English for Economic Sciences

Communication is essential to life and imperative if business is to prosper and

survive in a competitive environment.
It can be:
Verbal – the written word
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 Oral - the spoken word
Visual – the illustration
Numerical – the written and interpreted number
Electronic – using a computer
Communication should be received and understood so we must ask ourselves
not what we want but what the audience wants.
The term communication skills covers a number of defferent areas, including:
-speaking clearly, fluently, convincigly.
-understanding and responding to non verbal communication(body language).
-Producing effective written communications, including briefs and
presentations.
In business life it’ s important not only to be efficient and do your job but also
to look and sound friendly, confident, sincere and helpful.
Poor communication is the cause of all breakdowns in business relationships.
When they try to communicate people go through different stages and the lack
of care at any of them lead to confusion and wasted time and energy.
1.The need or desire to communicate with someone else- aiming.
2.The translation of internal thoughts and feelings into an external means of
transmitting them as a coherent message- encoding.
3.The transmission of the message(spoken, pictorial, written, body language,
tone of voice, timing)- transmitting.
4.The reception of the message(how and why people listen)-receiving
5.The translation of the message to internal thoughts and feelings on the part
of the receiver-decoding.
6.The need or desire to respond to the message that has been sent(thinking,
feeling, planning internally, setting objectives)-responding.
A successful communication is meant to beware that the meaning of the
message is the responsibility of the sender first. Having decided what it is that you
need to communicate and whom you are going to communicate with, you then need to
consider the impact the information will have- will it alarm people, will it make them
more efficient, irritable, more comfortable, resentful, dafer, happier, bored, more
productive, better informed, more motivated, more loyal? The impact that your
communication will have on the productivity of your organization has to be a primary
concern mostly if you are the bearer of bad news or your message is concerned with a
change that will affect the working life of others. Think about the questions people
will need answers to, ask yourself what you would feel if you were to hear this for the
first time, decide just what you want your audience to do after you have
communicated with them, think about the actions and changes that your
communication will cause.
Then, you have to make your message of interest to the receiver. The more
you can personalise your communication to fit with the needs and interests of your
audience, the better that information will be received and acted upon. We have to list
the information that is to be sent and then prioritize the points into categories such as:
must know, important to know, helps understanding, gives examples, nice to
know, interesting but not important; this is important when communication is verbal
since it is linear and it moves the whole time; the listener is required to take part in
and remember all that was said. After organizing our thoughts we put them into words
and images.They are based on our internal dictionaries, assumptions, experiences,
education, mood. Clarifying the meaning comes next as sometimes words alone are
not enough to get the meaning when we deal with complicated concepts or spatial
information.

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 We think at least three times faster than we speak. It is easy to mishear, ignore
or miss a great deal of information. So, written communication is easier to focus on
because we can return again to parts that we need to consider carefully.

What impression do you try to give to the people you deal with in business?
• pleasant, sincere, efficient, confident, calm, honest, skilful, intelligent,
nice , polite.
• Unfriendly, shy, aggressive, sleepy, unclear, lazy, dishonest, clumsy,
stupid, inefficient, nasty, unhelpful, off hand, rude.
Asking questions is something people have to do a lot in business.

Decide what the questions are that led to each of these answers :
1.Yes, thanks I had a very good flight.
2.I’d like to see Mr. Barry if he’s in the office.
3.On my last visit I spoke to Mrs. Helen.
4.It was Mr. Weber who recommended this hotel to me.
5.I think I’d like to see round the factory after lunch.
6.No, my husband is traveling with me. I’m meeting him later
7.We’ll probably be staying till Friday morning.
8.No, this is his first visit; he has never been here before.
a.Did you have a good flight?
b.Who would you like to see?
c.Who did you speak to last time you came?
d.Who recommended this particular hotel to you?
e.When would you like to see round the factory?
f.Are you traveling alone?
g.How long are you planning to stay?
h.Has he been here before?

Imagine you’re having dinner with Mr. Johnson who is visiting your country
for the first time.

Write down ten questions beginning like this:

 Are…?/Is…?
 Do…?/Does…?/ Did…?
 Have…?/Has…?
 Who..?/When…?/Where…?
 What…?/ Why…?
 How many...?/How much…?/How long…?

What do you consider difficult and/or enjoyable about talking to:

• Someone you’ve never met before?
• A superior or someone who could influence your future career?
• Someone who is considerably older than you?
• A foreigner?
• A member of the public?
• What experience did you have with a public person?
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 • What does the meaning of a message depend on?
• How do you respond to change?

Principal Comunication Media

Written Oral/Aural
Internal External
Memoranda
Notices
Bulletins
Agendas
Minutes
Reports
House-journals
Contracts
Handbooks Letters
Circulars
Invitations
Estimates
Quotations
Advertisements
Orders
Invoices
Statements
Export documents
Promotion literature
Press releases
Articles
Reports
Information
Booklets Face to face-encounters

Interviews
Briefing sessions
Seminars
Workshop
Meetings
Conferences
Telephone
Teleconferencing
Intercom
Public address system
Radio

The Principal Communication Media

Visual/Physical Telecommunication/
Technological
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 Charts
Diagrams
Graphs
Photographs
Slides
Films
Television
Video

Overhead projector Models

Conveyer belts
Messenger/
Courier services Telex
Tele text
Facsimile transmission

Electronic mail
Voice mail
Videoconferencing
View data
Wide area networks
Cellular radio/
Telephone
Cable television
Satellite transmission

MY EVERYDAY ACTIVITIES

I start work at the same time every day.

I wake up only when the alarm clock strikes.
I go to work by car/ underground/ I walk
I work overtime and have very short breaks.
I am never late at work. I am always in time.
I do not complain about my work.
I like my job and my boss.
I hate cigarettes and coffee.
I share my office with a smoker who is…my husband.
I get a lot of important calls.
I attend meetings and I talk with people.
I ask questions and I give answers.
I take decisions, I negotiate.
I reach agreements, I create a climate of co-operation or expectation.
I work with money. I know that it bewitches people.
People fret for it, swear for it, devise most ingenious ways to get it and to get
rid of it.
I work in the banking system/accountancy/management/trade/
I operate with consumer/ market/ current/ overhead/ top/ bottom/
ceiling(maximal) flat(unic)/floor(minimal)/closing(la inchiderea bursei de
valori)/fair(convenabil)/ force account rate(de regie)/knock out(derizoriu)/
upset(initial, de pornire))/ price

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 I operate in a Stock Exchange with securities: marketable(usor
realizabile/quoted/unquoted
I operate with : bearer bond-(obligatiune la purtator)/irredeemable bond
(neamortizabila)./registered bond-(nominativa)/junk bond-(riscanta, cu evaluare de
credit scazut).
I operate with shares: preference/ ordinary/deferred/forteited/ in trust.
I do market research and I check the mercurial(fluctuanta)/ sluggish(activa)/
sagging(in scadere)/steady(stabila)market.
I direct the sales for future delivery(vanzare la termen)
I talk about costs: flat(uniform)overheads(indirect)sunk(investit)capital(de
investitie).
I chair meetings and take the floor.
I order a cake as I like to eat sweets.
I go home late in the evening, very tired.
I have supper and I eat some fruit.
I listen to the news on TV.
I go to bed and I have nice dreams.
I relax on weekends: I go shopping, I watch TV, I go to picnic, I breathe fresh
air, I chat with my friends, I rest in the countryside, I get away from the noisy and
dusty town, I listen to music, I cook, I read the latest books, I meet my friends, I drive
my car.

Are you in control of your life?

I am keen on my job, enthusiastic, bursting with energy, confident with

myself. I love new challenges, I analyze problems methodically, I am an objective
thinker, I am friendly, highly trained, well informed, generous, easy going, polite,
Sometimes I am boastful, uncertain, embarrassed, moody, annoyed, bored,
lacking confidence, reluctant, incomprehensible
I often feel that I am at the mercy of outside forces beyond my control.
I often feel that life is passing me by.
When people praise my work I believe that usually they really mean it.
I have at least one habit that I can’t break.
I think it’s a waste of time planning ahead because something always turns up
which makes me change my plans.
I often dream about work problems.
I have at least three important leisure interests or hobbies that have nothing to
do with my work.
I often refuse my friend’s invitations because I have too much work to do.
When I read newspapers my mind keeps wandering back to work problems.
I enjoy meeting new people.
I like to be successful in my job
I want to know as much as possible about customers.
I never believe only in luck.
I don’t like outdated and inefficient things.
I admire smart people
I enjoy discussions and to hear other people’s opinions.
I find it easy to choose rich colour combinations in clothes, furniture,(yellow-
happiness, fulfillment, positive thoughts, creativity, orange-positive energy, well
being, blue-infinite power, balance, wisdom, red-courage, determination, energy, ..
I make important decisions based on what looks best to me, on my feeling and
intuition. I think of myself as someone who dresses sensibly, neatly, tidily.
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 I like to share attitudes and values with my partner.
I like to meet the highest demands and standards.
I consider signs important in life:nr.1.-creative power, unity, nr.2-balance,nr.3-
the Trinity,nr.4-order, nr.5-the figure of man, nr. 6- universal harmony, nr.7-cosmic
order, nr.8-the initiated one,nr.9- eternity…

What are your weaknesses ?

I am inexperienced, too enthusiastic. Not very confident in using the
computers, shy, not a very good communicator.
Sometimes I have no direction in life, I feel like getting lost.

Do you agree or disagree?

1. whatever reason people have for living together, it is a private matter.

2. couples need support of other families, of society.
3. young passions die and interests change.
4. rooms reflect our personalities and colours too.
5. man is confronted with possibilities or alternatives on the basis of
which he can project his life.
6. we are left with the freedom of choice as long as we consider
experience never limited and never complete.
7. we will always search for temporary solutions, we will always move
away from the values and authority of the older generations.
8. relationships will always remain incomplete even if with wonderful
moments.
9. we create versions of reality out of our desires and when they clash
with the external world they disappoint us.
10. we become complete when we assume the responsibility for our own
lives.
11. if we fail to look into ourselves we remain fragments, unsatisfied,
incomplete, empty.
12. never look into the past in order to find out how to live in the present
but always make the effort to find a new direction in life.

13. some of us fill the gap in our life by the help of traditional values and
yearn for the stability and security of marriage, others respond only emotionally being
“prisoners” of impulses, following a logic of the soul.
14. if given a solution, we face reality and act6 creatively in terms of our
own powers and we answer the most important questions in life.
15. sometimes we live out an illusion all our life and realize that the
workings of fate are enigmatic. We get strength when we cooperate with it as we live
in an universe of oppositions where the vertical has to return to the horizontal.
16. sometimes human suffering is far from remedy and we find the
ordering of existence meaningless so that we come to doubt our own doubts.
17. sometimes we are too intellectualized and the intellect threatens and
stifles the life of feelings and emotions.
18. the awareness of our divided nature has constantly unsettled us.
Despite such a divided nature, we still manage to preserve our balance.
19. our attempts range from the ridiculous to the sublime to cross even if
only in dreams, the boundaries of existence.
20. even if our illusions are swept away, we prefer life’s restlessness.

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 The Interview

Fashions seem to change quite rapidly in interview techniques and the only
rules that applicants should be aware of may be “expect the unexpected” and “be
yourself”.
In different countries, different trades and different grades, the salary that goes
with a job may be only part of the package: perks like a company car or cheap
housing loans, bonuses paid, company pension schemes, generous holidays, flexible
working hours may contribute to the attractiveness of a job.
Everybody has to go through interviews to be offered a position. Recruiting a
new member of your staff is likely to be the most expensive decision you will make as
a manager. If you do it right you can make a fortune for your company. Most
managers inherit a team of workers who know what they are supposed to do, who
know something about your company, about the way your team works, about your
customers, about the business processes within the department.
What happens when you bring an outsider in to this situation? Some of the
possible outcomes if you do it wrong are:
-you and your staff spend ages helping the new team member to get started.
-Your team norms are threatened and possibly changed.
-You discover that the perfect qualifications on the new employee’s C.V are
no more than hype.
- You discover that the new employee is not fit for what you want.
So, the recruitment process has to take into consideration the following:
a) job advertisement
b) C.V
c) The interview
Both parties the interviewer and the interviewee have to communicate
effectively: open questions, right answers, positive opinions.
A job appraisal interview is one of the major tasks of the leader of a team of
people. It enables to: plan the future, look at individual performance, discuss and plan
training and development needs, contribute to company career planning, salary
planning and job progression, evaluate the efficiency of past targets and goals,
establish priorities, identify, assess, solve problems, look at resourceful needs.

Job appraisal needs to be systematic if it is to be of any use. All

effective managers have day to day or week to week contact with their team, they will
also be running up dating sessions where they inform the team of corporate, market or
local changes in working, policy or law and any changes that affect the workings of
their teams. These are day to day tasks of management. The job appraisal interview is
an opportunity for the team member and their manager to think about the future
months in an organized manner. Before an appraisal they both have the opportunity to
think in depth about what they have been doing and where this will lead in the future,
where the success and shortfalls are, and what objectives they will set each other in
the future.
Applying good communication practices to the appraisal process will ensure
that career progression has the best chance of success from the point of view of both
parties.
Interviews really aren’t out to trap people. They evaluate people, they know
how to assess your qualities.

Characteristics to have a successful interview :

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 • Be neat and well groomed.
• Be natural, friendly, relaxed but not sloppy or overly casual.
• Be interested in the work involved in the job.
• Have definite vocational goals.
• Articulate the goals you have in mind.

Attention to:
1.What to wear! Inappropriate clothing or
being late can cost you the job.
2.What to bring to the interview! Select those items from your
background that demonstrate what employers look for.
3.How to act. Sit straight, don’t mumble,
look at people when you talk, don’t smoke.

Parts of an Interview

I. The Opening (2-5’)

The interviewers will set you at ease. They will open with easy questions
about your major interests or by telling you about the job of the company.
II. The Body (10- 20’)
You should expect questions that give you the opportunity to show your
strong points and of course to raise questions.
III. The Close (2- 5’)

The interviewer will tell you what happens next.

Possible Interview Questions:

1.Tell me something about yourself.

2.Why do you want to work for us? -state your qualification
-state things that separate you
from other applicants
3.Did you have any accomplishments? -pick up one or two which you
are proud of.
4.What is your class rank? What University did you graduate?
5.Where do you see yourself in 5 years?
6.What would you see as the ideal job for you?
7.What do you know about our company?
8.What are your interests outside work?
9.What are your strengths and weaknesses/ shortcomings ?
10.When did you last lose your temper?
11.What is the best idea you have had lately?
12.What is your worst fault and what is your best quality?
13.How long do you think you would stay with us if you were appointed?
14.What makes you think you’d enjoy working for us?
15.Why are people unlucky or unsuccessful in getting jobs?
16.If you were me what other questions would you ask?
Attention: -Don’t focus on salary. -Draw the attention that you’ll
work hard with loyalty.

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 • Why are people unlucky or unsuccessful in getting jobs?
Imagine that a friend of yours is about to attend an interview. Write at least ten
pieces of advice that you would give him. You have as suggestions:
1. Wear smart, formal clothes
2. Don’t smoke
3. Sit up straight
4. Arrive on time
 Find out about your partner’s career.
Ask about:
-present job
-work experience
-education and training
-ambitions and prospects for the future
-its rewards and frustrations

 Discuss how the impression you may give especially to a foreign can
be affected by:
a) Your expression ( smiling, blinking, frowning, looking down, looking
straight in someone’s eyes…)
b) The noises you make ( sighs, yawns, knocking loudly or softly at a
door, clicking a ballpoint pen…. )
c) Body contact ( shaking hands, touching…)
d) Body language ( crossing your arms, sitting up straight )
e) Clothes and appearance ( hair, make up, suit, tie )
f) What you talk about ( politics, business, sport, family )
g) Your tone of voice (sounding cool, friendly, familiar, serious )
 Find out about your partner’s career.
Ask about:
1. Present – its rewards and frustrations
2. Work experience
3. Education and training
4. Ambitions and prospects for the future
 Employees are often given a “progress interview” some
months into a new job, so that they get feedback on their performance
so far. Participants on training courses often take part in similar mid-
course interviews too. Make a list of ten questions that might be asked
at such an interview in your firm. Here are some examples:
 What have been your most valuable experiences with us so far?
 Which parts of the course have been least valuable to you?
 What particular difficulties have you had?
 How will do you get on with the other members of the staff?
 Try this quiz with a partner.
1.Which is the best definition of good conversationalist?
a.Someone who always has plenty to say.
b.Someone who has plenty of amusing stories to tell.
c.Someone who will listen carefully to what you have to say.
d.None of them ( give your own definition. )

2. If someone just says “what?” after you’ve carefully explained something,

do you …
a.Go through the explanation again using different words?

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 b.Feel that you have been wasting your time?
c.Feel that you have not been believed?
d.None of these.
3. If someone always looks you straight in the eye this means that he is:
a.Honest
b.Rude
c.Friendly
d.Trying to frighten you
4. If someone shakes your hand very hard and long, it means:
a.He is very pleased to see you.
b.He is trying to show you that he is sincere.
c.He is waiting for you to say something
d.He is reliable and friendly.

5. If a man wearing jeans and no tie comes into your office, do you think he:
a.Isn’t correctly dressed?
b.Can’t be important?
c.Is quite normal?
d.Is someone who has come to fix the electricity or something?

6. If you are meeting an Arab client it is polite to:

a.Get straight down to business.
b.Wait until he raises the topic of business.
c.Stick to small talk for the first few minutes.
d.Ask him to close the door of his office to prevent interruptions.
7. If someone smiles while you’re explaining something, this means he is:
a.Not sincere.
b.Happy.
c.Not listening.
d.Crazy.

Managing our Time

Are you a busy person?

Are you crowded by events?
Do you make your life manageable?

Well, time may be infinite, but each of us has a finite allocation: time is
something you can’t increase or decrease. As far as, no matter how clever you are,
how wealthy, how industrious, you still get 24 hours every day. What you need to do
is to carefully manage the time you have got putting it to the best use possible.
Before you can save time you have to spend some. You have to understand
time management and make a little effort to do things like: plan, organize, review,
rearrange, sort, think.
Can you invest time in time management?
Well, most of the words commonly used about time are money orientated:
buying, losing, saving, spending, wasting time. Time becomes important because you
can use it to make money but…no amount of money can buy you one extra second of
time; time becomes more valuable the less of it we have: it is like most commodities.

Good time management can:

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 • give you more time to do what you want
• improve your availability
• improve your decision making
• improve your health
• improve your productivity, efficiency, effectiveness
• make you easier to live with
• make you easier to work with
• make you feel more relaxed
• minimize the risks you take
• reduce stress
Good time management is about setting limits for:
*availability (how willing you are to be disturbed, to make yourself available)
*duration (how long you spend doing things)
*importance (how you prioritize things)
*involvement (how much you do yourself as opposed to delegate to others)
*standards (how well you do things)
*urgency (how quickly you do things)

Why are interruptions urgent?( when the phone rings or on there is someone at
the door)
Do you treat all work for a particular person as important?
Do you check how important something is when you receive work?
Do you limit your involvement in things?
If we aren’t perfectionists what standards do we set?
Is it important to give priority to things that are non urgent?
Do you agree with the following statement? : “you need to spend your time on
actually doing things, not being busy.”

! So, you can spend time doing the right things, doing what you like doing,
doing what you’re good at, achieving things not just being busy.
! Then, setting goals is something that we must do because they increase our
motivation, raise our self confidence, help us achieve more, improves our
performance, increase our satisfaction, improve our concentration.

Which would you choose?

• creative (decorate your house, landscape your garden, write a book….)
• career ( become a manager, gain a pay rise, work part time…)
• educational (gain an extra qualification, learn a language, read more..)
• family (get married, spend more time with the family, visit your
relatives more often…)
• financial (save at least 100$ every month, reduce mortgage payments,
repay debts and credit cards…)
• mental (accept your faults, be more sociable, control your temper
more, stop criticizing..)
• physical (cut down on junk food, lose weight, reduce tea and coffee,
stop smoking…
• social ( have friends round once a month, read more, start a hobby,
take a long weekend twice a year and go away..)

Discussion points:
1. Consider your personal goals and make a list of these. Do any of them
conflict with your work goals? If so, which is the most important to you?
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 2. Are you aware of your own limits? Which are they?
3. Do you set unnecessary high standards, do you aim for perfection?
4. Where do you belong to: the optimist, the perfectionist, the rebel, the
socialite(important persons) , the worrier? Do you agree with the following:
- being too optimistic is being unrealistic
- optimists are good starters of work but poor finishers.
- perfectionists often take so long to do something that its value is
reduced; they set impossibly high standards and then set about achieving them.
- rebels set their own deadlines with no reference to others; relish(enjoy)
crises and problems as they can overcome these to show how much in control they
really are; they are good finishers but poor starters of work.
- socialites like to be involved with people; they like to talk, to gather
information.
- the worriers never seem to develop confidence in their own ability;
they may avoid certain types of work as they worry of not being able to do it.

The world would be a very simple place indeed if it were an easy matter to
analyze what sort of person someone was, and to handle them accordingly. It would
even be simpler if there were definite types of persons. But they aren’t. In time
management terms two types of people cause the majority of problems and they are
at the two extremes: perfectionists and procrastinators. Both tend to achieve less in a
longer time.

Perfectionism can be a good thing: society has long valued accuracy, attention
to detail, low error rates. But it can actually interfere with your progress and work, to
the overall detriment of your work. Trying to be perfect can stop you feeling satisfied
and motivated.
Recognizing perfectionism:
• all or nothing thinking or black and white thinking. There is always
one right answer if only you can find it.
• being afraid of disapproval
• being afraid to make mistakes
• being over sensitive to criticism and the opinions of others
• constantly looking for a mistake or slip up
• difficult personal relationships
• difficult keeping things in perspective
• equating failure with being worthless
• expecting too much of others
• feeling that what you achieve is never enough
• living life with a set of rules: a life full of “shoulds” and “mustn’ts”
• never feeling satisfied with anything you have done
• putting off completing work to improve it or get it just right
• valuing yourself based on what others think of you
Working with perfectionists:
• ask them to help you set your goals so they can see how others
motivate themselves and think
• be approachable, so they encouraged to admit mistakes and not cover
them up
• be careful of rewarding over achievement
• check that they are progressing in the right direction; stop them
focusing on quality at the expense of getting the job done
• discuss your own mistakes openly and constructively
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 • encourage them to set goals based on past performance not their best
hopes
• help them set goals and make sure they are realistic
• let them know what standard is required
• never laugh at them for lack of success or making mistakes
• openly discuss priorities
Procrastination (postponement) is like perfectionism- it’s faulty thinking and
feelings; you are being dishonest to yourself when you say lies such as “I’ll do it after
this cup of coffee” and you know that you won’t.
Recognizing procrastination:
• accepting low standards
• being easily distracted
• dawdling
• getting side tracked
• ignoring things in the hope they will go away
• “just one minute’ syndrome”
• low priority tasks get in the way of high priority ones
• putting things off until later
• underestimating the effort or time needed to achieve a task
• waiting until you are in the mood

Working with procrastinators:

• compliment and encourage them when they do make progress
• don’t let them get distracted
• don’t laugh at their putting things off
• help them break down large tasks into phases or sub tasks
• monitor their progress and let them know they are being monitored
• reward them for progress
• set deadlines

Discussion points:
1. Can we understand the causes of perfectionism?/ procrastination?
2. Do you impose your high standards on others?
3. Do perfectionists lose track of the deadlines?
4. Look carefully through the signs of perfectionism. How many can you
see in yourself? How can you work on this situation? What about procrastination?
5. What is the impact of fearing success, failure, the unknown? Can it
become a cause of procrastination?
6. What do lack of information, of motivation entail?
7. How can you work on your weaknesses?

Little perfectionism can work wonders. But it isn’t normal thinking; it is faulty
thinking. Beliefs and feelings are inaccurate; appropriate working is far more valuable
than perfectionism to any company.

The Job I Like

People have always worked. So they have had different occupations along
centuries.
All professions require much training, learning and responsibility.

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 To get a job it’s not enough to be good, but you must convince others that you
are good.
You have to manage your own work easily, to be flexible in any situations, to
come up with new ideas to inspire confidence, to have well established priorities, to
be a good team player.
More and more people have part time jobs such as: babysitter, waiter/
waitress, shop assistant, paper boy, taxi driver .Among the advantages of part time
jobs there might be:
 -the sense of financial independence
 -self reliance
 -getting to know other people
 -stronger links to real life

There are jobs in all the fields of human activity:

Industry :
o Worker
o Foreman
o Technician
o Engineer
o Economist
o Mechanic
o Computer operator
Services
• Carpenter
• Potter
• House painter
• Blacksmith
• Glazier
• Locksmith
• Chimney sweeper
• Cooper
• Plumber
• Electrician
• Dustman
• Watchmaker
• Dressmaker / tailor
• Shoemaker
• Cobbler
• Hatter
• Receptionist
• Milliner
• Furrier
• Seamstress
• Barber
• Hairdresser
• Dyer
• Dry cleaner
• Waiter/ waitress
• Cook
• Typewriter
• Accountant
• Clerk
15
• Designer
Law
 Judge
 Prosecutor
 Lawyer/ solicitor
 Notary
 Clerk of the court
Education and culture
 Writer
 Printer
 Publisher
 Bookseller
 Bookbinder
 Journalist
 Producer
 Playwright
 Stage manager
 Actor/ actress
 Painter
 Librarian
 Singer
 Dancer
 Musician
 Composer
 Conductor
 Sculptor
 Teacher
 Philosopher
 Linguist
 Critic
 Priest
 Cameraman

Commerce
 Shop assistant
 Butcher
 Baker
 Greengrocer
 Salesman
 Grocer
 Confectioner/ pastry cook

Transport and telecommunication

 Driver
 Sailor
 Railway man
 Airman
 Postman
 Phone operator
 Telegraph operator
 Air hostess

16
 Construction
 Architect
 Planer
 Bricklayer
 House painter

Agriculture and forestry

o Farmer
o Forester
o Agronomist
o Woodcutter
o Winegrower
o Fisherman

Health
• Physician
• Surgeon
• Oculist
• Dentist
• Chemist
• Nurse

Other jobs
 Policeman
 Fireman
 Officer
 Soldier
 Custom officer

I. Answer the following questions:

1. Who are those making and repairing things?

2. Advantages and disadvantages of the teaching profession?
3. What does the medical profession require?
4. What do computer operators do?
5. Whom does the profession of arms include?
6. What could the ideal job be?
7. What qualities would somebody need for the following careers: police
officer, politician, journalist?
8. Explain what a part time job means?
9. What are the qualities that business people look for when they want to
employ someone?
10. What will you look for in your future career?
II. Find out the correct definition for:
a. Accountant
b. Civil engineer
c. Computer operator
d. Babysitter
17
e. Stevedore
f. Economist

1. An engineer involved in construction

2.An expert in economics
3.A person qualified to keep a company’ accounts
4.A person who works in the docks loading and unloading goods
5.A person who translates information into a form computers can understand
6.A person paid to look after a baby

III. What careers are the following qualities needed for?

Determination Curiosity Skill

Patience Shrewdness Tenacity
Inventiveness Ability Courage
Faith Tolerance Perceptiveness
Self-denial Physical appearance Modesty

IV. Match the following columns containing interest jobs

1. scientific a. plumber
2. artistic b. nurse
3. practical c. accountant
4. welfare d. academician
5. computational e. novelist

V. What are the things you should do or shouldn’t do if you want to get a job?
2) Find out as much as you can about your future job.
3) Sit down immediately when you enter the room.
4) Be careful about the clothes you wear.
5) Make sure where the interview is since you should always be
on time.
6) Stress poor aspects of yourself.
7) Have a light meal before you go to the interview.
8) Have a drink; so you will pluck up courage.
9) Bring your school certificates or letters of introduction.
10) Smoke if you like.
11) Criticize your last boss.

VI. Describe your ideal boss:

• Strong/ weak personality
• Very ambitious
• Easily adapting
• Good organizer
• Modest
• Funny
• Well informed
• Efficient

What do you think of the following situations?

1. You don’t like your boss.
18
 2. You think your boss is rubbish.
3. The boss is picking on you personally.
4. Your boss is prejudiced against you.
5. Your boss seems to think you’re permanently on call.
6. Your boss is having a tough time and is taking it out on you.
7. Your boss takes credit for your ideas.
8. Your boss blames you for their mistakes.

VII. How important are each of the following to you in providing you with job
satisfaction?
 Challenge
 Meeting people through work
 Security
 The respect of colleagues
 Working conditions
 Status in your organization
 Learning something new
 Personal freedom
 Exercising power
 Helping other people
 Being promoted
 Making money
VIII. Advertisements for jobs vary considerably in style. There are advantages
and disadvantages in using the dynamic style.
Imagine that you are interested in applying for a job. And you have come
across the following advertisement. Read the advert and write two more.

Sdk International
Has an immediate career opportunity in your city:
SALESMAN
Candidates should have excellent verbal communication; skills in both English
and Romanian, strong personality and creativity and age should be under 30.
Please respond in English with your CV and Letter of Application to Sdk
International Romania CP 129 OP 16 Bucharest

Read the advert and write two more.

IX. Write a Letter of Application having the following as model:

Dear Sir,
With reference to your advertisement in the Adevărul of October 23 I’d like to
apply for the job
I’ m 26 years old and I have graduated a course in Economics and Law.
Last summer I acquired some professional experience working in the
accountancy department of an office automation equipment company.
I am fluent in English, German and French.
I am not married and I can work on weekends too.
I enclose a CV and hoping that I will suit your requirements I look foreword to
hearing from you.
Sincerely
Adrian Voicu

19
 X. A CV is essential if you are applying for a new job or for promotion; it
usually accompanies a letter of application.
Name
Address
Telephone
Date of Birth
Age
Nationality
Status
Education:
School
College
University
Results obtained
Post school qualifications
Post graduate qualifications
Languages
Experience/ achievements
Interests
Published works
References

How Can you Manage Difficult People?

At work and in our leisure time we are often confronted by difficult people
and awkward situations and they seem to come at us from every angle. How can we
cope? People do not change easily.
20
 What is a difficult person? In general they are people who demonstrate bad
behavior, who don’t care how their behavior affects others and who even use it to
their advantage.
Being difficult is effective because it works but in the short term. Long term
relationships need a greater complexity of behavior. Difficult people hope that due to
their behavior we will either start to give priority to their wishes or that you will leave
them alone.
Difficult people are not restricted to the workplace. Working relationships
have few emotional ties and are more detached whereas within the home environment
lurks a complex web of history and emotions.
When you deal with difficult people effective listening is very important; you
must be able to tune in to what he/she is trying to tell you. A good listening means: to
hear the message- genuinely listen to what is being said; to interpret the message- to
take in all aspects of body language, tone of voice and interpret their significance; to
evaluate the message; to respond to it.
It is not always the people that are difficult but sometimes it is the situation.
Working relationships and environments bring together a whole host of situations for
which you cannot always prepare. At some point in your career you will have to deal
with difficult situations. They come up at the workplace. Difficult colleagues create
added pressure.
Then, conflict can hardly be avoided. You also have to cope with difficult
managers and with difficult staffs.
Difficult people and awkward situations are everywhere; therefore, running
away is not really an option unless you want to live a hermit for the remainder of your
days. So, a far better strategy is to learn to deal with such situations; this does not
mean being weak or let everyone take advantage of you; it means having some firm
strategies for dealing with people and situations.

Advantages:
-the ability to work with all people
-being known as a person who can get things done
-being seen as flexible and someone who can “deliver’ whether that be
projects or products.
Disadvantages:
- being restricted as to whom you can work with
- being seen as weak and ineffectual and being given a wide
berth(mostly in times of promotion)
- being thought difficult yourself owing to your inability to work
effectively with others.

Answer the following:

1. Where do you encounter difficult people most?
2. How can you achieve a responsible and effective working relationship?
3. Are difficult people at work fixed in your life?

21
 4. Do you find that life will become easier each time you deal with a
difficult situation?
5. Who are the people at the top?
6. Is it still possible to bully people into doing what they want?
7. What kind of people are the negativists?
8. How important is body language?
9. Do teams need to celebrate success?
10. How can you win people’s respect and your own peace of mind?
11. How important is the environment when you deal with difficult
people?
12. How important is timing in tackling a situation?

Action Points
1. Think of three things that you could do now to make you feel more
confident about your ability to tackle the next difficult person or situation which
comes along.
2. Make a list of all the people you have difficult working relationships
with, then write one thing you like about them beside each name. Try at some point in
future to complement them on that one thing- it will build bridges for the future.
3. Reflect on the last time you were criticized by a colleague. How would
you handle that if the same thing happens again tomorrow? Are there lessons you
have learnt?
4. Think of three people who have displayed difficult behavior in the last
month. What did their difficult behavior have in common?
5. Have you ever seen anyone or been involved yourself in a bullying
situation at work? What could you have done to help or done differently?

The Media

It is impossible to imagine a modern society functioning without the media

which remains a powerful means of spreading news and information.
We want to get informed and the T.V., the press, the radio have turned out to
be great transformers of minds or society.
•Answer the following questions.
I. Which of the media provides most of your:
a.) International information.
b.) National information.
c.) Local information
d.) Entertainment
II. If you had to rely on only one of the media, which would you choose ?
Why?
III. You’ve heard about a local radio program in which ordinary people are
interviewed about their lives and opinions. Each week there is a different theme e.g..
Fear “my most frightening experience”
Achievements “the proudest moment of my life”
Disasters “the worst holiday of my life”
Leisure “my hobby is so important to me”
Add possible themes for the next programs.
Do you classify the news when you listen to or watch it?
Do you prefer listening or watching the news?
IV. List the negative effects of T.V.
22
 V. Mention some of your favourite T.V programs on T.V
You may refer to:
-documentaries
-soap operas
-bulletins
-topics
-broadcast
-commercials

•Answer the following questions:

1. Is T.V. a great transformer of minds or society?
2. Do you remember much from a T.V. documentary?
3. Can you name some ideal subjects?
4. Do you think that a night’s viewing is wonderfully forgettable?
5. Is T.V. harmful to children?
6. What effect does quantity of viewing have on people?
7. What is the most interesting documentary you have seen?
8. What do soap operas have all in common?
9. Are the news always interesting?
10. What topics do you prefer?
11. What happens when you watch a boring film?
12. Can you name some commercials that you liked most?
13. Do you watch politics?
14. Are you better informed after watching T.V.?
15. Do you consider that some subjects are out of place/

The Press

The newspaper remains a powerful means of spreading news and information.

The purpose of the press is to publish news and give information on politics,
finance, economics, arts, theatre, science.
Apart from the ideological difference, there is also one in the way they are
designed.
We read newspapers, magazines, revues, journals.
There are daily newspapers, weekly, monthly newspapers quality and popular
newspapers.

The newspaper:
-instructs
-informs
-reports
-caters
-entertains.
A newspaper article is based on:
1. a discussion
2. a description
3. a narrative or a combination of more than one of these.
The backbone of an article is:
a) headline/ heading opening
b) paragraphing
c) quoting
23
 d) ending
Journalists aim at covering five W’s and an H( who, what,when,where,
why,how) about the event.
Newspaper columns express opinions. Writers contributing to them are
famous and influential and they adopt their own style. They say that a column can be
appreciated after reading it in order to understand the attitudes of its author.
Popular headlines frequently use slang and punning references to an article’s
content while quality newspapers tend to provide more information in their headlines.
Both types of newspaper use common jargon words to save space.
Look at the headlines and chose the correct answer:
Day the jailbirds came out in sympathy
1. prisoners
a) were extremely co-operative
b) planned an escape from jail
c) supported a strike
d) were released from jail
Lazy’ doc gets a rap
2. The doctor has been
a) Criticized
b) Sued
c) Fined
d) Dismissed
Shoplift slur on Doris, 72
3. An accusation of shoplifting has:
a) Made an elderly woman furious
b) Made an elderly woman confused
c) Damaged her reputation
d) Damaged her health

•Answer the following questions:

-Are you a great reader of periodical press?
-What sort of articles can a newspaper carry?
-What kind of newspapers do you know?

• Supply the suitable words:

A person -who sends news, articles, reports to a newspaper
- who looks through the manuscript of an article, corrects it, suggests, changes
and prepares it for printing.
-sets up type for printing
-who buys a newspaper, a magazine regularly
-who is engaged in publishing, editing or working for a newspaper.

But:
Whatever the T.V./ video industry might now say, television will never have
the impact on civilization that the written word has had.
The book – this little hinged thing – is cheap, portable, unbreakable, can be
stored indefinitely, can be written and manufactured by relatively unprivileged
individuals or groups, dozens of different ones can be going at the same time, in the
same room without a sound.

Advertising

24
 Advertising is the greatest art form of the 20th century. It may be described as
a science of arresting human intelligence long enough to get money from it. It
stimulates debate and sometimes controversy. It has a powerful effect on the human
consciousness as it is around us on television, radio, cinemas, newspapers and
magazines. The way we dress, talk and behave sends a message to other people. It is
about manipulating public opinion and getting a message across to an audience so that
they will behave in a particular way.
The advertising industry has been in existence since the end of the 17th
century when newssheets carried printed advertisements for products and information.
Merchants returning from voyages overseas needed to generate markets for the
products they imported and so they had to advertise. By the end of the 19th century,
advertising was big business. Advertisements dominated the newspapers, posters were
commonplace and spawned a whole art form. But the new communication technology
gave the industry its biggest boost. Modern advertising exploits every medium of
communication. We tend to think of advertisements in terms of the mainstream media
but we also have posters, billboards, point of sale displays, direct selling and cold
calling by phone and fax, the internet which taps into worldwide audiences.
If you work in advertising , you will for sure be part of an influential band of
people who can change public attitudes and behaviour.
The heart of this industry lies in the advertising agencies. The large ones are
multinationals with in such far flung places as Beijing and Buenos Aires. If you work
in a small agency, you may be expected to do everything, including account
management, client liaison, concept development, creative work. In a larger one, job
roles will be more structured. You will have a specific role and a greater chance of
more formal career development. Advertising agencies vary in the services they offer.
The most familiar names are full service agencies but there are also other companies
that specialize in media services or focus on particular areas of advertising, such as
recruitment or business to business advertising.

Business need to advertise so that we should learn of the existence of

different products.
Advertising is aimed at conveying information to potential customers and
clients.
Advertising is used to persuade the public to buy.
At the lowest level people need food, shelter, warmth and sex. Then, people
begin to think about personal possessions and finally we move on to egocentricity.
The ultimate need is for fulfillment. This would come when we have all that
the advertisers say we so desperately need. For most of us it seems that that day will
never come!
Sometimes advertisements are misleading. Advertisers shouldn’t make untrue
statements about their products but they so often do it. They create a demand which
would not otherwise exist.
Advertising goes far beyond T.V. and hoardings, newspapers and magazines,
they enrich our lives.

• Answer the following questions:

 What are the arguments for and against modern advertising methods?
Are there any controls which you think should be imposed on advertisers?

25
  Glamour and humour are two of the appeals which ads try to make for
us. What other appeals do they make?
 In what other ways, apart from advertising are we persuaded to buy
one product rather than another?
 How do national newspapers benefit from advertising?
 How can window dressing be seen as forms of advertising?

Arguments for advertising

 It tells consumers about the products that are available, allowing them
to make a wider choice.
 It encourages competition between firms.
 By creating a wider market for products it makes large scale
production and sales possible.
 Media would be more expensive without it.

Arguments against
 It is expensive.
 It can be wasteful, sometimes involving the same firm advertising
virtually identical products against each other. (eg. washing powder )
 It can be misleading.
 It can exert control over media.
 It can put pressure upon people to buy products that they don’t really
need or can’t afford.
Advertising media
 National newspapers
 Regional newspapers
 Consumer magazines
 Business and Professional Directories
 Press production costs
 Poster and Transport
 Cinema
 T.V, Radio
* Banners on Internet sites
Television commercials
 The most effective medium for reaching large numbers of people.
 They have to be brief.
But:
 They cannot be very informative and display images rather than
information.
 They are selective – it is hard to reach a particular group of people
except for certain programs.
Radio
-advertising is cheap and can be effective in reaching certain types of people:
old people and housewives.

National press
- it is expensive too but if has a large geographical selectivity and allows
detailed information to be given.
Magazines and trade press
It is a way of reaching a specialized group of customers.
There are magazines for almost any interest and for any type of product.
Posters and hoardings
26
 -Effective if good locations can be found.

Sales promotions
-They include free gifts, competitions, give away samples, special offers.
Sponsorship
-Of the arts, public works, sport can be very effective in putting a product or
company name before the public.
Packaging and display
-In shops; they maintain existing sales but also encourage first time buyers.
Here are some advertisements.
a. “when you can’t say good bye!”
b. “from here to eternity”
c. “you know the name. It’s the face you may not recognize”
Enlarge on them.
•Make an advertisement for:
a. a shampoo
b. a drink
c. a book
d. a restaurant
e. a sofa

 Write some adverts that promise:

 you’ll feel happier
 you’ll enjoy life more
 you’ll have a nice holiday
 you’ll be rich
 you’ll be famous

 Make an advert as the one below:

Friendly, humourous boy 20, not very good looking but funny, seeks nice girl
to go swimming, dancing, walking.

 Complete the following sentences using your own words:

 Advertising can help a business to …………………
 A good advertising agency will ……………………
 Although newspapers and magazines ………………
 One of the weaknesses of human beings is that ……
 It is essential that the packing of a product should be ………

 This is the information about a job advertisement:

Asian Monetary Institute

Computer Programmer in the Statistics Division
The successful candidate will have
 A University degree in economics or statistics
 Work experience in banking and financial accounts
 Fluent English and Mandarin
Applicants should send a C.V., a recent photo and references from previous
employers to the Asian Monetary Institute P.O. Box 6707

27
 • Answer the following
1. What is Hello: a magazine or a newspaper?
2. Which country in the world spends the most on advertising: U.S.A or
Japan?
3. Why is William Caxton famous: he produced the first printed
advertisement in England or in U.S.A. ?
4. How did the earliest advertising take place?
5. Who invented paper?
6. How do we promote ourselves?
7. When did TV advertising come to Britain?
8. What is advertising industry entitled to do?
9. What is the difference between small and large advertising agencies?
10. What does modern advertising exploit?
11. What do advertising campaigns bring?
12. What is business to business advertising?
13. What does concept development refer to?
14. How important is timing in advertising?
15. Which are the advantages and disadvantages of advertisements on
the internet?

Make an advertisement for:

1. Your Town and the Surroundings.
2. A Museum
3. A Car.
4. A Hypermarket
5. A Magazine
Enlarge upon the following:
“ More than a watch. A dream that has come true!”
“ It is not just a broken vase. It is the silence you feel when your shoppings are
being protected with the credit card.”
“ They are the snapshots of a challenge, they are always with us!”

Meetings

Managers spend a lot of time in meetings.

In fact they would argue “too much time” a meeting = the gathering of a
group of people for a controlled discussion with a specific purpose.
1. People should call a meeting
a) When decisions require judging rather than calculation or expertise.
b) When pooling ideas improves the chances of good decisions.
c) If ‘acceptance’ of the decision is an important consideration for
members.
d) To discuss multi-faced problems requiring different skills or
specialists.
2. Essential elements of a meeting:
a) A purpose
- problem solving
- idea gathering
- training
b) An agenda

28
 c) Members
-the chairman – presides the meeting.
-the secretary
-the other participants
d) A result (most resolutions are voted by a mere show of hands. For
important decisions, the so called “constitutional majority” is necessary, amounting to
two- thirds of the assembly.
e) A report, the minutes

Every meeting has an agenda. Whoever controls the agenda controls the
meeting. If the agenda is not made public, the meeting may be hijacked by private
agendas: the result will be confusion, frustration and failure. A written agenda allows
everyone to focus on what they are to do: before, during and after the meeting. It acts
as a plan of the meeting to aid preparation, an objective control of the meeting’s
progress, a measure of the meeting’s success. The responsibility for setting the agenda
is the Chair’s. The agenda should follow a natural shape: the most difficult items will
be placed in the middle third of the meeting, when the group’s physical and mental
alertness are at their peak. The easiest items can be put at the end. The agenda should
also reflect the thinking process that we wish to follow as problem solving, evaluation
of information and conflict resolution will need different approaches.
An agenda contains the following:
- title of meeting, date, time, venue, apologies for absence, minutes of
previous meetings, matters arising from the previous meeting, other items to be
discussed and decided, reports from subcommittees, contributions from guest
speakers, any other business, date, time and venue of next meeting.
Minutes are considered: a reminder of what happened at the meeting, a
basis for discussion of matters arising at the next meeting, a guide for non attendees, a
permanent record. Taking minutes involves two skills: listening and note taking. In a
society that communicates through visual images, listening has become a highly
complex skill. Most people will be thinking and speaking at the same time and
sometimes they will all be talking at once. Only a small proportion of the words we
use carries the information we wish to communicate. Most people surround their
thoughts with words which express feelings, attitudes to the listeners or their
relationship to the group.
You cannot listen and take notes at the same time; your primary task is to
understand what is going on: most of your time in a meeting should be spent listening.
You should take notes only intermittently. The trick is to be able to note down only
keywords but you have to be attentive to record information properly.
The minutes have to be written as soon as possible after the meeting and they
should follow the agenda exactly.

Opening a meeting

• Good morning ladies and gentlemen

• If we are all here
29
 -shall we start
-make a start
-let’s start
-I think we should start
• First of all I’d like to introduce
let me introduce

two colleagues from our Munich office

Would you like to say a few words about yourselves?
•Right, thank you.
•Have you all got a copy of the agenda?
•If everyone has got a copy of the agenda, let me first explain the purpose of
the meeting.
•The purpose / aim / target of the meeting is to …
•Now; let’s look at the agenda in detail.
•As you can there are 5 main points / items.
•I suggested that we take them in the following order.
•As we have a lot to get through this morning, can we agree on ground rules?
•I suggest the following ……
Moving to the first point
Handing over to another person
Bringing people in ( encouraging hesitant speakers ) “would you like to add
anything?”
Stopping people talking
 One at a time please!
 We can’t speak at once. John first, then Mary.
 Would you mind addressing your remarks to the chair?
 Could we have some other opinions?
 I think that’s clear now. We’ve all got the point. Shall we move on?
If you didn’t hear you can say:
• I’m sorry. Would you mind repeating?
If you didn’t understand you can say:
• I’m sorry. I don’t quite follow you. Could you go over that again?
If you feel the speaker is being vague or imprecise you can say:
• What exactly do you mean by?
Preventing irrelevance
•I’m afraid that’s outside the scope of this meeting.
• We lose sight of the main point.
• Keep to the point.
• I think we’d better leave that subject for another meeting.
Keeping on eye on the time
• We’re running short of time.
• There’s not much time left
• Could you please be brief?

Moving to the next point

• Let’s move on to the next point!
• Would like to introduce the next point?
• Well, I think that covers everything on that point.
Let’s move on!.
Controlling decision-making
• I’d like to propose that…
30
 • I’d like to propose the following amendment.
• Can we take a vote on that proposal?
• All those in favour. Right?
• All those against. Right?
• Well then we agree / with some reservations.
• Well then we agree / unanimously.
• Well it seems that we are broadly in agreement that…
Indicating follow up tasks.
• Do you think you could…?
• How about preparing some figures for the next meetings?
Closing
• I’d like to thank Mr. X & Y for coming over from Paris

Participating in a Meeting

1.Getting the chair’s attention.

• I’d like to comment on that.
• May I have the floor for a moment?
2. Asking for and giving opinions.
• I’m convinced that / sure / positive.
• I strongly believe that …
• I have absolutely no doubt.
• I definitely think that ….
• I really do think that …
• To my mind …
• As I see it …
• From my point of view …
• Am I right in thinking that …
• Would I be right …
• Don’t you think that …
• Are you absolutely sure / convinced / that …

Sample sentences
• In my opinion we shouldn’t rush into a long term agreement before
considering the implications.
• I tend to think that the loss of key personnel has damaged their confidence.
• Do you think that national advertising is the right way to launch our
products?

3. Agreeing and disagreeing

• I totally / agree with you / accept fully.
• I’m in total agreement.
• I’m in favour of that.
• Up to a point.
• To a certain extend.
• You may / could / be right but …
• That may be so, but …
• I can’t / agree / accept.
• I don’t /agree / accept.
• I can’t go along with …

31
 Sample sentences:
• I have talked to the foremen and they completely agree with the idea to set
up a quality circle.
• We are in agreement over the payment terms.
• I agree with Peter to a certain extend but I still feel that we are exposing
ourselves to unnecessary risks.
• I’m afraid we can’t agree to the terms in your latest offer. Please reconsider
them and get back to us.
• A productivity bonus for the workers? I totally disagree with that type of
incentive.
4. Advising and suggesting
• Shall we get started?
• Why don’t we move to the next point?
• Let’s postpone this till...
• I suggest we close the meeting.
• We should meet again next …
• Why don’t you present it at the next meeting?
• How about …
• I would recommend …
• It’s advisable to …
• He suggested that we analyze the threats and opportunities.
Sample sentences
• I don’t think we’ve got enough for all the points in the agreements.
• Why don’t we discuss point 4 at the next meeting?
• First you should do an audit of your present operations!
• The consultant suggested that we should focus on the threats to our business.

5. Requesting information and action.

• Can / could you tell me …
• Will / would …
• I’d like to …
• Do you happen to know …
• I wonder if you could tell me …
16. Write a complete report having the following as a model.
Report
Meeting held on 15 October 2000.
Location: Danavian Insurance Company, Stockholm
Present: Ulf Edberg (Treasurer, Denavian) self
Agenda: Letter of Credit Facility.
Client is not yet sure about company requirements for 2000.
Expressed worry, however, over the increase in our commissions and
estimates that this will cost Denavian three times as much as before.
Client pointed out that the counter value of SEK 800 million is deposited with
us. Currently pays 0.24% for outstanding volume of standby letters of credit but
changes will mean paying 0.75% flat on this amount. Requested that we look into the
possibility of setting up a trust found with Denavian’s securities. Volume of letters of
credit likely to fall quite heavily because of increased charges. I promised to
investigate the possibilities of setting up a trust fund and to contact the client early
next month with our outline proposals.

What do you think about the following:

32
 1. “Training and experience go hand in hand if we want to reach a high
level of responsibility in our career.”
2. “Managers spend too much of their time in meetings and they may
be sometimes too confident”.
3. “Don’t learn from books but from practice and make things
happen”!
4. “Team work and the know how offers you stability”.
5. ” Everybody has to be aware that competition makes us tougher
and more resourceful.”

Market

Originally it was a physical place where buyers and sellers gathered to

exchange goods and services.
To an economist, a market describes all the buyers and sellers who transact
over some goods or services.
A market is:
-the set of all actual and potential buyers of a product
-the set of buyers and an industry in the set of sellers.
1) Potential market – the set of consumers who profess some level of
interest in a particular product or service.
2) Available market – the set of customers who have interest, income and
access to a particular product or service.
3) Served market – the part of the qualified available market the company
decide to pursue. The company may decide to concentrate its marketing and
distribution efforts on Central and Eastern Europe.
4) Penetrated market – the set of consumers who have already bought the
goods.
If a company is not satisfied with current sales it can consider a number of
actions. It can try to attract a larger percentage of buyers from its served market.
It can expand to other available markets.
It can lower its price to expand the size of the available market.
It can try to expand the potential market by increasing its advertising.

Marketing

It is a creative management function which promotes business and

employment by assessing needs of the end user of products or services, initiates
research and development and produces products or services which can be profitably
provided to service market requirements. It coordinates the resources of production
and distribution of goods and services, determines and directs the nature and scale of
the total effort required to sell profitably the maximum production to the ultimate
user.
This is the process of:
-identifying
-maximizing
-satisfying consumer demand for a company’s products.
Marketing a product involves:
-anticipating changes in demand
-promotion of the product
33
 -ensuring that its quality, availability and price meet the
needs of the market
-providing after sales service.
Marketing can be split into four components:
1.research
2.strategy.
3.planning.
4.implementation.
Marketing and selling influence and control almost every part of a company’s
activities.
Marketing is customer rather than product focused. That means understanding
how everything about your product or service impinges on the customer. It is not just
the product itself that counts, but the way in which it is presented, delivered, repaired,
replaced. Marketing touches on many areas of product management; the marketing
department will be involved from the very beginning of a product’s life in
determining its image, deciding when, where and how it should be launched and
monitoring its success in the marketplace.
Market research is based on the idea that if you find the customers’ needs and
wants and then use the information to provide a package that meets these, then you
will be no doubt successful. There are two main types of research: desk (local library)
and field research (phone research, written questionnaires, street interviewing, face to
face interview, product tests, consumer panels, focus groups).
Marketing offers a range of career opportunities at different levels for people
who are interested in making things sell. In a large organization, the marketing
function will work in tandem with other functions, such as buying, logistics,
distribution, retailing. If this is the chosen field, then you will be working at the heart
of your company and will gain valuable experience.
Marketing staff may work on re-branding a product if it starts to loose
popularity or launching the product into new markets overseas.

All kinds of products and services are actively marketed these days, even
public services and monopolies.
Think of eight products ( goods and services ) that are produced or provided in
your city or region and answer the following questions:
• What competition does each product face?
• What is the image of each product?
• What is the image of the company that produces it?
Fill in the gaps using the words from the list:
profitable,. price, promotion, need, image, design, place, product, creative
process, satisfy.
1. What is marketing? Marketing is the ……….satisfying customer needs……
2.What is ’the marketing mix’? It consist of ‘the four P’s’: providing the
customer with the right P …. at the right P ……. presented in the most attractive way
( P…..) and available in the easiest way ( P……).
3. What is a product? It is something customers buy to…… a …….. they feel
they have. The ……. and the …… of the product are as important as it’s specification.
• How strongly or weakly is each of the products marketed?
• Where is each product advertised?
e.g.
a. A brand of beer or soft drink.
b. A grocery product.
c. An industrial product.
34
 d. A service
e. A place of entertainment
f. A public service
g. An educational service
h. A financial service
• What sort of questions are most useful in a sales meeting?
• What answer is each of these questions likely to provide/
• Which of the questions are likely to give more useful information?
Give your own examples.
#In marketing a product we should:
• analyze statistics
• conduct market research
• devise a questionnaire
• carry out a market survey
• consider the strengths and weaknesses
• devise a marketing strategy
•draft an advertisement
 Comment on the advertisements
•Iceland as nature intended
•Sweden refreshing
•Malawi the warm heart of Africa
# Make a list of five or more regions or countries that are in competition with
yours.
Design a questionnaire to find out about people’s attitudes to your region and
to its competitors.
The people you ask should rate each destination for its qualities on a scale 1 to
10:
Good value for money
Good entertainment
Friendliness
Culture
Easy to get to
Health and sport
Hospitality
Beautiful scenery
Peace and quiet
Uniqueness
Ask them to describe each place in one sentence like this:
“When I think of Sweden I think of cold winds and a flat landscape”
#The promotion of a product involves considering it as a “total product”; its
brand name, presentation, labeling, packaging, instructions, reliability, after sales
service.
Promoting a product involves developing a “Unique Selling Proposition”
( USP ): the features and benefits which make it unlike any of the competing products.
There are 4 stages in promoting a product (AIDA):
a) Attract the Attention of potential customers.
b) Arouse Interest in the product.
c) Create a Desire for its benefits.
d) Encourage customers to take good Action.
# Did you know that:
1) The world’s largest advertising agency is British Saatchi& Saatchi.

35
 2) The world’s greatest consumers of coffee are the Swedes. (8 kg per
person per year).
3) The world’s largest employer is Indian National Railways with 2
million employees.
4) 99% of all business is Japan and Switzerland employ an average of 15
people.
5) The world’s biggest manufactures of motor vehicles is Japan.
6) Over $1 billion a year is spent on advertising in the USA and the rest
of the world is over $1.5 billion.
7) The world’s largest airport is Jeddah (by area) or Chicago (by number
of passengers)
8) Most Japanese companies pay professional trouble- makers not to
cause trouble at their shareholders’ meetings otherwise the meeting is sure to be
disrupted.
9) The airport that handles the second largest number of international
passengers in the world is Gatwick. Number one is Heathrow.
10) The average person over 15 smokes, 1,750 cigarettes annually.
11) The world’s number one exporting country is Germany.
12) The world’s biggest restaurant chain McDonald’s serves about 15
million hamburgers a day at its 9000 restaurants.
13) The world’s largest food company is Nestle.
14) The world’s greatest and busiest port is Rotterdam.
15) The world’s greatest beer drinkers are the Germans.
# how would you deal with Mr. Call. as – he keeps raising objections to your
products: he say they are too expensive, that he’s worried about your after sales
service, that your new technology may not be reliable, that your design may not
appeal to his customers.
# What would you do if you worked in marketing for “Dentallo”.
Dentallo is a medium size firm marketing toothpaste and toothbrushes. Your
Dazzle toothpaste and Protect toothbrushes are market leaders in the domestic market,
but due to heavy competition from multinational companies with big advertising
budgets you are no longer able to reach your export sales targets. Market research
shows that a large proportion of consumers aboard find your product image is old
fashioned and dull though your prices are lower than the competition.

Travelling

People travel abroad on business or for pleasure by road, by air and by sea.
They travel at their own expense or at the firms’ expense, they arrange
accommodation, they make travel arrangements, they even find out the “romance” of
travel.
Travel is a solitary enterprise: to see, to examine, to assess.
Travelling on your own can be very lonely so even if we crave for a little risk,
some danger, an experience we should have companions.
• What are the advantages / disadvantages / of travelling:
-alone
-with a companion
-in a group with a guide?
• Can travel broaden the mind? How?
• Advantages and disadvantages of travelling on business.
• Speak about your experiences and feelings about:
-staying in a hotel
36
 -driving a car abroad
-traveling by train
-visiting new places
-leaving out of a suitcase
-eating in restaurants abroad
-weekends away from home
-waiting for a delayed flight
• Which are enjoyable, exciting?
• Which are stressful, annoying, depressing?
• What difference does it make if you’re on holiday and not traveling on
business.
• Do you agree or disagree?
-take hand luggage not large suitcases.
-it’s essential to organize everything before you travel.
-you should take a walkman and plenty of reading matter.
-learn as much as you can about the customs of the people.
-it’s important to arrive a day earlier to give yourself time to adjust and
acclimatize.
-be careful about local food and drink.
-don’t get involved in a political discussion.
-treat everyone you meet with respect.
-“never forget that you’re a foreigner”
Add some more pieces of advice.
• How many of these tips for travelers are worth following?
-never get to the airport too early in case the plane is late.
-always take a good long book to read on a journey.
-always try to get some sleep on the plane.
-never take more than one suitcase on a journey.
-always try to do some work on the plane.
-never drink alcohol on a plane.
-you can avoid losing any important document by keeping it in your hand
luggage.
-you can save money on a hotel accommodation by getting rooms at a
discount through your travel agent.
-you can avoid delays by taking carry on luggage onto a plane.
-always have some water with you.
• You may depend on a travel agent or your firm’s travel department to make
your travel arrangements but there may be times when you want to change an
itinerary for a visitor or yourself.
Some phrases you might need to use:
 I want to fly to Miami on the 10 of the next month, returning on the 20.
 I’d like to reserve a seat on Flight number …
 I’d like to change my reservation on Flight no..
 I need to get to the airport / railway station / as quickly as possible.
 One coach class / round trip / one way to Huston.
 One first class / club class / tourist class return / single.
 Is it too late to check in for flight nr. E009?
 Which platform / track / gate does the 13: 40 to London leave from?
 Can you tell me what time flight nr. … is due to arrive / depart/ ?
• Who would you speak to in each case to get the information you require?
What would you say?
-You have heard that flight BZ 431 is delayed.
37
 -You want a rail ticket to Manchester.
-You want a plane ticket to Paris.
-You are in hurry to get to the airport.
-You have arrived at the airport three hours before your flight.
-You have three minutes before your train leaves.
-You want to make sure of a hotel room in Madrid before your flight departs.
• Do you know:
-where a visitor could go on a free day or at the weekend?
-when the museums are open?
-how a visitor can get tickets for a show?
-which restaurant to go?
-where a visitor can buy local specialities to take home?
• Imagine you’ll welcome two people from the other side of the world who
haven’t left their own country before. They’re coming to work with you for a few
months.
Make a list of customs and habits that will seem strange to them and which
will be different from their country. What will you explain them about:
-eating
-public transport
-shopping
-work
-entertainments
-sports
Accommodation
• Where can you find accommodation:
-in comfortable chalets/villas/?
-private houses / bungalows /?
-motels/
-holiday camps?
• What kind of hotel do you prefer to stay in on a business trip?
• What facilities do you know? Chose those you are interested in:
-buffet style breakfast
-fitness centre /gym/
-jacuzzi &sauna
-secretarial service
-video movies /T.V. /
-restaurant serving local specialities
-cocktail lounge
-free car parking
-photocopying
-self service cafeteria
-24 hour coffee shop
-room service
-swimming pool
-lifeguard
-golf course
-beach
Travel and hotels have always been closely related.
We place hotels in four groups:
 Commercial hotels providing services mainly for transients. Most of
them traveling on business.

38
  Resort hotels located in vacation areas providing recreational
facilities of their own.
 Conventions hotels which service conventions meetings usually held
yearly of business or professional groups.
 Resident hotels where people can rent accommodations on a seasonal
basis or even permanently.
Each hotel has got:
-a large lounge furnished with settees and chairs.
-a lobby with the reception desk.
-a service bureau.
-information desk.
-foreign exchange desk.
-waiting room with new stands.
-post office desk.
-souvenirs shop.
-lifts.
-restaurants
-bars.
-modern convenience.

• The hotel staff include:

-manager
-assistant manager
-night auditor
-cashier
-desk clerk
-reception clerk
-bellboy
-porter
-doorkeeper
-chambermaid
-houseman
-cook
-waiter /waitress
-storekeeper
-wine steward
-bartender
• What sort of rooms can you book in a hotel.
-single
-double
-suites
-rooms with bath /shower
-room looking out to …
• What modern convenience can you have in a hotel?
-central heating
-laundry service
-air conditioning
-disco
• Name some of the do’s and don’ts of the hotels. Start with:
-when going out you should not forget to leave the keys at the desk.
-you must pay the bill before leaving the hotel.
-rooms must be vacant by 12 am on the day of departure.
39
 -you are requested not to disturb other people’s rest.
-complaints should be made to Reception or to the manager.
• Describe a hotel that you liked most.

Travelling by Train

Railways today still carry the bulk of passenger and goods traffic.
It is one of the cheapest ways of transporting freight over long distances.
The railway station is provided with:
 A waiting room
 An inquire office
 Parcels office (heavy luggage is registered and labeled)
 Left luggage office
 Book stalls
 Post office
 Telephone booth
 Booking office
 Catering facilities ( restaurant, snack bar, coffee room, tea room..)
 Time table
 Shop
The passengers hurry along the platforms getting on or off the train; the
porters carry the luggage to the train or push it on their trucks to the luggage van.
The luggage van is placed behind the engine, then the mail van and the
passenger carriages with smoking and non smoking compartments, a dining car.
The passengers’ compartments have numbered seats.
At intervals a guard or a special inspector checks the travelers’ tickets.
The train arrivals and departures are posted up in time, the passengers being
invited to the trains by loudspeaker.

• What kind of trains can passengers get on?

Express trains
Fast trains
Slow trains
Through trains
Commuting trains
• What luggage do you usually have about you?
Light luggage
Heavy luggage
A suit case
A truck
Hand luggage
• Under what circumstances do you book?
A single, one way ticket
A return, round trip ticket
A platform ticket
A season ticket
• I wonder whether you have watched the rush in a railway station.
People looking up members in the Telephone Directory.
People consulting the time table.
People booking in advance.
People getting on and off the trains.
40
 Porters seeing to the passengers’ luggage.
The incoming and outgoing trains.
Trains pulling out the station and picking up speed.

• Find the definition for each of the words:

a. railway
b. railroad
c. railhead
d. bulk
e. station
f. bulky 1. U.S. system using trains to carry
2. end of a railway line
3. B.E. system using trains to carry passengers & goods
4. large and awkward
5. large quantity of goods
6. place where trains stop

• Describe your last journey by train using the following vocabulary:

First class sleeper
Through train
Booking office
Luggage rack
Smoking carriage
Return ticket
Entrance gate platform
Ticket collector
Breath talking landscape
Unique landscapes To travel light
To run on time
To change times
To delay
To enjoy
To put out / off the lights
To have a change

Travelling by Air

It is most comfortable and speediest of all means of transport.

Airlines are constantly improving their services.
They are concerned about improving check in facilities hiring well trained
deck-in personnel providing excellent in flight services such as: cabin services, seat
comfort, in flight entertainment, good catering.
It is advisable to book tickets in advance. You can book :
A first class (P) seat
A Business class (C)

An Economy class (Y)

Before boarding the plane the passengers must have their tickets and passports
checked, their luggage inspected, weighed and tag attached to it.
The passengers can avail themselves of the various services offered by the
airport:
41
  the exchange office
 the duty free shop
 the book stall
 the restaurants
They will be waiting for the announcer calling the flight.
The stewardess will take the passengers to the concrete runway where the
plane is ready to take off.
• What sort of classes and tickets can you book on any flight?
First class (P)
Business (C)
Economy (Y)
Single –one way
Return –round trip
Direct –point to point
Open dated return
Dated ticket
• Which are the airport formalities?
Flying ticket checking
Luggage weighing
Customs control formalities
Passport control
Security check
• Why are these necessary when the plane takes off?
Fasten your seat belt
Stop smoking
Listen to the instructions given by the air hostess
• What are these for?
The information desk
The currency exchange office
The public address system
Telephone booth
• Can you explain?
Aircraft
Aircrash
To board a plane
To book a ticket
Check in facilities
Catering To hit an air pocket
Liable to duty
Non stop flight
Point to point flight
Runway

• Find the definition for the words and expressions:

1) A direct flight
2) Catering
3) Load factor
4) Open dated ticket
5) Check in facilities
6) Break even point
7) Return ticket
8) Long haul
42
 9) Yield a) a point where sales cover cost but do not make a profit
b) one way flight
c) round trip ticket
d) amount of weighed factor
e) long distance
f) to book a ticket leaving the date of the return open.
g) supplying food ready to eat
h) profit
i) places where passengers give in their tickets for a flight

• You want to fly from Bucharest to New York.

Book a flight.
Write down a short dialogue.
 Why do people prefer to travel by air?
 What might a travel by plane depend on?
 What aspects are the airlines all over the world concerned about?

The Customs System

Customs clearance consists in the following operations of the means of

conveyance to customs units and production of the accompanying documents.
- customs inspection of the means of conveyance and of the merchandise
carried.
- the checking of customs declarations.
The customs Tariffs are applied when clearing the goods through the customs
– then customs duties are being charged in conformity with the guide to the law of
Import Customs Tariffs.
The guide enters the goods under several columns:
 tariff heading and subheading
 description of the goods
 rate of duty
Customs bodies should check whether the merchandise is in accordance with
the customs declaration and transport documents.
Customs duties are charged on the customs value of the goods. If the goods
fall under customs restrictions they are liable to duties, if they don’t exceed the free
tax quota they are un dutiable.
Natural persons may bring in the country personal effects which are duty free.
The Customs Regulations prohibits the introduction into the country of: arms,
narcotics, toxic substances, radio transmitters and receivers, documents and printed
matter under law restriction.
It is prohibited to take out of the country securities, goods that belong to the
national cultural patrimony.
Any traveler who has items coming under customs restrictions should declare
them either orally or in writing on a special form.
• What should the officer do in case of contraventions?
-fine you
-confiscate your objects.
-charge a penalty for dutiable goods, for deliberate concealment of prohibited
goods.
• How can your passport be?
-in order
43
 -needs the entry / transit visa
-needs no visa
-has expired

• Chose the correct definitions:

a. customs
b. to go through the customs
c. customs clearance
d. customs formalities
e. customs officers
f. customs tariffs
g. customs union
1. agreement between several countries that goods can travel between
them paying duty.
2. the government department that organize the collection of taxes or
imports.
3. to pass through the area of an airport (port where customs officials
examine goods).
4. documents given by customs to show that customs duty has been paid
and the goods can be moved.
5. declaration of goods and examination of them by the customs.
6. people working for the customs.
7. list of duties to be paid on imported goods.

• Make up a dialogue using the following vocabulary:

I came from …
I’ll spend a few days as a tourist
Your passport is in regular order
I have no cash
Liable on duty
Personal effects
No charge on
On condition
Prohibited goods
We are through with the customs
Clearance
Restrictions
To register
Visa

Money

All values in the economic system are measured in terms of money.

Our goods and services are sold for money and money is in turn exchanged for
other goods and services.
Coins are adequate for small transactions, while paper notes are used for
general business.
We also have a wider sense of the word “money” covering anything which is
used as a means of exchange.
Originally, a valuable metal (gold, silver, cooper) served as a constant store of
value; even today, the American dollar is “backed” by the store of gold which the US
government maintains.
44
 As gold has been universally regarded as a valuable metal, national currencies
were many years judged in terms of “gold standard”
Today national currencies are considered to be as strong as the national
economies which support them.
Valuable metal has been replaced by paper notes. They are issued by
governments and authorized banks and are know as “legal tender”.
Cheques and money orders perform the function of substitute money and are
known as “instruments of credit”
Credit is offered when creditors believe that they have a good chance of
obtaining legal tender.
If a man’s assets are known to be considerable then his credit will be good. If
his assets are in doubt then it may be difficult for him to obtain large sums of credit.
The value of money is basically its value as a medium of exchange or its
“purchasing power” which is dependent on supply and demand.
The demand for money is reckonable as the quantity needed to effect business
transactions.
An increase in business requires an increase in the amount of money coming
into general circulation.
But the demand for money is related not only to the quantity of business but to
the rapidity with which the business is done. The supply of money is the actual
amount in notes and coins available for business purposes. If too much money is
available, its value decreases and this condition is known as “inflation.”
The unit of English coinage is the pound sterling which is worth 100 new
pennies.
The symbol £ is always placed before the figures.
The abbreviation of “p” is written after the corresponding figures.
The Bank of England issues banknotes for £1, £5, £10, £50 and £100. there are
three bronze coins ½ (half penny), the one and two new penny, two copper- nickel
coins: the five and ten new penny. Then there is the 50p. coin.
# The unit currency in U.S.A:
dollar – a paper bill or a silver coin.
- banknotes of $ 1, 2, 5, 10, 20, 50, 100, 500, 1000
- coins 1¢ 5¢ (nickel), 10¢ (dime), 25¢ (quarter), 50¢ (half dollar) are made of
silver.
# How can you ask for a price?
• How much is it?
• How much does it come to?
• How much do I owe you?
• How much do you charge?
• It’s very expensive…
• It’s rather cheap…
• I’m short of money, can I buy cheaper?
# Say whether these statements are true (T) or false (F)
• The U.S. dollar is a constant store of value.
• Instruments of credit are accepted because they can be converted easily into
substitute money.
• The purchasing power of money depends upon supply and demands.
• The demand for money is related to the rapidity with which business is done.
• You can earn interest on a current account.
• Banks lend money to depositors who need capital.
• The main profits of a bank come from lending money at a fixed rate of
interest.
45
 • Money is described as “liquid” because it is compared to flowing water.

Everyone borrows money. And when you do this you improve your lifestyle.
It may be a risk but it also promises great rewards. Where do you borrow money
from? Banks are considered to be profit making machines. They come in all shapes
and sizes and they help you.
Lending money becomes one of the main functions of a bank. It is the interest
earned from banks that brings in most of the revenue to pay the expenses, including
staff salaries of the bank and give a sufficient surplus to pay shareholders a dividend
and retain funds in reserves accounts for the expansion of the bank. Before any loan is
granted, the following questions must be answered by the customer:
- how much is required?
- the purpose of the loan
- length of time the advance is requested
- the source of repayment
We have the following sources of funds for the Romanian banks:
- bank deposits(Short term, long term)
- borrowed funds
- own funds(own capital, supplementary capital)
The funds that are put out on loans belong to customers. It is their money that
is put at risk, so if a bank is making bad or unprofitable loans, this will be reflected in
the deposits.
Types of credit or loans:
1.Country loans.(in order to achieve national, political, social and economic
goals)
2.Corporate lending.( such as loans for:
- working capital and fixed assets
- overdrafts
- term loans
- syndicated loans
- revolving credit
.
Types of credits:
We can have:
1. Revocable credits( may be cancelled or amended at any time without
prior notice being given to the beneficiary)
2. Irrevocable credits(can be cancelled with the agreement of all parties)
3. Sight credits(allow for payment to be made as soon as documents are
presented)
4. Deferred credits(it allows for payment at a future date without calling
for a Bill of Exchange).
5. Transferable credit( it can be transferred by the original beneficiary to
one or more second beneficiaries).
6. Red clause credits(incorporate a special concession to the beneficiary
allowing the advising bank to advance a percentage of the total credit amount before
presentation of the shipping documents).
7. Revolving credit(the amount can be renewed or reinstated without
specific amendments to the credit being needed).
8. Stand by credits(acts as a guarantee by the issuing bank to the overseas
beneficiary against defaults by its applicant customer).

The main principles of granting credits are:

46
 - the banking prudence
- the creditworthiness of the borrowers
- the credits granted should be profitable both for the bank and for the
borrowers
- the credits have a destination precise and mandatory which cannot be
changed by the borrowers.
- credits are granted under guarantees that are written in the credit
contract.
- The bank shall reserve the right to verify its customers.

Forms of Payment:
1. Cash( small amounts can be sent in note form very easily, impractical
and expensive if in large amounts).
2. Cheque(remittance is quick and simple, exchange risks unless issued
on appropriate currency account, delay in receipt of proceeds by beneficiary where
bank insists on collection)
3. Banker’s Draft( issue process is straight forward; available in major
currencies, expensive to purchase, involves lengthy formalities including giving an
indemnity to the bank)
4. International Money Order(cheap, issue process is quick, but
appropriate for smaller amounts up to GBP 1000 or USD 2,500..)
5. International Payment Order(no limit of amount, documents can be
attached, payment is inter- bank, therefore secure, not appropriate for urgent transfers)
6. Telegraphic Transfer(quick, no limit on amount, an expensive
method)
7. Giro Cheque(inexpensive, but can be lost or stolen, remittance is quick
and simple)
8. Giro Transfer(simple and quick, number of countries limited)
9. Postal Order(exchange risk for the recipient, can be lost or stolen,
number of countries limited).

How ca you define a bank risk?

It is that risk that the bank is being confronted with in its current operations.
Banks are subject to all the risks that their customers face. The most significant is the
the credit one that arises from lending to individuals, companies, banks, governments.
The main types of risks involved in the banking activity are:
1. The Financial Risks
2. Delivery Risks
3. Environmental Risks
Financial risks:
- Credit risk
- Interest rate risk
- Liquidity risk
- Foreign exchange risk
- Capital risk

Delivery risks:
- operational risk
- technological risk
- new product risk
47
 - strategic risk
Environmental risks:
- defalcation
- economic
- competitive
- regulatory
Some British authors divide the main risks into :
1. product market risks
2. capital market risks
Product Market Risk
- credit risk
- strategy risk
- bank risk
- operating risk
- merchandise risk
- human risk
- legal risk
- product risk

Capital Market Risk

- interest rate risk
- liquidity risk
- currency risk
- discount risk
- basic risk
We may also have:
• The fraud risk
• The country risk
• The market risk

Electronic Banking Services

Electronic banking- essentially automated payment by computer - will
increase in importance and volume. The main forms of electronic banking services
are:
Telephone Banking
Such a service represents a competitive area and it may be either voice-
activated (i.e. the computer is expected to react to customer's voice and comply with
his or her instructions accordingly), or electronically activated ( the client speaks over
the microphone of their telephone and dials certain numbers meaning a certain
transaction). The telephone banking can offer transfers of funds, payments of regular
bills, applications for loans and overdrafts etc.
Bankers Automated Clearing System
This system is especially used for funds transfers between the participating
members and essentially operates standing orders, direct debits, payment of wages,
salaries, rentals, trade debts, etc. Bankers Automated Clearing is supplied with a
magnetic tape containing the details of the accounts to be debited or credited. It sorts
them into bank orders and, then, it provides each paying bank with the relevant
details, a printout being also
Electronic and Internet -Based Payments

48
 Internet banking is a banking product, which follows the older
solutions like e banking. E-banking represents a solution which is technologically
obsolete, supposing at the client level of that service a phone line and a computer
dedicated for such an operation, able to fulfill technical needs quested by the bank and
to run (execute) a software program necessary for lie optimal communication with the
client's bank. In that way, the person who will handle the e-banking application have
to work only from that computer which it is not very good for someone with a
dynamical job and with many physical places of work even in different localities or
countries.
Despite e banking, the I-banking (Internet-banking) supposes the usage
of a computer from wide world on which is installed a browser and an Internet
connection. The performances of such a solution are far away better also for the bank
and for the end user (the client).

The costs are calculated to a number of 100 banks from the United
States of America which are using all the channels, but the costs are represented at a
world wide level because they are common to all the banks that promote the
electronic pazments.
World tendencies

63 % from the great banks are offering Internet banking services and
59 % are offering electronic banking services. Not all Internet banking institutions are
charging the services, but most of those, which do, are starting to use a monthly
subscription for the base services . 61 % from the firsts 150-th banks of the United
States of America are offering on-line banking services, 15 % don't have included in
their strategies for the future the offer of on-line banking service and 19 % already
announced their intention to provide such services by the end of 2001.
In May 2000, Forrester Research estimated that by the end of the year
2003 there will exist over 20 million of home users in the United States of America
which will use the I-banking services, that means around 30 % of the profits obtained
from retail.
At the end of 2000, the specialists from Data monitor estimated that at
the end of the year 2005, around 20% of the world population would be connected at
the Internet.
Regarding Europe, since March 19, 2001 the British group Vodafone
has announced that the first transaction pilot project that will use the digital signature
using the mobile phone will start in April 2001 together with the Radio
Communications Agency. That announcement was made at a short period of time
after the British Government announced that it intended to allow all physical persons
to pay their taxes throw an electronic environment, using digital signatures.
On July 19, 2001, the cut-off time until which all the member state of
the European Union had to implement the Directive regarding digital signature
expired. The ending of that period will lead inevitably to a new beginning in the
development of electronic transactions field and in the e-business area.

As a consequence of that, the banks renounced at their territorially

development and instead they are concentrating on the new products which are based
on new technologies and the Internet development. So, the banks are reorienting their
investment politics to new technologies. That supposes the reconsideration of the
concept of territorial network of a bank, which is about to become an informational
network. At the end, the new technologies allow the banks to be closer to their clients
and in the same time to provide them more comfort and a depersonalization of the
49
services due to the elimination of the classical physical direct relation between the
account officer and the bank's customer.
SWIFT
These initials stand for the Society for Worldwide Interbank Financial
Telecommunication, which is an international organization whose members consist of
several hundred of the largest international banks. The society, which was created
under Belgian Law and located in Brussels, was formed to accelerate the transfer of
funds and other messages between the member banks. .
The system works by means of a telecommunication link between the
computer systems of the banks, which allows the rapid transmission of messages. The
system is used to execute telegraphic transfers previously sent by cable or telegraph
and may also be used for international payment orders/airmail transfers at the
discretion of the bank, making for a much faster execution of a customer's
instructions. When instructions are transmitted in this way the bank is said to be
sending a SWIFT message and for telegraphic transfers the phrase used is urgent
SWIFT message.

Lexical Index
Advertising
Advert - anunţ în ziar
Advertisement – anunţ, reclamă, publicitate
Advertisement canvasser – prospector de publicitate
Advertisement column – rubrică anunţuri
Advertisement department – serviciu de publicitate
Advertisement manager – director de publicitate
Advertisement office – birou de primire a anunţurilor
Advertising agent - agent de publicitate
Advertising appeal - atracţie publicitară
Advertising contest - concurs de reclame
Advertising directory - anuar de publicitate
Advertising expenditure - cheltuieli de publicitate
Advertising rates - tarif de publicitate
Advertising schedule - calendar al anunţurilor
Drawback - neajuns
Folder – pliant, dosar
Hoarding.- plancardă
Misleading – înşelător
Poster – afiş
Target customer – client ţintă
To advertise – a face reclamă
To boost - a populariza prin reclamă
Want ads – anunţ la rubrica cereri de serviciu

Mass media

Blurb – prezentare, reclamă.

Broadsheets – ziar popular
Cover – copertă.
Coverage – relatare.
Feature – rubrică fixă.
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Headline – titlu.
Headlines – rezumatul ştirilor principale.
Item – articol.
Jacket – supra copertă.
Layout – aranjarea materialului pentru o carte.
News caster – crainic.
News hawk – reporter.
News release – comunicat autorizat.
News sheet – gazetă de format redus.
News stand – chioşc de ziare.
Newsbill – afiş de ziar.
Newsbutcher – vânzător ambulant.
Newsreel – jurnal de actualităţi.
Oblituary – anunţ mortuar.
Peak viewing time – oră de maximă audienţă
Press clipping – tăietură din ziar.
Press release – comunicat de presă.
Printing works - tipografie.
Radio schedule – programul emisiunulor.
Rumour – zvon.
Script – scenariu
Sequel – continuare
Sets – decor
Skim – a atinge uşor.
Snap shot – instantaneu
Soap opera – telenovelă
Stunt artist – cascador
Tabloids – presă de scandal.
The picture flickers – imaginea pâlpâie
The picture is blurred – imaginea este estompată.
The picture is distorted – imaginea este deformată.
The picture washing out – imaginea se şterge.
Time signal – ora exactă.
To bribe – a mitui
To broadcast – a transmite
To browse through – a răsfoi
To cover news – a relata, a comenta.
To hint – a face aluzie.
To issue – a edita..
To re-edit – a reface
To release – a lansa

Market
Base rate - curs de referinţă
Blue chips stock - acţiuni sigure
Bond - obligaţiune,garanţie
Bond market - piaţa hărtiilor de valoare
Brand image - imagine de marcă
Brand leader - cap de serie
Brisk - piaţa activa
Canvasser - prospector de piaţă
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Deferred shares - acţiuni eşalonate
Demand - cerere
Demand rate - curs la vedere
Futures - piaţa livrărilor la termen
Hardening of the futures - redresarea pieţei
Home demand - cerere internă
Home market - piaţa internă
Margin - marjă
Margin in cash - acont în numerar
Margin of profit - marjă de beneficii
Market overt - piaţă publică
Market share - cota pieţei
Market swing - tendinţa pieţei
Market value - valoarea comercială
Prices levelled off – preţurile au atins un nivel constant
Prices picked up - preţurile s-au redresat
Prices rocketed - preţurile au crescut vertiginos
Rate of exchange - curs de referinţă
Rate of interest -.rata dobănzii
Rate of return - rata de recuperare
Revenue - venit al statului
Sales plummetted - văntările s-au prăbuşit…
Sales topped - vănzările au depăşit…
Securities - garanţii,titluri
Security - valoare,titlu
Settlement day - zi de referinţă
Soft market - piaţă în scădere
Steady demand - cerere permanentă
Steady market - piaţă stabilă
Stock account - cont de capital
Stock adventure - speculare de acţiuni
Stock holder - acţionar
Stock on hand - stocuri nevândute
Supply - ofertă
Terms of supply - condiţiile livrării
To dabble in the stocks - a juca la bursă
To take stocks - a cumpăra acţiuni
Uncertain market - piaţă nesigură
Underwriter - garant
Venture capital - capital de risc
Yield - venit al unei investiţii

Travelling

Accommodation – găzduire.
Amenity - farmec,plăcere.
Appeal – atracţie.
Appropriate – adecvat.
Available – accesibil.
Booking – rezervare.
Clerk – funcţionar.
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Chargeable call – convorbire taxată
Commercial hotels- hoteluri pentru oameni de afaceri
Continental breakfast - mic dejun uşor
Convenience – confort.
Courses - feluri de mâncare
Discount price - preţ redus
Discount - bonificaţie
Half fare ticket – bilet cu preţ redus
Height - înălţime
Joint destination – combinarea a două destinaţii.
Junction – încrucişare de drumuri
Lobby – culoar, hol mic.
Lounge – hol.
Maid – cameristă.
Promotional fares – preţuri promoţionale
Registration card – registru de hotel
Resort hotels – hoteluri în staţiuni.
Roundabout – ocol.
Season ticket – abonament
Settee – canapea.
Shallow water – apă puţin adâncă
Silversmith – argintar
Soft drinks - băuturi slabe
Sparkling landscapes – peisaje strălucitoare.
Spicy – condimentat
Straight ahead - drept înainte
Tender – ofertă.
Ticket nipper – compostor
Ticket window – ghişeu de bilete
Tip - bacşiş
To accommodate – a găzdui.
To add – a adăuga
To cater – a se îngriji de nevoile cuiva
To chill – a răcii
To chop – a tăia
To dip – a înmuia
To disturb – a deranja.
To go sight seeing – a vizita oraşul.
To melt – a topi
To offer facilities – a oferii condiţii.
To outline – a contura
To peel – a descoji
To pour – a turna
To provide with – a furniza
To put up at a hotel – a se opri la hotel
To season – a condimenta
To shake – a agita
To sprinkle – a stropi
To whisk – a bate ouăle
Undercooked – crud
Vacant – liber.
Well sitted – comod.
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Width - lărgime
To put through – a face legătura

Money

Account – cont
Account book – registru de conturi
Assets- active
Bank return – venitul băncii
Bill of exchange /draft – cambie
Board of trade returns – statistică comercială
Bounds – obligaţiuni
Bullion - lingou
Cash account – cont în casă
Cash assets – capital în numerar
Cash deposits – vărsăminte în numerar
Cash flow – fluxul numerarului
Cash in hand – numerar disponibil
Cheque to bearer – cec la purtător
Cheque to order – cec la ordin
Currency depreciation – devalorizare monetară
Current account – cont curent
Debenture bounds – obligaţiune cu dobândă fixă
Deferred payments - plaţi întârziate
Deposit account – cont de depozit
Earnings – venituri
Expenses – cheltuieli
Figure – cifră
Financial backing – sprijin financiar
Financial futures – contracte pe termen
Gamble – joc de noroc
Gross return – beneficiu brut
Hard currency – valută forte
Interest – dobândă
Legal tender currency – monedă legală
Let down – declin
Money chest – casă de fier, seif
Money in cash – bani lichizi
Money market – piaţă monetară
Money on deposit – bani depuşi
Money pressure – lipsă de bani
Overdraft- sold debitor
Pay in ship – borderou de vărsământ
Payee - beneficiar
Return – venit, beneficiu, rambursare
Revenue – venit mare, câştig
Revenue assets – capital circulant
Revenue office – administraţie financiară
Saving bonds – titluri de economii
Savings – economii
Tax return – declaraţie de impozit
Tenor – scadenţa unei obligaţiuni
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To earn – a câştiga
To get into dept – a avea datorii
To grant a loan – a acorda un împrumut
To open an account – a deschide un cont
To owe – a datora
To save money – a economisi bani
To settle an account – a lichida un cont

BUSINESS and BUSINESSES

55
 Business is a long term, highly repetitious activity, frequently requiring people
to do the same thing today, tomorrow, the next day.
Many of today’s well known businesses were started by one or two people and
the ownership of those businesses was very simple. It was during the 19th century that
businesses wanted to expand and increase the number of owners. To do this they
needed to sell shares. To encourage people to buy shares, governments around the
world passed laws which gave people limited liability. During the 20th century many
people bought shares in sucessful businesses for the following reasons:
- to have a share in the profit made by the business.
- the hope that a profitable business would attract more and more
people to buy shares and this will make the price rise so that shares could be sold at a
profit.
The simplest form of business ownership is the sole trader. Here, one person
owns the business, takes all the decisions and risks his own money. People enjoy to be
self employed and they are happy to have complete control of their own business. But
there is no one to share the responsibilities involved in decision making and raising
finance is a problem. Sole traders finance their business through a bank loan and the
bank will charge a high rate of interest. A bank will ensure that it can get the money
back, if the loan is not repaid, by requiring security on the loan. Sole traders are liable
for any debts they have, even if they are not the trader’s fault. A trader may do a job
for a larger business; it may be worth 20 000$ but it will not be paid until the job is
complete. The sole trader must spend 9 000 $ on equipment, but when the job is
complete the larger business closes down and the 20 000$ are not paid; still, the sole
trader has to cover the 9 000 already spent as he has unlimited liability.
Sometimes, a pair of a small group of people will get together to run a
business. This is called a partnership. Partnerships face unlimited liability as sole
traders do.
Partners may put some money into the partnership in return for a share of the
profits but take no part in the running of the partnership, do not work for it and have
„no say” in any decisions.Under these circumstances, it is only the money that has
been invested that is liable to be used in order to apy off any debts. This is a silent
partner and he has only limited liability.
The technical name for both private and public limited companies is joint
stock company. It means that the stock in a company is owned jointly by several
people.
Some business activity is carried on by the government and this forms the
public sector.
Profit maximisation may not be the only aim of a busines; in public companies
there is a separation of ownership and control, so that directors and managers may run
a company in their own interests.
Business is the production,buying, and selling of goods and services. A
business, company or firm is an organization that sells goods or services. A business
may be referred to formally as a concern. Then, it may be referred to approvingly as
an enterprise in order to emphasize its adventurous, risk taking qualities and business
in general may be referred to in the same way, in combinations such as free enterprise
and private enterprise.
A business requires tremendous effort to get it going and once going, it
requires minimum effort to keep it going. The role of business is to stay in business,
providing wages, goods and services into the community and meeting the profit needs
of the business and the key stakeholders in the business. The source of funding and
capital is considered to be the main difference between the stakeholders and the
56
shareholders. In the stakeholder model, funding is being supplied through bank loans.
This means that they will ask for managerial consideration and response from those
running the company.
In the shareholder model, stockholders advance capital to managers who act as
their agents in pre-authorized ways. Shareholdes buy shares to maximise the return on
their investment; the responsibility of the manager in a firm is to engage in activities
designed to increase the profits, that is to engage in open and free competition. To
create shareholder wealth, the management needs to outperform the expectations
shareholders had when they made their investment decisions. In the shareholder
model of corporate governance, the focus is on institutional agents monitoring
corporate agents in order to enhance the investment prospects of investors. In the
stakeholder model, the premise is that a company is more likely to perform well and
the shareholders are more likely to benefit, if opportunities are created for the various
groups holding an interest in the company to enter into binding relationship. The
emphasis in the stakeholder model is the way enterprises are governed while in
shareholder model the emphasis is on the way enterprises are managed. The
shareholder based entity is more responsive to changes in market conditions.
Both approaches take account of the issues of board checks and balances,
abuse of authority and power, the role of boards, director rewards and participation in
setting standards for accounting, safety, employee relations and risk management.
In today”s business world we have to take into consideration the two models.
The shareholder model encourages a top down, command and control leadership
approach whereas in the stakeholder model a team based, shared decision making,
servant leadership approach is more likely.
Stakeholder based governance refers to how the organization makes cost
effective decisions in terms of wealth creation but with consideration of stakeholders’
rights. Corporations have multiple responsibilities and need to balance competing
conditions, such as long and short term notion of gain, profit and sustainability, cash
and accounting concepts of value, democracy and authority, power and
accountability. This model is more common in continental Europe and Japan.
The micro approach to corporate governance refers to shareholders. This is
concerned with maximizing wealth creation for shareholders. Control is linked here to
profitability, an Anglo American model.

Then business may be referred to as commerce, commercial distinguishing the

business sphere from other areas such as government or arts or from non money
making activities.
Large companies are being referred to as corporations. Corporate is used to
describe things relating to a corporation or to corporations. Large companies
operationg in many countries are multinationals. Big business can refer to large
business organizations or to any business activity that makes a lot of money. Small
companies are referred to as small businesses or small firms.
When a private company is bought by the state and brought into the public
sector in a sell off, it is privatized. The first to be sold in a privatization programme
are often the companies responsible for the public supply of electricity, water and gas:
the utilities.
If a company A owns shares or equity in company B, then A holds a stake,
holding or shareholding in B. If A owns less than half the shares in B, then it has a
minority stake in B. If A owns more than half the shares in B, it has a majority stake
or controlling stake in B. If you have shares in a company you are a shareholder.
A holding or holding company is the one that holds stakes in one or more
subsidiaries. If it owns all the shares in a subsidiary, then the subsidiary is a wholly
57
owned one. A holding company”s relationship to its subsidiaries is that of parent
company and the subsidiaries” relationship to each other is that of sister companies. A
holding and its subsidiaries form a group. A conglomerate is a group containing a lot
of different companies in different businesses.
Company A may be attempting to gain control of company B in a takeover
bid, maybe by increasing its holding or stake in company B if it already owns shares
in B. Company B makes or launches a bid against company A, the takeover target. If
company B does not want to be taken ober, the bid is hostile. There are other ways of
saying that one company is taking over another one and it means that the company is
acquiring another or making an acquisition.
In a leveraged buyout or LBO, a company is acquired by a group of investors,
often financed by heavy borrowing. The debt is then paid out of the target company”s
operating revenues or by selling its assets. The borrowing involved inLBOs is often
high risk debt called junk bonds. LBOs financed by junk were frequent in the 1980s
and after an absence following the excesses of that period, they are now coming up
again.
Two or more companies may decide to work together by setting up a joint
venture or alliance in which each holds a stake. When two companies combine
voluntarily, they merge in a merger.
The social role of any business is linked to what we call as serving the future:
sufficient profits to satisfy the business and the stakeholders meet today’s profits
needs. But as the expectations increase society has to invest in ideas and technology
that expands the economic base and the wealth of the society. An essential
requirement is that each and every business strives to achieve profits over and above
immediate business needs and the stakeholders’ needs. Without this „surplus profit”
there can be no venture capital. Without venture capital, economic growth will
struggle to match population growth and the growth in social expectations.
Any business requires true professionalism- the courage to care about people,
clients, career.
True professionalism means the pursuit of excellence. If you value something,
then you must monitor your performance in that area, acept nothing less than
excellence and actively work to learn what to do differently every time you fall short
of excellence. Firms must provide help and counsel to those who are encountering
difficulties in living uo to their standards, in order to help them get back on track.
Once professionals have confirmed their core values, they need to design systems
which provide consequences for noncompliance. By leaving each individual
professional to decide for himself what level to achieve in key value areas, firms say
that the company as a society has no standards that must be adhered to. Excellence in
such areas become a matter of personal professional choice. Professionals must live
by the slogan „ you are allowed to fail, you are not allowed to give up trying.”
The oposite of the word professional is not unprofessional, but rather
technician. These may be highly skilled, but they aren’t professionals until they
demonstrate characteristics such as:taking pride in their work, showing a personal
commitment to quality, reaching out for responsibility,getting involved, looking for
ways to make things easier for those they serve, listening to the needs of those they
serve, being team players, honest, trustworthy, loyal, open to constructive critiques.
Professionalism is an attitude not a set of competences. A true professional is a
technician who cares. And if finding people with technical skill is usually easy,
finding people who are filled with energy, drive, enthusiasm personal commitment to
excellence is hard. Because real professionalism has little to do with which business
you are in, what role within that business you perform, how many degrees you have.

