Basics of

International
Business
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Basics of
International
Business

James P. Neelankavil and Anoop Rai

 ____________________________
To
Angel, Prince, Erica, and Salve
and
Justin, Sonali, and Pat
with our love
____________________________

First published 2009 by M.E. Sharpe

Published 2015 by Routledge

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711 Third Avenue, New York, NY 10017, USA

Routledge is an imprint of the Taylor & Francis Group, an informa business

Copyright © 2009 Taylor & Francis. All rights reserved.

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Notices
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or from any use of operation of any methods, products, instructions or ideas
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Practitioners and researchers must always rely on their own experience and
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be mindful of their own safety and the safety of others, including parties for
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Library of Congress Cataloging-in-Publication Data

Neelankavil, James P.
Basics of international business / by James P. Neelankavil and Anoop Rai.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-7656-2392-8 (pbk. : alk. paper)
1. International business enterprises. 2. International finance. I. Rai, Anoop, 1955– II. Title.

HD2755.5.N44 2009
658'.049—dc22 2008049003

ISBN 13: 9780765623928 (pbk)

 Contents

PREFAcE AND AcKNOWLEDGMENTS ix

1. INTRODUCTiON AND OVERViEW 3
Learning Objectives 3
Reasons for Growth in International Business 7
Types of International Operations 8
International Business Research and the Need for Information 11
Ethical Considerations in International Business 17
Stakeholder Theory and Corporate Social Responsibility 22
Corruption 28
Chapter Summary 35
2. INTERNATiONAL BUSiNESS ENViRONMENT: CULTURE 38
Learning Objectives 38
Cultural Environment 39
Framework of Cultural Classification 47
Cultural Generalization 60
Cultural Convergence 61
Culture Shock 61
Cultural Orientation 62
Chapter Summary 63
Application Case: Business Negotiations and Cultural Pitfalls—Mexico 65
3. ECONOMiC AND OTHER RELATED ENViRONMENTAL VARiAbLES 67
Learning Objectives 67
The Economy 67
Economic Development and International Business 72
Economic Factors and International Business Strategy 78
Economic Factors and Country Risk Analysis 81
Chapter Summary 90
Application Case: China’s Economy and Foreign Direct Investment Flows 92
4. THE POLiTiCAL AND LEGAL ENViRONMENT 94
Learning Objectives 94
The Political Environment 94

v
VI CONTENTS

The Legal Environment 107

Chapter Summary 114
Application Case: Adapting Finance to Islam 115
5. INTERNATiONAL TRADE AND FOREiGN DiRECT INVESTMENTS 117
Learning Objectives 117
International Trade 117
Mercantilism 118
Theory of Absolute Advantage 118
Theory of Comparative Advantage 119
Heckscher-Ohlin Factor Proportions Explanation for International Trade 121
The Product Life Cycle Theory 121
Global Patterns of Trade: Statistics 122
World Trade Organization 124
International Trade in the Future 125
Foreign Direct Investment 126
Chapter Summary 142
Application Case: Siemens in Argentina 144
6. ENTRY STRATEGiES 146
Learning Objectives 146
Export/Import Strategy 147
Direct Investments 160
Comparison of the Various Modes of Entry Strategies 168
Chapter Summary 169
Application Case: General Electric 170
7. FUNCTiONAL INTEGRATiON 172
Learning Objectives 172
Production and Operations Management 174
Finance 176
Marketing 177
Human Resources 180
Accounting 182
Management Information Systems 183
Research and Development 184
Chapter Summary 185
Application Case: BMW in India 187
8. INTERNATiONAL PRODUCTiON & OpERATiONS MANAGEMENT
AND SUppLY-CHAiN MANAGEMENT 189
Learning Objectives 189
Operations Management in Manufacturing vs. Services 190
Internationalization of Production & Operations Management 191
Decisions in Production & Operations Management 192
Operations Management Strategies and Supply-Chain Management 215
 CONTENTS VII

Chapter Summary 218

Application Case: Toyota and Lean Manufacturing 219
9. GLObAL OUTSOURCiNG OR OffSHORiNG 221
Learning Objectives 221
Outsourcing, Offshoring, Inshoring, and Near-Shoring 223
Offshoring of Services: Internet Technology vs. Business
  Process Offshoring 225
Future of Offshoring Services 230
Toward a Global Offshoring Strategy 232
Advantages and Disadvantages of Offshoring Services 233
Chapter Summary 241
Application Case: Evalueserve and Knowledge Process Outsourcing 243
10. THE FOREiGN EXCHANGE MARKET 245
Learning Objectives 245
Definition of Foreign Exchange 246
Appreciation and Depreciation of Currencies 247
Major Currencies of the World 249
The Euro 249
History of Foreign Exchange 250
Size of the Foreign Exchange Market 255
Determination of Foreign Exchange Rates 256
Participants in the Foreign Exchange Market 258
Exchange Rate Regimes 259
Multinationals and Foreign Exchange 260
Chapter Summary 264
Application Case: Dollarization and the Case of Ecuador and El Salvador 265
11. INTERNATiONAL MARKETiNG 268
Learning Objectives 268
Final and Industrial Consumers 269
Goods vs. Services 269
Marketing Activities 270
Basics Steps in International Marketing 273
Developing an International Marketing Strategy 274
Chapter Summary 297
Application Case: Natura—A Brazilian Success Story 299
12. INTERNATiONAL HUMAN RESOURCES MANAGEMENT AND
ORGANiZATiONAL STRUCTURES 301
Learning Objectives 301
Managing the Human Resources Function 303
Organizational Structures 314
Chapter Summary 326
Application Case: Chiba International 329
VIII CONTENTS

13. INTERNATiONAL FiNANCiAL MANAGEMENT 331

Learning Objectives 331
International Expansion 331
International Banks 334
International Transactions 337
International Shipping 341
International Insurance 343
Stock Exchanges and Markets 344
Regulatory Agencies 347
The Foreign Corrupt Trade Practices Act of 1977 349
The Financial Crisis of 2008 349
Chapter Summary 350
Application Case: Iceland 2008—Concern for Exporters and Importers 352
14. INTERNATiONAL ACCOUNTiNG 354
Learning Objectives 354
Basics of International Accounting 355
History of Accounting 359
Toward a Global Accounting System 360
International Accounting and Taxes 367
Chapter Summary 373
Application Case: The Fannie Mae Accounting Scandal 375
Appendix 14.1. Summary of Some Similarities and Differences
  between IFRS and U.S. GAAP 377
Appendix 14.2. Global Corporate and Indirect Taxes, 2007 380
AppENDiX 1. REGiONAL ECONOMiC INTEGRATiONS 382
Benefits of Integration 383
Activities and Operations of NAFTA and the European Union 384
AppENDiX 2. WORLDWiDE ORGANiZATiONS AND INTERNATiONAL AGENCiES 402
The International Monetary Fund 402
The Organisation for Economic Co-operation and Development 408
The United Nations 411
The World Bank 422
AppENDiX 3. THE INTERNET iN INTERNATiONAL BUSiNESS 427
The Internet and Business 427
The Internet and International Business 428
Appendix 3 Summary 433
NOTES 435
GLOSSARY 455
NAME INDEX 463
SUBJEcT INDEX 465
ABOUT THE AUTHORS 485
Preface and Acknowledgments

This textbook is aimed at students who wish to learn and work in the field of in-
ternational business. International business consists of the activities of commercial
organizations across borders. Over the past 50 years, international business has
grown rapidly, and it is now fair to say that it makes up a large portion of the busi-
ness activities around the world. Moreover, the globalization of markets—that is, the
trend toward borderless markets—has further enhanced the growth in activities of
international companies.
The field of international business is dynamic, complex, and challenging. Daily
worldwide events such as changes in governments, economic shifts, political tur-
moil, and natural disasters all affect the operations of international companies. To
function under these challenging conditions, international business executives need
to understand the complexities of their external environments; furthermore, they
need to have a sound knowledge of business practices that can help them develop
viable strategies to manage their operations. With this in mind, the objectives of this
introductory textbook are to familiarize students with the external environments that
affect international businesses, to show students how to recognize the processes in
identifying potential foreign markets, and to help students understand the functional
strategies that can be developed to succeed in this highly competitive environment.
Every student of international business should be familiar with this process.
The concepts, theories, and techniques presented here are organized around seven
major topical areas:

1. An introduction and overview of international business

2. Environmental variables and in-depth discussion of the key variables

a. Culture and its effects on businesses and customers

b. Political and legal environment
c. Economic and competitive environment

3. Discussion of entry strategies

4. International trade and foreign direct investments
5. Integration of functional areas
6. Discussion of specific functional areas

ix
X PREFAcE AND AcKNOWLEDGMENTS

a. Production and operations management

b. International marketing
c. Human resources management and organizational structures
d. International financial decisions
e. Managing foreign exchange
f. International accounting

7. Global outsourcing and its role in international operations

In writing this book, we have drawn from our collective experiences in teaching
international business courses. Our philosophy in developing this textbook has been
shaped by many authors, who over the years have influenced our thinking.
Many people assisted us in the preparation of this book by contributing their time
and efforts in suggesting revisions, compiling data, writing programs, and being
cheerleaders. To them we owe a great debt of gratitude. Of the many individuals who
helped in the development of this text, the following went out of their way to see this
work to its completion: our colleagues Mauritz Blonder, Claudia Caffereli, Debra
Comer, Songpol Kulviwat, Keun Sok Lee, Rusty Mae Moore, Shawn Thelen, Rick
Wilson, and Yong Zhang; our graduate assistants Eugene Dotsenko, Daniel Novello,
and Sila Saylak; and Eileen G. Chetti for her editorial work.

ACKNOWLEDGMENTS
We appreciate the helpful suggestions of our peers who took time out from their busy
schedules to read individual chapters and suggest changes that have considerably
improved the material in the text:

Dr. Sandip Dutta, Southern Connecticut University

Dr. Tao Gao, Northeastern University
Dr. Jing Hu, California State Polytechnic University
Dr. M. P. Narayanan, University of Michigan
Dr. Sam Rabino, Northeastern University
Dr. Gladys Torres-Baumgarten, Kean University
Dr. Ashok Vora, Baruch College
Dr. Erik Devos, University of Texas—El Paso

We would like to extend a special thanks to Harry M. Briggs, executive editor of

M.E. Sharpe, for his interest in and wholehearted support of this project. Also, thanks
to all the staff at M.E. Sharpe, especially Stacey Victor, Production Editor, and Eliza-
beth Granda, Associate Editor for their help during the production process.
Finally, we would like to thank our families—Angel, Prince, Erica, and Salve, and
Justin, Sonali, and Pat—for being there for us throughout this process and encouraging
us during times of frustrations and setbacks; to them, we are eternally indebted.
Basics of
International
Business
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 1 Introduction and Overview

International business involves understanding the external environment,

conducting country risk analysis, deciding on an entry strategy, managing the
strategic functions, understanding the effects of foreign exchange
transactions, and recognizing the value of global outsourcing.

LEARNiNG ObJECTiVES
• To understand the growth and importance of international business
• To understand the scope of international business
• To recognize the differences among various international organizations
• To understand the importance of international business research
• To understand the ethical considerations in international operations
• To understand stakeholder theory and corporate social responsibility in an inter-
national setting
• To understand the causes and effects of corruption

Businesses have engaged in international trade for thousands of years. In fact, in-
ternational business has played a major role in shaping world history, from nations’
attempts to control trading routes to their colonization of countries. International trade
(exports and imports) has grown from US$50 billion just 50 years ago to US$12 tril-
lion in 2006.1 Between 2000 and 2006, international trade grew at an annual rate of
13 percent for a total growth rate of 87 percent over the course of just six years. The
following sections discuss some of the critical activities involved in international com-
panies’ business operations, including (1) the reasons for pursuing overseas markets,
(2) the various forms of entry into foreign markets, (3) the types of organizations that
are involved in international operations, (4) the need for information and functional
strategies among international companies, and (5) the ethical and corporate social
responsibility considerations in international operations.
In the new world order, Chinese, European, Japanese, South Korean, and U.S.
companies will not only be competing with each other; they will also be competing
with highly competitive companies from many parts of the world, including companies
from other Asian countries, Latin American countries, and central European countries.

3
4 CHApTER 1

Because of these changes, the World Economic Forum’s Global Competitiveness Index
(GCI) will reflect the emergence of many countries that were not on the previous lists.
For example, Brazil and Russia have both moved up to the top half of the list. One
surprising element is that the United States—even with its recent economic turmoil
due to the 2008 credit crisis—is still ranked number one on the index.
International business management is a complex, multidimensional field. The
intense competition for world markets, global expansion, and dramatic changes in
technology have made the task of managing an international firm very challenging.
Phenomenal growth in many Asian and Latin American countries is shifting the world
economic order from the West to other parts of the world. Singapore, which a few years
ago was labeled a newly industrialized country (NIC), is now a fully industrialized
country. China has been experiencing double-digit economic growth rates for nearly
a decade and projections point to a sustained growth rate of greater than 8 percent for
the coming decade. India’s real gross domestic product (GDP) grew by 7.5 percent
in 2005, by 8.1 percent in 2006, and by an estimated 8.5 percent in 2007.2 China
and India are expected to be major economic powers of the twenty-first century. On
a macroeconomic level, these countries pursue different strategies: China follows
a state-driven export-oriented economy; India, however, follows a market-oriented
consumption-driven economy. Both countries have been successful in their pursuit
of economic growth.
The emergence of China and India as major forces in international trade is not an
isolated random occurrence. Countries such as Brazil, South Korea, and Taiwan are
leading exporters of high value goods, including automobiles, commercial airplanes,
and computer hardware. South Korea is one of the world’s leading shipbuilders. These
countries present a vast and untapped market for goods and services. Such growth,
coupled with stagnant and saturated markets in most of the industrialized nations, is
forcing many companies to seek their own growth in these emerging markets. For
example, Hewlett-Packard (HP) has weathered the softening of demand for its com-
puters through its expanding international operations. HP generates approximately
65 percent of its revenues from overseas markets.3 Similarly, domestic sales for
Power Curbers, a U.S.-based machinery manufacturer, are expected to decline by 10
percent, but this decline is offset by the firm’s foreign sales, which are growing at
a much higher rate.4 Hence, the foreign expansion of U.S. companies into overseas
markets is driven by both large and small to medium-sized companies, and most U.S.
companies have recognized the immense potential for growth in foreign markets.
According to the Standard & Poor’s 500 stock index (S&P 500), more than half of
these companies’ sales are expected to come from abroad.5
Rising input costs in industrialized countries are another motivation for compa-
nies to expand their operations into overseas markets. An assembly line worker in
the Volkswagen plant in Wolfsburg, Germany, earns $25 an hour and works 33 to
35 hours per week compared to a factory worker in China who earns $2 to $3 a day
and works 45 to 48 hours per week. (Minimum wage standards in China vary from
province to province. For example, in Shenzhen the minimum wage is $101.25 per
month, in Shanghai it is $86.25 per month, and in Fujian it is $53.75 per month.)6 The
availability of low-cost resources such as labor and raw materials in foreign markets
 INTRODUcTION AND OVERVIEW 5

Table 1.1

Average Hourly, Weekly, and Monthly Wage Rates in the Manufacturing Sector for
Selected Countries (US$), 2006

# Country Hourly Wage Rate Weekly Wage Rate Monthly Wage Rate
 1 Austria 19.38 — —
 2 Australia — 870.00 —
 3 Canada 17.76 — —
 4 Czech Republic — — 884.32
 5 China — — 102.00a
 6 Ireland 19.04 758.10 —
 7 Japan — — 3,569.10
 8 Netherlands — 1,082.72 —
 9 Philippines 5.32 — —
10 Romania — — 383.83
11 Singapore — — 2,364.70
12 South Korea — — 2,799.35
13 Spain 16.97 — 2,382.50
14 Taiwan — — 1,298.40
15 United Kingdom 19.25b — —
16 United States 16.50–25.00c — —
Source: ILO Statistics and Database, available at http://www.ilo.org/ (accessed June 19, 2007).
Notes: The International Labor Organization (ILO) reports labor rates in hourly, weekly, and monthly
rates depending on how each country reports the data. The ILO reports rates in local currency. Rates have
been translated in U.S. dollars using the average exchange rate for the year.
aAs reported by China Labor Watch, July 2006, pp. 1–4.
bUK Statitistics Authority, “Wage Rates.” Available at http://www.statistics.gov.uk/ (accessed June 19,

2007).
cU.S. Bureau of Labor Statistics, available at http://www.bls.gove/oes (accessed June 19, 2007).

makes global expansion attractive to international firms. For example, Motorola, a

U.S.-based electronics company, has set up two large manufacturing plants in China
to tap into the low-cost but highly trained workforce. Motorola has invested more
than $3 billion in China and is the largest foreign investor in China’s electronics
industry. It employs 9,000 Chinese workers and has committed itself to improving
China’s technological base. Similarly, Intel is building a chip manufacturing facility
at Dalian at a cost of $2.5 billion. Table 1.1 presents hourly, weekly, or monthly labor
costs for 16 selected countries.
As shown in Table 1.1, wage rates range widely from country to country. China’s
monthly wage rate, one of the lowest at $102.00, is one-thirty-fifth of Japan’s monthly
rate of $3,569.10. It is no wonder, then, that international companies seek out countries
where they can benefit from these low wage rates, provided the skill and productivity
levels of the workers from the low-wage-rate countries are comparable to those of
higher-wage-rate countries.
Businesses are adapting to a more global philosophy, as well. Globalization im-
plies that the countries of the world are more interdependent on each other and that
the people in these countries are affected by events and conditions outside their own
country. Take for example the 2008 credit crisis. The mess caused by fast-and-loose
6 CHApTER 1

Table 1.2

The World’s Ten Largest International Corporations Ranked by Revenues, 2007

Revenues Net Earnings Total Assets Employees In # of

Rank Company Country (000,000,000) (000,000,000) (000,000,000) (000) Countries
 1 Wal-Mart U.S. 351.1 11.2 151.2 1,900.0   15
 2 ExxonMobil U.S. 347.2 39.5 235.3 108.0 130
 3 Royal Dutch Shell Netherlands 318.8 25.4 192.8 114.0 145
 4 British Petroleum U.K. 274.3 22.0 217.6 96.0 100
 5 General Motors U.S. 207.3 (2.0) 284.0 186.2 150
 6 Toyota Japan 204.7 4.1 244.6 299.4 170
 7 Chevron U.S. 200.6 17.1 125.8 62.5 180
 8 DaimlerChrysler Germany 190.2 3.2 201.6 360.4 Over 100
 9 ConocoPhillips U.S. 172.5 15.6 164.8 32.7   40
10 Total France 168.4 14.8 126.3 96.4 130
Source: “Global Five Hundred,” Fortune, July 24, 2008, pp. 89–98; Fortune Global 500, July 23, 2008,
pp. 130–139, and company financial reports, December 2007.

mortgage lending in the United States escalated into a perilous global crisis of con-
fidence that revealed both the scale and the limitations of globalization. The credit
crisis worsened and became a global problem because of the interdependence of the
countries of the world. Tied together in an increasingly tattered web of loans, banks
around the world dragged one another down.
Globalization proposes that companies view the world as one single market to as-
semble, produce, and market goods and services. Globalization is defined as sourcing,
manufacturing, and marketing goods and services that consciously address global
customers, markets, and competition in formulating a business strategy. According
to John Zeglis, CEO and president of AT&T, in the future, there will be two kinds of
companies: those companies that go global and those companies that go bankrupt.7
From simple across-the-border transactions a few decades ago, international busi-
ness has grown to encompass a vast network of countries, installations, individuals,
resources, and organizations. Table 1.2 presents the world’s ten largest international
corporations ranked by revenues for the year 2007.
The dynamic changes affecting the economic, political, and social climate in many
countries represent a new challenge to businesses. Western Europe has dismantled
the internal barriers to form a unified region with a single currency and a vast market
made up of 500 million consumers. The former Soviet Union has spawned 18 new
countries. Eastern Europe and Russia have acknowledged the failure of centrally
managed economies and have adapted free market economic structures and privatiza-
tion. Indeed, the world has changed profoundly over the past decade. Some perceive
these dynamic shifts as problem areas, but these changes also provide some rare
opportunities that never existed before. Higher economic growth among emerging
economies, coupled with stagnant economic growth in Europe and Japan in the past
decade, has shifted the balance of and direction in investments. Since the 1950s,
growth in international investments has been substantially larger than the growth
 INTRODUcTION AND OVERVIEW 7

in the U.S. economy. Large multinational companies derive more than half of their
revenues and profits from international operations. Examples of such companies and
their percentage of international earnings include Siemens (77 percent), Philips (73
percent), Sony (71 percent), Coca-Cola (70 percent), Toyota (66 percent), Procter &
Gamble (51 percent), and Unilever (50 percent).

REASONS fOR GROWTH iN INTERNATiONAL BUSiNESS

We have mentioned many reasons for the growth in international business. Some are
related to the internal workings of a company; others are market-related factors; and
still others are related to the external environment. The following list includes some
of the main reasons for international business growth over the last 20 years.

• Saturation of domestic markets. In many of the industrialized countries, market

penetration of most goods and services has reached saturation levels. For ex-
ample, penetration of appliances, telephones, and televisions in Europe, Japan,
and the United States is over 95 percent. Therefore, further growth potential in
these countries is nonexistent.
• Sales and profit opportunities in foreign markets. As the markets in industrialized
countries attain saturation levels, consumers in countries that are just attaining
economic growth are demanding goods and services at unprecedented levels—
levels that most often only international companies can meet. For instance, the
number of cars sold in Asia is growing rapidly, with sales in China alone expected
to reach more than 6 million by the year 2008.8
• Availability of low-cost labor. As show in Table 1.1, labor rates in industri-
alized countries are high, driving production costs higher. To counter this
increased cost, international companies shift production facilities to countries
with lower labor costs. For example, 90 percent of the clothes bought by
Americans come from places like China, Mexico, Bangladesh, Honduras,
Indonesia, and Vietnam.9
• Phenomenal economic growth in many emerging economies. The economic
growth occurring in Brazil, China, the Czech Republic, India, South Korea,
Tunisia, and Taiwan, for example, has created a large middle-class consumer
base that is in a position to acquire high-priced quality goods and services from
global brand-name producers.
• Competitive reasons. Either to stem the increased presence of foreign companies
in their own domestic markets or to counter the expansion of their domestic
competitors into foreign markets, international companies have used overseas
market entry as a countermeasure to increased competition. Both these actions are
defensive measures that prevent domestic and foreign competitors from gaining
undue advantage.
• Pent-up demand for goods and services among the population of the emerging
economies. Consumers in countries that did not have the purchasing power to
acquire high-quality goods and services are now able to buy them due to improved
economic conditions.
8 CHApTER 1

• Diversification attempts by international companies to reduce risk. One benefit

of the international expansion of businesses is that international companies are
able to counter the cyclical patterns of growth observed in different parts of
the world. For example, if Asian countries are undergoing a downturn in their
economies that affects profitability, the robust economies of Latin America will
provide opportunities for substantial profits.
• Progressive reduction of trade barriers among nations through cooperation. This
shift has stimulated cross-border trade between countries and opened markets
that were previously unavailable for international companies due to tariff and
nontariff barriers.
• Cultural convergence in tastes and values. Due to advances in telecommunication
technology, the world is well informed about events, product offerings, and sites
(McDonalds, Starbucks, and MTV) that offer goods and services online. This
has led consumers from all over the world to buy goods and services made in
different countries through Web sites such as Amazon.com, eBay, and the like.
• The spread of economic integration among nations facilitating trade and the
barrier-free flow of resources from country to country (expanded European
Union, NAFTA, and other bilateral arrangements). In addition, the integration of
countries has created vast domestic markets that open up investments in capital-
intensive industries.
• Advances in technology in such areas as computers, telecommunications, and
travel. Technological advances have reduced the costs of transportation and
logistics and have also produced improvements in supply-chain management,
significantly reducing the costs of coordinating production among globally dis-
tributed suppliers.

As international companies venture into foreign markets, these companies will need
managers and other personnel who understand and are exposed to the concepts and
practices that govern international companies. Therefore, the study of international
business may be essential to work in a global environment.

TYpES Of INTERNATiONAL OpERATiONS

Businesses can get involved in international operations in many different ways. The
most common and perhaps the easiest way for companies to venture into international
operations is through exports and/or imports of goods and services. Other types of
international operations include licensing agreements such as franchising; direct in-
vestments; and portfolio investments. Chapter 6 discusses these operations in detail
as part of the entry strategies available for an international company.

EXpORTS/IMpORTS
Trading through exporting and importing is a good way for companies to enter and
establish a presence in foreign markets. It may serve as a stepping stone for greater
commitment in the market at a later date. This is especially true for larger interna-
 INTRODUcTION AND OVERVIEW 9

tional companies. In most countries, smaller firms are in the business of exporting or
importing (or both) goods and services. These operations require minimal capital and
very few staff. Typically, exports are the easiest means of generating foreign-currency
reserves, provided the country imports fewer goods and services than it exports. For
example, China’s trade surplus for 2007 was estimated to be more than US$200 billion.
Chinese and foreign companies operating in China exported US$350 billion worth
of goods, while their imports for the year were valued at US$150 billion. Through
exports, an international company can sell any type of goods from slippers to large
commercial airplanes.
Services too, can be exported. Service exports may be in the form of travel,
tourism, financial services (banking, insurance, investment banking, and the like),
and other services such as accounting, education, engineering, and management
consulting. Many Caribbean countries earn a major share of their foreign-currency
reserves through tourism. As people travel to these islands for vacations, they ex-
change their currencies for local currency, which they then use for food, lodging,
and sightseeing.

LIcENSING AND FRANcHISING AGREEMENTS

Licensing agreements allow a local company to use a copyright, patent, or a trademark
that is owned by a foreign company for a preset fee. Franchising is a specific type
of licensing agreement in which the foreign company (the franchisor) sells to a local
company or independent party (the franchise) the use of a brand name or trademark,
which is considered an important business asset. For example, many McDonald’s
outlets in overseas markets are set up as franchise agreements.

FOREIGN DIREcT INVESTMENTS

A foreign direct investment (FDI) is the acquisition of plant, machinery, and other
assets in foreign countries. These investments may be through joint venture partner-
ships or through a wholly owned subsidiary in a foreign country. Through direct
investments, management has partial or full control of its operations. For example,
when Intel invests US$2 billion in Leixlip Ireland to manufacture chips, it is involved
in FDI operations.10 Intel assumes that its investments will generate sufficient cash
flows to justify this investment. In recent years, China has been the world’s biggest
recipient of FDI: in 2006 alone its FDI inflows were nearly US$70 billion. Table 1.3
presents the FDI flows of ten selected countries for 2006.

PORTFOLIO INVESTMENTS
Portfolio investments are purchases of financial assets with a maturity greater than
one year (as opposed to short-term investments, which mature in less than one
year). As companies go global, so do increasing numbers of investors. Investors
are buying foreign stocks and bonds as part of their financial portfolios. The total
return on an investment is made up of dividend or interest income, capital gains
10 CHApTER 1

Table 1.3

FDI Flows to a Few Selected Countries, 2006

# Country FDI flows (US$ hundred millions)

 1 Australia 24.0
 2 Brazil 18.2
 3 Canada 69.0
 4 China 69.5
 5 Czech Republic 5.9
 6 India 16.9
 7 Mexico 19.0
 8 New Zealand 8.0
 9 Philippines 2.3
10 United States 175.3
Source: United Nations Conference on Trade and Development, World Investment Report, 2007.

and losses, and currency gains and losses. International investing diversifies an
investor’s portfolio, which helps reduce risk and provides greater opportunities
than domestic investing.

ORGANIZATIONAL LABELS FOR INTERNATIONAL COMpANIES

International companies are given different names depending on who labels them, that
is, government agencies, international organizations, the business press, or academi-
cians. Though they have similar meanings, these labels are quite often confusing. The
following is a list of labels that apply to international companies.

• International company—a company of any size that participates in any form of

business operation (export/import, licensing/franchising, strategic alliances, and
FDI) outside its national boundaries (cross-border activity).
• Multinational corporation (MNC)—a large international company that has ex-
tensive involvement in international operations through direct investments and
control of operations.
• Multinational enterprise (MNE)—similar to an MNC; a large, well-organized
international company that operates in overseas locations and has considerable
resources invested abroad.
• Transnational corporation (TNC)—an international company owned and managed
by nationals from different countries. For example, Unilever is a joint holding of
British and Dutch nationals. The term “transnational” is also used by the United
Nations in reference to international companies.
• Global company—an international company with a network of worldwide inte-
grative activities that attempts to standardize its products and service offerings.
A global company might have its manufacturing in one country, technology from
another country, capital from a third country, and distribution covering many
countries. For example, Canon Inc. manufactures its products in China, uses
 INTRODUcTION AND OVERVIEW 11

Japanese technology, gets financing from outside Japan, and sells its finished
goods worldwide.

INTERNATiONAL BUSiNESS RESEARCH AND THE NEED fOR INfORMATiON

As businesses venture outside their own countries, the need to understand the
market conditions in foreign countries becomes more and more critical. Business
research, like all business activity, has become increasingly global. Companies
that have operations in foreign countries must understand the unique features of
these markets and determine whether they need to develop customized strategies
to be successful. For example, to tap into the vast Chinese market, international
companies are dispatching legions of researchers to China in order to get a sense
of consumers’ tastes.11 Before 1990 there was only one professional marketing
research firm in the whole of China; today there are more than 300 professional
firms.12 From the first quarter of 2000 to the second quarter of 2002, requests for
market research proposals in China increased dramatically, from 22 percent to 42
percent.13 Most of the world’s large research suppliers now have offices in China.
It is no longer sufficient to try to determine what Chinese consumers want simply
by accessing lists of how much individuals earn and what they own. Companies
need to understand what motivates Chinese consumers and what products they
want and can use.
Information about environments, customers, market forces, and competition is es-
sential in planning entry into an overseas market. Generally, business executives lack
detailed knowledge of overseas market conditions. Compounding the problem is the
unpredictability of the foreign markets compared to markets in many of the industri-
alized countries, which are more stable and predictable. For instance, the economic
turmoil experienced in countries such as Indonesia, Malaysia, and Thailand in July
1997 came as a surprise to most business leaders and economists, as these countries
had been projected to continue their strong growth into the twenty-first century. The
home market presents a known environment for business executives, whereas a foreign
market appears to be a black hole for many of these same executives. The availability
of accurate information is most often the equalizer in this equation, which is why
large international companies spend millions of dollars on information acquisition.
For example, Hitachi Corporation of Japan spends a major portion of its $4 billion
research and development (R&D) budget on understanding its target customers.14
Information is essential to business decision making. Information gathered through
research is useful in defining problems, resolving critical issues, identifying oppor-
tunities, and fundamentally improving the strategic decision-making process in an
organization. Specifically, in international business, research may be used to identify
countries with the greatest growth potential, to predict changes in the political envi-
ronment of a country, to decide on a location for a manufacturing plant, to identify
sources of capital, or to select a target market. In addition, information may be used
to evaluate the effectiveness of a business plan.
Access to current, high-quality information is essential for businesses, whether
they operate domestically or internationally; for international companies, however,
12 CHApTER 1

the need for useful information is much greater because of the uncertainties of
the international markets. As mentioned earlier, international business operates in
an unknown and more volatile environment than domestic business. Many of the
external variables that have little effect on businesses in domestic markets play a
critical role in international operations. For example, changes in political stabil-
ity, exchange-rate volatility, and sudden surges in inflation do not ordinarily take
place in Japan, the United States, and other industrialized countries. For companies
and their executives operating in these countries, managing such environments is
much easier than, say, running a subsidiary in Bolivia, Ghana, or Indonesia, where
inflation sometimes reaches double and triple digits. In addition, some developing
countries can present serious problems such as the sudden collapse of governments,
the unpredicted devaluation of local currencies, or unexplained changes in business
regulations. Outside of the industrialized group of countries, the business environ-
ment tends to be unpredictable.
Many international business failures result from executives neglecting to rec-
ognize cultural and market-related differences. Consider the following examples,
which show how research would have helped the international company avoid an
embarrassing situation while preventing the loss of market share and/or profits.
When a furniture polish company introduced its aerosol spray polish and advertised
its timesaving attribute in Portugal, the product failed miserably; the housewives in
Portugal were reluctant to buy such a labor-saving device for their maids. A com-
prehensive consumer study might have revealed the cleaning habits of Portuguese
households and helped the company avoid this costly mistake. In a similar case,
when General Mills introduced one of its breakfast cereals in the United Kingdom,
its package showed a grinning freckle-faced redheaded kid with a crew cut saying,
“See, kids, it’s great.” The campaign failed to recognize that in the United King-
dom, the family is not as child oriented as it is in the United States; hence, mothers
seldom turn over the decision of which foods to buy to their kids. Also, depicting a
so-called typical American kid on the package was not very helpful either. Again,
some research on food-buying habits in the United Kingdom could have saved
General Mills some time and money without significantly delaying their cereal
entry into the UK market.15
Most international executives recognize the need for and usefulness of reliable
information, but quite often time and competitive pressures force them to act quickly,
without doing adequate research. A systematic approach to business research is a
critical first step in exploring international markets. Gathering information through
research is not just confined to the marketing function anymore; more and more fi-
nancial institutions, manufacturing firms, and even human resource departments of
international companies are using business research to be more efficient and effective
in their decision making. For example, as the competitive landscape for financial
services became crowded, investment companies and brokerage houses rushed to
grab consumer deposits. This meant that these institutions needed information. Today,
financial service companies in many parts of the world use an array of qualitative and
quantitative research techniques to guide their decisions, both strategic and tactical.16
Similarly, sophisticated new techniques in cognitive mapping are now being used
 INTRODUcTION AND OVERVIEW 13

by the human resources departments of international companies to assess managers’

mental models.17
Conducting international research is challenging, expensive, and time-consuming.
There are many factors that affect international research. Key factors that need to be
addressed include the cost of research, the availability of secondary data, the quality of
data, time pressures, lead time (time that it takes to complete an international research
study), the complexity of the study, whether a multicountry study is necessary, and
how the research is ultimately used.

COSTS
International research is expensive, and the cost of conducting research varies considerably
from country to country. However, information is essential in reducing operational costs
through improved decision making, and research should be viewed as an investment, not
an expense. One of the reasons for the higher costs in international research is the inabil-
ity to find uniformly qualified staff to execute research studies. A lack of well-qualified
research staff implies that the people hired to conduct the research need to be trained,
which adds to the overall cost of the research. In addition, many developing countries
lack a research infrastructure (focus-group facilities, training facilities, computing skills,
and so on). Therefore, international companies have to either not use the local research
setup or develop the necessary infrastructure on their own. Choosing the latter means
these companies have to train staff, establish research facilities, and develop the needed
computing systems. Such efforts add costs far and beyond the normal costs associated with
conducting research. In some industrialized countries, the costs of conducting research
are higher due to higher personnel wages. Even among industrialized countries, however,
costs vary considerably. For example, a focus group study may cost as little as $5,000 in
the United States, and the same focus group might cost about $10,000 in Japan.

AVAILABILITY OF SEcONDARY DATA

Secondary data is the backbone of international research. It is cost efficient and easily
gathered. Secondary data is sometimes the only information available for international
executives facing critical decisions. In many countries, though, secondary data is sparse
or nonexistent. Local governments do not have the resources or personnel to collect
data; therefore, economic, financial, and other relevant information at the macro level
is often outdated or unavailable. Researchers in the United States, Japan, and other
industrialized countries who are accustomed to an abundance of government-provided
secondary data find their forays into other countries shockingly disappointing.
In some instances when secondary data is available, it is often inaccurate or unreli-
able. In Middle Eastern and African countries where there are large nomadic tribes,
the size of the population might vary depending on the season. Similarly, population
figures would be less accurate where estimates are drawn from village elders, who
sometimes exaggerate the number of villagers residing in a village. In countries where
national income statistics are compiled from tax returns, population figures tend to
be notoriously understated.
14 CHApTER 1

QUALITY OF DATA
International research suffers from inconsistency in quality. In some countries, such
as Germany, Japan, the Netherlands, and the United States, the quality and the reli-
ability of the data collected are high. In other countries, however, especially among
less-developed countries, the quality and reliability of data collected may be ques-
tionable. Quality problems apply to both secondary data and primary data. In many
countries of Africa, Asia, and Latin America, commonly used secondary data such as
the population census, industrial output, and national incomes are often two to three
years old, and in some cases are not available at all.

TIME PRESSURES
Quite often the decision to enter an overseas market is made under considerable time
pressure. Decisions have to be made fast in order for a firm to be the first in a new
country and attain certain competitive advantages. In some instances competitors are
already in the market, and there is an urgency to follow. At other times the necessary
negotiations with host-government agencies dictate the need for quick action. These
conditions lead to a very small window of opportunity for an international company,
forcing executives to arrive at a decision under less-than-ideal time constraints and
leading to actions based on very little information.

LEAD TIME
Generally, it takes more time to obtain information from overseas markets than from
domestic ones. Some of the problems associated with data collection abroad have
already been identified. In addition, an international executive’s lack of knowledge
of the overseas markets makes the task of compiling data even harder. Sometimes,
to overcome its lack of knowledge in the target country, an international company
will rely on local research suppliers or local staff to collect and process data. Other
factors that contribute to the need for longer lead time in international research are the
lack of sophistication in data-collection techniques, the unavailability of databases to
gather up-to-date information, and the lack of single-source data (scanners that read
bar codes off packaged items).

