2.

National Differences in Political, Economic, & Legal Systems

How the political, economic, and legal systems of countries vary. The potential
benefits, costs, and risks of doing business in a country are a function of its political,
economic, and legal systems.
International business is much more complicated than domestic business due to variations
in political, economic, and legal systems. These differences significantly impact the
benefits, costs, and risks of operating internationally, as well as how businesses should be
managed and the strategies they should pursue in different countries.

Political economy is a term used to stress that political, economic, & legal systems of a
country are interdependent, which collectively influence economic well-being.

Political systems have two dimensions:

1. the degree of collectivism versus individualism,

2. and the degree of democracy versus totalitarianism.

Collectivism is an ideology that views the needs of society as being more important than
the needs of the individual. Collectivism translates into an advocacy for state intervention
in economic activity and, in the case of communism, a totalitarian dictatorship.

Individualism is an ideology that is built on an emphasis of the primacy of the individual’s

freedoms in the political, economic, and cultural realms. Individualism translates into an
advocacy for democratic ideals and free market economics.

Democracy and totalitarianism are at different ends of the political spectrum. In a

representative democracy, citizens periodically elect individuals to represent them, and
political freedoms are guaranteed by a constitution.

In a totalitarian state, political power is monopolized by a party, group, or individual, and

basic political freedoms are denied to citizens of the state.

Four major forms of totalitarianism exist today: Communist totalitarianism, Theocratic

totalitarianism, Tribal totalitarianism, and Right-wing totalitarianism.

Economic Systems: There are three types of economic systems

1. Market economy, prices are free of controls, and private ownership is predominant
Command economies.
2. Command economy, prices are set by central planners, productive assets are owned
by the state, and private ownership is forbidden.
3. Mixed economy has elements of both a market economy and a command economy
Legal systems

The legal system of a country refers to rules/laws that regulate behaviour along with
processes by which laws are enforced & through which redress for grievances is obtained.

There are three types of legal systems:

1. Common law - based on tradition, precedent, and custom

2. Civic law - based on detailed set of laws organized into codes

3. Theocratic law - law is based on religious teachings

Differences in the structure of law between countries can have important implications for
the practice of international business. The degree to which property rights are protected
can vary dramatically from country to country, as can product safety and product liability
legislation and the nature of contract law.

3. National Differences in Economic Development

How the political, economic, and legal systems of countries vary. The potential
benefits, costs, and risks of doing business in a country are a function of its political,
economic, and legal systems.
1. The rate of economic progress in a country seems to depend on the extent to which that
country has a well-functioning market economy in which property rights are protected.

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

3. The attractiveness of a country as a market and/or investment site depends on

balancing the likely long-run benefits of doing business in that country against the likely
costs and risks.

4. The benefits of doing business in a country are a function of the size of the market
(population), its present wealth (purchasing power), and its future growth prospects. By
investing early in countries that are currently poor but are nevertheless growing rapidly,
firms can gain first-mover advantages that will pay back substantial dividends in the future.

5. The costs of doing business in a country tend to be greater where political payoffs are
required to gain market access, where supporting infrastructure is lacking or
underdeveloped, and where adhering to local laws and regulations is costly.
6. The risks of doing business in a country tend to be greater in countries that are politically
unstable, subject to economic mismanagement, and lacking a legal system to provide
adequate safeguards in the case of contract or property rights violations.

7. Global Trade and Investment Environment

In this chapter, we reported the various instruments of trade policy, reviewed the political
and economic arguments for government intervention in international trade, reexamined
the economic case for free trade in light of the strategic trade policy argument, and looked
at the evolution of the world trading framework. While a policy of free trade may not
always be the theoretically optimal policy (given the arguments of the new trade theorists),
in practice it is probably the best policy for a government to pursue. In particular, the long
run interests of business and consumers may be best served by strengthening international
institutions such as the WTO. Given the danger that isolated protectionism might escalate
into a trade war, business probably has far more to gain from government efforts to open
protected markets to imports and foreign direct investment (through the WTO) than from
government efforts to protect domestic industries from foreign competition.

1. Trade policies such as tariffs, subsidies, antidumping regulations, and local content
requirements tend to be pro-producer and anti-consumer. Gains accrue to producers (who
are protected from foreign competitors), but consumers lose because they must pay more
for imports.

