home nation, those of the host nation, or something in between? Whilefew would suggest that pay and work conditions should be the same across nations, how different can they be before wefind it to be unacceptable? For example, while 12-hour workdays, extremely low pay, and a failure to protect workersagainst toxic chemicals may be common in some less developed and so-called emerging nations, does this mean that it isokay for a multinational company to tolerate such working conditions in its subsidiaries or to condone it by using localsubcontractors in those countries? Without taking into account the potential financial implications, it would be easy tosimply say that every company should be as ethical, socially responsible, and sustainable as its home-countryenvironment dictates. But it’s not really that simple.

Some time ago, Nike found itself in the center of a storm of protests when news reports revealed that workingconditions at many of its subcontractors were poor. A 48 Hours report on CBS painted a picture of young women whoworked with toxic materials six days a week in poor conditions for only 20 cents an hour at a Vietnamese subcontractor.The report also stated that a living wage in Vietnam was at least $3 a day, an income that could not be achieved at thesubcontractor without working substantial overtime. Nike and its subcontractors were not breaking any laws, butquestions were raised about the ethics of using “sweatshop labor” to make what were essentially fashion accessories. Itmay have been legal, but was it ethical to use subcontractors who, by developed-nation standards, clearly exploited theirworkforce? Nike’s critics thought not, and the company found itself the focus of a wave of demonstrations and consumerboycotts. These exposés surrounding Nike’s use of subcontractors forced the company to reexamine its policies.Realizing that even though it was breaking no law, its subcontracting policies were perceived as unethical, Nike’smanagement established a code of conduct for its subcontractors and instituted annual monitoring by independentauditors of all subcontractors.2

As the Nike case demonstrates, a strong argument can be made that it is not appropriate for a multinational firm totolerate poor working conditions in its foreign operations or those of subcontractors. However, this still leavesunanswered the question of which standards should be applied. We shall return to and consider this issue in more detaillater in the chapter. For now, note that establishing minimal acceptable standards that safeguard the basic rights anddignity of employees, auditing foreign subsidiaries and subcontractors on a regular basis to make sure those standards aremet, and taking corrective action if they are not up to standards are a good way to guard against ethical abuses.

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For another example of problems with working practices among suppliers, read the accompanying Management Focus,which looks at Volkswagen and the company’s staggering public debacle regarding software used to unethically, and inmany cases illegally, lower the output data for air polluting emissions.

HUMAN RIGHTSBasic human rights still are not respected in a large number of nations, and several historical and current examples existto illustrate this point. Rights taken for granted in developed nations, such as freedom of association, freedom of speech,freedom of assembly, freedom of movement, and freedom from political repression, for example, are not universallyaccepted worldwide (see Chapter 2 for details). One of the most obvious historical examples was South Africa during thedays of white rule and apartheid, which did not end until 1994. This may seem like a long time ago, but the effects of theold system still linger to this day. Also, in many countries today we see an increase in authoritarian populists who areattacking human rights principles and fueling distrust of democratic institutions.

South Africa represents an example that most people can relate to, remember, or at least know about, and isrelatively easy to understand (compared with authoritarian populist politicians infringing on human rights). The apartheidsystem denied basic political rights to the majority nonwhite population of South Africa, mandated segregation betweenwhites and nonwhites, reserved certain occupations exclusively for whites, and prohibited blacks from being placed inpositions where they would manage whites. Despite the odious nature of this system, businesses from developed nationsoperated in South Africa for decades before changes started happening. In the decade prior to apartheid’s abolishment,however, many questioned the ethics of doing so. They argued that inward investment by foreign multinationalssupported the repressive apartheid regime, at least indirectly, by boosting the South African economy. Thankfully,several businesses started to change their policies in the 1990s and 2000s.3 Gearing up for the 2030s and beyond, theassumption is that most businesses will follow the idea of, for example, the United Nation’s all-encompassingSustainable Development Goals 2030 (established in September 2015). In doing so, more and more companies are nowusing ethical behavior as a core philosophy when competing for work.

General Motors, which had significant activities in South Africa, was at the forefront of this trend. GM adoptedwhat came to be called the Sullivan principles, named after Leon Sullivan, an African American Baptist minister wholater became a member of GM’s board of directors. Sullivan argued that it was ethically justified for GM to operate inSouth Africa so long as two conditions were fulfilled. First, the company should not obey the apartheid laws in its ownSouth African operations (a form of passive resistance). Second, the company should do everything within its power topromote the abolition of apartheid laws. As a practical matter, Sullivan’s principles ultimately became widely adopted byU.S. firms operating in South Africa. The beginning of the end of apartheid, we think, was when these foreigncompanies, like GM, violated the South African apartheid laws and the government of South Africa did not take anyaction against the companies. Clearly, South Africa did not want to antagonize important foreign investors, which thenled to more and more foreign companies operating in the country choosing to disobey the apartheid laws.

After 10 years, Leon Sullivan concluded that simply following the two principles was not sufficient to break downthe apartheid regime and that American companies, even those adhering to his principles, could not ethically justify theircontinued presence in South Africa. Over the next few years, numerous companies divested their South Africanoperations, including Exxon, General Motors, IBM, and Xerox. At the same time, many state pension funds signaledthey would no longer hold stock in companies that did business in South Africa, which helped persuade severalcompanies to divest their South African operations. These divestments, coupled with the imposition ofeconomic sanctions from the United States and other governments, contributed to the abandonment of white minorityrule and apartheid in South Africa and the introduction of democratic elections in 1994. This is when Nelson Mandelawas elected president of South Africa, after having served 27 years in prison for conspiracy and sabotage to overthrowthe white government of South Africa (Mandela won the Nobel Peace Prize in 1993 and passed away in 2013).Ultimately, adopting an ethical stance by these large multinational corporations was argued to have helped improvehuman rights in South Africa.4

MANAGEMENT FOCUS

“Emissionsgate” at VolkswagenVolkswagen, often abbreviated as VW, is a German automaker founded by the German Labor Front. The company isheadquartered in Wolfsburg. It is the flagship marquee of the Volkswagen Group and, for the first time ever, became the top

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automaker in the world in 2017 and has maintained that number one position. Volkswagen said it delivered 10.8 million vehiclesworldwide, while the nearest competitors Renault Nissan Mitsubishi (10.3 million) and Toyota (10.3 million) had very similarglobal sales, some 500,000 units below VW (with General Motors following just behind, but with strong sales in China).

To go along with its car numbers, VW had revenue of about $129 billion for these vehicles and an employee workforce ofsome 630,000 people. These staggering numbers and the ranking as the top automobile manufacturer in the world came at thesame time Volkswagen was facing perhaps the biggest challenge in its 80-year history (the company was founded in 1937).

Sometimes referred to as “emissionsgate” or “dieselgate,” the Volkswagen emissions scandal began in September 2015 whenthe U.S. Environmental Protection Agency (EPA) issued a notice of violation of the Clean Air Act to the German automaker. EPAis an agency of the U.S. federal government that was created to protect human health and the environment by writing andenforcing regulations based on laws passed by the U.S. Congress. The EPA has been around since 1970, although the Trumpadministration has proposed a series of more than 40 cuts to the EPA (slashing the EPA workforce by more than 3,000 people and$2 billion in funding).

In a rather astonishing finding, the EPA determined that Volkswagen had intentionally programmed engines to activateemissions controls only during lab testing. The unethical programming by VW caused the vehicles’ nitrogen oxide output—whichis the most relevant factor for air pollution standards—to register at lower levels to meet strict U.S. standards during the cruciallaboratory regulatory testing. In reality, the vehicles emitted up to 40 times more NOx on the streets. Volkswagen used thisunethical and very sophisticated computer programming in about 11 million cars worldwide, out of which 500,000 vehicles werein use in the United States (for model years 2009–2015).

VW went to great lengths to make this work. The software in the cars sensed when the car was being tested in a regulatory lab,and then the software automatically activated equipment in the vehicle that reduced emissions. Think about that in terms of thedecision making that had to go into making this unethical choice! Additionally, the software turned the car’s equipment downduring regular driving on the streets or highways, resulting in increasing emissions way above legal limits. The only reasoning fordoing this is to save fuel or to improve the car’s torque and acceleration. Thus, not only were the emissions off, and unethicallyadjusted, the car’s performance statistics were also affected in a positive way—which, obviously, can be seen as another unethicaldecision or by-product of the emissions software.

Raymond Boyd/Michael Ochs Archives/Getty Images

The software was modified to adjust components such as catalytic converters or valves that were used to recycle a portion ofthe exhaust gases. These are the components that are meant to reduce emissions of nitrogen oxide, an air pollutant that can causeemphysema, bronchitis, and several other respiratory diseases. The severity of this air pollution resulted in a $4.3 billion settlementwith U.S. regulators. VW also agreed to sweeping reforms, new audits, and oversight by an independent monitor for three years.Internally, VW disciplined dozens of engineers, which is interesting because it at least implies that the top-level managers were notaware of the software installation and unethical use.Sources: Nathan Bomey, “Volkswagen Passes Toyota as World’s Largest Automaker Despite Scandal,” USA Today, January 30, 2017; Bertel Schmitt, “It’s Official:Volkswagen Is World‘s Largest Automaker in 2016. Or Maybe Toyota,” Forbes, January 30, 2017; Rob Davis, “Here Are 42 of President Donald Trump’s Planned EPABudget Cuts,” The Oregonian, March 2, 2017; “VW Expects to Sanction More Employees in Emissions Scandal: Chairman,” CNBC, March 7, 2017.

Although change has come in South Africa, many repressive regimes still exist in the world. In fact, according tothe Freedom House, only about 45 percent of the world’s population of 7.6 billion people are living in free democraticcountries (30 percent are partly free and 25 percent are not free). People in countries that are not considered free by theFreedom House typically face severe consequences if they try to exercise their most basic rights, such as expressing theirviews, assembling peacefully, and organizing independently of the countries in which they live.

This lack of universal freedom in many countries begs the question: Is it ethical for multinational corporations to dobusiness in these repressive countries? As an answer, it is often argued that inward investment by a multinational can bea force for economic, political, and social progress that ultimately improves the rights of people in repressive regimes.This position was first discussed in Chapter 2, when we noted that economic progress in a nation could create pressure

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for democratization. In general, this belief suggests that it is ethical for a multinational to do business in nations that lackthe democratic structures and human rights records of developed nations. Investment in China, for example, is frequentlyjustified on the grounds that although China’s human rights record is often questioned by human rights groups andalthough the country is not a democracy, continuing inward investment will help boost economic growth and raise livingstandards. These developments will ultimately create pressures from the Chinese people for more participatorygovernment, political pluralism, and freedom of expression and speech.

There is a limit to this argument. As in the case of South Africa, some regimes are so repressive that investmentcannot be justified on ethical grounds. Another example would be Myanmar (formerly known as Burma). Ruled by amilitary dictatorship since 1962, Myanmar has one of the worst human rights records in the world. Beginning in the mid-1990s, many companies exited Myanmar, judging the human rights violations to be so extreme that doing business therecould not be justified on ethical grounds. However, a cynic might note that Myanmar has a small economy and thatdivestment carries no great economic penalty for firms, unlike, for example, divestment from China. Interestingly, afterdecades of pressure from the international community, the military government of Myanmar finally acquiesced andallowed limited democratic elections to be held, resulting in the country being rated as “partly free” today according tothe Freedom House.

ENVIRONMENTAL POLLUTIONEthics, social responsibility, and sustainability issues can arise when environmental regulations in host nations areinferior to those in the home nation. Ethics drive what people decide to do, and corporate social responsibility andsustainability drive what companies ultimately decide to do. Many developed nations have substantial regulationsgoverning the emission of pollutants, the dumping of toxic chemicals, the use of toxic materials in the workplace, and soon. Those regulations are often lacking in developing nations, and, according to critics, the result can be higher levels ofpollution from the operations of multinationals than would be allowed at home.

From a practical and moneymaking standpoint, we can ask: Should a multinational corporation feel free to pollutein a developing nation? The answer seems simplistic: To do so hardly seems ethical. Is there a danger thatamoral management might move production to a developing nation precisely because costly pollution controlsare not required and the company is, therefore, free to despoil the environment and perhaps endanger local people in itsquest to lower production costs and gain a competitive advantage? What is the right and moral thing to do in suchcircumstances: pollute to gain an economic advantage or make sure that foreign subsidiaries adhere to common standardsregarding pollution controls?

People wearing breathing masks at Tian’anmen Square in China’s capital city, Beijing.Kevin Frayer/Getty Images News/Getty Images

These questions take on added importance because some parts of the environment are a public good that no oneowns but anyone can despoil. Even so, many companies answer illogically and say that some degree of pollution isacceptable. If the issue becomes degree of pollution instead of preventing as much pollution as possible, then thestrategic decision has been turned around—everyone will start arguing about the degree that is acceptable instead of whatto do to prevent pollution in the first place. The problematic part of this argument and equation for measuring pollution isthat no one owns the atmosphere or the oceans, but polluting both, no matter where the pollution originates, harms all.5In such cases, a phenomenon known as the tragedy of the commons becomes applicable. The tragedy of the commons

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occurs when a resource held in common by all but owned by no one is overused by individuals, resulting in itsdegradation. The phenomenon was first named by Garrett Hardin when describing a particular problem in sixteenth-century England. Large open areas, called commons, were free for all to use as pasture. The poor put out livestock onthese commons and supplemented their meager incomes. It was advantageous for each to put out more and morelivestock, but the social consequence was far more livestock than the commons could handle. The result wasovergrazing, degradation of the commons, and the loss of this much-needed supplement.6

Corporations can contribute to the global tragedy of the commons by moving production to locations where they arefree to pump pollutants into the atmosphere or dump them in oceans or rivers, thereby harming these valuable globalcommons. While such action may be legal, is it ethical? Again, such actions seem to violate basic societal notions ofethics and corporate social responsibility. This issue is taking on greater importance as concerns about human-inducedglobal warming move to center stage. Most climate scientists argue that human industrial and commercial activity isincreasing the amount of carbon dioxide in the atmosphere; carbon dioxide is a greenhouse gas, which reflects heat backto the earth’s surface, warming the globe; and as a result, the average temperature of the earth is increasing. Theaccumulated scientific evidence from numerous databases supports this argument.7 Consequently, societies around theworld are starting to restrict the amount of carbon dioxide that can be emitted into the atmosphere as a by-product ofindustrial and commercial activity. However, regulations differ from nation to nation. Given this, is it ethical for acompany to try to escape tight emission limits by moving production to a country with lax regulations, when doing sowill contribute to global warming? Again, many would argue that doing so violates basic ethical principles.

CORRUPTIONAs noted in Chapter 2, corruption has been a problem in almost every society in history, and it continues to be onetoday.8 There always have been and always will be corrupt government officials. International businesses can gain andhave gained economic advantages by making payments to those officials. A classic example concerns a well-publicizedincident involving Carl Kotchian, then president of Lockheed. He made a $12.6 million payment to Japaneseagents and government officials to secure a large order for Lockheed’s TriStar jet from Nippon Air. When thepayments were discovered, U.S. officials charged Lockheed with falsification of its records and tax violations. Althoughsuch payments were supposed to be an accepted business practice in Japan (they might be viewed as an exceptionallylavish form of gift giving), the revelations created a scandal there, too. The government ministers in question werecriminally charged, one committed suicide, the government fell in disgrace, and the Japanese people were outraged.Apparently, such a payment was not an accepted way of doing business in Japan! The payment was nothing more than abribe, paid to corrupt officials, to secure a large order that might otherwise have gone to another manufacturer, such asBoeing. Kotchian clearly engaged in unethical behavior—and to argue that the payment was an “acceptable form ofdoing business in Japan” was self-serving and incorrect.

The Lockheed case was the impetus for the Foreign Corrupt Practices Act (FCPA) in the United States,discussed in Chapter 2. The act outlawed paying of bribes to foreign government officials to gain business, and this wasthe case even if other countries’ companies could do it. Some U.S. businesses immediately objected that the act wouldput U.S. firms at a competitive disadvantage (there is no evidence that has occurred).9 The act was subsequentlyamended to allow for “facilitating payments.” Sometimes known as speed money or grease payments, facilitatingpayments are not payments to secure contracts that would not otherwise be secured, nor are they payments to obtainexclusive preferential treatment. Rather they are payments to ensure receiving the standard treatment that a businessought to receive from a foreign government but might not due to the obstruction of a foreign official.

The trade and finance ministers from the member states of the Organization for Economic Co-operation andDevelopment (OECD) later on followed the U.S. lead and adopted the Convention on Combating Bribery of ForeignPublic Officials in International Business Transactions.10 The convention, which went into force in 1999, obligesmember states and other signatories to make the bribery of foreign public officials a criminal offense. The conventionexcludes facilitating payments made to expedite routine government action.

While facilitating payments, or speed money, are excluded from both the Foreign Corrupt Practices Act and theOECD convention on bribery, the ethical implications of making such payments are unclear. From a practical standpoint,giving bribes might be the price that must be paid to do a greater good (assuming the investment creates jobs andassuming the practice is not illegal). Several economists advocate this reasoning, suggesting that in the context ofpervasive and cumbersome regulations in developing countries, corruption may improve efficiency and help growth!These economists theorize that in a country where preexisting political structures distort or limit the workings of themarket mechanism, corruption in the form of black-marketeering, smuggling, and side payments to governmentbureaucrats to “speed up” approval for business investments may enhance welfare.11 Arguments such as this persuadedthe U.S. Congress to exempt facilitating payments from the FCPA.

In contrast, other economists have argued that corruption reduces the returns on business investment and leads to

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low economic growth.12 In a country where corruption is common, unproductive bureaucrats who demand sidepayments for granting the enterprise permission to operate may siphon off the profits from a business activity. Thisreduces businesses’ incentive to invest and may retard a country’s economic growth rate. One study of the connectionbetween corruption and economic growth in 70 countries found that corruption had a significant negative impact on acountry’s growth rate.13 Another study found that firms that paid more in bribes are likely to spend more, not less,management time with bureaucrats negotiating regulations and that this tended to raise the costs of the firm.14

Consequently, many multinationals have adopted a zero-tolerance policy. For example, the large oil multinationalBP has a zero-tolerance approach toward facilitating payments. Other corporations have a more nuanced approach. DowCorning used to formally state a few years ago in its Code of Conduct that “in countries where local businesspractice dictates such [facilitating] payments and there is no alternative, facilitating payments are to be for theminimum amount necessary and must be accurately documented and recorded.”15 This statement recognized thatbusiness practices and customs differ from country to country. At the same time, Dow Corning allowed for facilitatingpayments when “there is no alternative,” although they were also stated to be strongly discouraged. More recently, thelatest version of Dow Corning’s Code of Conduct has removed the section on “international business guidelines”altogether, so our assumption has to be that the company is taking a stronger zero-tolerance approach.

At the same time, as with many companies, Dow Corning may have realized that the nuances between a bribe and afacilitating payment are unclear. Many U.S. companies have sustained FCPA violations due to facilitating payments thatwere made but did not fall within the general rules allowing such payments. For example, global freight forwarder Con-way paid a $300,000 penalty for making hundreds of what could be considered small payments to various customsofficials in the Philippines. In total, Con-way distributed some $244,000 to these officials who were induced to violatecustoms regulations, settle disputes, and not enforce fines for administrative violations.16

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Ethical Dilemmas

LO5-2Recognize an ethical, corporate social responsibility, and/or sustainability dilemma.The ethical obligations of a multinational corporation toward employment conditions, human rights, corruption, andenvironmental pollution are not always clear-cut. However, what is becoming clear-cut is that managers and theircompanies are feeling more of the marketplace pressures from customers and other stakeholders to be transparent in theirethical decision making. At the same time, there is no universal worldwide agreement about what constitutes acceptedethical principles. From an international business perspective, some argue that what is ethical depends on one’s culturalperspective.17 In the United States, it is considered acceptable to execute murderers, but in many cultures, this type ofpunishment is not acceptable—execution is viewed as an affront to human dignity, and the death penalty is outlawed.Many Americans find this attitude strange, but, for example, many Europeans find the American approach barbaric. Fora more busi ness-or iented exampl e, cons i der t he pr act i ce of “g i f t g i vi ng” between t he p arti es t o a bus iness negoti ation.While this is considered right and proper behavior in many Asian cultures, some Westerners view the practice as a formof bribery and therefore unethical, particularly if the gifts are substantial.

International managers often confront very real ethical dilemmas where the appropriate course of action is not clear.For example, imagine that a visiting American executive finds that a foreign subsidiary in a poor nation has hired a 12-year-old girl to work on a factory floor. Appalled to find that the subsidiary is using child labor in direct violation of thecompany’s own ethical code, the American instructs the local manager to replace the child with an adult. The localmanager dutifully complies. The girl, an orphan, who is the only breadwinner for herself and her six-year-old brother, isunable to find another job, so in desperation she turns to prostitution. Two years later, she dies of AIDS. Had the visitingAmerican understood the gravity of the girl’s situation, would he still have requested her replacement? Would it havebeen better to stick with the status quo and allow the girl to continue working? Probably not, because that would haveviolated the reasonable prohibition against child labor found in the company’s own ethical code. What then would have

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been the right thing to do? What was the obligation of the executive given this ethical dilemma?

A young girl making cigarettes in Bagan, Myanmar.Angela N Perryman/Shutterstock

There are no easy answers to these questions. That is the nature of ethical dilemmas—situations in which none ofthe available alternatives seems ethically acceptable.18 In this case, employing child labor was not acceptable,but given that she was employed, neither was denying the child her only source of income. What this Americanexecutive needs, what all managers need, is a moral compass, or perhaps an ethical algorithm, to guide them throughsuch an ethical dilemma to find an acceptable solution. Later, we will outline what such a moral compass, or ethicalalgorithm, might look like. For now, it is enough to note that ethical dilemmas exist because many real-world decisionsare complex; difficult to frame; and involve first-, second-, and third-order consequences that are hard to quantify. Doingthe right thing, or even knowing what the right thing might be, is often far from easy.19

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Roots of Unethical Behavior

LO5-3Identify the causes of unethical behavior by managers as they relate to business, corporate social responsibility, orsustainability.Examples are plentiful of international managers behaving in a manner that might be judged unethical in an internationalbusiness setting. Why do managers behave in an unethical manner? There is no simple answer to this question becausethe causes are complex, but some generalizations can be made and these issues are rooted in six determinants of ethicalbehavior: personal ethics, decision-making processes, organizational culture, unrealistic performance goals, leadership,and societal culture (see Figure 5.1).20

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FIGURE 5.1 Determinants of ethical behavior.

PERSONAL ETHICSSocietal business ethics are not divorced from personal ethics, which are the generally accepted principles of right andwrong governing the conduct of individuals. Personal ethics have an effect on business ethics, which ultimately, as wewill see in the Focus on Managerial Implications section of this chapter, have an effect on a company’s sociallyresponsible practices and sustainability activities. As individuals, we are typically taught that it is wrong to lie and cheat—it is unethical—and that it is right to behave with integrity and honor and to stand up for what we believe to be rightand true. This is generally true across societies. The personal ethical code that guides our behavior comes from a numberof sources, including our parents, our schools, our religion, and the media. Our personal ethical code exerts a profoundinfluence on the way we behave as businesspeople. An individual with a strong sense of personal ethics is less likely tobehave in an unethical manner in a business setting. It follows that the first step to establishing a strong senseof business ethics is for a society to emphasize strong personal ethics.

Home-country managers working abroad in multinational firms (expatriate managers) may experience more thanthe usual degree of pressure to violate their personal ethics. They are away from their ordinary social context andsupporting culture, and they are psychologically and geographically distant from the parent company. They may bebased in a culture that does not place the same value on ethical norms important in the manager’s home country, and theymay be surrounded by local employees who have less rigorous ethical standards. The parent company may pressureexpatriate managers to meet unrealistic goals that can only be fulfilled by cutting corners or acting unethically. Forexample, to meet centrally mandated performance goals, expatriate managers might give bribes to win contracts or mightimplement working conditions and environmental controls that are below minimally acceptable standards. Localmanagers might encourage the expatriate to adopt such behavior. Due to its geographic distance, the parent companymay be unable to see how expatriate managers are meeting goals or may choose not to see how they are doing so,allowing such behavior to flourish and persist.

DECISION-MAKING PROCESSESSeveral studies of unethical behavior in a business setting have concluded that businesspeople sometimes do not realizethey are behaving unethically, primarily because they simply fail to ask, “Is this decision or action ethical?”21 Instead,they apply a straightforward business calculus to what they perceive to be a business decision, forgetting that thedecision may also have an important ethical dimension. The fault lies in processes that do not incorporate ethicalconsiderations into business decision making. This may have been the case at Nike when managers originally madesubcontracting decisions. Those decisions were probably made based on good economic logic. Subcontractors wereprobably chosen based on business variables such as cost, delivery, and product quality, but the key managers simply

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failed to ask, “How does this subcontractor treat its workforce?” If they thought about the question at all, they probablyreasoned that it was the subcontractor’s concern, not theirs.

To improve ethical decision making in a multinational firm, the best starting point is to better understand howindividuals make decisions that can be considered ethical or unethical in an organizational environment.22 Twoassumptions must be taken into account. First, too often it is assumed that individuals in the workplace make ethicaldecisions in the same way as they would if they were home. Second, too often it is assumed that people from differentcultures make ethical decisions following a similar process (see Chapter 4 for more on cultural differences). Both ofthese assumptions are problematic. First, within an organization, there are very few individuals who have the freedom(e.g., power) to decide ethical issues independent of pressures that may exist in an organizational setting (e.g., should wemake a facilitating payment or resort to bribery?). Second, while the process for making an ethical decision may largelybe the same in many countries, the relative emphasis on certain issues is unlikely to be the same. Some cultures maystress organizational factors (Japan), while others stress individual personal factors (United States), yet some may base adecision purely on the opportunity (Myanmar) and others base it on the importance to their superiors (India).

ORGANIZATIONAL CULTUREThe culture in some businesses does not encourage people to think through the ethical consequences of businessdecisions. This brings us to the third cause of unethical behavior in businesses: an organizational culture thatdeemphasizes business ethics, reducing all decisions to the purely economic. The term organizational culture refers tothe values and norms that are shared among employees of an organization. You will recall from Chapter 4 that values areabstract ideas about what a group believes to be good, right, and desirable, while norms are the social rules andguidelines that prescribe appropriate behavior in particular situations. Just as societies have cultures, so dobusiness organizations, as we discussed in Chapter 4. Together, values and norms shape the culture of abusiness organization, and that culture has an important influence on the ethics of business decision making.

For example, paying bribes to secure business contracts was long viewed as an acceptable way of doing businesswithin certain companies. It was, in the words of an investigator of a case against Daimler, “standard business practice”that permeated much of the organization, including departments such as auditing and finance that were supposed todetect and halt such behavior. It can be argued that such a widespread practice could have persisted only if the values andnorms of the organization implicitly approved of paying bribes to secure business.

UNREALISTIC PERFORMANCE GOALSThe fourth cause of unethical behavior has already been hinted at: the pressure from the parent company to meetunrealistic performance goals that can be attained only by cutting corners or acting in an unethical manner. In thesecases, bribery may be viewed as a way to hit challenging performance goals. The combination of an organizationalculture that legitimizes unethical behavior, or at least turns a blind eye to such behavior, and unrealistic performancegoals may be particularly toxic. In such circumstances, there is a greater than average probability that managers willviolate their own personal ethics and engage in unethical behavior. Conversely, an organization’s culture can do just theopposite and reinforce the need for ethical behavior. At Hewlett-Packard, for example, Bill Hewlett and David Packard,the company’s founders, propagated a set of values known as The HP Way. These values, which shape the way businessis conducted both within and by the corporation, have an important ethical component. Among other things, they stressthe need for confidence in and respect for people, open communication, and concern for the individual employee.

LEADERSHIPThe Hewlett-Packard example suggests a fifth root cause of unethical behavior: leadership. Leaders help establish theculture of an organization, and they set the example, rules, and guidelines that others follow as well as the structure andprocesses for operating both strategically and in daily operations. Employees often operate and work within a definedstructure with a mindset very much similar to the overall culture of the organization that employs them.

Additionally, employees in business often take their cue from business leaders, and if those leaders do not behavein an ethical manner, the employees might not either. It is not just what leaders say that matters but what they do or donot do. What message, then, did the leaders at Daimler send about corrupt practices? Presumably, they did very little todiscourage them and may have encouraged such behavior.

SOCIETAL CULTURESocietal culture may well have an impact on the propensity of people and organizations to behave in an unethicalmanner. One study of 2,700 firms in 24 countries found that there were significant differences among the ethical policiesof firms headquartered in different countries.23 Using Hofstede’s dimensions of social culture (see Chapter 4), the studyfound that enterprises headquartered in cultures where individualism and uncertainty avoidance are strong were more

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likely to emphasize the importance of behaving ethically than firms headquartered in cultures where masculinity andpower distance are important cultural attributes. Such analysis suggests that enterprises headquartered in a country suchas Russia, which scores high on masculinity and power distance measures, and where corruption is endemic, are morelikely to engage in unethical behavior than enterprises headquartered in Scandinavia.

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Philosophical Approaches to Ethics

LO5-4Describe the different philosophical approaches to business ethics that apply globally.In this section, we look at several different philosophical approaches to business ethics in the global marketplace.Basically, all individuals adopt a process for making ethical (or unethical) decisions. This process is based on theirpersonal philosophical approach to ethics—that is, the underlying moral fabric of the individual.

We begin with what can best be described as straw men, which either deny the value of business ethics or apply theconcept in a very unsatisfactory way. Having discussed and, we hope you agree, dismissed the straw men, we move on toconsider approaches that are favored by most moral philosophers and form the basis for current models of ethicalbehavior in international businesses.

STRAW MENThe straw men approach to business ethics is raised by scholars primarily to demonstrate that they offer inappropriateguidelines for ethical decision making in a multinational enterprise. Four such approaches to business ethics arecommonly discussed in the literature. These approaches can be characterized as the Friedman doctrine, culturalrelativism, the righteous moralist, and the naive immoralist. All these approaches have some inherent value, but all areunsatisfactory in important ways. Nevertheless, sometimes companies adopt these approaches.

The Friedman DoctrineThe Nobel Prize–winning economist Milton Friedman wrote an article in The New York Times in 1970 that has sincebecome a classic straw man example that business ethics scholars outline only to then tear down.24 Friedman’s basicposition is that “the social responsibility of business is to increase profits,” so long as the company stays within the rulesof law. He explicitly rejects the idea that businesses should undertake social expenditures beyond those mandated by thelaw and required for the efficient running of a business. For example, his arguments suggest that improving workingconditions beyond the level required by the law and necessary to maximize employee productivity will reduce profitsand is therefore not appropriate. His belief is that a firm should maximize its profits because that is the way to maximizethe returns that accrue to the owners of the firm, its shareholders. If the shareholders then wish to use the proceeds tomake social investments, that is their right, according to Friedman, but managers of the firm should not make thatdecision for them.

Although Friedman is talking about social responsibility and “ethical custom,” rather than business ethics per se,many business ethics scholars equate social responsibility with ethical behavior and thus believe Friedman is alsoarguing against business ethics. However, the assumption that Friedman is arguing against ethics is not quite true, forFriedman does argue that there is only one social responsibility of business: to increase the profitability of the enterpriseso long as it stays within the law, which is taken to mean that it engages in open and free competition without deceptionor fraud.25

There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase itsprofits so long as it stays within the rules of the game, which is to say that it engages in open and free competition withoutdeception or fraud.26

In other words, Friedman argues that businesses should behave in a socially responsible manner, according toethical custom and without deception and fraud.

Critics charge that Friedman’s arguments break down under examination. This is particularly true in international

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business, where the “rules of the game” are not well established and differ from country to country. Consider again thecase of sweatshop labor. Child labor may not be against the law in a developing nation, and maximizing productivitymay not require that a multinational firm stop using child labor in that country, but it is still immoral to use child laborbecause the practice conflicts with widely held views about what is the right and proper thing to do. Similarly,there may be no rules against pollution in a less developed nation and spending money on pollution controlmay reduce the profit rate of the firm, but generalized notions of morality would hold that it is still unethical to dumptoxic pollutants into rivers or foul the air with gas releases. In addition to the local consequences of such pollution, whichmay have serious health effects for the surrounding population, there is also a global consequence as pollutants degradethose two global commons so important to us all: the atmosphere and the oceans.

Cultural RelativismAnother straw man often raised by business ethics scholars is cultural relativism, which is the belief that ethics arenothing more than the reflection of a culture—all ethics are culturally determined—and that accordingly, a firm shouldadopt the ethics of the culture in which it is operating.27 This approach is often summarized by the maxim when inRome, do as the Romans do. As with Friedman’s approach, cultural relativism does not stand up to a closer look. At itsextreme, cultural relativism suggests that if a culture supports slavery, it is okay to use slave labor in a country. Clearly,it is not! Cultural relativism implicitly rejects the idea that universal notions of morality transcend different cultures, butas we argue later in the chapter, some universal notions of morality are found across cultures.

While dismissing cultural relativism in its most sweeping form, some ethicists argue there is residual value in thisapproach.28 We agree. As we noted in Chapter 3, societal values and norms do vary from culture to culture, and customsdo differ, so it might follow that certain business practices are ethical in one country but not another. Indeed, thefacilitating payments allowed in the Foreign Corrupt Practices Act can be seen as an acknowledgment that in somecountries, the payment of speed money to government officials is necessary to get business done, and, if not ethicallydesirable, it is at least ethically acceptable.

The Righteous MoralistA righteous moralist claims that a multinational’s home-country standards of ethics are the appropriate ones forcompanies to follow in foreign countries. This approach is typically associated with managers from developed nations.While this seems reasonable at first blush, the approach can create problems. Consider the following example: AnAmerican bank manager was sent to Italy and was appalled to learn that the local branch’s accounting departmentrecommended grossly underreporting the bank’s profits for income tax purposes.29 The manager insisted that the bankreport its earnings accurately, American style. When he was called by the Italian tax department to the firm’s tax hearing,he was told the firm owed three times as much tax as it had paid, reflecting the department’s standard assumption thateach firm underreports its earnings by two-thirds. Despite his protests, the new assessment stood. In this case, therighteous moralist has run into a problem caused by the prevailing cultural norms in the country where he was doingbusiness. How should he respond? The righteous moralist would argue for maintaining the position, while a morepragmatic view might be that in this case, the right thing to do is to follow the prevailing cultural norms because there isa big penalty for not doing so.

The main criticism of the righteous moralist approach is that its proponents go too far. While there are someuniversal moral principles that should not be violated, it does not always follow that the appropriate thing to do is adopthome-country standards. For example, U.S. laws set down strict guidelines with regard to minimum wage and workingconditions. Does this mean it is ethical to apply the same guidelines in a foreign country, paying people the same as theyare paid in the United States, providing the same benefits and working conditions? Probably not, because doing so mightnullify the reason for investing in that country and therefore deny locals the benefits of inward investment by themultinational. Clearly, a more nuanced approach is needed.

The Naive ImmoralistA naive immoralist asserts that if a manager of a multinational sees that firms from other nations are not followingethical norms in a host nation, that manager should not either. The classic example to illustrate the approach is known asthe drug lord problem. In one variant of this problem, an American manager in Colombia routinely pays off the localdrug lord to guarantee that her plant will not be bombed and that none of her employees will be kidnapped. The managerargues that such payments are ethically defensible because everyone is doing it.

The objection is twofold. First, to say that an action is ethically justified if everyone is doing it is not sufficient. Iffirms in a country routinely employ 12-year-olds and make them work 10-hour days, is it therefore ethically defensibleto do the same? Obviously not, and the company does have a clear choice. It does not have to abide by local practices,and it can decide not to invest in a country where the practices are particularly odious. Second, the multinational mustrecognize that it does have the ability to change the prevailing practice in a country. It can use its power for a positivemoral purpose. This is what BP is doing by adopting a zero-tolerance policy with regard to facilitating payments. BP is

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stating that the prevailing practice of making facilitating payments is ethically wrong, and it is incumbent upon thecompany to use its power to try to change the standard. While some might argue that such an approach smells of moralimperialism and a lack of cultural sensitivity, if it is consistent with standards in the global community, it may beethically justified.

UTILITARIAN AND KANTIAN ETHICSIn contrast to the straw men just discussed, most moral philosophers see value in utilitarian and Kantian approaches tobusiness ethics. These approaches were developed in the eighteenth and nineteenth centuries, and although they havebeen largely superseded by more modern approaches, they form part of the tradition on which newer approaches havebeen constructed.

The utilitarian approach to business ethics dates to philosophers such as David Hume (1711–1776), JeremyBentham (1748–1832), and John Stuart Mill (1806–1873). The utilitarian approach to ethics holds that the moralworth of actions or practices is determined by their consequences.30 An action is judged desirable if it leads to the bestpossible balance of good consequences over bad consequences. Utilitarianism is committed to the maximization of goodand the minimization of harm. Utilitarianism recognizes that actions have multiple consequences, some of which aregood in a social sense and some of which are harmful. As a philosophy for business ethics, it focuses attention on theneed to weigh carefully all the social benefits and costs of business activity and to pursue only those actions where thebenefits outweigh the costs. The best decisions, from a utilitarian perspective, are those that produce the greatest good forthe greatest number of people.