COMpLEXITY OF INTERNATIONAL RESEARcH

Conducting a successful research project in one’s own country is challenging in
itself. When the project is international in scope, the dynamics are even more com-
plex. In an international setting, even the basic research steps have their own twists.
Schedules tend to be longer, vendor selection is more difficult, and depth of analysis
can be weak. Even more difficult is controlling the exact design and methodology
for each country in a multicountry study.18 Among the factors that contribute to the
complexity in international research are different levels of market development, the
vast differences in government policies toward foreign firms, unique sets of external
 INTRODUcTION AND OVERVIEW 15

variables present in foreign markets, and the unfamiliarity of international managers

with consumers and markets in foreign countries.

COORDINATING MULTIcOUNTRY RESEARcH

By definition, international research is conducted across many countries. The differ-
ences in languages, cultures, business practices, and customs make the coordination
of research activities across these markets all the more difficult. Difficulties in estab-
lishing the comparability and equivalency in data collection and analysis can make
research across countries difficult and unusable.
International operations encompass a multitude of activities from a simple export
operation to management of a wholly owned subsidiary. The information requirements
for decision makers vary from situation to situation, depending on a firm’s level of
international activity.
By nature, the operations of international companies are far-flung. Diverse activities
located, in some instances, thousands of miles away from the home office complicate
the management of an international company. For instance, it is much easier for a
Japanese multinational to manage one of its subsidiaries in Guangdong province in
China, just three hours away by air, than to manage one of its operations in Munich,
Germany, which is more than 12 hours and several time zones away.
The issues discussed in the previous section reinforce the importance of research
in international business. At the same time, they highlight the difficulties of conduct-
ing international research, especially considering how the extent and the method of
international research vary from situation to situation. In other words, the information
required to develop an export strategy is quite different and less involved than that
needed to set up a wholly owned subsidiary.
An early decision that many international companies have to make is the choice of
a country in which to expand their operations. Companies choose different approaches
in selecting which markets to enter. Larger companies tend to do their own (internal)
country risk analysis. For medium-sized companies, outside research suppliers pro-
vide this type of research. For smaller companies, secondary data through government
publications or through periodic reports published by the business press can be used to
assess country risk. There are a few research studies available for free or at a reasonable
cost for companies that do not have the personnel or capabilities to conduct a country
risk analysis; Euromoney’s Country Risk Analysis is one such study.

USES OF RESEARcH
International companies use research to identify market potential, to make financial
decisions, to select locations for manufacturing plants, and to develop strategies.

Determining Market Potential

As domestic markets become saturated, companies branch out into foreign countries
to seek newer, untapped markets and maintain a steady flow of revenues and profits.
16 CHApTER 1

Market potential, which is defined as the upper limit of market demand, is the basis
for selecting a country for entry. In estimating market potential, companies consider
factors such as total demand, the size of the target market, overall sales potential,
the size of the subsegment, the buying power of the target segment, frequency of
purchase, volume of purchase per shopping trip, and individual competitors’ share of
market. Information on these and other related areas can make the decision simpler
for international executives.

Financial Decisions

Financial decisions in the international field are complex and risky. Exchange-rate
fluctuations, different accounting systems, and government intervention often compli-
cate financial decisions. Timely, high-quality information assists financial planners in
making objective financing and investment choices. As technology and computers play
a key role in financial decisions, the need for a fast information turnaround becomes
a necessity. Thus, to compete in a complex global financial market, international
companies need to invest in information systems. International companies, which
have more options for acquiring funds than domestic companies, can borrow euro-
based currencies, make use of offshore banking facilities, and borrow from financial
institutions in the countries where they have operations. Because of the number of
choices available for acquiring funds, information becomes crucial in selecting the
most cost-efficient funding source.
The many options available to international companies also force them to obtain
the most current information to minimize their cost of capital and remain efficient in
the management of their funds. Some of the factors that affect financial decisions are
unpredictable and may undergo dynamic shifts. A case in point is the recent exchange-
rate volatility observed in Latin America, Russia, and Southeast Asian countries.
Exchange-rate fluctuations, along with a rise in inflation, increase both the cost and
the risk associated with financial decisions.

Manufacturing Plant Location Decisions

Production facilities are located to take advantage of such factors as inexpensive

and technically qualified labor forces, abundant supplies of raw materials, qualified
supplier sources, efficient transportation systems, and proximity to markets. If raw
materials and adequate parts suppliers are available near major markets, then a pro-
duction facility can be located closer to both the source and the market, completing
the value chain. However, for many multinational firms, inputs come from around
the world, and markets may or may not be located near supply sources.
In addition to location of the production facility, international companies must
decide on the size of the plant, or the capacity, for each of its manufacturing facilities.
Some companies adopt a concentrated production approach, that is, a small number
of large plants in a few locations. Other companies have set up a dispersed strategy,
that is, a large number of small plants in many locations. Matsushita of Japan has just
a few manufacturing facilities, most of them concentrated around Asia and servicing
 INTRODUcTION AND OVERVIEW 17

the entire world market. On the other hand, Philips of the Netherlands has hundreds
of plants located in many countries and servicing one or two markets each.
As international companies develop their manufacturing strategies, they need to
be aware of the highly competitive environment in which they operate. Many fac-
tors affect manufacturing strategies. Some, like costs, are relatively easy to control,
while others, such as quality, are affected by a combination of variables and tend to
be difficult to manage. Efficiency, reliability, and flexibility are the other factors that
international firms need to manage well to gain a competitive advantage in global
operations. Competitive reports and information on sources of materials and suppliers
can help companies create an effective manufacturing strategy. As the globalization
process continues, the need for information on business-related areas also grows.

Formalizing Strategies

High-quality information is essential for developing strategies. By understanding

competitors’ strengths and weaknesses and taking that information through a thor-
ough internal analysis, firms are better able to develop both functional and corporate
winning strategies in the marketplace. Functional strategies focus on individual func-
tions such as manufacturing and marketing. Corporate strategies guide the company’s
overall efforts in all its functional areas. For example, Sharp, the large consumer
electronics company based in Japan, was able to use market research information
called “Town Watching” to increase its operating income by 25 percent in fiscal year
1994 alone.19
Most companies realize that going global is more important than ever before and
something they can no longer avoid. In developing a global strategy these companies
must assess global opportunities and establish a tracking system to evaluate their
efforts. International research is the key to the development of a global strategy.20
International business research has definitely increased since the late 1990s. Many
large international companies make use of research to chart their strategies. In cases
where resources are scarce, global companies typically concentrate on the data that
is most important in conducting their overseas operations.21 The size of the non-U.S.
market for research is now larger than it was in the past. Additionally, some small
exporters are using research to explore foreign markets. These exporters do not make
use of traditional research approaches but rely on personal contact with distributors,
agents, customers, and even competitors to gather information concerning the markets
they serve.22

ETHiCAL CONSiDERATiONS iN INTERNATiONAL BUSiNESS

Ethical behavior in general relates to actions that affect people and their well being.
Whereas the need for ethical behavior at the corporate level applies both to domestic
and international firms and their management, our discussion focuses on international
companies and their managers.
In business, the wrongful actions of managers and their companies can have dras-
tic effects on their employees, their customers, their suppliers, the general public,
18 CHApTER 1

and the environment. When companies disregard safety standards, employees risk
injury or death due to dangerous working conditions, customers may be harmed by
unsafe products, the lives of the general public may be endangered due to dumping of
chemicals in residential neighborhoods, and the environment may be harmed due to
the emission of pollutants into air and water. A firm’s disregard of legal and financial
rules—using corrupt bookkeeping practices, for instance—may result in suppliers
incurring losses or, in a worst case scenario, a company going bankrupt.
It is generally accepted that beyond their normal profit maximization goals,
businesses have a responsibility to society at large, referred to as “corporate social
responsibility,” or CSR. CSR involves the ethical consequences of companies’ ac-
tions, policies, and procedures and is defined as “the social responsibility of business,
[which] encompasses the economic, legal, ethical, and discretionary expectations that
society has of organizations at a given point in time.”23 Mark S. Schwartz and Archie
B. Carroll advanced the three-domain model of CSR, stressing that economic, legal,
and ethical responsibilities are equally important and that managers need to find a
balance among the three in developing their strategies.24 The definition implies that
social responsibility requires companies not only to strive for economic gains, but
also to address the moral issues that they face.
Companies seek economic gains to enhance the value of their investors (U.S.
model of business). Accordingly, the primary duty of managers is to maximize share-
holder returns. Some argue, however, that management’s responsibility is to balance
shareholders’ financial interests against the interests of others, including employees,
customers, and the local community, even if it reduces shareholders’ returns. Ad-
vocates of this opinion feel that employees, customers, and the general community
(called the stakeholders) contribute either voluntarily or involuntarily to a company’s
wealth, creating capacity and activity, and are therefore its potential beneficiaries and/
or risk bearers.25 The principle of social responsibility means that companies need
to be concerned as much about the wider group of stakeholders as about the typical
company stockholders. The issue of satisfying the shareholders versus satisfying
the stakeholders is not as simple as it appears. In a competitive global environment,
executives who wish to make their organizations better “corporate citizens” face sig-
nificant obstacles. If they undertake costly initiatives that their rivals do not embrace,
they risk eroding their competitive position.26
Companies are often held responsible for behavior that in some way affects the
society in which they operate; clearly, businesses must consider the welfare of the
people and their environs. International companies have made major shifts in their
CSR policies and actions in recent years. Initiatives such as investing in organic
products, sustainable energy, and environmentally sound practices are becoming
part of international companies’ standard business operations; such practices now
are considered mainstream.27 For example, in its efforts to improve its CSR, Royal
Dutch Shell, the large Anglo-Dutch oil company, has initiated a three-step process
in dealing with stakeholders’ concerns: after soliciting input from stakeholders, the
company develops an organizational language so that CSR is uniformly understood
by every member of the organization, and finally it takes actions that resolve some
of its stakeholders’ concerns.28 Shareholders are increasingly pressuring companies
 INTRODUcTION AND OVERVIEW 19

to ensure that their investments are morally and ethically justified, showing the close
relationship between business ethics and social responsibility. Some of the initiatives
taken by international companies in the area of CSR include donating money for
improving neighborhoods, providing grants to improve agricultural practices, setting
up medical clinics, and sponsoring educational programs.29
For international managers and their companies, these issues are complicated, as
they are foreigners in the countries where they operate. As a result, their behavior is
scrutinized more closely than that of local businesses and their managers. Furthermore,
because of cultural differences and unique business customs, there may be differences
in what is considered harmful. Depending on the country, the extent to which unethical
behavior is tolerated might vary, as well. For example, under the banner of economic
development, logging has reached new heights in countries with vast tracts of forest.
Logging in the Amazon forests of Brazil and the jungles of Borneo has helped efforts
to increase arable land and add to housing stocks. At the same time, indiscriminate
logging has created vast tracts of barren land that have changed the weather pat-
terns, increased soil erosion, decreased the land’s fertility, and created devastating
mudslides. The governments of developing countries such as Bangladesh, Mexico,
and Nigeria may set a premium on employment to the detriment of the environment,
making them unintended supporters of environmental hazards. Hence, international
managers constantly face ethical issue that they may not be equipped to deal with.
In a dynamic global community, potential conflicts in ethical business behavior
become inevitable due to differences in values and business practices across cultures.
Global business ethics is the application of moral values and principles to complex
cross-cultural situations.30 The question is, Which country’s moral values should be
applied? That is, should business executives adopt the moral values of their home
country, called “absolutism,” or the moral values of the host country, called “rela-
tivism”? Absolutism theorists suggest that the home country’s ethical values must
be applied everywhere the multinational corporation operates. In contrast, relativ-
ism theorists follow the adage “when in Rome, do as the Romans do.” In practice,
however, companies do not tend to adopt one of these two extreme positions when
faced with cross-cultural ethical questions, but consider a middle range of ethical
responses that might be less controversial.31 The case of Levi Strauss & Co. illus-
trates this issue very clearly. Levi Strauss & Co.’s contractors in Bangladesh employ
young children, a legal practice in Bangladesh, but one contrary to U.S. laws and the
company’s own policy. The fact that these children were often the sole providers—
or supplied a significant source—of their family’s income did not change the fact
that Levi Strauss was using child labor. The company’s response to the problem was
to send the children to school and at the same time pay the families their children’s
wages as if they were working.
Local cultures and customs also affect business ethics in other ways. Research has
shown that dimensions of national cultures could serve as predictors of the ethical
standards desired in a specific society.32 It has been suggested that in some countries
societal norms and local institutions may unwittingly encourage people to behave
unethically. For example, cultures that value high achievement and are highly indi-
vidualistic societies are likely to pursue achievement at any cost, even if it means
20 CHApTER 1

Table 1.4

International Companies: Areas of Ethical and Social Responsibility Concerns

Affected Stakeholder Ethical/CSR Issues Situations

Customers • Product safety • Should a company delete safety features to make
• Fair price a product more affordable for people in poorer
• Labels countries?
• Should a sole supplier of goods or services take
advantage of its monopoly?
• Should a company assume the cost of translating all
its product information into other languages?
Stockholders • Fair return on invest- • If a product is banned because it is unsafe in one
ment country, should it be sold in other countries where it
• Fair wages is not banned to maintain profit margins?
• Safety and working • What should a company do if it is found that its
conditions executives have been involved in accounting scan-
dals?
• How much should CEOs be paid? Should share-
holders ignore extremely generous severance
packages?
• Should company pay more than market wages
when such wages result in people living in poverty?
• Should a company be responsible for the working
conditions at its own facilities as well as those of its
suppliers?
• Should an international company use transfer
pricing and other internal accounting measures to
reduce its actual tax base in a foreign country?
Employees • Child labor • Should an international company use child labor if it
• Discrimination is legal in the host country?
• Impact on local • Should a company assign a woman to a country
economies where women are expected to remain separate
from men in public?
Host country • Following local laws • Should an international company follow local laws
• Impact on local that violate home-country laws?
social situations • Should an international company require its workers
• Environment to work on local religious holidays?
• Is an international company obligated to control its
hazardous waste to a degree higher than local laws
require?
Society in general • Raw-material deple- • Should an international company deplete natural
tion resources in countries that are willing to let them
do so?
Source: John B. Cullen and K. Praveen Parboteeah, Multinational Management: A Strategic Approach,
4th ed. (Mason, OH: Thomson Publishing), p. 138.

taking unethical actions.33 Therefore, it is more likely that international managers from
the United States—a nation that values high achievement and is an individualistic
society—will engage in unethical behavior than will Japanese managers, who belong
to a collectivistic society in which high achievement is not pursued as vigorously as
it is in the United States. Table 1.4 summarizes the ethical and social responsibility
concerns of international companies.
 INTRODUcTION AND OVERVIEW 21

ETHIcAL THEORIES
From a philosophical point of view, business ethics can be discussed from three dif-
ferent perspectives: the utilitarian (also called teleological), the deontological, and
the moral language philosophies. Utilitarian philosophy suggests that “what is good
and moral comes from acts that produce the greatest good for the greatest number of
people.”34 Many international companies operate under this philosophy, especially
when establishing offices or plants in developing countries. It would be morally justifi-
able, then, to operate plants that fail to comply fully with home-country environmental
laws as long as they meet the host-country standards. Although the plant’s operation
would most probably pollute the environment, it would likely result in higher em-
ployment, as well, thus aiding in the host country’s economic growth and providing
the nation’s people with an opportunity to use modern technology.
Deontological philosophy focuses on actions by themselves, regardless of the
consequences that factor into utilitarian philosophy. Deontology philosophy is also
called the theory of obligation: it postulates that rightness or wrongness resides in
the action itself.35 Therefore, actions themselves are morally good or bad. Hence,
in the previous example, the international company that pollutes the environment is
doing something morally wrong in spite of the positive benefits that are accrued due
to higher employment or improvement in the economy.
The moral language approach builds on the utilitarian and deontological theories
and focuses on international business ethics. First proposed by Thomas Donaldson,
it suggests that the moral code of international corporations can be explained through
the “language of international business ethics.”36 The key questions raised by this
philosophy are: “In what ways do people think about ethical decisions, and how do
they view their choices?” The moral language that is based on rights and duties, avoid-
ance of harm, and social contracts is more appropriate for understanding international
corporate ethics than those based on virtues, self-control, or the maximization of
human happiness. Each one of these variables is entrenched in human behavior and
results in how managers act in international business situations. For example, rights
and duties imply that each individual has certain responsibilities that bestow on the
individual certain rights. Similarly, avoidance of harm focuses on the consequences
of behavior, but unlike the utilitarian principle, it stresses avoiding unpleasant conse-
quences; therefore, actions by managers that do not harm people or the environment
are considered acceptable behavior.

REGULATIONS AND SELF-REGULATIONS TO COMBAT ETHIcAL BEHAVIOR

Today, there are different management standards, codes of conduct, and certification
requirements at the international level. These standards and codes are meant to reduce
or correct unethical corporate behavior and promote adherence to CSR by international
companies. Most international regulations are aimed at transnational corporations,
but business regulations can be created by governments or by nongovernmental or-
ganizations. When the regulations are established by a particular industry—known as
self-regulation—individual industries or firms establish their own rules of behavior
22 CHApTER 1

and codes of conduct.37 Similarly, the European Union has developed policies to
ensure that international companies operating within its boundaries follow certain
accepted behavior in terms of CSR and have become part of the European regula-
tion process.38 In self-regulation, certification is a system by which a firm’s products
and services comply with basic management or output standards agreed upon by the
industry group. For example, the International Advertising Association monitors and
certifies the actions of its members.
To assist their managers in avoiding unethical behavior, international companies
often develop programs that help these managers to behave ethically. Such programs
have a definite country bias. For example, international companies in France rely on
ethical codes; in the United Kingdom and the United States, international managers
depend on a set of written procedures; and in Germany, international companies rely
on training as a means to foster ethical behavior.39

STAKEHOLDER THEORY AND CORpORATE SOCiAL RESpONSibiLiTY

From the earliest of times, safeguarding shareholders’ and/or owners’ interests has
been the paramount goal of corporate executives; taking responsibility for the con-
cerns of and interests of stakeholders, on the other hand, is a relatively new concept,
probably less than a hundred years old. The earliest recorded reference to stakeholders
was made by E. Merrick Dodd, Jr., a Harvard law professor, in the 1930s. Based on
information from General Electric (GE) executives, Dodd referred to shareholders,
employees, customers, and the general public as the stakeholders of a company.40 The
only current major stakeholder missing from Dodd’s original grouping is the suppli-
ers. This implies that GE and probably a few other American companies may have
considered the stakeholder concept even before the 1930s. Since Dodd embraced the
stakeholder concept, about a dozen books and more than a hundred articles focusing
on stakeholder issues have been published.41
The formal introduction of the stakeholders concept into management literature,
though not by that name, is credited to William R. Dill based on a 1958 Scandinavian
field study that referred to many of the present groups considered stakeholders.42
Other equally important figures in the evolution of the stakeholder concept and gen-
eral stakeholder theory are Edward R. Freeman, who traced the term “stakeholder”
to a 1963 CRI internal memo,43 and James D. Thompson,44 who along with Freeman
formalized the stakeholders’ principles and wrote extensively about them.

WHO ARE STAKEHOLDERS?

A stakeholder “is an individual or group, inside or outside the organization that has a
stake in and can influence an organization’s performance.”45 Among the many defini-
tions that are used to describe stakeholders, this one seems to capture the essence of
the group. Using this definition, we can identify a number of stakeholders, including
shareholders/owners, employees, customers, suppliers, the community at large, the
government, banks, other service providers (accounting firms, consultants, and so
on), trade unions, and even competitors. Although the potential list of stakeholders
 INTRODUcTION AND OVERVIEW 23

can number into the double digits, in most research studies related to stakeholders,
the commonly identified groups are the shareholders/owners, employees, customers,
suppliers, and the community.

STAKEHOLDER THEORY
According to the stakeholder theory, every company should identify individuals
or groups whose involvement is critical to a company’s success and make every
attempt to satisfy each one’s needs and interests. Moreover, the company must be
seen through numerous interactions with its stakeholders.46 The theory implies that
as a company strives to create shareholder wealth, it should also meet the expecta-
tions of its employees, customers, suppliers, the community in which it operates,
and any other individual or group that it affects. The theory does not imply that
any one stakeholder is more important than the others; hence, it assumes that a
company and its managers should strive to satisfy the interests and concerns of
all. From a practical standpoint, the level of satisfaction that needs to be delivered
to the stakeholders is not defined, and herein lies the conundrum for executives,
practitioners, academicians, and community representatives. Is it possible to satisfy
the needs and interests of all concerned parties? Some believe it is, but others view
this notion as impractical.

INTERESTS AND CONcERNS OF VARIOUS STAKEHOLDERS

To simplify the discussion of the issues concerning the stakeholders, only the major
stakeholders are addressed here. As noted earlier, researchers have identified the major
stakeholders of a company as the shareholders/owners, the employees, the customers,
the suppliers, and the general community.47,48 Each of these stakeholder groups has
varied concerns and interests, and they may not all fit into one neat package. Some
of the concerns of the community may be part of CSR. Table 1.5 offers a brief listing
of the interests, needs, and concerns of the major stakeholders.
As seen in the table, the interests, needs, and concerns of the major stakeholders
seem diverse and sometimes conflicting. For example, one way to increase profits
and create shareholder wealth, at least in the short run, would be to offer acceptable
quality products at the highest possible prices and pay employees low salaries and
wages. This strategy may help the shareholders achieve their goals, but it goes against
the interests and concerns of employees and customers.

STAKEHOLDERS’ DYADIc VS. SYMBIOTIc RELATIONSHIp WITH THE COMpANY

One of the controversial discussions in regard to the stakeholder theory has been
whether the relationship between a company and its stakeholders is dyadic or symbi-
otic. In the dyadic mode, each company establishes a relationship with and meets the
interests and needs of each stakeholder on a one-to-one basis (see Figure 1.1). This
model is simple and presumably easy to maintain, but it does not take into account
the interrelationships among the stakeholders. For example, employees and customers
24 CHApTER 1

Table 1.5

Interests, Needs, and Concerns of Major Stakeholders

# Stakeholder Interest, Need, and Concerns Major Driving Force in Achieving the Goals
1 Shareholder/owner • Wealth • Costs
• Capital gains • Efficiency
• Dividends • Effective management
• Core competency
• Competitive advantage
2 Employees • Job satisfaction • Recruiting
• Salaries/wages • Competitive salaries and benefits
• Fringe benefits • Training
• Working conditions • Motivation
• Opportunities • Fair evaluations
• Fair treatment
3 Customers • Quality products/services • Reasonable quality
• Satisfaction • Effective communication
• Value • Extensive distribution
• Reasonably priced • Customer relationship
• After-sales service • Dependability
4 Suppliers • Fair prices • Competitive prices
• Good accounts payable policy • Good quality
• Strong commitment • Flexible
• Long-term relationships • Innovative
• Flexible • Financially sound
• Prompt
5 The community • Safe environment • Setting up plants and facilities with fewest
• Employment affects on the environment
• Funds for community • Hiring locally
development • Funding projects for schools, hospitals, the
• Socially responsible arts etc.

not only are in direct contact with the company, but also happen to be members of a
larger community in which the company operates.
Proponents of the symbiotic relationship acknowledge a wider network of rela-
tionships between the stakeholders and the company (see Figure 1.2). According
to this theory, the stakeholders are dependent on one another for their success and
well being; hence, managers must acknowledge interdependence among employees,
customers, suppliers, shareholders, and the community.49 Furthermore, this type of
relationship is not simply a contractual exchange between parties: it involves interac-
tion and network effects, as well.50 It also means that in order to solve core strategic
problems associated with the stakeholders, one must understand the firm’s entire set
of relationships with all entities.
Once the symbiotic relationship is accepted, the task of providing above-minimum
levels of satisfaction to each member of the stakeholder group becomes difficult and
complex. The interconnectivity among the groups assumes that each stakeholder is
in contact with all the others and understands their needs. Therefore, the company’s
employees not only want good wages and benefits, they also want the company to
spend money on improving the community in which they live.
 INTRODUcTION AND OVERVIEW 25

Figure 1.1  Dyadic Relationship between the Company and the Stakeholder

COMPANY Shareholder

Employees

Customer

Supplier

Community

Figure 1.2  The Symbiotic Relationship between the Company and Its Stakeholders

Supplier Shareholder

COMPANY Employees

Customer Community
26 CHApTER 1

COMpLEXITY AND PROBLEMS WITH AcHIEVING SUccESS WITHIN A

SYMBIOTIc MODEL
The symbiotic relationship believes in the importance of the interactions and intercon-
nectivity between the stakeholder groups and the company. Therefore, it suggests that
the company be knowledgeable about each stakeholder’s interests, needs, and concerns
and develop a strategic action plan to deliver the desired results. Based on current
research, some companies have at least partially accomplished this. For example,
Sears has successfully provided a high level of employee satisfaction and customer
satisfaction, and at the same time has delivered very good financial results.51 In a study
of some Australian companies, Jeremy Galbreath found that corporate governance and
employee management are positively associated with corporate performance.52 In a
similar vein, DuPont has decided to widen its sustainable goals for 2015 to include
a commitment to expand its reach by addressing safety, environment, energy, and
climate change, according to its CEO Charles Holliday.53
Though the evidence suggests that companies can meet multiple concerns through
their symbiotic relationships with the stakeholders group, in reality this ideal has
not yet been reached. For starters, not everyone believes that the various primary
stakeholders are equally important for the company. According to this view, the
needs of the most important stakeholders must be met first; only then should the
needs of others be addressed. In the traditional American corporate model, the most
important stakeholders are the shareholders, and satisfying their needs overrides the
interests of all others. This may seem contrary to the proposed direction advocated
by the stakeholder theorists, but a surprising amount of influential individuals are
staunch supporters of the idea that increasing the value of the shareholders is the
most critical goal for corporate executives. People like the late economist Milton
Friedman have always stressed this point; according to Friedman, “Corporations
exist entirely for the benefit of their shareholders.”54 Similarly, Robert Lutz, former
vice chairman of Chrysler Corporation and now a top executive with General Mo-
tors, once stated that “we are here to serve the shareholder and create shareholder
value.”
From a theoretical standpoint, it seems easy to fulfill the needs and concerns of
all stakeholders equally. But, based on current research, it appears that meeting the
expectations of all stakeholders is bound to create some imbalances. Hence, many
suggest a proportionate approach to satisfying the needs of the stakeholders by find-
ing a balance among the diverse and potentially competing interests.

REASONS FOR A BALANcED AppROAcH TO SATISFYING STAKEHOLDERS’ INTERESTS

Stakeholder groups are connected through dynamic relationships. The question is how
to create an acceptable level of satisfaction for each group. Ideally, a company would
like to create a high level of employee satisfaction, which leads to greater employee
effort, which leads to higher-quality products and services, which results in customer
satisfaction, which leads to more repeat business, which generates higher revenues
and profits, which leads to investor satisfaction and more investment in the company,
 INTRODUcTION AND OVERVIEW 27

which then provides additional funds for community development projects, which
leads to a satisfied community and general public.55
It is difficult to present a case for treating all stakeholders equally. Who is more
critical to the company: the investors who supply the funds; the employees who labor
to deliver goods and services; the customers who provide the main source of revenue
for the company; the suppliers who provide the necessary materials for assembling
goods and services; or the community, which to a large extent supports the company,
its employees, and its customers? Strong arguments can be made for considering the
investors most important, and in many quarters they still are. A strong case could also
be made for either the employees or the customers.
It is not easy for corporate executives to devote equal amounts of energy and time
to shareholders’ expectations and community concerns. Moreover, in each company
there may be specialists who are responsible for dealing with different stakeholder
groups. For example, the marketing group may have the primary responsibility for
satisfying customer’s needs and developing programs to maintain a core group of
loyal customers. Similarly, the purchasing group may be responsible for maintaining
supplier relationships. In some companies, there may even be a group responsible for
community activity. But, the question remains, if the shareholders clamor for higher
dividends and at the same time the community wants a school playground, which
group will get the most attention?
Added to the aforementioned concerns are modern global corporations’ problems.
These companies operate in several countries with equally large numbers of stake-
holders whose interests and concerns may not be homogenous. How should these
companies proceed when local laws differ and internal policies may not necessarily
meet the expectations of all the diverse stakeholders?

WHAT IS A BALANcED AppROAcH TO DEALING WITH STAKEHOLDER’S INTERESTS?

Assuming a symbiotic relationship among the various stakeholders, a company needs
to develop programs and procedures to meet those stakeholders’ diverse needs. Stake-
holders’ concerns are a part of the business environment, and there is no escaping the
effects of poorly planned strategies to meet their needs. This implies that companies
must to some extent satisfy some or all of the stakeholders’ needs. The results of inef-
fective stakeholder relationships may be a decline in sales, a boycott of the company
and its products by the general public, or even government sanctions. Following are
suggested steps to deal with growing stakeholder concerns.

• The first step in developing a comprehensive stakeholder strategy is to develop a

communication link between the company and its stakeholders. This link should
be used for understanding the concerns of the various stakeholders, determining
priorities, and preempting problems. The keys are, “informing,” “responding,”
and “involving.”56 It is important that managers build legitimacy and a positive
reputation.
• The next step in the process is ranking the effects and consequences of not
meeting the needs of each stakeholder and setting priorities accordingly. For
28 CHApTER 1

example, the shareholders are expecting their stock prices to go up; at the same
time, the employees are seeking substantial pay raises. Which is more critical?
Each company must have a system for addressing these competing demands.
• Reevaluate stakeholder relationships periodically to see whether any of the
dynamics have changed. If they have changed, then the priorities need to be
reconfigured.
• In all dealings with the various stakeholders, it is important to make sure that
the treatment of each is perceived to be fair. For example, a community will not
demand a major water-treatment plant from a company if it is losing money.

ADDITIONAL REcOMMENDATIONS AND CONcLUSIONS

Based on our review of the literature, it is apparent that all the concerns of all stake-
holders cannot be met all the time. As one gets its wishes, others may lose. Hence,
this process may be viewed as a zero-sum game. But is there an approach by which
the losses of one party could be reduced without significantly compromising the
gains of the others?
Corporate executives are often driven to satisfy the interests of the most criti-
cal member(s) of their stakeholder group. This drive is based on their fundamental
business training and their mindset that every action has a cost-benefit trade-off
relationship attached to it. In making decisions, these executives must decide which
of their actions returns the highest reward or has the lowest cost. In such a decision-
making environment, corporate executives aim to meet the minimum expectations
(threshold) of each stakeholder group; at the same time, they try to deliver satisfac-
tion levels above the minimum for different stakeholders. Usually, a company might
aim to satisfy its customers, perform well for its employees, and deliver a threshold
level of satisfaction to the general public. In setting these levels, the executives must
be careful not to violate the various stakeholder groups’ sense of fairness about the
relative treatment they are getting.57

CORRUpTiON
International business corruption affects adversely national economies as well as the
international business environment. Some attempts have been made in the past two
decades to resolve this complex problem. Although some success has been achieved,
the problem is far from being totally eradicated.
Corruption is not a new phenomenon: incidents of bribing and seeking illicit favors
have been recorded for centuries and existed in early Chinese, Egyptian, Greek, and
Indian civilizations. Mankind, with its proclivity for power and wealth, has always
succumbed to corruption in one form or another.
Corruption is found in all walks of life. Naturally, it is endemic to the business
world. Internationally, it is even more pervasive, and it affects many aspects of business
from cost of operations to business relationships and even government-to-government
relationships. Understanding corruption in the international environment is made more
difficult because international business transcends many countries and cultures. How
 INTRODUcTION AND OVERVIEW 29

Table 1.6

Types of Corruption

# Type of Corruption Examples Predominantly found in

1 Business corruption • Bribing officials Most countries
• Accounting irregularities
• Tax evasion
• Insider trading
• Money laundering
• Embezzlement
• Falsifying documents (research data)

2 Political corruption • Voting irregularities Mostly in developing and

• Holding on to power against the will of less developed countries
the people
• Nepotism and cronyism
• Rule of the few

should international companies with one set of rules and codes of conduct in their
home country operate in countries that may have different sets of rules, especially if
the host-country rules are less stringent than the ones in their home country?

TYpES OF CORRUpTION
Corruption involves many types of misdeeds. The extent to which people abuse their
position for personal gain is virtually limitless. At one end of the spectrum we have
a local low-level official taking small sums of money to expedite routine approvals
or transactions, called petty corruption; in the middle we have defense contractors
paying millions of dollars to lawmakers for awarding them major defense or transpor-
tation projects, called grand corruption; at the far end of the spectrum are the huge
campaign contributions by lobbyists to politicians, called influence peddling.58 Cor-
ruption is also classified by sphere—business corruption and political corruption—as
shown in Table 1.6.

DEFINITION OF CORRUpTION
Corruption implies some form of illicit and criminal behavior for personal enrich-
ment. Any definition of corruption starts with the premise of “abuse of power.” In
the international business context, there are three key players who are part of the
corruption problem: the principal or the receiver, the entity that has the authority to
grant and approve projects (for example, a government agency such as the ministry
of industry); the agent or the intermediary who represents the principal and is actu-
ally responsible for granting permission on behalf of the principal (for example, a
civil servant); and the client or the solicitor, a company or an individual who seeks a
favor such as a permit for projects or investments (for example, a business entity).59
See Figure 1.3.
30 CHApTER 1

Figure 1.3  Key Actors in International Business Corruption

Principal

Agent Client

In this model, corruption occurs when the agent betrays the interests of the principal
and accepts gifts or monies from the client to grant a favor to the client; the agent acts
without any thought for the fairness of such an exchange. Corruption could also stem from
the principal going directly to the client. Therefore, in defining corruption all three actors
must be included in this triumvirate. Over the years various agencies have tried to define
corruption. Table 1.7 presents the five most commonly used definitions of corruption.60

CORRUpTION PERcEpTION INDEX

In light of the ongoing problem with international business corruption, Transparency
International (TI) has developed a scale called the corruption perception index (CPI)
to measure the level of corruption among different countries. Each year using various
factors and survey methods, TI classifies countries on a ten-point scale, with 10 = least
corrupt and 0 = the most corrupt. The CPI uses seven different sources to assemble
its ranking, including the World Competitiveness Yearbook, Gallup International,
and DRI/McGraw-Hill Global Risk Service. Table 1.8 presents the ten least corrupt
countries listed by TI among the 179 that it surveyed in 2007.
Countries like Finland and Denmark that rank very high on the CPI list have a
relatively stable political system, very efficient government agencies, and a high level
of trust between politicians and the populace.
The ten most corrupt countries in the world for 2007, according TI’s corruption
perception index, are presented in Table 1.9 (p. 32).
According to TI, Somalia and Myanmar rank as the worst two countries in terms
of corruption. Over the years TI has successfully publicized the problem of inter-
national business corruption. Hence, more and more people are becoming aware of
this issue.

EFFEcTS OF CORRUpTION
Corruption can have adverse economic/monetary, social, and political effects.

• Economic effects. Corrupt systems do not provide open and equal market op-
portunities to all the firms. Payments and/or bribes do not have a market value,
 INTRODUcTION AND OVERVIEW 31

Table 1.7

Definition of Corruption as Defined by a Particular International Organization

International organization
# that defines it Definition of corruption
1 The United Nations (UN) “Commission or Omission of an act in the performance of or in con-
nection with one’s duties, in response to gifts, promises or incentives
demanded or accepted, or the wrongful receipt of these once the act
has been committed or omitted.”

2 Organisation for Economic “The offering, giving, receiving, or soliciting of any thing of value to
Co-operation and Develop- influence the action of a public official in the procurement process or
ment (OECD) in contract execution.”

3 Transparency International “The misuse of entrusted power for private gain.” Transparency
(TI) International further differentiates corruption “according to rule’ or
“against the rule.” In the first instance, the definition covers all the
areas in which the receiver is required by law to receive some form
of compensation (bribe), and in the second instance, the receiver is
prohibited from providing some of these services and therefore is not
entitled to any compensation (bribe).

4 World Bank and Asian De- “Corruption involves behavior on the part of officials in the public
velopment Bank (ADB) and private sectors, in which they improperly and unlawfully enrich
themselves and/or those close to them, or induce others to do so, by
misusing the position in which they are placed.”

Table 1.8

The Ten Least Corrupt Countries of the World, 2007

Rank Country Corruption Perception Index (CPI)*

1 Denmark 9.4
1 Finland 9.4
1 New Zealand 9.4
4 Singapore 9.3
4 Sweden 9.3
6 Iceland 9.2
7 Netherlands 9.0
7 Switzerland 9.0
9 Canada 8.7
9 Norway 8.7
Source: Transparency International, “Corruption Perception Index.” Available at http://www.transpar-
ency.org/ (accessed June 5, 2008).
*CPI Scale: 10 = Clean; 0 = Corrupt.

so they raise the overall cost of operations. Many international companies try to
avoid investing in countries that appear to be corrupt. A lack of foreign direct
investment (FDI) flows to a country increases financing costs for both private
and public projects. The limited capital within the country forces local investors
to pay higher rates for borrowings. For example, a study done by the Milken
32 CHApTER 1

Table 1.9

Ten Most Corrupt Countries of the World, 2007

Rank Country Corruption Perception Index (CPI)*

179 Somalia 1.4
179 Myanmar 1.4
178 Iraq 1.5
177 Haiti 1.6
175 Uzbekistan 1.7
175 Tonga 1.7
172 Sudan 1.8
172 Chad 1.8
168 Laos 1.9
168 Guinea 1.9
Source: Transparency International, “Corruption Perception Index.” Available at http://www.transpar-
ency.org/ (accessed June 5, 2008).
*CPI Scale: 10 = Clean; 0 = Corrupt.