2. There are two types of arguments for government intervention in international trade:
political and economic. Political arguments for intervention are concerned with protecting
the interests of certain groups, often at the expense of other groups, or with promoting
goals with regard to foreign policy, human rights, consumer protection, and the like.
Economic arguments for intervention are about boosting the overall wealth of a nation.

3. A common political argument for intervention is that it is necessary to protect jobs.

However, political intervention often hurts consumers, and it can be self-defeating.
Countries sometimes argue that it is important to protect certain industries for reasons of
national security. Some argue that government should use the threat to intervene in trade
policy as a bargaining tool to open foreign markets. This can be a risky policy; if it fails, the
result can be higher trade barriers.

4. The infant industry argument for government intervention contends that to let
manufacturing get a toehold, governments should temporarily support new industries. In
practice, however, governments often end up protecting the inefficient.
5. Strategic trade policy suggests that, with subsidies, government can help domestic firms
gain first-mover advantages in global industries where economies of scale are important.
Government subsidies may also help domestic firms overcome barriers to entry into such
industries.

6. The problems with strategic trade policy are twofold: (a) Such a policy may invite
retaliation, in which case all will lose, and (b) strategic trade policy may be captured by
special-interest groups, which will distort it to their own ends.

7. The GATT was a product of the postwar free trade movement. The GATT was
successful in lowering trade barriers on manufactured goods and commodities. The move
toward greater free trade under the GATT appeared to stimulate economic growth.

8. The completion of the Uruguay Round of GATT talks and the establishment of the World
Trade Organization have strengthened the world trading system by extending GATT rules
to services, increasing protection for intellectual property, reducing agricultural subsidies,
and enhancing monitoring and enforcement mechanisms.

9. Trade barriers act as a constraint on a firm’s ability to disperse its various production
activities to optimal locations around the globe. One response to trade barriers is to
establish more production activities in the protected country.

10. Business may have more to gain from government efforts to open protected markets to
imports and foreign direct investment than from government efforts to protect domestic
industries from foreign competition.

8. Foreign Direct Investment

This chapter reviewed theories that attempt to explain the pattern of FDI between
countries and to examine the influence of governments on firms’ decisions to invest
in foreign countries.
1. Any theory seeking to explain FDI must explain why firms go to the trouble of acquiring
or establishing operations abroad when the alternatives of exporting and licensing are
available to them.

2. High transportation costs or tariffs imposed on imports help explain why many firms
prefer FDI or licensing over exporting.

3. Firms often prefer FDI to licensing when (a) a firm has valuable know-how that cannot
be adequately protected by a licensing contract, (b) a firm needs tight control over a foreign
entity in order to maximize its market share and earnings in that country, and (c) a firm’s
skills and capabilities are not amenable to licensing.

4. Knickerbocker’s theory suggests that much FDI is explained by imitative behavior by

rival firms in an oligopolistic industry.

5. Dunning has argued that location-specific advantages are of considerable importance in

explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to
exploit resource endowments or assets that are location specific.

6. Political ideology is an important determinant of government policy toward FDI.

Ideology ranges from a radical stance that is hostile to FDI to a noninterventionist, free
market stance. Between the two extremes is an approach best described as pragmatic
nationalism.

7. Benefits of FDI to a host country arise from resource-transfer effects, employment

effects, and balance-of payments effects.

8. The costs of FDI to a host country include adverse effects on competition and balance of
payments and a perceived loss of national sovereignty.

9. The benefits of FDI to the home (source) country include improvement in the balance of
payments as a result of the inward flow of foreign earnings, positive employment effects
when the foreign subsidiary creates demand for home-country exports, and benefits from a
reverse resource-transfer effect. A reverse resource transfer effect arises when the foreign
subsidiary learns valuable skills abroad that can be transferred back to the home country.

10. The costs of FDI to the home country include adverse balance-of-payments effects that
arise from the initial capital outflow and from the export substitution effects of FDI. Costs
also arise when FDI exports jobs abroad.