58
It implies a pride in work, a commitment to quality, a dedication to the interests of the
client, a sincere desire to help.
Traditional definitions of professionalism are filled with references to status,
educational attainments, noble calling. Now, we refer to attitude and character. So,
firms should hire people for attitude and train for skill. Being a professional asks for
treating people as professionals that is invest in them. Then professional success
requires more than talent, it asks for initiative, involvement, enthusiasm,
commitment.Being good at business development involves nothing more than a
sincere interest in clients and their problems and a willingness to go out and spend the
time being helpful to them.
Success in business life means not only good professionalism but effective
functioning of the firms, positive outlooks.

The Secrets of Achieving More with Less

Some things are likely to be considered more important than others. You can
achieve more with less effort, time and resources. We think that there is an inbuilt
imbalance between causes and results, inputs and outputs, effort and rewards. But
each individual can be more effective and happier, each profit seeking corporation can
become very much more profitable, each non profit organization can also deliver
more useful outputs, every government can ensure that its citizens benefit much more
from its existence. For everyone and every institution it is possible to obtain much
more that is of value and avoid what has negative value, with less input of effort,
expense or investment. At the heart of this progress there is a process of substitution.
Resources that have weak effects in any particular use are not being used sparingly.
Those which have powerful effects are being used as much as possible. Every
resource is ideally used where it has the greatest value. Wherever possible, weak
resources are developed so that they can mimic the behaviour of the stronger
resources. Business and markets have used this process for many years.
And so we call for a well known principle namely “the 80/20Principle”
which tells us that a minority of causes, inputs, efforts lead to a majority of the results,
outputs or rewards and that our daily lives can be improved by using this principle. A
new way to use this principle is the 80/20 thinking, that is about any issue that is
important to you and asks you to make a judgement on whether the principle is
working. This is the daily life , non quantitative putting into practice of the principle.
It is used to change behaviour and to focus on the most important 20 per cent. It
works when it multiplies effectiveness. Action resulting should lead us to get much
more from much less. When using this principle we do not assume that its results are
good or bad or that the powerful forces we observe are necessarily good. We decide
whether they are good and either determine to give the minority of powerful forces a
further shove in the right direction or to work out how to frustrate their operation.
By putting it into practice, this principle implies that we should do the
following:
- celebrate exceptional productivity, rather than raise
average efforts.
- look for the short cut, rather than run the full course
- exercise control over our lives with the least possible
effort
- be selective
- strive for excellence in few things, rather than good
performance in many
59
 - delegate or outsource as much as possible in our daily
lives and be encouraged rather than penalized by tax systems to do this
- choose our careers and employers with extraordinary
care
- only do the thing we are best at doing and enjoy most
- look beneath the normal texture of life to uncover
ironies and oddities
- in every important sphere work out where 20 per cent of
effort can lead to 80 per cent of returns
- calm down, work less and target a limited number of
very valuable goals where the 80/20 principle will work for us, rather than pursuing
every available opportunity
- make the most of those few ”lucky streaks” in our life
where we are at our creative peak and the stars line up to guarantee success.
The 80/20 Principle applied to business has one key theme- to generate the
most money with the least expenditure of assets and effort.
The classical economists of the XIXth and XXth century developed a theory
of economic equilibrium and of the firm that has dominated thinking ever since. The
theory states that under perfect competition firms do not make excess returns, and
profitability is either zero or the normal cost of capital, the latter usually being defined
by a modest interest charge. Then the theory of the firm goes like this: in any market,
some suppliers will be better than others at satisfying customer needs. They will
obtain the highest price achievements and the highest market shares.
More than this, the objective of 80/20 thinking is to generate action which will
make sharp improvements in your life and that of the others. Thinking escapes from
the linear logic trap by appealing to experience, introspection and imagination. If we
are unhappy we do not worry about the proximate cause. We think about the times we
have been happy, we do not look for causes of failure, we imagine and then create the
circumstances that will make us both happy and productive.

What do you think about the following insights for our personal life:

 80 per cent of achievement and happiness takes place in 20 per

cent of our time.
 Our life can be affected by a few events and a few decisions.
The decisions are often taken by default rather than conscious choice; we let life
happen to us rather than shape it; we can improve it by admitting the turning points
and by making the decisions that will make us happy and productive.
 There are always a few key inputs to what happens and they are
often not the obvious ones; if the key causes can be identified and isolated we can
very often exert more influence on them that we think possible.
 Everyone can achieve something significant. The key is not the
effort but to find the right thing to achieve. You are no doubt more productive at some
things than at others but one have to dilute the effectiveness of this by doing too many
others where our skill is nowhere near as great.
 There are always winners and losers and always more of the
latter. You can be a winner by choosing the right competition, the right team and the
right methods to win.

60
  Most of our failures are in races for which others enter us. Most
of our success comes from races we ourselves want to enter. We fail to win most
races because we enter too many of the wrong ones: their ones, not our ones.
 Few people take objectives really seriously. They put average
effort into too many things, rather than superior thought and effort into a few
important things. People who achieve the most are selective as well as determined.
 Most people spend most of their time on activities that are of
low value to themselves and others. The 80/20 thinker escapes this trap and can
achieve much more of the few higher value objectives without noticeable more effort.
 An important decision is the choice of allies. Almost nothing
can be achieved without allies; but most people do not choose them carefully. Some
of us have too many and do not use them properly. 80/20 thinkers choose a few allies
carefully and build the alliances carefully to achieve their specific objectives.
 Money used rightly can be a source of opportunity to shift
towards a better lifestyle.
 Few people spend enough time and thought cultivating their
own happiness. They seek indirect goals(money, promotion), that may be difficult to
attain and will prove to be extremely inefficient sources of happiness. Happiness not
spent today does not lead to happiness tomorrow. It will atrophy if not exercised. The
80/20 thinkers know what generates their happiness and pursue it consciously,
cheerfully and intelligently, using happiness today to build and multiply happiness
tomorrow.
 The logic of professional success leads to ever greater
professional demands. To succeed you must aim for the top. To get there, you must
turn yourself into a business. To obtain maximum leverage, you must employ a large
number of people. To maximize the value of your business, you must use other
people’s money and exploit capital leverage- to become even larger and more
profitable.
 If you decide which shares to buy it is good to specialize in an
area in which you consider yourself an expert. Possibilities are almost endless; you
could specialize in shares of the industry in which you work or of your hobby, your
local area or anything else you are interested in. if you like shopping you might decide
to specialize in the shares of retailers. Then, if you notice a new chain springing up,
where new store seem to be full of keen shoppers, you might want to invest in those
shares.
 The key to making a career out of an enthusiasm is knowledge.
You must know more about an area than anybody else does; then work out a way to
market it, to create a set of loyal customers. It is not enough to know a lot about a
little. You have to know more than anybody else, at least about something. You
should not stop improving your expertise until you are sure you know more, and are
better in your niche than anybody else. Then, reinforce your lead by constant practice
and do not expect to become a leader unless you really are more knowledgeable than
anyone else.

Many years ago, Aristotle said that the goal of all human activity should be
happiness. It seems that we haven’t listened too much to him. Perhaps he should have
told us how to be happy. So, he could have started by analyzing the causes of
happiness and unhappiness. Happiness is profoundly existential. Past happiness may
be remembered or future happiness planned, but the pleasure it gives can only be
experienced in the “now”. One of the 80/20 hypothesis would be that 80 per cent of
61
happiness occurs in 20 per cent of our time. It is interesting that those who are happy
with most of their lives are more likely to be happier overall; those whose happiness
is concentrated in short bursts are likely to be less happy with life overall.

Are there some ways to be happier?

 Identify the times when you are happiest and expand them as
much as possible.
 Identify the times when you are at least happy and reduce them
as much as possible.
Or :
-spend more time on the type of activities that are very effective at making you
happy and less time on other activities.
- start by cutting off the spots of unhappiness, the things that tend to
make you actively unhappy.
The best way to start being happier is to stop being unhappy. You have more
control over this by avoiding situations where experience suggests you are likely to
become unhappy.
- for such activities that are ineffective at making you happy it is
good to think systematically of ways that you could enjoy more.
- by cultivating habits of optimism we can have a happier life as
optimism is an ingredient for both success and happiness.
- we must sometimes change the way we think about events; we can
train ourselves to break the self reinforcing pattern of depression by simple steps such
as seeking out company, changing our physical setting or forcing ourselves to
exercise.
- we can change the way we think about ourselves; we can make ourselves
happy or unhappy by the way we decide to feel. We must make the choice that we
want to be happy. We owe it to ourselves and to other people too. A positive self
image is very important, a sense of self worth can and should be cultivated; you know
that you can do it: give up guilt, forget about your weaknesses, focus and build on
your strengths, remember all the good things you have done, all the small and big
achievements.
- we tell ourselves stories about us. We have to do this and we will
increase the sum of human happiness by starting with ourselves and radiating out to
others.
- we can make ourselves happier by changing events we encounter and
that make us depressed or miserable.
- we can become happier by changing the people we see most( the amount
of time spend with them has to be changed).

62
 Dialogue

Richard , the reporter: Good morning Mr. Osborne, thank you for being so
kind to me and give me some answers.
Mr. Osborne: I am available for only 20 minutes because I am meeting the
Company executive.
Richard: Would you be so kind and tell me if there are secrets for successful
businessmen because people wonder how you managed to become in such a short
time a well known businessman.
Mr. Osborne: Well, first you have to be open minded and explore ideas, to
aim for the top. You must turn yourself into a business. You must use other people’s
money and exploit capital leverage.
Richard: Do you think that professionals have to be very close to you?
Mr. Osborne: You need them to get excellence and then money will come, no
doubt.
Richard: Why is strategy important?
Mr. Osborne: If you arrive at a useful business strategy you can be successful
and raise profit.
Richard: Where are you making the most money?
Mr. Osborne: I am attentive to long term investments when the stock market
is low, I build my investments on expertise, I consider the merits of the emerging
markets, I run my gains…
Richard: What is the key to understanding and driving up profitability?
Mr. Osborne: Competitive segments as parts of our business where we face
different competitors or competitive dynamics.
Richard: What does business require?
Mr. Osborne: Decisions tacking and analysis. Since 1950 business has been
blessed by management scientists and analytical managers incubated in business
schools, accounting firms and consultancies who can bring analysis to bear on any
issue.
Richard: Can you work less, earn and enjoy more?
Mr. Osborne: Yes, your thinking has to be strategic, you have to be ambitious
and trust your own values.
Richard: Are you happy? If so, what makes you be happy?
Mr. Osborne: I have found two ways to be happy: first to identify the times
when you are happiest and expand them as much as possible, and to identify the times
when you are least happy and reduce them as much as possible.
Richard: Thank you for your time given and I wish you a prosperous life.

63
 Enlarge upon the following:

1. Happiness is a duty. We should choose to be happy. We

should work at happiness. And in doing so, we should help those closest to us, and
even those who just stumble across us, to share our happiness.

2. Time is the benign link between the past, present and

future. Time keeps coming round, bringing with it the opportunity to learn, to deepen
a few valued relationships, to produce a better product or outcome and to add more
value to life. We do not exist just in the present, we spring from the past and have a
treasure trove of past associations, and our future is immanent in the present.

3. One good rule for being successful is: ”realize that knowledge is
power”.

Do you agree or disagree:

1.An essential ingredient of a happy day is mental stimulation, as well as a

spiritual and artistic one.
2. Lack of control is the root cause of much unease and uncertainty.
3. Objectives that are too easy will lead us to be complacent, accepting
mediocre performance. Those which are too tough lead us to self fulfilling, self
perceptions of failure.
4. Life’s unplanned contribution should be incorporated into our own plan so
that it can proceed to an even higher level.
5. People with low self esteem and self confidence are a nightmare to live
with, however much mutual love abounds.
6. Most of the satisfaction you draw from all of your friends will be focused in
your relationship with a small number of close friends.
7. A short cut to lasting happiness is to evolve the lifestyle you and your
partner want and this requires of course a harmonious balance between your work life,
home life and social life.
8. The impact of the quality revolution on customer satisfaction and value,
and on the competitive positions of individual firms is truly great.
9. The information revolution has a long way to run.
10. Cause and effect, input and output operate in a non linear way. You do not
usually get back what you put in; you may sometimes get very much less and
sometimes get very much more.
11. The real world comprises a mass of influences where cause and effect are
blurred, where complex feedback loops distort inputs, where equilibrium is fleeting,
where there are patterns of repeated but irregular performance, where firms never
compete head to head and prosper by differentiation, where a few favoured souls are
able to corner the market for high returns.

This principle can help people get a great deal more out of their lives, to raise
their effectiveness and happiness, to boost profits and what leads to profits. It is a
practical tool for making a more sensible world. Business leaders who observe the
64
principle at work and see that 20 per cent of products or revenues are producing 80
per cent of profits and that 80 per cent are contributing only 20 per cent of profits- do
not shrug their shoulders. Sensible and profit maximizing entrepreneurs do something
to correct the imbalance; they make the really productive 20 per cent of activities a
larger proportion, they use the 80/20 principle in the pursuit of progress to improve on
reality as progress relies on finding a better way to do everything.
Now we do not prefer life to be quiet, stable or unaccountable. Now the
competition is very tough, and so we strive for solutions and for efficiency in all
domains. Any good business asks for
- good and trustful professionals
- developing personal career strategies
- caring for the genuine clients
- cost reduction and service improvement
- good marketing strategy
- the right management
- the valuable negotiation stages
- the appropriate funding
- finding the best solutions in order to increase profit
- sticking to the rule of the few: the search for the high
product quality
- using technology at its best
- a good fitting into the world
- courage in entering a business, faith in progress, in the
great leaps forward, in mankind’s efforts to improve life.
- creativity and determination

More than these all, I do think that we have to ponder over the following:

“ God plays dice with the universe. But they’re loaded dice. And the main
objective is to find out by what rules that were loaded and how we can use them
for our own ends”!

Discussion points:

1. How can development in business life be carried out?

2. Is life different for a businessman?
3. What do businesses operate with?
4. How important are trust and confidentiality?
5. What do we expect from a professional?

Enlarge upon the following:

1. It is better to make the wrong decision than to make no decision at

all!
2. Support any of your views regarding true professionalism with
examples from your own experience.
3. Everybody begins at the bottom!
4. Tackling challenges in business life is not easy at all!
5. There will always be a time for healing....

65
66
 Additional Vocabulary

To set up in a business- a se lansa în afaceri

Bid- ofertă
Bidder- licitant
Bond- obligaţiune
Business forecast- prognoză economică
Business data processing- informatică de gestiune
Business assets- active comerciale
Business environment- mediu de afaceri
Business expenditure- cheltuieli de reprezentare
Business outlook- prespective economice
Business manager- director comercial
Corporation earnings- veniturile societăţilor pe acţiuni
Corporation income tax- impozit asupra veniturilor corporaţiilor
Corporation sole- corporaţie individuală
Corporate acquisition- achiziţie de firmă
Corporate banking- servicii bancare pentru firme
Corporate body- persoană juridică
Corporate bond- obligaţiune emisă de o societate
Corporate equity- capital social/ fonduri proprii
Corporate securities- titluri de societate
Corporate venturing- furnizare de capital de investiţie de către o companie
altei companii
Equity- capital al acţionarilor într-o companie
Equity shares- capital investit în acţiuni cu drepturi asupra profitului
To hold- a cuprinde,a reţine,a ţine sub control,a organiza, a menţine, a se
aplica.
Holder- deţinător, purtător, proprietar, concesionar
Junk bonds- obligaţiuni riscante
Joint venture- societate mixtă
Interest- dobândă
Leverage-putere, influenţă, randament,raport dintre creanţe şi capital, indice
de îndatorare, mijloc de majorare a profitului.
Leveraged buyout- preluare asistată, pe credit.
Leveraged management buyout- cumpărare de câtre salariaţi
Liability- responsabilitate, răspundere
Security- titlu de valoare
Security market- bursă de valori
Sole trader- comerciant pe cont propriu
Take over- preluare
To merge- a fuziona
Trader- speculator la bursa de valori, comerciant
Merchandise- marfă
Merchant- comerciant
Willingness- bunăvoinţă
Willing- dispus, binevoitor

67
 THE COMPANY

A company is a very special form of business. It is owned by the shareholders

but has a separate legal existence from the people who own it. The shareholders elect
a board of directors to run the company on their behalf. If the company has 2- 50
shareholders it is a private one. The liability is limited to the money that the
shareholders have used to buy shares. If the shares are traded on the stock exchange
we have a public limited company. Members of the public can buy these shares by
going through a stockbroker or bank.

In business we must create for ourselves a set of attitudes and values that
balance the conflicting factors, enabling us to act effectively with integrity, dignity,
understanding. So we’ll have better relationships with our partners and our life
becomes richer. Emotional containment ensures then that the business values are not
undermined by other values from our society, such as we perhaps learned early in life.
We then have to know that there is no social health without economic wealth;
the role of business is to stay in business, providing wages, goods and services into
the community and meeting the profit needs of the business and the key stakeholders
in the business.
The business does not operate in a vacuum; there are competitors, there is a
level of economic activity, there is rapidly changing technology.
The visions we have for our businesses are what makes them and us really
successful. Setting goals and objectives will help us achieve our vision. The key to
success and happiness in life is to create a positive vision, to remain true to one’s own
spirit, to have the energy of challenge.
But running a business is never easy. It’s a ride through a range of hazards and
difficulties but one thing is sure: life will rarely, if ever, be dull. If you do not enjoy
running your business, you can’t expect to do it well.
Some ways to make a business successful are the following:
1. Ideas- bad or good- are important as the lifeblood of business and vital to its
long term success. Ideas are vital to develop new or existing products or services or
even to take the first step into a new business.
2. Choosing professional advisers is essential and they can make or break your
business.
3. Finding and keeping clients must form an integral part of your planning if
you want to grow your business.
4. Research your target companies does take time, but it’s well spent. If
knowledge is power, then researching a company can give you a much better
understanding of what they do and help you to prepare a successful bid.
5. Brand your business and you’ll be set apart and enable you to introduce a
wider range of products and services more easily.
6. Team up with another business to enhance yours and be competitive on the
market.
7. Consider a project based working which has many advantages for the
employer and employee. This means working for just one or two employers at any
time.
8. Be creative, have an open mind philosophy and a “I can do” attitude. Any
business can benefit from using it creatively.
9. Focus on creating a win/win situation.
10. Use your time wisely, as it is not elastic and it will not magically expand to
accommodate all we have to do.
68
 11. Keep your employees happy and remember that a happy workforce is a
productive one and will contribute to the performance and profits of your business.
12. Make powerful presentations by a good planning and preparation.
Exhibitions can be invaluable marketing exercises for any business.
13. Event management is important: organizing gatherings, conferences,
seminars, training courses.
14. Networking for success is a way to meet new people, exchange
information and get new business.
15. Master the media and you may get rewards by being attentive to the
interviews.
16. The success of a business will depend on how well you sell products and
services. How do you persuade people to buy the product? The more work you put
into planning and developing your sales strategy, the easier it will be to close and
develop a loyal customer base.
17. Lasting customer relationships are very important as profitable business
starts and ends with the customer. So it’s worth giving them the attention they
deserve.
18.Ensure that success will come from a website but be careful to a sound
strategy. E-commerce revolution is on its way and the staff has to be well trained in
this respect.
19. Maintain a positive flow of money in your business by realistic forecasting
which will only be of benefit if it is checked and reconciled on a regular basis.
20. Enter into partnership agreement and make sure that your partner can
contribute to the business and will strengthen it.
In business life time is important to be taken into consideration as it is our
most precious resource. We have to maintain a balance, we have to give ourselves
time and opportunity to do things right; we do not get a second chance with time, so
we must do our best to make every minute purposeful and enjoyable. Then our goals
are set as we want them to be and we can reward ourselves for gains.

A business is a coordinated effort to achieve certain ends summarized in the

profit and loss. Joining a business means embracing some part of that at least. The
assumption is that everyone wants to be successful and for this within a company it is
important to:
* consolidate the aims of the team, the team spirit.
* understand the team’ effort to strive for achievements.
* focus on creating a team climate.
* understand the energy of challenge.
* be aware on one’s responsibility.
Desire or will is the very essence of success. Without this intensity the actions
of success have a hollowness, the hallmark of “but I tried”.

Successful business asks for good leadership and this is not some mystical act
performed by the few and only able to be performed by them through some luck of
upbringing or genetics that made them natural leaders. We can become better leaders
than we are; to achieve this means that we need to do the right things at the right time
more often than we usually do and we also need to examine ourselves. We also need
to have a clear idea of what to do in order to gain the best possible result from others.
The actions identified must be the appropriate actions in what is broadly called
”western society”(North America, U.K., Europe, Australia, New Zealand).
Leadership is to be taken into account whenever we have in view any
business; there are some steps to be followed:
69
 1. The agreement to success for every team member. Everyone wants to be
successful as far as goals are clear and business processes are far from being clumsy.
Everyone has positive and negative thoughts in their minds most of the time. We
know how easy it is for the negative thoughts: the company is not good, the boss is
bad…We represent the positive assertively in our mind- “work is rewarding”. But we
select our thoughts and they influence us. If a person has negative thoughts about the
job and the company, work performance is suffering. The negative impact can make
the team output less than it should otherwise be. But we are responsible for our own
thoughts, so what a manager can do is to point out the consequences. It is clear that
when the team becomes focused, gets people organized, celebrates success, then bad
attitudes disappear.
Defining success entails the idea of challenge which energizes people.
The team leaders and managers must live as exemplary models of how they
expect others in their team to act. Each management team member is expected to be
an “ inspiring player.” The team effort has to be understood properly. The team spirit
must be a consequence of doing other things well. Coordinating the effort is to be
achieved by the profit profile with each team member being accountable for some
number on the profile and this will define success for a team. People have seen now
the standards required.
Identifying the behaviours of success. As the goals have been agreed, the steps
to be followed are to make clear what actions were most likely to bring about the
goals.
In the goal-action principle, the idea of action becomes clear now, we have
those behaviours that will best fulfill the goal, derived from the goal and belonging to
it. It is important to find the balance between two things in conflict as a crucial act of
insight and creativity for the manager and the team. If the issue is finding sales tactics,
then the problem is one of creativity for the team to brainstorm possible tactics and
then select one or several that best achieves the balance of the required result.

Provide monitoring and feedback on progress and performance. The main

concern among the teams was to provide useful guidance on what should be changed
to improve the results. Better reports were being sought, better information.
Celebrate success, large and small. Teams celebrate success as people have
risen to the challenge. Team results were evident. The progressive build up of life
satisfaction was something that occurred beneath the daily flux and it should increase
each year. It was seen as related to goals and work had the potential to be a major
component.

Teams will remain the core of the business. Before demanding better
performance one have to be sure that this can be achieved. So, for every goal there are
tasks that must be acted out if the goal is to be achieved. Everyone succeeds if the
team succeeds. It is important to recognize individual performance, but from within
the framework of the team.
A management team should be a team, not a collection of individuals with
personal accountability. This means that every team member understands that they
can win only if the team wins and the team wins by achieving the targeted operating
profit. Within that, each person has his or her role and tasks within this role. If people
can fully perform their own jobs and have the mental, emotional and physical energy
to assist others, and if the others accept and appreciate the assistance, then those
people should be encouraged and celebrated within the team.

70
 A management team operates within the framework and policy prescribed by
the strategic plan and is accountable for creating sales revenue and converting it into
operating profit.
To develop a manager means to develop the person. That is, to improve
business management or business leadership is not merely an act of adding some
skills or some knowledge to the person; knowledge alone is not power; only if it is
backed by the ability and willingness of how, the judgement of when to use that
knowledge is power.
Intellectual honesty is an important quality that must be taken into
consideration. That means being truthful with yourself and not only. We have wishes
and dreams, sensitivities about ourselves; so often we do not want to think poorly of
ourselves; it is easier and more comfortable to find reasons beyond us for the
unfortunate things that happen or for results that should have been . Such emotional
forces can and do push us to think in certain ways. Then, intellectual honesty comes
to help us: a process of conceiving the factors accurately as a scientist might, without
the comfort of the excuses. It allows us to avoid giving up too early and this is one of
the hallmarks of all champions.
There are some situations we meet within a company:

T here are all kinds of reasons for w anting to be your ow n boss. Som e people like the idea of
there being no one in authority over them , telling them w hat to do, wsaying ork is their
not up to
standard, turning dow n their ideas, or insisting on m ethodspointless.
that seemO thers are attracted by
the thought of deciding their ow n hours, or days,
w ork.of
R unning your ow n business gives you the status of being self-em ployed, also perhaps
of
being a com pany director. There is the general feeling of independence, yourandincom
that e - and
perhaps even your w ay of life - is in your ow n hands. Som e are attracted to the idea of starting a sm all
enterprise and m aking it grow , m uch as a gardener tends his plot and m akes a num ber of plants com e
to m aturity, each in turn
creating further grow th.
If you are your ow n boss, say som e people, w ork is so m uch m ore pleasant. get Y ou can
som eone else to do the less interesting jobs and you are not bogged annoying
dow n in details. W ork
becom es easier, too, because you can get som eone else the mtoore
do difficult tasks.
M any others w ant to set up a little business of their ow n to occupy their spare tim e, and as a
pleasant w ay of earning extra m oney from w ork they like doing.
These are just a few of the reasons com m only given. Som e have good them sense; behind
others are based on com pletely false ideas. M ost contain som e elem ent of truth w hich gets m agnified
out of all proportion, and seized upon w ithout it being borne in m ind that there are other points to
consider as w ell.
A s w ith so m uch else in life, running an enterprise of your ow n entails disadvantages
as w ell
as advantages. It is surprising how rarely people stop to consider injust real
w hat
detail
the draw backs
are, yet this is an essential first step for anyone thinking
w hether
aboutit is even practicable for him to
be his ow n boss.
A n im portant reason w hy there is such glam our about being in charge of your ow n business is
that w hen you are w orking for som eone else, m any of the petty irritations as w ellofaslife,
the chore
of often having to get dow n to w ork that you do notdoing feel like
at that particular tim e, becom e
associated w ith being an em ployee. There is a feeling that, if only you w ere your ow n boss, life
w ould im m ediately becom e infinitely
pleasurable and free from irksom e detail.
This is alm ost entirely m isleading. M any of the little annoyances probably nothinghaveto
do w ith being an em ployee: being interrupted w hen you have im m at
ersed
last yourself in som e
disagreeable task, m issing the bus w hen you are infeeling
a hurry,tired or in other w ays not really up
to w orking hard at the m om ent, and so on.
These occur just as m uch w hen you are your own m aster. In fact, they tend m uch
to happen
m ore often, w hile at the sam e tim e, their effects can be far m ore upsetting.
71
 There are very real draw backs to running your own business, though for the of right kind
person, im m easurable benefits also.
A company has two ways of delivering value to clients: either the clients
obtain just the accumulated wisdom and talents of the specific professionals who are
servicing their work, or the clients can get this, “plus” all the relevant accumulated
wisdom, experience, tools, methodologies of the rest of the firm. What does it mean
for a company to have value above and beyond the talents of individual professionals?
What can a firm do that will help a professional to be more successful than he or she
would be at a halfway decent competitor? Maybe:
- provide professionals with the benefit of shared skills and experiences within
the practice group.
- facilitate access to the skills of others in different disciplines.
- establish procedures to produce well trained junior professionals.
- achieve a high level of cross selling and access to clients of other
professionals.
- provide superior support staff and systems.
- instill a system of supportive challenging, coaching to bring out the best in
each professional.
- create an emotionally supportive friendly environment.
- provide for diversification of personal risk.
- establish a powerful brand name that makes marketing easier.
Interesting but more and more in our concern the firm, the company has to be
viewed in future. The strategic challenge for professional firms is not to forecast the
future, but to ensure that the firm is effective at adapting to already observable market
changes. Most professional firms are resistant to change.
Old ways of doing business suffer from inertia and few firms are either willing
or able to implement significant changes in the way they manage their affairs. Major
trends are being identified and big schemes are announced as responding to them. But
a professional firm is not completely at the mercy of unknowable fates. You can make
things happen if you want to. Why plan in an unpredictable world? Because you can
make sure that the way you run your affairs makes you more adaptable and adaptive.
Through a combination of planning and reexamination of current management
practices, firms can become better at listening to the environment and picking up its
change signals early. They can also become better at ensuring that they have
numerous experiments going on to test new ideas and approaches. Firms should be
testing what the market will and will not respond to.
They must avoid complacency, be adaptive by constantly asking:” is there a
better way to do what we do?”
Firms are very good at figuring out what they want their people to do
differently. They are not so good at figuring out management systems to get them to
do it. So, planning means managing in new and different ways. Many companies miss
a central truth: if you haven’t changed your measures and rewards, you haven’t
changed your strategy.
A firm has to be better than the competition in the following ways:
- Aggressive listening to the market.- good tactics: focus groups,
feedback survey, client panels, formal market research..
- Using market intelligence: each practice is actively gathering
market intelligence and is devising new things to do for clients.
- Raising the level of innovation- the management’s job is to
stimulate experiments and encourage innovation.
- Sharing new knowledge- firms must become good at sharing the
results of their experiments.
72
 - Pressure for personal growth through professional performance
counseling and practice leadership.
- Management behaviour- management must be perceived as leaders
of a changed effort; stimulating new ideas, willingness to provide seed capital for
those who wish to try new things.
- Measuring success not only by the volume of work performance
but by the type of work it brings in.

What do you think about the following:

1. Visionary companies share a common subset of correct core values

2. Visionary companies require great charismatic visionary leaders.
3. The most successful companies exist first and foremost to
maximize profits.
4. Visionary companies are great places to work for everyone.
5. Highly successful companies make their best moves by brilliant
and complex strategic planning.
6. Companies should outside CEOs to stimulate fundamental change.
7. The most successful companies focus on beating competition.
8. The only constant is change.
9. Flexibility means drafting several possible scenarios for the future.
10. Companies employed bottom up planning.

Enlarge upon:

1. The Firm of the Future is so Close to us!

2. How Can You Manage Your Clients” Projects?
3. When does a Professional Company Merger Make Sense?
4. What Should a Firm Be Tolerant about?
5. How will the Adaptive Firm measure its success?

Dialogue

Mr. Norman General Manager of a large company is meeting Mr. Cleary a

reporter who wants to be informed about the success of the B&Y Company.
Mr.Cleary: Good morning Mr. Norman and thank you for the time you have
allowed to me.
Mr.Norman: It is my pleasure and I do not mind sparing some minutes with
you!
Mr. Cleary: I would like to write a few lines about your company in the
“Capitalul” magazine.
Mr. Norman: Our business has increased and as you may be acquainted with,
we have deemed it advisable to open more branches in the country.
Mr.Cleary: What kind of investment would you care for?
Mr. Norman: We deal with textiles. We enlarged our business by getting new
partners and we expect higher dividends. The quality of our products has been
maintained at a high level. So, wool prices are excellent and the revenue too. If we
73
refer to the profit and loss account, an increase of more than 20% is to be taken into
consideration.
Mr.Cleary: How did you manage that?
Mr. Norman: By working with a well trained team, by finding good partners,
by having a stroke of luck, by keeping with the new market trends.
Mr. Cleary: I do have some questions if you don’t mind. Such as:
- How quickly can one hope to climb the promotion ladder to partner level?
- What are salaries based on as your career progresses?
- How long do most people stay in your company?
- How successful is the company?
- Are you enthusiastic about the development of the company?
- Do you spend money on staff training?
- Where do you intend to expand the sales?
- What persons do you work with?
Mr. Norman:
The best are being promoted to partners; unless you make partner by the age
of 35, you will basically never make it.
Salaries reflect the assessment of the employees.
Over a ten year period, less than 40% of those hired are to be retained by the
company.
- The shareholders are content as the loss is small.
- Yes, as far as the turnover has increased and we have subsidiaries all over
the world.
- There are full and part time courses, most of them being paid by our
company.
- In Eastern Europe.
- Those experienced on the sales side, with first class technical knowledge,
young, full of energy and new ideas; those who know what competition means.

Additional Vocabulary:

chartered company- companie înfiinţată pe baza unei Carte Regale

joint stock c.- societate pe acţiuni
unlimited c.- societate cu răspundere nelimitată
limited c.- societate cu răspundere limitată
parent c.- societate mamă
wholly owned c.- societate în propietate integrală
unincorporated c.- societate neînregistrată
winding up of a c.- încetarea activităţii unei societăţi
greenfield c.- societate la început de drum
bogus company- societate fictică
close c.- societate închisă
dormant c.- societate inactivă
company funds – capital al firmei
company identity- imagine de marcă
to stay afloat- a se menţine pe linia de plutire
shareholder-acţionar
shares- acţiuni, titluri de valoare
preference shares- acţiuni privişegiate
deferred shares- acţiuni cu plata dividendului după satisfacerea celorlalte
outstanding shares- acţiuni în circuşaţie
74
share capital- capital social, în acţiuni
share market- bursă de acţiuni
share prices- curs
share index- indice
share split- divizare a acţiunilor
to share the profit- a împărţi profitul
to share one’s views- a împărtăşi părerile cuiva
to share one’s experience- a împărtăşi experienţă
to assess-a evalua
assessment- evaluare
assessed- evaluat
turnover- cifra de afaceri
loss-pierdere, deficit
to run at a loss- a lucra în pierdere
loss ratio- rata pierderilor
relocation- mutare
core business- activitate de bază
break up- lichidare
liable- responsabil de

75
 Dealing with a Customer

When dealing with a customer you may encounter some situations:

You have an angry customer because you messed up
T h e f i r s t s t e p in d e a l i n g w i t h any angry customer, whatever t h e reason, isto
l i s t e n w h i l e t h e y get t h e i r anger out oft h e i r s ys te m . Sympathizew i t h t h e p r o b le m
w i t h phrases su c h as, 'H o w f r u s t r a t i n g for you,' or '1 can see howi n f u r i a t i n g t h a t
must: be'.
Once t h e y have expressedt h e i r feelings, andre a liz e d t h a t you are li s t e n in g
a n d s y m p a t h e t i c ,t h e y w i l l c a l m down. Atth i s point it isw ise, as well ash o n e s t , to
h o l d your hands up and admit your mistake sa byyi ng s o m e t h i n g l i k e .I ’ m t e r r i b l y
sorry. 1 should have putt h e order t h r o u g h manually and Ic l e a n forgot. I doa p ologiz e,
e s p e cia llyafter it's caused you so muchtr o u b le '. T h i s w i l l ta k e t h e wind o u t of t h e i r
s a ils , not least because so few peoplea c t u a l l y a d m it lo t h e i r mistakes.
So long as you offer to put things right: in any reasonable way that suits the
customer, they are likely to end up feeling very satisfied. Not only have you resolved
the problem, you've also been honest with them. It should reassure them that
you're a good organization to do business with: everyone makes the occasional
mistake, and at least you admit to it and p u t it right magnanimously.
Some people will advise you never to admit blame when dealing with
customers in case they sue you. It may be wise to take legal advice if your mistake
has cost them thousands, but in most cases they're not going to sue. If you've cost
them jus t a few pounds, what's the problem? You ought to pay up, so there should
be no question of suing. From a legal point of view, refusing to admit blame may
sometimes be wise. From an ethical and customer relations standpoint, it is always
better to admit your mistakes.

You have an angry customer because one of your team messed up.
Handle this exactly as you would if it was you that had messed up. You are
responsible for your team, and you should carry the can. The customer doesn't
need to know which individual in your team messed up; it's enough to know that it's
your team. Don't ever try to pass the buck when speaking to a customer, tempting
though it may seem to say, 'I'm afraid a ju ni or member of my department made a
mistake'.
You w i ll obviously need to talk to the team member in question privately.
However, you need to separate the mistake from the customer's reaction to i t . If
the customer overreacted wildly to a minor error of judgement or an
understandable mistake, don't make a big deal of it with your team member jus t
because the customer made a big deal of it with you. If you're angry and upset by your
exchange w i t h the customer, wait until you've calmed down before tackling the
person who made the mistake.

You can't deliver on a promise to a customer

The important thing is to limit the damage, and there are two key ways to do
this:
1. The most important thing is to give your customer as much notice as you
possibly can. The later you tell them, the deeper the hole you land them in. Plenty of
warning gives them time to find a contingency without it becoming a major issue. If
you're not sure whether you can deliver but it's looking increasingly dodgy, you'll need
to explain the situation before you know for certain whether you'll have to let them

76
down. Then they can choose whether to take the risk or whether to find an
alternative.
2. When you tell them, apologize profusely and let them know that you
recognize how inconvenient it is for them. Then offer them whatever you can to make
up for it. This might mean telling them you can deliver part of what they want, or
they can have everything they want but later than they hoped or to a lower standard.
Or you might say, 'I can't do this, but I can find you someone who can'.

A major customer threatens to go elsewhere unless you make concessions you

can't afford
They say that they'll go to your manager/the top of your organization/the
press. The answer is in the question here. If you really can't afford the
concessions, you can't afford the customer and you're better off letting them go.
Before you do, however, make sure that there really aren't any other concessions chat
would suit you both. If you can't drop your prices low enough, maybe they can pay
in installments or on other very good terms. If you can't deliver soon enough,
perhaps you could deliver part of the order.
If there is no meeting ground, make sure you part on friendly terms. Don't
tell them they'll regret changing supplier. That way, they may well come back to you.
If they were bluffing to get you to make concessions, or if their new supplier lets
them down, you want them to feel they can come back to you easily.

A disgruntled customer threatens to report you

They say that they'll go to your manager/top of your organization/the press.
Let them. Presumably you've done nothing wrong, so you have nothing to worry
about. Arguing with them will make it worse, and look as if you're running scared. If
you say to them, 'If you feel you want to take it further, that's up to you,' it's more
likely to deter them. After all, they were threatening in order to get a response from
you. The tactic clearly hasn't worked so they may well abandon it.
If the customer threatens to go to someone internally, from your immediate
boss to the MD, forewarn the manager concerned. They won't be too pleased if they
get a call from a customer and look a fool because they don't have any of the facts. So
brief them fully.
If by any chance you are at fault, you're still better off 'fessing up. It is better
for your boss to hear it from you first than from an angry customer.

A customer is wrong
Sometimes a customer accuses you of doing something that you really
haven't done. In fact, maybe their subsequent problems have arisen because they
failed to give you their full address, or sign the cheque. So what do you do when they
complain? Is the customer really always right?
You need to listen to their complaint, and sympathize with their problem just
as yon would if the complaint were justified. You can still say, 'How frustrating!' or
I can see that must have put you in a difficult position,' without admitting blame.
Tactfully explain what has caused the problem, but don't make them feel
stupid or they could get defensive. Avoid words and phrases such as 'fault' or 'you
should have . . Give them an excuse for their mistake. For example, 'Our delivery
terms are 28 days unless you specify express delivery. I know how easy it can be to
overlook that sort of thing, especially when you're in a hurry.'
Let them feel their point is valid, without accepting blame. Say for example,
'Maybe we should print our delivery terms on the order form as well as on the terms
and conditions. I'll suggest that to the department concerned.'
77
 Don't offer refunds or replace items just to calm a customer down, in case it
implies that you were at fault. This might be an unwise precedent. However, if you
really want to do something, describe it as a gesture of appreciation for bringing
their problem to your attention.

You know one of your customers is lying to you

You get them occasionally, customers who frequently claim, for example,
that the goods arrived faulty or damaged when you know for a fact that they didn't.
Whatever you do, don't bother arguing. You've got two options:
1. give the customer the benefit of the doubt
2. stop supplying them and ask them to go elsewhere.
You've already got a dishonest customer. If you argue with them, you'll have
an angry, dishonest customer - and that's worse. They may spread rumours or
damaging gossip about your organization. So don't fall out with them.
The other trap to avoid is changing your systems in order to try and combat
their dishonesty. You could inconvenience all your honest customers, and make
your own lives more complicated, just for the sake of a customer who doesn't
deserve that kind of effort. So if you don't want to put up with it, just drop the
customer.

An important customer demands more of your time than you can spare
If you have a very talkative customer who engages you in long-winded
conversations, you need to find a way to get the information you need from them
and then terminate the conversation without upsetting them. You can't keep
interrupting them without sounding rude, so you need to interrupt yourself.
It may sound strange, b u t it makes sense really. You need to get a word in,
b u t to do it by joining t he i r conversation rather than deflecting it. Once you're
in, then you can change the subject, like this: 'I quite agree, the traffic's getting silly
on the North Circular these days. By the way, when do you need these delivered by?'

There's a no th er k i n d of demanding customer, too: the one who's on the

phone 10 times a day w ith endless minor queries. You can't avoid this customer
altogether, and you'll offend them if you try. You just need to get them to be less of a
nuisance:
If someone's calling several times a day, tell them the first time they call t h a t
you're very busy at the moment and you want to wait until you can give them your
full attention. Ask if you can call back at the end of the day. They can save all their
questions until you ring back, and you have only one call all day, at a time of your
choosing.
Put your voicemail on or have someone field your calls. You do have to talk
to this customer sometimes, however, so don't wind them up by taking ages to call
back. Once they learn they can trust you to call back the same day - albeit at the end of
the day - they'll start to feel happier about leaving messages.
If the customer is on email, ask them to email you instead of calling. Explain
that you prefer to have everything in writing so you can be sure you have all the
details, and you don't forget to follow anything up. Now you can deal with the queries
at a time that suits you. You may have to speak to them occasionally but, again, you
can choose the time.

A good and previously reliable supplier lets you down badly.

In t h e short term, you need to find another supplier. The question is whether in
the long term you should change to a new supplier or whether you should give this
78
one another chance. In the end it's your decision, but here are some considerations to
lake into account:
-Why did th ey let you down? Is it something they should have foreseen and
avoided? Or was it t h e k ind of freak problem that no one could haveanticipated?
- H o w did they let you down? Did they give you as much warning as
possible that trouble was brewing? Did they soundsuitably concerned at letting you
down? Did they do anything to try to mitigate the damage?
- Have they ever let you down before? Have there been other minorincidents,
or is this the first problem in years?
- Why were you using them in the first place? What is it that makes them
better than other suppliers?
- Could you find another supplier as good as them in all the essentials -price,
quality, reliability, service and so on? Shop around and see what elseis available.
By t h e tim e you've thought through all these questions, you should be in a
position to decide whether to stick w ith this supplier or not. And there's one other
thing you can do- monitor the service and quality you get from whichever supplier you
use as a replacement (assuming you find another supplier forthis order). This should
give you an idea of whetherit's worth moving your contract.

You have a PR crisis on your hands

Everyone loves a drama - except perhaps the people caught up in it.
Inevitably, then, many crises will attract the attention of the press. They gather like
hyenas around the kill, each hungry to get first bite at the story. And not only do
you have to deal with the crisis itself but you also have to cope with the press, who
will be ready at any moment to turn on you if you make a wrong move.
The press can be either a blessing or a curse in a crisis, and the balance can
lie in how you handle them. Of course, sometimes the press are on your side from
the start. If your buildings have been damaged by severe weather, or a lorry has
careered off the road straight through your shop window, you have the sympathy of
the media from the outset.
But the press always want someone to blame, and all too often they will pick
on you. If you're making redundancies, if you've polluted the river that runs past the
factory or if an accident has been caused by faulty equipment then they'll be
sniffing round for evidence to pin the blame on you.
So what can you do? The good news is that there is a wealth of advice,
derived from the experience of thousands of organizations over many years. There
are ways to handle the press (and other media) that will at least minimize the
damage and, at best, turn their attitude around to one of support for your case. So
below are the key rules for handling a PR crisis.

Tell the press what's going on right from the start. The more information you
give them,th e less th e y w i l l need to d ig d i e d i r t to get a decent story.D on't wait u n t i l
you've solved th e crisis - keep t h e m posted from the moment theyt u r n tip ask in g
questions.
I t ' s no good k e e p i n g th e press informed if youd o n 't also keep your ownpeople
posted. Otherwise disgruntled staff, who are being kept in the dark, may well decide
to pass on to the press their own outdated or misunderstood version of the facts.

Honesty can actually be a disarmingly smart policy. Many years ago, the BBC
accidentally double booked two key political figures to give one of the prestigious
Reith lectures. One had to be cancelled, of course, and the press were f u l l of how
and why he had been snubbed. The Director General of the BBC adopted a simple
79
but ingenious approach when questioned by the press. He j u s t said: 'It was a cock
up, OK?' He was open, honest and wrong-footed the press completely. We all have
cock tips from time to time, and the press understand that as well as anyone.

There are three rules to remember to keep things simple. First: the press
don't know your organisation or your indus try as well as you do, and they want to
print a clear, s imple story (or t he ir readers. So don't confuse them with
unnecessary details, jargon or background information they don't want. Just keep
your message uncluttered. If they ask for more, give it to them if you can. But
don't volunteer it.
The second rule of keeping your story simple is to make sure you have only
one spokesperson if you possibly can. Otherwise there is a danger that they may
contradict each other. One single point of communication means one single,
consistent voice.
And the third rule is: never speculate. This simply adds to the confusion.
Speculation may be reported as fact - it often is. So if you're asked to guess at the
cause of the chemical leak, how many redundancies there are likely to be or when the
building will be operational again, politely decline to comment. Or just say, I
don't know'.
So, the three rules of keeping it simple are:
1.don't give more information than you need to
2.have a single, consistent message delivered by a single spokesperson
3.never speculate.
Then, get your priorities right
You will horrify readers, listeners or viewers if you start to talk about the
financial cost of this disaster when people have been killed or injured.

Be aware how things look to other people

Be aware of what the public perception of your crisis handling will be. It's not
enough to be right - you have to be seen to be right. Suppose a press story breaks
reporting that many supermarket eggs are infected with salmonella, and there is a
slight risk of serious illness. You are an egg producer. If you react by insisting that
there is no danger at all, people will just think, 'They would say that, wouldn't, they?'
There may indeed be no danger - or there may be. It doesn't matter. What
matters is that people will think you are trying to cover up the facts for your own
ends; that you're prepared to lie to people about their health rather than lose profits.
So consider how your version of events, which people will consider potentially
very biased, will look. It is better to say that you are very concerned about the health
scare over eggs - you have no evidence that there is any risk at all, but you're taking
action to find out the facts as fast as possible. Support any research - maybe donate
funds to it - and invite inspectors to check out your operation. Say you would
welcome official guidelines on how your organization can remove any risk, and
generally be seen to be taking the action the public, wants, not just paying lip service
to it.
Never 'no comment'
What do you think when you hear an interviewee say 'no comment', or when a
report says that 'the company declined to comment'? You think they're guilty,
don't you? You reckon they've got something to hide. That's what everyone thinks.
And it's what they'll think about you, if you say 'no comment'. So don't. If there's
nothing you can tell them, it's better to say, Tin afraid I don't have any more
information at the moment'.
Be positive
80
 If you seem worried or down beat in interviews, people will assume you're in
trouble. If you come across as angry they will take a dislike to you. People will read a
great deal into your attitude, so make sure it is always friendly and positive,
especially when you're talking to the broadcast media. If people have suffered, it
doesn't do to look too cheerful about it, of course. But you can still be open and
courteous. Make sure you show sympathy for any victims of the disaster, whether or
not you accept responsibility.
Be friendly
The press are only doing their job. If you want them on your side, you need to
accept this and not hold grudges against them the phone and the cafeteria and give them a
warm room. Treat them politely and with respect and be as helpful as you can.

Get your friends on your side

If the press are against you, recruit people outside the company who will
speak on your behalf. Satisfied customers, trade association contacts, suppliers, ex-
employees . . . anyone who the press will be interested to talk to and whom you can rely
on to back you up. They will assure the press that your safety standards are exemplary,
that you're a great company to work for, that you are known for your reliability or
whatever it is you need said. Outsiders always have more credibility than insiders.
Go the extra mile
If you've made a mistake, or are believed to have made a mistake, do everything
you can to put it right. Even if people blame you for the crisis itself don't give anyone
an excuse to complain about your response to it. Do even more than you have to give
people extra time off, replace their damaged property without quibble and better than
it was before, pay to clean up the river and fund a new wildlife reserve along its banks.
Show that you're sorry you messed up, but you genuinely want to make everything better.
You may remember a few years ago a cross channel ferry ran aground on a
sandbank. Due to the vagaries of the tide it was a day or so before they could float it off
again. Meantime everyone was stuck on board. But the ferry company and the crew
leapt into action as soon as the disaster struck. They kept everyone informed,
refunded the cost of the tickets, gave away all the free food and drink they could and
generally bent over backwards to make up for the discomfort and inconvenience.
When the ferry finally docked, the press were waiting to interview the
passengers as they disembarked. But much to their disappointment , they couldn't
find a single passenger who had a bad word to say about the ferry operator. They
all insisted, 'It was just bad luck, and they looked after us beautifully.
Remember, you don't have to deal with very many crises , but the press deal
with them for a living. They are bound to be smarter than you at it, so don't try to
fool them - they'll make you look the fool. Just play it straight, honest and open.

Topics for discussion:

2. How can you discover the way the client defines quality?
3. Can you guarantee your clients” satisfaction?
4. How important is listening when you deal with difficult clients?
5. Which is the key talent in good selling?
6. Who decides value?

Enlarge upon the following:

81
 • “Do good work and the clients will come”!
• “Professionals are supposed to care about their clients, aren’t
they”?
• “Quality must be negotiated continually.”
• “New business will be won only to the extent that the client
believes the professional cares and is trying to help.”
• “Continuous investment must be made in getting better and better”!

Dialogue

Mr. Slide aims at success in business. He is a middle aged, talkative merchant,

a retailer and wholesaler too. He has got a large warehouse and a wide range of
products. The storage is done in a new, modern building. How important quality is
for him might be guessed in the following discussion:
Mr. Daube, the customer: Good morning to you my friend!
Mr. Slide: How are you? I haven’t seen you for a month!
Mr. Daube: Well, I was away in France. Now I am back and I do have plenty
of products to buy for my store. I would like good quality as you have inured me so
far. I need to buy coffee, tea, cigarettes, butter, juice, mineral water, olives, sweets,
dairy products, fresh vegetables. I don’t want them to be damaged, so please be
careful with the packaging. They may be easily spoiled by dampness.
Mr.Slide: They are all well packed, you need not worry. And the quality is the
expected one as far as I will always be concerned in stocking only the best goods. I
hate to deal in cheap lines. As far as the vegetables are being concerned, I would like
to recommend you the ones I brought from Craiova.
Mr. Daube: Are they ripe enough?
Mr. Slide: You will be pleased I do promise you!
Mr. Daube: Now, what about the payment? How would you prefer?
Mr.Slide: As you wish. Cash or by check. If you have a purchase in excess of
5 mil.lei the store grants a 10% discount and 2% additional rebate for cash payment.
Mr. Daube: You are very kind.
Mr. Slide: The prices have gone up lately due to the inflation and to the
alignment of the most important products to the European prices(gas, energy.) So that
I had no choice but to cope with them. Cigarettes and coffee are a luxury and still
most of us cannot live without them. But they are worth buying as the quality is the
best one.
Mr. Daube: Maybe more smokers will give up in future or will care more
about their health…. And we’ll drink less coffee and try to be less stresses and
nervous…
Mr.Slide: You see, even if this rise in wholesale prices entails an immediate
increase in the retail ones, the consumers are not alarmed. Then retailers will have to
change their price labels again and the profits in the luxury trade may not be the ones
we wish. Maybe some people living on a present day salary or fixed income will have
to do without a luxury that they could have still afforded some months ago. The retail
trade can be duller in this respect. Anyway, let’s not be so pessimistic because things
may change unexpectedly.
Mr. Daube: I trust your products and I will remain your faithful client!

82
Additional Vocabulary:

to grant- a acorda
storage- depozitare
subsidized price- preţ subvenţionat
brand name- marcă de fabrică
to book an order- a înregistra o comandă
sale- vânzare
sale by sample- vânzare cu mostră
sale for future delivery- v. la termen
sale on hire purchase- v. cu plata în rate
sales outlet-punct de desfacere
sales quota- cota de vănzări
sales records- evidenţa vânzărilor
sales department- serviciul commercial
overstock- depăşire a stocului
price advance- majorare
price alignment- aliniere
price collapse- cădere
price cut- reducere
price gap- decalaj
price maintenance- menţinere
price shading- reducere mică
price freeze- îngheţare
price ceiling- plafon de preţuri
blanket price- preţ global
bid price- preţ oferit
bottom price- preţul cel mai scăzut
ceiling price- preţul maxim
flat price- preţ unic
floor price- preţ minimal
peg price- stabilizare
purchase price- preţ de cumpărare
sell price- preţ de vânzare
invoice- factura
delivery- livrare
middleman- intermediary
convenience stores- magazine locale
out of stock- lipseşte din stoc
sole selling rights- drepturi de vânzare exclusivistă
world market price- preţ de pe piaţa mondială
store layout- configuraţia magazinului

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 Negotiations

Negotiation is not a science nor is it a branch of technology. It is a life skill.

We start to negotiate when we are very young and as we grow older we build up
patterns of behaviour that reflect what we feel “works for us”. And this will be based
partly upon the kind of personality we may have inherited and partly upon the kind of
personality we have lived and grown up.
Negotiation in business is no doubt about facts, costs, profits, logical decision
making but also about people, their emotions(joy, surprise, fear, doubt, anger, sorrow)
, goals and the kind of human beings they are. An understanding of people’s
motivation and how their personalities can affect their behaviour can be vital in
discovering how you can do business with them better and better.
To negotiate effectively one must communicate as such. The message has to
be conveyed, received, understood, accepted in order to entail the right actions or
responses. The process of transmission is very important – not all negotiations are
conducted face to face but there are other choices too: letters, the fax, the electronic
mail, the phone. Still there might be some problems such as: they may get missed or
misunderstood.

To many personnel managers, negotiation implies collective bargaining. To a

sales executive, it w ill be thought of in terms of making a commercial deal.
Quantity surveyors, purchasing managers and lawyers all have their own specialist
interpretations of what, in essence, is a process common to all managerial work. In
reality, all managers negotiate, if not with outside parties then with each other.
T h e procedures and language of formal negotiation vary with the type of
negotiation involved. A set-piece pay bargaining session has its own system and
jargon that differ from those of a meeting of solicitors to settle a claim for libel
damages. Yet the underlying principles and much of the psychology of the process
are the same for all forms of negotiation.
It is also easy for managers to overlook the fact that much of their informal
daily activity is, in effect, negotiation. All managers spend a large proportion of their
time trying to influence and persuade other managers over whom they have no
executive authority. Consider two examples:
A personnel manager attempts to 'sell' the need for a more systematic form of
employee consultation to a reluctant office manager. The company has a general policy
of support for employee involvement practices, but has not laid down any specific
system or procedure. Neither the extent to which the personnel manager can use the
general policy to require the office manager's cooperation, nor the right of the office
manager to reject the personnel manager's suggestions is clearly defined. The outcome
will be influenced by their possibly differing perceptions of the formal position, and
by the powers of argument or persuasion of the personnel manager.
A sales executive tries to persuade the production manager to change a
manufacturing schedule to fit in a small order for a special customer. The production
manager has full authority to decide production schedules against a weekly output plan
set by top management. Officially, the sales manager should make a request through the
sales director for an urgent variation to this plan but because the order is only a small
one, he approaches the production manager informally and must, therefore, rely on
persuasion.
Negotiating skills are, therefore, a very important element in the effective
manager's portfolio of personal competencies.

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 Recognizing when negotiation is occurring is the first step towards acquiring
the necessary skills, and this is aided by an understanding of the basic principles
involved.
Negotiation is a process, not a single skill. A range of skills are involved in
handling this process effectively, but to identify the skills relevant to any negotiating
episode, it is important to recognize which elements or principles of negotiation are
involved. There are seven principles common to all forms of negotiation:
• Negotiation involves two or more parties who need or think they need each
other's involvement in achieving some desired outcome. There must be some common
interest, either in the subject matter of the negotiation or in the negotiating context that
puts or keeps the parties in contact.
• Although sharing a degree of interest, the parties start with different opinions or
objectives, and these differences initially prevent the achievement of an outcome.
• At least initially, the parties consider that negotiation is a more satisfactory
way of trying to resolve their differences than alternatives such as coercion or
arbitration.
• Each party considers that there is some possibility of persuading the other to
modify their original position. It is not essential - though it is usually highly desirable
for each party to be willing to compromise. But negotiation can begin when parties have
an initial intention of maintaining their opening positions, but each has some hope of
persuading the other to change.
* Similarly even when their ideal outcomes prove unattainable, both parties
retain hope of an acceptable final agreement.
* Each party has some influence or power - real or assumed -over the other's
ability to act. If one party is entirely powerless, there may he no point in the other party
committing itself to a negotiating process. The matter can be settled unilaterally by the
party with the untrammeled power to act. This power or influence may, however, be indirect
and bear on issues other than those that are the direct subject of negotiation.
* The negotiating process itself is one of interaction between people in most
cases by direct, verbal interchange. Even when the negotiation is being conducted
through correspondence, there is an essential underlying human element. The progress
of all types of negotiation is strongly influenced by emotion and attitudes, not just by
the facts or logic of each party's arguments.
Negotiation is a process of interaction by which two or more parties who consider
they need to be jointly involved in an outcome, but who initially have different
objectives, seek by the use of argument and persuasion to resolve their differences in
order to achieve a mutually acceptable solution.
It will probably be readily accepted that this definition is relevant to formal
negotiations such as pay bargaining or the settlement of a legal claim for damages. Trade
unions and employers or the solicitors representing two parties to litigation obviously
accept that they need jointly to evolve a mutually satisfactory outcome, starting from
differing positions. Each party knows that the other has some power to influence the
outcome. A trade union might apply the sanction of industrial action: an employer might
reduce the labor force: the claimant's solicitors might stop negotiating and take the case
to court: the respondent has some defense if this occurs.
In the second of these examples, the sales executive has no direct power to require
the production manager to alter production schedules: the production manager can just
say no -- so where does negotiation come in? A willingness at least to consider the
request and thereby become involved in a discussion about a possible jointly
satisfactory outcome - will stem from several aspects of common interest, or from a
recognition of more subtle forms of power.

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 The sales executive wants the production schedules altered, the production
manager does not, but both managers, it is to be hoped, share an interest in the success of
the business. To disappoint an important customer may be of more immediate concern
to the sales executive than to the production manager, but a good production manager
will pay heed to the importance of good customer service. Similarly, the sales
executive will recognize the costs and perhaps delays to other orders that a change in
the production schedule might give rise to. So a common interest in the good of the
business enables both to see something in the other's point of view, and thus
encourages a dialogue, rather than the simple exercise of formal authority.
It may be that the sales executive (or the customer on whose behalf the request
is being made) is known by the production manager to be highly regarded by the
managing director. It might thus be unwise, in terms of company politics, for the
production manager to run the risk of being considered unhelpful.
Both managers also know that they have to continue to work together. Without
anything being said, both will probably be influenced by knowing that this long-term
working relationship could be adversely affected by mishandling the particular incident.
The production manager may have the right to say no in other words, not to negotiate
but will wonder whether this would cause avoidable friction. There may also be the
thought that by agreeing some concession, an obligation may be created that might be
capitalized on at some future date.

In the other example, considerations of a similar kind might also lead to the
office manager's being willing to discuss the personnel manager's advice. Both have an
interest in the smooth running of the company and in compliance with the company policy:
the personnel manager may be known to have top management backing: the managers
have to go on working together, and therefore the office manager will have to consider
the implications of rejecting the personnel manager's advice if employee relations are
then seen to deteriorate.

Some key points to have in mind:

All managers negotiate - with each other, as well as with customers,

suppliers, trade unions, and other outside par ties.
Negotiation is about achieving a mutually acceptable out come to a
situation in which the parties involved initially have differing aims.
Negotiations are affected by the emotions and attitudes of the negotiators
- not just by the logic of the arguments they use.
Consultation needs to be distinguished from negotiation. In negotiation,
the parties accept that joint agreement is necessary; in consultation, one party
reserves the right to act unilaterally.
Negotiators need to identify a top line objective - the best achievable
outcome - and a bottom line - the lowest, still acceptable outcome.
Over optimism about the probable outcome is often linked to a failure to
consider the bottom line. Top and bottom lines may each consist of several
alternative permutations of the issues under negotiation. Possible outcomes need
to be considered from the other party's viewpoint as well as one's own. It is
important to retain credibility by restricting statements about 'final offers' or
sticking-points to genuine bottom lines.
If possible, one objective should be to help the other party to feel satisfied
with the outcome; but an aggressive or damaging claim has to be resisted with
vigour.
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 In planning and conducting negotiations, positive attention should be
paid to the duration of bargaining sessions, formal presentations, and individual
contributions to the discussion.
A continuous session should rarely exceed two hours, a formal
presentation 15 to 20 minutes, and an informal con tribution two to three
minutes.
Adjournments coincident with refreshments should be used to break a
lengthy negotiation into two-hour segments. Adjournments should be used as
powerful aids to nego tiation by:
providing time to consider progress or new proposals
within the team and avoid snap decisions - bringing unconstructive or
personalized arguments to an end
providing an opportunity for informal, exploratory talks between
individual members of the two parties.

The purpose of negotiation is to reach agreement, not to score points in

argument.
Effective negotiators are good listeners: they ask questions more often than
they make statements. Humor, or good-natured banter, can be used to reduce tension
and help create a bond between the two parties. It is important to look for verbal and
non-verbal clues or sig nals of the other party's changes of mood or approach. There
should be a concentration on issues or outcomes of common interest, rather than on
the original differences.
The closer a negotiation is to agreement; the more sensi tively the
discussion should be handled. Periodic, jointly agreed summaries of progress can
secure a phased agreement and prevent reversion to earlier argument. Proposals
may initially be put as hypothetical suggestions. This makes it easier for both
parties to avoid the pressure of immediate acceptance or withdrawal.
There is a positive advantage in making it easy for the other side to move,
rather than challenging them on a win/lose basis. Proposals are best sold on their
advantages to the other party, not to one's own.
Fear of losing personal or corporate face can severely inhibit progress.
Compromise should be seen as constructive, not weakness. In assessing
the benefits of an agreement, consideration should be given to factors beyond the
context of the immediate negotiation - such as the creation of useful precedents,
and the quality of long-term relationships.

The final offer and agreement needs to be timed to coincide with a period
of constructive discussion - and not be done during a combative phase.
It is important to achieve credibility for any statement about an offer's
being final - the tone and style of such a state ment may be as important as its
substance. Devices can be used to break a deadlock in reaching agree ment - such as
promises of future negotiations on a related topic, or making the introduction of
a new conditions sub ject to later review.
Before finalizing an agreement, check that all aspects have been agreed,
particularly dates for implementation, review or completion; and definitions of
terms. Ensure full understanding of what has been agreed through final
summaries and by producing written confirmation. Unresolved issues should
not be 'fudged' by producing vague or ambiguous forms of words in order to
achieve ap parent agreement.

87
 An agreement is not successful until it has been effectively implemented.
It is often helpful to include an implementation program as an integral
part of a negotiated agreement. An implementation program defines what has
to be done, when, and by whom.
For some agreements, implementation may be best effect ed by a joint
team.
Those affected by, or required to apply, an agreement (though not
themselves involved in the actual negotiation) need adequate information and
explanation. Such action should be based on defining who needs to know what,
how, and by whom this information should be given, by what methods, and to
what time-scales.

Face-to-face discussions are not the only form of negotiation: effective use can
also be made of correspondence and the telephone.
An opening letter can help to set the parameters and styleof later negotiation.
Dealing with all or part of a negotiation by correspondence may well save
time, avoid an emotional confrontation, provide a record of the negotiation, and
enable carefully drafted and complex proposals to be produced. Some negotiators are
less resistant to proposals when discussing them on the telephone.
Telephone discussions may be used to settle minor or simple negotiating
points extremely quickly.

Negotiations cannot be conducted through the media, but the media can be
used to influence the attitudes of those concerned, as well as - where appropriate -
public understanding and support.
The common characteristics of media communications of all kinds are
accuracy, clarity, and reasonableness. Press advertisements offer full control over
what is said, but their status as advertisements may reduce their credibility. Press
releases provide initial control over content, but it cannot be guaranteed that they
will be reproduced fully, or at all.
Press releases need to be written in the style of the mediato which they are
issued.
Journalists may be assisted or persuaded to write news stories. These may
carry more public credibility than company statements, but incur the risk of error or
distortion.
Radio or TV interviews should be seen as opportunities to put across a
message in clear, simple terms, regardless of the precise questions asked.
• Commercial negotiations often differ from other forms of bargaining
in that the two parties have no working relation ship outside the issues under
negotiation.
• Internal market negotiations should focus on the joint re sponsibility of
purchaser and provider for the survival and success of the organization they
both work for.
• The most common feature of commercial negotiations is buying and
selling - often to produce a contractually bind ing agreement.
• In buying and selling, the balance of power frequently lies with the
buyer who can choose to deal with an alternative source of supply.
• Consequently, business literature and training programmes concentrate
far more on developing selling skills than on the expertise involved in buying.
• Sales techniques include the avoidance of direct competi tion by
emphasizing the unique qualities of the goods or services being sold, an

88
emphasis on the benefits of a deal to the buyer, and encouraging the buyer to
make an im mediate decision.
• General bargaining principles include an emphasis on care ful planning,
the trading of concessions, and the avoidance of impasse.
• Because most commercial agreements constitute legally enforceable
contracts, it is important that they should be in writing, unambiguous, and
founded on a basis of accurate information.
• Legal remedies for breach of contract include injunctions to enforce
performance and also compensation for financial damages.

Although some people are better natural negotiators than others,

negotiating skills can be acquired or improved by practice, coaching and
training.
There are three main elements involved in improving one's negotiating
abilities - knowledge, skills and attitudes. Effective negotiation demands a
knowledge of the princi ples of the negotiating process, the context of the
particular negotiation, and its detailed subject matter. The main types of skill
involved are analytical, interactive and communicative.
Different approaches are needed to deal effectively with dif ferent types
of difficult negotiations.
Negotiations are strongly influenced by underlying atti tudes to the
process itself, to the issues and personalities involved in the particular case, and
by one's own self-perception and personal needs for recognition and achieve -
ment.
Planning to improve one's negotiating skills should be an el ement in most
personnel professionals' personal develop ment plans.

Dialogue

Mr. Nagel is the owner of a beautiful estate located 20 km far from Sibiu.
Alex Feeny came from the USA two months ago and now he is looking for a
place to settle with his family. He met Mr. Nagel at a meeting last week. Mr. Nagel
owns several estates and this one is worth buying. But he wants to deal directly with
the person willing to become owner.
A. Feeny: Good morning Mr. Nagel how are you today?
Mr. Nagel: I am very tired as I have been looking for some agencies to help
me with the sale. It costs a lot, so I do want to deal with the client and not through a
middleman.
A. Feeny: I agree and I would like to talk with you about this. Have you
thought of a price?
Mr.Nagel: Well, the estate is worth around 570 000$ but the price may be
negotiable.
A. Feeny: It is a bit too expensive for me. Even if I am a businessman, I do
think I cannot afford the price unless you drop it.
Mr Nagel: Prices here have skyrocketed lately and they are not leveling off.
A. Feeny: I can only pay 550 000 $ cash. If you agree then I can give you the
money tomorrow.

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 Mr. Nagel: I agree only if you take into consideration the terms regarding the
insurance of the house. You have to pay the installments in advance as I had already
done this so far.
A.Feeny: I agree. I think we have to meet a notary and sign the papers.
Mr.Nagel: Therefore, we can see him at 9 tomorrow morning. I will bring all
the papers and as far as you are concerned do not forget to have the money with you!
A. Feendy: I will. Thank you very much. You are a very nice person. My
family is going to be very grateful to you as they enjoy this gorgeous land.

Additional Vocabulary:

to negotiate a loan- a negocia un împrumut

ongoing negotiations- tratative în desfăşurare
negotiations in progress- tratative în desfăşurare
joint- comun
joint bargaining- negocieri commune
joint owner- copropietar
joint management- conducere colectivă
outcome- rezultat, consecinţă
to settle- a stabili, a soluţiona, a reglementa
to claim- a pretinde, a cere, a revendica
to score- a înregistra, a nota, a marca, a obţine, a realiza
scheme- plan, aranjament, combinaţie
damage- daună, prejudiciu
to adjourn- a amâna, a suspenda
adjournment- amânare, suspendare, întrerupere
to adjust- a adapta, a ajusta, a corecta, a aranja, a pune în ordine, a aplana
adjustment- ajustare, potrivire, corectare, adaptare, aplanare, acoperire.
to involve- a implica, a antrena
involvement- implicare,participare
to enforce- a aplica, a pune în vigoare
enforceable- aplicabil
enforceability- aplicabilitate
enforcement- aplicare a unei legi
to bind- a lega, a încheia, a impune, a oblige, a se lega, a se oblige
binding- legătură
concession- concesie, recunoaştere
to incur- a contracta, a asuma, a suporta, a suferi
to induce- a convinge, a determina la, a impinge la, a hotărî la
guaranteed- garantat
guarantee- garanţie, siguranţă

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 Topics for discussion:

1.How can you be successful in a negotiation?

2.Can you be persuasive with a client? In what way?
3.Are there secrets in communication?
4.How can you be inventive in negotiating a product?
5.What mistakes do you have to avoid?

Enlarge upon:

1.There is no failure, but results and only results!

2.There is no long lasting success without sacrifices…
3.There are of three kind of people: those who make things happen, those who
look at things to happen, those who do not understand what is happening.
4.Keep close with those who win and avoid those who lose!
5.Never negotiate without being afraid, but never be afraid to negotiate!

Meetings

Meetings have to be an efficient tool to assist us in getting decisions,

information and action. We discuss, decide, decree, demolish. Sometimes they can
take over our life. Some are efficient, others are not and for some of us they have even
become a way of life. The objective of a meeting should never be to have a meeting.
They are a means to an end, never an end.
If handled well, meetings can be invaluable tools for getting things agreed or
discussed. Enjoyable meetings that are productive and help to get the job done are an
ideal that becomes possible with a little effort. An unsuccessful meeting may do more
harm than one which never takes place. So, the success is judged by the actions that
result from it. And this is linked to running the meeting as the responsibility of the
whole group not only the chairman.

There are many reasons to call a meeting:

briefing people
exchanging and evaluate information
negotiating a deal
making decisions
taking things through
solving a conflict
establishing a plan
We hold or attend meetings which serve a number of purposes. People have to
be sure why the meeting is being held. Not only does the meeting need to achieve
business but also people have to be satisfied that this has been done. Meetings are at
the very heart of management. More and more time is spent in attending them. They
can be inspiring, energizing and fun.

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 Sometimes meetings fail because of:

interruptions such as noisy rooms, mobile phones, messages, people arriving

late.
lack of focus: irrelevant discussions
objective not achieved: decisions are not taken, people say they need more
time.
politics motives are being brought in: confronting discussions
poor preparation: research has not been done properly.
poor chairing
poor environment: people crammed into a room, tables covered with tea and
coffee cups and room for the papers.
poor timing: people arriving late, meetings starting and ending late.
right people absent: people with necessary input or information are not invited
or not available.
unnecessary meetings: you need a quick decision
wrong people present: they can ruin a meeting.

What is important to know in a meeting:

• to clarify the purpose of the meeting

• to have meetings only if they are necessary
• to invite people who need to give approval, have the required
expertise or information, have the creativity or intelligence to help the group generate
ideas, will carry out decisions made, will support your issue, will be directly affected
by the outcome.
• to send out a background information
• to create an agenda in order to give the start time of the meeting
and location, list participants expected to attend, list issues, give the order in which
they will be dealt with.

• to anticipate and prevent problems: problem people, hot topics,

alliances and politics, support.

• the agenda can do half of your work before the meeting even
starts: assessing items, standard items, have an order for the items, time each item,
write the agenda.

• to chair the meeting carefully and well balanced: bring in quiet

people, be open about input, stimulate a debate or discussion, listen actively, control
discussions, gain agreement and approval by bringing discussions to an end, by letting
people know it is time to make decisions or to agree, summarize different viewpoints,
discourage interruptions, ask for a decision or consensus, make sure the quiet people
speak up, take a vote if necessary.

• to satisfy the participants as well as the agenda.

• to consider that a compromise could achieve both completion

of business as well as satisfying the participants.
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 • to be a good communicator by: making people feel good and
value them and their opinion, getting them involved in the meeting, by showing you
understand the way someone feels.

• to handle challenges by focusing on the issue not the behaviour

or opinion of others, bring in others on your side, do not lose temper, give in and then
raise the matter with a higher authority or at another time.

• to announce a finishing time, to limit the number of items on

the agenda to the time allowed.

• to allocate a task owner to each item who will control the

conversation and take responsibility for any decision.

• to summarize within items, at the end of them and at the end of

the meeting.

Types of Meetings

Team Meetings
Consultancy and client meetings
Negotiations
I. Team briefing develops the team meeting into a management information
system. The objective is to ensure that every employee knows and understands what
they and the others in the organization do and why. Team leaders and their teams get
together regularly to talk about issues relevant to them and their work. There are some
benefits to team briefing such as:
• it reinforces management
• it increases commitment
• it prevents misunderstandings
• it helps to facilitate change
• it improves upward communication
II. Whenever you meet a client to present a proposal, however uncommercial
the situation, something is being sold. So, the meeting will fail if the client’s
requirements are not defined adequately beforehand. Part of our job may be to help
the client to clarify what he wants. So preparation becomes essential, a pre- meeting is
useful to define the problem and agree the client’s requirements as clearly as possible.
First stage thinking has to be used to clarify what the client wants, before suggesting
solutions. The following guidelines have to be used:
• create agreement with the client.
• identify the client’s need.
• present your solution.
• explain the proposal in detail
• anticipate any objections you know the client has.
• restate the proposal by summarizing, discussing.
• keep discussion separate from your presentation.
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 III. Doing deals is a fundamental way to achieve goals; but it is a means not an
end. A successful negotiation closes with everybody satisfied, the negotiator is
delighted when the meeting creates genuine agreement. Once you recognized a
meeting as a forum for negotiation we have established as adversarial situation. As a
result, scoring over the opposition becomes an important strategy. The negotiation
becomes an exercise in game playing: secrecy, bullying, hood-winking. So, this tacit
agreement entails stress, wastes time and catastrophe may follow, new problems may
arrive, commitment will suffer, promises will be broken, reputations will be bruised.
The responsibility will be to seek agreement: a specific plan of action to
which all parties can commit themselves.

How to hold better meetings

Conflict
Conflict is undoubtedly one of the most common sources of anxiety in
meetings. Many meetings seem to collapse into argu ment, hostility and ritual
recrimination almost as a matter of course. Do not regard conflict as inevitable or
desirable. You are not powerless in the face of emotional hostility; but, in order to
handle it well, you need to distance yourself from it.
Begin by trying to locate the source of the problem. Sometimes this is
obvious: insecurity at a time of great change, stress, a new set of working
relationships or pressure from public exposure. On other occasions, it may seem
to bubble up from nowhere, starting with something small and escalating quickly
as it takes hold of the group. Conflict thrives on confusion and doubt. Some
group members may seek to manipulate it for their own ends or use it to justify
their cynicism about all matters managerial. As conflict grows through a group, it
becomes more emotional, generalized and unfocused. Looking for a target, it can
find the Chair, turning the meeting into an all-purpose 'grouse session'.
Hostility often results from a sense of powerlessness. It is the feeling of
being at the mercy of forces outside our control that is so disabling. This is why
anger often centres on what has happened in the past, and in particular on what
'they' have done: senior management, other teams, department heads , rogue
operators' who have bucked the system, engineers or
sales staff who are never in the office, customers, suppliers, competitors. Be prepared.
If you are facing conflict or group
resistance, you must give yourself a single overriding objective: to empower the group to
do something practical. Only by focusing their thoughts on the future, and on what they
can do
will you transform people's energy from conflict into purposeful activity. Arm yourself
with a few guiding principles.
- Make the objective of the meeting clear at the outset. Write it up on a flip chart
and be ready to refer back to it frequently.
Challenge people to explain the relevance of their remarks to the meeting's
objectives.
- Remember that your task is to control the conversation.
Resist being drawn into the emotional maelstrom, however hard that may be.
- Slow the conversation down. Do not mirror the tone, pitch or speed of
others' speech.
- Do not interrupt or cut people off in mid-sentence.
- Listen to the points people are making and display them openly on the flip
chart.

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 - Do not be tempted to argue, or to contradict opinions or generalizations:
about what 'they' do, or what 'always' happens. A good response to such remarks
would be: 'In what circumstances?
- Turn complaints into objectives by asking people to restate them as 'how to'
statements. Write these up on the flip chart and display them.
- Stop people from talking about others who are not at the meeting. Insist
that 'they' are not here and we are, and that only we can address our objectives.
-Focus on solutions, not problems.
-Be a broken record! Repeat your questions to the group, over and over -
'What are we trying to do? What can we do about it? How does this relate to our
objectives?'
Be specific. People should know what contribution they are being asked to
make, and how their contribution will contribute to wider objectives. Being explicit
about goals and targets is the only way to achieve this. If you genuinely consult -
asking for suggestions, inviting people to participate in finding solutions - a great
deal of resistance will melt away.
Focus on action. Draw the group's attention away from what others have
done or are doing, towards what we will do in the future. You will have to be
sensitive about this. Demonstrating that you understand people's grievances can be
useful in winning them over to your own ideas; and in rooting out areas for
improvement. However, there will come a point in a 'grouse session' when you
should start asking, insistently but quietly: 'So what are we going to do?' In this
way, you will divert attention from damaging 'storytelling' and complaint towards
commitment and agreement. By showing that something can be done, you can show
people that they have power to change things.

CONVERSATION: THE HEART OF THE MEETING

At the heart of any meeting is conversation. It is by conversing that we express

our thinking and relationships to each other. If we want to improve our meetings, we
must improve the quality of the conversations that take place in them.

THE DYNAMICS OF CONVERSATION

Conversation is a verbal dance. The word, from Latin, has the root meaning of
'to keep turning with'. Conversation relies for its success on all participants moving.
Like any dance, conversation has rules and standard moves. These allow
people to move more harmoniously together, without stepping on each other's toes.
Different kinds of conversation have different conventions. Some are implicitly
understood; others must be spelled out in detail and rehearsed.
This sense of a conversation is well expressed in the word 'dialogue'. The
purpose of dialogue (from the Greek, 'meaning through') is to construct a new, shared
meaning through conversation: a meaning that would not come into being if the
conversation did not happen. We explore each other's perceptions, offer our own for

95
examination and transform our thinking in the light of others'. This, at its very best, is
what conversation can achieve.

Talking and listening

The dynamic of conversation involves two elements: talking and listening.

These two activities do not happen merely in sequence, but simultaneously: each
participant in a conversation is both speaker and listener throughout the conversation.
Most of us are better at talking than at listening. As managers, we are trained
in the techniques of presenting, explaining and influencing. Our education mostly
stresses the value of arguing: taking a position, holding it, defending it, convincing
others of its worth and attacking any argument that threatens it. As a result, our
conversations tend not to dance but to push and shove.

Adversarial thinking

In an attempt to impose order on our conversations, we have invented debate

(from the Latin, 'to beat down')- Debate fosters adversarial thinking: a form of group
thinking so common that, for many of us, it is the only way any group can think.
Instead of enduring a verbal brawl, we set up a boxing match, in which ideas -
preferably two opposing ideas - fight it out according to more or less strict rules. The
idea left standing at the end is considered to be 'true'.
Much is made in management theory of the virtue of debate. It is said to be
not merely unavoidable in business, but positively desirable: a recent article in
Harvard Business Review calls it 'creative abrasion'. No less an authority than Peter
Drucker has written: 'the understanding that underlies the right decision grows out of
the clash and conflict of divergent opinions and out of the serious consideration of
competing alternatives'.
By the rules of debate, if you prove the opposing idea to be wrong, you have
somehow proved that yours is correct. This is clearly ridiculous: both arguments may
be wrong; both may be partly right. Yet debate cannot allow us to consider these
possibilities - or any others. A debate is a conflict of rigid opinions.
Opinions are ideas gone cold. They are our assumptions about

• what might, or should, be true rather than what is true in specific

circumstances. They may take the form of:
- stories (about what happened, what may have happened,
• why it may have happened);
- explanations (for why something went wrong, or why
we
• failed);
• justifications (for taking action or not);
• wrong making (I am right, you are wrong);
• gossip (to make us feel better at the expense of others);
• generalizations (to save us the trouble of thinking).
We are so used to voicing and listening to opinions that we can easily mistake
them for the truth. Whenever you hear the word 'fact' in a meeting, you can be almost
certain that somebody is voicing an opinion.

96
 The overwhelming limitation of adversarial thinking is that it is destructive. The
'clash and conflict of divergent opinions' actually prevents people from exploring or
developing ideas. They are too busy defending themselves, too frightened to venture
from their corners, too battle-fatigued.
It is unusual for any meeting to avoid adversarial thinking. It
usually appears in one of four forms.

Critical thinking
For most of us, to think about something is automatically to look for
something wrong with it. Take note next time you ask anybody for their response to an
issue: invariably their first thoughts will be critical.
The rationale behind critical thinking is presumably that, by looking for the
weaknesses in an idea, we can strengthen it. But we rarely receive criticism in this way;
instead, we try to defend our idea from the criticism or attack the criticism itself, in an
effort to discredit it.

Ego thinking
In adversarial thinking, we become identified with our ideas. Criticism of an
idea quickly becomes an attack on the person holding it. Debate is used as a pretext
for scoring points against others. Reason gets infected with emotion.
Meetings often devote enormous amounts of energy to preventing emotion
from overwhelming debate, but the dynamic of debate makes emotional conflict
inevitable.

Rigid thinking
All thinking starts from propositions about reality. Adversarial thinking
merely pits these propositions against each other. It limits itself to their terms and
their consequences: any thinking that questions the thinking behind a proposition,
or strays beyond its boundaries, can be dismissed as 'irrelevant' (or 'deviant').
Indeed, the adversarial mode actually serves to entrench propositions rather than
adapt or modify them. Rigid thinking is usually the result of:
• conforming to authority ('if senior management see it this
• way, it must be right');
• the influence of custom ('our profession has thought like
• this for the last two hundred years');
• habit ('this is the way we think around here');
• willful ignorance ('thinking like this saves us the bother of
• dealing with inconvenient detail or finding out more').

Political thinking

When ideas become identified with individuals, people realize that

achieving action is a matter of aligning themselves with ideas, and with those
promoting them. As rigid thinking limits the growth of ideas, propositions can only
be attacked or defended. To attack an idea is to attack its sponsor; to support it is to
create an alliance. We begin to use conversational gambits, ploys, manoeuvres and
defence mechanisms, not to develop the conversation but to play politics: creating
'power bases' and undermining 'opponents', bureaucratic conniving, behind-the-
scenes manipulation and rumour-mongering. We accord adversarial thinking
enormous prestige. Managers

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 who can defend their ideas and withstand the onslaught of their peers - or,
better still, their superiors - gain status and may be promoted on the basis of their
'strong character'. They become 'heroes' and the stuff of myth.
Adversarial thinking is self-perpetuating. Like other kinds of conflict, it is
cyclical and can escalate easily. Being attacked for our ideas causes pain; we
respond in kind and help to pro long the conflict. We may engage in 'pre-emptive
strikes', attacking before being attacked. Adversarial thinking expresses our lack of
security, and the need to protect ourselves from future threats.
Thus we become locked in a 'cold war' of argument and counter-argument.
Although we may recognize that our behaviour is unproductive, we feel we cannot
do anything dif ferent. We do not know how to; and we may be too frightened to
who can defend their ideas and withstand the onslaught of their peers - or,
better still, their superiors - gain status and may be promoted on the basis of their
'strong character'. They become 'heroes' and the stuff of myth.
Adversarial thinking is self-perpetuating. Like other kinds of conflict, it is
cyclical and can escalate easily. Being attacked for our ideas causes pain; we
respond in kind and help to pro long the conflict. We may engage in 'pre-emptive
strikes', attacking before being attacked. Adversarial thinking expresses our lack of
security, and the need to protect ourselves from future threats.
Thus we become locked in a 'cold war' of argument and counter-argument.
Although we may recognize that our behaviour is unproductive, we feel we cannot
do anything dif ferent. We do not know how to; and we may be too frightened to

How, then, can we break out of the vicious spiral? What can we do to help
meetings evolve beyond the fruitless and exhausting ritual of adversarial thinking?
Perhaps the first step is to improve our listening.

The gentle art of listening

The quality of any conversation depends on the quality of the listening.

Listening is far more than simply not speaking. The listener controls the speaker's
behaviour by their own: by maintaining or breaking eye contact, by their body
position, by nodding or shaking their head, by taking notes or doodling, and so on.
Similarly, when we speak, we demonstrate the quality of our listening. If we interrupt,
we demonstrate that we have stopped listening, that we are not interested in listening
any longer. This, in turn, will affect the other's speaking and listening.
We all know the symptoms of poor listening. They are so familiar that we
even expect them and develop tactics to cope with them. They include:
• outright condemnation of an idea;
• criticizing the speaker's delivery;
• only replying to a part of what somebody has said;
• interrupting;
• daydreaming;
• paying attention to a distraction;
• holding another conversation at the same time;
• evading the issue;
• using emotional words;
• going to sleep.
We are all able, however, to listen effectively. We listen well when we:
98
 • like or admire the speaker;
• want to trip them up;
• think they have something interesting to say;
• expect to be rewarded or punished for listening well;
• know that we will be asked to comment;
• have an overwhelming need to listen;
• are not distracted;
• know or have learnt that effective listening improves group
behaviour and leads to improved results in the meeting.
The first step in improving our listening skills is to become aware of the
obstacles. Some we will have control over; others we may have to endure.

Talking:

Arguing
Multiple conversations
Asking an irrelevant question
Changing the subject
Wandering off the point
Unfamiliar voice patterns
Ambiguity: double meanings, woolz use of language, jargon
Lack of detail in speaking
Speaking too long

Behavioral:

Avoiding eye-contact
Looking bored
Sending the wrong signals: head-shaking, foot-tapping
Yawning
Fidgeting
Clock-watching
Rustling papers
Misinterpreting behaviour
Cross-cultural confusion

Psihological:

Shyness
Aggressiveness
Intimidation
Inappropriate use of authoritz
Personalitz clashes
Bias
Favourism
Prejudice: race, gender, class, age, educational background
Cultural habits

Physical:

99
 Noise
Other people
Other meetings
Sub-meetings
Interruptions from outside
Technical interruptions: phones, bleepers, computer malfunctions
Poor ventilation
Fierce air-conditioning
Extremes of temperature
Uncomfortable furniture
Sitting too long
Inappropriately shaped table
Disability not accomodated

Conversation is the way we think together. What we say is what we think.

We are paid to think. Our success depends on our results; we think when we want
results that are better than they would be without thinking. And yet most of us are
not trained to think. Thinking is not yet regarded as a key managerial skill. As a
result, we have developed a number of damaging misconceptions about thinking.
Thinking is not an alternative to doing. We can use thinking as an excuse
not to act; and we can act without thinking. The reason we do both so much is that
we regard thinking and action as opposed. They are not. Effec tive thinking improves
the effectiveness of our actions; and our actions are a rich source of good ideas.
Thinking is not intelligence. Thinking unintelligently may still achieve
something. Intelligence without thinking is useless.
Thinking is not a function of education. Highly educated people are not
necessarily good thinkers; and many people with little education can think
extremely effectively.
Thinking is not being clever. An increase of knowledge is not thinking: it
is simply hoarding. Too much information can seriously hamper our ability to
think.
Thinking is not only the operation of logic. It involves looking, exploring,
choosing, designing, evaluating and having hunches. It includes considering
priorities, objec tives, alternatives, consequences and other people's opinions.
There is a Japanese proverb: 'None of us are as smart as all of us.' Yet most
groups of people think far less well than any one of them individually. Two main
reasons suggest themselves.
1. We confuse conversation about the task with conversation about
process. We identify thoughts with people. We talk in code. We use conversation to
express loyalties or alliances, to bid for power, to protect our position or sense of
self-worth. We persist in old conventions or habits of conversation to feel more
comfortable.
2. We fail to manage the structure of the conversation. A well-managed
conversation will begin with clear objectives and end with clear actions. Many
conversations have unclear agendas (or hidden agendas); others are combinations of
several conversations at once. We allow our conversations to ramble, to get stuck, to
be hijacked or stifled. Because the behavioural or 'political' aspects of conversation are
so powerful, we find it difficult to influence the course of conversations productively -
particularly in a meeting, when a group of people are involved.
Tackling these two failings is critically important if we want to help ourselves
and others to think better in meetings.
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 Thinking 'hats'

Serious conversations should seek to distinguish ideas from people. Edward de

Bono's 'Six Thinking Hats' are becoming increasingly popular as tools for clarifying
this distinction. De Bono suggests that we label every contribution to a conversation by
means of a coloured 'hat' that the speaker is 'wearing' as they make it. Chairs can also
ask participants deliberately to make contributions 'wearing' a particular hat. The six
'hats' are:
White hat: facts and figures. Red hat: emotion, feelings, hunches and
intuition ;lack hat: caution, judgement, fitting propositions to facts.
Yellow hat: advantages, benefits, savings.
Green hat: creativity, new ideas, exploration, suggestions.
Blue hat: thinking about thinking, control of the thinking
process, 'points of order'.
The beauty of de Bono's hats is that we can put them on and take them off
very easily. It would be utterly inappropriate to suggest that someone is a 'red-hat
thinker' or a 'black-hat thinker'. Anybody can use the hats whenever they want. Indeed,
using the hats allows people to make remarks that they might not ordinarily
risk making.
We can use the hats informally or systematically. Judging which hat to pick at
which point can become a sophisticated chairing skill in itself. Consultancies now
exist that train managers in the use of the thinking hats.

The two stages of thinking ,

We can imagine thinking as a process in two stages.

First-stage thinking is concerned with perception: we recognize something
because it fits into some pre-existing mental pattern. We can call these mental patterns
'ideas'. Ideas are arrangements of experience in our minds. They allow us to make sense
of our experiences; they are the means by which we have experiences. In first-stage
thinking, we encode experience so that we can use it at the second stage. We name an
object or event; we translate complex activity into an equation; we simplify a structure
by drawing a diagram.
In second-stage thinking, we make judgements about our
experience by manipulating the code. Having named something
as, say, a 'cup', we apply logic, custom and aesthetics to judge
its effectiveness as a cup. Having labelled a downturn in sales
as 'a marketing problem', we use market research, spreadsheets,
past experience and critical scrutiny of the marketing depart
ment to judge how best to solve it.
Managing our thinking begins by:
- separating the two stages of thinking;
- becoming conscious of which stage we are in at any point; - applying
only the tools and techniques appropriate to that stage.
We are highly skilled in second-stage thinking. We are taught it at school: we
learn verbal and mathematical languages, we are encouraged to analyse, to deduce, to
argue and to evaluate. So sophisticated is our second-stage thinking that we can
construct computers to do it for us. We are so good at it that we regard it as the sum
total of thinking. IQ (intelligence quotient) is a measure of our ability to manipulate
language and symbols.

101
 We are not nearly so skilled at first-stage thinking. We are taught virtually no
techniques to help us improve our percep tions. Yet a change in our first-stage
thinking can have dramatic consequences at the second stage. If we decide that the
cup is not a cup but a trophy - or a vase, a mug, a chalice - our second- stage thinking
about it will change. Our 'marketing problem' may actually be a 'product quality
problem', a 'distribution problem', 'a personnel problem', a 'macroeconomic problem'
or a subtle combination of all five.
Second-stage thinking is focused on results. First-stage thinking is not focused
at all, and this makes us uncomfortable. Where second-stage thinking is 'deep',
concentrating our atten tion on a single idea, first-stage thinking is 'shallow',
scanning a wide area of experience. It creates anxiety because it delays the moment
of deciding, forces us to suspend judgement and challenges our current way of seeing
reality.
We prefer to take our perceptions for granted, but no amount of good
.second-stage thinking will be effective if it is based on limited or faulty
perceptions. Good thinking pays attention at both stages of the process.
The great Swiss psychologist, Carl Jung, developed the two stages of
thinking into two sets of paired complementary func tions: sensation and intuition at
the first stage; feeling and thinking at the second. Jung himself used this model as
the basis of a theory of personality types; it will be familiar to many managers as the
basis of the Myers-Briggs type indicator.
First-stage thinking questions include:
1. 'What can we see?' (Sensation). 2.'What might it mean?' (Intuition).
Second-stage questions include:
1. 'What can we do?' (Thinking). 2.'What shall we do?' (Feeling).

Vocabulary:

to chair- a prezida
chairman- preşedinte
to decree- a decide, a emite un decret
meeting- întrunire, şedinţă
to call a meeting- a convoca o şedinţă
notice of meeting- notificare a aunării generale
to brief- a rezuma, a instrui
briefing- instruire, informare
briefing conference- conferinţă de îndrumare
to exchange- a face schimb
to establish- a stabili,a institui, a întemeia, a instala
establishment- instituţie oficială, stabiliment,organizaţie publică sau privată,
fondare
timing- sincronizare
outright- deschis, cistit, total
outright loan to a project- împrumut direct pentru proiect
outright grants for research- alocaţii integrale pentru cercetare
bias- eroare sistematică, distorsiune
disability- neputinţă, incapacitate
disabled- incapabil de
to trigger- a declanşa, a porni, a lansa
liable- răspunzător, supus
commitment- angajament
102
 to reinforce- a consolida,a întări
reinforcement- consolidare
to share- a împărţi
to share in- a lua parte la
to share out- a repartiza, a distribui

Topics for discussion:

1.How important is conversation in a meeting?

2.Which are the symptoms of poor listening?
3.What happens to a meeting if it is stuck on a problem?
4.How important is timing in a meeting?
5.What is adversarial thinking?

Enlarge upon:

*“Meetings will not improve by magic. People must want change and be
willing to implement it.”
*“Thinking is an alternative to doing”.
*“A decision is committing to a course of action: choosing from among a
number of alternatives and making a rational and emotional commitment to that
choice.”
*“Meetings are the very heart of management.”
*“Getting agreement is easy. Getting everyone to confirm afterwards about
what exactly was agreed is the hard part!”