Institute61 found that in comparing sovereign bond issues, countries with a higher
corruption index had to pay much higher premiums than those with a lower cor-
ruption index. In comparing Sweden and Brazil with a similar amount of bond
issuance for 1997 and 1998 ($23 billion versus $22 billion, respectively), Brazil’s
financing costs were about 25 times greater than that of Sweden ($38,157 billion
versus $1,531 billion) because of graft and corruption.
• Social effects. Besides the monetary costs, corruption leads to some social costs
that could be detrimental to a country’s overall economic growth. Some of the
social costs associated with higher corruption levels are seen in the areas of
health, education, and hygiene. Because of corruption, the amount spent on
public services is considerably lower than the spending in other comparable
countries with lower corruption levels.62 Using regression analysis, Paulo
Mauro demonstrated that a country that improves its corruption perception
index (CPI) by 2 points ends up increasing its education budget at least by 1
percent of its GDP.63
• Political effects. Politically, corruption strengthens the power of corrupt, self-
serving leaders. They amass wealth for themselves, allocate very low levels of
funds for projects that could benefit the country, perpetuate the rule of a few, and
suppress the rights and voices of the majority of the population. To continue in
power, these leaders need funds, and most often the monies come from bribes.

PREScRIpTION TO REDUcE INTERNATIONAL BUSINESS CORRUpTION

Efforts to curb corruption in the past three decades have had somewhat less than stellar
results. Some improvements have come with the actions of individual governments
like the United States, international organizations such as the Organisation for Eco-
nomic Co-operation and Development (OECD) and TI, and individual companies.64
Because of globalization, many more companies operate internationally compared
 INTRODUcTION AND OVERVIEW 33

to 20 years ago. All indications are that the number of cases of corruption is on the
rise. In order to reduce worldwide corruption that affects businesses, there has to be
a concerted and well-coordinated effort on the part of all concerned. The parties that
must take an active role in this effort are listed below.

Individual Country Governments

Any attempt to curb corruption has to start at the country level. Governments in the
most corrupt countries must introduce programs to root out the offenders. Since many
highly corrupt countries are economically poor, the incentives for these countries to
get rid of corruption must be economic in nature. Through greater FDI flows, transfer
of technology from industrialized countries, and reduction in unemployment, these
countries can attain an unprecedented level of economic growth. Some specific steps
that countries with high levels of corruption should undertake to curb corruption are
listed below.

1. Enact anticorruption regulations. Most of the countries with high levels of

corruption either do not have anticorruption laws or have them but do not
enforce them.
2. Set up monitoring systems. Laws and regulations will be observed only if
there is a mechanism to monitor and enforce them.
3. Penalties. Anticorruption laws will not be obeyed unless there are severe
penalties meted out to law breakers.
4. Codes of conduct for government employees. It is imperative that codes of
conduct for government employees be developed and then enforced.
5. Incentive systems for government employees. Most social scientists agree that
individuals are more likely to obey rules if compliance is reinforced with a
reward system. Rewarding employees who are honest and obey the codes of
conduct lowers the temptation to take bribes.
6. Better salary structure for government employees. In many developing coun-
tries, taking bribes is almost a necessity for some government employees
because of poor wages.

International Organizations

Because of lack of funds and technical knowledge, attempts by individual countries

to reduce corruption would not work without outside help. To assist the countries in
curbing corruption, some of the international agencies must get involved with neces-
sary financing and training. Corruption is a worldwide problem that funnels produc-
tive funds out of the economic system and into the hands of a few who then use it for
personal gains without contributing to the developments efforts of the country.
Some specific steps that these agencies could undertake include:

1. Providing knowledge and training. Organizations such as the World Bank, the
International Monetary Fund (IMF), TI, and the United Nations could provide
34 CHApTER 1

technical help to those countries suffering from high corruption. Initiatives

might include formulating laws, developing codes of conduct for government
employees, and helping in the development of monitoring systems to track
the violators of these corruption codes.
2. Providing funding. In order to curb corruption in developing countries, fund-
ing is needed to carry out some of the prescriptions/steps outlined earlier. The
countries with highest level of corruption are those that are economically
poor; therefore, it is imperative that some of the international organizations
that have developmental funds at their disposal—for example, the IMF and
the Asian Development Bank—provide some of these funds.
3. Harmonizing the codes. At present countries (especially the industrialized
countries) set their own standards for business behavior. The process of
curbing corruption would go a long way, if anticorruption codes could be
standardized so that there is no confusion, especially when an international
firm operating in two different countries has to follow two different sets
of rule.

International Firms

Among the key participants in the corruption process are the international firms who
try to use influence, gifts, and bribes to get better deals from host nations. It is impor-
tant that international firms collectively follow uniform codes of conduct in dealing
with host countries for the benefit of the consumers, the economic growth of the host
country, and for their own profit objectives. To help in the fight against corruption,
international firms could:

1. Set up internal codes of conduct. Typically, international firms have their

own internal codes of conduct for conducting business with host nations and
vendors. For example, in many companies, the specific amount of gift that
one can accept from vendors is limited to a very small amount. Similarly,
there are written rules banning bribes to host-country officials and also an
explanation of what constitutes a bribe. Firms need to improve the way they
monitor and enforce these rules and policies.
2. Employee training. Employee training programs can help employees under-
stand the rationale for the good behavior rules.
3. Provide funding. For the worldwide anticorruption program to succeed, it needs
developmental funds that could be used at the country level for establishing
various programs. The countries themselves are poor and do not have the funds
to set up anticorruption programs. Some of the international organization may
provide some funding, but it appears that this is not adequate. To augment the
existing budgets, international firms could step in and fill the need. The funds
that are provided by the international firms should not go to individual countries,
but to the international agencies who then can distribute these funds.

Figure 1.4 presents a summary of the key issues of international business corruption.
 INTRODUcTION AND OVERVIEW 35

Figure 1.4  Framework of Corruption: Summary of Causes and Prescriptions

CAUSES PRESCRIPTIONS
1. Environmental 1. Country Level
• Power concentration • Setting up a monitoring
• Lack of rules system
• Economic conditions • Enact regulations
• Poverty • Severe penalties for law
• Cultural traits breakers
• Moral standards • Codes of conduct for
• Lack of Competition government employees
• Incentive systems for
2. Individual government employees who
• Greed follow the rules
• Integrity/honesty • Better salary structure for
• Living wages government employees
• Maintain power • Establish democracy

3. International Firms 2. International Organizations

• Market expansion • Harmonize codes of conduct
• Competitive advantage for business
• Profit motive • Assist country governments in
CORRUPTION TYPES
setting up anticorruption
1. Petty legislation
Misuse of power 2. Grand • Provide funding to fight
3. Influence peddling EFFECTS corruption
• Set up systems to monitor
1. Economic corruption
• Decrease in FDI
• Lack of capital 3. International Firms
• Lower growth • Draw up codes of conduct for
• Unemployment employees
• Provide training to employees
2. Consumers on corruption
• Higher prices for goods • Adhere to rules
• Poor quality goods • Provide funding to
international organizations
3. International Firms
• Higher investments
• Higher operating costs
• Unfair competition
• Loss of projects
• Breaking the law

Source: James P. Neelankavil, “International Business Corruption: A Framework of Causes, Effects, and
Prescriptions,” Conference Presentation, Academy of European International Business, Athens, Greece,
December 8–10, 2002.

CHApTER SUMMARY
International business management is a complex, multidimensional field. The intense
competition for world markets, global expansion, and dramatic changes in technol-
ogy have made the task of managing an international firm challenging. Phenomenal
growth in many Asian and Latin American countries is shifting the world economic
order from the West to other parts of the world.
As a result, businesses are adapting to a more global philosophy. Globalization
proposes that companies view the world as one single market to assemble, produce,
and market goods and services. Globalization is defined as sourcing, manufacturing,
and marketing goods and services that consciously address global customers, markets,
and competition in formulating a business strategy.
The dynamic changes occurring in the economic, political, and social climate
36 CHApTER 1

in many countries represent a new challenge to businesses. Western Europe has

dismantled its internal barriers to form a unified region with a single currency and
a vast market made up of 500 million consumers. The Soviet Union does not exist
anymore, but instead has spawned 18 new countries. Among the many reasons for
the growth in international business are those that are related to the internal workings
of a company, others that are market-related factors, and still others that are related
to the external environment.
Businesses can get involved in international operations in many different ways. The
most common and probably the easiest way companies get involved in international
operations is through exports and/or imports of goods and services. Other types of
international operations include licensing agreements and franchising, direct invest-
ments, and portfolio investments.
As businesses venture outside their own countries, the need to understand that the
market conditions in foreign countries is becoming more and more critical. Business
research, like all business activity, has become increasingly global. Firms that conduct
business in overseas markets must understand the unique features of these markets
and determine whether they need to develop customized strategies to be successful.
Information is essential to business decision making. Information gathered through
research is useful in defining problems, resolving critical issues, identifying oppor-
tunities, and fundamentally improving an organization’s strategic decision-making
processes. Conducting international research is challenging, expensive, and time-
consuming. Many factors affect its outcome, including the cost of conducting the
research, the availability of secondary data, the quality of the data collected, time
pressures, lead time (the time it takes to complete an international research study),
the complexity of the study, and whether a multicountry study is necessary.
Ethical behavior in general relates to actions that affect people and their well-being.
In business, the actions of managers and their companies may have drastic effects on
their employees, customers, suppliers, the general public, and the environment. The
need for ethical behavior among managers and their companies is not restricted to
international companies, but extends to domestic firms as well. In a dynamic global
community, potential conflicts in ethical business behavior due to differences in values
and business practices across cultures are inevitable. Global business ethics is the
application of moral values and principles to complex cross-cultural situations.
It is generally accepted that beyond their normal profit-maximization goals, referred
to as corporate social responsibility (CSR), businesses have a responsibility to society
at large. CSR is generally defined as the ethical consequences of companies’ actions,
policies, and procedures.
Companies seek economic gains chiefly to enhance the value for their investors.
Accordingly, managers have a duty primarily to maximize shareholder returns. Some
argue, though, that a manager’s duty is to balance the financial interests of the share-
holders against the interests of others such as employees, customers, and the local
community, even if it reduces shareholder returns. In their opinion, these individuals,
called the stakeholders, contribute either voluntarily or involuntarily to a company’s
wealth, creating capacity and activity, and are therefore its potential beneficiaries and/
or risk bearers. The principle of social responsibility means that companies need to
 INTRODUcTION AND OVERVIEW 37

be concerned about the wider group of company stakeholders, not just the typical
company stockholders.
A large number of stakeholders exist, including shareholders/owners, employees,
customers, suppliers, the community at large, the government, banks, other service
providers (accounting firms, consultants, and so on), trade unions, and even competi-
tors. Although the potential list of stakeholders can number into the double digits, in
most research studies related to stakeholders, the commonly identified groups are the
shareholders/owners, employees, customers, suppliers, and the community.
International business corruption is a worldwide phenomenon with no end in sight.
Its effects on local economies are very damaging. A few industrialized nations and
international organizations such as the OECD and Transparency International have
introduced new initiatives to curb the problem of corruption. The collective efforts of
these groups have succeeded to some extent in publicizing the problem and forcing
countries to take action.
The three main actors in the corruption equation are: the principal, the agent, and
the client. Any attempt to curb corruption has to bring order into all three parties;
attempting to solve the problem from one entity alone will definitely fail. To truly
reduce corruption, the efforts of the countries involved, the international firms who
participate in corruption, and international watchdog organizations must all work
together. The main focus of their efforts must be in developing codes of conduct,
harmonizing those codes, providing training, establishing monitoring systems, and
setting up a judicial process to hear corruption cases.

KEY CONCEpTS
Globalization
Reasons for International Expansion
International Business Ethics
Corporate Social Responsibility

DiSCUSSiON QUESTiONS
1. Identify and explain the reasons why companies seek foreign markets.
2. Define globalization. What are the implications of globalization for companies?
3. How do companies get involved in international business?
4. Identify and distinguish among the various types of international organizations.
5. Why is international research important?
6. What are some of the complexities and difficulties inherent in conducting
international research?
7. How do international companies use research?
8. What is corporate social responsibility (CSR)?
9. Why is corporate social responsibility important?
10. Enumerate and explain the various ethical theories of international business.
11. How does corruption affect international business?
12. What is the corruption perception index (CPI)?
 2 International Business
Environment: Culture

Culture, because it is learned, constitutes the major method that people

use to adapt to a changing environment, whether the changes happen
through traditional means or through technological advances.

LEARNiNG ObJECTiVES
• To understand the importance of the international business environment
• To understand the cultural environment
• To understand cultural components
• To understand the various dimensions of culture
• To understand cross-cultural differences
• To learn about cultural clusters
• To understand the differences between cultural convergence, culture shock, and
cultural orientation

Every business operates in an environment that is outside its control. This envi-
ronment is external to the firm and influences its actions. Therefore, the external
environment in which a business operates is the sum of all forces surrounding
and affecting its operations. Each factor plays a critical role in a firm’s decisions,
whether these decisions include entering a particular market or how to behave once
a firm enters this market.
The external environment in which a firm operates includes:

• The cultural environment

• Economic factors
• The political system
• Technological development
• The banking and financial systems
• Infrastructural capabilities
• The competitive environment
• Regulatory developments
• Social systems
• Supplier networks

38
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 39

These external factors confront all companies—both domestic and international—

though dealing with the environmental factors is easier in the domestic market than
in international markets. The external environment of international markets is more
complex and unpredictable, making it difficult to analyze. Take, for example, the is-
sue of foreign exchange. The costs, prices, revenues, and profits for a domestic firm
such as Toshiba, operating in Japan, are expressed in the local currency, the yen,
and so Toshiba’s domestic division is not subject to the exchange-rate risks that its
international division faces. Exchange rates can make costs rise and profits disappear.
Tracking and predicting exchange-rate movements are important for international
companies, but at the same time it is difficult to forecast exact rate changes. In con-
trast, for a purely domestic firm, this is less of a problem (unless that firm imports all
its raw materials and supplies). Similarly, culture plays an important role in business
strategy, but for domestic firms operating under a single cultural environment, this
is not a major issue. On the other hand, international firms often operate in countries
with cultures that are very different from those of their home countries, and in many
instances the firms have little familiarity with these cultural distinctions.
All of the above-mentioned external factors are collectively very important and dictate
how an international firm operates. Depending on the industry and product category,
some factors are more important than others; for example, in the computer and software
industry, technological development may be more important than social systems.
Analysis of the external environment is useful in the selection of foreign countries/
markets, as well as for developing viable strategies once a firm enters a particular
market. Most environmental analysis is done using secondary sources, that is, us-
ing existing information that is available through government sources, journal and
newspaper publications, and databases, and utilizing internal information that was
previously collected for other purposes.
For international companies, the most critical external variables are culture, the
economy, political stability, the banking and financial systems, and the competitive
environment. Culture is important because a majority of international business blun-
ders can be traced to a lack of understanding of the host country’s cultural values
and business customs. Economy is important because economic factors contribute
to the firm’s overall financial viability. Political systems are important because it is
difficult for an international firm to succeed when the host country’s political systems
are unstable. A sound banking and financial system helps international companies
avail themselves of operating capital, manage export transactions through letters of
credit and other instruments, and repatriate profits to the home country. Finally, the
competitive environment is critical because competitive forces dictate strategic ac-
tions and ultimately influence performance in the marketplace.

CULTURAL ENViRONMENT
International companies have to deal with different cultures in different countries.
Companies such as Coca-Cola that operate in many countries (about 197 in Coke’s
case) have to learn, understand, and use these cultural differences in their strategic
action plans. Learning new cultures does not mean just mastering a few of the “hid-
40 CHApTER 2

den languages” of the host country; it also means learning to bridge the differences
between cultures to create successful interactions. Culture operates on the unconscious
level, and its effects are subtle. For example, the French are very proud of their culture
and language and therefore are sensitive to issues that deal with the cultural environ-
ment, especially in business transactions. The Japanese run their meetings not with
a set agenda, but with a flexible one, which sometimes unnerves Western business
executives. And one has to be aware when dealing with German executives that they
are sensitive about titles and are very formal in their business negotiations.1
In fact, as cultures tend to be more societal in nature (each society has its own cul-
ture), international companies sometimes have to deal with more than one culture in
a single country. For instance, culturally, northern Italians are different from southern
Italians in their behavior and tastes. Similarly, the various regions of China are made
up of multiple cultures with contrasting cultural differences. Hence, different layers of
culture exist at the national, regional, societal, gender, social class, and corporate levels.2
At the country level, research has shown that cultural values have significant effects on
a country’s economic development, regulatory policies, and levels of corruption.3 At the
regional level, studies indicate that cultural settings create opportunities and limitations
for people that vary from country to country within the same region.4 Similarly, at the
corporate level, research reveals that culture affects not only the strategic level, but also
the area of management and its market orientation.5 In the discussions on culture that
follow, the terms “country” and “society” are used interchangeably.
Cultural changes take place very slowly, and their influence endures for centuries. Even
with the technological advances in travel and communications, cultural traits within societ-
ies have remained virtually unchanged. The static nature of culture is often a mechanism
whereby a society can preserve its values and guard against outside influences.
The impact of culture on international business is real and far-reaching. The effects
of culture can be seen as a firm selects a country for market entry and determines what
mode of entry it will use. For example, researchers have found that for international
companies the choice between licensing and establishing a wholly owned subsidiary
depended to a large extent on cultural differences between the host and home coun-
tries. Specifically, differences in levels of trust impact perceptions of transaction costs
and thereby influence a firm’s choice of entry mode into a foreign market.6 Culture
also affects international companies’ strategic actions. For example, the relationship
between culture and brand image has been found to be very strong and is often a
key consideration in developing brand image in foreign markets.7 For international
companies, culture might be a key variable to consider in their efforts to standardize
their international strategies or develop global brands. In a study that examined trans-
ferring advertising strategies across countries, researchers found that the consumers
in the host markets did not always understand the focus of the advertising campaign
and therefore did not buy the product.8 Finally, culture also plays a role in how an
international company is organized in foreign markets.9 In many collectivistic societ-
ies, organizational structures need to consider the effect of a particular design on the
group as a whole rather than on the individual.
The student of international business must recognize that culture does not fit into
a neat, compact, and manageable model. Each society and its culture is a unique and
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 41

complex system of values, norms, folklore, mores, codes of conduct, standards of

behavior, and relationships. Hence, most definitions of culture tend to be descriptive
ones that identify a culture’s individual elements.

CULTURE DEFINED
A good working definition of culture is the knowledge, beliefs, art, law, morals,
customs, and other capabilities of one group distinguishing it from other groups.
In other words, culture is the way of life of a society. From a practical standpoint,
culture includes behavior, symbols, skills, heroes, knowledge, superstitions, motives,
traditional ideas, artifacts, and achievements that are learned and perpetuated through
a society’s institutions to enhance its chances for survival. Since culture contains so
many elements, it is no wonder that businesses find it very difficult to fully understand
its influence on a society. It also explains international business failures that can be
traced to ignoring and/or not understanding the basic cultural patterns of a country.
Culture is mostly an internalized phenomenon. Cultural behaviors evolve over time;
they are learned and tend to be passed down from generation to generation. Few if
any books are prescribed by a society to understand its own culture. Most individu-
als are hard-pressed to explain these natural values, customs, attitudes, and behavior
patterns, and practice them without a second thought.

CULTURAL PROcESS AND CULTURAL COMpONENTS

As a learned behavior, culture is influenced by and learned through experiences. Some
of the institutions that play a critical role in learning a particular culture include fam-
ily, religious institutions, schools, and social groups such as friends, neighbors, and
the general society. These institutions, through their dominant role in many societies,
shape the value systems of that society.
The key components of culture are:

• Language and communication

• Social structure
• Religion
• Values
• Attitudes
• Customs
• Aesthetics
• Artifacts

These components also form the core of the definition of culture.

Language and Communication

Language is one of the defining expressions of culture. It is used for communicating

ideas, thoughts, emotions, and decisions. Language includes spoken thoughts (vocal),
42 CHApTER 2

signs, gestures, and other nonspoken means that people use to communicate with one
another. It is the means by which a society transfers its value systems to others and
how norms and customs are expressed and communicated. To understand another
culture, one first has to learn the language of that culture.
In the Internet age, English is becoming the lingua franca of the business world.
Though English is the official language of only about 500 million people (less than 8
percent of the world’s total population), it is universally accepted as the language of
business because of its extensive business-related vocabulary.10 In a borderless global
marketplace, the importance of communication is forcing the emergence of one busi-
ness language that can be understood by all. This does not mean that communication
among people and businesses is simple. Even if people use the same language, it does
not necessarily mean that the language is equally understood by people who come
from different backgrounds. Words and expressions in the same language differ from
society to society. English in the United States is not the same as English spoken in
the United Kingdom, especially in the use of slang words. For example, truck in the
United States is lorry in England, and gas is petrol. If the Americans and the British
have problems understanding each other, one can imagine the difficulties that arise
in business negotiations if participants come from different parts of the world, even
if they all speak English.
Nonverbal language, which includes hand gestures and body language, is unique
to each society, as well. In fact, in some cultures the nonverbal language may be
more important than the spoken language. Italians, for example, are known to be
animated in their conversations, with hand gestures that demonstrate the feelings
behind their spoken words. Nonverbal language is also an area that leads many in-
ternational companies to embarrassing blunders. For example, the A-OK sign used
by Americans (closing of the thumb and index figure to form an O) implies zero for
the French, money or change for the Japanese, and an obscene symbol for Brazilians
and Greeks.
For international companies, knowing the nuances of languages, understanding
the differences in dialects, and recognizing the usage of slang is very important. To
succeed in international business, it is important to respect different languages and
gain knowledge of host cultures.11 Language blunders by international companies are
common. Calling one of its automobile models Nova in Puerto Rico, General Mo-
tors virtually killed the car’s launch. Though the literal translation of nova is “star,”
when spoken, it sounds like no va, which in Spanish means “it doesn’t go.” Similarly,
the now-defunct Braniff, an American airline that proudly advertised “rendez-vous
lounges” on its newest jets, may have wished that its advertisements had never reached
Brazil. In Portuguese, rendez-vous means “a room rented out for prostitution.” Braniff
also inadvertently exhorted Mexican airline passengers to “fly naked for major com-
fort,” when they actually meant to promote the comfort of their leather seats. Other
examples of language blunders include Pepsi-Cola’s advertisement “comes alive,”
which translated into Chinese as “brings your ancestors from their burial place,” and
a hair product, Mist Stick, which unintentionally conjured up thoughts of “manure”
in Germany, as “mist” is slang for manure in German.12
As mentioned earlier, in international business, language can be a problem even if
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 43

the language in question is the same language spoken in different countries. Use of
words and contexts differ from country to country. For example, the Spanish word for
“wastebasket” in Colombia is caneca; in Puerto Rico it is zafacón; and in Venezuela it
is basurero. In an interesting case, Electrolux, a Swedish appliance maker, introduced
its vacuum cleaners in the United Kingdom with the tagline “nothing sucks like an
Electrolux.” In introducing the vacuum cleaner in the United States, the company
used the same previously successful tagline from the United Kingdom with disas-
trous results. In the United States, “sucks” has an entirely different meaning (in fact
several meanings, none of them very complimentary). This example demonstrates
the complexities of selling products in countries where the same language may be
spoken, but the local slang and use of words may be different.

Social Structure

Social structure is a society’s fundamental organization; it determines the roles of in-

dividuals within different groups. A social group is a collection of two or more people
who identify and interact with one another and have common interests. The different
groups that members of a society belong to include family, households, social class/
caste, and other similar institutions, such as friendship groups and reference groups.
Social structure also determines individuals’ social positions and their relationships
to others within the group.
International companies strive to understand social structures in their management
of foreign operations. In many societies, traditional social structures are strong and
have great impact on how workers relate to one another. It has been observed that a
key distinguishing characteristic of work behavior in societies is the way in which
members relate to one another as a group.13 Companies may use social classes to
segment markets. Social groups are also used in international advertising as a way
to disseminate information.

Family. Family units differ in size and structure from country to country. The basic
family unit is the nuclear family, which is made up of a father, a mother, and their
children. The nuclear family structure is often found in industrialized countries,
including Australia, Canada, most of Europe, and the United States. Even in these
countries, however, the traditional nuclear family structure is changing. With the high
divorce rate in these countries, it is common to find families where only one of the
parents resides with the child (or children).
In many societies, an extended-family structure exists. An extended family is made
up of the basic nuclear family plus grandparents, uncles, aunts, and other relatives.
Countries in Africa, Asia, the Middle East, and Latin America have extended-family
structures. The relationships and influences of family members differ in an extended-
family structure as compared to a nuclear-family structure. In an extended-family
system, grandparents and uncles may have influence over children and their behav-
ior. Therefore, while marketing products to children in these societies, companies
may have to consider the role of other extended-family members in influencing the
purchase decision.
44 CHApTER 2

Household. A household includes single people or unrelated individuals living in a single

dwelling. Mostly found in industrialized countries (the United States, for example),
households are targeted by companies as potential purchasers of goods and services. In
households that have more than one individual, the group dynamics and social relation-
ships can be strong, as in the case of friends or classmates living together; a household
can also be simply an arrangement among people to save on living expenses, in which
case the social structure is loose and does not influence behavior. In either case, the
structure forces consumption of common household items such as appliances and fur-
niture. Each type of household has a distinctive set of buying habits.

Social Class. Social class refers to relatively homogeneous divisions in a society, divi-
sions that are hierarchically ordered and whose members share similar values, interests,
and behaviors. Social classes exist in every society and are quite often determined
by social status, including income level, education, occupation, area of residence,
and other such variables. Typically, people in a particular class have similar buying
habits and seek similar products. In fact, they also exhibit similar brand preferences.
They tend to behave more alike than people from other social classes. Hence, social
classes tend to be used by companies for segmenting markets and determining market
trends. In extreme cases, the social class structure may be very rigid and formalized
into a caste system, as in India. Whereas social mobility is easy under a social class
system, it is virtually impossible to change under the caste system.

Religion

In many industrialized countries, especially in Europe, religion has lost its position
as a cultural institution that influences society’s value systems. Sweden, for example,
is a secular country with no national role for religion, and, to some extent, this is true
in China, too, though for different reasons. In Sweden, religion has lost its impact on
society due to the country’s economic success and the liberal attitudes adopted by its
people; in China, the years of communist rule have made religion less of a factor in
people’s daily lives. But in many countries, religion plays a critical role in people’s
lives. To some extent, religion’s impact touches people’s secular lives, as well. It is
important for international companies to understand and adopt practices that will
satisfy religious decrees or beliefs. The religious taboo on eating meat among the
Hindus in India led to the introduction of veggie burgers by McDonald’s. Similarly,
in Muslim countries where Islamic law prohibits charging interest on loans, banks
have devised other alternatives such as offering shares to depositors and charging a
nominal fee. The success of these alternate means to charge customers has led many
Islamic banks in the Persian Gulf area to enter many of the predominantly Muslim
countries of North Africa.14
The four major religions of the world are:

• Christianity (including Roman Catholic, Protestant, and Orthodox), with more

than 1.7 billion followers
• Islam, with more than 1.2 billion followers
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 45

• Hinduism, with more than 750 million followers

• Buddhism, with more than 350 million followers

Christianity and Islam are termed “global religions” because their followers are found
in many countries of the world, whereas religions that are dominant in one culture or
country—Hinduism, for instance—are called cultural religions. Hinduism is found
largely only in India. Islam is the fastest-growing of the world’s religions and its fol-
lowers are passionate about their beliefs. The other important religions of the world
are Sikhism, Judaism, and Shinto. Confucianism holds a similar place in the lives of
its followers, though it is technically a philosophy of life rather than a religion.
Many human values and attitudes are derived from religious tenets. The direct con-
sequences of religion can sometimes be seen and felt in how managers and businesses
behave in international negotiations and competition. For example, the Protestant work
ethic states that there is more economic growth when work is viewed as a means of
salvation and when people prefer to transform productivity gains into additional output
rather than additional leisure. In other words, you need to give glory to God and at the
same time work hard. This has led to the hard-charging work ethic of many Western
societies. Buddhists believe in spiritual life, self-control, and the attainment of nirvana
(salvation) rather than amassing wealth. There is very little conflict and aggression
among the followers of Buddha, resulting in calm interpersonal relationships. Buddhism
and other similar religions are also the roots of the collectivistic societies in Far East
Asia. Similarly, followers of Hinduism tend to view the world and its purpose in terms
of spiritual redemption and, to a lesser degree, accumulation of wealth. Islam asks of
its followers their total dedication to Allah (the prophet); anything and everything they
do, including how businesses are conducted, is viewed through this belief.

Values

Values are the belief systems that underlie a society’s behaviors, the things that people
believe to be important. People are emotionally attached to these belief systems, so to
some extent they influence people’s behavior. The work ethics that are practiced by
different societies are value based. For example, the Japanese believe that work is very
important, and their philosophy is “live to work.” In contrast, the Europeans’ philoso-
phy is “work to live.” Both philosophies are culture based and deeply rooted in their
respective value systems. Therefore, values are important to international companies
because they affect human behavior in organizations. In addition, some universal value
elements are observed among international managers from different countries. In a
study of managers from five different countries, researchers observed that managers
from Australia and the United States were similar in social processes used to devise
strategies for industrial development. The researchers also found similarities between
American managers and Japanese managers in their pursuit of international expansion.15
Despite these similarities, international companies must manage their employees in
a way that recognizes prevailing cultural value systems. Treating all employees the
same, irrespective of their cultural backgrounds, can often lead to disastrous results.
Take, for example, the experience of an American company that introduced the merit
46 CHApTER 2

system to its operations in Japan. To help coordinate the various individual tasks, the
American manager delegated one individual to be the leader of one of the groups. In
no time, the group was functioning poorly, with performance levels lower than those
before the change was made. In investigating the cause of the decline in productivity,
the American manager realized that he had essentially destroyed the harmony of the
workgroup. Japan is a collectivist society, where individuals in a group are all equal;
no single individual is ranked above the rest. By appointing a leader, the manager had
created disharmony in the system. The employee who was appointed leader did not
want to be the leader, and the group did not feel appreciated.

Attitudes

Attitude is a person’s enduring favorable or unfavorable evaluations, emotions, and

tendencies toward some object or idea. Attitudes put people into a frame of mind of
liking or disliking, and in general, attitudes lead people to behave in a fairly consistent
way in similar situations. For example, attitudes toward time vary among cultures.
For Swedes, being on time is very important, and they will adhere to this attitude at
all costs. In Mexico and other South American countries, however, the attitude toward
time is casual; therefore, being prompt may not be given the high priority there that
it receives in other cultures, particularly if a family member or other relationship
simultaneously vied for the individual’s attention. Business executives from Japan,
Sweden, and the United States, where being prompt and on time for meetings is very
important, find it difficult to function in societies where time is viewed casually.
People’s attitudes affect the international companies’ operations in two ways. First,
a manager’s attitude affects how he or she runs a foreign subsidiary; attitudes about
work, time, and age need to be considered in managing employees. People’s attitudes
regarding family-career trade-off, workplace relations, and salary scales differ from
country to country. In Asian countries, women often choose family over career,
whereas in many Western countries, women balance family and career. Important
cultural differences exist in attitude toward age. In Asian and Arab cultures, age is
respected and elders are revered. Important positions in companies are often held by
experienced older people. In the United States, however, age does not matter. Com-
panies often appoint capable young people to very senior positions. In international
operations, this can sometimes lead to problems. Sending a young fast-track executive
to negotiate with senior government officials in Japan is probably unwise.
Second, in selling products and services in a given market, international companies must
consider people’s attitudes toward them. For example, Levi Strauss has sold jeans in the
United States using functional and reliable positioning, whereas in many overseas markets,
it stresses its American/Western toughness as a strong reason to buy its products.

Customs

Customs are ways of behaving under specific circumstances. Like culture, customs
are handed down from generation to generation. Customs dictate how people
react to situations. For example, a custom that varies from country to country
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 47

is the role of alcohol in business dealings. In Asian countries, alcoholic drinks

such as beer, liquor, and sake are usually shared at business events and are part
of the business custom, whereas in the United States, alcohol consumption has
no place in business.16

Aesthetics

Aesthetics play an important role in culture. Cultural preferences in color, beauty,

arts, and architecture are unique to each society. International companies need to
recognize these cultural differences in packaging and advertising their products and
services. For example, the use of the color green in any commercial transactions is
unacceptable for Islamic countries (it is the color of their flag), and red in China is a
royal color and therefore not used for commercial purposes. The color of mourning
differs from country to country: in the West it is black, in Japan it is white, and in
many Latin American countries it is purple, and therefore avoided in some product
categories, especially clothing. International companies need be aware of host coun-
tries’ preferences, which may differ from those of the home country, in order to avoid
business blunders.

Artifacts

Artifacts are buildings, monuments, architectural objects, and other works of art built
by people to reflect some of the values and beliefs of their respective societies. These
buildings are designed and built to last for a long time. Some ancient structures such
as the Great Wall of China, the Parthenon in Athens, the pyramids of Egypt, and the
Coliseum in Rome have withstood the passage of time and speak volumes about the
people of that time. Similarly, seventeenth- and eighteenth-century monuments such
as the London Bridge, the Taj Mahal in India, and the Eiffel Tower in Paris also tell
us about the people of that era. More recently, buildings such as the Empire State
Building in New York, the Tokyo Tower, and the Petronas Twin Towers (at present
the tallest building in the world) in Kuala Lumpur, Malaysia, all reflect something of
the people and society in their respective countries.

FRAMEWORK Of CULTURAL CLASSifiCATiON

Cross-cultural management is defined as the study of the behavior of people from dif-
ferent cultures working in organizations. To understand the cultural variations across
countries, researchers have created useful frameworks that make it easier to compare
them. A variety of cultural classification models have been developed to assess cultural
similarities and differences, four of which are presented here. By no means do these
four provide all the answers to cultural issues faced by international managers, but
collectively they present a useful framework for understanding cultural differences.
These models may also assist international companies in managing employees suc-
cessfully across cultures.
The four cultural frameworks discussed here are:
48 CHApTER 2

• Hofstede’s cultural dimensions

• Kluckhohn and Strodtbeck’s value orientation
• Hall’s low-context high-context approach
• Ronen and Shenkar’s cluster approach

HOFSTEDE’S CULTURAL DIMENSIONS

By far the most discussed work on cultural classifications was written by Gert Hofstede,
who as human resources manager at IBM surveyed about 100,000 IBM employees in
many countries in the 1980s.17 Based on his study, Hofstede proposed five dimensions
of culture (he first proposed four; later, in 1989, he added the fifth).

• Individualism-collectivism
• Power distance
• Uncertainty avoidance
• Masculinity-femininity
• Long-term/short-term orientation

A few of these dimensions were originally proposed in 1961 by the anthropologists

Florence Kluckhohn and Fred Strodtbeck, but Hofstede is the one who studied them
extensively in a corporate setting.

Individualism-Collectivism

Individualism-collectivism refers to the degree to which a society accepts individual

actions or the degree to which individuals perceive themselves to be separate from
others. In a collectivist society, group actions are emphasized. In some ways, the
individualism-collectivism dimension is the most observed and practiced of the five
dimensions studied by Hofstede.
In individualistic societies, such as Australia, Canada, the United Kingdom, and
the United States, people exhibit more individualistic behavior, often pursuing their
own goals, and more likely making decisions that affect their own situations. In col-
lectivistic societies, people tend to consider the group’s interest first and put the good
of the group ahead of their own personal welfare. Countries that have been found to
have collectivist societies include China, Colombia, Greece, and Mexico.
For international companies the individualism-collectivism dimension is a very
important consideration in the management of foreign operations. In individualistic
societies, individual performance is rewarded, individual initiatives are encour-
aged, and individual decision making is the norm; the corporate cultures in these
countries tend to be more impersonal. Research has shown that employees from
individualistic countries prefer individual rather than group-based compensation
practices.18 Corporate policies in individualistic-oriented cultures tend to allow
individuals to take initiatives, work on their own, and make individual decisions.
In collectivistic societies, groups make decisions, work is performed in groups, and
compensation packages are based on the groups’ results. In addition, in collectivist
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 49

societies, group performance is more important, and the organizational structures

tend to reflect a “family” orientation.19 Corporate policies in collectivistic cultures
are set up to encourage group results, group actions, and harmony within the group’s
structure.

Power Distance

Power distance refers to the degree to which a society accepts hierarchical (power)
differences; societies will accept either equal or unequal distribution of power. In
countries where power is distributed evenly, that is, where power distances are low,
there is greater acceptance of ideas among people. In these societies senior executives
consult with their subordinates in the workplace. This behavior is also exhibited within
families and in other social settings. In countries with low power distance, children
are encouraged to participate in family decisions and students are encouraged to dis-
cuss and present their points of view in the classrooms. Low power distance is also
called “power tolerance.” Low power distance countries include Austria, Denmark,
Norway, and Sweden.
In high power distance countries, the society believes that there should be a
well-defined order in which everyone knows their individual positions. In these
societies children are supposed to respect their parents and obey them, the teacher
is the center of the educational process, and subordinates are told what to do by
their superiors. Higher power distance countries include India, Mexico, and the
Philippines.
For international companies, the implications of power distance dimensions affect
organizational structure, decision making, and overall management of foreign opera-
tions. Studies have shown that power distance and uncertainty avoidance hinder the
acceptance of new products in some countries.20 Generally, in high power distance
countries, international companies need to set up centralized decision making, a
well-defined hierarchy, and close control. The opposite may be adopted in low power
distance countries.