11. Home countries can adopt policies designed to both encourage and restrict FDI. Host
countries try to attract FDI by offering incentives and try to restrict FDI by dictating
ownership restraints and requiring that foreign MNEs meet specific performance
requirements.
10. Foreign Exchange Market
This chapter explained how the foreign exchange market works, examined the
forces that determine exchange rates, and then discussed the implications of these
factors for international business. Given that changes in exchange rates can
dramatically alter the profitability of foreign trade and investment deals, this is an
area of major interest to international business.
1. One function of the foreign exchange market is to convert the currency of one country
into the currency of another. A second function of the foreign exchange market is to
provide insurance against foreign exchange risk.

2. The spot exchange rate is the exchange rate at which a dealer converts one currency
into another currency on a particular day.

3. Foreign exchange risk can be reduced by using forward exchange rates. A forward
exchange rate is an exchange rate governing future transactions. Foreign exchange risk can
also be reduced by engaging in currency swaps. A swap is the simultaneous purchase and
sale of a given amount of foreign exchange for two different value dates.

4. The law of one price holds that in competitive markets that are free of transportation
costs and barriers to trade, identical products sold in different countries must sell for the
same price when their price is expressed in the same currency.

5. Purchasing power parity (PPP) theory states the price of a basket of particular goods
should be roughly equivalent in each country. PPP theory predicts that the exchange rate
will change if relative prices change.

6. The rate of change in countries’ relative prices depends on their relative inflation rates. A
country’s inflation rate seems to be a function of the growth in its money supply.

7. The PPP theory of exchange rate changes yields relatively accurate predictions of long-
term trends in exchange rates but not of short-term movements. The failure of PPP theory
to predict exchange rate changes more accurately may be due to transportation costs,
barriers to trade and investment, and the impact of psychological factors such as
bandwagon effects on market movements and short-run exchange rates.

8. Interest rates reflect expectations about inflation. In countries where inflation is expected
to be high, interest rates also will be high.

9. The international Fisher effect states that for any two countries, the spot exchange rate
should change in an equal amount but in the opposite direction to the difference in nominal
interest rates.
10. The most common approach to exchange rate forecasting is fundamental analysis. This
relies on variables such as money supply growth, inflation rates, nominal interest rates, and
bal anceof- payments positions to predict future changes in exchange rates.

11. In many countries, the ability of residents and nonresidents to convert local currency
into a foreign currency is restricted by government policy. A government restricts the
convertibility of its currency to protect the country’s foreign exchange reserves and to halt
any capital flight.

12. Nonconvertibility of a currency makes it very difficult to engage in international trade

and investment in the country. One way of coping with the nonconvertibility problem is to
engage in countertrade—to trade goods and services for other goods and services.

13. The three types of exposure to foreign exchange risk are transaction exposure,
translation exposure, and economic exposure.

14. Tactics that insure against transaction and translation exposure include buying forward,
using currency swaps, and leading and lagging payables and receivables.

15. Reducing a firm’s economic exposure requires strategic choices about how the firm’s
productive assets are distributed around the globe.

11.The International Monetary System

This chapter explained the workings of the international monetary system and
pointed out its implications for international business.
1. The gold standard is a monetary standard that pegs currencies to gold and guarantees
convertibility to gold. It was thought that the gold standard contained an automatic
mechanism that contributed to the simultaneous achievement of a balance-of-payments
equilibrium by all countries. The gold standard broke down during the 1930s as countries
engaged in competitive devaluations.

2. The Bretton Woods system of fixed exchange rates was established in 1944. The U.S.
dollar was the central currency of this system; the value of every other currency was
pegged to its value. Significant exchange rate devaluations were allowed only with the
permission of the International Monetary Fund (IMF). The role of the IMF was to maintain
order in the international monetary system (a) to avoid a repetition of the competitive
devaluations of the 1930s and (b) to control price inflation by imposing monetary discipline
on countries.
3. The fixed exchange rate system collapsed in 1973, primarily due to speculative pressure
on the dollar following a rise in U.S. inflation and a growing U.S. balance-of-trade deficit.

4. Since 1973, the world has operated with a floating exchange rate regime, and exchange
rates have become more volatile and far less predictable. Volatile exchange rate
movements have helped reopen the debate over the merits of fixed and floating systems.

5. The case for a floating exchange rate regime claims (a) such a system gives countries
autonomy regarding their monetary policy and (b) floating exchange rates facilitate smooth
adjustment of trade imbalances.