Dialogue

Mr. Brown is the General Manager of “Imperial Industries”, an important

Company. He is attending the Annual General Meeting in a huge hall crowded with
shareholders, all very excited. Mr. Crossly , the Sales Manager is going to preside the
meeting.
Mr. Crossly: Good morning and I am glad you are here today.
He turns the floor to Mr. Brown who is impatient and ready to convince the
audience with facts and figures.
Mr. Brown: We must be very pleased with the turnover of the company which
has enlarged considerably. Even if we had to face a tough competition, I’m glad to tell
you that we are highly appreciated on the domestic and foreign markets. We have
fine, reliable products for the next financial year and we do hope to merge with other
well known companies. One of them will be “ T&T” Company in the South of
Europe.
Mr. Monro, Marketing Manager for the “Liox”Company in Germany :
How did you succeed in spite of the unsuitable buildings? It seems to me
almost impossible now that I have in front of me the figures.
Mr. Brown: It is true that the buildings are in a deplorable condition but we
have updated machinery and highly trained staff. We are extending within an area of
4 square miles. The new location will cost a fortune but it’s worth. New openings
abroad are to be found and new funds are being expected.
103
 Mr. Monro: I cannot agree with this. Until money arrives what is going to
happen? Are you aware of this? How can you be so optimistic?
Mr.Brown: We are very prompt and efficient, promising and hard working.
Mr. Monro: But we talk about huge sums of money!
More and more excitement among those present at the meeting as they are
shaking their heads…
Mr. Crossly: You need not worry because we’ll manage to carry on our plan.
The outlook is good, we have no unemployment, the output is high, we have good
forecasts, the percentage of the business is the expected one.
Mr. Monro: Which are the export outlets figuring in marketing plans?
Is there any drawback to be expected?
Mr. Crossly: Mostly Eastern European outlets, and as far as drawbacks are
concerned, I’m thinking of a depreciation regarding the dollar any time.
In the end there was a unanimous consent to wait for the further funds and for
an outright loan.

Additional Vocabulary:

guidelines- directive
deputy manager- director adjunct
sales manager- director commercial
acting manager- director interimar
layout of a meeting- amplasare
to take charge- a-şi asuma responsabilitatea
turnover-cifra de afaceri
merger- fuziune
outright loan- împrumut direct
outlet- piaţă de desfacere
slump- criză
funding- finanţare
boom- avânt
long term- pe termen lung
medium term- pe termen mediu
short term- pe termen scurt
restrictive practices- practice anticoncurenţiale
leveraged- îndatorat
divestitures- sciziune
to bail out- a salva
golden parachutes- compensaţii financiare garantate
lay offs, redundancies- concedieri, disponibilizări
joint ventures- societăţi mixte
ailing- în dificultate
to spin off assets- a distribui activele
tender offer- ofertă publică de cumpărare
junk bond- obligaţiune speculativă
corporate governance- conducerea înterprinderii
leveraged buyouts- preluarea controlului prin împrumut, cumpărarea de către
salariaţi.
to bid- a face o ofertă financiară
buyout- cumpărarea unei firme în totalitate

104
 E- Business for the Small Business

W h a t is e - c o m m e r c e ?

All businesses exist because they serve a market. Successful enterprises,

big or small, keep their customers by providing what they need. In a traditional
business it means knowing your market, buying in the necessary raw components,
combining them in your own unique way, pricing products to suit the market and
distributing them efficiently. The final element is collecting the money. All of
these stages take time to get right, not to mention the boundless energy. Unless you
are very lucky indeed most traditional businesses take up to three years to show a
profit on the bottom line.
What the new technology has done is to solve, for some businesses, two basic
issues which until now have been major causes of early failure: cash flow and
distribution. Using the Internet as your shop-front, you can ask for the money before
you dispatch any goods or services to customers, thereby reducing your exposure.
In some cases you may not even need to produce the product until an order is
received. The second main benefit of a Web site is being able to reach potential
customers on a global basis with very little marketing cost. This makes your break-
even model completely different from making profits in a traditional business. You
could be profitable within a few months rather than having to wait for a couple of
years or more.
But e-commerce is also about the back end of the business. The side benefits
of installing linked PCs, whether they are all hooked up to the Internet or not,
include a more efficient business in terms of dealing with enquiries, product data
and pricing issues. These benefits extend back into your relationship with your
suppliers, in other words, obtaining and debt collection. If your suppliers are
themselves on the Internet, that is even better. At the very least you will no
longer need to write letters or send confirmations by mail for agreement. Just imagine
how much time that would save for the average business. By linking your staff
together using a company-wide 'intranet" (people sending each other messages on a
private, company-only system) would abolish the wasteful practice of internal paper
memos at a stroke. Decision making right across the company would be improved both
in its speed and the discussion of any relevant issues.
Whenever you need to do some research, the Internet can provide access to
information and market data which until now has only been available to big
companies with big resources and big margins or to members of expensive trade
associations. National statistics, trade trends, other people's prices and terms, new
products, impending legislation, competitor details are all available, often at little or
no cost. All you need is a little patience and skill in knowing how to search out
such information on publicly available and often free Web sites.

History of the Internet

The Internet did not suddenly come into being overnight. The system has
been in development in one form or another for more than 35 years. Understanding
how it all started provides current users w i t h a better appreciation of what it can do.

105
 When did it all start?

The US Department of Defense was concerned in the mid-1960s that in the

event of a nuclear war the armed forces would not be able to communicate with each
other through the usual telephone networks. These networks relied on central control
exchanges. Scientists argued that such control exchanges would be the first to be
attacked in hostilities and therefore could never be the basis of a secure telecommunica-
tions system. So they proposed that new technology should be developed whereby
messages could be sent directly from one party to another without having to go through
an exchange. Each sending station or 'node' had equal status within the system.
Messages would be packaged in electronic parcels and let loose on the network to find
their own way to their destination through the most efficient route. If any part of the
network were to be destroyed, the message parcel simply found an alternative route.
The principles of the new system were tested in the UK at the National
Physical Laboratory in 1968 and then later developed by the Pentagon. The first node
was a supercomputer based in UCLA (University of California at Los Angeles) to
which four more nodes were linked in 1969. For the first time scientists were able to
share computer facilities even though they were in different locations, by exchanging
data between the five nodes. By 1972 there were 37 nodes in the network known as
ARPAnet (Advanced Research Projects Agency net). The Internet today is largely a
development of ARPAnet.

When was e-mail invented?

During the trial periods it was noted that scientists were sending each other
personal messages as well as academic data and were exchanging ideas of a less formal
nature. The concept of 'e-mail' was born. By the late 1980s the National Science
Foundation (NSF), a US federal agency, had taken up the task of developing its own
network for some government employees using the technology of the ARPAnet, sending
messages via new, higher speed transmission lines. To distinguish whether the sender was
an academic or from the government, 'edu' or 'gov' was added to the sender's network address.
Later on other codes were developed to distinguish the type of user and were included in
their electronic address.

How did the system become available to the wider world?

As other organisations acquired computers that could convert messages into packages
to be sent electronically (and receive them back) new commercial networks were developed. It
was then a fairly simple idea for some of these organisations to link up to create even wider
networks. In time, computers bought for businesses and the home came with the necessary
decoding programs to send and receive messages through telephone lines which were in turn
linked to other networks through Internet Service Providers (ISPs). It has been estimated that
over 200 million people are now connected to the Internet via their nodes (computers) and the
numbers are growing each month.

Is the World Wide Web something different?

106
 It can be confusing. The terms 'Internet', 'Net' and 'World Wide Web' are often used
to mean the same thing. To be more accurate, the World Wide Web is the multimedia part of
the Internet. The Web is the collective name for all the documents on the Internet that can be
accessed through programs stored on your computer. These access programs are called Web
browsers. In essence, the Web browser converts electronic information from other computers
into displayed material that you can read or see. Anyone can create a document and make it
available on the World Wide Web for other computer users to read. This displayed
material is known as a Web site.

The importance of the Internet as a business tool

When you are running a business you need to grasp issues quickly if you are
going to keep ahead. You may already be wondering from the description above
what relevance such a system would have for you in your everyday business life.

E-mail

The Internet provides the facility to send and receive written business
messages through the telephone network. If you want you can set up your system to
be available to receive messages on a 24-hour basis, which is important if you trade
with overseas customers. You may want to place or receive an order late at night or
during the weekend. Or you may need a rush order completed to help you meet a
deadline for one of your own customers and you've missed the post. E-mail sends the
message virtually instantaneouslv.

Data collection

Almost any type of information can be found on the World Wide Web. If you
are not sure where the information is you can ask Internet companies called "search
engines' to help you find it. If you know the name of the organization that has the
information, you can visit its Web site from the comfort of your own office and print
off or store in a file any parts or all of it without having to declare your identity.

Discussion groups

Sometimesin b u s i n e s s ,y o u ju st want tot a l k to someone whoh a s been th ro u g ha

s i m i l a r commerciale x p e rie n c eso t h a t y o u can a v o id c o stly errors. U s i n g t h e I n t e r n e t
you can j o i n ' l i v e ' d isc u ss io n son yourc o m p u te rm onito r,o f t e n on a w o rld w id ebasis,
a n d ask q ue stion sabout your p a r t i c u l a rissue. You may want to know if there is a market
for y o u r p r o d u c t sin a f o r e i g n c o u n t r y .J o i n a USHNET group or a news- grouponline
a n d a s k th o se people whoa c t u a l l yl i v e there w h a t t h e y t h i n k .

Long distance data transfer

You may need tose nd a 40-page documentw i t h complexd i a g r a m sto a p ote ntial
c l i e n t on anotherc ontine nt.If you m a i l it this could take days, p o s si b ly weeks to get there
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and even then there is no guaranteewiti l l a r r i v e in one piece. U s i n g th e In te r n e t you
can 'a t t a c h ' th e document toan e - m a il and yourc l ie n t can print out the document onh is
or her o w n computer w i t h i n seconds. Developments in th e speed of d a t a transfer mean
t h a t p ic t u r e sand m o v i n g imagesc a n be sent bythe same method.

The building blocks of e-commerce

Once you have realised the potential savings in tim e and expense w h i c h even
average use of t h e Internet can deliver, you w i l l be keen to get started. The process of
getting online is not difficult, but as you w i l l discover, once you are connected you
may w ell have to changeth e entire way you dobusiness.
Here are j u s t some of the basic steps you w i l l need to ta k e to set up and
develop your own e-commercebusiness:
• buy su ita ble computers;
• lin k them together;
• rent an extra telephone line(s);
• choose anIS P and go online;

• create a Web site;

•choose appropriate money collection and security software:
•decide what products you can sell online:
•think through sending products to overseas customers:
•be aware of any legal issues that may result:
•create a marketing strategy and business plan for e-business:
•consider how e-business will affect your existing trade:
•develop your database.
It looks like a simple list. From a mechanical viewpoint, it is. Some experts
will tell you that they can get you online within a day but a Web site is not necessarily
an e-business. Each step requires you, as a small business owner, to consider all the
alternatives currently available if you want to achieve a profitable and sustainable
business. It is not easy. The language suppliers use is often confusing as are the claims
of speed, efficiency and suitability for your particular business.
Because the skills to help you develop e-commerce are all relatively new, the
costs can vary enormously. Equally, because this way of doing business is so new, no one
has all the answers. The advice from both start-ups and established players is to take
each stage in sequence. Think through how you need to organise your staff to get the
best results. It will be a frustrating as well as a rewarding experience, like all new
businesses, so be prepared for some hard work.
Finally, do not be afraid to ask so-called experts to explain what they mean. The
computer industry is probably the best example in the world of an industry that likes to
cloud the issue. At times the jargon can be overwhelming. So do not suffer in silence.
Get your new technology suppliers to explain in simple terms what the new piece of
equipment can do specifically for your business. If you do not understand it you
probably won't use it, so the investment will have been wasted. Remember that many
so-called e-businesses are often nothing more than direct marketing operations that
happen to take customer orders electronically. The vast majority of e-businesses still
only use the Internet as a way to get enquiries or orders.

As you grow in confidence, so will your awareness of how products, particularly

software, could enhance what you do. Use the Internet itself to ask for opinions and ideas.

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You'll be amazed how helpful other e-business owners around the world will be when you ask
for advice.

F r o ms m a l l b u s i n e s s t o b i g b u s i n e s s

There is no doubt that the early years of the dot.com revolution have been
littered with a number of high profile failures. Some of the losses have been
spectacular. Such bad news has always been good news for the newspaper publishing
industry - it is always much more entertaining for readers when things go wrong. But
there have also been some remarkable success stories that have received less public
attention.
Finding the right level of funds at the right time for a budding e-business on an
ongoing basis needs to be planned for. It is likely that the funds will not come from
the big banks as it has done in the past for most small businesses wishing to expand
their business.

The current trading background for dot.coms

When two twenty something Cornell University graduates floated

Theglobe.com on the New York Stock Exchange in the late 1990s the share price
recorded the highest ever one-day rise on Wall Street - 606 per cent. Within 12 months
the price had fallen by 9S.5 per cent and they were both replaced by a 50-year-old
advertising executive.
The tale of high expectations followed by poor sales and dubious management
has been repeated in the UK. There is even a Web site dedicated to tracking dot.com
failures, although there are rumours, ironically, that this too may be having financial
difficulties. The availability of investment funds seems to have receded in line with
the absence of any real evidence of future profits. But it need not be the same for
every dot.com business by any means. There are still many investors in the
marketplace who are keen to back new e-businesses provided there is a convincing
business plan.

Developing your e-business plan

Assuming you have a general idea that you are going to need more than you
currently have in the bank to fund the development of your e-business, the first thing
to consider is the main headings of expendi ture over, say a five-year period:
• Salaries: list all the salaries you will need to pay including any secretarial
help and the estimated outcomes of inflation.
• Benefits: add on all the salary-related extras like National Insurance, cars,
expenses, travel, pensions, bonuses, overtime, recruitment fees.
• Marketing: allow for new campaigns and procedures, ongoing Web site
development, selling aids, public relations, ASP soft ware, trading licences.
• Distribution: postage or shipping costs, packaging, warehousing, dispatch,
returns allowance, stocks and stocks unsold, insurances, taxes if applicable,
percentage per country market.
• Central support: finance, legal, human resources, professional advice.

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 • Equipment: new office hardware, warehousing plant, buildings, cleaning,
security, depreciation, servicing/leases.
The easiest way to approach this is to take your normal end-of-year list of costs
as drafted by your accountant and complete a s imilar list for your new e-business.
Depending on your market you may have other more specific costs without which
you could not trade on the Internet or deliver your customers' orders. The next list
is probably several tables showing what sales you expect to generate from various
markets and at what margin:
• Sales from the traditional business: static, growing or declining.
• Sales from the e-business: speed of take-up, global markets.
• Sales from associates/affiliations/agents.
• Indirect sales from reciprocal site links.
This section w i l l necessarily be estimated, but you should err on the side
of caution and if possible give sound evidence as to why you think sales will be at
the level stated within each category. It is quite possible that there may be no sales
for some time, so you should come clean and say so. An overview of your intended
market, with plausible-estimates of your share over the first five years, will help to
add credibility to your claims that somewhere in all your figures is a viable business.
From this first pass through the planning stages you should be able to draw
your own conclusions as to whether you t hi nk you have a viable business idea. If
you do not believe it, neither will the investors. Case histories and anecdotal
evidence may be the only third-party support you can get as to whether what you
are proposing w i l l work but it is worth compiling as there is unlikely to be any
other market survey or industry statistics you could use to support your plan. Clearly
the most important support you could receive for your plan would be future
customers. Research could bring these out in the open, but do not rely too heavily on
them as would-be customers can be notoriously fickle as soon as you ask them for
money up front to fund your first year.

The business model

Once you have satisfied yourselfth a t what you are attempting couldactually
return a sustainable profit, you need to articulate your business model in terms sim p le
enough for a non-specialist to understand. You should also provide some evidence
that you are ahead of the game in business terms and th at your sla nt on the idea
represents the way the market is going within your particular industry niche.
For example, the printing industry is already well advanced in most uses ofthe
Internet so if you are in th is field you may w i s h to highlight that you intend to do
things using WAP technology. Or itcould be that you supply archaeological site
maps to academics butth a t you would supply them on lin e as 3-D. all-around images.
Whatever it is, it needsto add a new dim ension to what already exists.
One of the m ain advantages of any business is its scalability. Could your e-
concept be rolled o u t to many markets aroundt h e w o rld, both geog raphically and
across many in d us t ri es ? If so it stands a better chance of attracting development
funds. You need to hav e worked o u t the e stim ate d numbers of your market, both
a c t u a l and po ten tial, so that any backers can seethe scale of the returns that are
possible g ive n the right level of investment.
How easily can your idea be replicated? If it can be, is there any way you can
protect it throughpatents, licences, trad ing righ ts or special equipment to protectits
growth over the fi rs t few years'? The te chnology needs to be bespoke whenever
possible so that competitorsw il l not be able to replicate easily what you intend to do.
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 Is there any way that you can persuade one or two strategic buyers sign to a
letter of in ten t to work w i t h you on an e x c lu s iv e basis in the early stages? A u se fu l
way forward may be togive the m some e qu ity options in return for their use of your
idea so that you will have at least one big customer even before you launch.
Another way to reducethe ri sk of early fa i l u r e is to save cash by leasing
rather than b uy in g equipment and going for reciprocalmarketing whenever possible
rather than large scale brand-building. It goes without saying that excessive salaries
and c lu b class a ir tickets should not be "policy " in the first few years, if ata ll .
Do we really know who our competitors are and whatth ey charge? It is not
uncommon for a new e-business idea to be thought of at around the sametime by
several people aroundthe world. There can be no copyright on an idea. The keyth in g
is to get your idea to market as soon aspossible and b u i l d volume. Attend seminars, go
to e x h i b itions, read the trade press and start collecting articles about anything w i t h
even a remote connection to your big idea. At worst you could save yo u rse lf a great
deal of t im e and effort if you discovered someoneelse had already doneit. At best you
might see a fatal fl a w in the technical detail of your competitors'pla n which could
propel your idea into a world-beater.
Perhaps the most important aspect concernsthe senior people who w i ll take
day-to-day charge ofthe business as it grows. Theyw i l l need to be robust, know th ei r
industry, be w e ll connected and get onw e ll together as a team. When it comes togoing
for funds, the VCs (venture capitalists) w i l l set great store bythe maturity of the team
and how they interact, as at the end ofthe day if there is a problem these are the people
who are going to have to knuckle down andt u r n it around.

Finding the funds

There are many sources of funds for a business wishing to expand. In theory
there is nothing special about e-businesses. The high profile stories about raising
millions on the markets are really the tip of a very large iceberg and the vast majority
of companies use the traditional routes to raise capital:
• friends and family;
• banks;
• private investors;
• VCs;
• government agencies;
• joint ventures with complementary businesses;
• customer equity partnerships.
Apart perhaps from the friends and family route, these sources will
certainly want a detailed business plan and a defensible sales plan on which they can
safely make a decision. All your assumptions need to be shown. You should also
ensure that there are a number of 'safely factors' built in to the plan so that if
things do not grow as fast as you said they would, you have an alternative scenario.
Backers are never very keen on being asked for more money at some later stage
when things go wrong, so getting your sums right in the first place makes good
sense.
A further factor to consider is that your funding can come fr om a variety
of sources: it does not all have to come from a single source. In fact the majority of e-
business start-ups have a combination of private investors, founders money, local
grants, some medium-term bank loans and perhaps one longer-term venture capital
arrangement. Each of these sources will have different rates attached and different
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time-scales, so your cash flow plan becomes one of the most important business
measures you will need to use in the first few years. Government support should not be
sniffed at either. Often government agencies are very keen to have a local company
"showing the way' to the rest of the business community and make it relatively easy
for you to qualify for grants. Some can be as much as £250.000 or more, which for
many c-businesses is more than enough to get you going in the right direction.

Venture capital

Of all the sources of funds, the largest will be either private investors known
as "business angels", or VCs. Private investors may want less return and a longer
payback period but may insist on some equity. They will be interested in how they
could save tax from their investment, so you need to be prepared to be flexible as to
how the investment is brought into the company. They are useful investors to have as
they are generally the easiest people to go to if more funds are required at a later
stage and are likely to have the least demands in terms of payback periods, if they
are convinced you have a good idea.
VCs, on the other hand, tend to be very precise about what they want and when
they want it. They will probably have a brochure explaining the type of businesses
they want to be involved with and the type of funding they generally provide.
They may specialise in start-ups or they may prefer to invest later in the cycle.
They could introduce you to complementary business partners with whom they see
synergies for your business. Or they might provide the missing technical or people
management expertise to complete your senior team. You could do some initial
research by logging on to the British Venture Capital Association to see the range of
members they represent.
In general they will not be technical experts in your field but they have had
a lot of experience of what works and what does not. So, when you are preparing
your presentation to send them, you need to be as succinct as possible. Your
accountant or solicitor might arrange an introduction to the three or four who would
he most likely to look at your plan sympathetically. But unlike dealing with a bank,
you are in the driving seat. The VCs will offer the finance if the plan stands up as
viable, so you need to consider caref u l l y each offer you receive and choose the one
you think can add value to what you are doing. All of them will be looking for high
returns within a three to five year period, so the relationship will not go on for ever, but
it would be better to take the funding from people you get on with rather than sacrifice
good business empathy for a few less generous terms.
The VC presentation
If your idea is attractive to the VC they w i l l want to meet you and perhaps
one other member of your senior team and have a presentation from you about your e-
business. Meetings are normally scheduled for an hour or so. You need to be brief
and direct. This is not the time for waxing lyrical about how you started your
business 20 years ago in a garden shed. You need to plan your presentation
carefully to leave yourself enough time to go through the basic idea and the
figures in your plan. No more than a dozen laptop images will be required to get the
main ideas across.
In this first session they will give you an opportunity to ask them questions,
so prepare what you need to know beforehand and make a careful note of the answers,
as you may need to compare what they say with what other VCs tell you. If all goes
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well you will be invited back for a longer discussion with perhaps an industry expert
sitting in and more people from the VC. This session is to help them get a clearer
picture of your depth of thinking and for you to see if you could work with the VC
on a medium term basis as they w i l l probably want to put one of their own
consultants on your board and may even insist that they chair it to protect their
investment.
The deal
Depending on the amount of money required, the VC will attach a range of
terms and conditions to any funding offered. It w i l l include the percentage of their
equity, which will be based on their initial valuation of your new e-business. It will
also include how much of the debt you need to repay on an ongoing basis and what
happens if you default on any payments. These terms may change if after due
diligence they find that your plan is not as watertight as they thought. So, if there
is anything negative w i t h i n the plan or perhaps a market change, you should
declare it as soon as you can.

Becoming a dot.com millionaire

Typically, if things go well, your initial funding of, say. £1 million w i l l have
been enough to get things going. But a year or so later you find that you need to
establish the brand on a national basis to get the real returns. So, you may need to
go back and ask for £10 million.
Two years later the business model is working well in the UK hut you see an
opportunity to expand the concept into Europe, so you go back and ask for £30
million. The stage after this could well be a flotation or IPO (I ni ti al Public
Offering) after which you may w ell realize all your initial equity and become a
dot.com millionaire.

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 Topics for discussion:

1. Do you think E- commerce is being destined to become a

big business?
2. What is the E revolution about?
3. Which are the advantages and disadvantages of the E
commerce?

Enlarge upon the following:

“Within the E- business environment the journey from your first networked
computer to your first million could be a very short step.”

“The challenge is one of constant change and tuning to the new. If you can
work these new changes into your unique e- business idea to gain the competitive
edge, you stand to increase your chances of success…until another advance is made.
Dealing with those changes will not be easy. But no one ever said running a business
would be easy.”

“Your business model should bring you sustainable profit”.

Translate into English:

1.Îţi trebuie bani pentru a demara o afacere? Bine-înţeles că îţi trebuie. Mulţi?
Depinde de specificul fiecărei afaceri, dar nu e greu de aflat câţi anume- nu trebuie
decât să pui pe hârtie toate cheltuielile strict necesare şi să vezi ce iese. Te poţi trezi
cu o surpriză foarte plăcută: poţi să descoperi că banii de start nu constituie o
problemă chiar aşa de mare şi că e posibil să demarezi o afacere de care te vei putea
bucura.
2. Orice succes porneşte de la mintea omului şi nici o decizie nu poate fi mai
bună decât informaţiile pe care se bazează. Există oameni care fac lucrurile să se
întâmple, apoi cei care pivesc aşteptând ca lucrurile să se întâmple şi cei care nu
înţeleg ce se întâmplă.
3. Aceste investiţii au fost făcute cu un scop: pentru a se crea condiţii bune de
muncă iar astfel randamentul va fi mai bun, dar şi pentru imaginea firmei. Sediile
companiilor trebuie să fie dotate cu săli de conferinţe, cu computere şi acces nelimitat
la internet, cu mobilier ergonomic.

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 Negocierea se bazează pe principiul câştig- câştig, ambele părţi având de
câştigat în urma discuţiilor. Flexibilitatea ne va ajuta să nu capitulăm în faţa unor
cerinţe pe care nu le acceptăm la început. Vom continua pentru a câştiga, vom ţine
cont şi de nevoile celeilalte părţi.
Se recurge la manipularea interlocutorilor pentru a ne îndeplini scopurile. Într-
o lume ideală ar fi minunat dacă n-ar trebui să renunţăm la nimic pentru satisfacerea
nevoilor nostre, dar pentru că acest lucru nu este posibil, renunţăm la ceva pentru a
obţine altceva în schimb.
Există câteva lucruri în care cred persoanele care au success, ca de pildă : nu
există eşec, ci doar rezultate, lucrurile nu se îmbunătăţesc din întâmplare, ci numai în
urma unor acţiuni adecvate, succesul cere sacrificii, oamenii reprezintă resursa cea
mai importantă, iar ceea ce faci trebuie să fie util cuiva indifferent cât de bine este
făcut sau cât effort s-a depus.

Pentru directorul general, angajatul perfect este cel interesat de clienţi şi care
încearcă permanent să îmbunătăţească serviciile companiei. Dacă îţi pasă de angajat,
vei fi în afaceri pentru totdeauna. Trebuie să-ţi aduci mereu aminte că ei, clienţii sunt
cei care îţi plătesc chitanţele iar cei care reuşesc să se concentreze asupra clienţilor
sunt de fapt angajaţii perfecţi.
Prin onestitate, siguranţă, inteligenţă, inovaţie, flexibilitate vom evolua.
Preţuim inovaţia, pentru că modul nostru de a gândi este revoluţionar. Chiar şi atunci
când suntem pe un drum bătătorit îndrăznim să redescoperim noutatea şi valoarea.
Eficacitatea şi pasiunea pentru servicii a fiecăruia dintre noi sunt condiţii cerute de
orice companie.
Compania Augsburg are un pachet larg de beneficii şi indemnizaţii, ce
include, subvenţie pentru transport, maşină de serviciu pentru cei din management,
abonamente la o clinică medicală, preţuri reduse la produsele firmei. Dorim să-i
fidelizăm şi să-i stimulăm pe angajaţii firmei şi să completăm oferta salarială.

Comerţul electronic mondial are o dinamică ascendentă pe măsură ce tot mai

mulţi consumatori şi tot mai multe afaceri se conectează la web. Principalele bariere
în dezvoltarea comerţului electronic rămân problemele legate de securitate şi
încredere. Pe măsura creşterii utilizatorilor casnici de internet, procedurile legate de
autentificare şi criptare a datelor personale primesc o importanţă tot mai mare şi
succesul comercianţilor de pe web depinde de succesul implementării.
Obstacolul principal pentru o dezvoltare mai rapidă este cel financiar.
Romania este o ţară cu constrângeri bugetare, iar varianta testării unor soluţii la nivel
mic, precum şi luarea unor decizii de extindere a acestora este destul de potrivită
acum.

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 Translate into Romanian:

A truly effective client- service plan will include a set of activities that will
help professionals to know the client’s business better and in a more organized way.
A good client service plan will include activities meant to deepen the business
relationship by expanding the amount of client contact.
Business requires decisions: frequent, fast and often without much idea
whether they are right or wrong. When a business consistently outperforms
expectations, there is at least a good chance that it can be multiplied by ten or a
hundred times. In these circumstances most people settle for modest growth. Those
who seize the day become seriously rich.
In a firm which relies mostly on firmwide or group rewards, all the partners or
owners share the consequences if an individual’s performance is down. Accordingly,
other professionals have a direct incentive to take steps to help that individual or
group improve either formally through practice group leaders or informally through
the efforts of fellow partners.

You do not need to be a high tech business to benefit from the Internet. The
best success stories have been the more traditional businesses that have found new
ways to do business by using the basic technology currently available. Like all new
business you need to use your common sense and plan for profits on a gradual basis.
But unlike traditional businesses the process of building e-commerce profits will
differ both in scale and in the type of markets available. The more aware you are of
what is likely to happen with your new e-commerce venture, the more sensible your
decisions will be.

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Vocabulary:

Boundless- nemărginit
Bottom line- de bază
To dispatch-a trimite, a rezolva rapid, promt
Cash flow- flux monetary
To draft- a redacta, a întocmi
To exchange- a face schimb
Web browser- program software pentru navigare pe internet
Joint venture- societate mixtă
To display- a expune, a afişa
Impending- imminent
Expenditure- cheltuială
Allowance- reducere
Scalability- capacitate de a grada
To hook- a prinde, a agăţa
Hook up- program comun, înlănţuire
To knuckle down- a se apuca de
Tip- informaţie
Secure- în siguranţă, care nu prezintă risc, garantat
To secure- a proteja, a asigura
To store- a stoca, a memora
Ongoing- neîntrerupt
Backer- susţinător,girant
To back- a sprijini, a susţine, a gira,a da îndărăt
To back down- a o lăsa mai moale, a bate în retragere
To err- a greşi, a face o eroare
To bud- a începe
To litter- a murdări
Fickle- nestatornic, capricios
To highlight- a evidenţia
Claims- cereri, revendicări
To comply with- a se conforma
Encasement- încasare, plată în numerar
Rental- valoare locativă
Obsolete- demodat, învechit
Would be customers- clienţi potenţiali
In sequence- în succesiune, unul după altul
Venture capital- capital de risc
Venture- speculaţie, risc,acţiune comercială
Watertight- ireproşabil, impecabil, clar
To default- a fi în restanţă, în întârziere cu plata
Diligence- osteneală
Due- cele cuvenite
To slant- a denature,a prezenta tendenţios
Slant- punct de vedere, opinie, înclinaţie, tendinţă
Onerous- apăsător,împovătător

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 THE JOY OF BEING CLIENTS
FOR LIFE

WE WOULD ALL LIKE to have loyal clients who come back to us year after year.
Clients who treat us as valued professionals and seek our advice on their most
important issues and prob lems. Clients who don't shop around each time they
think about buying our services, who come back because they will always get
fresh perspectives, insights, and ideas from us and because they trust us. Clients
who will enthusiastically rec ommend us to others even if we aren't serving them
at that moment.
Reflect for a moment on your own client relationships. If you're like most
professionals, you may have a few loyal clients who have drawn you into their
inner circle of advisers. They consult you on a broad range of issues and wouldn't
dream of using a com petitor to provide your service.
Others, though, are just buying your expertise—they use you because you
have specific knowledge and skills that you deliver at a competitive price. The
next time around, how ever, these same clients may very well turn to someone
else. They view you as a commodity.
Somewhere in the middle, there are those bread-and-butter clients who
keep asking you back, year after year, but never seem to let you get very close to
them. You may have worked for them for years, but your influence and the scope
of your work is limited; and although they feel some loyalty to you, it's not enough
to prevent them from switching to someone else if they see a major economic
benefit.
Do you wish you had more clients who would draw you into their inner
circle?
Do you sometimes feel you're treated like a vendor instead of a respected
professional?
Would you like to compete less on price and more on the value you can
add?
Is it getting harder to differentiate yourself from other professionals in
your field, be they other management con sultants, lawyers, or accountants?
If you answered yes to some or all of these questions, we wouldn't be
surprised. The fact is, most professionals are on a journey—defined by the role
they play with their clients— and few have finished it. When it begins, you're an
expert for hire who offers information and expertise to your clients on a transaction
basis. Further along, you may earn the right to be a steady supplier, and you'll be
asked back repeatedly. When you've reached the final and most rewarding stage,
you'll be come a trusted adviser who consistently develops collabora tive
relationships with your clients and provides insight rather than just information.
At this stage you will have break through relationships. Because of the broad,
influential role that you play and the unusual degree of trust that you de velop,
these relationships will be of a significantly higher order than the run-of-the-mill
associations that so many pro fessionals have with their clients.
This developmental journey—from expert for hire to trusted adviser—is
the focus of what we mean by studying about clients in general. From extensive
research, there is a client-validated model for suc cess—a roadmap of the specific
characteristics that underlie extraordinary performance with clients—that will
help you establish and sustain more of these enduring, advisory rela tionships.

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 FORGETING CONVENTIONAL WISDOM

The abiding client relationships not only bring us immense personal and
professional satisfac tion, but in fact they make our careers. Unfortunately, the
conventional wisdom about how to develop them and achieve professional
success is woefully inadequate.
“Do good work, act with integrity, and the rest will follow" has been the
time-honored prescription for individuals who sell and deliver services.
"Find an area to specialize in, focus on it, and make your name there" could
be added to it.
Clients today are highly sophisticated, educated, and in formed buyers who
select professionals from increasingly competitive and mature service industries. In
a world of con tinual corporate cost-cutting and almost unlimited informa tion,
institutional buyers have less loyalty to suppliers than ever before. Studies have
shown, for example, that over 50 percent of executives who switch providers say
they were "sat isfied" with them before switching. And though specializa tion is
important to a point, the corporate leaders say that most of the highly specialized
profes sionals they deal with are incapable of advising them on broader business
issues. You have to do far more, in other words, than "satisfy" your clients and do
a "good job" if you want to create long-term loyalty and enter into the collabora tive
relationships that allow you to have a major impact on your clients and their
decisions.

WHY DO SOME PROFESSIONALS COMMAND

ENDURING CLIENT
LOYALTY?

There is a simple observation the telephones of some professionals we

knew never stopped ringing—clients called them, rather than vice versa. At the
same time, we saw others treated like vendors by their clients: these professionals
were constantly challenged on price, and they often struggled to get new business
through laborious RFPs (requests for proposal) that eliminate practically all
human contact during the client's decision-making process. Was the difference
just that the former worked harder, I were smarter, and did higher-quality work?
These were the obvious reasons, and while certainly relevant, they did not
provide anything near a satisfactory explanation for the in tense client loyalty we
observed. After all, we also knew many smart, hard-working professionals who were
not able to de velop so many loyal clients. Clearly, these qualities were necessary but
not sufficient.
We must set out, then, to comprehensively research and an swer a series of
fundamental questions: Why do some profes sionals manage to develop long-term
relationships and become trusted business advisers to their clients while others get
called in on a one-off basis like commodities? What quali ties do leaders look for in the
professionals—in fields as di verse as law, consulting, finance, and technology—
whom they bring into their inner circle? How do clients define value?
The starting point may be fifty years of combined experience in advising
senior managers in many organiza tions around the world. People went well beyond
their own per sonal experience, however, and spoke at length with the present and
past leaders of dozens of major corporations, such as Kodak, BellSouth, Cox
Communications, Motorola, American Express, Citibank, Eli Lilly, and General
Electric, listening as these chief executives shared their lifetimes of ex perience in buying
services and seeking advice from profes sionals. Such interviews were eye-opening,
and they debunked many of the widely held notions about why clients value certain
professionals over others.

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 What could strike us was the dissatisfaction many clients expressed about the
outside pro fessionals they engaged and by the difficulty they experi enced in
finding truly objective individuals to help them resolve their most important issues.
A number of well- known advisers who counsel and consult to leading
executives and politicians, as well as many less-known but high-performing
professionals who face the same day-to-day challenges that we all do in trying to
build client relation ships are ready to be interviewed.
Some of the greatest advisers in history, such as Aristotle, Thomas More, j.
P. Morgan, George Mar shall, David Ogilvy, and Henry Kissinger are always asked
to be studied.
It is not easy to identify the essence of what it takes to become an
extraordinary professional and consis tently provide value to clients. There are
some attributes and attitudes that will enable you to develop your own break -
through client relationships.
The meaning about clients for life has several distinct connotations. The
first is literal: how to develop lifetime clients—or at least long-term ones—when
such a relation ship is mutually beneficial for the client and the professional.
Second, is figurative because in some cases a continual relationship may
not be practical, realistic, or even desired. A client, for example, may need the
ongoing services of an accountant every year for many years, whereas he might call
in a management consultant or executive recruiter only once every four or five
years. A few professionals may also choose a transactional model of serving
clients, where they work on specific issues rather than on a retainer basis (the law
firm Wachtell, Lipton, Rosen & Katz, for example, success fully adopted this
approach in the early 1970s). Even a trans actional strategy, however, will succeed
or fail based on having repeat clients.
Clients, thus, can be attitudinally loyal for life—they re member us for
having done an outstanding job, they call us back if they ever need our particular
service again, and they enthusiastically recommend us to others.

C LIENT S FO R L IFE: W H O CAN BENE FIT ?

We define a professional as someone who practices an occupation

requiring a high degree of education and train ing, and who has clients rather than
customers. This defini tion includes not just service professionals, but also
technology consultants and sales executives who sell a com plex product. It does
not include teachers or musicians, for example, because they don't have
individual or organiza tional clients the way consultants and accountants do.
The professionals used as examples are drawn from a variety of fields,
including consulting, law, accounting, advertising, finance, medicine, sales,
and the military. Although each profession has specific skills and knowledge
that its practitioners must master—consumer be havior for an advertiser, financial
reporting requirements if you're an accountant, contract law if you're a lawyer,
and so on - achieving client leadership is premised on a set of common factors that
transcend individual professional requirements.
All types of professionals—and their clients—can bene fit from long-term
relationships. These relationships give you the opportunity to engage in extensive
client learning, which greatly increases your ability to offer tailored solutions, de -
velop new ideas, and provide germane insights rather than generic platitudes.
They are also the proving grounds where you can expand your service offering
and therefore your pro fessional experience—a loyal client who trusts you will try
you out in areas that a new client wouldn't let you touch.
Finally, the positive financial impact of having even just a few lifelong
advisory relationships, if they are managed profitably, can be enormous.
The distinction between a client and a customer is more than semantic.
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 Customers, for example, buy a product or serv ice with well-defined
characteristics that match their needs, with little or no negotiation and
discussion between buyer and seller; the professional's relationship with a client,
in con trast, has a consultative aspect to it—there is give-and-take to clarify needs,
identify problems, and recommend solutions. While there doesn't have to be a
personal relationship be tween a customer and the seller of the product or service,
with a client there is typically a close, personal relationship with a high degree of
trust.
And finally, a professional offers a client an authoritative body of
knowledge and expertise. So while the customer can have it his way at Burger
King, a client taking tax advice can't always have it his way (unless he wants to get
into trouble with the IRS).
The focus on clients, therefore, is a deliberate one. If you have customers,
your relationships will tend to be narrow in scope, whereas if you serve clients, you
have the opportu nity to develop the collaborative, broad-gauge relationships that
are the focal point.
A different ap proach is required for sophisticated clients who buy complex
products and services. For example, although we may believe that the customer is
always right—a standard prescription for managing customers—we sometimes
have to tell our clients how they are wrong and why we disagree with them.

W H A T K IN D O F P R O F E S S IO N A L A R E Y O U ?

There are three types of professionals to be taken into account.

The first group includes service pro fessionals—lawyers, management and

technology consul tants, accountants, corporate bankers, financial advisers,
executive recruiters, advertising executives, and so on. These individuals are in an
ideal position to become broad-based business advisers to their clients: their
services are of high strategic importance to their clients, and they are intimately
involved in the sale and delivery of the service. If you are one of these
professionals, all of the material in this book should speak directly to you.
The second group consists of sales executives who want to be considered
business consultants rather than simply sales people. If you sell a complex product or
service that is critical to your client's business, such as telecommunications sys -
tems, computer equipment, power plants, or mission-critical software, your client
will have a significant need for advice and consultation, and the opportunity
exists for you to be come an adviser to him rather than just a salesperson.
Finally, there are professionals who are staff or functional man agers
within corporations. Human resources or finance specialists who re port to line
executives, for example, face the same challenges that outride professionals do in
creating value, and they are held back by similar barriers.
It’s interesting to look at some extraordinary professionals who have
consistently engaged clients for life, identify how they add value, and discuss the
barriers that prevent other professionals from achieving the same level of success,
to grasp core attributes of great client advisers—the ingredients for success with
clients—and provide specific suggestions for how you can cultivate these
qualities, to see the major pitfalls that profes sionals can fall into as they develop
and manage client rela tionship.
Virtually all of the large service firms endeavor to de velop advisory or
consultative relationships with their clients, emulating those very few—McKinsey
in consulting, for exam ple, or Goldman Sachs in investment banking—that have a
history and culture of building deep relationships. Stockbro kers are now
"financial advisers"; accounting and consulting firms aspire to advise senior
management, not just undertake reengineering projects; software programmers
are referred to as "consultants"; and companies like Reuters don't just sell
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databases but want to be your "information adviser." Often, however, the words
"adviser" and "consultant" lack substance and have a hollow ring to them.
Ironically, just at a time when the professions are experi encing their
greatest growth in history, just as so many are striving to become trusted
advisers, many clients are in fact dissatisfied with the quality of the advice they
receive and the attitude of those who give it. It's getting harder and harder for
them to find professionals like James Kelly and Nancy Peretsman.
Why then? What holds professionals back from an undeni ably attractive role
that is highly valued by clients?

B A R R IE R S T O D E V E L O P IN G B R E A K T H R O U G H R E L A T IO N S H IP S

Three barriers stand in the way of becoming a business adviser to your

clients, and of experiencing the client loyalty and professional fulfillment that
accompany this role:

1. Most professional service firms demand specialization. If you work for a

large consulting or accounting firm, you might become a reengineering expert
for the chemical industry or an auditor for automotive companies. This is fine for
starters, but the problem is that the more expert you become in the niche where
your company has placed you, the more "valuable"—at least in the short term—
your firm thinks you are. This becomes a disin centive to providing you with other
experiences.
While there is great benefit in developing a deep ex pertise, this specialization
will eventually become a liabil ity if you want to play a broader-gauge role with
clients. Some firms recognize this issue and try to address it by systematically
diversifying the experience of their junior staff, but many do not. (This push for
specialization, by the way, is pervasive not just in the business world but in
medicine, academia, science, and other fields.) In addi tion, while large firms
provide tremendous opportuni ties and training for young professionals, they also
have financial and growth goals that must be met (many are now publicly held
companies). Sometimes, these short- term pressures override the long-term process
necessary to build deep, trusted client relationships.

2. Expertise is becoming automated and reduced to a commodity. Ironically, while

service professionals have been major beneficiaries of the late twentieth-century
infor mation economy, there are now signs that many types of expertise are losing
value. Just as the industrial revolu tion replaced skilled craftsmen with low-wage
factory workers during the early nineteenth century, the "ex pertise" sold by
professionals is becoming easily replica ble, more widely available, and
increasingly cheaper in our Internet-speed, technology-driven economy. Al ready,
the average incomes of some classes of profession als—doctors, for example—are
starting to decline.
Several forces combine to diminish the value of ex pertise:

• The supply of service professionals is growing significantly. The historically

rigid controls on the supply of gradu ates have been relaxed, and many individuals
with lesser certifications (e.g., paralegals, physicians' assis tants) are doing the
work formerly entrusted to de greed professionals such as lawyers or doctors.
Price based competition has become a permanent feature of the market for
professional services. In the corporate world, most major contracts for
professional services are now competitively bid, and the competition (for
management consulting and advertising services, for example) can be ferocious.

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 The internet and expert software now provide unparalleled access to all
kinds of expertise, at far lower prices than ever before.
Market research reports that used to cost thousands of dollars or that
investment banks provided only to their big-spending corporate clients can now
be obtained free over the Internet. Increasingly, professionals are paying to have
their "expertise" put in front of clients. A new Web site for CEOs, which already
has the participa tion of big names such as Michael Dell of Dell Com puter
Corporation, is charging professional firms $50,000 for the privilege of putting their
articles or research up on the site.
In other areas, Web-based sales automation is re ducing the need for
expensive sales forces; and mil lions of consumers use inexpensive software like
TurboTax to do their taxes and even write wills, thus avoiding tax advisers and
lawyers.
L abor m obility am ong know ledge w orkers is increasing.
firms, U
for.S example,
. are
tapping into pools of English- speaking talent in countries such as India, South
Africa, and Australia. Law school graduates are cross ing over into adjacent fields,
such as consulting and investment banking.

The effects of these trends are readily apparent. In fields as diverse as law,
accounting, consulting, and tech nology services there is significant consolidation
occur ring, with new mergers being announced almost monthly. What used to be
the "Big 8" accounting firms are now the "Big 5." Law firms, which historically
enjoyed long-term retainer relationships with their clients, are being asked to bid
competitively for work; some even went out of business altogether in the 1990s,
and we are now beginning to see a growth in mergers as law firms consolidate.
Consulting firms are being asked by major corporations to submit breakdowns of
their cost struc ture, their partner-to-associate ratios, and their billing schedules so
that the profitability of their projects can be managed and reduced. Many
companies are now con ducting frequent, tough reviews of their advertising
agencies, forcing incumbents to continually justify their relationship.
These and other signs of intense competition and industry maturation are
now widespread. High-end ser vices, such as merger and acquisition advisory work,
may never become commodities. But just as we can now put a vacation out to bid
on the Internet to see which airline wants to sell us a ticket at the best price, we
believe the day is not far away when this will be done for services as well. Imagine
asking doctors to "bid" to conduct a rou tine surgical procedure or inviting
lawyers to compete for your estate planning business.

3. Many professionals are held back by stereotypes about what clients want them to
be and how they should behave. Here are typical statements we have heard from
these profes sionals:

• "My job is to provide answers."

• "I need to become as expert as possible in one specific subject area within
my field and then to make my name in it."
• "When I meet prospective clients, I need to demon strate my expertise.
After all, that's what they're buy ing from me."
• "If I work in a new industry or function, I will be igno rant of basic
concepts. I will add little value, and clients will reject me."
• "This is a professional, business relationship. The per sonal side is
separate. Furthermore, my loyalty is to the greater goals of the institution, not to
the individ ual."
• "Clients will take advantage of you. You have to stick up for your own
interests."

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 There is some validity to all these statements. They are incomplete,
however. In contrast, consider these comments from clients who have spent a
lifetime using professionals:

• "The really good professionals ask great questions. Often, they enable
solutions rather than supply them."
• "The best business advisers have a good understand ing of my industry,
but also breadth.. Some of the best insights I have gotten have come from
professionals who bring analogies from other fields."
• "Good professionals are great listeners. They hear what you mean,
not necessarily what you say."
• "It's very tough finding 'honest brokers” who are unbi ased and not
pushing their own agenda with you. Everyone walks in here wanting
something."
• "Investment bankers cannot be true advisers. They are too focused on
the deals."
• "Our consultants always end the session with a half- hour presentation
on 'next steps,' the execution of which cannot, of course, be accomplished
without the consultants. What I really value instead are working sessions which
advance our thinking."
• "Our lawyers focus on every detail with equal empha sis. That's OK to a
point, but they rarely pull back and help us see the big picture."

Many professionals, in short, focus on providing an swers, being

perceived as "experts," doing great analysis, and specializing more and more
during their careers. Clients, in contrast, seek professionals who can ask the right
questions, provide knowledge breadth as well as depth, demonstrate big-picture
thinking as well as analysis, and listen rather than just tell.
Professor J. Brian Quinn of Dartmouth's Amos Tuck School of Business,
who has spent nearly forty years advising business and political leaders, including
several U.S. presi dents, puts his own slant on the issue of stereotypes: "I used to
believe that solving the problem was paramount. In reality, when the good advisers
deliver their recommendations, most of them have already been implemented. I
realize now that the process of problem solving is more important than the solution."
Clients do value professionals who can play a broad advi sory role. Theodore
Sorensen, in his book The Kennedy Legacy,
reports that just a few days before his inauguration, John F. Kennedy was presented
with a list of 250 items requiring a de cision from him. He apparently blurted out,
"Now I know
why Ike had Sherman Adams!" (Adams was President Eisen hower's trusted adviser).
The fact is, clients at any level, whether they are presidents of nations or corporate
managers, appreciate someone who can help them put there issues in perspective,
solve problems, and make better, faster decisions.

T H E IN G R E D IE N T S
F O R B R E A K T H R O U G H R E L A T IO N S H IP S

There are seven key attributes that, when blended to gether in the right
quantities and in the right manner, facili tate the development of insight and the
formation of deep, trusting relationships. These characteristics are a blend of in nate
talent, acquired skill, and attitude, and it's pointless to try to determine exactly
which is which. That's why we use the more general term "attribute" to describe
them. Empathy, for example, is definitely something you develop at a young age
(a "talent"), yet we know that people can improve their empathetic ability late in
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life. Native ability certainly counts, but hard work and openness to change can
improve any of these qualities, an assertion borne out by the experiences of the
many great professionals we've studied.
There is a natural, logical progression to the develop ment of these
attributes and to the order in which they usu ally come into play in building an
advisory relationship. The two foundational attributes for any professional who
aspires to serve clients are selfless independence and empathy. Great ad visers have an
attitude of complete financial, intellectual, and emotional independence. They
balance this independence, however, with selflessness—they are dedicated,
loyal, and focus on their client's agenda, not their own. It is a fine line to draw: on
the one hand, being responsive to a client's needs and problems and, on the
other, maintaining objectivity and honesty at all times. This selfless
independence illustrates why clients are different from customers.
The second attribute, empathy, is what opens the door to learning.
Empathy fuels your ability to discern a client's emotions and thoughts, and to
appreciate the context within which that client operates. It enables you to
diagnose what the problem really is and later underpins a learning relation ship
with your client. Dr. Michael Gormley, a London-based physician and renowned
diagnostician who treats several members of the British royal family, provides an
apt medical metaphor when he tells us, 'You can't just chop the patient up into
little pieces and then examine each one of them under the microscope. You
have to understand the whole context of his daily life."
The next three attributes concern your ability to think and reason. You
simply have to have something valuable to say before you can develop the long-
term professional rela tionship. A passion for learning drives the professional to de -
velop a core expertise and then to become a deep generalist by continually
broadening her knowledge. Synthesis is the ability to see the big picture, to draw out
the themes and patterns in herent in masses of data and information. It includes
related skills, such as critical thinking and problem solving. The abil ity to synthesize
sets the business adviser apart from the sub ject matter expert who relies mainly on
analysis. Judgment is often—but not always—the culmination of a particular en -
gagement or advice session, drawing on all the learning and synthesis you have
undertaken.
Conviction and integrity constitute two important charac ter attributes that are
common to all of the extraordinary professionals we have studied. When
credibility of content has been established, trust can follow, and the depth of a
client's trust in you will be very much governed by his assess ment of your character.
Conviction comes into play as the adviser begins to offer opinions,
recommendations, and judgments in earnest. Con viction, however, does not exist in
a vacuum; it is based on a set of compelling, explicit personal beliefs and values.
Properly harnessed, it is a powerful force that can motivate and energize both
professional and client.
The attribute of integrity comprises a constellation of skills and behaviors
that build trust, including discretion, consistency, reliability, and the ability to
discern right from wrong. Without this trust, it is unlikely you will develop a col -
laborative relationship. Your client will always keep you at arm's length and treat
you like a supplier.
There are other qualities, of course—motivation, opti mism, tenacity,
determination, analytical skills, and so on— that are valuable for professionals and
indeed necessary to be a successful expert. The seven we have identified, however,
are the ones that truly stand out and make a difference in a professional's
effectiveness. They enable you to go beyond expertise and become a broad-based
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adviser. These are the qualities that foster the development of the insights and rela -
tionships that lead to consistent value creation for clients, and they are the
characteristics that great advisers themselves have intuitively developed. If you
want, in short, to become an extraordinary professional who commands
unwavering client loyalty, you need especially to develop and strengthen these
attributes.

Becoming an Integrated Professional

These attributes build on and interact with each other to create a whole that
is greater than the sum of the parts. Ca sual observers might call an individual who
has successfully integrated them a "seasoned professional" or someone who
really "has a head on her shoulders." Drawing on his thirty- eight years as a
successful client adviser, James Kelly articu lates this state of integration and its
benefits:
“I have come to accept that I am constantly learning, and will never, ever
know it all. I've learned to become an intense observer of people—I know that
situations are never quite what they seem at first. I accept that sometimes I'm
wrong, but that's the cost of intellectual boldness, of daring to be right. I have a
constant sense of being surrounded by expert resources that I can call on—they're
everywhere. When you get your ego out of it and allow yourself to relax and
observe, you really do get into the flow of events and ideas. I'm working for my
clients, but I'm also feeling quite independent from them— I'm driven not
because I'm being paid but by a desire to help my clients, to learn, to satisfy a
higher pur pose. The ideas and solutions come quite freely in this state.
This happened just last week—I was the last speaker at a three-day
conference for a group of top executives. When I was younger, I would have
prepared a canned speech days in advance. This time I listened intensely for the
first two days. I observed the participants carefully. I opened up my mind to the
variety of ideas that were being presented and discussed—even though I didn't
like some of them. On the third morning, I got up early and took out a pen and
paper.”

Characteristics of a Successful Client Adviser

• Clients often ask you for advice, both on subjects directly within your field
of expertise and in pe ripheral areas that happen to be of concern.
• Most of your client relationships are long-term ones. The vast majority of
your clients would en thusiastically recommend you to someone else.
• There is strong mutual trust, on a professional and a personal level, between
you and your clients.
• You collaborate extensively with your clients to de fine the product or service
you deliver to them and match it to their needs.
• You frequently approach your clients with unso licited ideas and
suggestions.
• Your clients believe you consistently deliver value in excess of your fees.
They rarely if ever shop around to see if they can get the kind of services you offer
more cheaply elsewhere.
THESE BUILDING -BLOCK attributes are fundamental and straightforward. The reality,
however, is that most profession als don't practice or actively develop them. Or
they delude themselves into thinking that they have already mastered them.
Often, what they think passes for insight is, to their clients, merely expertise.
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They forget that this year's insight has a very limited shelf life and can quickly
revert to simple expertise—debt underwriting and reengineering consulting used
to be value-added services, for example. Now they are virtual commodities.

THE IMPORTANCE OF KEEN JUDGMENT

Consultants, attorneys, bankers, accountants, and other professionals are

involved in high-risk, high-stakes decisions every day: Should the case go to trial or
be settled out of court? Should a microchip manufacturer invest another 1 billion
dollars to increase production capacity? Do the company fi nancial statements
represent the actual condition of the busi ness? A keen judgment is one of the most
valuable asset a professional can have. Few clients, for obvious reasons, go back to
a professional whose judgment is poor. Many of the executives we have
interviewed, in fact, remember all too clearly the poor judgments offered by some of
their advisers, even though the incidents occurred years ago.
Good judgment, in contrast, is invaluable to clients. Win Bischoff, chairman of
the British merchant bank Schroders, recalls a seminal decision he made and how
the accurate judgment of his adviser contributed to Schroders' interna tional
success:
It was in the early 1980s, and we felt we needed tore- capitalize our U.S. bank,
which engaged in commercial lending. We were convinced we could issue debt to
do this. I went to see the head of Warburgs [a major British merchant bank], David
Scholey, to seek advice. In the space of an hour he delivered an unequivocal set of
judgments. Issuing debt would be all but impossible, he of fered, quickly turning the
conversation to the topic of Schroders' overall strategy, and the need for us to assess
it in detail at this critical juncture.
We were already considering undertaking a strate gic review, and Scholey's
advice was important encour agement. We subsequently made a series of important
decisions, including eventually selling the U.S. bank in stead of recapitalizing it, as
well as making other strate gic choices that enabled us to prosper as an institution.
That short, singular conversation, and the rapid-fire but incisive views
provided by Scholey, became a significant influence on our thinking.
Instinctively, Scholey did several things when asked to advise Schroders.
First, he made a rapid, intuitive judgment about the feasibility of issuing debt. The
situation fit a pattern in his experience, and he knew what the answer was without
hesitating. In the process, he thought two or three steps ahead, and was able to
visualize the chain of events following a hypothetical debt issue by Schroders, and the
negative con sequences that could ensue. In effect, he helped Bischoff avoid a
potentially bad judgment. Second, he reframed the question Bischoff was asking.
The right question wasn't "Should we recapitalize our American bank?" but "Should
we be in the U.S. banking business at all?" Since that time, Schroders' market
value has increased fifteen-fold, from about $300 million to $5 billion today.

F IV E J U D G M E N T T R A P S T O A V O ID

Before we look at the specific practices that allow great professional

advisers to arrive at high-quality judgments, we have to understand how to avoid
bad judgments. First, bad judgments can be deadly for an organization; second,
they will ruin your reputation as a professional—your clients will never forget the
poor decisions you recommend; and third, it's very common to make mistakes of
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judgment, since so many factors can cloud our decision making. The fact is,
avoiding bad decisions is one-half of the battle: even if you don't make particularly
good ones, you can muddle along and survive, whereas a poor judgment can put
you out of business, for good. The exceptional professional, therefore, constantly
examines his client's thinking and behavior to help prevent these wrong turns.
Here are five of the most important judgment traps that professionals
should be aware of as they advise their clients:

I. W eak Prem ises: Starting O ut on the W rong Foot

Many clients approach a problem or decision with wrong or partial facts at
the outset, resulting in a chain reac tion of faulty thinking. The two most common
errors that bias clients are anchoring— the decision maker allows himself to get
"anchored" on a specific starting number—and avail ability, the tendency to use the
most available, recent, or vivid information.
If two real estate appraisers, for example, are asked to as sess a house that is
already for sale, their valuations will vary based on what selling price they're given.
The appraiser who thinks the house is for sale at $200,000 will assign a lower val -
uation than the second appraiser who is told it's on the mar ket for $250,000, even
though it's the same house. Where you start often determines where you end up.
Clients can get anchored in many ways. Incumbent cor porations in
deregulated industries like telecommunications and utilities, for example, often
get anchored in their old growth paradigms. Compared to their historic growth
rates of 3 percent or 4 percent a year, achieving 5 percent or 10 percent now
seems wondrously high. But the new standard, in order for a company to be
considered a "growth" business, is more like 15 percent annual growth. Because
many of these companies are anchored on the old standards, they end up being
acquired.
Whatever happens to be the most available, recent, and vivid data can also
bias us. This perception bias can operate when managers go out and talk to just a
few customers and then draw sweeping conclusions about their company's prod ucts
and positioning. Bad personnel decisions are often rooted in this judgment trap
—we sometimes pick people we already know for a job rather than the most
qualified candidate.

2 . C o n firm a tio n : S e ein g W h at Y o u W a n t to S ee

Many people start out wanting to confirm—consciously or unconsciously—
what they already believe and tend to ig nore subsequent evidence that contradicts
their beliefs.
The confirmation trap is often triggered during mergers or acquisitions. Some
years ago, two large professional serv ice firms decided to pursue a merger, which, if
completed, would have resulted in large financial payouts to manage ment. A
subsequent study commissioned to assess the cul tural compatibility of the two
companies pointed out very major differences in the two cultures, and an unbiased
observer would have concluded that the organizations were vir tually incompatible
and shouldn't merge. Some partners who read the report, however, came to the
opposite conclu sion—that there was a strong cultural fit. They ignored the
differences that the study cited, or reframed them as "strengths" that would actually
aid the merger. As a result, the two firms went through significant post-merger
trauma as their different cultures clashed, resulting in bitter conflicts and an exodus
of partners.
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 3. O verconfidence:

U n d e re stim a tin g W h a t It T a k e s to S u cc eed

Overconfidence is probably the most common and fatal judgment trap. In

his book, When Giants Stumble, historian Robert Sobel chronicles famous business
blunders by major corporations. He sums up by saying, "If there is any single
moral to the tales [about corporate failures] it is that for all but one of these entities
failure was preceded by great suc cess." Business success, Sobel cautions, can breed
overconfi dence and complacency.
Clearly, the Decca record executive was suffering from a major case of over-
confidence (and maybe incompetence as well) when he so brusquely turned down
the Beatles. A famous historical ex ample of overconfidence is Germany's invasion of
Russia dur ing World War II. Adolf Hitler, buoyed by easy victories over Poland,
France, and other European countries, became filled with hubris as the war
progressed. He then ignored the warnings of his generals and insisted on invading
Russia nearly a month too late. His armies were virtually destroyed by the
combination of the severe Russian winter and the un expectedly large number of
Russian troops that Stalin was able to mobilize.
Several other classic judgment traps that are related to overconfidence
include an over-reliance on rules of thumb and a misunderstanding of base-rates.
Rules of thumb include "When writing an ad, use sentences of no more than twelve
words," or "Summer is the best time of year to sell your house." We tend to
simplify our experiences and reduce them to easy-to-remember rules and
guidelines. Problems arise when these cherished rules just don't apply. For exam ple,
Long Term Capital, a hedge fund manager, had lever aged $160 billion worth of
securities with just $4.8 billion in capital (the underlying value of the derivatives was
estimated at$l trillion). The company bet large sums of money that the yields on
twenty-nine-year government bonds would con verge with the yields on thirty-year
bonds—something that had always happened in the past (this expected convergence
was a "rule of thumb"). In July and August of 1998 the yields actually diverged and
Long Term Capital lost virtually all of its capital, nearly causing a global panic in
the process.
Misunderstanding or ignoring the underlying statistics regarding an event is
also common. For example, most stud ies on the success of corporate acquisitions
demonstrate that 50 to 60 percent of acquisitions are considered failures within five
years. The figure is even higher for cross-border mergers, which only succeed 30
percent of the time. Yet many execu tives pay no attention to these sobering
statistics.

4 . P rio r C o m m itm en ts: M ak in g N ew , Ina pp ro priate C om m itm en ts B a sed o n P rev io us O n es

Prior investments or decisions can unduly influence the formulation of new

commitments: once we take a stand or position, we often resist changing our mind.
This phenomenon may explain why President Kennedy gave the go-ahead for the
Bay of Pigs incursion—it was already planned, orga nized, and ready to go when he
was elected. Companies fre quently ignore an analogous rule of finance—don't
consider sunk investments when making new ones—and they mistak enly pour good
money after bad.
In his classic book Influence: The Psychology of Persuasion, Robert Cialdini
cites many examples of how even very small prior commitments can induce level-
headed individuals to agree to things that make no sense. In one study, for exam ple,
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homeowners consented to have large billboards encour aging traffic safety installed
on their front lawns, simply because they had previously agreed to put a small
sticker bearing a similar message in the corner of a window!

5. G ro up th in k: B eliev ing T hat It's "U s A gainst Th em "

The author Irving Janis, in a book entitled Groupthink, identifies eight

symptoms that can distort judgments and be haviors. These include:
• An illusion of invulnerability, which leads to excessive risk taking
• An unflinching belief in the morality and Tightness of the group
• Stereotyped views of adversaries as either evil or in competent, and
therefore not worth dealing with
Corporate organizations often suffer from groupthink, and it can lead
their managers to make poor judgments.
When Mexico deregulated its long-distance telephone mar ket, for example,
several large U.S. telecommunications com panies entered the Mexican market
believing they could easily dislodge the national phone company. They held its
management in disdain and considered it a stodgy, unworthy competitor. To their
surprise, they sustained heavy losses as the national company beat them at every turn
with innovative marketing and pricing strategies.
During World War I, this attitude resulted in the slaugh ter of tens of thousands
of soldiers in Turkey. In The Broken Years: Australian Soldiers in the Great War, Bill
Gammage describes the first Australian soldiers who went into action at Gallipoli:
"They thought themselves the equal to twenty Turks, they bowed to no man, and with
the eagerness of chil dren they restlessly awaited their glory." Within nine months they
had suffered appalling casualties and were forced to creep away in defeat.

H o w to A void B ad ju d gm en ts

You need to be constantly vigilant for signs that your client is about to fall
into one of these judgment traps. Do you see a client using rules of thumb that are
shopworn and out dated? Has your client already made up his mind and just wants
your stamp of approval? Do you have clients who rush to judgment based on too
much "intuition" and too few facts, or who grossly underestimate what it will take to
succeed?
Here are some specific actions you can take as an outside professional to help
your client avoid lapses in judgment:
• Always vigorously challenge your clients' assumptions. What makes their
starting number right? What would justify a number that was 50 percent less or 50
percent more? Do their customers really only buy on price? Do their products really
have the highest quality? Intro duce as much contradictory information as you can
and ask lots of "discontinuing" questions whose an swers might undermine the
initial premise.
• Keep yourself up-to-date on key statistics and research in your field—
remember, there's a lot of folklore out there. Beware of accepted wisdom: the
"dogs of the Dow" stock-buying strategy, for example—popular for many years
with investors—has worked poorly during the last five years. (This popular
investment strategy involves buying the ten stocks in the Dow Jones Indus trial
Average with the highest dividend yields during the previous year; holding them

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for one year; and then going through the same selection process again for the
following year, picking a new group of ten).
• Be careful how you ask and frame questions. "Do you feel the market is
saturated now?" is a leading ques tion; a better phrasing would be "What is the
market potential?" Many professionals ask questions that are biased and reflect
what they think or what they feel their clients already believe.
• Try to identify independent thinkers who can help challenge your
clients' thinking. These can be outside speakers, for example, or perhaps mid-level
managers who see the need for change more clearly than top management does.
• Finally, don't ever let yourself be used simply to con firm something a
client already believes—your collu sion may help undo the client. An assignment
like this may help out with short-term bookings, but it won't build your
reputation as a professional with integrity and an independent point of view.
(The exception would be the case of a legal advocate who commits to
demonstrating the truth of her client's story in court).

W H A T IS SO U N D JU D G M E N T ?

What is sound judgment and how does a professional develop it? We are
concerned with a definition of judgment that is the ability to arrive at opinions about
issues; the power of comparing and deciding; good sense.
The elements that contribute to sound judgment can be expressed in a formula
with three basic parts:

Judgment = (Facts) X (Experience) X (Personal Values)

The facts about the issue at hand—too few and you'll be hip- shooting, too many
and you'll risk overanalyzing the situa tion—represent the first major input.
Experience, which fuels intuition, is the mechanism by which the adviser adds to and
processes these facts. Good decision makers then filter the resulting options through a
strong set of personal beliefs and values.
Historically, good judgment was associated with age and experience. The elders in
a society were considered the wis est, and therefore they were consulted on the most
important decisions. Today, there are several, contradictory schools of thought on what
constitutes good judgment and decision making. Most researchers in the field embrace
the cognitive model and believe that solid judgments can only be reached through a
highly logical, step-by-step, rational process, focus ing almost exclusively on the factual
inputs described in our judgment formula. Many popular books have been written that
propose this approach, and they're filled with elaborate, quantitative tables and charts,
which decision makers are supposed to use in order to come to sound conclusions. Un -
fortunately, research into decision making in the real world clearly demonstrates that
good decision makers rarely under take this much rational analysis.
Another, smaller group of scholars believes that judg ment is essentially
intuitive, and that most real-world deci sions are made with little analysis. Based on our
own research into professionals and the clients who employ them, we be lieve that the
best decision makers blend these two ap proaches—cognitive and intuitive—and they
add a third dimension, which is the personal value system.

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 FIV E ST E PS T O G O O D JU D G M E N T

Great professionals excel at a number of specific prac tices that underpin

sound judgment. They:
• Frame problems appropriately at the outset
• Engage in creative but selective fact gathering
• Use intuition: they leverage their personal experience to find similar
patterns and relevant analogs
• Filter their judgments through a clear set of personal beliefs and values
• Are honest enough to learn from experience

I. F ra m e th e P ro b le m
The first critical step is to identify the right problem and frame it correctly.
Diagnosing the wrong problem is one of the most common mistakes that
professionals make, regard less of their field. Many corporate executives will ask
consultants to help "reorganize," when the real problem—for example,
ineffective communication or poor leadership— often has nothing to do with
organizational structure.
Professor Joseph Bower of Harvard Business School, who actively consults
to industry leaders, told the following story about problem framing, or rather,
reframing:
“The head of a large company called me in to advise on a major
revitalization program that he wanted to launch. He had identified a host of
problems with his or ganization structure, distribution network, technology
platforms, and so on. He was also going to engage a large consulting firm to help
with the effort. I sat in on the kick-off meeting with the CEO and his fifteen top
execu tives. For two hours the CEO waxed eloquent about the need to change, and
the new program he was about to launch. There was little discussion, and the
meeting ended. Afterward, I sat with the CEO and he asked me for my reaction. I
looked at him and said, "Did you see the faces in that room? There isn't one of your
top exec utives who buys into your program. I think that's your real problem."
Initially, he was stunned, but then he nodded his head. He began to smile. "You're
right," he said quietly. "They're not on board at all, are they?"
Ironically, that was the end of the consulting assign ment for both me and the
large firm he had lined up. In his mind, the engagement had been a success and was
over. The real problem had been identified and he set to work fixing it, personally.
The consultants were a bit stunned, but to me it was a good outcome. The CEO sub -
sequently replaced half his senior team with outsiders, and they went on to be quite
successful.”

2. E n g age in C reativ e bu t S electiv e F act G ath ering

Horserace handicappers use historical data on horses to set the odds for each
race. In a classic study, a group of pro fessional handicappers was asked to make
predictions for var ious races. In the study they were given increasingly more facts
about each horse and then, after absorbing the new batch of facts, asked to predict
its performance. For the first round, they were given only five facts on each horse;
for the second round, ten; the third round, twenty; and finally, forty pieces of
information on which to make a judgment. What happened? After each round, the
handicappers' confidence in their judgments increased. But their accuracy stayed
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the same! After a minimum threshold of key facts is reached, having more
information does not increase the quality of de cision making. In certain business
situations where time is of the essence, gathering more information can actually
decrease the quality of decisions because key actions are delayed as managers
conduct more and more analysis.
While somewhat counterintuitive, the idea that more in formation and
expertise isn't always helpful has been born out in a variety of settings. In our
largest corporations, for example, the careful review and analysis of decisions by
large numbers of internal staff experts and external professional advisers often
decreases rather than increases the quality and robustness of decision making. This
may happen be cause excessive analysis screens out promising creative ideas that do
not stand up to the scrutiny of traditional financial benchmarks.

3 . U seI n t u i t i o ton L ev erag e F acts

an d P e rso n a l E x p e rie n ce

Intuition is a powerful tool for making judgments. Just look at this

example: a fire chief leads his men into a house where a kitchen fire is burning. It
is a relatively small fire and shouldn't be a problem for the half-dozen trained fire
fight ers arrayed to put it out. Suddenly, the chief has a terrible feeling about the
fire. Without thinking, he orders his men to evacuate immediately. They rush
outside, and as they leave the house, the entire first floor collapses in an explosive
inferno. They have just escaped with their lives. When a post mortem is done on
the situation, the chief believes that his "sixth sense" perceived the danger and
saved him and his m en.”
Researcher and author Gary Klein, who studies decision making under
pressure, recorded this case, and he knows that it wasn't the chiefs extrasensory
perception that saved the day (Klein's book Sources of Power examines how people
make decisions in real life as opposed to the laboratory). Using innovative
interview techniques, Klein reveals the real reason: the chief's experience-based
intuition. The fireman sensed that, even though the fire was small, it was
generating an unusually large amount of heat. Furthermore, there was very little
noise—it was too quiet for such a hot fire. In fact, what had happened was that
the basement was on fire, and what seemed like a kitchen fire was actually a huge
basement conflagration leaking upstairs. Subconsciously, the chief compared this
fire to similar fires in his experience. It didn't fit established patterns, and this set
off warning bells. He knew something was wrong—he didn't know exactly what yet.
So he ordered a retreat to reexamine the situation from a safe vantage point.
The example of the kitchen fire illustrates the first key component of intuition:
the subconscious analysis of 'patterns. We often experience it as "good feel," but a
better description would be "experience feel." After we have seen many, many similar
cases, we develop an ability to sense whether a new ex ample fits—or diverges from—
the patterns we have come to recognize. Chess grandmasters function very much the
same way. They spend most of their time studying games and posi tions, and they
develop the ability to rapidly size up any situa tion they encounter on the chessboard.
As you can see, developing your powers of observation, a theme we high lighted in
the previous two chapters on learning and synthe sis, will help sharpen your
judgment skills. In order to leverage your experience, you have to cultivate the
ability to observe intensely what is going on around you.
The second step in using intuition involves imagining how the decision will
play out. Various researchers use ex pressions like "mental simulation" or
"imagining the out come" to describe this. Very skilled professionals can rapidly
simulate scenarios in their minds. Bain & Company CEO Orit Gadiesh implicitly
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refers to this when she tells us: "The good client advisers always keep three or four
moves ahead. They are constantly imagining steps two, three, four, and five of the
process while their clients are still focused on step one."
The intuitive part of judgment also involves the ability to identify analogs— to
be able to say, "This here is like that over there." Analogies are also an important
tool for synthesis. Here, we are trying to use analo gies to make better judgments, to
enhance our understand ing of the immediate decision we have to make. American
military advisers during World War II, for example, might have foreseen the
attack on Pearl Harbor if they had studied the history of the Russo-Japanese war. In
that situation, the war was also preceded by a Pearl Harbor—like attack on the
Russian fleet at Port Arthur in 1905.

4 . In co rp orate Y ou r P erso na l V alu es a nd S tan da rd s

Good judgment, or at least judgment that is consistent with your own

character, is also based on having a strong, ex plicit set of personal beliefs and values
that guide your de cisions .
The following story, told by the chief executive of a $2 billion company,
illustrates the power of an adviser's per sonal value system. You may not agree with the
values, but you can't argue with the result:
“Some years ago, we faced a class action suit from a group of dealers,
which potentially was going to cost us $50 million. We believed we had done
nothing wrong, but our lawyers advised us that if it went to court, we stood only a
50-50 or worse chance of winning. A major distributor, who used to be the chairman
of my company, originated the suit. He had died just shortly after the suit was filed,
and on his deathbed he had his sons swear they would not relent in their pursuit of
the lawsuit.
One of my long-standing advisers is a minister who excels at taking
principles from the scriptures and apply ing them to business problems. I explained
the situation to him, and he gave me this advice: he told me to go see the sons of
the major distributor (who had just died) and tell them that we were donating
$200,000 to a charity of their choice "to honor their father." "He was the
founder," I was to tell him, and "this is to honor him." I did this, and they
accepted. Then my adviser told me to go around and personally visit each
distributor who was a party to the lawsuit. He told me to ask them what their issues
really were and what they needed. I spent six weeks traveling to see them. At the
end of this, I offered to settle for something like $2 million over three years.
Eventually they settled for $1 million up front. This ad vice saved the
company tens of millions of dollars and helped reestablish the loyalty of our key
distributors.”
The pharmaceutical company Merck's development of Mectizan, a drug for
river blindness, is another example of how a clear set of personal values can and
should influence business decision making. In The Leadership Moment, Professor
Michael Useem of the Wharton School of Business chron icles the story of Roy
Vagelos, who was the head of Merck's laboratories in the 1980s. Vagelos made a
personal decision to support development of a revolutionary drug that could cure or
forestall the spread of river blindness, which is caused by a devastating parasite
infection affecting 60 million people in developing nations. The problem was that
none of the cus tomers for Mectizan could afford to pay for it.
Vagelos advised Merck's management committee, and later, when he
became CEO, its board of directors, to support the production and distribution of
Mectizan—for free, for ever. This was a huge and risky decision that by 1997 cost
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Merck $200 million in lost income. Yet Vagelos never hesi tated. A physician himself,
he deeply espoused a personal mis sion to "preserve and improve human life." His
own beliefs and values were carefully factored into his decision making.

5. D on 't B e M isled by Y ou r E x perience

On November 23, 1951, Ivy League rivals Dartmouth and Princeton

played a hotly contested football game. The game was marked by fierce rivalry and
very rough play on the field. Princeton's star player broke his nose and a Dartmouth
player broke his leg. Afterward, a bitter dispute erupted about the way the game
was played, with each side accusing the other of unsportsmanlike conduct. A
psychologist from Dartmouth, Albert Hastorf, and a researcher from Prince-ton,
Hadley Cantril, teamed up to study the incident. They surveyed students who had
seen the game, and they showed a film of the game to students at both colleges who
had not at tended the match. Predictably, each side reported that the other team had
committed the most infractions. Even with the benefit of objective evidence—a film
that recorded every thing—the students couldn't agree. The researchers con cluded,
"It seems clear that the 'game' was actually many different games. It is inaccurate
and misleading to say that different people have different 'attitudes' concerning the
same 'thing.' For the 'thing' simply is not the same for differ ent people."
As this example illustrates, although it would seem very natural for us to
learn from experience, memories are "re constructed" after the fact and sometimes
not very accurately. Researchers in the legal field, for example, have found that
eyewitness" accounts can be very unreliable. In short, we lend to see what we want
to see.
Physicians can be particularly susceptible to this phe nomenon. A study
done many years ago asked a group of ex perienced doctors to assess who among 500
children needed tonsillectomies. They concluded that about 50 percent needed to
have their tonsils removed. They then separated out the 50 percent whose tonsils
were deemed healthy and asked another group of doctors to examine them. Again,
just under 50 percent were deemed in need of surgery to remove their tonsils. The
"healthy" children were again culled from this group and assessed by yet a third
group of doctors. In credibly, nearly 50 percent were still diagnosed with un -
healthy tonsils requiring removal!
There are three major pitfalls that prevent us from learn ing from experience:
• We claim credit for all successes. Not all good things are due to our genius;
luck and happenstance affect a lot of outcomes. We have to recognize this and
develop a measured understanding of our capabilities.
• We minimize and dismiss failures. Often, we will reframe events with
hindsight so they are more favorable to us, or we simply forget them. This keeps us
from learning.
• We distort actual events, in our favor. Like the students at Dartmouth and
Princeton, we allow personal biases to color our recollections.
You can enhance your ability to learn from experience by doing a few
simple things. First of all, keep track of your advice. Six or twelve months after the
fact, ask yourself if you would give the same advice, or if, perhaps, you would say or
do something different. Second, think about how past events might have turned out
differently. Research has shown that you can reduce hindsight biases by looking at
how the results of decisions could have been different. It's not enough to say, "Why
did things turn out the way they did?" You also have to ask, "How else might it have
turned out, and why?"
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 TECH NIQ UES TO DEVELO P BETTER JUDG M ENT

Based on our observations of professionals who have great judgment, here

are some suggestions for improving your own decision-making ability:
Overinvest in problem identification. Lack of up-front investment in thorough
understanding of the issues that the client faces is one of the biggest mistakes
professionals make. At least 50 percent of the time, the "problem" presented by
your client will change and evolve from the one you discussed at your initial
meeting. It is a dangerous mistake to accept your client's first "problem statement"
at face value.
Examine alternative problem definitions. Be creative in examining all the root
causes of the issue at hand. Harvard's Joseph Bower, in our earlier example,
correctly identified that his client's first problem was executive alignment and
buy-in, not antiquated processes or information systems.
Make sure the problem is really apriority. Given the strategy, goals, and current
situation of the organization or individual you're dealing with, does it make sense to
work on this problem? A few years ago, a major bank had lost nearly $500 mil lion in
just twelve months. Management began soliciting multimillion-dollar bids to develop
a "cultural change" program. Was this really the place to start, given the huge losses
and other associated problems of cost efficiency and strategic positioning that the bank
faced?
Ask "disconfirming" questions. As we mentioned earlier, you can avoid the
confirmation judgment trap by asking questions and collecting data that you
suspect might dis prove the initial hypothesis. For example, the United States
decided to drop the atom bomb on Japan in 1945 be cause of a firm belief that the
Japanese would never surren der. U.S. officials believed that an invasion of
mainland Japan, which would cost an estimated 1 million Allied casu alties, was the
only other viable option. But what if the fol lowing question had been seriously
pursued: "Short of dropping the atom bomb or invading the mainland, what event
could lead the Japanese to surrender?" This line of in quiry, if advanced in a
thorough manner, might have re vealed other options to the Allies, including the
obvious one of just waiting for a few more weeks, since constant Ameri can
firebombing had already destroyed a large number of Japanese cities.
Develop both standard and outlandish alternatives. We often put boundaries
around our thinking, and this severely limits the range of alternatives or
possibilities we are able to con sider. What if we do nothing? What if we do the
opposite of what everyone is suggesting? An outlandish alternative pro posed at a
Drexel Burnham brainstorming session in 1983 was the concept of an "air fund"
for corporate acquisitions--- a fund with no money in it. At first, the idea seemed
absurd. But it eventually evolved and developed into the "highly con fident" letter
that Drexel would send out prior to a takeover. Basically, the letter stated that
Drexel was highly confident the financing could be raised in the high-yield bond
market.
There was no money available yet, just the promise of billions of dollars soon to
materialize.
Engage in prospective hindsight. Try stating a question about the future in two
different ways:
• How likely is it that our closest competitor will take ten points of market share
away from us in the next two years and surpass us in revenue? Give reasons why this
might occur.
Here is a slightly different version of this question:

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 • Pretend it is two years from now. Our closest competi tor has increased its
market share by ten points and surpassed us in revenue. Explain how and why this has
happened.
When a hypothetical event is stated as a reality—as in the second question above—
people are far more creative in com ing up with reasons for why it could happen, and the
quality of their thinking improves dramatically.
Understand your client's tolerance for risk and uncertainty. Every client has different
levels of tolerance for risk, and this tolerance will vary from situation to situation.
Several years ago, for example, a leading European travel company commissioned a
group of consultants to review its U.S. operations. Although the firm's U.S. office was
at a serious disadvantage against bigger players, and losing money, the consultants
believed that with a great deal of work and further investment it could grow and
achieve greater market clout and economies of scale, finally becoming profitable.
Their conclusions bothered the CEO, however, and he asked a friend, a former
top executive in the travel business who had retired, to come see him. Sitting over lunch
the next week, his friend said, "It all comes down to what management really wants here.
So what do you really want out of your U.S. operations? And what risks will you
tolerate?" The CEO paused, since no one had bothered to ask him these ques tions
in quite this way. He replied, "I basically need to show the flag in the United States.
The business doesn't have to be big—in fact it can be very small—we just need a
visible pres ence. And I can't risk it ever losing any money. I just cannot af ford it
anymore—the government won't put up with the losses." The CEO declined the
follow-on consulting contract and instead spent a month downsizing the U.S. office
to the point where it could break even under any circumstances. The CEO was
happy, and so were his shareholders, who were more interested in national
representation—"showing the flag"—than market share. The consultants, in short,
had mis judged their client's appetite for risk and misunderstood his business
objectives in the United States.
Enhance your ability to reach for patterns in your experience. You can deepen
your effective experience by learning from other, more seasoned peers. Get them to
share stories and an ecdotes. You might consider questions like: "What was the most
difficult client you ever had? What was the most awk ward professional moment of
your career, and how did you handle it? Have you ever taken on a case that seemed
hopeless? Why?" Stories are a powerful means of enhancing your experience.

BECOMING A GOOD THINKER

Good judgment flourishes, first of all, in the absence of bad judgments.

Great professionals help their clients avoid the many subtle judgment traps that
can lead to poor deci sions. Then they actively exploit each part of the judgment
equation in a balanced fashion. They combine known facts with their
experience and assess the alternatives through the lens of their beliefs and values,
by becoming a deep generalist, cultivating your powers.

D o Y ou H ave G ood Ju d gm en t?

• When your clients face tough choices, they often use you as a
sounding board. They share their dilemmas with you.
• You're right more than 50 percent of the time.

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 • You have the confidence to make judgments rela tively quickly. You
identify and marshal the key facts and perspectives that you need, but it doesn't
bother you if you don't have all the facts.
• If you're asked by a client to judge an issue where you lack experience
and important information, you're not afraid to come out and say you just don't
know.
• You're honest about your track record at giving ad vice and making
recommendations. You've made mistakes and learned from them.
• You're very aware of your clients' tolerance for risk and loss, having
discussed this openly with them.
Of synthesis, and developing good judgment, you will be well on the road to
becoming a good thinker, a person aptly defined by Vincent Ruggiero in his book
The Art of Thinking:
Good thinkers produce both more ideas and better ideas than poor
thinkers. They become more adept in using a variety of invention techniques,
enabling them to discover ideas. More specifically, good thinkers tend to see the
problem from many perspectives before choosing any one, to consider many
different investiga tive approaches, and to produce many ideas before turn ing to
judgment. In addition, they are more willing to take intellectual risks, to be
adventurous and consider outrageous or zany ideas, and to use their imaginations
and aim for originality.
IF YOU ARE able not only to demonstrate sound judgment yourself but also help
your clients arrive at their own good judgments, your value as an adviser will increase
significantly. By developing a reputation among your clients as a good thinker, you
will be asked back by them again and again.

WHAT MONEY CANNOT BUY

Creating Trust through Integrity

QUESTION: Is not commercial credit based primarily upon money or property ?

j. PIERPONT MORGAN: No, sir, the first thing is character.
QUESTION: Before money or property ?
j. PIERPONT MORGAN: Before money or anything
else. Money cannot buy it. . . . Because
a man I do not trust could not get money from me on all the bonds in Christendom.
J. P. MORGAN'S 1912 Congression Testimony'

AMERICA is slowly becoming a low-trust society. In 1960, 58 percent of

Americans surveyed felt that "most people could be trusted," but when asked
the same question in 1993, only 37 percent replied in the affirmative. Evidence
of low trust is everywhere: politicians routinely lie, litigation proliferates, and
the confidence we have in a variety of pro fessional figures—doctors, lawyers,
consultants, stockbro kers, journalists, and others—appears to be at a low
ebb. Even our trust in respected institutions such as local police, the FBI,
clergy, and the military has waned in recent years.

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 A lack of trust in business and personal dealings carries many costs.
Corporate managers and public officials, for ex ample, are reluctant to share
information that could empower their organizations, resulting in sharply
reduced employee loyalty. Transaction costs, such as legal fees and overly detailed
contracting, are major expenses for both cor porations and individuals. And because
of a fear that they will be sued, many employers refuse to give recommendations for
former employees—the two parties, in essence, don't trust each other.
Service professionals, who have historically enjoyed a reputation for
unimpeachable integrity, have contributed their fair share to the diminution of
trust that clients place in them. Stories are reported in the press—and also occa -
sionally circulated among clients—about investment banks whose client loyalties
are a function of deal size rather than prior commitments; about consultants who
oversell and put inexperienced staff on projects; of lawyers who create con flicts of
interest by allowing themselves to become finan cially intertwined with their
clients; and so on. Litigation against large professional service firms, once rare,
has be come commonplace.
The basic patterns are all fairly familiar by now: confi dential information is
misused; a client's interests are put last rather than first; standards are
compromised in order to re tain client business; and conflicts of interest are not
disclosed. As the service industries become more competitive, there is an
increasing tendency to compromise principles in order to meet growth and
profitability objectives. Integrity, inexorably followed by a decline in trust, is the
casualty.
Great professionals, however, never concede their in tegrity in order to win.
They may be bold and determined in pursuit of their objectives, but integrity and
their clients' needs—not selling the next assignment, not earning a large bonus,
not pleasing their boss—come first. And if there ever is a conflict between the two
—between what a client wants and what the professional's integrity dictates—
integrity al ways wins out.

YO UR M O ST PO W ERFUL ALLY

Trust is especially important in situations where there is a "high degree of

dependence on someone else—precisely the situation when a client hires a
professional for advice or buys a complex product or service from him. Trust
between a client and a professional is both a necessity and an important asset for
both parties: if there is mutual trust, everything works better, faster, and more
smoothly. When a client trusts her professional adviser, a number of positive things
happen:

• When you suggest additional work to your client, she believes you are
proposing the work because you hon estly believe it will help her, not because you
need more business.
• Your client will be willing to buy services from you that extend beyond your
core expertise. Trust allows you to increase the depth and breadth of the
relationship.
• If you make an honest mistake or slip up in some way, your client will most
likely forgive you and won't hold it against you.
• You will be able to work with your client on a more in formal basis, leading
to a more relaxed and creative process. There will be a decreased need to carefully
document and check everything you do.
• When you make recommendations, they will have more impact. Your
client will believe that your words are backed with integrity and that your only
agenda is to help solve her problem.

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 Trust, in other words, is a professional's most powerful ally. Trust is worth a
fortune (it is, literally, if we're talking about keeping a client for life), yet you can't
purchase it, a fact noted b. P. Morgan when he testified before Congress in 1912.
What is trust, exactly? We know it's missing in many aspects of our society, and we
know how powerful it can be when it's present, but it's easier to articulate the feeling
of trust than the elements that actually create it. Trust is complex: in some
situations, it means "I believe you are competent to per form this service"; in others, "I
know you will act in my inter ests, not yours." Author Robert Shaw proposes a
general definition of trust: "A belief that those on whom we depend will meet our
expectations of them."

H a r ry H o p k in s: F ra n k lin R o o sev elt's M ost T ru ste d A d v iser

Harry Hopkins, who served as an adviser to Franklin Roosevelt from 1936

to 1945, was one of the most remarkable political advisers in U.S. history. Much of
his success was based on a relationship of extraordinary trust that he devel oped
not just with the U.S. president but with other world leaders at the time, such as
Winston Churchill and Joseph Stalin. Hopkins, who had almost no formal
position in the White House during World War II, was influential in both the success
of the New Deal and the effective conduct of the war. The trust he engendered,
added to his native abilities, en abled him to play a highly unusual role in both
increasing Roosevelt's effectiveness as president and in facilitating a highly
productive relationship among the Allied war leaders. Secretary of the Army George
Marshall, who was not prone to hyperbole, said that Hopkins "rendered a service to
this country which will never even vaguely be appreciated."
A professional social worker by training, Hopkins as a young man showed
little hint of the greatness he would achieve as the most important adviser to a
famous U.S. presi dent. He headed the Federal Emergency Relief Administra tion
and the Works Progress Administration during the mid-1930s and was secretary of
commerce from 1938 to 1940. Ironically, it was when Hopkins abandoned any
personal po litical aspirations that his power increased exponentially. He had a bout
with cancer, then was diagnosed with a chronic, wasting intestinal ailment that
doctors believed would be fatal. Because of his health, he gracefully stepped
down as commerce secretary in 1940, but soon after Roosevelt was re- elected, he
asked Hopkins to move into the White House and become his informal adviser. It
was during the war years, when he held no major post, that Hopkins established a
unique relationship with Roosevelt.
Living in a guestroom at the White House, Hopkins joined Roosevelt for
virtually all his meals and attended every important meeting with him. Roosevelt
got to know Hopkins intimately, reinforcing their personal chemistry and a sense
that they shared many of the same values. Based on Roosevelt's deep trust in
Hopkins, he sent him as his personal emissary to London in January 1941, to meet
with Churchill (Roosevelt and Churchill did not yet know each other per sonally,
although they had met once years earlier). Hopkins and Churchill spent two
weeks together, including three weekends in the countryside at Chequers, the
prime minis ter's country estate, where they talked, drank, and relaxed to gether. The
relationship Hopkins established with Churchill during this trip built a foundation
of trust that allowed Hopkins to create an unusual link between the two leaders.
Moreover, as Hopkins's biographer, Robert Sherwood, notes, "there was by
now an intimacy between the two men which developed to such a degree that it is
no exaggeration to say that Churchill reposed the same confidence in Hopkins
that Roosevelt did." After yet a second visit with Churchill, Sherwood tells us,
"there was started at this time correspondence without precedent: an informal,
off-the- record but none the less official correspondence between the heads of two
governments through a third party, Hopkins, in whose discretion and judgment each
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had complete confidence. Time and time again, when the Prime Minister wanted to
sound out the President's views on some new move, he would ad dress a private
cable to Hopkins . . .
Hopkins exercised impeccable discretion. Despite being privy to virtually
every state secret and private conversation of the president, he never, ever—not even
once—betrayed the confidences placed in him. He never leaked news or used his
information for personal gain. In July 1941, shortly after the Germans had invaded
Russia, Roosevelt sent Hopkins to meet with Stalin in Moscow to assess the situation.
It was a his toric set of meetings, the first between Stalin and a direct rep -
resentative of the U.S. president. Very little was reported in the newspapers,
however. During the press conferences he held afterward, Hopkins revealed
virtually nothing about the substance of their talks, even though to do so would
have enhanced his prestige and highlighted the powerful and unprecedented role
he was playing. Roosevelt knew that Hopkins was as silent as a tomb, and it
magnified his ability to trust him.
Hopkins's reliability and consistency further reinforced Roosevelt's belief
in his integrity. He never overstepped his bounds; if Roosevelt sent him on a
mission to meet with a for eign leader, he knew that Hopkins would assiduously
adhere to the agenda and limits that had been set for him.
After every meeting, Hopkins would carefully draw up a detailed memo
for the president that succinctly laid out the key points and issues to consider.
Hopkins didn't believe in political patronage, and he was incorruptible.
When he administered relief funds for Roosevelt as head of the Federal Emergency
Relief Adminis tration, he did it strictly by the book, favoring no particular state or
constituency. A few times, Roosevelt had to intervene to satisfy some political ally
whom Hopkins had treated too impartially.
Hopkins never profited from his position of enor mous influence; when he
died in 1945, his estate was worth only a few hundred dollars. Yet this had been a
man who had personally overseen the disbursement of $9 billion in aid dur ing the
Depression and who had been a director of the lend- lease program during World
War II, which allocated over $50 billion in military spending.
In Roosevelt and Hopkins, Robert Sherwood sums up Hopkins the
adviser: "Hopkins did not originate policy and then convince Roosevelt it was
right. He had too much intel ligence as well as respect for his Chief to attempt the
role of mastermind. He made it his job to provide a sounding board for
discussions of the best means of attaining the goals that the President set for
himself. Roosevelt liked to think out loud, but his greatest difficulty was finding a
listener who was both understanding and entirely trustworthy. That was Hop kins.
Because he had set aside his own personal ambitions for formal office, Hopkins's
agenda was Roosevelt's agenda. This, together with his unwavering integrity, made
it easy for Roosevelt to trust him.
If we look at Harry Hopkins and his relationship with Roosevelt—indeed,
if we examine any business relationship with a high degree of trust—several
factors stand out that uniquely affect the level of trust that a client has in you.
The first major quality that underpins trust is integrity. The dis cretion,
consistency, and reliability that you demonstrate, and your sense of right and
wrong—these will influence, more than just about anything else, the degree of
trust people place in you. Hopkins exhibited these qualities to Roosevelt on a
daily basis, always coming through for the president, never forgetting a
commitment, as incorruptible on the last day of his tenure as on the first.
Hopkins's strong performance at every task Roosevelt gave him
illustrates an additional factor that builds trust: competence. In a business
setting, a client's trust will natu rally be influenced by whether or not he thinks
you're com petent to do the job you've promised. The risk of trusting someone is
a final consideration, and that perceived risk will raise or lower the total amount of
trust that a client has in you.
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 These three factors—integrity, competence, and risk— can be combined
into a trust formula:

Trust = (Integrity X Competence)

Risk

Your clients' perception of each factor in the equation will raise or lower
the trust they place in you.