Many businesses have adopted specific tools such as cost-benefit analysis and risk assessment that are firmly rootedin a utilitarian philosophy. Managers often weigh the benefits and costs of an action before deciding whether to pursue it.An oil company considering drilling in the Alaskan wildlife preserve must weigh the economic benefits of increased oilproduction and the creation of jobs against the costs of environmental degradation in a fragile ecosystem. An agriculturalbiotechnology company such as Monsanto must decide whether the benefits of genetically modified crops that producenatural pesticides outweigh the risks. The benefits include increased crop yields and reduced need for chemicalfertilizers. The risks include the possibility that Monsanto’s insect-resistant crops might make matters worse over time ifinsects evolve a resistance to the natural pesticides engineered into Monsanto’s plants, rendering the plants vulnerable toa new generation of superbugs.

The utilitarian philosophy does have some serious drawbacks as an approach to business ethics. One problem ismeasuring the benefits, costs, and risks of a course of action. In the case of an oil company considering drilling inAlaska, how does one measure the potential harm done to the region’s ecosystem? The second problem withutilitarianism is that the philosophy omits the consideration of justice. The action that produces the greatestgood for the greatest number of people may result in the unjustified treatment of a minority. Such action cannot beethical, precisely because it is unjust. For example, suppose that in the interests of keeping down health insurance costs,the government decides to screen people for the HIV virus and deny insurance coverage to those who are HIV positive.By reducing health costs, such action might produce significant benefits for a large number of people, but the action isunjust because it discriminates unfairly against a minority.

Kantian ethics is based on the philosophy of Immanuel Kant (1724–1804). Kantian ethics holds that people shouldbe treated as ends and never purely as means to the ends of others. People are not instruments, like a machine. Peoplehave dignity and need to be respected as such. Employing people in sweatshops, making them work long hours for lowpay in poor working conditions, is a violation of ethics, according to Kantian philosophy, because it treats people as merecogs in a machine and not as conscious moral beings that have dignity. Although contemporary moral philosophers tendto view Kant’s ethical philosophy as incomplete—for example, his system has no place for moral emotions or sentimentssuch as sympathy or caring—the notion that people should be respected and treated with dignity resonates in the modernworld.

RIGHTS THEORIESDeveloped in the twentieth century, rights theories recognize that human beings have fundamental rights and privilegesthat transcend national boundaries and cultures. Rights establish a minimum level of morally acceptable behavior. Onewell-known definition of a fundamental right construes it as something that takes precedence over or “trumps” acollective good. Thus, we might say that the right to free speech is a fundamental right that takes precedence over all butthe most compelling collective goals and overrides, for example, the interest of the state in civil harmony or moralconsensus.31 Moral theorists argue that fundamental human rights form the basis for the moral compass that managersshould navigate by when making decisions that have an ethical component. More precisely, they should not pursueactions that violate these rights.

The notion that there are fundamental rights that transcend national borders and cultures was the underlyingmotivation for the United Nations Universal Declaration of Human Rights, adopted in 1948, which has been ratified

1.

2.3.

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by almost every country and lays down principles that should be adhered to irrespective of the culture in which one isdoing business.32 Echoing Kantian ethics, Article 1 of this declaration states

All human beings are born free and equal in dignity and rights. They are endowed with reason and conscience and should acttowards one another in a spirit of brotherhood.33

Article 23 of this declaration, which relates directly to employment, states:Everyone has the right to work, to free choice of employment, to just and favorable conditions of work, and toprotection against unemployment.Everyone, without any discrimination, has the right to equal pay for equal work.Everyone who works has the right to just and favorable remuneration ensuring for himself and his family anexistence worthy of human dignity, and supplemented, if necessary, by other means of social protection.

Everyone has the right to form and to join trade unions for the protection of his interests.34

Clearly, the rights to “just and favorable conditions of work,” “equal pay for equal work,” and remuneration thatensures an “existence worthy of human dignity” embodied in Article 23 imply that it is unethical to employ child labor insweatshop settings and pay less than subsistence wages, even if that happens to be common practice in some countries.These are fundamental human rights that transcend national borders.

It is important to note that along with rights come obligations. Because we have the right to free speech,we are also obligated to make sure that we respect the free speech of others. The notion that people have obligations isstated in Article 29 of the Universal Declaration of Human Rights:

Everyone has duties to the community in which alone the free and full development of his personality ispossible.35

Within the framework of a theory of rights, certain people or institutions are obligated to provide benefits orservices that secure the rights of others. Such obligations also fall on more than one class of moral agent (a moral agentis any person or institution that is capable of moral action such as a government or corporation).

For example, to escape the high costs of toxic waste disposal in the West, several firms shipped their waste in bulkto African nations, where it was disposed of at a much lower cost. At one time, five European ships unloaded toxic wastecontaining dangerous poisons in Nigeria. Workers wearing sandals and shorts unloaded the barrels for $2.50 a day andplaced them in a dirt lot in a residential area. They were not told about the contents of the barrels.36 Who bears theobligation for protecting the rights of workers and residents to safety in a case like this? According to rights theorists, theobligation rests not on the shoulders of one moral agent but on the shoulders of all moral agents whose actions mightharm or contribute to the harm of the workers and residents. Thus, it was the obligation not just of the Nigeriangovernment but also of the multinational firms that shipped the toxic waste to make sure it did no harm to residents andworkers. In this case, both the government and the multinationals apparently failed to recognize their basic obligation toprotect the fundamental human rights of others.

JUSTICE THEORIESJustice theories focus on the attainment of a just distribution of economic goods and services. A just distribution is onethat is considered fair and equitable. There is no one theory of justice, and several theories of justice conflict with eachother in important ways.37 Here, we focus on one particular theory of justice that is both very influential and hasimportant ethical implications. The theory is attributed to philosopher John Rawls.38 Rawls argues that all economicgoods and services should be distributed equally except when an unequal distribution would work to everyone’sadvantage.

According to Rawls, valid principles of justice are those with which all persons would agree if they could freelyand impartially consider the situation. Impartiality is guaranteed by a conceptual device that Rawls calls the veil ofignorance. Under the veil of ignorance, everyone is imagined to be ignorant of all of his or her particular characteristics,for example, race, sex, intelligence, nationality, family background, and special talents. Rawls then asks what systempeople would design under a veil of ignorance. Under these conditions, people would unanimously agree on twofundamental principles of justice.

The first principle is that each person is permitted the maximum amount of basic liberty compatible with a similarliberty for others. Rawls takes these to be political liberty (e.g., the right to vote), freedom of speech and assembly,liberty of conscience and freedom of thought, the freedom and right to hold personal property, and freedom fromarbitrary arrest and seizure.

The second principle is that once equal basic liberty is ensured, inequality in basic social goods—such as incomeand wealth distribution, and opportunities—is to be allowed only if such inequalities benefit everyone. Rawls acceptsthat inequalities can be justified if the system that produces inequalities is to the advantage of everyone. More precisely,

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he formulates what he calls the difference principle, which is that inequalities are justified if they benefit the position ofthe least-advantaged person. So, for example, wide variations in income and wealth can be considered just if the market-based system that produces this unequal distribution also benefits the least-advantaged members of society. One canargue that a well-regulated, market-based economy and free trade, by promoting economic growth, benefit theleast-advantaged members of society. In principle at least, the inequalities inherent in such systems aretherefore just (in other words, the rising tide of wealth created by a market-based economy and free trade lifts all boats,even those of the most disadvantaged).

In the context of international business ethics, Rawls’ theory creates an interesting perspective. Managers could askthemselves whether the policies they adopt in foreign operations would be considered just under Rawls’ veil ofignorance. Is it just, for example, to pay foreign workers less than workers in the firm’s home country? Rawls’ theorywould suggest it is, so long as the inequality benefits the least-advantaged members of the global society (which is whateconomic theory suggests). Alternatively, it is difficult to imagine that managers operating under a veil of ignorancewould design a system where foreign employees were paid subsistence wages to work long hours in sweatshopconditions and where they were exposed to toxic materials. Such working conditions are clearly unjust in Rawls’framework, and therefore, it is unethical to adopt them. Similarly, operating under a veil of ignorance, most peoplewould probably design a system that imparts some protection from environmental degradation to important globalcommons, such as the oceans, atmosphere, and tropical rain forests. To the extent that this is the case, it follows that it isunjust, and by extension unethical, for companies to pursue actions that contribute toward extensive degradation of thesecommons. Thus, Rawls’ veil of ignorance is a conceptual tool that contributes to the moral compass that managers canuse to help them navigate through difficult ethical dilemmas.

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FOCUS ON MANAGERIAL IMPLICATIONS

LO5-5Explain how global managers can incorporate ethical considerations into their decision making in general, as well ascorporate social responsibility and sustainability initiatives.

MAKING ETHICAL DECISIONS INTERNATIONALLYWhat, then, is the best way for managers in a multinational corporation to make sure that ethical considerations figureinto international business decisions?

How do managers decide on an ethical course of action when confronted with decisions pertaining to workingconditions, human rights, corruption, and environmental pollution? From an ethical perspective, how do managersdetermine the moral obligations that flow from the power of a multinational? In many cases, there are no easy answers tothese questions: Many of the most vexing ethical problems arise because there are very real dilemmas inherent in themand no obvious correct action. Nevertheless, managers can and should do many things to make sure that basic ethicalprinciples are adhered to and that ethical issues are routinely inserted into international business decisions.

Here, we focus on seven actions that an international business and its managers can take to make sure ethical issuesare considered in business decisions: (1) favor hiring and promoting people with a well-grounded sense of personalethics; (2) build an organizational culture and exemplify leadership behaviors that place a high value on ethical behavior;(3) put decision-making processes in place that require people to consider the ethical dimension of business decisions;(4) institute ethics officers in the organization; (5) develop moral courage; (6) make corporate social responsibility acornerstone of enterprise policy; and (7) pursue strategies that are sustainable.

Hiring and PromotionIt seems obvious that businesses should strive to hire people who have a strong sense of personal ethics and would notengage in unethical or illegal behavior. Similarly, you would expect a business to not promote people, and perhaps to firepeople, whose behavior does not match generally accepted ethical standards. However, actually doing so is very difficult.How do you know that someone has a poor sense of personal ethics? In our society, we have an incentive to hide a lackof personal ethics from public view. Once people realize that you are unethical, they will no longer trust you.

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Is there anything that businesses can do to make sure they do not hire people who subsequently turn out to havepoor personal ethics, particularly given that people have an incentive to hide this from public view (indeed, theunethical person may lie about his or her nature)? Businesses can give potential employees psychological teststo try to discern their ethical predispositions, and they can check with prior employers or other employees regardingsomeone’s reputation (e.g., by asking for letters of reference and talking to people who have worked with the prospectiveemployee). The latter is common and does influence the hiring process. Promoting people who have displayed poorethics should not occur in a company where the organizational culture values the need for ethical behavior and whereleaders act accordingly.

Not only should businesses strive to identify and hire people with a strong sense of personal ethics, but it also is inthe interests of prospective employees to find out as much as they can about the ethical climate in an organization. Whowants to work at a multinational such as Enron, which ultimately entered bankruptcy because unethical executives hadestablished risky partnerships that were hidden from public view and that existed in part to enrich those same executives?

Organizational Culture and LeadershipTo foster ethical behavior, businesses need to build an organizational culture that values ethical behavior. Three thingsare particularly important in building an organizational culture that emphasizes ethical behavior. First, the businessesmust explicitly articulate values that emphasize ethical behavior. Virtually all great companies do this by establishing acode of ethics, which is a formal statement of the ethical priorities a business adheres to. Often, the code of ethics drawsheavily on documents such as the UN Universal Declaration of Human Rights, which itself is grounded in Kantian andrights-based theories of moral philosophy. Others have incorporated ethical statements into documents that articulate thevalues or mission of the business. For example, the Academy of International Business (the top professional organizationin international business) has a Code of Ethics for its leadership (as well as a COE for its members):39

AIB’s Motivation for the Code of Ethics of the Leadership: The leadership of an organization is ultimately responsible for thecreation of the values, norms and practices that permeate the organization and its membership. A strong ethically groundedorganization is only possible when it is governed by a strong ethical committee. The term “committee” is used for succinctness; itincludes all organizational structures that have managerial, custodial, decision-making or financial authority within anorganization.*

Having articulated values in a code of ethics or some other document, leaders in the business must give life andmeaning to those words by repeatedly emphasizing their importance and then acting on them. This means using everyrelevant opportunity to stress the importance of business ethics and making sure that key business decisions not onlymake good economic sense but also are ethical. Many companies have gone a step further by hiring independent auditorsto make sure they are behaving in a manner consistent with their ethical codes. Nike, for example, has hired independentauditors to make sure that subcontractors used by the company are living up to Nike’s code of conduct.

Finally, building an organizational culture that places a high value on ethical behavior requires incentive andreward systems, including promotions that reward people who engage in ethical behavior and sanction those who do not.At General Electric, for example, former CEO Jack Welch has described how he reviewed the performance of managers,dividing them into several different groups. These included over-performers who displayed the right values and weres ingl ed out f or advancement and bonuses, as we l l as over -per f ormer s who di sp l ayed t he wr ong values and were l et go.Welch was not willing to tolerate leaders within the company who did not act in accordance with the central values of thecompany, even if they were in all other respects skilled managers.40

*“Code of Ethics for the Academy of International Business Leadership,” Academy of International Business, October 11, 2018,ht t ps : // doc uments. aib.msu. edu/ p oli cies /AIB- Leadersh i p-Code-o f -Ethi cs -201 81011 . pdf.

Decision-Making ProcessesIn addition to establishing the right kind of ethical culture in an organization, businesspeople must be able to thinkthrough the ethical implications of decisions in a systematic way. To do this, they need a moral compass, and both rightstheories and Rawls’ theory of justice help provide such a compass. Beyond these theories, some experts on ethics haveproposed a straightforward practical guide—or ethical algorithm—to determine whether a decision is ethical.41According to these experts, a decision is acceptable on ethical grounds if a businessperson can answer yes to each ofthese questions:

Does my decision fall within the accepted values or standards that typically apply in the organizationalenvironment (as articulated in a code of ethics or some other corporate statement)?Am I willing to see the decision communicated to all stakeholders affected by it—for example, by having itreported in newspapers, on television, or via social media?Would the people with whom I have a significant personal relationship, such as family members, friends, oreven managers in other businesses, approve of the decision?

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Others have recommended a five-step process to think through ethical problems (this is another example of anethical algorithm).42 In step 1, businesspeople should identify which stakeholders a decision would affect and in whatways. A firm’s stakeholders are individuals or groups that have an interest, claim, or stake in the company, in what itdoes, and in how well it performs.43 They can be divided into internal stakeholders and external stakeholders. Internalstakeholders are individuals or groups who work for or own the business. They include primary stakeholders such asemployees, the board of directors, and shareholders. External stakeholders are all the other individuals and groups thathave some direct or indirect claim on the firm. Typically, this group comprises primary stakeholders such as customers,suppliers, governments, and local communities as well as secondary stakeholders such as special-interest groups,competitors, trade associations, mass media, and social media.44

All stakeholders are in an exchange relationship with the company.45 Each stakeholder group supplies theorganization with important resources (or contributions), and in exchange each expects its interests to be satisfied (byinducements).46 For example, employees provide labor, skills, knowledge, and time and in exchange expectcommensurate income, job satisfaction, job security, and good working conditions. Customers provide a company withits revenues and in exchange want quality products that represent value for money. Communities provide businesses withlocal infrastructure and in exchange want businesses that are responsible citizens and seek some assurance that thequality of life will be improved as a result of the business firm’s existence.

Stakeholder analysis involves a certain amount of what has been called moral imagination.47 This means standingin the shoes of a stakeholder and asking how a proposed decision might impact that stakeholder. For example, whenconsidering outsourcing to subcontractors, managers might need to ask themselves how it might feel to be working undersubstandard health conditions for long hours.

Step 2 involves judging the ethics of the proposed strategic decision, given the information gained in step 1.Managers need to determine whether a proposed decision would violate the fundamental rights of any stakeholders. Forexample, we might argue that the right to information about health risks in the workplace is a fundamental entitlement ofemployees. Similarly, the right to know about potentially dangerous features of a product is a fundamental entitlement ofcustomers (something tobacco companies violated when they did not reveal to their customers what they knew about thehealth risks of smoking). Managers might also want to ask themselves whether they would allow the proposed strategicdecision if they were designing a system under Rawls’ veil of ignorance. For example, if the issue under considerationwas whether to outsource work to a subcontractor with low pay and poor working conditions, managers might want toask themselves whether they would allow such action if they were considering it under a veil of ignorance, where theythemselves might ultimately be the ones to work for the subcontractor.

The judgment at this stage should be guided by various moral principles that should not be violated. Theprinciples might be those articulated in a corporate code of ethics or other company documents. In addition, certainmoral principles that we have adopted as members of society—for instance, the prohibition on stealing—should not beviolated. The judgment at this stage will also be guided by the decision rule that is chosen to assess the proposedstrategic decision. Although maximizing long-run profitability is the decision rule that most businesses stress, it shouldbe applied subject to the constraint that no moral principles are violated—that the business behaves in an ethical manner.

Step 3 requires managers to establish moral intent. This means the business must resolve to place moral concernsahead of other concerns in cases where either the fundamental rights of stakeholders or key moral principles have beenviolated. At this stage, input from top management might be particularly valuable. Without the proactive encouragementof top managers, middle-level managers might tend to place the narrow economic interests of the company before theinterests of stakeholders. They might do so in the (usually erroneous) belief that top managers favor such an approach.

Step 4 requires the company to engage in ethical behavior. Step 5 requires the business to audit its decisions,reviewing them to make sure they were consistent with ethical principles, such as those stated in the company’s code ofethics. This final step is critical and often overlooked. Without auditing past decisions, businesspeople may not know iftheir decision process is working and if changes should be made to ensure greater compliance with a code of ethics.

Ethics OfficersTo make sure that a business behaves in an ethical manner, firms now must have oversight by a high-ranking person orpeople known to respect legal and ethical standards. These individuals—often referred to as ethics officers—areresponsible for managing their organization’s ethics and legal compliance programs. They are typically responsible for(1) assessing the needs and risks that an ethics program must address; (2) developing and distributing a code of ethics;(3) conducting training programs for employees; (4) establishing and maintaining a confidential service to addressemployees’ questions about issues that may be ethical or unethical; (5) making sure that the organization is incompliance with government laws and regulations; (6) monitoring and auditing ethical conduct; (7) taking action, asappropriate, on possible violations; and (8) reviewing and updating the code of ethics periodically.48 Because of thesebroad topics covered by the ethics officer, in many businesses ethics officers act as an internal ombudsperson withresponsibility for handling confidential inquiries from employees, investigating complaints from employees or others,

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reporting findings, and making recommendations for change.For example, United Technologies, a multinational aerospace company with worldwide revenues of more than $60

billion, has had a formal code of ethics since 1990.49 United Technologies has some 450 business practice officers (thecompany’s name for ethics officers), who are responsible for making sure the code is followed. United Technologies alsoestablished an “ombudsperson” program in 1986 that lets employees inquire anonymously about ethics issues. Theprogram has received some 60,000 inquiries since 1986, and more than 10,000 cases have been handled by theombudsperson. These very early initiatives by United Technologies have led to a robust, ethical, and responsiblecorporate infrastructure.

Moral CourageIt is important to recognize that employees in an international business may need significant moral courage. Moralcourage enables managers to walk away from a decision that is profitable but unethical. Moral courage gives anemployee the strength to say no to a superior who instructs her to pursue actions that are unethical. Moral courage givesemployees the integrity to go public to the media and blow the whistle on persistent unethical behavior in a company.Moral courage does not come easily; there are well-known cases where individuals have lost their jobs because theyblew the whistle on corporate behaviors they thought unethical, telling the media about what was occurring.50

However, companies can strengthen the moral courage of employees by committing themselves to notretaliate against employees who exercise moral courage, say no to superiors, or otherwise complain about unethicalactions. For example, consider the following excerpt from the Academy of International Business Code of Ethics:

AIB Statement of Commitment by Its Leadership: In establishing policy for and on behalf of the Academy of InternationalBusiness’s members, I am a custodian in trust of the assets of this organization. The AIB’s members recognize the need forcompetent and committed elected committee members to serve their organization and have put their trust in my sincerity andabilities. In return, the members deserve my utmost effort, dedication, and support. Therefore, as a committee member of theAIB, I acknowledge and commit that I will observe a high standard of ethics and conduct as I devote my best efforts, skills andresources in the interest of the AIB and its members. I will perform my duties as a committee member in such a manner that themembers’ confidence and trust in the integrity, objectivity and impartiality of the AIB are conserved and enhanced. To dootherwise would be a breach of the trust which the membership has bestowed upon me.51

This statement ensures that all members serving in leadership positions within the Academy of InternationalBusiness adhere to and uphold the highest commitment and responsibility to be ethical in their AIB leadership activities.A freestanding and independent AIB Ombuds Committee handles all ethical issues and violations to ensureindependence and the highest moral code.

Corporate Social ResponsibilityMultinational corporations have power that comes from their control over resources and their ability to move productionfrom country to country. Although that power is constrained not only by laws and regulations but also by the disciplineof the market and the competitive process, it is substantial. Some moral philosophers argue that with power comes thesocial responsibility for multinationals to give something back to the societies that enable them to prosper and grow.

The concept of corporate social responsibility (CSR) refers to the idea that businesspeople should consider thesocial consequences of economic actions when making business decisions and that there should be a presumption infavor of decisions that have both good economic and social consequences.52 In its purest form, corporate socialresponsibility can be supported for its own sake simply because it is the right way for a business to behave. Advocates ofthis approach argue that businesses, particularly large successful businesses, need to recognize their noblesse oblige andgive something back to the societies that have made their success possible. Noblesse oblige is a French term that refers tohonorable and benevolent behavior considered the responsibility of people of high (noble) birth. In a business setting, itis taken to mean benevolent behavior that is the responsibility of successful enterprises. This has long been recognized bymany businesspeople, resulting in a substantial and venerable history of corporate giving to society, with businessesmaking social investments designed to enhance the welfare of the communities in which they operate.

Power itself is morally neutral; how power is used is what matters. It can be used in a positive way to increasesocial welfare, which is ethical, or it can be used in a manner that is ethically and morally suspect. Managers at somemultinationals have acknowledged a moral obligation to use their power to enhance social welfare in the communitieswhere they do business. BP, one of the world’s largest oil companies, has made it part of the company policy toundertake “social investments” in the countries where it does business.53 In Algeria, BP has been investing in a majorproject to develop gas fields near the desert town of Salah. When the company noticed the lack of clean water in Salah, itbuilt two desalination plants to provide drinking water for the local community and distributed containers to residents sothey could take water from the plants to their homes. There was no economic reason for BP to make this socialinvestment, but the company believes it is morally obligated to use its power in constructive ways. The action, while asmall thing for BP, is a very important thing for the local community. For another example of corporate socialresponsibility in practice, see the accompanying Management Focus feature on the Finnish company Stora Enso.

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Corporate Social Responsibility at Stora EnsoStora Enso is a Finnish pulp and paper manufacturer that was formed by the merger of Swedish mining and forestry productscompany Stora and Finnish forestry products company Enso-Gutzeit Oy in 1998. The company is headquartered in Helsinki, thecapital of Finland, and it has approximately 25,000 employees. In 2000, the company bought Consolidated Papers in NorthAmerica. Stora Enso also expanded into South America, Asia, and Russia. By 2005, Stora Enso had become the world’s largestpulp and paper manufacturer as measured by production capacity. However, the North American operations were sold in 2007 toNewPage Corporation.

To this day, Stora Enso has a long-standing tradition of corporate social responsibility on a global scale. As part of thecompany’s section “Global Responsibility in Stora Enso,” the company states that “for Stora Enso, Global Responsibility meansrealizing concrete actions that will help us fulfil [sic] our Purpose, which is to do good for the people and the planet.” Stora Ensocontinues to state:

Our purpose “do good for the people and the planet” is the ultimate reason why we run our business. It is the overridingrule that guides us in all that we do: producing and selling our renewable products, buying trees from a local forest-owner in Finland, selling electricity generated at Stora Enso Skoghall Mill, or managing our logistics on a globalscale.54

Interestingly, Stora Enso also asserts that it realizes that this statement is rather bold and perhaps not even fully believable. Butthe company suggests that it makes the company accountable for its actions; that is, setting its purpose boldly in writing. At thesame time, Stora Enso positions the company as though it has always been attending to the “socially responsible” needs of doinggood for the people and the planet. It illustrates this by maintaining that it has created and enhanced communities around its mills,developed innovative systems to reduce the use of scarce resources, and maintained good relationships with key stakeholders suchas forest owners, their own employees, governments, and local communities near its mills.

Tracing its past and reflecting on its future, Stora Enso has adopted three lead areas for its global responsibility strategy:people and ethics, forests and land use, and environment and efficiency. For people and ethics, the company focuses on conductingbusiness in a socially responsible manner throughout its global value chain. For forests and land use, it focuses on an innovativeand responsible approach on forestry and land use to make it a preferred partner and a good local community citizen. For theenvironment and efficiency, the focus is on resource-efficient operations that help the company achieve superior environmentalperformance related to its products.

While a number of companies have corporate social responsibility statements incorporated as part of their websites, annualreports, and talking points, Stora Enso also presents clear targets and performance goals that are assessed by established metrics.Its overall operations are guided by corporate-level targets for environmental and social performance, aptly named Stora Enso’sGlobal Responsibility Key Performance Indicators (KPIs). Targets are publicly listed in a document titled “Targets andPerformance” and include two to five basic categories of measures for each of the three lead areas. For people and ethics, thedimensions cover health and safety, human rights, ethics and compliance, sustainable leadership, and responsible sourcing. Forforests and land use, the dimensions cover efficiency of land use and sustainable forestry. For environment and efficiency, thedimensions cover climate and energy, material efficiency, and process water discharges. The “Targets and Performance” documentalso lists performance in the prior year, targets in the current year, and strategic objectives related to each dimension.Sources: “Global Responsibility in Stora Enso,” www.storaenso.com; K. Vita, “Stora Enso Falls as UBS Plays Down Merger Talk: Helsinki Mover,” BloombergBusinessweek, September 30, 2013; M. Huuhtanen, “Paper Maker Stora Enso Selling North American Mills,” USA Today, September 21, 2007.

SustainabilityAs managers in international businesses strive to translate ideas about corporate social responsibility intostrategic actions, many are gravitating toward strategies that are viewed as sustainable. By sustainable strategies, werefer to strategies that not only help the multinational firm make good profits, but that also do so without harming theenvironment while simultaneously ensuring that the corporation acts in a socially responsible manner with regard to itsstakeholders.55 The core idea of sustainability is that the organization—through its actions—does not exert a negativeimpact on the ability of future generations to meet their own economic needs and that its actions impart long-runeconomic and social benefits on stakeholders.56

A company pursuing a sustainable strategy would not adopt business practices that deplete the environment forshort-term economic gain because doing so would impose a cost on future generations. In other words, internationalbusinesses that pursue sustainable strategies try to ensure that they do not precipitate or participate in a situation thatresults in a tragedy of the commons Thus, for example, a company pursuing a sustainable strategy would try to reduce itscarbon footprint (CO2 emissions) so that it does not contribute to global warming.

Nor would a company pursuing a sustainable strategy adopt policies that negatively affect the well-being of key

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stakeholders such as employees and suppliers because managers would recognize that in the long run, this would harmthe company. The company that pays its employees so little that it forces them into poverty, for example, may find ithard to recruit employees in the future and may have to deal with high employee turnover, which imposes its own costson an enterprise. Similarly, a company that drives down the prices it pays to its suppliers so far that the suppliers cannotmake enough money to invest in upgrading their operations may find that in the long run, its business suffers poor-quality inputs and a lack of innovation among its supplier base.

Starbucks has a goal of ensuring that 100 percent of its coffee is ethically sourced. By this, it means that the farmerswho grow the coffee beans it purchases use sustainable farming methods that do not harm the environment and that theytreat their employees well and pay them fairly. Starbucks agronomists work directly with farmers in places such as CostaRica and Rwanda to make sure that they use environmentally responsible farming methods. The company also providesloans to farmers to help them upgrade their production methods. As a result of these policies, some 9 percent ofStarbucks coffee beans are “fair trade” sourced and the remaining 91 percent are ethically sourced.

Key Termsbusiness ethics, p. 135ethical strategy, p. 135Foreign Corrupt Practices Act (FCPA), p. 141Convention on Combating Bribery of Foreign Public Officials in International Business Transactions, p. 141ethical dilemma, p. 142organizational culture, p. 144cultural relativism, p. 147righteous moralist, p. 147naive immoralist, p. 148utilitarian approach to ethics, p. 148Kantian ethics, p. 149rights theories, p. 149Universal Declaration of Human Rights, p. 149just distribution, p. 150code of ethics, p. 152stakeholders, p. 153internal stakeholders, p. 153external stakeholders, p. 153corporate social responsibility (CSR), p. 155sustainable strategies, p. 157

SUMMARYThis chapter discussed the source and nature of ethical issues in international businesses, the different philosophicalapproaches to business ethics, the steps managers can take to ensure that ethical issues are respected in internationalbusiness decisions, and the roles of corporate social responsibility and sustainability in practice. The chapter madethe following points:

1. The term ethics refers to accepted principles of right or wrong that govern the conduct of a person, themembers of a profession, or the actions of an organization. Business ethics are the accepted principles of rightor wrong governing the conduct of businesspeople. An ethical strategy is one that does not violate theseaccepted principles.

2. Ethical issues and dilemmas in international business are rooted in the variations among political systems,law, economic development, and culture from country to country.

3. The most common ethical issues in international business involve employment practices, human rights,environmental regulations, corruption, and social responsibility of multinational corporations.

4. Ethical dilemmas are situations in which none of the available alternatives seems ethically acceptable.5. Unethical behavior is rooted in personal ethics, societal culture, psychological and geographic distances of a

foreign subsidiary from the home office, a failure to incorporate ethical issues into strategic and operationaldecision making, a dysfunctional culture, and failure of leaders to act in an ethical manner.

6. Moral philosophers contend that approaches to business ethics such as the Friedman doctrine, cultural

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relativism, the righteous moralist, and the naive immoralist are unsatisfactory in important ways.7. The Friedman doctrine states that the only social responsibility of business is to increase profits, as long as the

company stays within the rules of law. Cultural relativism contends that one should adopt the ethics of theculture in which one is doing business. The righteous moralist monolithically applies home-country ethics to aforeign situation, while the naive immoralist believes that if a manager of a multinational sees that firms fromother nations are not following ethical norms in a host nation, that manager should not either.

8. Utilitarian approaches to ethics hold that the moral worth of actions or practices is determined by theirconsequences, and the best decisions are those that produce the greatest good for the greatest number ofpeople.

9. Kantian ethics state that people should be treated as ends and never purely as means to the ends of others.People are not instruments, like a machine. People have dignity and need to be respected as such.

10. Rights theories recognize that human beings have fundamental rights and privileges that transcend nationalboundaries and cultures. These rights establish a minimum level of morally acceptable behavior.

11. The concept of justice developed by John Rawls suggests that a decision is just and ethical if people wouldallow it when designing a social system under a veil of ignorance.

12. To make sure that ethical issues are considered in international business decisions, managers should (a) favorhiring and promoting people with a well-grounded sense of personal ethics, (b) build an organizational cultureand exemplify leadership behaviors that place a high value on ethical behavior, (c) putdeci si on -making processes in place that require people to consider the ethical dimension of business decisions, (d)establish ethics officers in the organization with responsibility for ethical decision making, (e) be morallycourageous and encourage others to do the same, (f) make corporate social responsibility a cornerstone ofenterprise policy, and (g) pursue strategies that are sustainable.

13. Multinational corporations that are practicing business-focused sustainability integrate a focus on marketorientation, addressing the needs of multiple stakeholders, and adhering to corporate social responsibilityprinciples.

Critical Thinking and Discussion Questions

1. A visiting American executive finds that a foreign subsidiary in a less developed country has hired a 12-year-old girl to work on a factory floor, in violation of the company’s prohibition on child labor. He tells the localmanager to replace the child and tell her to go back to school. The local manager tells the American executivethat the child is an orphan with no other means of support, and she will probably become a street child if she isdenied work. What should the American executive do?

2. Drawing on John Rawls’s concept of the veil of ignorance, develop an ethical code that will (a) guide thedecisions of a large oil multinational toward environmental protection and (b) influence the policies of aclothing company in their potential decision of outsourcing their manufacturing operations.

3. Under what conditions is it ethically defensible to outsource production to the developing world where laborcosts are lower when such actions also involve laying off long-term employees in the firm’s home country?

4. Do you think facilitating payments (speed payments) should be ethical? Does it matter in which country, orpart of the world, such payments are made?

5. A manager from a developing country is overseeing a multinational’s operations in a country where drugtrafficking and lawlessness are rife. One day, a representative of a local “big man” approaches the managerand asks for a “donation” to help the big man provide housing for the poor. The representative tells themanager that in return for the donation, the big man will make sure that the manager has a productive stay inhis country. No threats are made, but the manager is well aware that the big man heads a criminal organizationthat is engaged in drug trafficking. He also knows that the big man does indeed help the poor in the rundownneighborhood of the city where he was born. What should the manager do?

6. Milton Friedman stated in his famous article in The New York Times in 1970 that “the social responsibility ofbusiness is to increase profits.”* Do you agree? If not, do you prefer that multinational corporations adopt afocus on corporate social responsibility or sustainability practices?

7. Can a company be good at corporate social responsibility but not be sustainability oriented? Is it possible tofocus on sustainability but not corporate social responsibility? Based on reading the Focus on ManagerialImplications section, discuss how much CSR and sustainability are related and how much the concepts differfrom each other.

*M. Friedman, “The Social Responsibility of Business Is to Increase Profits,” The New York Times Magazine, September 13, 1970.

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global EDGE research task globaledge.msu.eduUse the globalEDGE™ website (globaledge.msu.edu) to complete the following exercises:

1. Promoting respect for universal human rights is a central dimension of many countries’ foreign policy. Ashistory has shown, human rights abuses are an important concern worldwide. Some countries are more readyto work with other governments and civil society organizations to prevent abuses of power. The annualCountry Reports on Human Rights Practices are designed to assess the state of democracy and human rightsaround the world, call attention to violations, and—where needed—prompt needed changes in U.S. policiestoward particular countries. Find the latest annual Country Reports on Human Right Practices for the BRICcountries (Brazil, Russia, India, and China), and create a table to compare the findings under the “WorkerRights” sections. What commonalities do you see? What differences are there?

2. The use of bribery in the business setting is an important ethical dilemma many companies face bothdomestically and abroad. The Bribe Payers Index is a study published every three years to assess thelikelihood of firms from leading economies to win business overseas by offering bribes. It also ranks industrysectors based on the prevalence of bribery. Compare the five industries thought to have the largest problemswith bribery with those five that have the least problems. What patterns do you see? What factors make someindustries more conducive to bribery than others?

CLOSING CASE

Sustainability Initiatives at Natura, The Body Shop, and AesopCorporate Knights, a research firm from Toronto, Canada, puts together the Global 100, a ranking of the world’s mostsustainable companies, based on annual data analytics. Using data available publicly, Corporate Knights rates large firmson 17 key measures, evaluating their management of resources, finances, and employees (e.g., energy, carbon footprint,water use, waste productivity, clean air). They consider about 4,000 companies worldwide with market values of at least$2 billion.

For several years, Natura & Co SA from Brazil has been among the world’s leaders, regularly ranking in the Top20 each year. This is an incredibly admirable feat, because Natura is also the world’s largest cosmetics company.Cosmetics has a lot of potential to be less than sustainable in manufacturing and operations, but Natura has bucked thattrend. Natura (naturaeco.com), headquartered in São Paulo, Brazil, was founded in 1969. The company has more than18,000 employees and revenue of about $4.4 billion. Natura has three prominent subsidiaries that strive to be assustainable in their operations as possible: Natura Cosmetics, The Body Shop, and Aesop. The latter two brands are oftenviewed as standalone organizations by customers.

Natura Cosmetics develops, produces, distributes, and sells cosmetics, fragrances, and hygiene products. Natura’sproducts include creams, deodorants, lipsticks, lotions, makeup accessories, perfumes, shampoos, shaving creams, soaps,and sunscreens, among others. Its portfolio is made up of brand names such as Amo, Ekos, Tododia, Aguas, Chronos,Erva Doce, Homem, Horus, Seve, and Luna. The company employs more than 7,000 people in seven countries: Brazil,Argentina, Chile, Mexico, Peru, Colombia, and France. Sustainable development has been Natura’s guiding principlesince it was founded. Sustainability, along with a passion for Customer Relationship Management (CRM), led thecompany to adopt direct sales as its main commercial strategy. To support its direct sales model, more than 1,421,000consultants around the world promote the company’s values and products directly to customers. To be sustainable,innovation is at the heart of Natura’s development policy. For example, last year the company spent about $75 million onproduct development, launching 164 products and achieving an innovation index of 64.8 percent (the percentage ofrevenue from products launched in the last two years).