Uncertainty Avoidance

Uncertainty avoidance refers to the degree to which a society is willing to accept

and deal with uncertainty; in other words, it ranks how a society deals with risk. In
countries with high uncertainty avoidance, people seek security and certainty. They
are comfortable knowing the parameters of their lives and are eager to avoid risk.
People in these societies do not want to deal with ambiguous situations. Countries with
high uncertainty avoidance include Japan, France, Greece, and Portugal. In countries
with low uncertainty avoidance (uncertainty acceptance), people like change and
constantly seek new opportunities. In these countries routine activities and certainty
in future actions lead to boredom, and people tend to be less productive. Countries
with low uncertainty avoidance include Denmark, Sweden, the United Kingdom,
and the United States.
In a study that assessed cross-cultural differences in the perception of financial
50 CHApTER 2

risk, researchers found that the risk judgment differed with nationality and culture.
The attitudes toward risk of respondents from Western societies such as the Nether-
lands and the United States differed from those respondents in Eastern societies such
as China.21 This finding was consistent with cross-country variations in uncertainty
avoidance, suggesting that multinationals operating in countries with high uncertainty
avoidance countries have to provide clearly defined work rules and job security (such
as lifetime employment, which until recently was offered by Japanese firms). In
contrast, when operating in countries with low uncertainty avoidance, international
companies should provide opportunities for quick decision making and should also
encourage risk taking.

Masculinity-Femininity

Masculinity-femininity refers to the degree to which traditional male values are ac-
cepted and followed in a society. In a highly masculine society, behaviors such as
aggressiveness and materialism are viewed favorably. Cultures with a strong mascu-
linity dimension have clearly differentiated sex roles, and men in these societies tend
to be dominant. Men in masculine societies are expected to work and provide for the
whole family. Highly masculine countries include Austria, Italy, Japan, and Mexico.
In highly feministic societies both men and women tend to work and provide for the
family. The sexes have less defined roles and share the responsibilities of parenting,
doing chores, and shopping equally. Countries with a stronger femininity dimension
include Denmark, Finland, and Sweden.
The masculinity-femininity dimension impacts the operations of international
companies in several ways. For example, companies that operate in feministic cul-
tures find that it is more important to maintain easy work schedules and offer better
fringe benefits (maternity/paternity leaves), and they find their employees to be less
interested in promotions. In these countries workers also tend to be more concerned
with community and environmental issues. In countries with a greater masculinity
dimension, workers are interested in pay raises and promotions and tend to be much
more goal oriented.

Long-Term/Short-Term Orientation

Long-term/short-term view refers to time orientation and view of life and work in
terms of a time horizon, either long-term or short-term. People living in cultures that
are long-term oriented, such as Brazil, China, India, and South Korea, tend to be
thrifty; they worry about the future, and they are more dedicated to tasks and causes.
Some experts refer to long-term orientation as a Confucian philosophy. Short-term
oriented cultures, such as Canada, New Zealand, the United Kingdom, and the
United States, worry about the present, seek instant gratification, and are less likely
to save. International companies operating in long-term oriented cultures may find it
necessary to treat their workers differently than do those that operate in short-term
oriented cultures.
Researchers have observed the collective effects of Hofstede’s five cultural dimen-
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 51

sions in marketing situations. Studies have found that consumers from collectivist, high
power distance, uncertainty-avoidance, and Confucian (long-term oriented) cultures
such as China and Taiwan definitely have different preferences in their consumption
of goods and services when compared with masculine, individualistic cultures such
as the United States.22

Criticism of Hofstede’s Cultural Dimensions

Hofstede’s cultural dimensions are probably the most studied and discussed of all
cultural dimension models. Hofstede’s is also one of the few cultural models to receive
worldwide publicity. Since it is based on a large sample covering many countries, it
is generally viewed as a reliable model. In addition, some of the dimensions identi-
fied by Hofstede have been identified by other anthropologists and social scientists.
In empirical studies by Sondergraad (1994);23 Hoppe (1998);24 and Neelankavil,
Mathur, and Zhang (2000),25 some of Hofstede’s results on a few of the dimensions
have been validated.
The criticisms leveled against Hofstede’s cultural dimensions relate to:

• appropriateness of the sample

• labeling of the terms
• other biases

Appropriateness of the Sample. Hofstede’s survey was conducted at one company,

IBM. Because IBM is a large multinational company with a strong corporate culture,
its employees may not be a representative sample of the general population. Doubts
exist about results based on a sample from a single company; therefore, researchers
are not sure whether Hofstede’s original four dimensions would have been identified
if the study had been done across many companies. Despite Hofstede’s large sample
size, researchers question the validity of the results based on the fact that the responses
may have actually represented the values of just a few.

Labeling of Terms. Hofstede studied business cultures. The information he gathered

and the conclusions he reached may not shed light on the core societal culture and the
values that are prevalent in a given society. Additionally, Hofstede studied manag-
ers’ attitudes, which may not necessarily reflect a society’s behavior patterns. In fact,
a few studies have demonstrated that cultural categorization is based on dominant
cultural value orientations; it does not provide a complete explanation of cultural
similarities and differences among cultures (a general criticism of all cultural dimen-
sion models).26

Other Biases. Hofstede’s survey was based on an instrument (questionnaire) and scales
that were developed for people in Western societies. Therefore, the terms used in the
questionnaire may not be exactly translated across cultures and in some cases may have
entirely different meanings in different cultures. Some research studies have shown
that questionnaires in organizational psychology are skewed by Western assumptions
52 CHApTER 2

Table 2.1

Summary of Hofstede’s Cultural Dimensions

Dimension Definition Characteristics Countries

Individualism- Extent to which the self or Interest of the indi- Individualistic: Australia, Canada,
collectivism the group constitutes the vidual versus United Kingdom, United States
center point the group

Collectivistic: China, Colombia,

Greece, Mexico

Power Extent to which hierarchical Centralization Power respect: Brazil, India, Mexico,
distance differences are accepted, versus decentral- Philippines
ranging from power ization
respectability to power
tolerance Power tolerance: Austria, Denmark,
Norway, Sweden

Uncertainty Extent to which uncertainty Structure versus Structured: Japan, France, Greece,
avoidance or ambiguity is tolerated, less structure Portugal
ranging from uncertainty (more rules or
avoidance to uncertainty fewer rules) Less structured: Denmark, Sweden,
acceptance United Kingdom, United States

Masculinity- Extent to which traditional How sex roles Masculine: Austria, Italy, Japan,
Femininity masculine (aggressiveness are defined and Mexico
and assertiveness) values practiced
are emphasized Feminine: Denmark, Finland, Sweden

Long-term– Extent to which a society Short-term view vs. Long-term view: Brazil, China, India,
Short-term values thrift and respect of long-term view South Korea
social obligations
Short-term view: Canada, New Zea-
land, United Kingdom, United States

and values that might not be appropriate for use in more traditional societies.27 In
fact, Hofstede originally had only four dimensions. The fifth, long-term orientation,
based on Chinese philosophies, was added much later. Other problems associated
with Hofstede’s study include the difficulties of measuring cultural variables that are
highly subject to contextual interpretation and judgment.
Despite these criticisms, Hofstede’s work has been recognized as a centerpiece
of corporate cultural studies and is widely referred to by scholars and practitioners
of international business research. Table 2.1 summarizes Hofstede’s five cultural
dimensions.

KLUcKHOHN AND STRODTBEcK’S VALUE ORIENTATIONS

Anthropologists Florence Kluckhohn and Fred Strodtbeck were the first (1961) to
describe a cultural framework that was based on dimensions or factors.28 They pro-
posed a framework for identifying cultural differences using six dimensions based
on past versus future and beliefs in individual versus group. To arrive at their cultural
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 53

dimensions, Kluckhohn and Strodtbeck looked at the following set of relationships

in a society:

• Are people viewed as good, bad, or a combination?

• Do people live in harmony with or subjugate (conquer) nature?
• Should people in a society act in an individual manner, or should they consider
the group?
• Should people accept and enjoy the current situation or change and make it better?
• What is the concept of space in a society; that is, do people think that most things
are private or public?
• What is the temporal orientation of a society—past, present, or future?

Based on their research, Kluckhohn and Strodtbeck concluded that most societ-
ies have a dominant cultural orientation that could be explained through six cultural
dimensions:

• Human nature
• Relationship to nature
• Human relationship
• Activity orientation
• Concept of space
• Time orientation

Human Nature

Human nature refers to society’s belief in people. Some societies, such as the Japanese,
believe that people are essentially good. In these societies, people trust one another
and are more likely to rely on verbal agreements. There are also societies in which
people are viewed as essentially evil; hence, these societies enact codes and set up rules
of behavior. The result of the mistrust in such societies is that they draw up detailed
contracts in business dealings and specify up front the penalty for not fulfilling the
contract. Contracts with penalty clauses are common in many European countries. A
third type of society views people as both good and evil. In these societies, of which
the United States is an example, people are viewed as changeable, and the members
of these societies try to develop systems to modify behavior.
The human-nature dimension may provide international companies with the clues
that dictate how they run their operations. Therefore, international companies may
have a very participative form of management, with unwritten rules and verbal agree-
ments, in a country where people are viewed as essentially good. In countries where
people are viewed as evil, a more directive form of management should be adopted,
with written rules and formal contracts. For the third group of countries, where people
are viewed as both good and evil, employees may be rewarded for good behavior and
punished for bad (evil) behavior. In a study conducted in China, researchers found
that trust played a significant role in resolving conflicts between expatriate managers
and their Chinese workers.29
54 CHApTER 2

Relationship to Nature

The relationship to nature refers to a society’s relationship between people and

nature—in other words, whether people live in harmony with or subjugate nature.
Societies that believe in living in harmony with nature, such as people in Middle
Eastern countries, tend to alter their behavior to accommodate nature. Countries
where the people view themselves as able to master nature, such as Australia, tend
to harness the forces of nature.
International companies can make use of the relationship-with-nature dimension
by encouraging innovation, changing existing beliefs, and implementing planning
in those countries where people believe that they can conquer (master) nature.
In societies where people tend to view nature as part of their lives, international
companies should be more environmentally conscious, for example, by using
biodegradable packing and by selling goods and services that foster ecological
concerns.

Human Relationship

The human relationship (the same as Hofstede’s individualism-collectivism dimen-

sion) refers to a society’s understanding of relationships among people. In some
societies, people focus on themselves in their actions, decisions, and interactions.
These societies are said to be individualistic; and examples include Denmark, Sweden,
and the United States. The opposite of individualism is groupism, or collectivism.
In collectivist societies people tend to place the interests and welfare of the group
ahead of themselves. In these societies group accomplishments, group decisions, and
group interactions are encouraged. Groupism is practiced in countries such as China,
Japan, and South Korea.
For international companies operating in collectivistic countries, group deci-
sions must be emphasized and individual recognitions and rewards should be
avoided.

Activity Orientation

Activity orientation refers to the primary mode of activity in a given society, that is,
whether people in the society accept or attempt to change their current situations.
Societies that accept the status quo, such as Brazil, Italy, and Mexico, go along with
the flow of events and tend to enjoy the current situation. In those societies where
change is desired, people seek ways to improve the current situation by setting spe-
cific goals, planning for the future, and working toward results. People in Finland,
Sweden, and Switzerland normally tend to be change oriented.
International companies can use the activity dimension in decision making and
the development of long-term plans. If they are operating in a society that looks for
change, employees should be encouraged to innovate and suggest ideas for improve-
ments, and they should be rewarded for successful innovations.
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 55

Concept of Space

The concept of space describes the extent to which a society views meetings be-
tween people as private or public. In countries that view space as private, such as the
United Kingdom, people do not get too close to one another. Open discussions are
not common, and ideas are restricted to just a few at one time. The opposite is true for
those countries in which space is considered public, such as Italy. In these countries,
participation is encouraged, decision making is more democratic, and feelings are
expressed publicly.
International companies must consider the space concept in running their for-
eign operations. In a very private society, for example, management-employee
meetings and discussions must be managed differently than those that take place
in a public society.

Time Orientation

The time orientation (somewhat similar to Hofstede’s long-term/short-term view) is

the extent to which people view their value systems based on time frames. Are their
value systems governed by the past, present, or future? In some societies, the past is
very important. People in these societies use historical experiences and traditions to
guide them in their day-to-day activities. These societies also make use of the past in
their business dealings. For example, the Chinese are traditionalists and use the past
as their reference point in conducting business.
In some societies the past is not that important; the present and the immediate are
what counts. Instant gratification is the norm among people that value the present.
Businesses in these societies tend to develop short-term plans. Companies publish
quarterly financial reports and managers are rewarded on short-term goals. The United
States is often cited as a society focused on the present.
Societies that are future oriented are interested in long-term results. Japan is an
example of a society that is long-term oriented. The Japanese people have one of
the highest savings rates in the world, and they value lifetime employment. Japanese
companies emphasize long-term planning; for example, Matsushita Company (now
Panasonic) set up a 100-year business plan, but more commonly Japanese companies
have 25-year plans.
The time orientation has significance for international companies not only
in terms of corporate planning, but also in terms of how their employees view
their day-to-day activities. In past-oriented societies, traditional practices never
go away; hence, management has to be careful when introducing new systems.
International companies that operate in future-oriented societies have difficulty
operating in a present-oriented society. Japanese companies operating in the
United States encounter difficulties in instituting long-term business plans for
American managers. Table 2.2 summarizes the six Kluckhohn-Strodtbeck cultural
dimensions.
56 CHApTER 2

Table 2.2

Summary of Kluckhohn-Strodtbeck Cultural Dimensions

Dimension Definition Characteristics Countries

Human Extent to which people Focus on good, evil, or a Focus on good: Asian
nature view one as good or evil combination countries (Japan)

Focus on evil: European

countries

Focus on good and evil:

United States

Relationship Extent to which people live Belief in accepting, altering, Accepting: Middle Eastern
with nature in harmony or try to subju- or managing their destinies countries
gate (harness) nature

Harnessing: Australia,
United Kingdom, United
States

Human rela- Extent to which people Individualistic versus group Individualistic: Denmark,
tionship believe in independence or oriented United Kingdom, United
dependence States

Group oriented: China,

Japan, South Korea

Activity orien- Extent to which people ac- Expression of feelings vs. Accept: Brazil, Italy, Mexico
tation cept the current situation seeking change Change: Finland, Sweden,
Switzerland

Concept of Extent to which a society In private society people are Private: United Kingdom
space views meetings as private distant; in public society peo- Public: Italy
or public ple encourage participation

Time Extent to which people Past provides the solutions; Past: China
orientation view the past, present, or effects of present are impor- Present: United States
future as important tant; effects in the long run Future: Japan

HALL’S LOW-CONTEXT–HIGH-CONTEXT FRAMEWORK

In explaining the use of language and how information is obtained, Edward T. Hall
characterized the differences in cultures as low-context and high-context cultures.30
In low-context cultures, the words used by the speaker convey precisely what the
speaker has in mind. Hence, in obtaining information in a low-context culture, only
firsthand information is considered relevant. Communication in low-context societies
is direct and people avoid small talk. Many European countries and the United States
are considered low-context cultures.
In high-context cultures, it is not the words alone that convey the message, but
also the context. Cultural clues are important in understanding what is being com-
municated, making the context as important as the spoken words. When interpreting
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 57

information in these cultures, one has to be sensitive to the peripheral information.

In countries with high-context cultures, the person’s status and the importance of the
situation are just as important as the communication itself. High-context cultures are
found in Asia, Latin America, and the Middle East.
From a practical standpoint, the context dimension of culture affects commu-
nication, information gathering, and decision making. For managers from low-
context cultures supervising subordinates from high-context cultures, information
provided by subordinates may sound as if it is an excuse as they explain the current
status of the task in a roundabout way. The opposite may happen if managers are
from high-context cultures are supervising subordinates from low-context cul-
tures. Managers from high-context cultures may feel that their subordinates are
too aggressive and do not like to follow orders. The low-context–high-context
dimension is equally problematic in business negotiations, as either side may feel
offended due to differences in approaches. Many negotiations between Japanese
executives and Western European executives have been strained due to commu-
nication problems.
It is important for business executives from low-context cultures to under-
stand that in high-context cultures, building a good relationship is the first order
of business and must occur before actual long-term arrangements are made.
The initial meetings between the parties are simply to earn one another’s trust.
Therefore, bringing lawyers to early meetings sends the wrong signal (implies a
lack of trust). In this environment, negotiations and agreements take a long time;
managers from low-context cultures must be prepared for delays in completing
business arrangements.
The low-context–high-context cultural dimension also affects international compa-
nies’ advertising strategies. In Austria, Germany, and the United Kingdom, advertising
is fact based and contains few words. Therefore, companies from high-context cultures
need to adapt to the direct approach used by low-context cultures in presenting their
messages. For example, Japanese automakers’ ads in Europe are very direct and to
the point in comparison to the lengthy ads used in Japan. In high-context cultures,
advertisements take on emotional overtones and the ad copy is long. International
companies from low-context cultures need to adjust their ad copy to fit into the cultural
context in which they are operating. For example, in high-context countries Procter
& Gamble’s ads for its Joy brand of dishwashing soap are especially descriptive and
explain in detail the merits of the soap.

RONEN AND SHENKAR’S CLUSTER AppROAcH

By grouping countries that share cultural dimensions such as language, Simcha Ronen
and Oded Shenkar were able to classify countries into nine clusters:31

• Anglo
• Arab
• Far Eastern
• Germanic
58 CHApTER 2

Table 2.3

Ronen and Shenkar Culture Clustering

# Culture cluster Characteristics

1 Anglo (7 countries): Australia, Canada, Ireland, Common language, British influence in busi-
New Zealand, South Africa, United Kingdom, ness and law
United States

2 Arab (6 countries): Abu Dhabi, Bahrain, Kuwait, Common language, common religion, common
Oman, Saudi Arabia, United Arab Emirates customs and practices, proximity to one another

3 Far Eastern (8 countries): Hong Kong (not a Common Asian traditions and customs
country anymore), Indonesia, Malaysia, Philip-
pines, Singapore, Taiwan, Thailand, Vietnam

4 Germanic (3 counties): Austria, Germany, Common language, historic links, and proximity
Switzerland to one another

5 Independent (4 countries): Brazil, India, Israel, No common characteristics

Japan

6 Latin American (6 countries): Argentina, Chile, Common language, former colonies of Spain,
Colombia, Mexico, Peru, Venezuela proximity to one another

7 Latin European (5 countries): Belgium, France, Some common cultural values and proximity to
Italy, Portugal, Spain one another

8 Near Eastern (3 countries): Greece, Iran, Historic links and proximity to one another
Turkey

9 Nordic (4 countries): Denmark, Finland, Many common cultural dimensions, historic

Norway, and Sweden links, proximity to one another
Source: Simcha Ronen and Oded Shenkar, “Clustering Countries on Attitudinal Dimensions: A Review
and Synthesis,” Academy of Management Review, 10, no. 3 (1985): 435–454.

• Independent—nothing in common
• Latin American
• Latin European
• Near Eastern
• Nordic

The basic premise of Ronen and Shenkar’s cultural clustering is that similarities
among cultures do exist. It follows, then, that it is possible for international com-
panies to implement standardized strategies across countries. In addition, Ronen
and Shenkar’s culture clustering can be used to select countries for market entry.
By using a similar analysis for countries in the same clusters, international compa-
nies can more quickly evaluate potential locations. If there are cultural differences
between the home country and the host country, an international firm may want to
avoid the uncertainty these countries present. Cultural differences may foreshadow
difficulties in adapting to local conditions. For example, recognizing the similarities
in cultures, many U.S. companies often choose Canada and the United Kingdom
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 59

as their first overseas markets. Similarly, China is the first entry point for some
Taiwanese companies.
International companies have also used cultural clustering to design organiza-
tional structures that take into consideration the similarities and differences among
cultures. In designing organizational structures, international firms try to create
balance between international/global integration (coordination of activities) and
local responsiveness (response to specific needs by the subsidiary). This balanc-
ing act is often dependent on how culturally similar or dissimilar the home and
host cultures are. For example, Unilever’s organizational setups in Germany and
Switzerland are similar, whereas the organizational structure in India is totally
different from that found in Europe. Table 2.3 presents the Ronen and Shenkar
culture clustering.

OTHER CULTURAL CLASSIFIcATIONS

Besides the four frameworks of cultural dimensions that have already been examined,
there are two other cultural classification models that are often discussed in the inter-
national business context. The first is the cultural classification by S.H. Schwartz and
the second is the Charles Hampden-Turner and Fons Trompenaars cultural model.
Schwartz’s classification focuses on the social relationships and social environ-
ment in which people interact. Schwartz’s model identifies three key dimensions: (1)
embeddedness versus autonomy; (2) hierarchy versus egalitarianism; and (3) mastery
versus harmony.32 The first dimension, embeddedness versus autonomy, explains
people’s cultural orientation toward social relationships. In some societies, people
are very independent and express their feelings with no regard for others (autonomy).
Countries in which individuals seek autonomy include Denmark, France, and Ger-
many. In contrast, societies that exhibit embeddedness (also called conservatism) are
more traditionalists. Countries in which embeddedness is observed include Singapore,
Taiwan, and Turkey.
The hierarchy versus egalitarianism dimension deals with the roles of people in
social situations—those who seek important roles versus those who are more con-
cerned with their relationships with others. Countries such as China and Thailand
are very hierarchical; countries such as Estonia and Mexico are more egalitarian.
Schwartz’s third dimension deals with mastery of nature versus harmony. In some
societies, people value success, and in others they pursue harmony with nature and
tend be less ambitious. People in Brazil and Spain are found to be driven by ambi-
tion, whereas people from Italy and Finland are more concerned with the broader
social system.
Hampden-Turner and Trompenaars developed a classification that is based on
the premise that foreign cultures are basically not very different, but rather mirror
images of one another. According to their theory, a society’s values and rewards are
based on order and sequence of looking and learning. In a very basic sense, we need
to understand why in some societies people write their given name first and family
name last, as in many Western cultures, whereas in many Asian cultures the family
name comes first. At the same time, most Western societies are individualistic and
60 CHApTER 2

Asian societies are collectivist (community oriented). Is there a link between these
two patterns? Is the reason that members of Western society write their given name
first because they are very individualistic in their behavior, and vice versa? Similarly,
in some societies people write left to right and in others they write right to left (Arabic
language). How much of this is value driven? Based on their research, Hampden-
Turner and Trompenaars developed three value dimensions: (1) universalism (applies
to many) versus particularism (emphasizes exceptions); (2) individualism versus com-
munitarianism (collectivism); and (3) specificity (precision or getting to the point)
versus diffuseness (larger context).33 There are similarities between Hampden-Turner
and Trompenaars’s classifications and other cultural classifications, most obviously
Hofstede’s individualism-collectivism and Hampden-Turner and Trompenaars’s
individualism/communitarianism.
Some overlap exists among all the cultural dimension models. For example, the
individualism-versus-collectivism dimension is mentioned in three of the models.
Similarly, Hofstede’s power distance dimension is the same as the hierarchy dimen-
sion in Schwartz’s framework.
Clearly, culture can have a powerful effect on international business operations.
Because people belong to different societies that have their own cultural norms,
beliefs, and values, their behavior and expectations at the workplace are affected. If
international companies make a concerted effort to understand foreign cultures, some
of the problems associated with differences in culture may be reduced.
One suggestion for global managers to be successful in overseas markets is to
develop five cultural competencies; cultural self-awareness, cultural consciousness,
ability to lead cultural teams, ability to negotiate across cultures, and a global mind-
set.34 Though these skills are extremely useful, in practice they are hard to teach. In
understanding different cultures, it becomes apparent that it is quite difficult to master
and be proficient in all their variations.
All the cultural models that are presented here have some common themes, but
they do not address each and every unique aspect of the hundreds of cultures that
exist around the world.

CULTURAL GENERALiZATiON
The cultural models presented here, along with others, may give the impression that
one can easily capture, compartmentalize, and learn about other cultures. The truth
of the matter is, cultures cannot be classified, it is not easy to understand them, and
learning individual cultures is a long and tedious process. Some cultural differences
are easy to observe and learn, such as a society’s acceptable attire or how to greet
people. However, it is difficult to learn the culturally ingrained responses to situations
that are second nature to the locals but completely unfamiliar to foreign executives.
The best way to learn a culture fully is to immerse oneself in that culture, that is, to
live and practice the culture for a long period of time and learn the language. Time,
however, is one item that international businesses and their executives do not have.
Therefore, many international managers end up receiving only a macro treatment of
culture and never become well-versed in the deep-rooted cultural values, norms, and
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 61

customs of their host nations. It is no wonder that many international blunders can
be traced to cultural misunderstandings.
Cultural generalizations based on different models, though useful, are often
the problem in learning about foreign cultures. Armed with a few cultural dimen-
sions, executives feel confident that they are ready to conduct business in foreign
countries. But these dimensions may not provide the complete picture. Some of
the information gathered about foreign cultures may be stereotypes that can pose
even more problems. A few examples of stereotypical generalizations include:
“Americans are brash and make quick decisions,” “Japanese are slow to come
to an agreement,” and “Italians love to talk.” There are so many cultural varia-
tions and nuances that it is not possible to understand or memorize all of them
for every country.

CULTURAL CONVERGENCE
Advances in technology that have enabled people to travel and communicate in
ways that were difficult if not impossible just a decade ago have made the world
smaller and brought people closer. This phenomenon has led to a better understand-
ing of foreign cultures and an acceptance of values and norms that until recently
had been foreign to many. In addition, some uniform consumption patterns have
emerged that seem to transcend cultures. In a study conducted among Web us-
ers, it was found that the satisfaction levels across cultures provided equivalent
measurement.35 Take, for example, the success of Starbucks coffee in China, a
tea-drinking society; the proliferation of American-style fast food in Japan, India,
and Latin American countries; the widespread wearing of denim jeans among
young people in many parts of the world; and the success of Japanese cuisine in
America (especially raw fish, which differs from the traditional preferences.) Add
to this the spread of globalization; it is not surprising to see more similarities in
cultural practices.

CULTURE SHOCK
Even after managers complete their cross-cultural training in preparation for an
international assignment, many are likely to feel disoriented upon arrival at the
new location. For instance, someone accustomed to calling colleagues by their first
names must adjust to the widespread use of titles and last names in the workplace.
In some countries, the degree of respect given to people and use of proper names in
addressing people is very important.36 How does one adjust to people coming late
for meetings? How does a manager from a cold weather country adjust to hot and
humid climates? This disorientation faced by foreign workers is generally referred
to as “culture shock.”
Culture shock is defined as “a generalized distress one experiences in a new and
different culture because of a lack of understanding of the local culture.” If often
occurs because the foreign worker is facing an unfamiliar set of behavioral cues that
are different from the ones he or she is used to or knows about.
62 CHApTER 2

Most experts agree that culture shock is accentuated by the difficulty in interacting
in the local environment, leading to a focus on the negative aspects of the local cul-
ture and its people. The more successful foreign workers are those who are willing to
learn the culture, accept the differences in cultures, and adapt to the new environment.
There are no shortcuts in preparing international managers to be ready for cultural
shock, but training, role-playing, and exposure to people from different cultures and
environments can often make the transition a little easier.

CULTURAL ORiENTATiON
Understanding foreign national cultures and adapting to these cultures in the business
world depend on two factors: (1) the cultural similarities found between the home
country’s culture and the host country’s culture, and (2) the managers’ attitudes toward
other cultures. The attitudes of managers and their companies toward outside cultures
can be classified as ethnocentric, polycentric, or geocentric.

ETHNOcENTRISM
Ethnocentrism—the belief that one’s own culture is better than or superior to other
cultures—is one of the most common attitudes found among international managers.
Managers with an ethnocentric attitude often ignore important host-country cultural
values. For example, a study of Chinese workers employed by multinational companies
found that the expatriate managers were persistent in maintaining their own cultural
values in relationship building.37 Of course, this resulted in poor working relation-
ships between the locals and the expatriates. It was also noticed that the expatriate
managers tried to change the cultural orientation of the host-country personnel, which
did not help the situation. International companies that tend to have an ethnocentric
attitude more often use a centralized organizational structure. These companies often
dictate policies and procedures from headquarters, with very little input from sub-
sidiary personnel. Interestingly, the managers themselves may not be aware of their
ethnocentric attitudes, and herein lies the challenge for international firms in handling
their executives’ ethnocentric behavior. Ethnocentrism has been identified as a major
cause of many international business difficulties.

POLYcENTRISM
Polycentrism is the recognition that it is important to understand the differences in
cultures and act accordingly in interacting with people from other cultures. Interna-
tional companies and their polycentric managers try to accommodate cultural dif-
ferences, and to facilitate its local responsiveness, the company is often organized
in a decentralized structure. Some experts feel that while polycentric firms adapt
readily to various countries, this adaptation can lead to serious inefficiencies for the
firm (as it is often unable to capitalize on economies of scale). This situation may
ultimately have a negative impact on the firm’s competitiveness. Trade-offs between
local adaptation and cost efficiency usually depend on the nature of the product or
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 63

service being marketed. For example, consumer packaged-goods companies may

need to be more sensitive to national differences than, say, firms selling industrial
goods. International companies that have a polycentric attitude may also be reluctant
to adopt certain practices and procedures simply because they were successful in the
home country or other host countries; in this way, polycentric companies are being
sensitive to a given host-country personnel’s attitudes and behaviors.

GEOcENTRISM
Geocentrism is the belief that in certain cultures change can be made and in oth-
ers one has to adapt to the host culture. In these cases, international companies and
their managers base their decisions and manage their operations after thoroughly
understanding the host culture and its unique features. The geocentric attitude avoids
the main problems associated with ethnocentric and polycentric attitudes, and the
international company is able to introduce proven systems and be innovative at the
same time.

CHApTER SUMMARY
Culture is a critical environmental variable that international companies need to con-
sider in entering and managing their foreign operations. Mistakes rooted in cultural
misunderstandings are some of the most common blunders committed by international
executives. Hence, there have been many attempts made to identify similarities and
differences between cultures through cultural dimensions.
A good working definition of culture is the knowledge, beliefs, art, law, morals,
customs, and other capabilities of one group distinguishing it from other groups.
Culture is a learned behavior that is passed down from generation to generation and
evolves over a long period of time. The key institutions that instill culture are family,
schools, and religion.
Language, religion, and social structures are important correlates of culture that
influence international business operations. Researchers have attempted to study and
understand the reasons for cultural similarities and differences. Based on these studies,
researchers have developed various classifications of country cultures. The most cited
and discussed cultural classification is the one proposed by Gert Hofstede. Hofstede
identified five cultural dimensions that may be used to find similarities between cul-
tures. The other classifications of culture include those of Kluckhohn and Strodtbeck;
Hall; and Ronen and Shenkar. Though each of these systems explains some of the
similarities between cultures, they do not provide all the answers to cultural behavior
and the differences found between cultures.
International companies need to recognize the importance of culture and use it to
avoid major mistakes. The influence of culture should be considered in developing
entry strategies, designing organizational structures, managing subsidiary operations,
and developing marketing strategies.
In understanding cultural influences, international businesses have to recognize
concepts such as cultural generalization, cultural convergence, cultural shock, and
64 CHApTER 2

various types of management orientation such as ethnocentrism, polycentrism, and

geocentrism.

KEY CONCEpTS
Cultural Components
Cultural Dimensions
Culture Shock
Cultural Convergence
Cultural Orientation

DiSCUSSiON QUESTiONS
1. What is culture?
2. Identify the key elements of culture.
3. How is culture learned?
4. What are the key institutions that influence cultural behavior?
5. How do societies communicate, and what role does language play in inter-
national operations?
6. Explain the role of religion in culture and how it affects international business
operations.
7. What are social structures? How do international companies use social struc-
tures in designing their organizational structures?
8. What are cultural dimensions?
9. Identify and discuss some of the important cultural dimensions.
10. What is cultural convergence?
11. What is culture shock?
12. Explain and discuss ethnocentrism, polycentrism, and geocentrism.

ADDiTiONAL READiNGS
Ajiferuke, Musbau, and Jean J. Boddewyn. “Culture, and Other Exploratory Variables in Comparative
Management Studies.” Academy of Management Journal (June 1970): 153–63.
Ashkansay, Neal M., and Celeste P.M. Wilderom. Handbook of Organizational Culture and Climate.
Beverly Hills, CA: Sage Publications, 2000.
Dunlop, J.T., F.H. Harbison, C. Kerr, and C.A. Myers. Industrialism and Industrial Man Reconsidered.
Princeton, NJ: Princeton University Press, 1990.
Gannon, Martin J., and Associates. Understanding Global Cultures: Metaphorical Journeys through
17 Countries. Beverly Hills, CA: Sage Publications, 1994.
Griffin, Ricky W., and Michael W. Pustay. International Business. 4th ed. Upper Saddle River, NJ:
Pearson-Prentice Hall Publishers, 2005, chap. 4.
Krech, David, Richard S. Crutchfield, and Egerton L. Ballachey. Individual in Society. New York:
McGraw-Hill, 1962.
Punnet, Betty Jane, and David A. Ricks. International Business. Boston, MA: PWS-Kent, 1992, chap. 6.
Shenkar, Oded, and Yadong Luo. International Business. Hoboken, NJ: John Wiley & Sons, 2004,
chap. 6.
 INTERNATIONAL BUSINESS ENVIRONMENT: CULTURE 65

AppLiCATiON CASE: BUSiNESS NEGOTiATiONS AND CULTURAL

PiTfALLS—MEXiCO
Two companies had been shortlisted for a major infrastructural contract in Mexico:
one was an American and the other Swedish. Both companies were invited to Mexico
to present their proposals to the relevant ministry and to start negotiating the terms
of the deal.
The Americans put a lot of effort into producing a high-tech, hard-hitting presen-
tation. Their message was clear: “We can give you the most technically advanced
equipment and quality of service at a price our competitors can’t match.” The team,
which consisted of senior technical experts, lawyers, and interpreters, flew down
from the company’s New York head office to Mexico City, where they had reserved
rooms in one of the top hotels for a week.
In order to put on the best possible performance for the minister and his officials,
the Americans arranged to give the presentation in a conference room at the hotel.
They brought all the necessary equipment with them from the United States. All the
arrangements had been written down in great detail and sent to the Mexican officials
two weeks earlier.
At the agreed-upon time, the American team was ready to present, but they had
no one to present to. The people from the ministry arrived at various times over
the next hour. The ministry staff did not apologize for being late, but just began to
chat amicably with the Americans about a wide range of nonbusiness matters. The
leader of the American team kept glancing anxiously at his watch. Finally, he sug-
gested that the presentation should start. Though the Mexicans seemed surprised,
they politely agreed and took their seats. Twenty minutes later, the minister, ac-
companied by some senior officials, walked in. He looked extremely angry and
asked the Americans to start the presentation again from the beginning. Ten minutes
later, the minister started talking to an aide who had just arrived with a message
for him. When the American presenter stopped talking, the minister signaled that
he should continue. By this time, most of the Mexican representatives were talk-
ing amongst themselves. When invited to ask questions at the end, the only thing
the minister wanted to know was why the Americans had told them so little about
their company’s history.
Later, during lunch, the Americans were very surprised to be asked questions about
their individual backgrounds and qualifications, rather than technical details about
their products. The minister had a brief word with the American team leader and left
without eating or drinking anything.
Over the next few days, the American team contacted their Mexican counterparts
several times in an attempt to fix a meeting time and start the negotiations again. The
Americans reminded the Mexican team that they had to fly back to the United States
at the end of the week. But the Mexican response was always the same: “We need
time to examine your proposal amongst ourselves first.” At the end of the week, the
Americans left Mexico angry and frustrated.
66 CHAPTER 2

QUESTIONS
1. Who do you think received the contract?
2. Explain in specific detail the American team’s steps (right or wrong) that
produced this outcome.

ADDITIONAL READINGS
Shirley Taylor, “Communicating across Cultures,” British Journal of Administrative Management
(June-July 2006): 12–21.

SOURcE
Chris Fox, “Cross-Border Negotiation,” British Journal of Administrative Management (June-July
2006): 20–23.
 3 Economic and Other Related
Environmental Variables

Economic variables such as the gross domestic product, balance of payments, inflation,
and other such factors have a great impact on the operations of a global company.

LEARNiNG ObJECTiVES
• To understand the environmental variables that affect international business
• To understand the influence of macroeconomic factors on international opera-
tions
• To understand the variables used to measure the strengths and weaknesses of
individual economies
• To understand the differences among industrialized, emerging, and developing
economies
• To understand the differences among market-based, centrally planned, and mixed
economies
• To learn about the underground, or parallel, economies and their effects on in-
ternational companies
• To understand techniques to conduct country risk analysis
• To understand the importance of competitive analysis in international business
operations

Aside from the cultural factor, discussed in Chapter 2, the environmental factors
that affect an international business include a country’s economy, competition,
infrastructure, technology, political stability, and government regulations. In this
chapter, the effects of economy, competition, infrastructure, and technological fac-
tors are discussed.