6. The case for a fixed exchange rate regime claims (a) the need to maintain a fixed
exchange rate imposes monetary discipline on a country; (b) floating exchange rate
regimes are vulnerable to speculative pressure; (c) the uncertainty that accompanies
floating exchange rates dampens the growth of international trade and investment; and (d)
far from correcting trade imbalances, depreciating a currency on the foreign exchange
market tends to cause price inflation.

7. In today’s international monetary system, some countries have adopted floating

exchange rates; some have pegged their currency to another currency, such as the U.S.
dollar; and some have pegged their currency to a basket of other currencies, allowing their
currency to fluctuate within a zone around the basket.

8. In the post–Bretton Woods era, the IMF has continued to play an important role in
helping countries navigate their way through financial crises by lending significant capital
to embattled governments and by requiring them to adopt certain macroeconomic policies.

9. An important debate is occurring over the appropriateness of IMF-mandated

macroeconomic policies. Critics charge that the IMF often imposes inappropriate
conditions on developing nations that are the recipients of its loans.

10. The current managed-float system of exchange rate determination has increased the
importance of currency management in international businesses.

11. The volatility of exchange rates under the current managed-float system creates both
opportunities and threats. One way of responding to this volatility is for companies to build
strategic flexibility and limit their economic exposure by dispersing production to different
locations around the globe by contracting out manufacturing (in the case of low-value-
added manufacturing) and other means.
15.Entering Foreign Markets
The chapter made the following points:
1. Basic entry decisions include identifying which markets to enter, when to enter those
markets, and on what scale.

2. The most attractive foreign markets tend to be found in politically stable developed and
developing nations that have free market systems and where there is not a dramatic
upsurge in either inflation rates or private sector debt.

3. There are several advantages associated with entering a national market early, before
other international businesses have established themselves. These advantages must be
balanced against the pioneering costs that early entrants often have to bear, including the
greater risk of business failure.

4. Large-scale entry into a national market constitutes a major strategic commitment that is
likely to change the nature of competition in that market and limit the entrant’s future
strategic flexibility. Although making major strategic commitments can yield many benefits,
there are also risks associated with such a strategy.

5. There are six modes of entering a foreign market: exporting, creating turnkey projects,
licensing, franchising, establishing joint ventures, and setting up a wholly owned subsidiary.

6. Exporting has the advantages of facilitating the realization of experience curve

economies and of avoiding the costs of setting up manufacturing operations in another
country. Disadvantages include high transport costs, trade barriers, and problems with
local marketing agents.

7. Turnkey projects allow firms to export their process know-how to countries where
foreign direct investment (FDI) might be prohibited, thereby enabling the firm to earn a
greater return from this asset. The disadvantage is that the firm may inadvertently create
efficient global competitors in the process.

8. The main advantage of licensing is that the licensee bears the costs and risks of opening
a foreign market. Disadvantages include the risk of losing technological know-how to the
licensee and a lack of tight controlover licensees.

9. The main advantage of franchising is that the franchisee bears the costs and risks of
opening a foreign market. Disadvantages center on problems of quality control of distant
franchisees.
10. Joint ventures have the advantages of sharing the costs and risks of opening a foreign
market and of gaining local knowledge and political influence. Disadvantages include the
risk of losing control over technology and a lack of tight control.

11. The advantages of wholly owned subsidiaries include tight control over technological
know-how. The main disadvantage is that the firm must bear all the costs and risks of
opening a foreign market.

12. The optimal choice of entry mode depends on the firm’s strategy. When technological
know-how constitutes a firm’s core competence, wholly owned subsidiaries are preferred,
because they best control technology. When management know-how constitutes a firm’s
core competence, foreign franchises controlled by joint ventures seem to be optimal. When
the firm is pursuing a global standardization or transnational strategy, the need for tight
control over operations to realize location and experience curve economies suggests
wholly owned subsidiaries are the best entry mode.

13. When establishing a wholly owned subsidiary in a country, a firm must decide whether
to do so by a greenfield venture strategy or by acquiring an established enterprise in the
target market.