The Body Shop is a well-known, formerly British cosmetics, skin care, and perfume company that was founded in1976 by Anita and Gordon Roddick. The company offers more than 1,000 products, which it sells in some 3,100 ownedand franchised stores in 66 countries. The Body Shop is still based in East Croydon and Littlehampton in the UnitedKingdom, but was bought from French cosmetics company L’Oréal (which owned The Body Shop from 2006 to 2017)by Natura in June 2017 for $1.2 billion (£880 million). Famously, The Body Shop has been a leader in banning animaltesting of cosmetics products worldwide since the 1980s and is tirelessly working to ban animal testing in the cosmeticsindustry. This position also feeds into its sustainability initiatives. Anita Roddick said that “My hope for the future ofThe Body Shop is primarily vested in those people who will be the custodians of our culture and values.”* Thiscustodianship includes the pledge of being the world’s most ethical, sustainable company. For example, The Body Shophas unveiled an “Enrich Not Exploit” slogan that will underpin all aspects of its operations. This pioneering commitment

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reaffirmed the global cosmetics brand’s positioning as a leader in ethical and sustainable business practices.Aesop was founded by hairdresser Dennis Paphitis in 1987 in Melbourne, Australia. Suzanne Santos, as Aesop’s

first employee, was also instrumental in the foundation and growth of the company. Aesop is viewed as an Australianskin care brand, owned fully by Natura since 2016 (although Natura had part ownership since 2012). The brand has beenidentified as unique in the way it markets itself in today’s social media world. In a somewhat unorthodox way, thisincludes not using traditional advertisements or discount sales to promote its products. Instead, Aesop gets itspromotional communication mostly by word-of-mouth for the design of its products, stores, and events, which are asingular mix of indulgent product experiences, thoughtful language, and modern minimalist design (compare this withthe Swedish furniture giant IKEA that often receives similar reviews of minimalist but superb design in the furniturebusiness).

With its core subsidiaries (Natura Cosmetics, The Body Shop, and Aesop), Natura & Co SA has redefined successin business on a global scale. It was the first publicly traded company to become a “Certified B Corporation.”A Certified B Corporation is a company that focuses on two specific sustainability issues. First, it has reacheda threshold standard for its impact on society and the environment. Second, the company must have committed toconsider the impact of its business decisions on its wider stakeholders, not just its shareholders. Currently, only 2,200 BCorps exist worldwide, and their core sustainability focus is on the interdependence between society, environment, andeconomy. Importantly, Natura’s actions show that it is possible to make a positive difference for the environment whilealso ensuring the financial viability of the company through profit making. This mindset also drove Natura’s purchase ofThe Body Shop in 2017, the first billion-dollar B Corp acquisition by another B Corp.*Roddick, Anita Dame, “Building For The Future. Our Values Performance 2014/2015 & Our New Commitment,” The Body Shop, 2016.

Sources: Deanna Utroske, “The Body Shop Launches New Campaign for UN Animal Testing Ban,” Cosmetics Design, March 22, 2018; Andres Schipani, “Body Shop Owner NaturaTargets Global Growth,” Financial Times, February 4, 2018; Corporate Knights, “2018 Global 100 Results,” www.corporateknights.com/reports/2018-global-100; “The Body ShopMarks 40th Year with Pledge to Be World’s Most Ethical, Sustainable Global Company,” Sustainable Brands, February 12, 2016; Charmain Love, Katie Hill, and Marcel Fukayama,“Building Bridges: Natura, Aesop and The Body Shop Join Their Businesses as Forces for Good,” B the Change, September 13, 2017.

CASE DISCUSSION QUESTIONS

1. With its three core companies (Natura Cosmetics, The Body Shop, and Aesop), Natura & Co SA blends threedifferent business models for interacting with the customer. In the end, all three models are focused on sustainablebusiness practices. What can other companies learn from Natura & Co SA on how to be sustainable?

2. The Body Shop has been a leader in banning animal testing of cosmetics products worldwide since the 1980s andis tirelessly working to ban animal testing in the cosmetics industry. Is this part of being sustainable or is animaltesting a different focus?

3. Aesop is not using traditional advertisements or discount sales to promote its products. Instead, Aesop gets itspromotional communication mostly by word-of-mouth for the design of its products, stores, and events, which area singular mix of indulgent product experiences, thoughtful language, and modern minimalist design. If you hadto interact with Natura & Co SA, which customer engagement model—Natura’s, The Body Shop’s, or Aesop’s—would be the best for you and why?

4. How much would it mean to you that a company operated in a sustainable way? Would you pay 5 percent, 10p er ce nt , o r 25 perc ent more f or a pr oduc t i f t he qual ity was t he s ame as non-s us tai nabl e alt ernat ives ? What i f t hequality of the product was lower but the price the same?

Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education

Endnotes

1. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!” Journal of the Academy of Marketing Science39 (2011) , pp. 1 –6; T . Hult , J. Mena, O. C. Ferre ll, and L. Fer rel l, “St ak e holder Marketing: A Definition andConceptual Framework,” AMS Review 1 (2011), pp. 44–65.

2. S. Greenhouse, “Nike Shoe Plant in Vietnam Is Called Unsafe for Workers,” The New York Times, November 8,1997; V. Dobnik, “Chinese Workers Abused Making Nikes, Reeboks,” Seattle Times, September 21, 1997, p. A4.

3. R. K. Massie, Loosing the Bonds: The United States and South Africa in the Apartheid Years (New York:Doubleday, 1997).

4. Not everyone agrees that the divestment trend had much influence on the South African economy. For acounterview, see S. H. Teoh, I. Welch, and C. P. Wazzan, “The Effect of Socially Activist Investing on theFinancial Markets: Evidence from South Africa,” The Journal of Business 72, no. 1 (January 1999), pp. 35–60.

5. Peter Singer, One World: The Ethics of Globalization (New Haven, CT: Yale University Press, 2002).6. Garrett Hardin, “The Tragedy of the Commons,” Science 162, no. 1 (1968), pp. 243–48.

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7. For a summary of the evidence, see S. Solomon, D. Qin, M. Manning, Z. Chen, M. Marquis, K. B. Averyt, M.Tignor, and H. L. Miller, eds., Contribution of Working Group I to the Fourth Assessment Report of theIntergovernmental Panel on Climate Change (Cambridge, UK: Cambridge University Press, 2007).

8. J. Everett, D. Neu, and A. S. Rahaman, “The Global Fight against Corruption,” Journal of Business Ethics 65(2006), pp. 1–18.

9. R. T. De George, Competing with Integrity in International Business (Oxford, UK: Oxford UniversityPress, 1993).

10. Details can be found at www.oecd.org/corruption/oecdantibriberyconvention.htm.11. B. Pranab, “Corruption and Development,” Journal of Economic Literature 36 (September 1997), pp. 1320–46.12. A. Shleifer and R. W. Vishny, “Corruption,” Quarterly Journal of Economics 108 (1993), pp. 599–617; I. Ehrlich

and F. Lui, “Bureaucratic Corruption and Endogenous Economic Growth,” Journal of Political Economy 107(December 1999), pp. 270–92.

13. P. Mauro, “Corruption and Growth,” Quarterly Journal of Economics 110 (1995), pp. 681–712.14. D. Kaufman and S. J. Wei, “Does Grease Money Speed up the Wheels of Commerce?” World Bank policy

research working paper, January 11, 2000.15. Center for the Study of Ethics in the Professions, http://ethics.iit.edu.16. B. Vitou, R. Kovalevsky, and T. Fox, “Time to Call a Spade a Spade. Facilitation Payments and Why Neither

Bans Nor Exemption Work,” http://thebriberyact.com/2011/02/03/time-to-call-a-spade-a-spade-facilitation-payments-why-neither-bans-nor-exemptions-work, accessed March 8, 2014.

17. This is known as the “when in Rome perspective.” T. Donaldson, “Values in Tension: Ethics Away from Home,”Harvard Business Review, September–October 1996.

18. De George, Competing with Integrity in International Business.19. For a discussion of the ethics of using child labor, see J. Isern, “Bittersweet Chocolate: The Legacy of Child

Labor in Cocoa Production in Cote d’Ivoire,” Journal of Applied Management and Entrepreneurship 11 (2006),pp. 115–32.

20. S. W. Gellerman, “Why Good Managers Make Bad Ethical Choices,” in Ethics in Practice: Managing the MoralCorporation, ed. K. R. Andrews (Cambridge, MA: Harvard Business School Press, 1989).

21. D. Messick and M. H. Bazerman, “Ethical Leadership and the Psychology of Decision Making,” SloanManagement Review 37 (Winter 1996), pp. 9–20.

22. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics, 9th ed. (Mason, OH: Cengage, 2013).23. B. Scholtens and L. Dam, “Cultural Values and International Differences in Business Ethics,” Journal of Business

Ethics, 2007.24. M. Friedman, “The Social Responsibility of Business Is to Increase Profits,” The New York Times Magazine,

September 13, 1970. Reprinted in T. L. Beauchamp and N. E. Bowie, Ethical Theory and Business, 7th ed.(Englewood Cliffs, NJ: Prentice Hall, 2001).

25. Friedman, “The Social Responsibility of Business Is to Increase Profits.”26. Friedman, Milton. ‘’The Social Responsibility of Business Is to Increase Profits.’’ The New York Times,

September 13, 1970.27. For example, see Donaldson, “Values in Tension: Ethics Away from Home.” See also N. Bowie, “Relativism and

the Moral Obligations of Multinational Corporations,” in T. L. Beauchamp and N. E. Bowie, Ethical Theory andBusiness, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).

28. For example, see De George, Competing with Integrity in International Business.29. This example is often repeated in the literature on international business ethics. It was first outlined by A. Kelly in

“Case Study—Italian Style Mores,” in T. Donaldson and P. Werhane, Ethical Issues in Business (EnglewoodCliffs, NJ: Prentice Hall, 1979).

30. See Beauchamp and Bowie, Ethical Theory and Business.31. T. Donaldson, The Ethics of International Business (Oxford: Oxford University Press, 1989).32. Found at www.un.org/Overview/rights.html.33. The Universal Declaration of Human Rights.’’ Article 1, United Nations, 1948.

https://www.un.org/en/universal-declaration-human-rights.34. The Universal Declaration of Human Rights.’’ Article 23, United Nations, 1948.

https://www.un.org/en/universal-declaration-human-rights.35. UN Universal Declaration of Human Rights, Article 29.36. Donaldson, The Ethics of International Business.37. See Chapter 10 in Beauchamp and Bowie, Ethical Theory and Business.38. J. Rawls, A Theory of Justice, rev. ed. (Cambridge, MA: Belknap Press, 1999).39. https://aib.msu.edu/aboutleadership.asp.40. J. Bower and J. Dial, “Jack Welch: General Electric’s Revolutionary,” Harvard Business School Case 9–394–065,

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April 1994.41. For example, see R. E. Freeman and D. Gilbert, Corporate Strategy and the Search for Ethics (Englewood Cliffs,

NJ: Prentice Hall, 1988); T. Jones, “Ethical Decision Making by Individuals in Organizations,” Academy ofManagement Review 16 (1991), pp. 366–95; J. R. Rest, Moral Development: Advances in Research and Theory(New York: Praeger, 1986).

42. Freeman and Gilbert, Corporate Strategy and the Search for Ethics; Jones, “Ethical Decision Making byIndividuals in Organizations”; Rest, Moral Development.

43. See E. Freeman, Strategic Management: A Stakeholder Approach (Boston: Pitman Press, 1984); C. W. L. Hilland T. M. Jones, “Stakeholder-Agency Theory,” Journal of Management Studies 29 (1992), pp. 131–54; J. G.March and H. A. Simon, Organizations (New York: Wiley, 1958).

44. Hult et al., “Stakeholder Marketing.”45. Hult, “Market-Focused Sustainability: Market Orientation Plus!”; Hult et al., “Stakeholder Marketing.”46. Hill and Jones, “Stakeholder-Agency Theory”; March and Simon, Organizations.47. De George, Competing with Integrity in International Business.48. “Our Principles,” Unilever, www.unilever.com.49. The code can be accessed at the United Technologies website, www.utc.com.50. C. Grant, “Whistle Blowers: Saints of Secular Culture,” Journal of Business Ethics, September 2002,

pp. 391–400.51. “Code of Ethics for the Academy of International Business Leadership,” Academy of International Business,

October 11, 2018, https://documents.aib.msu.edu/policies/AIB-Leadership-Code-of-Ethics-20181011.pdf.52. S. A. Waddock and S. B. Graves, “The Corporate Social Performance–Financial Performance Link,” Strategic

Management Journal 8 (1997), pp. 303–19; I. Maignan, O. C. Ferrell, and T. Hult, “Corporate Citizenship:Cultural Antecedents and Business Benefits,” Journal of the Academy of Marketing Science 27 (1999), pp. 455–69.

53. Details can be found at BP’s website, www.bp.com.54. Hult, G. Tomas M. “Market-Focused Sustainability: Market Orientation Plus!” Journal of the Academy of

Marketing Science 39, no. 1 (2011). https://ssrn.com/abstract=1671794 or http://dx.doi.org/10.2139/ssrn.1671794.55. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!”56. M. Clarkson, “A Stakeholder Framework for Analyzing and Evaluating Corporate Social Performance,” Academy

of Management Review 20 (1995), pp. 92–117; R. Freeman, Strategic Management: A StakeholderApproach(Marshfield, MA: Pitman, 1984); T. Hult, J. Mena, O. Ferrell, and L. Ferrell, “Stakeholder Marketing:A Definition and Conceptual Framework,” AMS Review 1 (2011), pp. 44–65.

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part three The Global Trade and InvestmentEnvironment

International Trade Theory

LEARNING OBJECTIVESAfter reading this chapter, you will be able to:

Understand why nations trade with each other.

Summarize the different theories explaining trade flows between nations.

Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare ofcountries that participate in a free trade system.

Explain the arguments of those who maintain that government can play a proactive role in promoting national competitiveadvantage in certain industries.

Understand the important implications that international trade theory holds for management practice.

Nick Haslam/Alamy Stock Photo

A Tale of Two Nations: Ghana and South Korea

OPENING CASEIn 1970, South Korea and the West African nation of Ghana had similar living standards. South Korea’s GDP per capita was $260,and Ghana’s was $250. Nearly 50 years later, South Korea boasts the world’s 11th-largest economy and has a GDP per capita of$32,000, while Ghana’s GDP per capita is just $1,786. Clearly, South Korea has grown much faster than Ghana over the last half

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century. According to a World Bank study, part of the explanation can be found in the different attitudes of both countries towardinternational trade during the second half of the twentieth century.

Ghana gained its independence from Great Britain in 1957. The country’s first President, Kwame Nkrumah, was an earlyadvocate of pan-African socialism. His policies included high tariffs on many imported goods in an effort to foster self-sufficiency incertain manufactured goods, and the adoption of policies that discouraged exports. The results of these inward-oriented policies werea disaster for Ghana. Between 1970 and 1983, living standards in Ghana fell by 35 percent.

For example, when Ghana gained independence, it was a major producer and exporter of cocoa. A combination of favorableclimate, good soils, and ready access to world shipping routes made Ghana an ideal place to produce cocoa. Following independence,the government created a state-controlled cocoa marketing board. The board set prices for cocoa and was the sole buyer of cocoa inthe country. The board held down the prices it paid farmers for cocoa, while selling their produce on the world market at world prices.Thus, the board might pay farmers 25 cents a pound, and then resell the cocoa on the world market at 50 cents a pound. In effect, theboard was taxing exports by paying cocoa producers considerably less than they would get for their product on the world market. Theproceeds were then used by the government to fund a policy of nationalization and industrialization to promote self-sufficiency.

Over time, the price that farmers got paid for their cocoa increased by far less than the rate of inflation and the price of cocoa onthe world market. As returns to growing cocoa declined, farmers started to switch from producing cocoa to producing subsistencefoodstuffs that could be sold profitably within Ghana. The country’s production of cocoa and its cocoa exports plummeted. At thesame time, the government’s attempts to build an industrial base through investments in state-run enterprises failed to yield theanticipated gains. By the 1980s, Ghana was a country in economic crisis, with falling exports and a lack of foreign currency earningsto pay for imports.

In contrast, South Korea embraced a policy of low import barriers on manufactured goods and the creation of incentives topromote exports. Import tariffs and quotas were progressively reduced from the late 1950s onward. In the late 1950s, import tariffsstood at 60 percent. By the 1980s, they were reduced to nearly zero on most manufactured goods. The number of goods subjected torestrictive import quotas was also reduced from more than 90 percent in the 1950s to zero by the early 1980s. Export incentivesincluded lower tax rates on export earnings and low-interest financing for investments in export-oriented industries.

Faced with competition from imports, Korean enterprises had to be efficient to survive. Given the incentives to engage in exportactivity, in the 1960s Korean producers took advantage of the country’s abundant supply of low-cost labor to produce labor-intensivemanufactured goods, such as textiles and clothing for the world market. This led to a shift in Korea away from agriculture, towardmanufacturing. As labor costs rose, Korean enterprises progressively moved into more capital-intensive goods, including steel,shipbuilding, automobiles, electronics, and telecommunications. In making these shifts, Korean firms were able to draw upon thecountry’s well-educated labor force. The result was export-led growth that dramatically raised living standards for the averageKorean.

By the 1990s, Ghana recognized that its economic policies had failed. In 1992, the government started to liberalize the economy,removing price controls, privatizing state-owned enterprises, instituting market-based reforms, and opening Ghana up to foreigninvestors. Over the next decade, more than 300 state-owned enterprises were privatized, and the new, largely privately held economywas booming, enabling Ghana to achieve one of the highest growth rates in sub-Saharan Africa. The country was helped by thediscovery of oil in 2007. Ghana is now a significant exporter of oil. In addition, Ghana remains a major producer and exporter ofcocoa, as well as gold. Although the state-run cocoa marketing board still exists, it has been reformed to ensure that farmers get a fairshare of their export earnings. Today, one of its stated functions is to promote exports and protect farmers from the adverse impact ofvolatile commodity prices. In short, Ghana has shifted away from its inward-oriented trade policy.Sources: “Poor Man’s Burden: A Survey of the Third World,” The Economist, September 23, 1980; J. S. Mah, “Export Promotion Policies, Export Composition and EconomicDevelopment in Korea,” Law and Development Review, 2011; D. M. Quaye, “Export Promotion Programs and Export Performance,” Review of International Business andStrategy, 2016; T. Williams, “An African Success Story: Ghana’s Cocoa Marketing System,” IDS Working Papers, January 2009.

IntroductionThe opening case illustrates the gains that can come from international trade. The economic policies of the Ghanaiangovernment after its independence from Great Britain discouraged trade with other nations. The result was a shift inGhana’s resources away from productive uses (growing cocoa) and toward unproductive uses (subsistence agriculture).In contrast, the economic policies of the South Korean government strongly encouraged trade with other nations. Theresult was a shift in South Korean resources away from uses where it had no comparative advantage (agriculture) andtoward more productive uses (manufacturing). Partly as a consequence of their divergent policies toward internationaltrade, South Korea has grown significantly faster than Ghana over the last half century.

To understand why different approaches to international trade yield different results, we need to take a close look atthe intellectual foundations for trade policy; at the impact of trade policy on jobs, income, and economic growth; and athow global trade policy has evolved over the last 70 years. We should also consider the reasons for foreign directinvestment (FDI) by corporations because FDI may be a substitute for trade (i.e., exports), or it may support greaterglobal trade. For example, many car companies invest in production facilities in Mexico because that is a good base fromwhich to export finished cars to many other countries.

This is the first of four chapters that deal with the global trade and investment environment. In this chapter, wefocus on the theoretical foundations of trade policy. We will also look at what the economic evidence tells us about the

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relationship between trade policies and economic growth. In Chapter 7, we chart the development of the world tradingsystem, discuss different aspects of trade policy, and look at how trade policy is managed by national and globalinstitutions. In Chapter 8, we discuss the reasons for foreign direct investment and the government policies adopted tomanage foreign investment. In Chapter 9, we look at the reasons for creating trading blocks such as the European Unionand NAFTA, and we discuss how these transnational agreements have worked out in practice. By the time you havefinished these four chapters, you should have a very solid understanding of the international trade and investmentenvironment, and you will understand the extremely important impact that trade and investment policies have upon thepractice of international business.

An Overview of Trade TheoryWe open this chapter with a discussion of mercantilism. Propagated in the sixteenth and seventeenth centuries,mercantilism advocated that countries should simultaneously encourage exports and discourage imports. Althoughmercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the tradepolicies of many countries. Indeed, some have argued that Donald Trump espouses mercantilist views. Next, we look atAdam Smith’s theory of absolute advantage. Proposed in 1776, Smith’s theory was the first to explain why unrestrictedfree trade is beneficial to a country. Free trade refers to a situation in which a government does not attempt to influencethrough quotas or duties what its citizens can buy from another country or what they can produce and sell to anothercountry. Smith argued that the invisible hand of the market mechanism, rather than government policy, should determinewhat a country imports and what it exports. His arguments imply that such a laissez-faire stance toward trade was in thebest interests of a country. Building on Smith’s work are two additional theories that we review. One is the theory ofcomparati ve advantage, advance d by t he nine teent h-cent ur y E ngl i s h economis t Davi d Ri car do. Thi s th eory is t heintellectual basis of the modern argument for unrestricted free trade. In the twentieth century, Ricardo’s work was refinedby two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher–Ohlin theory.

THE BENEFITS OF TRADE

LO6-1Understand why nations trade with each other.The great strength of the theories of Smith, Ricardo, and Heckscher–Ohlin is that they identify with precision thespecific benefits of international trade. Common sense suggests that some international trade is beneficial. For example,nobody would suggest that Iceland should grow its own oranges. Iceland can benefit from trade by exchanging some ofthe products that it can produce at a low cost (fish) for some products that it cannot produce at all (oranges). Thus, byengaging in international trade, Icelanders are able to add oranges to their diet of fish.

The theories of Smith, Ricardo, and Heckscher–Ohlin go beyond this commonsense notion, however, to show whyit is beneficial for a country to engage in international trade even for products it is able to produce for itself. This is adifficult concept for people to grasp. For example, many people in the United States believe that American consumersshould buy products made in the United States by American companies whenever possible to help save American jobsfrom foreign competition. The same kind of nationalistic sentiments can be observed in many other countries.

Did You Know?Did you know that the last time the United States imposed tariffs on imports of steel it led to job losses?Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation fromthe author.

However, the theories of Smith, Ricardo, and Heckscher–Ohlin tell us that a country’s economy may gain if itscitizens buy certain products from other nations that could be produced at home. The gains arise because internationaltrade allows a country to specialize in the manufacture and export of products that can be produced most efficiently inthat country, while importing products that can be produced more efficiently in other countries.

global EDGE TRADE TUTORIALS

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In this chapter, we discuss benefits and costs associated with free trade, discuss the benefits of international trade, and explain the patternof international trade in today’s world economy. The general idea is that international trade theories explain why it can be beneficial for acountry to engage in trade across country borders, even though countries are at different stages of development, have different productneeds, and produce different types of products. International trade theory assumes that countries—through their governments, laws, andregulations—engage in more or less trade across borders. In reality, the vast majority of trade happens across borders by companies fromdifferent countries. As related to this chapter, check out globalEDGE™’s “trade tutorials” section, where lots of information, data, andtools are compiled related to trading internationally(resources/trade-tutorials). The potpourri of trade resources includes export tutorials, online course modules, a glossary, a free tradeagreement tariff tool, and much more. The glossary includes lots of terms related to trade. For example, “trade surplus” is defined as asituation in which a country’s exports exceeds its imports (i.e., it represents a net inflow of domestic currency from foreign markets). Theopposite is called trade deficit and is considered a net outflow, but how is it really defined? The globalEDGE™ glossary can help.

Thus, it may make sense for the United States to specialize in the production and export of commercial jet aircraftbecause the efficient production of commercial jet aircraft requires resources that are abundant in the United States, suchas a highly skilled labor force and cutting-edge technological know-how. On the other hand, it may make sense for theUnited States to import textiles from Bangladesh because the efficient production of textiles requires a relatively cheaplabor force—and cheap labor is not abundant in the United States.

Of course, this economic argument is often difficult for segments of a country’s population to accept. With theirfuture threatened by imports, U.S. textile companies and their employees have tried hard to persuade thegovernment to limit the importation of textiles by demanding quotas and tariffs. Although such import controlsmay benefit particular groups, such as textile businesses and their employees, the theories of Smith, Ricardo, andHeckscher–Ohlin suggest that the economy as a whole is hurt by such action. One of the key insights of internationaltrade theory is that limits on imports are often in the interests of domestic producers but not domestic consumers.

A Rolex Group logo sits on display above a luxury wristwatch store in Vienna, Austria.Bloomberg/Getty Images

THE PATTERN OF INTERNATIONAL TRADEThe theories of Smith, Ricardo, and Heckscher–Ohlin help explain the pattern of international trade that we observe inthe world economy. Some aspects of the pattern are easy to understand. Climate and natural resource endowmentsexplain why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports crawfish. However,much of the observed pattern of international trade is more difficult to explain. For example, why does Japan exportautomobiles, consumer electronics, and machine tools? Why does Switzerland export chemicals, pharmaceuticals,watches, and jewelry? Why does Bangladesh export garments? David Ricardo’s theory of comparative advantage offersan explanation in terms of international differences in labor productivity. The more sophisticated Heckscher–Ohlintheory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, andcapital) are available in different countries and the proportions in which they are needed for producing particular goods.This explanation rests on the assumption that countries have varying endowments of the various factors of production.Tests of this theory, however, suggest that it is a less powerful explanation of real-world trade patterns than oncethought.

One early response to the failure of the Heckscher–Ohlin theory to explain the observed pattern of international

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trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory suggests that early in their life cycle,most new products are produced in and exported from the country in which they were developed. As a new productbecomes widely accepted internationally, however, production starts in other countries. As a result, the theory suggests,the product may ultimately be exported back to the country of its original innovation.

In a similar vein, during the 1980s, economists such as Paul Krugman developed what has come to be known as thenew trade theory. New trade theory (for which Krugman won the Nobel Prize in economics in 2008) stresses that insome cases, countries specialize in the production and export of particular products not because of underlying differencesin factor endowments but because in certain industries the world market can support only a limited number of firms.(This is argued to be the case for the commercial aircraft industry.) In such industries, firms that enter the market first areable to build a competitive advantage that is subsequently difficult to challenge. Thus, the observed pattern of tradebetween nations may be due in part to the ability of firms within a given nation to capture first-mover advantages. TheUnited States is a major exporter of commercial jet aircraft because American firms such as Boeing were first movers inthe world market. Boeing built a competitive advantage that has subsequently been difficult for firms from countries withequally favorable factor endowments to challenge (although Europe’s Airbus has succeeded in doing that). In a workrelated to the new trade theory, Michael Porter developed a theory referred to as the theory of national competitiveadvantage. This attempts to explain why particular nations achieve international success in particular industries. Inaddition to factor endowments, Porter points out the importance of country factors such as domestic demand anddomestic rivalry in explaining a nation’s dominance in the production and export of particular products.

TRADE THEORY AND GOVERNMENT POLICYAlthough all these theories agree that international trade is beneficial to a country, they lack agreement in theirrecommendations for government policy. Mercantilism makes a case for government involvement in promoting exportsand limiting imports. The theories of Smith, Ricardo, and Heckscher–Ohlin form part of the case for unrestricted freetrade. The argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) areself-defeating and result in wasted resources. Both the new trade theory and Porter’s theory of national competitiveadvantage can be interpreted as justifying some limited government intervention to support the development of certainexport-oriented industries. We discuss the pros and cons of this argument, known as strategic trade policy, as well as thepros and cons of the argument for unrestricted free trade, in Chapter 7.

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Mercantilism

LO6-2Summarize the different theories explaining trade flows between nations.The first theory of international trade, mercantilism, emerged in England in the mid-sixteenth century. The principleassertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to vigorouscommerce. At that time, gold and silver were the currency of trade between countries; a country could earn gold andsilver by exporting goods. Conversely, importing goods from other countries would result in an outflow of gold andsilver from those countries. The main tenet of mercantilism was that it was in a country’s best interests to maintain atrade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and,consequently, increase its national wealth, prestige, and power. As the English mercantilist writer Thomas Mun put it in1630:

The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: tosell more to strangers yearly than we consume of theirs in value.1

Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in thebalance of trade. The mercantilists saw no virtue in a large volume of trade. Rather, they recommended policies tomaximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports weresubsidized.

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The classical economist David Hume pointed out an inherent inconsistency in the mercantilist doctrine in 1752.According to Hume, if England had a balance-of-trade surplus with France (it exported more than it imported), theresulting inflow of gold and silver would swell the domestic money supply and generate inflation in England. In France,however, the outflow of gold and silver would have the opposite effect. France’s money supply would contract, and itsprices would fall. This change in relative prices between France and England would encourage the French to buy fewerEnglish goods (because they were becoming more expensive) and the English to buy more French goods (because theywere becoming cheaper). The result would be a deterioration in the English balance of trade and an improvement inFrance’s trade balance, until the English surplus was eliminated. Hence, according to Hume, in the long run, no countrycould sustain a surplus on the balance of trade and so accumulate gold and silver as the mercantilists had envisaged.

The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gainby one country results in a loss by another.) It was left to Adam Smith and David Ricardo to show the limitations of thisapproach and to demonstrate that trade is a positive-sum game, or a situation in which all countries can benefit. Despitethis, the mercantilist doctrine is by no means dead. For example, the U.S. President Donald Trump appears to advocateneo-mercantilist policies.2 Neo-mercantilists equate political power with economic power and economic power with abalance-of-trade surplus. Critics argue that several nations have adopted a neo-mercantilist strategy that is designed tosimultaneously boost exports and limit imports.3 For example, they charge that China long pursued a neo-mercantilistpolicy, deliberately keeping its currency value low against the U.S. dollar in order to sell more goods to the United Statesand other developed nations, and thus amass a trade surplus and foreign exchange reserves (see the accompanyingCountry Focus).

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COUNTRY FOCUS

Is China Manipulating Its Currency in Pursuit of a Neo-Mercantilist Policy?China’s rapid rise in economic power has been built on export-led growth. For decades, the country’s exports have been growingfaster than its imports. This has led some critics to claim that China is pursuing a neo-mercantilist policy, trying to amass recordtrade surpluses and foreign currency that will give it economic power over developed nations. By the end of 2014, its foreignexchange reserves exceeded $3.8 trillion, some 60 percent of which were held in U.S.-denominated assets such as U.S. Treasurybills. Observers worried that if China ever decided to sell its holdings of U.S. currency, that would depress the value of the dollaragainst other currencies and increase the price of imports into America.

America’s trade deficit with China has been a particular cause for concern. In 2017, this reached a record $375 billion. At thesame time, China has long resisted attempts to let its currency float freely against the U.S. dollar. Many have claimed that China’scurrency has been too cheap and that this keeps the prices of China’s goods artificially low, which fuels the country’s exports.China, the critics charge, is guilty of currency manipulation.

So is China manipulating the value of its currency to keep exports artificially cheap? The facts of the matter are less clear thanthe rhetoric. China actually started to allow the value of the yuan (China’s currency) to appreciate against the dollar in July 2005,albeit at a slow pace. In July 2005, one U.S. dollar purchased 8.11 yuan. By January 2014 one U.S. dollar purchased 6.05 yuan,which implied a 25 percent increase in the price of Chinese exports, not what one would expect from a country that was trying tokeep the price of its exports low through currency manipulation.

Moreover, in 2015 and 2016, the rate of growth in China started to slow significantly. China’s stock market fell sharply, andcapital started to leave the country, with investors selling yuan and buying U.S. dollars. To stop the yuan from declining in valueagainst the U.S. dollar, China began to spend about $100 billion of its foreign exchange reserves every month to buy yuan on theopen market. Far from allowing its currency to decline against the U.S. dollar, thereby giving a boost to its exports, China wastrying to prop up its value, running down its foreign exchange reserves by $2 trillion in the process. This action seems inconsistentwith the charges that the country is pursuing a neo-mercantilist policy by artificially depressing the value of its currency. Inrecognition of these developments, in late 2017 the U.S. Treasury Department declined to name China a currency manipulator andmoderated its criticism of the country’s foreign exchange policies. On the other hand, The Treasury said that it remained concernedby the lack of progress in reducing China’s bilateral trade surplus with the United States.Sources: S. H. Hanke, “Stop the Mercantilists,” Forbes, June 20, 2005, p. 164; G. Dyer and A. Balls, “Dollar Threat as China Signals Shift,” Financial Times, January 6,2006; Richard Silk, “China’s Foreign Exchange Reserves Jump Again,” The Wall Street Journal, October 15, 2013; Terence Jeffrey, “U.S. Merchandise Trade Deficit withChina Hit Record in 2015,” cnsnews.com, February 9, 2016; “Trump’s Chinese Currency Manipulation,” The Wall Street Journal, December 7, 2016; Elena Holodny, “TheTreasury Department Backs Down on Some of Its Criticisms of China’s Currency Policies,” Business Insider, October 18, 2017; and Ana Swanson,“U.S.-China Trade DeficitHits Record, Fueling Trade Fight,” The New York Times, February 6, 2018.

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Absolute Advantage

LO6-2Summarize the different theories explaining trade flows between nations.In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently. In his time, the English, byvirtue of their superior manufacturing processes, were the world’s most efficient textile manufacturers. Due to thecombination of favorable climate, good soils, and accumulated expertise, the French had the world’s most efficient wineindustry. The English had an absolute advantage in the production of textiles, while the French had an absoluteadvantage in the production of wine. Thus, a country has an absolute advantage in the production of a product when itis more efficient than any other country at producing it.

According to Smith, countries should specialize in the production of goods for which they have an absoluteadvantage and then trade these goods for those produced by other countries. In Smith’s time, this suggested the Englishshould specialize in the production of textiles, while the French should specialize in the production of wine.England could get all the wine it needed by selling its textiles to France and buying wine in exchange.Similarly, France could get all the textiles it needed by selling wine to England and buying textiles in exchange. Smith’sbasic argument, therefore, is that a country should never produce goods at home that it can buy at a lower cost from othercountries. Smith demonstrates that by specializing in the production of goods in which each has an absolute advantage,both countries benefit by engaging in trade.

Consider the effects of trade between two countries, Ghana and South Korea. The production of any good (output)requires resources (inputs) such as land, labor, and capital. Assume that Ghana and South Korea both have the sameamount of resources and that these resources can be used to produce either rice or cocoa. Assume further that 200 unitsof resources are available in each country. Imagine that in Ghana it takes 10 resources to produce 1 ton of cocoa and 20resources to produce 1 ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa,or some combination of rice and cocoa between these two extremes. The different combinations that Ghana couldproduce are represented by the line GG’ in Figure 6.1. This is referred to as Ghana’s production possibility frontier(PPF). Similarly, imagine that in South Korea it takes 40 resources to produce 1 ton of cocoa and 10 resources toproduce 1 ton of rice. Thus, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, orsome combination between these two extremes. The different combinations available to South Korea are represented bythe line KK’ in Figure 6.1, which is South Korea’s PPF. Clearly, Ghana has an absolute advantage in the production ofcocoa. (More resources are needed to produce a ton of cocoa in South Korea than in Ghana.) By the same token, SouthKorea has an absolute advantage in the production of rice.

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FIGURE 6.1 The theory of absolute advantage.

Now consider a situation in which neither country trades with any other. Each country devotes half its resources tothe production of rice and half to the production of cocoa. Each country must also consume what it produces. Ghanawould be able to produce 10 tons of cocoa and 5 tons of rice (point A in Figure 6.1), while South Korea would be able toproduce 10 tons of rice and 2.5 tons of cocoa (point B in Figure 6.1). Without trade, the combined production of bothcountries would be 12.5 tons of cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons inGhana and 10 tons in South Korea). If each country were to specialize in producing the good for which it had an absoluteadvantage and then trade with the other for the good it lacks, Ghana could produce 20 tons of cocoa, and South Koreacould produce 20 tons of rice. Thus, by specializing, the production of both goods could be increased. Production ofcocoa would increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20tons. The increase in production that would result from specialization is therefore 7.5 tons of cocoa and 5 tonsof rice. Table 6.1 summarizes these figures.

TABLE 6.1 Absolute Advantage and the Gains from Trade

By engaging in trade and swapping 1 ton of cocoa for 1 ton of rice, producers in both countries could consumemore of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and rice on a one-to-one basis; that is, theprice of 1 ton of cocoa is equal to the price of 1 ton of rice. If Ghana decided to export 6 tons of cocoa to South Koreaand import 6 tons of rice in return, its final consumption after trade would be 14 tons of cocoa and 6 tons of rice. This is4 tons more cocoa than it could have consumed before specialization and trade and 1 ton more rice. Similarly, SouthKorea’s final consumption after trade would be 6 tons of cocoa and 14 tons of rice. This is 3.5 tons more cocoa than it

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could have consumed before specialization and trade and 4 tons more rice. Thus, as a result of specialization and trade,output of both cocoa and rice would be increased, and consumers in both nations would be able to consume more. Thus,we can see that trade is a positive-sum game; it produces net gains for all involved.

Comparative Advantage

LO6-2Summarize the different theories explaining trade flows between nations.David Ricardo took Adam Smith’s theory one step further by exploring what might happen when one country has anabsolute advantage in the production of all goods.4 Smith’s theory of absolute advantage suggests that such a countrymight derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed thatthis was not the case. According to Ricardo’s theory of comparative advantage, it makes sense for a country tospecialize in the production of those goods that it produces most efficiently and to buy the goods that itproduces less efficiently from other countries, even if this means buying goods from other countries that it could producemore efficiently itself.5 While this may seem counterintuitive, the logic can be explained with a simple example.