THE ECONOMY
The last 20 years have brought the world more trade, more globalization, and more
economic growth than in any such period in history.1 The economy of a country af-
fects businesses in many ways. Economic downturns might result in a reduction in
consumer expenditures, affecting sales revenues. A drop in a country’s gross domestic

67
68 CHApTER 3

product (GDP; the total value of all goods and services produced in a country in a
given period of time) or gross national income (GNI; includes the total value of goods
and services produced within the country together with external net income received
in the form interests and dividends; the World Bank uses the GNI measures to report
on a country’s economic activity) may imply a contraction in a country’s total output.
A decline in a country’s currency value may suggest an underlining weakness in the
economic structure of country and, hence, may mean difficulties for businesses.
Recognizing the possible impact of this key external variable, international manag-
ers continuously monitor economic factors to be prepared for the dynamic shifts that
occur in each country’s economic activities. The unexpected Asian crisis in July 1997
sent shockwaves throughout the region. As a result, many investors were unwilling to
provide loans and subsidies to developing countries. The ensuing credit crunch led to
an economic slowdown in many developing countries, which resulted in a decrease
in demand for foreign goods, affecting many international companies. Similarly, the
continuing decline in the value of the U.S. dollar against the European euro and the
British pound is affecting businesses on both continents.
More recently, the credit crisis of 2008 that started in the United States has had
global financial repercussions; the crisis is engulfing developing countries from Latin
America to Central Europe, raising the specter of market panic and even social un-
rest. The list of countries under threat is growing by the day and now includes such
emerging market stalwarts as Brazil, South Africa, and Turkey. The fast-growing
economies of the world depend on money from Western banks to build factories, buy
machinery, and export goods to the United States and Europe. When those banks stop
lending and the money dries up, as it did in 2008, investor confidence vanishes and
the countries suddenly find themselves in crisis.
International managers consider the changes in the economic environment when
selecting countries for market entry, and when developing specific market-related
strategies. Among the various external factors, the economic environment is more
consistently structured and the information on economic activities for most countries
is readily available; hence, this external factor can be accessed easily.
In international markets, the level of a country’s economic activity as measured by
its GDP, GNI, inflation rate, and/or exchange rates is critical to a company’s opera-
tions. These economic variables attempt to describe a set of conditions that influence
the company’s strategic operations. A growing and robust economy implies higher
consumption expenditures by consumers and better revenues for companies. A higher
inflation rate creates economic instability and leads to increases in commodities prices,
and a depreciating local currency makes imports cheaper and domestic exports more
expensive, resulting in trade deficits.
Evaluating countries for market entry or for developing operational strategies
depends to a large extent on the soundness of the selected country’s macroeconomic
conditions. Economic strength is dependent on the structural foundation of the econ-
omy for sustained economic growth and economic stability. Specific components of a
country’s economic strengths include investments, both internal and foreign, domestic
consumption, the population’s real income levels, performance of the individual sec-
tors within the economy, and infrastructure development.
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 69

Local and foreign investments add to the factors of production, including the cre-
ation of jobs. They also stimulate the economy through the introduction of advanced
technologies, higher productivity levels, and overall improvements in key sectors
of the economy. A case in point is the phenomenal economic growth in the United
States during the 1990s that was brought on by investments in technologies during
the previous decade. Equally important are changes in the consumption expenditures,
specifically per capita consumption. Increases in consumption expenditures imply
that the people have steady jobs, their real incomes (income minus rate of inflation)
are rising, and many of them are very confident about the robustness of the economy.
When consumption expenditures in a country decline, its economy suffers. A case in
point is the situation that the Japanese economy experienced in the late 1990s. Due
to general weaknesses in the economy and a lack of confidence in the government
leaders to pull the economy out of its downturn, many consumers in Japan reduced
their consumption expenditures, which further destabilized the economy.
Economic strength and stability are also affected by the performance of a coun-
try’s economic sectors—agriculture, manufacturing, and service. Quality of output,
efficiencies in each sector, use of technology in each sector, and overall productivity
levels greatly influence the economy. A strong and stable economy normally relies
on the development of its economic sectors. Countries with a strong manufacturing
base, such as China, or those that rely heavily on the service sector, as the United
States does, normally have strong economies. Countries that rely heavily on the
agricultural sector and have relatively fewer workforces in the manufacturing and
service sectors typically have underdeveloped economies. Countries in Africa, parts
of Asia, and Latin America are good examples of countries that are underdeveloped.
These countries are not competitive and receive very little foreign investment, which
further hinders their economic development.
As mentioned earlier, an economy’s strength is normally deduced through key
economic variables such as GDP/GNI growth rates, per capita GDP/GNI, inflation,
current account balance (part of the balance of payments), and external debt.2

GROSS DOMESTIc PRODUcT AND GROSS NATIONAL INcOME

Gross domestic product (GDP) can be calculated by totaling up the amount of a country
spent on final goods and services; this is called the expenditure method. It can also be
calculated by totaling up all the wages, rents, interest incomes, and profits earned by
all factors in producing the final goods and services; this is called the income method,
or gross national income (GNI). The GDP/GNI is used as a measure of a nation’s
total output. The GDP/GNI growth rate measures the annual increase in a nation’s
total output from the previous year to the next. For example, the German economy
grew by 2.7 percent in 2006, a moderate increase; in contrast, the Chinese economy
grew by 9 percent during the same year, a substantial growth rate. The growth rate
is a good indicator of a nation’s economic vitality. The stronger the growth rate, the
more robust the economy. For international companies, countries with a strong growth
rate are attractive locations for investment.
Per capita GDP/GNI is a nation’s total GDP/GNI divided by its population. The
70 CHApTER 3

Table 3.1

Inflation Rates for Few Select Countries, 2007

Country Inflation Rate (%)

 1 Zimbabwe 1,035.5
 2 Iraq 53.2
 3 Guinea 30.0
 4 Sao Tome and Principe 23.1
 5 Yemen 20.8
 6 Myanmar 20.0
 7 Uzbekistan 19.8
 8 Congo 18.2
 9 Afghanistan 16.3
10 Serbia 15.5
Source: “World Statistics,” http://www.infoplease.com/January 2008.

GDP/GNI per capita is a better reflection than overall GDP/GNI of the well being
of the country’s people. Based on GNI per capita figures for 2006, the people of
Switzerland at $58,050 seem to be leading a very good life. On the other hand, with
a GNI per capita for 2006 of only $230, the people of Malawi seem to have a dif-
ficult life.3 For international companies, the higher the GNI per capita, the better the
market potential, as the people in the country with higher GNI per capita can afford
to spend more on a vast variety of goods and services.

INFLATION
Inflation is another factor that international companies use to measure a country’s
economic strength. Inflation is defined as an increase in the overall price level of
goods and services in a country. The rate of inflation is calculated by averaging the
percentage growth rate of the prices of a selected sample of commodities. Inflation
affects many aspects of an economy, including prices of goods and services and prices
of raw materials and components used by companies in the manufacture of goods.
The inflation rate also determines the real cost of borrowing and affects a country’s
exchange rate. Real interest rates are calculated by subtracting inflation from the
nominal interest rate. Most countries control inflation through monetary and fiscal
policies. Japan and the United States, for example, have a good record in keeping
inflation under control through monetary and fiscal policies.
Inflation rates vary from country to country. Most industrialized countries try to
maintain low inflation—in the single digits. For example, for the year 2007 the infla-
tion in Japan was 0.8 percent; during the same time period Serbia registered a 15.5
percent rate of inflation. Developing economies have difficulty maintaining single-
digit inflation, however. For example, Zimbabwe experienced an inflation rate of
1,035.5 percent for 2007, and Iraq’s inflation rate for 2007 was 53.2 percent. Table
3.1 presents the inflation rates for selected countries for the year 2007.
Due to fundamental structural problems, it is difficult for developing countries to
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 71

keep inflation under control. For most developing countries, an unending cycle of
high unemployment and low incomes combined with scarcity of goods and services
leads to a general rise in price levels. Long-term inflation is caused by excessive
demand, called demand-pull inflation, or a rise in costs, called cost-push inflation or
supply-side inflation. Demand-pull inflation occurs when there are general increases
in the aggregate demand and the supply of goods and services lags behind—that is,
consumers are purchasing too many goods, and the producers are not able to meet
the needs, resulting in higher prices. In cost-push inflation, input costs keep rising;
the producers pass this increase on to the consumers.
Setting prices is never an easy task for international companies. Prices are affected
by many factors, including competition, price elasticity of demand, government
regulations, and other internal factors. However, when a firm must set a price within
a high-inflation market, these factors become compounded.4

BALANcE OF PAYMENTS
Balance of payments refers to all of a nation’s transactions in goods, services, assets,
and donations with all of its trading partners. It is a double-entry bookkeeping system
that is balanced at the end of a specific time frame, usually a year. Balance of payments
consists of two separate accounts: (1) the current account, which is made up of all
of a country’s exports and imports, any income earned or remitted because of assets,
and employee compensation received or paid, and (2) the capital account, a financial
transaction between countries in which assets are purchased or sold. The current ac-
count is the one most watched by policy makers and international companies.
The difference between a country’s exports and its imports in goods and services
is referred to as its balance of trade. A trade surplus is said to occur when a country’s
exports are greater than its imports; a trade deficit occurs when a country’s imports
are greater than its exports. Countries such as Japan and China have huge trade
surpluses each year. China had a trade surplus of $262.2 billion for the year 2007,
a nearly 50 percent increase from the previous year.5 In contrast, the United States
runs deficits every year. The U.S. trade deficit for just one month (March 2008) was
close to $60 billion.

EXTERNAL DEBT
A country’s external debt is its total borrowing through foreign government sources
or private banks. Many developing countries borrow from foreign sources to finance
their developmental programs, as they themselves lack the required capital. In many
instances, the poorer countries are not able to pay back the amount outstanding, and
banks have to reschedule their debts. An agreement is reached whereby the debtors
are given extensions on their payment schedules, and in some cases a portion of the
debt may be written off. During the 1970s and 1980s some American banks, primar-
ily Citigroup and JPMorgan Chase, lent considerable funds (close to $700 billion)
to foreign countries, including Brazil, Mexico, and Venezuela. Table 3.2 presents
the current external debt of selected countries. Countries with large external debts
72 CHApTER 3

Table 3.2

External Debt for Selected Countries, 2007 (estimate)

# Country External Debt (in $ billions) External Debt as a % of GDP

1 Brazil 557.1 43.9
2 China 614.1 18.9
3 Mexico 204.8 23.1
4 Russia   90.0   7.0
Source: Central Intelligence Agency, “Country Statistics,” The World Factbook. Available at https://www.
cia.gov/library/publications/the-world-factbook/ (accessed June 10, 2008).

have fundamental problems in their economies. Any economic downturn among the
industrialized countries hurts poorer countries’ exports, reducing their capacity to
pay back the loans. The profits and other remittances of international companies that
plan to operate in these countries may be compromised.

ECONOMiC DEVELOpMENT AND INTERNATiONAL BUSiNESS

Traditionally, international companies have sought countries that have substantial market
potential—specifically, the industrialized countries of the world, such as Japan, most
of the Western European countries, and the United States. These countries provide
economic stability but also a larger than average consumer base that can buy goods and
services beyond basic necessities. For example, the European Union had an estimated
population in 2006 of 457 million. Of this population, nearly 70 percent or 320 million
were in the middle-income category, providing a substantial consumer base to which
foreign companies could sell their goods and services. Because of the economic stability
and high purchasing power of the fully developed countries’ population, international
companies find the business environment in these countries safer. For example, com-
panies such as Boeing and Coca-Cola in the United States, Switzerland’s Nestlé, and
Unilever of the Netherlands derive a substantial portion of their revenues from a select
few countries. Coca-Cola obtains about 15 percent of its revenues from Japan alone,
and Nestle receives about 20 percent of its revenues from the United States, the world’s
two largest economies. Hence, a country’s economic development has considerable
influence on whether an international company will invest in it.
Less industrialized countries offer smaller markets for international companies and
also have marginal growth rates. The total market potential of all the less developed
countries put together is relatively small. Hence, the business environment in these
countries is riskier for international companies. But some radical changes are taking
place in the flow of globally based companies’ investments and operations. In recent
years, because of the saturation of industrialized countries’ domestic markets and the
dynamic changes that have occurred in some of the developing economies, interna-
tional companies are investing in these economies to tap into the newfound opportu-
nities. For example, countries such as Brazil, China, the Czech Republic, Hungary,
Malaysia, Peru, and Thailand are attracting attention in the corporate sphere. In fact,
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 73

China has become the world’s “manufacturing base,” with many foreign companies
investing heavily there. Currently China is the world’s single largest cellular phone
user, with more than 432 million subscribers. By the year 2020, China will be the
second-largest market for automobiles, with expected sales of 9 million cars per year.
It is no wonder that the world’s major automobile manufacturers, including Mercedes-
Benz of Germany, are setting up manufacturing operations in China.
A country’s economic development is measured by the following variables: per
capita GDP/GNI, wealth distribution, quality of life, literacy rates, and life expec-
tancy. Using a country’s level of economic activity, various international agencies
such as the United Nations (UN), the World Bank, and the International Monetary
Fund (IMF) have grouped countries of the world into different classes. The tradi-
tional (and old) economic development classifications included industrialized/fully
developed countries; newly industrialized countries; less developed countries; and
underdeveloped, or third world, countries. These classifications are often based on
a multitude of factors including the level of industrialization, the country’s wealth,
availability of capital for investments, and the general well-being of the country’s
citizens. Under this system, Canada, France, Germany, Japan, Singapore, Sweden,
the United Kingdom, and the United States would be classified as “industrialized,”
or “fully developed,” nations. “Newly industrialized” countries include Brazil, South
Korea, and Taiwan. Examples of countries that are considered “less developed” or
“developing” are Chile, India, Malaysia, Mexico, Peru, and Thailand. And Angola,
Burundi, and Myanmar are countries that could be classified as “underdeveloped.”
The current classification of a country’s stage of economic development no longer
contains categories such “third world” or “underdeveloped,” but rather more accept-
able terms such as “developing” or “less developed.” Each international agency uses
not only different terminology to classify countries but also different variables to group
them. For example, the IMF uses terms such as “advanced economies” that include
both “developed countries” and “newly industrialized economies.” Similarly, the
United Nations generally uses just two categories to classify countries—”developed”
and “developing” economies.
Perhaps the simplest and most useful classification of countries based on their
stage of economic development was developed by the World Bank, which uses GNI
as the sole variable to classify countries. A country’s gross national income is defined
as “income generated by a country’s residents from domestic and international ac-
tivity.” Using GNI per capita, the World Bank classifies countries as “high income”
(54 countries), “upper-middle income” (37 countries), “lower-middle income” (56
countries), and “lower income” (61 countries). The exact statistics used by the World
Bank to group the countries are as follows:

High income $10,726 or more

Upper-middle income $9,075–2,936
Lower-middle income $2,935–736
Low income $735 or less
Table 3.3 presents selected countries classified according to GNI.
74 CHApTER 3

Table 3.3

Selected Countries as Classified by the World Bank, 2006

GNI per Capita

# Country (Current US$)
High-Income Countries
 1 Australia 33,940
 2 Canada 36,280
 3 Denmark 36,190
 4 Germany 32,680
 5 Italy 28,970
 6 Japan 32,840
 7 Netherlands 37,940
 8 Singapore 43,300
 9 United Kingdom 33,650
10 United States 44,070
Upper-Middle Income Countries
 1 Argentina 11,670
 2 Chile 11,300
 3 Gabon 11,180
 4 Hungary 16,970
 5 Malaysia 12,160
 6 Mexico 11,990
 7 Slovak Republic 17,060
 8 South Africa 8,900
 9 Uruguay 9,940
10 Venezuela 10,970
Lower-Middle Income Countries
 1 Albania 6,000
 2 Belarus 9,700
 3 Brazil 8,700
 4 Ecuador 6,810
 5 Egypt 4,940
 6 Honduras 3,420
 7 Jordan 4,820
 8 Morocco 3,860
 9 Philippines 3,430
10 Thailand 7,440
Low-Income Countries
 1 Bangladesh 1,230
 2 Chad 1,170
 3 Eritrea 680
 4 Haiti 1,070
 5 Kenya 1,470
 6 Liberia 260
 7 Nigeria 1,410
 8 Senegal 1,560
 9 Tajikistan 1,560
10 Vietnam 2,310
Source: The World Bank, “World Development Data.” Available at http://devdata.worldbank.org/data-
query (accessed June 10, 2008).
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 75

A problem faced in GNI and other economic statistics is the question of comparability
between various data. Is 100 euros in Berlin equivalent to 600 Chinese yuan at an ex-
change rate of !1.00 = 6.00 yuan? The answer is no. With !100, a German family would
probably be able to buy one week’s worth of food and beverages. In contrast, a Chinese
family might need only 100 yuan to buy food for a week. Since 1 yuan is not equal to
!1, the Chinese person is spending only !16.60 (100/6.00) per week, compared to the
German’s !100. Therefore, a simple conversion of a country’s GNI per capita or GDP
per capita into another currency in which country statistics are maintained (U.S. dollars
or euros) might not be an accurate measurement of that country’s economic state.
To overcome the conversion problem, international organizations such as the United
Nations have developed a technique to compare economic statistics across countries.
The technique, known as “purchasing power parity” (PPP), is defined as the number of
units of a currency required to buy the same amount of goods and services in the domes-
tic market that could be bought with the U.S. dollar in the United States. For example,
suppose a basket of essential goods (food, rent, clothing, and the like) for a family in the
United States costs $1,000.00. That same basket of goods costs a family in the Philippines
P1,000. When the cost of goods is converted from pesos into U.S. dollars, a family in the
Philippines spends only $200, at an exchange rate of US$1 = P50. Therefore, it appears
that a Filipino family needs only a fifth (200/1000) of the expenditure of an American
family to buy the same quantity of essential goods. Hence, according to purchasing power
parity, if the GDP per capita of the Philippines was $1,000, using the PPP method it will
be recorded as US$5,000 (multiplied by a factor of 1,000/200 = 5).
The World Bank does not use straightforward official exchange rates or the purchas-
ing power parity approach to a country’s economic data; instead, it uses the “Atlas”
methodology. Conversions using the Atlas method are normally more stable and take
into account historic exchange rates by utilizing three factors: (1) the average of the
current exchange rate, (2) the exchange rates for the two previous years, and (3) the
ratio of domestic inflation to the combined inflation rates of the European Union,
Japan, the United Kingdom, and the United States. In calculating the conversion of
economic data using the Atlas approach, the World Bank adjusts the two-year historic
domestic exchange rate by the ratio of domestic inflation to the combined inflation
of the four aforementioned groups/countries. Table 3.4 presents GNI per capita for
selected countries using the Atlas method and the PPP method.
Because of the lower cost of living in countries such as Argentina, Bangladesh,
and Colombia, the GNI per capita using the PPP method is higher than the GNI per
capita using the Atlas method for these countries. In contrast, for Norway, the GNI
per capita using the PPP method is much lower than the Atlas method.
In addition to the GNI classification of countries, the World Bank uses a measure of
indebtedness to group countries when compiling global economic data. Using indebted-
ness as an economic factor, countries are classified into four groups: “severely indebted”
(53 countries, including Argentina, Indonesia, and Turkey); “moderately indebted” (39
countries, including Bolivia, Malaysia, and Slovak Republic); “less indebted” (44 coun-
tries, including Algeria, Guatemala, and Thailand); and “not classified” (77 countries,
including the wealthiest in the world such as the Nordic countries).
The GNI classification of economic development is useful for a broad-based macroanal-
76 CHApTER 3

Table 3.4

GNI per Capita for Selected Countries Using the Atlas and PPP Methods, 2006

GNI per Capita GNI per Capita

Country (Atlas Method) (PPP Method)
Argentina 5,150 11,670
Australia 35,860 33,940
Bangladesh 450 1,230
Canada 36,650 36,280
Colombia 3,120 6,130
Germany 36,810 32,680
Ireland 49,960 33,740
Malaysia 5,620 12,160
Norway 68,440 50,070
Philippines 1,390 3,430
Sweden 43,530 34,310
United States 44,710 44,070
Source: The World Bank, http://devdata.worldbank.org/data-query (accessed June 10, 2008).

ysis of countries. However, in evaluating countries or formulating operational strategies,

international managers make use of the more traditional economic indicators such as GDP
growth rate, GDP per capita, rate of inflation, current account balance, and so on. These
statistics have more direct influences on the consumption patterns of a population.
Countries can also be classified by their overall economic systems. An economic sys-
tem explains how a country allocates its resources. A country’s resources may be owned
by private citizens, by private companies, collectively by the country’s people, or by the
government. When private citizens and private companies own and control resources,
the economy is referred to as a “market-based system.” When the government owns
and controls resources, the system is referred to as a “centrally planned economy” or a
“command economy.” Ownership of resources translates into control of the resources
and the right to allocate them, as in the case of the Netherlands and the United States. In a
market economy, most of the resources are owned and controlled by the private sector. In
a centrally planned economy, such as those found in Cuba or North Korea, the resources
are owned and controlled by the public sector. There are some economies where the re-
sources are owned and controlled by the private sector and the public sector, as seen in
France and India. Table 3.5 presents countries organized by their economic systems.

MARKET-BASED EcONOMY
If given a choice, international managers prefer to operate in a market-based economy
because, by definition, it is consumer driven; that is, consumers have unlimited choices,
and their decisions are not controlled by outside forces. The freedom the consum-
ers enjoy also extends to firms operating within the country. In a pure market-based
system, companies decide what to produce, what to sell, at what prices to sell their
goods and services, and how to market them. Supply and demand dictates prices; they
are not preset by any entity—government or private. That is, when the demand for
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 77

Table 3.5

Types of Economic Systems in the World

Type of economy Selected countries No. of countries

Market-based Hong Kong, Singapore, United States   10
Mixed Brazil, Canada, India, Japan, Mexico 125
Centrally planned Cuba, North Korea   27

a particular product increases, companies may raise prices to take advantage of this
opportunity, and when demand falls, they may lower price to stimulate demand.
For international companies, operating in a market-based economy implies that the
country’s economic framework is open to accepting foreign companies and foreign
investments. In an open economy, the country’s economic structure is invariably
sound, and private companies can thrive under these conditions. A company’s suc-
cess or failure is totally dependent on its own strategic actions and the actions of its
competitors. This is similar to the environment that most international companies
are used to in their home countries, and therefore the level of uncertainty for these
companies is minimized.

CENTRALLY PLANNED EcONOMY

In a centrally planned economy, the consumers have no freedom of choice regarding
what they can buy, and most of the country’s goods and services are produced by
government enterprises. Consumers buy what is available, and within a product cat-
egory only one brand is available. If a family wishes to buy sneakers, the only brand
that is available is the one made by the government factory producing them, unlike in
market-based economies such as the United States, where there are plenty of choices.
In a centrally planned economy, resources are allocated to various production facilities
based on the plans of the country’s government, which considers itself a much better
judge than the private sector of what is good for its people. It can divert resources to
various segments of the economy as it sees fit. Economic principles of demand and
supply do not function in a centrally planned economy. Hence, the quality, prices, and
marketing of goods and services are determined by the government. One advantage
for the people in a centrally planned economy is that the prices of commodities remain
the same during high demand as well as low demand. The downside of the system is
that when supply of a product runs out, no efforts are made to add to the supply, no
matter what price a consumer is willing to pay.
The general principle behind centrally planned economies is that everyone in a
society should be able to buy and consume goods and services equally. The concept
of rich versus poor does not exist in these economies. Since the breakup of the Soviet
Union, few countries follow a centrally planned system. In fact, China, which used
to have a centrally based economy, is slowly shifting toward a mixed economy.
Operating in centrally planned economies is often a struggle for international com-
panies. Their success is dependent on factors that are outside their control. Interna-
78 CHApTER 3

tional companies have to fit their plans into an overall country-based economic plan
developed by the country’s government. Depending on the industry, this quite often
puts an international company at odds with local governments. For example, if the
Cuban government in its current five-year (2005–2010) economic plan has identified
food production, health services, and infrastructure as the key sectors toward which
to direct its efforts, and if Unilever plans to enter the Cuban market by introducing
a brand of detergent, the Cuban government may not necessarily deny Unilever’s
request to invest in Cuba, as it seeks foreign investments; at the same time it may not
be too helpful to the company, either.

MIXED EcONOMY
In a mixed economy, the resources are owned and controlled not by individuals or
the government alone, but by both groups. In fact, there are more mixed economies
in the world than there are either market-based or centrally planned economies. The
principle behind mixed economies is that there are some segments of production that
for various reasons should be controlled by the government and some that should
be left to the private sector. Transportation, energy production, telecommunications,
and distribution of food are segments typically controlled by the government. The
reasoning is that these are the lifelines to the existence of a society, and leaving their
control to the private sector may threaten the supply of these essential goods and
services, especially during a national crisis. Mixed economies range widely regarding
how much of the private sector controls the resources versus how much the public
sector controls the resources. France, India, and the Scandinavian countries are good
examples of mixed economies.
In mixed economies, the opportunities in some sectors of the economy are very
attractive for international companies, as they may not have to compete with public-
sector companies. The market environment for nonpublic-sector undertakings in
many of these mixed economies is similar to that of market-based economies. They
are driven by market forces, although at times the government may decide to take
over a particular sector if it determines that this action will serve the public’s best
interest. For example, the French government has slowly reestablished its presence
in the energy industry, especially in the production of electric power, to safeguard
against foreign control of this sector.

ECONOMiC FACTORS AND INTERNATiONAL BUSiNESS STRATEGY

Analysis of the economic and other environmental factors that affect foreign countries
and their markets can help international managers understand the behavior of these
markets and assist them in developing effective strategies. By predicting market
trends and analyzing the size, potential, and characteristics of countries’ markets,
international managers can develop unique strategies to tap into the potential of these
countries. However, the many differences among countries make this process diffi-
cult. Countries vary in size, economic development, economic policies, and view of
investments from abroad. Countries from the former Soviet Union bloc, for example,
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 79

do not necessarily look favorably on foreign companies. The governments of these

countries make it difficult for foreign companies to invest in them, even if it would
mean improvements in their economic conditions. Sometimes these countries fear a
change in their political systems due to the influence of international companies. It
is difficult for governments that have been immersed in socialistic ideals to suddenly
forgo these ideals and embrace democratic rules and privatization.
Frequently, international companies find foreign countries’ economic systems
totally alien in comparison to their own domestic economic environment. The learn-
ing process for these companies can be time-consuming and difficult. For example,
the Japanese economy was a puzzle to many American and European companies:
the close relationship between Japanese companies and the various Japanese govern-
ment agencies, whose role was to help private companies and act on their behalf in
negotiations, was new to the American and European managers. Since many inter-
national companies operate in multiple countries, they are required to learn different
economic systems. For example, Siemens of Germany operates in 137 countries, and
the economic patterns that they encounter in Europe are vastly different from those
they find in the Latin American region. The economic compositions of countries vary
widely; no two systems are exactly alike. What is learned in one system may not be
transferable to another. A company that operates in Brazil may find the economic
system in Argentina quite different, even though both countries are situated in the
same region. Therefore, international managers have to learn a new system every
time they enter a new country.
Economic systems in some countries are very volatile. Without warning, the local
economy may enter into a downward spiral; overnight the rate of inflation may hit
double digits; and the local currency may be devalued by 20 to 40 percent in no time,
as happened in Argentina in the fall of 2004. Each of these events places great stress
on the operations of international companies. International managers must always be
prepared to deal with such sudden changes.
As economic conditions shift, international companies have to adjust their cor-
porate strategies. Compared to domestic economic forces, international economic
factors are quite dynamic and difficult to predict. Unfamiliarity with local economic
conditions also makes it difficult for international managers to plan for sudden swings
in a country’s economy. For example, a rise in inflation might affect the costs of
inputs such as labor and material. A sudden appreciation in the local currency might
make exports of goods and services more expensive and cause a country to lose its
competitive advantage. An increase in the local country’s external debt may affect
government expenditures and soften consumption expenditures. In fact, changes in
economic variables affect the overall business environment. These changes mean
that international companies that operate in many countries must react to shifts in
economic conditions in a timely, effective, and well-programmed manner.
To address the difficulties of planning in an uncertain world economy, international
managers follow a systematic strategy-formulation process. The individual steps in the
process are: scenario analysis, business analysis, strategic action plans, execution, and
monitoring/control. Most of these steps are standard management prescriptions used in
developing strategies. Due to uncertainties in the international context, however, these
80 CHApTER 3

tasks become increasingly important. (Some steps are presented in later chapters in the
discussion of functional strategies.) Because of its impact on the overall business envi-
ronment, scenario analysis is the first step undertaken by most international companies.
It helps international managers to develop alternative business strategies.
Scenario analysis is built on the assumption that the future of an economy or event
can be realistically and systematically predicted and that it is possible to identify
the chain of events that might take place in certain situations. Scenario analysis is
defined as quantitative and qualitative descriptions of the possible future state of
an organization developed within the framework of relevant interdependent factors
or events in the external environment. That is, scenario analysis (1) focuses on the
external environment, (2) considers the future of this environment, (3) identifies
the interdependence of the various factors that affect this environment, and (4) uses
research to predict future events.
Scenario analysis is an exercise in identifying the events in the environment that
are most likely to affect a company’s performance. These future events are developed
under logical assumptions about what might impact the market and include existing
uncertainties. International managers developing scenario analyses may use them to
forecast possible actions that would minimize or overcome existing uncertainties,
asking themselves what the best possible course of action would be in a given sce-
nario. To be useful, the scenario analysis should focus on the one or two most likely
possibilities and use indicators that confirm or refute the laid-out scenario.6 A good
example of the application of scenario analysis comes from Southwest Airlines. It was
one of the few American companies that entered into a futures contract to buy oil at
$34 per barrel during the gradual price increases of crude oil in the summer of 2005.
When the price reached $77 in the summer of 2006, Southwest was competitively
well placed in controlling its costs, as it was paying only half the amount for oil that
other U.S. domestic airlines were paying. Similarly, Deutsch Bahn (DB), the Ger-
man railway system, wanted to predict the ridership under different scenarios for its
express trains, which take people to different parts of the country and connect them
to the other rail systems in Europe. DB considered the effects of gasoline prices on
automobile and air travel, and it also considered weather patterns that may influence
people’s travel plans when calculating the number of trains that it should put into
service each year. This action resulted in substantial cost savings for the railways.
As we have said, the economic scenario is made difficult due to its unpredictabil-
ity. Despite their sophistication, the existing econometric models that use complex
simultaneous regression equations are unreliable. Two years ago, no one could have
predicted that a barrel of crude oil would hit $135; nor could anyone have predicted
that the downturn in the Japanese economy would last for more than 10 years. Reces-
sion, the spiraling cost of energy, interest rate hikes, and trade deficits are all variables
that do not behave logically.
In developing a scenario analysis, the following steps may be helpful.7

• Enumerate the strategic intent of the analysis—the analysis may help international
companies to forecast the environment in preparation for subsequent decisions
or for evaluating strategies against chosen scenarios.
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 81

• Conduct a trend-impact analysis—using information, media scanning, forecasts,

judgments, and past experiences to identify possible trends.
• Create scenarios—predict which events will occur, at what time, and in what
order.
• Outline actions—for each possible scenario, develop an action plan to take (what
should be done).

ECONOMiC FACTORS AND COUNTRY RiSK ANALYSiS

In selecting a country for entry, international companies conduct a risk analysis to
consider those factors that expose them to various types of risks. Aside from finan-
cial losses, international companies face (1) loss of intellectual property rights (for
example, many pharmaceutical companies have lost their patent rights in India; local
Indian companies have produced generic drugs that are sold at reduced prices, out-
selling international companies); (2) loss of brand image; (3) liability lawsuits (for
example, in 1999 Coca-Cola products were banned in six European countries after
children in school cafeterias became ill after drinking Coke; this was a public rela-
tions nightmare for Coca-Cola, and the company lost close to $300 million in sales
after the recall of its products); and (4) human loss (in some Latin American countries
expatriate executives have been kidnapped, and a few have lost their lives). Factors
used in country risk analyses include political stability, economic conditions, banking
and finance risk systems, laws and regulations, and cultural dynamics. In addition to
these factors, international companies may analyze the quality of infrastructure, level
of technology, quality of life, and a country’s external debt.
Depending on the industry, some factors may be more important than others. For
example, for a fast food company, the cultural and infrastructure variables might be
more critical than the technology factor. For a telecommunications company, however,
the technology factor will most likely be more critical than many others. In most in-
stances, however, researchers believe that the economic and political factors are most
important in an assessment of a country’s risk. In analyzing countries, researchers
assign weights to each factor and then rank the risk element for each country. For
example, in its semiannual country risk rankings, Euromoney, a U.K. publication,
assigns a weight of 25 percent each to the economic and political factors.
Euromoney uses a multiple approach in arriving at its rankings, taking into account
both qualitative information and quantitative data in assessing a country’s risks. To
obtain some of the qualitative data, Euromoney polls economists, political analysts,
and insurance brokers. The quantitative data is collected from the World Bank, the
International Monetary Fund, and credit agencies such as Moody’s and Standard &
Poor’s to arrive at a score for each country. Table 3.6 lists the nine variables consid-
ered by Euromoney in its ranking of countries and the respective weights assigned
to each variable.
Using these variables, Euromoney ranks 185 countries of the world every six
months. Table 3.7 lists the 10 least risky countries to invest in based on Euromoney’s
March 2008 rankings. Table 3.8 lists the 10 most risky countries to invest in based
on Euromoney’s March 2008 rankings.
82 CHApTER 3

Table 3.6

Variables Used in Euromoney’s Country Rankings

Variable Weight %
1 Political risk 25
2 Economic performance 25
3 Debt indicators 10
4 Debt in default 10
5 Credit ratings 10
6 Access to bank financing  5
7 Access to short-term finance  5
8 Access to capital markets  5
9 Forfaiting (discount rate on letter of credit)  5

Table 3.7

The Ten Least Risky Countries of the World, March 2008 Euromoney Rankings

Variables
Country V1 V2 V3 V4 V5 V6 V7 V8 V9 Totals
 1 Luxembourg 25.00 25.00 10.00 10.00 10.00 5.00 5.00 5.00 4.88 99.88
 2 Norway 24.67 22.93 10.00 10.00 10.00 5.00 5.00 5.00 4.65 97.47
 3 Switzerland 24.71 21.63 10.00 10.00 10.00 5.00 5.00 5.00 4.88 96.21
 4 Denmark 24.54 19.58 10.00 10.00 10.00 5.00 5.00 5.00 4.27 93.39
 5 Sweden 24.68 18.40 10.00 10.00 10.00 5.00 5.00 5.00 4.88 92.96
 6 Ireland 24.39 18.09 10.00 10.00 10.00 5.00 5.00 5.00 4.88 92.36
 7 Austria 24.36 18.01 10.00 10.00 10.00 5.00 5.00 5.00 4.88 92.25
 8 Finland 24.76 17.32 10.00 10.00 10.00 5.00 5.00 5.00 4.88 91.95
 9 Netherlands 24.50 17.58 10.00 10.00 10.00 5.00 5.00 5.00 4.88 91.95
10 Austria 23.74 17.53 10.00 10.00 10.00 5.00 5.00 5.00 5.00 91.27
Source: Euromoney magazine, “Country Risk Analysis,” March 2008. Available at http://www.euromoney.com/
Article/1886310/country-risk-March-2008-overall-results.html.

Some large international companies do not rely on rankings published by the busi-
ness press, but conduct their own country risk analyses. Most of the factors considered
by these companies are similar to the ones published by the business journals. For
example, the U.S.-based American Can Company assigns the most weight to economic
and political risk factors in developing its own country risk ranking lists. Table 3.9
lists a few of the key factors used by American Can in its country risk analysis and
the respective weights assigned to each factor.
The World Economic Forum (WEF) conducts a global competitiveness ranking
of countries using both publicly available data and an executive opinion survey.
For the 2007–2008 report, WEF polled more than 11,000 business leaders. Table
3.10 lists the top 10 competitive countries among the 131 WEF polled. United
States was ranked as the top country by WEF, followed by Switzerland and three
other Nordic countries—Denmark, Sweden, and Norway—ranking third, fourth,
and sixth. Similarly, in the “Doing Business” report released by the World Bank,
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 83

Table 3.8

The Ten Most Risky Countries of the World, March 2008 Euromoney Rankings

Variables
Country V1 V2 V3 V4 V5 V6 V7 V8 V9 Total
176 Micronesia 13.84 3.98 0.00 0.00 0.00 0.00 0.77 0.44 0.00 19.03
177 Zimbabwe 0.56 0.07 6.97 10.00 0.00 0.00 0.19 1.13 0.00 18.92
178 Zaire 4.48 2.98 0.00 10.00 0.00 0.00 0.58 0.86 0.00 18.89
179 Liberia 4.58 1.78 0.00 10.00 0.00 0.00 0.19 0.38 0.00 16.93
180 Cuba 3.85 5.75 0.00 0.00 3.44 0.00 0.58 0.60 0.61 14.82
181 Marshall Islands 9.83 3.41 0.00 0.00 0.00 0.00 0.00 0.38 0.00 13.61
182 Somalia 0.00 2.37 0.00 10.00 0.00 0.00 0.58 0.38 0.00 13.32
183 Iraq 1.74 3.22 0.00 0.00 0.00 0.00 0.19 0.95 0.00 6.11
184 North Korea 0.29 4.50 0.00 0.00 0.00 0.00 0.58 0.64 0.00 6.01
185 Afghanistan 1.71 3.46 0.00 0.00 0.00 0.00 0.19 0.08 0.00 5.45
Source: Euromoney magazine, “Country Risk Analysis,” March 2008. Available at http://www.euromoney.com/
Article/1886310/country-risk-March-2008-overall-results.html.