INTEGRITY: THE BACKBONE OF TRUST

Integrity is a state of wholeness in which you act in accor dance with a set of
coherent values or principles. In other
words, you know what's right, you're clear about what you be lieve in, and you
consistently follow your beliefs.
Integrity has several main dimensions to it. The first, ac cording to Yale law
7
professor Stephen Carter, is discernment between right and wrong. Just acting
consistently with your beliefs is not enough; you have to have beliefs that are ethical
and moral. Adolph Hitler, for example, passed many of the tests of integrity—he
acted on his beliefs quite consistently— but he had evil, wrong beliefs. There was
no discernment.
In Dante's Inferno, which is the first part of his Divine Comedy, the "false
counselors" are found in the eighth circle of hell, one of the lowest, just below
common thieves.
These false counselors are spiritual thieves, who advised others to commit
fraud. They used their intellect to rob people of their integrity, and as a result
must walk for eternity en veloped in painful flames.
Using one's intellectual powers to deceive and encourage wrongdoing was,
for Dante, an espe cially egregious crime. Honesty is an important manifestation of
discernment.

HOW YOU CAN BUILD TRUST

Trust is like a fine Oriental rug that is carefully woven over many months
or even years, rather than an edifice that is set up overnight. Lots of small things go
into building trust. Here are some areas to consider:

1. Face Tim e with Clients

"One of my few client relationships that went badly," Spencer Stuart's

Andrea de Cholnoky tells us, "was due to lack of face time. The client told me
that he just hadn't seen enough of me, that it didn't seem like I had the energy in the
assignment. I immediately called up every single one of my other clients and took
them out to lunch! You've got to in vest, continually, in face-to-face time with
clients."
There is simply no substitute for meeting with a client and allowing time
so that the two of you can come to know each other personally. The purpose is not
to make the client like you—we're not talking about "schmoozing." And there's no
guarantee that if you spend time together the trust will in crease.
If, however, there is personal chemistry, as well as shared values and
interests, personal time together will bring this out, and it will subtly facilitate the
development of trust. Face time provides an opportunity for your client to see your
sterling qualities firsthand. It amplifies your competence and integrity.
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 2. Setting and Reviewing Expectations

We said early on that a client's satisfaction is a function of expectations versus

actual (or perceived) performance. Trust works the same way: you may very well
fulfill your commit ments on time, but if you and your client don't agree on what a
particular commitment was in the first place, your perceived integrity will suffer and
trust will diminish.

3. C arefu lly M ak in g P rom ises

The worst kind of professional is someone who con stantly promises things
and never delivers. This kind of credi bility gap, once established, is almost
insuperable. Lewis Smedes, an ordained minister, beautifully sums up the mean ing
of a promise in a sermon entitled "The Power of Promises": "When a person
makes a promise, he stretches himself out into circumstances that no one can
control and controls at least one thing: he will be there no matter what the
circumstances turn out to be."
Here are some suggestions for how to keep commit ments:

• Don't be cavalier with promises. Don't say, "Let's have lunch" or "I'll call
so-and-so for you" unless you really mean it. Being known as a person of your
word is a powerful thing. Don't dilute your integrity with thoughtless
commitments.
• If necessary, make conditional agreements. If an event or occurrence
could get in the way of a promise, state it clearly up front. This way there will be
no surprises.
• If you can't keep a promise, let the other person know as early as
possible. The longer you wait to reveal the bad news, the worse things get. If you
have built up trust by keeping your previous commitments, then that client will
probably understand.
• Learn to say no. Busy, successful people are the ones who are always
asked to do things. Be selective about what you commit to.

4. D em onstrating L oyalty

Loyalty means having an allegiance to your client and putting her agenda
before your own. When clients experi ence a sense of loyalty from you, it
reinforces their percep tion of your integrity and strengthens their ability to trust
you. Someone who feels third or fourth on your list of priori ties, who gets the
impression that she's just one of dozens or hundreds of clients, is never going to
trust you very deeply. Think about how you feel when a doctor barely recognizes
you and has to visibly reorient himself as he walks into the ex amining room.
Everyone wants to feel special—your clients are no different.
It's also important never to criticize anyone who is not present. You win
the trust of the people you're with by show ing loyalty to those who aren't there. If
someone is indiscreet and tells you a piece of gossip or confidential information, it
becomes difficult to trust that individual. If he or she is always criticizing other
people, it makes you wonder, What will this person say about me to others?

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 5. Nurturing Trust on a Daily Basis

There is no doubt that one dramatic event can establish a great deal of trust.
For example, when George Washington voluntarily relinquished the presidency
after his second term had expired, he instilled a deep public trust both in himself
and in the new American government. Few if any major heads of state before him
had ever stepped down of their own free will. What really cements and develops a
sense of trust, however, is the daily nurturing of your relationships. Stephen Covey's
metaphor for this reservoir of trust is the emotional bank account. When an action
reinforces trust, you have made a deposit; when you do something to undermine
trust, such as letting someone down, you make a withdrawal. You have to make
lots of deposits, regularly, to sustain trust.

6. There Are No "Minor" Commitments

At Beth Israel Hospital in Boston, legendary chief of sur gery Dr. William
Silen tells his residents, "I don't know what the difference is between 'major' and
'minor' surgery. I just know that no one performs 'minor' surgery on me!" In a sim -
ilar vein, there is no such thing as a minor commitment. Each promise you make,
large or small, should be treated with the same seriousness. "Character is made in
the small moments of our lives," offered nineteenth-century clergyman Phillips
Brooks. It's all the little things that you do—often when no one is looking— that
constitute your character and define your integrity.

7 . K n o w in g W h a t Y o u S ta n d F o r

By definition, integrity is a wholeness or completeness that is underpinned

and bounded by a set of beliefs and val ues. What are your principles? What do you
stand for? What guides your professional and personal life? Where do you draw
the line when your beliefs are challenged or threat ened?
Law professor and best-selling author Alan Dershowitz told us this story
about clarity of principles and integrity: "Several years ago I helped a large law
firm win a very impor tant case. To celebrate, the partners took me out to dinner to a
private club. I learned that the club did not allow women in side the door, however, a
practice that violated one of my basic beliefs about equality between the sexes
and non-discrimination. When I refused to go to the club, they said 'but there's
no other good place to eat.' I insisted, and we ended up holding the victory dinner
at McDonalds."

8 . B ein g P r ep a red to T a lk o n T V

All professionals are faced with ethical and moral dilem mas just about every
week of their lives. Some are relatively minor. Should I fly first class or economy?
Should I put hotel laundry on my expense report? Some are major. Should I agree
to an accounting practice that I feel is wrong? There are no simple rules for how to
conduct yourself. Hemingway's quip that "I only know that moral is what you feel
good after and immoral is what you feel bad after" can take you only so far.

One good principle to follow as a professional is what we call the "light-of-day"

test. Whatever action you take, be it stay ing in a certain class of hotel or meeting with a
client's com petitor, would you be comfortable discussing it with your client the
next morning in the full light of day? What if you were interviewed on television
and asked about something you did? Would you feel comfortable explaining it?
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 "Anything related to issues of integrity, trust, and ethics are fatal flaws"
commented Rebecca Guerra, the vice presi dent for human resources at eBay, the
online auction house. Speaking to The New York Times, she emphasized that while
failure in one's past was OK, questions about character were unacceptable to her
company.
Another way of looking at this is that you shouldn't have any secrets. By
secrets we don't mean confidential client in formation, which you are duty-bound to
protect. Rather, you should have nothing to hide; you should be comfortable
sharing details of your professional conduct with a client, without
embarrassment or defensiveness.

9. Reducing Your Client's Risk

Recall that the amount of trust a client has in you will go up or down
depending on the risk he perceives. You can do several things to reduce this risk.
First of all, you have to demonstrate consistency and reliability right from the
start, even for the smallest of things. Showing integrity itself, in other words,
reduces risk.
Second, you can either implicitly or explicitly guarantee your work. A
guarantee doesn't have to take the form of a cer tificate that your clients mail in to
you. More likely, it will be an understanding between you and your client. You
want your clients to feel that if they are not satisfied at any time with your work,
you will rectify it as best you can—period. The words "we'll work on this until
you're satisfied" can be the occasional reminder of the fact that you'll stand behind
your work and strive to address any issues they may have with your performance.

W H E NT R U S T IS L O S T

Sometimes, even though you feel you have demon strated a high level of
integrity and competence, trust is lost. Here are some principles to remember about
losing trust:

Clients don't inform you when they stop trusting you. Trust can vanish rapidly and
mysteriously, and you're always the last to know. Because the symptoms of a loss of
trust can be so var ied, and because some of them can also signify other prob lems
or issues, it's always hard to pinpoint when your client stops trusting you. Perhaps
you lose a follow-on assignment that you were sure you would win; or suddenly
the client throws your business open for a competitive bid. Often, a client can't
even articulate that she's lost trust in you. She feels a vague dissatisfaction, and
she stops sharing informa tion with you and turning to you for advice. You have to
watch and listen very carefully.

It's useful to hold a frank and open discussion with your client when the
engagement ends, something that is easier to do if you set the expectation, right up
front, that you'll be having this discus sion three or six months down the road.
Unfortunately, by the time you discover that the trust has dried up, it may be too
late to do anything about it.

Clients don't care why you let them down. Unless a catastrophe has occurred—
an earthquake or a death in the family— clients, like most people, don't
particularly care what the reason was that caused you not to deliver on a
commitment. You may believe you had perfectly good reason to let them down,
and the excuses are myriad: you caught a cold, the work took longer than you had
planned, another client had an emergency, your computer crashed, you forgot to
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write it down in your agenda, you wrote it down in the wrong agenda, your secretary
forgot to tell you about it, and so on. But your client doesn't really care, and trying
to explain it won't help. It's better to say, "I let you down, I'm sorry, and it won't hap -
pen again." If you have built up a reservoir of trust with your client, he may let it
pass.

Sometimes, repairing a lapse in trust can enhance your relationship. If you let a
client down, you may be able to recover her confidence. How you react to the
incident and the way in which you go about remediating it are critically important.
Several years ago, a management consultant conducting an assignment for a large
West Coast company carelessly left a draft copy of his report on a BART train in
San Francisco. An unscrupulous passenger found it, contacted the client, and
demanded $50,000 in ransom for the return of the docu ment. All hell broke
loose: the company threatened not just to terminate its relationship with the
consultants, but to file a major lawsuit as well. The consulting firm went into
action immediately. Its president flew out to California the next day and met with
the CEO of the client company. He apologized for the incident, offering no
excuses. He informed the CEO that the consultant had been disciplined and that
the firm was assigning a task force of partners to develop new policies and
procedures to minimize the possibility that such an inci dent could reoccur. Then
he offered to conduct a major study for the client, free of charge, on a key issue
the com pany faced. The client accepted, and the relationship contin ued
successfully for another four years.
This anecdote illustrates some cardinal rules for dealing with a breach of
trust:

• Admit that you've made a mistake. Own up to the lapse.

• Don't make excuses—no one wants to hear them.

H a ve Y ou D evelop ed T ru st w ithC lYi eoun rt s ?

• Sometimes, you conduct assignments based on a minimum of

documentation. Once you and your client have agreed on the objectives and
deliver ables, your client trusts you to follow through.
• Clients may remind you of something you're sup posed to do, but they
rarely "check up" on you.
• Clients ask you to tackle issues that are of major importance to them.
• If on a rare occasion you slip up and miss a com mitment, your clients
are very forgiving.
• There is a quality of openness to your client rela tionships. Both you
and your clients feel free to bring up touchy or awkward subjects with each
other.
• Your clients have become familiar with your partic ular skills as well as
your values and beliefs. They can predict how you will react to a particular situa -
tion or dilemma.
• Clients' trust in you extends beyond their belief that you will do
good work; it is a deeper, broader trust based on both professional
competence and personal integrity.

• Provide value-added compensation to the client. Some clients might

value having the fee reduced; for others, such as the client in the example
above, a free piece of work can he appropriate.

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 • Learn from the incident, and let your client know that you are
learning from it. Tell them what you're going to do to make sure it doesn't
happen again.

There may be situations where you feel that you are 100 percent in the
right and that the client is absolutely in the wrong. Even in these cases, keep
in mind that the client per ceives that you have let him down. You may have to
walk away from the relationship, but be careful about how you deal with it; you
don't want to leave burned bridges behind you. If there has been good
communication between you and the client, however, and expectations have
been set, you should be able to avoid this kind of confrontation.

DEEP PERSONAL and professional trust, which boils down to a client's belief in
your integrity and your competence, is a hallmark of the long-term relationships
that great profession als are able to develop. Clients expect and will forgive occa -
sional errors of judgment, but lapses of integrity are a red flag to everyone around
you. As the fifth-century religious leader St. Augustine wrote in his essay On
Lying. "When regard for the truth has been broken down or even slightly
weakened, all things will remain doubtful." Set high standards of con duct for
yourself. Tirelessly develop your reputation for in tegrity and honesty, and it will
become one of your biggest assets as a professional.

T H E S O U L OTFH E G R E A T P R O F E SSIO N A L

This is the true joy of life, the being used by a purpose recognized by yourself as a
mighty one; the being thoroughly worn out before you are thrown on the scrap heap; the
being a force of nature instead of a feverish, selfish little clod of ailments and grievances
complaining that the world will not devote itself to making you happy.
GEORGE BERNARD SHAW, Man and Superman

GREAT PROFESSIONALS become extraordinary client ad visers by developing

some important attributes. These attributes encompass the im portant talents,
skills, and attitudes that enable professionals in any field to build and sustain
long-term, broad-gauge client relationships on a consistent basis.
The great advisers we've studied also possess certain out looks that frame
and inform their work. We call these out looks the soul of the great
professional. They are not so much personal characteristics as they are ways
of looking at the world. If you cultivate them, your ability to add value will be
enhanced, and you'll become a more appealing person to your clients—
someone they will both respect and enjoy spending time with. In addition,
you'll be better able to shape and manage your own career. These outlooks—
the elements of this soul— can be discerned in virtually all of the professionals
we have studied who command strong client lo y alty .

G reat P rofession als H ave an A b u n d an ce M en tality

An abundance mentality allows you to see the possibili ties and opportunities
inherent in every situation. 1 The opposite is a scarcity mentality, which focuses on
limitations and risks.

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 Professionals with an abundance mentality:

• Always look for opportunities, growth, and expansion

• Constantly generate new ideas
• Are positive and upbeat in their demeanor
• Feel that there are rewards enough to go around for everyone—they
know that a "rising tide" lifts all boats
• Are willing to invest time and money in the short term in order to earn
more later on.

Professionals with a scarcity mentality, in contrast, have very different

attitudes. They:

• Are primarily concerned with what might go wrong and what won't
work
• Focus on the risks of new proposals rather than the po tential rewards
• Believe that life is a zero-sum game, with a limited amount of
opportunity to go around
• Are concerned with "getting their fair share" at all times
• Won't make investments that don't show an immedi ate return

If you were a client, whom would you rather spend time with? There's no
contest here: all of us would prefer a posi tive, energizing individual to someone
who always sees the dark side of things. Some situations, such as a tax audit, may
benefit from the scarcity mentality we've described. But in general, clients prefer
and benefit from the expansive think ing of the professional who sees abundance,
not scarcity.
Don't confuse an abundance mentality with laxness, lazi ness, or imprudence.
The professionals who perceive abun dance often have a healthy dissatisfaction
with the way things are done today. They know there's often a better solution.
Like strong organizational leaders, they push and stretch for new ideas and
innovations; they don't wait for them to float down from the sky. That's why
clients like having them around so much: these professionals constantly
energize, motivate, and inspire others.
The sources of your fundamental outlook on life—abun dance versus
scarcity—are varied and complex. Your early childhood experiences and
upbringing clearly have a strong influence on this dimension of your
personality. Someone who suffers physical or emotional deprivation as a child,
for example, may always harbor a deep-seated sense of scarcity. A lack of love and
affection damages self-esteem, making it hard to have an abundance outlook.
There is no doubt an el ement of personal "constitution" involved—some
individuals just seem to be born with more resilience against the vicissi tudes of
life—but family and parental role models are also an important influence on your
adult attitudes of either abun dance or scarcity.
We believe that the education you receive plays a critical role as well.
Economics and engineering, which are typical backgrounds of many
professionals in business, are founded on principles of scarcity. Both disciplines
are concerned with the optimal use of scarce resources. They focus on the trade offs
that have to be made—for example, "guns versus butter," a graph recognizable to
many readers, which is found in many introductory economics textbooks. The
liberal arts, in contrast, are premised on abundance. The liberal arts per spective
sees a world of nearly infinite ideas and resources, a world where trade-offs are not
always necessary. It also raises important philosophical questions.
Rajat Gupta, McKinsey's worldwide managing director, says that he reads
poetry at the end of each partners' meet ing: "At first, that took people by surprise.

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But over time, po etry has affected what we're doing. Poetry helps us reflect on the
important questions: What is the purpose of our busi ness? What are our values?"
The European Renaissance, which was a time of enor mous scientific as well
as artistic ferment and innovation, ex emplifies the power of the liberal arts
perspective. The concept of humanism, which fueled the Renaissance, was based
on a belief in the potential of human beings and their ability to reach self-
fulfillment without recourse to higher powers or supernatural means. The most
accomplished and inventive figures of the period, from Niccolo Machiavelli to
Leonardo DaVinci, were consummate liberal arts scholars, equally at home with
art, science, mathematics, philosophy, history, and literature.
Does this mean you have to study liberal arts to become an accomplished
professional and develop lifelong clients? Yes and no. What we have found is that
the best client advis ers, regardless of what they majored in at college or studied in
graduate school, become deep generalists. They read widely, take an interest in a
variety of subjects and disciplines, and cultivate personal in terests as well as
professional expertise. Recall Peter Drucker, for example, who has a passion for
Japanese art, or David Ogilvy, who had a deep interest in French culture (he eventu -
ally went to live in France). The risk of burrowing too deeply into one discipline
like economics, engineering, or account ing is that you will begin to adopt a scarcity
mentality. Broad knowledge and learning, in contrast, open the way for an out look of
abundance.

G reat P rofessionals H ave a M ission O rientation

The individuals who have had a significant impact on history—figures such

as Jesus, Buddha, Joan of Arc, Gandhi, and Abraham Lincoln—had clear missions
that led them to perform at extraordinary levels. The great advisers we've
looked at in this book also had well-developed personal mis sions. For
Thomas More, it was fulfilling God's work in this life; for Niccolo Machiavelli, it
was creating a stable, unified Italian state; for J. P. Morgan, it was establishing an
orderly financial system in the absence of regulatory agencies. Gertrude Bell's
mission was to promulgate an understanding of the Arab world among Westerners
and ensure peaceful co habitation of the Iraqis and the British. Early on, General
George Marshall was driven by a desire to create a profes sional, respected U.S.
Army founded on principles of excel lence, efficiency, compassion, and hard
work; later, his mission became no less than ensuring that the United States kept
the world safe for democracy.
For most of us, our personal missions are perhaps more down-to-earth but
no less sincere, sacred, and important to us. When you ask great professionals
what drives them in their careers, you will hear phrases such as "making a differ -
ence to my clients' business"; "enriching management prac tice through my ideas";
"being a teacher—teaching and explaining the importance of people's rights";
"educating managers so they lead more successful, effective lives"; or simply
"practicing excellence in everything I do."
Fred Brown, who descends from the famed Brown Brothers Harriman
banking family, is an example of an ex traordinary adviser who has a clear
mission that drives his daily behavior. A highly successful personal financial
consul tant, Brown has authored several books on financial manage ment. He writes a
weekly newspaper column entitled "Money and Spirit," and he has a waiting list of
clients. He could well afford a trophy house and late-model luxury cars, but his
relatively modest home in the Southwest and his utilitarian Subaru suit him just
fine—he prefers to live his values of moderation and balance rather than flaunt
his achievements through flashy possessions. Using a powerful, unique ap proach
to financial management that blends cutting-edge fi nancial expertise with a deep
understanding of each client's personal, familial, professional, and spiritual life,
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Brown has developed an intensely loyal following of individuals and families
who come back to him year after year.
Brown charges an hourly rate that is a fraction of what the market could bear,
but this is a conscious choice he has made that is consistent with his mission of
helping people lead bet ter lives through improved financial management. "By charg -
ing what I do," Brown tells us, "I am able to serve a very broad clientele—I get the
millionaires but also people who are scraping by and desperately need help just to
survive."
The opposite of a mission orientation is the strictly ma terial orientation.
Your main focus becomes money, title, pro motion, or publicity. When a
professional has no sense of mission, he or she risks becoming a mercenary—
someone that Machiavelli cautioned against five hundred years ago when he wrote,
"Mercenaries are disunited, thirsty for power, undisciplined, and disloyal."
Machiavelli urged the creation of national militias—citizens' armies with an
overriding pur pose and an intense loyalty to their home state—a revolu tionary
concept at the time but now the accepted norm.
The author Victor Frankl, who survived the Nazi con centration camp at
Auschwitz during World War II, wrote that "Nothing is more likely to help a
person overcome or endure troubles than the consciousness of having a task in
life." A mission orientation not only helps you overcome difficulties, but it will
give you great strength in practicing the seven attributes. It will be easier for you
to be an empathetic listener; your conviction will intensify; your integrity will be
strengthened; and it will be far easier to practice self less independence.

G reat Professionals Channel Adversity into W isdom and Confidence

The extraordinary client advisers we've profiled have all gone through
difficult experiences. They've made mistakes, suffered reversals of fortune, and
even been humiliated. Whereas many people become embittered, cynical, or dis -
trustful as a result of these setbacks, the really great profession als get stronger. They
become wiser, more confident, and humble. Their comfort zones expand, enabling
them to tackle an ever-broader variety of situations and client assignments. Laura
Herring's story illustrates how extraordinary set backs can create resolve and
determination. In less than ten years, Herring's firm, The IMPACT Group, has
grown to 120 professionals who deliver a variety of relocation support ser vices,
from counseling to resume preparation. It had an in auspicious beginning,
however. The concept got its start when Herring, originally a family therapist,
pointed out to a Fortune 500 executive that relocation was one of the toughest
personal issues facing his employees. Challenged to develop a solution, Herring
invested $360,000 and months of time to create a program called Momentum. Just
after the company placed a major order for her services, however, its relocation
manager vetoed the idea, leaving Herring with no business. "I had double-
mortgaged my house," she tells us, "and sold some real estate my husband and I
owned. I was deeply in debt, with no cash flow. Panic set in." She goes on to say:

I was unable to go home and tell my husband what had happened. So I

went to the phone book, and began looking through the Yellow Pages for other
companies that I could sell the program to. I called the vice presi dent of
marketing at United Van Lines and told him I thought he should have the first
shot at buying our ser vices. He agreed to meet the next day. He loved the ma -
terials so much that he immediately placed an order for 10,000 tapes, books, and
related services—it was a $1 million sale. I was ecstatic. Two days later,
however, he called me back with terrible news. "We've decided to de velop this

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internally," he told me. "We can't go forward with the order." Unfortunately, I
didn't have a signed contract.

Shortly afterward, Herring flew to a relocation confer ence being held in

Florida—her last hope—but after arriv ing, she learned she couldn't actively
market to any of the participants. There, after three fruitless days walking the
floors of the conference hall, she finally met a top Johnson & Johnson
executive who was literally walking out the door. In trigued with her new (but still
untested) service, he invited Herring to come to his office to make a presentation.
"Gary Gorran," Herring concludes, "was the J&J executive. He be came our first
client, and thirteen years later he is still one of our best and largest clients."
When asked about how this and other difficult experi ences affected her,
Herring replies: "The other day I took my young niece to a club I belong to in St.
Louis. When we walked in, a lot of people came over and greeted me. My niece
was a bit shocked—she said to me, 'Everyone knows you—do you ever marvel at
how far you've come? And I told her that I know what it's like to be invisible, and
therefore I never take the end result for granted—you've got to earn it. There's
always someone out there who is better and smarter than you are. There's always
someone's uncle who knows more. You just have to keep driving toward your goals. I
believe that failure is not a possibility."
Herring's account, and how it steeled rather than dimin ished her resolve
and determination, is typical of great pro fessionals. Consultant James Kelly tells
another story of early-career trauma:

When I finished business school, Professor Dick Van cil hired me with the
idea of building a faculty-based con sulting firm [which under Kelly's leadership
became the MAC Group, a $125 million strategy consul ting business]. The second
year we did so well that we extended employ ment offers to a dozen top MBA
graduates from around the country. But suddenly our backlog of business just
died. It was early summer, and we were going to go bank rupt if we took on all these
new hires. I had to call each one of them up, tell them what had happened, and
rescind the offers. It was one of the worst days of my professional life.

Although it may seem that Kelly (who was twenty-six at the time)
exercised poor judgment in hiring so many new people, he learned from the
episode. He could have become gun-shy, retrenched, and never made a bold
hiring move again. Instead, he assimilated the experience in a balanced,
constructive way. His subsequent careful management of rev enues, backlog, and
professional staffing at the MAC Group resulted in twenty-five years of continual
growth and prof itability under his leadership—a far better record than most
consulting firms can show.

G reat P rofession als A lw ays V iew

C l iO
e nldt sA s N ewC l i e n t s

A marriage requires constant work and investment—-just ask any Couple

that has successfully been together for fifteen or twenty years. When a couple
divorces, the partners will often look back and describe a long period of mutual
neglect prior to the eruption of real acrimony. If one spouse is work ing in a
demanding occupation, for example, it may seem as if his or her job gets all the
time and attention, leaving little energy for the other person.
The bases for successful marriages and successful long- term client
relationships are similar. When you've been work ing with a client for many years,
the tendency is to take each other for granted. If you're like the vast majority of
profes sionals, most of your marketing and promotional resources go to new,
prospective clients rather than to your existing clients. As benign neglect sets in,
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your long-term client may become intrigued by other professionals in your field
competitors whose ideas seem newer and fresher, who are court ing him
aggressively. Just as in a marriage, the antidote to wandering clients is constant
reinvestment that revitalizes the relationship.
When we look at professionals who have long-term, broad-based client
relationships, who inspire great client loy alty, they all have a similar approach: they
treat each assign ment as if it were the first one for that client. They bring the same
energy, creativity, and drive to their long-term clients as they do to the new client
they are trying to impress. They communicate constantly, and the flow of ideas
never stops. Even if they aren't working on an assignment for the client at that
moment, they are in touch at least two or three times a year. The courtship, so to
speak, never stops.

Great Professionals Engage in Continual Self-renewal

Most professionals focus on their income statement— their annual tally of

expenses and revenues, leading to a fig ure that represents their total income for
that year. This is true whether you work for a large firm or on your own. If you
invested a lot in a client proposal that fell through, your year- end bonus may be
reduced. If you sold a large piece of follow- on business, your bonus may be larger
than usual. The focus is this year's sacrifices and rewards.
If you earnestly develop the attributes and outlooks we've been discussing,
however, you will naturally build your balance sheet assets. Deep generalists, for
example, make in vestments in learning and acquiring knowledge that may have
no immediate payback but bring rewards two or three years down the road.
Your personal capital—the sum of your talents, skills, ex periences, and
knowledge—can be developed in many ways. This personal development can but
doesn't have to occur through dramatic actions, such as taking a formal sabbatical
or making a career change. Often, professionals embed it in their daily routines,
indulging in leisurely reading, self-study, and the gradual cultivation of new areas
of interest.
Harvard Law School professor Alan Dershowitz, for ex ample, after writing
a series of very successful nonfiction books, recently published his first novel.
Renowned manage ment consultant Ram Charan just followed up several years of
work on how effective corporate boards function with a book on growth
strategies. Although part of the pre-Internet generation, financial consultant Fred
Brown is going up learning curve and setting up an interactive Web site, which
may not yield significant results for a year or two, to ex tend the reach of a steep his
innovative financial counseling.
How do you know when it's time to push into new areas? Peter Drucker
counsels that it's time for a change "When the harder you work, the less you seem
to accomplish—or when you're sure that you know all the answers, and you've
stopped asking, 'What are the right questions?' " 5
Just as successful professionals take a long-term view of client
relationships, they also have a multiyear perspective on their own personal and
professional development. They fol low Thomas More's injunction to "live as if
you are to die tomorrow, study as if you were to live forever." When you focus on
building your balance sheet—on self-renewal— remember that your income
statement may take some hits. This is why it's so important to cultivate qualities
such as inde pendence and conviction. Without them it will be difficult to navigate
the inevitable squalls that are part of asset building.

Great professionals successfully develop and integrate the seven core

attributes into a powerful whole, and then in-
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The Ingredients for Breakthrough Relationships

153
 Knowledge
Depth and Breadth

Selfless .
Independence Abundance

T h e S ou l of the G reat P rofession al,

fuse everything they do with their soul of abundance, mis sion, and self-
renewal. This combination of attributes and outlooks, summarized in the
accompanying illustration, en ables professionals to create broad-based, abiding
client rela tionships that engender collaboration and insight.

TOPICS FOR DISSCUSSION

1. What happens when client loyalties shift unpredictably?

2. What do professionals focus on ?
3. Can you anticipate client needs?
4. What makes you a deep generalist?
5. How important is keen judgment?
6. Is overconfidence a judgment trap?
7. Can we use intuition to leverage facts and personal experience?
8. Do you have a good judgment?
9. What do the lack of trust in business and personal dealings entail?
10. How can you build trust in a low trusted world?
11. Can overconfidence be considered the most common judgment
trap?

12. Can you be misled by experience?

13. How can you improve your own decision making ability?

ENLARGE ON:
1. A professional adviser should be independently wealthy; then he would be
objective, independent.
2. The great client advisers are constant learners not wedded to past concepts,
they help accelerate learning within the organizations they serve.
3. One cool judgment is worth a thousand hasty councils. The thing to do is to
supply light and not heat.

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 4. Clients don’t care why you let them down, they don’t inform you when
they stop trusting you.
5. Princes like to be helped, but not surpassed. When you counsel someone,
you should appear to be reminding him of something he had forgotten, not the light he
was unable to see.

Tips on Managing Relationship Value

If you want to keep a relationship on an even keel, manage it as you would

any other activity that matters to you.
• Create trust. Trust is created when people see tangible evidence that one's
words and actions are in harmony. So avoid making commitments you may be unable
to honor, and always do what you have committed to do. Trust is also created when
you acknowledge and demonstrate respect for the other party's core interests.
• Communicate. The different parties should communicate their interests, their
capabilities, and their concerns to each other. For example, if you agreed to complete
a customer survey for the marketing vice president within thirty days but have hit a
logjam, communicate that information to him.
• Never sweep mistakes under the rug. Mistakes are bound to happen.
Acknowledging and addressing them—quickly—is always the best course of action.
• Ask for feedback. If everything appears to be going as planned, never
assume that the other side sees it the same way. Be proactive in uncovering problems.
The other side will respect you for it. Ask questions such as these: "Is everything
happening as you expected?" "Are the parts reaching your plant on schedule?" "Did
my report cover all important points?"

Negotiation

Negotiation is a means by which people deal with their differences. Whether

such differences involve the purchase of a new car, a labor contract dispute, the terms
of a sale, a complex alliance between two companies or a peace accord, resolutions
are sought through negotiations. To negotiate is to seek mutual agreement through
dialogue.
Negotiation became an ever present feature of our lives both at home and at
work.
A business negotiation may be a formal affair that takes place across the
bargaining table where you haggle over price and performance or the complex terms
of a partnership venture. It may be less formal such as a meeting between you and
several employees whose collaboration is needed to get a job done. Whether a
supervisor, manager or executive you will probably spend a good part of your day
negotiating with people inside or outside your organization. If you are closing a sale
or getting a subordinate to agree to certain performance goals you are negotiating too.

***
The basic types of negotiation you're likely to encounter are the following:

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 • A distributive negotiation which pits two or more parties in competition for a
fixed amount of value. Here, each side's goal is to claim as much value as possible, as
in the sale of a rug at a street bazaar. Value gained by one party is unavailable to
others.
• Integrative negotiation is about creating and claiming value. Through
collaboration and information sharing, the parties look for opportunities to satisfy the
key objectives of each, recognizing that they will probably have to give ground on
other objectives.
• The negotiator's dilemma describes the situation faced by people who enter
any type of bargaining situation. They must determine which game to play:
aggressively claim the value currently on the table (and possibly come out the loser),
or work with the other side to create even better opportunities that can be shared.
• No matter which type of negotiation you're faced with, it's bound to be more
complex if it is multi phased or involves multiple parties. If your negotiation is multi
phased, use the early phases to build trust and to become familiar with the other
parties. If many parties are involved, consider the benefits of forming a coalition to
improve your bargaining power.

When people don’t have the power to force a desired outcome, they negotiate-
but only when they believe it is to their advantage to do so. A negotiated solution is
advantageous only under certain condition, that is when a better option is not
available. Any successful negotiation must have a fundamental framework based on
knowing the following: the alternative to negotiation, the minimum threshold for a
negotiated deal, how flexible a party is willing to be and what trade offs it is willing to
make. We consider three concepts important for establishing this framework: BATNA
(best alternative to a negotiated agreement), reservation price and ZOPA (zone of
possible agreement).
*BATNA is the best alternative to a negotiated agreement. It is one's preferred
course of action in the absence of a deal. Knowing your BATNA means knowing
what you will do or what will happen it you fail to reach agreement. Don't enter a
negotiation without knowing your BATN A.
• It your BATNA is weak, do what you can to improve it. Anything that
strengthens your BATNA improves your negotiating position.
• Identity the other side's BATNA. (Fit is strong, think of what you can do to
weaken it.
* Reservation price is the price at which the rational negotiator will walk
away. Don't enter a negotiation without a clear reservation price.
* Z0PA is the zone of possible agreement. It is the area in which a deal will
satisfy all parties. This area exists when the parties have different reservation prices,
as when a home buyer is willing to pay up to $275,000 and the home seller is willing
to take an offer that is at least $250,000.
* Value creation through trades is possible when a party has something he or
she values less than does the other party— and vice versa. By trading these values, the
parties lose little but gain greatly.

*****

If your aim is to be an effective negotiator, take the time and make the effort
needed to become fully prepared. There are nine preparatory steps:

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 1. Know what a good outcome would be from your point of view and that of
the other side. Never enter into a negotiation without first asking yourself: what would
be a good outcome for me? Then ask the same question from the perspective of the
other side.

2. Look for opportunities to create value in the deal. You can identify areas of
common ground, compromise, opportunities for favorable trades.
3. Know your BATNA and reservation price. Make an effort to estimate those
benchmarks for the other side.
4. If your BATNA isn't strong, find ways to improve it. Good negotiators
work to improve their BATNA before and during deliberations with the other side.
5. Find out if the person or team you're dealing with has the authority to make
a deal. You find real advantages to negotiate with the person who has the power to
sign on the dotted line: all of your reasoning is heard directly by the decision maker,
the benefits of the good relationship build at the bargaining table are likely to be
reflected in the deal and its implementation, there are fewer chances of disputes or
misinterpretation of particular provisions..
6. Know those with whom you're dealing. Learn as much as you can about the
people and the culture on the other side and how they've framed the issue.
7. If a future relationship with the other side matters, gather the external
standards and criteria that will show your offer to be fair and reasonable.
8. Don't expect things to follow a linear path to a conclusion. Be prepared for
bumps in the road and periodic delays.
9. Alter the agenda and process moves in your favor. Learning about the issues
and about the other side is always limited by time, the cost of gathering information
and the fact that some information will be deliberately hidden. We have to be
prepared to learn as negotiations unfold.

*****
The first challenge in negotiation is to get the other side to the table.
This won't happen unless the other side sees that it is better off negotiating
than going with the status quo. Encourage negotiation by uttering incentives, making
the status quo expensive, and by enlisting the help of allies.
Once you've gotten the other side to the table, get things off to a good start by
relieving tension, making sure that all parties agree with the agenda and the process,
and setting the right tone.
Several tactics are particularly useful in distributed (or win-lose) deals:
* Establish an anchor, an initial position around which negotiations make
adjustments.
» It an initial anchor is unacceptable to you, steer the conversation away from
numbers and proposals. Focus instead on interests, concerns, and generalities. Then,
after some time has passed and more information has surfaced, put your number or
proposal on the table, and support it with sound reasoning.
* Make concessionary moves if you must. But remember, many interpret a
large concessionary move as an indicator that you're capable of conceding still more.
A small concession, on the other hand, is generally seen as an indication that the
bidding is approaching the reservation price and that any succeeding concessions will
be smaller and smaller.

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 Tactics for distributive (win-win) negotiations are fundamentally different
from those just described since value creation is one of the goals. So concentrate on
these tactics:
• Active listening: keep your eyes on the speaker, take notes as appropriate,
don’t allow yourself to think about anything but what the speaker is saying, resist the
urge to formulate your response until after the speaker has finished, pay attention to
the speaker’s body language, ask questions to get more information and to encourage
the speaker to continue, repeat in your own words what you’ve heard to ensure that
you understand and to let the speaker know that you’ve processed his or her words.
• Exploiting complementary interests
• Packaging options for more favorable deals

Some of the questions in negotiation are organized under three categories:

price, procedures, and people.

1. Should I ever state my acceptable range? (Some negotiators will ask

you to state a monetary range of what you are willing to pay).
Should I tell the other side my real bottom line?(you can reveal your bottom
line only if you’ve reached it)
2. Is it ever acceptable to bid against myself- to make two moves in a
row? (Just say: wait, you seem to be asking me to make another move here. I made
the last offer; I don’t want to bid against myself; give me your offer).
3. Is it smart or fair to bluff?( as long as what you bring to the table has
real value, you need not reveal all the circumstances that make you willing to
conclude a deal. You may describe the major projects for which you have been
responsible if negotiating the terms of a job offer)
4. Is it better to reach agreement issues by issue or wait until the end?
(It’s better to aim for tentative agreements or agreed upon ranges for each issue, one
at a time).
5. Is it better to deal with difficult or easy issues first? (Dealing with
easier issues will build momentum, deepen the parties’ commitments to the process,
enable the parties to become familiar with each other’s negotiation and
communication styles before hitting the tough stuff).
6. What if there is an unexpected turn in the road before or after an
agreement? (You have to determine if a deal still makes sense or if you need to undo
the deal that has been negotiated)
7. What happens when you pit a collaborative negotiator against a
positional hard bargainer? (if the collaborative negotiator is effective, he should be
able to tease out some of the interests underlying the hard bargainer’s positions)
8. How should I respond if the other side seeks to change something in its
offer after a deal has been reached? (express surprise or disappointment)
9. What should I do when the negotiator on the other side has a temper
tantrum?(help him regain control, the right response will depend upon how angry or
upset you feel, the value of the deal).
10. I don’t believe what the other side is saying. What should I do?(you
require that they provide back up documentation and that the deal be explicitly
contingent on its accuracy)
11. When is it appropriate to negotiate, over the telephone or by e-mail?
Or is it essential to insist on a face to face meeting? ( e-mail communication is devoid
of emotions; for an inexperienced negotiator this can be a big plus)

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 12. How should I react when the other side challenges my credentials,
status, authority to make a deal?(the best approach is to shift the discussion to general
ground rules).

*****
Typical barriers to negotiated agreements and what you can do to
overcome or eliminate them

• Die-hard bargainers will pull for every advantage and try to make every
concession come from you. You can deal with these people if you understand the
game they are playing, withhold useful information from them (they'll only use it
against you) unless they demonstrate a willingness to reciprocate, and make it clear
that you don't mind walking away. If you don't want to walk away—or cannot—do
whatever you can to strengthen your position and your alternative to a deal.
• Lack of trust is a serious impediment to making a deal. Nevertheless,
agreements are possible if you take precautions, require enforcement mechanisms,
build incentives for compliance into the deal, and insist on compliance transparency.
• It's difficult to make a deal—and impossible to create value—in the absence
of information. What are the other side's interests?
What does it have to offer? What is it willing to trade? Ironically, fear of
advantaging the other side encourages parties to withhold the information needed to
create value for both sides. Each is reluctant to be the first to open up. This is the
negotiator's dilemma. The solution to this dilemma is cautious, mutual, and
incremental information sharing.
Structural impediments include the absence of important parties at the table,
the presence of others who don't belong there but get in the way, and lack of pressure
to move toward an agreement. Remedies to these impediments were provided.
Spoilers are people who block or undermine negotiations. Several tips were
offered for neutralizing or winning over these individuals, including the creation of
winning coalitions.
Cultural and gender difference can be barriers to agreement, particularly when
one of the parties brings to the table a set of assumptions that the other side fails to
notice: assumptions about who will make key decisions, what is of value, and what
will happen if agreement is reached. Negotiators who represent organizations with
conflicting cultures (e.g., entrepreneurial versus bureaucratic) are also likely to
experience problems in reaching agreements.
Communication problems can also create barriers .You can diffuse them by
insisting that each team be led by an effective communicator and by practicing active
listening, documenting progress as it is made, and establishing real dialogue between
parties.
Dialogue can eliminate or lower all of the barriers.

Mental errors by negotiators can result in no deal or a bad deal.

• Escalation—that is, irrational escalation—is the continuation of a previously
selected course of action beyond the point where it continues to makes sense. Some
people commit this error because they cannot stand losing. Others fall prey to auction
fever.

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 • Partisan perception is the psychological phenomenon that causes people to
perceive truth with a built-in bias in their own favor or toward their own point of
view.
• Irrational expectations are an error insofar as they eliminate zones of
possible agreement.
1. Overconfidence in negotiating is dangerous. It encourages negotiators to
overestimate their strengths and underestimate their rivals. It is reinforced by
groupthink, a mode of thinking driven by consensus that tends to override the
motivation to realistically appraise alternative courses of action. The antidote to both
overconfidence and groupthink is to have one or more objective outsiders examine
one's assumptions.
Unchecked emotions are frequently observed in business negotiations, and
generally result in self-injury. Among the remedies recommended are a cooling-off
period and the use of an objective moderator. In the absence of a moderator we have
to do the following:
-determine what is making the other negotiator angry. What does this deal or
this dispute mean to him? listen very carefully when he gets angry.
-respond to what appears to be the emotional problem.
-remember that people are most often angered and frustrated at a personal
level by perceived deception, unfairness, humiliation or loss of pride and lack of
respect. You can avoid these land mines by focusing discussion on the issues and the
problems instead of on individuals and their personalities.

The relationship value that is part of so many of today's agreements, both

between separate entities and between employees of the same organization.
• Flatter organizations and the desire of companies to build long-term links
with suppliers are two important reasons why relationships matter in many of today's
negotiations.
• Relationship value moderates extreme value-claiming behavior. Negotiating
parties understand that trying too hard to claim value today will risk losing
opportunities for claiming value in future transactions.
• Parties who perceive no relationship value will aggressively claim value.
• Even when both parties recognize a relationship value, there is likely to be an
imbalance in how strongly each party feels about that value. This can lead to
manipulation of the party to whom the relationship matters most.
• Negotiators must separate the deal from the broader relationship.

*****
People and organizations represent their own interests but in many other cases,
they are represented by others. These others may be independent agents contracted to
represent one of the parties. They may be non independent agents- employees-
charged with representing their companies; or they may be officials of an organization
whose responsibility is to represent the interests of their members.
• An agent is a person charged with representing the interests of another (a
principal) in negotiations with a third party.
• People engage agents to represent them in negotiations when the agent has
greater expertise and when they want to reduce the risk of damaging their relationship
with the other side.
Information asymmetries, divided interests, and conflicts of interest are three
important problems in the agent/principal relationship.

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 Information asymmetry means that one party has more information than the
other. If the principal has much more information than the agent, the agent may have
a difficult time representing the principal's interests; in the reverse situation, the agent
may discover value-creating opportunities that the principal does not understand or
appreciate.
Not every organization is of one mind as to its core interests. This fact puts
those who represent the organization into a difficult position.
Principals face the problem of preventing agents from putting agent interests
ahead of their own. Incentive systems that align the agent's interests with those of the
principal can help, especially when combined with oversight and communication.

*****
It's one thing to develop one's individual negotiating skills. Developing the
negotiating skills of an organization at many levels is a very different challenge, but
one with great potential rewards.
• The discipline of continuous improvement can develop the effectiveness of
an organization's internal capabilities and, over time, improve bottom-line results.
This same discipline can be applied to the negotiation process.
• The first step toward continuous improvement in negotiations is to treat
negotiation as a process with a fairly universal set of process steps: pre-negotiations,
preparation, negotiations, agreement or non agreement, postmortem learning, and
learning capture. Learning capture feeds back to the next negotiating experience. The
second step is to organize to learn from the process as it takes place, and at the
conclusion of the negotiation itself.
• An organization can improve its overall negotiating skill and turn that skill
into an important capability by doing the following: providing training and
preparation for negotiators, clarifying organizational goals and expectations from any
agreement and clarifying when negotiators should walk away, insisting that every
negotiating team develop a BATNA and work to improve it, developing mechanisms
for capturing and reusing lessons learned from previous negotiations, and developing
negotiating performance measures and linking them to rewards.
Because organizational competence is the sum of the competences of an
organization's individual members, we have to know the characteristics of effective
negotiators. These define the goals that management should aim for in developing
organization-wide capabilities. An effective negotiator
• Aligns negotiating goals with organizational goals
• Prepares thoroughly and uses each negotiating phase to prepare further
• Uses negotiating sessions to learn more about the issues at stake and the
other side's BATNA and reservation price
• Has the mental dexterity to identify the interests of both sides, and the
creativity to think of value-creating options that produce win-win situations
• Can separate personal issues from negotiating issues
• Can recognize potential barriers to agreement
• Knows how to form coalitions
• Develops a reputation for reliability and trustworthiness
Difficulties in Communication
Communication is the medium of negotiation. You cannot make progress
without it. Poor communication renders the simple treacherous and the difficult
impossible. Communication problems cause deals to go sour and disputes to ripen.

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When you suspect that communication is causing the negotiation to go oft track, try
the following tactics:
• Ask for a break. Replay in your mind what has been communicated, how,
and by whom. Look for a pattern. Does the confusion or misunderstanding arise from
a single issue? Were important assumptions or expectations not articulated? After the
break, raise the issue in a non accusatory way. Offer to listen while the other side
explains its perspective on the issue. Listen actively acknowledging their point of
view. Explain your perspective. Then, try to pinpoint the problem.
If the spokesperson of your negotiating team seems to infuriate the other side,
have someone else act as spokesperson. Ask the other side to do the same if their
spokesperson drives your people up the wall.
Jointly document progress as it is made. This is particularly important in
multiphase negotiations. It will solve the problem of someone saying, "I don't
remember agreeing to that."

In multiparty negotiations, certain stakeholders may prefer ”no deal” as the

outcome. They may have the power to block or sabotage your negotiations. They are
called spoilers. They may have seats at the table or they may not. The president of the
USA may negotiate a trade deal with a foreign nation, but two or three powerful
senators may block ratification in Congress. An influential executive who has the ear
of key board members can sometimes accomplish the same result. This barrier can be
anticipated by identifying all key stakeholders, their respective interests and the power
of each to affect the agreement and its implementation. Then it’s important to identify
potential spoilers and consider the necessity of sweetening the deal in a way that
would neutralize their incentive to sabotage an agreement.
Many internal negotiations aim to create change within the organization;
change is a necessary condition of vitality but it often creates winners and losers. And
those who see themselves as potential losers do what they can to resist or undermine
change. Some people enjoy advantages that they view as threatened by change. They
may perceive change as a threat to their livelihoods, perks, workplace social
arrangements, status in the organization. Anytime they expect resistance and possible
sabotage. Resistance may be passive, in the form of non commitment to the goals and
the process for reaching them, or active indirect opposition or subversion. Some tips
for dealing with resistance and possible sabotage:
# always try to answer the question: where and how will this change create
pain or loss in the organization?
# identify people who have something to lose and try to anticipate how they
will respond.
# communicate the “why” of change to potential resisters.
# emphasize the benefits of change to potential resisters. Those benefits might
be greater future job security, higher pay.
# help resisters find new roles that represent genuine contributions .
# remember that some resist change because it represents a loss of control over
their daily lives. You can return some of that control by making them active partners
in your change program.
# built a coalition with sufficient strength to overpower the spoilers.

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 The Power of Dialogue

Dialogue is a powerful mode of communication and an effective antidote to

most, if not all, of the human barriers identified in this chapter. It is a time-tested
communication form in which parties exchange views and ideas with the goal of
reaching amicable agreement.
Dialogue is usually the very best way to peel back the layers of problems,
bring undisclosed concerns to center stage, develop solutions, and reach common
understandings.
Though the practice of dialogue between two or more individuals undoubtedly
goes back into the mists of time, Plato, through his Socratic dialogues, helped the
Western world appreciate its power. Plato's purpose was not to tell us what he thought
directly, but to teach us how to toss ideas back and forth in a logical process that
eventually leads to the truth and common understanding. That same logical process
makes negotiations run more smoothly, draws out the best ideas, and builds
agreement around them.
Dialogue can also help you give direction without telling people what to do in
so many words—which is what managers in today's participatory organizations must
learn to do. For such managers, negotiating with people is as important as directing
them.
For example, instead of saying, "Have the inventory report on my desk at 3
P.M. tomorrow," try something like this:
Manager: What progress have you made on the inventory report?
Employee: It's almost ready. I only have one section to complete.
Manager: Good. Do you see any problem in getting it all wrapped up by
tomorrow afternoon?
Employee: No, not if you need it by then.
Manager: Yes, I do need it by 3 P.M. at the latest.
Employee: You can count on it.
What works between managers and their people can also work between
negotiating parties if they start slowly, practice active listening, and gradually develop
the level of trust that problem solving requires.

TOPICS FOR DISCUSSION:

1. What are some of the impediments to making a deal?

2. Is information necessary in creating value?
3. What are spoilers?
4. Does dialogue help people give direction?
5. When do people negotiate?
6. How can you be more flexible in a negotiation?
7. Is it important to be prepared for changes on both sides: new people
and unanticipated developments?
8. Have you ever felt that your ideas were ignored during meetings?
9. What happens when communication is poor?
10. What tactics can be useful in distributed deals?

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11. What is the first challenge in negotiations?
12. Which are the most frequent errors made in dealings?
13. What does active listening help you to do?
14. Why is the two way exchange of information important?
15. What happens when one or another party has better alternatives elsewhere?

Accounting

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 The purpose of accounting is to provide information about the economic
affairs of an organization. This information may be used in a number of ways: by the
organization's managers to help them plan and control the organization's operations;
by owners and legislative or regulatory bodies to help them appraise the
organization's performance and make decisions as to its future; by owners, lenders,
suppliers, employees, and others to help them decide how much time or money to
devote to the organization; by governmental bodies to determine how much tax the
organization must pay; and occasionally by customers to determine the price to be
paid when contracts call for cost-based payments. Accounting provides
information for all these purposes through the maintenance of files of data, analysis
and interpretation of these data, and the preparation of various kinds of reports. Most
accounting information is historical--that is, the accountant observes the things that
the organization does, records their effects, and prepares reports summarizing what
has been recorded; the rest consists of forecasts and plans for current and future
periods. Accounting information can be developed for any kind
of organization, not just for privately owned, profit-seeking businesses. One branch of
accounting deals with the economic operations of entire nations.

COMPANY FINANCIAL STATEMENTS

Among the most common accounting reports are those sent to investors and
others outside the management group. The reports most likely to go to investors are
called financial statements, and their preparation is the province of the branch of
accounting known as financial accounting. Three financial statements will be
discussed: the balance sheet, the income statement, and the statement of cash flows.

The balance sheet.

A balance sheet describes the resources that are under a company's control
on a specified date and indicates where these resources have come from. It consists of
three major sections: (1) the assets: valuable rights owned by the company; (2) the
liabilities: the funds that have been provided by outside lenders and other creditors in
exchange for the company's promise to make payments or to provide services in the
future; and (3) the owners' equity: the funds that have been provided by the
company's owners or on their behalf. The list of assets shows
the forms in which the company's resources are lodged; the lists of liabilities and the
owners' equity indicate where these same resources have come from. The balance
sheet, in other words, shows the company's resources from two points of view, and
the following relationship must always exist: total assets equals total liabilities plus
total owners' equity. This same identity is also expressed in another way: total assets
minus total liabilities equals total owners' equity. In this form, the equation
emphasizes that the owners' equity in the company is always equal to the net assets
(assets minus liabilities). Any increase in one will inevitably be accompanied by an
increase in the other, and the only way to increase the owners' equity is to increase the
net assets. Assets are ordinarily subdivided into current
assets and noncurrent assets. The former include cash, amounts receivable from

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customers, inventories, and other assets that are expected to be consumed or can be
readily converted into cash during the next operating cycle (production, sale, and
collection). Noncurrent assets may include noncurrent receivables, fixed assets (such
as land and buildings), and long-term investments. The liabilities are
similarly divided into current liabilities and noncurrent liabilities. Most amounts
payable to the company's suppliers (accounts payable), to employees (wages payable),
or to governments (taxes payable) are included among the current liabilities.
Noncurrent liabilities consist mainly of amounts payable to holders of the company's
long-term bonds and such items as obligations to employees under company pension
plans. The difference between total current assets and total current liabilities is known
as net current assets, or working capital. The
owners' equity of an American company is divided between paid-in capital and
retained earnings. Paid-in capital represents the amounts paid to the corporation in
exchange for shares of the company's preferred and common stock. The major part of
this, the capital paid in by the common shareholders, is usually divided into two parts,
one representing the par value, or stated value, of the shares, the other representing
the excess over this amount. The amount of retained earnings is the difference
between the amounts earned by the company in the past and the dividends that have
been distributed to the owners. A slightly
different breakdown of the owners' equity is used in most of continental Europe and
in other parts of the world. The classification distinguishes between those amounts
that cannot be distributed except as part of a formal liquidation of all or part of the
company (capital and legal reserves) and those amounts that are not restricted in this
way (free reserves and undistributed profits).
The income statement is usually accompanied by a statement that
shows how the company's retained earnings has changed during the year. Net
income increases retained earnings; net operating loss or the distribution of cash
dividends reduces it.

The statement of cash flows.

Companies also prepare a third financial statement, the statement of cash

flows. Cash flows result from three major groups of activities: (1) operating
activities, (2) investing activities, and (3) financing activities. The
income statement differs from the cash flow statement in other ways, too. Cash was
received from the issuance of bonds and was paid to shareowners as dividends;
neither of those figured in the income statement. Cash was also paid to purchase
equipment; this added to the plant and equipment asset but was not subtracted from
current revenues because it would be used for many years, not just this one.
Cash from operations is not the same as net income (revenues minus
expenses). For one thing, not all revenues are collected in cash. Revenue is usually
recorded when a customer receives merchandise and either pays for it or promises to
pay the company in the future (in which case the revenue is recorded in accounts
receivable). Cash from operating activities, on the other hand, reflects the actual cash
collected, not the inflow of accounts receivable. Similarly, an expense may be
recorded without an actual cash payment. The purpose of the
statement of cash flows is to throw light on management's use of the financial

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resources available to it and to help the users of the statements to evaluate the
company's liquidity, its ability to pay its bills when they come due.

Consolidated statements.

Most large corporations in the United States and other industrialized

countries own other corporations. Their primary financial statements are consolidated
statements, reflecting the total assets, liabilities, owners' equity, net income, and cash
flows of all the corporations in the group. Thus, for example, the consolidated balance
sheet of the parent corporation (the corporation that owns the others) does not list its
investments in its subsidiaries (the companies it owns) as assets; instead, it includes
their assets and liabilities with its own.

Some subsidiary corporations are not wholly owned by the parent; that is,
some shares of their common stock are owned by others. The equity of these minority
shareholders in the subsidiary companies is shown separately on the balance sheet.
For example, if Any Company, Inc., had minority shareholders in one or more
subsidiaries, the owners' equity section of its Dec. 31, 19--, balance sheet might
appear as follows:

The consolidated income statement also must show the minority owners'
equity in the earnings of a subsidiary as a deduction in the determination of net
income. For example:

Disclosure and auditing requirements.

A corporation's obligations to issue financial statements are prescribed in

the company's own statutes or bylaws and in public laws and regulations. The
financial statements of most large and medium-size companies in the United States
fall primarily within the jurisdiction of the federal Securities and Exchange
Commission (SEC). The SEC has a good deal of authority to prescribe the content
and structure of the financial statements that are submitted to it. Similar authority is
vested in provincial regulatory bodies and the stock exchanges in Canada; disclosure
in the United Kingdom is governed by the provisions of the Companies Act.
A company's financial statements

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are ordinarily prepared initially by its own accountants. Outsiders review, or audit,
the statements and the systems the company used to accumulate the data from which
the statements were prepared. In most countries, including the United States, these
outside auditors are selected by the company's shareholders. The audit of a company's
statements is ordinarily performed by professionally qualified, independent
accountants who bear the title of certified public accountant (CPA) in the United
States and chartered accountant (CA) in the United Kingdom and many other
countries with British-based accounting traditions. Their primary task is to investigate
the company's accounting data and methods carefully enough to permit them to give
their opinion that the financial statements present fairly the company's position,
results, and cash flows.

MEASUREMENT PRINCIPLES

In preparing financial statements, the accountant has several measurement

systems to choose from. Assets, for example, may be measured at what they cost in
the past or what they could be sold for now, to mention only two possibilities. To
enable users to interpret statements with confidence, companies in similar industries
should use the same measurement concepts or principles. In some countries
these concepts or principles are prescribed by government bodies; in the United States
they are embodied in "generally accepted accounting principles" (GAAP), which
represent partly the consensus of experts and partly the work of the Financial
Accounting Standards Board (FASB), a private body. The principles or standards
issued by the FASB can be overridden by the SEC. In practice, however, the SEC
generally requires corporations within its jurisdiction to conform to the standards of
the FASB.

Asset value.

One principle that accountants may adopt is to measure assets at their value
to their owners. The economic value of an asset is the maximum amount that the
company would be willing to pay for it. This amount depends on what the company
expects to be able to do with the asset. For business assets, these expectations are
usually expressed in terms of forecasts of the inflows of cash the company will
receive in the future. If, for example, the company believes that by spending $1 on
advertising and other forms of sales promotion it can sell a certain product for $5,
then this product is worth $4 to the company.
When cash inflows are expected to be delayed, value is less than the
anticipated cash flow. For example, if the company has to pay interest at the rate of 10
percent a year, an investment of $100 in a one-year asset today will not be worthwhile
unless it will return at least $110 a year from now ($100 plus 10 percent interest for
one year). In this example, $100 is the present value of the right to receive $110 one
year later. Present value is the maximum amount the company would be willing to
pay for a future inflow of cash after deducting interest on the investment at a specified
rate for the time the company has to wait before it receives its cash.
Value, in other words, depends on three factors:

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 (1)the amount of the anticipated future cash flows,
(2) their timing, and (3) the interest rate. The lower the expectation, the more
distant the timing, or the higher the interest rate, the less valuable the asset will be.
Value may also be represented by the amount the company could obtain by
selling its assets. This sale price is seldom a good measure of the assets' value to the
company, however, because few companies are likely to keep many assets that are
worth no more to the company than their market value. Continued ownership of an
asset implies that its present value to the owner exceeds its market value, which is its
apparent value to outsiders.

Asset cost.

Accountants are traditionally reluctant to accept value as the basis of asset

measurement in the going concern. Although monetary assets such as cash or
accounts receivable are usually measured by their value, most other assets are
measured at cost. The reason is that the accountant finds it difficult to verify the
forecasts upon which a generalized value measurement system would have to be
based. As a result, the balance sheet does not pretend to show how much the
company's assets are worth; it shows how much the company has invested in them.
The historical cost of an
asset is the sum of all the expenditures the company made to acquire it. This amount
is not always easily measurable. If, for example, a company has built a special-
purpose machine in one of its own factories for use in manufacturing other products,
and the project required logistical support from all parts of the factory organization,
from purchasing to quality control, then a good deal of judgment must be reflected in
any estimate of how much of the costs of these logistical activities should be
"capitalized" (i.e., placed on the balance sheet) as part of the cost of the machine.

Net income.

From an economic point of view, income is defined as the change in the

company's wealth during a period of time, from all sources other than the injection or
withdrawal of investment funds. Income is the amount the company could consume
during the period and still have as much real wealth at the end of the period as it had
at the beginning. For example, if the value of the net assets (assets minus liabilities)
has gone from $1,000 to $1,200 during a period and dividends of $100 have been
distributed, income measured on a value basis would be $300 ($1,200 minus $1,000,
plus $100). Accountants generally have rejected this approach for the same
reason that they have found value an unacceptable basis for asset measurement: Such
a measure would rely too much on estimates of what will happen in the future,
estimates that would not be readily susceptible to independent verification. Instead,
accountants have adopted what might be called a transactions approach to income
measurement. They recognize as income only those increases in wealth that can be
substantiated from data pertaining to actual transactions that have taken place with
persons outside the company. In such systems, income is measured when work is
performed for an outside customer, when goods are delivered, or when the customer

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is billed. Recognition of income at this time requires two sets of estimates: (1)
revenue estimates, representing the value of the cash that the company expects to
receive from the customer; and (2) expense estimates, representing the resources that
have been consumed in the creation of the revenues. Revenue estimation is the easier
of the two, but it still requires judgment. The main problem is to estimate the
percentage of gross sales for which payment will never be received, either because
some customers will not pay their bills ("bad debts") or because they will demand and
receive credit for returned merchandise or defective work.
Expense estimates are generally based on the historical cost of the
resources consumed. Net income, in other words, is the difference between the value
received from the use of resources and the cost of the resources that were consumed
in the process. As with asset measurement, the main problem is to estimate what
portion of the cost of an asset has been consumed during the period in question.
Some assets give up their services gradually rather than all at
once. The cost of the portion of these assets the company uses to produce revenues in
any period is that period's depreciation expense, and the amount shown for these
assets on the balance sheet is their historical cost less an allowance for depreciation,
representing the cost of the portion of the asset's anticipated lifetime services that has
already been used. To estimate depreciation, the accountant must predict both how
long the asset will continue to provide useful services and how much of its potential
to provide these services will be used up in each period.
Depreciation is usually computed by some simple formula. The two
most popular formulas in the United States are straight-line depreciation, in which
the same amount of depreciation is recognized each year, and declining-charge
depreciation, in which more depreciation is recognized during the early years of life
than during the later years, on the assumption that the value of the asset's service
declines as it gets older. The role of the independent accountant (the
auditor) is to see whether the company's estimates are based on formulas that seem
reasonable in the light of whatever evidence is available and whether these formulas
are applied consistently from year to year. Again, what is "reasonable" is clearly a
matter of judgment. Depreciation is not the only expense for which
more than one measurement principle is available. Another is the cost of goods sold.
The cost of goods available for sale in any period is the sum of the cost of the
beginning inventory and the cost of goods purchased in that period. This sum then
must be divided between the cost of goods sold and the cost of the ending inventory:

Accountants can make this division by any of three main inventory costing
methods: (1) first in, first out (FIFO), (2) last in, first out (LIFO), or (3) average cost.
The LIFO method is widely used in the United States, where it is also an acceptable
costing method for income tax purposes; companies in most other countries measure
inventory cost and the cost of goods sold by some variant of the FIFO or average cost
methods. Average cost is very similar in its results to FIFO, so only FIFO and LIFO
need be described. Each purchase of goods
constitutes a single batch, acquired at a specific price. Under FIFO, the cost of goods
sold is determined by adding the costs of various batches of the goods available,
starting with the oldest batch in the beginning inventory, continuing with the next

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oldest batch, and so on until the total number of units equals the number of units sold.
The ending inventory, therefore, is assigned the costs of the most recently acquired
batches. For example, suppose the beginning inventory and purchases were as
follows:

The company sold 1,900 units during the year and had 1,100 units remaining
in inventory at the end of the year. The FIFO cost of goods sold is:

The ending inventory consists of 1,100 units at a FIFO cost of $5.50 each (the
price of the last 1,100 units purchased), or $6,050. Under
LIFO, the cost of goods sold is the sum of the most recent purchase, the next most
recent, and so on, until the total number of units equals the number sold during the
period. In the example, the LIFO cost of goods sold is:

The LIFO cost of the ending inventory is the cost of the oldest units in the
cost of goods available. In this simple example, assuming the company adopted LIFO
at the beginning of the year, the ending inventory cost is the 1,000 units in the
beginning inventory at $5 each ($5,000), plus 100 units from the first purchase during
the year at $5.25 each ($525), a total of $5,525.

Problems of measurement.

Accounting income does not include all of the company's holding gains or
losses (increases or decreases in the market values of its assets). For example,
construction of a superhighway may increase the value of a company's land, but
neither the income statement nor the balance sheet will report this holding gain.
Similarly, introduction of a successful new product increases the company's
anticipated future cash flows, and this increase makes the company more valuable.
Those additional future sales show up neither in the conventional income statement
nor in the balance sheet. Accounting reports have also been
criticized on the grounds that they confuse monetary measures with the underlying

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realities when the prices of many goods and services have been changing rapidly. For
example, if the wholesale price of an item has risen from $100 to $150 between the
time the company bought it and the time it is sold, many accountants claim that $150
is the better measure of the amount of resources consumed by the sale. They also
contend that the $50 increase in the item's wholesale value before it is sold is a special
kind of holding gain that should not be classified as ordinary income.
When inventory purchase prices are rising, LIFO
inventory costing keeps many gains from the holding of inventories out of net income.
If purchases equal the quantity sold, the entire cost of goods sold will be measured at
the higher current prices; the ending inventory will be measured at the lower prices
shown for the beginning-of-year inventory. The difference between the LIFO
inventory cost and the replacement cost at the end of the year is an unrealized (and
unreported) holding gain. In
the inventory example cited earlier, the LIFO cost of goods sold ($10,275) exceeded
the FIFO cost of goods sold ($9,750) by $525. In other words, LIFO kept $525 more
of the inventory holding gain out of the income statement than FIFO did.
Furthermore, the replacement cost of the inventory at the end of the year was $6,050
(1,100 $5.50), which was just equal to the inventory's FIFO cost; under LIFO, in
contrast, there was an unrealized holding gain of $525 ($6,050 minus the $5,525
LIFO inventory cost). The amount of inventory
holding gain that is included in net income is usually called the "inventory profit."
The implication is that this is a component of net income that is less "real" than other
components because it results from the holding of inventories rather than from trading
with customers. When most of the changes in the
prices of the company's resources are in the same direction, the purchasing power of
money is said to change. Conventional accounting statements are stated in nominal
currency units (dollars, francs, lire, etc.), not in units of constant purchasing power.
Changes in purchasing power--that is, changes in the average level of prices of
goods and services--have two effects. First, net monetary assets (essentially cash and
receivables minus liabilities calling for fixed monetary payments) lose purchasing
power as the general price level rises. These losses do not appear in conventional
accounting statements. Second, holding gains measured in nominal currency units
may merely result from changes in the general price level. If so, they represent no
increase in the company's purchasing power.
In some countries that have experienced severe and prolonged inflation,
companies have been allowed or even required to restate their assets to reflect the
more recent and higher levels of purchase prices. The increment in the asset balances
in such cases has not been reported as income, but depreciation thereafter has been
based on these higher amounts. Companies in the United States are not allowed to
make these adjustments in their primary financial statements.

MANAGERIAL ACCOUNTING

Although published financial statements are the most widely visible

products of business accounting systems and the ones with which the public is most
concerned, they are only the tip of the iceberg. Most accounting data and most
accounting reports are generated solely or mainly for the company's managers.
Reports to management may be either summaries of past events, forecasts of the

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future, or a combination of the two. Preparation of these data and reports is the focus
of managerial accounting, which consists mainly of four broad functions: (1)
budgetary planning, (2) cost finding, (3) cost and profit analysis, and (4)
performance reporting.

Budgetary planning.

The first major component of internal accounting systems for

management's use is the company's system for establishing budgetary plans and
setting performance standards. The setting of performance standards requires also a
system for measuring actual results and reporting differences between actual
performance and the plans.

Figure 1: Budget planning and performance reporting.

The simplified diagram in Figure 1 illustrates the interrelationships

between these elements. The planning process leads to the establishment of explicit
plans, which then are translated into action. The results of these actions are compared
with the plans and reported in comparative form. Management can then respond to
substantial deviations from plan, either by taking corrective action or, if outside
conditions differ from those predicted or assumed in the plans, by preparing revised
plans.

Although plans can be either broad, strategic outlines of the company's

future or schedules of the inputs and outputs associated with specific independent
programs, most business plans are periodic plans--that is, they refer to company
operations for a specified period of time. These periodic plans are summarized in a
series of projected financial statements, or budgets. The two principal
budget statements are the profit plan and the cash forecast. The profit plan is an
estimated income statement for the budget period. It summarizes the planned level of
selling effort, shown as selling expense, and the results of that effort, shown as sales
revenue and the accompanying cost of goods sold. Separate profit plans are ordinarily
prepared for each major segment of the company's operations.

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 Figure 2: Relationship of company profit plan to responsibility structure.

The details underlying the profit plan are contained in departmental sales
and cost budgets, each part identified with the executive or group responsible for
carrying out that part. Figure 2 shows the essence of this relationship: the company's
profit plan is really the integrated product of the plans of its two major product
divisions. The arrows connecting the two divisional plans represent the coordinative
communications that tie them together on matters of mutual concern.
The exhibit also goes one level farther down, showing that
division B's profit plan is really a coordinated synthesis of the plans of the division's
marketing department and manufacturing department. Arrows again emphasize the
necessary coordination between the two. Each of these departmental plans, in turn, is
a summary of the plans of the major offices, plants, or other units within the division.
A complete representation of the company's profit plan would require an extension of
the diagram through several layers to encompass every single responsibility centre in
the entire company. Many companies also prepare alternative
budgets for operating volumes other than the volume anticipated for the period. A set
of such alternative budgets is known as the flexible budget. The practice of flexible
budgeting has been adopted widely by factory management to facilitate evaluation of
cost performance at different volume levels and has also been extended to other
elements of the profit plan. The second major
component of the annual budgetary plan, the cash forecast or cash budget,
summarizes the anticipated effects on cash of all the company's activities. It lists the
anticipated cash payments, cash receipts, and amount of cash on hand, month by
month throughout the year. In most companies, responsibility for cash management
rests mainly in the head office rather than at the divisional level. For this reason,
divisional cash forecasts tend to be less important than divisional profit plans.
Company-wide cash forecasts, on the
other hand, are just as important as company profit plans. Preliminary cash forecasts
are used in deciding how much money will be made available for the payment of
dividends, for the purchase or construction of buildings and equipment, and for other
programs that do not pay for themselves immediately. The amount of short-term
borrowing or short-term investment of temporarily idle funds is then generally geared
to the requirements summarized in the final, adjusted forecast.
Other elements of the budgetary plan, in addition to the profit plan and the
cash forecast, include capital expenditure budgets, personnel budgets, production
budgets, and budgeted balance sheets. They all serve the same purpose: to help
management decide upon a course of action and to serve as a point of reference
against which to measure subsequent performance. Planning is a management

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responsibility, not an accounting function. To plan is to decide, and only the manager
has the authority to choose the direction the company is to take. Accounting personnel
are nevertheless deeply involved in the planning process. First, they administer the
budgetary planning system, establishing deadlines for the completion of each part of
the process and seeing that these deadlines are met. Second, they analyze data and
help management at various levels compare the estimated effects of different courses
of action. Third, they are responsible for collating the tentative plans and proposals
coming from the individual departments and divisions and then reviewing them for
consistency and feasibility and sometimes for desirability as well. Finally, they must
assemble the final plans management has chosen and see that these plans are
understood by the operating executives.

Cost finding.

A major factor in business planning is the cost of producing the company's

products. Cost finding is the process by which the company obtains estimates of the
costs of producing a product, providing a service, performing a function, or operating
a department. Some of these estimates are historical--how much did it cost?--while
others are predictive--what will it cost? The basic principle in cost
finding is that the cost assigned to any object--an activity or a product--should
represent the amount of cost that object causes. The most fully developed methods of
cost finding are used to estimate the costs that have been incurred in a factory to
manufacture specific products. The simplest of these methods is known as process
costing. In this method, the accountant first accumulates the costs of each separate
production operation or process for a specified period of time. The total of these costs
is then restated as an average by dividing it by the total output of the process during
the same period. Process costing can be used whenever
the output of individual processes is reasonably uniform or homogeneous, as in
cement manufacturing, flour milling, and other relatively continuous production
processes.

A second method, job order costing, is used when individual production

centres or departments work on a variety of products rather than just one during a
typical time period. Two categories of factory cost are recognized under this method:
prime costs and factory overhead costs. Prime costs are those that can be traced
directly to a specific batch, or job lot, of products. These are the direct labour and
direct materials costs of production. Overhead costs, on the other hand, are those that
can be traced only to departmental operations or to the factory as a whole and not to
individual job orders. The salary of a departmental supervisor is an example of an
overhead cost. Direct materials and direct labour
costs are recorded directly on the job order cost sheets, one for each job. Although not
traceable to individual jobs, overhead costs are generally assigned to them by means
of overhead rates--i.e., the ratio of total overhead cost to total production volume for a
given time period. A separate overhead rate is usually calculated for each production
department, and, if the operations of a department are varied, it is often subdivided
into a set of more homogeneous cost centres, each with its own overhead rate.
Separate overhead rates are sometimes used even for individual processing machines
within a department if the machines differ widely in such factors as power

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consumption, maintenance cost, and depreciation. Because output within a
cost centre is not homogeneous, production volume must be measured by something
other than the number of units of product, such as the number of machine hours or
direct labour hours. Once the overhead rate has been determined, a provision for
overhead cost can be entered on each job order cost sheet on the basis of the number
of direct labour hours or machine hours used on that job. For example, if the overhead
rate is $3 a machine hour and Job No. 7128 used 600 machine hours, then $1,800
would be shown as the overhead cost of this job. Many production costs are
incurred in departments that don't actually produce goods or provide salable services.
Instead, they provide services or support to the departments that do produce products.
Examples include maintenance departments, quality control departments, and internal
power plants. Estimates of these costs are included in the estimated overhead costs of
the production departments by a process known as allocation--that is, estimated
service department costs are allocated among the production departments in
proportion to the amount of service or support each receives. The departmental
overhead rates then include provisions for these allocated costs.
A third method of cost finding, activity-based costing, is based on the fact
that many costs are driven by factors other than product volume. The first task is to
identify the activities that drive costs. The next step is to estimate the costs that are
driven by each activity and state them as averages per unit of activity. Management
can use these averages to guide its efforts to reduce costs. In addition, if management
wants an estimate of the cost of a specific product, the accountant can estimate how
many of the activity units are associated with that product and multiply those numbers
by the average costs per activity unit.

For example, suppose that costs driven by the number of machine hours
average $12 per machine hour, costs driven by the number of production batches
average $100 a batch, and the costs of keeping a product in the line average $100 a
year for each kind of material or component part used. Keeping in the line a product
that is assembled from six component parts thus incurs costs of 6 $100 = $600 a
year, irrespective of volume and even if the product is not made at all during the
period. If annual production amounts to 10,000 units, the unit cost of product
maintenance is $600/10,000 = $.06 a unit. If this product is manufactured in batches
of 1,000 units, then batch-driven costs average $100/1,000 = $.10 a unit. And, if a
batch requires 15 machine hours, hour-driven costs average 15 $12/1,000 = $.18 a
unit. At the 10,000-unit volume, then, the cost of this product is $.06 + $.10 + $.18 =
$.34 a unit plus the cost of materials. Product cost finding under activity-based
costing is almost always a process of estimating costs before production takes place.
The method of process costing and job order costing can be used either in preparing
estimates before the fact or in assigning costs to products as production proceeds.
Even when job order costing is used to tally the costs actually incurred on individual
jobs, the overhead rates are usually predetermined--that is, they represent the average
planned overhead cost at some production volume. The main reason for this is that
actual overhead cost averages depend on the total volume and efficiency of operations
and not on any one job alone. The relevance of job order cost information will be
impaired if these external fluctuations are allowed to change the amount of overhead
cost assigned to a particular job. Many
systems go even farther than this. Estimates of the average costs of each type of
material, each operation, and each product are prepared routinely and identified as
standard costs. These are then readily available whenever estimates are needed and

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can also serve as an important element in the company's performance reporting
system, as described below. Similar methods of cost finding can be used to
determine or estimate the cost of providing services rather than physical goods. Most
advertising agencies and consulting firms, for example, maintain some form of job
cost records, either as a basis for billing their clients or as a means of estimating the
profitability of individual jobs or accounts.
The methods of cost finding described in the preceding paragraphs are
known as full, or absorption, costing methods, in that the overhead rates are intended
to include provisions for all manufacturing costs. Both process and job order costing
methods can also be adapted to variable costing in which only variable manufacturing
costs are included in product cost. Variable costs are those that will be greater in total
in the upper portions of the company's normal range of volumes than in the lower
portion. Total fixed costs, in contrast, are the same at all volume levels within the
normal range. Unit cost under variable costing represents the average variable cost
of making the product. The main argument for the variable costing approach is that
average variable cost is more relevant to short-horizon managerial decisions than
average full cost. In deciding whether to manufacture goods in large lots, for example,
management needs to estimate the cost of carrying larger amounts of finished goods
in inventory. More variable costs will have to be incurred to build the inventory to a
higher level; fixed manufacturing costs presumably will be unaffected.
Furthermore, when a management decision changes the
company's fixed costs, the change is unlikely to be proportional to the change in
volume; therefore, average fixed cost is seldom a valid basis for estimating the cost
effects of such decisions. Variable costing eliminates the temptation to assume
without question that average fixed cost can be used to estimate changes in total fixed
cost. When variable costing is used, supplemental rates for fixed overhead production
costs must be provided to measure the costs to be assigned to end-of-year inventories
because generally accepted accounting principles in the United States and in most
other countries require that inventories be measured at full product cost for external
financial reporting.

Cost and profit analysis.

Accountants share with many other people the task of analyzing cost and
profit data in order to provide guidance in managerial decision making. Even if the
analytical work is done largely by others, they have an interest in analytical methods
because the systems they design must collect data in forms suitable for analysis.
Managerial decisions are based on comparisons of the estimated future
results of the alternative courses of action that the decision maker is choosing among.
Recorded historical accounting data, in contrast, reflect conditions and experience of
the past. Furthermore, they are absolute, not comparative, in that they show the effects
of one course of action but not whether these were better or worse than those that
would have resulted from some other course.
For decision making, therefore, historical accounting data must be
examined, modified, and placed on a comparative basis. Even estimated data, such as
budgets and standard costs, must be examined to see whether the estimates are still
valid and relevant to managerial comparisons. To a large extent, this job of review
and restatement is an accounting responsibility. Accordingly, a major part of the

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accountant's preparation for the profession is devoted to the study of methods and
principles of analysis for managerial decision making.

Performance reporting.

Once the budgetary plan has been adopted, accounting's next task is to
prepare information on the results of company activities and make it available to
management. The manager's main interest in this information centres on three
questions: Have his or her own actions had the results expected, and, if not, why not?
How successful have subordinates been in managing the activities entrusted to them?
What problems and opportunities seem to have arisen since the budgetary plan was
prepared? For these purposes, the information must be comparative, relating actual
results to the level of results that management regards as satisfactory. In each case, the
standard for comparison is provided by the budgetary plan.
Much of this information is contained in periodic financial reports. At the
top management and divisional levels, the most important of these is the comparative
income statement. This shows the profit that was planned for this period, the actual
results received for this period, and the differences, or variances, between the two. It
also gives an explanation of some of the reasons for the difference between a planned
and an actual income. The report in this exhibit employs the widely used profit
contribution format, in which divisional results reflect sales and expenses traceable to
the individual divisions, with no deduction for head office expenses. Company net
income is then obtained by deducting head office expenses as a lump sum from the
total of the divisional profit contributions. A similar format can be used within the
division, reporting the profit contribution of each of the division's product lines, with
divisional headquarters expenses deducted at the bottom. By far the greatest
number of reports, however, are cost or sales reports, mostly on a departmental basis.
Departmental sales reports usually compare actual sales with the volumes planned for
the period. Departmental cost performance reports, in contrast, typically compare
actual costs incurred with standards or budgets that have been adjusted to correspond
to the actual volume of work done during the period. This practice reflects a
recognition that volume fluctuations generally originate outside the department and
that the department head's responsibility is ordinarily limited to minimizing cost while
meeting the delivery schedules imposed by higher management.

For example, a factory department's output consists entirely of a single

product, with a standard materials cost of $3 a unit and standard labour cost of $16.
Materials cost represents three pounds of raw materials at $1 a pound; standard labour
cost is two hours of labour at $8 an hour. Overhead costs in the department are
budgeted at $10,000 a month plus $2 a unit. Under normal conditions, volume is
7,000 units a month, but during October only 6,000 units were produced. The cost
standards for the month would be as follows:

The actual cost this month was $17,850 for materials (17,000 pounds at
$1.05), $101,250 for labour (12,500 hours at $8.10 an hour), and $23,000 for

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overhead. A summary report would show the following:

These variances may be analyzed even further in order to identify the

underlying causes. The labour variance, for example, can be seen to be the result of
both high wage rates ($8.10 instead of $8.00) and high labour usage (12,500 hours
instead of 12,000). The factory accountant ordinarily would measure the effect of the
rate change in the following way:

In most cases, the labour rate variance would not be reported to the department
head, because it is not subject to his or her control.
Standard costing systems no longer have the central importance they
commanded in many industries up to the 1970s. One reason is that significant changes
in management technology have shifted the focus of cost control from the individual
production department to larger, more interdependent groups. Just-in-time production
systems require changes in factory layouts to reduce the time it takes to move work
from one station to the next. They also reduce the number of partly processed units at
each work station, thereby requiring greater station-to-station coordination.
At the same time, management's emphasis has shifted from cost
control to cost reduction, quality enhancement, and closer coordination of production
and customer deliveries. Most large manufacturing companies and many service
companies have launched programs of total quality control and continuous
improvement, and many have replaced standard costs with a more flexible approach
using prior period results as current performance standards. Management is also likely
to focus on the amount of system waste by identifying and minimizing activities that
contribute nothing to the value that customers place on the product.
Reducing set-up time, inspection time, and time spent moving work from
place to place while maintaining or improving quality are some of the results of these
programs. Advances in computer-based models have enabled companies to tie
production schedules more closely to customer delivery schedules while increasing
the rate of plant utilization. Some of these changes actually increase variances from
standard costs in some departments but are undertaken because they benefit the
company as a whole. The overall result is that
control systems are likely to focus in the first instance on operational controls (real-
time signals to operating personnel that some immediate remedial action is required),

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with after-the-fact analysis of results focusing on aggregate comparisons with past
performance and the planned results of current improvement programs.

OTHER PURPOSES OF ACCOUNTING SYSTEMS

Accounting systems are designed mainly to provide information that

managers and outsiders can use in decision making. They also serve other purposes:
to produce operating documents, to protect the company's assets, to provide data for
company tax returns, and, in some cases, to provide the basis for reimbursement of
costs by clients or customers. The accounting
organization is responsible for preparing documents that contain instructions for a
variety of tasks, such as payment of customer bills or preparing employee payrolls. It
also must prepare documents that serve what might be called private information
purposes, such as the employees' own records of their salaries and wages. Many of
these documents also serve other accounting purposes, but they would have to be
prepared even if no information reports were necessary. Measured by the number of
people involved and the amount of time required, document preparation is one of
accounting's biggest jobs. Accounting systems must provide means of
reducing the chance of losses of assets due to carelessness or dishonesty on the part of
employees, suppliers, and customers. Asset protection devices are often very simple;
for example, many restaurants use numbered meal checks so that waiters will not be
able to submit one check to the customer and another, with a lower total, to the
cashier. Other devices entail a partial duplication of effort or a division of tasks
between two individuals to reduce the opportunity for unobserved thefts.

These are all part of the company's system of internal controls. Another
important element in the internal control system is internal auditing. The task of
internal auditors is to see whether prescribed data handling and asset protection
procedures are being followed. To accomplish this, they usually observe some of the
work as it is being performed and examine a sample of past transactions for accuracy
and fidelity to the system. They may insert a set of fictitious data into the system to
see whether the resulting output meets a predetermined standard. This technique is
particularly useful in testing the validity of the programs that are used to process data
through electronic computers. The accounting system
must also provide data for use in the completion of the company's tax returns. This
function is the concern of tax accounting. In some countries financial accounting must
obey rules laid down for tax accounting by national tax laws and regulations, but no
such requirement is imposed in the United States, and tabulations prepared for tax
purposes often diverge from those submitted to shareholders and others. "Taxable
income" is a legal concept rather than an accounting concept. Tax laws include
incentives to encourage companies to do certain things and discourage them from
doing others. Accordingly, what is "income" or "capital" to a tax agency may be far
different from the accountant's measures of these same concepts. Finally,
accounting systems in some companies must provide cost data in the forms required
for submission to customers who have agreed to reimburse the companies for the
costs they have incurred on the customers' behalf.

Banks and Banking

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 The principal types of banking in the modern industrial world are
commercial banking and central banking. A commercial banker is a dealer in money
and in substitutes for money, such as checks or bills of exchange. The banker also
provides a variety of financial services. The basis of the banking business is
borrowing from individuals, firms, and occasionally governments--i.e., receiving
"deposits" from them. With these resources and also with the bank's own capital, the
banker makes loans or extends credit and also invests in securities. The banker makes
profit by borrowing at one rate of interest and lending at a higher rate and by charging
commissions for services rendered. A bank
must always have cash balances on hand in order to pay its depositors upon demand
or when the amounts credited to them become due. It must also keep a proportion of
its assets in forms that can readily be converted into cash. Only in this way can
confidence in the banking system be maintained. Provided it honours its promises
(e.g., to provide cash in exchange for deposit balances), a bank can create credit for
use by its customers by issuing additional notes or by making new loans, which in
their turn become new deposits. The amount of credit it extends may considerably
exceed the sums available to it in cash. But a bank is able to do this only as long as
the public believes the bank can and will honour its obligations, which are then
accepted at face value and circulate as money. So long as they remain outstanding,
these promises or obligations constitute claims against that bank and can be
transferred by means of checks or other negotiable instruments from one party to
another. These are the essentials of deposit banking as practiced throughout the world
today, with the partial exception of socialist-type institutions. Another
type of banking is carried on by central banks, bankers to governments and "lenders
of last resort" to commercial banks and other financial institutions. They are often
responsible for formulating and implementing monetary and credit policies, usually in
cooperation with the government. In some cases--e.g., the U.S. Federal Reserve
System--they have been established specifically to lead or regulate the banking
system; in other cases--e.g., the Bank of England--they have come to perform these
functions through a process of evolution.
Some institutions often called banks, such as finance companies, savings
banks, investment banks, trust companies, and home-loan banks, do not perform the
banking functions described above and are best classified as financial intermediaries.
Their economic function is that of channelling savings from private individuals into
the hands of those who will use them, in the form of loans for building purposes or for
the purchase of capital assets. These financial intermediaries cannot, however, create
money (i.e., credit) as the commercial banks do; they can lend no more than savers
place with them.

The development of banking systems

Banking is of ancient origin, though little is known about it prior to the 13th
century. Many of the early "banks" dealt primarily in coin and bullion, much of their
business being money changing and the supplying of foreign and domestic coin of the
correct weight and fineness. Another important early group of banking institutions
was the merchant bankers, who dealt both in goods and in bills of exchange,

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providing for the remittance of money and payment of accounts at a distance but
without shipping actual coin. Their business arose from the fact that many of these
merchants traded internationally and held assets at different points along trade routes.
For a certain consideration, a merchant stood prepared to accept instructions to pay
money to a named party through one of his agents elsewhere; the amount of the bill of
exchange would be debited by his agent to the account of the merchant banker, who
would also hope to make an additional profit from exchanging one currency against
another. Because there was a possibility of loss, any profit or gain was not subject to
the medieval ban on usury. There were, moreover, techniques for concealing a loan by
making foreign exchange available at a distance but deferring payment for it so that
the interest charge could be camouflaged as a fluctuation in the exchange rate.
Another form of early banking activity was the acceptance of deposits.
These might derive from the deposit of money or valuables for safekeeping or for
purposes of transfer to another party; or, more straightforwardly, they might represent
the deposit of money in a current account. A balance in a current account could also
represent the proceeds of a loan that had been granted by the banker, perhaps based on
an oral agreement between the parties (recorded in the banker's journal) whereby the
customer would be allowed to overdraw his account.
English bankers in particular had by the 17th century begun to develop a
deposit banking business, and the techniques they evolved were to prove influential
elsewhere. The London goldsmiths kept money and valuables in safe custody for their
customers. In addition, they dealt in bullion and foreign exchange, acquiring and
sorting coin for profit. As a means of attracting coin for sorting, they were prepared to
pay a rate of interest, and it was largely in this way that they began to supplant as
deposit bankers their great rivals, the "money scriveners." The latter were notaries
who had come to specialize in bringing together borrowers and lenders; they also
accepted deposits. It was found that when
money was deposited by a number of people with a goldsmith or a scrivener a fund of
deposits came to be maintained at a fairly steady level; over a period of time, deposits
and withdrawals tended to balance. In any event, customers preferred to leave their
surplus money with the goldsmith, keeping only enough for their everyday needs. The
result was a fund of idle cash that could be lent out at interest to other parties.
About the same time, a practice grew up whereby a customer could arrange
for the transfer of part of his credit balance to another party by addressing an order to
the banker. This was the origin of the modern check. It was only a short step from
making a loan in specie or coin to allowing customers to borrow by check: the amount
borrowed would be debited to a loan account and credited to a current account against
which checks could be drawn; or the customer would be allowed to overdraw his
account up to a specified limit. In the first case, interest was charged on the full
amount of the debit, and in the second the customer paid interest only on the amount
actually borrowed. A check was a claim against the bank, which had a corresponding
claim against its customer. Another way in
which a bank could create claims against itself was by issuing bank notes. The
amount actually issued depended on the banker's judgment of the possible demand for
specie, and this depended in large part on public confidence in the bank itself. In
London, goldsmith bankers were probably developing the use of the bank note about
the same time as that of the check. (The first bank notes issued in Europe were by the
Bank of Stockholm in 1661.) Some commercial banks are still permitted to issue their
own notes, but in most countries this has become a prerogative of the central bank.
In Britain the check soon proved to be such a convenient means of

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payment that the public began to use checks for the larger part of their monetary
transactions, reserving coin (and, later, notes) for small payments. As a result, banks
began to grant their borrowers the right to draw checks much in excess of the amounts
of cash actually held, in this way "creating money"--i.e., claims that were generally
accepted as means of payment. Such money came to be known as "bank money" or
"credit." Excluding bank notes, this money consisted of no more than figures in bank
ledgers; it was acceptable because of the public's confidence in the ability of the bank
to honour its liabilities when called upon to do so.
When a check is drawn and passes into the hands of another party in
payment for goods or services, it is usually paid into another bank account. Assuming
that the overdraft technique is employed, if the check has been drawn by a borrower,
the mere act of drawing and passing the check will create a loan as soon as the check
is paid by the borrower's banker. Since every loan so made tends to return to the
banking system as a deposit, deposits will tend to increase for the system as a whole
to about the same extent as loans. On the other hand, if the money lent has been
debited to a loan account and the amount of the loan has been credited to the
customer's current account, a deposit will have been created immediately.
One of the most important factors in the
development of banking in England was the early legal recognition of the
negotiability of credit instruments or bills of exchange. The check was expressly
defined as a bill of exchange. In continental Europe, on the other hand, limitations on
the negotiability of an order of payment prevented the extension of deposit banking
based on the check. Continental countries developed their own system, known as giro
payments, whereby transfers were effected on the basis of written instructions to debit
the account of the payer and to credit that of the payee.

The business of banking

The business of banking consists of borrowing and lending. As in other

businesses, operations must be based on capital, but banks employ comparatively
little of their own capital in relation to the total volume of their transactions. The
purpose of capital and reserve accounts is primarily to provide an ultimate cover
against losses on loans and investments. In the United States capital accounts also
have a legal significance, since the laws limit the proportion of its capital a bank may
lend to a single borrower. Similar arrangements exist elsewhere.

FUNCTIONS OF COMMERCIAL BANKS

The essential characteristics of the banking business may be described

within the framework of a simplified balance sheet. A bank's main liabilities are its
capital (including reserves and, often, subordinated debt) and deposits. The latter may
be from domestic or foreign sources (corporations and firms, private individuals,
other banks, and even governments). They may be repayable on demand (sight
deposits or current accounts) or repayable only after the lapse of a period of time
(time, term, or fixed deposits and, occasionally, savings deposits). A bank's assets
include cash (which may be held in the form of credit balances with other banks,
usually with a central bank but also, in varying degrees, with correspondent banks);
liquid assets (money at call and short notice, day-to-day money, short-term
government paper such as treasury bills and notes, and commercial bills of exchange,

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all of which can be converted readily into cash without risk of substantial loss);
investments or securities (substantially medium-term and longer term government
securities--sometimes including those of local authorities such as states, provinces, or
municipalities--and, in certain countries, participations and shares in industrial
concerns); loans and advances made to customers of all kinds, though primarily to
trade and industry (in an increasing number of countries, these include term loans and
also mortgage loans); and, finally, the bank's premises, furniture, and fittings (written
down, as a rule, to quite nominal figures).
All bank balance sheets must include an item that relates to contingent
liabilities (e.g., bills of exchange "accepted" or endorsed by the bank), exactly
balanced by an item on the other side of the balance sheet representing the customer's
obligation to indemnify the bank (which may also be supported by a form of security
taken by the bank over its customer's assets). Most banks of any size stand prepared to
provide acceptance credits (also called bankers' acceptances); when a bank accepts a
bill, it lends its name and reputation to the transaction in question and, in this way,
ensures that the paper will be more readily discounted.

Deposits.

The bulk of the resources employed by a modern bank consists of borrowed

money (that is, deposits), which is lent out as profitably as is consistent with safety.
Insofar as an increase in deposits provides a bank with additional cash (which is an
asset), the increase in cash supplements its loanable resources and permits a more than
proportionate increase in its loans. An increase in deposits
may arise in two ways. (1) When a bank makes a loan, it may transfer the sum to a
current account, thus directly creating a new deposit; or it may arrange a line of credit
for the borrower upon which he will be permitted to draw checks, which, when
deposited by third parties, likewise create new deposits. (2) An enlargement of
government expenditure financed by the central bank may occasion a growth in
deposits, since claims on the government that are equivalent to cash will be paid into
the commercial banks as deposits. In the first instance, with the increase in bank
deposits goes a related increase in the potential liability to pay out cash; in the second
case, the increase in deposits with the commercial banks is accompanied by a
corresponding increase in commercial bank holdings of money claims that are
equivalent to cash. Taking one bank in isolation, an increase
in its loans may result in a direct increase in deposits. This may occur either as a result
of a transfer to a current account (as above) or a transfer to another customer of the
same bank. Once again, there is an increase in the potential liability to pay out cash.
On the other hand, if there has been an increase in loans by another bank (including
an increase in central bank loans to the government), this may give rise to increased
deposits with the first bank, matched by a corresponding claim to cash (or its
equivalent). For these reasons a bank can generally expect that, if there is an increase
in deposits, there will also be some net acquisition of cash or of claims for receipt of
cash. It is in this way that an increase in deposits usually provides the basis for further
bank lending. Except in countries where banks
are small and insecure, banks as a whole can usually depend on their current account
debits being largely offset by credits to current accounts, though from time to time an
individual bank may experience marked fluctuations in its deposit totals, and all banks
in a country may be subject to seasonal variations. Even when deposits are repayable
on demand, there is usually a degree of inertia in the deposit structure that prevents

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sharp fluctuations; if money is accepted contractually for a fixed term or if notice
must be given before its repayment, this inertia will be greater. On the other hand, if a
significant proportion of total deposits derives from foreign sources, there is likely to
be an element of volatility arising from international conditions.
In banking, confidence on the part of the depositors is
the true basis of stability. Confidence is steadier if there exists a central bank to act as
a "lender of last resort." Another means of maintaining confidence employed in some
countries is deposit insurance, which protects the small depositor against loss in the
event of a bank failure. Such protection was the declared purpose of the
"nationalization" of bank deposits in Argentina between 1946 and 1957; banks
receiving deposits acted merely as agents of the government-owned and government-
controlled central bank, all deposits being guaranteed by the state.