Assume that Ghana is more efficient in the production of both cocoa and rice; that is, Ghana has an absoluteadvantage in the production of both products. In Ghana it takes 10 resources to produce 1 ton of cocoa and 13.33resources to produce 1 ton of rice. Thus, given its 200 units of resources, Ghana can produce 20 tons of cocoa and norice, 15 tons of rice and no cocoa, or any combination in between on its PPF (the line GG’ in Figure 6.2). In SouthKorea, it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, South Korea canproduce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK’ in Figure6.2). Again assume that without trade, each country uses half its resources to produce rice and half to produce cocoa.Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice (point A in Figure 6.2), while South Koreawill produce 2.5 tons of cocoa and 5 tons of rice (point B in Figure 6.2).

FIGURE 6.2 The theory of comparative advantage.

In light of Ghana’s absolute advantage in the production of both goods, why should it trade with South Korea?Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage onlyin the production of cocoa: Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice.Ghana is comparatively more efficient at producing cocoa than it is at producing rice.

Without trade the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), andthe combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade eachcountry must consume what it produces. By engaging in trade, the two countries can increase their combined production

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of rice and cocoa, and consumers in both nations can consume more of both goods.

THE GAINS FROM TRADEImagine that Ghana exploits its comparative advantage in the production of cocoa to increase its output from 10 tons to15 tons. This uses up 150 units of resources, leaving the remaining 50 units of resources to use in producing 3.75 tons ofrice (point C in Figure 6.2). Meanwhile, South Korea specializes in the production of rice, producing 10 tons. Thecombined output of both cocoa and rice has now increased. Before specialization, the combined output was 12.5 tons ofcocoa and 12.5 tons of rice. Now it is 15 tons of cocoa and 13.75 tons of rice (3.75 tons in Ghana and 10 tons in SouthKorea). The source of the increase in production is summarized in Table 6.2.

TABLE 6.2 Comparative Advantage and the Gains from Trade

Not only is output higher, but both countries also can now benefit from trade. If Ghana and South Korea swapcocoa and rice on a one-to-one basis, with both countries choosing to exchange 4 tons of their export for 4 tons of theimport, both countries are able to consume more cocoa and rice than they could before specialization and trade (seeTable 6.2). Thus, if Ghana exchanges 4 tons of cocoa with South Korea for 4 tons of rice, it is still left with 11 tons ofcocoa, which is 1 ton more than it had before trade. The 4 tons of rice it gets from South Korea in exchange for its 4 tonsof cocoa, when added to the 3.75 tons it now produces domestically, leave it with a total of 7.75 tons of rice, which is0.25 ton more than it had before specialization. Similarly, after swapping 4 tons of rice with Ghana, South Korea stillends up with 6 tons of rice, which is more than it had before specialization. In addition, the 4 tons of cocoa it receives inexchange is 1.5 tons more than it produced before trade. Thus, consumption of cocoa and rice can increase in bothcountries as a result of specialization and trade.

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The basic message of the theory of comparative advantage is that potential world production is greater withunrestricted free trade than it is with restricted trade. Ricardo’s theory suggests that consumers in all nations canconsume more if there are no restrictions on trade. This occurs even in countries that lack an absolute advantage in theproduction of any good. In other words, to an even greater degree than the theory of absolute advantage, the theory ofcomparative advantage suggests that trade is a positive-sum game in which all countries that participate realizeeconomic gains. This theory provides a strong rationale for encouraging free trade. So powerful is Ricardo’s theory thatit remains a major intellectual weapon for those who argue for free trade.

QUALIFICATIONS AND ASSUMPTIONS

LO6-3Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare ofcountries that participate in a free trade system.The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. Our simplemodel includes many unrealistic assumptions:

We have assumed a simple world in which there are only two countries and two goods. In the real world, thereare many countries and many goods.We have assumed away transportation costs between countries.We have assumed away differences in the prices of resources in different countries. We have said nothing aboutexchange rates, simply assuming that cocoa and rice could be swapped on a one-to-one basis.We have assumed that resources can move freely from the production of one good to another within a country.In reality, this is not always the case.We have assumed constant returns to scale; that is, that specialization by Ghana or South Korea has no effect onthe amount of resources required to produce one ton of cocoa or rice. In reality, both diminishing and increasingreturns to specialization exist. The amount of resources required to produce a good might decrease or increase asa nation specializes in production of that good.We have assumed that each country has a fixed stock of resources and that free trade does not change theefficiency with which a country uses its resources. This static assumption makes no allowances for the dynamicchanges in a country’s stock of resources and in the efficiency with which the country uses its resources thatmight result from free trade.We have assumed away the effects of trade on income distribution within a country.

Given these assumptions, can the conclusion that free trade is mutually beneficial be extended to the real world ofmany countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources,nonconstant returns to specialization, and dynamic changes? Although a detailed extension of the theory of comparativeadvantage is beyond the scope of this book, economists have shown that the basic result derived from our simple modelcan be generalized to a world composed of many countries producing many different goods.6 Despite the shortcomingsof the Ricardian model, research suggests that the basic proposition that countries will export the goods that they aremost efficient at producing is borne out by the data.7

However, once all the assumptions are dropped, the case for unrestricted free trade, while still positive, has beenargued by some economists associated with the “new trade theory” to lose some of its strength.8 We return to this issuelater in this chapter and in the next when we discuss the new trade theory. In a recent and widely discussed analysis, theNobel Prize–winning economist Paul Samuelson argued that contrary to the standard interpretation, in certaincircumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switchingto a free trade regime with a poor nation.9 We consider Samuelson’s critique in the next section.

EXTENSIONS OF THE RICARDIAN MODELLet us explore the effect of relaxing three of the assumptions identified earlier in the simple comparative advantagemodel. Next, we relax the assumptions that resources move freely from the production of one good to another within acountry, that there are constant returns to scale, and that trade does not change a country’s stock of resources or theefficiency with which those resources are utilized.

Immobile ResourcesIn our simple comparative model of Ghana and South Korea, we assumed that producers (farmers) could easily convert

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land from the production of cocoa to rice and vice versa. While this assumption may hold for some agricultural products,resources do not always shift quite so easily from producing one good to another. A certain amount of friction isinvolved. For example, embracing a free trade regime for an advanced economy such as the United Statesoften implies that the country will produce less of some labor-intensive goods, such as textiles, and more ofsome knowledge-intensive goods, such as computer software or biotechnology products. Although the country as awhole will gain from such a shift, textile producers will lose. A textile worker in South Carolina is probably not qualifiedto write software for Microsoft. Thus, the shift to free trade may mean that she becomes unemployed or has to acceptanother less attractive job, such as working at a fast-food restaurant.

Resources do not always move easily from one economic activity to another. The process creates friction andhuman suffering, too. While the theory predicts that the benefits of free trade outweigh the costs by a significant margin,this is of cold comfort to those who bear the costs. Accordingly, political opposition to the adoption of a free traderegime typically comes from those whose jobs are most at risk. In the United States, for example, textile workers andtheir unions have long opposed the move toward free trade precisely because this group has much to lose from free trade.Governments often ease the transition toward free trade by helping retrain those who lose their jobs as a result. The paincaused by the movement toward a free trade regime is a short-term phenomenon, while the gains from trade once thetransition has been made are both significant and enduring.

Diminishing ReturnsThe simple comparative advantage model developed above assumes constant returns to specialization. By constantreturns to specialization we mean the units of resources required to produce a good (cocoa or rice) are assumed toremain constant no matter where one is on a country’s production possibility frontier (PPF). Thus, we assumed that italways took Ghana 10 units of resources to produce 1 ton of cocoa. However, it is more realistic to assume diminishingreturns to specialization. Diminishing returns to specialization occur when more units of resources are required toproduce each additional unit. While 10 units of resources may be sufficient to increase Ghana’s output of cocoa from 12tons to 13 tons, 11 units of resources may be needed to increase output from 13 to 14 tons, 12 units of resources toincrease output from 14 tons to 15 tons, and so on. Diminishing returns imply a convex PPF for Ghana (see Figure 6.3),rather than the straight line depicted in Figure 6.2.

FIGURE 6.3 Ghana’s PPF under diminishing returns.

It is more realistic to assume diminishing returns for two reasons. First, not all resources are of the same quality. Asa country tries to increase its output of a certain good, it is increasingly likely to draw on more marginal resources whoseproductivity is not as great as those initially employed. The result is that it requires ever more resources toproduce an equal increase in output. For example, some land is more productive than other land. As Ghanatries to expand its output of cocoa, it might have to utilize increasingly marginal land that is less fertile than the land itoriginally used. As yields per acre decline, Ghana must use more land to produce 1 ton of cocoa.

A second reason for diminishing returns is that different goods use resources in different proportions. For example,

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imagine that growing cocoa uses more land and less labor than growing rice and that Ghana tries to transfer resourcesfrom rice production to cocoa production. The rice industry will release proportionately too much labor and too littleland for efficient cocoa production. To absorb the additional resources of labor and land, the cocoa industry will have toshift toward more labor-intensive methods of production. The effect is that the efficiency with which the cocoa industryuses labor will decline, and returns will diminish.

Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the simpleRicardian model outlined earlier. Diminishing returns to specialization suggest that the gains from specialization arelikely to be exhausted before specialization is complete. In reality, most countries do not specialize, but instead produce arange of goods. However, the theory predicts that it is worthwhile to specialize until that point where the resulting gainsfrom trade are outweighed by diminishing returns. Thus, the basic conclusion that unrestricted free trade is beneficial stillholds, although because of diminishing returns, the gains may not be as great as suggested in the constant returns case.

Dynamic Effects and Economic Growth

LO6-3Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare ofcountries that participate in a free trade system.The simple comparative advantage model assumed that trade does not change a country’s stock of resources or theefficiency with which it utilizes those resources. This static assumption makes no allowances for the dynamic changesthat might result from trade. If we relax this assumption, it becomes apparent that opening an economy to trade is likelyto generate dynamic gains of two sorts.10 First, free trade might increase a country’s stock of resources as increasedsupplies of labor and capital from abroad become available for use within the country. For example, this has beenoccurring in eastern Europe since the early 1990s, with many western businesses investing significant capital in theformer communist countries.

Second, free trade might also increase the efficiency with which a country uses its resources. Gains in the efficiencyof resource utilization could arise from a number of factors. For example, economies of large-scale production mightbecome available as trade expands the size of the total market available to domestic firms. Trade might make bettertechnology from abroad available to domestic firms; better technology can increase labor productivity or the productivityof land. (The so-called green revolution had this effect on agricultural outputs in developing countries.) Also, opening aneconomy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency. Again,this phenomenon has arguably been occurring in the once-protected markets of eastern Europe, where many former statemonopolies have had to increase the efficiency of their operations to survive in the competitive world market.

Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized willcause a country’s PPF to shift outward. This is illustrated in Figure 6.4, where the shift from PPF1 to PPF2 results fromthe dynamic gains that arise from free trade. As a consequence of this outward shift, the country in Figure 6.4 canproduce more of both goods than it did before introduction of free trade. The theory suggests that opening an economy tofree trade not only results in static gains of the type discussed earlier but also results in dynamic gains that stimulateeconomic growth. If this is so, then one might think that the case for free trade becomes stronger still, and in general itdoes. However, as noted, one of the leading economic theorists of the twentieth century, Paul Samuelson, argued that insome circumstances, dynamic gains can lead to an outcome that is not so beneficial.

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FIGURE 6.4 The influence of free trade on the PPF.

Trade, Jobs, and Wages: The Samuelson CritiquePaul Samuelson’s critique looks at what happens when a rich country—the United States—enters into a free tradeagreement with a poor country—China—that rapidly improves its productivity after the introduction of a free traderegime (i.e., there is a dynamic gain in the efficiency with which resources are used in the poor country). Samuelson’smodel suggests that in such cases, the lower prices that U.S. consumers pay for goods imported from China following theintroduction of a free trade regime may not be enough to produce a net gain for the U.S. economy if the dynamic effectof free trade is to lower real wage rates in the United States. As he stated in a New York Times interview, “Being able topurchase groceries 20 percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wagelosses (in America).”11

Samuelson was particularly concerned about the ability to offshore service jobs that traditionally were notinternationally mobile, such as software debugging, call-center jobs, accounting jobs, and even medical diagnosis ofMRI scans (see the accompanying Country Focus for details). Advances in communications technology since thedevelopment of the World Wide Web in the early 1990s have made this possible, effectively expanding the labor marketfor these jobs to include educated people in places such as India, the Philippines, and China. When coupled with rapidadvances in the productivity of foreign labor due to better education, the effect on middle-class wages in the UnitedStates, according to Samuelson, may be similar to mass inward migration into the country: It will lower the marketclearing wage rate, perhaps by enough to outweigh the positive benefits of international trade.

Having said this, it should be noted that Samuelson concedes that free trade has historically benefited rich countries(as data discussed later seem to confirm). Moreover, he notes that introducing protectionist measures (e.g., trade barriers)to guard against the theoretical possibility that free trade may harm the United States in the future may produce asituation that is worse than the disease they are trying to prevent. To quote Samuelson: “Free trade may turn outpragmatically to be still best for each region in comparison to lobbyist-induced tariffs and quotas which involve both aperversion of democracy and non-subtle deadweight distortion losses.”12

One notable recent study by MIT economist David Autor and his associates found evidence in support ofSamuelson’s thesis. The study has been widely quoted in the media and cited by politicians. Autor and his associateslooked at every county in the United States for its manufacturers’ exposure to competition from China.13 The researchersfound that regions most exposed to China tended not only to lose more manufacturing jobs, but also to seeoverall employment decline. Areas with higher exposure to China also had larger increases in workersreceiving unemployment insurance, food stamps, and disability payments. The costs to the economy from theincreased government payments amounted to two-thirds of the gains from trade with China. In other words, many of theways trade with China has helped the United States—such as providing inexpensive goods to U.S. consumers—havebeen wiped out. Even so, like Samuelson the authors of this study argued that in the long run, free trade is a good thing.They note, however, that the rapid rise of China has resulted in some large adjustment costs that, in the short run,significantly reduce the gains from trade.

COUNTRY FOCUS

Moving U.S. White-Collar Jobs OffshoreEconomists have long argued that free trade produces gains for all countries that participate in a free trading system. Asglobalization continues to sweep through the U.S. economy, many people are wondering if this is true. During the 1980s and1990s, free trade was associated with the movement of low-skill, blue-collar manufacturing jobs out of rich countries such as theUnited States and toward low-wage countries—textiles to Costa Rica, athletic shoes to the Philippines, steel to Brazil, electronicproducts to Thailand, and so on. While many observers bemoaned the “hollowing out” of U.S. manufacturing, economists statedthat high-skill and high-wage white-collar jobs associated with the knowledge-based economy would stay in the United States.Computers might be assembled in Thailand, so the argument went, but they would continue to be designed in Silicon Valley byhighly skilled U.S. engineers, and software applications would be written in the United States by programmers at Apple,Microsoft, Adobe, Oracle, and the like.

Employees walk below the Infosys Ltd. logo at the company’s campus in Electronics City inBangalore, India.Vivek Prakash/Bloomberg/Getty Images

Developments over the past several decades have people questioning this assumption. Many American companies have beenmoving white-collar, knowledge-based jobs to developing nations where they can be performed for a fraction of the cost. Forexample, a few years ago Bank of America cut nearly 5,000 jobs from its 25,000-strong, U.S.-based information technologyworkforce. Some of these jobs were transferred to India, where work that costs $100 an hour in the United States could be done for$20 an hour. One beneficiary of Bank of America’s downsizing is Infosys Technologies Ltd., a Bangalore, India, informationtechnology firm where 250 engineers now develop information technology applications for the bank. Other Infosys employees arebusy processing home loan applications for U.S. mortgage companies. Nearby in the offices of another Indian firm, Wipro Ltd.,radiologists interpret 30 CT scans a day for Massachusetts General Hospital that are sent over the internet. At yet anotherBangalore business, engineers earn $10,000 a year designing leading-edge semiconductor chips for Texas Instruments. Nor isIndia the only beneficiary of these changes.

Some architectural work also is being outsourced to lower-cost locations. Flour Corp., a Texas-based construction company,employs engineers and drafters in the Philippines, Poland, and India to turn layouts of industrial facilities into detailedspecifications. For a Saudi Arabian chemical plant Flour designed, 200 young engineers based in the Philippines earning less than$3,000 a year collaborated in real time over the internet with elite U.S. and British engineers who make up to $100,000 a year.Why did Flour do this? According to the company, the answer was simple. Doing so reduces the prices of a project by 15 percent,giving the company a cost-based competitive advantage in the global market for construction design. Also troubling for future jobgrowth in the United States, some high-tech start-ups are outsourcing significant work right from inception. For example, ZohoCorporation, a California-based start-up offering online web applications for small businesses, has about 20 employees in theUnited States and more than 1,000 in India!Sources: P. Engardio, A. Bernstein, and M. Kripalani, “Is Your Job Next?” BusinessWeek, February 3, 2003, pp. 50–60; “America’s Pain, India’s Gain,” The Economist,January 11, 2003, p. 57; M. Schroeder and T. Aeppel, “Skilled Workers Mount Opposition to Free Trade, Swaying Politicians,” The Wall Street Journal, October 10, 2003,pp. A1, A11; D. Clark,“New U.S. Fees on Visas Irk Outsources,” The Wall Street Journal, August 16, 2010, p. 6; and J. R. Hagerty, “U.S. Loses High Tech Jobs as R&DShifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.

Other economists have dismissed Samuelson’s fears.14 While not questioning his analysis, they note that as apractical matter, developing nations are unlikely to be able to upgrade the skill level of their workforce rapidly enough to

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give rise to the situation in Samuelson’s model. In other words, they will quickly run into diminishing returns. However,such rebuttals are at odds with data suggesting that Asian countries are rapidly upgrading their educational systems. Forexample, about 56 percent of the world’s engineering degrees awarded in 2008 were in Asia, compared with 4 percent inthe United States!15

Evidence for the Link between Trade and Growth

Many economic studies have looked at the relationship between trade and economic growth.16 In general, these studiessuggest that as predicted by the standard theory of comparative advantage, countries that adopt a more open stancetoward international trade enjoy higher growth rates than those that close their economies to trade. Jeffrey Sachs andAndrew Warner created a measure of how “open” to international trade an economy was and then looked at therelationship between “openness” and economic growth for a sample of more than 100 countries from 1970 to 1990.17Among other findings, they reported

We find a strong association between openness and growth, both within the group of developing and the group of developedcountries. Within the group of developing countries, the open economies grew at 4.49 percent per year, and the closed economiesgrew at 0.69 percent per year. Within the group of developed economies, the open economies grew at 2.29 percent per year, andthe closed economies grew at 0.74 percent per year.18

A study by Wacziarg and Welch updated the Sachs and Warner data through the late 1990s. They found that overthe period 1950–1998, countries that liberalized their trade regimes experienced, on average, increases in their annualgrowth rates of 1.5–2.0 percent compared to preliberalization times.19 An exhaustive survey of 61 studies publishedbetween 1967 and 2009 concluded: “The macroeconomic evidence provides dominant support for the positive andsignificant effects of trade on output and growth.”20

The message seems clear: Adopt an open economy and embrace free trade, and your nation will be rewarded withhigher economic growth rates. Higher growth will raise income levels and living standards. This last point has beenconfirmed by a study that looked at the relationship between trade and growth in incomes. The study, undertaken byJeffrey Frankel and David Romer, found that on average, a 1 percentage point increase in the ratio of a country’s trade toits gross domestic product increases income per person by at least 0.5 percent.21 For every 10 percent increase in theimportance of international trade in an economy, average income levels will rise by at least 5 percent. Despite the short-term adjustment costs associated with adopting a free trade regime, which can be significant, trade would seem toproduce greater economic growth and higher living standards in the long run, just as the theory of Ricardo would lead usto expect.22

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Heckscher–Ohlin Theory

LO6-2Summarize the different theories explaining trade flows between nations.Ricardo’s theory stresses that comparative advantage arises from differences in productivity. Thus, whether Ghana ismore efficient than South Korea in the production of cocoa depends on how productively it uses its resources. Ricardostressed labor productivity and argued that differences in labor productivity between nations underlie thenotion of comparative advantage. Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) putforward a different explanation of comparative advantage. They argued that comparative advantage arises fromdifferences in national factor endowments.23 By factor endowments, they meant the extent to which a country isendowed with such resources as land, labor, and capital. Nations have varying factor endowments, and different factorendowments explain differences in factor costs; specifically, the more abundant a factor, the lower its cost. TheHeckscher–Ohlin theory predicts that countries will export those goods that make intensive use of factors that are locallyabundant, while importing goods that make intensive use of factors that are locally scarce. Thus, the Heckscher–Ohlintheory attempts to explain the pattern of international trade that we observe in the world economy. Like Ricardo’s theory,

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the Heckscher–Ohlin theory argues that free trade is beneficial. Unlike Ricardo’s theory, however, the Heckscher–Ohlintheory argues that the pattern of international trade is determined by differences in factor endowments, rather thandifferences in productivity.

The Heckscher–Ohlin theory has commonsense appeal. For example, the United States has long been a substantialexporter of agricultural goods, reflecting in part its unusual abundance of arable land. In contrast, China has excelled inthe export of goods produced in labor-intensive manufacturing industries. This reflects China’s relative abundance oflow-cost labor. The United States, which lacks abundant low-cost labor, has been a primary importer of these goods.Note that it is relative, not absolute, endowments that are important; a country may have larger absolute amounts of landand labor than another country but be relatively abundant in one of them.

THE LEONTIEF PARADOXThe Heckscher–Ohlin theory has been one of the most influential theoretical ideas in international economics. Mosteconomists prefer the Heckscher–Ohlin theory to Ricardo’s theory because it makes fewer simplifying assumptions.Because of its influence, the theory has been subjected to many empirical tests. Beginning with a famous study publishedin 1953 by Wassily Leontief (winner of the Nobel Prize in economics in 1973), many of these tests have raised questionsabout the validity of the Heckscher–Ohlin theory.24 Using the Heckscher–Ohlin theory, Leontief postulated that becausethe United States was relatively abundant in capital compared to other nations, the United States would be an exporter ofcapital-intensive goods and an importer of labor-intensive goods. To his surprise, however, he found that U.S. exportswere less capital intensive than U.S. imports. Because this result was at variance with the predictions of the theory, it hasbecome known as the Leontief paradox.

No one is quite sure why we observe the Leontief paradox. One possible explanation is that the United States has aspecial advantage in producing new products or goods made with innovative technologies. Such products may be lesscapital intensive than products whose technology has had time to mature and become suitable for mass production. Thus,the United States may be exporting goods that heavily use skilled labor and innovative entrepreneurship, such ascomputer software, while importing heavy manufacturing products that use large amounts of capital. Some empiricalstudies tend to confirm this.25 Still, tests of the Heckscher–Ohlin theory using data for a large number of countries tendto confirm the existence of the Leontief paradox.26

This leaves economists with a difficult dilemma. They prefer the Heckscher–Ohlin theory on theoretical grounds,but it is a relatively poor predictor of real-world international trade patterns. On the other hand, the theory they regard asbeing too limited, Ricardo’s theory of comparative advantage, actually predicts trade patterns with greater accuracy. Thebest solution to this dilemma may be to return to the Ricardian idea that trade patterns are largely driven by internationaldifferences in productivity. Thus, one might argue that the United States exports commercial aircraft and imports textilesnot because its factor endowments are especially suited to aircraft manufacture and not suited to textilemanufacture, but because the United States is relatively more efficient at producing aircraft than textiles. A keyassumption in the Heckscher–Ohlin theory is that technologies are the same across countries. This may not be the case.Differences in technology may lead to differences in productivity, which in turn, drives international trade patterns.27Thus, Japan’s success in exporting automobiles from the 1970s onward has been based not only on the relativeabundance of capital but also on its development of innovative manufacturing technology that enabled it to achievehigher productivity levels in automobile production than other countries that also had abundant capital. Empirical worksuggests that this theoretical explanation may be correct.28 The new research shows that once differences in technologyacross countries are controlled for, countries do indeed export those goods that make intensive use of factors that arelocally abundant, while importing goods that make intensive use of factors that are locally scarce. In other words, oncethe impact of differences of technology on productivity is controlled for, the Heckscher–Ohlin theory seems to gainpredictive power.

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The Product Life-Cycle Theory

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LO6-2Summarize the different theories explaining trade flows between nations.

Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.29 Vernon’s theory was based on theobservation that, for most of the twentieth century, a very large proportion of the world’s new products had beendeveloped by U.S. firms and sold first in the U.S. market (e.g., mass-produced automobiles, televisions, instant cameras,photocopiers, personal computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size ofthe U.S. market gave U.S. firms a strong incentive to develop new consumer products. In addition, the high cost of U.S.labor gave U.S. firms an incentive to develop cost-saving process innovations.

Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not follow that theproduct must be produced in the United States. It could be produced abroad at some low-cost location and then exportedback into the United States. However, Vernon argued that most new products were initially produced in America.Apparently, the pioneering firms believed it was better to keep production facilities close to the market and to the firm’scenter of decision making, given the uncertainty and risks inherent in introducing new products. Also, the demand formost new products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices for newproducts, which obviates the need to look for low-cost production sites in other countries.

Vernon went on to argue that early in the life cycle of a typical new product, while demand is starting to growrapidly in the United States, demand in other advanced countries is limited to high-income groups. The limited initialdemand in other advanced countries does not make it worthwhile for firms in those countries to start producing the newproduct, but it does necessitate some exports from the United States to those countries.

Over time, demand for the new product starts to grow in other advanced countries (e.g., Great Britain, France,Germany, and Japan). As it does, it becomes worthwhile for foreign producers to begin producing for their homemarkets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing.Consequently, production within other advanced countries begins to limit the potential for exports from the UnitedStates.

As the market in the United States and other advanced nations matures, the product becomes more standardized,and price becomes the main competitive weapon. As this occurs, cost considerations start to play a greater role in thecompetitive process. Producers based in advanced countries where labor costs are lower than in the United States (e.g.,Italy and Spain) might now be able to export to the United States. If cost pressures become intense, the process might notstop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated oncemore, as developing countries (e.g., Thailand) begin to acquire a production advantage over advancedcountries. Thus, the locus of global production initially switches from the United States to other advancednations and then from those nations to developing countries.

The consequence of these trends for the pattern of world trade is that over time, the United States switches frombeing an exporter of the product to an importer of the product as production becomes concentrated in lower-cost foreignlocations.

PRODUCT LIFE-CYCLE THEORY IN THE TWENTY-FIRST CENTURYHistorically, the product life-cycle theory seems to be an accurate explanation of international trade patterns. Considerphotocopiers: The product was first developed in the early 1960s by Xerox in the United States and sold initially to U.S.users. Originally, Xerox exported photocopiers from the United States, primarily to Japan and the advanced countries ofWestern Europe. As demand began to grow in those countries, Xerox entered into joint ventures to set up production inJapan (Fuji-Xerox) and Great Britain (Rank-Xerox). In addition, once Xerox’s patents on the photocopier processexpired, other foreign competitors began to enter the market (e.g., Canon in Japan and Olivetti in Italy). As aconsequence, exports from the United States declined, and U.S. users began to buy some photocopiers from lower-costforeign sources, particularly Japan. More recently, Japanese companies found that manufacturing costs are too high intheir own country, so they have begun to switch production to developing countries such as Thailand. Thus, initially theUnited States and now other advanced countries (e.g., Japan and Great Britain) have switched from being exporters ofphotocopiers to importers. This evolution in the pattern of international trade in photocopiers is consistent with thepredictions of the product life-cycle theory that mature industries tend to go out of the United States and into low-costassembly locations.

However, the product life-cycle theory is not without weaknesses. Viewed from an Asian or European perspective,Vernon’s argument that most new products are developed and introduced in the United States seems ethnocentric anddated. Although it may be true that during U.S. dominance of the global economy (from 1945 to 1975), most newproducts were introduced in the United States, there have always been important exceptions. These exceptions appear tohave become more common in recent years. Many new products are now first introduced in Japan (e.g., video-game

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consoles) or South Korea (e.g., Samsung smartphones). Moreover, with the increased globalization and integration of theworld economy discussed in Chapter 1, an increasing number of new products (e.g., tablet computers, smartphones, anddigital cameras) are now introduced simultaneously in the United States and many European and Asian nations. Thismay be accompanied by globally dispersed production, with particular components of a new product being produced inthose locations around the globe where the mix of factor costs and skills is most favorable (as predicted by the theory ofcomparative advantage). In sum, although Vernon’s theory may be useful for explaining the pattern of international tradeduring the period of American global dominance, its relevance in the modern world seems more limited.

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New Trade Theory

LO6-2Summarize the different theories explaining trade flows between nations.The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms toattain economies of scale might have important implications for international trade.30 Economies of scale are unit costreductions associated with a large scale of output. Economies of scale have a number of sources, including the ability tospread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees andequipment that are more productive than less specialized employees and equipment. Economies of scale are a majorsource of cost reductions in many industries, from computer software to automobiles and from pharmaceuticals toaerospace. For example, Microsoft realizes economies of scale by spreading the fixed costs of developing new versionsof its Windows operating system, which runs to about $10 billion, over the 2 billion or so personal computers on whicheach new system is ultimately installed. Similarly, automobile companies realize economies of scale byproducing a high volume of automobiles from an assembly line where each employee has a specialized task.

New trade theory makes two important points: First, through its impact on economies of scale, trade can increasethe variety of goods available to consumers and decrease the average cost of those goods. Second, in those industries inwhich the output required to attain economies of scale represents a significant proportion of total world demand, theglobal market may be able to support only a small number of enterprises. Thus, world trade in certain products may bedominated by countries whose firms were first movers in their production.

INCREASING PRODUCT VARIETY AND REDUCING COSTS

LO6-3Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare ofcountries that participate in a free trade system.Imagine first a world without trade. In industries where economies of scale are important, both the variety of goods that acountry can produce and the scale of production are limited by the size of the market. If a national market is small, theremay not be enough demand to enable producers to realize economies of scale for certain products. Accordingly, thoseproducts may not be produced, thereby limiting the variety of products available to consumers. Alternatively, they maybe produced but at such low volumes that unit costs and prices are considerably higher than they might be if economiesof scale could be realized.

Now consider what happens when nations trade with each other. Individual national markets are combined into alarger world market. As the size of the market expands due to trade, individual firms may be able to better attaineconomies of scale. The implication, according to new trade theory, is that each nation may be able to specialize inproducing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not makefrom other countries, each nation can simultaneously increase the variety of goods available to its consumers and lowerthe costs of those goods; thus, trade offers an opportunity for mutual gain even when countries do not differ in their

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resource endowments or technology.Suppose there are two countries, each with an annual market for 1 million automobiles. By trading with each other,

these countries can create a combined market for 2 million cars. In this combined market, due to the ability to betterrealize economies of scale, more varieties (models) of cars can be produced, and cars can be produced at a lower averagecost, than in either market alone. For example, demand for a sports car may be limited to 55,000 units in each nationalmarket, while a total output of at least 100,000 per year may be required to realize significant scale economies. Similarly,demand for a minivan may be 80,000 units in each national market, and again a total output of at least 100,000 per yearmay be required to realize significant scale economies. Faced with limited domestic market demand, firms in each nationmay decide not to produce a sports car, because the costs of doing so at such low volume are too great. Although theymay produce minivans, the cost of doing so will be higher, as will prices, than if significant economies of scale had beenattained. Once the two countries decide to trade, however, a firm in one nation may specialize in producing sports cars,while a firm in the other nation may produce minivans. The combined demand for 110,000 sports cars and 160,000minivans allows each firm to realize scale economies. Consumers in this case benefit from having access to a product(sports cars) that was not available before international trade and from the lower price for a product (minivans) that couldnot be produced at the most efficient scale before international trade. Trade is thus mutually beneficial because it allowsthe specialization of production, the realization of scale economies, the production of a greater variety of products, andlower prices.

ECONOMIES OF SCALE, FIRST-MOVER ADVANTAGES, AND THE PATTERNOF TRADEA second theme in new trade theory is that the pattern of trade we observe in the world economy may be the result ofeconomies of scale and first-mover advantages. First-mover advantages are the economic and strategic advantages thataccrue to early entrants into an industry.31 The ability to capture scale economies ahead of later entrants, and thus benefitfrom a lower cost structure, is an important first-mover advantage. New trade theory argues that for thoseproducts where economies of scale are significant and represent a substantial proportion of world demand, thefirst movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match.Thus, the pattern of trade that we observe for such products may reflect first-mover advantages. Countries may dominatein the export of certain goods because economies of scale are important in their production and because firms located inthose countries were the first to capture scale economies, giving them a first-mover advantage.

For example, consider the commercial aerospace industry. In aerospace, there are substantial scale economies thatcome from the ability to spread the fixed costs of developing a new jet aircraft over a large number of sales. It costAirbus some $25 billion to develop its superjumbo jet, the 550-seat A380, which entered service in 2007. To recoupthose costs and break even, Airbus will have to sell at least 250 A380 planes. By 2018, it had sold some 240 aircraft. IfAirbus can sell more than 350 A380 planes, it will apparently be a profitable venture. Total demand over the first 20years of service for this class of aircraft was estimated to be between 400 and 600 units. Thus, at best, the global marketcould probably profitably support only one producer of jet aircraft in the superjumbo category. It follows that theEuropean Union might come to dominate in the export of very large jet aircraft, primarily because a European-basedfirm, Airbus, was the first to produce a superjumbo jet aircraft and realize scale economies. Other potential producers,such as Boeing, might have been shut out of the market because they lack the scale economies that Airbus enjoys.Because it pioneered this market category, Airbus captured a first-mover advantage based on scale economies that wasdifficult for rivals to match, and that resulted in the European Union becoming the leading exporter of very large jetaircraft. (As it turns out, however, the super-jumbo market may not be big enough to support even one producer. In early2019, Airbus announced that it will stop producing the A380 in 2021 due to weak demand.)

IMPLICATIONS OF NEW TRADE THEORYNew trade theory has important implications. The theory suggests that nations may benefit from trade even when they donot differ in resource endowments or technology. Trade allows a nation to specialize in the production of certainproducts, attaining scale economies and lowering the costs of producing those products, while buying products that itdoes not produce from other nations that specialize in the production of other products. By this mechanism, the variety ofproducts available to consumers in each nation is increased, while the average costs of those products should fall, asshould their price, freeing resources to produce other goods and services.

The theory also suggests that a country may predominate in the export of a good simply because it was luckyenough to have one or more firms among the first to produce that good. Because they are able to gain economies ofscale, the first movers in an industry may get a lock on the world market that discourages subsequent entry. First-movers’ ability to benefit from increasing returns creates a barrier to entry. In the commercial aircraft industry, the factthat Boeing and Airbus are already in the industry and have the benefits of economies of scale discourages new entry andreinforces the dominance of America and Europe in the trade of midsize and large jet aircraft. This dominance is further

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reinforced because global demand may not be sufficient to profitably support another producer of midsize and large jetaircraft in the industry. So although Japanese firms might be able to compete in the market, they have decided not toenter the industry but to ally themselves as major subcontractors with primary producers (e.g., Mitsubishi HeavyIndustries is a major subcontractor for Boeing on the 777 and 787 programs).

New trade theory is at variance with the Heckscher–Ohlin theory, which suggests a country will predominate in theexport of a product when it is particularly well endowed with those factors used intensively in its manufacture. Newtrade theorists argue that the United States is a major exporter of commercial jet aircraft not because it is betterendowed with the factors of production required to manufacture aircraft, but because one of the first movers inthe industry, Boeing, was a U.S. firm. The new trade theory is not at variance with the theory of comparative advantage.Economies of scale increase productivity. Thus, the new trade theory identifies an important source of comparativeadvantage.

This theory is quite useful in explaining trade patterns. Empirical studies seem to support the predictions of thetheory that trade increases the specialization of production within an industry, increases the variety of products availableto consumers, and results in lower average prices.32 With regard to first-mover advantages and international trade, astudy by Harvard business historian Alfred Chandler suggests the existence of first-mover advantages is an importantfactor in explaining the dominance of firms from certain nations in specific industries.33 The number of firms is verylimited in many global industries, including the chemical industry, the heavy construction-equipment industry, the heavytruck industry, the tire industry, the consumer electronics industry, the jet engine industry, and the computer softwareindustry.

Perhaps the most contentious implication of the new trade theory is the argument that it generates for governmentintervention and strategic trade policy.34 New trade theorists stress the role of luck, entrepreneurship, and innovation ingiving a firm first-mover advantages. According to this argument, the reason Boeing was the first mover in commercialjet aircraft manufacture—rather than firms such as Great Britain’s De Havilland and Hawker Siddeley or Holland’sFokker, all of which could have been—was that Boeing was both lucky and innovative. One way Boeing was lucky isthat De Havilland shot itself in the foot when its Comet jet airliner, introduced two years earlier than Boeing’s first jetairliner, the 707, was found to be full of serious technological flaws. Had De Havilland not made some serioustechnological mistakes, Great Britain might have become the world’s leading exporter of commercial jet aircraft.Boeing’s innovativeness was demonstrated by its independent development of the technological know-how required tobuild a commercial jet airliner. Several new trade theorists have pointed out, however, that Boeing’s research anddevelopment (R&D) was largely paid for by the U.S. government; the 707 was a spin-off from a government-fundedmilitary program (the entry of Airbus into the industry was also supported by significant government subsidies). Hereinis a rationale for government intervention: By the sophisticated and judicious use of subsidies, could a governmentincrease the chances of its domestic firms becoming first movers in newly emerging industries, as the U.S. governmentapparently did with Boeing (and the European Union did with Airbus)? If this is possible, and the new trade theorysuggests it might be, we have an economic rationale for a proactive trade policy that is at variance with the free tradeprescriptions of the trade theories we have reviewed so far. We consider the policy implications of this issue in Chapter7.