Table 3.9

Relative Factor Weights Used by American Can for Analyzing Country Risk

Factor Weight (%)

Political stability 26.0
Political freedom 7.0
Quality of infrastructure 6.7
Inflation 3.6
Currency stability 3.3
Balance of payments 3.3

Table 3.10

The Global Competitiveness Rankings, 2007–2008

Rank Country Score (out of 7)

 1 United States 5.67
 2 Switzerland 5.65
 3 Denmark 5.55
 4 Sweden 5.54
 5 Germany 5.51
 6 Finland 5.49
 7 Singapore 5.45
 8 Japan 5.43
 9 United Kingdom 5.41
10 Netherlands 5.40
Source: The World Economic Forum, “World Competitive Ranking.” Available at http://www.weforum.
org/en/initative/gcp/Global%/20competitivness/20report/index.htm.
84 CHApTER 3

Denmark, Finland, Norway, and Sweden were ranked near the top as well. The
United States was ranked second.
These rankings by the various agencies show that there is some uniformity in all
rankings, and their lists are quite reliable.8
UNDERGROUND EcONOMY
Most of the economic data compiled by individual national governments and various
international organizations is the result of reported economic activity by corporations,
small businesses, and individuals. The official economic statistics, called the “ob-
served economy,” are measured by totaling all expenditures for newly produced goods
and services that are not resold in any form. These expenditures include consumer
spending, investment by businesses, government expenditures, and net exports. It is
believed that in many countries reported economic activity is understated, as some
corporations, small businesses, and private citizens do not fully disclose their financial
records. There may be many reasons for underreporting income and related financials,
including internal tax codes and other government regulations. It is generally alleged
that the higher the income tax rate and the more bureaucratic the process of reporting
financial statements and filing taxes, the greater the nondisclosure of incomes.9
The economic activities that go unreported are commonly referred to as “underground
economic activities.” The underground economies are sometimes called “parallel
economies,” “shadow economies,” or “submerged economies.” Underground economies
were originally thought to be a problem of developing economies or centrally planned
economies (economic systems found in predominantly socialist countries including
China and the bloc of countries that made up the former Soviet Union). Recent statis-
tics compiled by business journals such as the Economist paint a different picture. In
fact, many of the culprit nations of huge underground economies are some of the most
developed countries of Western Europe, particularly Italy and Spain. In addition, three
Scandinavian countries with some of the highest tax rates due to their social welfare
systems are among the top six countries in terms of highest underground economies.
The size of the underground economies among developing countries remains high due
to structural deficiencies and corruption. Some estimates place the figure between 35
and 44 percent. Table 3.11 presents countries with the highest percentage of underground
economies among the industrialized countries in relation to their total GDP.10
For international companies, operating in an economy that is to a large extent based
on the parallel economy poses problems. As foreign companies, they need to adhere
to the country’s laws, and their actions are scrutinized much more carefully than are
those of domestic companies. At the same time, local competitors have an advantage,
as they are used to these conditions and can operate under the radar.
In addition to economic factors, the other four environmental factors that need to be
discussed are competitive environment, infrastructure, technology, and quality of life.
COMpETITIVE ENVIRONMENT
Competitive environment can be divided into two parts: macro and micro. In the
macro competitive environment, the country’s competitive advantage or disadvan-
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 85

Table 3.11

Estimate of Underground Economy as Percentage of Total GDP, 2006

Total GDPa Current % of Underground

Country ($ hundred million) Economy of GDPb Corporate tax (%)c
 1 Australia 768.20 13.00 30.00
 2 Belgium 392.00 21.00 33.99
 3 Canada 1,251.50 16.00 36.60
 4 Denmark 275.20 19.00 24.00
 5 France 2,230.70 16.00 34.33
 6 Germany 2,906.70 16.00 25.00
 7 Ireland 222.60 10.00 20.00–42.00
 8 Italy 1,844.70 26.00 33.00
 9 Japan 4,340.10   9.00 30.00
10 Netherlands 657.60 14.00 29.00–34.50
12 Norway 311.00 20.00 28–51.3
13 Spain 1,224.00 24.00 15.00–45.00
14 United Kingdom 2,345.00 12.00 30.00
15 United States 13,201.80   9.00 35.00
Sources:
a The World Bank, http://www.worldbank.org/data/countryclass/countryclass.html (accessed October

15, 2007).
b “Black Hole,” The Economist, August 28, 1999, p. 59.
c Worldwide-Tax.com, available at http://www.worldwide-tax.com (accessed January 2007).

tage as a whole is considered. In the microenvironment, the competitive advantage

or disadvantage at the firm level is evaluated. The macro competitive environment
deals with attractiveness of countries to investors. As Michael Porter put it, “Why
do some nations become the home base for successful international competitors in
an industry?”11 A few countries are more attractive than others for some specific
industries. For example, Switzerland is home to many of the leading pharmaceuti-
cal companies; similarly, China is home to many of the garment manufacturers of
the world, and India has many of the leading software development companies of
the world. Countries attain competitive advantage through various means, including
factor-input costs (India and China), economic stability and regulatory environment
(Switzerland), size of domestic market (Europe and the United States), and techno-
logical developments (Germany and Japan). None of these reasons by themselves
may provide the competitive advantage a country seeks, but a combination of these
factors may explain some of it.
At the micro level, international companies face an array of competitors with var-
ied and unique advantages. Some of the competition comes from local companies,
which are already entrenched in the host country—local competitors. Others are
international firms operating in the global marketplace—global competitors. A third
category of competitors are companies from the same country as the international
firm—home competitors. For example, for General Motors operating in Germany,
BMW, Mercedes-Benz, and Volkswagen are local competitors; Fiat, Renault, Saab,
and Toyota are global competitors; and Ford Motors is the home competitor. By
86 CHApTER 3

understanding the competitive and strategic advantages of each of these groups, an

international company might be able develop its own unique strategies.
International companies conduct competitive analyses to identify current and poten-
tial competitors, to predict the possible strategic actions of these competitors, and to
account for unforeseen events that may give competitors an advantage. In identifying
current competitors, companies consider the following key variables:

• How similar are the company’s product or service offerings to those of other
firms in the same country? For example, Coca-Cola and Pepsi-Cola both offer
cola products that could easily be substituted for each other. Therefore, these
two companies are competing directly with each other for the same target
customers. In contrast, Coca-Cola and Cadbury Schweppes offer carbonated
beverages, but their products are not similar; Cadbury Schweppes offers more
noncola products.
• How similar are the benefits that customers derive from the company’s products
to those they derive from the products or services that the other firms offer?
Once again, the more similar the benefits derived from the products or services,
the higher the substitutability. Weight Watchers and Jenny Craig, two American
companies, offer diet programs, but their methods of losing weight are different,
even though customers signing up for the two programs seek the same benefit.
• Lastly, a company should consider how other firms define the scope of their mar-
ket. Again, the more similar the companies’ definitions of the target customers
or markets, the more likely the companies will view each other as competitors.
For example, BMW, Lexus, and Mercedes-Benz focus on the high end of the
automobile market, where as Hyundai focuses on the low end of the market.
Therefore, BMW, Lexus, and Mercedes-Benz compete with one another, but
they are not in direct competition with Hyundai.

International companies have learned to deal with many of the competitive chal-
lenges that they face on a daily basis. Some successful companies use systematic
approaches to survive the intense competitive pressure they face. One such approach
is to compare competing firms on key variables that may provide a competitive edge.
For example, in the automobile industry critical competitive factors may include fuel
efficiency, level of safety, engine performance, roominess, and acceleration. Some of
these factors are easily measurable: fuel efficiency (EPA ratings), safety (crash tests),
acceleration (industry standards), and roominess (cubic feet of space or distance
between the front seats and the backseats). Using these factors, a company could do
a brand-by-brand comparison across competitors. Table 3.12 presents competitive
analysis for competing brands of cars.
By reviewing the matrix shown in Table 3.12, Ford, for example, could evaluate
its competitive position vis-à-vis of other brands. It is clear that if these factor rank-
ings hold true, in order to be competitive and attract more buyers, Ford will have to
improve its offerings in many areas. The systematic approach to competitive analysis
helps international companies weigh their positions in each country and develop
strategic steps to be successful.
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 87

Table 3.12

Systematic Competitive Analysis—Automobiles (Sedans)

Safety (good, Engine Perfor-

MPG acceptable, mance (high, Acceleration (0 to
Brand (city/highway) marginal, poor) medium, low) Roominess 60 in seconds)
Accord 24/33    Good    High Moderate 8.6
Century 19/30    Good    Medium Moderate 8.5
Camry 23/32    Acceptable    High Moderate 8.6
Maxima 20/28    Good    Medium Moderate 8.2
Taurus 19/28    Good    Medium Moderate 9.0
Source: National Automobile Dealers Association, McLean, Virginia, and Insurance Institute for Highway
Safety, http://www.iihs.org/vehicle_ratings/ratings.html (accessed January 2008).

INFRASTRUcTURE
Infrastructure is the collection of systems, activities, and structures that facilitate lo-
gistics and communications. The efficiency of an infrastructure affects production and
business operations. These systems and structures are able to move the raw materials
and finished goods of a country from suppliers to the marketplace, that is, facilitate both
upstream and downstream distribution. For international companies, the networks of
roads, railroads, communication systems, and warehouse facilities are critical variables
in their choice of target countries. Infrastructure undertakings require substantial gov-
ernment investment, and countries that are in the developmental stages find it harder to
allocate funds for this area than established economies do. At the same time, to attract
foreign investors, developing countries need to provide the basic means of transporting
supplies to manufacturing plants and finished goods to markets.
Industrialized countries continuously improve their infrastructure facilities to lower
costs and improve delivery time. New airports are built to accommodate travel and
shipment of goods. Take, for example, Hong Kong International Airport (HKIA), built
at a cost of $300 billion, which can be used for passenger travel, cargo, shipping, and
air delivery. As a gateway to China and other Asian countries, HKIA has become one
of the most important hubs for international passenger and cargo flow. This facility
has attracted many foreign businesses, which find it cheaper and faster to redistribute
goods through Hong Kong. Similarly, Japan has built the longest combined rail and
road bridge in the world, at a cost of $7.6 billion; it connects the island of Shikoku
with Honshu, the main industrial and commercial center of Japan. The route hops from
island to island and is made up of six separate bridges. Seto Ohashi bridge reduces
travel time between these two islands from two hours to ten minutes, facilitating the
transportation of goods and improving the economy of Shikoku.12

TEcHNOLOGY
Technology has become a key driving force in the development of industrialized coun-
tries. It enables these countries to increase productivity, lower costs, and improve the
88 CHApTER 3

general welfare of their citizens. Use of technology in the agricultural sector has helped
the United States to attain a level output with only 3 percent of its labor force devoted
to farming. Use of computers and software such as CAD (computer-aided design) has
helped automobile manufacturers to design and introduce new models of automobiles
in less than three years (compared to the seven or eight years that it took previously).
Use of broadband communication technology helps companies to transmit data and
information in an instant to any part of the world. Technology allows international
companies to gain competitive advantages through the introduction of innovative and
better-quality products, to lower costs, and to achieve internal efficiencies.
Technology is broadly defined as the science of systematic knowledge used by
industries to help in the production and marketing of goods and services. Technol-
ogy in business has three components—technology of production, technology of
processes, and technology of management.13 Technology used in the development
and manufacturing of goods is called “product technology.” This type of technology
is responsible for the invention of new ideas and the innovation of products. Toyota
is known for its production and product technology. Technology used to organize and
coordinate activities of operations is called “process technology.” Procter & Gamble
has been very successful through its emphasis on process technology. This technology
helps companies to take the innovations to the marketplace more efficiently. Technol-
ogy that enables management to improve efficiencies, manage its people better, and
improve communication and decision making is called “management technology.”
This technology helps companies apply their new knowledge across all parts of their
organizations. GE is a good example of a company that has attained significant com-
petitive advantage through its management technology.
For companies in high-technology industries such as aircraft manufacturing, chemicals,
computers, pharmaceuticals, and telecommunications, the level of technology available
in a country quite often dictates whether the firm will invest in that country. Therefore,
in assessing countries for entry, technology—along with the economy, political stability,
and business regulations—becomes a critical environmental factor that these companies
consider. In some instances, international companies may consider transfer of technology
into some of the less sophisticated countries if the long-term market potential is attrac-
tive. Transfer of technology implies that international firms are willing to disseminate
their scientific knowledge where it is not currently available. By doing so, they are able
to achieve a competitive advantage in these countries, at the same time helping the local
country attain a level of technological advancement that it had not yet achieved on its own.
In fact, many governments of developing countries may insist on transfer of technology
as a requirement before permitting foreign firms to enter their countries. A major concern
for international companies in transferring technology into other countries is the protection
of their technology against pirating and misuse. Consequently, international companies
seek intellectual property rights protection when transferring technology.

QUALITY OF LIFE
Quality of life issues deal with people’s comfort and fulfillment in all aspects of life
in a particular town, city, or locality. Factors that contribute to quality of life include
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 89

Table 3.13

World’s Top Ten Cities in Terms of Quality of Life, 2006

Rank City Country Index

1 Zurich Switzerland 108.1
2 Geneva Switzerland 108.0
3 Vancouver Canada 107.7
4 Vienna Austria 107.7
5 Auckland New Zealand 107.3
6 Dusseldorf Germany 107.3
7 Frankfurt Germany 107.1
8 Munich Germany 106.9
9 Bern Switzerland 106.5
9 Sydney Australia 106.5
Source: City Mayors, “Quality of Life Rankings.” Available at http://www.citymayors.com/features/
quality_survey.html (accessed March 7, 2009).

standard of living; quality of education; availability of public transportation; health

services, including life expectancy and availability and quality of hospitals and medical
facilities; crime rate; availability of cultural attractions; freedoms of speech, religion,
and politics; job opportunities; and weather conditions.
Various research groups rank cities by their quality of life. Two such groups are
Mercer Consulting and the Economist Intelligence Unit. The Mercer Consulting annual
Worldwide Quality of Living Survey covers 350 cities and is based on 39 different
criteria, including political, social, economic, environmental, personal safety, health,
education, and transport factors, as well as the availability of other public services.
Cities are ranked against New York as the base city, which has an index score of 100.
The Economist Intelligence Unit, a global business intelligence research firm, uses
nine factors in its quality of life index, including such items as material well-being,
health, and family life. Table 3.13 presents the world’s top 10 cities in quality of life
based on the Mercer Consulting survey.
Based on the survey, Zurich and Geneva, Switzerland, are the top two cities in
terms of quality of life. Both Switzerland and Germany have three cities each among
the top 10 in the Mercer Consulting survey, as reported by city mayors. Honolulu
(ranked twenty-seventh) and San Francisco (ranked twenty-eighth) are the only two
U.S. cities that are ranked among the top thirty.
Besides quality of life, an equally useful ranking for international companies in
selecting locations for setting up operations is a list of the most expensive cities of
the world. A survey for the City Mayors group conducted by UBS, the Swiss financial
company, ranks the most expensive cities based on living costs in 71 metropolises. The
City Mayors is an international network of professionals working to promote strong
cities. The cost of living is based on a shopping basket containing 122 goods and
services geared toward Western European consumers. Cities are ranked against New
York as the base city, which has an index score of 100. Moscow is the most expensive
city in the world. Three of the other 10 most expensive cities are in Asia: Tokyo, Seoul,
and Hong Kong. Table 3.14 lists the 10 most expensive cities to live in.
90 CHApTER 3

Table 3.14

The Ten Most Expensive Cities in the World, 2008

Rank City Country Index

 1 Moscow Russia 105.5
 2 Tokyo Japan 100.0
 3 London UK 94.6
 4 Oslo Norway 93.4
 5 Seoul South Korea 87.3
 6 Hong Kong China 86.3
 7 Copenhagen Denmark 85.8
 8 Geneva Switzerland 84.3
 9 Zurich Switzerland 82.2
10 Milan Italy 80.6
Source: City Mayors, “Most Expensive Cities.” Available at http://www.citymayors.com/economics/
expensive_cities2.html (accessed January 14, 2007).

International executives use the quality of life and cost of living index in assessing
countries for entry. Both indexes are critical in attracting qualified employees from
within the country and from overseas. In addition, since international companies pay
for the cost of living of its overseas staff, a more expensive city may drive up the
cost of operations.

CHApTER SUMMARY
The economy of a country is an important variable that international companies con-
sider in selecting countries for entry as well as for developing strategies. A country’s
economic strength is measured through its gross domestic product, rate of inflation,
balance of payments, and external debt.
A country’s economic development is classified by a variety of factors, including
GDP per capita and income levels. Different international organizations, such as
the International Monetary Fund, the United Nations, and the World Bank, classify
countries using different variables. The World Bank classifies countries using the
gross national income (GNI) factor, with the categories high income, upper-middle
income, lower-middle income, and lower income. High income countries have a GNI
per capita of more than $10,726; upper-middle income countries have a GNI per capita
between $3,466 and $10,725; lower-middle income countries have a GNI per capita
between $876 and $3,465; and lower income countries have a GNI of $875 or less.
When countries are compared across economic data, due to variations in purchasing
power, income levels across countries may not be comparable. To rectify this problem,
most international organizations use a factoring approach called “purchasing power
parity” (PPP). Purchasing power parity is defined as the number of units of a currency
required to buy the same amount of goods and services in the domestic market that
the American dollar would buy in the U.S. market.
Countries are also classified by the economic systems that they follow or use to
allocate their resources. The three basic economic systems are market based, cen-
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 91

trally planned, and mixed. In a market-based economy, the allocation of resources

is driven by demand and supply; in a centrally planned economy, the government
decides on the allocation of resources based on its developmental plans; and in a
mixed economy, some resources are allocated by the government and some are al-
located by the private sector.
Many international companies use scenario analyses to plan their activities in
foreign countries. A scenario analysis helps international managers to operate under
uncertainties and in volatile conditions by asking “what if” questions. Knowing the
answers to these questions, companies can develop alternate strategies.
Strategically, international companies analyze economic factors to decide on a
country for entry and also to develop strategies. In choosing a country for entry,
international companies conduct a country risk analysis, which evaluates the
critical economic variables that may impact the companies’ entry. Factors such
as GDP per capita, prevailing inflation rate, interest rate, and balance of pay-
ments are some of the economic factors that international companies consider.
Larger global companies conduct their own country risk analyses, but smaller
companies rely on freely available analyses that are conducted by governments
or a business press. One such country risk analysis is published every six months
by Euromoney.
A major concern for international companies in entering a country is the level
of economic activity that goes unreported. Called the “underground,” or “parallel”
economy, these individual and corporate activities are not part of the country’s eco-
nomic data. International companies have to be careful in their activities in a foreign
country; the underground economy may sometimes pose problems, especially if an
international company directly competes with smaller companies that are part of the
underground economic system. These local companies may have cost advantages that
are not feasible for international companies.
Competitive environment is also a critical factor in the operations of international
companies. Local competitors have unique advantages because of their knowledge of
the local conditions, relationships with local distributors, and influence with the local
government. In conducting a competitive analysis, companies should consider how
similar their products are to the products and services offered by their competitors,
how similar the target customers are, and how similar the benefits derived from the
products or services are.
Infrastructure is another external variable that international companies consider in
their decision-making framework. Infrastructures are systems that facilitate logistics
and distribution. It is essential that countries selected for entry by international com-
panies have some sort of infrastructure in place. These systems facilitate the supply
of goods from the raw-material stage to the production centers, and then on to the
markets where they are sold.
Technology is another environmental variable that has been the driving force behind
the growth of many economies. Use of technology helps international companies
improve productivity, reduce cost, and remain competitive. For those firms that are
in a high-tech industry, the level of a country’s technological capability may be a
critical factor in considering that country for market entry.
92 CHApTER 3

International companies use quality of life and cost of living indexes in selecting
countries for entry. Cities with higher quality of life and lower cost of living are at-
tractive, as they may be used to induce qualified personnel to relocate.

KEY CONCEpTS
Economic Factors
Types of Economies
Economic Stages
Country Risk Analysis
Underground Economy
Competitive Environment

DiSCUSSiON QUESTiONS
1. Why is the economy of a country a critical environmental variable?
2. How is the level of economic activity in a country measured?
3. What is current account balance?
4. How are the countries of the world classified in terms of their economic de-
velopment?
5. What is purchasing power parity?
6. What are the three types of economic systems?
7. Differentiate between market economies and centrally planned economies.
8. What is scenario analysis? How do international companies make use of
scenario analysis?
9. What is country risk analysis and how is it conducted?
10. Identify the critical variables considered by Euromoney in its country rankings.
11. What is an underground economy?
12. How important is the competitive environment?
13. How do international companies conduct competitive analysis?
14. Why is the infrastructure of a country important for international companies?
15. Why is the level of technology in a country important for international
companies?
16. What are some of the factors used in ranking quality of life indexes?

AppLiCATiON CASE: CHiNA’S ECONOMY AND FOREiGN DiRECT

INVESTMENT FLOWS
The People’s Republic of China (China) is one of the fastest-growing economies in
the world. Since the late 1990s it has consistently attained double-digit economic
growth rates. Between 1997 and 2007, China’s average economic growth was more
than 10 percent. For the period 1980 to 2006, China’s GDP per capita rose from $300
to $2,000. This economic growth is fueled by considerable inflows of foreign direct
investments (FDI flows), which have poured millions of dollars into the manufactur-
ing sector, making China the manufacturing center of the world.
 EcONOMIc AND OTHER RELATED ENVIRONMENTAL VARIABLES 93

Over a five-year period, net FDI flows into China doubled from $38.4 billion in
2000 to $79.1 billion in 2005. In just the past 10 years, China has been the benefi-
ciary of FDI flows of more than $200 billion. Inward FDI flows account for nearly
10 percent of the gross fixed capital formation of China compared to 4 percent for
the United States. China receives FDI flows from many countries, including Hong
Kong, Japan, South Korea, and the United States.
In addition to the FDI flows, China has also benefited from an increase in its ex-
ports, which has resulted in a current account balance of nearly $180 billion. These
surpluses have helped China accumulate foreign reserves in excess of $1.2 trillion.
China is the second-largest holder of U.S. long-term debt securities, at $677 billion,
surpassed only by Japan, which holds about $827 billion. China, with a GDP of more
than $10 trillion (PPP), ranks second only to the United States in terms of size of the
economy. The two key economic policies that have stimulated the Chinese economy
are trade liberalization and the opening of the country for foreign trade and invest-
ments. China’s trade policy changed from import-substitution and self-reliance before
economic reforms to export promotion and openness.
China has become an attractive market for international and global companies, first
as a low-cost manufacturing center, and second as a vast consumer market. With a
population of more than 1.3 billion, China alone can be a major market for foreign
companies. Currently there are more than 14 million U.S. businesses operating in
China; among them Boeing, Ford, GE, GM, Motorola, and TRW have large opera-
tions in China.
China is expected to become one of the largest markets for many products, in-
cluding automobiles, commercial aircraft, and computers. By late 2009 the Chinese
automobile market is expected to reach 7 million cars per year, the second-largest
market after the United States. Similarly, China will have the second-largest airline
industry in the world and will need about 1,790 commercial aircraft, worth more than
$83 billion over the next 10 years. Moreover, China will be the second-largest market
for personal computers after the United States, and it already has the largest mobile
network in the world, with over 432 million cellular phone users.

QUESTIONS
1. What has led to China’s phenomenal economic growth?
2. How do you think China’s expected economic dominance will affect the Asian
region?
 4 The Political and Legal
Environment

International business decisions are affected by developments in the political and legal
environment. Political instability that results in sudden changes in the government and its
policies are risks that international businesses face on a regular basis.

LEARNiNG ObJECTiVES
• To identify and understand different political systems
• To understand the working relationships between governments and international
companies
• To understand political risks
• To understand the factors affecting a host government’s political system
• To learn how to analyze political risks
• To understand the world’s major legal systems
• To understand the various aspects of business affected by the legal system

THE POLiTiCAL ENViRONMENT

A country’s political and legal environments are interrelated. The political system
integrates society into a viable, functioning unit, and the legal environment helps the
society maintain its peace and order. Governments that are designed to rule a country
are set up through a political system. Governments create laws and regulations that
affect every aspect of life in a country, including how businesses are operated. Stable
political systems generally have stable governments that enact laws to benefit the
population and at the same time encourage a receptive environment for businesses.
For many years, the political landscape of Africa has been strewn with governments
that have been dictatorial and have ruled with an iron hand. As these rulers sup-
pressed democratic movements, their relationships with the rest of the world seemed
to have been frayed. Recent studies conducted on African nations seem to indicate
that the Northern African groups of countries that have followed more open political
systems have fared better in their relationships with Europe and North America than
the rest of Africa.1 International businesses face increased political risk when there
is uncertainty about the stability of the host country’s political system. For example,

94
 THE POLITIcAL AND LEGAL ENVIRONMENT 95

if President Hugo Chávez of Venezuela goes ahead with his threat to nationalize the
country’s telecommunication and electric utilities, Verizon Communications of the
United States could lose up to several hundred million dollars.2 Political risk is not a
new threat facing international companies; it has existed for centuries—for as long
as there has been business activity across national borders. Due to advanced telecom-
munication technologies, many of the decisions and actions by various governments
in many parts of the world are instantly flashed by the media for everyone to know. In
a knowledge-based environment, information seems to help improve the democratic
control of policy makers.3
Political risk has taken on a new meaning and significance because of the prolifera-
tion of international business activities over past 30 years and also due to the changes
in governments of many countries of the world. Since 1950 many countries in Africa,
Asia, Eastern Europe, and Latin America have gained independence from their former
colonizers and taken steps to rule themselves. In the process many of these countries
have had unsettled governments that were either autocratic or weak, resulting in un-
predictable shifts in laws and business regulations. Many multinational companies
anticipate changes in government and make their decision to invest accordingly. That
is, if an international company expects a left-wing government to take over in a country,
then they will decide against investing in that country, but if they expect a right-wing
government to be elected then they will definitely decide to invest in that country.4 In
the past, political risk analysis was more of an art than a science and was designated to
staff analysts with very little input from upper management. In an environment such as
this, political risk assessment was hit or miss, resulting in some costly investments. For
example, during the Vietnam War, a U.S. oil company that in 1968 was contemplating
an aggressive program of oil exploration in South Vietnamese waters based its rosy
forecasts on the expectations of a win by the South Vietnamese government with the
help of U.S.-led forces. The international managers were expecting to reap great re-
wards from these exploration efforts. But the company’s analysts working in the United
States predicted a downfall of the South Vietnamese government within a few years and
recommended abandoning the project. In spite of these warnings, senior management
went ahead with the project based on the line manager’s recommendations. Needless to
say, the oil company had to abandon the project in the early 1970s, costing the company
millions of dollars.5 Without a focused environmental scanning, many international
companies have been caught off guard by large-scale environmental shifts.6 For the
oil company, not having a systematic political risk analysis with considerable support
from top management was the reason that it failed in recognizing the seriousness of the
political situation in South Vietnam.
Most senior executives of international companies recognize the importance of
conducting political risk analyses. They also understand that it is easy to distinguish
between very stable political countries and very unstable political countries. The
difficulty is in recognizing the gray area between the two extremes. Therefore, con-
ducting an integrated and scientific political risk analysis is critical to the success
of international companies. Effective strategic planning requires that international
companies conduct a thorough environmental assessment, especially a political risk
assessment, or PRA.7,8
96 CHApTER 4

POLITIcAL SYSTEMS
Political systems are institutions that set standards, rules, and policies to govern a
society. These institutions include political parties, political organizations, inter-
est groups, and members of the leading industry groups. There are many types of
political systems, including autocracy, democracy, monarchy, one-party states,
plutocracy, socialism, and theocracy. The three basic and most common political
systems are:

• Democracy
• One-party states
• Theocracy

Democracy

Democracy is a political system in which elections by a country’s citizens form

the basis for the formation of a government. A truly democratic system must
have free and fair elections. Over the years, multiparty democracies have proved
to be the most stable, and the experiences of international companies in such a
system have been risk free. When elections are not controlled or manipulated by
any single party or entity (notably the existing government) and are free of out-
side influences, the result is a free and fair election. In some countries of Africa,
Asia, and Latin America, the ruling party controls the election process, leading
to fraudulent results.
There are two types of democracies—direct and republic. In direct democracy,
the government is formed by elected officials voted on by the citizens, and most
laws are directly enacted by the citizens. The earliest form of direct democracy
was practiced by the Greeks in Athens in the fifth century B.C.E. In modern times,
direct democracy exists to some extent in Switzerland, where citizens vote on
issues that affect their communities and districts. In a republic form of govern-
ment, citizens elect representatives, who, in turn, vote on laws. The leader of the
government most responsible for running the republic is called president (as in
the Philippines and the United States), prime minister (as in India and the United
Kingdom), or chancellor (as in Germany). The Roman Empire was the earliest
known republic.

One-Party States

In the one-party system, only one political party is allowed to form the government.
Countries such as Cuba, China, and North Korea that have communist rules are
prime examples of countries with one-party states. Communism implies a classless
society and a means of equalizing living conditions for all. Therefore, in communist
countries, wealth is distributed equally and no single individual owns any property.
In these societies, collectivism is practiced. There are no elected officials in one-party
systems; rather, a group of party leaders rule the country. Under such a system, the
 THE POLITIcAL AND LEGAL ENVIRONMENT 97

will and preferences of the population are secondary to the overall well being of the
country, as determined by the leaders of the party in power.

Theocracy

Theocracy is a form of government in which a particular religion plays a critical

role in the formation of the government and influences the enactment of laws and
regulations. In some instances, religious leaders may hold key government posts. The
government in Iran is an example of a theocratic system. Once again, in this system,
the will of the people may not be the basis for the laws of the country; instead, laws
are based on religious edicts. For example, in Iran, serving alcohol in restaurants is
not permitted, as it is against the country’s religious codes.
For an international company to succeed in a foreign country, its management must
first determine if its corporate philosophy and practices fit with the host country’s po-
litical and legal environments. The political process faced by international companies,
though not unique compared to that faced by domestic firms, is more complex and
problematic.9 The political process in a domestic market is at least a known entity,
and companies have experience with the political system. Furthermore, they might
even have some influence in the home country’s political process. In addition, they
can anticipate changes and plan accordingly. In the international arena, the political
process is an unknown quantity for international companies, and they have very little
influence in the host country’s political process. Internationally, political problems
range from catastrophic events such as revolution to a broad range of destabilizing
issues, including endemic corruption, labor unrest, crooked elections, religious vio-
lence, and incompetent economic management.10

MODELS TO ANALYZE INTERNATIONAL COMpANIES’ RELATIONSHIpS WITH

HOST GOVERNMENTS
Three models have been suggested to analyze the relationship between international
companies and the host country’s government.11 All three models make the assump-
tion that the relationship and interactions between the international company and
the host government are conflictual-adversarial, especially in the case of developing
countries. This assumption may not always be true. When an adversarial relationship
exists, the models suggest that the relationship could be labeled as:

• Sovereignty at bay. Most countries consider themselves to be sovereign states

that are free from external control. The host country views the international
company as a threat. First proposed by Jack Behrman,12 the sovereignty at bay
model posits that the multinationals enterprise (MNE) is in a more powerful
position than the national government in their relationship to each other. This
leads to conflicts, as the host country views the MNE as a threat. When the host
country is less developed, the MNE, with its financial strength, seems to have
control over most negotiations, especially if the MNE’s operations are in a vital
industry such as mining, transportation, food, or the like.
98 CHApTER 4

• Neomercantilism. The host country sees benefits in its relationship with the
international company. Therefore, the relations between the MNE and the host
government are more cordial. This leads to favorable treatment of the foreign
company and both parties benefit from such a relationship.
• Dependency. In the dependency relationship, there is more cooperation between
the international company and its host government. The extent of the relation-
ship may vary depending on the economic level of development of the host
country. If the host country is a fully industrialized country, the relationship
between the country and the MNE might be that of two equals. However, if
the host country is a developing or less developed country, the government in
this case might be more dependent on the MNE, and the balance of power may
shift in favor of the MNE.

Though all the three models have some merit, international companies must use their
judgment in assessing the kind of relationship they can develop with the host country’s
government and not be constrained by theories or labels.

FAcTORS IN POLITIcAL ENVIRONMENTS

Political risks faced by international companies are due to sudden changes in the
existing political conditions that affect government policies and rules toward for-
eign and domestic companies. International business executives agree that a stable
government that is hospitable to foreign companies attracts foreign direct investment
(FDI) and encourages international businesses to establish operations in that coun-
try. FDI is the acquisition abroad of physical assets, such as plant and equipment,
with operating control residing with the parent company. Research has shown that a
country’s political system influences an international company’s decision to invest
in a foreign country. Studies have identified that a democratic form of government is
important for FDI flows in the service sector.13 While FDI is beneficial to the invest-
ing company, it also provides valuable foreign currency reserves to the host country.
These investments, therefore, help the host country to improve its own economic
conditions. More on FDI and its workings is discussed in the international finance
chapter of this text (Chapter 5).
The purpose of a sound political system is to integrate various parts of a soci-
ety into a single functioning unit.14 A country’s political policies are established
through a continuous interaction of people, philosophies, and institutions. The
aggregated viewpoints of politicians, businesspeople, interest groups, and the gen-
eral masses form the core principles of a country’s political system.15 The needs
and proposals of this wide group of interested parties are then considered by
the government and proposed as policy alternatives. Policy initiatives may be
further influenced by lobbying groups, who have their own vested interests. In
many countries the U.S. Chamber of Commerce acts on the behalf of American
international companies on policy initiatives that may be detrimental to them.
These policy initiatives then become a country’s laws, which are implemented
by the government’s bureaucrats.
 THE POLITIcAL AND LEGAL ENVIRONMENT 99

Many factors influence a country’s political environment, including ideology,

nationalism, unstable governments, traditional hostilities, public-sector enterprises
(the proportion of businesses that are government owned), terrorism, corruption, and
international companies.

Political Ideology

Political ideology is a set of ideas, theories, and goals that constitute a sociopolitical
program. Ideology is the thought process that guides individuals in the formation of
institutions or social movements. Since no single ideology is acceptable to all the people
in a given country, diverse political views coexist side-by-side, forming a pluralistic
society. In India, for example, more than 36 ideological views coexist, forming the great-
est number of political parties in a democratic country. The major ideological systems
that form governments to manage a country’s economic policies include:

• Capitalism
• Socialism
• Conservativism and liberalism
• Communism
• Authoritarianism

Capitalism is an economic system in which the means of production and distribution

of goods and services are for the most part privately owned; the businesses in a capi-
talistic system operate for profit, and market forces determine demand and supply. In
capitalism, or the free-enterprise system, the government’s role is limited. Capitalism
is practiced in most Western European countries, Japan, and the United States.
Capitalism goes hand in hand with democratic forms of government. Democracy
implies rule of the people, by the people, for the people. In a democratic system,
people make the decisions. Democracy affords its people unique rights that are the
envy of people living under other forms of government. Democracy guarantees people
the following basic rights:

• Freedom—freedom of expression, freedom of opinion, freedom of association,

freedom of the press, and freedom to organize. These freedoms allow the citizens to
participate in the government and express their views without the fear of repercus-
sions. Freedom of the press ensures the dissemination of views, opinions, and other
relevant information whether it is favorable to or critical of the ruling party.
• Elections—democratic governments are elected by the people. Elections are
held periodically to ensure representation by the people’s choices and a smooth
transition of the government.
• Limits on terms—a major benefit of democracies, the term limit placed on elected
officials guarantees that they do not become complacent and that they continue to
work for the people. For example, the president of the United States is allowed
to serve only two four-year terms.
• Independent judiciary—The independence of the judicial systems guarantees the
100 CHApTER 4

people a place for bringing up disputes, an assurance of fair trials, and protection
of individual rights.

Socialism is the opposite of capitalism. Under this system, the government owns
or controls the production and distribution of goods and services. The goal of the
state-run enterprises in a socialist system is not profits but rather the availability of
basic commodities for all of its citizens at reasonable prices.
Conservativism and liberalism are not political systems; they represent people’s
views of the role of the government. Conservatives feel that the government’s role
should be minimal and encourage private ownership. Liberals feel that there is a role
for the government in the free-enterprise system that includes social spending by the
government to benefit its people.
Communism proposes a classless society. In communist countries, the government
owns and controls production and distribution of all goods and services. Communism
promotes the seizure of power by suppression of internal opposition. It is a single-
party rule, with communists being in power. Examples of countries with communism
as the core political ideology are China, Cuba, and Russia.
Authoritarianism describes a government in which authority is centered in one
person within a small group, and that person is not accountable to the nation’s people.
In most instances of authoritarianism, a single person rules the country, as in the case
of dictatorships, and tries to control the people through intimidation. Zaire under the
rule of President Mobutu Sese Seko is a good example of an authoritarian regime.
During his rule as president for life, Mobutu controlled all aspects of civilian life
and plundered the nation of all its resources. In some instances, a junta made up of
three or four military leaders may rule the country and try to control the people, as
in the case of Myanmar.

Nationalism

Nationalism is the attachment and dedication of people to their own country. Some
experts suggest that in earlier times, when people of a country shared the same race,
language, and religion, it made sense to be nationalistic. In the twenty-first century,
however, many countries are based on borders that were politically drawn, and the
homogeneity that was there before does not exist anymore; hence, the true spirit of
nationalism no longer exists. For example, immigration has made the United States
into a country of diverse nationalities, languages, and religions.

Unstable Governments

A government is considered stable if it is able to maintain power and sustain uniform

rules and regulations; that is, its political, fiscal, and monetary policies are predictable.
In an unstable government, political, fiscal, and monetary policies change suddenly
and drastically. As mentioned earlier, a stable government encourages foreign direct
investments.
Control of power by the government does not imply that it holds on to the power
 THE POLITIcAL AND LEGAL ENVIRONMENT 101

by force, but by democratic means. In fact, when a group of people maintain power
by force, that government is not very attractive for foreign investors.

Traditional Hostilities

Traditional hostilities are those that constitute a deeply rooted hatred between people
of the warring countries, and the conflict is long-standing. Affinity or animosity
between nations reflects how closely aligned or estranged they are based on histori-
cal, religious, cultural, and political realities.16 These affinities or animosities affect
international companies. Businesses from friendlier countries are welcomed by the
host countries, and those viewed as unfriendly are not so welcome. For example, most
French international firms are welcome in many of the western African countries, as
these countries were former colonies of France, and they therefore have a friendly
relationship with each other. Conflicts in central Europe and the Middle East are
historic in nature—they are deeply rooted and will not end soon—and the resulting
instability has discouraged foreign investments. The lack of FDI flows might have
deprived these countries of potential economic growth.