Reserves.

Since the banker undertakes to provide depositors with cash on demand or

upon prior notice, it is necessary to hold a cash reserve and to maintain a "safe" ratio
of cash to deposits. The safe ratio is determined largely through experience. It may be
established by convention (as it was for many years in England) or by statute (as in
the United States and elsewhere). If a minimum cash ratio is required by law, a
portion of a bank's assets is in effect frozen and not available to meet sudden demands
for cash from the bank's customers. In order to provide more flexibility, required
ratios are frequently based on the average of cash holdings over a specified period,
such as a week or a month. In addition to holding part of the bank's assets in cash, a
banker will hold a proportion of the remainder in assets that can quickly be converted
into cash without significant loss. No banker can safely ignore the necessity of
maintaining adequate reserves of liquid assets; some prefer to limit the sum of loans
and investments to a certain percentage of deposits, not allowing their loan-deposit
ratio to run for any length of time at too high a level.
Unless a bank held cash covering 100 percent of its demand deposits, it
could not meet the claims of depositors if they were all to exercise in full and at the
same time their rights to demand cash. If that were a common phenomenon, deposit
banking could not long survive. For the most part, the public is prepared to leave its
surplus funds on deposit with the banks, confident that they will be repaid if needed.
But there may be times when unexpected demands for cash exceed what might
reasonably have been anticipated; therefore, a bank must not only hold part of its
assets in cash but also must keep a proportion of the remainder in assets that can be
quickly converted into cash without significant loss. Indeed, in theory, even its less
liquid assets should be self-liquidating within a reasonable time. A
bank may mobilize its assets in several ways. It may demand repayment of loans,
immediately or at short notice; it may sell securities; or it may borrow from the
central bank, using paper representing investments or loans as security. Banks do not
precipitately call in loans or sell marketable assets, because this would disrupt the
delicate debtor-creditor relationships and increase any loss of confidence, probably
resulting in a run on the banks. Ready cash may be obtainable in this way only at a
very high price. Banks must either maintain their cash reserves and other liquid assets
at a high level or have access to a "lender of last resort," such as a central bank, able
and willing to provide cash against the security of eligible assets. In a number of
countries, the commercial banks have at times been required to maintain a minimum
liquid assets ratio. But central banks impose such requirements less as a means of

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maintaining appropriate levels of commercial bank liquidity than as a technique for
influencing directly the lending potential of the banks.
Among the assets of commercial banks, investments are less liquid
than money-market assets such as call money and treasury bills. By maintaining an
appropriate spread of maturities, however, it is possible to ensure that a proportion of
a bank's investments is regularly approaching redemption, thereby producing a steady
flow of liquidity and in that way constituting a secondary liquid assets reserve. Some
banks, particularly in the United States and Canada, have at times favoured the
"dumbbell" distribution of maturities, a significant proportion of the total portfolio
being held in long-dated maturities with a high yield, a small proportion in the middle
ranges, and another significant proportion in short-dated maturities. Following
redemption, the banks usually reinvest all or most of the proceeds in longer-term
maturities that in due course become increasingly short-term. Interest-rate
expectations frequently modify the shape of a maturity distribution, and, in times of
great uncertainty with regard to interest rates, banks will tend to hold the bulk of their
securities at short term, and something like a T-distribution may then be preferred
(mainly shorts, supported by small amounts of medium to longer dated paper).
Investments and money-market assets merge into each other. The dividing line is
arbitrary, but there is an essential difference: the liquidity of investments depends
primarily on marketability (though sometimes it also depends on the readiness of the
government or its agent to exchange its own securities for cash); the liquidity of
money-market assets, on the other hand, depends partly on marketability but mainly
on the willingness of the central bank to purchase them or accept them as collateral
for a loan. This is why money-market assets are more liquid than investments.

INDUSTRIAL FINANCE

Long-term and medium-term lending.

Banks that do a great deal of long-term lending to industry must ensure

their liquidity by maintaining relatively large capital funds and a relatively high
proportion of long-term borrowings (e.g., time deposits, or issues of bonds or
debentures), as well as valuing their investments very conservatively. Such banks,
notably the French banques d'affaires and the German commercial banks, have
developed special means of reducing their degree of risk. Every investment is
preceded by a thorough technical and financial investigation. The initial advance may
be an interim credit, later converted into a participation. Only when market conditions
are favourable is the original investment converted into marketable securities, and an
issue of shares to the public is arranged. One function of these banks is to nurse an
investment along until the venture is well established. Even assuming its ultimate
success, a bank may be obliged to hold such shares for long periods before being able
to liquidate them. In addition, they often retain an interest in a firm as an ordinary
investment as well as to ensure a degree of continuing control over it. The
long-term provision of industrial finance in Britain and the Commonwealth countries
is usually handled by specialist institutions, with the commercial banks providing only
part of the necessary capital. In Japan the long-term financial needs of industry are
met partly by special industrial banks (which also issue debentures as well as

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accepting deposits) and partly by the ordinary commercial banks. In Germany the
commercial banks customarily handle long-term finance. Since World War II the
commercial banks in the United States have developed the so-called term loan,
especially for financing industrial capital requirements. The attempt to popularize the
term loan began in the economic depression of the 1930s, when the banks tried to
expand their business by offering finance for a period of years. Most term loans have
an effective maturity of little more than five years, though some run for 10 years or
more. They are usually arranged between the customer and a group of lending banks,
sometimes in cooperation with other institutions such as insurance companies, and are
normally subject to a formal term loan agreement. Banks in Britain, western Europe,
the Commonwealth, and Japan began during the 1960s to give term loans both to
industry and to agriculture.

Short-term lending.

Short-term loans are the core of the banking business even in countries
where commercial banks make long-term loans to industry. Much short-term lending
consists in the provision of working capital, but the banks also provide temporary
finance for fixed capital development, aiding a customer until long-term finance can
be found elsewhere. Much of this short-term
lending is done by overdraft, particularly in the United Kingdom and a number of the
Commonwealth countries, or by way of "current account lending" in many western
European countries. The overdraft permits a depositor to overdraw an account up to
an agreed limit. In theory, overdrafts are repayable on demand or after reasonable
notice has been given, but often they are allowed to run on indefinitely, subject to a
periodic review. An advance is reduced or repaid whenever the account is credited
with deposits and recreated when new checks are drawn upon it, interest being paid
only on the amount outstanding. An alternative method of short-
term lending is to debit a loan account with the amount borrowed, crediting the
proceeds to a current account; interest is usually payable on the whole amount of the
loan, which normally is for a fixed period of time. (In Britain arrangements are
sometimes more flexible, and the term of the loan may be set by oral agreement.)
In a number of countries, including the United States,
the United Kingdom, France, Germany, and Japan, short-term finance is often made
available on the basis of discountable paper--commercial bills or promissory notes.
Some of this paper is usually rediscountable at the central bank, thus becoming
virtually a liquid asset, unlike a bank advance or loan. Credit may
be offered with or without formal security, depending on the reputation and financial
strength of the borrower. In many countries, a customer may use a number of banks,
and these institutions usually freely exchange information about joint credit risks. In
Britain and The Netherlands, however, most concerns tend to use a single banking
institution for most of their needs.
Traditionally bankers took the view that the liabilities of a bank (in
particular, its deposits) were more or less stable and concerned themselves primarily
with the investment of these funds. Since the late 1950s and '60s, especially in North
America and latterly in the United Kingdom, there has been a change in emphasis.
Banks began to find it more difficult to obtain deposits. Interest rates rose to high
levels, and banks were obliged to compete with each other and with other institutions
for funds. At the same time, there was little point in paying a high rate of interest for
money unless it could be employed profitably. Bankers began to relate the cost of

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borrowed money directly to the return on loans and investments. Previously the main
limitation on a bank's expansion had been its ability to find profitable new business,
but now the determining factor became the availability of funds to lend out. The
essence of assets and liabilities management, as it came to be called, was deciding
what kinds of new money to buy and what to pay for it. In the United States the
liabilities side of bank balance sheets now included, inter alia, in much larger
proportion than during the 1960s, repurchase agreements (under which securities are
sold subject to an agreement to repurchase at a stated date), federal funds purchases
(on the assets side, federal funds sales), excess balances of commercial banks and
other depository institutions (regularly traded throughout the United States),
negotiable certificates of deposit (which can be traded on a secondary market), and,
for the larger banks, Eurocurrency borrowings, mostly Eurodollars (dollar balances
held abroad). In the United Kingdom, "bought" money consisted of wholesale (i.e.,
large) deposits (on which money market rates were paid), negotiable certificates of
deposit, interbank borrowings, and Eurocurrency purchases. This bought money could
then be used to finance the loan demand, including term loans, long favoured in the
United States but a more recent innovation in the United Kingdom and elsewhere,
where they were developed considerably in the 1970s. Although much of the lending
financed by bought money was by way of term loans, these could be "rolled over,"
with an interest rate adjustment, every three or six months, and there could therefore
be a measure of interest-rate matching and also sometimes a matching of maturities.
In less sophisticated environments than North America and the United Kingdom,
there was again an increasing emphasis on bought money to meet any expansion in
loan demands (much of which was now term lending), with an adjustment at the
margin when more funds were needed--e.g., wholesale deposits, certificates of
deposit, interbank borrowings, and purchases of Eurocurrencies.

The principles of central banking

The principles of central banking grew up in response to the recurrent

British financial crises of the 19th century and were later adopted in other countries.
Modern market economies are subject to frequent fluctuations in output and
employment. Although the causes of these fluctuations are various, there is general
agreement that the ability of banks to create new money may exacerbate them.
Although an individual bank may be cautious enough in maintaining its own liquidity
position, the expansion or contraction of the money supply to which it contributes
may be excessive. This raises the need for a disinterested outside authority able to
view economic and financial developments objectively and to exert some measure of
control over the activities of the banks. A central bank should also be capable of
acting to offset forces originating outside the economy, although this is much more
difficult.

RESPONSIBILITIES OF CENTRAL BANKS

The first concern of a central bank is the maintenance of a soundly based

commercial banking structure. While this concern has grown to comprehend the

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operations of all financial institutions, including the several groups of nonbank
financial intermediaries, the commercial banks remain the core of the banking system.
A central bank must also cooperate closely with the national government. Indeed,
most governments and central banks have become intimately associated in the
formulation of policy.

Relationships with commercial banks.

One source of economic instability is the supply of money. Even in

relatively well-controlled banking systems, banks have sometimes expanded credit to
such an extent that inflationary pressures developed. Such an overexpansion in bank
lending would be followed almost inevitably by a period of undue caution in the
making of loans. Frequently the turning point was associated with a financial crisis,
and bank failures were not uncommon. Even today, failures occur from time to time.
Such crises in the past often threatened the existence of financial institutions that were
essentially sound, and the authorities sometimes intervened to prevent complete
collapse. The willingness of a central bank
to offer support to the commercial banks and other financial institutions in time of
crisis was greatly encouraged by the gradual disappearance of weaker institutions and
a general improvement in bank management. The dangers of excessive lending came
to be more fully appreciated, and the banks also became more experienced in the
evaluation of risks. In some cases, the central bank itself has gone out of its way to
educate commercial banks in the canons of sound finance. In the United States the
Federal Reserve System examines the books of the commercial banks and carries on
a range of frankly educational activities. In other countries, such as India and
Pakistan, central banks have also set up departments to maintain a regular scrutiny of
commercial bank operations. The most
obvious danger to the banks is a sudden and overwhelming run on their cash resources
in consequence of their liability to depositors to pay on demand. In the ordinary
course of business, the demand for cash is fairly constant or subject to seasonal
fluctuations that can be foreseen. It has become the responsibility of the central bank
to protect banks that have been honestly and competently managed from the
consequences of a sudden and unexpected demand for cash. In other words, the
central bank came to act as the "lender of last resort." To do this effectively, it was
necessary that the central bank be permitted either to buy the assets of commercial
banks or to make advances against them. It was also necessary that the central bank
have the power to issue money acceptable to bank depositors. But if a central bank
was to play this role with respect to commercial banks, it was only reasonable that it
or some related authority be allowed to exercise a degree of control over the way in
which the banks conducted their business. Most central banks now
take a continuing day-to-day part in the operations of the banking system. The Bank
of England, for example, has been increasingly in the market to ensure that the banks
have a steady supply of cash, even during periods of credit restriction. It also lends
regularly to the discount houses, supplementing their resources whenever the
commercial banks feel the need to call back money they have on loan to them. In the
United States the Federal Reserve System has operated in a similar way by buying

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and selling securities on the open market and by lending to dealers in government
securities on the basis of repurchase agreements. The Federal Reserve may also
discount paper submitted by the commercial banks through the Federal Reserve
banks. The various techniques of credit control in use are discussed in greater detail
below. The evolution of those working relations among banks
implies a community of outlook that in some countries is relatively recent. The whole
concept of a central bank as responsible for the stability of the banking system
presupposes mutual confidence and cooperation. For this reason, contact between the
central bank and the commercial banks must be close and continuous. The latter must
be encouraged to feel that the central bank will give careful consideration to their
views on matters of common concern. Once the central bank has formulated its policy
after a full consideration of the facts and of the views expressed, however, the
commercial banks must be prepared to accept its leadership. Otherwise, the whole
basis of central banking would be undermined.

The central bank and the national economy.

Relationships with other countries.

Since no modern economy is self-contained, central banks must give

considerable attention to trading and financial relationships with other countries. If
goods are bought abroad, there is a demand for foreign currency to pay for them.
Alternatively, if goods are sold abroad, foreign currency is acquired that the seller
ordinarily wishes to convert into the home currency. These two sets of transactions
usually pass through the banking system, but there is no necessary reason why, over
the short period, they should balance. Sometimes there is a surplus of purchases and
sometimes a surplus of sales. Short-period disequilibrium is not likely to matter very
much, but it is rather important that there be a tendency to balance over a longer
period, since it is difficult for a country to continue indefinitely as a permanent
borrower or to continue building up a command over goods and services that it does
not exercise. Short-period disequilibrium can be met very simply by
diminishing or building up balances of foreign exchange. If a country has no balances
to diminish, it may borrow, but normally it at least carries working balances. If the
commercial banks find it unprofitable to hold such balances, the central bank is
available to carry them; indeed, it may insist on concentrating the bulk of the
country's foreign-exchange resources in its hands or in those of an associated agency.
Long-period equilibrium is more difficult to achieve. It may be
approached in three different ways: price movements, exchange revaluation
(appreciation or depreciation of the currency), or exchange controls.
Price levels may be influenced by expansion or contraction in the supply of
bank credit. If the monetary authorities wish to stimulate imports, for example, they
can induce a relative rise in home prices by encouraging an expansion of credit. If
additional exports are necessary in order to achieve a more balanced position, the
authorities can attempt to force down costs at home by operating to restrict credit.
The objective may be achieved more directly by
revaluing a country's exchange rate. Depending on the circumstances, the rate may

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be appreciated or depreciated, or it may be allowed to "float." Appreciation means
that the home currency becomes more valuable in terms of the currencies of other
countries and that exports consequently become more expensive for foreigners to buy.
Depreciation involves a cheapening of the home currency, thus lowering the prices of
export goods in the world's markets. In both cases, however, the effects are likely to
be only temporary, and for this reason the authorities often prefer relative stability in
exchange rates even at the cost of some fluctuation in internal prices.
Quite often governments have resorted to exchange controls (sometimes
combined with import licensing) to allocate foreign exchange more or less directly in
payment for specific imports. At times, a considerable apparatus has been assembled
for this purpose, and, despite "leakages" of various kinds, the system has proved
reasonably efficient in achieving balance on external payments account. Its chief
disadvantage is that it interferes with normal market processes, thereby encouraging
rigidities in the economy, reinforcing vested interests, and restricting the growth of
world trade. Whatever method is chosen, the process of adjustment is generally
supervised by some central authority--the central bank or some institution closely
associated with it--that can assemble the information necessary to ensure that the
proper responses are made to changing conditions.

Economic fluctuations.

As noted above, monetary influences may be an important contributory

factor in economic fluctuations. An expansion in bank credit makes possible, if it
does not cause, the relative overexpansion of investment activity characteristic of a
boom. Insofar as monetary policy can assist in mitigating the worst excesses of the
boom, it is the responsibility of the central bank to regulate the amount of lending by
banks and perhaps by other financial institutions as well. The central bank may even
wish to influence in some degree the direction of lending as well as the amount.
An even greater responsibility of the central bank is that
of taking measures to prevent or overcome a slump. Recessions, when they occur, are
often in the nature of adjustments to eliminate the effects of previous overexpansion.
Such adjustments are necessary to restore economic health, but at times they have
tended to go too far; depressive factors have been reinforced by a general lack of
confidence, and, once this has happened, it has proved extremely difficult to stimulate
recovery. In these circumstances, prevention is likely to be far easier than cure. It has
therefore become a recognized function of the central bank to take steps to preclude,
if possible, any such general deterioration in economic activity.

For the central bank to be effective in regulating the volume and distribution
of credit so that economic fluctuations may be damped, if not eliminated, it must at
least be able to regulate commercial bank liquidity (the supply of cash and "near
cash"), because this is the basis of bank lending. Monetary authorities in a number of
countries have begun to resort increasingly to the management of monetary
aggregates as a basic policy. This does not mean an uncritical acceptance of
monetarist philosophy but rather what the U.S. economist and banker Paul A. Volcker
has called "practical monetarism." In addition to the Federal Reserve in the United
States, a growing number of western European countries have adopted the practice of
setting growth targets for the money supply and sometimes other monetary targets as
well (like domestic credit expansion), usually setting some range of allowable
variation. Japan has had reservations and has preferred to indicate monetary

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projections or forecasts, partly because of the difficulty of changing a set target should
it become necessary. Nor is there any great degree of consensus as to which target or
aggregate to employ. In general terms, choice of a particular aggregate as a basis for
reference would be linked to the theories--more or less explicit--on which the actions
of a particular central bank are based and also on the state of the country's economy
and its financial environment. Where there are publicly declared targets, these can
have an important effect by the very fact of being announced.
There is now little dispute about the broad objectives, though the
techniques of control are various and depend to some extent on environmental factors.
It would be incorrect to suppose, however, that the actions of the central bank can,
unaided, achieve a high degree of stability. It can by wise guidance contribute to that
end, but monetary action is in no sense a panacea; at all times, the degree to which it
is likely to be effective depends on the provision of an appropriate fiscal environment

Banking services.

Another responsibility of the central bank is to ensure that banking services

are adequately supplied to all members of the community that need them. Some areas
of a country may be "under-banked" (e.g., the rural areas of India and the northern
and more remote parts of Norway), and central banks have attempted, directly or
indirectly, to meet such needs. In France, this need underlay the early extension of
branches of the Bank of France to the départements. In India the authorities
encouraged the opening of "pioneer" branches by the former Imperial Bank of India
and its successor, the State Bank of India, latterly by all the nationalized banks, and
particularly their extension to rural and semirural areas. In Pakistan, officials of the
State Bank of Pakistan played an active part in the foundation of the semipublic
National Bank of Pakistan with a similar objective in view.
A different sort of problem arises when the business
methods of existing banks are unsatisfactory. In such circumstances, a system of bank
inspection and audit organized by the central banking authorities (as in India and
Pakistan) or of bank "examinations" (as in the United States) may be the appropriate
answer. Alternatively, the supervision of bank operations may be handed over to a
separate authority, such as France's Banking Control Commission or South Africa's
Registrar of Banks. In developing countries, central banks may encourage
the establishment and growth of specialist institutions such as savings institutions and
agricultural credit or industrial finance corporations. These serve to improve the
mechanism for tapping existing liquid resources and to supplement the flow of funds
for investment in specific fields.

Responsibilities to the government.

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 Central banks have over the years acquired a number of well-defined
responsibilities to their respective national governments. Some, notably the Bank of
England, developed into central banks after being, in origin, bankers to the
government. More recently it has become a matter of course for a new central bank to
accept responsibility for the financial affairs of its government. The reasons are self-
evident. Government transactions have become of increasing importance in
influencing the workings of the economy, and the institution that holds the
government's account is in a strategic position to cushion the commercial banks
against the impact of large movements of cash originating in this way. As banker to
the government, furthermore, the central bank has an obvious responsibility to
provide routine banking services, such as arranging loan flotations and supervising
their service, renewal, and redemption. The central bank also usually issues the
currency. Equally important are its responsibilities as an
adviser on the probable monetary consequences of any proposed action. In this role
the central bank should scrutinize the government's proposals with a certain amount
of objectivity and state its point of view with vigour. One may cite a now-famous
dictum of Montagu Norman as governor of the Bank of England:

I think it is of the utmost importance that the policy of the Bank and
the policy of the Government should at all times be in harmony--in as
complete harmony as possible. I look upon the Bank as having the unique
right to offer advice and to press such advice even to the point of "nagging";
but always of course subject to the supreme authority of the Government.

Many central banks are now nationalized, reflecting the increasingly

general recognition of the significance of the central bank's role as a servant, if not a
creature, of the government. This development is also, in a way, a final recognition of
the central bank as a responsible public institution whose major function is to serve
the community as a whole, untrammelled by narrow dictates of profit and loss. Most
central banks, nevertheless, make very handsome profits.

TECHNIQUES OF CREDIT CONTROL

Central banks have developed a variety of techniques for influencing,

regulating, and controlling the activities of commercial banks. These may be divided
into (1) the so-called classical, or indirect, techniques and (2) various direct controls.
The classical techniques make use of open-market purchases or sales by the central
bank of certain types of assets that are invariably associated with fluctuations in
interest rates. Direct, or quantitative, credit controls are employed to influence the
cash and liquidity bases of commercial bank lending by means of freezing or
unfreezing their liquid resources; sometimes ceilings are imposed on bank loans.

Open-market operations.

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 The way in which open-market operations influence the cash reserves and,
through them, the general liquidity of the commercial banks is essentially simple. If
the central bank buys securities in the open market, the cash it offers in exchange adds
to the reserves of the banks; if the central bank sells securities in the open market, the
cash necessary to pay for them is either withdrawn from the banks' reserves or
obtained by diminishing holdings of other assets (with the possibility of capital losses
in consequence of these sales). It does not matter whether this buying and selling
takes place between the central bank and the commercial banks directly or between
the central bank and other financial sectors, including the public at large, since these
are the customers of the commercial banks.

Open-market operations are invariably associated with related changes in one

or more "strategic" rates of interest, the most influential of these rates being the
minimum rate at which the central bank does business (the bank rate, or the discount
rate), since other rates tend to move in sympathy with it. The central bank seeks to
achieve an appropriate and consistent structure of interest rates. If a particular rate
structure is desired (e.g., prior to a new issue of government securities or in order to
change the emphasis of institutional investment between, say, long-term and short-
term securities), it may be necessary to precondition the market by means of open-
market operations. To achieve its purposes the central bank must possess (if it is
selling) or be willing to absorb (if it is buying) the appropriate types of securities.
In London the specialist banks known as discount houses effectively put to
work the revolving fund of cash that circulates through the British banking system. If
temporarily there is an inadequate supply of cash, the Bank of England either lends on
a short-term basis or buys some of the assets held by the discount market. (From 1980
there was a shift in emphasis from lending to open-market operations, especially by
dealing in bankers' acceptances.) Alternatively, the Bank of England may buy assets
from the clearing banks (the large joint-stock banks), which then make the relevant
moneys available to the market. On the other hand, if the discount market is
oversupplied with funds, the Bank of England sells treasury bills, in this way mopping
up the excess of cash. These transactions are known as smoothing-out operations. In
addition, the Bank of England is also responsible for managing the national debt, and,
whether the object is to influence the flows of money or not, such transactions in fact
have monetary effects. In the United States the Federal Reserve
System regulates the money supply. Within the Federal Reserve System, the Federal
Open Market Committee is the most important single policy-making body. It is
presided over by the chairman of the Board of Governors, with the president of the
Federal Reserve Bank of New York as its permanent vice chairman. The main
responsibility of the Open Market Committee is to decide upon the timing and amount
of open-market purchases or sales of government securities. Since open-market
operations must obviously be consistent with other aspects of monetary and credit
policy, it is in the committee that broad agreement is reached on matters such as
changes in discount rates or reserve requirements.
One of the big differences between London and New York is that the
central banking authorities in New York maintain direct relationships more or less
continuously with the nonbank government securities dealers as well as with the
commercial banks. The Federal Reserve Bank of New York may make temporary
accommodation available to some 35 primary dealers (including certain banks) under

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a repurchase agreement, whereby securities are sold to the bank under an agreement
that they be repurchased after a stipulated time. These agreements are made only for
the purpose of supplying reserves to the banking system, but from the dealer's
standpoint they are helpful in financing portfolios. Such repos, as they are called, may
also be done with foreign official accounts. Since early 1966 the bank has also been
prepared to mop up money by undertaking reverse repurchase agreements, in which
the dealers act as intermediaries for large commercial banks with temporarily surplus
money that they are prepared to place against bills, subject to the bank's repurchasing
them a few days later; the commercial bank concerned lends the dealer the money to
finance the holding of the bill. Similar arrangements are also made by the Federal
Reserve directly with bank dealers. All
member banks of the Federal Reserve System, and now also other depository
institutions, have direct access to the discount service of their Federal Reserve Bank,
of which there is one in each of 12 districts. This is a privilege, however, and not a
right. In the early years of the system, the banks would sell discountable paper to the
Federal Reserve, but now they usually borrow against a pledge of government
securities held in safe custody with the Federal Reserve Bank in question. The Federal
Reserve lends for a number of purposes but always at a time of general stress. It is
assumed that, as the pressure abates, borrowing banks will repay their indebtedness as
quickly as possible. Under ordinary conditions, the continuous use of Federal Reserve
credit by a member bank over a considerable period is not regarded as appropriate.

Direct control of assets.

The so-called classical techniques of credit control--open-market operations

and discount policy--can be employed only where there is a sufficiently developed
complex of markets in which to buy and sell assets of the type that commercial banks
ordinarily hold. Direct credit controls have a wider range of application. They may be
used either as a substitute for the classical techniques or as a supplement to them.
Direct controls are more likely to be resorted to when the money market is
undeveloped, because then a central bank can only impose its authority by means of
direct action. This is often the situation facing a newly established central bank.
Rather than wait for the slow evolution of a money market, the authorities may
provide the central bank from the start (as in Pakistan, the Philippines, Sri Lanka, and
Malaysia) with very full powers to control the banking system.
The aim in imposing a direct, quantitative regulation of
credit is to curb inflationary pressures that may result from an expansion of
commercial bank lending. This can be done in four main ways: (1) the commercial
banks may be required to maintain stated minimum reserve ratios of cash to deposits,
a stated liquid assets ratio, or some combination of both; (2) part of the cash resources
of the commercial banks may be immobilized at the discretion of the central bank; (3)
ceilings may be imposed on the amount of accommodation to be made available to the
commercial banks at the central bank (sometimes referred to as "discount quotas");
and (4) a ceiling may be prescribed for commercial bank lending itself.

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 Minimum reserve requirements.

The variation of minimum cash reserve requirements as a direct means of

quantitative credit control has become increasingly general in recent years. The
practice has largely derived from experience in the United States. In its origin the U.S.
insistence on stated minimum reserve requirements for commercial banks was simply
a means of prescribing minimum standards of sound behaviour. Only later did such
ratios come to be seen as a useful supplementary quantitative credit control.
The power granted by the Banking Act of 1935 to the Federal Reserve
System to determine the cash reserves of the commercial banks in the United States
was employed for the first time during the boom of 1936-37, and periodic variation of
minimum reserve requirements subsequently came to be recognized as an appropriate
technique for controlling the money supply. The Federal Reserve Board's decisions
were sometimes subject to considerable criticism, but, as it became more experienced
in the use of this technique, variation in reserve requirements combined with other
measures came to be regarded as a useful means of cushioning the economy against a
recession. The variation of reserve requirements did not prove as effective in
preventing inflation, largely because of the government's insistence that the Federal
Reserve simultaneously support the prices of government bonds through open-market
operations. This insistence was abandoned by the Treasury in March 1951. Since
then, much greater emphasis has been placed on the use of open-market operations,
which had become more effective, and the importance of varying minimum reserve
requirements as a means of controlling the credit base has diminished in the United
States. The technique is still widely used, however, in many countries.
In some countries, the authorities require the maintenance of
minimum liquid assets ratios. This is often combined with minimum requirements for
cash reserves, as in India, Pakistan, and Germany, though not always (in France, for
example, until 1967 there were no minimum cash reserve requirements). Where
prescribed minima relate to liquid assets and not to cash as such, reserves are held in
the form of earning assets--an important distinction from the point of view of the
commercial banks. An important step toward
a uniform and explicit minimum liquidity ratio for the London clearing banks was
taken in 1951, when the governor of the Bank of England indicated to the banks that a
liquidity ratio of from 32 to 28 percent would be regarded as normal and that it would
be undesirable for the ratio to be allowed to fall below 25 percent. By 1957 a fairly
rigid 30-percent minimum was in place (it was reduced to 28 percent in 1963). After
1946 the London clearing banks (but not the Scottish banks) also observed a more or
less fixed cash ratio of 8 percent. A new element was introduced in 1960, when the
Bank of England launched its system of "special deposits" as a means of reinforcing
other methods of credit control. Calls were made from time to time on the London
clearing banks to deposit with the Bank of England by a specified date some specified
percentage of their gross deposits; similar arrangements applied to the Scottish banks,
but the calls were smaller. This system lasted until 1971, when a new 12.5-percent
minimum reserve ratio (excluding till cash) was introduced. This ratio related to
"eligible liabilities" (primarily sterling deposits of up to two years maturity, including
sterling certificates of deposit). The banks could also be required to place special
deposits with the Bank of England. These arrangements were replaced in August 1981
by a voluntary holding of operational funds with the Bank of England by the London
clearing banks ("for clearing purposes") and a uniform requirement of 0.5 percent of
an institution's eligible liabilities that would be applied to all banks and licensed

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deposit-takers with eligible liabilities averaging more than 10,000,000. All banks
that were eligible acceptors were also normally required to hold an average equivalent
to 6 percent of their eligible liabilities either as secured money with discount houses
or as secured call money with money brokers and gilt-edged jobbers, but the amount
held in the form of secured money with a discount house was not normally to fall
below 4 percent of eligible liabilities. This money became known as "club money."
The use of variable minimum reserve requirements as a means of
credit control can, if carried far enough, produce results, especially when the
requirements include the holding of cash balances. It is more useful as an anti-
inflationary weapon than as a means of countering recession, since it cannot
overcome a possible unwillingness of the banks to lend or of their customers to
borrow. It is a somewhat clumsy technique, however, and cannot make adequate
allowance for the special needs of different institutions.

Immobilization of cash resources

A second group of direct quantitative credit controls involves keeping a

portion of the cash resources of commercial banks immobilized at the discretion of
the central bank. Two leading examples of this technique were the use of the Treasury
Deposit Receipt (TDR) in the United Kingdom during and after World War II and the
"special account procedure" adopted in Australia in 1941. Both were means of
immobilizing the increased liquidity deriving from wartime government expenditure.
The direct issue of Treasury Deposit Receipts at a nominal rate of interest
to banks in the United Kingdom began in July 1940. They were not negotiable in the
market or transferrable between banks, but they could be tendered in payment for
government bonds (and tax certificates); hence, during the war years they had a
limited degree of liquidity. The Bank of England communicated to the banks
collectively the amount of the weekly call, which was divided among them in
proportion to their deposits. After the war, TDR's were replaced by treasury bills; in
order to reduce the consequent high liquidity of the banks, there was a "forced
funding" of 1,000,000,000 of treasury bills in November 1951, which were required
to be invested in Serial Funding Stocks. The special
account procedure introduced in Australia in 1941 had a similar objective. The
surplus investable funds of the Australian trading banks, defined as the amount by
which each bank's total assets in Australia at any time exceeded the average of its
total assets in Australia in August 1939, were required to be placed in special deposit
accounts with the Commonwealth Bank (then the central bank) at a nominal rate of
interest. A bank was not to withdraw any sum from its special account except with the
consent of the Commonwealth Bank; during the war years, the bank generally
directed the trading banks to lodge in their special accounts each month an amount
equal to the increase in their total assets in Australia during the preceding month,
although as a rule a lodgment was not required if it was known that a rise in assets
would be followed by an early fall. Legislation in 1945 adopted the special account
procedures as a means of general credit control (e.g., to curb inflation), but the
provisions were made more flexible. In 1953 a more complicated formula was
introduced, and in 1960 the system was abandoned in favour of minimum reserve
ratios.

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 Direct control of loans.

Accommodation ceilings.

Some countries have tried limiting the amount of accommodation that the
central bank may make available to the commercial banks. The difficulty in this type
of quantitative credit control is to make it effective while also allowing for changes in
the economy; its most obvious use is as a means of checking inflation, but, if the
upward pressures on prices are strong, there is a temptation to increase the ceilings so
that the restraint then becomes little more than a temporary check. Usually, it
is only when a control begins to be felt and to affect bank profits that the banks
become really sensitive to changes in credit policy and the implementation of the
control becomes truly effective. The postwar experience of France is a case in point.
Plafonds, or "ceilings," were first introduced in France in 1948. Rediscount ceilings
(or discount quotas) were fixed for each bank, though some categories of paper were
excluded. Ceilings could be increased or (after 1957) reduced.
From the authorities' point of view, the chief difficulty
in operating this control was the persistent building up of pressure against the ceilings.
This was met partly by upward revisions in the ceilings themselves and partly by
instituting a number of safety valves. The degree of elasticity required constituted the
chief weakness of the ceiling technique. The central bank was constantly under
pressure to adjust the ceilings upward. Some upward revisions were unavoidable, but
the problem was to decide which claims were legitimate and which not. Much
bilateral bargaining took place between the Bank of France and individual
commercial banks, but the banks continued to complain that the strictness of the
control was excessive and that the technique was lacking in flexibility.
The inadequacies of the plafonds technique in its
original form became apparent when prices began to rise rapidly during the Korean
War boom, and even the built-in safety valves failed fully to accommodate the
pressures on bank liquidity. The need to strengthen the mechanism was obvious, and
this was attempted in 1951. Previously, rediscounts had frequently exceeded the
ceilings during the month and were only brought within the plafonds by special action
(e.g., through open-market purchases). The situation was brought under control by
introducing a secondary ceiling to which a penalty rate of interest was applied. This
was extended in 1958 to permit rediscounts even beyond the secondary ceiling,
provided a further penalty was paid; each application, however, was scrutinized by the
Bank of France. The system lasted until about the spring of 1964, though it did not
finally disappear until 1968, when it was largely replaced by Bank of France
operations in the open market. After early 1967, banks also were subject to minimum
reserve requirements. Plafonds, or discount
quotas, also are employed in Germany. They were introduced in West Germany in
1952 and strengthened in 1955. Quotas may be reduced periodically (after 1964 they
were also used to discourage institutions from borrowing abroad). Again there were
safety valves (although less generous than in France) and the possibility of extra
accommodation (Lombard credits) at a higher rate. In some circumstances,
supplementary quotas might be approved for up to six months. A bank might also
raise funds through the money market, though likely at higher cost. Discount quotas
are still an important tool of credit control in Germany. Other countries
have employed this technique, including Sweden, where for a time the central bank
imposed formal or informal ceilings on banks and sometimes on finance companies.

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If the banks failed to observe the ceiling, a penalty was applied based on the amount
of the excess borrowing and its duration. In Finland, commercial banks have at times
been able to borrow limited amounts from the Bank of Finland by way of traditional
credit quotas. Beyond these quotas, funds could formerly be obtained as supra-quota
credit at a higher rate, but banks now are forced into the official call-money market.
Denmark, too, has permitted borrowing from the central bank in tranches, with
higher (penalty) rates applying after the first tranche of the loan quota has been
resorted to, a practice that can be expensive.

General ceilings on credit.

Attempts have been made to prescribe a general ceiling within which the
quantity of commercial bank lending must be held. This is even more difficult to
achieve. One example of such an attempt was the adoption of a "rising ceiling" by
Chile in 1953. All banks were required not to expand the volume of their loans to
businesses and individuals by more than 1.5 per-cent a month, using as their basis the
average of a bank's advances on selected dates in 1953. Certain types of loans were
forbidden, and bank resources were to be directed to productive and distributive
activities that really contributed to the expansion of the national economy. Banks
were also required to provide information on the destination of their loans. In
succeeding years, adjustments were made on several occasions in the maximum
permitted credit increase, expressed either as a percentage of advances or sometimes
as a total for the banking system as a whole. In 1959 all quantitative credit restrictions
were removed, and banks were permitted to advance funds up to their financial
capacity, provided that they operated within the general banking law. There was no
evidence the controls had been effective, but the major problem in Chile was
budgetary rather than monetary. A temporary ceiling on loans was imposed by
agreement in Canada (in 1951-52), The Netherlands (1957-58), and France (1958-
59). The United Kingdom had considerable experience with this type of ceiling,
introducing it as a temporary measure in 1955, when the banks were asked to bring
their advances down by an average of 10 percent. Later an attempt was made to
impose a true ceiling, requiring that bank advances not exceed the average of the
period October 1956 to September 1957. This was continued until July 1958. Again,
in 1961, the authorities indicated the banks must aim at checking the rate of rise in
bank advances; this came to be interpreted as a request that the level of advances at
the end of 1961 be no higher than in the previous June. The banks also were not to
encourage an increase in the volume of commercial bills. The request was modified in
May 1962 and largely withdrawn in October; but it was made again in May 1965,
when the clearing banks were requested not to increase their advances to the private
sector, at an annual rate of more than about 5 percent, in the 12 months to mid-March
1966 (likewise with commercial bills). Other financial institutions were requested to
observe a comparable degree of restraint. For 12 months after March 1966, advances
and discounts, allowing for seasonal factors, were not permitted to rise above levels
set for March 1966. This represented an intensification of the credit squeeze because
prices were rising. The credit restriction led to a falling off in business confidence,
and, consequently, toward the end of 1966, bank lending was well below the official
ceiling. In April 1967, authorities announced a change in techniques, with an
emphasis on making calls to special deposits, but the ceilings returned again in
November 1967. There was to be no increase in bank advances to the private sector
(excluding exports and shipbuilding) except for seasonal reasons. In May 1968 a new

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ceiling was instituted for all such lending (including that for exports and
shipbuilding); the clearing banks were asked to restrict the total of this lending, after
seasonal adjustment, to 104 percent of the November 1967 figure, with priority to be
given to finance for exports and for activities directly related to improving the balance
of payments. The restrictions also extended to other types of credit. Credit became
even tighter (in March 1969) when the ceiling was reduced to 98 percent of the
November 1967 level. The banks had considerable difficulty in meeting this
requirement and agreed merely to "do their best." Advances increased above the
ceiling, and, as a penalty, the interest paid by the Bank of England on special deposits
was halved. Not until late 1969 did it become clear that the authorities were prepared
to abandon their long campaign to get bank loans down to the target figure. The
ceiling was subsequently replaced by minimum reserve requirements. The system of
quantitative credit control requires, for its successful implementation, the full
cooperation of the banking community. In the United Kingdom, where banks base
much of their lending on the overdraft technique, the system was very unpopular.

In France, however, the encadrement du crédit, as it is called, temporarily

imposed in 1958-59, was revived during the first half of 1973. Subject to certain
exclusions (e.g., certain investment credits, agricultural credits, export credits, the
financing of energy savings and innovation, leasing transactions, and special medium-
term construction loans), the mechanism chosen was to permit a certain percentage
rate of growth in bank credits in relation to a particular month in the previous year,
these limits being fixed quarterly and subject to variation from time to time.
Subsequently, in early 1975, reference was made to a fixed base defined as equal to
an index of 100, in relation to which the index might be increased (or decreased) and
credit expanded (or contracted). The system was further refined to vary the rate of
change of credits within different financial sectors, and it has been subject in the
interests of flexibility to many amendments over the years. In effect, there has been a
combination of quantitative and qualitative credit controls. In addition
to regulating the quantity of credit, central banks have sometimes attempted to
influence the directions in which the commercial banks lend. A loose system of
control prevailed in the United Kingdom during World War II and afterward, based
initially on directives from the Capital Issues Committee and later on requests from
the Bank of England. A highly formalized technique was employed in Australia
during the war and earlier postwar years; detailed and specific instructions were given
to the trading banks, marginal cases being referred to the central bank. The system of
Voluntary Credit Restraint in the United States in 1951 was similar. The more formal
controls seemed to be no more effective than the looser system employed in the
United Kingdom. Selective controls have been imposed on consumer installment
finance in the United States and elsewhere (e.g., by stipulating the percentage of
deposit that is required and the length of the term over which repayments may be
made). Even when these are not varied in order to serve as a control over credit, there
is a case for insisting on such requirements for prudential reasons. In the United
States, under the Securities Exchange Act of 1934, the Federal Reserve can vary the
margins that purchasers of securities must pay in cash, thereby limiting the credit
available for this purpose.

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 The structure of modern banking systems

The banking systems of the world have many similarities, but they also
differ, sometimes in quite material respects. The principal differences are in the
details of organization and technique. The differences are gradually becoming less
pronounced because of the growing efficiency of international communication and the
tendency in each country to emulate practices that have been successful elsewhere.
Banking systems may be classified in terms of their structure as
unit banking, branch banking, or hybrids of the two. For example, unit banking
prevails in large areas of the United States. In other countries it is more usual to find a
small number of large commercial banks, each operating a highly developed network
of branches. This is the system used in England and Wales, among others. Examples
of hybrid systems include those of France, Germany, and India, where banks that are
national in scope are supplemented by regional or local banks. Some of these hybrid
systems are slowly changing their character, the banks becoming fewer in number and
individually larger, with a larger number of branches.

UNIT BANKING: THE UNITED STATES

Bank organization in the United States during the years after World War II
was still passing through a phase of structural development that many other countries
had completed some decades earlier. Development in the United States has been
subject to constraints not found elsewhere. The federal Constitution permits both the
national and state governments to regulate banking. Some states prohibit branch
banking, largely because of the political influence of small local bankers, thus
encouraging the establishment and retention of a large number of unit banks.
Even in its early years, the United States had an unusually large
number of banks. As the frontiers of settlement were pushed rapidly westward, banks
sprang up across the country. One reason for this was the demand for capital in the
expanding frontier economy. There was also an obvious need for a large number of
banks to serve the diverse and rapidly expanding demands of a growing and
constantly migrating population. It must be remembered, too, that at this time
communications between the frontiers of settlement and the established centres of
commerce and finance were still inadequately developed.

As long as communications remained imperfect, the existence of large

numbers of competing institutions is not difficult to explain. The subsequent failure of
bank mergers or amalgamations to produce a concentration of financial resources in
the hands of large banking units can be attributed in part to the character of the federal
Constitution as noted above. Among the people, moreover, there was a widespread
distrust of monopoly and a deep-rooted fear that a "money trust" might develop. This
went hand in hand with a political philosophy that emphasized the virtues of
individualism and free competition; restrictions on branching, merging, and on the
formation of holding companies were a feature of both the state and the federal
banking laws. Where permitted, however, bank branches are numerous in the United
States (especially in California and in New York); in states in which branching is
prohibited, one often finds local bank monopolies in small towns. Interstate banking is
prohibited by federal law, but large banking organizations have provided financial

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services (e.g., through loan offices and offices of nonbank subsidiaries) for many
years across state lines. A number of states have passed limited interstate or reciprocal
banking laws, so that banks in other states with similar laws can acquire or merge
with local banks. The banking system of the United States would not work without a
network of correspondent bank relationships, which are more highly developed there
than in any other country. From the 1970s there was an acceleration in the
evolution of U.S. banking patterns. Unregulated financial institutions (and some
nonfinancial institutions) moved into traditional banking activities; at the same time,
depository institutions began offering a fuller range of financial services. Money-
market mutual funds, for example, secured access to open-market interest rates for
investors with relatively small amounts of money. Securities firms and insurance
companies moved aggressively into providing a range of liquid financial instruments.
Likewise, large manufacturing and retail firms moved into the commercial and retail
lending businesses--e.g., by acquiring a savings and loan association, a securities
brokerage house, an industrial loan company, a consumer banking business, or even a
commercial bank. Meanwhile, depository institutions developed a number of new
services, most notably the Negotiable Order of Withdrawal (NOW) account, an
interest-bearing savings account with a near substitute for checks. These appeared
first in 1972 in New England and after 1980 spread to the whole nation; they were
offered both by commercial banks and by thrift institutions. Share drafts at credit
unions also became a means of payment, and after 1978 the automatic transfer
services of commercial banks permitted savings account funds to be transferred
automatically to cover overdrafts in checking accounts. So-called Super-NOW
accounts (with no interest rate ceilings and unlimited checking facilities with a
minimum balance) were subsequently introduced, along with money-market deposit
accounts, free of interest rate restrictions but with limited checking.
Rapid changes in financial structure and the supply of financial services
posed a host of questions for regulators, and, after much discussion, the Depository
Institutions Deregulation and Monetary Control Act was passed in 1980. The object
was to change some of the rules--many of them obsolete--under which U.S. financial
institutions had operated for nearly half a century. The principal objectives were to
improve monetary control and equalize more nearly its cost among depository
institutions; to remove impediments to competition for funds by depository
institutions, while allowing the small saver a market rate of return; and to expand the
availability of financial services to the public and reduce competitive inequalities
among financial institutions offering them. The major changes were: (1) Uniform
Federal Reserve requirements were phased in on transaction accounts (demand
deposits, NOW accounts, telephone transfers, automatic transfers, and share drafts) at
all depository institutions--commercial banks (whether Federal Reserve members or
not), savings and loan associations, mutual savings banks, and credit unions. (2) The
Federal Reserve Board was authorized to collect all data necessary for the monitoring
and control of money and credit aggregates. (3) Access to the discount window at
Federal Reserve banks was widened to include any depository institution issuing
transaction accounts or nonpersonal time deposits. (4) The Federal Reserve was to
price its services, to which all depository institutions would now have access. (5)
Regulation Q, which had long set interest-rate ceilings on deposits, was to be phased
out over a six-year period. (6) An attempt was made to grasp the nettle of the state
usury laws. (7) NOW accounts were authorized on a nationwide basis and could be
offered by all depository institutions. Other services were extended. (8) The
permissible activities of thrift institutions were broadened considerably. (9) Deposit

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insurance at commercial banks, savings banks, savings and loan associations, and
credit unions was raised from $40,000 to $100,000. (10) The "truth in lending"
disclosure and financial regulations were simplified to make it easier for creditors to
comply.

BRANCH BANKING: THE UNITED KINGDOM

If the United States banks can be taken as representative of a unit banking

system, the British system is the prototype of branch banking. Its development was
linked to the growth of transportation and communications, for otherwise banks
cannot clear checks drawn on other banks and effect remittances speedily and
efficiently. The Scots favoured branch banking from the very beginning (the Bank of
Scotland was founded in 1695), but at first they were not very successful--largely
because of poor communications and the difficulty of supplying branches with
adequate amounts of coin. Not until after the Napoleonic Wars, when the road system
of Scotland had been greatly improved, did branch banking begin to develop
vigorously there. As the Industrial Revolution progressed and as the size of businesses
increased, the structure of English banking underwent a corresponding change.
Greater resources were required for lending, and banks also needed more extensive
interconnections in order to provide an increasing range of services. Where banks
remained small, they were frequently unable to take the strain of the larger demand;
they tended to become overextended and often failed.

The growth in size of banks was also greatly encouraged by legislation that
encouraged joint-stock ownership, beginning in 1826. Joint-stock ownership, which
reduced the risk to any individual, must be distinguished from limited liability, which
did not become widely accepted until the failure of the City of Glasgow Bank in 1878
demonstrated the need for a legal device to protect the stockholder. The early joint-
stock banks tended to remain localized in their business interests; it was only
gradually (with the spread of limited liability and disclosure of accounts) that
amalgamations began to convert the banking system in England and Wales into its
highly concentrated modern form. The main movement was completed before World
War I, though there was to be a further degree of concentration in the years after
World War II. By these means, British banks were able to attract deposits from all
parts of the country and to spread the banking risk over a wide range of industries and
areas.

HYBRID SYSTEMS

A third group of banking systems differs from the unit banking system of
the United States and also from the branch banking systems of countries that have
followed the British model (such as Australia, Canada, New Zealand, and South
Africa). This group is characterized by the existence of a small number of banks with
branches throughout the country, holding a significant part of total deposits, along
with a relatively large number of smaller banks that are regional or local in emphasis.

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Such systems exist in France, Germany, and India. Japan has a small number of large
city banks with branch networks but a larger number of local banks.

France.

Banking institutions in France were classified after World War II into three
main groups: deposit banks, banques d'affaires (or investment banks), and institutions
that were either specialized or operated mainly outside France. New banking
legislation in 1966 greatly reduced the importance of the distinction between deposit
banks and banques d'affaires. There was also (1) a further concentration of banking
resources, as a result of several large mergers and also of greater financial integration
through share-exchange agreements and interlocking directorates, and (2) the
conversion of a number of banques d'affaires into deposit banks, which hived off their
investment interests into separate investment or holding companies.
Further legislation in 1982 nationalized the remaining large and
medium-sized banks (36 in all, plus two financial holding companies--those of
Indosuez and Paribas); the largest deposit banks had already been nationalized after
World War II. Another new law in 1984 abolished the old divisions between the
several categories of banks, which were now defined simply as établissements de
crédit, able to receive deposits from the public, undertake credit operations (including
loans), and provide means of payment. The intention was to move cautiously toward a
system of "universal banking." The new law was extended to cover the Caisse
Nationale de Crédit Agricole, the banques populaires, the crédit mutuel, the central
organizations of the cooperatives and the savings banks (and thereby institutions
affiliated with them), and semipublic institutions like the Crédit Foncier and the
Crédit National, but not the Caisse des Dépôts et Consignations nor the central
banking institutions. All the regional banks and some local banks have
branches. The balanced character of the regional economies often provides these
banks with a good portfolio of risks; they serve not only a prosperous agriculture but
also a number of local industries. Some of the local banks are also very sound
institutions, despite their small size. The
survival of a hybrid system in France, despite the long-run trend toward
centralization, reflects certain characteristics of French society. These included, until
recently, a strong emphasis on small business, together with a preference for
individual and personal service. Particularism in some parts of France manifests itself
in support for local institutions, and the local banker also often has the advantage of
special knowledge of local industries and people, which makes possible the
acceptance of risks that the big banks decline.

Germany.

An even more direct conflict between the forces favouring concentration

and those working against it may be seen in Germany, where banking grew in the
latter part of the 19th century along with industry. The banks were inclined to rely
mainly on their own capital resources and did not at first try to attract deposits from
the public. Not until 1874 did the Deutsche Bank A.G. begin to seek deposits through
offices specially opened for the purpose. This was done to provide cheap finance for
traders, the deposits being invested in mercantile bills that were regarded as both safe
and liquid. In pursuit of deposits, the banks built up a widespread network of branch
offices, which were also used to establish and maintain industrial contacts throughout

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the country. The unification of Germany in 1871 removed the political obstacles to a
more integrated banking system, and the selection of Berlin as the capital made that
city the country's financial centre. Four of the largest banks were already established
there; the new Reichsbank was set up in 1876. In addition, the larger and more
enterprising of the provincial banks were attracted to the capital. The Berlin stock
exchange rapidly displaced that of Frankfurt am Main as the country's leading
securities market. The Berlin banks extended their influence by
developing correspondent relationships and subsequently by acquiring a financial
interest in the provincial banks and being represented on their boards. Each of the big
Berlin banks came to be associated with a group of provincial banks more or less
under its control. At the same time, all of the banks, Berlin and provincial alike,
expanded their business by opening branches. During World War I the degree
of centralization increased; by 1918 the big Berlin banks held more than 65 percent of
total deposits. In the early 1920s there were amalgamations, and branch systems
became much larger. Bank failures and the financial crisis of 1931 resulted in further
consolidation until the German banking system was dominated by three giants. But
there were countervailing forces. Probably the most important of these was the
establishment of publicly owned banking institutions, such as the communal savings
banks and their central institutions, the Girozentralen, which became of increasing
importance after World War II. German savings banks, which were permitted to
have checks drawn on them from 1909 and which had giro clearing from the 1920s,
now offer a wide range of services, especially to lower income groups and smaller
businesses. The large commercial banks have concerned themselves more with big
business and with wealthy individuals. The savings banks now compete in wholesale
banking as well. A number of them, together with their Girozentralen, are to all
intents and purposes "universal banks," like the Big Three and the larger regional
banks. The Big Three (the Deutsche Bank, the Dresdner Bank, and the
Commerzbank) remain unchallenged only in stock exchange and foreign banking
business. Of the private bankers, only
about a half-dozen are of any size. The bigger private banks are important in the fields
of investment and wholesale banking, while the smaller ones flourish in the leading
stock-exchange cities, such as Düsseldorf and Frankfurt am Main. Many of these
private bankers, however, are not bankers in the true sense; they subsist mainly on
stock-exchange transactions, investment services, portfolio management, and
insurance and mortgage brokerage. There are also consumer finance institutions,
mortgage and other specialist banks, and a large number of cooperatives. Regional
and private banks are often within the sphere of influence of the Big Three. In some
cases the latter have a financial interest in these banks, and in some cases they own
them. The Big Three also have shares in certain of the private mortgage banks. There
are also "cooperation agreements," and a number of mergers have taken place. In
these several ways, much more integration exists than appears on the surface. While
banking in Germany remains a hybrid system, a trend toward greater concentration is
evident.

India.

Until the 1950s, banking in India was carried on by a large number of banks,
many of them quite small. India is still primarily an agricultural country, with an
economic and social structure based largely on the village. The integration of banking
has been impeded by poor communications, by illiteracy, and by the barriers of

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language and caste. Banking and credit have remained largely in the hands of the so-
called indigenous banker and the village moneylender. Although their influence has
been greatly reduced in recent years, they still remain important in many an up-
country area. The indigenous banker, who is also a merchant, offers genuine banking
services: accepting deposits and remitting funds; making loans quickly and with a
minimum of formality; and, by means of the hundi (a credit instrument in the form of
a bill of exchange), financing a still significant, if declining, portion of India's internal
trade and commerce. Efforts were made to eliminate the moneylender by developing
a network of rural credit cooperatives. When progress proved to be slow, a more
successful alternative was found in requiring banks to open "pioneer" branches in
rural areas. The first branches were those of the semipublic Imperial Bank of India
and its nationalized successor, the State Bank of India (and its subsidiaries). Many
smaller banks began to disappear, sometimes by merger and sometimes as a result of
failure. Between 1952 and 1967 the number of "reporting" banks fell from 517 to 90.
Nationalized banks, including the State Bank of India and its seven subsidiaries, the
14 large commercial banks taken over in 1969, and the six additional banks
nationalized in 1980, accounted for more than 90 percent of aggregate deposits in
commercial banks. Banking services are also provided by chit funds, which accept
and pay interest on monthly deposits against which it is possible to draw only by way
of loan, and by Nidhis, mutual loan societies that have developed into semibanking
institutions but deal only with their member shareholders. The
main path of banking development in India is the expansion of bank branches into the
under-banked areas. The authorities have sought to expand the number of branches
but to avoid their concentration in the larger towns and cities and, in particular, to
provide the rural areas with adequate facilities. The ultimate objective is to encourage
the mobilization of deposits on a massive scale throughout the country, a formidable
challenge in a country of 575,000 villages, and a stepping up of lending to weak
sectors of the economy.

Japan.

Banking business in Japan is largely concentrated in the hands of the big

banks (some of which are specialized), though a number of small banks still survive.
The principal classes of banks are city banks and regional banks, but it should be
noted that the distinction has no legal basis, though they are separately supervised.
Both belong to the Federation of Bankers' Associations of Japan. The city banks
service mainly manufacturing industry and commerce, particularly the big firms,
while the regional banks are based on a prefecture, though some extend their
operations into neighbouring prefectures, collecting deposits and lending to local
businesses and smaller firms. The regional banks have city bank correspondents, not
only to hold surplus balances but also for assistance in investing their funds,
especially in the call-money market. In addition, a city bank may introduce certain of
its large customers to a regional bank (e.g., a big company having a local factory).
City correspondents in Japan do not, however, provide the wide range of ancillary
services common in the United States. Since
World War II there has been much stability in Japanese banking, but the city banks
have suffered a relative decline in the importance of their business in competition
with other institutions, especially the agricultural cooperatives, which attract the
larger part of the Treasury's payments owing to government purchases of the rice
crop. There has also been a relative increase in the importance of the life insurance

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companies and the trust funds, which have attracted sizable funds from the general
public.

Insurance

Insurance is a method of coping with risk. Its primary function is to

substitute certainty for uncertainty as regards the economic cost of loss-producing
events. Insurance may be defined more formally as a system under which the insurer,
for a consideration usually agreed upon in advance, promises to reimburse the insured
or to render services to the insured in the event that certain accidental occurrences
result in losses during a given period. Insurance
relies heavily on the "law of large numbers." In large homogeneous populations it is
possible to estimate the normal frequency of common events such as deaths and
accidents. Losses can be predicted with reasonable accuracy, and this accuracy
increases as the size of the group expands. From a theoretical standpoint, it is possible
to eliminate all pure risk if an infinitely large group is selected.
From the standpoint of the insurer, an insurable risk must meet the
following requirements:

1. The objects to be insured must be numerous enough and homogeneous

enough to allow a reasonably close calculation of the probable frequency and severity
of losses.

2. The insured objects must not be subject to simultaneous destruction. For

example, if all the buildings insured by one insurer are in an area subject to flood, and
a flood occurs, the loss to the insurance underwriter may be catastrophic.

3. The possible loss must be accidental in nature, and beyond the control of the
insured. If the insured could cause the loss, the element of randomness and
predictability would be destroyed.

4. There must be some way to determine whether a loss has occurred and how
great that loss is. This is why insurance contracts specify very definitely what events
must take place, what constitutes loss, and how it is to be measured.
From the viewpoint of the insured person, an
insurable risk is one for which the probability of loss is not so high as to require
excessive premiums. What is "excessive" depends on individual circumstances,
including the insured's attitude toward risk. At the same time, the potential loss must
be severe enough to cause financial hardship if it is not insured against. Insurable
risks include losses to property resulting from fire, explosion, windstorm, etc.; losses
of life or health; and the legal liability arising out of use of automobiles, occupancy of
buildings, employment, or manufacture. Uninsurable risks include losses resulting
from price changes and competitive conditions in the market. Political risks such as
war or currency debasement are usually not insurable by private parties but may be
insurable by governmental institutions. Very often contracts can be drawn in such a
way that an "uninsurable risk" can be turned into an "insurable" one through
restrictions on losses, redefinitions of perils, or other methods.

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 Insurance

Insurance is a method of coping with risk. Its primary function is to

substitute certainty for uncertainty as regards the economic cost of loss-producing
events. Insurance may be defined more formally as a system under which the insurer,
for a consideration usually agreed upon in advance, promises to reimburse the insured
or to render services to the insured in the event that certain accidental occurrences
result in losses during a given period. Insurance
relies heavily on the "law of large numbers." In large homogeneous populations it is
possible to estimate the normal frequency of common events such as deaths and
accidents. Losses can be predicted with reasonable accuracy, and this accuracy
increases as the size of the group expands. From a theoretical standpoint, it is possible
to eliminate all pure risk if an infinitely large group is selected.
From the standpoint of the insurer, an insurable risk must meet the
following requirements:

1. The objects to be insured must be numerous enough and homogeneous

enough to allow a reasonably close calculation of the probable frequency and severity
of losses.

2. The insured objects must not be subject to simultaneous destruction. For

example, if all the buildings insured by one insurer are in an area subject to flood, and
a flood occurs, the loss to the insurance underwriter may be catastrophic.

3. The possible loss must be accidental in nature, and beyond the control of the
insured. If the insured could cause the loss, the element of randomness and
predictability would be destroyed.

4. There must be some way to determine whether a loss has occurred and how
great that loss is. This is why insurance contracts specify very definitely what events
must take place, what constitutes loss, and how it is to be measured.

From the viewpoint of the insured person, an insurable risk is one for which
the probability of loss is not so high as to require excessive premiums. What is
"excessive" depends on individual circumstances, including the insured's attitude
toward risk. At the same time, the potential loss must be severe enough to cause
financial hardship if it is not insured against. Insurable risks include losses to property
resulting from fire, explosion, windstorm, etc.; losses of life or health; and the legal
liability arising out of use of automobiles, occupancy of buildings, employment, or
manufacture. Uninsurable risks include losses resulting from price changes and
competitive conditions in the market. Political risks such as war or currency
debasement are usually not insurable by private parties but may be insurable by
governmental institutions. Very often contracts can be drawn in such a way that an
"uninsurable risk" can be turned into an "insurable" one through restrictions on losses,
redefinitions of perils, or other methods.

Kinds of insurance

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 PROPERTY INSURANCE

Two main types of contracts--homeowner's and commercial--have been

developed to insure against loss from accidental destruction of property. These
contracts (or forms) typically are divided into three or four parts: insuring agreements,
identification of covered property, conditions and stipulations, and exclusions.

Homeowner's insurance.

Homeowner's insurance covers individual, or nonbusiness, property.

Introduced in 1958, it gradually replaced the older method of insuring individual
property under the "standard fire policy."

Perils insured.

In homeowner's policies, of which there are several types, coverage can be

"all risk" or "named peril." All-risk policies offer insurance on any peril except those
later excluded in the policy. The advantage of these contracts is that if property is
destroyed by a peril not specifically excluded the insurance is good. In named-peril
policies, no coverage is provided unless the property is damaged by a peril
specifically listed in the contract. In
addition to protection against the loss from destruction of an owner's property by
perils such as fire, lightning, theft, explosion, and windstorm, homeowner's policies
typically insure against other types of risks faced by a homeowner such as legal
liability to others for injuries, medical payments to others, and additional expenses
incurred when the insured owner is required to vacate the premises after an insured
peril occurs. Thus the homeowner's policy is multi-peril in nature, covering a wide
variety of risks formerly written under separate contracts.

Property covered.

Homeowner's forms are written to cover damage to or loss of not only an

owner's dwelling but also structures (such as garages and fences), trees and shrubs,
personal property (excluding certain listed items), property away from the premises
(such as boats), money and securities (subject to dollar limits), and losses due to
forgery. They also cover removal of debris following a loss, expenditures to protect
property from further loss, and loss of property removed from the premises for safety
once an insured peril has occurred.

Limitations on amount recoverable.

Recovery under homeowner's forms is limited to loss due directly to the

occurrence of an insured peril. Losses caused by some intervening source not insured
by the policy are not covered. For example, if a flood or a landslide, which usually are
excluded perils, severely damages a house that subsequently is destroyed by fire, the
homeowner's recovery from the fire is limited to the value of the house already
damaged by the flood or landslide.

Recovery under homeowner's forms may be on the basis of either full

replacement cost or actual cash value (ACV). Under the former, the owner suffers no

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reduction in loss recovery due to depreciation of the property from its original value.
This basis applies if the owner took out coverage that is at least equal to a named
percentage--for example, 80 percent--of the replacement value of the property.
If the insurance amount is less than 80
percent, a coinsurance clause is triggered, the operation of which reduces the
recovery amount to the value of the loss times the ratio of the amount of insurance
actually carried to the amount equal to 80 percent of the value of the property.
However, the reduced recovery will not be less than the "actual cash value" of the
property, defined as the full replacement cost minus an allowance for depreciation, up
to the amount of the policy. For example, assume that a property is valued at
$100,000 new, has depreciated 20 percent in value, insurance of $60,000 is taken, and
a $10,000 loss occurs. The actual cash value of the loss is $8,000 ($10,000 minus 20
percent depreciation). The operation of the coinsurance clause would limit recovery to
6/8 of the loss, or $7,500. However, since the actual cash value of the loss is $8,000,
this is the amount of the recovery. Recovery under homeowner's forms is
also limited if more than one policy applies to the loss. For example, if two policies
with equal limits are taken out, each contributes one-half of any insured loss. Loss
payments also are limited to the amount of an insured person's insurable interest.
Thus, if a homeowner has only a one-half interest in a building, the recovery is
limited to one-half of the insured loss. The co-owners would need to have arranged
insurance for their interest.

Excluded perils.

Among the excluded perils (or exclusions) of homeowner's policies are the
following: loss due to freezing when the dwelling is vacant or unoccupied, unless
stated precautions are taken; loss from weight of ice or snow to property such as
fences, swimming pools, docks, or retaining walls; theft loss when the building is
under construction; vandalism loss when the dwelling is vacant beyond 30 days;
damage from gradual water leakage; termite damage; loss from rust, mold, dry rot,
contamination, smog, and settling and cracking; loss from animals or insects; loss
from earth movement, flood, war, or spoilage (e.g., chemical deterioration); loss from
neglect of the insured to protect the property following a loss; and losses arising out
of business pursuits. Special forms for business risks are available. Under
named-peril forms, only losses from the perils named in the policy are covered. The
named perils are sometimes defined narrowly; for example, theft claims are not paid if
the property is merely lost and theft cannot be established.
Earthquake and flood loss, while excluded from the basic homeowner's
forms, may usually be covered by endorsement.

Conditions.

Homeowner's policies may include the following conditions: (1) Owners

are required to give immediate written notice of loss to the insurer or the insurer's
agent. (2) The insured must provide proof of the amount of loss. This suggests that
owners should keep accurate records of the items in a building and of their original

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cost. (3) The insured must cooperate with the insurer in settling a loss. (4) The insured
must pay the premium in advance. (5) The insurer has a right of subrogation (i.e., of
pursuing liable third parties for any loss). This prevents an owner from collecting
twice, once from the insurer and once from a liable third party. (6) A mortgagee's
interest in a property can be protected. (7) The policy may be canceled by the insurer
upon due notice, usually 10 days. If the insurer cancels, a pro rata refund of premium
must be returned to the insured; if the insured cancels, a less-than-proportionate return
of a premium may be recovered from the insurer. (8) Fraud by the insured, including
misrepresentation or concealment of material facts concerning the risk, is ground for
denial of benefits by the insurer. Also available is a
form called renter's insurance, which provides personal property insurance for tenants.

Business property insurance.

Insurance for business property follows a pattern that is similar in many

ways to the one for individual property. A commonly used form is the "building and
personal property coverage form" (BPP). This form permits a business owner to cover
in one policy the buildings, fixtures, machinery and equipment, and personal property
used in business and the personal property of others for which the business owner is
responsible. Coverage also can be extended to insure newly acquired property,
property on newly acquired premises, valuable papers and records, property
temporarily off the business premises, and outdoor property such as fences, signs, and
antennas.

Direct losses.

Coverage on the BPP form can be written on a scheduled basis, whereby

specific items of property are listed and insured, or on a blanket basis, whereby
property at several locations can be insured for a single sum.
Perils insured under the BPP are listed in the policy.
All-risk coverage is also written, subject to specified exclusions.
Losses may be settled on a replacement-cost coverage on the
BPP by endorsement. Otherwise recovery is on an actual cash value basis that makes
an adjustment for depreciation. Coverage
for business personal property with constantly changing values is available on a
reporting form. The business owner reports values monthly to the insurer and pays
premiums based on the values reported. In this way, only the insurance actually
needed is purchased.

Indirect losses.

An entirely different branch of the insurance business has been developed

to insure losses that are indirectly the result of one of the specified perils. A prominent
example of this type of insurance is business income insurance. The insurer
undertakes to reimburse the insured for lost profits or for fixed charges incurred as a
result of direct damage. For example, a retail store might have a fire and be
completely shut down for one month and partially shut down for another month. If the

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fire had not occurred, sales would have been much higher, and therefore substantial
revenues have been lost. In addition, fixed costs such as salaries, taxes, and
maintenance must continue to be paid. A business income policy would respond to
these losses. Forms of indirect insurance include the
following: (1) contingent business income insurance, designed to cover the
consequential losses if the plant of a supplier or a major customer is destroyed,
resulting in either reduced orders or reduced deliveries that force a shutdown of the
insured firm, (2) extra expense insurance, which pays the additional cost occasioned
by having extra expenses to pay, such as rent on substitute facilities after a disaster,
and (3) rent and rental value insurance, covering losses in rents that the owner of an
apartment house may incur if the building is destroyed. Rental income insurance pays
for rent lost when a peril destroys an owner's property that has been rented to others.

MARINE INSURANCE

Marine insurance is actually transportation insurance. After insurance

coverage on ocean voyages had been developed, it was a natural step to offer
insurance on inland trips. This branch of insurance became known as inland marine.
In many policy forms, the distinction between inland and ocean marine has
disappeared; it is common to cover goods from the time they leave the warehouse of
the shipper, even if this warehouse is situated at a substantial distance from the
nearest seaport, until they reach the warehouse of the buyer, which likewise may be
located far inland.

Ocean marine insurance.

Ocean marine contracts are written to cover four major types of property
interest: (1) the vessel or hull, (2) the cargo, (3) the freight revenue to be received by
the ship owner, and (4) legal liability for negligence of the shipper or the carrier. Hull
insurance covers losses to the vessel itself from specified perils. Usually there is a
provision that the marine hull should be covered only within specified geographic
limits. Cargo insurance is usually written on an open contract basis under which
shipments, both incoming and outgoing, are automatically covered for the interests of
the shipper, who reports periodically the values exposed and pays a premium based
upon these values. By means of a negotiable open cargo certificate, which is attached
to the bill of lading, insurance coverage is automatically transferred to whoever has
legal title to the goods in the course of their movement from seller to buyer.
Freight revenue may be insured in
several different ways. If there is an obligation by the shipper to pay the carrier's
freight bill regardless of whether the goods are delivered, the value of the freight is
declared a part of the value of the cargo and is insured as part of this value. If the
freight revenue is contingent upon safe delivery of the goods, the carrier insures the
freight as a part of the regular hull coverage.
Major clauses or provisions that are fairly standardized are (1) the perils
clause, (2) the "running down" clause, or RDC, (3) the "free of particular average," or
FPA, clause, (4) the general average clause, (5) the sue and labour clause, (6) the
abandonment clause, (7) coinsurance, and (8) express and implied warranties. Each of
these will be discussed in turn.

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 Perils clause.

Until 1978 the main insuring clause of modern ocean marine policies was
preserved almost unchanged from the original 1779 Lloyd's of London form. The
clause is as follows:

Touching the adventures and perils which we the assurers are

contented to bear and do take upon us in this voyage: they are of the seas,
men-of-war, fire, enemies, pirates, rovers, thieves, jettisons, letters of mart
and countermart, surprisals, takings at sea, arrests, restraints, and
detainments of all kings, princes, and people, of what nation, condition, or
quality soever, barratry of the master and mariners, and of all other perils,
losses, and misfortunes, that have or shall come to the hurt, detriment, or
damage of the said goods and merchandises, and ship, etc., or any part
thereof.

Although the clause reads as if it were an all-risk agreement, courts have

interpreted it to cover only the perils mentioned. Essentially, the clause insures the
voyage from perils "of" the sea. Perils on the sea, such as fire, are not covered unless
specifically mentioned. Furthermore, although the perils clause indicates coverage
from "enemies, pirates, rovers, thieves," the policy does not cover losses from war.
(War risk insurance is offered in some nations through governmental agencies.)
In 1978, at the request of the UN Conference on Trade
and Development, the 1779 language was modernized and a revised insuring clause
was proposed. The new form restricts coverage on losses from poor packing, places
the burden of proof of seaworthiness on the shipper rather than on the carrier, and
excludes losses resulting from insolvency of the common carrier, with the burden of
proof placed on the shipper that the carrier is financially sound. The revised form has
not been adopted by all insurers.

RDC clause.

The RDC, or "running down" clause, provides coverage for legal liability
of either the shipper or the common carrier for claims arising out of collisions.
(Collision loss to the vessel itself is part of the hull coverage.) The RDC clause covers
negligence of the carrier or shipper that results in damage to the property of others. A
companion clause, the protection and indemnity clause (P and I), covers the carrier or
shipper for negligence that causes bodily injury to others.

FPA clause.

The FPA, or "free of particular average," clause excludes from coverage

partial losses to the cargo or to the hull except those resulting from stranding, sinking,
burning, or collision. Under its provisions, losses below a given percentage of value,
say 10 percent, are excluded. In this way the insurer does not pay for relatively small
losses to cargo. The percentage deductible varies according to the type of cargo and
its susceptibility to loss.

General average clause.

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 The general average clause in ocean marine insurance obligates the insurers
of various interests to share the cost of losses incurred voluntarily to save the voyage
from complete destruction. Such sacrifices must be made voluntarily, must be
necessary, and must be successful. For example, if a shipper's cargo is voluntarily
jettisoned in a storm in order to save the vessel from total loss, the general average
clause requires the insurers of the hull and of all other cargo interests to make a
contribution to the loss of the shipper whose goods were sacrificed. Other types of
losses may also be covered. It has been held, for example, that losses suffered from
efforts to put out a fire on shipboard, which result in damage to specific goods, can be
included in a general average claim. Similarly, losses from salvage efforts to free a
stranded vessel may qualify under a general average claim to which all interests must
contribute.

Sue and labour clause.

The sue and labour clause requires the ship owner to make every attempt to
reduce or save the exposed interests from loss. Under the terms of the clause, the
insurer pays for any necessary costs incurred in carrying out the requirements of the
sue and labour clause. Thus, if a ship is stranded, under the sue and labour clause the
hull owner would be required to hire salvors to attempt to save the ship. Such
expenses are paid even if the salvage attempts fail.

Abandonment clause.

If salvaging or rehabilitating a ship or cargo following a marine loss costs

more than the goods are worth, the loss is said to be constructively total. Under such
conditions, the ocean marine policy permits the insured to abandon the damaged ship
or cargo to the insurer and make a claim for the entire value. In this case, the salvage
belongs to the insurer, who may dispose of it in any way. Abandonment is not
permitted in other forms of property insurance.

Coinsurance.

Although there is no coinsurance clause as such in the ocean marine

policy, losses are settled as though a 100 percent coinsurance clause existed. Thus, if
an insured takes out coverage equal to 50 percent of the true replacement cost of the
goods, only 50 percent of any partial loss may be recovered.

Warranties.

In the field of ocean marine insurance there are two general types of
warranties that must be considered: express and implied. Express warranties are
promises written into the contract. There are also three implied warranties, which do
not appear in written form but bind the parties nevertheless.
Examples of expressed warranties are the FC&S warranty and the strike,
riot, and civil commotion warranty. The FC&S, or "free of capture and seizure,"
warranty excludes war as a cause of loss. The strike, riot, and civil commotion
warranty states that the insurer will pay no losses resulting from strikes, walkouts,

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riots, or other labour disturbances. The three implied warranties relate to the following
conditions: seaworthiness, deviation, and legality. Under the first, the shipper and the
common carrier warrant that the ship will be seaworthy when it leaves port, in the
sense that the hull will be sound, the captain and crew will be qualified, and supplies
and other necessary equipment for the voyage will be on hand. Any losses stemming
from lack of seaworthiness will be excluded from coverage. Under the deviation
warranty, the ship may not deviate from its intended course except to save lives.
Clauses may be attached to the ocean marine policy to eliminate the implied
warranties of seaworthiness or deviation. The implied warranty of legality, however,
may not be waived. Under this warranty, if the voyage itself is illegal under the laws
of the country under whose flag the ship sails, the insurance is void.

Inland marine insurance.

Although there are no standard forms in inland marine insurance, most

contracts follow a typical pattern. They are usually written on a named-peril basis
covering such perils of transportation as collision, derailment, rising water, tornado,
fire, lightning, and windstorm. The policies generally exclude losses resulting from
pilferage, strike, riot, civil commotion, war, delay of shipments, loss of markets,
illegal trade, or leakage and breakage. The scope of inland marine is greatly
extended by means of "floater" policies. These are used to insure certain types of
movable property whether or not the property is actually in transit. Business floater
policies are purchased by jewelers, launderers, dry cleaners, tailors, upholsterers, and
other persons who hold the property of others while performing services. Personal
property floaters are used to cover, on a comprehensive basis, any item of personal
property owned by a private individual. They may also cover the property of visitors,
or the property of servants while on the premises of the insured. They exclude certain
types of property for which other contracts have been designed, such as automobiles,
aircraft, motorcycles, animals, or business and professional equipment.

LIABILITY INSURANCE

Liability insurance arises mainly from the operation of the law of

negligence. Individuals who, in the eyes of the law, fail to act reasonably or to
exercise due care may find themselves subject to large liability claims. Court
judgments have been issued for sums so large as to require a lifetime to pay.
There are at least four major types of liability insurance
contracts: (1) liability arising out of the use of automobiles, (2) liability arising out of
the conduct of a business, (3) liability arising from professional negligence
(applicable to doctors, lawyers, etc.), and (4) personal liability, including the liability
of a private individual operating a home, carrying on sporting activities, and so on.
Practically all liability contracts falling in these
four categories have some common elements. One is the insuring clause, in which the
insurer agrees to pay on behalf of the insured all sums that the insured shall become

215
legally obligated to pay as damages because of bodily injury, sickness or disease,
wrongful death, or injury to another person's property. The liability policy covers only
claims that an insured becomes legally obligated to pay; voluntary payments are not
covered. It is often necessary to resort to legal or court action to determine the amount
of these damages, although in a vast majority of cases the damages are settled out of
court by negotiation between the parties.

All liability insurance contracts contain clauses that obligate the insurer to
conduct a court defense and to pay any settlement, including premiums on bonds,
interest on judgments pending appeal, medical and surgical expenses that are
necessary at the time of the accident, and other costs. Liability insurance has
sometimes been termed defense insurance because of this provision. The insurer
agrees to defend a suit even though it is false or fraudulent, so long as it is a suit
stemming from a peril insured against. The insured is required to cooperate with the
insurer in all court actions by appearing in court, if necessary, to give testimony.

Limits of liability.

Practically all liability insurance policies contain limitations on the

maximum amount of a judgment payable under the contract. Further, the cost of
defense, supplementary payments, and punitive damages may or may not be paid in
addition to the judgment limits. Separate limits often apply to claims for property
damage and bodily injury. An annual aggregate limit may also be purchased, which
puts a maximum on the amount an insurer must pay in any one policy period.
Limits may apply on a per-occurrence or a claims-made basis. In the
former, which gives the most comprehensive coverage, the policy in force in year one
covers a negligent act that took place in year one, no matter when a claim is made. If
the policy is made on a claims-made basis, the insurance in force when a claim is
presented pays the loss. Under this policy, a claim can be made for losses that occur
during the policy period but have their origins in events preceding its starting date; the
period of time before this date for which claims can be made is, however, restricted.
For an additional premium the discovery period can be extended beyond the end of
the policy period. The claims-made basis for liability insurance is considered much
more restrictive than a per-occurrence policy.
Liability insurance contracts have in common the fact that the definition of
"the insured" is broad. An automobile liability policy, for example, includes not only
the owner but anyone else operating the car with permission. In business liability
insurance, all partners, officers, directors, or proprietors are covered by the policy
regardless of their direct responsibility for any act of negligence. Other parties may be
included for an extra premium. Another
element common to all liability insurance policies is certain exclusions. Policies
covering business activities almost invariably exclude liability arising out of the
personal activities of the insured. Each kind of liability contract tends to exclude the
liability for which another contract has been devised: a personal liability coverage in
the homeowner's contract, for example, excludes automobile liability because a
special contract has been created for this particular type of liability. Another
common element in liability policies is subrogation: the insurer retains the right to
bring an action against a liable third party for any loss this third party has caused.

Business liability insurance.

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 Business liability contracts commonly written include the following:
liability of a building owner, landlord, or tenant; liability of an employer for acts of
negligence involving employees; liability of contractors or manufacturers; liability to
members of the public resulting from faulty products or services; liability as a result
of contractual agreements under which liability of others is assumed; and
comprehensive liability. The latter contract is designed to be broad enough to
encompass almost any type of business liability, including automobiles. There has
been increasing use of coverage for liability stemming from defective products,
because some court judgments have awarded huge compensations.
Business liability contracts may be written to cover loss even if the act
that produced the claim was not accidental. The only requirement is that the result of
the act be accidental or unintended. Thus if a contractor is making an excavation that
produces large amounts of dust and this dust causes loss to neighbouring property, the
contractor's liability policy would respond to claims for loss, even though the act that
produced the dust was a deliberate act.

Professional liability insurance.

Known as malpractice, or errors-and-omissions, insurance, professional

liability contracts are distinguished from general business liability policies because of
the specialized nature of the liability. Professional persons requiring liability contracts
include physicians and surgeons, lawyers, accountants, engineers, and insurance
agents. Important differences between professional and other liability contracts are the
following:

1. No distinction is made between bodily injury or property damage liability,

and there is no limit on the number of claims per accident but rather a limit of liability
per claim. This recognizes the fact that one negligent act on the part of a professional
person may involve more than one party, each of whom could bring a legal action
against the professional person. Thus a doctor might administer the wrong medicine
to a number of patients, each of whom could bring a legal action.

2. Claims against a professional person may have an adverse effect upon his or
her reputation. The policy therefore permits the insured to carry any action to court,
since an out-of-court settlement might conceivably imply guilt in the eyes of the
professional's public or clientele.

3. In professional liability insurance there is an exclusion for any agreement

guaranteeing the result of any treatment. Suits stemming from clients' dissatisfaction
with the service performed are thus not covered.

Personal liability insurance.

The most common form of personal liability insurance is issued as part of

the homeowner's liability insurance policy. It is an all-risk agreement and contains
relatively few exclusions. The policy covers any act of negligence of the insured or
residents of the home that results in legal liability. It may also include medical
payments insurance covering accidental injury to guests and other nonresidents
without regard to the question of negligence.

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 Automobile insurance.

Nearly half of all property-liability insurance written in the United States is

in the area of automobile insurance. Set up as a comprehensive contract in most
parts of the world, automobile insurance covers liability, collision loss of the vehicle,
all other types of loss (called comprehensive loss), and medical expenses incurred by
the driver, passengers, and other persons. Coverage usually applies to anyone driving
the car with permission of the owner. Thus, drivers are insured whether driving their
own or someone else's car. Automobile liability coverage is
mandated by law in many countries up to specified monetary limits. The policy states
what happens if the driver is covered by other automobile policies that may cover the
loss. It also covers the liability of persons, such as parents, who have legal
responsibility for actions of the driver. Coverage includes legal defense costs, usually
in addition to the policy liability limits. Many policies exclude coverage for the time
the automobile is driven in a foreign country.

Theft insurance.

Theft generally covers all acts of stealing. There are three major types of
insurance contracts for burglary, robbery, and other theft. Burglary is defined to
mean the unlawful taking of property within premises that have been closed and in
which there are visible marks evidencing forcible entry. Such narrow definition is
necessary to restrict burglary coverage to a particular class of criminal act. Robbery
is defined as that type of unlawful taking of property in which another person is
threatened by either force or violence. In the robbery peril, therefore, the element of
personal contact is necessary. Perhaps
the most common of all burglary coverages is on safes. Often the loss in the form of
damage to the safe itself from the use of explosives and other devices is as great as the
loss of the money, jewelry, or securities it contains. Accordingly, the policy covers
both types of claims. Another common burglary policy applies to mercantile open
stock. In this type of policy, there is usually a limit applicable on any article of
jewelry or any article contained in a showcase where susceptibility to loss is high. In
order to prevent underinsurance, the mercantile open stock policy is usually written
with a coinsurance requirement or with some minimum amount of coverage.
Another common theft policy for business firms
is a comprehensive crime contract covering employee dishonesty as well as losses on
money and securities both inside and outside the premises, loss from counterfeit
money or money orders, and loss from forgery. This policy is designed to cover in
one package most of the crime perils to which an average business is subject. A
broad form of crime protection for individuals is offered both as a separate contract
and as part of a "homeowner's policy." It covers all losses of personal property from
theft and mysterious disappearance.

Aviation insurance.

Aviation insurance normally covers physical damage to the aircraft and

legal liability arising out of its ownership and operation. Specific policies are also
available to cover the legal liability of airport owners arising out of the operation of

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hangars or from the sale of various aviation products. These latter policies are similar
to other types of liability contracts. Perhaps the major underwriting
problem is the "catastrophic" exposure to loss. The largest passenger aircraft may
incur losses of $300,000,000 or more, counting both liability and physical damage
exposures. The number of aircraft of any particular type is not large enough for the
accurate prediction of losses, and each type of aircraft has its special characteristics
and equipment. Thus a great deal of independent individual underwriting is necessary.
Rate making is complex and specialized. It is further complicated by rapid
technological change and by the constant appearance of new hazards.
Policies are written to cover liability of the owner or
operator for bodily injury to passengers or to persons other than passengers and for
property damage. Medical costs, including loss of income, are usually paid to
passengers suffering permanent total disability without the requirement of proving
negligence. This type of coverage has been called admitted liability insurance.

Workers' compensation insurance.

Workers' compensation insurance, sometimes called industrial injury

insurance, compensates workers for losses suffered as a result of work-related
injuries. Payments are made regardless of negligence. The schedule of benefits
making up the compensation is determined by statute.
The scope of employment injury laws, originally limited to persons in
forms of employment recognized as hazardous, has, as the result of associating the
right to compensation with the existence of a contract of service, been gradually
extended to clerical employment. Nevertheless, the large exception of agricultural
employees continues in some Third World countries, Canada, much of the United
States, and the countries of eastern Europe. Other classes of exception are employees
in very small undertakings and domestic servants. The exclusion of employees with
middle-class salaries persists in parts of the former British Empire. In a few countries,
working employers are permitted to insure themselves as well as their employees.
The notion of employment injury was at first confined to injuries of
accidental origin, but during the 20th century it was extended to include occupational
diseases in increasing number. To entitle the worker to benefit, the accident must
occur during employment, and many laws also require the accident to have been
caused by the employment in some way; however, the trend seems to be toward
accepting the former condition as sufficient. Following the German law of 1925, some
30 countries included accidents occurring on the way to and from work. Injuries due
to the employee's willful misconduct are generally excluded. Occupational diseases
are covered to some extent by virtually all national laws.

Classes of benefits.

Four classes of benefits are provided by compulsory insurance, and, except

for certain diseases, a right to them is acquired without any qualifying period of

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previous employment. First is a medical benefit, which includes all necessary
treatment and the supply of artificial limbs. If its duration is limited, the maximum is
likely to be one year. Second is a temporary incapacity benefit, which lasts as long as
the medical benefit except that a waiting period of a few days is frequently prescribed.
The benefit varies from country to country, ranging from 50 percent of the employee's
wage to 100 percent; the most common benefits are 66 2/3 percent and 75 percent.
Third is a permanent incapacity benefit, which, unless the degree is very small, in
which case a lump sum is paid, takes the form of a pension. If the incapacity is total,
the pension is usually equal to the temporary incapacity benefit. If the incapacity is
partial, the pension is proportionately smaller. In some 60 countries an additional
pension is granted if the victim needs constant attendance. In cases of death, the
pensions are distributed to the widow (or invalid widower) and minor children, and, if
the maximum total has not then been attained, other dependents may receive small
pensions. The maximum is the same as for total incapacity.

In a growing number of industrialized countries (Austria, France, Germany,

Ireland, Israel, The Netherlands, and Switzerland) the fourth type of benefit--
systematic arrangements for retraining and rehabilitation of seriously injured
persons--is provided, and employers may even be required to provide employment to
such persons.

Financing and administering employment

injury insurance.

Almost all systems of employment injury insurance are financed by

employers' contributions exclusively, and in almost all these systems the contribution
is proportional to the risk represented by the class of activity in which the employer is
engaged. Usually the insurance institution adapts the contribution to the accident
experience of the undertaking individually or to any special preventive measures it
may have taken. On the other hand, mainly for simplicity, but partly perhaps in order
to subsidize basic but dangerous industries, a uniform contribution rate for all classes
of activity has been established in several countries. Social insurance
against employment injury, as against other risks, is in most countries administered by
institutions under the joint management of employers and employees and often of
government representatives as well; in eastern Europe, however, the administration is
entrusted to trade unions. Disputes are settled by arbitral organs without resort to the
courts.

In the United States an employer may comply with the provisions of most
workers' compensation laws in three ways: by purchasing a private workers'
compensation and employer liability policy from a commercial insurer, by purchasing
coverage through a state fund set up for this purpose, or by setting aside reserves
sufficient to cover the risks involved. Most workers' compensation benefits are
financed by the first two methods. State laws in the United States
are not uniform with respect to the amount of the monetary compensation or length of
time for which income payments are made. For example, only about half the states
give lifetime income benefits for occupational injuries. In others there is a statutory
limitation of between 400 and 500 weeks of payments. Again, most states provide

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liquidating damages for an injury that is permanent but does not totally incapacitate
the worker, such as the loss of an arm or leg. The size of these liquidating damages
varies greatly. Most state laws also provide complete medical benefits, including
rehabilitation expenses, and survivors' benefits in the event of the worker's death.

Costs.

Following the publication in the early 1970s of about 40 studies revealing

inadequacies in workers' compensation in the United States, most states passed laws
increasing the number of workers covered, raising weekly benefits to equal or exceed
66 2/3 percent of the average weekly wage, and making other improvements.
Compensable claims now include those involving back pain, stress, and heart
conditions traceable to employment conditions. Many claims also involve court
litigation, which greatly magnifies settlement costs. For employers, these and other
factors have increased the average cost of benefits from less than 1 percent of wages
before 1960 to 2.3 percent in 1992.

Credit insurance.

The use of credit in modern societies is so various and widespread that

many types of insurance have grown up to cover some of the risks involved.
Examples of these risks are the risk of bad debts from insolvency, death, and
disability; the risk of loss of savings from bank failure; the risk attaching to home-
loan debts when installments are not paid for various reasons, resulting in foreclosure
with subsequent loss to the creditor; and the risk of loss from export credit because of
war, currency restrictions, cancellation of import licenses, or other political causes.

Merchandise credit insurance.

Credit insurance for domestic buyers and sellers is available in the United
States, Canada, Mexico, and most European countries. It is sold only to
manufacturers, wholesalers, and certain service agencies, not to retailers. The
insurance is designed to enable the seller to recover a certain percentage of losses
from insolvency of the debtor, but the contracts list a number of conditions under
which the creditor may initiate a claim regardless of the question of insolvency. The
policy is designed primarily to meet the needs of those sellers whose business is
concentrated on a few buyers, insolvency of any one of which would seriously
jeopardize the financial stability of the seller.

Export credit insurance.

A special form of credit insurance is available to exporters against losses

from both commercial and political risks. In the United States, for example, export
credit insurance is written through a consortium of insurance companies organized by
the Foreign Credit Insurance Association (FCIA). The Export-Import Bank of the
United States assumes the ultimate liability for loss, while the FCIA serves as the
underwriting agency. Coverage is usually limited to 90 or 95 percent of the account.
Prior approval from the FCIA is usually required before export credit insurance is
granted. In some cases, the exporter is required to purchase coverage on all credit

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sales in a given country as a device to reduce adverse selection.
Export credit insurance is used more widely in some countries than in
others. In the United Kingdom approximately one-quarter of all export sales are
covered, compared with about 6 percent in the United States. Export sales are not
eligible for insurance if they are made for cash or financed directly or indirectly
through government-guaranteed loans.

Title insurance.

Title insurance is a contract guaranteeing the purchaser of real estate

against loss from undiscovered defects in the title to property that has been purchased.
Such loss may stem from unmarketability of the property because of defective title or
from costs incurred to cure defects of the title.

The need for title insurance arises from the fact that real estate transactions are
complex and technical. Any legal error, no matter how detailed or minute, may cause
a defect in the title that impairs its marketability. Examples of such defects are
forgeries, invalid or undiscovered wills, defective probate proceedings, or transfers of
property by persons lacking full legal capacity to contract.

Miscellaneous insurance.

Special casualty forms are issued to cover the hazards of sudden explosions
from equipment such as steam boilers, compressors, electric motors, flywheels, air
tanks, furnaces, and engines. Boiler and machinery insurance has several distinctive
features. A substantial portion of the premium collected is used for inspection services
rather than loss protection. Second, the boiler policy provides that its coverage will be
in excess of any other applicable insurance. In this sense, it may be looked upon as an
"umbrella policy" to fill in gaps in the insured's program. Third, the policy lists the
specific losses that will be paid, such as the loss of the boiler or machinery itself due
to accident, expediting expenses, property damage liability, bodily injury liability,
defense settlement and supplementary payments, business interruption, outage
(interruption of service), power interruption, consequential loss due to spoilage of
goods, and furnace explosion. The policy will satisfy each of these claims in the order
in which they appear, up to the limit of the coverage.
The extensive use of plate glass in modern architecture has produced a
special comprehensive insurance that covers not only plate glass but glass signs,
motion-picture screens, halftone screens and lenses, glass bricks, glass doors, and so
forth. It may be written to cover loss from any source except fire or nuclear radiation.
Increasing international business activity
has caused greater use of policies generally termed difference-in-conditions insurance
(DIC). The DIC policy insures property and liability losses not covered by basic
insurance contracts. It can be written to insure almost any peril, including earthquake
and flood, subject to deductibles and stated exclusions. It is often written on an all-
risk basis. An international business firm may use the DIC to secure uniform coverage
for all countries in which it operates and to obtain higher policy limits than those
available from domestic insurers in the various foreign countries.