14. Acquisitions are quick to execute, may enable a firm to preempt its global competitors,
and involve buying a known revenue and profit stream. Acquisitions may fail when the
acquiring firm overpays for the target, when the cultures of the acquiring and acquired
firms clash, when there is a high level of management attrition after the acquisition, and
when there is a failure to integrate the operations of the acquiring and acquired firm.

15. The advantage of a greenfield venture in a foreign country is that it gives the firm a
much greater ability to build the kind of subsidiary company that it wants. For example, it is
much easier to build an organizational culture from scratch than it is to change the culture
of an acquired unit.

16. Strategic alliances are cooperative agreements between actual or potential competitors.
The advantage of alliances is that they facilitate entry into foreign markets, enable partners
to share the fixed costs and risks associated with new products and processes, facilitate the
transfer of complementary skills between companies, and help firms establish technical
standards.

17. The disadvantage of a strategic alliance is that the firm risks giving away technological
know-how and market access to its alliance partner.

18. The disadvantages associated with alliances can be reduced if the firm selects partners
carefully, paying close attention to the firm’s reputation and the structure of the alliance
to avoid unintended transfers of know-how.
19. Two keys to making alliances work seem to be building trust and informal
communications networks between partners and taking proactive steps to learn from
alliance partners.

17. Global Production & Supply Chain Management

This chapter explained how global production and supply chain management can improve
the competitive position of an international business by lowering the total costs of value
creation and by performing value creation activities in such ways that customer service is
enhanced and value added is maximized. We looked closely at five issues central to global
production and supply chain management: where to produce, the strategic role of foreign
production sites, what to make and what to buy, global supply chain functions, and
managing a global supply chain. The chapter made the following points:

1. The choice of an optimal production location must consider country factors,

technological factors, and production factors.

2. Country factors include the influence of factor costs, political economy, and national
culture on production costs, along with the presence of location externalities.

3. Technological factors include the fixed costs of setting up production facilities, the
minimum efficient scale of production, and the availability of flexible manufacturing
technologies that allow for mass customization.

4. Production factors include product features, locating production facilities, and strategic
roles for production facilities.

5. Location strategies either concentrate or decentralize manufacturing. The choice should

be made in light of country, technological, and production factors. All location decisions
involve trade-offs.

6. Foreign factories can improve their capabilities over time, and this can be of immense
strategic benefit to the firm. Managers need to view foreign factories as potential centers of
excellence and encourage and foster attempts by local managers to upgrade factory
capabilities.

7. An essential issue in many international businesses is determining which component

parts should be manufactured in-house and which should be outsourced to independent
suppliers. Both making and buying component parts are primarily based on cost
considerations and production capacity constraints, but each decision (make or buy) is also
influenced by several different factors.
8. The core global supply chain functions are logistics, purchasing (sourcing), production
(and operations management), and marketing channels.

9. Logistics is the part of the supply chain that plans, implements, and controls the effective
flows and inventory of raw material, component parts, and products used in manufacturing.
The core activities performed in logistics are to manage global distribution centers,
inventory management, packaging and materials handling, transportation, and reverse
logistics.

10. Purchasing represents the part of the supply chain that involves worldwide buying of
raw material, component parts, and products used in manufacturing of the company’s
products and services. The core activities performed in purchasing include development of
an appropriate strategy for global purchasing and selecting the type of purchasing strategy
best suited for the company.

11. Managing a supply chain involves orchestrating effective just-in-time inventory

systems, using information technology, coordination among functions and entities in the
chain, and developing interorganizational relationships.

12. Just-in-time systems generate major cost savings by reducing warehousing and
inventory holding costs and by reducing the need to write off excess inventory. In addition,
JIT systems help the firm spot defective parts and remove them from the manufacturing
process quickly, thereby improving product quality.

13. Information technology, particularly internet-based electronic data interchange, plays a

major role in materials management. EDI facilitates the tracking of inputs, allows the firm
to optimize its production schedule, lets the firm and its suppliers communicate in real
time, and eliminates the flow of paperwork between a firm and its suppliers.

14. Global supply chain coordination refers to shared decision-making opportunities and
operational collaboration of key global supply chain activities.

15. The depth and involvement in interorganizational relationships in global supply chains
should be based on the degree of coordination, integration, and transactional versus
relationship emphasis that the firm should adopt in partnering with other entities in the
global supply chain.