Public Sector Enterprises

When a government gets involved in the business sector, its objective is to provide
goods and services at a reasonable price to its citizens. In most instances, though,
the entry of governments into the business sector results in poor-quality products,
fewer choices, and inefficient utilization of resources. International companies find
it difficult to operate in countries where the large businesses are in the hands of the
government. Government-owned companies have distinct competitive advantages
over foreign-based companies: they are not driven by profits and consequently can
control prices to the detriment of international companies. Moreover, the governments
that already own businesses may be tempted to expropriate foreign-owned companies
if they view them as threats.

Terrorism

Part of the problem of unstable political environments is terrorism. Terrorism con-

sists of unlawful acts of violence committed by individuals or groups against people
and their institutions. Terrorism violates the basic principles of human rights, and
unfortunately it has become a worldwide phenomenon. To spread their cause, ter-
rorists groups have kidnapped people for ransom, murdered kidnapped individuals,
hijacked planes, and bombed buildings. In the past 30 years, 80 percent of terrorist
attacks against the United States have been aimed at American businesses.17 Therefore,
American international companies are very sensitive to the issue of terrorism and
spend considerable sums of money to protect their operations from terrorist attacks.
Terrorism creates political instability, and international companies are reluctant to
invest in countries and regions that are hotbeds of terrorism, such as Latin America
and the Middle East.
102 CHApTER 4

Corruption

Corruption is defined by the United Nations as the commission or omission of an act

in the performance of or in connection with one’s duties, in response to gifts, promises
or incentives demanded or accepted, or the wrongful receipt of these once the act has
been committed or omitted. In simple terms, corruption implies some form of illicit
and criminal behavior for personal enrichment.
Corruption is part of the political process, as it is tied to the lack of political will
to root it out. Corruption is a means for shady politicians to enrich themselves and
perpetuate their rule. For international companies, corruption increases the cost of
operations and creates an uneven playing field—that is, those companies that bribe
officials are granted favors, while those that follow the rules are at a competitive
disadvantage. Chapter 1 contains a more detailed discussion on corruption.

International Companies

International companies also play a role in influencing political systems with their
financial strength (some companies such as ExxonMobil and Wal-Mart have rev-
enues greater than the GNP of many of the countries in which they operate). Inter-
national companies are sometimes drawn into local politics because of the friendly
or adversarial relationship that may exist between the company’s home country and
the host country in which they operate. For example, the Cold War defined much
of what U.S. international companies could do in some overseas markets. The U.S.
government basically influenced the actions of U.S. corporations, including which
countries they could invest in and which goods and services they could sell abroad.
If the U.S. government’s policy changed toward a traditionally hostile nation, then
that country became an immediate opportunity for American companies, as in the
case of China.18 On the other hand, the United States views Cuba as an unfriendly
country, so American companies are prohibited from operating there. At other times,
international companies may be drawn into host countries’ politics through pres-
sures from the international community at large. For example, some multinational
companies left South Africa and its apartheid policies in the 1970s as a result of the
diplomatic stance taken by European countries. U.S. international companies are
not always passive victims of political forces; at times they are the force.19 Through
their links to the U.S. government and strong financial and economic might, some
U.S. firms become indirect yet active participants in local politics and influence the
actions of the local governments.

COUNTRY RISK ASSESSMENT

One of the critical decisions that an international company has to make is the choice
of which country to enter. As discussed in Chapter 3, in selecting a country for entry,
international companies assess the country’s risk by analyzing various factors, includ-
ing political dynamics. Political risk is one of the major factors that most companies
consider in evaluating country risk.20 Political risk is defined as the fear of losses
 THE POLITIcAL AND LEGAL ENVIRONMENT 103

incurred by international companies through sudden and unexpected changes in the

host country’s political environment. These losses can vary in nature from financial
to human to corporate image to intellectual property rights to expropriation. Because
of the vulnerability to political risks, many international companies have started
conducting nonmarket-related scientific research, including studies that shed light
on political risks and issues.21
In most country risk analyses, the factors that carry the most weight are economic
and political variables. Political risk is one of the key factors that all international
companies consider in assessing countries.22 Political instability is caused by the
sudden changes that occur in a given environment. These changes might be in the
form of revolutions, social unrest, labor strikes, wars, or terrorism. Such conditions
pose problems for international companies. Political unrest often results in economic
upheaval and may pose a risk to humans, especially expatriates. Some international
companies conduct their own political risk analysis by actually visiting the country
they are interested in and exploring its political environment firsthand. A few oth-
ers rely on the opinions of trusted and knowledgeable people, including academic
scholars, consultants, journalists, and diplomats. These approaches generally take
time; consequently, many international companies use their own internally devel-
oped models to assess political risk or employ outside research suppliers to conduct
these assessments. For example, Embraer of Brazil was able to set up a joint venture
partnership with a Chinese aerospace company after conducting a thorough political
and business analysis, even though the Chinese authorities wanted to build their own
aerospace industry.23
Many research studies have reviewed the practices of international companies in
assessing political risk as they conduct country risk analysis. It is generally agreed
that the political environment has become more complex in recent years. The unifica-
tion of Europe, the breakup of the Soviet Union, the emergence of China as a super-
power, the continuing conflicts in the Middle East, and the collapse of governments
in Africa have changed the economic landscape and heightened the political risk for
international companies.24 In a study of American-based international companies,
researchers observed that these companies conduct mostly an organizational-based
analysis of political risk.
Many of the political risk analyses conducted by external agencies use a combina-
tion of factors in assessing a country’s political risk. The PRS Group, an East Syra-
cuse, New York-based research company, ranks countries on political risk using two
methodologies: Political Risk Services and International Country Risk Guide (ICRG).
ICRG uses 12 factors, including government stability, socioeconomic conditions,
internal conflicts, external conflicts, and corruption (see Table 4.1 for all 12 factors
used by ICRG and the corresponding weights for each factor). The scores are based
on a rating scale that uses various internal and external sources to assess the risk for
each factor. The list of factors used by ICRG provides a glimpse into the underlying
causes that may lead to a destabilized political environment. The PRS Group also
publishes the Political Risk Yearbook, which is available online and contains detailed
information on the political, economic, and general business environment in most
countries of the world.
104 CHApTER 4

Table 4.1

ICRG Factors and Corresponding Weights

Factor Explanation of Factors Weight (%)

 1 Government stability Consistency of policy and continuity 12
 2 Socioeconomic conditions Unemployment, consumer confidence, poverty 12
 3 Investment profile Profit repatriation, payment delays, expropriation 12
 4 Internal conflict Civil war, terrorism, coup threats 12
 5 External conflict Cross-border conflicts, wars, foreign pressures 12
 6 Corruption Bribery, fairness in awarding contracts 6
 7 Military politics Military’s influence in politics and the government 6
 8 Religious tensions Single dominant religion that exerts influence in framing 6
government policies
 9 Law and order Crime rate, independence of the judicial system 6
10 Ethnic tensions Periodic ethnic conflicts, acts of genocide 6
11 Government accountability Responsiveness of government to people’s concerns 6
12 Bureaucracy Qualifications and abilities of government officials 4
Total 100
Source: Political Risk Services, International Country Risk Guide. Available at http://www.prsgroup.
com/ (accessed June 2008). International Country Risk Guide, http://www.countryrisk.com/reviews/ar-
chives/000029.html, June 2008.

The scores obtained for each country provide the level of political risk associated
with that country. The higher the score, the less risky that country’s political environ-
ment. The ICRG scores are grouped into five categories, as follows:

Score Risk
00.00–49.90 Very high risk
50.00–59.90 High risk
60.00–69.90 Moderate risk
70.00–79.90 Low risk
80.00–100.0 Very low risk
Using these ratings, ICRG lists the level of political risk faced by international
companies in many parts of the world. Table 4.2 lists the 10 least politically risky
countries of the world.

STRATEGIc AcTIONS
International companies must develop specific strategic action plans to overcome
political instability before they enter a foreign country. These plans can help the
companies to be better prepared for anticipated or unanticipated political shifts. To
protect themselves from adverse political events by reducing some of the risk factors,
international companies rely on forecasting models to predict the risk-reward matri-
ces. In addition, many companies operating in overseas markets might also insure
themselves as a protection against political upheavals in the country in which they are
Table 4.2

Ten Least Politically Risky Countries

Factor Factor Factor Factor Factor Factor Factor Factor Factor Factor Factor Factor
Country 1 2 3 4 5 6 7 8 9 10 11 12 Total
Luxembourg 11.0 11.0 12.0 12.0 11.5 5.0 6.0 6.0 6.0 5.0 5.0 4.0 94.5
Finland 9.5 9.5 12.0 11.0 11.5 6.0 6.0 6.0 6.0 6.0 6.0 4.0 93.5
Ireland 10.5 11.0 12.0 11.5 11.0 3.5 6.0 5.0 6.0 5.5 6.0 4.0 92.0
Sweden 8.5 10.0 12.0 11.0 11.5 5.5 5.5 6.0 6.0 5.0 6.0 4.0 91.0
Netherlands 8.5 10.5 12.0 11.0 12.0 5.0 6.0 5.0 6.0 4.5 6.0 4.0 90.5
New Zealand 9.0 10.0 11.5 11.5 <11.0 5.5 6.0 6.0 6.0 4.0 6.0 4.0 90.5
Austria 9.0 10.0 12.0 11.5 11.5 5.0 6.0 6.0 6.0 4.0 5.0 4.0 90.0
Canada 9.5 8.5 12.0 12.0 11.0 5.0 6.0 6.0 6.0 3.5 6.0 4.0 89.5
Norway 7.5 10.0 11.5 11.5 11.5 5.0 6.0 5.0 6.0 4.5 6.0 4.0 88.5
Switzerland <8.5 10.5 11.5 12.0 11.5 4.5 6.0 5.0 <5.0 4.0 6.0 4.0 88.5
Source: Political Risk Services, International Country Risk Guide. Available at http://www.prsgroup.com/ (accessed June 2008). International Country
Risk Guide, http://www.countryrisk.com/reviews/archives/000029.html, June 2008.
105
106 CHApTER 4

operating. For example, global financial companies that face political risks such as
nationalization of the banking industry have developed sophisticated computer models
that test insurance policies against worst-case political scenarios.25 Similarly, a few
international companies have developed models that assesses the effects of political
risk on direct investment projects by considering all the elements that generate losses
and relating them to the risk’s evolution process.26 As more and more international
companies enter the transitional economies of Central and Eastern Europe—economies
that can experience significant political turbulence—they have adopted some unique
strategies to overcome the uncertainties. A few of these international companies have
developed a diverse network that includes the host government, local businesses, and
public partners to help them navigate through the political minefield.27 Of course, this
opportunity for networking might not always be available, which means international
companies must devise other approaches to combat political uncertainties. Before
the advent of computer-generated models, many international companies dealt with
political risk by investing in a wide group of countries, thereby spreading out the risk
that they would encounter through political instability; this strategy is known as the
portfolio approach28 and to some extent is still very useful.
Generally, international companies are well prepared to deal with most political
uncertainties, and if the risks are very high, they pass up the opportunity to invest in
such countries. The key concern for international business executives is the loss of
their assets. Research has shown that after the initial difficulties and insecurity, inter-
national businesses find that political risk might actually decrease once they are able
to understand the intricacies of the system.29 One of the reasons for such a shift might
be the familiarity of the situation and the subsequent confidence international business
managers develop in dealing with the existing uncertainty. The keys to developing politi-
cal strategies are understanding how political decisions are made, how the government
operates, what some key current political agendas of the ruling government are, and the
general political climate. If the governments are democratically elected, it is much easier
to formulate strategies for avoiding political risks because drastic shifts in the political
environment can be predicted. In contrast, the more authoritarian the government, the
more difficult it is to predict the political shifts. One approach to deal with political risk
is to understand the key issues and follow the steps outlined below.30

• Identify the specific political actions facing the company.

• Analyze the issues upon which these political actions are based.
• Determine which interest groups are behind the political actions.
• Identify the parties affected by the political actions (other international companies).
• Identify the key players that may have a role in the political actions (legislators,
government agencies, and so on).
• Formulate strategies based on company goals, resources, core competencies, and
management know-how.
• Identify the potential outcome of implementing the outlined strategies in the host
country and home country (determine, for example, whether the strategies or its
effect are unpopular).
• Select the most suitable strategy from a list of options.
 THE POLITIcAL AND LEGAL ENVIRONMENT 107

Although the aforementioned steps seem simple, in practice they can be challenging.
Often it can be difficult to identify the key players and interest groups in the system,
specific political actions might not be clear, the effects of some political actions are
not apparent, and the possible strategic options might be limited.

THE LEGAL ENViRONMENT

The following quotes from Newton Minow, the former chairman of the U.S. Federal
Communications Commission, seem appropriate in understanding the international
legal landscape.31

“In Germany, under the law, everything is prohibited, except that which is permitted.”

“In France, under the law, everything is permitted, except that which is prohibited.”

“In the Soviet Union, under the law, everything is prohibited, including that which is
permitted.”

“In Italy, under the law, everything is permitted, especially that which is prohibited.”

Like other environmental variables, legal systems vary from country to country. The
two key differences observed in the legal systems around the world are the nature of
the system and the degree of independence of the judiciary. Most of the world’s legal
systems are derived from three major legal structures. These are

• Civil law. Legal codes are the basis of civil law. Rules are developed for every
aspect of life, including how to conduct business. Most countries of the world,
including Germany and Japan, follow the civil law system.
• Common law. The common law system is based on traditions, precedent, cus-
toms, usage, and interpretation. Common law is practiced in about 30 countries
of the world, especially former British colonies. The United States follows the
common law system.
• Theocratic law. Theocratic law is based on religious doctrines and teachings.
Most Islamic countries follow the theocratic legal system.

The key differences in the three legal systems center on how the legal system is
developed and how the courts decide on issues. Civil law is based on how the law
is applied to the given facts and on the application of preset codes. Common law is
based on the courts’ interpretation of events; and theocratic law is based on what is
acceptable within the religious precepts.
Besides these three legal systems, many other tribal legal systems are practiced
in Africa, some parts of Asia, and Latin America. Such systems are based on tradi-
tions and cultural influences. Until recently, these legal systems were not studied
and analyzed because very few international companies ever ventured into the
more remote parts of the world where they prevail. An increase in exploration and
108 CHApTER 4

heightened interest in the search for natural ingredients and minerals has forced
some international companies to deal with tribal legal systems that have no writ-
ten records.
For international companies that operate in more than one foreign country, varia-
tions in laws from country to country pose problems. Additionally, there is no single
body of codes or laws that applies across country borders. Hence, disputes between
international companies and host governments are harder to resolve than domestic
disputes. To facilitate resolution of disputes between international companies and
host governments, a few international agreements have been reached, resulting in the
establishment of institutions that can be used for mediation. These institutions include
the World Trade Organization (WTO), the International Court of Justice (ICJ), and
the International Labor Organization (ILO).
The WTO was set up to negotiate trading agreements and resolve trade disputes
between countries. The ICJ, also called the World Court, renders legal decisions in-
volving disputes between countries and helps resolve broader issues that may affect
international companies. The ILO is a multilateral organization that promotes the
adoption of humane labor conditions.
At the macro level, a country’s legal system affects international companies in
many different ways, including how they conduct business in the host country, how
they deal with cross-border legal issues, and how they deal with international trea-
ties (tax treaties between countries, trade agreements, intellectual property rights
agreements, and the like). At the micro level, a country’s legal system affects many
aspects of business, including

• Ownership
• Mode of entry
• Taxation
• Labor laws
• Currency controls
• Expatriates issues
• Price controls
• Antitrust laws
• Product liability
• Repatriation of profits
• Tariffs and other nontariff barriers

Every country has its own set of laws governing the aforementioned aspects
of business. International companies must review these laws carefully to ensure
compliance.

OWNERSHIp
Ownership laws are those that govern the extent to which foreigners can own busi-
nesses and the types of businesses that they can own. These laws are meant to ensure
that sensitive industries—industries that may have national security implications,
 THE POLITIcAL AND LEGAL ENVIRONMENT 109

such as media, food distribution, and defense—are not owned by foreigners, as they
could become a national safety issue.
Individual countries’ ownership laws are intended to help the growth of domestic
businesses, increase competitiveness, and encourage transfer of technology and man-
agement skills. Typically, international companies have superior products, efficient
production technology, and sound management and marketing skills that often over-
power those of domestic companies. The protection afforded by their governments
through ownership rules provides the local companies with some relief and gives
them an opportunity to compete.
In many industrialized countries, foreign companies are allowed to have 100
percent ownership (these are referred to as wholly owned or fully owned subsid-
iaries). In most cases, international companies prefer 100 percent ownership of
their subsidiaries, as it gives them complete control of their operations. It also
allows them to apply their own management and marketing skills, and protect
their technology and intellectual property rights (IPR) without interference. But in
many countries of the world, foreign ownership is restricted to joint ventures only.
Even in joint ventures, foreign companies are restricted to minority ownership.
For example, in China, joint ventures are restricted and in some cases entirely
prohibited in such industries as banking, insurance, and distribution. Similarly,
in India, foreign ownership in the telecommunications industry is limited to 49
percent, and in Brazil, foreign ownership is limited to 20 percent in aviation and
mass media.

MODE OF ENTRY
Laws governing mode of entry deal with how foreign-owned companies can enter
a given country. These laws specify whether a foreign company can enter through
exports, licensing agreements, franchise operations, strategic alliances, joint ven-
tures, or Greenfield investments. For example, in China, the government permits
foreign-owned service companies to enter Chinese markets only through joint
ventures (Chapter 6 discusses the various entry modes and the advantages and
disadvantages of each).

TAXATION
Most countries levy some form of tax on their citizens as well as businesses in the
form of personal tax, business tax, value-added tax, or some other tax. Through taxa-
tion, governments collect revenues from their people and businesses. Revenues are
used for providing services that benefit its citizens, such as police protection, social
programs, national defense, and infrastructure. In addition, tax revenues are used by
governments to redistribute income, discourage consumption of some products (such
as alcohol and tobacco), and encourage consumption of domestic products (through
tariffs). Tax laws vary from country to country and govern various issues including
tax levels, tax type, tax treaties, and tax incentives.
Tax levels determine the amount owed by individuals (as income tax) and busi-
110 CHApTER 4

Table 4.3

Tax Rates for Select Countries

Income tax rate Corporate tax rate Tax treaty with

Country (%) (%) other countries
Belgium 25–50 33.99 Yes
Brazil 15–27.5 34 Yes
Canada 15–29 36.1 Yes
China 5–45 33 Yes
Egypt 20–40 40 Yes
France 48.09 34.33 Yes
Germany 15–42 25 Yes
India 10–30 30–40 Yes
Italy 23–43 33 Yes
Japan 10–37 30 Yes
Mexico 3–29 29 Yes
Netherlands 0–52 29.6 Yes
Spain 15–45 35 Yes
Taiwan 6–40 25 Yes
United Kingdom 0–40 30 Yes
United States 0–35 35 Yes
Source: Worldwide-tax.com, The Complete Worldwide Tax & Finance Site, www.worldwide-tax.com,
January 2007.

nesses (as corporate profit taxes) to the government. These levels can range from
zero tax policy to 70 percent tax policies. Table 4.3 presents tax rates for a selected
group of countries.
Tax types are the various categories of taxes a government levies against its citizens
and businesses. The most common types of taxes are the following:

• Personal income tax—levied on the income of individuals

• Corporate income tax—levied on corporations on incomes earned
• Capital gains tax—levied on sales of assets when the asset is sold for an amount
greater than its cost
• Value-added tax—levied at each step of the production-to-distribution process.

Tax treaties are arrangements between governments that agree (1) to share infor-
mation about taxpayers, (2) to cooperate in tax law enforcement, and (3) to avoid
double taxation (that is, an individual from one country working in another is not
subject to income taxes in both countries). Tax treaties define and explain “tax terms”
and “taxable activities.” Some of the tax terms defined includes income, source of
income, and residency.
Tax incentives are exemptions and allowances offered by governments to encourage
foreign direct investment and other forms of participation by international companies.
These incentives may include reduced corporate tax rates for a period of time, ad-
ditional depreciation allowance, and foreign tax credit (credits offered to individuals
or companies for taxes paid in another country).
 THE POLITIcAL AND LEGAL ENVIRONMENT 111

LABOR LAWS
Labor laws are enacted to protect workers’ rights. Most countries have laws that
deal with working conditions, workplace safety, minimum wages, hiring practices,
termination guidelines, health benefits, working hours, sick leaves, vacation leaves,
and general working conditions. Most of these laws apply to international companies,
too.
The governments of some countries have passed laws mandating minimum wage
rates for workers. This ensures that workers are compensated sufficiently to earn a
decent living. For example, in the Philippines, by law, the minimum wage rate has
been set at 250 pesos per day (equivalent to $5.00 a day or 63 cents an hour) and in
the United States as of 2008, minimum wage was $7.50 an hour (in some states such
as Washington, the rates are higher, at $8.75 per hour).

CURRENcY CONTROLS
Most developing countries have currency exchange controls that deal with the pur-
chase and sale of foreign currencies. These countries tend to have weak economies,
and they impose regulations on foreign exchange transactions to stem the outflow of
foreign currencies and help shore up their own currencies. Some of the currencies
held as reserves by many of the world’s countries are the euro, Japanese yen, Swiss
franc, and the U.S. dollar. Developing countries hold foreign currencies as reserves
to undertake economic development projects such as infrastructure improvements,
including investing in electricity generation and water works. In order to make these
advances, foreign governments have to buy industrial goods such as farm equipment
(tractors), road-building equipment (earth movers), construction equipment (bull-
dozers), and transportation equipment (railroads, ships, airplanes). If controls were
not imposed on foreign exchange transactions, individuals and companies in these
developing countries could easily use up their limited amount of foreign reserves and
cause economic disaster.
In countries that impose exchange controls, the government allocates and controls
the trading of foreign currencies. Individuals entering and leaving these countries
must declare the value of funds that they have in foreign currencies. Anyone wish-
ing to buy foreign currency must have a permit to do so, and, normally, the amounts
are limited.

EXpATRIATE ISSUES
Expatriates are foreign workers brought into a country by international companies.
These workers include technical staff, specialists, and executives. International com-
panies bring in expatriates for a variety of reasons, including (1) to ensure control
over their operations, (2) to establish policies and procedures that are in line with
those of the parent company, and (3) to provide training to executives that might be
tapped for future senior assignments. For host countries, the presence of expatriates
results in lower opportunities for local personnel. In addition, expatriates also inhibit
112 CHApTER 4

the development of local managers. In some countries, the government restricts the
number of expatriates an international company can bring in.
In addition to restrictions on the number of expatriates that can be brought into a
country, host governments in some cases might restrict expatriates born in certain
countries. For example, European and American international companies are not
permitted to bring Israeli expatriates into some Middle Eastern countries.

PRIcE CONTROLS
Some countries have laws that govern commodities prices. These countries prohibit
upward price spirals, especially on food items. The intent of these laws is to protect
the citizens from sudden changes in commodities prices that cause unnecessary strain
on the poor. In addition, these laws are intended to control inflation.

ANTITRUST LAWS
Antitrust or restrictive trade practices laws are intended to free up competition and en-
able the free market system to operate efficiently. Antitrust laws are generally directed
at price fixing, the sharing of competitive information, and the formation of monopolies.
Most of the industrialized countries of the world have some form of antitrust laws on
their books. The recently formed European Union monitors business operations within
its member countries, including operations of international companies. The European
Union’s antitrust laws govern issues such as cartels and price fixing (Article 81 EC)
and price discrimination and exclusive dealings (Article 82 EC). In 2002, the European
Union’s Competition Commission played a critical role in blocking the proposed merger
of General Electric and Honeywell, both U.S. firms. The rationale for the commission’s
action was that the merger would create a virtual monopoly that might hinder overall
competition in the field of electricity generation in Europe.
In the United States, the major antirust laws are the Sherman Act, the Clayton
Act, and the Robinson-Patman Act. The Sherman Act, passed in 1890, was the first
of many U.S. government actions addressing such competitive issues as cartels and
antitrust activities. The U.S. government did not actively enforce the Sherman Act,
and its effectiveness was questioned by many. The Clayton Act was passed in 1914
to address some of the weaknesses of the Sherman Act. Specifically, the Clayton Act
addressed price discrimination and business merger issues. The Robinson-Patman
Act, passed in 1936, was a further refinement of the earlier acts; it governed such
issues as price discrimination and exclusivity that reduces competition. Under the
act, the same goods could not be sold to different purchasers at different prices if the
effect of such sales reduced competition or made it difficult for small, independent
retail firms to stay in business.

PRODUcT LIABILITY
Product liability laws are intended to hold manufacturers, their executives, and their outside
directors responsible for causing injury, harm, death, or any other damage to consumers.
 THE POLITIcAL AND LEGAL ENVIRONMENT 113

The challenge for international companies is how to deal with the different legal systems
that provide various consumer safeguards. In some countries, the scarcity of lawyers and
the long delays in the legal process discourage consumers from seeking legal help to col-
lect compensatory or punitive damages from companies whose products may have failed
or caused them harm. A good example of a country that has few cases of product liability
is Japan: lawyers in Japan are scarce, the Japanese Bar Association sets all legal fees, and
foreign lawyers are not allowed to file cases against companies. In contrast, in the United
States, consumers use the court systems to extract damages for various reasons, including
for injuries and deaths caused by using a particular product. In fact, one U.S. automobile
company was hit with 250 product liability suits in just one year.32

REpATRIATION OF PROFITS
International companies operate in foreign countries to earn profits. Once they earn these
profits, foreign-owned companies normally repatriate their profits to the parent office.
The profits generated from various operations are then pooled as a source of funds for
investments. In many countries, international companies have the freedom to transfer
funds and profits as they wish; in others, however, the host government restricts these
outflows through local laws. These laws basically ensure the channeling of profits by
the international companies to local investments, as well as the protection of the foreign
currency reserves held by the country. International companies’ continuous outflow of
profits may weaken the local currency and raise concerns of inflation.

TARIFFS AND OTHER NONTARIFF BARRIERS

Tariffs are taxes on imported goods that raise the prices of imported goods and services,
thereby discouraging their local consumption. The purpose of tariffs is to restrict the flow
of imports that may jeopardize the host country’s industries and put pressure on foreign
currency reserves. Through the passage of various laws, these countries are able to con-
trol the flow of imports. Tariffs aid and protect local producers and reduce competition.
Though the intent of the tariff is to develop local industries, in most cases it fails to attain
the stated objective. Because local businesses lack some of the basic ingredients for ef-
ficient use of resources, they are not able to compete with the larger and more efficient
foreign firms. The price and quality of locally produced goods and services never attain
international standards, and local consumers suffer. For example, after gaining indepen-
dence from the British, the Indian government levied high duties on imported cars (as
much as 150 percent) and also restricted foreign investments in the automobile sector.
The intent was to develop its own automobile industry. But the automobile industry was
not able to produce efficient cars at reasonable enough prices for the industry to prosper.
Car models that were introduced in the 1950s continued to be manufactured and marketed
year after year without change or improvement. Once the government opened the industry
to foreign manufacturers, the competitive dynamics were altered. Foreign manufacturers
introduced more fuel-efficient and better-performing cars at much lower prices, resulting
in a considerable drop in the local producer’s market share, from more than 85 percent of
the market in the 1950s to only 7 percent of the market in 2000.
114 CHApTER 4

CHApTER SUMMARY
Political and legal environments play a critical role in international business. Some
political and legal factors create problems for international companies in managing
their operations in the host country.
The purpose of a sound political system is to integrate various parts of a society into
a single functioning unit. The aggregated viewpoints of politicians, businesspeople,
interest groups, and the general masses form the core principles of a country’s political
system. Political systems are influenced by ideology, nationalism, unstable govern-
ments, traditional hostilities, proportion of government ownership of businesses,
terrorism, corruption, and the activities of international companies.
There are five basic ideological systems that form governments to manage a coun-
try’s economic policies: (1) capitalism, (2) socialism, (3) conservative versus liberal
views, (4) communism, and (5) authoritarianism. Democratic forms of government
and capitalism go hand in hand.
International companies conduct political risk analyses before entering foreign
markets. Political strategic actions assist international companies in better managing
their operations.
Like the political environment, a country’s legal system plays a critical role in a
company’s operations. Legal systems vary from country to country, but differences
can be categorized as differences in the nature of the legal system and the degree
of judicial independence. The three major judicial systems are civil law, based on
legal codes and rules; common law, based on precedents; and theocratic law, based
on religious precepts.
At the macro level, a country’s legal system affects how international businesses
operate in the host country, how the system affects cross-border issues, and how
laws affect international treaties. At the micro level, the legal system affects specific
aspects of business operations, including ownership, taxation, antitrust issues, and
trade regulations. The best laid plans by an international company may be sabotaged
by political upheaval or legal obstacles, the apparent signs of which the company
may have totally missed or misunderstood.

KEY CONCEpTS
Political Systems
Political Ideology
Political Risk Assessment
Legal Systems

DiSCUSSiON QUESTiONS
1. What is the purpose of a political system?
2. Define a political system.
3. What are the components of a political environment?
4. What are the key influencers of a country’s political environment?
 THE POLITIcAL AND LEGAL ENVIRONMENT 115

5. What is a political ideology?

6. How many different political ideologies exist?
7. What are the basic differences between capitalism and socialism?
8. What specific strategies does an international company develop to handle
diverse political systems?
9. What are the two key differences in legal systems among countries?
10. Identify and explain the three major judicial systems.
11. Enumerate the various business activities that come under the legal system.
12. How can international companies prepare to deal with the legal environment
when entering a new market?

AppLiCATiON CASE: ADApTiNG FiNANCE TO ISLAM

Deutsche Bank entered the Malaysian market in 1967 with one branch. Focusing
mainly on affiliates of foreign companies, the bank did well, but it was not a force
in the retail business of banking. Competitors such as HSBC (Hong Kong Shanghai
Bank Corporation), which had a presence in Malaysia since 1884, and Citigroup were
much bigger and had multiple branches. To further extend their reach in the banking
sector, HSBC bought out the Mercantile Bank of Malaysia and became one of the
largest foreign banks in the country. Meanwhile, by 2006, Deutsche Bank had two
offices in Malaysia and employed 130 professionals.
A major problem for most overseas banks, including Deutsche Bank, was under-
standing banking rules in a predominantly Muslim country that must adhere to the
laws of the Koran. Islamic laws prohibit charging interest on loans; for bankers,
this means sharing borrowers’ risks. Therefore, Islamic banking rules resulted in
financial institutions treating their customers as shareholders, sharing a portion of
the profits. Hence, when a bank wants to lend funds to one of its customers to buy
a house or other property, it enters into a partnership by forming a joint venture
to raise the capital to acquire the property. The customer and the bank become the
joint owners of the property, and each has its respective shares based on a ratio
equivalent to the capital raised. The bank then leases its share to the customer. The
customer makes monthly payments over an agreed-upon period of time. Over time,
the bank’s share diminishes and the customer becomes the 100 percent owner of
the property.
Similarly, to avoid the problems created by interest earned on deposits by custom-
ers, local banks in Muslim countries enter into an agreement with their customers
through which the bank is allowed to invest a customer’s deposits for profits. The
ensuing profits are then shared between the customer and the bank according to a
predetermined profit-sharing ratio. The local Islamic banking institutions, which
were controlled by nationals, thrived under this law, but foreign banks had difficulty
understanding the law’s nuances and adapting to them. However, HSBC—through
its merger with Mercantile Bank of Malaysia—and Citigroup—by hiring locals as
senior executives—were able to succeed under the Islamic banking laws. Deutsche
Bank, with its entrenched European-style banking, had problems adjusting to the
local religious laws.
116 CHApTER 4

QUESTIONS
1. As Malaysia’s country manager for Deutsche Bank, would you train your for-
eign staff to adapt to the Islamic laws, hire a few Malaysians as senior execu-
tives, or remain as an institutional banker? Give reasons for your choice.

SOURcE
This case was developed from information gathered from the Deutsche Bank, Citigroup, and HSBC
Web sites, and also from an article on Islamic banking in Malaysia by Arnold Wayne titled “Adapting
Finance to Islam,” New York Times, November 22, 2007, pp. C1, C4.
 5 International Trade and Foreign
Direct Investments

Since NAFTA went into effect, U.S. trade with NAFTA partners has more than
doubled. Today, nearly half of total U.S. exports to the world go to Canada and
Mexico. The only “giant sucking sound” we have heard over the last 10 years is the
sound of U.S. goods and services headed to Mexico and Canada.1

LEARNiNG ObJECTiVES
• To understand the economic reasons for international trade
• To recognize the impact of international trade on domestic welfare
• To appreciate the role of the World Trade Organization (WTO) in regulating trade
• To understand the economic reasons for foreign direct investment
• To learn the impact of foreign direct investment on domestic welfare
• To offer insights into the future of global trade and investments in the twenty-first
century

INTERNATiONAL TRADE
International trade refers to the exchange of goods and services between countries. In pre-
historic times, when there were no formal countries or boundaries, international trade was
simply a barter of goods between two individuals or groups separated by a “long” distance,
which over time spanned continents. Evidence exists of trading routes connecting Egypt,
Mesopotamia (the area around modern-day Iraq), and the Indus Valley civilizations (near
modern-day Pakistan and western India) as early as 3000 B.C.2 Trade did not take place
only via land routes, however. The Phoenicians (modern-day Lebanese) were sea traders
who established trading posts throughout the Mediterranean coasts in 1000 B.C.E.
International trade continued to flourish right through the periods of the Greek
and Roman empires, increasing in volume as technological advances progressed in
shipbuilding and navigation. Famous personalities in the history of international trade
include Venetian Marco Polo, who traveled to China in the thirteenth century, and
Vasco de Gama, from modern Portugal, who opened the spice trade when he sailed
around Africa to India in 1498. In the 1600s, Holland became a center of trade in
several commodities, including financial futures contracts. In 1688 Edward Lloyd

117
118 CHApTER 5

opened a coffee house in London where marine insurance was openly traded. Today
Lloyd’s continues to be a leading market for insurance in the world.
The term “international trade,” as understood today, is more applicable to the
practice that took place after the formation of nation-states in the eighteenth century,
when feudal states coalesced and formed specific boundaries and a formal currency
was created to establish clear legal and political boundaries. However, boundaries
continued to change as a result of wars or popular uprisings, making it difficult to
measure the exact volume of trade between nation-states prior to the twentieth cen-
tury. Recent examples include Italy, whose boundaries were only defined in 1870, and
Ireland, which separated from the United Kingdom in 1922 and became a separate
country formally after World War II.
Irrespective of boundaries, when does trade benefit a nation-state or country? From
an economic perspective, it is clear that individual traders engage in the export and
import of goods and services to enjoy monetary benefits. However, it is not clear
whether international trade benefits a country as a whole. Initial works on the topic,
written as early as the 1500s, all considered international trade as beneficial only if
a country managed to export, rather than import, in exchange for gold or silver. This
doctrine, termed mercantilism, was widely popular until the nineteenth century.

MERCANTiLiSM
The theory of mercantilism evolved gradually as trade increased in importance after
the fifteenth century. Exporting allowed a country to obtain gold and silver, the two
most widely accepted forms of payment prior to the introduction of paper money. Gold
enabled a country to become rich and powerful and increased its ability to finance
wars. However, excess gold without a corresponding increase in output can lead to
inflation in the economy. If inflation continues, it is difficult for a country to maintain
its exports, as prices become less favorable. Under the price-specie flow mechanism
proposed by the British economist David Hume in the middle of the eighteenth cen-
tury, such increases in prices ultimately reduce exports, and the balance of trade is
restored back to equilibrium. (Specie refers to gold and silver.)
Unfortunately, mercantilism continued to be popular and accepted by rulers and
thinkers alike until the 1800s. Monarchs and feudal lords encouraged the expansion
of exports, mostly to finance wars. It was easy to justify and enact laws—and to
intervene militarily—to protect local industry and employment. It was not until the
dissemination of works by Adam Smith (1732–1790) and later economists, which
showed how countries could be better off when engaged in mutually beneficial two-
way trade, that mercantilism philosophy fell from favor. Two-way trade required
countries to specialize in products where they possessed distinct advantages in pro-
ductive efficiency, as explained in the next section.

THEORY Of AbSOLUTE ADVANTAGE

With his book The Wealth of Nations, Smith became the first economist to openly
oppose the doctrine of mercantilism. He was a proponent of laissez-faire economics
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 119

and is considered the first free market economist. Instead of focusing only on exports,
Smith argued that it was beneficial for countries to specialize in the production of goods
in which they enjoyed productive efficiency. Goods can be exported in exchange for
other goods produced more efficiently elsewhere. The net result is an overall increase
in output for all countries, as shown in the following example.
Assume that Country A and Country B, for a given amount of capital and labor,
can produce 100 bushels and 50 bushels of wheat and 200 yards and 300 yards of
textiles, respectively.

Wheat Textiles If Resources Are Divided Equally

Country A 100 bushels 200 yards 50 bushels of wheat and 100 yards of textiles
Country B 50 bushels 300 yards 25 bushels of wheat and 150 yards of textiles
If the resources in each country are divided equally between farming and textiles,
the combined output is 75 bushels of wheat and 250 yards of textiles.
Adam Smith’s theory of absolute advantage requires each country to specialize
in goods in which it enjoys a production advantage. In the above example, Country
A has an absolute advantage in producing wheat, while Country B has an absolute
advantage in producing textiles. If Country A specializes in and devotes all its re-
sources to wheat, the total output is 100 bushels. Similarly, if Country B devotes all
its resources to textiles, its output will be 300 yards. Through specialization, total
output increases by 25 bushels of wheat and 50 yards of textiles.
This additional output can be shared by both countries through trade. For example,
Country A could export 40 bushels of wheat to Country B in exchange for 125 yards
of textiles. This leaves Country A with 10 more bushels of wheat and 25 more yards
of textiles than it would have if it had produced both the wheat and the textiles on
its own. Country B will end up with 15 more bushels of wheat and 25 more yards of
textiles than it would have if it had produced both products on its own. This simple
example highlights the benefits of specialization under Adam Smith’s theory of ab-
solute advantage. The actual gains to each country will depend on the exchange rates
and the countries’ bargaining power.