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 SURETYSHIP

Surety contracts are designed to protect businesses against the possible

dishonesty of their employees. Surety and fidelity bonds fill the gap left by theft
insurance, which always excludes losses from persons in a position of trust. A bond
involves three contracting parties instead of two. The three parties are the principal,
who is the person bonded; the obligee, the person who is protected; and the surety, the
person or corporation agreeing to reimburse the obligee for any losses stemming from
failures or dishonesty of the principal. The bond covers events within the control of
the person bonded, whereas insurance in the strict sense covers loss from random
events generally outside the direct control of the insured. In bonding, the surety
always has the right to try to collect its losses from the person bonded, whereas in
insurance the insurer may not attempt to recover losses from the insured. Of course,
under property and liability policies the insurer may attempt to recover from liable
third parties under the right of subrogation, but subrogation rights are often not
possible to enforce in practice. Bonds are not usually cancelable by the insurer,
whereas most insurance contracts, except life, are cancelable by the insurer upon due
notice. Fidelity bonds are written to cover the obligee, usually an employer,
against loss from dishonest acts of employees; surety bonds cover not only dishonesty
but also incapacity to perform the work agreed upon. Surety bonds are normally
written on principals who are acting in an independent or semi-independent capacity,
such as building contractors or public officials, whereas fidelity bonds are written on
employees acting under the guidance and supervision of their employer. Finally,
surety bonds are often issued with the requirement of collateral, whereas fidelity
bonds are not. The surety bond is an instrument through which the superior credit of
the surety is substituted for the uncertain credit of the principal; hence, if the surety is
asked to bond a principal of somewhat doubtful credit, the requirement of cash
collateral is frequently imposed.

Major types of fidelity bonds.

Fidelity bonds differ according to whether specific persons are named as

principals or whether all employees or persons are covered as a group. The latter are
most frequently used by employers with a large number of employees, because they
offer automatic coverage on given classes of workers, including new employees, and
greater ease of administration, including simpler claims procedures. Fidelity bonds are
usually written on a continuous basis--that is, they are effective until canceled and
have no expiration date. The penalty of the bond (the maximum amount payable for
any one loss) is unchanged from year to year and is not cumulative. The bonds specify
a discovery period (usually two years) limiting the time for discovering losses after a
bond is discontinued. When a new bond is put into effect, it can be written to cover
losses that have occurred but are undiscovered before the effective issue date of the
bond. A salvage clause also is included, stating the way in which any salvage
recovered by the surety from the principal is to be divided between the surety and the

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obligee. This clause is significant, because the obligee may have losses in excess of
the penalty of the bond. Some salvage clauses require that any salvage be paid to the
obligee up to the full amount of all losses, and others provide that any salvage be
divided between the surety and the obligee on a pro rata basis, in the proportion that
each party has suffered loss.

Major types of surety bonds.

There are various classes of surety bonds. Contract construction bonds are
written to guarantee the performance of contractors on building projects. Bonds are
particularly important in this field because of the general practice of awarding
commercial building contracts to the lowest bidder, who may promise more than can
actually be performed. The surety who is experienced in this field is in a position to
make sounder judgment about the liability of the various bidders than anyone else and
backs up its judgment with a financial guarantee.
Court bonds include several different types of surety bonds. Fiduciary
bonds are required for court-appointed officials entrusted with managing the property
of others; executors of estates and receivers in bankruptcy are frequently required to
post fiduciary bonds. Other types of surety bonds include official bonds, lost
instrument bonds, and license and permit bonds. Public official bonds guarantee that
public officials will faithfully and honestly discharge their obligations to the state or
to other public agencies. Lost instrument bonds guarantee that if a lost stock
certificate, money order, warehouse receipt, or other financial instrument falls into
unauthorized hands and causes a loss to the issuer of a substitute instrument, this loss
will be reimbursed. License and permit bonds are issued on persons such as owners of
small businesses to guarantee reimbursement for violations of the licenses or permits
under which they operate.
LIFE AND HEALTH INSURANCE

Life insurance.

Life insurance may be defined as a plan under which large groups of

individuals can equalize the burden of loss from death by distributing funds to the
beneficiaries of those who die. From the individual standpoint life insurance is a
means by which an estate may be created immediately for one's heirs and dependents.
It has achieved its greatest acceptance in Canada, the United States, Belgium, South
Korea, Australia, Ireland, New Zealand, The Netherlands, and Japan, countries in
which the face value of life insurance policies in force generally exceeds the national
income. In the United States in 1990 nearly $9.4 trillion
of life insurance was in force. The assets of the more than 2,200 U.S. life insurance
companies totaled nearly $1.4 trillion, making life insurance one of the largest savings
institutions in the United States. Much the same is true of other wealthy countries, in
which life insurance has become a major channel of saving and investment, with
important consequences for the national economy. Life insurance is
relatively little used in poor countries, although its acceptance has been increasing.

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 Types of contracts.

The major types of life insurance contracts are term, whole life, and
universal life, but innumerable combinations of these basic types are sold. Term
insurance contracts, issued for specified periods of years, are the simplest. Protection
under these contracts expires at the end of the stated period, with no cash value
remaining. Whole life contracts, on the other hand, run for the whole of the insured's
life and gradually accumulate a cash value. The cash value, which is less than the face
value of the policy, is paid to the policyholder when the contract matures or is
surrendered. Universal life contracts, a relatively new form of coverage introduced in
the United States in 1979, have become a major class of life insurance. They allow the
owner to decide the timing and size of the premium and amount of death benefits of
the policy. In this contract, the insurer makes a charge each month for general
expenses and mortality costs and credits the amount of interest earned to the
policyholder. There are two general types of universal life contracts, type A and type
B. In type-A policies the death benefit is a set amount, while in type-B policies the
death benefit is a set amount plus whatever cash value has been built up in the policy.
Life insurance may also be classified, according to type of customer, as
ordinary, group, industrial, and credit. The ordinary insurance market includes
customers of whole life, term, and universal life contracts and is made up primarily of
individual purchasers of annual-premium insurance. The group insurance market
consists mainly of employers who arrange group contracts to cover their employees.
The industrial insurance market consists of individual contracts sold in small amounts
with premiums collected weekly or monthly at the policyholder's home. Credit life
insurance is sold to individuals, usually as part of an installment purchase contract;
under these contracts, if the insured dies before the installment payments are
completed, the seller is protected for the balance of the unpaid debt.

Insurance may be issued with a premium that remains the same throughout
the premium-paying period, or it may be issued with a premium that increases
periodically according to the age of the insured. Practically all ordinary life insurance
policies are issued on a level-premium basis, which makes it necessary to charge more
than the true cost of the insurance in the earlier years of the contract in order to make
up for much higher costs in the later years; the so-called overcharges in the earlier
years are not really overcharges but are a necessary part of the total insurance plan,
reflecting the fact that mortality rates increase with age. The insured is not overpaying
for protection, because of the claim on the cash values that accumulate in the early
years; the policyholder may borrow on this value or may recapture it completely by
lapsing the policy. The insured does not, however, have a claim on all the earnings
that accrue to the insurance company from investing the funds of its policyholders.
By combining term and whole
life insurance, an insurer can provide many different kinds of policies. Two examples
of such "package" contracts are the family income policy and the mortgage protection
policy. In each of these, a base policy, usually whole life insurance, is combined with
term insurance calculated so that the amount of protection declines as the policy runs
its course. In the case of the mortgage protection contract, for example, the amount of
the decreasing term insurance is designed roughly to approximate the amount of the
mortgage on a property. As the mortgage is paid off, the amount of insurance declines
correspondingly. At the end of the mortgage period the decreasing term insurance
expires, leaving the base policy still in force. Similarly, in a family income policy, the

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decreasing term insurance is arranged to provide a given income to the beneficiary
over a period of years roughly corresponding to the period during which the children
are young and dependent. Some whole life
policies permit the insured to limit the period during which premiums are to be paid.
Common examples of these are 20-year life, 30-year life, and life paid up at age 65.
On these contracts, the insured pays a higher premium to compensate for the limited
premium-paying period. At the end of the stated period, the policy is said to be "paid
up," but it remains effective until death or surrender.
Term insurance is most appropriate when the need for protection runs for
only a limited period; whole life insurance is most appropriate when the protection
need is permanent. The universal life plan, which earns interest at a rate roughly
equal to that earned by the insurer (approximately the rate available in long-term
bonds and mortgages), may be used as a convenient vehicle by which to save money.
The owner can vary the amount of death protection as the need for it changes in the
course of life. The policy offers flexibility and saves the owner commission expense
by eliminating the need for dropping one policy and taking out another as protection
requirements change.

Settlement options.

The death proceeds or cash values of insurance may be settled in various

ways. The insured may take the cash value and lapse the policy. A beneficiary may
take a lump sum settlement of the face amount upon the death of the insured. The
beneficiary may, instead, elect to receive the proceeds over a given number of years
or in some fixed amount, such as $100 a month, for as long as the proceeds last. The
money may be left with the insurer temporarily to draw interest. Or the proceeds may
be used to purchase a life annuity, which in effect is another insurance policy
guaranteeing regular payments for the life of the insured.

Other provisions.

Life insurance policies contain various clauses that protect the rights of
beneficiaries and the insured. Perhaps the best-known is the incontestable clause,
which provides that if a policy has been in force for two years the insurer may not
afterward refuse to pay the proceeds or cancel the contract for any reason except
nonpayment of premiums. Thus, if the insured made a material misrepresentation
when the policy was originally obtained, and this misrepresentation is not discovered
until after the contestable period, beneficiaries may still receive the value of the policy
so long as the premiums are maintained. Another protective clause is the suicide
clause, which states that after a given period, usually two years, the insurer may not
deny liability for subsequent suicide of the insured. If suicide occurs within the
period, the insurer tenders to the beneficiary only the premiums that have been paid. If
the age of the insured was misstated when the policy was taken out, the misstatement-
of-age clause provides that the amount payable is the amount of insurance that would
have been purchased for the premium had the correct age been stated. Many life
insurance policies, known as participating policies, return dividends to the insured.
The dividends, which may amount to 20 percent of the premiums, may be

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accumulated in cash left with the insurer at interest, used to buy additional life
insurance, used to reduce premium payments, or used to pay up the contract sooner
than would otherwise have been possible.

Special riders.

The insured may, at a nominal charge, attach to the contract a waiver-of-

premium rider under which premium payments will be waived in the event of total
and permanent disability before the age of 60. Under the disability income rider,
should the insured become totally and permanently disabled, a monthly income will
be paid. Under the double indemnity rider, if death occurs through accident, the
insurance payable is double the face amount.

Private health insurance.

In many countries health insurance has become a governmental

institution. In some, doctors and other professional staff are employed, directly or
indirectly, by a government agency on a full-time or part-time salaried basis, and
health facilities are owned or operated by the government. This has been the practice
in Australia, Brazil, Canada, Chile, Greece, Ireland, Mexico, New Zealand, Sweden,
Turkey, and the countries of eastern Europe. In other countries the government pays
for medical care provided by private physicians; these countries include Austria,
Denmark, The Netherlands, Norway, and Spain. In some countries private health
insurance programs exist along with, or as part of, the government program. Various
combinations of programs are possible, and it is difficult to summarize all the
arrangements that actually exist. The United States provides government-run medical
services in veterans' hospitals and mental hospitals, and it also has a governmental
health insurance program for citizens age 65 and over (Medicare) under the Social
Security Act amendments of 1965, but most health insurance in the United States still
consists of private programs. Much private health insurance in the United States is
operated on a group basis, generally through groups of employees whose payments
may be subsidized by their employer.

Types of policies.

The major types of health insurance coverage are hospitalization, surgical,

regular medical, major medical, disability income, dental, and long-term care. Health
insurance contracts are not highly standardized. The policy provisions discussed
below should be considered as typical, not universal or invariant.
Hospitalization insurance indemnifies for room and board in the hospital,
laboratory fees, use of special facilities, nursing care, and certain medicines and
supplies. The contracts contain specific limitations on coverage, such as a maximum
number of days in the hospital and maximum allowances for room and board.
Surgical expense insurance covers the surgeon's charge for given operations or
medical procedures, usually up to a maximum for each type of operation. Regular
medical insurance contracts indemnify the insured for expenses such as physicians'
home or office visits, medicines, and other medical expenses. Major medical
contracts are distinguished from other health insurance policies by offering coverage
without many specific limitations; usually there is only a maximum per person, a
deductible amount, and a percentage deductible, called coinsurance, under which the

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insured usually pays 20 percent of each medical bill above the deductible amount.
Disability income coverage provides periodic payments when the insured is unable to
work as a result of accident or illness. There is normally a waiting period before the
payments begin. Definitions of disability vary considerably. A strict definition of
disability requires that one be unable to perform each and every duty of one's regular
occupation for a given period, say two years, and thereafter be unable to perform the
duties of any occupation for which one is reasonably fitted by training or experience.
More liberal definitions of disability require only the inability to perform the duties of
one's usual occupation. Dental insurance, usually sold on a group plan and
sponsored by an employer, covers such dental services as fillings, crowns, extractions,
bridgework, and dentures. Most policies contain relatively low annual limits of
coverage, such as $2,500, as well as deductibles and coinsurance provisions. Some
policies limit benefits to a percentage of the cost of services.
Long-term care insurance (LTC) has been developed to cover expenses
associated with old age, such as care in nursing homes and home care visits. LTC
insurance, though relatively new, is already attracting strong interest because of the
rapid growth of the elderly population in the United States. Policies specify a
maximum limit per day plus an overall maximum benefit amount, with the result that
the insurance typically covers the expenses of a maximum of four or five years in a
nursing home. A common provision is a 20-day waiting period before benefits begin.
Some policies exclude certain conditions such as Alzheimer's disease and do not
cover custodial care. For an additional premium, some LTC policies offer an inflation
provision, which increases the daily benefit by some percentage, such as 5 percent a
year.

Renewability.

An important condition of health insurance is that of renewability. Some

contracts are cancelable at any time upon short notice. Others are not cancelable
during the year's term of coverage, but the insurer may refuse to renew coverage for a
subsequent year or may renew only at higher rates or under restrictive conditions.
Thus the insured may become ill with a chronic disease and discover that upon
renewal the policy excludes all future coverage for this disease. Only policies that are
both noncancelable and guaranteed renewable assure continuous coverage, but these
are much more expensive.

Problems.

Private health insurance contracts are in general quite restricted in

coverage, to the point that many consider them to be inadequate for modern
conditions. They also lend themselves to abuses such as overutilization of coverage,
multiple policies, and insuring for more than 100 percent of the expected loss. Health
insurance, by its very existence, helps to escalate rising medical care costs; for
example, insured medical losses tend to run higher than noninsured losses because
physicians often charge according to "ability to pay," and insurance increases this
ability. Through insurance it is also easier to pass on rising hospital costs to the
patient. Finally, since there is a tendency for those most likely to have losses to take
out health insurance, an element of adverse selection exists. Careful underwriting to
screen out those who are trying to take advantage of the insurance mechanism to pay

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for known bills is considered essential, but this undoubtedly denies coverage to many
who need protection.

Group insurance.

Groups have always been important in the insurance field, from the burial
societies of the Romans and the insurance funds of the medieval guilds to the fraternal
and religious insurance plans of modern times. In the 20th century private insurance
companies have written increasingly large amounts of group insurance, particularly in
life insurance, health insurance, and annuities. In 1990 more than 95 percent of the
industrial labour force in the United States was covered by group life and health
insurance plans established by employers. Much of the impetus for these employee
benefit plans came from the labour unions, which pressed for such "fringe benefits" in
bargaining with employers. Group insurance is widely used throughout the world,
both in the form of private plans and as social insurance plans. Social security plans
with group coverage exist in more than 140 nations. Private group plans are generally
offered wherever private life and health insurance companies operate. Group life
insurance is the most commonly offered plan; group health plans are government-
operated in many nations. In many countries, group pension plans are common as a
supplement to social insurance pension schemes. Group insurance
has been especially popular in Japan, where many employees serve a company for
life. All Japanese life insurance companies offer group life insurance. Health
insurance is provided by the government. Funded group pensions became popular
after a 1962 tax law made contributions tax-deductible for Japanese employers. In
addition, virtually all Japanese employers provide lump-sum retirement allowances to
their workers.

Group life insurance.

Under group life insurance an employer signs a master contract with the
insurance company outlining the provisions of the plan. Each employee receives a
certificate that gives evidence of participation in the plan. The amount of insurance
depends on the employee's salary or job classification; usually the employer pays a
portion of the premium and the employee pays the rest, but sometimes the employer
pays the entire cost of the plan.
A major advantage of group life insurance to an employee is that usually
coverage may be obtained regardless of health. An employee who leaves the group
may, without a medical examination, convert the group coverage to an individual
policy. The premiums on group life insurance are considerably less than on
comparable individual policies, mainly because the selling and administrative costs
are minimal.

Group health insurance.

Major types of health insurance written on a group basis include insurance

against the losses occasioned by hospitalization, surgical expense, and disability.
Hospitalization insurance is designed to cover daily room and board and other
expenses. Surgical expense insurance usually provides specified allowances for
physicians' charges for various operations. Regular medical expense coverage is
generally aimed at covering part of the costs of medicines and doctor calls. Major

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medical insurance offers the insured a large monetary coverage, designed to meet
catastrophic costs of illness or accident with few restrictions as to the type of medical
expense for which reimbursement is allowed. The insured must bear a percentage of
any loss, usually 20 percent. Temporary disability income offers the insured a weekly
indemnity for a period of up to six months if the insured is temporarily disabled and
unable to work. Long-term disability extends the income for periods longer than six
months. Accidental death and dismemberment insurance offers an insured or a
beneficiary a lump sum; it is used widely as a form of travel accident insurance.
Under the typical group health insurance contract, the insured person
enjoys several elements of protection not obtainable in individual contracts.
Cancellation of coverage is not permitted unless coverage for the entire group is
canceled. The insured enjoys protection against rate increases unless the rate for all
members of the class is increased. Typically the group protection may be converted to
some kind of individual policy, or the insured may transfer to another group plan. The
insurer tends to be liberal on claims settlement because the typical premium under a
group plan is large enough for the insurer to be unwilling to jeopardize the good will
of the clientele through miserly claims treatment. Most group insurance
plans require that certain conditions be met. Sometimes there must be a minimum
number of persons covered, such as 10 or 25. The group must also have some reason
for existence other than to obtain insurance. The most usual types of groups are
employees of a common employer, members of a labour organization, debtors of a
common creditor, or members of a professional or trade association.
Mention must also be made of nonprofit prepayment plans (e.g., the Blue
Cross-Blue Shield plans and health maintenance organizations [HMOs] in the
United States), which resemble the above plans in most respects but are not operated
by insurance companies. These plans often indemnify the hospital or the physician, on
the basis of services performed, rather than the patient. Health insurance plans may
also be established independently by large employers, labour unions, communities, or
cooperatives. Outside the United States this kind of health insurance has been taken
over by government programs. In Sweden, before the enactment of the compulsory
insurance program in 1955, 70 percent of the population was covered by private
plans. In Great Britain, before the National Health Service was instituted in 1948,
about half the population was privately covered. In The Netherlands about half the
population was so covered before the government program began, and there were still
many private funds run by various groups. In spite of the success of private group
health insurance in the United States, it is estimated that in 1992 approximately 37
million people were without health insurance coverage. Many attempts over the years
to establish universal national health insurance in the United States have failed.

Group annuities.

An annuity in the literal sense is a series of annual payments. More broadly

it may be defined as a series of equal payments over equal intervals of time. A life
annuity, a subclass of annuities in general, is one in which the payments are
guaranteed for the lifetime of one or more individuals. A group annuity differs from
an individual annuity in that the annuity payments are based upon the assumed length
of lives of members of a given group. The size of the payments depends on several
factors: the assumed interest rate, the life expectancy of the individual or of the
individuals making up the group, the length of the period during which payments are
guaranteed, the length of time elapsing before the payments begin, and the number of

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lives on which the payments are continued. For example, if payments to an annuitant
aged 65 are to be guaranteed for 20 years, they will be substantially smaller than if
they are guaranteed only for the remainder of the person's life.

The typical group life annuity is sponsored by an employer, who may pay
all or part of the cost. Under the usual arrangement, every employee receives each
year a credit with the life insurance company for an annuity purchased to begin at age
65. The final pension received is made up of the sum of the individual annuities
purchased throughout the worker's life. As a rule, an irrevocable claim to these
annuity rights is gained only after the person has worked with the employer for a
given number of years or has reached a given age. The basic
advantage of an annuity is that it provides an income for life that is larger than the
amount that the holder would receive by putting money out at simple interest. It is the
reverse of life insurance, in that the insurer pays premiums to the insured; it resembles
insurance in that the payment is based on life expectancy. The problem of inflation
has led to experimentation with variable annuities in order to protect annuitants
against decreases in purchasing power. The major distinguishing characteristic of a
variable annuity is that the payments vary according to underlying trends in the stock
market. Funds paid in for the variable annuity are invested in common stock rather
than in bonds, mortgages, or other fixed-interest investments as is true of regular
annuities. In simplified terms, if the stock market rises 10 percent in one year, the
annuitant may expect payments to go up by approximately 10 percent in the following
year. Conversely, if the stock market drops 10 percent, the annuitant will suffer a 10
percent reduction in income. To the extent that the stock market reflects changes in
the cost of living, the annuitant's income is automatically adjusted for these changes
each year; and, if the stock market also reflects increases in productivity in the
economy, then the annuitant may expect to receive a share in such increases in the
productivity as the economy may gain. Some variable annuity plans are
tied directly to a cost-of-living index. In order to finance the increased benefits, the
employer invests a portion of the funds in equities such as common stock and real
estate. An assumption is made that there will be a sufficient gain from this source to
enable the employer to pay the increased cost of living, but the employee is not
expected to suffer reductions in annuity payments.
The problem of adjusting retirement benefits to changes in the economy has
been of concern in many countries. Some governments have pegged the price of
government bonds to the cost-of-living index. Retired individuals purchasing
government bonds may then receive automatic increases in interest payments if the
cost of living rises. Their interest will not fall below a specified amount. Social
security legislation in most parts of the world is geared in various ways to changes in
the cost of living. In some cases benefits are directly tied to a price index. In other
cases the legislature from time to time must be asked to make adjustments in social
security benefits.

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 Insurance practice

UNDERWRITING AND RATE MAKING

The two basic functions in insurance are underwriting and rating, which are
closely related to each other. Underwriting deals with the selection of risks, and rating
deals with the pricing system applicable to the risks accepted.

Underwriting principles.

Underwriting has to do with the selection of subjects for insurance in such a

manner that general company objectives are met. The main objective of underwriting
is to see that the risk accepted by the insurer corresponds to that assumed in the rating
structure. There is often a tendency toward adverse selection, which the underwriter
must try to prevent. Adverse selection occurs when those most likely to suffer loss are
covered in greater proportion than others. The insurer must decide upon certain
standards, terms, and conditions for applicants, project estimated losses and expenses
through the anticipated period of coverage, and calculate reasonably accurate rates to
cover these losses and expenses. Since many factors affect losses and expenses, the
underwriting task is complex and uncertain. Bad underwriting has resulted in the
failure of many insurers. In some types of insurance major
underwriting decisions are made in the field, and in other types they are made at the
home office. In the field of life insurance the agent's judgment is not accepted as final
until the home-office underwriter can make a decision, for the life insurance contract
is usually noncancelable, once written. In the field of property and liability insurance,
on the other hand, the contract is cancelable if the home-office underwriter later finds
the risk to be unacceptable. It is not uncommon for a property and liability insurer to
accept large risks only to cancel them at a later time after the full facts are analyzed.
The insurance underwriter must tread a thin line between undue strictness and undue
laxity in the acceptance of risk. The underwriter's position is not unlike that of the
credit manager in a business corporation, in which unreasonably strict credit standards
discourage sales but overly weak credit standards invite losses.
An important initial task of the underwriter is to try to prevent adverse
selection by analyzing the hazards that surround the risk. Three basic types of hazards
have been identified as moral, psychological, and physical. A moral hazard exists
when the applicant may either want an outright loss to occur or may have a tendency
to be less than careful with property. A psychological hazard exists when an
individual unconsciously behaves in such a way as to engender losses. Physical
hazards are conditions surrounding property or persons that increase the danger of
loss.
An underwriter may suspect the existence of a moral hazard on applications
submitted by persons with known records of dishonesty or when excessive coverage
is sought or the replacement value of the property exceeds its value as a profit-making
enterprise. Underwriters are aware that fire losses are more likely to occur during
business depressions. The underwriter can detect moral hazard in various ways: An
applicant's credit may be checked; courthouse and police records may reveal a
criminal history or a history of bankruptcy; and other insurance companies can be
queried for information when it is suspected that an individual is trying to obtain an
excessive amount of coverage or has been turned down by other insurers.
The psychological type of hazard can take a number of forms. Some

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persons are said to be "accident-prone" because they have far more than their share of
accidents, suggesting that unconsciously they want them. It is well known that
persons applying for annuities tend to have longer than average lives, and
consequently a special mortality table is used for annuitants. Certain types of insanity
have to be watched for--notably the impulse to set fires.
Physical hazards include such things as wood-frame construction in
buildings, particularly in areas where such properties are densely concentrated.
Earthquake insurance rates tend to be high where geologic faults exist (as in San
Francisco, which is built almost directly over such a fault).
Each kind of insurance has its characteristic hazards. In fire insurance
the physical hazards are analyzed according to four major factors: type of
construction, the protection rating of the city in which the property is located,
exposure to other structures that may spread a conflagration, and type of occupancy.
In underwriting automobile insurance, the underwriter considers the
following factors: the age, sex, and marital status of the driver and members of the
driver's household; length of driving experience; occupation; stability of employment
and residence; physical impairments; accident and conviction record; extent of use of
alcohol and drugs; customary use of the vehicle; age, condition, and maintenance of
the vehicle; and records of insurance cancellation or refusal. In some cases tests of
emotional maturity are administered. Some underwriters even consider such factors as
the school records of student drivers and whether or not driving courses have been
taken.
The hazards considered in the underwriting of general liability
insurance depend on the type of business and the record of the person applying for
coverage. In the field of contracting, for example, the underwriter is interested in the
type of equipment owned or rented by the applicant; the applicant's losses in the past,
attitude toward safe practice, cooperation with building inspectors, and financial
position and credit standing; the stability of supervisory employees; and the degree to
which the applicant has been a successful contractor in the past.

Rate making.

Closely associated with underwriting is the rate-making function. If, for

example, the underwriter decides that the most important factor in discriminating
between different risk characteristics is age, the rates will be differentiated according
to age.
The rate is the price per unit of exposure. In fire insurance, for example,
the rate may be expressed as $1 per $100 of exposed property; if an insured has
$1,000 of exposed property, the premium will thus be $10. The rate reflects three
major elements: the loss cost per unit of exposure, the administrative expenses, or
"loading," and the profit. In property insurance, approximately one-third of the
premium covers expenses and profit, and two-thirds covers the expected cost of loss
payments. These percentages vary somewhat according to the particular type of
insurance.
Rates are calculated in the following way. A policy, for instance, may be
written covering a class of automobiles with an expected loss frequency of 10 percent

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and an average collision loss of $400. The expenses of the insurer are to average 35
percent of the premium, and there must be a profit of 5 percent. The pure loss cost per
unit is 10 percent of $400, or $40. The gross premium is calculated by the formula L/
[1 - (E + P)], in which L equals the loss cost per unit, E equals the expense ratio, and
P equals the profit ratio. In this case the gross premium would be $40/[1 - (.35 + .05)],
or $66.67.
Four basic standards are used in rate making: (1) the structure of rates should
allocate the burden of expenses and costs in a way that reflects as accurately as
possible the differences in risk--in other words, rates should be fair; (2) a rate should
produce a premium adequate to meet total losses but should not bring unreasonably
large profits; (3) the rate should be revised often enough to reflect current costs; and
(4) the rate structure should tend to encourage loss prevention among those who are
insured.
Some examples will illustrate the nature and application of the criteria
outlined above. In life insurance, the rate is generally more than adequate to meet all
reasonably anticipated losses and expenses; in other words, the insured is charged an
excessive premium, part of which is then returned as a dividend according to actual
losses and expenses. The requirement that the rate reflect fairly the risk involved is
much more difficult to achieve. In workers' compensation insurance, the rate is
expressed as a percentage of the employer's payroll for each occupational class. This
may seem fair enough, but an employer with relatively high-paid workers has fewer
employees for a given amount of payroll than one whose workers are paid a lower
wage. If the two employers fall into the same occupational class and have the same
total payroll, they are charged the same premium even though one may have a larger
number of workers than the other and hence greater exposure to loss. Fairness may be
an elusive goal. Insurance rates are revised only slowly, and, since they are
based upon past experience, they tend to remain out of date. In life insurance, for
example, the mortality tables used are changed only every several years, and rate
adjustments are reflected in dividends. In automobile insurance, rates are revised
annually or even more often, but they still tend to be out of date.
Two basic rate-making systems are in use: the manual, or class-rating,
method and the individual, or merit-rating, method. Sometimes a combination of the
two methods is used. A manual rate is one that applies uniformly to each exposure
unit falling in some predetermined class or group, such as people of the same age,
workers of one employer, drivers meeting certain characteristics, or all residences in a
given area. Presumably the members of each class are so homogeneous as to be
indistinguishable so far as risk characteristics are concerned. Merit rating is used to
give recognition to individual characteristics. In commercial buildings, for example,
fire insurance rates depend on such individual characteristics as the type of
occupancy, the number and type of safety features, and the quality of housecleaning.
In an attempt to reflect the true quality of the risk, a percentage charge or credit may
be applied to the base rate for each of these features. Another example is found in
employer group health insurance plans where the premium or the rate may be adjusted
annually depending on the loss experience or on the amount of claims service
provided. In order to obtain broader and statistically sounder rates, insurers often pool
loss and claims experience by setting up rating bureaus to calculate rates based on
industrywide experience. They may have an agreement that all member companies
must use the rates thus developed. The rationale for such agreements is that they help
insurers meet the criteria of adequacy and fairness. Rating bureaus are used
extensively in fire, marine, workers' compensation, automobile, and crime insurance.

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 Underwriting cycle.

Profits in property and liability insurance have tended to rise and fall in
fairly regular patterns lasting between five and seven years from peak to peak; this
phenomenon is termed the underwriting cycle. Stages of the underwriting cycle may
be described as follows: initially, when profits are relatively high, some insurers,
wishing to expand sales, start to lower prices and become more lenient in
underwriting. This leads to greater underwriting losses. Rising losses and falling
prices cause profits to suffer. In the second stage of the cycle, insurers attempt to
restore profits by increasing rates and restricting underwriting, offering coverage only
to the safest risks. These restrictions may be so severe that insurance in some lines
becomes unavailable in the marketplace. Insurers are able to offset a portion of their
underwriting loses through earnings on investments. Eventually the increased rates
and reduced underwriting losses restore profits. At this point, the underwriting cycle
repeats itself. The general effect of the underwriting cycle on the public is to cause
the price of property and liability insurance to rise and fall fairly regularly and to
make it more difficult to purchase insurance in some years than in others. The
competition among insurers caused by the underwriting cycle tends to create cost
bargains in some years. This is especially evident when interest rates are high,
because greater underwriting losses will, in part, be offset by greater investment
earnings.

Reinsurance.

A significant insurance practice is that of reinsurance, whereby risk may be

divided among several insurers, reducing the exposure to loss faced by each insurer.
Reinsurance is effected through contracts called treaties, which specify how the
premiums and losses will be shared by participating insurers.
Two main types of treaties exist-- pro rata and excess-of-loss treaties. In the
former, all premiums and losses may be divided according to stated percentages. In
the latter, the originating insurer accepts the risk of loss up to a stated amount, and
above this amount the reinsurers divide any losses. Reinsurance is also frequently
arranged on an individual basis, called facultative reinsurance, under which an
originating insurer contracts with another insurer to accept part or all of a specific
risk. Reinsurance enlarges the ability of an originating insurer to accept risk, since
unwanted portions of the risk can be passed on to others. Reinsurance stabilizes
insurer profits, evens out loss ratios, reduces the capital needed to underwrite
business, and offers a way for insurers to divest themselves of an entire segment of
their risk portfolio.

LEGAL ASPECTS OF INSURANCE

Government regulation.

The insurance business is subject to extensive government regulation in all

countries. In European countries insurance regulation is a mixture of central and local

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controls. In Germany central authority over insurance regulation is provided by the
Federal Insurance Supervisory Authority (BAV), which exercises tight control of
premiums, reserves, and investments of insurers. The BAV's regulation of life
insurance, for example, allows no more than 20 percent of investments in equities.
In the United Kingdom, regulation generally allows the managing agency
fairly complete liberty of action and is concerned only with final business results. In
this the United Kingdom differs from most other European countries, in which the
purpose of insurance supervision is to regulate more closely the conditions in which
insurers operate.
In the countries of the European Community (EC; under articles 59-60 of
the Treaty of Rome) an attempt is being made to obtain greater uniformity among
national insurance statutes. This is intended to facilitate the operations of insurers
across national borders. Rate regulation, however, remains within the jurisdiction of
individual countries.
Although 1992 was established as the goal year for completing the
harmonization process for insurance in the EC, separate regulation in the various
countries continues. Many legal and regulatory barriers to expansion of insurance
operations in various countries in the world still exist. Examples include strict
licensing requirements, prohibiting of unadmitted insurance, mandatory hiring of
local nationals, requirements that insurers make local investments or enter into joint
ventures with local insurers, prohibition of free exchange of currencies or repatriation
of profits, and onerous taxation. An
important legal force influencing insurance regulation in such countries as France,
Belgium, Egypt, Greece, Italy, Lebanon, Spain, Turkey, and the former French
African colonies is the Napoleonic Code. The influence of the code may be seen, for
example, in the matter of third-party liability, in which the burden of proof may be
upon the defendant rather than upon the plaintiff.
In some countries not all classes of insurance are regulated. In
The Netherlands only life insurance is regulated, and in Belgium only life, industrial
injury, and thirdparty motor vehicle liability insurance. In some countries the scope of
supervision may embrace many aspects of the insurance business, but in the United
Kingdom and The Netherlands only financial matters are subject to regulation.
In several European countries insurers may not write both life
insurance and general insurance (property and liability insurance). Minimum capital
requirements vary, depending on the type of business written, usually being highest
for life insurance.
In most European countries policies are submitted to supervisory authorities
for approval or for information. In some countries standard clauses or forms of
contracts must be used; for instance, in Sweden insurers must use a standard
compulsory motor vehicle third-party liability policy, and in Switzerland a standard
contract for war risks and life insurance is required. Insurance is often compulsory. In
general, laws frequently require individuals to carry third-party liability insurance and
industrial injury insurance. Fire insurance is required on immovable property in
Germany. A number of countries require aviation insurance (for accident and
sickness) on airline passengers and crews. Although individuals generally
have the freedom to select whichever insurer they wish, there are restrictions on
buying insurance from foreign insurers. In some countries buyers must use domestic
insurers for compulsory coverages but are free to take out insurance from foreign
insurers when coverage is not available from domestic insurers. In other countries
certain types of insurance may not be placed in foreign countries. About half the

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countries of the world prohibit "nonadmitted" insurance, defined as insurance written
by an insurer not authorized to do business in that country. In the United States most
regulation of insurance is in the hands of the individual states, although the federal
government also has authority over insurers when it is deemed that state regulation
fails to regulate effectively activities such as unfair trade practices, misleading
advertising, boycotts, and monopolistic practices. States regulate four main aspects:
rate making, minimum standards for financial solvency, investments, and marketing
practices.In rate making, three basic requirements must be met: rates must be
adequate to cover expected losses, must not be excessive, and must not be unfairly
discriminatory among different classes of risk. In meeting minimum standards of
financial solvency, state laws specify minimum capital requirements, accounting
practices, minimum security deposits with state insurance commissioners, and
procedures for liquidating insolvent insurers. In investments, states limit the types and
quality of securities in which insurers may invest their assets. In marketing, states
regulate advertising, licensing of agents, policy forms and wording, service and
process procedures for handling claim disputes, expense allowances for acquiring new
business, and other agency and insurer operations, including being admitted to do
business in the state. Many states maintain a special division to register and handle
consumer complaints.

Contract law.

In general, an insurance contract must meet four conditions in order to be

legally valid: it must be for a legal purpose; the parties must have a legal capacity to
contract; there must be evidence of a meeting of minds between the insurer and the
insured; and there must be a payment or consideration.
To meet the requirement of legal purpose, the insurance contract must be
supported by an insurable interest (see further discussion below); it may not be issued
in such a way as to encourage illegal ventures (as with marine insurance placed on a
ship used to carry contraband).
The requirement of capacity to
contract usually means that the individual obtaining insurance must be of a minimum
age and must be legally competent; the contract will not hold if the insured is found to
be insane or intoxicated or if the insured is a corporation operating outside the scope
of its authority as defined in its charter, bylaws, or articles of incorporation.
The requirement of meeting of minds is met when a valid offer
is made by one party and accepted by another. The offer is generally made on a
written application for insurance. In the field of property and liability insurance, the
agent generally has the right to accept the insured's offer for coverage and bind the
contract immediately. In the field of life insurance, the agent generally does not have
this power, and the contract is not valid until the home office of the insurer has
examined the application and has returned it to the insured through the agent.

The payment or consideration is generally made up of two parts--the

premiums and the promise to adhere to all conditions stated in the contract. These
may include, for example, a warranty that the insured will take certain loss-prevention
measures in the care and preservation of the covered property.

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 Warranties.

In applying for insurance, the applicant makes certain representations or

warranties. If the applicant makes a false representation, the insurer has the option of
voiding the contract. Concealment of vital information may be considered
misrepresentation. In general, the misrepresentation or concealment must concern a
material fact--defined as a fact that would, if it were known, cause the insurer to
change the terms of the contract or be unwilling to issue it in the first place. If the
agent of the insurer asks the applicant a question the answer to which is a matter of
opinion and if the answer turns out to be wrong, the insurer must demonstrate bad
faith or fraudulent intent in order to void the contract. If, for example, in answer to an
agent's question, the applicant reports no history of serious illness, in the mistaken
belief that a past illness was minor, the court may find the statement to be an honest
opinion and not a misrepresented fact.
A basic principle of property liability insurance contracts is the principle of
subrogation, under which the insurer may be entitled to recovery from liable third
parties. In fire insurance, for example, if a neighbour carelessly sets fire to the
insured's house and the insurance company indemnifies the insured for the loss, the
company may then bring a legal action in the name of the insured to recover the loss
from the negligent neighbour. The principle of subrogation is complemented by
another basic principle of insurance contract law, the principle of indemnity. Under
the principle of indemnity a person may recover no more than the actual cash loss;
one may not, for example, recover in full from two separate policies if the total
amount exceeds the true value of the property insured.

Insurable interest.

Closely associated with the above legal principles is that of insurable

interest. This requires that the insured be exposed to a personal loss if the peril
insured against should occur. Otherwise it would be possible for a person to take out a
fire insurance policy on the property of others and collect if the property burned. Any
financial interest in property, or reasonable expectation of having a financial interest,
is sufficient to establish insurable interest. A secured creditor such as a mortgagee has
an insurable interest in the property on which money has been lent.
In the field of personal insurance one is held to have an unlimited interest
in one's own life. A corporation may take life insurance on the life of a key executive.
A wife may insure the life of her husband, and a father may insure the life of a minor
child, because there is a sufficient pecuniary relationship between them to establish an
insurable interest.In life insurance the insurable interest must exist at the time of the
contract. Continued insurable interest, however, need not be demonstrated. A
divorced woman may continue life insurance on the life of her former husband and
legitimately collect the proceeds upon his death even though she is no longer his wife.
In the field of property insurance, on the other hand, the insurable interest
must be demonstrated at the time of the loss. If an individual insures a home but later
sells it, no recovery can be made if the house burns after the sale, because the insured
has suffered no loss at the time of the fire.

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 Liability law.

In most countries, an individual may be held legally liable to another for

acts or omissions and be required to pay damages. Liability insurance may be
purchased to cover these contingencies. Legal liability
exists when an individual commits a legal injury that wrongly encroaches on another
person's rights. Such injuries include slander, assault, and negligent acts. A negligent
act involves failure to behave in a manner expected when the results of this failure
cause a financial loss to others. An act may be classed as negligent even if it is
unintentional. Negligence may be imputed from one person to another. For example, a
master is liable not only for his own acts but also for the negligent acts of servants or
others legally representing him. It is not uncommon for a municipality to require that
businesses using city property assume what would otherwise have been the city's
negligence for the use of its property. Statutes may impute liability on individuals
when no liability would exist otherwise; thus a parent may be legally liable for the
acts of a minor child who is driving the family automobile. In
common-law countries such as the United States and the United Kingdom, three
defenses may be used in a negligence action. These are assumed risk, contributory
negligence, and the fellow servant doctrine. Under the assumed risk rule, the
defendant may argue that the plaintiff has assumed the risk of loss in entering into a
given venture and understands the risks. Employers formerly used the assumed risk
doctrine in suits by injured employees, arguing that the employee understood and
assumed the risks of employment in accepting the job.
The contributory negligence defense is frequently used
to defeat negligence actions. If it can be shown that one party was partly to blame,
then that party may not collect from any negligence of the other party. Some courts
have applied a substitute doctrine known as comparative negligence. Under this, each
party is held responsible for a portion of the loss corresponding to the degree of blame
attached to that party; a person who is judged to be 20 percent to blame for an
accident may be required to pay 20 percent of the injured person's losses. The fellow
servant defense has been used at times by employers; an employer would argue in
some cases that the injury to an employee was caused not by the employer's
negligence but by the negligence of another employee. However, workers'
compensation statutes in some countries have nullified such common law defenses in
industrial injury cases. In many countries, the
courts have tended to apply increasingly strict standards in adjudicating negligence.
This has been termed the trend toward strict liability, under which the plaintiff may
recover for almost any accidental injury, even if it can be shown that the defendant
has used "due care" and thus is not negligent in the traditional sense. In the United
States, manufacturers of polio vaccine that was found to have caused polio were
required to pay large damage claims although it was demonstrated that they had taken
all normal precautions and safeguards in the manufacture of the vaccine.

Historical development of insurance

Insurance in some form is as old as historical society. So-called bottomry

contracts were known to merchants of Babylon as early as 4000-3000 BC. Bottomry
was also practiced by the Hindus in 600 BC and was well understood in ancient

239
Greece as early as the 4th century BC. Under a bottomry contract, loans were granted
to merchants with the provision that if the shipment was lost at sea the loan did not
have to be repaid. The interest on the loan covered the insurance risk. Ancient Roman
law recognized the bottomry contract in which an article of agreement was drawn up
and funds were deposited with a money changer. Marine insurance became highly
developed in the 15th century. In Rome there were also
burial societies that paid funeral costs of their members out of monthly dues.

The insurance contract also developed early. It was known in ancient Greece
and among other maritime nations in commercial contact with Greece.

England.

Fire insurance arose much later, obtaining impetus from the Great Fire of
London in 1666. A number of insurance companies were started in England after
1711, during the so-called bubble era. Many of them were fraudulent, get-rich-quick
schemes concerned mainly with selling their securities to the public. Nevertheless,
two important and successful English insurance companies were formed during this
period -- the London Assurance Corporation and the Royal Exchange Assurance
Corporation. Their operation marked the beginning of modern property and liability
insurance. No discussion of the early development of insurance in Europe would
be complete without reference to Lloyd's of London, the international insurance
market. It began in the 17th century as a coffeehouse patronized by merchants,
bankers, and insurance underwriters, gradually becoming recognized as the most
likely place to find underwriters for marine insurance. Edward Lloyd supplied his
customers with shipping information gathered from the docks and other sources; this
eventually grew into the publication Lloyd's List, still in existence. Lloyd's was
reorganized in 1769 as a formal group of underwriters accepting marine risks. (The
word underwriter is said to have derived from the practice of having each risk taker
write his name under the total amount of risk that he was willing to accept at a
specified premium.) With the growth of British sea power, Lloyd's became the
dominant insurer of marine risks, to which were later added fire and other property
risks. Today Lloyd's is a major reinsurer as well as primary insurer, but it does not
itself transact insurance business; this is done by the member underwriters, who
accept insurance on their own account and bear the full risk in competition with each
other.

United States.

The first American insurance company was organized by Benjamin

Franklin in 1752 as the Philadelphia Contributionship. The first life insurance
company in the American colonies was the Presbyterian Ministers' Fund, organized in
1759. By 1820 there were 17 stock life insurance companies in the state of New York
alone. Many of the early property insurance companies failed from speculative
investments, poor management, and inadequate distribution systems. Others failed
after the Great Chicago Fire in 1871 and the San Francisco earthquake and fire of

240
1906. There was little effective regulation, and rate making was difficult in the
absence of cooperative development of sound statistics. Many problems also beset the
life insurance business. In the era following the U.S. Civil War, bad practices
developed: dividends were declared that had not been earned, reserves were
inadequate, advertising claims were exaggerated, and office buildings were erected
that sometimes cost more than the total assets of the companies. Thirty-three life
insurance companies failed between 1870 and 1872, and another 48 between 1873
and 1877.
After 1910 life insurance enjoyed a steady growth in the United States. The
annual growth rate of insurance in force over the period 1910-90 was approximately
8.4 percent--amounting to a 626-fold increase for the 80-year period. Property-
liability insurance had a somewhat smaller increase. By 1989 some 3,800 property-
liability and 2,270 life insurance companies were in business, employing nearly two
million workers. In 1987 U.S. insurers wrote about 37 percent of all premiums
collected worldwide.

Japan.

Insurance in Japan is mainly in the hands of private enterprise, although

government insurance agencies write crop, livestock, forest fire, fishery, export credit,
accident and health, and installment sales credit insurance as well as social security.
Private insurance companies are regulated under various statutes. Major classes of
property insurance written include automobile and workers' compensation (which are
compulsory), fire, and marine. Rates are controlled by voluntary rating bureaus under
government supervision, and Japanese law requires rates to be "reasonable and
nondiscriminatory." Policy forms generally resemble those of Western nations.
Personal insurance lines are also well developed in Japan and include ordinary life,
group life, and group pensions. Health insurance, however, is incorporated into
Japanese social security.
Japan's rapid industrialization after World War II was accompanied by an
impressive growth in the insurance business. Toward the end of the 20th century,
Japan ranked number one in the world in life insurance in force. It accounted for
about 25 percent of all insurance premiums collected in the world, ranking second
behind the United States. The number of domestic insurers is relatively small; foreign
insurers operate in Japan but account for less than 3 percent of total premiums
collected.

Worldwide operations.

Because of the great expansion in world trade and the extent to which
business firms make investments outside their home countries, the market for
insurance on a worldwide scale has expanded rapidly in the 20th century. This
development has required a worldwide network of offices to provide brokerage
services, underwriting assistance, claims service, and so forth. The majority of the
world's insurance businesses are concentrated in Europe and North America. These
companies must service a large part of the insurance needs of the rest of the world.

241
The legal and regulatory hurdles that must be overcome in order to do so are
formidable.
In 1990 the 10 leading insurance markets in the world in terms of the
percentage of total premiums collected were the United States (35.6 percent); Japan
(20.5 percent); the United Kingdom (7.5 percent); Germany (6.8 percent); France (5.5
percent); the Soviet Union (2.6 percent); Canada (2.3 percent); Italy (2.2 percent);
South Korea (2.0 percent); and Oceania (1.8 percent). Major world trends in
insurance include a gradual movement away from nationalism of insurance, the
development of worldwide insurance programs to cover the operations of
multinational corporations, increasing use of reinsurance, increasing use by
corporations of self-insurance programs administered by wholly owned insurance
subsidiaries (captive companies), and increasing use of mergers among both insurers
and brokerage firms.

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 Economic Theory

Introduction

Economic theory is the name commonly given to the more general and
abstract parts of economics, the principles. These parts are no less practical than
concrete-descriptive or applied economics but are less directly related to immediate
problems. The mechanics of price relations or of markets afford a general explanation
of the organization of production and distribution insofar as this is actually worked
out and controlled through competitive buying and selling--which would largely be
true even in a planned or socialistic economy that stopped short of complete military
regimentation. This branch of the study bears somewhat the same relation to
economic politics that pure physics bears to the engineering sciences. Hence the
problems of value and distribution have continued to hold their place among the
central concerns of economists. However, there has been a notable--one might say a
revolutionary--change in the general character of the analysis. The older classical
economists centered their attention on the long-run relations between value and costs
and were generally content to dispose of short-run variations of price by merely
invoking the formula of supply and demand. This was used without careful analysis of
the short-run situation, particularly of the role of demand. Work directed toward
filling in this gap had important effects in changing the whole conceptual picture.
Enlarged theories of production, distribution, consumption, business fluctuations, and
other economic elements
have been introduced and continually reconsidered from a variety of
viewpoints.

Utility and value

One purpose of value theory in economics is to explain how the prices of

goods and services are determined. This is only a step, however, in the analysis of a
deeper problem. The modern industrial economy is characterized by a high degree of
interdependence of its parts. The supplier of components or raw materials, for
example, must deliver the desired quantities of his products at the right moment and
in the desired specifications. In economies such as those of Western Europe, North
America, and Japan, the coordination of these activities is done through the price
system. The relative prices of the various inputs (e.g., labour, materials, and
machinery) tend to determine the proportions in which they will be used. Prices also
affect the relative outputs of the various final products, and they determine who will
consume them. Value theory, therefore, studies the structure of these decisions,
analyzes the influence of prices, and examines the efficiency of the resulting
allocation of resources. Value theory is also applied by business firms and
government agencies in their decisions that relate to pricing and the allocation of
resources.

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 THEORIES OF VALUE

Cost-of-production analysis.

Modern value theory began with Adam Smith (1776), David Ricardo (1817),
and a number of other writers, who are generally lumped together as the classical
school. These writers sought to explain pricing primarily on the basis of cost of
production. That is, if commodity A costs twice as much to produce as commodity B,
the price of A will be pushed toward a level twice as high as that of B. If this were not
the case--if, for example, A sold for three times the price of B--then the greater
profitability of investment in A would cause its production to increase and drive down
its price, while the production of B would decline, thus raising its price. Prices would
finally be driven to the 2:1 ratio of the costs of production.
The classical economists were well aware of the oversimplification in this
explanation, but, as with most theoretical analysis, its strength lay in the amount it
was able to explain with a very simple model. (It is highly misleading to interpret the
classical analysis literally, as a picture of its authors' views of the complex world of
reality.) It was soon recognized, however, that the cost-of-production analysis
considered only part of the relevant problem. Since cost depends on the quantity
produced (e.g., costs per unit may decline as production of an item increases), the
analysis must take into account the demand for the product. The analysis of demand
was made possible by the theory of utility, developed by H.H. Gossen in Germany
(1854), Karl Menger in Austria (1871), Léon Walras in France (1874-77), and W.S.
Jevons in England (1871).
The role of utility analysis in value theory will be discussed later. It need only
be added at this point that modern value theory, following the lead of the English
economist Alfred Marshall ( Principles of Economics, 8th ed., 1920), considers prices
to be determined simultaneously by cost and demand considerations. The analysis
also recognizes the complex interdependencies in the system, with demands and
supplies of various commodities affecting one another.

THEORIES OF UTILITY

There are two sides to the analysis of price and value: the supply side and the
demand side. If cost can be said to underlie the supply relationship that determines
price, the demand side must be taken to reflect consumer tastes and preferences.
"Utility" is a concept that has been used to describe these tastes. As already indicated,
the cost-of-production analysis of value given above is incomplete, because cost itself
depends on the quantity produced. The cost analysis, moreover, applies only to
commodities the production of which can be expanded and contracted. The price of a
first-folio Shakespeare has no relation to cost of production; it must depend in some
sense on its utility to purchasers as it affects their bids.

Marginal utility.

The classical economists suggested that this leads to a paradox. They argued
that utility could not explain the relative price of fine jade and bread, because the
latter was for many consumers essential to life, and hence its utility must surely be
greater than that of jade. Yet the price of bread is far lower than that of jade. The
theory of marginal utility that flowered toward the end of the 19th century supplied

244
the key to the paradox and provided the basis for today's analysis of demand.
Marginal utility was defined as the value to the consumer of an additional unit of
some commodity. If, for example, the consumer is offered a choice between 22 and
23 slices of bread for his family, marginal utility measures how much more valuable
23 slices are than 22. It is clear that the magnitude of the marginal utility varies with
the magnitude of, say, the smaller of the alternatives. That is, for a family of four, the
difference between seven and eight slices of bread per day can be substantial, if the
family will still be hungry in either case. But the difference in value between 31 and
32 slices may be negligible. If 31 slices offer enough for everyone to fill his stomach,
a 32nd slice may be worth very little. Moreover, the difference in value between 122
and 123 slices may be negative--a 123rd slice may just add to the family's disposal
problem. These observations lead directly to the plausible notion that marginal utility
in some sense diminishes with the base from which one starts the calculation. With
only seven or eight slices the marginal utility (incremental value) of an eighth slice is
high. With 31 or 32 slices it is lower, and so on. The less scarce a commodity, the
lower is its marginal utility, because its possessor in any case will have enough to
satisfy his most pressing uses for it, and an increment in his holdings will only permit
him to satisfy, in addition, desires of lower priority.
The consumer will be motivated to adjust his purchases so that the price of
each and every good will be approximately equal to its marginal utility (that is, to the
amount of money he is willing to pay for an additional unit). If the price of an item is
P dollars, for example, and the consumer is considering buying, say, 10 units, at
which point the marginal utility of the good to him is M (which is greater than P), the
consumer will be better off if he purchases 11 rather than 10 units, since the additional
unit costs him P dollars. He will keep revising his purchase plans upward until he
reaches the point where the marginal utility of the item falls to P dollars. In sum, the
consumer's self-interest will lead him (without conscious calculation) to purchase an
amount such that the marginal utility is as close as possible to market price. So long
as the consumer selects a bundle of purchases that gives him the most benefit
(pleasure, utility) for his money, he must end up with quantities such that the marginal
utility of each commodity in the bundle is approximately equal to its price.
It now becomes easy to explain the paradox underlying the relationship
between the prices of jade and bread. Because a piece of fine jade is scarce, its
marginal utility is high, and consumers are willing to pay comparatively high prices
for it. The explanation is perfectly consistent with a utility analysis of demand, so
long as one relates price to the marginal utility of the item rather than to its total
utility. A family's bread may be very valuable to it, but, if it has enough, the marginal
utility of the bread will be small, and this will be reflected in its low price.

Figure 1: Relationship
between marginal utility
and quantity

The relationship between

price and marginal utility is
important not because it
explains issues like the
jade- bread paradox but

245
because it enables one to analyze the relationship between prices and quantities
demanded. It also, as a practical matter, permits one to judge how well any portion of
the price mechanism is working as a device to secure the efficient satisfaction of the
wants of the public, within the limits set by available resources. The conclusion that at
any price the consumer will purchase the quantity at which marginal utility is equal to
price makes it possible to draw a demand curve showing--to a reasonable degree of
approximation--how the amount demanded will vary with price. A curve based on the
previous example of bread consumption is given in Figure 1. This shows that if the
family gets 10 slices per day the marginal utility of bread will be nine cents (point A).
One may reverse the question and ask how much the family would purchase at any
particular price, say three cents. The graph indicates that at this price the quantity
would be 30 slices, because only at that quantity is marginal utility equal to the three-
cent price (point B). Thus the curve in Figure 1, to a reasonable degree of
approximation, may be able to do double duty: it may serve as a marginal-utility
curve relating marginal utility to quantity and, at the same time, as a demand curve
relating quantity demanded to price.

Consumers' surplus.

Figure 1 leads to an important conclusion about the consumer's gains from his
purchases. The diagram shows that the difference between 10 and 11 slices of bread is
worth nine cents to the consumer (marginal utility = nine cents). Similarly, a 12th
slice of bread is worth eight cents (see the shaded bars). Thus, the two slices of bread
together are worth 17 cents, the area of the two rectangles together. Suppose the price
of bread is actually three cents, and the consumer, therefore, purchases 30 slices per
day. The total value of his purchases to him is the sum of the areas of all such
rectangles for each of the 30 slices; i.e., it is (approximately) equal to all of the area
under the demand curve; that is, the area defined by the points 0CBE. The amount the
consumer pays, however, is less than this area. His total expenditure is given by the
area of rectangle 0CBD--90 cents. The difference between these two areas, the quasi-
triangular area DBE, represents how much more the consumer would be willing to
spend on the bread over and above the 90 cents he actually pays for it, if he were
forced to do so. It represents the absolute maximum that could be extracted from the
consumer for the bread by an unscrupulous merchant who had cornered the market.
Since, normally, the consumer only pays quantity 0CBD, the area DBE is a net gain
derived by the consumer from the transaction. It is called consumers' surplus.
Virtually every purchase yields such a surplus to the buyer.
The concept of consumers' surplus is important for public policy, because it
offers at least a crude measure of the public benefits of various types of economic
activity. In deciding whether a government agency should build a dam, for example,
one may estimate the consumers' surplus from the electricity the dam would generate
and seek to compare it with the surplus that could be yielded by alternative uses of the
resources needed to construct and operate the dam.

Utility measurement and ordinal utility.

As originally conceived, utility was taken to be a subjective measure of

strength of feeling. An item that might be described as worth "40 utils" was to be
interpreted to yield "twice as much pleasure" as one valued at 20 utils. It was not long
before the usefulness of this concept was questioned. It was criticized for its

246
subjectivity and the difficulty (if not impossibility) of quantifying it. An alternative
line of analysis developed that was able to accomplish most of the same purposes but
without as many assumptions. First introduced by the economists F.Y. Edgeworth in
England (1881) and Vilfredo Pareto in Italy (1896-97), it was brought to fruition by
Eugen Slutsky in Russia (1915) and J.R. Hicks and R.D.G. Allen in Great Britain
(1934). The idea was that to analyze consumer choice between, say, two bundles of
commodities, A and B, given their costs, one need know only that one is preferred to
another. This may at first seem a trivial observation, but it is not as simple as it
sounds.

Figure 2: Commodities X and Y

In the following discussion, it is assumed for simplicity that there are only two
commodities in the world. Figure 2 is a graph in which the axes measure the
quantities of two commodities, X and Y. Thus, point A represents a bundle composed
of seven units of commodity X and five units of commodity Y. The assumption is
made that the consumer prefers to own more of either or both commodities. That
means he must prefer bundle C to bundle A, because C lies directly to the right of A
and hence contains more of X and no less of Y. Similarly, B must be preferred to A.
But one cannot say, in general, whether A is preferred to D or vice versa, since one
offers more of X and the other more of Y.

Figure 3: Indifference
curves

The consumer may in

fact not care whether he receives
A or D--that is, he may be
indifferent (see Figure
3). Assuming that there is
some continuity in his
preferences, there will be
a locus connecting A and D, any
point on which (E or A or D)
represents bundles of
commodities of equal
interest to this consumer. This locus (I-I' in Figure 3) is called an indifference curve. It
represents the consumer's subjective trade off between the two commodities--how

247
much more of one he will have to get to make up for the loss of a given amount of
another. That is, one may treat the choice between bundle D and bundle E as
involving the comparison of the gain of quantity FD of X with the loss of FE of Y. If
the consumer is indifferent between D and E, the gain and loss just offset one another;
hence, they indicate the proportion in which he is willing to exchange the two
commodities. In mathematical terms, FE divided by FD represents the average slope
of the indifference curve over arc ED; it is called the marginal rate of substitution
between X and Y.
Figure 3 also contains other indifference curves, some representing
combinations preferred to A (curves lying above and to the right of A) and some
representing combinations to which A is preferred. These are like contour lines on a
map, each such line being a locus of combinations that the consumer considers
equally desirable. Conceptually, through every point in the diagram there is an
indifference curve. Figure 3, with its family of indifference curves, is called an
indifference map. This map obviously does no more than rank the available
possibilities; it indicates whether one point is preferred to another but not by how
much it is preferred.
It is easy to show that at any point such as E the slope of the indifference
curve, roughly FE divided by ED, equals the ratio of the marginal utility of X to the
marginal utility of Y for the corresponding quantities. For in moving from E to D the
consumer gives up FE of Y, a loss valued, by definition, at approximately FE
multiplied by the marginal utility of Y, and he gains FD of X, a gain worth FD
multiplied by the marginal utility of X. Relative marginal utilities can be measured in
this way because their ratio does not measure subjective quantities--rather, it
represents a rate of exchange of two commodities. The marginal utility of X measured
in money terms tells one how much of the commodity used as money the consumer is
willing to give for more of the commodity X but not what psychic pleasure the
consumer gains.

PRICES AND INCOMES

One other type of information is needed to complete the analysis of consumer

choice: the prices of X and Y and the amount the consumer has available to spend. In
what follows, it will be assumed that the consumer spends all his money on the
available commodities (savings bonds being among the commodities). If PX and PY
are the prices of commodities X and Y, respectively, and M represents the amount of
money available for spending, the condition that all of the money is spent yields the
equation

or, solving for Y in terms of X,

248
 (2)This is obviously the equation of a straight line with slope and with y-
intercept.
The line, called the budget line, or price line, represents all the combinations
of X and Y that the consumer can afford to buy with income M at the given prices.

Equilibrium of the consumer.

Figure 4: Indifference
curves and a price line

Figure 4 combines this

price line and the indifference
curves, permitting direct analysis
of the consumer purchase
decision. Line PP' is the price line
corresponding to equation
(2) above. Any point R on
that line represents a combination
of X and Y that a given consumer
can afford to purchase;
however, R is not an optimal choice. This can be seen by comparing R with S on the
same price line. Since S lies on a higher indifference curve than R, the former is the
preferred position, and, since S costs no more than R (they are on the same price line,
so each costs M dollars), S gives the consumer more for his money. It is at T,
however, the point of tangency between the price line and an indifference curve, that
the consumer reaches his highest indifference curve; this is, therefore, the optimal
point for him, given his pattern of tastes as shown by the shapes of his indifference
curves. This is the solution of the choice problem—it explains, in principle, the
consumer's purchase decision on the basis of his given preferences, with no
assumptions as to degrees of measurable utility.
The tangency at the solution point has a significant interpretation. It was noted
above that the slope of the indifference curve is the ratio of the marginal utilities of
the two commodities. It follows that, at the optimal point T, a dollar of expenditure
must offer the same utility whether spent on X or on Y. If this is not so--as at point R
in Figure 4, where the consumer gets more for his money by spending a dollar on Y
rather than on X--it will pay him to reallocate his expenditures between the two
commodities accordingly, moving toward S from R.

Changes in prices and incomes.

249
 Figure 5: (A) Positive and (B) negative income-consumption curves

The diagram becomes more illuminating when one investigates how the
consumer's decision is affected by a change in his income or in the price of a
commodity. Equation (2) indicates that a change in income, M, does not affect the
slope of the price line, only its intercept. Thus, as the person's income increases, the
price line undergoes a sequence of parallel shifts (Figure 5). For each such line there
will be a point of tangency, T, with an indifference curve, showing the consumer's
optimal bundle of purchases with the corresponding income. The locus of these points
(T1, T2, T3 . . .) may be called the income-consumption curve; it shows how the
consumer's purchases vary with his income. Normally the curve will have a positive
slope, as EE' does in Figure 5A, meaning that as a person grows wealthier he will buy
more of each commodity. But the slope can be negative for some stretches (GG' in
Figure 5B). In that case, X is said to be an inferior good of which the consumer buys
less as his income rises.

Figure 6: Price-consumption curve

The diagram can also be used to show what happens as the price of X varies.
From equation (2) it can be seen that the Y-intercept is not affected by an increase in
the price of X but that the slope of the price line grows. Thus, as PX rises, the price
line shifts from PP' to PR' in Figure 6. This means that, as PX rises, M dollars will buy
as much of good Y as before (the position of point P at which all M dollars are spent
on commodity Y does not change), but that M dollars will now buy less of good X, so
that the position of point P' must move toward the left. Once again, by following the
points of tangency between indifference curves and the price lines for various values
of PX, one contains a locus UU', the price-consumption curve, showing how the
consumer's purchases vary with PX.

250
 Income and substitution effects.

Figure 7: Income effect and substitution effect

It is useful to divide the effects of the price change conceptually into two
parts. An increase in the price of X obviously affects the relative cost of X and Y. But
it also decreases the consumer's overall purchasing power. The effect on purchases of
this reduction of purchasing power is called the income effect of the price change. Its
effect via the relative price change is called the substitution effect. The division can
be carried out graphically as follows: let the price of X increase so that the price line
in Figure 7 moves from PP' to PR', and assume an imaginary intermediate price line,
LL', with the slope of PR' but tangent to the indifference curve that was attained with
the old price line PP'. The imaginary price line has the following properties: (1) it
involves the same real income as PP' (tangency points T and S are the same
indifference curve), and (2) it involves the same relative prices as the new price line
since their slopes are the same. The rise in price has, in the figure, caused the demand
for X to fall from C to A (the quantities of X corresponding to tangency points T and
U). It has been possible to divide the total effect, CA, into two parts, the income
effect, BA, and the substitution effect, CB. This breakdown is important, because a
number of interesting and important theorems can be proved about the substitution
effect. Two of these theorems will illustrate the point.
Under the normal assumptions of demand theory it can be proved that a rise in
the price of X must, via the substitution effect, work to reduce the demand for X; the
second theorem states the surprising result that, considering only substitution effects,
a dollar rise in the price of X must change the demand for Y by precisely the same
amount as a dollar rise in the price of Y changes the demand for X. Similar
relationships have been shown to hold when there are more than two commodities
involved.

Price

The price system, as it exists in western Europe and the Americas, is a means
of organizing economic activity. It does this primarily by coordinating the decisions
of consumers, producers, and owners of productive resources. Millions of economic
agents who have no direct communication with each other are led by the price system
to supply each other's wants. In a modern economy the price system enables a
consumer to buy a product he has never previously purchased, produced by a firm of

251
whose existence he is unaware, which is operating with funds partially obtained from
his own savings.
Prices are an expression of the consensus on the values of different things, and
every society that permits exchanges among men has prices. Because prices are
expressed in terms of a widely acceptable commodity, they permit a ready
comparison of the comparative values of various commodities--if shoes are $15 per
pair and bread 30 cents per loaf, a pair of shoes is worth 50 loaves of bread. The price
of anything is its value in exchange for a commodity of wide acceptability (money):
the price of an automobile may be some 50 ounces of gold or 25 pieces of paper
bearing the picture of an eminent statesman.
A system of prices exists because individual prices are related to each other.
If, for example, copper rods cost 40 cents a pound and the process of drawing a rod
into wire costs 25 cents a pound, then, if the price of wire exceeds 65 cents, it will be
profitable to produce wire; and if the price of wire falls below 65 cents, it will be
ruinous to produce wire. Competition, therefore, will hold the price of wire about 25
cents per pound above that of rods. A variety of such economic forces ties the entire
structure of prices together.
The system of prices can be arranged to reward or penalize any kind of
activity. Society discourages the production of electric shoestring-tying machines by
the simple expedient of making such a machine's attainable selling price less than the
prices of the resources necessary to produce it. Society stimulates people of large
athletic promise to learn golf (rather than polo or cricket) by the immense prizes (=
prices) that are given to tournament winners. The air in many cities is dirty because no
one is charged a price for dirtying it and no one can pay a price for having it cleaned.

THE BASIC FUNCTIONS OF ECONOMIC SYSTEMS

Every economic system has three functions. In a decentralized (usually private

enterprise) economic system, the price mechanism is the instrument by which these
functions are performed.

Product and quantity.

One function is to determine what is to be produced and in what quantity.

Even a primitive economy must choose between food and shelter, weapons and tools,
priests and hunters. In a modern economy the potential variety of goods and services
that may be produced is immense. Consider simply the 10,000 new book titles that are
published each year or the hundreds of colours of paint or the thousands of styles of
clothing that are produced--each of these actual collections being much smaller than
modern technology permits.
A price system weighs the desires of consumers in terms of the prices they are
willing to pay for various quantities of each commodity or service. The payment of
$1,000 for the services of a skilled surgeon (a price much influenced by the number of
surgeons) reflects the great importance of his services to the buyer-patient, whereas
the offer of 75 cents for a month's use of an additional telephone outlet reflects the
minor convenience it provides. Of course the offers of consumers are influenced by
their wealth as well as their desires, but for any one consumer relative desires are
proportional to price offers.
Universal laws are most uncommon in social life. Economists nonetheless
place immense confidence in the proposition that the consumer will buy less of any

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commodity when its price rises. This law of demand is by no means a necessary fact
of life; rather it is an empirical rule to which there are no known, reliable exceptions.
Bread, caviar, education, narcotics--a man will buy more of each when its price falls.
These demand prices are the guides to producers that in effect tell them which
commodities to produce and in what quantities.

Production.

The second function an economy must perform is to decide how the desired
goods are to be produced. There is more than one way not only to skin a cat but also
to grow wheat, train lawyers, refine petroleum, and transport baggage. The efficient
production of goods requires that certain obvious rules be followed: no resource
should be used in producing one thing when it could be producing something more
valuable elsewhere; and each product should be made with the smallest possible
amount of resources.
A functioning price system steers resources into their most important use by
appealing to the desires of their owners for large incomes. For example, the person
capable of being a surgeon is drawn to this occupation from, say, that of a high school
teacher by the promise of annual earnings (= price of labour) much more than those of
the high school teacher. Capital is drawn from a faltering trade to a booming new
industry in which it receives a higher return.
This same price system seeks to achieve production efficiency through the
sanction of competition. If one firm, for instance, can produce shoes with fewer
resources than its rivals, it will make larger profits; so it is stirred to discover more
efficient combinations of inputs and location of plant, to devise wage systems to
stimulate its workers, to use computers to reduce inventories, and so forth without
end.

Distribution.

The third function of an economy is to determine who gets the product. Family
A gets $5,000 worth of goods this year, family B five times as much--how is the
division to be decided? The incomes of individuals are determined by the quantities of
resources (labour skills, capital in all its forms) they own and the prices they receive
for the use of these resources. Workers are incited by the price system to acquire new
skills and to exercise them diligently, and families are encouraged to savings (capital
accumulation) by the payment of interest or dividends. The inheritance of both
personal ability and wealth also enter into the distribution of income.
If the price system is working reasonably well (some of the common failures
will be noted later), it performs all of these economic functions with remarkable
subtlety and precision. Society desires not only the correct amount of wheat but also
that it be consumed more or less evenly over the crop year, with a surplus to carry
over in case of a partial failure of the next year's crop. The price system provides a
seasonal price pattern that encourages the holding of inventories rather than early
splurging and richly rewards speculators who correctly anticipate a crop failure and
hold grain that will alleviate it. In the same way, the desires of every sizable group of
consumers (or resource owners) are registered through the price system; entrepreneurs
are incited by price offers to provide opera and musical comedy, kosher food, and
Persian delicacies. One might almost say that the price system is devoted to minority

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rule, since the only pressure toward uniformity is in the possibility of lowering costs
of production by standardizing goods.
High prices in a properly functioning price system thus serve as incentives to
produce more and consume less, and lower prices serve as corresponding deterrents.
In addition the price system is a method of communicating information. Herbert
Spencer once stated, rather ponderously, that only by constant iteration can alien
truths be impressed upon reluctant minds: the price system, with its capacity for
infinite repetition, is well suited to this sometimes unpleasant task. A higher price of
steel scrap, for example, tells thousands of owners and collectors of scrap that more
scrap is wanted and that more exhaustive search for abandoned rails, boilers,
radiators, and machines is worth undertaking. A higher price of gasoline tells
thousands of automobile drivers that gasoline should be used more sparingly, and the
message is repeated each time each driver purchases more gasoline.

THE WORKINGS OF THE PRICE SYSTEM

The complexity and variety of tasks performed by the price system will be
illuminated by an examination of three specific economic problems.

The choice of occupation.

Individuals must be distributed among occupations in such a way as to serve

two basic purposes. First, the labourer must be placed where he is most productive--
making certain that Enrico Fermi becomes a physicist rather than a chef and that there
are not too many plumbers and too few electricians. Second, the individual worker
should be given an occupation that is congenial to him: since he will spend a large
part of his life at work, it will be a better life if he can choose the type he prefers.
The price of labour is the instrument by which workers are distributed among
occupations: wages in rapidly growing occupations and rapidly growing parts of the
nation are higher than in corresponding employment in declining occupations and
areas. The choice of occupation involves, however, much more than simply a
comparison of wage rates. The following are a few of the complications: (1) The
wages of an occupation must as a rule be sufficient to compensate the costs of
training. (2) The wages of an occupation must be sufficient to compensate special
disadvantages (such as a large chance of unemployment). (3) Wages must be higher in
large cities than in small because living costs are higher in large cities. (4) Wages
must compensate workers for their additional skill as they acquire experience (they
usually reach a peak of earnings between ages 40 and 55) and thereafter decline as the
worker's efficiency declines. (5) Wages will reflect differences in taxation, fringe
benefits (pensions, vacations), etc. Accordingly the wage structure even for a single
occupation in a single city is elaborate. When a single wage (price) is imposed upon
an occupation, labourers are no longer properly distributed by wages; for example, a
city school system that pays all teachers of given experience the same wage finds it
difficult to staff its less attractive schools.
The preferences of the individual worker cannot be given full play, or each
person would become president of the corporation at a sumptuous salary. Yet the
labourer may choose to live in California rather than Maine; then the price system will
incite employers to move their operations to California, where they can hire this
labourer more cheaply. The labourer may prefer to work long hours or short hours,
and employers are induced by wage offers to cater to the labourer's diverse

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preferences. In fact it is equally appropriate to speak of the worker buying conditions
of work and of the employer buying the services of the worker.

The conservation of resources.

A society has some resources that can be replaced by investment: timber is

now largely grown as a commercial crop. Farmland is a more ancient example: the
fertility of soil can be increased by prudent cultivation. Other resources are not
replaceable, such as coal and petroleum. How does the price system conserve these
exhaustible resources?
The method of using a resource is independent of the pattern over time of
income and expenditures that the owner of the resource desires. Suppose that a farm
will have a value of $100,000 if it is maintained at a constant level of fertility and
yields a yearly income of $10,000 forever but that it can be cultivated ("mined")
intensively to yield $12,000 a year for five years at the cost of a much reduced yield
thereafter, with a value of $90,000. Even if the farmer is in urgent need of immediate
funds and does not expect to live more than five years, he will still cultivate the farm
at the uniform rate. Only then is it worth its maximum value to him, and only then (by
sale or mortgage) can he obtain the largest possible funds even in the near future. In
short, one need not adapt his expenditure pattern to his income pattern so long as he
can borrow or lend.
If the growth of consumption or the decline of reserves threaten the exhaustion
of supplies of a resource, then the price of that resource will rise and promise to rise
more in the future, and this rise will serve to reduce current consumption and to
reward the owner of the resource for holding back much of the supply for the future.
This rise in price will therefore also stimulate buyers to find more economical ways of
using the commodity (for example, burning the fuel more efficiently) and stimulate
producers to find new supplies or substitute products. The price system will,
therefore, ensure that the supply of the resource will be stretched out so that the
resource will be available in both the present and the future.
LIMITATIONS AND FAILURES OF THE PRICE SYSTEM

The price system is an extraordinarily powerful instrument in organizing an

economic system, but it is subject to three broad classes of limitations.

Private and public price control.

Sometimes prices are not permitted to do their work. Monopolies are able to
exert control over prices; and they use it, sensibly enough, to raise their profits above
the level allowed by competition. The monopolist (or group of colluding enterprises)
sets prices at a level such that prices are above costs or, to use words of identical
significance, such that resources earn more in the monopolized industry than they can
earn elsewhere. The basis of the monopoly is its ability to prevent outsiders from
entering the industry to share in the unusual profits and, by the act of producing,
actually serve to eliminate them.
The fixing of prices by monopolists reduces the income of society. This is, in
fact, the only well-established criticism (on grounds of efficiency) to be levied against
monopolies: there is no reason to assume that they will make products less suited to
consumer tastes or innovate more slowly or pay lower wages or otherwise misallocate
resources. But the basic inefficiency led, first in the United States in 1890 and then

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increasingly in European nations, to governmental policies to maintain or restore
competition.
Public price control has two aspects. A large part of public regulation is
intended to correct monopolistic pricing (or other failures of the price system); this
includes most public-utility regulation in the United States (transportation, electricity,
and gas, etc.). Whatever the success of these endeavours--and on the whole there has
been a substantial decline in confidence in the regulatory bodies--they are usually
instructed to achieve the goals of an efficient price system.
Other public price controls are designed to serve ends outside the reach of the
price system. Prices of farm products are regulated (raised) in most nations with the
intention of improving farmers' incomes, and the fixing of interest rates paid by banks
is undertaken to improve bank earnings. Such policies are invariably defended on
various economic and ethical grounds but reflect primarily the political strength of
large and well organized producer groups.

Externalities and the price system.

A second class of limitations consists of things that should be done but are not
performable by a price system. Even when prices are freely established by
competition, there is a class of economic relationships called "externalities" not
efficiently controlled by prices. These may be illustrated by the air pollution caused
by automobiles. Since no single automobile makes a significant contribution to air
pollution, the owner has no incentive to bear the cost of installing antipollution
devices even though all drivers would be better off if each did so. Yet if there are
many automobiles in a region, it would be prohibitively expensive for drivers to
contract with one another to have each install devices in his automobile to reduce
pollution. The external effects of any one automobile's exhaust fumes are so diffuse
and affect any one person so triflingly that they cannot be regulated by the price
system.
The class of "externalities" is as broad as the class of actions that have effects
upon people who are not parties to the contracts governing the actions. An attractive
garden pleases passers-by, but they cannot be charged a portion of its cost. A new
piece of scientific knowledge will prove useful to unknown persons. These two
examples indicate that some externalities are economically trivial and some are highly
important.
When the price system cannot deal with diffused effects, other social controls
often take its place. The state invokes a whole arsenal of policies to deal with
externalities, of which the following are only examples: (1) The state may subsidize
activities that do not end in a product that can be sold. Thus basic scientific research
that does not lead to patentable processes is subsidized. (2) Individuals may be
compelled to act uniformly in areas where contracts would be too expensive; traffic
laws, zoning laws, and compulsory vaccination are examples. (3) The state may itself
undertake an activity that cannot be financed by sale of services, the most obvious
example being national defense.
An interesting type of externality is the problem of highway congestion. Any
one person's presence on a highway at a time and place of peak density has only a
negligible effect upon others, so that, except on toll roads, private contracts have not
been feasible. The state itself has not been able to deal effectively with highway
congestion. More highways can be built until no highway is ever crowded, but this
would be intolerably expensive. The state has lacked a method of inducing drivers to

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shift to less crowded hours and routes by charging fees to those drivers who impose
high congestion costs by driving at peak times. Recent developments in technology
may make it feasible to use the price system to reduce congestion. For example,
cameras at appropriate points could photograph automobile licenses and a computer
could accumulate the charges based on route and time for each automobile. Then only
a person for whom travel at peak times was worth, for example, 25 cents per mile
would impose (and pay for) the congestion he created.

Imperfect knowledge and tastes.

A third class of limitations to which the price system is subject has to do with
the control of knowledge and tastes. To the extent that an economic actor, whether a
consumer, a labourer, or an investor, is poorly informed, he is likely to make
decisions whose consequences are much different from those he desired and expected.
What follows relates only to consumer decisions, but parallel issues arise in labour
markets, securities markets, etc.
A consumer can satisfy his desires only if he makes intelligent purchases--that
is, only if the goods he buys are what he believes them to be. How can the consumer
know whether the meat is free of disease or whether the washing machine will
function well and long or whether the fabric of the garment is one synthetic fibre or
another? To ascertain these facts personally, the consumer would have to be a
versatile scientist equipped with a superb laboratory--and then he would need to spend
so much time testing goods that he would have little time to enjoy them.
In some measure the consumer does experiment in his buying: whenever he
buys a thing repeatedly, experience tells him much concerning its properties. Direct
experience is a sufficient guide in buying celery or hiring domestic servants, but
usually the purchase of information takes a less direct form. The city's premier
department store can sell at prices somewhat higher than less well-known retailers;
and the difference represents the payment of a price for reliability, responsibility, and
the guarantee of quality. In parallel fashion the consumer buys the washing machine
of a company that made his excellent refrigerator. Occasionally, information is bought
directly: the advice of a lawyer, the knowledge of an appraiser, the taste of an interior
decorator.
The most important and controversial method of informing consumers is by
advertising. Many critics are outraged by the self-serving statements of sellers, some
of whom indubitably provide irrelevance and deception rather than information. Yet
the informational content of advertising may not be as deficient as its critics believe:
advertising itself meets two market tests. In the first place, the direct sale of
information by consumer advisory services has never become important, although
there are no obstacles to entering this business. In the second place, there has been a
general, sustained improvement in the quality of consumer goods over time: the
automobile tire goes many more miles than formerly; the airplane flies more safely.
Nevertheless, recent public policy has paid great attention to increasing the
safety of products and to raising the accuracy of advertising claims.
Knowledge is sometimes difficult to distinguish from taste: does the consumer
who persists in smoking cigarettes have inadequate knowledge or simply different
comparative values for the pleasures and risks of smoking? Censorship, in any event,
is fairly common in every economic system: no society allows young children or
incompetents full freedom of action or allows the unlimited sale of narcotics. Since
the price system never forbids an effective demand (a demand backed by a

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willingness to pay the supply price), some form of restriction of prices is, therefore,
necessary if certain tastes are to be forbidden or restricted. Compulsory school
attendance can be viewed as, in effect, a form of censorship; and so are the controls
on sale of firearms and the taxes on tobacco and liquor.

NONCAPITALIST PRICE SYSTEMS

The foregoing discussion has been confined to the price system as it exists in
capitalist economies. The Communist countries have prices, but not autonomous price
systems; in those countries the direction of economic activity is largely in the hands of
the central authorities, and prices are used mainly as a marketing device. None of the
three allocative functions of an economy--determination of what will be produced, of
how it will be produced, and of who will get the product--is performed by the price
mechanism in the socialist economies.
The relative scarcities that money prices measure exist, of course, in all
countries and would exist in a world where no money or exchanges were allowed.
Robinson Crusoe had a problem of allocating his time between sleep, garnering food,
building shelter, etc.; and he confronted implicit costs of extending any one activity,
for more food meant less of other things. The economist calls these implicit exchange
ratios "shadow prices," and they appear in all areas of life in which deliberate choices
are made.
Price systems are therefore the result of scarcity. The basic proposition of
economics, that scarcities are essentially ubiquitous, is often phrased as "there is no
such thing as a free lunch"; and it reminds one that the price of the lunch may be
future patronage, a reciprocal lunch, or a boring monologue. The task of economic
organization is the task of devising price systems that allow a society to achieve its
basic goals.
Market structure: competition, oligopoly, monopoly
When economists use such words as "competition" and "monopoly" they have
in mind certain complex relations among firms in an industry. An industry, as
economists define it, is a group of sellers of close-substitute products who supply a
common group of buyers. For the economy as a whole an industry would include all
sellers having this relation. Thus one can recognize a cigarette or automobile or
aluminum industry--in all, hundreds of industries.

TYPES OF MARKET STRUCTURES

Different industries have different market structures--that is, different market

characteristics that determine the relations of sellers to one another, of sellers to
buyers, and so forth. Probably the most important aspects of market structure are (1)
the degree of concentration of sellers in an industry, (2) the degree of product
differentiation, and (3) the ease or difficulty with which new sellers can enter the
industry.

Concentration of sellers.

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 Seller concentration refers to the number of sellers in an industry together with
their comparative shares of industry sales. When the number of sellers is quite large,
and each seller's share of the market is so small that in practice he cannot, by
changing his selling price or output, perceptibly influence the market share or income
of any competing seller, economists speak of atomistic competition. A more common
situation is that of oligopoly, in which the number of sellers is so few that the market
share of each is large enough for even a modest change in price or output by one
seller to have a perceptible effect on the market shares or incomes of rival sellers, and
to cause them to react to the change. In a broader sense, oligopoly exists in any
industry in which at least some sellers have large shares of the market, even though
there may be an additional number of small sellers. When a single seller supplies the
entire output of an industry, and thus can determine his selling price and output
without concern for the reactions of rival sellers, a single-firm monopoly exists.

Product differentiation.

The structure of a market is also affected by the extent to which those who buy
from it prefer some products to others. In some industries the products are regarded as
identical by their buyers--as, for example, basic farm crops. In others the products are
differentiated in some way so that various buyers prefer various products. Notably,
the criterion is a subjective one; the buyers' preferences may have little to do with
tangible differences in the products but are related to advertising, brand names, and
distinctive designs. The degree of product differentiation as registered in the strength
of buyer preferences ranges from slight to fairly large, tending to be greatest among
infrequently purchased consumer goods and "prestige goods," particularly those
purchased as gifts.

Ease of entry.

Industries vary in the ease with which new sellers can enter them. The barriers
to entry consist of the advantages that sellers already established in an industry have
over the potential entrant. Such a barrier is generally measurable by the extent to
which established sellers can persistently elevate their selling prices above minimal
average costs without attracting new sellers. The barriers may exist because costs for
established sellers are lower than they would be for new entrants, or because the
established sellers can command higher prices from buyers who prefer their products
to those of potential entrants. The economics of the industry also may be such that
new entrants would have to be able to command a substantial share of the market
before they could operate profitably.
The effective height of these barriers varies. One may distinguish three rough
degrees of difficulty in entering an industry: blockaded entry, which allows
established sellers to set monopolistic prices, if they wish, without attracting entry;
impeded entry, which allows established sellers to raise their selling prices above
minimal average costs without attracting new sellers, but not as high as a monopolist's
price; and easy entry, which does not permit established sellers to raise their prices at
all above minimal average costs without attracting new entrants.

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 Classification of industries.

This discussion of market characteristics suggests a general way of classifying

industries according to their market structures:
Under atomistic competition, in which entry is generally easy, there are no
barriers to entry. By the same token, product differentiation among sellers is
obviously inconsistent with single-firm monopoly.
The comparative importance of these types of market structure differs among
various sectors of the economy. In the manufacturing sector in the United States,
which includes about 400 industries, single-firm monopolies are almost completely
absent. But in more than half of the manufacturing industries there is enough seller
concentration for them to qualify as oligopolies. The remaining industries are more or
less atomistic in their market structure. An appreciable degree of product
differentiation is found in about half of the oligopolistic industries and in about half of
the atomistic industries. Very strong product differentiation is usually found among
oligopolistic industries. Easy entry is typical of atomistic industries, impeded entry of
oligopolies. Entry is probably blockaded in a minor fraction of the latter, generally
those with very high seller concentration.
The proportions of oligopolistic and atomistic manufacturing industries are
about the same in the United Kingdom as in the United States. The incidence of
oligopolies is slightly higher in Japan and progressively higher in France, Italy,
Canada, and Sweden. Single-firm monopolies in manufacturing are found in a few
industries in some of these countries, but they are typically under government
ownership.
In the public-utility sector in the United States, single-firm monopolies are
typically found in industries supplying gas, electricity, and telephone and telegraph
service. Oligopoly, frequently highly concentrated, is typical in the radio and
television and transportation industries; entry into these industries is usually very
difficult or blockaded. The significance of such structural conditions is lessened,
however, by the fact that these industries are subject to various degrees of public
regulation. The situation is much the same in other Western countries, except that
public utilities are frequently under government ownership.
In the distributive trades (wholesaling and retailing), a number of United
States industries are fairly atomistic, while a somewhat larger number are relatively
unconcentrated oligopolies in which a few large sellers supply about half the
industry's output and a very large number of small sellers supply the remainder.
Product differentiation is important. Entry is relatively easy. The service-trade
industries in the United States display a similar range of characteristics. In the
distributive- and service-trade sectors in other Western countries, oligopoly is less
frequent and atomistic industries are proportionally more important. The residential-
construction industries in the U.S. and elsewhere are relatively atomistic in structure,
have significant product differentiation, and are easy to enter. Industries in the
agricultural sectors of Western countries generally are typically atomistic in structure,
with easy entry. But the significance of these structural conditions is lessened by
governmental interference designed to modify the working of market forces.

MARKET CONDUCT AND PERFORMANCE

How do sellers behave in determining their selling prices, outputs, advertising

costs, and so forth; and in what ways does this market behaviour differ among

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industries with different types of market structure? An educated layman might ask, for
example, whether sellers cut their selling prices in order to take customers away from
each other until some rock-bottom market price is reached just high enough to allow
them minimal interest returns on their investments or whether, on the other hand, they
agree with each other to set a uniform higher price well above their production costs,
sharing the market and reaping excessive profits.
It is helpful to distinguish the related ideas of market conduct and market
performance. Market conduct refers to the price and other market policies pursued by
sellers, in terms both of their aims and of the way in which they coordinate their
decisions and make them mutually compatible. Market performance refers to the end
results of these policies--the relationship of selling price to costs, the size of output,
the efficiency of production, progressiveness in techniques and products, and so forth.

Pure competition.

Market conduct and performance in atomistic industries provide good

standards against which to measure behaviour in other types of industry. The
atomistic category includes both pure competition and monopolistic competition. In
pure competition, a large number of small sellers supply a homogeneous product to a
common buying market. In this situation no individual seller can perceptibly influence
the market price at which he sells but must accept a market price that is impersonally
determined by the total supply of the product offered by all sellers and the total
demand for the product of all buyers. The large number of sellers precludes the
possibility of a common agreement among them, and each must therefore act
independently. At any going market price, each seller tends to adjust his output to that
quantity that will yield him the largest aggregate profit, assuming that the market
price will not change as a result. But the collective effect of such adjustments by all
sellers will cause the total supply in the market to change significantly so that the
market price falls or rises. Theoretically, the process will go on until a market price is
reached at which the total output that sellers wish to produce is equal to the total
output that all buyers wish to purchase. This way of reaching a provisional
equilibrium price is what Adam Smith was referring to when he wrote of prices being
determined by "the invisible hand" of the market
If the provisional equilibrium price is high enough to allow the established
sellers profits in excess of a normal interest return on investment, then added sellers
will be drawn to enter the industry, and supply will increase until a final equilibrium
price is reached that is equal to the minimal average cost of production (including an
interest return) of all sellers. Conversely, if the provisional equilibrium price is so low
that established sellers incur losses, some will tend to withdraw from the industry, and
supply will decline until the same sort of long-run equilibrium price is reached.
The long-run performance of a purely competitive industry therefore embodies
these features: (1) industry output is at a feasible maximum and industry selling price
at a feasible minimum; (2) all production is undertaken at minimum attainable
average costs, since competition forces them down; and (3) income distribution is not
influenced by the receipt of any excess profits by sellers.
This performance has often been applauded as ideal from the standpoint of
general economic welfare. But the applause, for several reasons, should not be

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unqualified. Pure competition is truly ideal only if all or most industries in the
economy are purely competitive and if in addition there is free and easy mobility of
productive factors among industries. Otherwise, the relative outputs of different
industries will not be such as to maximize consumer satisfaction. There is also some
question whether producers in purely competitive industries will generally earn
enough to plow back some of their earnings into improved equipment and thus
maintain a satisfactory rate of technological progress. Finally, some purely
competitive industries have been afflicted with "destructive competition"--the coal
industry and the basic agricultural industries, for example. For some historical reason
such an industry accumulates excess capacity to the point where sellers suffer chronic
losses, and the situation is not corrected by the exit of people and resources from the
industry. The invisible hand of the market works too slowly for society to accept. In
some cases, notably in agriculture, government has intervened to restrict supply or
raise prices. Leaving these qualifications aside, however, the market performance of
pure competition furnishes some sort of a standard to which the performance of
industries of different structure may be compared.

Monopolistic competition.

In the more complex situation of monopolistic competition (atomistic structure

with product differentiation) market conduct and performance may be said to follow
roughly the tendencies attributed to pure competition. The principal differences are
the following. First, individual sellers, because of the differentiation of their products,
are able to raise or lower their individual selling prices slightly; they cannot do so by
very much, however, because they remain strongly subject to the impersonal forces of
the market operating through the general level of prices. Second, rivalry among sellers
is likely to involve sales promotion costs as well as the expense of altering products to
appeal to buyers. This is a competitive game that all will play but that nobody, on the
average, will win, and the long-run equilibrium price will reflect the added costs
involved. In return, however, buyers will get more variety. Third, since not every
seller is likely to be equally successful in his sales-promotion and product policies,
some will receive profits in excess of a basic interest return on their investment; such
profits will come from their success in winning buyers. Monopolistic competition
may, like pure competition, include industries that are afflicted with what has been
called above destructive competition. This may result not only from a failure to get rid
of excess capacity but also from the entry of too many new firms despite the danger of
losses.

Monopoly.

While single-firm monopolies are rare, except for those subject to public
regulation, it is useful to examine the monopolist's market conduct and performance
to establish a standard at the other pole from pure competition. As the sole supplier of
a distinctive product, the monopolist can set any selling price provided he accepts the
sales that correspond to that price. Since the market demand will generally be less the
higher the price he sets, the monopolist presumably will set that price that produces
the greatest profits, given the relationship of production costs to output. By restricting
output he can raise his selling price significantly--an option not opens to sellers in
atomistic industries.

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 The monopolist will generally charge prices well in excess of production costs
and reap profits well above a normal interest return on investment. His output will be
substantially smaller, and his price higher, than if he had to meet established market
prices as in pure competition. The monopolist may or may not produce at minimal
average cost, depending on his cost-output relationship; if he does not, there are no
market pressures to force him to do so.
If the monopolist is subject to no threat of entry by a competitor, he will
presumably set a selling price that maximizes profits for the industry he monopolizes.
If he faces only impeded entry, he may elect to charge a price sufficiently low to
discourage entry but above a competitive price--if this will maximize his long-run
profits.

Oligopoly.

Market conduct and performance in oligopolistic industries generally combine

monopolistic and competitive tendencies, with the relative strength of the two
tendencies depending roughly on the detailed market structure of the oligopoly.

Rivalry among sellers.

In the simplest form of oligopolistic industry, sellers are few and every seller
supplies a sufficiently large share of the market so that any feasible and modest
change in his policies will appreciably affect the market shares of all his rival sellers
and induce them to react or respond. For example, if seller A reduces his selling price
below the general level of prices being charged by all sellers sufficiently to permit
him to capture significant numbers of customers from his rivals if they hold their
selling prices unchanged, they may react by reducing their prices by a similar amount,
so that none gains at the expense of others and the group has probably reduced its
combined profits. Or seller A's rivals may retaliate by reducing their selling prices
more than he did, thus forcing a further reaction from him. Conversely, if seller A
increases his selling price above the general level being charged by all sellers (thus
tending to lose at least some of his customers to his rivals), they may react by holding
their prices unchanged, in which event seller A will probably retract his increase and
bring his price back to the previous level. But his rivals may also react by raising their
prices as much as seller A raised his, in which case the general level of prices in the
industry rises and the combined profits of all sellers are probably increased.
Any seller A in an oligopoly will therefore determine whether or not to alter
his price or other market policy in the light of his conjectures about the reactions of
his rivals. Correspondingly, his rivals will determine their reactions in the light of
their conjectures about what seller A will do in response. The process is not likely to
bring the industry price level down to minimal average cost (as in atomistic
competition). Many different "equilibrium" levels between the competitive and
monopolistic limits are possible, depending on further circumstances.
Thus in an oligopoly viable collusive agreements among rival sellers are quite
possible. They may be express agreements established by contract or tacit
understandings that develop as a pattern of reactions among sellers to changes in each
others' prices or market policies becomes customary. In the United States, express
collusive agreements are forbidden by law, but tacit agreements or "gentlemen's
understandings" are common in oligopolies. In numerous other Western countries,
formal collusive agreements (often called cartels if comprehensive in scope) are legal.