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National Competitive Advantage: Porter’s Diamond

LO6-2Summarize the different theories explaining trade flows between nations.Michael Porter, the famous Harvard strategy professor, has also written extensively on international trade.35Porter and his team looked at 100 industries in 10 nations. Like the work of the new trade theorists, Porter’s work wasdriven by a belief that existing theories of international trade told only part of the story. For Porter, the essential task wasto explain why a nation achieves international success in a particular industry. Why does Japan do so well in theautomobile industry? Why does Switzerland excel in the production and export of precision instruments and

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pharmaceuticals? Why do Germany and the United States do so well in the chemical industry? These questions cannot beanswered easily by the Heckscher–Ohlin theory, and the theory of comparative advantage offers only a partialexplanation. The theory of comparative advantage would say that Switzerland excels in the production and export ofprecision instruments because it uses its resources very productively in these industries. Although this may be correct,this does not explain why Switzerland is more productive in this industry than Great Britain, Germany, or Spain. Portertries to solve this puzzle.

Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and theseattributes promote or impede the creation of competitive advantage (see Figure 6.5). These attributes are

FIGURE 6.5 The determinants of national competitive advantage: Porter’s diamond.Source: Michael E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990; republished with a new introduction, 1998), p. 72.

Factor endowments—a nation’s position in factors of production, such as skilled labor or the infrastructurenecessary to compete in a given industry.Demand conditions—the nature of home-country demand for the industry’s product or service.Related and supporting industries—the presence or absence of supplier industries and related industries that areinternationally competitive.Firm strategy, structure, and rivalry—the conditions governing how companies are created, organized, andmanaged and the nature of domestic rivalry.

Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed inindustries or industry segments where the diamond is most favorable. He also argues that the diamond is a mutuallyreinforcing system. The effect of one attribute is contingent on the state of others. For example, Porter argues favorabledemand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms torespond to them.

Porter maintains that two additional variables can influence the national diamond in important ways: chance andgovernment. Chance events, such as major innovations, can reshape industry structure and provide the opportunity forone nation’s firms to supplant another’s. Government, by its choice of policies, can detract from or improve nationaladvantage. For example, regulation can alter home demand conditions, antitrust policies can influence the intensity ofrivalry within an industry, and government investments in education can change factor endowments.

FACTOR ENDOWMENTSFactor endowments lie at the center of the Heckscher–Ohlin theory. While Porter does not propose anything radicallynew, he does analyze the characteristics of factors of production. He recognizes hierarchies among factors, distinguishingbetween basic factors (e.g., natural resources, climate, location, and demographics) and advanced factors (e.g.,communication infrastructure, sophisticated and skilled labor, research facilities, and technological know-how). Heargues that advanced factors are the most significant for competitive advantage. Unlike the naturally endowed basicfactors, advanced factors are a product of investment by individuals, companies, and governments. Thus, governmentinvestments in basic and higher education, by improving the general skill and knowledge level of the population and bystimulating advanced research at higher education institutions, can upgrade a nation’s advanced factors.

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The relationship between advanced and basic factors is complex. Basic factors can provide an initial advantage thatis subsequently reinforced and extended by investment in advanced factors. Conversely, disadvantages in basic factorscan create pressures to invest in advanced factors. An obvious example of this phenomenon is Japan, a country that lacksarable land and mineral deposits and yet through investment has built a substantial endowment of advanced factors.Porter notes that Japan’s large pool of engineers (reflecting a much higher number of engineering graduates per capitathan almost any other nation) has been vital to Japan’s success in many manufacturing industries.

DEMAND CONDITIONSPorter emphasizes the role home demand plays in upgrading competitive advantage. Firms are typically most sensitive tothe needs of their closest customers. Thus, the characteristics of home demand are particularly important in shaping theattributes of domestically made products and in creating pressures for innovation and quality. Porter argues that anation’s firms gain competitive advantage if their domestic consumers are sophisticated and demanding. Such consumerspressure local firms to meet high standards of product quality and to produce innovative products. For example, Porternotes that Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate the Japanese camera industry toimprove product quality and to introduce innovative models.

RELATED AND SUPPORTING INDUSTRIESThe third broad attribute of national advantage in an industry is the presence of suppliers or related industries that areinternationally competitive. The benefits of investments in advanced factors of production by related and supportingindustries can spill over into an industry, thereby helping it achieve a strong competitive position internationally.Swedish strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn on strengths in Sweden’sspecialty steel industry. Technological leadership in the U.S. semiconductor industry provided the basis for U.S. successin personal computers and several other technically advanced electronic products. Similarly, Switzerland’s success inpharmaceuticals is closely related to its previous international success in the technologically related dye industry.

One consequence of this process is that successful industries within a country tend to be grouped into clusters ofrelated industries. This was one of the most pervasive findings of Porter’s study. One such cluster Porter identified wasin the German textile and apparel sector, which included high-quality cotton, wool, synthetic fibers, sewing machineneedles, and a wide range of textile machinery. Such clusters are important because valuable knowledge can flowbetween the firms within a geographic cluster, benefiting all within that cluster. Knowledge flows occur when employeesmove between firms within a region and when national industry associations bring employees from different companiestogether for regular conferences or workshops.36

FIRM STRATEGY, STRUCTURE, AND RIVALRYThe fourth broad attribute of national competitive advantage in Porter’s model is the strategy, structure, and rivalry offirms within a nation. Porter makes two important points here. First, different nations are characterized by differentmanagement ideologies, which either help them or do not help them build national competitive advantage. For example,Porter noted the predominance of engineers in top management at German and Japanese firms. He attributed this to thesefirms’ emphasis on improving manufacturing processes and product design. In contrast, Porter noted a predominance ofpeople with finance backgrounds leading many U.S. firms. He linked this to U.S. firms’ lack of attention to improvingmanufacturing processes and product design. He argued that the dominance of finance led to an overemphasis onmaximizing short-term financial returns. According to Porter, one consequence of these different management ideologieswas a relative loss of U.S. competitiveness in those engineering-based industries where manufacturingprocesses and product design issues are all-important (e.g., the automobile industry).

Porter’s second point is that there is a strong association between vigorous domestic rivalry and the creation andpersistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improveefficiency, which makes them better international competitors. Domestic rivalry creates pressures to innovate, to improvequality, to reduce costs, and to invest in upgrading advanced factors. All this helps create world-class competitors. Portercites the case of Japan:

Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out warfare in which many companies fail toachieve profitability. With goals that stress market share, Japanese companies engage in a continuing struggle to outdo each other.Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings measure whichcompanies are most popular with university graduates. The rate of new product and process development is breathtaking.37

EVALUATING PORTER’S THEORY

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LO6-4Explain the arguments of those who maintain that government can play a proactive role in promoting nationalcompetitive advantage in certain industries.Porter contends that the degree to which a nation is likely to achieve international success in a certain industry is afunction of the combined impact of factor endowments, domestic demand conditions, related and supporting industries,and domestic rivalry. He argues that the presence of all four components is usually required for this diamond to boostcompetitive performance (although there are exceptions). Porter also contends that government can influence each of thefour components of the diamond—either positively or negatively. Factor endowments can be affected by subsidies,policies toward capital markets, policies toward education, and so on. Government can shape domestic demand throughlocal product standards or with regulations that mandate or influence buyer needs. Government policy can influencesupporting and related industries through regulation and influence firm rivalry through such devices as capital marketregulation, tax policy, and antitrust laws.

If Porter is correct, we would expect his model to predict the pattern of international trade that we observe in thereal world. Countries should be exporting products from those industries where all four components of the diamond arefavorable, while importing in those areas where the components are not favorable. Is he correct? We simply do notknow. Porter’s theory has not been subjected to detailed empirical testing. Much about the theory rings true, but the samecan be said for the new trade theory, the theory of comparative advantage, and the Heckscher–Ohlin theory. It may bethat each of these theories, which complement each other, explains something about the pattern of international trade.

TEST PREPUse SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBookor go to learnsmartadvantage.com for help.

FOCUS ON MANAGERIAL IMPLICATIONSLOCATION, FIRST-MOVER ADVANTAGES, AND GOVERNMENT POLICY

LO6-5Understand the important implications that international trade theory holds for management practice.Why does all this matter for business? There are at least three main implications for international businesses of thematerial discussed in this chapter: location implications, first-mover implications, and government policy implications.

LocationUnderlying most of the theories we have discussed is the notion that different countries have particular advantages indifferent productive activities. Thus, from a profit perspective, it makes sense for a firm to disperse its productiveactivities to those countries where, according to the theory of international trade, they can be performed most efficiently.If design can be performed most efficiently in France, that is where design facilities should be located; if the manufactureof basic components can be performed most efficiently in Singapore, that is where they should be manufactured; and iffinal assembly can be performed most efficiently in China, that is where final assembly should be performed.The result is a global web of productive activities, with different activities being performed in differentlocations around the globe depending on considerations of comparative advantage, factor endowments, and the like. Ifthe firm does not do this, it may find itself at a competitive disadvantage relative to firms that do.

First-Mover AdvantagesAccording to the new trade theory, firms that establish a first-mover advantage with regard to the production of aparticular new product may subsequently dominate global trade in that product. This is particularly true in industrieswhere the global market can profitably support only a limited number of firms, such as the aerospace market, but earlycommitments may also seem to be important in less concentrated industries. For the individual firm, the clear message isthat it pays to invest substantial financial resources in trying to build a first-mover, or early mover, advantage, even ifthat means several years of losses before a new venture becomes profitable. The idea is to preempt the available demand,

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gain cost advantages related to volume, build an enduring brand ahead of later competitors, and, consequently, establisha long-term sustainable competitive advantage. Although the details of how to achieve this are beyond the scope of thisbook, many publications offer strategies for exploiting first-mover advantages and for avoiding the traps associated withpioneering a market (first-mover disadvantages).38

Government PolicyThe theories of international trade also matter to international businesses because firms are major players on theinternational trade scene. Business firms produce exports, and business firms import the products of other countries.Because of their pivotal role in international trade, businesses can exert a strong influence on government trade policy,lobbying to promote free trade or trade restrictions. The theories of international trade claim that promoting free trade isgenerally in the best interests of a country, although it may not always be in the best interest of an individual firm. Manyfirms recognize this and lobby for open markets.

For example, when the U.S. government announced its intention to place a tariff on Japanese imports of liquidcrystal display (LCD) screens in the 1990s, IBM and Apple Computer protested strongly. Both IBM and Apple pointedout that (1) Japan was the lowest-cost source of LCD screens; (2) they used these screens in their own laptop computers;and (3) the proposed tariff, by increasing the cost of LCD screens, would increase the cost of laptop computers producedby IBM and Apple, thus making them less competitive in the world market. In other words, the tariff, designed to protectU.S. firms, would be self-defeating. In response to these pressures, the U.S. government reversed its posture.

Unlike IBM and Apple, however, businesses do not always lobby for free trade. In the United States, for example,restrictions on imports of steel have periodically been put into place in response to direct pressure by U.S. firms on thegovernment (the latest example being in March 2018 when the Trump administration placed a 25 percent tariff onimports of foreign steel). In some cases, the government has responded to pressure from domestic companies seekingprotection by getting foreign companies to agree to “voluntary” restrictions on their imports, using the implicit threat ofmore comprehensive formal trade barriers to get them to adhere to these agreements (historically, this has occurred in theautomobile industry). In other cases, the government used what are called “antidumping” actions to justify tariffs onimports from other nations (these mechanisms will be discussed in detail in Chapter 7).

As predicted by international trade theory, many of these agreements have been self-defeating, such as thevoluntary restriction on machine tool imports agreed to in 1985. Shielded from international competition by importbarriers, the U.S. machine tool industry had no incentive to increase its efficiency. Consequently, it lost many of itsexport markets to more efficient foreign competitors. Because of this misguided action, the U.S. machine toolindustry shrunk during the period when the agreement was in force. For anyone schooled in international tradetheory, this was not surprising.39

Finally, Porter’s theory of national competitive advantage also contains policy implications. Porter’s theorysuggests that it is in the best interest of business for a firm to invest in upgrading advanced factors of production (forexample, to invest in better training for its employees) and to increase its commitment to research and development. It isalso in the best interests of business to lobby the government to adopt policies that have a favorable impact on eachcomponent of the national diamond. Thus, according to Porter, businesses should urge government to increaseinvestment in education, infrastructure, and basic research (because all these enhance advanced factors) and to adoptpolicies that promote strong competition within domestic markets (because this makes firms stronger internationalcompetitors, according to Porter’s findings).

Key Termsfree trade, p. 166new trade theory, p. 168mercantilism, p. 169zero-sum game, p. 169absolute advantage, p. 170constant returns to specialization, p. 176factor endowments, p. 181economies of scale, p. 183first-mover advantages, p. 184balance-of-payments accounts, p. 195current account, p. 196current account deficit, p. 196current account surplus, p. 196capital account, p. 196financial account, p. 196

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SUMMARYThis chapter reviewed a number of theories that explain why it is beneficial for a country to engage in internationaltrade and explained the pattern of international trade observed in the world economy. The theories of Smith, Ricardo,and Heckscher–Ohlin all make strong cases for unrestricted free trade. In contrast, the mercantilist doctrine and, to alesser extent, the new trade theory can be interpreted to support government intervention to promote exports throughsubsidies and to limit imports through tariffs and quotas.

In explaining the pattern of international trade, this chapter shows that, with the exception of mercantilism,which is silent on this issue, the different theories offer largely complementary explanations. Although no one theorymay explain the apparent pattern of international trade, taken together, the theory of comparative advantage, theHeckscher–Ohlin theory, the product life-cycle theory, the new trade theory, and Porter’s theory of nationalcompetitive advantage do suggest which factors are important. Comparative advantage tells us that productivitydifferences are important; Heckscher–Ohlin tells us that factor endowments matter; the product life-cycle theory tellsus that where a new product is introduced is important; the new trade theory tells us that increasing returns tospecialization and first-mover advantages matter; Porter tells us that all these factors may be important insofar as theyaffect the four components of the national diamond. The chapter made the following points:

1. Mercantilists argued that it was in a country’s best interests to run a balance-of-trade surplus. They viewedtrade as a zero-sum game, in which one country’s gains cause losses for other countries.

2. The theory of absolute advantage suggests that countries differ in their ability to produce goods efficiently.The theory suggests that a country should specialize in producing goods in areas where it has an absoluteadvantage and import goods in areas where other countries have absolute advantages.

3. The theory of comparative advantage suggests that it makes sense for a country to specialize in producingthose goods that it can produce most efficiently, while buying goods that it can produce relatively lessefficiently from other countries—even if that means buying goods from other countries that it could producemore efficiently itself.

4. The theory of comparative advantage suggests that unrestricted free trade brings about increasedworld production—that is, that trade is a positive-sum game.

5. The theory of comparative advantage also suggests that opening a country to free trade stimulates economicgrowth, which creates dynamic gains from trade. The empirical evidence seems to be consistent with thisclaim.

6. The Heckscher–Ohlin theory argues that the pattern of international trade is determined by differences infactor endowments. It predicts that countries will export those goods that make intensive use of locallyabundant factors and will import goods that make intensive use of factors that are locally scarce.

7. The product life-cycle theory suggests that trade patterns are influenced by where a new product is introduced.In an increasingly integrated global economy, the product life-cycle theory seems to be less predictive than itonce was.

8. New trade theory states that trade allows a nation to specialize in the production of certain goods, attainingscale economies and lowering the costs of producing those goods, while buying goods that it does not producefrom other nations that are similarly specialized. By this mechanism, the variety of goods available toconsumers in each nation is increased, while the average costs of those goods should fall.

9. New trade theory also states that in those industries where substantial economies of scale imply that the worldmarket will profitably support only a few firms, countries may predominate in the export of certain productssimply because they had a firm that was a first mover in that industry.

10. Some new trade theorists have promoted the idea of strategic trade policy. The argument is that government,by the sophisticated and judicious use of subsidies, might be able to increase the chances of domestic firmsbecoming first movers in newly emerging industries.

11. Porter’s theory of national competitive advantage suggests that the pattern of trade is influenced by fourattributes of a nation: (a) factor endowments, (b) domestic demand conditions, (c) related and supportingindustries, and (d) firm strategy, structure, and rivalry.

12. Theories of international trade are important to an individual business firm primarily because they can help thefirm decide where to locate its various production activities.

13. Firms involved in international trade can and do exert a strong influence on government policy toward trade.By lobbying government, business firms can promote free trade or trade restrictions.

Critical Thinking and Discussion Questions

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1. Mercantilism is a bankrupt theory that has no place in the modern world. Discuss.2. Is free trade fair? Discuss.3. Unions in developed nations often oppose imports from low-wage countries and advocate trade barriers to

protect jobs from what they often characterize as “unfair” import competition. Is such competition “unfair”?Do you think that this argument is in the best interests of (a) the unions, (b) the people they represent, and/or(c) the country as a whole?

4. What are the potential costs of adopting a free trade regime? Do you think governments should do anything toreduce these costs? Why?

5. Reread the Country Focus “Is China Manipulating Its Currency in Pursuit of a Neo-Mercantilist Policy?”a. Do you think China is pursuing a currency policy that can be characterized as neo-mercantilist?b. What should the United States, and other countries, do about this?

6. Reread the Country Focus “Moving U.S. White-Collar Jobs Offshore.”a. Who benefits from the outsourcing of skilled white-collar jobs to developing nations? Who are the losers?b. Will developed nations like the United States suffer from the loss of high-skilled and high-paying jobs?

7. Is there a difference between the transference of high-paying white-collar jobs, such as computerprogramming and accounting, to developing nations, and low-paying blue-collar jobs? If so, what is thedifference, and should government do anything to stop the flow of white-collar jobs out of the country tocountries such as India?

8. Drawing upon the new trade theory and Porter’s theory of national competitive advantage, outline the case forgovernment policies that would build national competitive advantage in biotechnology. What kinds of policieswould you recommend that the government adopt? Are these policies at variance with the basic freetrade philosophy?

9. The world’s poorest countries are at a competitive disadvantage in every sector of their economies. They havelittle to export; they have no capital; their land is of poor quality; they often have too many people givenavailable work opportunities; and they are poorly educated. Free trade cannot possibly be in the interests ofsuch nations. Discuss.

global EDGE research task globaledge.msu.eduUse the globalEDGE™ website (globaledge.msu.edu) to complete the following exercises:

1. The World Trade Organization International Trade Statistics is an annual report that provides comprehensive,comparable, and updated statistics on trade in merchandise and commercial services. The report is anassessment of world trade flows by country, region, and main product or service categories. Using the mostrecent statistics available, identify the top 10 countries that lead in the export and import of merchandise trade,respectively. Which countries appear in the top 10 in both exports and imports? Can you explain why thesecountries appear at the top of both lists?

2. Food is an integral part of understanding different countries, cultures, and lifestyles. You run a chain of high-end premium restaurants in the United States, and you are looking for unique Australian wines you canimport. However, you must first identify which Australian suppliers can provide you with premium wines.After searching through the Australian supplier directory, identify three to four companies that can bepotential suppliers. Then, develop a list of criteria you would need to ask these companies about to selectwhich one to work with.

CLOSING CASE

“Trade Wars Are Good and Easy to Win”At 3:50 a.m. on March 2, 2018, Donald Trump, the 45th President of the United States, took to his favorite medium,Twitter, to espouse his views on an important policy issue: international trade. He tweeted “When a country (USA) islosing many billions of dollars on trade with virtually every country it does business with, trade wars are good and easyto win. When we are down $100 billion with a certain country and they get cute, don’t trade anymore – we win big. It’seasy!”*

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Ron Sachs, Pool/Getty Images News/Getty Images

Trump’s tweet was a response to backlash over his decision to impose a 25 percent tariff on imports of steel, and a10 percent tariff on imports of aluminum. The Trump administration claimed these tariffs were necessary to protect twoindustries that were important for national security. His critics had a different take. They argued that the tariffs wouldraise input costs for consumers of steel and aluminum, which included construction companies, manufacturers ofconstruction equipment, appliance makers, auto manufacturers, makers of containers and packaging (e.g., beer cans), andaerospace companies. Among those hit by higher costs due to these tariffs would be two of the U.S.’s largest exporters:Boeing and Caterpillar Tractor. The critics also noted that there are only 140,000 people employed in the steel andaluminum industries, whereas 6.5 million Americans are employed in industries that use steel and aluminum, whereinput prices have just gone up.*Donald John Trump, Twitter, March 2, 2018, https://twitter.com/realdonaldtrump.

Trump’s actions should not have been a surprise. In contrast to all U.S. presidents since World War II,Donald Trump has long voiced strong opposition to trade deals designed to lower tariff barriers and foster thefree flow of goods and services between the United States and its trading partners. During the presidential electioncampaign, he called the North American Free Trade Agreement (NAFTA) “the worst trade deal maybe ever signedanywhere.” Upon taking office, his administration launched a renegotiation of NAFTA, with the aim of making thetreaty more favorable to the U.S. As a candidate, he vowed to “kill” the Trans Pacific Partnership (TPP), a free trade dealamong 12 Pacific Rim countries, including the United States (but excluding China), negotiated by the Obamaadministration. In his first week in office, he signed an executive order formally withdrawing the United States from theTPP. He has even threatened to pull the United States out of the World Trade Organization (WTO) if the global tradebody interferes with his plans to impose tariffs.

Trump’s position seems to be based on a belief that trade is a game that the United States needs to win. He appearsto equate winning with running a trade surplus, and sees the persistent U.S. trade deficit as a sign of American weakness.In his words, “you only have to look at our trade deficit to see that we are being taken to the cleaners by our tradingpartners.”** He believes that other countries have taken advantage of the United States in trade deals, and the result hasbeen a sharp decline in manufacturing jobs in the United States. China and Mexico have been frequent targets of hiscriticisms, and he has argued that China’s trade surplus with the United States is a result of that country’s currencymanipulation, which he believes has made Chinese exports artificially cheap. He seems to think that the U.S. can win atthe trade game by becoming a tougher negotiator and extracting favorable terms from foreign nations that want access tothe U.S. market. He has even characterized previous American trade negotiators as “stupid people,” “political hacks anddiplomats,” and “saps,” and has suggested that he should become “negotiator in chief.”

In contrast to Donald Trump’s espoused position, the pro-trade policies of the last 70 years were based upon asubstantial body of economic theory and evidence that suggests free trade has a positive impact on the economic growthrate of all nations that participate in a free trade system. According to this work, free trade doesn’t destroy jobs; it createsjobs and raises national income. To be sure, some sectors will lose jobs when a nation moves to a free trade regime, butthe argument is that jobs created elsewhere in the economy will more than compensate for such losses, and in aggregate,the nation will be better off.**Donald J. Trump and Dave Shiflett, The America We Deserve: on Free Trade, Renaissance Books, 2000.

The United States has long been the world’s largest economy, largest foreign investor, and one of the three largestexporters (along with China and Germany). Due to exports and foreign direct investments in other countries, 43 percentof the sales of all American firms in the S&P 500 stock market index are made outside of U.S. borders. As a result of the

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U.S.’s economic power, Americans’ long adherence to free trade policies has helped to set the tone for the world tradingsystem. In large part, the post–World War II international trading system, with its emphasis on lowering barriers tointernational trade and investment, was only possible because of vigorous American leadership. Now with theascendancy of Donald Trump to the presidency, that seems to be changing. Pro–free traders argue that if Trumpcontinues to push for more protectionist trade policies—and his rhetoric and cabinet picks suggest he will—theunintended consequences could include retaliation from the U.S.’s trading partners, a trade war characterized by highertariffs, a decline in the volume of world trade, job losses in the United States, and lower economic growth around theworld. As evidence, they point to the last time such protectionist policies were implemented. That was in the early 1930s,when a trade war between nations deepened the Great Depression.Sources: “Donald Trump on Free Trade,” On the Issues, www.ontheissues.org/2016/Donald_Trump_Free_Trade.htm; Keith Bradsher, “Trump’s Pick on Trade Could Put China in aDifficult Spot,” The New York Times, January 13, 2017; William Mauldin, “Trump Threatens to Pull U.S. Out of World Trade Organization,” The Wall Street Journal, July 24, 2016;“Trump’s Antitrade Warriors,” The Wall Street Journal, January 16, 2017; “Donald Trump’s Trade Bluster,” The Economist, December 10, 2016; and Chad Brown, “Trump’s Steel andAluminum Tariffs Are Counterproductive,” Peterson Institute for International Economics, March 7, 2018.

Case Discussion Questions

1. What economic theory of trade do Donald Trump’s views seem most closely aligned with?2. What are the possible benefits of Donald Trump’s position on international trade? What are the potential costs

and risks of his position?3. Do you think Trump is correct? Are trade wars good and easy to win? What does it mean to “win” a trade war?

What does it mean to “lose”?

Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education

Appendix: International Trade and the Balance of PaymentsInternational trade involves the sale of goods and services to residents in other countries (exports) and thepurchase of goods and services from residents in other countries (imports). A country’s balance-of-payments accountskeep track of the payments to and receipts from other countries for a particular time period. These include payments toforeigners for imports of goods and services, and receipts from foreigners for goods and services exported to them. Asummary copy of the U.S. balance-of-payments accounts for 2018 is given in Table A.1. In this appendix, we brieflydescribe the form of the balance-of-payments accounts, and we discuss whether a current account deficit, often a causeof much concern in the popular press, is something to worry about.

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Table A.1 U.S. Balance-of-Payments Accounts, 2018Source: Bureau of Economic Analysis.

BALANCE-OF-PAYMENTS ACCOUNTSBalance-of-payments accounts are divided into three main sections: the current account, the capital account, and thefinancial account (to confuse matters, what is now called the capital account until recently was part of thecurrent account, and the financial account used to be called the capital account). The current account recordstransactions that pertain to four categories, all of which can be seen in Table A.1. The first category, goods, refers to theexport or import of physical goods (e.g., agricultural foodstuffs, autos, computers, chemicals). The second category is theexport or import of services (e.g., intangible products such as banking and insurance services, royalty payments onintellectual property, and earnings from foreign tourists who visit the U.S.). The third category, primary income receiptsor payments, refers to income from foreign investments or payments to foreign investors (e.g., interest and dividendreceipts or payments). The third category also includes payments that foreigners have made to U.S. residents for workperformed outside the United States and payments that U.S. entities make to foreign residents. The fourth category,secondary income receipts or payments, refers to the transfer of a good, service, or asset to the U.S. government or U.S.

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private entities, or the transfer to a foreign government or entity in the case of payments (this includes tax payments,foreign pension payments, cash transfers, etc.).

A current account deficit occurs when a country imports more goods, services, and income than it exports. Acurrent account surplus occurs when a country exports more goods, services, and income than it imports. Table A.1shows that in 2018 the United States ran a current account deficit of $488.472 billion. This is often a headline-grabbingfigure and is widely reported in the news media. The U.S. current account deficit reflects the fact that America importsfar more physical goods than it exports. (The United States typically runs a surplus on trade in services and on incomepayments.)

The 2006 current account deficit of $803 billion was the largest on record and was equivalent to about 6.5 percentof the country’s GDP. The deficit has shrunk since then. The 2018 current account deficit represented just 2.4 percent ofGDP. Many people find the fact that the United States runs a persistent deficit on its current account to be disturbing, thecommon assumption being that high import of goods displaces domestic production, causes unemployment, and reducesthe growth of the U.S. economy. However, the issue is more complex than this. Fully understanding the implications of alarge and persistent deficit requires that we look at the rest of the balance-of-payments accounts.

The capital account records one-time changes in the stock of assets. As noted earlier, until recently this item wasincluded in the current account. The capital account includes capital transfers, such as debt forgiveness and migrants’transfers (the goods and financial assets that accompany migrants as they enter or leave the country). In the big schemeof things, this is a relatively small figure amounting to $9.4 billion in 2018.

The financial account (formerly the capital account) records transactions that involve the purchase or sale ofassets. Thus, when a German firm purchases stock in a U.S. company or buys a U.S. bond, the transaction enters the U.S.balance of payments as a credit on the financial account. This is because capital is flowing into the country. When capitalflows out of the United States, it enters the financial account as a debit.

The financial account is comprised of a number of elements. The net U.S. acquisition of financial assets includesthe change in foreign assets owned by the U.S. government (e.g., U.S. official reserve assets) and the change in foreignassets owned by private individuals and corporations (including changes in assets owned through foreign directinvestment). As can be seen from Table A.1, in 2018 there was a $301.6 billion increase in U.S. ownership of foreignassets, which tells us that the U.S. government and U.S. private entities were purchasing more foreign assets than theywere selling. The net U.S. incurrence of liabilities refers to the change in U.S. assets owned by foreigners. In 2018,foreigners increased their holdings of U.S. assets by $800 billion, signifying that foreigners were net acquirers of U.S.stocks, bonds (including Treasury bills), and physical assets such as real estate.

A basic principle of balance-of-payments accounting is double-entry bookkeeping. Every international transactionautomatically enters the balance of payments twice—once as a credit and once as a debit. Imagine that you purchase acar produced in Japan by Toyota for $20,000.

Because your purchase represents a payment to another country for goods, it will enter the balance of payments as adebit on the current account. Toyota now has the $20,000 and must do something with it. If Toyota deposits the money ata U.S. bank, Toyota has purchased a U.S. asset—a bank deposit worth $20,000—and the transaction will show up as a$20,000 credit on the financial account. Or Toyota might deposit the cash in a Japanese bank in return for Japanese yen.Now the Japanese bank must decide what to do with the $20,000. Any action that it takes will ultimately result in a creditfor the U.S. balance of payments. For example, if the bank lends the $20,000 to a Japanese firm that uses it to importpersonal computers from the United States, then the $20,000 must be credited to the U.S. balance-of-payments currentaccount. Or the Japanese bank might use the $20,000 to purchase U.S. government bonds, in which case it will show upas a credit on the U.S. balance-of-payments financial account.

Thus, any international transaction automatically gives rise to two offsetting entries in the balance of payments.Because of this, the sum of the current account balance, the capital account, and the financial account balanceshould always add up to zero. In practice, this does not always occur due to the existence of “statisticaldiscrepancies,” the source of which need not concern us here (note that in 2018, the statistical discrepancy amounted to$40.5 billion).

DOES THE CURRENT ACCOUNT DEFICIT MATTER?As discussed earlier, there is some concern when a country is running a deficit on the current account of its balance ofpayments.40 In recent years, a number of rich countries, including most notably the United States, have run persistentcurrent account deficits. When a country runs a current account deficit, the money that flows to other countries can thenbe used by those countries to purchase assets in the deficit country. Thus, when the United States runs a trade deficit withChina, the Chinese use the money that they receive from U.S. consumers to purchase U.S. assets such as stocks, bonds,and the like. Put another way, a deficit on the current account is financed by selling assets to other countries—that is, byincreasing liabilities on the financial account. Thus, the persistent U.S. current account deficit is being financed by asteady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to other countries. In short, countries thatrun current account deficits become net debtors.

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For example, as a result of financing its current account deficit through asset sales, the United States must deliver astream of interest payments to foreign bondholders, rents to foreign landowners, and dividends to foreign stockholders.One might argue that such payments to foreigners drain resources from a country and limit the funds available forinvestment within the country. Because investment within a country is necessary to stimulate economic growth, apersistent current account deficit can choke off a country’s future economic growth. This is the basis of the argument thatpersistent deficits are bad for an economy. However, things are not this simple. For one thing, in an era of global capitalmarkets, money is efficiently directed toward its highest value uses, and over the past quarter of a century, many of thehighest value uses of capital have been in the United States. So even though capital is flowing out of the United States inthe form of payments to foreigners, much of that capital finds its way right back into the country to fund productiveinvestments in the United States. In short, it is not clear that the current account deficit chokes off U.S. economic growth.In fact, notwithstanding the 2008–2009 recession, the U.S. economy has grown substantially over the past 30 years,despite running a persistent current account deficit and despite financing that deficit by selling U.S. assets to foreigners.This is precisely because foreigners reinvest much of the income earned from U.S. assets and from exports to the UnitedStates right back into the United States. This revisionist view, which has gained in popularity in recent years, suggeststhat a persistent current account deficit might not be the drag on economic growth it was once thought to be.41

Having said this, there is still a nagging fear that at some point, the appetite that foreigners have for U.S. assetsmight decline. If foreigners suddenly reduced their investments in the United States, what would happen? In short,instead of reinvesting the dollars that they earn from exports and investment in the United States back into the country,they would sell those dollars for another currency, European euros, Japanese yen, or Chinese yuan, for example, andinvest in euro-, yen-, and yuan-denominated assets instead. This would lead to a fall in the value of the dollar on foreignexchange markets, and that in turn would increase the price of imports and lower the price of U.S. exports, making themmore competitive, which should reduce the overall level of the current account deficit. Thus, in the long run, thepersistent U.S. current account deficit could be corrected via a reduction in the value of the U.S. dollar. The concern isthat such adjustments may not be smooth. Rather than a controlled decline in the value of the dollar, the dollar mightsuddenly lose a significant amount of its value in a very short time, precipitating a “dollar crisis.”42 Because the U.S.dollar is the world’s major reserve currency and is held by many foreign governments and banks, any dollar crisis coulddeliver a body blow to the world economy and at the very least trigger a global economic slowdown. That would not be agood thing.

Endnotes

1. Spiegel, W. Henry. The Growth of Economics Thought. NC: Duke University Press, 1991.2. Binyamin Applebaum, “On Trade, Donald Trump Breaks with 200 Years of Economic Orthodoxy,” The New

York Times, March 10, 2016.3. M. Solis, “The Politics of Self-Restraint: FDI Subsidies and Japanese Mercantilism,” The World Economy 26

(February 2003), pp. 153–70; Kevin Hamlin, “China Is a Growing Threat to Global Competitors, Kroeber Says,”Bloomberg News, June 28, 2016.

4. S. Hollander, The Economics of David Ricardo (Buffalo: University of Toronto Press, 1979).5. D. Ricardo, The Principles of Political Economy and Taxation (Homewood, IL: Irwin, 1967, first published in

1817).6. For example, R. Dornbusch, S. Fischer, and P. Samuelson, “Comparative Advantage: Trade and Payments in a

Ricardian Model with a Continuum of Goods,” American Economic Review 67 (December 1977), pp. 823–39.7. B. Balassa, “An Empirical Demonstration of Classic Comparative Cost Theory,” Review of Economics and

Statistics, 1963, pp. 231–38.8. See P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (Fall 1987), pp. 131–44.9. P. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting

Globalization,” Journal of Economic Perspectives 18, no. 3 (Summer 2004), pp. 135–46.10. P. Samuelson, “The Gains from International Trade Once Again,” Economic Journal 72 (1962), pp. 820–29.11. Lohr, Steve. “An Elder Challenges Outsourcing’s Orthodoxy.” The New York Times, September 9, 2004.

https://www.nytimes.com/2004/09/09/business/worldbusiness/an-elder-challenges-outsourcings-orthodoxy.html.

12. Samuelson, A. Paul. “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream EconomistsSupporting Globalization.” Journal of Economic Perspective 18, no. 3 (Summer 2004): 143.

13. D. H. Autor, D. Dorn, and Gordon H. Hanson, “The China Syndrome: Local Labor Market Effects of ImportCompetition in the United States,” American Economic Review 103, no. 6 (October 2013).

14. See A. Dixit and G. Grossman, “Samuelson Says Nothing about Trade Policy,” Princeton University, 2004,accessed from

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http://depts.washington.edu/teclass/ThinkEcon/readings/Kalles/Dixit%20and%20Grossman%20on%20Samuelson.pdf.15. J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p.

B1.16. For example, J. D. Sachs and A. Warner, “Economic Reform and the Process of Global Integration,” Brookings

Papers on Economic Activity, 1995, pp. 1–96; J. A. Frankel and D. Romer, “Does Trade Cause Growth?”American Economic Review 89, no. 3 (June 1999), pp. 379–99; D. Dollar and A. Kraay, “Trade, Growth andPoverty,” working paper, Development Research Group, World Bank, June 2001. Also, for an accessiblediscussion of the relationship between free trade and economic growth, see T. Taylor, “The Truth aboutGlobalization,” Public Interest, Spring 2002, pp. 24–44; D. Acemoglu, S. Johnson, and J. Robinson, “The Rise ofEurope: At l antic Trade, I nsti t ut i onal Change and Eco nomi c Growth, ” Amer i can Economic Revi ew 95, no. 3(2005), pp. 547–79; T. Singh, “Does International Trade Cause Economic Growth?” The World Economy 33, no.11 (2010), pp. 1517–64.

17. Sachs and Warner, “Economic Reform and the Process of Global Integration.”18. Warner, Andrew, and Jeffrey D. Sachs. “Economics Reform and the Process of Global Integration.” Brookings

Papers on Economic Activity, 1995. https://www.brookings.edu/wp-content/uploads/1995/01/1995a_bpea_sachs_warner_aslund_fischer.pdf.

19. R. Wacziarg and K. H. Welch, “Trade Liberalization and Growth: New Evidence,” World Bank Economic Review22, no. 2 (June 2008).