THEORY Of COMpARATiVE ADVANTAGE

The theory of absolute advantage requires each country to have an absolute advan-
tage in the production of at least one good. For some countries, the advantages come
about because of weather or geography. For example, coconuts and pineapples can
grow only in temperate climates, while production of oil and gas requires the natural
elements to be located physically in the country. For other countries, the advantages
may be realized through efficient production processes, superior managerial skills,
or technological superiority.
What happens when one country does not have the capacity to produce goods more
efficiently than another? Smith’s model will not work, because without specialization
and increased output, trade may not take place to benefit both countries. However,
David Ricardo (1772–1823) showed that it was still possible for countries to engage
120 CHApTER 5

in trade, even without possessing an absolute advantage. According to Ricardo, as

long as a country possessed a comparative advantage in producing one of the goods
to be traded, mutually beneficial trade could still take place. The following example
demonstrates how this is achieved.
Assume for given amounts of land, labor, and capital, Country A and Country B
can produce the following:

Wheat Textiles If Resources Are Divided Equally

Country A 100 bushels 200 yards 50 bushels of wheat and 100 yards of textiles
Country B 50 bushels 150 yards 25 bushels of wheat and 75 yards of textiles
In the above example, Country B does not have an absolute advantage in producing
either wheat or textiles. However, Country B has a relative advantage in producing
textiles over wheat. To understand this, recognize that Country A has to give up 2
yards of textiles for every 1 bushel of wheat produced (2 : 1 ratio). Country B has to
give up 3 yards of textiles for every 1 bushel of wheat (3 : 1 ratio). This difference in
ratios means that Country B has a relative advantage in producing textiles over wheat
compared to Country A. Ricardo showed that trade can still take place if Country B
specializes in producing textiles.
How much should Country A and Country B produce in order to maximize total output?
There are several possibilities, but one scenario is for Country A to specialize and produce
80 bushels of wheat. This would use up 80 percent of its resources, and the remaining
20 percent could be used to produce 40 yards of textiles. Country A can keep 50 bushels
of wheat for itself and export the remaining 30 bushels to Country B. Country B could
specialize in producing 150 yards of textiles and export 75 yards of textiles to Country A.
Country A will now have a total of 115 yards of textiles, 15 yards more than if it were to
spread its resources equally, without trade. Country B will have a total of 30 bushels of
wheat, 5 bushels more than if it were to equally split its resources, without trade.
Ricardo’s theory of comparative advantage was instrumental in showing countries
that international trade benefits all participants through specialization. It provided a
new paradigm to international trade theory by rejecting the principles of mercantilism
and offering a new approach that relied on specialization, two-way trade, and mutual
benefits. Unfortunately, it required cooperation and coordination between countries
that was often difficult to achieve, especially when domestic politics conflicted with
the consequences of free trade, specialization, and reliance on other countries for
imports of necessities or sensitive goods.
Indeed, it took a long time for specialization and free trade to be associated with
increased output and mutual benefits. The mercantilist philosophy continued to shape
public policy right up to World War II. Countries were often in dire need of gold
and money to finance their wars, and exports provided the quickest means to earn
bullion. Nationalist and labor groups often managed to blame free trade for loss of
industries and increased unemployment. Industrial and agricultural groups lobbied
governments to impose tariffs and laws that discouraged imports of goods, especially
those that threatened domestic production. It was not until the end of World War II
that the principles of free trade were formally incorporated into global treaties under
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 121

the auspices of the General Agreement on Trade and Tariffs (GATT; now the World
Trade Organization [WTO]).
The free trade theories of Adam Smith and David Ricardo continue to be relevant
today. One area of trade they do not delve into is why some countries produce goods
more efficiently than others. It is assumed that natural resources and technology play a
role in the way countries are able to gain relative advantage in production. Two theories
that purport to explain the patterns of trade are discussed in the next section.

HECKSCHER-OHLiN FACTOR PROpORTiONS EXpLANATiON fOR

INTERNATiONAL TRADE
Eli Heckscher (1879–1952) and Bertil Ohlin (1899–1979), two Swedish economists, were
among the first to offer explanations for the differences in trade specializations. They
proposed that the abundance of productive resources determines the ability of a country
to produce goods efficiently. If a country has an abundant source of labor, it should be
effective in producing labor-intensive goods. In contrast, if a country has an abundance
of capital, it should specialize in producing capital-intensive goods. Although capital in
economics usually refers to the nonlabor equipment and machinery required to produce
goods, it also can include money for investments in the purchase of capital goods.
The Heckscher-Ohlin (H-O) model is intuitively very consistent and appealing,
but it was not able to predict actual behavior in international trade. In 1954, Wassily
Leontief (1906–1999), found that that the Heckscher-Ohlin proposition did not hold
up empirically for U.S. trade patterns. His analysis showed that the United States
continued to export labor-intensive goods and import capital-intensive goods in spite
of having significant advantages in producing capital goods. The abundance of endow-
ments themselves appears not to be sufficient to guarantee the production of goods
efficiently. The use of technology and the effective management of the production
process also play a role in exploiting factors of production to increase output.
China and India are other examples that violate the H-O theory. Both countries
continue to lag in the production of agricultural output compared to countries with
lesser amounts of labor resources. For example, Europe and the United States have
continued to maintain their superiority in the production of agricultural commodities.
The explanation lies in their efficient implementation of farming methods, which
includes the use of harvesters, fertilizers, and pesticides, better drainage systems,
crop rotation, and cross-fertilization of seeds. Farms in the midwestern United States
continue to yield higher quantities of wheat and corn per acre than anywhere else in
the world. Thus, an abundance of natural resources alone does not appear to be able
to predict trade patterns. The efficient use of technology and capital also factor into
a country’s ability to specialize in production.

THE PRODUCT LifE CYCLE THEORY

The product life cycle (PLC) theory provides another explanation for patterns in inter-
national trade.3 Under this hypothesis, the flow of trade depends on the stage in the life
cycle of a product. It does not discount the comparative theories or the H-O hypothesis.
122 CHApTER 5

Rather, it complements them by adding another dimension to the explanation, the nature
of the product itself. Trade depends on the demand for a product by overseas customers.
As demand increases, not only is the product exported, but it eventually gets produced
overseas, a phenomenon unheard of in the times of Smith and Ricardo.
The PLC hypothesis begins with the premise that new products are usually devel-
oped in countries where purchasing power is high—in other words, rich countries.
This period is defined as the introductory stage. The product is manufactured locally
using available capital and labor. Demand for the product that spurred its innovation
is less sensitive to the price or cost of the product. This is followed by the second
stage, the growth stage, in which the product gets accepted more widely and usage
increases. Prices fall as market share increases and additional features are added to
the product to satisfy the demands of a larger clientele. During this period, the prod-
uct may change from being a luxury or exclusive item to being one of necessity. An
example is a copier machine or an automobile. Initially the product is considered an
item of luxury to a consumer, but over time it becomes a necessity.
During the latter part of the introductory stage and the beginning of the growth stage,
the product is likely to be exported to other countries as foreign consumers become
aware of its availability. Demand is most likely to come from other rich countries that
can afford the initial high prices. During the growth stage, some production may take
place overseas, as the higher demand for the product cannot be satisfied by domestic
production alone. Although patent protection may prevent duplication of the product,
near substitutes are likely to enter the market.
The next stage, defined as the mature stage, sees a flattening of the demand curve
as the product gets well established both locally and overseas. Production takes place
around the globe. Trade continues to increase as products are shipped from overseas
facilities to new markets. Products may even be imported back to the country that first
manufactured them as a result of cheaper manufacturing costs overseas. Innovations
and new features are likely to be standardized across competitor products, and prices
are likely to stabilize into a long-run equilibrium.
The final stage of the life cycle process is the declining period, when the product is
replaced by new innovations. During this declining phase, production is likely to take
place in countries that are able to produce the product at the lowest cost. Industrialized
and rich countries are likely to be the largest importers of these products.
To a large extent, the PLC theory provides a coherent explanation for the patterns of
trade of popular consumer durables. It can also predict the trade flows of raw materials
that are used in the production process and the sale of after-market supplies. Unfortu-
nately, the theory is better at explaining ex post trade patterns rather than providing a
formal framework for future trade flows. This is because at the product level, it is dif-
ficult to predict the demand, cost of production, exchange rates, innovations, and other
factors affecting supply and demand for the product during the life cycle.

GLObAL PATTERNS Of TRADE: STATiSTiCS

As international trade increases, the standard of living increases for all countries
involved, as more output is available to their citizens. Although international trade
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 123

Table 5.1

Merchandise Exports by Region

Region 1948 1963 1983 2003 2005

World1 $58 $157 $1,838 $7,369 $10,159
United States2 21.7% 14.9% 11.2% 9.8% 8.9%
Canada2 5.5% 4.3% 4.2% 3.7% 3.5%
Mexico2 0.9% 0.6% 1.4% 2.2% 2.1%
European Union2 n.a 27.5% 30.4% 42.4% 39.4%
Africa2 7.3% 5.7% 4.5% 2.4% 2.9%
Middle East2 2.0% 3.2% 6.8% 4.1% 5.3%
Asia2 14.0% 12.4% 19.15% 26.1% 27.4%
Japan2 0.4% 3.5% 8.0% 6.4% 5.9%
China2 0.9% 1.3% 1.2% 5.9% 7.5%
India2 2.2% 1.0% 0.5% 0.8% 0.9%
Source: World Trade Organization, World Merchandise Exports by Region and Selected Economy, Table
II–2. Available at http://www.wto.org/english/res_e/statis_e/its2006_e/its06_overview_e.pdf (accessed
August 27, 2008).
1In billions of U.S. dollars.
2In percentages (of world total).

has been increasing since the 1500s, its dramatic growth during the second half of the
twentieth century provides clear evidence that cooperative efforts benefit all countries.
During the interwar period between 1918 and 1939, countries around the world, in-
cluding the United States, were still engaging in antitrade policies. After World War
II, a concerted effort was made to increase international trade. As a result, it grew
at an unprecedented pace, not only among rich countries, but also between rich and
poor countries. Table 5.1 illustrates the increase in trade in the last six decades. Trade
increased from $58 billion in 1948 to more than $10 trillion in 2005, for an annualized
growth rate of more than 10 percent. The largest increases took place between 1963
and 1983, when trade increased at an average rate of 13.1 percent annually. Between
1983 and 2003, it increased by 7.2 percent annually.
Table 5.1 also shows some variations in trade patterns by region. The proportion of
international trade as a percentage of total trade in the United States dropped gradually
from a high of 27.1 percent in 1948 to 8.9 percent in 2005. Within North America,
Canada’s share of world trade also declined to 3.5 percent from a high of 5.5 percent
in 1948, while Mexico’s gradually increased to a high of 2.1 percent in 2005.
The increase in trade in the European Union (EU) is difficult to measure because
countries are continuously being added to the bloc. Table 5.2 shows the members
that have been gradually admitted to the union. The European Union, with 27 mem-
ber countries as of January 1, 2007, had a combined share of 39.4 percent of world
trade in 2005, with Germany and France registering the highest share at 9.5 percent
and 4.5 percent, respectively. The proportion of trade in Asia has also been showing
a steady growth since 1963, registering 27.4 percent in 2005. As expected, China
experienced rapid growth, reaching 7 percent in 2005, while Japan’s share declined
to 5.9 percent in 2005 from a high of 9.9 percent in 1993. India’s share has been
124 CHApTER 5

Table 5.2

European Union Members

Year Countries Total Comments

January 1, 1958 Belgium  6 Establishment of the European Economic Commu-
France nity (EEC)
Germany
Italy
Luxembourg
Netherlands
January 1, 1973 Denmark  9 No referendum keeps Norway out
Ireland
United Kingdom
January 1, 1981 Greece 10
January 1, 1986 Spain 12 Euro becomes official currency in 2002 except in
Portugal the UK
January 1, 1995 Austria 15 Euro is the currency of Austria since 2002
Finland
Sweden
May 1, 2004 Cyprus 25
Czech Republic
Estonia
Hungary
Latvia
Lithuania
Malta
Poland
Slovakia
Slovenia
January 1, 2007 Bulgaria 27 Slovenia adopts the Euro
Romania
January 1, 2008 Malta and Cyprus adopt the Euro
Source: Adapted from European Union, “Key dates in the history of European integration.” Available at
http://europa.eu/abc/12lessons/key_dates/index_en.htm (accessed July 7, 2008).

showing a gradual increase, reaching approximately 0.9 percent in 2005. In contrast,

the proportion of trade in Africa has decreased from a high of 7.3 percent in 1948 to
2.4 percent in 2003.

WORLD TRADE ORGANiZATiON

The World Trade Organization (WTO) is the successor to the General Agreement on
Tariffs and Trade (GATT). GATT was created as part of the Bretton Woods agreement
at the end of World War II.
The economic events that occurred between World War I and World War II convinced
several economists that the best approach to achieving postwar recovery was for all
countries to grow together toward full employment and output. GATT’s mission was to
ensure that the trading rules were fair to all countries, and a coordinated approach was
required to encourage countries to produce goods efficiently and export freely.
The initial work of GATT was to reduce the tariffs imposed by countries on im-
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 125

ports of commodities. Tariff reductions were later extended to other consumer and
capital goods. Between 1986 and 1994, under the aegis of the Uruguay Round of
conferences, countries began to work on reducing barriers to the free flow of services,
agriculture, capital, and intellectual property. The WTO is the result of this round of
negotiations. It should be noted that GATT, although much maligned and criticized
by various groups at times, deserves much of the credit for the successful growth in
trade in the postwar period.
The main objectives of the WTO, which was formally created in 1995, are to for-
mulate and implement trade rules through multilateral trading agreements rather than
bilateral agreements. The WTO’s members come from 150 countries, with another
30 countries in various stages of negotiations to join the organization. An important
task of the WTO is to handle disputes between countries in areas of trade violations,
including allegations of dumping, hidden taxation, and subsidies. The WTO, like its
predecessor, prefers to reach agreement by consensus, but unlike GATT, majority
voting is allowed in cases when a consensus is not achieved. A majority-approved
law is applicable only to those countries that accept the vote.

INTERNATiONAL TRADE iN THE FUTURE

International trade will continue to increase in the near future as more countries im-
prove their production capabilities and innovations continue to spur new products.
Earlier models that helped explain the growth and pattern of international trade are
less applicable today because of changes in the production environment. The major
change in international trade—one that began as early as the middle of the nineteenth
century—has been the movement of labor and capital across national boundaries. A
phenomenon such as this affects the dynamics of trade because goods can now be
produced using labor and capital imported from overseas. The United States, where
waves of immigrants contributed to a rapid increase in the speed of industrialization,
is the best example of this dramatic change in the international trade environment.
The United States also imported capital goods and machinery from Europe, which,
combined with new labor, made the country into a major manufacturer and consumer.
As its production processes became more efficient, it became a major exporter of
capital and consumer goods. Similarly, Japan, in spite of being an island with scarce
arable land and natural resources, became an industrial power by importing oil, steel,
and other natural resources to skillfully produce consumer durables for export around
the world. The old theories of comparative advantage would never have predicted
that Japan, with few natural resources, would become a leading exporter of industrial
goods in the second half of the twentieth century.
The second major change in the international trade environment was the formation
of multinational corporations in the twentieth century. Multinationals changed the
dynamics of international trade because their wealth and power allow them to estab-
lish production centers around the globe. Today they have the flexibility to relocate
globally, enabling them to maximize output at the lowest cost. Multinationals have the
ability to transform a country with few resources into a fledgling modern industrial-
ized state. Hypothetically, even in a country with few natural resources, unfavorable
126 CHApTER 5

climate, and a lack of skilled workers, multinationals can set up factories to produce
a range of goods from basic agricultural produce to advanced microchips. In such
cases, multinationals must construct the required infrastructure, including roads and
electricity, import the necessary raw materials, and recruit skilled labor to produce
and export the output. It should be noted that such an investment does not guarantee
a country will prosper, since development can be impaired by a corrupt government
or exploitation by multinationals themselves. Singapore and Taiwan are examples
that are close to such a model where multinationals were major contributors to their
development.
Multinationals foster the movement of labor and capital through foreign direct
investment. Foreign direct investment in recent years has been a major factor to
increase in global trade, accounting for nearly one-third of international trade flows.
Hence, international trade today cannot be studied in isolation. This new paradigm
recognizes that international trade and foreign direct investment go hand in hand,
unlike in the past. This topic is explored in the next section.

FOREiGN DiRECT INVESTMENT

Foreign direct investment (FDI) represents capital investments made by firms in
another country. When IBM invests in the construction of a plant in Belgium to
manufacture semiconductors, it represents U.S. FDI in Belgium. The United States is
considered the sending country and Belgium the receiving country of FDI. Similarly,
when Lenovo acquired IBM’s personal computing division in 2004, it represented
FDI by a Chinese company in the United States. The United States is the receiving
country of the FDI. The companies that engage in FDI are usually multinational
corporations (MNCs) or transnational companies (TNCs).
It is not necessary for a multinational to own 100 percent of an overseas firm for
its investment to be classified as FDI. An investment is considered FDI as long as the
multinational has a controlling interest in the overseas firm. The amount of shares a
multinational must own to possess a controlling interest can vary and in some cases
can be as low as 10 percent.
It should be noted that there is a difference between foreign direct investment and
overseas portfolio investment. The latter refers to the purchase of stocks in an over-
seas company for passive investment. A mutual fund, for example, may purchase up
to 10 percent of an overseas company’s shares and seek no controlling interest. The
fund is interested only in receiving dividends with the prospect of selling the shares
in the future at a higher price. It is difficult to separate overseas portfolio investment
and foreign direct investment, as there are no clear guidelines or accepted practice
for distinguishing them.
The U.S. State Department considers 15 percent ownership in a company sufficient
for classification as FDI. The European Union classifies FDI as follows: “Foreign
direct investment (FDI) is the category of international investment made by an entity
resident in one economy (direct investor) to acquire a lasting interest in an enterprise
operating in another economy (direct investment enterprise). The lasting interest is
deemed to exist if the direct investor acquires at least 10 percent of the equity capital
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 127

of the direct investment enterprise.”4 This is consistent with the definition used by the
Organisation for Economic Co-operation and Development (OECD), an influential
group of 30 countries that generates research for policy making.
For measurement purposes, countries prefer to categorize FDI by outward (OFDI)
or inward investment (IFDI). OFDI refers to outward foreign direct investment made
by residents of one country to another country. It represents an outflow of money and
investment from domestic investors to foreign countries. OFDI is usually perceived
negatively by domestic residents because it reduces investment and employment in the
domestic market. The positive aspect of OFDI is that at some future date earnings from
the overseas operations will be repatriated back to the originating country in the form of
dividends and interest, bringing income and foreign currency to the domestic country.
IFDI refers to foreign direct investment by foreign residents in the domestic economy.
Although it represents investment and employment in the domestic market, it is also
sometimes viewed negatively by domestic residents. The reasons are usually nationalis-
tic, as ownership of assets by foreigners rouses jingoistic sentiments among certain seg-
ments of the population. A recent example in the United States includes that of Japanese
investments during the 1980s. Japanese firms, flush with dollar reserves after a period
of rapid growth of exports, found investments attractive in the United States because of
the weakened dollar compared to the yen. It also represented a strategic move because
the weak dollar made it difficult for Japanese firms to maintain their exports from Japan
to the United States. As a result, several car companies, such as Honda, Nissan, and
Toyota, and other manufacturers decided to build plants in the United States.
Politicians and nationalists initially portrayed the investments as an economic
invasion, and the press often hyped the so-called Japanese domination of corporate
America. Over the years, this antagonism has disappeared, and time has shown that
the owners’ origin is irrelevant. What matters most is whether the capital is being
invested wisely to employ workers and produce goods competitively.

FORMS OF FOREIGN DIREcT INVESTMENT

There are three ways for companies to engage in foreign direct investment: construct
new plants or facilities (greenfield investments), acquire existing plants or facilities
(brownfield investments), or establish licensing arrangements.
Greenfield investments refer to the establishment of new plants and offices over-
seas by multinational corporations as a means of FDI. The process usually involves
setting up a separate corporation in the host country, either as a 100 percent–owned
subsidiary or as a joint venture with a local partner. The capital for the investment is
usually sent by the parent company in the form of equity or a combination of equity
and debt. The parent company maintains full control over the operations of the plant,
including control of the board of directors and the senior management.
Brownfield investments refer to the acquisition of existing firms or plants as a
means of FDI. Such investments save a multinational from building new plants and
incurring the associated costs of obtaining regulatory approvals, zoning, and dealing
with local contractors. Recent data suggest that 70–80 percent of new FDI takes place
in the form of mergers and acquisitions. Another benefit of brownfield investments
128 CHApTER 5

is the savings in time and money because a multinational does not have to recruit
new staff or establish vendor, supplier, and bank relationships. A disadvantage of
acquiring a firm or existing business is that it may be difficult to introduce change,
especially in countries with pro-labor laws and weak corporate governance. If a
multinational acquires a foreign firm with the intent to restructure the business and
change the existing work flow process, it may find it difficult to reassign workers or
close down divisions. Such institutional rigidities may turn out to be costly in terms
of both capital and employee morale.
Licensing agreements refer to contractual agreements between a parent company
(the multinational) and a local company, allowing the local company, with or with-
out partnership, to produce goods or services in exchange for fees and royalties.
This arrangement eliminates the risks associated with operating in an unfamiliar
local environment. Instead, the responsibility for the production and marketing of
goods is fully passed on to the local investor. A disadvantage of this approach is
that the local vendor is provided access to private business information, including
technology that may be misused in the future, resulting in new competition to the
parent company.

TYpES OF FOREIGN DIREcT INVESTMENT

FDI can also be classified by the types of investments a company makes, based on
whether they are horizontal or vertical to the existing line of business.

Horizontal FDI

Horizontal FDI refers to overseas investment in plants and services in the investing
company’s existing line of business. This is the most popular form of FDI. For ex-
ample, in June 2007, Hilton announced plans to build more than 55 hotels in Russia,
Britain, and Central America, to be completed in 2012, with total construction costs
exceeding $1.7 billion. In May 2007 Dell announced that it would open a second
plant in Hortolandia, close to São Paulo, Brazil, where 70 percent of Dell’s Brazilian
customer base is located. The new plant manufactures Dell’s traditional line of note-
books and desktops. Both these initiatives are classified as horizontal FDIs because
both companies are expanding their original line of business overseas.

Vertical FDI

Vertical FDI refers to overseas investments in plants or services that contribute either to
the upstream or downstream segment of a business. For example, in 1998, Total SA of
France announced plans to acquire Petrofina SA of Belgium. Total SA was primarily in
the business of oil exploration and extraction. Petrofina, in contrast, specialized in the
post-production marketing and refining of oil, considered downstream operations. Hence,
Total was acquiring a line of business downstream. Other examples include automotive
companies purchasing steel manufacturers, or McDonald’s purchasing farms to raise chick-
ens and grow potatoes so they can supply their franchisees with consistent ingredients.
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 129

MOTIVES FOR FOREIGN DIREcT INVESTMENT

In a perfectly competitive market, there is no reason for FDI because a company should
be able to distribute its products to all markets at some equilibrium price. A company
that produces a good in New York should be able to sell it throughout the United States
at one equilibrium price, plus transportation costs. Similarly, if the world market is per-
fectly competitive, the company should sell its output globally at one equilibrum price
and geographic boundaries should be of no consequence. The only reason for FDI to take
place is the existence of market imperfections. A majority of studies have focused on the
macroeconomic imperfections in the marketplace to explain the motivations for FDI. An-
other branch of study has looked at FDI from a microeconomic perspective; the skills and
know-how of a firm require that it be located overseas to exploit its full productivity.
Among the various theories offered in the literature, John Dunning’s eclectic
OLI paradigm provides an overview of both the imperfections in the market and the
uniqueness of the firm to explain FDI.5 The O stands for ownership, L for location,
and I for internalization.

• Ownership advantages refer to the special know-how belonging to a firm. It can

be in the form of a patent, technological skill, managerial skill, or process skill
that gives the firm an advantage in the production of a good or service.
• Location advantage refers to the exploitation of local resources that would oth-
erwise be unavailable to provide added value to the product. An example would
be the extractive industry, where the special know-how to dig very deeply for
ores still requires the company to be located near the mines.
• Internalization refers to the process by which it is more efficient for the multi-
national to execute the project through intracompany transfer than to transfer its
know-how to a third party. There can be many reasons for this scenario, including
special expertise as well as the potential loss of the know-how.

Dunning’s OLI paradigm is able to integrate the multiple motivations for FDI into
three broad and simple categories. It recognizes the impact of both macro and micro
factors involved in the decision to go overseas and substitute FDI for trade.
Other authors have classified the motives strictly from the perspective of the
multinational as it operates in a global environment without national boundaries.
Multinationals engage in FDI to seek resources and markets and to achieve global
efficiency and strategic fit. Strategic fit may encompass several different criteria such
as securing markets, cutting costs, and accommodating other factors, including import
barriers, shortage of foreign exchange, and uniqueness of product.

Resource-Seeking Motives

Multinationals are very adept at seeking locations globally to produce output at the
lowest cost. The lower costs may be the results of cheaper labor, lower transportation
costs, and lower costs of raw materials. Overseas expansion can also be viewed within
the context of the product life cycle (PLC) theory. As discussed earlier, during the
130 CHApTER 5

second stage of the PLC, when demand rises overseas, a firm may be better served
by plants established near customers. Overseas expansion also allows companies to
devote more attention to the tastes and needs of their overseas customers and build
separate R&D facilities for the overseas markets. Competition or the threat of com-
petition can also force companies to seek cheaper resources. If a competitor sets up
plants overseas to produce goods more cheaply than it can at home, it becomes dif-
ficult for a domestic company to maintain its competitive edge.

Market-Seeking Motives

Another reason for multinationals to engage in FDI is to create or increase new mar-
ket share, usually near their existing markets. The production of cars in the United
States by foreign automobile manufacturers is one example of market-seeking FDI.
Volkswagen was the first foreign car company to open a plant in the United States, in
Westmoreland, Pennsylvania, in 1978. Within a few years, many foreign car compa-
nies entered the market, beginning with Honda in Marysville, Ohio, in 1982. Similar
competitive positioning behavior is now being practiced by U.S. car manufacturers
overseas. In anticipation of a booming market, GM started to assemble Buick cars in
China in 1999. GM has now been joined by other U.S. car companies. Ford opened
its first factory in China in February 2003 and has already announced plans to build
a few additional plants. Such expansion also provides diversification benefits. For
example, while GM has announced plans in late 2008 to close plants in North America
as a result of an impending economic recession, it continued to open plants in China
where demand for cars is expected to grow for the foreseeable future.
In vertical FDI, the strategic motive focuses on gaining a competitive advantage
on a company’s upstream or downstream operations. Mergers and acquisitions that
seek to control upstream and downstream operations are subject to antitrust laws in
order to prevent the likelihood of a monopoly. In 2008, ALCOA, the world’s largest
producer of aluminum, announced a joint venture with Vietnam’s premier minerals
development company, Vietnam National Coal-Mineral Industries Group (Vinacomin),
to develop its aluminum industry. This will enable ALCOA to consolidate its upstream
operations by having access to Vietnam’s high quality bauxite reserves.6

Import Barriers

Another strategic reason for a company to use FDI to enter new markets or expand its
operations in existing markets is to overcome trade barriers, usually import restrictions.
Countries often discourage imports by imposing high import duties, labeling require-
ments, health certifications, and quality tests. Some countries may have legitimate
reasons for imposing restrictions on imports, most often as a result of scarce foreign
exchange. A developing country with limited foreign reserves may want to discourage
the import of luxury items such as perfumes, jewelry, and expensive cars and instead
encourage the import of capital equipment into vital or fledgling industries. A country
may also attempt to encourage selected industries to develop without fear of foreign
competition. The effectiveness of these measures depends on their implementation;
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 131

they can have negative consequences if they are exploited by domestic companies
for their own benefit.
For example, India banned the imports on luxury cars and charged very high du-
ties on other cars in the 1950s to promote its domestic car production. This led to the
development of three local car manufacturers who dominated the domestic market for
many years. Unfortunately, the lack of competition provided no incentive for these
companies to improve the quality of their cars, and over time they began to lag behind
cars produced overseas. When import restrictions were removed in the 1990s and for-
eign cars began to penetrate the Indian market, domestic manufacturers were forced to
focus on quality and service. By 2006, fierce competition among several car companies
led not only to increased quality but also to reduction in the prices of all cars. In 2007,
Tata Motors (an Indian car manufacturer) and Nissan-Renault announced plans to start
manufacturing cars that would cost less than $3,000, a clear signal that competition,
and not import barriers, helps local manufacturers in the long run.
Trade barriers have been coming down in recent years as a result of the work of
GATT and the WTO. Several studies have confirmed the impact of trade barriers on
FDI, including research by Theo Eicher and Jong Woo Kang (2004), who demonstrate
empirically that when trade barriers are low, overseas companies prefer to export but
will opt for FDI when trade barriers are high.7

Shortage of Foreign Exchange

As mentioned earlier, developing countries often face a shortage of foreign exchange

earnings, forcing governments to restrict their use for the import of essential items
such as capital goods, oil, and food. Luxury items such as cars get a lower priority.
Strategically, it makes sense for a foreign car manufacturer to produce locally rather
than exporting to a country that lacks foreign exchange. If the initial investment can
be obtained locally, the company needs only to secure foreign exchange sufficient to
remit profits as dividends back to the parent country, a much smaller amount than if
they imported the cars to the country.

Nature of Product

In some cases, the nature of the product or service requires that the company invest
locally in a plant or an office (Dunning’s location-specific advantage). Two prominent
examples are power plants and extractive industries. These industries require huge capital
investments in the local area and a long-term commitment. Such projects are also very
risky and require contractual agreements with the local government that will guarantee
the safety of their investments for many years. In some cases, it is possible for firms to
license their technology and collect only royalties and special fees for its use.
Other examples of foreign direct investment that require local presence include
several service industries such as the legal, financial, banking, and food services. In
the food industry, for instance, it is common for firms to franchise their services with
a local owner. The franchisee pays the parent company a percentage of the revenue in
exchange for use of the brand name and the process for food preparation and compli-
132 CHApTER 5

ance with the franchisor’s standards. The franchisee is also expected or required to
import the ingredients from the franchisor for preparation of their food products.

NEW TRENDS IN FOREIGN DIREcT INVESTMENT

As the WTO continues to reduce tariffs across the globe, firms are finding it strate-
gically necessary to reduce their costs of production at all stages of the product life
cycle. The trend is no longer to move overseas in the third stage of the product life
cycle; rather, the process may begin as early as the first stage. An entrepreneur or
company today has the luxury of patenting a product first before deciding on the loca-
tion to manufacture the output. With information from the Internet, and assisted by
the various branch offices of the U.S. Chamber of Commerce, companies can obtain
quotations and proposals worldwide to develop prototypes of their products.
Technological advances have also made it possible for a firm to develop a product
initially in electronic format, using advanced 3-D modeling and manufacturing software.
The software enables the computer to test the product for durability, strength, wear and
tear, and safety. Additional software also enables the prototype to be generated with dif-
ferent types of materials unique to each country. Based on the results, a firm can decide
to produce products in multiple locations using different materials and processes.

COSTS AND BENEFITS OF FOREIGN DIREcT INVESTMENT

The impact of FDI on both the sending and receiving countries depends on a number
of factors. There is a general consensus that FDI provides significant benefits to the
receiving or host countries in terms of employment, income, trade, investments in
human capital, infrastructure development, and technology transfers. Noneconomic
benefits include better corporate governance, awareness of the environment, social
equality, and political freedom. There are also costs associated with FDI, particularly
if host countries’ economic policies are not geared to spread the benefits of FDI
in a positive manner. Inappropriate policies can lead to income inequality, social
unrest, pollution, degradation of the environment, depletion of resources, and po-
litical instability. We first examine the impact on employment and income to both
the sending and receiving country, followed by the impact on trade, investment,
and technology transfer.
The impact of FDI on employment and income to the sending country is still open to
debate. When U.S. companies open subsidiaries overseas to take advantage of cheaper
labor costs, the initial impact on employment and income is usually negative. Labor
unions and economists complain that sending jobs overseas also generates negative
externalities to the domestic economy. When a company closes a plant down, it also
affects ancillary industries and local businesses. The net effect on society may be
larger than the savings generated for the company shareholders. Others have argued
that it is not labor costs that drive firms overseas but rather the tax breaks and other
financial incentives host countries provide to multinational corporations. However,
many economists cite the low unemployment rate in the United States over the last
two decades prior to 2008 as an indicator that FDI does not lead to lower employment
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 133

and income. Rather, the income from export services has been growing steadily over
the years, indicating that overseas investments are beginning to pay off.
From the perspective of the receiving country, the influx of FDI often means more
jobs and income and a boost to the economy. Unfortunately, there can also be nega-
tive externalities. Labor exploitation is among the most common criticisms leveled
against multinationals, especially when they operate in developing countries. They are
often accused of using child labor, compromising on worker safety measures, paying
substandard wages, and contributing to environmental degradation. It is difficult to
take sides on this issue as it can be viewed from several standpoints.
For example, on the issue of substandard wages, one needs to use the proper
benchmark to evaluate the wage level. The most appropriate index to use is the
median wage within the country or industry sector. By and large, most multina-
tionals pay higher than the local wages, but without proper controls, it is still
easy for labor to be exploited, most notably by firms that use contracted labor. In
August 2007, China Labor Watch, a watchdog group in New York, reported that
it investigated eight factories supplying toys to well-known companies in the
United States such as Disney, Hasbro, and Sega and found widespread violations,
including mandatory overtime, verbal and sexual abuse by managers, and hiring
of underage workers.8
Another consideration is the impact on employment and income when FDI is
achieved through mergers and acquisitions (M&A). In the case of FDI through M&A,
employment may either drop or not increase in the initial phase. This can happen if
the multinational introduces new technology or work flow processes that improve
efficiency in the firm. However, if the firm succeeds in its reorganization, employment
should increase in the long run.

TRADE, INVESTMENTS, AND TEcHNOLOGY TRANSFERS

One of the benefits of FDI for a receiving country is increased investments that may
not otherwise be available. When FDI flows into a country, the immediate benefits
that result from the influx of investment are increased employment and income to
local industries. The sending country generates a positive payoff only after a period
of time when it is able to repatriate profits and dividends. FDI can also lead to tech-
nology transfers and eventually help a receiving country upgrade its human capital
and productive capacity. This transfer may hurt the sending country in the long run
if the technology is duplicated or it results in an erosion of its technological lead. If
FDI leads to increased exports to a country, then it offers additional benefits in that
the country also earns foreign exchange through trade.
FDI’s impact on trade, investments, and technology transfers is considered next
for three industries: manufacturing, services, and extractive.

Manufacturing Industry

FDI for manufacturing is undertaken by companies that plan to produce goods for local
consumption or for export to other countries, including their home countries. Such
134 CHApTER 5

investments require machinery and other equipment to be imported from overseas for
installation in the receiving country. Examples include IBM building a semiconductor
plant in France or Siemens building a power plant in India.

Trade. Whether FDI increases or decreases a receiving country’s exports depends

on the reasons for the establishment of the plant. If the multinational opens the plant
because it is unable to meet local demand through exports, it is very likely that all the
output will be sold in the local market. If the plant was constructed for cost-savings
reasons, then the output is likely to be exported back to the sending country and ex-
ports will increase for the receiving country.

Investments. Plant production, especially new investments (greenfield investments),

usually require substantial investment in building infrastructure, equipment, and
manpower. Plant construction also leads to investment in ancillary industries that are
in close proximity to the new plant.

Technology Transfer. There is some transfer of technology whenever plants are

constructed overseas. The extent of the transfer depends to the kind of technology
chosen and the ease of adoption. If the technology is simple and requires low levels
of investment, it will be easier for local countries to imitate it or create near imita-
tions. If the technology is sophisticated or requires a large investment, it is unlikely
for technology to be transferred for many years.

Services Industry

FDI for establishing services overseas is made in the hotel and food businesses, theme
parks, retail chains, and transaction services including banking. Examples include
Hilton opening a chain of hotels in Mexico, American Express opening offices in
Colombia, and Disney opening a theme park in France. The core business model
remains the same globally, although local culture and tastes may require adaptations
and changes to the mix of services and delivery.

Trade. Most service industries usually cater to domestic consumption. However,

some services such as those in the leisure business may cater to foreign tour-
ists that can help earn foreign exchange indirectly for the country (export of
services). Examples include tourist resorts run by global brands such as Hilton,
Starwood Group, and Novotel, which are usually frequented by tourists and
foreign businesspeople.

Investments. The investments required to establish services overseas are usually

lower than those for plant construction. In the service industry, the main invest-
ments are in buildings and manpower. The returns on service investments are typi-
cally high, especially for brand-name companies. Examples include Citibank and
HSBC for banking services and McDonald’s and Burger King for food services.
However, service industries face higher risk than others, for they are subject to
 INTERNATIONAL TRADE AND FOREIGN DIREcT INVESTMENTS 135

expropriation or excessive regulation and are also often easy targets for nation-
alistic politicians.

Technology Transfer. Technology transfer is limited to the training of individuals and

the delivery of services. Such expertise may in the long run be transferable to local