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Whether tacit or explicit, legal or illegal, one may say that oligopolistic prices tend to
be "administered" by sellers, in the senses mentioned above, as distinct from being
determined by impersonal market forces.

Sellers' dual aims.

The varying market performance of oligopolies results from the fact that
individual sellers intrinsically have two conflicting aims. One common desire is to
establish among themselves a monopolistic level of price (and of selling costs, etc.),
which will maximize their combined profits, giving them the largest "profit pie" to
divide. But each seller also has a fundamental antagonism toward rival sellers and
wants to maximize his own profits even at the expense of theirs. The relative strengths
of these conflicting aims--the maximizing of combined profits and the maximizing of
individual profits--will likely depend on how concentrated the oligopoly is, because
when sellers are fewer and their individual market shares larger, their rivals' reactions
are stronger deterrents to independent actions.
This is why various sorts of market performance are to be expected in
oligopolistic industries. When the entry of other sellers is blockaded, collusive or
interdependent behaviour may lead to a full monopoly price. If entry is only impeded,
the resulting price may be far enough below the full monopoly level to discourage
further entry. But prices are not always what they seem. An announced price that is
well above cost may be undercut by clandestine price reductions to individual buyers,
bringing the average of actual selling prices down somewhat.
If an oligopolistic industry is made up of a "core" of a few large
interdependent sellers plus a "competitive fringe" of several or numerous quite small
sellers, the competition of the small sellers may induce the large ones to limit the
extent to which they raise their prices.
Price behaviour approaching full monopoly pricing seems to be found mainly
in oligopolies having very high seller concentration and blockaded entry. Where these
characteristics are less pronounced, prices and profits tend to be lower, though they
are likely to be somewhat above the competitive level. A few economists maintain
that oligopolistic prices in general do not significantly differ from atomistically
competitive prices, but the bulk of statistical evidence does not support them.
In oligopolies in which product differentiation is important, sales-promotion
costs and the costs of product improvement or development will display roughly the
same variety of tendencies found in pricing. Where there are a few large
interdependent sellers, these costs may be restricted to about the same level as those
of a single-firm monopolist; on the other hand, rivalry in sales promotion and product
development may be sufficient to raise them higher. Oligopolists may also arrive
collusively at relatively high uniform selling prices but simultaneously engage in
independent nonprice competition (perhaps more so where seller concentration is
lower).

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 WORKABLE COMPETITION

Definition and attributes.

Since the character of market performance varies among industries along with
their market characteristics, efforts have been made to devise some practical standard
for identifying the sorts of market structure that engender socially satisfactory
performance in a given industry. The term workable competition was coined to denote
competition that may be considered as leading to a reasonable or socially acceptable
approximation to ideal performance in the circumstances of a particular industry. The
limits of such an approximation are of course debatable, and so the idea of workable
competition must remain elusive because it is basically subjective.
Without entering into a complex theoretical discussion of the relationship of
individual-industry performance to overall welfare, it is plausible to suggest the
following principal attributes of workable performance in an industry: (1) In the long
term, selling price on the average should be equal to or not significantly above
average costs of production, so that profits do not appreciably exceed a normal
interest return on investment. Prices should be responsive to basic reductions in costs.
(2) In so far as average costs of production are affected by the scales or capacities of
plants and firms, the preponderance of industry output should be from plants and
firms of the most efficient scale or with closely comparable technical efficiency. (3)
The industry should not have chronic excess capacity--i.e., significant plant capacity
that is persistently unused even in periods of high general economic activity. (4) The
industry's sales-promotion costs should not be substantially greater than needed to
keep buyers informed of the availability, characteristics, and prices of products. (5)
The industry should be adequately progressive in introducing more economical
production techniques and improved products--balancing the costs of progress with
the gains.
While the first three of these attributes are easier to appraise than the others,
certain generalizations are possible concerning the workability of different market
structures: (1) Unregulated single-firm monopolies tend to generate unworkable
market performance, mainly in the form of output restriction, prices well above costs,
and consequent excess profits. They have undesirable effects on the uses to which
resources are put and on income distribution. (2) Oligopolies with high seller
concentration and also very high barriers to entry tend toward unworkable
performance, like that of single-firm monopoly. In general, however, they do not
show significant degrees of technical inefficiency resulting from inefficient plant
scales or excess capacity. (3) Oligopolies with fairly high seller concentration but
only moderate barriers to entry are also prone to unworkable performance of the sort
just mentioned, but not to as high a degree. (4) Oligopolies with only moderate seller
concentration and moderate-to-low barriers to entry tend toward workable
performance both in price-cost relations and in technical efficiency, except that some
of them may have recurrent chronic excess capacity due to periodic overentry. (If
cartels are legalized and their provisions are not rigorously controlled by government,
the last two categories of oligopoly may have the same sort of unworkable
performance as do very highly concentrated oligopolies.) (5) Industries of atomistic
structure tend generally toward workable performance unless they suffer from
destructive competition as described above.

Product differentiation and promotion.

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 In industries with significant differentiation of products among sellers--and
especially in oligopolies of this sort--there is a tendency for minor but significant
fractions of income to be devoted to persuasive (as distinct from informational)
advertising and other sales promotion and also to more or less idle variations of
product design, with the result that resources are in a sense "wasted" and costs
increased.
By the criteria of workable competition, a purely rational society would
presumably favour industries with moderate to low seller concentration, moderate to
low barriers to entry, and without extreme product differentiation--all this from the
standpoint of enhancing overall material welfare. The argument that oligopolistic and
atomistic industries generally need legal protection from destructive competition may
be discarded on the basis of evidence. Price and other market warfare in such
industries has been extremely rare in industrial countries in the last 50 years.
Production: the output of the factors of production
In economics, the theory of production is an effort to explain the principles by
which a business firm decides how much of each commodity that it sells (its "outputs"
or "products") it will produce, and how much of each kind of labour, raw material,
fixed capital good, etc., that it employs (its "inputs" or "factors of production") it will
use. The theory involves some of the most fundamental principles of economics.
These include the relationship between the prices of commodities and the prices (or
wages or rents) of the productive factors used to produce them and also the
relationships between the prices of commodities and productive factors, on the one
hand, and the quantities of these commodities and productive factors that are
produced or used, on the other.
The various decisions a business enterprise makes about its productive
activities can be classified into three layers of increasing complexity. The first layer
includes decisions about methods of producing a given quantity of the output in a
plant of given size and equipment. It involves the problem of what is called short-run
cost minimization. The second layer, including the determination of the most
profitable quantities of products to produce in any given plant, deals with what is
called short-run profit maximization. The third layer, concerning the determination of
the most profitable size and equipment of plant, relates to what is called long-run
profit maximization.

MINIMIZATION OF SHORT-RUN COSTS

The production function.

However much of a commodity a business firm produces, it endeavours to

produce it as cheaply as possible. Taking the quality of the product and the prices of
the productive factors as given, which is the usual situation, the firm's task is to
determine the cheapest combination of factors of production that can produce the
desired output. This task is best understood in terms of what is called the production
function, i.e., an equation that expresses the relationship between the quantities of
factors employed and the amount of product obtained. It states the amount of product
that can be obtained from each and every combination of factors. This relationship
can be written mathematically as y = f (x1, x2, . . . , xn; k1, k2, . . . , km). Here, y denotes
the quantity of output. The firm is presumed to use n variable factors of production;
that is, factors like hourly paid production workers and raw materials, the quantities of

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which can be increased or decreased. In the formula the quantity of the first variable
factor is denoted by x1 and so on. The firm is also presumed to use m fixed factors, or
factors like fixed machinery, salaried staff, etc., the quantities of which cannot be
varied readily or habitually. The available quantity of the first fixed factor is indicated
in the formal by k1 and so on. The entire formula expresses the amount of output that
results when specified quantities of factors are employed. It must be noted that though
the quantities of the factors determine the quantity of output, the reverse is not true,
and as a general rule there will be many combinations of productive factors that could
be used to produce the same output. Finding the cheapest of these is the problem of
cost minimization.
The cost of production is simply the sum of the costs of all of the various
factors. It can be written:

in which p1 denotes the price of a unit of the first variable factor, r1 denotes the
annual cost of owning and maintaining the first fixed factor, and so on. Here again
one group of terms, the first, covers variable cost (roughly" direct costs" in accounting
terminology), which can be changed readily; another group, the second, covers fixed
cost (accountants' "overhead costs"), which includes items not easily varied. The
discussion will deal first with variable cost.

Figure 8: Isoquant diagram of hours of labour and feet of gold wire used per
month.

The principles involved in selecting the cheapest combination of variable

factors can be seen in terms of a simple example. If a firm manufactures gold
necklace chains in such a way that there are only two variable factors, labour
(specifically, goldsmith-hours) and gold wire, the production function for such a firm
will be y = f (x1, x2; k), in which the symbol k is included simply as a reminder that the
number of chains producible by x1 feet of gold wire and x2 goldsmith-hours depends
on the amount of machinery and other fixed capital available. Since there are only two
variable factors, this production function can be portrayed graphically in a figure
known as an isoquant diagram (Figure 8). In the graph, goldsmith-hours per month
are plotted horizontally and the number of feet of gold wire used per month vertically.
Each of the curved lines, called an isoquant, will then represent a certain number of
necklace chains produced. The data displayed show that 100 goldsmith-hours plus
900 feet of gold wire can produce 200 necklace chains. But there are other
combinations of variable inputs that could also produce 200 necklace chains per

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month. If the goldsmiths work more carefully and slowly, they can produce 200
chains from 850 feet of wire; but to produce so many chains more goldsmith-hours
will be required, perhaps 130. The isoquant labelled "200" shows all the combinations
of the variable inputs that will just suffice to produce 200 chains. The other two
isoquants shown are interpreted similarly. It is obvious that many more isoquants, in
principle an infinite number, could also be drawn. This diagram is a graphic display of
the relationships expressed in the production function.

Substitution of factors.

The isoquants also illustrate an important economic phenomenon: that of

factor substitution. This means that one variable factor can be substituted for others;
as a general rule a more lavish use of one variable factor will permit an unchanged
amount of output to be produced with fewer units of some or all of the others. In the
example above, labour was literally as good as gold and could be substituted for it. If
it were not for factor substitution there would be no room for further decision after y,
the number of chains to be produced, had been established.
The shape of the isoquants shown, for which there is a good deal of empirical
support, is very important. In moving along any one isoquant, the more of one factor
that is employed, the less of the other will be needed to maintain the stated output;
this is the graphic representation of factor substitutability. But there is a corollary: the
more of one factor that is employed, the less it will be possible to reduce the use of
the other by using more of the first. This is the property known as "diminishing
marginal rates of substitution." The marginal rate of substitution of factor 1 for factor
2 is the number of units by which x1 can be reduced per unit increase in x, output
remaining unchanged. In the diagram, if feet of gold wire are indicated by x1 and
goldsmith-hours by x2, then the marginal rate of substitution is shown by the steepness
(the negative of the slope) of the isoquant; and it will be seen that it diminishes
steadily as x2 increases because it becomes harder and harder to economize on the use
of gold simply by taking more care. The remainder of the analysis rests heavily on the
assumption that diminishing marginal rates of substitution are characteristic of the
production process generally.

Figure 9: Isoquant diagram for two factors of production, x1 and x2

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 The cost data and the technological data can now be brought together. The
variable cost of using x1, x2 units of the factors of production is written p1x1 + p2x2, and
this information can be added to the isoquant diagram (Figure 9). The straight line
labelled v2, called the v2-isocost line, shows all the combinations of input that can be
purchased for a specified variable cost, v2. The other two isocost lines shown are
interpreted similarly. The general formula for an isocost line is p1x1 + p2x2 = v, in
which v is some particular variable cost. The slope of an isocost line is found by
dividing p2 by p1 and depends only on the ratio of the prices of the two factors.
Three isocost lines are shown, corresponding to variable costs amounting to v1,
v2, and v3. If 200 units are to be produced, expenditure of v1 on variable factors will
not suffice since the v1- in socost line never reaches the isoquant for 200 units. An
expenditure of v3 is more than sufficient; and v2 is the lowest variable cost for which
200 units can be produced. Thus v2 is found to be the minimum variable cost of
producing 200 units (as v3 is of 300 units) and the coordinates of the point where the
v2 isocost line touches the 200-unit isoquant are the quantities of the two factors that
will be used when 200 units are to be produced and the prices of the two factors are in
the ratio p2/p1. It may be noted that the cheapest combination for the production of any
quantity will be found at the point at which the relevant isoquant is tangent to an
isocost line. Thus, since the slope of an isoquant is given by the marginal rate of
substitution, any firm trying to produce as cheaply as possible will always purchase or
hire factors in quantities such that the marginal rate of substitution will equal the ratio
of their prices.
The isoquant-isocost diagram (or the corresponding solution by the alternative
means of the calculus) solves the short-run cost minimization problem by determining
the least-cost combination of variable factors that can produce a given output in a
given plant. The variable cost incurred when the least-cost combination of inputs is
used in conjunction with a given outfit of fixed equipment is called the variable cost
of that quantity of output and denoted VC(y). The total cost incurred, variable plus
fixed, is the short-run cost of that output, denoted SRC(y). Clearly SRC(y) = VC(y) +
R(K), in which the second term symbolizes the sum of the annual costs of the fixed
factors available.

Marginal cost.

Two other concepts now become important. The average variable cost, written
AVC(y), is the variable cost per unit of output. Algebraically, AVC(y) = VC(y)/y. The
marginal variable cost, or simply marginal cost [MC(y)] is, roughly, the increase in
variable cost incurred when output is increased by one unit; i.e., MC(y) = VC(y + 1) -
VC(y). Though for theoretical purposes a more precise definition can be obtained by
regarding VC(y) as a continuous function of output, this is not necessary in the
present case.

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 Figure 10: Average variable costs (AVC) and marginal variable costs (MC) in
relation to output.

The usual behaviour of average and marginal variable costs in response to

changes in the level of output from a given fixed plant is shown in Figure 10. In this
figure costs (in dollars per unit) are measured vertically and output (in units per year)
is shown horizontally. The figure is drawn for some particular fixed plant, and it can
be seen that average costs are fairly high for very low levels of output relative to the
size of the plant, largely because there is not enough work to keep a well-balanced
work force fully occupied. People are either idle much of the time or shifting,
expensively, from job to job. As output increases from a low level, average costs
decline to a low plateau. But as the capacity of the plant is approached, the
inefficiencies incident on plant congestion force average costs up quite rapidly.
Overtime may be incurred, outmoded equipment and inexperienced hands may be
called into use, there may not be time to take machinery off the line for routine
maintenance; or minor breakdowns and delays may disrupt schedules seriously
because of inadequate slack and reserves. Thus the AVC curve has the flat-bottomed
U-shape shown. The MC curve, as might be expected, falls faster and rises more
rapidly than the AVC curve.

MAXIMIZATION OF SHORT-RUN PROFITS

The average and marginal cost curves just deduced are the keys to the solution
of the second-level problem, the determination of the most profitable level of output
to produce in a given plant. The only additional datum needed is the price of the
product, say p0.
The most profitable amount of output may be found by using these data. If the
marginal cost of any given output (y) is less than the price, sales revenues will
increase more than costs if output is increased by one unit (or even a few more); and
profits will rise. Contrariwise, if the marginal cost is greater than the price, profits will
be increased by cutting back output by at least one unit. It then follows that the output
that maximizes profits is the one for which MC(y) = p0. This is the second basic
finding: in response to any price the profit-maximizing firm will produce and offer the
quantity for which the marginal cost equals that price
Such a conclusion is shown in Figure 10. In response to the price, p0, shown,
the firm will offer the quantity y* given by the value of y for which the ordinate of the
MC curve equals the price. If a denotes the corresponding average variable cost, net
revenue per unit will be equal to p0 - a, and the total excess of revenues over variable

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costs will be y*(p0 - a), which is represented graphically by the shaded rectangle in
the figure.

Marginal cost and price.

The conclusion that marginal cost tends to equal price is important in that it
shows how the quantity of output produced by a firm is influenced by the market
price. If the market price is lower than the lowest point on the average variable cost
curve, the firm will "cut its losses" by not producing anything. At any higher market
price, the firm will produce the quantity for which marginal cost equals that price.
Thus the quantity that the firm will produce in response to any price can be found in
Figure 10 by reading the marginal cost curve, and for this reason the marginal cost
curve is said to be the short-run supply curve for the firm.
The short-run supply curve for a product--that is, the total amount that all the
firms producing it will produce in response to any market price--follows immediately,
and is seen to be the sum of the short-run supply curves (or marginal cost curves,
except when the price is below the bottoms of the average variable cost curves for
some firms) of all the firms in the industry. This curve is of fundamental importance
for economic analysis, for together with the demand curve for the product it
determines the market price of the commodity and the amount that will be produced
and purchased.
One pitfall must, however, be noted. In the demonstration of the supply curves
for the firms, and hence of the industry, it was assumed that factor prices were fixed.
Though this is fair enough for a single firm, the fact is that if all firms together
attempt to increase their outputs in response to an increase in the price of the product,
they are likely to bid up the prices of some or all of the factors of production that they
use. In that event the product supply curve as calculated will overstate the increase in
output that will be elicited by an increase in price. A more sophisticated type of
supply curve, incorporating induced changes in factor prices, is therefore necessary.
Such curves are discussed in the standard literature of this subject.

Marginal product.

It is now possible to derive the relationship between product prices and factor
prices, which is the basis of the theory of income distribution. To this end, the
marginal product of a factor is defined as the amount that output would be increased if
one more unit of the factor were employed, all other circumstances remaining the
same. Algebraically, it may be expressed as the difference between the product of a
given amount of the factor and the product when that factor is increased by an
additional unit. Thus if MP1(x1) denotes the marginal product of factor 1 when x1 units
are employed, then MP1(x1) = f(x1 + 1, x2, . . . ,xn;k) - f(x1, x2 . . . ,xn; k). The marginal
products are closely related to the marginal rates of substitution previously defined. If
an additional unit of factor 1 will increase output by f1 units, for example, then one
more unit of output can be obtained by employing 1/f1 more units of factor 1.
Similarly, if the marginal product of factor 2 is f2, then output will fall by one unit if
the use of factor 2 is reduced by 1/f2 units. Thus output will remain unchanged, to a
good approximation, if 1/f1 units of factor 1 are used to replace 1/f2 units of factor 2.
The marginal rate of substitution is therefore f2/f1, or the ratio of the marginal products
of the two factors. It has already been shown that the marginal rate of substitution also

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equals the ratio of the prices of the factors, and it therefore follows that the prices (or
wages) of the factors are proportional to their marginal products.
This is one of the most significant theoretical findings in economics. To
restate it briefly: factors of production are paid in proportion to their marginal
products. This is not a question of social equity but merely a consequence of the
efforts of businessmen to produce as cheaply as possible.
Further, the marginal products of the factors are closely related to marginal
costs and, therefore, to product prices. For if one more unit of factor 1 is employed,
output will be increased by MP1(x1) units and variable cost by p1; so the marginal cost
of additional units produced will be p1/MP1(x1). Similarly, if additional output is
obtained by employing an additional unit of factor 2, the marginal cost will be
p2/MP2(x2). But, as shown above, these two numbers are the same; whichever factor i
is used to increase output, the marginal cost will be pi/MPi(xi) and, furthermore, the
firm will choose its output level so that the marginal cost will be equal to the price, p0.
Therefore it has been established that p1 = p0MP1(x1), p2 = p0MP2(x2), . . . , or
the price of each factor is the price of the product multiplied by its marginal product,
which is the value of its marginal product. This, also, is a fundamental theorem of
income distribution and one of the most significant theorems in economics. Its logic
can be perceived directly. If the equality is violated for any factor, the businessman
can increase his profits either by hiring units of the factor or by laying them off until
the equality is satisfied, and presumably the businessman will do so.
The theory of production decisions in the short run, as just outlined, leads to
two conclusions (of fundamental importance throughout the field of economics) about
the responses of business firms to the market prices of the commodities they produce
and the factors of production they buy or hire: (1) the firm will produce the quantity
of its product for which the marginal cost is equal to the market price and (2) it will
purchase or hire factors of production in such quantities that the price of the
commodity produced multiplied by the marginal product of the factor will be equal to
the cost of a unit of the factor. The first explains the supply curves of the commodities
produced in an economy. Though the conclusions were deduced within the context of
a firm that uses two factors of production, they are clearly applicable in general.

MAXIMIZATION OF LONG-RUN PROFITS

Relationship between the short run and the long run.

The theory of long-run profit-maximizing behaviour rests on the short-run

theory that has just been presented but is considerably more complex because of two
features: (1) long-run cost curves, to be defined below, are more varied in shape than
the corresponding short-run cost curves, and (2) the long-run behaviour of an industry
cannot be deduced simply from the long-run behaviour of the firms in it because the
roster of firms is subject to change. It is of the essence of long-run adjustments that
they take place by the addition or dismantling of fixed productive capacity by both
established firms and new or recently created firms.
At any one time an established firm with an existing plant will make its short-
run decisions by comparing the ruling price of its commodity with cost curves
corresponding to that plant. If the price is so high that the firm is operating on the

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rising leg of its short-run cost curve, its marginal costs will be high--higher than its
average costs--and it will be enjoying operating profits, as shown in Figure 10. The
firm will then consider whether it could increase its profits by enlarging its plant. The
effect of plant enlargement is to reduce the variable cost of producing high levels of
output by reducing the strain on limited production facilities, at the expense of
increasing the level of fixed costs.
In response to any level of output that it expects to continue for some time, the
firm will desire and eventually acquire the fixed plant for which the short-run costs of
that level of output are as low as possible. This leads to the concept of the long-run
cost curve: the long-run costs of any level of output are the short-run costs of
producing that output in the plant that makes those short-run costs as low as possible.
These result from balancing the fixed costs entailed by any plant against the short-run
costs of producing in that plant. The long-run costs of producing y are denoted by
LRC(y). The average long-run cost of y is the long-run cost per unit of y
[algebraically LAC(y) = LRC(y)/y]. The marginal long-run cost is the increase in
long-run cost resulting from an increase of one unit in the level of output. It represents
a combination of short-run and long-run adjustments to a slight increase in the rate of
output. It can be shown that the long-run marginal cost equals the marginal cost as
previously defined when the cost-minimizing fixed plant is used.

Long run cost curves.

Cost curves appropriate for long-run analysis are more varied in shape than
short-run cost curves and fall into three broad classes. In constant-cost industries,
average cost is about the same at all levels of output except the very lowest. Constant
costs prevail in manufacturing industries in which capacity is expanded by replicating
facilities without changing the technique of production, as a cotton mill expands by
increasing the number of spindles. In decreasing-cost industries, average cost declines
as the rate of output grows, at least until the plant is large enough to supply an
appreciable fraction of its market. Decreasing costs are characteristic of
manufacturing in which heavy, automated machinery is economical for large volumes
of output. Automobile and steel manufacturing are leading examples. Decreasing
costs are inconsistent with competitive conditions, since they permit a few large firms
to drive all smaller competitors out of business. Finally, in increasing-cost industries
average costs rise with the volume of output generally because the firm cannot obtain
additional fixed capacity that is as efficient as the plant it already has. The most
important examples are agriculture and extractive industries.

CRITICISMS OF THE THEORY

The theory of production has been subject to much criticism. One objection is
that the concept of the production function is not derived from observation or practice.
Even the most sophisticated firms do not know the direct functional relationship
between their basic raw inputs and their ultimate outputs. This objection can be got
around by applying the recently developed techniques of linear programming, which
employ observable data without recourse to the production function and lead to
practically the same conclusions.
On another level the theory has been charged with excessive simplification. It
assumes that there are no changes in the rest of the economy while individual firms
and industries are making the adjustments described in the theory; it neglects changes

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in the technique of production; and it pays no attention to the risks and uncertainties
that becloud all business decisions. These criticisms are especially damaging to the
theory of long-run profit maximization. On still another level, critics of the theory
maintain that businessmen are not always concerned with maximizing profits or
minimizing costs.
Though all of the criticisms have merit, the simplified theory of production
does nevertheless indicate some basic forces and tendencies operating in the
economy. The theorems should be understood as conditions that the economy tends
toward, rather than conditions that are always and instantaneously achieved. It is rare
for them to be attained exactly, but it is just as rare for substantial violations of the
theorems to endure.
Only the simplest aspects of the theory were described above. Without much
difficulty it could be extended to cover firms that produce more than one product, as
almost all firms do. With more difficulty it could be applied to firms whose decisions
affect the prices at which they sell and buy (monopoly, monopolistic competition,
monopsony). The behaviour of other firms that recognize the possibility that their
competitors may retaliate (oligopoly) is still a theory of production subject to
controversy and research.
Distribution: the shares of the factors of production
The factors of production, as suggested earlier, are the economic resources,
both human and other, which, if properly utilized, will bring about a flow or output of
goods and services. The factors are commonly classified into three groups: capital,
labour, and land. The first, in the simplest sense, refers to all the "produced"
instruments of production--the factories, their equipment, their stocks of raw materials
and finished goods, houses, trade facilities, and so on; the owners of capital receive
their income in various possible forms, profits and interest being the usual ones. The
factor of labour represents all those productive resources that can be applied only at
the cost of human effort; the wage (or salary) is the form of payment for use of this
factor. The factor of land represents resources whose supply is low in relation to
demand and cannot be increased as the result of production; the income derived from
the ownership of this factor is known as economic rent.
Distribution, in economics, generally refers to (1) explanations of how prices
for the services of the different factors of production are determined; (2) explanations
of how the total product of the economy is divided among the various factors, and (3)
descriptions of the ways in which the income is divided among various income
classes or groups of persons.

CAPITAL AND INTEREST

Capital in economics is a word of many meanings. They all imply that capital
is a "stock" by contrast with income, which is a "flow." In its broadest possible sense,
capital includes the human population; nonmaterial elements such as skills, abilities,
and education; land, buildings, machines, equipment of all kinds; and all stocks of
goods--finished or unfinished--in the hands of both firms and households.
In the business world the word capital usually refers to an item in the balance
sheet representing that part of the net worth of an enterprise that has not been
produced through the operations of the enterprise. In economics the word capital is
generally confined to "real" as opposed to merely "financial" assets. Different as the
two concepts may seem, they are not unrelated. If all balance sheets were
consolidated in a closed economic system, all debts would be cancelled out because

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every debt is an asset in one balance sheet and a liability in another. What is left in the
consolidated balance sheet, therefore, is a value of all the real assets of a society on
one side and its total net worth on the other. This is the economist's concept of capital.
A distinction may be made between goods in the hands of firms and goods in
the hands of households, and attempts have been made to confine the term capital
structure to the former. There is also a distinction between goods that have been
produced and goods that are gifts of nature; attempts have been made to confine the
term capital to the former, though the distinction is hard to maintain in practice.
Another important distinction is between the stock of human beings (and their
abilities) and the stock of nonhuman elements. In a slave society human beings are
counted as capital in the same way as livestock or machines. In a free society each
man is his own slave--the value of his body and mind is not, therefore, an article of
commerce and does not get into the accounting system. In strict logic persons should
continue to be regarded as part of the capital of a society; but in practice the
distinction between the part of the total stock that enters into the accounting system,
and the part that does not, is so important that it is not surprising that many writers
have excluded persons from the capital stock.
Another distinction that has some historical importance is that between
circulating and fixed capital. Fixed capital is usually defined as that which does not
change its form in the course of the process of production, such as land, buildings, and
machines. Circulating capital consists of goods in process, raw materials, and stocks
of finished goods waiting to be sold; these goods must either be transformed, as when
wheat is ground into flour, or they must change ownership, as when a stock of goods
is sold. This distinction, like many others, is not always easy to maintain.
Nevertheless, it represents a rough approach to an important problem of the relative
structure of capital; that is, of the proportions in which goods of various kinds are
found. The stock of real capital exhibits strong complementarities. A machine is of no
use without a skilled operator and without raw materials for it to work on.

The classical theory of capital.

Although ancient and medieval writers were interested in the ethics of interest
and usury, the concept of capital as such did not rise to prominence in economic
thought before the classical economists (Adam Smith, David Ricardo, Nassau Senior,
and John Stuart Mill).
Adam Smith laid great stress on the role played by the accumulation of a stock
of capital in facilitating the division of labour economics and in increasing the
productivity of labour in general. He recognized clearly that accumulation proceeds
from an excess of production over consumption. He distinguished between productive
labour, which creates objects of capital, and unproductive labour (services), the fruits
of which are enjoyed immediately. His thought was strongly coloured by observation
of the annual agricultural cycle. The end of the harvest saw society with a given stock
of grain. This stock was in the possession of the capitalists. A certain portion of it they
reserved for their own consumption and for the consumption of their menial servants,
the rest was used to feed "productive labourers" during the ensuing year. As a result,
by the end of the next harvest the barns were full again and the stock had replaced
itself, perhaps with something left over. The stock that the capitalists did not reserve
for their own use was the "wages fund"--the more grain there was in the barn in
October the sharper the competition of capitalists for workers, and the higher real
wages would be in the year to come. The picture is a crude one, of course, and does

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not indicate the complexity of the relationship between stocks and flows in an
industrial society. The last of the classical economists, John Stuart Mill, was forced to
abandon the wages-fund theory. Nevertheless, the wages fund is a crude
representation of some real but complex relationships, and the theory reappears in a
more sophisticated form in later writers.
The classical economists distinguished three categories of income--wages,
profit, and rent--and identified these with three factors of production--labour, capital,
and land. David Ricardo especially made a sharp distinction between capital as
"produced means of production," and land as the "original and indestructible powers
of the soil." In modern economics this distinction has become blurred.

The Austrian school.

About 1870 a new school developed, sometimes called the Austrian school
from the fact thatmany of its principal members taught in Vienna, but perhaps better
called the Marginalist school. The movement itself was thoroughly international, and
included such figures as William Stanley Jevons in England and Léon Walras in
France. The so-called Austrian theory of capital is mainly based on the work of Eugen
Böhm-Bawerk. His Positive Theory of Capital (1889) set off a controversy that has
not yet subsided. In the Austrian view the economic process consisted of the
embodiment of "original factors of production" in capital goods of greater or lesser
length of life that then yielded value or utility as they were consumed. Between the
original embodiment of the factor and the final fruition in consumption lay an interval
of time known as the period of production. In an equilibrium population it can easily
be shown that the total population (capital stock) equals the annual number of births
or deaths (income) multiplied by the average length of life (period of production). The
longer the period of production, therefore, the more capital goods there will be per
unit of income. If the period of production is constant, income depends directly on the
amount of capital previously accumulated. Here is the wages fund in a new form.
Unfortunately, the usefulness of Böhm-Bawerk's theory is much impaired by the fact
that it is confined to equilibrium states. The great problems of capital theory are
dynamic in character, and comparative statics throws only a dim light on them.

Marginalist and Keynesian theories.

The Marginalist school culminated in the work of three men--P.H. Wickstead

in England, Knut Wicksell in Sweden, and Irving Fisher in the United States. The last
two especially gave the Austrian theory clear mathematical expression. Perhaps the
greatest contribution of the Austrian theory was its recognition of the importance of
the valuation problem in the relation of capital to interest. From the mere fact that
physical capital produces an income stream, there is no explanation of the
phenomenon of interest, for the question is why the value of a piece of physical
capital should be less than the total of future values that are expected to accrue from
it. The theory also makes a contribution to the problem of rational choice in situations
involving waiting or maturing. The best example is that of slowly maturing goods
such as wines or timber. There is a problem here of the best time to draw wine or to
cut down a tree. According to the marginal theory this is at the time when the rate of
net value growth of the item is just equal to the rate of interest, or the rate of return in
alternative investments. Thus, if a tree or a wine is increasing in value at the rate of 7
percent per annum when the rate of interest is 6 percent it still pays to be patient and

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let it grow or mature. The longer it grows, however, the less the rate of value growth,
and when the rate of value growth has fallen to the rate of interest, then is the time to
reap the fruits of patience. (see also Index: profit maximization)
The contributions of John Maynard (Lord) Keynes to capital theory are
incidental rather than fundamental. Nevertheless, the “Keynesian revolution" had an
impact on this area of economic thought as on most others. It overthrew the traditional
assumption of most economists that savings were automatically invested. The great
contribution of Keynes, then, is the recognition that the attempt to save does not
automatically result in the accumulation of capital. A decision to restrict consumption
is only a decision to accumulate capital if the volume of production is constant. If
abstention from consumption itself results in a diminution of production, then
accumulation (production minus consumption) is correspondingly reduced.

Later thinking.

The theory of capital was not a matter of primary concern to economists in the
late 20th century, though some revival of interest occurred in the late 1950s.
Nevertheless, certain problems remain of perennial interest. They may be grouped as
follows.

Heterogeneous goods.

First are the problems involved in measuring aggregates of goods. Real capital
includes everything from screwdrivers to continuous strip-rolling mills. A single
measure of total real capital can be achieved only if each item can be expressed in a
common denominator such as a given monetary unit (e.g., dollars, sterling, francs,
pesos, etc.). The problem becomes particularly complicated in periods of rapid
technical change when there is change not only in the relative values of products but
in the nature of the list itself. Only approximate solutions can be found to this
problem, and no completely satisfactory measure is ever possible.
A related problem that has aroused considerable interest among accountants is
how to value capital assets that have no fixed price. In the conventional balance sheet
the value of some items is based on their cost at an earlier period than that of others.
When the general level of prices is changing this means that different items are valued
in monetary units of different purchasing power. The problem is particularly acute in
the valuation of inventory. Under the more conventional "FIFO" ( First In, First Out)
system, inventory is valued at the cost (purchase price) of the latest purchases. This
leads to an inflation of inventory values, and therefore of accounting profits, in time
of rising prices (and a corresponding deflation under falling prices), which may be an
exaggeration of the long-run position of the firm. This may be partially avoided by a
competing system of valuation known as LIFO ( Last In, First Out), in which
inventory is valued at the purchase price of the earliest purchases. This avoids the
fluctuations caused by short-run price-level changes, but it fails to record changes in
real long-run values. There seems to be no completely satisfactory solution to this
problem, and it is wise to recognize the fact that any single figure of capital value that
purports to represent a complex, many-dimensional reality will need careful
interpretation.

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 The accumulation process.

A second problem concerns the factors that determine the rate of accumulation
of capital; that is, the rate of investment. It has been seen that investment in real terms
is the difference between production and consumption. The classical economist laid
great stress on frugality as the principal source of capital accumulation. If production
is constant it is true that the only way to increase accumulation is by the reduction of
consumption. Keynes shifted the emphasis from the reduction of consumption to the
increase of production, and regarded the decision to produce investment goods as the
principal factor in determining the rate of growth of capital. In modern theories of
economic development great stress is laid on the problem of the structure of
production--the relative proportions of different kinds of activity. The advocates of
"balanced growth" emphasize the need for a developing country to invest in a wide
range of related and cooperative enterprises, public as well as private. There is no
point in building factories and machines, they say, if the educational system does not
provide a labour force capable of using them. There is also, however, a case to be
made for "unbalanced growth," in the sense that growth in one part of the economy
frequently stimulates growth in other parts. A big investment in mining or in
hydroelectric power, for example, creates strains on the whole society, which result in
growth responses in the complementary sectors. The relation of inflation to economic
growth and investment is an important though difficult problem. There seems to be
little doubt that deflation, mainly because it shifts the distribution of income away
from the profit maker toward the rentier and bondholder, has a deleterious effect on
investment and the growth of capital. In 1932, for instance, real investment had
practically ceased in the United States. It is less clear at what point inflation becomes
harmful to investment. In countries where there has been long continuing inflation
there seems to be some evidence that the structure of investment is distorted. Too
much goes into apartment houses and factories and not enough into schools and
communications.

Capital and time.

A third problem that exists in capital theory is that of the period of production
and the time structure of the economic process. This cannot be solved by the simple
formulas of the Austrian school. Nevertheless, the problem is a real one and there is
still a need for more useful theoretical formulations of it. Decisions taken today have
results extending far into the future. Similarly, the data of today's decisions are the
result of decisions that were taken long in the past. The existing capital structure is the
embodiment of past decisions and the raw material of present decisions. The
incompatibility of decisions is frequently not discovered at the time they are made
because of the lapse of time between the decision and its consequences. It is tempting
to regard the cyclical structure of human history, whether the business cycle or the
war cycle, as a process by which the consequences of bad decisions accumulate until
some kind of crisis point is reached. The crisis (a war or a depression) redistributes
power in the society and so leads to a new period of accumulating, but hidden, stress.
In this process, distortion in the capital structure is of great importance.

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 Capital and income.

A fourth problem to be considered is the relationship that exists between the

stocks and the flows of a society, or in a narrower sense the relation between capital
and income. Income, like capital, is a concept that is capable of many definitions; a
useful approach to the concept of income is to regard it as the gross addition to capital
in a given period. For any economic unit, whether a firm or an individual, income
may be measured by that hypothetical amount of consumption that would leave
capital intact. In real terms this is practically identical with the concept of production.
The total flow of income is closely related to both the quantity and the structure of
capital; the total real income of a society depends on the size and the skills of its
population, and on the nature and the extent of the equipment with which they have to
work. The most important single measure of economic well-being is real income per
person; this is closely related to the productivity of labour, and this in turn is closely
related to capital per person, especially if the results of investment in human
resources, skills, and education are included in the capital stock.

Interest.

Historically, the concept of capital has been so closely bound to the concept of
interest that it seems wise to take these two topics together, even though in the
modern view it is capital and income rather than capital and interest that are the
related concepts.
Interest as a form of income may be defined as income that is received as a
result of the possession of contractual obligations for payment on the part of another.
Interest, in other words, is income that is received as a result of the ownership of a
bond, a promissory note, or some other instrument that represents a promise on the
part of some other party to pay sums in the future. The obligations may take many
forms. In the case of the perpetuity, the undertaking is to pay a certain sum each year
or other interval of time for the indefinite future. A bond with a date of maturity
usually involves a promise to pay a certain sum each year for a given number of
years, and then a larger sum on the terminal date. A promissory note frequently
consists of a promise to pay a single sum at a date that is some time in the future.
If a1, a2, . . . an are the sums received by the bondholder in years 1, 2 . . . n, and
if P0 is the present value in year 0, or the sum for which the bond is purchased, the
rate of interest r in the whole transaction is given by the equation

There is no general solution for this equation, though in practice it can be

solved easily by successive approximation, and in special cases the equation reduces
to much simpler forms. In the case of a promissory note, for instance, the equation
reduces to the form

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 where an is the single promised payment. In the case of a perpetuity with an
annual payment of a, the formula reduces to

Thus if one had to pay $200 to purchase a perpetual annuity of $5 per annum,
the rate of interest would be 2 1/2 percent.
It should be observed that the dimensions of the rate of interest are those of a
rate of growth. The rate of interest is not a price or ratio of exchange; it is not itself
determined in the market. What is determined in the market is the price of contractual
obligations or "bonds." The higher the price of a given contractual obligation, the
lower the rate of interest on it. Suppose, for instance, that one has a promissory note
that is a promise to pay one $100 in one year's time. If I buy this for $100 now, the
rate of interest is zero; if I buy it for $95 now the rate of interest is a little over 5
percent; if I buy it for $90 now, the rate of interest is about 11 percent. The rate of
interest may be defined as the gross rate of growth of capital in a contractual
obligation.
A distinction is usually made between interest and profit as forms of income.
In ordinary speech, profit usually refers to income derived from the ownership of
aggregates or assets of all kinds organized in an enterprise. This aggregate is
described by a balance sheet. In the course of the operations of the enterprise, the net
worth grows, and profit is the gross growth of net worth. Stocks, as opposed to bonds,
usually imply a claim on the profits of some enterprise.

The development of interest theory.

In ancient and medieval times the main focus of inquiry into the theory of
interest was ethical, and the principal question was the moral justification of interest.
On the whole, the taking of interest was regarded unfavorably by both classical and
medieval writers. Aristotle regarded money as "barren" and the medieval schoolmen
were hostile to usury. Nevertheless, where interest fulfilled a useful social function
elaborate rationalizations were developed for it. Among the classical economists, the
focus of attention shifted away from ethical justification toward the problem of
mechanical equilibrium. The question then became this: Is there any equilibrium rate
of interest or rate of profit in the sense that where actual rates are above or below this,
forces are brought into play, tending to change them toward the equilibrium? The
classical economists did not provide any clear solution for this problem. They
believed that the rate of interest simply followed the rate of profit, for people would
not borrow or incur contractual obligations unless they could earn something more
than the cost of the borrowing by investing the proceeds in enterprises or aggregates
of real capital. They believed that the growth of capital itself would tend to reduce the
rate of profit because of the competition of the capitalists. This doctrine is important
in the Marxian dynamics in which the struggle of capital to avoid a falling rate of
profit is seen as a critical factor leading, for instance, to unemployment, foreign
investment, and imperialism.
In the framework of classical economics, the work of Nassau Senior deserves
mention. He raised the question whether profit or interest were "paid for" anything;
that is, whether there was any identifiable contribution to the general product of

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society that would not be forthcoming if this form of income were not paid. He
identified such a function and called it abstinence. Karl Marx denied the existence of
any such function and argued that the social product must be attributed entirely to acts
of labour, capital being merely the embodied labour of the past. On this view, profit
and interest are the result of pure exploitation in the sense that they consist of an
income derived from the power position of the capitalist and not from the
performance of any service. Non-Marxist economists have generally followed Senior
in finding some function in society that corresponds to these forms of income.
The Marginalists generally held that profit and interest were related to the
marginal productivity of the extension of the period of production. Böhm-Bawerk
assumed that "roundabout" processes of production would generally be more
productive than processes with shorter periods of production; he thought there was a
productivity of "waiting" (to use the term of Alfred Marshall) and saw the rate of
interest as an inducement to the capitalist to extend the period of productionA low rate
of interest leads to concentration on longer, more roundabout processes, and a high
rate of interest on shorter, less roundabout processes. There is a limit, however, on the
period of production imposed by the existing stock of accumulated capital. If one
embarks on a long process with insufficient capital, he will find that he has exhausted
his resources before the end of the process and before the fruits can be gathered. It is
the business of the rate of interest to prevent this, and to adjust the roundaboutness of
the processes used to the capital resources available. The Marginalists' theory of
interest reached its clearest expression in the work of Irving Fisher. He saw an
equilibrium rate of interest as determined by the interaction of two sets of forces: the
impatience of consumers on the one hand, and the returns from extending the period
of production on the other.
John Maynard Keynes brought a new approach. His liquidity preference
theory of interest is a short-run theory of the price of contractual obligations
("bonds"), and it is essentially an application of the general theory of market price. If
people as a whole decide that they want to hold a larger proportion of their assets in
the form of money, and if new money is not created to satisfy this desire, there will be
a net desire to sell securities and the price of securities will fall. This is the same thing
as a rise in the rate of interest. Conversely, if people want to get rid of money the
price of securities will rise and the rate of interest will fall. This, then, is the theory of
the "market" rate of interest, by contrast with the Marginalists' theory, which concerns
itself with whether or not there is a long-run equilibrium rate of interest. The
controversy, therefore, between the liquidity preference theory--which regards interest
as a "bribe" to prevent people holding money rather than bonds--and the time
preference theory--which regards interest as a bribe to persuade people to postpone
enjoyments to the future--can be resolved by placing the former in the short run and
the latter in the long run

Contemporary questions.

The middle of the 20th century saw a considerable shift in the focus of
concern relating to the theory of interest. Economists seemed to lose interest in the
equilibrium theory, and their main concern was with the effect of rates of interest as a
part of monetary policy in the control of inflation. It was recognized that the monetary
authority could control the rate of interest in the short run. The controversy lay mainly
between the advocates of "monetary policy" and the advocates of " fiscal policy." If

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inflation is regarded as a symptom of a desire on the part of a society to consume and
invest more in total than its resources permit, it is clear that the problem can be
attacked either by diminishing investment or by diminishing consumption. On the
whole, the attack of the advocates of monetary policy is on the side of diminishing
investment, through raising rates of interest and making it harder to obtain loans,
though the possibility that high rates of interest may restrict consumption is not
overlooked. The alternative would seem to restrict consumption by raising taxes. This
has the disadvantage of being politically unpopular. The mounting concern with
economic growth, however, has raised considerable doubts about the use of high rates
of interest as an instrument to control inflation. There is some doubt whether high
interest rates in fact restrict investment; if they do not, they are ineffective, and if they
do, they may be harmful to economic growth. This is a serious dilemma for the
advocates of monetary policy. On the other hand, it must be admitted that the type of
fiscal policy that might be most desirable theoretically has achieved very limited
public support.

The ethics of interest.

The problem of the ethics of interest is still unresolved after many centuries of
discussion; as long as the institution of private property is accepted, the usefulness of
borrowing and lending can hardly be denied. In the long historic process of
inheritance, widowhood, gain and loss, by which the distribution of the ownership of
capital is determined, there is no reason to suppose that the actual ownership of
capital falls into the hands of those best able to administer it. Much of the capital of an
advanced society, in fact, tends to be owned by elderly widows, simply because of the
greater longevity of the female. Society, therefore, needs some machinery for
separating the control of capital from its ownership. Financial instruments and
financial markets are the principal agency for performing this function. If all
securities took the form of stocks or equities, it might be argued that contractual
obligations (bonds), and therefore interest as a form of income, would not be
necessary. The case for bonds and interest, however, is the case for specialization.
There is a demand for many different degrees of ownership and responsibility, and
interest-bearing obligations tap a market that would be hard to reach with equity
securities; they are also peculiarly well adapted to the obligations of governments.
The principal justification for interest and interest-bearing securities is that they
provide an easy and convenient way for skilled administrators to control capital that
they do not own and for the owners of capital to relinquish its control. The price
society pays for this arrangement is interest.
There remains the problem of the socially optimum rate of interest. It could be
argued that there is no point in paying any higher price than one needs to and that the
rate of interest should be as low as is consistent with the performance of the function
of the financial markets. This position, of course, would place all the burden of
control of economic fluctuations on the fiscal system, and it is questionable whether
this would be acceptable politically.
The ancient problem of "usury," in the form of the exploitation of the ignorant
poor by moneylenders, is still important in many parts of the world. The remedy is the
development of adequate financial institutions for the needs of all classes of people
rather than the attempt to prohibit or even to limit the taking of interest. The complex
structure of lending institutions in a developed society--banks, building societies, land
banks, cooperative banks, credit unions, and so on--testifies to the reality of the

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service that the lender provides and that interest pays for. The democratization of
credit--that is, the extension of the power of borrowing to all classes in society--is one
of the important social movements of the 20th century.
Wages are income derived from human labour. Technically they cover all
payments for the use of labour, mental or physical, but in ordinary usage the term
excludes income of the self-employed and is restricted to compensation of employees.
Occasionally fringe benefits are included, but generally they are not. The term is not
fully synonymous with labour costs, which may include such items as cafeterias or
meeting rooms maintained for the convenience of employees (such items are part of
capital). Wages, in economic terms, however, do include remuneration in the form of
extra benefits, such as paid vacations, holidays, and sick leave, as well as wage
supplements in the form of pensions and health insurance paid for by the employer. A
worker in covered industries also receives the protection of governmentally provided
unemployment compensation, old-age pensions, and industrial accident
compensation. Government services provided for workers are of even greater
significance in European countries than in the United States and must be taken into
account when comparisons of earnings are made

Classical theories.

Theories of wage determination and the share of labour in the gross national
product have varied from time to time and have changed as the economic
environment has changed. The body of thought referred to today as wage theories
could not have emerged until the old feudal system had disappeared and the modern
economy with its modern institutions had come into existence. Adam Smith, in The
Wealth of Nations (1776), failed to propose a definitive theory of wages, but he
anticipated several theories that were developed by others later. Smith thought that
wages were determined in the marketplace through the law of supply and demand.
Workers and employers would naturally follow their own self-interest; labour would
be attracted to the jobs where labour was needed most, and the result would be the
greatest overall benefit to the workers and to society. But Smith gave no precise
analysis of the supply of and demand for labour; he discussed many elements that
were involved but did not weave them into a consistent theoretical pattern.

Subsistence theory.

Subsistence theories emphasize the supply aspects and neglect the demand
aspects of the labour market. They hold that change in the supply of workers is the
basic force that drives real wages to the minimum required for subsistence. Elements
of a subsistence theory appear in The Wealth of Nations, where Smith wrote that the
wages paid to workers had to be enough to allow them to live and to reproduce
themselves. Smith was more optimistic, however, than the British classical
economists, such as David Ricardo and Thomas Malthus, who followed him, for he
implied that--at least in an advancing nation--the wage level would have to be above
subsistence to permit the population to grow enough to supply the additional workers
needed. Ricardo maintained a more rigid view. He wrote that the "natural price" of
labour was the price necessary to enable the labourers to subsist and to perpetuate the
race without increase or diminution. Ricardo's statement was consistent with the
Malthusian theory of population, which held that population adjusts to the means of
supporting it. The market price of labour could not vary from the natural price for

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long: if wages rose above subsistence, the number of workers would increase and
bring the wage rates down; if wages fell below subsistence, the number of workers
would decrease and bring the wage rates up. At the time that these economists wrote,
most workers were actually living near the subsistence level, and population appeared
to be trying to outrun the means of subsistence. The subsistence theory seemed to fit
the facts; and, although Ricardo said that the natural price of labour was not fixed and
might be changed if custom and habit moderated population increases in relation to
food supply and other items necessary to maintain labour, later writers tended to
subscribe to the basic idea and not to admit exceptions. Their inflexible and inevitable
conclusion earned the theory the name "iron law of wages."

Wages-fund theory.

Smith said that the demand for labour could not increase except in proportion
to the increase of the funds destined for the payment of wages. Ricardo maintained
that an increase in capital would result in an increase in demand for labour.
Statements such as these foreshadowed the wages-fund theory, which held that a
predetermined fund of wealth existed for the payment of wages. The size of the fund
could be changed over periods of time, but at any given moment the amount was
fixed, and the average wage could be determined simply by dividing the fund by the
number of workers. Smith thought of the fund as surplus income of wealthy men--
beyond the needs of their families and trade--which they would use to employ others.
Ricardo thought of it in terms of capital--food, clothing, tools, raw materials,
machinery, etc., necessary to give effect to labour. Regardless of the makeup of the
fund, the obvious conclusion was that when the fund was large in relation to the
number of workers, wages would be high. When it was relatively small, wages would
be low. If population increased too rapidly in relation to food and other necessities (as
outlined by Malthus), wages would be driven to the subsistence level. Therefore, it
would be to the advantage of labour to help promote the accumulation of capital to
enlarge the fund rather than to discourage it by forming labour organizations and
making exorbitant demands. Also, it followed that legislation designed to raise wages
would not be successful, for, with only a fixed fund to draw upon, increases gained by
some workers could be maintained only at the expense of others.
This theory was generally accepted for 50 years by economists, including such
well-known figures as Nassau William Senior and John Stuart Mill. W.T. Thornton,
F.D. Longe, and Francis A. Walker were largely responsible for discrediting the
theory during the decade following 1865. They pointed out that the demand for labour
was not determined by a fund but was derived from the consumer demand for
products. The proponents of the wages-fund doctrine had been unable to prove that
there was a determinate wage fund, or any fund maintaining a predetermined
relationship with capital or with the portion of the proceeds of labour's product paid
out in wages. Actually the amount paid out depended upon a number of factors,
including the bargaining power of labour. Yet, in spite of these telling criticisms, the
wages-fund theory continued to exercise an important influence until the end of the
19th century.

Marxian surplus-value theory.

Karl Marx accepted Ricardo's labour theory of value, but he subscribed to a

subsistence theory of wages for a different reason than that given by the classical

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economists. In Marx's mind, it was not the pressure of population that drove wages to
the subsistence level but rather the existence of a large army of unemployed, which he
blamed on the capitalists. He stated that the exchange value of any product was
determined by the amount of labour time socially necessary to create it. He held that
under the capitalistic system, labour was merely a commodity and could get only its
subsistence. The capitalist, however, could force the worker to spend more time on his
job than was necessary to earn his subsistence, and the excess product, or surplus
value, thus created, was taken by the capitalist.
From the point of view of classical theory, Marx's argument appeared
persuasive, although the term "labour time socially necessary" hid some serious
objections. The fatal blow came when the labour theory of value and Marx's
subsistence theory of wages were found to be invalid. Without them, the surplus-value
theory collapsed.

Residual-claimant theory.

The residual-claimant theory holds that, after all other factors of production
have received their share of the product, the amount left goes to the remaining factor.
Adam Smith implied such a theory for wages, since he said that rent would be
deducted first and profits next. Francis A. Walker in 1875 worked out a residual
theory of wages in which the shares of the landlord, capitalist, and entrepreneur were
determined independently and subtracted, thus leaving the remainder for labour in the
form of wages. It should be noted, however, that any of the factors of production may
be selected as the residual claimant, assuming that independent determinations may be
made for the shares of the other factors. It is doubtful, therefore, that such a theory has
much value as an explanation of wage phenomena.

Bargaining theory.

The bargaining theory of wages holds that wages, hours, and working
conditions are determined by the relative bargaining strength of the parties to the
agreement. Smith hinted at such a theory when he noted that employers had greater
bargaining strength than employees, because it was easier for employers to combine
in opposition to employees' demands and also because employers were financially
able to withstand the loss of income for a longer period than the employees. This idea
was developed to a considerable extent by John Davidson, who argued, in 1898, that
the determination of wages is an extremely complicated process involving numerous
influences that interact to establish the relative bargaining strength of the parties.
There is no one factor or single combination of factors that determines wages, and
there is no one rate that necessarily prevails. Because there are many possibilities,
there is a range of rates within which any number of rates may exist simultaneously.
The upper limit of the range is set by the rate beyond which the employer refuses to
hire certain workers. This rate is influenced by such considerations as the productivity
of the workers, the competitive situation, the size of the investment, and the
employer's estimate of future business conditions. The lower limit of the range is set
by the rate below which the workers will not offer their services to the employer. This
rate is influenced by such considerations as minimum wage legislation, the workers'
standard of living, their appraisal of the employment situation, and their knowledge of
rates paid to others. Neither the upper nor the lower limit is fixed, and either may

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move upward or downward. The rate or rates within the range are determined by
relative bargaining power.
The bargaining theory is very attractive to labour organizations, for, contrary
to the subsistence and wages-fund theories, it provides a very cogent reason for the
existence of unions. The bargaining strength of a union is much greater than that of
the members acting as individuals. Also there are situations (bilateral monopoly, for
instance) under which theoretical analysis arrives at a range of wage rates rather than
a determinate rate. The actual rate must depend upon relative bargaining power. It
should be observed, however, that historically labour was able to improve its situation
before its bargaining power became more effective through organization. Factors
other than the relative bargaining strength of the parties must have been at work. The
bargaining theory often gives an excellent explanation of a short-run situation, such as
the existence of certain wage differentials, but over the long run it fails to provide an
adequate understanding of the changes that have taken place in the average level of
wages.

Marginal-productivity theory and its critics.

Toward the end of the 19th century, marginal-productivity analysis was

applied not only to labour but to other factors of production as well. It was not a new
idea as an explanation of wage phenomena, for Smith had observed that a relationship
existed between wage rates and the productivity of labour, and Johann Heinrich von
Thünen, a German economist, had worked out a marginal-productivity type of
analysis for wages in 1826. The Austrian economists made important contributions to
the marginal idea after 1870; and, building on these grounds, a number of economists
in the 1890s, including Philip Henry Wicksteed in England and John Bates Clark in
the United States, elaborated the idea into the marginal-productivity theory of
distribution. It is likely that the disturbing conclusions drawn by Marx from classical
economic theory inspired this development. In the early 1930s refinements to the
marginal-productivity analysis, particularly in the area of monopolistic competition,
were made by Joan Robinson in England and Edward H. Chamberlin in the United
States.
As applied to wages, the marginal-productivity theory holds that employers
will tend to hire workers of a particular type until the addition made by the last
(marginal) worker to the total value of the product is equal to the addition to total cost
caused by the hiring of one more worker. The wage rate is established in the market
through the demand for, and supply of, the type of labour, and the operation of
competition assures the workers that they will receive a wage equal to the marginal
product. Under the law of diminishing marginal productivity, the contribution of each
additional worker is less than that of his predecessor, but workers of a particular type
are assumed to be alike, making them interchangeable, and any one could be
considered the marginal worker. All receive the same wage, and, therefore, by hiring
to the margin, the employer maximizes his profits. As long as each additional worker
contributes more to total value than he costs in wages, it pays the employer to
continue hiring. Beyond the margin, additional workers would cost more than their
contribution and would subtract from attainable profits.
The theory also provides an explanation of wage differentials. Wage
differentials are caused by differences in marginal product. The wages of skilled
workers are higher than those of unskilled workers because there are fewer skilled
workers, and their marginal product, therefore, is higher.

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 The marginal-productivity theory of wages became the prevailing wage
theory, and, although it has been attacked by many and discarded by some, no
acceptable alternative has been devised. The chief basis for criticism of the theory is
that it rests on unrealistic assumptions, such as the existence of homogenous groups of
workers whose knowledge of the labour market is so complete that they will always
move to the best job opportunities. Workers are, in fact, not homogenous; usually they
have little knowledge of the labour market; and because of home ties, seniority, and
other considerations, they do not often move quickly from one job to another. The
assumption that employers are able to measure productivity accurately and compete
freely in the labour market also is farfetched. Even the assumption that all employers
attempt to maximize profits may be doubted. The profit motive does not affect
charitable institutions or government agencies. For the theory to operate properly,
labour and capital must be fully employed so that increased production can be secured
only at increased cost; capital and labour must be easily substitutable for each other;
and the situation must be completely competitive.
Obviously these assumptions do not fit the real world, and some critics feel
that the results of the theory are so misleading that the theory should be abandoned.
The proponents argue, however, that productivity gives a rough approximation of
wages, and that although productivity may not provide the immediate explanation in a
particular case, it certainly indicates long-run trends. The theory, therefore, has
important uses, and if the difficulties are kept in mind, it can be a valuable tool.
In a modern economy, monopolistic or near monopolistic conditions exist in
some important areas, particularly where there are only a few large producers (such as
in the automobile industry) on one side of the bargaining table and powerful labour
organizations on the other. Under such circumstances, the marginal productivity
analysis cannot determine wages precisely; it can show only the positions that the
union (as a monopolist of labour supply) and the employer (as a monopsonist, or
single purchaser of labour services) will strive to reach, depending upon their current
policies.

Purchasing-power theory.

The purchasing-power theory of wages involves the relation between wages

and employment and the business cycle and is not, therefore, a theory of wage
determination. It stresses the importance of spending through consumption and
investment as an influence upon the activity of the economy. The theory gained
prominence during the Great Depression of the 1930s, when it became apparent that
lowering wages might not increase employment as previously had been assumed.
John Maynard Keynes, the British economist, maintained in his General Theory of
Employment, Interest and Money (1936), that (1) depressional unemployment could
not be explained merely by frictions in the labour market that interrupted the smooth
movement of the economy toward full employment equilibrium and (2) the
assumption that "all other things remained equal" presented a special case that had no
real applicability to the existing situation. Keynes related changes in employment to
changes in consumption and investment, and he pointed out that stable equilibrium
could exist with less than full employment.
Because wages make up such a large percentage of the national income,
changes in wages usually have an important effect upon consumption. It is possible
that lowering wages will reduce consumption and that, with the decline in demand for

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goods and services, the demand for labour may also fall, thus decreasing employment
rather than improving it. Whether this will be the result, however, depends upon
several considerations, particularly the reaction upon prices. If wages fall more
rapidly than prices, labour's real wages will be drastically reduced, and consumption
will fall, accompanied by increased unemployment, unless total spending is
maintained by increased investment. Entrepreneurs may look upon the lower wage
costs in relation to prices as an encouraging sign toward greater profits, in which case
they may increase their investments and employ more people at the lower rates, thus
maintaining or even increasing total spending and employment. If employers look
upon the falling wages and prices as an indication of further declines, however, they
may contract their investments or do no more than maintain them. In this case, total
spending and employment will decline.
If wages fall less rapidly than prices, labour's real wages will increase, and
consumption may rise. If investment is at least maintained, total spending in terms of
constant dollars will increase, thus improving employment. If entrepreneurs look upon
the shrinking profit margin as a danger signal, however, they may reduce their
investments; and, if the result is a reduction in total spending, employment will fall. If
wages and prices fall the same amount, there should be no change in consumption and
investment; and, in that case, employment will remain unchanged.
The purchasing-power theory involves psychological considerations as well as
those that may be measured more objectively. Whether it can be used effectively to
control the business cycle depends upon political as well as economic factors, because
government expenditures are a part of total spending, taxes may affect private
spending, etc. The applicability of the theory is to the whole economy rather than to
the individual firm.

LAND AND RENT

Rent in economics is specially defined. According to the neoclassical

economist Alfred Marshall, rent is the income derived from the ownership of land and
other free gifts of nature. He, and others after him, chose this definition for technical
reasons, even though it is somewhat more restrictive than the meaning given the term
in popular usage. Apart from renting land, it is of course possible to rent (in other
words, to pay money for the temporary use of any property) houses, automobiles,
television sets, and lawn mowers on the understanding that the rented item is to be
returned to its owner in essentially the same physical condition.
The more restrictive use of the term became popular rather early among
writers on economic matters. For the classical economists of the 18th and 19th
centuries, society was divided into three groups: landlords, labourers, and
businessmen (or the "moneyed classes"). This division reflected more or less the
sociopolitical structure of Great Britain at the time. The concern of economic theorists
was to explain what determined the share of each class in the national product. The
income received by landlords as owners of land was called rent.
It was observed that the demand for the product of land would make it
profitable to extend cultivation to soils of lesser and lesser fertility, as long as the
addition to the value of output would cover the costs of cultivation on the least fertile
acreage cultivated. On land of greater fertility--intramarginal land--the costs of
cultivation per unit of output would be below that price. This difference between cost
and price could be appropriated by the owners of land, who benefitted in this way
from the fertility of the soil--a "free gift of nature."

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 Marginal land (the least fertile cultivated) earned no rent. Since, therefore, it
was differences in fertility that brought about the surplus for landowners, the return to
them was called differential rent. It was also observed, however, that rent emerged not
only as cultivation was pushed to the "extensive margin" (to less fertile acreage) but
also as it was pushed to the "intensive margin" through more intensive use of the
more fertile land. As long as the additional cost of cultivation was less than the
addition to the value of the product, it paid to apply more labour and capital to any
given piece of land until the net value of the output of the last unit of labour and
capital hired had fallen to the level of its incremental cost. The intensive margin
would exist even if all land were of equal fertility, as long as land was in scarce
supply. It can be called scarcity rent, therefore, to contrast it with differential rent.
However, because the return to any factor of production, not only to land, can
be determined in the same way as scarcity rent, it was often asked why the return to
land should be given a special name and special treatment. A justification was found
in the fact that land, unlike other factors of production, cannot be reproduced. Its
supply is fixed no matter what its price. Its supply price is effectively zero. By
contrast, the supply of labour or capital is responsive to the price that is offered for it.
With this in mind, rent was redefined as the return to any factor of production over
and above its supply price.
With the supply price of land zero, the whole of its return is rent, so defined.
The return to any other factor may also contain elements of rent, as long as the return
stands above the next-most-lucrative employment open to the factor. For example, a
singer's employment outside the opera may bring a great deal less than the opera
actually pays. A large part of what the opera pays must therefore be called rent.
The opera singer's specific talent may be nonreproducible; like land, it is a
"free gift of nature." A particularly effective machine also, though its supply can be
increased in time by productive effort, may for a period also earn a quasi-rent, until
supply has caught up with demand. Where its supply is artificially restricted by a
monopoly, the quasi-rent may in fact continue indefinitely. All monopoly profits, it
has been argued, should therefore be classified as quasi-rent. Once this point has been
reached in the argument, there is perhaps no logical barrier to extending the meaning
of rent to cover all property returns. After all, profits and interest can persist only as
long as there is no glut of capital. The possibility of producing capital would presage
such a glut, one that has been staved off only by new scarcities created by technical
progress.

GENERAL THEORIES OF DISTRIBUTION

The theory of distribution deals with the way in which a society's product is
distributed among the members of that society. It involves three distinguishable sets
of questions. First, how is the national income distributed among persons? How many
persons earn less than $10,000, how many between $10,000 and $20,000, how many
between $20,000 and $30,000, and so on? Are there regularities in these statistics? Is
it possible to generalize about them? This is the problem of personal distribution.
Second, what determines the prices of the factors of production? What are the
influences governing the wage rate for a specific kind of labour? Why is the general
wage level of a country not lower or higher than it is? What determines the rate of
interest? What determines profits and rents? These questions have to do with
functional distribution. Third, how is the national income distributed proportionally
among the factors of production? What determines the share of labour in the national

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income, the share of capital, the share of land? This is the problem of distributive
shares. Although the three sets of problems are obviously interrelated, they should not
be confused with one another. The theoretical approaches to each of them involve
quite different considerations.
The basic idea in neoclassical distribution theory is that incomes are earned in
the production of goods and services and that the value of the productive factor
reflects its contribution to the total product. Though this fundamental truth was
already recognized at the beginning of the 19th century (by the French economist J.B.
Say, for instance), its development was impeded by the difficulty of separating the
contributions of the various inputs. To a degree they are all necessary for the final
result: without labour there will be no product at all, and without capital total output
will be minimal. This difficulty was solved by J.B. Clark (c. 1900) with his theory of
marginal products. The marginal product of an input, say labour, is defined as the
extra output that results from adding one unit of the input to the existing combination
of productive factors. Clark pointed out that in an optimum situation the wage rate
would equal the marginal product of labour, while the rate of interest would equal the
marginal product of capital. The mechanism tending to produce this optimum begins
with the profit-maximizing businessman, who will hire more labour when the wage
rate is less than the marginal product of additional workers and who will employ more
capital when the rate of interest is lower than the marginal product of capital. In this
view, the value of the final output is separated (imputed) by the marginal products,
which can also be interpreted as the productive contributions of the various inputs.
The prices of the factors of production are determined by supply and demand, while
the demand for a factor is derived from the demand of the final good it helps to
produce. The word derived has a special significance since in mathematics the term
refers to the curvature of a function, and indeed the marginal product is the (partial)
derivative of the production function.
One of the great advantages of the neoclassical, or marginalist, theory of
distribution is that it treats wages, interest, and land rents in the same way, unlike the
older theories that gave diverging explanations. (Profits, however, do not fit so
smoothly into the neoclassical system.) A second advantage of the neoclassical theory
is its integration with the theory of production. A third advantage lies in its elegance:
the neoclassical theory of distributive shares lends itself to a relatively simple
mathematical statement.
An illustration of the mathematics is as follows. Suppose that the production
function (the relation between all hypothetical combinations of land, labour, and
capital on the one hand and total output on the other) is given as Q = f (L,K) in which
Q stands for total output, L for the amount of labour employed, and K for the stock of
capital goods. Land is subsumed under capital, to keep things as simple as possible.
According to the marginal productivity theory, the wage rate is equal to the partial
derivative of the production function, or Q/ L. The total wage bill is ( Q/ L) L. The
distributive share of wages equals (L/Q) ( Q/ L). In the same way the share of
capital equals (K/Q) ( Q/ K). Thus the distribution of the national income among
labour and capital is fully determined by three sets of data: the amount of capital, the
amount of labour, and the production function. On closer inspection the magnitude
(L/Q) ( Q/ L), which can also be written ( Q/Q)/( L/L), reflects the percentage
increase in production resulting from the addition of 1 percent to the amount of labour
employed. This magnitude is called the elasticity of production with respect to labour.
In the same way the share of capital equals the elasticity of production with respect to
capital. Distributive shares are, in this view, uniquely determined by technical data. If

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an additional 1 percent of labour adds 0.75 percent to total output, labour's share will
be 75 percent of the national income. This proposition is very challenging, if only
because it looks upon income distribution as independent of trade union action, labour
legislation, collective bargaining, and the social system in general. Obviously such a
theory cannot explain all of the real economic world. Yet its logical structure is
admirable. What remains to be seen is the degree to which it can be used as an
instrument for understanding the real economic world.

Criticisms of the neoclassical theory.

Returns to scale.

Neoclassical theory assumes that the total product Q is exactly exhausted

when the factors of production have received their marginal products; this is written
symbolically as Q = ( Q/ L) L + ( Q/ K) K. This relationship is only true if the
production function satisfies the condition that when L and K are multiplied by a
given constant then Q will increase correspondingly. In economics this is known as
constant returns to scale. If an increase in the scale of production were to increase
overall productivity, there would be too little product to remunerate all factors
according to their marginal productivities; likewise, under diminishing returns to
scale, the product would be more than enough to remunerate all factors according to
their marginal productivities.
Research has indicated that for countries as a whole the assumption of
constant returns to scale is not unrealistic. For particular industries, however, it does
not hold; in some cases increasing returns can be expected, and in others decreasing
returns. This situation means that the neoclassical theory furnishes at best only a
rough explanation of reality.
One difficulty in assessing the realism of the neoclassical theory lies in the
definition and measurement of labour, capital, and land, more specifically in the
problem of assessing differences in quality. In macroeconomic reasoning one usually
deals with the labour force as a whole, irrespective of the skills of the workers, and to
do so leaves enormous statistical discrepancies. The ideal solution is to take every
kind and quality of labour as a separate productive factor, and likewise with capital.
When the historical development of production is analyzed it must be concluded that
by far the greater part of the growth in output is attributable not to the growth of
labour and capital as such but to improvements in their quality. The stock of capital
goods is now often seen as consisting, like wine, of vintages, each with its own
productivity. The fact that a good deal of production growth stems from
improvements in the quality of the productive inputs leads to considerable flexibility
in the distribution of the national income. It also helps to explain the existence of
profits.

Substitution problems.

Another difficulty arises from the fact that marginal productivity assumes that
the factors of production can be added to each other in small quantities. If one must
choose between adding one big machine or none at all to production, the concept of
the marginal product becomes unworkable. This "lumpiness" creates indeterminacy in
the distribution of income. From the viewpoint of the individual firm, this objection to
neoclassical theory is more serious than from the macroeconomic viewpoint since in

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terms of the national economy almost all additions to labour and capital are very
small. A related problem is that of substitution among factors. The production
function implies that land, labour, and capital can be combined in varying
proportions, that every conceivable input mix is possible. But in some cases the input
mix is fixed (e.g., one operator at one machine), and in that situation the neoclassical
theory breaks down completely because the marginal product for every factor is zero.
These cases of fixed proportions are scarce, however, and from a macroeconomic
viewpoint it is safe to say that a flexible input mix is the rule.
This is not to say that substitution between labour and capital is so flexible in
the national economy that it can be assumed that a 1 percent increase in the wage rate
will reduce employment by a corresponding 1 percent. That would follow from the
neoclassical theory described above. It is not impossible, but it requires a very special
form of the production function known as the Cobb-Douglas function. The pioneering
research of Paul H. Douglas and Charles W. Cobb in the 1930s seemed to confirm the
rough equality between production elasticities and distributive shares, but that
conclusion was later questioned; in particular the assumption of easy substitution of
labour and capital seems unrealistic in the light of research by Robert M. Solow and
others. These investigators employ a production function in which labour and capital
can replace each other but not as readily as in the Cobb-Douglas function, a change
that has two very important consequences. First, the effect of a wage increase on the
share of labour is not completely offset by changes in the input mix, so that an
increase in wage rates does not lead to a proportionate reduction in total employment;
and second, the factor of production that grows fastest will see its share in the national
income diminished. The latter discovery, made by J.R. Hicks (1932), is extremely
significant. It explains why the remuneration of capital (interest, not profits) has
shrunk from 20 percent or more a century ago to less than 10 percent of the national
income in modern times. In a society where more and more capital is employed in
production, a continually smaller proportion of the income goes to the owners of
capital. The share of labour has gone up; the share of land has gone down
dramatically; the share of capital has gradually declined; and the share of profits has
remained about the same. This picture of the historical development of income
distribution fits roughly into the frame of neoclassical theory, although one must also
make allowance for the short-run effects of inflation and the long-run effects of
technological progress

Returns to the factors of production.

The demand side of the markets for productive factors is explained in large
degree by the theory of marginal productivity, but the supply side requires a separate
explanation, which differs for land, labour, and capital.

Rent.

The supply of land is unique in being rather inelastic; that is, an increase in
rent does not necessarily increase the amount of available land. Landowners as a
group receive what is left over after the other factors of production are paid. In this
sense, rent is a residual, and a good deal of the history of the theory of distribution is
concerned with the issue whether rent should be regarded as part of the cost of
production or not (as in Ricardo's famous dictum that the price of corn is not high
because of the rent of land but that land has a rent because the price of corn is high).

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But inelasticity of supply is not characteristic only of land; special kinds of labour and
the size of the total labour force also tend to be unresponsive to variations in wages.
The Ricardian issue, moreover, was important in the context of an agrarian society; it
lacks significance now, when land has so many different uses.

Wages.

In analyzing the earnings of labour, it is necessary to take account of the

imperfections of the labour market and the actions of trade unions. Imperfections in
the market make for a certain amount of indeterminacy in which considerations of
fairness, equity, and tradition play a part. These affect the structure of wages--i.e., the
relationships between wages for various kinds of labour and various skills. Therefore
one cannot say that the income difference between a carpenter and a physician, or
between a bank clerk and a truck driver, is completely determined by marginal
productivity, although it is true that in the long run the wage structure is influenced by
supply and demand.
The role of the trade unions has been a subject of much debate. The naive
view that unions can raise wages by their efforts irrespective of market forces is, of
course, incorrect. In any particular industry, exaggerated wage claims may lead to a
loss of employment; this is generally recognized by union leaders. The opposite view,
that trade unions cannot influence wages at all (unless they alter the basic relationship
between supply and demand for labour), is held by a number of economists with
respect to the real wage level of the economy as a whole. They agree that unions may
push up the money wage level, especially in a tight labour market, but argue that this
will lead to higher prices and so the real wage rate for the economy as a whole will
not be increased accordingly. These economists also point out that high wages tend to
encourage substitution of capital for labour (the cornerstone of neoclassical theory).
These factors do indeed operate to check the power of trade unions, although the
extreme position that the unions have no power at all against the iron laws of the
market system is untenable. It is safe to say that basic economic forces do far more to
determine labour's share than do the policies of the unions. The main function of the
unions lies rather in modifying the wage structure; they are able to raise the
bargaining power of weak groups of workers and prevent them from lagging behind
the others.

Interest and profit.

The earnings of capital are determined by various factors. Capital stems from
two sources: from saving (by households, financial institutions, and businesses) and
from the creation of money by the banks. The creation of money depresses the rate of
interest below what may be called its natural rate. At this lower rate, businessmen will
invest more, the capital stock will increase, and the marginal productivity of capital
will decline. Although this chain of reactions has drawn the attention of monetary
theorists, its impact on income distribution is probably not very important, at least not
in the long run. There are also other factors, such as government borrowing, that may
affect the distribution of income; it is difficult to say in what direction. The basic and
predominant determinant is marginal productivity: the continuous accumulation of
capital depresses the rate of interest.
One type of earning that is not explained by the neoclassical theory of
distribution is profit, a circumstance that is especially awkward because profits form a

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substantial part of national income (20-25 percent); they are an important incentive to
production and risk taking as well as being an important source of funds for
investment. The reason for the failure to explain profit lies in the essentially static
character of the neoclassical theory and in its preoccupation with perfect competition.
Under such assumptions, profit tends to disappear. In the real world, which is not
static and where competition does not conform to the theoretical assumptions, profit
may be explained by five causes. One is uncertainty. An essential characteristic of
business enterprise is that not all future developments can be foreseen or insured
against. Frank H. Knight (1921) introduced the distinction between risk, which can be
insured for and thus treated as a regular cost of production, and uncertainty, which
cannot. In a free enterprise economy, the willingness to cope with the uninsurable has
to be remunerated, and thus it is a factor of production. A second way of accounting
for profits is to explain them as a premium for introducing new technology or for
producing more efficiently than one's competitors. This dynamic element in profits
was stressed by Joseph Schumpeter (1911). In this view, prices are determined by the
level of costs in the least progressive firms; the firm that introduces a new product or
a new method will benefit from lower costs than its competitors. A third source of
profits is monopoly and related forms of market power, whether deliberate as with
cartels and other restrictive practices or arising from the industrial structure itself.
Some economists have developed theories in which the main influence determining
distributive shares is the relative "degree of monopoly" exerted by various factors of
production, but this seems a bit one-sided. A fourth source of profits is sudden shifts
in demand for a given product--so-called windfall profits, which may be accompanied
by losses elsewhere. Finally, there are profits arising from general increases in total
demand caused by a certain kind of inflationary process when costs, especially wages,
lag behind rising prices. Such is not always the case in modern inflations.

Dynamic influences on distribution.

Prices.

Neoclassical theory throws light upon the long-run changes in distribution of

income. It fails to take account of the short-run impact of business fluctuations, of
inflation and deflation, of rapidly rising prices. This failure is an omission, though it is
true that distributive shares do not fluctuate as much as employment, prices, and the
state of business generally. This lagging in the behaviour of shares can be understood
by remembering that they are determined by the quotient of the real remuneration of
the factor and its productivity; both variables move, according to marginal
productivity theory, in the same direction. Yet inflation and deflation do have a
certain impact upon distribution: if purchasing power shrinks, profits are the first
income category to suffer; next come wages, particularly through the effects of
unemployment. In a depression, the recipients of fixed money incomes (such as
interest and pensions) gain from lower prices. In an inflation the opposite happens.
The traditional inflationary sequence was that as prices rose, profits would
increase, with wages lagging behind; this would tend to diminish the share of labour
in the national income. Experience since World War II, however, has been different;
in many countries wage levels tended to run ahead in the inflationary spiral and
profits lagged behind, although most entrepreneurs eventually succeeded in shifting
the burden of wage inflation onto the consumers. The result of the postwar inflation
was a slight acceleration of the increase in the share of labour, while the shares of

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capital and land decreased faster than they would have in the absence of inflation.
Profits as a whole held their own. The struggle among the various participants in the
economic process no doubt added fuel to the inflationary fires.

Technology.

Another dynamic influence is technological progress. The concept of the

production function assumes a constant technology. But in reality the growth of
production is much less the consequence of increased quantities of labour and capital
than of improvements in their quality. This element in increased production is
distributed in a way not fully explained by neoclassical theory. Part of the change in
distribution that is caused by technological progress can be analyzed as resulting from
changes in the elasticities of

production. If goes up, technological change is said to be "capital-

using," and the share of capital will increase. This is what, in fact, may have
happened; the change in technology has offset, though it has not neutralized, the
decline in the share of capital caused by the employment of a higher amount of capital
per worker. But another part of the fruits of technological progress is garnered by
profit receivers, probably quite a substantial part. Businessmen who are quick
innovators make high profits; in a rapidly changing society, profits tend to be high, a
circumstance that is fortunate because profits are the mainspring of economic change.
The high rate of growth experienced by the post-World War I Western world
stemmed from this profit-innovation-profit nexus.

Personal income and neoclassical theory.

The neoclassical theory endeavours to explain the prices of productive factors

and the distributive shares received by them. It does not come to grips with a third
category of distribution, that of personal income, which is much more affected by
institutional arrangements and by characteristics of the social structure. Profits in
particular may be shared in various ways: they may accrue to stockholders, to
workers, to management, or to the government; or they may be retained in the
corporation. What happens depends on dividend policy, tax policy, and the existence
of profit-sharing arrangements with workers. Neoclassical theory has little to say on
these matters or on the fact that in present-day capitalist society the managers of big
business are virtually in a position to fix their own personal incomes. Managers have
so much power vis-à-vis the stockholders and their total share of profits is so
relatively little that their ability to pay themselves high salaries is limited only by the
conventions of the business world. These high incomes cannot be explained by the
categories of the neoclassical theory, and they do not constitute an argument against
the theory. They may well argue for changes in society's institutions, but that is a
matter on which the neoclassical theory of distribution does not pontificate. A great
deal of change could occur in the legal and social order without any disturbance to the
theory.

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 Consumption

In economics the word consumption means the using up of goods and

services. In modern economic terms it means, specifically, "final" consumption as
distinguished from the using up of goods to produce other goods in a manufacturing
industry. Final consumption must also be distinguished from the purchase by industry
of fixed assets such as buildings and machinery, which is known as capital formation
or investment. On the other hand, consumption expenditure by private persons is
understood to include the purchase of durable goods, such as furniture or vehicles, as
well as works of art that may increase in value over a period of time. The acquisition
of such goods should actually be considered asset formation rather than consumption
and should be classified with the acquisition of other assets such as houses, schools,
roads, and hospitals.
In modern industrial economies, consumption as previously defined accounts
for 70 or 80 percent of total national expenditure. Even in the Western capitalist
countries a significant part of total consumption is determined directly by the
expenditure of public authorities. Some of the benefits of this part of consumption,
such as expenditure on defense or on public health, are widely diffused; others are
directed by common consent to the benefit of particular sections of the community.
These consist in part of specialized services such as education or medical care; but
other services--such as unemployment compensation, state pensions for the elderly,
and assistance to families deprived of the support of a wage earner--are designed to
create greater equality in levels of consumption than would otherwise be obtained.

PATTERNS OF NATIONAL CONSUMPTION

The ways in which people spend their incomes show much uniformity among
countries at the same economic level. Expenditure patterns in the United Kingdom,
for example, are typical of western Europe. In 1949 the pattern was still affected by
postwar shortages and rationing, but the level of total consumption was not very
different from what it had been before the war. In the decades that followed, private
consumption expenditure per person (measured at constant prices) doubled. In
addition there was a great increase in public services such as health and education.
Yet the broad distribution of expenditures remained strikingly constant in spite of the
introduction of many new commodities and considerable changes in their relative
prices. The percentage of total expenditure devoted to food fell, a phenomenon that
usually accompanies a rising standard of living, and the largest proportionate
increases were in the purchase and maintenance of private motor vehicles, of furniture
and household goods, and of radio, television, and electrical goods. These three
categories represent in part net additions to private wealth in the form of durable
goods and also reflect the effect of technical progress. As in other industrial countries,
much of the improvement in living standards has taken the form of more travel, better
communication services, and the acquisition of labour-saving equipment.
In most of the industrialized countries there has been a compound rate of
increase in the total volume of consumption expenditure per person of 10 to 12
percent per year, the main exceptions to this being the United Kingdom and Japan,
where consumption has grown at double this rate. But the pattern of change is similar
in almost all countries. Food consumption has grown less rapidly than total
consumption, particularly in the Scandinavian countries, Germany, and the countries
of North America, where the rate of increase has been about 7 percent per year;

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expenditure on clothing has been growing at about the same rate as total consumption.
Increases in rent outlays reflect higher energy costs in all of the industrialized
countries. The acquisition of durable goods continues at a very high rate in all
countries.
Comparable data on consumption in the poorer countries of the world are
much harder to obtain and are usually less reliable, but it is probable that, expressed
as a proportion of total consumption, food expenditure is about twice as important in
much of Asia, Africa, and Latin America as it is in western Europe and North
America. In the most economically advanced countries, food expenditure represents
only one-quarter to one-third of the total, whereas in countries where the total
expenditure per household is less than the equivalent of $1,500, the proportion rises to
one-half or even greater. It should be noted that in the rural regions of poor countries
the housing expenditure is minimal; in these areas shelter is rudimentary and largely
self-provided
Food consumption varies in character from country to country. This variation
is due in part to climatic factors, and it also reflects differences in national food
habits. The diet that is normally eaten in northern Europe and in Scandinavia is
relatively low in fruit and vegetables but it contains a high proportion of milk, fats,
and sugar. In France the consumption of vegetables and meat is relatively high. Fruit
and vegetable consumption is generally high in southern Europe, while milk
consumption in this area is low. In the Mediterranean countries food grains are
generally preferred to potatoes and sugar as sources of carbohydrates.
But aside from these regional variations, the influence of general living
standards is evident. The North American diet, for example, with its low grain and
potato consumption and high consumption of sugar, meat, eggs, and fats is
attributable more to a high standard of living than to any regional peculiarities of
taste. These characteristics can be observed in the diets of the wealthier classes of
most countries.
The influence of the general standard of living is also shown in the relative
priorities that are accorded to the increased consumption of particular foods as
incomes increase. These priorities are measured by economic statisticians in the form
of income elasticities of expenditure, defined as the percentage increase in the
consumption of an item divided by the percentage increase in income that makes the
increased consumption possible. These elasticities are usually calculated for a given
country by comparing the budgets of wealthy households with those of poor families.
In countries such as the United States and Great Britain, the consumption of cereal
foods actually decreases as incomes increase. In the less developed countries the
elasticities are usually considerably higher, particularly for fruit and for products of
animal origin. In these countries the consumption of carbohydrate foods is also
increasing fairly rapidly as incomes rise.

THEORIES OF CONSUMER BEHAVIOUR

Factors influencing consumers.

Model of consumer behavior.

The theory and measurement of consumer behaviour forms an important part

of modern economic theory. It was first developed during the 19th century on the
basis of the following conceptions: that the purchase of any commodity gives the

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consumer a positive satisfaction or utility; the additional satisfaction derived from
additional purchases of the same commodity declines as the consumer's supply of that
commodity increases; and with a given amount of money to spend, the consumer
distributes the expenditure among commodities to maximize the total satisfaction or
utility attainable from all those purchases. This rather crude model of consumer
behaviour has undergone considerable refinement by modern mathematical
economists. The advantage of this approach, which has had a strong and enduring
effect on the theoretical and empirical work of economists, is that it separates the
main economic variables influencing consumer behaviour--that is, income and
prices--from all the remaining influences, such as individual preferences, social
pressures, customs, and habits, but at the same time it unites them in a single
analytical apparatus. Critics have often objected that the model assumes a rational
person bent on scrupulously maximizing his satisfaction and that the model is thus
part of a mechanistic stream of thought that has been substantially undermined by
20th-century advances in psychology. Still, the only useful criterion of any hypothesis
is the range of situations in which the derivative model is shown validly to predict
events. For example, it is useful to assume that the leaves of a tree attempt to
maximize the amount of sunlight they receive, since the assumption implies that
leaves are denser on the sunny side of trees than on the shady side, which can be
checked from experience, or that billiard players make their shots as if they knew the
mathematical formulas of mechanics. Similarly, to assume that consumers behave as
if they were rational utility maximizers helps to provide accurate predictions of a
broad range of market phenomena; e.g., a fall in the price of a commodity will
generally lead to increased consumption of that commodity, and an increase in
consumer income will lead to increased consumption of most commodities. Only
persistent discrepancies between predictions and events require a modification of the
model's assumptions; some examples of such cases are discussed below.

Income as determinant.

The theory points to the income of consumers as the most important single
determinant of their consumption patterns. It follows that in any community both the
average income level and the distribution of incomes are important influences on total
consumption. A community in which incomes are equally distributed consumes fewer
luxury goods and fewer low-quality goods than one containing a few wealthy
individuals and many poor people. Among wealthy people in early 19th-century
England, a dinner with five main protein dishes--fish, meat, game, poultry, and ragout
with truffles--was described as the minimum, while in poor years the families of
agricultural labourers ate mainly oatmeal and potatoes; today the standardized
produce of modern agriculture is part of most diets.
The classic model of consumers' behaviour implicitly assumes that the
individual enjoys a constant income. In practice it may fluctuate according to the
season, from year to year, or more generally over a lifetime. In the short run the
consumption of some commodities is much affected by these income fluctuations,
while the consumption of others is affected very little. Wage-earning households
commonly have a weekly housekeeping allowance, out of which the necessities of
food and clothing are bought, while the variable excess of earnings is spent on
tobacco, alcoholic drinks, and entertainment. The expected average level of future
income therefore influences consumption habits as much as actual present income,
and commodities may be divided into two classes. The first consists of goods people

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buy when temporarily affluent but give up when temporarily poor, and the second
consists of goods for which the pleasure of a temporarily higher level of consumption
would not be worth the financial or psychological cost of giving them up in the future.
Consumers can also be influenced by their previous incomes. A person who
owns an expensive car may continue to use it after his income falls, though at the
lower level of income the individual would not choose to replace it with a similarly
expensive vehicle in the long run. This may be a rational decision, in the sense that
the value of the car in use may be greater than what it is worth in the second-hand
automobile market; or it may be irrational, in the sense that an expensive habit that
should have been abandoned is continued beyond the point where it can rationally be
supported. The distinction is largely subjective and cannot be clearly made by an
outside observer.
Over the life cycle as a whole, consumption patterns are markedly different in
various occupations. In most of the unskilled or semiskilled occupations, the course of
earnings is fairly stable: a young worker of 21 may earn as much as an older person.
But in many of the professions an individual of 50 or 60 may earn many times the
income of a person of 21; this gives the young wage earner a strong incentive to incur
considerable debt with the expectation of amortizing it steadily throughout life, so that
the typical consumption pattern of the occupation can be achieved earlier than
otherwise. This applies particularly to such major purchases as houses, household
furniture and equipment, and vehicles. Manual workers, on the other hand, whose
expectations are little greater than their present consumption, generally prefer to rent
living space rather than to own a house and are unwilling to raise their current
consumption standards by incurring commitments of a longer term than that of
ordinary installment credit.

Nonrational influences.

To be fully rational and consistent, consumers need to have access to

sufficient information on goods and their prices so that they can choose those with the
lowest unit price for a given quality. But consumers do not always behave this way.
Natural pearls are sold at a much higher price than cultured pearls, though the
difference between them is demonstrable only by dissection or with X-rays, and their
quality in use is identical. Brand-name drugs sell better and at higher prices than
unbranded drugs that are manufactured from the same standard formula. To some
extent this is due to what an American economist, Thorstein Veblen, called the desire
for conspicuous consumption: part of the attraction of the good is simply its high
price. It is also the result of consumers' ignorance, made more acute by the increasing
sophistication of commodities whose qualities must be measured in many dimensions.
If it is costly in time for the individual to become fully informed about the
comparative qualities of competing products, it is not wholly irrational for the
consumer to take the market price as an indicator of quality. The lack of information
has given rise to consumers' organizations in most industrialized countries; these
organizations test and report on a wide range of products for their subscribers.
The influence of modern advertising techniques must also be considered.
Insofar as advertising informs the consumer of the range of alternatives, it can be
argued that advertising merely increases the consumer's information; and insofar as
advertising consciously or subconsciously changes consumer preferences, it remains
one of the many factors determining consumer preferences that the economist takes as
given. Advertising, however, cannot persuade the public to buy whatever the producer

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offers. Advertising is likely to be most effective in influencing consumers to choose
one of several almost identical products being offered, such as toothpaste, cigarettes,
or gasoline. But it may also raise the demand for the group of competing products as a
whole. In addition, it can be argued that the total effect of modern advertising is to
shift the preferences of consumers in favor of luxury goods rather than necessities, in
favor of consumption rather than saving, and in favor of employment rather than
leisure.

Attitudes toward necessities and luxuries.

The distinction between necessities and luxuries is imprecise. The dividing

line varies with the income and social class of the classifier and shifts as technology
develops and as social values change. Only in the most undeveloped communities can
necessities be defined purely in terms of physiological needs. Adam Smith wrote in
1776:
By necessaries I understand not only the kind of commodities which are
indispensably necessary for the support of life, but whatever the custom of the country
renders it indecent for creditable people, even of the lowest order, to be without. . . .
Under necessaries, therefore, I comprehend not only those things which nature, but
those things which the established rules of decency have rendered necessary to the
lowest rank of people. All other things I call luxuries; without meaning by this
appellation to throw the smallest degree of reproach upon the temperate use of them.
Beer and ale, for example, in Great Britain, and wine, even in the wine countries, I
call luxuries. A man of any rank may, without any reproach, abstain totally from
tasting such liquors. Nature does not render them necessary for the support of life, and
custom nowhere renders it indecent to live without them.
In the 19th century, with the development of more mathematical methods of
reasoning based on a utilitarian calculus, the distinction came to be phrased
differently. Necessities were defined as those commodities the demand for which has
an income elasticity less than unity, and luxuries as those with an income elasticity
greater than unity. These definitions imply that as a worker's income increases the
expenditure on necessities increases less than, and the expenditure on luxuries more
than, proportionately. But even with the elasticity approach the distinction must vary
over time. In 1950 the demand for television sets had high income elasticity, whereas
now, in some countries, television often is regarded as a necessity.
Economists of the early 19th century all believed that the living standards of
the working classes in capitalist societies would remain close to a subsistence level,
meaning that luxuries would be more or less permanently denied them. But in modern
industrialized economies even the poor consume goods that the early economists
would not have considered necessary.

Role of luxuries.

The historical and social role of luxury consumption is a subject of much

interest. In the Mediterranean city-states during the Renaissance, the demand for
luxuries provided a mainspring for the specialization of skilled labour and for the
development of foreign travel and long-distance trade. The duke of Milan, Filippo
Maria Visconti, possessed valuable English dogs, leopards from all parts of the East,
and hunting birds from northern Europe. Some writers have argued that the luxurious
consumption of the rich benefits the poor through the provision of employment

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opportunities that would not otherwise exist. A subtler version of this idea was
proposed by Adam Smith, who contrasted the uselessness of menial labour employed
by the rich for personal services with the benefits flowing from the employment of
craftsmen who created luxurious products of enduring merit that eventually became
available to society as a whole:
The houses, the furniture, the clothing of the rich, in a little time, become
useful to the inferior and middling ranks of people. . . . What was formerly a seat of
the family of Seymour is now an inn upon the Bath road. The marriage-bed of James
the First . . . was, a few years ago, the ornament of an ale-house at Dunfermline.
But Smith and most of the economists who succeeded him believed that if the
money spent on luxurious consumption by the rich was invested in useful production,
society would benefit as a whole. The Industrial Revolution brought an increasing
demand for funds for productive investment and made possible a more rapid rise in
general standards of living than the world had known before. The classical economists
thus argued that all luxury consumption involved a selfish diversion of labour and
capital and acted as a brake on human progress.
This view was not seriously challenged until the English economist J.M.
Keynes published his General Theory of Employment, Interest and Money in 1935-36.
Writing at a time when millions of workers were unemployed, Keynes argued that the
consumption of luxuries was socially desirable if it provided jobs that would
otherwise not exist. He also suggested that capitalism might be outrunning its
investment opportunities, so that in the long run the problem of finding employment
for capital itself would arise--a difficulty that might be postponed if the wealthy spent
more on themselves:
In so far as millionaires find their satisfaction in building mighty mansions to
contain their bodies when alive and pyramids to shelter them after death, . . . the day
when abundance of capital will interfere with abundance of output may be postponed.
In industrial countries since World War II, this pessimistic view has been
overborne by a seemingly endless expansion in consumer industries. As fast as
consumers accumulate durable goods, they become technologically or conventionally
obsolete and are replaced by new goods. Instead of seeking more leisure, previously
thought to be a main benefit of technical progress, the populations of the
industrialized countries seem to prefer to work in order to buy more luxuries. To this
extent the desire for leisure and the demand for luxuries are in direct competition.