20. T. Singh, “Does International Trade Cause Economic Growth?” The World Economy 33, no. 11 (November2010), pp. 1517–64.

21. J. A. Frankel and D. H. Romer, “Does Trade Cause Growth?” American Economic Review 89, no. 3 (June 1999),pp. 370–99.

22. A recent skeptical review of the empirical work on the relationship between trade and growth questions theseresults. See F. Rodriguez and D. Rodrik, “Trade Policy and Economic Growth: A Skeptic’s Guide to the Cross-National Evidence,” National Bureau of Economic Research Working Paper Series, working paper no. 7081(April 1999). Even these authors, however, cannot find any evidence that trade hurts economic growth or incomelevels.

23. B. Ohlin, Interregional and International Trade (Cambridge, MA: Harvard University Press, 1933). For asummary, see R. W. Jones and J. P. Neary, “The Positive Theory of International Trade,” in Handbook ofInternational Economics, R. W. Jones and P. B. Kenen, eds. (Amsterdam: North Holland, 1984).

24. W. Leontief, “Domestic Production and Foreign Trade: The American Capital Position Re-examined,”Proceedings of the American Philosophical Society 97 (1953), pp. 331–49.

25. R. M. Stern and K. Maskus, “Determinants of the Structure of U.S. Foreign Trade,” Journal of InternationalEconomics 11 (1981), pp. 207–44.

26. See H. P. Bowen, E. E. Leamer, and L. Sveikayskas, “Multicountry, Multifactor Tests of the Factor AbundanceTheory,” American Economic Review 77 (1987), pp. 791–809.

27. D. Trefler, “The Case of the Missing Trade and Other Mysteries,” American Economic Review 85 (December1995), pp. 1029–46.

28. D. R. Davis and D. E. Weinstein, “An Account of Global Factor Trade,” American Economic Review 91, no. 5(December 2001), pp. 1423–52.

29. R. Vernon, “International Investments and International Trade in the Product Life Cycle,” Quarterly Journal ofEconomics, May 1966, pp. 190–207; R. Vernon and L. T. Wells, The Economic Environment of I nte rna t i onalBusiness, 4th ed. (Englewood Cliffs, NJ: Prentice Hall, 1986).

30. For a good summary of this literature, see E. Helpman and P. Krugman, Market Structure and Foreign Trade:Increasing Returns, Imperfect Competition, and the International Economy (Boston: MIT Press, 1985). Also seeP. Krugman, “Does the New Trade Theory Require a New Trade Policy?” World Economy 15, no. 4 (1992), pp.423–41.

31. M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 (Summer1988), pp. 41–58; W. T. Robinson and Sungwook Min, “Is the First to Market the First to Fail?” Journal ofMarketing Research 29 (2002), pp. 120–28.

32. J. R. Tybout, “Plant and Firm Level Evidence on New Trade Theories,” National Bureau of Economic ResearchWorking Paper Series, working paper no. 8418 (August 2001), www.nber.org; S. Deraniyagala and B. Fine,“New Trade Theory versus Old Trade Policy: A Continuing Enigma,” Cambridge Journal of Economics 25(November 2001), pp. 809–25.

33. A. D. Chandler, Scale and Scope (New York: Free Press, 1990).34. Krugman, “Does the New Trade Theory Require a New Trade Policy?”35. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990). For a good review of this

book, see R. M. Grant, “Porter’s Competitive Advantage of Nations: An Assessment,” Strategic Management

Journal 12 (1991), pp. 535–48.36. B. Kogut, ed., Country Competitiveness: Technology and the Organizing of Work (New York: Oxford University

Press, 1993).37. Agrawal, Raj. International Trade. Excel Books India, 2001.38. Lieberman and Montgomery, “First-Mover Advantages.” See also Robinson and Min, “Is the First to Market the

First to Fail?”; W. Boulding and M. Christen, “First-Mover Disadvantage,” Harvard Business Review, October2001, pp. 20–21; R. Agarwal and M. Gort, “First-Mover Advantage and the Speed of Competitive Entry,”Journal of Law and Economics 44 (2001), pp. 131–59.

39. C. A. Hamilton, “Building Better Machine Tools,” Journal of Commerce, October 30, 1991, p. 8; “ManufacturingTrouble,” The Economist, October 12, 1991, p. 71.

40. P. Krugman, The Age of Diminished Expectations (Cambridge, MA: MIT Press, 1990); J. Bernstein and DeanBaker, “Why Trade Deficits Matter,” The Atlantic, December 8, 2016.

41. D. Griswold, “Are Trade Deficits a Drag on U.S. Economic Growth?” Free Trade Bulletin, March 12, 2007; O.Blanchard, “Current Account Deficits in Rich Countries,” National Bureau of Economic Research Working PaperSeries, working paper no. 12925, February 2007.

42. S. Edwards, “The U.S. Current Account Deficit: Gradual Correction or Abrupt Adjustment?” National Bureau ofEconomic Research Working Paper Series, working paper no. 12154, April 2006.

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part three The Global Trade and InvestmentEnvironment

Government Policy and International Trade

LEARNING OBJECTIVESAfter reading this chapter, you will be able to:

Identify the policy instruments used by governments to influence international trade flows.

Understand why governments sometimes intervene in international trade.

Summarize and explain the arguments against strategic trade policy.Describe the development of the world trading system and the current trade issue.

Explain the implications for managers of developments in the world trading system.

Chip Somodevilla/Getty Images News/Getty Images

American Steel Tariffs

OPENING CASEIn March 2018, President Trump imposed a 25 percent tariff on imports of foreign steel into the United States (and a 10 percent tariffon aluminum imports). In justifying the steel tariff, Trump argued that a strong domestic steel industry was necessary for the nationalsecurity of the United States. In 2017, some 36 million tons of steel were imported into the U.S., while 81.6 million tons wereproduced domestically. Import penetration into the U.S. had increased from about 23 percent of total steel consumption in 2007 to 31percent in 2017. The U.S. exports about 2 million tons of steel per year. There were roughly 140,000 people employed in the U.S.steel industry in 2018, and around 6.5 million employed in industries that consumed steel, including construction, machinery, and

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automobiles.This was not the first time the U.S. steel industry had been the beneficiary of import tariffs. The industry has a long history of

tariff protection. Some critics complain that this is linked to the importance of steel producing states such as Indiana, Pennsylvania,and Ohio in U.S. Presidential elections. In 2002, the Bush administration placed tariffs ranging from 8 percent to 30 percent onimports of foreign steel. The U.S. exempted its NAFTA partners Canada and Mexico from these tariffs. The Bush tariffs were liftednine months later after significant opposition from businesses in steel consuming industries, who claimed that higher steel prices wereresulting in significant job losses. In 2016, the Obama administration imposed punitive tariffs as high as 500 percent on imports ofsome steel products from China, arguing that Chinese producers were dumping excess steel production in the United States at belowthe costs of production. Due to the Obama tariffs (which remain in place), by the time of Trump’s announcement, China accountedfor only 2 percent of U.S. steel imports. The largest steel exporters to the U.S. in 2017 were Canada, South Korea, Mexico, andBrazil.

The Trump administration argued that this round of steel tariffs would help revitalize the struggling U.S. steel industry. Criticscountered that the result would be higher prices for steel consumers and job losses in those industries. The early evidence is mixed.Domestic steel production in the U.S. increased by around 7 percent in the first year after the tariffs were imposed, while imports fellaround 10 percent. The prices of U.S. steel products increased by around 20 percent in 2018 and profits for U.S. steel producersimproved. Flush with cash, there have been several announcements regarding planned expansions in capacity from domestic steelproducers, including Nucor, Steel Dynamics Inc., and U.S. Steel Corp. These plans would add about 8.3 million tons of production tothe U.S. steel industry, increasing its capacity by 14 percent.

On the other hand, some steel consumers have pushed back, pointing out that higher steel prices are hurting their businesses.General Motors, a major steel consumer, announced in November 2018 that Trump’s tariffs on steel (and aluminum) would cost itover $1 billion a year. The company announced plans to shut several plants and eliminate 15,000 jobs (although higher steel priceswere not the only factor here). Similarly, the iconic American motorcycle manufacturer Harley Davidson announced that its 2018profits were wiped out by higher metal costs due to Trump’s tariffs. The company has announced plans to move some productionoverseas as a way of avoiding the high costs of metals in the United States and supporting foreign sales. Only time will tell if theannouncements from GM and Harley Davidson are indicative of the impact that higher steel prices will have on many Americanbusinesses. If these are the first salvo, Trump’s steel tariffs may ultimately be judged to be no more successful than those imposed byGeorge Bush in 2002. Analysis of the Bush tariffs suggested that the gains to steel producers were outweighed by the losses to U.S.steel consumers.Sources: Bob Tita and Alistair MacDonald, “Foreign Steel Keeps Flowing into the U.S. despite Tariffs,” The Wall Street Journal, December 5, 2018; International TradeAdministration, Steel Imports Report: United States, June 2018; Alistair MacDonald, “Tariffs Roil Global Steel Trade, Creating Winners and Losers,” The Wall Street Journal,November 29, 2018; Doug Mataconis, “After Trump’s Tariffs, American Steel Industry Faces Downturn,” Outside the Beltway, January 19, 2019; Ruth Simon, “A Tale of TwoSteel Firms and Their Diverging Paths Under Trump’s Tariffs,” The Wall Street Journal, February 10, 2019; “Tariffs on Steel and Aluminum are Creating Some Winners,” TheEconomist, August 9, 2018; G. C. Hufbauer and B. Goodrich, “Steel Policy: The Good, the Bad, and the Ugly,” Peterson Institute: International Economics Policy Briefs, January2003.

IntroductionThe review of the classical trade theories of Smith, Ricardo, and Heckscher–Ohlin in Chapter 6 showed that in a worldwithout trade barriers, trade patterns are determined by the relative productivity of different factors of production indifferent countries. Countries will specialize in products they can make most efficiently, while importing products theycan produce less efficiently. Chapter 6 also laid out the intellectual case for free trade. Remember, free trade refers to asituation in which a government does not attempt to restrict what its citizens can buy from or sell to another country. Aswe saw in Chapter 6, the theories of Smith, Ricardo, and Heckscher–Ohlin predict that the consequences of free tradeinclude both static economic gains (because free trade supports a higher level of domestic consumption and moreefficient utilization of resources) and dynamic economic gains (because free trade stimulates economic growth and thecreation of wealth).

This chapter looks at the political reality of international trade. Although many nations are nominally committed tofree trade, they tend to intervene in international trade to protect the interests of politically important groups or promotethe interests of key domestic producers. For example, there is a long history of the U.S. government intervening in thesteel industry, imposing import tariffs to protect domestic producers from market share losses due to the importation ofless expensive foreign steel. The last three U.S. presidents, Bush, Obama, and Trump, have all authorized tariffs onforeign steel imports. Motivations for doing so include national security concerns, a belief that certain foreign steelproducers were dumping production of steel on the U.S. market at below the costs of production, and a desire to boostU.S. steel production and steel-making jobs. In every case, however, these potential benefits must be weighed against theimpact of higher steel prices for U.S. consumers of steel, which include firms in the automobile, construction, machinery,and appliance industries. By raising input costs, steel tariffs may have reduced profitability, led to job losses, andreduced competitiveness among firms that consume steel products.

This chapter starts by describing the range of policy instruments that governments use to intervene in internationaltrade. A detailed review of governments’ various political and economic motives for intervention follows. In the thirdsection of this chapter, we consider how the case for free trade stands up in view of the various justifications given for

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government intervention in international trade. Then we look at the emergence of the modern international tradingsystem, which is based on the General Agreement on Tariffs and Trade (GATT) and its successor, the World TradeOrganization (WTO). The GATT and WTO are the creations of a series of multinational treaties. The final section of thischapter discusses the implications of this material for management practice.

Instruments of Trade Policy

LO7-1Identify the policy instruments used by governments to influence international trade flows.Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export restraints, local contentrequirements, administrative policies, and antidumping duties. Tariffs are the oldest and simplest instrument of tradepolicy. As we shall see later in this chapter, they are also the instrument that the GATT and WTO have been mostsuccessful in limiting. A fall in tariff barriers in recent decades has been accompanied by a rise in nontariff barriers, suchas subsidies, quotas, voluntary export restraints, and antidumping duties.

TARIFFSA tariff is a tax levied on imports (or exports). Tariffs fall into two categories. Specific tariffs are levied as a fixedcharge for each unit of a good imported (e.g., $3 per barrel of oil). Ad valorem tariffs are levied as a proportion of thevalue of the imported good. In most cases, tariffs are placed on imports to protect domestic producers from foreigncompetition by raising the price of imported goods. However, tariffs also produce revenue for the government. Until theincome tax was introduced, for example, the U.S. government received most of its revenues from tariffs.

Did You Know?

Did you know that one of the first arguments for protectionist trade policies was proposed by Alexander Hamilton in1792?Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation fromthe author.

Import tariffs are paid by the importer (and export tariffs by the exporter). Thus, the 25 percent advalorem tariff placed on imports of foreign steel by President Trump in 2017 are paid for not by foreign steel producers,but by the American importers. These import tariffs are in effect a tax on American consumers. The important thing tounderstand about an import tariff is who suffers and who gains. The government gains because the tariff increasesgovernment revenues. Domestic producers gain because the tariff affords them some protection against foreigncompetitors by increasing the cost of imported foreign goods. Consumers lose because they must pay more for certainimports. For example, as noted in the opening case, in 2002 the U.S. government placed an ad valorem tariff of 8 to 30percent on imports of foreign steel. The idea was to protect domestic steel producers from cheap imports of foreign steel.In this case, however, the effect was to raise the price of steel products in the United States between 30 and 50 percent. Anumber of U.S. steel consumers, ranging from appliance makers to automobile companies, objected that the steel tariffswould raise their costs of production and make it more difficult for them to compete in the global marketplace. Whetherthe gains to the government and domestic producers exceed the loss to consumers depends on various factors, such as theamount of the tariff, the importance of the imported good to domestic consumers, the number of jobs saved in theprotected industry, and so on. In the steel case, many argued that the losses to steel consumers apparently outweighed thegains to steel producers. In November 2003, the World Trade Organization declared that the tariffs represented aviolation of the WTO treaty, and the United States removed them in December of that year. Interestingly, this ruling didnot stop Donald Trump from imposing a 25 percent tariff on imports of foreign steel in March 2018. If the tariffs arechallenged, as seems likely, the WTO will in all probability reach a similar conclusion.

In general, two conclusions can be derived from economic analysis of the effect of import tariffs.1 First, tariffs aregenerally pro-producer and anticonsumer. While they protect producers from foreign competitors, this restriction ofsupply also raises domestic prices. For example, a study by Japanese economists calculated that tariffs on imports offoodstuffs, cosmetics, and chemicals into Japan cost the average Japanese consumer about $890 per year in the form ofhigher prices. Almost all studies find that import tariffs impose significant costs on domestic consumers in the form ofhigher prices. Second, import tariffs reduce the overall efficiency of the world economy. They reduce efficiency because

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a protective tariff encourages domestic firms to produce products at home that could be produced more efficientlyabroad. The consequence is an inefficient utilization of resources.2

Sometimes tariffs are levied on exports of a product from a country. Export tariffs are less common than importtariffs. In general, export tariffs have two objectives: first, to raise revenue for the government, and second, to reduceexports from a sector, often for political reasons. For example, in 2004 China imposed a tariff on textile exports. Theprimary objective was to moderate the growth in exports of textiles from China, thereby alleviating tensions with othertrading partners. China also had tariffs on steel exports but removed many of those in late 2015.

SUBSIDIESA subsidy is a government payment to a domestic producer. Subsidies take many forms, including cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By lowering production costs,subsidies help domestic producers in two ways: (1) competing against foreign imports and (2) gaining export markets.Agriculture tends to be one of the largest beneficiaries of subsidies in most countries. The European Union has beenpaying out about €44 billion annually ($55 billion) in farm subsidies. The farm bill that passed the U.S. Congress in 2018contained subsidies to producers of roughly $25 billion a year for the next 10 years. The Japanese also have a longhistory of supporting inefficient domestic producers with farm subsidies. According to the World Trade Organization, inmid-2000 countries spent some $300 billion on subsidies, $250 billion of which was spent by 21 developed nations.3 Inresponse to a severe sales slump following the global financial crisis, between mid-2008 and mid-2009, somedeveloped nations gave $45 billion in subsidies to their automobile makers. While the purpose of the subsidieswas to help them survive a very difficult economic climate, one of the consequences was to give subsidized companiesan unfair competitive advantage in the global auto industry. Somewhat ironically, given the government bailouts of U.S.auto companies during the global financial crisis, in 2012 the Obama administration filed a complaint with the WTOarguing that the Chinese were illegally subsidizing exports of autos and auto parts. Details are given in the accompanyingCountry Focus feature.

COUNTRY FOCUS

Are the Chinese Illegally Subsidizing Auto Exports?In late 2012, during that year’s presidential election campaign, the Obama administration filed a complaint against China with theWorld Trade Organization. The complaint claimed that China was providing export subsidies to its auto and auto parts industries.The subsidies included cash grants for exporting, grants for R&D, subsidies to pay interest on loans, and preferential tax treatment.

The United States estimated the value of the subsidies to be at least $1 billion between 2009 and 2011. The complaint alsopointed out that in the years 2002 through 2011, the value of China’s exports of autos and auto parts increased more than ninefoldfrom $7.4 billion to $69.1 billion. The United States was China’s largest market for exports of auto parts during this period. TheUnited States asserted that, to some degree, this growth may have been helped by subsidies. The complaint went on to claim thatthese subsidies hurt producers of automobiles and auto parts in the United States. This is a large industry in the United States,employing more than 800,000 people and generating some $350 billion in sales.

While some in the labor movement applauded the move, the response from U.S. auto companies and auto parts producers wasmuted. One reason for this is that many U.S. producers do business in China and, in all probability, want to avoid retaliation fromthe Chinese government. GM, for example, has a joint venture and two wholly owned subsidiaries in China and is doing very wellthere. In addition, some U.S. producers benefit by purchasing cheap Chinese auto parts, so any retaliatory tariffs imposed on thoseimports might actually raise their costs.

More cynical observers saw the move as nothing more than political theater. The week before the complaint was filed, theRepublican presidential candidate, Mitt Romney, had accused the Obama administration of “failing American workers” by notlabeling China a currency manipulator. So perhaps the complaint was in part simply another move on the presidential campaignchessboard.

In February 2014, the United States expanded its complaint with the WTO against China, arguing that the country had anillegal export subsidy program that includes not only auto parts, but also textiles, apparel and footwear, advanced materials andmetals, speciality chemicals, medical products and agriculture. In 2016, after pressure from the WTO and U.S., China agreed toeliminate a wide range of subsidies for its exporters. Michael Froman, the U.S. Trade Representative, announced the deal, callingit “a win for Americans employed in seven diverse sectors that run the gamut from agriculture to textiles.”Sources: James Healey, “U.S. Alleges Unfair China Auto Subsidies in WTO Action,” USA Today, September 17, 2012; M. A. Memoli, “Obama to Tell WTO That ChinaIllegally Subsidizes Auto Imports,” Los Angeles Times, September 17, 2012; Vicki Needham, “US Launches Trade Case against China’s Export Subsidy Program,” The Hill,February 11, 2014; and David J. Lynch, “China Eliminates Subsidies for Its Exporters,” Financial Times, April 14, 2016.

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The main gains from subsidies accrue to domestic producers, whose international competitiveness is increased as aresult. Advocates of strategic trade policy (which, as you will recall from Chapter 6, is an outgrowth of the new tradetheory) favor subsidies to help domestic firms achieve a dominant position in those industries in which economies ofscale are important and the world market is not large enough to profitably support more than a few firms (aerospace andsemiconductors are two such industries). According to this argument, subsidies can help a firm achieve a first-moveradvantage in an emerging industry. If this is achieved, further gains to the domestic economy arise from the employmentand tax revenues that a major global company can generate. However, government subsidies must be paid for, typicallyby taxing individuals and corporations.

Whether subsidies generate national benefits that exceed their national costs is debatable. In practice,many subsidies are not that successful at increasing the international competitiveness of domestic producers. Rather, theytend to protect the inefficient and promote excess production. One study estimated that if advanced countries abandonedsubsidies to farmers, global trade in agricultural products would be 50 percent higher and the world as a whole would bebetter off by $160 billion.4 Another study estimated that removing all barriers to trade in agriculture (both subsidies andtariffs) would raise world income by $182 billion.5 This increase in wealth arises from the more efficient use ofagricultural land.

IMPORT QUOTAS AND VOLUNTARY EXPORT RESTRAINTSAn import quota is a direct restriction on the quantity of some good that may be imported into a country. The restrictionis usually enforced by issuing import licenses to a group of individuals or firms. For example, the United States has aquota on cheese imports. The only firms allowed to import cheese are certain trading companies, each of which isallocated the right to import a maximum number of pounds of cheese each year. In some cases, the right to sell is givendirectly to the governments of exporting countries.

A common hybrid of a quota and a tariff is known as a tariff rate quota. Under a tariff rate quota, a lower tariffrate is applied to imports within the quota than those over the quota. For example, as illustrated in Figure 7.1, an advalorem tariff rate of 10 percent might be levied on 1 million tons of rice imports into South Korea, after which an out-of-quota rate of 80 percent might be applied. Thus, South Korea might import 2 million tons of rice, 1 million at a 10percent tariff rate and another 1 million at an 80 percent tariff. Tariff rate quotas are common in agriculture, where theirgoal is to limit imports over quota.

FIGURE 7.1 Hypothetical tariff rate quota.

A variant on the import quota is the voluntary export restraint. A voluntary export restraint (VER) is a quota ontrade imposed by the exporting country, typically at the request of the importing country’s government. For example, in2012 Brazil imposed what amounts to voluntary export restraints on shipments of vehicles from Mexico to Brazil. Thetwo countries have a decade-old free trade agreement, but a surge in vehicles heading to Brazil from Mexico prompted

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Brazil to raise its protectionist walls. Mexico agreed to quotas on Brazil-bound vehicle exports for three years.6 Foreignproducers agree to VERs because they fear more damaging punitive tariffs or import quotas might follow if they do not.Agreeing to a VER is seen as a way to make the best of a bad situation by appeasing protectionist pressures in a country.

As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting importcompetition. As with all restrictions on trade, quotas do not benefit consumers. An import quota or VERalways raises the domestic price of an imported good. When imports are limited to a low percentage of the market by aquota or VER, the price is bid up for that limited foreign supply. The extra profit that producers make when supply isartificially limited by an import quota is referred to as a quota rent.

If a domestic industry lacks the capacity to meet demand, an import quota can raise prices for both the domesticallyproduced and the imported good. This happened in the U.S. sugar industry, in which a tariff rate quota system has longlimited the amount foreign producers can sell in the U.S. market. According to one study, import quotas have caused theprice of sugar in the United States to be as much as 40 percent greater than the world price.7 These higher prices havetranslated into greater profits for U.S. sugar producers, which have lobbied politicians to keep the lucrative agreement.They argue U.S. jobs in the sugar industry will be lost to foreign producers if the quota system is scrapped.

EXPORT TARIFFS AND BANSAn export tariff is a tax placed on the export of a good. The goal behind an export tariff is to discriminate againstexporting in order to ensure that there is sufficient supply of a good within a country. For example, in the past, China hasplaced an export tariff on the export of grain to ensure that there is sufficient supply in China. Similarly, during itsinfrastructure building boom, China had an export tariff in place on certain kinds of steel products to ensure that therewas sufficient supply of steel within the country. The steel tariffs were removed in late 2015. Because most countries tryto encourage exports, export tariffs are relatively rare.

An export ban is a policy that partially or entirely restricts the export of a good. One well-known example was theban on exports of U.S. crude oil production that was enacted by Congress in 1975. At the time, Organization of thePetroleum Exporting Countries (OPEC) was restricting the supply of oil in order to drive up prices and punish Westernnations for their support of Israel during conflicts between Arab nations and Israel. The export ban in the United Stateswas seen as a way of ensuring a sufficient supply of domestic oil at home, thereby helping to keep the domestic pricedown and boosting national security. The ban was lifted in 2015 after lobbying from American oil producers, whobelieved that they could get higher prices for some of their output if they were allowed to sell on world markets.

LOCAL CONTENT REQUIREMENTSA local content requirement (LCR) is a requirement that some specific fraction of a good be produced domestically.The requirement can be expressed either in physical terms (e.g., 75 percent of component parts for this product must beproduced locally) or in value terms (e.g., 75 percent of the value of this product must be produced locally). Local contentregulations have been widely used by developing countries to shift their manufacturing base from the simple assembly ofproducts whose parts are manufactured elsewhere into the local manufacture of component parts. They have also beenused in developed countries to try to protect local jobs and industry from foreign competition. For example, a little-known law in the United States, the Buy America Act, specifies that government agencies must give preference toAmerican products when putting contracts for equipment out to bid unless the foreign products have a significant priceadvantage. The law specifies a product as “American” if 51 percent of the materials by value are produced domestically.This amounts to a local content requirement. If a foreign company, or an American one for that matter, wishes to win acontract from a U.S. government agency to provide some equipment, it must ensure that at least 51 percent of theproduct by value is manufactured in the United States.

Local content regulations provide protection for a domestic producer of parts in the same way an import quotadoes: by limiting foreign competition. The aggregate economic effects are also the same; domestic producersbenefit, but the restrictions on imports raise the prices of imported components. In turn, higher prices forimported components are passed on to consumers of the final product in the form of higher final prices. So as with alltrade policies, local content regulations tend to benefit producers and not consumers.

ADMINISTRATIVE POLICIESIn addition to the formal instruments of trade policy, governments of all types sometimes use informal or administrativepolicies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make itdifficult for imports to enter a country. It has been argued that the Japanese are the masters of this trade barrier. In recentdecades, Japan’s formal tariff and nontariff barriers have been among the lowest in the world. However, critics chargethat the country’s informal administrative barriers to imports more than compensate for this. For example, Japan’s carmarket has been hard for foreigners to crack. In 2016, only 6 percent of the 4.9 million cars sold in Japan were foreign,and only 1 percent were U.S. cars. American car makers have argued for decades that Japan makes it difficult to compete

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by setting up regulatory hurdles, such as vehicle parts standards, that don’t exist anywhere else in the world. Ironically,the Trans Pacific Partnership (TPP) addressed this issue. America would have reduced tariffs on imports of Japaneselight trucks in return for Japan adopting U.S. standards on auto parts, which would have made it easier to import and sellAmerican cars in Japan. However, President Donald Trump pulled America out of the TPP in January 2017.8

ANTIDUMPING POLICIESIn the context of international trade, dumping is variously defined as selling goods in a foreign market at below theircosts of production or as selling goods in a foreign market at below their “fair” market value. There is a differencebetween these two definitions; the fair market value of a good is normally judged to be greater than the costs ofproducing that good because the former includes a “fair” profit margin. Dumping is viewed as a method by which firmsunload excess production in foreign markets. Some dumping may be the result of predatory behavior, with producersusing substantial profits from their home markets to subsidize prices in a foreign market with a view to drivingindigenous competitors out of that market. Once this has been achieved, so the argument goes, the predatory firm canraise prices and earn substantial profits.

Antidumping policies are designed to punish foreign firms that engage in dumping. The ultimate objective is toprotect domestic producers from unfair foreign competition. Although antidumping policies vary from country tocountry, the majority are similar to those used in the United States. If a domestic producer believes that a foreign firm isdumping production in the U.S. market, it can file a petition with two government agencies, the Commerce Departmentand the International Trade Commission (ITC). If a complaint has merit, the Commerce Department may impose anantidumping duty on the offending foreign imports (antidumping duties are often called countervailing duties). Theseduties, which represent a special tariff, can be fairly substantial and stay in place for up to five years. The accompanyingManagement Focus discusses how a firm, U.S. Magnesium, used antidumping legislation to gain protection from unfairforeign competitors.

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The Case for Government Intervention

LO7-2Understand why governments sometimes intervene in international trade.Now that we have reviewed the various instruments of trade policy that governments can use, it is time to lookat the case for government intervention in international trade. Arguments for government intervention take two paths:political and economic. Political arguments for intervention are concerned with protecting the interests of certain groupswithin a nation (normally producers), often at the expense of other groups (normally consumers), or with achieving somepolitical objective that lies outside the sphere of economic relationships, such as protecting the environment or humanrights. Economic arguments for intervention are typically concerned with boosting the overall wealth of a nation (to thebenefit of all, both producers and consumers).

MANAGEMENT FOCUS

Protecting U.S. MagnesiumIn February 2004, U.S. Magnesium, the sole surviving U.S. producer of magnesium, a metal that is primarily used in themanufacture of certain automobile parts and aluminum cans, filed a petition with the U.S. International Trade Commission (ITC)contending that a surge in imports had caused material damage to the U.S. industry’s employment, sales, market share, and

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profitability. According to U.S. Magnesium, Russian and Chinese producers had been selling the metal at prices significantlybelow market value. During 2002 and 2003, imports of magnesium into the United States rose 70 percent, while prices fell by 40percent, and the market share accounted for by imports jumped to 50 percent from 25 percent.

“The United States used to be the largest producer of magnesium in the world,” a U.S. Magnesium spokesperson said at thetime of the filing. “What’s really sad is that you can be state of the art and have modern technology, and if the Chinese, who paypeople less than 90 cents an hour, want to run you out of business, they can do it. And that’s why we are seeking relief.”*

During a yearlong investigation, the ITC solicited input from various sides in the dispute. Foreign producers and consumers ofmagnesium in the United States argued that falling prices for magnesium during 2002 and 2003 simply reflected an imbalancebetween supply and demand due to additional capacity coming on stream not from Russia or China but from a new Canadian plantthat opened in 2001 and from a planned Australian plant. The Canadian plant shut down in 2003, the Australian plant never cameon stream, and prices for magnesium rose again in 2004.

Magnesium consumers in the United States also argued to the ITC that imposing antidumping duties on foreign imports ofmagnesium would raise prices in the United States significantly above world levels. A spokesperson for Alcoa, which mixesmagnesium with aluminum to make alloys for cans, predicted that if antidumping duties were imposed, high magnesium prices inthe United States would force Alcoa to move some production out of the United States. Alcoa also noted that in 2003, U.S.Magnesium was unable to supply all of Alcoa’s needs, forcing the company to turn to imports. Consumers of magnesium in theautomobile industry asserted that high prices in the United States would drive engineers to design magnesium out of automobilesor force manufacturing elsewhere, which would ultimately hurt everyone.

The six members of the ITC were not convinced by these arguments. In March 2005, the ITC ruled that both China and Russiahad been dumping magnesium in the United States. The government decided to impose duties ranging from 50 percent to morethan 140 percent on imports of magnesium from China. Russian producers faced duties ranging from 19 percent to 22 percent. Theduties were to be levied for five years, after which the ITC would revisit the situation. The ITC revoked the antidumping order onRussia in February 2011 but decided to continue placing the duties on Chinese producers. They were finally removed by the ITCin 2014.

According to U.S. Magnesium, the initial favorable ruling allowed the company to reap the benefits of nearly $50 million ininvestments made in its manufacturing plant and enabled the company to boost its capacity by 28 percent by the end of 2005.Commenting on the favorable ruling, a U.S. Magnesium spokesperson noted, “Once unfair trade is removed from the marketplacewe’ll be able to compete with anyone.”

U.S. Magnesium’s customers and competitors, however, did not view the situation as one of unfair trade. While the impositionof antidumping duties no doubt helped to protect U.S. Magnesium and the 400 people it employed from foreign competition,magnesium consumers in the United States felt they were the ultimate losers, a view that seemed to be confirmed by price data. Inearly 2010, the price for magnesium alloy in the United States was $2.30 per pound, compared to $1.54 in Mexico, $1.49 inEurope, and $1.36 in China.*Dave Anderton, “U.S. Magnesium Lands Ruling on Unfair Imports,” Deseret News, October 1, 2004, https://www.deseretnews.com/article/595095137/US-Magnesium-lauds-ruling-on-unfair-imports.html.

Sources: Dave Anderton, “U.S. Magnesium Lands Ruling on Unfair Imports,” Deseret News, October 1, 2004, p. D10; “U.S. Magnesium and Its Largest Consumers Debatebefore U.S. ITC,” Platt’s Metals Week, February 28, 2005, p. 2; S. Oberbeck, “U.S. Magnesium Plans Big Utah Production Expansion,” Salt Lake Tribune, March 30, 2005;“US to Keep Anti-dumping Duty on China Pure Magnesium,” Chinadaily.com, September 13, 2012; Lance Duronl, “No Duties for Chinese Magnesium Exporter, CITAffirms,” Law360, June 2, 2015; and Dan Ikenson, “Death by Antidumping,” Forbes, January 3, 2011.

POLITICAL ARGUMENTS FOR INTERVENTIONPolitical arguments for government intervention cover a range of issues, including preserving jobs, protecting industriesdeemed important for national security, retaliating against unfair foreign competition, protecting consumers from“dangerous” products, furthering the goals of foreign policy, and advancing the human rights of individuals in exportingcountries.

Protecting Jobs and IndustriesPerhaps the most common political argument for government intervention is that it is necessary for protecting jobs andindustries from unfair foreign competition. Competition is most often viewed as unfair when producers in an exportingcountry are subsidized in some way by their government. For example, it has been repeatedly claimed that Chineseenterprises in several industries, including aluminum, steel, and auto parts, have benefited from extensive governmentsubsidies. Such logic was behind the complaint that the Obama administration filed with the WTO against Chinese autoparts producers in 2012 (see the Country Focus “Are the Chinese Illegally Subsidizing Auto Exports?” in this chapter).More generally, Robert Scott of the Economic Policy Institute has claimed that the growth in the U.S.–China trade deficitbetween 2001 and 2015 was, to a significant degree, the result of unfair competition, including direct subsidies toChinese producers and currency manipulations. Scott estimated that as many as 3.4 million U.S. jobs were lost as aconsequence.9 Donald Trump tapped into anxiety about job losses due to unfair trade from China during his successful2016 presidential run.

On the other hand, critics charge that claims of unfair competition are often overstated for political reasons. Forexample, as noted in the opening case, President George W. Bush placed tariffs on imports of foreign steel in 2002 as aresponse to “unfair competition,” but critics were quick to point out that many of the U.S. steel producers that benefitedfrom these tariffs were located in states that Bush needed to win reelection in 2004. A political motive also underlay

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establishment of the Common Agricultural Policy (CAP) by the European Union. The CAP was designed to protect thejobs of Europe’s politically powerful farmers by restricting imports and guaranteeing prices. However, the higher pricesthat resulted from the CAP have cost Europe’s consumers dearly. This is true of many attempts to protect jobs andindustries through government intervention. For example, the imposition of steel tariffs in 2002 raised steel prices forAmerican consumers, such as automobile companies, making them less competitive in the global marketplace.

Protecting National SecurityCountries sometimes argue that it is necessary to protect certain industries because they are important for nationalsecurity. Defense-related industries often get this kind of attention (e.g., aerospace, advanced electronics, andsemiconductors). Although now uncommon, this argument is still made sometimes. When the Trump administrationannounced tariffs on imports of foreign steel and aluminum on March 1, 2018, national security issues were cited as aprimary justification. This was the first time since 1986 that a national security threat was used to justify tariffs imposedby the United States. In 2017, the United States was importing about 30 percent of steel used in the country, with thelargest source of imports being Canada and Mexico. Interestingly, and counter to the argument of the Trumpadministration, critics argued that by raising input prices for many U.S. defense contractors, who tend to be bigconsumers of steel and aluminum, the tariffs would actually harm the U.S. defense industry and have a negative impacton national security.10

global EDGE TRADE LAW

Government policy and international trade is the core focus of this chapter. This topic area has far-ranging implications, such as tradepolicy, free trade, and the world’s international trading system. Basically, we are talking about a lot of legalistic aspects starting at thegovernment level and moving all the way to what organizations and even individuals can and cannot do globally when trading. TheglobalEDGE™ section “Trade Law” (globaledge.msu.edu/global-resources/trade-law) is a unique compilation of globalEDGE™partner -designed “compendiums of trade laws,” country- and region-specific trade law, free online learning modules created for globalEDGE™on various aspects of trade law, and much more. One fascinating resource related to trade law is the Anti-Counterfeiting and ProductProtection Program (A-CAPPP). A-CAPPP includes counterfeiting-related webinars, presentations, and research-related materials andworking papers. Do you know what counterfeiting is? Take a look at the “Trade Law” section of globalEDGE™ and especially the A-CAPPP site to become more familiar with the topic. (Is China really as bad as many in the international community think?)

RetaliatingSome argue that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreignmarkets and force trading partners to “play by the rules of the game.” The U.S. government has used the threat ofpunitive trade sanctions to try to get the Chinese government to enforce its intellectual property laws. Lax enforcement ofthese laws had given rise to massive copyright infringements in China that had been costing U.S. companies such asMicrosoft hundreds of millions of dollars per year in lost sales revenues. After the United States threatened to impose100 percent tariffs on a range of Chinese imports and after harsh words between officials from the two countries, theChinese agreed to tighter enforcement of intellectual property regulations.11

If it works, such a politically motivated rationale for government intervention may liberalize trade and bring with itresulting economic gains. It is a risky strategy, however. A country that is being pressured may not back down andinstead may respond to the imposition of punitive tariffs by raising trade barriers of its own. This is exactly what theChinese government threatened to do when pressured by the United States, although it ultimately did back down. If agovernment does not back down, the results could be higher trade barriers all around and an economic loss to allinvolved.

Protecting ConsumersMany governments have long had regulations to protect consumers from unsafe products. The indirect effect of suchregulations often is to limit or ban the importation of such products. For example, in 2003 several countries, includingJapan and South Korea, decided to ban imports of American beef after a single case of mad cow disease was found inWashington State. The ban was designed to protect consumers from what was seen to be an unsafe product. Together,Japan and South Korea accounted for about $2 billion of U.S. beef sales, so the ban had a significant impact on U.S. beefproducers. After two years, both countries lifted the ban, although they placed stringent requirements on U.S. beefimports to reduce the risk of importing beef that might be tainted by mad cow disease (e.g., Japan required that all beefmust come from cattle under 21 months of age).

Furthering Foreign Policy Objectives

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Governments sometimes use trade policy to support their foreign policy objectives.12 A government may grantpreferential trade terms to a country with which it wants to build strong relations. Trade policy has also been used severaltimes to pressure or punish “rogue states” that do not abide by international law or norms. Iraq labored underextensive trade sanctions after the UN coalition defeated the country in the 1991 Gulf War until the 2003invasion of Iraq by U.S.-led forces. The theory is that such pressure might persuade the rogue state to mend its ways, orit might hasten a change of government. In the case of Iraq, the sanctions were seen as a way of forcing that country tocomply with several UN resolutions. The United States has maintained long-running trade sanctions against Cuba(despite the move by the Obama administration to “normalize” relations with Cuba, these sanctions are still in place).Their principal function is to impoverish Cuba in the hope that the resulting economic hardship will lead to the downfallof Cuba’s communist government and its replacement with a more democratically inclined (and pro-U.S.) regime. TheUnited States has also had trade sanctions in place against Libya and Iran, both of which were accused of supportingterrorist action against U.S. interests and building weapons of mass destruction. In late 2003, the sanctions against Libyaseemed to yield some returns when that country announced it would terminate a program to build nuclear weapons. TheU.S. government responded by relaxing those sanctions. Similarly, the U.S. government used trade sanctions to pressurethe Iranian government to halt its alleged nuclear weapons program. Following a 2015 agreement to limit Iran’s nuclearprogram, it relaxed some of those sanctions. However, the Trump administration has since reimposed significantsanctions, arguing that Iran was not adhering to the 2015 agreement.

Other countries can undermine unilateral trade sanctions. The U.S. sanctions against Cuba, for example, did notstop other Western countries from trading with Cuba. The U.S. sanctions have done little more than help create a vacuuminto which other trading nations, such as Canada and Germany, have stepped.

Protecting Human RightsProtecting and promoting human rights in other countries is an important element of foreign policy for manydemocracies. Governments sometimes use trade policy to try to improve the human rights policies of trading partners.For example, as discussed in Chapter 5, the U.S. government long had trade sanctions in place against the nation ofMyanmar, in no small part due to the poor human rights practices in that nation. In late 2012, the United States said thatit would ease trade sanctions against Myanmar in response to democratic reforms in that country. Similarly, in the 1980sand 1990s, Western governments used trade sanctions against South Africa as a way of pressuring that nation to drop itsapartheid policies, which were seen as a violation of basic human rights.

ECONOMIC ARGUMENTS FOR INTERVENTIONWith the development of the new trade theory and strategic trade policy (see Chapter 6), the economic arguments forgovernment intervention have undergone a renaissance in recent years. Until the early 1980s, most economists saw littlebenefit in government intervention and strongly advocated a free trade policy. This position has changed at the marginswith the development of strategic trade policy, although as we will see in the next section, there are still strong economicarguments for sticking to a free trade stance.

The Infant Industry ArgumentThe infant industry argument is by far the oldest economic argument for government intervention. AlexanderHamilton proposed it in 1792. According to this argument, many developing countries have a potential comparativeadvantage in manufacturing, but new manufacturing industries cannot initially compete with established industries indeveloped countries. To allow manufacturing to get a toehold, the argument is that governments should temporarilysupport new industries (with tariffs, import quotas, and subsidies) until they have grown strong enough to meetinternational competition.

This argument has had substantial appeal for the governments of developing nations during the past 50 years, andthe GATT has recognized the infant industry argument as a legitimate reason for protectionism. Nevertheless,many economists remain critical of this argument for two main reasons. First, protection of manufacturingfrom foreign competition does no good unless the protection helps make the industry efficient. In case after case,however, protection seems to have done little more than foster the development of inefficient industries that have littlehope of ever competing in the world market. Brazil, for example, built the world’s 10th-largest auto industry behindtariff barriers and quotas. Once those barriers were removed in the late 1980s, however, foreign imports soared, and theindustry was forced to face up to the fact that after 30 years of protection, the Brazilian auto industry was one of theworld’s most inefficient.13

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The famous cigar maker Jose Castelar Cairo, better known as El Cueto, about to roll a cigar, in Havana,Cuba.Esben Hansen/123RF

Second, the infant industry argument relies on an assumption that firms are unable to make efficient long-terminvestments by borrowing money from the domestic or international capital market. Consequently, governments havebeen required to subsidize long-term investments. Given the development of global capital markets over the past 20years, this assumption no longer looks as valid as it once did. Today, if a developing country has a potential comparativeadvantage in a manufacturing industry, firms in that country should be able to borrow money from the capital markets tofinance the required investments. Given financial support, firms based in countries with a potential comparativeadvantage have an incentive to endure the necessary initial losses in order to make long-run gains without requiringgovernment protection. Many Taiwanese and South Korean firms did this in industries such as textiles, semiconductors,machine tools, steel, and shipping. Thus, given efficient global capital markets, the only industries that would requiregovernment protection would be those that are not worthwhile.

Strategic Trade Policy

Some new trade theorists have proposed the strategic trade policy argument.14 We reviewed the basic argument inChapter 6 when we considered the new trade theory. The new trade theory argues that in industries in which theexistence of substantial economies of scale implies that the world market will profitably support only a few firms,countries may predominate in the export of certain products simply because they have firms that were able tocapture first-mover advantages. The long-term dominance of Boeing in the commercial aircraft industry hasbeen attributed to such factors.

The strategic trade policy argument has two components. First, it is argued that by appropriate actions, agovernment can help raise national income if it can somehow ensure that the firm or firms that gain first-moveradvantages in an industry are domestic rather than foreign enterprises. Thus, according to the strategic trade policyargument, a government should use subsidies to support promising firms that are active in newly emerging industries.Advocates of this argument point out that the substantial R&D grants that the U.S. government gave Boeing in the 1950sand 1960s probably helped tilt the field of competition in the newly emerging market for passenger jets in Boeing’sfavor. (Boeing’s first commercial jet airliner, the 707, was derived from a military plane.) Similar arguments have beenmade with regard to Japan’s rise to dominance in the production of liquid crystal display screens (used in computers).Although these screens were invented in the United States, the Japanese government, in cooperation with majorelectronics companies, targeted this industry for research support in the late 1970s and early 1980s. The result was thatJapanese firms, not U.S. firms, subsequently captured first-mover advantages in this market.

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The second component of the strategic trade policy argument is that it might pay a government to intervene in anindustry by helping domestic firms overcome the barriers to entry created by foreign firms that have already reaped first-mover advantages. This argument underlies government support of Airbus, Boeing’s major competitor (see the openingcase). Formed in 1966 as a consortium of four companies from Great Britain, France, Germany, and Spain, Airbus hadless than 5 percent of the world commercial aircraft market when it began production in the mid-1970s. By 2017, it wassplitting the market with Boeing. How did Airbus achieve this? According to the U.S. government, the answer is an $18billion subsidy from the governments of Great Britain, France, Germany, and Spain.15 Without this subsidy, Airbuswould never have been able to break into the world market.

If these arguments are correct, they support a rationale for government intervention in international trade.Governments should target technologies that may be important in the future and use subsidies to support developmentwork aimed at commercializing those technologies. Furthermore, government should provide export subsidies until thedomestic firms have established first-mover advantages in the world market. Government support may also be justified ifit can help domestic firms overcome the first-mover advantages enjoyed by foreign competitors and emerge as viablecompet it ors i n t he world mar ket ( a s in the Airb us and s emiconduct or examples ). I n t hi s case, a combi nat i on of home–market protection and export-promoting subsidies may be needed.

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The Revised Case for Free Trade

LO7-3Summarize and explain the arguments against strategic trade policy.The strategic trade policy arguments of the new trade theorists suggest an economic justification for governmentintervention in international trade. This justification challenges the rationale for unrestricted free trade found in the workof classic trade theorists such as Adam Smith and David Ricardo. In response to this challenge to economic orthodoxy, anumber of economists—including some of those responsible for the development of the new trade theory, such as PaulKrugman—point out that although strategic trade policy looks appealing in theory, in practice it may be unworkable.This response to the strategic trade policy argument constitutes the revised case for free trade.16

RETALIATION AND TRADE WARKrugman argues that a strategic trade policy aimed at establishing domestic firms in a dominant position in a globalindustry is a beggar-thy-neighbor policy that boosts national income at the expense of other countries. A country thatattempts to use such policies will probably provoke retaliation. In many cases, the resulting trade war between two ormore interventionist governments will leave all countries involved worse off than if a hands-off approach hadbeen adopted in the first place. If the U.S. government were to respond to the Airbus subsidy by increasing itsown subsidies to Boeing, for example, the result might be that the subsidies would cancel each other out. In the process,both European and U.S. taxpayers would end up supporting an expensive and pointless trade war, and both Europe andthe United States would be worse off.

Krugman may be right about the danger of a strategic trade policy leading to a trade war. The problem, however, ishow to respond when one’s competitors are already being supported by government subsidies; that is, how shouldBoeing and the United States respond to the subsidization of Airbus? According to Krugman, the answer is probably notto engage in retaliatory action but to help establish rules of the game that minimize the use of trade-distorting subsidies.This is what the World Trade Organization seeks to do. It should also be noted that antidumping policies can be used totarget competitors supported by subsidies who are selling goods at prices that are below their costs of production.

DOMESTIC POLICIESGovernments do not always act in the national interest when they intervene in the economy; politically important interestgroups often influence them. The European Union’s support for the Common Agricultural Policy (CAP), which arosebecause of the political power of French and German farmers, is an example. The CAP benefits inefficient farmers and

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the politicians who rely on the farm vote but not consumers in the EU, who end up paying more for their foodstuffs.Thus, a further reason for not embracing strategic trade policy, according to Krugman, is that such a policy is almostcertain to be captured by special-interest groups within the economy, which will distort it to their own ends. Krugmanconcludes that in the United States,

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To ask the Commerce Department to ignore special-interest politics while formulating detailed policy for many industries is notrealistic; to establish a blanket policy of free trade, with exceptions granted only under extreme pressure, may not be the optimalpolicy according to the theory but may be the best policy that the country is likely to get.17

Development of the World Trading System

LO7-4Describe the development of the world trading system and the current trade issue.Economic arguments support unrestricted free trade. While many governments have recognized the value of thesearguments, they have been unwilling to unilaterally lower their trade barriers for fear that other nations might not followsuit. Consider the problem that two neighboring countries, say, Brazil and Argentina, face when deciding whether tolower trade barriers between them. In principle, the government of Brazil might favor lowering trade barriers, but itmight be unwilling to do so for fear that Argentina will not do the same. Instead, the government might fear that theArgentineans will take advantage of Brazil’s low barriers to enter the Brazilian market while continuing to shut Brazilianproducts out of their market through high trade barriers. The Argentinean government might believe that it faces thesame dilemma. The essence of the problem is a lack of trust. Both governments recognize that their respective nationswill benefit from lower trade barriers between them, but neither government is willing to lower barriers for fear that theother might not follow.18

Such a deadlock can be resolved if both countries negotiate a set of rules to govern cross-border trade and lowertrade barriers. But who is to monitor the governments to make sure they are playing by the trade rules? And who is toimpose sanctions on a government that cheats? Both governments could set up an independent body to act as a referee.This referee could monitor trade between the countries, make sure that no side cheats, and impose sanctions on a countryif it does cheat in the trade game.

While it might sound unlikely that any government would compromise its national sovereignty by submitting tosuch an arrangement, since World War II an international trading framework has evolved that has exactly thesefeatures. For its first 50 years, this framework was known as the General Agreement on Tariffs and Trade(GATT). Since 1995, it has been known as the World Trade Organization (WTO). Here, we look at the evolution andworkings of the GATT and WTO.

FROM SMITH TO THE GREAT DEPRESSIONAs noted in Chapter 5, the theoretical case for free trade dates to the late eighteenth century and the work of Adam Smithand David Ricardo. Free trade as a government policy was first officially embraced by Great Britain in 1846, when theBritish Parliament repealed the Corn Laws. The Corn Laws placed a high tariff on imports of foreign corn. Theobjectives of the Corn Laws tariff were to raise government revenues and to protect British corn producers. There hadbeen annual motions in Parliament in favor of free trade since the 1820s, when David Ricardo was a member. However,agricultural protection was withdrawn only as a result of a protracted debate when the effects of a harvest failure in GreatBritain were compounded by the imminent threat of famine in Ireland. Faced with considerable hardship and sufferingamong the populace, Parliament narrowly reversed its long-held position.

During the next 80 years or so, Great Britain, as one of the world’s dominant trading powers, pushed the case fortrade liberalization, but the British government was a voice in the wilderness. Its major trading partners did notreciprocate the British policy of unilateral free trade. The only reason Britain kept this policy for so long was that as theworld’s largest exporting nation, it had far more to lose from a trade war than did any other country.

By the 1930s, the British attempt to stimulate free trade was buried under the economic rubble of the GreatDepression. Economic problems were compounded in 1930, when the U.S. Congress passed the Smoot–Hawley tariff.Aimed at avoiding rising unemployment by protecting domestic industries and diverting consumer demand away from

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foreign products, the Smoot–Hawley Act erected an enormous wall of tariff barriers. Almost every industry wasrewarded with its “made-to-order” tariff. The Smoot–Hawley Act had a damaging effect on employment abroad. Othercountries reacted by raising their own tariff barriers. U.S. exports tumbled in response, and the world slid further into theGreat Depression.19

1947–1979: GATT, TRADE LIBERALIZATION, AND ECONOMIC GROWTHEc o n o mi c dam a g e ca u s e d b y t h e be g g ar – thy – n ei g h b o r t ra d e p o l ici es that t h e Smoot –Hawl ey Act usher ed in exert ed aprofound influence on the economic institutions and ideology of the post–World War II world. The United Statesemerged from the war both victorious and economically dominant. After the debacle of the Great Depression, opinion inthe U.S. Congress had swung strongly in favor of free trade. Under U.S. leadership, the GATT was established in 1947.

The GATT was a multilateral agreement whose objective was to liberalize trade by eliminating tariffs, subsidies,import quotas, and the like. From its foundation in 1947 until it was superseded by the WTO, the GATT’s membershipgrew from 19 to more than 120 nations. The GATT did not attempt to liberalize trade restrictions in one fell swoop; thatwould have been impossible. Rather, tariff reduction was spread over eight rounds.

In its early years, the GATT was by most measures very successful. For example, the average tariff declined bynearly 92 percent in the United States between the Geneva Round of 1947 and the Tokyo Round of 1973–1979.Consistent with the theoretical arguments first advanced by Ricardo and reviewed in Chapter 5, the move toward freetrade under the GATT appeared to stimulate economic growth.

1980–1993: PROTECTIONIST TRENDSDuring the 1980s and early 1990s, the trading system erected by the GATT came under strain as pressures for greaterprotectionism increased around the world. There were three reasons for the rise in such pressures during the 1980s. First,the economic success of Japan during that time strained the world trading system (much as the success of China hascreated strains today). Japan was in ruins when the GATT was created. By the early 1980s, however, it hadbecome the world’s second-largest economy and its largest exporter. Japan’s success in such industries asautomobiles and semiconductors might have been enough to strain the world trading system. Things were made worse bythe widespread perception in the West that despite low tariff rates and subsidies, Japanese markets were closed toimports and foreign investment by administrative trade barriers.

Second, the world trading system was strained by the persistent trade deficit in the world’s largest economy, theUnited States. The consequences of the U.S. deficit included painful adjustments in industries such as automobiles,machine tools, semiconductors, steel, and textiles, where domestic producers steadily lost market share to foreigncompetitors. The resulting unemployment gave rise to renewed demands in the U.S. Congress for protection againstimports.

A third reason for the trend toward greater protectionism was that many countries found ways to get around GATTregulations. Bilateral voluntary export restraints (VERs) circumvented GATT agreements, because neither the importingcountry nor the exporting country complained to the GATT bureaucracy in Geneva—and without a complaint, theGATT bureaucracy could do nothing. Exporting countries agreed to VERs to avoid more damaging punitive tariffs. Oneof the best-known examples was the automobile VER between Japan and the United States, under which Japaneseproducers promised to limit their auto imports into the United States as a way of defusing growing trade tensions.According to a World Bank study, 16 percent of the imports of industrialized countries in 1986 were subjected tonontariff trade barriers such as VERs.20

THE URUGUAY ROUND AND THE WORLD TRADE ORGANIZATIONAgainst the background of rising pressures for protectionism, in 1986, GATT members embarked on their eighth roundof negotiations to reduce tariffs, the Uruguay Round (so named because it occurred in Uruguay). This was the mostambitious round of negotiations yet. Until then, GATT rules had applied only to trade in manufactured goods andcommodities. In the Uruguay Round, member countries sought to extend GATT rules to cover trade in services. Theyalso sought to write rules governing the protection of intellectual property, to reduce agricultural subsidies, and tostrengthen the GATT’s monitoring and enforcement mechanisms.

The Uruguay Round dragged on for seven years before an agreement was reached on December 15, 1993. It wentinto effect July 1, 1995. The Uruguay Round contained the following provisions:

Tariffs on industrial goods were to be reduced by more than one-third, and tariffs were to be scrapped on morethan 40 percent of manufactured goods.Average tariff rates imposed by developed nations on manufactured goods were to be reduced to less than 4percent of value, the lowest level in modern history.Agricultural subsidies were to be substantially reduced.

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GATT fair trade and market access rules were to be extended to cover a wide range of services.GATT rules also were to be extended to provide enhanced protection for patents, copyrights, and trademarks(intellectual property).Barriers on trade in textiles were to be significantly reduced over 10 years.The World Trade Organization was to be created to implement the GATT agreement.

The World Trade OrganizationThe WTO acts as an umbrella organization that encompasses the GATT along with two new sister bodies, one onservices and the other on intellectual property. The WTO’s General Agreement on Trade in Services (GATS) has takenthe lead in extending free trade agreements to services. The WTO’s Agreement on Trade-Related Aspects of IntellectualProperty Rights (TRIPS) is an attempt to narrow the gaps in the way intellectual property rights are protected around theworld and to bring them under common international rules. WTO has taken over responsibility for arbitratingtrade disputes and monitoring the trade policies of member countries. While the WTO operates on the basis ofconsensus as the GATT did, in the area of dispute settlement, member countries are no longer able to block adoption ofarbitration reports. Arbitration panel reports on trade disputes between member countries are automatically adopted bythe WTO unless there is a consensus to reject them. Countries that have been found by the arbitration panel to violateGATT rules may appeal to a permanent appellate body, but its verdict is binding. If offenders fail to comply with therecommendations of the arbitration panel, trading partners have the right to compensation or, in the last resort, to impose(commensurate) trade sanctions. Every stage of the procedure is subject to strict time limits. Thus, the WTO hassomething that the GATT never had—teeth.21

WTO: EXPERIENCE TO DATEBy 2019, the WTO had 164 members, including China, which joined at the end of 2001, and Russia, which joined in2012. WTO members collectively account for 98 percent of world trade. Since its formation, the WTO has remained atthe forefront of efforts to promote global free trade. Its creators expressed the belief that the enforcement mechanismsgranted to the WTO would make it more effective at policing global trade rules than the GATT had been. The great hopewas that the WTO might emerge as an effective advocate and facilitator of future trade deals, particularly in areas such asservices. The experience so far has been mixed. After a strong early start, since the late 1990s the WTO has been unableto get agreements to further reduce barriers to international trade and trade and investment. There has been very slowprogress with the current round of trade talks (the Doha Round). There was also a shift back toward some limitedprotectionism following the global financial crisis of 2008–2009. More recently, the 2016 vote by the British to leave theEuropean Union (Brexit) and the election of Donald Trump to the presidency in the United States have suggested that theworld may be shifting back toward greater protectionism. These developments have raised a number of questions aboutthe future direction of the WTO. Donald Trump, in particular, has expressed ambivalence about the value of the WTO,and under his leadership the United States has stepped back from supporting the institution.

WTO as Global PoliceThe first two decades in the life of the WTO suggest that its policing and enforcement mechanisms are having a positiveeffect.22 Between 1995 and 2018, more than 500 trade disputes between member countries were brought to the WTO.23This record compares with a total of 196 cases handled by the GATT over almost half a century. Of the cases brought tothe WTO, three-fourths have been resolved by informal consultations between the disputing countries. Resolving theremainder has involved more formal procedures, but these have been largely successful. In general, countries involvedhave adopted the WTO’s recommendations. The fact that countries are using the WTO represents an important vote ofconfidence in the organization’s dispute resolution procedures.

Expanded Trade AgreementsAs explained earlier, the Uruguay Round of GATT negotiations extended global trading rules to cover trade in services.The WTO was given the role of brokering future agreements to open up global trade in services. The WTO was alsoencouraged to extend its reach to encompass regulations governing foreign direct investment, something the GATT hadnever done. Two of the first industries targeted for reform were the global telecommunication and financial servicesindustries.

In February 1997, the WTO brokered a deal to get countries to agree to open their telecommunication markets tocompetition, allowing foreign operators to purchase ownership stakes in domestic telecommunication providers andestablishing a set of common rules for fair competition. Most of the world’s biggest markets—including the UnitedStates, European Union, and Japan—were fully liberalized by January 1, 1998, when the pact went into effect.All forms of basic telecommunication service are covered, including voice telephone, data, and satellite andradio communications. Many telecommunication companies responded positively to the deal, pointing out that it would

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give them a much greater ability to offer their business customers one-stop shopping—a global, seamless service for alltheir corporate needs and a single bill.

This was followed in December 1997 with an agreement to liberalize cross-border trade in financial services. Thedeal covered more than 95 percent of the world’s financial services market. Under the agreement, which took effect atthe beginning of March 1999, 102 countries pledged to open (to varying degrees) their banking, securities, and insurancesectors to foreign competition. In common with the telecommunication deal, the accord covers not just cross-border tradebut also foreign direct investment. Seventy countries agreed to dramatically lower or eradicate barriers to foreign directinvestment in their financial services sector. The United States and the European Union (with minor exceptions) are fullyopen to inward investment by foreign banks, insurance, and securities companies. As part of the deal, many Asiancountries made important concessions that allow significant foreign participation in their financial services sectors for thefirst time.

THE FUTURE OF THE WTO: UNRESOLVED ISSUES AND THE DOHA ROUNDSince the successes of the 1990s, the World Trade Organization has struggled to make progress on the international tradefront. Confronted by a slower growing world economy after 2001, many national governments have been reluctant toagree to a fresh round of policies designed to reduce trade barriers. Political opposition to the WTO has been growing inmany nations. As the public face of globalization, some politicians and nongovernmental organizations blame the WTOfor a variety of ills, including high unemployment, environmental degradation, poor working conditions in developingnations, falling real wage rates among the lower paid in developed nations, and rising income inequality. The rapid riseof China as a dominant trading nation has also played a role here. Reflecting sentiments like those toward Japan 25 yearsago, many perceive China as failing to play by the international trading rules, even as it embraces the WTO.

Against this difficult political backdrop, much remains to be done on the international trade front. Four issues at theforefront of the agenda of the WTO are antidumping policies, the high level of protectionism in agriculture, the lack ofstrong protection for intellectual property rights in many nations, and continued high tariff rates on nonagricultural goodsand services in many nations. We shall look at each in turn before discussing the latest round of talks between WTOmembers aimed at reducing trade barriers, the Doha Round, which began in 2001 and now seem to be stalled.

Antidumping ActionsAntidumping actions proliferated during the 1990s and 2000s. WTO rules allow countries to impose antidumping dutieson foreign goods that are being sold cheaper than at home or below their cost of production when domestic producerscan show that they are being harmed. Unfortunately, the rather vague definition of what constitutes “dumping” hasproved to be a loophole that many countries are exploiting to pursue protectionism.

Between 1995 and December 2017, WTO members had reported implementation of some 5,529 antidumpingactions to the WTO. India initiated the largest number of antidumping actions, some 888; the EU initiated 502 over thesame period, and the United States, 659. China accounted for 1,269 complaints, South Korea for 417, the United Statesfor 283, Taipei (China) for 296, and Japan for 202. Antidumping actions seem to be concentrated in certain sectors of theeconomy, such as basic metal industries (e.g., aluminum and steel), chemicals, plastics, and machinery and electricalequipment.24 These sectors account for approximately 70 percent of all antidumping actions reported to the WTO. Since1995, these four sectors have been characterized by periods of intense competition and excess productive capacity, whichhave led to low prices and profits (or losses) for firms in those industries. It is not unreasonable, therefore, to hypothesizethat the high level of antidumping actions in these industries represents an attempt by beleagueredmanufacturers to use the political process in their nations to seek protection from foreign competitors, whichthey claim are engaging in unfair competition. While some of these claims may have merit, the process can become verypoliticized as representatives of businesses and their employees lobby government officials to “protect domestic jobsfrom unfair foreign competition,” and government officials, mindful of the need to get votes in future elections, obligeby pushing for antidumping actions. The WTO is clearly worried by the use of antidumping policies, suggesting that itreflects persistent protectionist tendencies and pushing members to strengthen the regulations governing the impositionof antidumping duties.

Protectionism in AgricultureAnother focus of the WTO has been the high level of tariffs and subsidies in the agricultural sector of many economies.Tariff rates on agricultural products are generally much higher than tariff rates on manufactured products or services. Forexample, the average tariff rates on nonagricultural products among developed nations are around 2 percent. Onagricultural products, however, the average tariff rates are 15.4 percent for Canada, 11.9 percent for the European Union,17.4 percent for Japan, and 4.8 percent for the United States.25 The implication is that consumers in countries with hightariffs are paying significantly higher prices than necessary for agricultural products imported from abroad, which leavesthem with less money to spend on other goods and services.

The historically high tariff rates on agricultural products reflect a desire to protect domestic agriculture and

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traditional farming communities from foreign competition. In addition to high tariffs, agricultural producers also benefitfrom substantial subsidies. According to estimates from the Organisation for Economic Co-operation and Development(OECD), government subsidies on average account for about 17 percent of the cost of agricultural production in Canada,21 percent in the United States, 35 percent in the European Union, and 59 percent in Japan.26 OECD countries spendmore than $300 billion a year in agricultural subsidies.

Not surprisingly, the combination of high tariff barriers and subsidies introduces significant distortions into theproduction of agricultural products and international trade of those products. The net effect is to raise prices toconsumers, reduce the volume of agricultural trade, and encourage the overproduction of products that areheavily subsidized (with the government typically buying the surplus). Because global trade in agriculture currentlyamounts to around 10 percent of total merchandized trade, the WTO argues that removing tariff barriers and subsidiescould significantly boost the overall level of trade, lower prices to consumers, and raise global economic growth byfreeing consumption and investment resources for more productive uses. According to estimates from the InternationalMonetary Fund, removal of tariffs and subsidies on agricultural products would raise global economic welfare by $128billion annually.27 Others suggest gains as high as $182 billion.28

Production operations at J.M. Larson Dairy.Mark Elias/Bloomberg/Getty Images

The biggest defenders of the existing system have been the advanced nations of the world, which want to protecttheir agricultural sectors from competition by low-cost producers in developing nations. In contrast, developing nationshave been pushing hard for reforms that would allow their producers greater access to the protected markets of thedeveloped nations. Estimates suggest that removing all subsidies on agricultural production alone in OECD countriescould return to the developing nations of the world three times more than all the foreign aid they currently receive fromthe OECD nations.29 In other words, free trade in agriculture could help jump-start economic growth among the world’spoorer nations and alleviate global poverty.

Protection of Intellectual PropertyAnother issue that has become increasingly important to the WTO has been protecting intellectual property. The 1995Uruguay agreement that established the WTO also contained an agreement to protect intellectual property (the Trade-Related Aspects of Intellectual Property Rights, or TRIPS, agreement). The TRIPS regulations oblige WTO members togrant and enforce patents lasting at least 20 years and copyrights lasting 50 years. Rich countries had to comply with therules within a year. Poor countries, in which such protection was generally much weaker, had five years’ grace, and thevery poorest had 10 years.’ The basis for this agreement was a strong belief among signatory nations that the protection

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of intellectual property through patents, trademarks, and copyrights must be an essential element of the internationaltrading system. Inadequate protections for intellectual property reduce the incentive for innovation. Because innovationis a central engine of economic growth and rising living standards, the argument has been that a multilateral agreement isneeded to protect intellectual property.

Without such an agreement, it is feared that producers in a country—let’s say, India—might market imitations ofpatented innovations pioneered in a different country—say, the United States. This can affect international trade in twoways. First, it reduces the export opportunities in India for the original innovator in the United States. Second, to theextent that the Indian producer is able to export its pirated imitation to additional countries, it also reduces the exportopportunities in those countries for the U.S. inventor. Also, one can argue that because the size of the total world marketfor the innovator is reduced, its incentive to pursue risky and expensive innovations is also reduced. The net effect wouldbe less innovation in the world economy and less economic growth.

Market Access for Nonagricultural Goods and ServicesAlthough the WTO and the GATT have made big strides in reducing the tariff rates on nonagricultural products, muchwork remains. Although most developed nations have brought their tariff rates on industrial products down to under 4percent of value, exceptions still remain. In particular, while average tariffs are low, high tariff rates persist on certainimports into developed nations, which limit market access and economic growth. For example, Australia and SouthKorea, both OECD countries, still have bound tariff rates of 15.1 percent and 24.6 percent, respectively, on imports oftransportation equipment (bound tariff rates are the highest rate that can be charged, which is often, but not always, therate that is charged). In contrast, the bound tariff rates on imports of transportation equipment into the UnitedStates, European Union, and Japan are 2.7 percent, 4.8 percent, and 0 percent, respectively. A particular areafor concern is high tariff rates on imports of selected goods from developing nations into developed nations.

COUNTRY FOCUS

Estimating the Gains from Trade for the United StatesA study published by the Institute for International Economics tried to estimate the gains to the American economy from freetrade. According to the study, due to reductions in tariff barriers under the GATT and WTO since 1947, by 2003 the grossdomestic product (GDP) of the United States was 7.3 percent higher than would otherwise be the case. The benefits of thatamounted to roughly $1 trillion a year, or $9,000 extra income for each American household per year.

The same study tried to estimate what would happen if America concluded free trade deals with all its trading partners,reducing tariff barriers on all goods and services to zero. Using several methods to estimate the impact, the study concluded thatadditional annual gains of between $450 billion and $1.3 trillion could be realized. This final march to free trade, according to theauthors of the study, could safely be expected to raise incomes of the average American household by an additional $4,500 peryear.

The authors also tried to estimate the scale and cost of employment disruption that would be caused by a move to universalfree trade. Jobs would be lost in certain sectors and gained in others if the country abolished all tariff barriers. Using historical dataas a guide, they estimated that 226,000 jobs would be lost every year due to expanded trade, although some two-thirds of thoselosing jobs would find reemployment after a year. Reemployment, however, would be at a wage that was 13 to 14 percent lower.The study concluded that the disruption costs would total some $54 billion annually, primarily in the form of lower lifetime wagesto those whose jobs were disrupted as a result of free trade. Offset against this, however, must be the higher economic growthresulting from free trade, which creates many new jobs and raises household incomes, creating another $450 billion to $1.3 trillionannually in net gains to the economy. In other words, the estimated annual gains from trade are far greater than the estimatedannual costs associated with job disruption, and more people benefit than lose as a result of a shift to a universal free trade regime.Source: S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Payoff to America from Global Integration,” in The United States and the World Economy: Foreign Policyfor the Next Decade, C. F. Bergsten, ed. (Washington, DC: Institute for International Economics, 2005).

In addition, tariffs on services remain higher than on industrial goods. The average tariff on business and financialservices imported into the United States, for example, is 8.2 percent, into the EU it is 8.5 percent, and into Japan it is19.7 percent.30 Given the rising value of cross-border trade in services, reducing these figures can be expected to yieldsubstantial gains.

The WTO would like to bring down tariff rates still further and reduce the scope for the selective use of high tariffrates. The ultimate aim is to reduce tariff rates to zero. Although this might sound ambitious, 40 nations have alreadymoved to zero tariffs on information technology goods, so a precedent exists. Empirical work suggests that further

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reductions in average tariff rates toward zero would yield substantial gains. One estimate by economists at the WorldBank suggests that a broad global trade agreement coming out of the Doha negotiations could increase world income by$263 billion annually, of which $109 billion would go to poor countries.31 Another estimate from the OECD suggests afigure closer to $300 billion annually.32 See the accompanying Country Focus for estimates of the benefits to theAmerican economy from free trade.

Looking farther out, the WTO would like to bring down tariff rates on imports of nonagricultural goods intodeveloping nations. Many of these nations use the infant industry argument to justify the continued imposition of hightariff rates; however, ultimately these rates need to come down for these nations to reap the full benefits of internationaltrade. For example, the bound tariff rates of 53.9 percent on imports of transportation equipment into India and 33.6percent on imports into Brazil, by raising domestic prices, help protect inefficient domestic producers and limiteconomic growth by reducing the real income of consumers who must pay more for transportation equipmentand related services.

A New Round of Talks: DohaIn 2001, the WTO launched a new round of talks between member states aimed at further liberalizing the global tradeand investment framework. For this meeting, it picked the remote location of Doha in the Persian Gulf state of Qatar.The talks were originally scheduled to last three years, although they have already gone on for 17 years and are currentlystalled.

The Doha agenda includes cutting tariffs on industrial goods and services, phasing out subsidies to agriculturalproducers, reducing barriers to cross-border investment, and limiting the use of antidumping laws. The talks are currentlyongoing. They have been characterized by halting progress punctuated by significant setbacks and missed deadlines. ASeptember 2003 meeting in Cancún, Mexico, broke down, primarily because there was no agreement on how to proceedwith reducing agricultural subsidies and tariffs; the EU, United States, and India, among others, proved less than willingto reduce tariffs and subsidies to their politically important farmers, while countries such as Brazil and certain WestAfrican nations wanted free trade as quickly as possible. In 2004, both the United States and the EU made a determinedpush to start the talks again. Since then, however, no progress has been made, and the talks are in deadlock, primarilybecause of disagreements over how deep the cuts in subsidies to agricultural producers should be. As of 2018, the goalwas to reduce tariffs for manufactured and agricultural goods by 60 to 70 percent and to cut subsidies to half of theircurrent level—but getting nations to agree to these goals was proving exceedingly difficult.

MULTILATERAL AND BILATERAL TRADE AGREEMENTSIn response to the apparent failure of the Doha Round to progress, many nations have pushed forward with multilateralor bilateral trade agreements, which are reciprocal trade agreements between two or more partners. For example, in2014 Australia and China entered into a bilateral free trade agreement. Similarly, in March 2012 the United Statesentered into a bilateral free trade agreement with South Korea. Under this agreement, 80 percent of U.S. exports ofconsumer and industrial products became duty free, and 95 percent of bilateral trade in industrial and consumer productswill be duty free by 2017 (this agreement was revised in 2018; see the Closing Case). The agreement was estimated toboost U.S. GDP by some $10 to $12 billion. Under the Obama administration, the United States pursued two majormultilateral trade agreements, one with 11 other Pacific Rim countries including Australia, New Zealand, Japan,Malaysia, and Chile (the TPP), and another with the European Union. However, following the accession of DonaldTrump to the presidency in the United States, the U.S. withdrew from the TPP (although the remaining 11 nations wentahead with a revised agreement) and the trade agreement being negotiated with the EU was put on ice.

Multilateral and bilateral trade agreements are designed to capture gain from trade beyond those agreementscurrently attainable under WTO treaties. Multilateral and bilateral trade agreements are allowed under WTO rules, andcountries entering into these agreements are required to notify the WTO. As of 2019, more than 470 regional or bilateraltrade agreements were in force. Reflecting the lack of progress on the Doha Round, the number of such agreements hasincreased significantly since 2000 when only 94 were in force.

THE WORLD TRADING SYSTEM UNDER THREATIn 2016, two events challenged the long-held belief that there was a global consensus behind the 70-year push toembrace free trade and lower barriers to the cross-border flow of goods and services. The first was the decision by theBritish to withdraw from the European Union following a national referendum (Brexit). We discuss Brexit in more detailin Chapter 9, but it is worth noting that the British intention to withdraw from what is arguably one of the mostsuccessful free trade zones in the world is a big setback for those who argue that free trade is a good thing. Thesecond event was the victory of Donald Trump in the 2016 U.S. presidential election. As discussed in Chapter 6, Trumpappears to hold mercantilist views on trade. He seems opposed to many free trade deals. Indeed, one of his first actionswas to pull the United States out of the Trans Pacific Partnership, a 12-nation free trade zone that was close to

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ratification. In early 2018, he placed tariffs on imports of solar panels, washing machines, steel, and aluminum into theUnited States, in all probability in violation of WTO rules. Trump also renegotiated NAFTA and has expressed hostilityto the WTO. Most notably, Trump sidestepped the WTO’s rules-based arbitration mechanisms in his trade dispute withChina. In late 2019, the Trump administration also blocked replacements for two judges on the WTO’s appellate body,which hears appeals in trade disputes. With just one judge remaining, it will no longer be able to hear new cases, whicheffectively undermines the WTO’s enforcement mechanism. The significance of these developments is that heretoforeboth Britain and America have been leaders in the global push toward greater free trade. While Britain still seemscommitted to free trade, despite the Brexit decision, the position of the United States, the world’s largest economy, is lessclear. If the U.S. continues to turn its back on new free trade deals (such as the TPP) dismantles existing ones (as Trumpthreatened to do with NAFTA), and sidesteps the WTO, other nations could follow. If this happens, the impact on theworld economy will almost certainly be negative, resulting in greater protectionism, slower economic growth, and higherunemployment around the globe.

TEST PREPUse SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBookor go to learnsmartadvantage.com for help.

FOCUS ON MANAGERIAL IMPLICATIONSTRADE BARRIERS, FIRM STRATEGY, AND POLICY IMPLICATIONS

LO7-5Explain the implications for managers of developments in the world trading system.What are the implications for business practice? Why should the international manager care about the political economyof free trade or about the relative merits of arguments for free trade and protectionism? There are two answers to thisquestion. The first concerns the impact of trade barriers on a firm’s strategy. The second concerns the role that businessfirms can play in promoting free trade or trade barriers.

Trade Barriers and Firm StrategyTo understand how trade barriers affect a firm’s strategy, consider first the material in Chapter 6. Drawing on thetheories of international trade, we discussed how it makes sense for the firm to disperse its various production activitiesto those countries around the globe where they can be performed most efficiently. Thus, it may make sense for a firm todesign and engineer its product in one country, to manufacture components in another, to perform final assemblyoperations in yet another country, and then export the finished product to the rest of the world.

Clearly, trade barriers constrain a firm’s ability to disperse its productive activities in such a manner. First and mostobvious, tariff barriers raise the costs of exporting products to a country (or of exporting partly finished productsbetween countries). This may put the firm at a competitive disadvantage relative to indigenous competitors in thatcountry. In response, the firm may then find it economical to locate production facilities in that country so that it cancompete on even footing. Second, quotas may limit a firm’s ability to serve a country from locations outside thatcountry. Again, the response by the firm might be to set up production facilities in that country—even though it mayresult in higher production costs.

Such reasoning was one of the factors behind the rapid expansion of Japanese automaking capacity in the UnitedStates during the 1980s and 1990s. This followed the establishment of a VER agreement between the United States andJapan that limited U.S. imports of Japanese automobiles. Today, Donald Trump’s threat to impose high tariffs oncompanies that shift their production to other nations in order to reduce costs—and then export goods back to the UnitedStates—is forcing some enterprises to rethink their outsourcing strategy. In particular, a number of automobilecompanies, including Ford and General Motors, have modified their plans to shift some production to factoriesin Mexico and have announced plans to expand U.S. production in order to appease the Trumpadministration.33

Third, to conform to local content regulations, a firm may have to locate more production activities in a givenmarket than it would otherwise. Again, from the firm’s perspective, the consequence might be to raise costs above thelevel that could be achieved if each production activity were dispersed to the optimal location for that activity. Andfinally, even when trade barriers do not exist, the firm may still want to locate some production activities in a given

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country to reduce the threat of trade barriers being imposed in the future.All these effects are likely to raise the firm’s costs above the level that could be achieved in a world without trade

barriers. The higher costs that result need not translate into a significant competitive disadvantage relative to otherforeign firms, however, if the countries imposing trade barriers do so to the imported products of all foreign firms,irrespective of their national origin. But when trade barriers are targeted at exports from a particular nation, firms basedin that nation are at a competitive disadvantage to firms of other nations. The firm may deal with such targeted tradebarriers by moving production into the country imposing barriers. Another strategy may be to move production tocountries whose exports are not targeted by the specific trade barrier.

Finally, the threat of antidumping action limits the ability of a firm to use aggressive pricing to gain market share ina country. Firms in a country also can make strategic use of antidumping measures to limit aggressive competition fromlow-cost foreign producers. For example, the U.S. steel industry has been very aggressive in bringing antidumpingactions against foreign steelmakers, particularly in times of weak global demand for steel and excess capacity. In 1998and 1999, the United States faced a surge in low-cost steel imports as a severe recession in Asia left producers there withexcess capacity. The U.S. producers filed several complaints with the International Trade Commission. One argued thatJapanese producers of hot rolled steel were selling it at below cost in the United States. The ITC agreed and levied tariffsranging from 18 to 67 percent on imports of certain steel products from Japan (these tariffs are separate from the steeltariffs discussed earlier).34

Policy ImplicationsAs noted in Chapter 6, business firms are major players on the international trade scene. Because of their pivotal role ininternational trade, firms can and do exert a strong influence on government policy toward trade. This influence canencourage protectionism, or it can encourage the government to support the WTO and push for open markets and freertrade among all nations. Government policies with regard to international trade can have a direct impact on business.

Consistent with strategic trade policy, examples can be found of government intervention in the form of tariffs,quotas, antidumping actions, and subsidies helping firms and industries establish a competitive advantage in the worldeconomy. In general, however, the arguments contained in this chapter and in Chapter 6 suggest that governmentintervention has three drawbacks. Intervention can be self-defeating because it tends to protect the inefficient rather thanhelp firms become efficient global competitors. Intervention is dangerous; it may invite retaliation and trigger a tradewar. Finally, intervention is unlikely to be well executed, given the opportunity for such a policy to be captured byspecial-interest groups. Does this mean that business should simply encourage government to adopt a laissez-faire freetrade policy?

Most economists would probably argue that the best interests of international business are served by a free tradestance but not a laissez-faire stance. It is probably in the best long-run interests of the business community to encouragethe government to aggressively promote greater free trade by, for example, strengthening the WTO. Business probablyhas much more to gain from government efforts to open protected markets to imports and foreign direct investment thanfrom government efforts to support certain domestic industries in a manner consistent with the recommendations ofstrategic trade policy.

This conclusion is reinforced by a phenomenon we touched on in Chapter 1—the increasing integration of theworld economy and internationalization of production that has occurred over the past two decades. We live in a worldwhere many firms of all national origins increasingly depend on globally dispersed production systems for theircompetitive advantage. Such systems are the result of freer trade. Freer trade has brought great advantages tofirms that have exploited it and to consumers who benefit from the resulting lower prices. Given the danger ofretaliatory action, business firms that lobby their governments to engage in protectionism must realize that by doing so,they may be denying themselves the opportunity to build a competitive advantage by constructing a globally dispersedproduction system. By encouraging their governments to engage in protectionism, their own activities and sales overseasmay be jeopardized if other governments retaliate. This does not mean a firm should never seek protection in the form ofantidumping actions and the like, but it should review its options carefully and think through the larger consequences.

Key Termsfree trade, p. 202General Agreement on Tariffs and Trade (GATT), p. 202tariff, p. 202specific tariff, p. 202ad valorem tariff, p. 202subsidy, p. 203import quota, p. 205tariff rate quota, p. 205voluntary export restraint (VER), p. 205

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quota rent, p. 206export tariff, p. 206export ban, p. 206local content requirement (LCR), p. 206administrative trade policies, p. 207dumping, p. 207antidumping policies, p. 207countervailing duties, p. 207infant industry argument, p. 211strategic trade policy, p. 213Smoot–Hawley Act, p. 215multilateral or bilateral trade agreements, p. 222

SUMMARYThis chapter described how the reality of international trade deviates from the theoretical ideal of unrestricted freetrade reviewed in Chapter 6. In this chapter, we reported the various instruments of trade policy, reviewed thepolitical and economic arguments for government intervention in international trade, reexamined the economic casefor free trade in light of the strategic trade policy argument, and looked at the evolution of the world tradingframework. While a policy of free trade may not always be the theoretically optimal policy (given the arguments ofthe new trade theorists), in practice it is probably the best policy for a government to pursue. In particular, the long-run interests of business and consumers may be best served by strengthening international institutions such as theWTO. Given the danger that isolated protectionism might escalate into a trade war, business probably has far more togain from government efforts to open protected markets to imports and foreign direct investment (through the WTO)than from government efforts to protect domestic industries from foreign competition. The chapter made thefollowing points:

1. Trade policies such as tariffs, subsidies, antidumping regulations, and local content requirements tend to bepro-producer and anticonsumer. Gains accrue to producers (who are protected from foreign competitors), butconsumers lose because they must pay more for imports.

2. There are two types of arguments for government intervention in international trade: political and economic.Political arguments for intervention are concerned with protecting the interests of certain groups, often at theexpense of other groups, or with promoting goals with regard to foreign policy, human rights, consumerprotection, and the like. Economic arguments for intervention are about boosting the overall wealth of anation.

3. A common political argument for intervention is that it is necessary to protect jobs. However, politicalintervention often hurts consumers, and it can be self-defeating. Countries sometimes argue that it is importantto protect certain industries for reasons of national security. Some argue that government should use the threatto intervene in trade policy as a bargaining tool to open foreign markets. This can be a risky policy; if it fails,the result can be higher trade barriers.

4. The infant industry argument for government intervention contends that to let manufacturing get a toehold,governments should temporarily support new industries. In practice, however, governments often end upprotecting the inefficient.

5. Strategic trade policy suggests that, with subsidies, government can help domestic firms gain first-moveradvantages in global industries where economies of scale are important. Government subsidies may also helpdomestic firms overcome barriers to entry into such industries.

6. The problems with strategic trade policy are twofold: (a) Such a policy may invite retaliation, inwhich case all will lose, and (b) strategic trade policy may be captured by special-interest groups, which willdistort it to their own ends.

7. The GATT was a product of the postwar free trade movement. The GATT was successful in lowering tradebarriers on manufactured goods and commodities. The move toward greater free trade under the GATTappeared to stimulate economic growth.

8. The completion of the Uruguay Round of GATT talks and the establishment of the World Trade Organizationhave strengthened the world trading system by extending GATT rules to services, increasing protection forintellectual property, reducing agricultural subsidies, and enhancing monitoring and enforcement mechanisms.

9. Trade barriers act as a constraint on a firm’s ability to disperse its various production activities to optimallocations around the globe. One response to trade barriers is to establish more production activities in the

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protected country.10. Business may have more to gain from government efforts to open protected markets to imports and foreign

direct investment than from government efforts to protect domestic industries from foreign competition.

Critical Thinking and Discussion Questions

1. Do you think governments should consider human rights when granting preferential trading rights tocountries? What are the arguments for and against taking such a position?

2. Whose interests should be the paramount concern of government trade policy: the interests of producers(businesses and their employees) or those of consumers?

3. Given the arguments relating to the new trade theory and strategic trade policy, what kind of trade policyshould business be pressuring government to adopt?

4. You are an employee of a U.S. firm that produces personal computers in Thailand and then exports them tothe United States and other countries for sale. The personal computers were originally produced in Thailand totake advantage of relatively low labor costs and a skilled workforce. Other possible locations considered at thetime were Malaysia and Hong Kong. The U.S. government decides to impose punitive 100 percent ad valoremtariffs on imports of computers from Thailand to punish the country for administrative trade barriers thatrestrict U.S. exports to Thailand. How should your firm respond? What does this tell you about the use oftargeted trade barriers?

5. Reread the Management Focus “Protecting U.S. Magnesium.” Who gains most from the antidumping dutieslevied by the United States on imports of magnesium from China and Russia? Who are the losers? Are theseduties in the best national interests of the United States?

global EDGE research task globaledge.msu.eduUse the globalEDGE™ website (globaledge.msu.edu) to complete the following exercises:

1. You work for a pharmaceutical company that hopes to provide products and services in New Zealand. Yetmanagement’s current knowledge of this country’s trade policies and barriers is limited. After searching aresource that summarizes the import and export regulations, outline the most important foreign trade barriersyour firm’s managers must keep in mind while developing a strategy for entry into New Zealand’spharmaceutical market.

2. The number of member nations of the World Trade Organization has increased considerably in recent years.In addition, some nonmember countries have observer status in the WTO. Such status requires accessionnegotiations to begin within five years of attaining this preliminary position. Visit the WTO’s website toidentify a list of current members and observers. Identify the last five countries that joined the WTO asmembers. Also, examine the list of current observer countries. Do you notice anything in particular about thecountries that have recently joined or have observer status?

CLOSING CASE

The United States and South Korea Strike a Revised Trade DealIn 2012, a free trade deal between the United States and South Korea went into effect. In 2016, the United Statesexported $63.8 billion in goods and services to South Korea, and imported $80.8 billion, resulting in a trade deficit of$17 billion. During the U.S. election campaign in 2016, Donald Trump, who became President in 2017, called the deal“horrible” and a “job killer.”

Given Trump’s opposition to the free trade deal, it was no surprise when, in January 2018, the U.S. announced itwas entering into negotiations with South Korea to revise the terms of the agreement. Complicating matters were twofactors. First, in early March 2018, the Trump administration placed a 25 percent tariff on imports of steel. As the third-largest supplier of foreign steel to the United States, these tariffs threatened to harm the South Korean steel industry.Moreover, the global tariffs were technically in violation of the World Trade Organization treaty, to which both theUnited States and South Korea were signatories. Second, South Korea is an important U.S. ally. The country’s supportwas crucial in putting pressure on North Korea to halt its nuclear weapons program. Given this, many observerswondered why the Trump administration was pressuring South Korea at a time when it needed to work together with thenation to keep North Korea in check.

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Perhaps because of geopolitical considerations, the negotiations proceeded very quickly. Trade in automobiles wascentral to the negotiations, because the Trump administration saw it as a primary cause of the trade deficit. In 2017, theUnited States imported nearly $16 billion worth of South Korean passenger cars, but exported only $1.5 billion worth toSouth Korea. Significant automobile production in the U.S. is concentrated in swing states such as Michigan and Ohio,which helped elect Trump to the presidency.

In late March, the two countries announced they had reached a revised deal. Under the terms of this deal, SouthKorea would be exempt from the 25 percent tariff on steel imports into the United States. Instead, South Korea agreed toa quota that would limit its steel exports to the U.S. to about 70 percent of what they had been in 2017.

In return, South Korea made two concessions. First, the deal extended for 20 years a 25 percent tariff on exports ofSouth Korean light trucks to the United States (under the original agreement, the 25 percent tariff was set to expire in2021). This will likely be a significant boon to U.S. auto manufactures, because the light truck segment is one that theydominate. Second, the Koreans agreed to lift their annual quota on imports of U.S. cars into the country from 25,000 permanufacturer to 50,000 per manufacturer. Beyond that, U.S. cars sold in South Korea would have to adhere to Korea’sstringent safety and environmental standards, which the Trump administration has characterized as “burdensomeregulations” designed to make it difficult for U.S. companies to sell vehicles in Korea. That being said, the reality is thatU.S. auto companies were not even close to reaching the old quota limit of 25,000 cars a year, so lifting the cap may beprimarily symbolic.

Kim Jae-Hwan/AFP/Getty Images

The deal will also establish a side agreement between the United States and South Korea that is intended to deter“competitive devaluation” of both countries’ currencies—which can artificially lower the cost of imports bought byconsumers—and to create more transparency on issues of monetary policy. Administration officials suggested that thisnew type of arrangement was likely to be replicated in other trade deals, though they acknowledged it was notenforceable.

The deal allows President Trump to claim that his “get tough” approach to trade negotiations works. For their part,the South Koreans were reportedly pleased that they didn’t have to give ground on opening up their agricultural industryto U.S. imports, where administrative tariff barriers have limited importation of some low-priced American foodstuffssuch as rice and potatoes.Sources: Michael Shear and Alan Rappeport, “Trump Secures Trade Deal with South Korea Ahead of Nuclear Talks,” The New York Times, March 27, 2018; Scott Horsley, “TrumpAdministration Strikes Trade Deal with South Korea,” NPR Politics, March 27, 2018; Patrick Gillespie, “New US Deal with South Korea: What You Need to Know,” CNN Money, March28, 2018.

Case Discussion Questions

1. Why do you think the Obama administration pursued a trade deal with Korea in 2012? What were the potentialeconomic and political benefits? What were the potential costs?

2. Is there any evidence that the 2012 free trade deal between the United States and South Korea was a “job killer”as claimed by President Trump?

3. What were the motivations of the Trump administration in renegotiating the 2012 deal?4. Who benefits from the revised (2018) deal? Who might lose? Does the 2018 deal represent an improvement over

that ratified in 2012?

Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education

Endnotes

1. For a detailed welfare analysis of the effect of a tariff, see P. R. Krugman and M. Obstfeld, InternationalEconomics: Theory and Policy (New York: HarperCollins, 2000), Ch. 8.

2. Christian Henn and Brad McDonald, “Crisis Protectionism: The Observed Trade Impact,” IMF Economic Review62, no. 1 (April 2014), pp. 77–118.

3. World Trade Organization, World Trade Report 2006 (Geneva: WTO, 2006).4. The study was undertaken by Kym Anderson of the University of Adelaide. See “A Not So Perfect Market,” The

Economist: Survey of Agriculture and Technology, March 25, 2000, pp. 8–10.5. K. Anderson, W. Martin, and D. van der Mensbrugghe, “Distortions to World Trade: Impact on Agricultural

Markets and Farm Incomes,” Review of Agricultural Economics 28 (Summer 2006), pp. 168–94.6. J. B. Teece, “Voluntary Export Restraints Are Back; They Didn’t Work the Last Time,” Automotive News, April

23, 2012.7. G. Hufbauer and Z. A. Elliott, Measuring the Costs of Protectionism in the United States (Washington, DC:

Institute for International Economics, 1993).8. Sean McLain, “American Cars in Japan: Lost in Translation,” The Wall Street Journal, January 26, 2017.9. Robert E. Scott. “Growth in US-China Trade Deficit Between 2001–2015 Cost 3.4 Million Jobs,” Economic

Policy Institute, January 31, 2017.10. Alan Goldstein, “Sematech Members Facing Dues Increase; 30% Jump to Make Up for Loss of Federal

Funding,” Dallas Morning News, July 27, 1996, p. 2F.11. N. Dunne and R. Waters, “U.S. Waves a Big Stick at Chinese Pirates,” Financial Times, January 6, 1995, p. 4.12. Peter S. Jordan, “Country Sanctions and the International Business Community,” American Society of

International Law Proceedings of the Annual Meeting 20, no. 9 (1997), pp. 333–42.13. “Brazil’s Auto Industry Struggles to Boost Global Competitiveness,” Journal of Commerce, October 10, 1991, p.

6A.14. For reviews, see J. A. Brander, “Rationales for Strategic Trade and Industrial Policy,” in Strategic Trade Policy

and the New International Economics, P. R. Krugman, ed. (Cambridge, MA: MIT Press, 1986); P. R. Krugman,“Is Free Trade Passé?” Journal of Economic Perspectives 1 (1987), pp. 131–44; P. R. Krugman, “Does the NewTrade Theory Require a New Trade Policy?” World Economy 15, no. 4 (1992), pp. 423–41.

15. “Airbus and Boeing: The Jumbo War,” The Economist, June 15, 1991, pp. 65–66.16. For details, see Krugman, “Is Free Trade Passé?”; Brander, “Rationales for Strategic Trade and Industrial Policy.”17. Krugman, R. Paul. ‘’Is Free Trade Passé?’’ The Journal of Economic Perspectives 1, no. 2 (Autumn 1987), 131–

44. https://www.jstor.org/stable/1942985?seq=1#page_scan_tab_contents.18. This dilemma is a variant of the famous prisoner’s dilemma, which has become a classic metaphor for the

difficulty of achieving cooperation between self-interested and mutually suspicious entities. For a good generalintroduction, see A. Dixit and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics,and Everyday Life (New York: Norton, 1991).

19. Note that the Smoot-Hawley Act did not cause the Great Depression. However, the beggar-thy-neighbor tradepolicies that it ushered in certainly made things worse. See J. Bhagwati, Protectionism (Cambridge, MA: MITPress, 1988).

20. World Bank, World Development Report (New York: Oxford University Press, 1987).21. Frances Williams, “WTO—New Name Heralds New Powers,” Financial Times, December 16, 1993, p. 5;

Frances Williams, “GATT’s Successor to Be Given Real Clout,” Financial Times, April 4, 1994, p. 6.22. W. J. Davey, “The WTO Dispute Settlement System: The First Ten Years,” Journal of International Economic

Law, March 2005, pp. 17–28; WTO Annual Report, 2016, archived atwww.wto.org/english/res_e/publications_e/anrep16_e.htm.

23. Information provided on WTO website, www.wto.org/english/tratop_e/dispu_e/dispu_status_e.htm.24. Data at www.wto.org/english/tratop_e/adp_e/adp_e.htm.25. World Trade Organization, World Tariff Profiles 2017 (Geneva: WTO, 2017).26. OECD (2018), Agricultural Policy Monitoring and Evaluation 2018, OECD Publishing, Paris,

https://doi.org/10.1787/agr_pol-2018-en.27. World Trade Organization, Annual Report by the Director General 2003 (Geneva: WTO, 2003).28. Anderson et al., “Distortions to World Trade.”29. World Trade Organization, Annual Report 2002 (Geneva: WTO, 2002).30. S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Payoff to America from Global Integration,” in The

United States and the World Economy: Foreign Policy for the Next Decade, C. F. Bergsten, ed. (Washington, DC: Institute for International Economics, 2005).

31. World Bank, Global Economic Prospects 2005 (Washington, DC: World Bank, 2005).

32. “Doha Development Agenda,” OECD Observer, September 2006, pp. 64–67.33. Peter Nicholas, “Trump Warns Auto Executive on Moving Business Overseas,” The Wall Street Journal, January

24, 2017.34. “Punitive Tariffs Are Approved on Imports of Japanese Steel,” The New York Times, June 12, 1999, p. A3.

LO8-1

LO8-2

LO8-3

LO8-4

LO8-5

LO8-6

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part three The Global Trade and InvestmentEnvironment

Foreign Direct Investment

LEARNING OBJECTIVESAfter reading this chapter, you will be able to:

Recognize current trends regarding foreign direct investment (FDI) in the world economy.

Explain the different theories of FDI.

Understand how political ideology shapes a government’s attitudes toward FDI.Describe the benefits and costs of FDI to home and host countries.

Explain the range of policy instruments that governments use to influence FDI.

Identify the implications for managers of the theory and government policies associated with FDI.

Shen Chunchen/VCG/Getty Images

Starbucks’ Foreign Direct Investment

OPENING CASEForty years ago, Starbucks was a single store in Seattle’s Pike Place Market selling premium-roasted coffee. Today, it is a globalroaster and retailer of coffee, with more than 28,000 stores in 76 countries. Starbucks set out on its current course in the 1980s whenthe company’s director of marketing, Howard Schultz, came back from a trip to Italy enchanted with the Italian coffeehouseexperience. Schultz, who later became CEO, persuaded the company’s owners to experiment with the coffeehouse format—and the

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Starbucks experience was born. The strategy was to sell the company’s own premium roasted coffee and freshly brewed espresso-style coffee beverages, along with a variety of pastries, coffee accessories, teas, and other products, in a tastefully designedcoffeehouse setting. From the outset, the company focused on selling “a third-place experience,” rather than just the coffee. Theformula led to spectacular success in the United States, where Starbucks went from obscurity to one of the best-known brands in thecountry in a decade. Thanks to Starbucks, coffee stores became places for relaxation, chatting with friends, reading the newspaper,holding business meetings, or (more recently) browsing the web.

In 1995, with 700 stores across the United States, Starbucks began exploring foreign opportunities. The first target market wasJapan. The company established a joint venture with a local retailer, Sazaby Inc. Each company held a 50 percent stake in the venture:Starbucks Coffee of Japan. Starbucks initially invested $10 million in this venture, its first foreign direct investment. The Starbucksformat was then licensed to the venture, which was charged with taking over responsibility for growing Starbucks’ presence in Japan.

To make sure the Japanese operations replicated the “Starbucks experience” in North America, Starbucks transferred someemployees to the Japanese operation. The joint venture agreement required all Japanese store managers and employees to attendtraining classes similar to those given to U.S. employees. The agreement also required that stores adhere to the design parametersestablished in the United States. In 2001, the company introduced a stock option plan for all Japanese employees, making it the firstcompany in Japan to do so. Skeptics doubted that Starbucks would be able to replicate its North American success overseas, but bythe end of 2018 Starbucks’ had some 1,286 stores and a profitable business in Japan. Along the way, in 2015, Starbucks acquiredStarbucks Coffee of Japan, making the stores wholly owned as opposed to licensed.

After Japan, the company embarked on an aggressive foreign investment program. In 1998, it purchased Seattle Coffee, a Britishcoffee chain with 60 retail stores, for $84 million. An American couple, originally from Seattle, had started Seattle Coffee with theintention of establishing a Starbucks-like chain in Britain. By 2018, Starbucks had almost 1,000 stores in the UK.

In the late 1990s, Starbucks also opened stores in Taiwan, China, Singapore, Thailand, New Zealand, South Korea, and Malaysia.In Asia, Starbucks’ most common strategy was to license its format to a local operator or joint venture partner in return for initiallicensing fees and royalties on store revenues. As in Japan, Starbucks insisted on an intensive employee-training program and strictspecifications regarding the format and layout of the store.

China has developed into Starbucks’ fastest-growing market and is now second only to the United States in terms of store countand revenues. Although China has historically been a nation of tea drinkers, the third-place coffee culture pioneered by Starbucks hasgained significant traction in the nation’s large cities where wealthy and middle-class customers will pay $5 for a cup of coffee. Aswith many other nations, Starbucks originally entered China by setting up a joint venture with a local company and licensing itsformat to that entity. That changed in 2018 when Starbucks bought out its East China venture partner in order to attain greater controlover its growth strategy. According to Belinda Wong, CEO of Starbucks’ China operations, “Full ownership will give us theopportunity to fully leverage the company’s robust business infrastructure to deliver an elevated coffee, in-store third placeexperience and digital innovation to our customers, and further strengthen the career development opportunities for our people”.* Thecompany now aims to have 6,000 wholly owned stores in China by the end of 2022, up from 3,500 at the end of fiscal 2018.*Belinda Wong, “Starbucks Acquires Remaining Shares of East China Business; Move Accelerates Company’s Long-term Commitment to China,” Starbucks, 2017.

Sources: Starbucks 2018 10K; J. Ordonez, “Starbucks to Start Major Expansion in Overseas Market,” The Wall Street Journal, October 27, 2000, p. B10; S. Homes and D.Bennett, “Planet Starbucks,” BusinessWeek, September 9, 2002, pp. 99–110; “Starbucks Outlines International Growth Strategy,” Business Wire, October 14, 2004; A. Yeh,“Starbucks Aims for New Tier in China,” Financial Times, February 14, 2006, p. 17; Laurie Burkitt, “Starbucks to Add Thousands of Stores in China,” The Wall Street Journal,January 12, 2016; “Starbucks to Acquire remaining Shares of East China JV,” Starbucks press release, July 27, 2017; Jon Bird, “Roasted: How China Is Showing the Way forStarbucks in the US,” Forbes, January 15, 2019; Eric Sylvers, “After 25,000 Stores in 78 Countries, Starbucks Turns to Italy,” The Wall Street Journal, September 6, 2018.

IntroductionForeign direct investment (FDI) occurs when a firm invests directly in facilities to produce or market a good or service ina foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, oraffiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI, itbecomes a multinational enterprise. The investments made by Starbucks in stores in countries such as Japan, the UK, andChina are all examples of FDI (see the opening case). While much FDI takes the form of greenfield ventures—buildingup subsidiaries from scratch—acquisitions and joint ventures with well-established foreign entities are also importantvehicles for foreign direct investment. Starbucks has used both of these.

This chapter begins by looking at the importance of FDI in the world economy. Next, we review the theories thathave been used to explain why enterprises undertake foreign direct investment. These theories can explain whyStarbucks entered into joint venture partnerships with local producers in order to license its store format in countries suchas Japan and China. These countries are so different from the U.S. in terms of their business systems, laws, and culturethat Starbucks needed the expertise of a foreign partner to help navigate the problems associated with doing business in aforeign country. After discussing theories of FDI, this chapter then looks at U.S. government policy toward foreign directinvestment. The chapter closes with a section on the implications of the material discussed here, as they relate tomanagement practice.

Foreign Direct Investment in the World Economy

LO8-1Recognize current trends regarding foreign direct investment (FDI) in the world economy.When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI.The flow of FDI refers to the amount of FDI undertaken over a given time period (normally a year). The stock of FDIrefers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI, meaningthe flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country.

TRENDS IN FDIThe past 25 years have seen a marked increase in both the flow and stock of FDI in the world economy. The averageyearly outflow of FDI increased from $250 billion in 1990 to a peak of $2.2 trillion in 2007, before slipping back toaround $1 trillion by 2018 (see Figure 8.1).1 Despite the pullback since 2007, since 1990 the flow of FDI has acceleratedfaster than the growth in world trade and world output. For example, between 1990 and 2017, the total flow of FDI fromall countries increased around sixfold, while world trade by value grew fourfold and world output by around 60 percent.2As a result of the strong FDI flows, by 2018 the global stock of FDI was about $31 trillion. The foreign affiliates ofmultinationals had $27 trillion in global sales in 2018, compared to $23 trillion in global exports of goods and services,and accounted for more than one-third of all cross-border trade in goods and services.3 Clearly, by any measure, FDI is avery important phenomenon in the global economy.

FIGURE 8.1 FDI outflows, 1990–2018 ($ billions).Source: UNCTAD statistical data set, http://unctadstat.unctad.org.

FDI has grown rapidly for several reasons. First, despite the general decline in trade barriers over the past 30 years,firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Given therising pressures for protectionism associated with the election of Donald Trump as President in the United States and thedecision by the British to leave the European Union, this seems likely to continue for some time. Second, much of theincrease in FDI has been driven by the political and economic changes that have been occurring in many of the world’sdeveloping nations. The general shift toward democratic political institutions and free market economies that wediscussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America, economic growth,economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on

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FDI have made these countries more attractive to foreign multinationals. According to the United Nations,According to UN data, some 80 percent of the more that 1,500 changes made to national laws governingforeign direct investment since 2000 have created a more favorable environment.4

The globalization of the world economy has also had a positive effect on the volume of FDI. Many firms see thewhole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence inmany regions of the world. For example, around 43 percent of the sales of American firms in the S&P 500 index aregenerated abroad.5 For reasons that we explore later in this book, many firms now believe it is important to haveproduction facilities close to their major customers. This too creates pressure for greater FDI.

THE DIRECTION OF FDIHistorically, most FDI has been directed at the developed nations of the world as firms based in advanced countriesinvested in the others’ markets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favoritetarget for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthydomestic markets, its dynamic and stable economy, a favorable political environment, and the openness of thecountry to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investmentinto the United States remained high during the 2000s and stood at $252 billion in 2018. The developed nations ofEurope have also been recipients of significant FDI inflows, principally from the United States and other Europeannations. In 2017, inward investment into Europe was $172 billion. The United Kingdom and France have historicallybeen the largest recipients of inward FDI.6

FIGURE 8.2 FDI inflows by region, 1995–2018 ($ billions).Source: UNCTAD statistical data set, http://unctadstat.unctad.org.

However, over the last decade, FDI inflows directed at developing nations and the transition economies of easternEurope and the old Soviet Union have increased markedly (see Figure 8.2) and in 2018 they surpassed inflows intodeveloped nations for the first time. Most recent inflows into developing nations have been targeted at the emergingeconomies of Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient ofFDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $139 billion in 2018.7 The reasonsfor the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the nextmost important region in the developing world for FDI inflows. In 2017, total inward investments into this regionreached $147 billion. Brazil has historically been the top recipient of inward FDI in Latin America. In Central America,Mexico has been a big recipient of inward investment thanks to its proximity to the United States and to NAFTA. In2018, some $32 billion of investments were made by foreigners in Mexico. At the other end of the scale, Africa has longreceived the smallest amount of inward investment, $46 billion in 2018. In recent years, Chinese enterprises have

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emerged as major investors in Africa, particularly in extraction industries, where they seem to be trying to ensure futuresupplies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of thepolitical unrest, armed conflict, and frequent changes in economic policy in the region.8

Did You Know?Did you know that the value of Foreign Direct Investment has been growing faster than world trade and world output?Visit your instructor’s Connect® course and click on your eBook or Smartbook® to view a short video explanation fromthe author.

THE SOURCE OF FDISince World War II, the United States has consistently been the largest source country for FDI. Other important sourcecountries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countriesaccounted for 60 percent of all FDI outflows for 1998–2018 (see Figure 8.3). As might be expected, these countries havelong predominated in rankings of the world’s largest multinationals, although as noted in Chapter 1, mainland China isnow rising fast in the rankings.9 Excluding China, these nations dominate primarily because they were themost developed nations with the largest economies during much of the postwar period and therefore home tomany of the largest and best-capitalized enterprises. Many of these countries also had a long history as trading nationsand naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises basedthere have been at the forefront of foreign investment trends.

FIGURE 8.3 Cumulative FDI outflows, 1998–2018 ($ billions).Source: UNCTAD statistical data set, http://unctadstat.unctad.org.

COUNTRY FOCUS

Foreign Direct Investment in ChinaBeginning in late 1978, China’s leadership decided to move the economy away from a centrally planned socialist system to onethat was more market driven. The result has been 40 years of sustained high economic growth rates of between 6–10 percent,compounded annually. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment

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increased to an annual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late1990s, making China the second-biggest recipient of FDI inflows in the world after the United States. The growth has continued,with inward investments into China hitting $136 billion in 2017 (with another $104 billion going into Hong Kong). Over the past20 years, this inflow has resulted in the establishment of more than 300,000 foreign-funded enterprises in China. The total stock ofFDI in mainland China grew from almost nothing in 1978 to $1.49 trillion in 2017 (another $1.97 trillion of FDI stock was inHong Kong).

The reasons for this investment are fairly obvious. With a population of more than 1.3 billion people, China represents theworld’s largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if acompany wanted to tap into the country’s huge potential. China joined the World Trade Organization in 2001. As a result, averagetariff rates on imports have fallen from 15.4 percent to about 8 percent today. Even so, avoiding the tariff on imports is still amotive for investing in China (at 8 percent, tariffs are still significantly above the average of 1.9 percent found in many developednations). Notwithstanding tariff rates, many foreign firms believe that doing business in China requires a substantial presence inthe country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relativelyinexpensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes Chinaan attractive base from which to serve Asian or world markets with exports (although rising labor costs in China are now makingthis less important).

Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. For one thing,despite decades of growth, China still lags behind developed nations in the wealth and sophistication of its consumer market. Thislimits opportunities for Western firms. For example, real GDP per capita in China was only $7,329 in 2017, compared to $53,129in the United States. Moreover, income and wealth in China is skewed towards a few areas, notably around Beijing and Shanghai,where real household income per capita is about four times the level in the country’s poorest provinces.

Other problems include a highly regulated environment, which can make it problematic to conduct business transactions, andshifting tax and regulatory regimes. Then there are problems with local joint-venture partners that are inexperienced, opportunistic,or simply operate according to different goals. One U.S. manager explained that when he laid off 200 people to reduce costs, hisChinese partner hired them all back the next day. When he inquired why they had been hired back, the Chinese partner, which wasgovernment owned, explained that as an agency of the government, it had an “obligation” to reduce unemployment. Western firmsalso need to be concerned about protecting their intellectual property because there is a history of intellectual property not beingrespected in China, although this may now be starting to change.Sources: Interviews by the author while in China; United Nations, World Investment Report, 2017; Linda Ng and C. Tuan, “Building a Favorable Investment Environment:Evidence for the Facilitation of FDI in China,” The World Economy, 2002, pp. 1095–114; S. Chan and G. Qingyang, “Investment in China Migrates Inland,” Far EasternEconomic Review, May 2006, pp. 52–57; Rachel Chang, “Here’s What China’s Middle Classes Really Earn—and Spend,” Bloomberg, March 9, 2016; Yi Wen, Income andLiving Standards Across China,” On the Economy Blog, Federal Reserve Bank of St Louis, January 8, 2018; Gordon Orr, “A Pocket Guide to Doing Business in China,”McKinsey, October 2014, archived at www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/a-pocket-guide-to-doing-business-in-china.

The dramatic rise of China, particularly since 2010 when outward investment by Chinese multinationalsstarted to surge, may soon upset this long established narrative. In 2005, Chinese firms invested some $12billion internationally. Since then, the figure has risen steadily, reaching a record $196 billion in 2016 before slippingback to $130 billion in 2018. Firms based in Hong Kong accounted for another $87 billion of outward FDI in 2017 and$85 billion in 2018. Much of the outward investment by Chinese firms has been directed at extractive industries in lessdeveloped nations (e.g., China has been a major investor in African countries). A major motive for these investments hasbeen to gain access to raw materials, of which China is one of the world’s largest consumers. There are signs, however,that Chinese firms are starting to turn their attention to more advanced nations. In 2017, Chinese firms invested $25billion in the United States, up from $146 million in 2003.10

THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTSFDI takes two main forms. The first is a greenfield investment, which involves the establishment of a new operation ina foreign country. The second involves acquiring or merging with an existing firm in the foreign country. UN estimatesindicate that some 40 to 80 percent of all FDI inflows were in the form of mergers and acqui