Standards of consumption.

In Communist countries, public consumption has long been treated as more

important than private luxury. In the last part of the 20th century this emphasis
seemed to be giving way to the aim of catching up with the standards of consumption
that prevail in capitalist countries. In the undeveloped countries of the Third World,
the tension between the demand for luxuries and the low standard of living gives rise
to acute economic and social problems. The rapid growth of international travel and
communications since World War II has led the literate and skilled classes of every
nation to seek similar standards of private consumption regardless of their national
environment. This, in undeveloped countries, leads either to a highly unbalanced
distribution of the national income or to the emigration of the skilled population. Thus
the increasing awareness of the consumption habits of the most fortunate sections of
the world's population is both a spur and a hindrance to general progress.

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 Economic fluctuations: stability and instability

BUSINESS CYCLES

Figure 11: Wholesale price indexes for United States, Great Britain, Germany,
and France, 1790-1940.

Business cycles are best defined as fluctuations in the general level of

economic activity, or more specifically, in the levels of employment, production, and
prices. Figure 11 shows fluctuations in wholesale prices in four Western industrialized
countries over the period from 1790 to 1940. Though some regularities in price
movements are apparent, it is possible to ask whether the movements are regular
enough to be called cycles.
The word cycle derives from the Greek word for circle. An object moving
around a circle returns to its starting point; a wave motion, with upward and
downward curves, may also be considered a cycle. The various movements
characteristic of economic activity are not always as regular as waves, and for this
reason some prefer to call them fluctuations.
There are many types of economic fluctuations. Because of the complexity of
economic phenomena, it may be that there are as many types of fluctuations or cycles
as there are economic variables. There are daily cycles in commuter traffic or the
consumption of electricity, to cite only two examples. Almost every aspect of
economic life displays seasonal variations: sales of coal or ice, deposits in savings
banks, monetary circulation, agricultural production, purchases of clothing, travel, and
so on. As one lengthens the span of observation, one finds new kinds of fluctuations
such as the hog cycle and the wheat cycle, the inventory cycle, and the construction
cycle. Finally, there are movements of general economic activity that extend over
periods of years.
Modern economic history has recorded a number of periods of difficult times,
often called depressions, during which the business economy was marked by sudden
stock market declines, commercial bankruptcies, bank failures, and mounting
unemployment. Such crises were once looked upon as pathological incidents or
catastrophes in economic life, rather than as a normal part of it. The notion of a
"cycle" implies a different view.

Juglar's eight-year cycle.

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 The first authority to explore economic cycles as periodically recurring
phenomena was probably a French physician, Clément Juglar, in 1860. Other writers
who developed Juglar's approach suggested that the cycles recur every nine or 10
years, and distinguished three phases, or periods, of a typical cycle: prosperity, crisis,
and liquidation. Subsequent analysis has tended to designate 1825, 1836, 1847, 1857,
1866, 1873, 1882, 1890, 1900, 1907, 1913, 1920, and 1929 as initial years of crisis. If
that is correct, then the average interval between them was eight years, rather than
nine or 10 as suggested by Juglar. In the years since 1929, the regularity of business
fluctuations has been somewhat offset by government anticyclical policies.
The so-called Juglar cycle has often been regarded as the true, or major,
economic cycle, but several smaller cycles have also been distinguished. Close study
of the interval between the peaks of the Juglar cycle suggests that partial setbacks
occur during the expansion, or upswing, and that there are partial recoveries during
the contraction, or downswing. These smaller cycles generally coincide with changes
in business inventories, lasting an average of 40 months. Other small cycles result
from changes in the demand for and supply of particular agricultural products such as
hogs (three to four years), cotton (two years), and beef (five years in the Netherlands).
Hide and leather production fluctuates in an 18-month cycle.

Kondratev's waves.

Longer cycles have also been studied. The construction industry has been
found to have cycles of 17 to 18 years in the United States and 20 to 22 years in
England. Finally, there are the long waves, or so-called Kondratev cycles, named for a
Russian economist, Nikolai D. Kondratev, who showed that in the major Western
countries during the 150 years from 1790 to 1940 it was possible to distinguish three
periods of slow expansions and contractions of economic activity averaging 50 years
in length
1. 1792-1850 Expansion: 1792-1815 23 years
Contraction: 1815-50 35 years
2. 1850-96 Expansion: 1850-73 23 years
Contraction: 1873-96 23 years
3. 1896-1940 Expansion: 1896-1920 24 years
Contraction: 1920-40 20 years
Only these three Kondratev waves have been observed.
Some students of business cycles have analyzed them by statistical methods,
in the hope of finding regularities that are not immediately apparent. One speculative
theory has held that the larger cycles were built up from smaller ones. Thus, two
seasonal cycles would produce a two-year cycle, two of which would produce a four-
year cycle; two four-year cycles would become an eight-year, or Juglar, cycle, and so
on. The hypothesis is not widely accepted.

Patterns of depressions and upswings.

Cycles of varying lengths are closely bound up with economic growth. In

19th-century Germany, for example, upswings in total economic activity were
associated with the growth of the railroad, metallurgy, textile, and building industries.
Periodic crises brought slowdowns in growth. The crisis of 1873 led to a wave of
financial and industrial bankruptcies; recovery started in 1877, when iron production
ceased to fall, and by 1880 a new upswing was under way. The recession of 1882 was

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less severe than the previous one, but a slump that began in 1890 led to a serious
depression, with complaints of overproduction.
The year 1890 was also one of financial crisis in England and the United
States. The British banking house of Baring Brothers failed, partly because of a
revolution in Argentina. English pig-iron production fell from 8,300,000 tons in 1889
to 6,700,000 in 1892, and unemployment increased. That depression might have been
less severe but for the international financial crisis, especially intense in the United
States, where in 1893 a stock market panic led to widespread bank failures.
The recession of 1900 was followed by an unusually vigorous upsurge in
almost all of the Western economies. U.S. pig-iron production increased by more than
150 percent during the expansion, which lasted until 1907; building permits more than
doubled; and freight traffic rose by more than 50 percent. Prices rose more and more
rapidly as the U.S. economy approached full employment.

Deviations from cycle patterns.

Cycles are compounded of many elements. Historical fluctuations in economic

activity cannot be explained entirely in terms of combinations of cycles and
subcycles; there is always some factor left over, some element that does not fit the
pattern of other fluctuations. It is possible, for example, to analyze a particular
fluctuation into three principal components: a long component or trend; a very short,
seasonal component; and an intermediate component, or Juglar cycle. But these
components cannot be found exactly recombined in another fluctuation because of a
residual element in the original fluctuation that does not have a cyclical form. If the
residual is small, it might be attributed to errors of calculation or of measurement. Or,
the residual might be regarded as the result of such accidental events as epidemics,
floods, earthquakes, riots, strikes, revolutions, or wars, which obviously cannot be
fitted into a recurring pattern. On a more sophisticated statistical level, it can be
treated as "random movement." If the random element is always present, it becomes
an essential element of the analysis to be dealt with in terms of probability.
A more rigorous analysis has to go even further. One difficulty in separating
out the components of economic movements is that the components are not perfectly
independent of each other. The determination of a long component or trend assumes
that the Juglar component is already known. In the same way, determining the Juglar
component requires isolating it from the long-term component. Probably only the
seasonal component can be isolated independently of the others, and that because it is
immediately related to such noneconomic factors as climate or custom. To avoid such
difficulties, researchers have tried looking for "hidden periodicities," using a
mathematical technique known as harmonic analysis, or Fourier series. Two
alternative methods are open to them: they may assume a certain periodicity and try to
fit the statistical data to the resulting equation, or they may ask mathematicians to
supply all of the possible periodicities contained in the data and then determine which
are the most probable.
For practical purposes, it would be useful to know the typical shape of a cycle
and how to recognize its peak and trough. A great amount of work has been done in
what may be called the morphology of cycles. In the United States, Arthur F. Burns
and Wesley C. Mitchell have based such studies on the assumption that at any specific
time there are as many cycles as there are forms of economic activity or variables to
be studied and have tried to measure these in relation to a "reference cycle," which
they artificially constructed as a standard of comparison. The object in such studies

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was to describe the shape of each specific cycle, to analyze its phases, to measure its
duration and velocity, and to measure the amplitude or size of the cycle.
In studying various cycles, it has been possible to construct "lead and lag
indicators"--that is, statistical series with cyclical turning points consistently leading
or lagging behind the turns in general business activity. Researchers using these
methods have identified a number of series, each of which reaches its turning point
from two to 10 months before the turns in general business activity, and another group
of series, which has followed the turns in business by two to seven months. Examples
of leading series include published data for new business orders, residential building
contracts, the stock market index, business failures, and the length of the average
workweek. These and other leading indicators are widely used in economic
forecasting.

Dynamic analyses of cycles.

A satisfactory explanation of cycles must isolate the forces and relationships

that tend to produce these recurrent movements. There have been many theories of the
business cycle. An understanding of them requires analysis of some of the factors that
can cause cyclical movements.
One such factor is the relationship between investment and consumption. Any
new expenditure--e.g., on building a road or a factory--generates several times as
much income as the expenditure itself. This is so because those who are paid to build
the road or factory will spend more of what they receive; their expenditures will thus
become income for others, who will in their turn spend most of what they receive.
Every new act of investment will, thus, have a stimulating effect on aggregate income.
This relationship is known as the investment multiplier. Of itself, it cannot produce
cyclical movements in the economy; it merely provides a positive impulse in an
upward direction
To the relationship between investment and consumption must be added that
between consumer demand and investment. An increase in demand for refrigerators,
for example, will eventually require increased investment in the facilities for
producing them. This relationship is known as the accelerator; and it implies that an
increase in national income will stimulate investment. As with the multiplier, it cannot
of itself explain cyclical movements; it merely accounts for a fundamental instability.
It can be shown, however, that the multiplier and accelerator in combination
may produce very strong cyclical movements. Thus, when an increase in investment
occurs, it raises income by some larger amount, depending on the value of the
multiplier. That increase in income may in turn induce a further increase in
investment. The new investment will stimulate a further multiplier process, producing
additional income and investment. In theory, the interaction might continue until a
point is reached at which such resources as labour and capital are being fully utilized.
At that point--with no increase in employment and, therefore, no rise in consumer
demand--the operation of the accelerator would cease. That halt in demand, plus the
lack of new capital, would cause new investment to decline and workers to be laid off.
The process thus would go into reverse. The fluctuations in national income could
take various forms, depending on the characteristics of the economy and the way in
which the population allocated its income between consumption and savings. Such
spending habits, of course, affect both the levels of consumer demand and capital

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investment. This theoretical analysis does not explain actual economic fluctuations; it
is merely an aid to understanding them.
The analysis can be made more realistic by taking into account three other
factors. First, since the theoretical, wide-swinging cycles engendered by the
interaction of the multiplier and the accelerator are observed to occur only within
narrow limits, one may assume that although the economy has an inherent tendency to
swing very widely there are limits beyond which it cannot go. The upper limit to the
swings would be the point at which full employment or full capacity is reached; the
lower limit is more difficult to define, but it would be established when the forces that
make for long-term economic growth begin to operate. Thus, the upswing of a cycle
stops when it meets the upper limit; and the downswing stops at the lower limit,
resulting in continuous cyclical movements with an overall upward trend--a pattern
corresponding to the one found in history.
The occurrence of time lags--the inevitable delays between every decision and
its effects--provides another reason for expecting cyclical fluctuations to occur in any
economic process. This phenomenon is illustrated, for example, in the relation
between the action of a thermostat and the temperature of a room. A fall in room
temperature causes the thermostat to turn on the heater; but there is a lag in time until
the room warms up sufficiently to cause the thermostat to turn the heat off,
whereupon the temperature begins to fall again. The shape of the curve of the
temperature cycle will depend on the responsiveness of the thermostat and on the time
required to raise the temperature of the room. By making various adjustments, it is
possible to minimize the cycle, but it can never be eliminated entirely. In economic
life, there are many such time lags: between the decision to invest and the completion
of the project; between the farmer's decision to raise hogs and the arrival of pork
chops at the store; between prices at the time of a decision and prices at the time the
action is completed.
Random shocks, or what economists call exogenous factors, constitute the
third type of phenomena affecting business cycles. These are such external
disturbances to the system as weather changes, unexpected discoveries, political
changes, wars, and so on. It is possible for such external impulses to cause cyclical
motions within the system, in much the same way that striking a rocking horse with a
stick will cause the horse to rock back and forth. The length of the cycle will be
determined by the internal relationships of the system, but its intensity is governed by
the external impulse.

Theories of economic fluctuation.

The analytic concepts above may be found in most of the realistic attempts to
explain economic fluctuations. Theories of the business cycle, or, more properly, of
economic fluctuations, may be classified in two groups: those that ascribe cyclical
movements to external forces (exogenous factors); and those that attribute the
fluctuations to internal forces (endogenous factors).

Agricultural theories.

Perhaps the oldest theories of the business cycle are those that link their cause
to fluctuations of the harvest. Since crops depend upon soil, climate, and other natural
factors that in turn may be affected by biological or meteorological cycles, such
cycles will transmit their effects through the harvests to the rest of the economy. The

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19th-century English economist William Stanley Jevons thought he had found the key
to such a process in the behaviour of sunspots, which seemed to display a 10-year
cycle. His naive explanation could not long withstand critical examination. It had a
certain interest, however, in suggesting a causal factor that was completely detached
from the economic system and one that could not be influenced by it in turn.

Psychological theories.

A number of writers have explored mass psychology and its consequences for
economic behaviour. Individuals are strongly influenced by the beliefs of the group or
groups to which they belong. There are times when the general mood is optimistic,
and others when it is pessimistic. An English economist, Arthur C. Pigou, in his
Industrial Fluctuations (1927), put forward a theory of "noncompensated errors." He
pointed out that if individuals behave in a completely autonomous way their errors in
expectations will tend to offset each other. But if they imitate each other, their errors
will accumulate until they acquire a global magnitude that may have powerful
economic effects. This follow-the-crowd tendency obviously operates as a factor in
the ups and downs of the stock exchanges, financial booms and crashes, and the
behaviour of investors. One can say, however, that the psychological factor is not
enough to explain economic fluctuations; moods of optimism and pessimism must
themselves rest upon economic factors.

Political theories.

Some observers have maintained that economic fluctuations result from

political events. It is obvious that such events as the Napoleonic Wars, World Wars I
and II, and even the Korean War of 1950-53 have had strong economic consequences.
Even the imposition of a tax or an import restriction may have some dynamic effect
upon the economy. The question is whether such political factors are capable of
producing cyclical movements.

Technological theories.

Ever since the Industrial Revolution at the end of the 18th century, technical
innovations have followed each other without end but not without pause. There have
been periods of innovation and quieter periods in which the innovations were being
absorbed. The world has passed through the era of steam, the era of petroleum, and
the era of electricity and has entered the era of atomic energy. It is possible that if a
rhythm could be found in these waves of change, the same rhythm might be
responsible for corresponding movements in the economy. But it is equally possible
that the technical innovations themselves have been dictated by the prior needs of the
economy.

Demographic theories.

Even population has been postulated as a cause of economic fluctuations.

There are, undeniably, cyclical movements of population; it is possible to find
fluctuations in the rates of marriage, birth, mortality, and migration; but the extent to
which such fluctuations may have been caused by economic conditions is not clear.

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 Monetary theories.

Some writers have ascribed economic fluctuations to the existence of money.

Changes in the money supply do not always conform to underlying economic
changes, and it is not difficult to see how this lack of coordination could produce
disturbances in the economic system. Thus, an increase in the total quantity of money,
if it is not matched by an increase in economic activity, will tend to produce higher
prices; the higher prices in turn may stimulate an investment boom, and so on.
The banking system, with its ability to expand the supply of credit in a time of
boom and to contract the supply of credit in time of recession, may in this way
amplify small economic fluctuations into major cycles of prosperity and depression.
Some theorists have emphasized the influence of the rate of interest: if the rate fixed
by the banking system does not correspond to the "natural" rate dictated by the
requirements of the economy, the disparity may of itself induce an expansion or
contraction in economic activity.

Underconsumption theories.

In a progressive economy, production tends to expand more rapidly than

consumption. The disparity results from the unequal distribution of income; the rich
do not consume all their income, while the poor do not have sufficient income to meet
their consumption needs. This imbalance between output and sales has led to theories
that the business cycle is caused by overproduction or underconsumption. But the
basic, underlying cause is society's inadequate provision for an even flow of savings
out of the excess of what is produced over what is consumed. In other words, saving
is out of step with the requirements of the economy; it is improperly distributed over
time.

Investment theories.

The fact that changes in the supply of savings, or loanable funds, are not
closely coordinated with changes in the rest of the economy lies at the heart of the
numerous theories that link investment imbalance to the business cycle. Savings
accumulate when there is no immediate outlet for them in the form of new investment
opportunities. When times become more favourable, these savings are invested in new
industrial projects, and a wave of investment occurs that sweeps the rest of the
economy along with it. It is in this context that the tools of analysis--the accelerator
and the multiplier--find their application: the new investment creates new income,
which in turn acts as a further stimulus to investment. An early observer of this
phenomenon, a Russian economist, Mikhayl Tugan-Baranovsky, in 1894 published a
study of industrial crises in England in which he maintained that the cycle of
investment continues until all the capital funds have been used up. Bank credit
expands as the cycle progresses. Disproportions then begin to develop among the
various branches of production as well as between production in general and
consumption. These imbalances lead to a new period of stagnation and depression.

STABILIZATION THEORIES AND POLICIES

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 The ultimate objective of research into the problems of economic instability
(including fluctuations in output, employment, and prices) is to provide the
foundation for stabilization policy--that is, for the systematic use of fiscal and
monetary policies to improve an economy's performance. The main tasks, therefore,
are to explain how levels of prices, output, and employment are determined and, on a
more applied level, to furnish predictions of changes in these variables--predictions on
which stabilization policy can be based.

Keynesian analysis.

The problems of economic stability and instability have, naturally, been of

concern to economists for a very long time. But, as a special field of investigation, it
emerged most strongly from the confluence of two developments of the depression
decade of the 1930s. One was the development of national income statistics; the other
was the reorientation of theoretical thinking often referred to as the "Keynesian
revolution."
To understand why the theoretical contributions of John Maynard Keynes are
regarded as so important, one must examine the workings of a modern economy. Such
an economy comprises millions of people engaged in millions of distinct activities;
these activities include the production, distribution, and consumption of all of the
different goods and services that a modern economy provides. Some of the economic
units are large, with hierarchies of executives and other managerial specialists who
coordinate the productive activities of thousands or tens of thousands of people. Aside
from these relatively small islands of preplanned and coordinated activity, most of the
population pursues its myriad economic tasks without any overall supervised
direction. It resembles an immensely complicated, continuously changing puzzle that
is continually being solved and solved again through the market system. A breakdown
in the coordination of activities, such as occurred in the depression decade of the
1930s, is very rare--in fact, it happened on that scale only once--or this system of
organization would not survive. The way in which the economic puzzle is solved
without anyone thinking about it has been the broad main theme of economic theory
since the time of the English economist Adam Smith (1723-90).

The problem of coordination.

If one singles out a particular household from the millions of economic units
and studies it over a period of time, one can draw up a budget of that household's
transactions. The budget will come out as a long list of amounts sold and amounts
bought. If at any time this economic unit had tried to do something different from
what it actually did (cutting down, say, on meat purchases to buy another pair of
shoes), the solution of the economic puzzle would have been correspondingly
different. At the prevailing prices the supply of meat would have exceeded the
demand, and the demand for shoes would have exceeded the supply
The point is that, if the economy is to function as a coordinated system, the
activities of each economic unit must be somehow controlled--and controlled quite
precisely. This is done through price incentives. By raising the price of a good
(relative to the prices of everything else), any economic unit can, generally speaking,
be made to demand less of it or to supply more of it; by lowering the price, it can be
made to demand more or to supply less. Through the conflux of prices, an individual

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unit is thus led to fit its activities into the overall puzzle of market demands and
supplies. If economic units could not be controlled in this fashion, the market-
organized system could not possibly functionIn any given situation there exists,
theoretically, one and only one list of prices that will make the puzzle come out
exactly right. But the amounts that economic units choose to supply or demand of
various goods at any given price list depend on numerous factors, all of which change
over time: the size of the population and labour force; the stock of material resources,
technology, and labour skills; "tastes" for particular consumer goods; and attitudes
toward consumption as against saving, toward leisure as against work, and so on.
Government policies--tax rates, expenditures, welfare policies, money supply, the
debt--also belong among the determinants of demand and supply. A change in any of
these determinants will mean that the list of prices that previously would have
equilibrated all of the different markets must be changed accordingly. If prices are
"rigid," the system cannot adjust and coordination will break down.

Price flexibility.

For coordination of activities to be preserved (or restored) when the economy

is disturbed by changes in these determinants, something still more is required: each
separate price must move in a direction that will restore equilibrium. This necessity
for prices to adjust in certain directions may be expressed as a communications
requirement. To put it in somewhat extreme form: for a given economic unit to plan
its activities so that they will "mesh" with those of others, it must have information
about the intentions of everyone else in the system. When one of the determinants
underlying market supplies and demands changes so as to disequilibrate the system,
ensuing price movements must communicate the requisite information to everyone
concerned.)
One may suppose, for example, that in some period of political crisis the
supply of crude oil from the Middle East is cut off. The immediate result will be a
worldwide excess demand for oil and oil products of large proportions--that is, supply
will fall far short of demand at going prices. At the same time, those who derive their
income from Middle East oil production will have their incomes reduced, and excess
supplies will emerge in the markets for the goods on which those incomes previously
were spent. For the system to adjust, orders will have to go out to all demanders to cut
down on their consumption of oil and for all other suppliers of oil to increase their
output so that the gap between demand and supply can be closed. This is, in effect,
what a rise in the world price of oil and oil products will accomplish--millions of
gasoline and heating oil users the world over will respond to the pinch of higher
prices, and the higher prices will also create a profit incentive for supply to be
increased. (Falling prices will, in an analogous manner, close the gaps in the markets
in which the initial disturbance caused excess supplies to develop.)
Prices that are not rigid for some institutional reason will move in response to
excess demands and excess supplies. When demand exceeds supply, disappointed
buyers will bid up the price; when supply exceeds demand, unsuccessful suppliers
will bid it down. This mechanism solved the excess demand for the oil problem in the
illustration above. The question, however, is whether throughout the system as a
whole it will always act so as to move each of the prices toward its general
equilibrium value.
Keynes said no. He maintained that there can be conditions under which
excess demands (or supplies) will not be "effectively" communicated so that, although

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certain prices are at disequilibrium levels, no process of bidding them away from
these inappropriate levels will get started. This is the flaw in the traditional conception
of the operation of the price system that prompted Keynes to introduce the concept of
"effective demand." To pre-Keynesian economists the implied distinction between
"effective" and (presumably) "ineffective" demand would have had no analytical
meaning. The logic of traditional economic theory suggested two possibilities that
might make the price system inoperative: (1) that, in some markets, neither demanders
nor suppliers respond to price incentives, so that a "gap" between demand and supply
cannot be closed by price adjustments and (2) that, for various institutional reasons,
prices in some markets are "rigid" and will not budge in response to the competitive
pressures of excess demands or excess supplies. Keynes discovered a third possibility
that, he argued, was responsible for the depth and duration of severe depressions:
under certain conditions, some prices may show no tendency to change even though
desires to buy and to sell do not coincide in the respective markets and even though
no institutional reasons exist for the prices to be rigid

Say's Law.

Many writers before Keynes raised the question of whether a capitalist

economic system, relying as it did on the profit incentive to keep production going
and maintain employment, was not in danger of running into depressed states from
which the automatic workings of the price mechanism could not extricate it. But they
tended to formulate the question in ways that allowed traditional economics to
provide a demonstrable, reassuring answer. The answer is known in the economic
literature as Say's Law of Markets, after the early 19th-century French economist
Jean-Baptiste Say.
For western Europe, the 19th century was a period of rapid economic growth
interrupted by several sharp and deep de pressions. The growth was made possible in
large measure by new modes of organizing production and new technologies, such as
the spreading use of steam power. Was it possible that output might grow so great that
there would not be a market for it all? Say's Law denied the possibility. "Supply
creates its own demand," ran the answer. More precisely, the law asserted that the
sum of all excess supplies, evaluated at market prices, must be identically equal to the
sum of the market values of all excess demands. It could be neither more nor less. In
the theoretical system of traditional economics, any inequality between these sums
would quickly work itself out
An important special case should be noted. The good in excess demand might,
for instance, be money. One possibility, then, is excess supply for all the other goods,
matched by an excess demand for money. A situation with excess demand for money
matched by an excess supply of everything else is one in which the level of all money
prices is too high relative to the existing stock of money. If this is the only trouble,
however, Say's Law suggests a relatively simple remedy: increase the money supply
to whatever extent required to eliminate the excess demand. The alternative is to wait
for the deflation to work itself out. As the general level of prices declines, the "real"
value of the money stock increases; this too, will, in the end, eliminate the excess
demand for money.

Model of a Keynesian depression.

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 Involuntary unemployment.

Another possible cause of a general depression was suggested by Keynes. It

may be approached in a highly simplified way by lumping all occupations together
into one labour market and all goods and services together into a single commodity
market. The aggregative system would thus include simply three goods: labour,
commodities, and money. The Table provides a rough outline (a full treatment would
be both technical and lengthy) of the development of a "Keynesian" depression. One
may begin by assuming (line 1) that the system is in full employment equilibrium--
that is, prices and wages are at their equilibrium levels and there is no excess demand.
Next the model may be put on the path to disaster by postulating either (1) some
disturbance causing a shift of demand away from commodities and into money or (2)
a reduction in the money supply. Either event will result in the situation described in
the Table as State 2, but the one assumed is a reduction in the money supply by, say,
10 percent. The result is shown in the right-hand column of the Table, where the
quantity of commodities supplied minus the quantity demanded multiplied by the
price level (p) is equal in value to the excess demand for money.
If money wages and money prices could immediately be reduced in the same
proportion (10 percent), output and employment could be maintained, and profits and
wages would be unchanged in "real" terms. If money wages are initially inflexible,
however, business firms cannot be induced to lower prices by 10 percent and maintain
output. In this example they maintain prices in the neighbourhood of the initial price
level--prices, then, are also "inflexible"--and deal with the excess supply by cutting
back output and laying off workers. Reducing supply eliminates the excess supply of
commodities by throwing the burden of excess supply back on the labour market.
Thus, output and employment (which are "quantities") give way before prices do.
This brings us to State 3 where, as in the Table, the excess supply of labour times the
money wage rate (w) equals the excess demand for money in value.
If, with the system in this state, money wages do not give way and the money
supply is not increased, the economy will remain at this level of unemployment
indefinitely. One should recall that the only explanation for persistent unemployment
that the pre-Keynesian economics had to offer was that money wages were "too high"
relative to the money stock and tended to remain rigid at that level.
Money wages might, nevertheless, give way so that, gradually, both wages
and prices go down by 10 percent--that is to say, a reduction of the size that would
have solved the entire problem had it occurred immediately (before unemployment
could develop). This is shown in the last line of the Table, which represents (albeit
crudely) what Keynes described as a state of "involuntary unemployment" and
explained in terms of a failure of "effective demand."
In State 4, it is assumed, the excess demand for money is zero. Hence there is,
at least temporarily, no tendency for money income either to fall further or to rise.
The prevailing level of money income is too low to provide full employment. The
excess supply of labour and the corresponding excess demand for commodities (of the
same market value) show State 4 to be a disequilibrium state. The question is why the
state tends to persist. Why is there no tendency for income and output to increase and
to absorb the unemployment? Specifically, why does not the excess demand for
commodities induce this expansion of output and absorption of unemployment?
Basically, the answer is that the unemployed do not have the cash (or the
credit) to make the excess demand for commodities effective. The traditional
economic theory would postulate that, when actual output is kept at a level below that

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of demand, competition between unsuccessful potential buyers would tend to raise
prices, thereby stimulating an expansion. But this does not occur. The unemployed
lack the means to engage in such bidding for the limited volume of output. The excess
demand for commodities is not effective. It fails to produce the market signals that
would induce adjustments of activities in the right direction. Business firms, on their
side of the market, remain unwilling to hire from the pool of unemployed--even at
low wages--because there is nothing to indicate that the resulting increment of output
can actually be sold at remunerative prices.
Keynes called this "involuntary unemployment." It was not a happy choice of
phrase since the term is neither self-explanatory nor very descriptive. Some earlier
analysts of the unemployment problem had, however, tended to stress the kind of
deadlock that might develop if workers held out for wages exceeding the market value
of the product attributable to labour or if business firms insisted on trying to "exploit"
labour by refusing to pay a wage corresponding to the value of labour's product. With
the term "involuntary unemployment," Keynes wanted to emphasize that a thoroughly
intractable unemployment situation could develop for which neither party was to
blame in this sense. His theory envisaged a situation in which both parties were
willing to cooperate, yet failed to get together. An effective demand failure might be
described as "a failure to communicateThe failure of the market system to
communicate the necessary information arises because, in modern economies, money
is the only means of payment. In offering their labour services, the unemployed will
not demand payment in the form of the products of the individual firms. If they did,
the excess demand for products would be effectively communicated to producers. The
worker must have cash in order to exercise effective demand for goods. But to obtain
the cash he must first succeed in selling his services.

Effects of business contraction.

When business begins to contract, the first manifestation is a decrease in

investment that causes unemployment in the capital goods industries; the unemployed
are deprived of the cash wage receipts required to make their consumption demands
effective. Unemployment then spreads to consumer goods industries. In expansion,
the opposite occurs: an increase in investment (or in government spending) leads to
rehiring of workers out of the pool of unemployed. Re-employed workers will have
the cash with which to exert effective demand. Hence business will pick up also in the
consumer goods industries. Thus the theory suggests the use of fiscal policy (an
increase in government spending or a decrease in taxes) to bring the economy out of
an unemployment state that is due to a failure of effective demand
Another observation may be made on Keynes's doctrine of effective demand.
The fact that the persistence of unemployment will put pressure on wages also turns
out to be a problem. The assumption in the foregoing discussion was that money
wages were at the equilibrium level. Unemployment will tend to drive them down.
Prices will tend to follow wages down, since declining money earnings for the
employed will mean a declining volume of expenditures. In short, both wages and
prices will tend to move away from, rather than toward, their "correct" equilibrium
values. Once the economy has fallen into such a situation, Keynes pointed out, wage
rigidity may actually be a blessing--a paradoxical conclusion from the standpoint of
traditional economics

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 National income accounting.

The circular flow of income and expenditure.

A proper understanding of income and expenditure theory requires some

acquaintance with the concepts used in national income accounting. These accounts
provide quantitative data on national income and national product. Reliable
information on these was, for the most part, not available to economists working on
problems of economic instability before the 1930s. Modern economics differs from
earlier work most markedly in its quantitative, empirical orientation. The development
of national income accounting made this possible
The definitions of the major components of national income and product may,
accordingly, be introduced in the course of explaining income and employment
theory. The basic characteristic of the national income accounts is that they measure
the level of economic activity in terms of both product supplied and of income
generated. Correspondingly, national income analysis divides the economic system
into distinct sectors. The simplest approach uses two sectors: a business sector and a
household sector. All product is regarded as created by the business sector (thus, self-
employed persons have to be treated as businesses in earning their income and as
households in disposing of it). Final goods output is divided into two components:
consumer goods produced for sale to households and investment goods for sale to
firms. Similarly, all income is generated in the business sector and none of it in the
household sector (nonmarket activities, such as the work of homemakers or home
improvements, are not counted in national product and income). The level of income
generated equals the market value of final goods output.
Next is the household sector. All resources in the economy ultimately belong
to households. The households, therefore, have claim to all of the income generated
through the utilization of these resources by firms in creating the national product.
Not all of the income is, however, actually paid out to households, since corporations
retain part of their earnings. In building a simple model of the economy, one can
disregard the "gross business saving" item of the national income accounts and deal
with income as if it were all paid out (which means adopting the fiction that retained
earnings are first paid out to shareholders who then reinvest the same amount in the
same firms). The households, finally, dispose of their income in two ways: as
expenditure on consumption goods and as saving.
The foregoing discussion has made two accounting statements involving
income. First, income generated (Y) equals the value of consumption goods output
(Cs) plus the value of investment goods output (I): Y Cs + I. Second, consumption
goods expenditures (Cd) plus savings (S) equal income disposal: Y Cd + S. Both
equalities hold simply because of the way that the variables are defined in the national
income accounts. They hold true, moreover, whatever the actual level of income
happens to be. Such equalities, which are true simply by definition, are called
identities (and are marked as such by using the sign instead of the usual equality
sign). Another accounting convention may be noted here. Investment (I) is defined to
include any discrepancy between consumer goods produced and consumer goods
sold. If production exceeds sales, the unsold goods are part of inventory investment; if
sales exceed output, inventory investment is negative, and I is reduced by the
corresponding amount. It follows that Cs and Cd must be identically equal, so that it
becomes unnecessary to distinguish between them by superscript. Since income

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generated is identically equal to income disposal, finally, it is clear that actual
investment must always equal actual saving: I S. Investment is the value of additions
to the system's stock of capital. Saving is the increase in the value of the household
sector's wealth. For the system as a whole, the two must be equal.

Figure 12: The circular flow of income expenditures

Figure 12 shows the circular flow of income and expenditures connecting the
two sectors. Investment and consumption expenditures add up to the aggregate
demand for final goods output. The value of final goods output is paid out by the
business sector as income to the household sector. The major part of income goes
back to the business sector as expenditures on consumption goods; the remainder is
allocated by households to saving. Corresponding to the counterclockwise money
flow (but not shown) is the clockwise flow of the things that the money is paid for:
labour and other resource services from households to firms in exchange for money
income; consumer goods and services in exchange for consumption expenditures from
firms to households; and equities, bonds, and other debt instruments issued by firms
in return for the funds saved by households.
Figure 12 shows a break in the flow of saving as it passes into investment.
From the accounting standpoint--where investment necessarily equals saving--there is
no rationale for this. It has been done here to focus attention on the point in the
circular flow that, in the income-expenditure theory, represents the causal nexus in the
income-determining process. This theory, in its simplest form, is the next topic.

A simple income-expenditure model

.
Because accounting identities--between gross national product and gross
national income, between saving and investment, and so on--express relationships that
must hold whatever the level of income, they cannot be used to explain what
determines the particular level of income in a given period or what causes the level of
income to change from one period to the next. The explanation of what happens must
be based on statements about the behaviour of the participants in the economic
system; in the present context, this means the behaviour of firms and households.
The following oversimplified model of an economy assumes that the business
sector will be satisfied to maintain any given level of output as long as aggregate
demand (that is, expenditures on final goods) exactly equals the volume of income
generated at that level of output. If, in a given period, aggregate demand exceeds the
income payments made by firms in producing that period's output, firms will be
expanding in the next period; if aggregate demand falls short of the income payments
made, firms will contract in the next period. The naïveté of this supply hypothesis is
evident from the fact that the behaviour of firms is described without any reference to
the costs of their inputs or to the price of their outputs; the business sector passively
adapts output and income generated to the level of aggregate demand. In this model,
the level of income is entirely determined by aggregate demand. Firms will act so as
to maintain that income flow if, and only if, the exact same amount that they pay out

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as incomes "comes back to them" in the form of spending on final goods output. If
aggregate demand shrinks, production and employment will decline and there will be
downward pressure on the price level; if aggregate demand swells, there will be an
inflationary problem.
In the system of Figure 12, all of the income generated accrues to households.
Households allocate their income to consumption and saving. With consumption there
is no problem--it constitutes spending on final goods. Saving, however, does not
constitute spending on final goods output. This part of the income generated by the
business sector does not automatically come back to it in the form of revenue from
sales. Saving, therefore, may be treated as a leakage from the circular flow.
Investment, which consists of spending of capital by the business sector on
new plant and equipment and on desired additions to inventories, is, in the same
terminology, an injection into the circular flow. If, for example, investment and
saving each amount to $20,000,000 per year, the leakage and the injection will
balance. But if saving is $20,000,000 per year and the injection of investment
expenditures is only $10,000,000 per year, there will be a disequilibrium. Unsold
goods will accumulate at an annual rate of $10,000,000. The business sector,
however, will not rest content with this state of affairs but will act to reduce output,
employment, and (perhaps) prices. Households will be forced to reduce their
consumption spending. The reduction of income will go on until the planned (or
desired) rates of saving and investment become equal. A similar argument will show
that, if the leakage of planned saving were to fall short of the injection of planned
investment, the level of income would rise.
When income is at a level such that there is no ongoing tendency for it to
change in either direction, the system is in "income equilibrium." The simple system
depicted in Figure 12 is in income equilibrium when the condition shown by this
equation is fulfilled: I = S. This is not, however, the accounting identity discussed
earlier. The symbols I and S now refer to planned, or desired, magnitudes, which may
very well be unequal. When planned investment exceeds planned saving, income will
be rising. When planned saving exceeds planned investment, income will be falling.
An equivalent way of stating the above "equilibrium condition" is to write Y = C + I.
In this equation the left-hand side is actual income and the right-hand side is planned
aggregate demand.
This is the simplest class of income-determination model. It makes no
allowance for international trade or government economic activity. Those may be
treated in the same way that saving and investment were treated--as leakages or
injections. Thus exports constitute spending by foreign nationals on domestic goods--
an injection. Imports constitute spending out of domestic income on foreign goods--a
leakage. Taxes are taken out of the circular flow--a leakage--whereas government
expenditures are an injection. The effects of these leakages and injections on the level
of income are analogous to those of saving and investment. If income is initially at an
equilibrium level, an increase in a leakage (if not at the same time offset by a decrease
in another leakage or an increase in an injection) will cause income to fall. An
increase in an injection (not offset by a decrease in another injection or an increase in
a leakage) will cause income to rise. An income equilibrium is reached when the sum
of all leakages is balanced by the sum of all injections.

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 The multiplier.

The simple income-expenditure model of the economy is not a complete

model. It suffices to show only the direction of the change in income that would result
from, say, a decline in planned investment (or a rise in taxes or a decline of exports).
It does not show the extent of the income change.
To do this the model must be expanded to include a description of how
consumers spend their incomes. For the sake of the exposition, one may assume that
the spending of households varies according to the size of their incomes. A simple
way of putting this is the following equation: C = a + by. In this equation the
coefficient a is a constant indicating the amount that households will spend on
consumption independently of the level of income received in the current period, and
the coefficient b gives the fraction of each dollar of income that will be spent on
consumption goods.
If one were able to obtain reliable quantitative information on the volume of
investment spending being planned and on the coefficients a and b of the
"consumption function" above, one could then calculate the value of aggregate
demand (C + I) for every possible level of income Y. Only one of these alternative
levels of income is an equilibrium one; that is, one for which aggregate demand will
ensure that all of the income paid out by firms "comes back" to the business sector as
spending on final goods. The equilibrium condition is: Y = C + I.

Figure 13: Relation between income and aggregate demand

Figure 13 shows how the level of income in the system is determined, on the
assumption that investment is $20,000,000, that the coefficient a is $20,000,000, and
that the coefficient b (the fraction of each dollar of income that consumers will spend)
is 0.6. The horizontal axis measures income, the vertical, aggregate demand (C + I).
The line drawn at a 45 angle (from 0) contains all of the points at which suppliers
might be in equilibrium; i.e., the points in the space at which aggregate demand would
have the same value as income. The investment schedule (marked I = I0) is drawn
parallel to the income axis at height 20, showing that investment spending does not
depend on income. The consumption function (marked C = a + by) starts at 20 on the
vertical axis (the value of a) and rises 60 cents for each dollar of income (the value of
b) to the right. The aggregate demand schedule (marked C + I0) is obtained by the
vertical summation of the C and I0 schedules. It contains all of the points at which
demanders would be in equilibrium, showing, for each level of income, the volume of
spending on final goods that they would be satisfied to maintain.

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 The only position that demanders and suppliers will both be satisfied to
maintain is given by the intersection of the aggregate demand schedule with the 45
line. In Figure 13 this point ({Y circumflex}0) is found at an income level of
$100,000,000. For this simple system, which has but one leakage and one injection,
the equilibrium level of income may equally well be regarded as determined by the
condition that planned saving equals planned investment. Since saving is defined as
household income not spent on consumption (i.e., Y - C S), one obtains (by
substituting a + by for c) the saving schedules S = -a + (1 - b) Y, which in Figure 13 is
shown to intersect the investment schedule at Y = $100,000,000.
Figure 13 shows what will happen if this equilibrium is disturbed. Consider a
(temporary) situation in which income is running at more than $100,000,000 per year.
At all levels of income to the right of {Y circumflex} 0 aggregate demand (C + I0) is
seen to fall below supply as given by the 45 line. (Also, saving exceeds investment.)
The business sector will not be willing to maintain this state of affairs but will
contract. An excess supply of final goods is associated with falling income. Similarly,
at income levels to the left of {Y circumflex} 0, where investment exceeds saving,
aggregate demand will exceed supply. An excess demand for final goods is associated
with rising income.
Finally, Figure 13 shows how much income would fall as a result of a decline
in investment by $10,000,000 per year (cf. the dotted lines). The decline in investment
is shown by the shift of the investment schedule from I0 to I1, which results in a
downward shift of the aggregate demand schedule from C + I0 to C + I1. The new
income equilibrium ({Y circumflex}1) is found at Y = $75,000,000.
Thus a change in investment spending ( I) of $10,000,000 is found to lead to
a change in income ( Y) of a larger amount, here $25,000,000, which is to say, by a
multiple of 2.5. The reason is that, when the $10,000,000 is transmitted to households
as income, households will increase their consumption spending by $6,000,000 (b
$10,000,000). This rise in consumption spending again raises income, and of this
additional income 60 percent is also spent on consumption--and so on. Each time, 40
percent of the increment to income "leaks" into saving. The relationship between the
initial change in "autonomous spending" ( I) and the change in the level of income (
Y), which will have taken place once this process has run its course, is given by:

where, following Keynes, the expression (1 - b1) is called the "Multiplier."

The model of income determination presented above is exceedingly simple; it
captures little of the complexity of a modern industrialized economy. It does,
however, suggest one approach to the problem of stabilizing the economy at a high
level of income and employment. Assuming that the consumption function is fairly
stable (i.e., that the level of consumption spending associated with any level of
income can, with a fair degree of accuracy, be predicted on the basis of past
experience), fluctuations in income may be attributed to changes in the other
variables. Historical statistics show investment spending by private business to have
been the most volatile of the major components of national income; changes in
investment, therefore, tend (as in the example above) to be the focus of concern for
one school of economists. The implication is that the government can manipulate
"injections" and "leakages" so as to offset changes in private investment. Thus a drop
in investment might be offset by a corresponding increase in government expenditures
(increasing an injection) or a decrease in taxes (decreasing a leakage). These measures
belong to fiscal policy.

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 Monetary policy.

Another point of view holds that the fiscal approach presented above is
misleading because it ignores the part played by monetary factors in determining the
level of economic activity. The following discussion presents an alternative model,
which, though equally simplistic, suggests that primary reliance be put on monetary
policy.
"Money" in what follows may be taken to refer to currency (coins and notes)
plus the checking deposit liabilities of commercial banks. For the sake of brevity, the
model developed in the preceding section will be referred to as the income model.
The naive quantity theory model that will be explained here may be labelled the
money model.
The income model dealt with changes in money income in terms of the
demand for and supply of output. The money model focusses on the supply of and
demand for money. The income model explained the determination of the level of
income in terms of relationships between its component flows. The money model
emphasizes the relationship between money supply and income. The structure of the
income model was based on the distinction between household and business (and
government) sectors. In the money model, the distinction is between the banking
sector (supplying the money) and the nonbanking sectors (the demanders). The
concept of income is the same in both models.
In the money model, the supply of money is treated with the same simplicity
that was accorded investment in the income model--as "autonomously" determined,
which is to say that it is not affected by other factors: M s = M. This assumes that the
central bank is able completely to control the stock of money, which is held at
whatever level the bank desires.
The dynamic relationship in the income model was the consumption function.
Here it is the money demand function. The amount of money demanded is assumed to
vary with income (and, in this naive version of quantity theory, with nothing else).
The simplest relationship between income and the demand for money would be: Md =
kY. Here, k is a constant. Since Y is a flow (measured per year) and Md a stock (the
average stock of money over the year), k has the dimension of a "storage period." If k
= 1/4, for example, the equation states that the nonbanking public desires on the
average to hold a cash balance that is equal to the total of three months' income.

Figure 14: Relation between money demand and income

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 Since there is a determined amount of money in the system, it can be in
equilibrium only when the nonbanking sector is satisfied to hold exactly the amount
of money that exists, no more and no less: Md = Ms. The system represented by these
three equations is shown in Figure 14. The determination of income in the system is
shown by assuming Ms = $25,000,000 and k = 1/4. The amount of money demanded
is equal to supply when income is $100,000,000. A reduction of the money supply to
$20,000,000 will cause income to decline to a level of $80,000,000 per year.
Figure 14 shows what will happen if income temporarily exceeds the figure of
$100,000,000 per year. To the right of {Y circumflex}0, the amount of money
demanded exceeds the existing stock of it. The way for an individual to build up his
cash balance is to reduce his disbursements below his receipts. But his spending (to
the extent that it is spending on final goods at least) is somebody else's income. A
general attempt to build up cash balances cannot succeed--it does not induce an
increase in the money supply in this model--because it will result in a decline of
income throughout the system. This decline will continue to whatever level is
required to make the nonbanking sector bring the amount of money it demands into
line with the amount in existence. An excess demand for money is associated with
falling income. Similarly, if the amount of money demanded falls short of the amount
supplied, an individual may decide to reduce his cash balance by increasing his
disbursements--but the money stays in the system; incomes will rise all around. An
excess supply of money is associated with rising income.
The stabilization policy that this model suggests is obvious: if the relationship
between income and the demand for money is stable, the system can be maintained in
equilibrium by keeping the money supply constant or, in a growing economy, by
allowing the money stock to grow at roughly the same rate as real output. If the
relationship between income and the demand for money is found to shift about over
time, the money stock should be made to grow more rapidly in periods of increasing
demand for money and more slowly in periods of decreasing demand.

Comparisons of the income and money models.

Although the two models seem to have nothing in common--the crucial

variables of one do not even appear in the other--their descriptions of what happens
during income level movements are not contradictory. Falling income is associated
with an excess supply of goods and services in the income model, with an excess
demand for money in the money model. Rising income is associated with an excess
demand for goods in the first model, with an excess supply of money in the other.
Evidently the two models give only partial descriptions of what is going on: one
model looks at the process from the "real" side only and the other from the
"monetary" side. But an excess demand for goods on one side will be associated with
an excess supply of money on the other, and vice versa, so in this respect the two are
consistent.
The controversy between the two schools of thought represented by the
models has mainly to do with two issues. One issue is which set of policy
instruments--fiscal or monetary--provides the best means of stabilizing the economy.
The other, more fundamental, issue concerns the causes of income movements. As
seen above, changes in investment were the main cause of income movements in the
income model; changes in the money stock were the main cause in the money model.
Simplistic as the two models are, they embody the conflicting hypotheses of the two
contending schools. Income-expenditure theorists attribute the instability of income

320
primarily to events that influence the business sector's expectations with regard to the
profitability of new investment, thus influencing investment. The modern quantity
theorists see the irregular time path of the money stock as the most important factor.
The gross features of economic history do not contradict either hypothesis.
Private investment has indeed been the most volatile component of Gross National
Product. Similarly, the movements of the money stock have conformed to those of
money income: rapid inflation has been associated with a rapid growth of the money
supply; severe recessions, with a decline in the money supply; and mild recessions,
with a slowdown in the growth of the money supply. ("Mild" recessions may be
thought of as recessions during which total employment stagnates, and the growth in
unemployment, therefore, is largely due to the growth of the labour force.) The
controversy has in large measure come to concern the direction of causation: one side
maintains that shifts in investment cause income changes and infers that these in turn
induce changes in the money stock which go in the same direction; the other side
maintains that changes in the size or rate of growth of the money stock cause income
changes that in turn will tend to fall most heavily on the investment component of
income.
The problem of resolving this controversy is twofold. First, the theoretical
issue is less clear-cut than implied above. Each side acknowledges that neither
investment nor the money supply is autonomous and that each affects the other. The
question has become, therefore, which model is "most nearly true" and which model,
consequently, should be regarded as a "first approximation" in guiding stabilization
policy.
Second, the empirical methods at the disposal of economists are not yet
adequate for settling such issues. Attempts have been made to compare the
performance of the two models by testing whether the best predictions of income are
obtained by using actual data for "autonomous expenditures" and assuming that
consumption will obey the consumption-income relation that has generally obtained
in the past or by using actual money stock figures and assuming that money demand
will obey the relation to income that has generally obtained in the past. These
attempts have bogged down in disagreements on various statistical matters and must
be judged inconclusive. They have shown, however, that even with consumption
functions and money demand functions that are a good deal more "reasonable" than
the naive relationships above, the predictions of both models are too inaccurate for the
purposes of stabilization policy.
Each model emphasizes one set of disturbances ("real" or "monetary",
respectively) that will cause income to change. Each gives a partial view of the
process of income-level movements. What is needed, therefore, is a third model
explaining the linkages between "real" and "monetary" forces that these two simple
models leave out.

Interest-rate policy.

The third model brings a crucially important--but hitherto generally

neglected--element into the picture of the economic system; namely, financial
markets. For simplicity, the model has only one financial market; there is only one
class of financial instruments (referred to as "securities") and only one yield (a single
interest rate). The standard security may be thought of as a bond promising to pay
annually a fixed number of dollars. The interest rate is the value of the coupon
expressed as a percentage of the market price of the bond. Consequently, if excess

321
demand for bonds brings their price up, the interest rate falls; if excess supply sends
the bond price down, the interest rate rises
The working of the financial market is depicted in the model as follows.
Investment by the business sector is assumed to be financed through the issue of
securities. The higher the interest rate that firms must pay on their securities, the
smaller will be the investment program that they see as promising to be profitable.
Thus investment will be discouraged by a rise and encouraged by a fall in the interest
rate. Households, in deciding how to divide their income between consumption and
saving, will consider the amount of future consumption that can be gained by
abstaining from consumption now (i.e., by saving). The higher the rate of interest, the
larger the amount that can be spent on future consumption per dollar not spent in the
present. Thus saving is encouraged by a rise and discouraged by a fall in the interest
rate. Coins, notes, and some checking deposits are assets on which interest is not paid.
An individual who holds them has the alternative of converting some part of his
money holdings into interest-bearing form. Thus the amount of money demanded will
tend to diminish when the interest rate rises and to increase when it falls. The banking
system creates money by buying assets from the public, paying for the assets through
the issuance of additional monetary liabilities (e.g., checking deposits). Banks must
decide whether turning part of their cash reserves to an income-earning use is worth
the risks of decreased "liquidity" entailed by lower bank reserves. Hence there is a
tendency for the money supply to increase when the interest rate rises and to decrease
when it falls
In this model, then, the interest rate acts as a price in controlling the behaviour
of the individual agents whose activities are to be coordinated. The interest rate itself
is determined by the demand for and supply of money and securities. An increase in
planned investment will be associated with the issuance of a large volume of
securities. It will tend, therefore, to create an excess supply of securities, to lower
securities prices, and to raise the rate of interest. Similarly, an increase in planned
saving will tend to create an excess demand for securities, to raise their prices, and to
lower the rate of interest. An increased demand for money will, in part, reduce the
demand for and increase the supply of securities; it tends to create an excess supply of
securities and to raise the interest rate. An increase in the supply of money will tend to
reduce the rate of interest
These qualitative propositions are the framework of the new model,
integrating the two previous models as follows: (1) I = I(r); (2) C = C(Y,r); (3) S = Y -
C; (4) S = I; (5) Md = Md(Y,r); (6) Ms = Ms(r); and (7) Md = Ms. Here, Equations 1
through 4 restate the income model with the modification that investment is no longer
simply "autonomous" but depends on the current level of the interest rate (r).
Equations 5 through 7 restate the money model with the modification that the demand
for money and the supply of money also depend on the interest rate. Two conditions
now have to be simultaneously fulfilled for the system to be in equilibrium: desired
saving must equal desired investment (Equation 4), and the amount of money that
individuals and firms desire to hold must equal the amount that the banking sector
desires to supply (Equation 7).
Only a partial account of the ways in which this model works can be given
here. The following illustrative examples begin with the system in equilibrium at full
employment. The first illustration adopts the view of someone who has learned the
income model and hence is thoroughly imbued with the idea that rising income results
from an excess of planned investment over planned saving. Faced with the
proposition, drawn from the money model, that an increase in the money supply will

322
also cause income to rise, he will ask how such a change in the money supply can
cause a discrepancy between saving and investment when there was none to begin
with. The answer is that an increase in Ms will mean that there is an excess supply of
money and a corresponding excess demand for commodities and securities, but the
immediate impact of excess demand will be felt almost exclusively in the securities
market. The excess demand for securities drives the rate of interest down--and this
encourages investment and discourages saving. At that point, consequently, a "gap"
opens up between desired saving and investment.
For the second illustration, consider instead someone who has learned the
money model and who, consequently, knows that income falls when the amount of
money demanded exceeds the supply. In Keynes's work the "disturbance" given the
most play is some unspecified event that makes business firms take a darker view of
the returns to be expected from new investment. Hence, the amount of investment that
they will want to undertake at the prevailing interest rate declines. The question is
how such a change in planned investment can cause a discrepancy between money
demand and money supply when there was none to begin with. The simplest answer is
that a decline in planned investment will be associated with a reduction in the amount
of securities floated on the market and thus with the emergence of an excess demand
for securities. This drives securities prices up, which is to say that the interest rate
falls. At a lower rate of interest, individuals will desire larger money balances than
before; in addition, the banks will tend to reduce the money stock somewhat. At that
point, consequently, a gap will open between the amount of money demanded and the
amount supplied.
The analysis of the consequences of government fiscal action is somewhat
more complicated. If the government tries to stimulate the economy through increased
expenditures, the effects will be felt in at least two ways. First, the increased spending
is an "injection" added to commodity demand and may be treated, therefore, from the
Model A standpoint in the same way as an increase in private investment. Second,
however, this spending may be financed through increased taxes, through government
borrowing, through creation of new money, or through some combination of the three.
The strongest effects are gained by following the third alternative, the creation of new
money. The excess demand for goods and services created by the increase in spending
will then be matched by an excess supply of money, which, as seen above, will drive
down the interest rate and cause increased investment, etc. To the direct stimulus of
the spending program, this method of paying for it adds the indirectly achieved
stimulus of increased private investment. (Needless to say, the double effect on
money income is not always desirable. The fact that this method of financing
government spending has almost always been heavily resorted to in wartime accounts
for the historical association of large inflations with wars.) The method of the second
alternative, government borrowing, consists of financing the increase in spending
through the issue of government bonds. This creates an excess supply of securities,
driving up the interest rate. At the higher interest rate, money demand is lessened and
money supply somewhat increased, but the consequent excess supply of money will
be of smaller magnitude than that entailed by creating new money. The higher interest
rate will also discourage private investment. Thus the indirect effects of government
borrowing are seen to involve a decrease in private investment partially offsetting the
initial increase in government spending. The size of this offset has become one of the
major issues between "monetarist" and "income-expenditure" economists. The
monetarists argue that the offset is so nearly complete that fiscal action will be largely
ineffectual unless it is accompanied by an increase in the money supply, but an

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increase in the money supply will have almost as powerful effects without any
simultaneous fiscal action. The other side concedes that fiscal action will be more
powerful when financed through changes in the money supply but maintains that
countercyclical variations in government spending financed through borrowing must
still be regarded as an important stabilization method.

The "natural" rate of interest and effective demand.

The thought of Knut Wicksell.

Around the turn of the century, the Swedish economist Knut Wicksell
contributed greatly to the understanding of the function of the rate of interest in the
mechanism determining income and price-level movements. Assuming an economy
initially in full-employment equilibrium, Wicksell analyzed the various ways in which
the system might depart from that position because of discrepancies between the
prevailing market rate of interest and what he termed the "natural rate." The latter
rate, hypothetical rather than directly observable, may be thought of as the interest
rate level that would have to prevail for the system to remain at full employment with
stable prices. In illustrating the use made of this concept, one should distinguish
between processes initiated by "real" disturbances (the first two examples below) and
those initiated by "monetary" disturbances (the third example).
The first example is one in which business firms see increased opportunities
for profitable investment. The system is already at full employment, and hence an
increase in spending on investment without a corresponding decrease in spending for
consumption would spell inflation. What kind of adjustment will maintain stable
prices? A rise in the interest rate will (1) moderate the increase in investment
spending and (2) cause households to divert some of their income from consumption
into increased saving. The hypothetical level of the interest rate that will exactly
match the net increase in investment with the decrease in consumption (increase in
saving) is the new value of Wicksell's "natural rate." But the adjustment of the market
rate may, for several reasons, come to a halt after going only part of the way to the
new natural rate level. At some level of the market rate below natural rate, where
planned investment still exceeds the savings that households provide for its financing,
the banks may step in and finance the difference through expansion of the money
supply. Thus inflation results. In Wicksell's theory there is inflationary pressure on the
system associated with a market rate below the natural level and, in the version of it
given here, with an increase in the money supply.
The second example involves a change in public behaviour in that households
desire to save more and consume less, out of any given level of income. The
decreased demand for consumption goods threatens to cause deflation (or
unemployment). To prevent this it is necessary to switch resources over to investment
goods production, which requires a lowering of the interest rate. Thus an increase in
saving means that the natural rate of interest declines. The adjustment of the market
rate of interest may again be incomplete if falling rates induce banks, say, to reduce
their new lending below scheduled loan repayments, thus reducing the money supply.
Part of the saving done by households then goes, directly or indirectly, into reducing
the private sector's indebtedness to banks rather than into financing investment. Thus
deflationary pressure on the system is, in Wicksell's theory, associated with a market

324
rate of interest above the natural rate and, in this example, with a decreased supply of
money.
The third example is one in which banks desire to expand their loans and,
thereby, their monetary liabilities--creating a "monetary" disturbance. Since "real"
incentives to save and to invest have not changed, the natural rate of interest has not
changed. The increased supply of bank credit will, however, drive the market rate
down. It goes below the natural rate, the money supply is increased in the process, and
inflation is the result.

Keynes and Wicksell.

Keynes first took up Wicksell's idea in his Treatise on Money (1930). In

Wicksell's writings, discrepancies between the natural and market rates had invariably
been associated with expansion or contraction of bank credit. Keynes emphasized that
such discrepancies may develop and continue without expansion or contraction of the
money supply, because of speculation in the securities markets. For example, if the
natural rate has decreased and the market rate starts to edge down in response to an
excess of the household savings offered in demand for securities over the supply of
new securities marketed to finance investment, securities prices will rise. This,
Keynes suggested, will cause some speculators in "old" securities to enter the market
and supply savers with securities from their holdings. The excess demand pressure on
the market is thus relieved and the rise in prices (fall of the market rate) halted. The
motive for these transactions is the speculators' hope that they can buy back their
securities at lower prices later. In the meantime, the speculators hold their funds in the
form of ready money; there has been an increase in the amount of money demanded
rather than, as Wicksell assumed, a decrease in the money supply.
The Wicksell-Keynes theory was an important contribution to the theory of
the income-determination process. Yet there is nothing in its main elements that
should have startled a pre-Wicksellian traditional economist. The natural rate is
essentially the interest rate that would prevail in general equilibrium, and a market
rate different from the natural rate is a disequilibrium interest rate. Traditional
economics was clear enough as to the consequences that will follow if one or more of
the prices in the system "gets stuck" at a disequilibrium level. The Wicksell-Keynes
theory, therefore, may be regarded as a particular application of previously familiar
principles.
Keynes returned to the Wicksellian theme in The General Theory of
Employment, Interest and Money (1936), but in that revolutionary work he gave the
theory a genuinely novel twist: he argued that the system might be seriously out of
equilibrium even though the prevailing interest rate was exactly at the Wicksellian
natural level. This might happen because the interest rate mechanism cannot ensure
that the plans of households and business firms with regard to future consumption and
production will mesh with each other. There might, for example, be an increase in
household saving--that is, a decrease in the demand for current consumption goods
and an increase in the planned demand for future goods. Coordination of household
and business activities requires that business firms respond by shifting resources out
of the production of present consumption goods and into investment activities that lay
the groundwork for increased output in the future. Households, in carrying out their
saving decisions, do not place contractual orders with producers for future deliveries
of particular goods and services. Thus the future demands implicit in current saving
decisions may not be effectively communicated to producers, as efficient coordination

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would require. If producers draw up their investment plans on the basis of forecasts of
future demand that do not correspond to the spending that households are prepared to
undertake in the future, there will be an excess demand (or excess supply) for future
output.
Such effective demand failure is not the result of changes in interest rates or in
the supply of money. The logical way of dealing with it--when it occurs--is through
fiscal policy measures. The effective demand doctrine is the signal contribution of
Keynesian economics to income and employment theory. It is thus no coincidence
that Keynesian economics has become associated with an emphasis on the use of
fiscal, rather than monetary, stabilization policies.

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 MICROECONOMICS AND MACROECONOMICS

Many economists specialize in a particular branch of the subject. For example,

there are labour economists, energy economists, monetary economists, and
international economists. What distinguishes these economists is the segment of
economic life in which they are interested. Labour economics deals with problems of
the labour market as viewed by firms, workers, and society as a whole. Urban
economics deals with city problems: land use, transport, congestion, and housing.
However, we need not classify branches of economics according to the area of
economic life in which we ask the standard questions what, how, and for whom. We
can also classify branches of economics according to the approach or methodology
that is used. The very broad division of approaches into microeconomic and
macroeconomic cuts across the large number of subject groupings cited above.
Microeconomic analysis offers a detailed treatment of individual decisions
about particular commodities.
For example, we might study why individual households prefer cars to
bicycles and how producers decide whether to produce cars or bicycles. We can then
aggregate the behavior of all households and all firms to discuss total car purchases
and total car production. Within a market economy we can discuss the market for
cars. Comparing this with the market for bicycles, we may be able to explain the
relative price of cars and bicycles and the relative output of these two goods. The
sophisticated branch of microeconomics known as general equilibrium theory
extends this approach to its logical conclusion. It studies simultaneously every market
for every commodity. From this it is hoped that we can understand the complete
pattern of consumption, production, and exchange in the whole economy at a point in
time.
If you think this sounds very complicated you are correct. It is. For many
purposes, the analysis becomes so complicated that we tend to lose track of the
phenomena in which we were interested. The interesting task for economics, a task
that retains an element of art in economic science, is to devise judicious
simplifications which keep the analysis manageable without distorting reality too
much. It is here that microeconomists and macroeconomists proceed down different
avenues. Microeconomists tend to offer a detailed treatment of one aspect of
economic behaviour but ignore interactions with the rest of the economy in order to
preserve the simplicity of the analysis. A microeconomic analysis of miners’ wages
would emphasize the characteristics of miners and the ability of mine owners to pay.
It would largely neglect the chain of indirect effects to which a rise in miners’ wages
might give rise. For example, car workers might use the precedent of the miners’ pay
increase to secure higher wages in the car industry, thus being able to afford larger
houses which burned more coal in heating systems. When microeconomic analysis
ignores such indirectly induced effects it is said to be partial analysis.
In some instances, indirect effects may not be too important and it will make
sense for economists to devote their effort to very detailed analyses of particular
industries or activities. In other circumstances, the indirect effects are too important‘
to be swept under the carpet and an alternative simplification must be found.
Macroeconomics emphasizes the interactions in the economy as a whole. It

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deliberately simplifies the individual building blocks of the analysis in order to retain
a manageable analysis of the complete interaction of the economy. For example,
macroeconomists typically do not worry about the breakdown of consumer goods into
cars, bicycles, televisions, and calculators. They prefer to treat them all as a single
bundle called ‘consumer goods’ because they are more interested in studying the
interaction between households’ purchases of consumer goods and firms’ decisions
about purchases of machinery and buildings.
Macroeconomics is the study of the economy as a whole.
Macroeconomics is concerned not with the details — the price of cigarettes
relative to the price of bread, or the output of cars relative to the output of steel — but
with the overall picture.
The distinction between microeconomics and macroeconomics is more than
the difference between economics in the small and economics in the large, which the
Greek prefixes micro and macro suggest. The purpose of the analysis is also different.
A model is a deliberate simplification to enable us to pick out the key
elements of a problem and think about them clearly. Although we could study the
whole economy by piecing together our microeconomic analysis of each and every
market, the resulting model would be so cumbersome that it would be hard to keep
track of all the economic forces at work. Microeconomics and macroeconomics take
different approaches to keep the analysis manageable.
Microeconomics places the emphasis on a detailed understanding of
particular markets. To achieve this amount of detail or magnification many of the
interactions with other markets are suppressed. In saying that a tax on cars reduces the
equilibrium quantity of cars we ignore the question of what the government does with
the revenue. If government has to borrow less money it is possible that interest rates
and the exchange rate will fall and that improved international competitiveness of
U.K car producers will increase the equilibrium output of cars in the U.K.
Microeconomics is a bit like looking at a horse through a pair of binoculars. It
is great for details but sometimes we get a clearer picture of the whole race by using
the naked eye. Because macroeconomics is concerned primarily with the interaction
of different parts of the economy, it relies on a different simplification to keep the
analysis manageable. Macroeconomics simplifies the building blocks in order to focus
on how they fit together and influence one another.
The main issues in macroeconomics:
1.Inflation –the annual inflation rate is the percentage increase per annum in
the average price of goods and services.
What causes inflation? The money supply? Trade unions?
Why do people mind so much about inflation? Does it cause unemployment?
2.Unemployment. It is a measure of the number of people registered as
looking for work but without a job. The unemployment rate is the percentage of the
labour force that is unemployed. The labour force is the number of people working or
looking for work. It excludes all those –from rich landowners to heroin addicts- who
are neither working nor looking for work.
.Why has it increased so much?Are workers pricing themselves out of jobs by
greedy wage claims? Is high unemployment necessary to keep inflation under control,
or could the government create more jobs?

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 3.Output and Growth .Real gross national product measures the total income
of the economy. It tells us the quantity of goods and services the economy as a whole
can afford to purchase. Increases in real gross national product are called economic
growth.
-What determines the level of real GNP? Why do some countries grow faster
than others?

4. Macroeconomic policy. Almost every day the newspapers and television

refer to the problems of inflation, unemployment, and slow growth. These issues are
widely discussed; they help determine the outcome of elections, and make some
people interested in learning more about macroeconomics. The government has a
variety of policy measures through which it can try to affect the performance of the
economy as a whole. It levies taxes, commissions spending, influences the money
supply, interest rates, and the exchange rate, and it sets targets for the output and
prices of nationalized industries.
What the government can and should do is the subject of lively debate both
within the field of economics and in the country at large. As usual, it is important to
distinguish between positive issues relating to how the economy works and normative
issues relating to priorities or value judgements.
Economic Growth
There is general agreement amongst economists concerned with the problems
of less developed countries (LDCs) that a distinction should be made between
economic growth and economic development.
Economic growth is defined as an increase in the productive capacity of an
economy over time, giving rise to an increase in real National Income (NI). If the rate
of growth of income is greater than the rate of growth of population, income per
capita will also rise.
Economists distinguish between the Gross Domestic Product (GDP) and the
Gross National Product (GNP) of an economy. GDP is the total final output of goods
and services produced within an economy for any given year, by both residents and
non-residents. GNP is equal to GDP plus net factor (or property) incomes from
abroad (that is, the difference between returns to the inhabitants of the country from
property located overseas minus the returns accruing to foreigners from their property
located within the reporting country). For most LDCs, net property income from
abroad is likely to be negative and thus GDP will be greater than GNP.
Both domestic product and national product can be expressed in net terms
(that is, after allowing for capital depreciation) and either at market prices or factor
costs (that is, including and excluding respectively, indirect taxes net of subsidies).
Net National Product (NNP) at factor cost is identical to National Income.
For many LDCs, economic growth has been rapid and sustained for much of
the post-Second World War period. World Bank projections for the 1980s predicted
that higher rates of economic growth would be difficult to reach and sustain and that
there would occur a widening in both the relative and absolute gaps between the
richest and the poorest countries, including the gap between the middle- and low-
income LDCs.

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 In the early years of the evolution of development economics as a distinct
area of study, economic growth and economic development were generally seen as
being synonymous. The deficiencies of using GNP per capita as an indicator of
economic welfare (and by implication, the level of economic development) were
recognised by economists, however, and over time it became increasingly evident that
economic growth on its own, although undoubtedly a necessary condition, was
certainly not a sufficient condition to ensure increases in economic, let alone social,
welfare.Within the concept of economic development was some notion of progress.
Economic development meant growth plus structutal and institutional change which
involved the move towards certain normative goals or objectives.Growth without
development was a possibility if increases in per capita incomes were not
accompanied either by structural changes or by the diffusion of the gains in real
income among all sectors of the population.

Vocabulary

Commodity-goods sold in large quantities

Consumption- using,consuming
Cumbersome- large and difficult to move
Debate- formal discussion, contest between two speakers
Economics-study of macro and micro economics
Economy-financial state of a country
Gain- increase of possessions, increase in amount or power
Housing- accomodation
Income-money received during a given period
Issue- giving out shares, outgoing, result, outcome
Levy- money collected by authorities
Manageable- that can be managed,easily controlled
Overseas- abroad, across the sea
Purchase-something which has been bought
Rate- charge for service or work.-market price
Subsidy- money given to support unprofitable enterprises
Supply-providing something
To accrue- to come as a natural growth or development
To cite- to mention
To deal with- to do business
To distort- to give a false account of
To ensure- to make sure, guarantee

330
 To exchange-to give one thing for another
To increase- to make, to become greater
To levy- to demand payment of taxes and dues
To owe- to have to pay money
To purchase- to buy
To subsidise- to help or support financially
To trade- to buy and sell
Trade- buisness of buying and selling
Transaction- exchange of goods or services for money
Welfare- condition of having good health, comfortable living and working
conditions

The Medium of Exchange

Money, the medium of exchange, is used in one- half of almost all exchange.
Workers exchange labour services for money. People buy or sell goods in exchange
for money. We accept money not to consume it directly but because it can
subsequently be used to buy things we do wish to consume. Money is the medium
through which people exchange goods and services.
To see that society benefits from a medium of exchange, we should imagine a
barter economy.
A barter economy has no medium of exchange. Goods are traded directly or
swapped for other goods.
In a barter economy the seller and the buyer each must want something the
other has to offer. Each person is simultaneously a seller and a buyer. In order to see a
film, you must hand over in exchange a good or service that the cinema manager
wants. There has to be a double coincidence of wants. You have to find a cinema
where the manager wants what you have to offer in exchange.
Trading is very expensive in a barter economy. People must spend a lot of
time and effort finding others with whom they can make mutually satisfactory swaps.
Since time and effort are scarce resources, a barter economy is wasteful. The use of
money — any commodity generally accepted in payment for goods, services, and
debts — makes the trading process simpler and more efficient.

Money
The unit of account is the unit in which prices are quoted and accounts are
kept.
In Britain prices are quoted in pounds sterling; in France, in French francs. It
is usually convenient to use the units in which the medium of exchange is measured
as the unit of account as well. However there are exceptions. During she rapid

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German inflation of 1922—23 when prices in marks were changing very quickly,
German shopkeepers found it more convenient to use dollars as the unit of account.
Prices were quoted in dollars even though payment was made in marks, the German
medium of exchange.
Money is a store of value because it can be used to make purchases in the
future.
To be accepted in exchange, money has to be a store of value. Nobody would
accept money as payment for goods supplied today if the money was going to be
worthless when they tried to buy goods with it tomorrow. But money is neither the
only nor necessarily the best store of value. Houses, stamp collections, and interest-
bearing bank accounts all serve as stores of value. Since money pays no interest and
its real purchasing power is eroded by inflation, there are almost certainly better ways
to store value.
Finally, money serves as a standard of deferred payment or a unit of account
over time. When you borrow, the amount to be repaid next year is measured in
pounds sterling. Although convenient, this is not an essential function of money. UK
citizens can get bank loans specifying in dollars the amount that must be repaid next
year. Thus the key feature of money is its use as a medium of exchange. For this, it
must act as a store of value as well. And it is usually, though not invariably,
convenient to make money the unit of account and standard of deferred payment as
well.

Different Kinds of Money

In prisoner-of-war camps, cigarettes served as money. In the nineteenth
century money was mainly gold and silver coins. These are examples of commodity
money, ordinary goods with industrial uses (gold) and consumption uses (cigarettes)
which also serve as a medium of exchange. To use commodity money, society must
either cut back on other uses of that commodity or devote scarce resources to
producing additional quantities of the commodity. But there are less expensive ways
for society to produce money.
- A token money is a means of payment whose value or purchasing power as
money greatly exceeds its cost of production or value in uses other than as money.
A £10 note is worth far more as money than as a 3 x 6 inch piece of high-
quality paper. Similarly, the monetary value of most coins exceeds the amount you
would get by melting them down and selling off the metals they contain. By
collectively agreeing to use token money, society economizes on the scarce resources
required to produce money as a medium of exchange. Since the manufacturing costs
are tiny, why doesn’t every-one make ₤10 notes?
The essential condition for the survival of token money is the restriction of the
right to supply it.
Society enforces the use of token money by making it legal tender. The law
says it must be accepted as a means of payment.
In modern economies token money is supplemented by IOU money. An IOU
money is a medium of exchange based on the debt of a private firm or individual.
A bank deposit is IOU money because it is a debt of a bank. When you have a
bank deposit the bank owes you money. Bank deposits are a medium of exchange
because they are generally accepted as payment.

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Vocabulary

Exchange-giving one thing for another

To trade-to do business by buying and selling
Swap-an exchange
Barter-interchange of goods or services without the intervention of money.
Commodity-goods sold in large quantities.
Share-a small part of a company’s capital
To purchase-to buy
Purchase-something which has been bought
Bearer-person who holds a cheque or certificate
Bear market-period when share prices are falling
To defer-to put to a later date
Deferred payments-payments postponed to a later date

Bank organization

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 The way in which a bank is organized and operates is determined by its
objectives and by the type of economy in which it conducts its business. A bank may
not necessarily be in business to make a profit. Central banks, for example, provide a
country with a number of services, while development banks exist to increase the
economic growth of a country and raise the living standard of its population. On the
other hand, the aim of commercial banks is to earn profits. They therefore provide and
develop services that can be sold at a price that will yield a profit.
A commercial bank which provides the same range of services year after year
is less likely to be successful than one which assesses changes in the demand for its
products and which tries to match products to its customers’ needs. New services are
constantly being introduced and developed by commercial banks, and the full- service
philosophy of many banks means that they are akin to financial supermarkets,
offering a wide variety of services. However, not every bank may want to offer every
kind of financial service.
Many banks offer a combination of wholesale and retail banking. The former
provides large-scale services to companies, government agencies and other banks.
The latter mainly provides smaller-scale services to the general public. Both types of
banking, however, have three essential functions, which are:
• deposits, payments, credits
These three functions are the basis of the services offered by banks. They
make it possible for banks to generate profits and to achieve their operating aims.
Several factors have combined to make banking an international business.
These include the growth of multinational companies and of international capital
markets, the increased competition between the banks themselves, and important
improvements in communications and transportation .The major banks of the world
have established extensive international operations by acquiring banks in other
countries, by extending their own branch network abroad and by establishing
correspondent relationships with foreign banks so as to develop profitable joint
operations. The operations of these major commercial banks are dynamic and rapidly
changing, and their organization is of a global nature.

TEXT1

William Sands meets David Black an ex-mate and tries to describe him the
structure of the bank where he is the president.
William: I can show you an organization chart David, in the back of the
annual report,which we can run through, just to make things a little clearer:
David :That’s O.K
William: We were reorganized earlier this year, so the organization is still
fairly new.
Actually, as you can see, we have split into six line divisions. The first of
these, the Banking Division, consists of three geographic groups: Group One The
Americas, Group Two Europe, and Group Three Africa, Asia and the Middle East.
All these groups are offering a full range of international banking services.
Then we have the Private Banking Division which serves consumers in the
domestic and international markets.

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 The Treasurer’s Division has a wide spread of operations which includes
investment portfolio management, commercial paper, government and municipal
bonds, foreign exchange, bullion, and public finance.
David: So there are three operative divisions.
William :That’s right, and these three operative divisions are backed up by
another three servicing divisions. We have the Administrative Division which covers
administrative services as well as personnel, premises and economic analysis.
The Financial and Information Systems Division includes the Comptroller’s
Department, the Corporate Tax Department, and the Systems and Data Processing
Department.
And then finally, the Corporate Planning Division includes strategic planning,
and credit policy and administration.
Here you have the annual report in case you need it for reference.
David: Thank you very much. It was extremelly interesting but i think your
work is not at all easy,is it?
So, I wish you good luck.

Vocabulary:
Annual: for one year.
Annual report: a report presented each year giving details of the company’s
activities and financial performance during the previous financial year.
Portfolio: range, collection.
Portfolio management: buying /selling a range of shares for a client.
Domestic: in your country, not abroad.
Bullion: bars of gold or silver.
Municipal bonds: documents issued by a local government authority
promising to repay loans at a certain time.
Premises: buildings and surrounding land.
To back up: to support
Backing: financial support.
Credit: time given to a customer to pay.
To credit: to put money into someone’s account.
Credit control- checking that customers pay on time.
Credit limit- a maximum amount that a customer can owe.
Creditor-person who is owed money.
Credit rating-amount which a credit agency thinks a company/person should
be allowed to borrow.

*Match the following words with the correct deffinition: (premises,annual

report,credit policy, domestic,comptroller's department, investment portfolio
management, bullion,line division, personnel, reorganized, consumers, strategic
planning, commercial paper, municipal bonds)
1.Formed or structured in a new way.
2 A report presented each year,giving details of the company's activities and
financial performance during the previous financial year.

335
 3 Sections of a company which deal with different products or services from
each other.
4.People who buy goods or services.
5.In your own country, not abroad.
6.Management of a client's collected investments.
7.Short-term documents usually sold by big U.S corporations, promising to
pay a specified sum of money on a particular date; they may be sold again by the
buyer.
8.Documents issued by a local government authority, promising to repay loans
at a certain time.
9.Bars of gold or silver.
10.Employees,staff.
11.Buildings and surrounding land.
12.A department which controls the internal finances of a company.
13.Deciding the main aims of an organization.
14 Plans for the lending of money.

TEXT 2

Adam Regan is interviewed about his bank’s organization.

Interviewer: I would like you to tell me how you’re organized could you?
Adam: Yes, certainly. Just to give you the background, it was in 1869 when
we were established as a merchant bank . We operated independently as one of the
major merchant banks in the City until 1977, when Metropolitan and Provincial
acquired one third interest in us, and as of last year we are now a wholly-owned
subsidiary of that bank.
Interviewer: Oh, really? I didn’t realize that.
Adam: One of the consequences of our acquisition was that we sold off our
non- banking related activities, though of course we still cover a full range of
international banking services. Now in terms of management structure, we have an
Administration Division which looks after all administrative matters. These include
planning, group financial control, accounting and audit, computer services, legal
services, personnel, premises and so forth.
Interviewer: Ah, yes. That’s cost centre services then?
Adam: That’s cost centre services, right. Next we have the Banking Division
and they deal with loans, syndicated loans, project finance, overdrafts, documentary
credits and correspondent banking.
Interviewer: I see.
Adam: We’re very active in the markets and so therefore we have a Dealing
Division. They cover foreign exchange, currency options, money market transactions,
bonds, floating rate notes, Eurodollar CDs,...
Interviewer: CDs?
Adam: Certificates of Deposit.
Interviewer: Oh, I see. Yes.
Adam: CDs, financial futures and bullion. Then there’s our Corporate Finance
Division which has expanded quite rapidly over the last couple of years. They provide
advice to a large number of UK and international companies. The activities of the
Corporate Finance Division include mergers, takeovers, acquisitions and divestments,
as well as stock market and USM flotations in London, and of course capital raising.

336
 Interviewer: I see.
Adam: We also have an Investment Management Division which provides
services to companies: pension funds, investment trusts, unit trusts and offshore
funds. And finally there’s a Leasing Division which organizes leasing packages for
lessors and lessees. Well, that’s who we are, and what we do. I think that sums it up.

Vocabulary

Merchant bank-a bank concerned with the financing of international trade.

Interest-percentage of the capital paid by a borrower to a lender.
Accounting and audit-the keeping of financial records and their periodic
examination.
Syndicated loans- a very large loan for one borrower, arranged by several
banks.
Overdraft- money overdrawn on a bank accounts to agreed limits.
Correspondent banking- activities where one bank acts as an agent for another
bank.
To deal- to trade, buy, sell.
Deal- business agreement.
Bonds- documents promising to pay sums of money at specified times.
Floating rate note- note on which interest rates are fixed periodically and
which can be traded on the market.
Financial futures- contracts to buy or sell currencies, bonds, bills at a stated
price at some future time.
To merge- to join together.
Merger- the joining of two or more companies into one.
Takeover- the buying of a majority of the shares of a company.
Divestment- the selling-off of interests.
U.S.M flotation- the starting of a new limited company where the shares are
not included in the official list on the Stock Exchange.
Unit trust- an organization which collects and pools money from many small
investors and invests it in securities for them.
Offshore funds-money placed in countries with very low taxes.
Lease-contract for renting property or equipment for a period of time.
Lessee-person who pays for a lease.
Lessor- person who receives money for a lease.

* Match the terms (1-20) with the right definition(A-T).

1. merchant bank
2. clearing bank
3. wholly-owned subsidiary
4. accounting and audit
5. syndicated loan
6. overdraft
7. documentary credit
8. correspondent banking
9. currency option
10. bonds
11. floating rate note

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 12. Eurodollar CD
13. financial futures
14. merger
15. takeover
16. divestment
17. USM flotation
18. investment trust
19. unit trust offshore funds
20. offshore funds

A. The selling-off of interests.

B. A very large loan for one borrower, arranged by several banks.
C. Money overdrawn on bank accounts to agreed limits.
D. Documents promising to pay sums of money at specified times.
E. Money placed in countries with very low taxes.
F. The joining of two or more companies into one.
G. A bank which is a member of a central organization through which cheques
are presented for payment.
H. Activities where one bank acts as an agent for another bank.
I. A contract where the buyer has the right to demand purchase or sale of a
specified currency, but no obligation to do so.
J. A bank mainly concerned with the financing of international trade.
K. An organization which collects and pools money from many small
investors and invests it in securities for them.
L. A company entirely owned by another company.
M. A limited company formed to invest in securities.
N. A method of financing international trade where the bank accepts a bill of
exchange from the exporter for the invoice amount, in return for receipt of the invoice
and certain shipping documents.
O. The buying of a majority of the shares of companies.
P. Contracts to buy or sell currencies, bonds and bills, etc. at a stated price at
some future time.
Q. Note on which interest rates are fixed periodically, and which can be traded
on the market.
R. Document given for a deposit repayable on a fixed date, the currency being
dollars which are deposited outside the USA.
S. The keeping of financial records and their periodic examination.
T. The starting of a new limited company, where the shares are not included in
the official list on the Stock Exchange.

TEXT 3

Ronald Sims describes the organization of a Scandinavian Savings Bank.

Ronald: In order to understand how we’re organized, it’s perhaps first
necessary to understand just what we are, and that means a Savings Bank. This has
some important implications as to why we’re organized the way we are. We were the
oldest and largest Savings Bank in the country. In 1990 we merged with the two

338
largest regional Savings Banks and effectively this now gives us a nationwide
network of branches to serve the private customer.
Head Office of course is here, that’s in the central region, and there are two
other regional offices. There’s a Board of Directors, which is elected by the Board of
Trustees of the bank, and a Managing Director, who has two Deputy Managing
Directors who are responsible to him.
The one Deputy Managing Director is responsible for the branch network of
offices, and reporting to him are the three Regional Managers, for the northern,
central and southern regions.
The other Deputy Managing Director is responsible for the Corporate Business
Division, and the formation of this division, really, was one of the main objectives of
the merger: to pool our resources and to gain access to the lucrative markets
dominated by the commercial banks.
We’ve still got a long way to go, of course, but we’ve turned from a Savings
bank which, prior to 1980, was not able to accept deposits in excess of the equivalent
of ten thousand dollars, because of the regulations, into a commercially competitive
bank which last year, for instance, granted an international debenture loan of forty-
five million dollars and which had a loan portfolio fifty per cent of which, in terms of
volume, related to corporate customers.
And we’ve done this virtually from scratch, building up our client list of small
and medium-sized companies, establishing and expanding worldwide correspondent
banking relationships, and, of course, making major investments in terms of personnel
and technology. In our case, the new organization structure was very necessary for us
to be able to broaden the scope of our activities.

Vocabulary

Savings bank- bank where your money earns interest.

Trustees- people responsible for administering money or property for the
benefit of others.
Lucrative markets- markets in which there are good profits.
Commercial banks- banks which offer a wide range of services to the public,
to companies .
Debenture loan- loan of money at a fixed rate of interest, involving a
certificate of the debt.
Loan portfolio-an entire collection of loans.
To broaden-to increase, to extend.
Corporate-referring to the whole company.
Company-a registered business
To invest- to put money into a bank, building society, shares or other project in
order to earn interest.
Investment- money put into a bank or project with the intention that it should
increase in value.
Safe investment- non-risky investment

What can you say instead of the following words:

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 *set up in 1990
*bank set up to accept deposits from members of the public.
*joined together.
*system of local offices over the whole country.
*people responsible for administering money or property for the benefit of
others.
*markets in which there are good profits.
*before
*banks which offer a wide range of services to the public, to companies and
other organizations.
*more than
*loan of money at a fixed rate of interest, involving a certificate of the debt.
*an entire collection of loans.
*arrangements with banks who act for each other.
*people who work here.
*increase the range or extent of our operations.

Bank performance

Banks necessarily use sophisticated accounting systems to record as clearly as

possible what the financial situation of the bank is. Normally such a system is based
on the principle of the double entry, which means that each transaction is entered
twice, as a credit in one account and as a debit in another account. If we deposit £100
with a bank, for example, the bank enters a debit for the receiver and a credit for the
giver. The former represents an asset to the bank, since it is a sum of money at the
bank’s disposal, as well as a liability, since it will one day have to be repaid. The
balance sheet of a bank gives us a view of its financial situation at one point in time,
usually 31 December of a particular year. But we do not know what has happened
between two balance sheets. This information is provided by the profit and loss
account for the period in question. Neither statement is exactly uniform from bank to
bank, but both contain certain essential features.
The largest asset of a bank is normally its total portfolio of loans. Deposits
usually constitute the largest liability. Balance sheets usually include the following
items listed as assets:
• Cash on hand and due from banks - money in vaults, balances with other
banks, cheques in process of collection.
• Investments - bonds, shares, etc.
• Loans - to companies, the general public, etc.
• Fixed assets - buildings, equipment, etc.
Items listed in the balance sheet as liabilities are:
• Deposits - all money owed to depositors
• Taxes payable - national and local
• Dividends payable - decided on, but not yet paid
The profit and loss account records the income of a bank, and here, typically,
the items in order of size are:
• interest on loans

340
 • return on investments
• fees, commissions, service charges
The granting of credit provides the largest single source of bank income.
Typically, two thirds of an American commercial bank’s yearly earnings result from
interest on loans. Nine out of every ten dollars they lend come from depositors’ funds.
The following items normally constitute the main expenses in a bank’s profit and loss
account, again in typical order of size:
• interest paid
• salaries and other benefits
• taxes
A bank’s accounting systems, then, are designed to record and present the
many transactions that take place every day. Substantial reserves over and above
statutory requirements are an indication to customers of the bank’s strength, that it has
run its business well and has retained profits in the business for future operations.
Profitability indicates the effectiveness of a bank’s performance and how well it has
managed the resources under its control. Published figures thus provide some
essential data on the liquidity, safety and income of a bank.

TEXT 4

Presenter: Bill River gives an informal presentation of his bank to a

prospective client.
Bill:I have here a copy of our last annual report for your reference which
you’ll probably want to look through later. But I can give you right now a very brief
overview of our last year performance.
Client: That’s o.k.
Bill: As of January 31st 1994, the Lacey Bank Corporation was the fifth
largest bank in the United States, based on stockholders’ equity, and sixth largest
based on deposits. This bank has over one thousand two hundred offices around the
world with some fourteen thousand employees spread over thirty-five foreign
countries. And within this worldwide framework we are offering a wide range of
financial services to a very diverse customer base which includes corporate clients,
government agencies and correspondent banks.
In 1994 we achieved record earnings coupled with our tenth consecutive year
of profit growth in what is, as you know, an intensely competitive environment.
Consolidated net income was five hundred and fifty million dollars, ten per
cent up on 1988, and this was the second year that our net income reached the half-
billion dollar mark.
A part of the bank’s policy is to maintain a strong capital base and at the end
of 1994 our total assets amounted to over sixty-five billion dollars. We hold deposits
of around thirty-seven point eight billion dollars and net interest income alone in
fiscal 90 was one point nine billion dollars. In addition, we hold two point two billion
dollars’ worth of investment securities. Net income, the net income per share for the
period was five dollars sixty-five. We think it was a good year and we are proud of it.

Vocabulary

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 Overview-description
Stock-quantity of goods for sale, inventories.
Stockholders’ equity-based on money received from the sale of the parts into
which the capital of a company is divided.
Deposit-sums of money left with the bank.
Corporate clients- company customers.
Correspondent banks- banks in other countries with whom we have an agency
relationship.
To earn-to receive money for work
Earnings-salaries, profits, dividends, interest received.
Earnings per share- dividends per share shown as percentage of the market
value of a share.
Income-money received through operations or investment
Earned income- money earned through work.
Consolidated net income-the annual income of the group of companies after
the payment of costs.
Assets-something of value which is owned by a company
Current assets- assets in daily use by a business.
Fixed assets- property and machinery
Frozen assets- assets which cannot be sold.
Intangible assets- assets which cannot be seen.
Liquid assets- cash or bills which can be easily converted into cash.
Tangible assets- assets which can be seen.
Securities- investments in stocks and shares.
Security- guaranty that a debt will repaid.
The securities market- place where shares can be bought/should.
Investment securities- placement of money in shares to produce profit.

Try to find the meaning of the following :

*a very short general description.
*sums of money left with the bank.
*money received from the sale of the parts into which the capital of a
company is divided.
*it includes company customers.
*banks in other countries with whom we have an agency relationship.
*the highest ever profits after transfers to reserves.
*the tenth year in a row of profit growth.
*the annual income of the group of companies after the payment of costs.
*the value of all the things we own.
*the financial year.
*placements of money in shares so as to produce profit.
*the last report presented each year giving details of the company’s activities
and financial performance during the previous financial year.

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 TEXT 5

Max Proney gives some information about his bank to a group of professional
visitors from abroad.
Max: We have a diagram which gives a very brief summary of some of the
key figures relating to our performance in 1994. We’ll be meeting these figures again
later in greater detail, but it may be useful at this stage to present them and to indicate
a number of important trends.
If we begin with income then, you will see that the total group income
amounted to a record level of one hundred and fifty-five million pounds, an increase
of nearly fifteen per cent on the previous year, a rate of increase slightly above that of
recent years. Interest received amounted to six hundred and fifteen million pounds,
and interest paid to five hundred and sixteen million, leaving us with a net interest
income of ninety-nine million pounds. This is eleven per cent up over the 1989 figure
and represents sixty-four per cent of the total group income for 1994. The net interest
income is quite satisfactory in itself, given the very difficult market conditions, but
what is especially significant is the increase in non-interest income from forty-six to
fifty-six million pounds, an increase of some twenty-two per cent. A very important
part of the bank’s policy lies in limiting dependence on net interest as a source of
income and in developing its fee and commission earning activities, and 1994 income
in this area accounted for a two per cent higher contribution to total income than was
the case in 1989. This is an encouraging trend, as it reflects the bank’s response to the
changing economic environment in general and to the sensitivity of interest rates in
particular.
Non-interest income then of fifty-six million pounds, making the total income
for the year of one hundred and fifty-five million pounds, twenty million pounds
higher than the previous year.

Vocabulary

Trends-general development in a market, business.

Income-money received through operations or investment.
Earned income- money earned through work.
Unearned income- money received from investments.
Net interest income-the amount by which the total interest received is higher
then the total interest paid during the period.
Key figures- the most important figures.
Rate- charge for service or work or for loans.
Going rate- market price.

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 To run - to manage, to organise.
Running- operating,continuing,consecutively.

*Choose the best answer.

1 A brief summary is:
a) a small amount of something; b) several numbers added together to make a
total;c) a short report of the main points; d) a full report with details.
2 Key figures are:
a) figures that are easy to understand; b) the most important figures; c) figures
that give an answer to a problem; d) figures that are well-known.
3 Trends are:
a) movements or directions; b) goals that you try to reach; c) events that are
likely to happen; d) events that happen quite often.
4 A record level of income is:
a) an amount that will never be reached again;
b) an amount that is written down so that it will not be lost or forgotten;
c) an amount that stays the same and does not go up or down;
d) a higher amount than ever before.
5 Net interest income is:
a) the amount by which the total interest received is higher than the total
interest paid during the period;
b) the amount by which the total interest received is lower than the total
interest paid during the period;
c) the total interest received by the lender;
d) the amount earned on an investment after paying for its capital cost.
6 Something which is especially significant is:
a) the only one of its kind; b) the very best of its kind; c) important and worth
noting; d) widely-known and accepted.
7.Fee and commission earning activities are:
a) the buying and selling of currencies for profit;
b) plans to lend money profit;
c) services that are sold by an agent;
d) services for which charges can be made.
8.A contribution to total income is:
a) a fixed amount of money paid at regular intervals;
b) money that is owed or payable;
c) an amount of money that is taken away from the total.
d) an amount given or supplied.
9.The economic environment is:
a) an area of the economy;
b) the future of the economy;
c) the economic situation;
d) financial laws and regulations.
10.The sensitivity of interest rates is:
a) the way in which interest rates affect each other;
b) the way in which interest rates are easily influenced or affected;
c) the changes in interest rates;
d) the way in which interest rates are worked out.

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 TEXT 6

The presentation continues:

Max: We’ve seen the income; let’s now look at the outgoings. The largest of
these is staff costs which increased by ten million pounds, or eighteen per cent, to
sixty-five million pounds in 1992. This increase is larger than in previous years and is
partly due to the increase in staff numbers needed to handle the expansion of the
bank’s fee-generating activities which I have just mentioned.
Provisions for doubtful debts increased to eight million pounds. Depreciation
on leased assets and on premises and equipment, calculated on a straight line basis,
amounted to fifteen million pounds.
Other expenses increased by a little under seventeen per cent, from twenty-
four million to twenty-eight million pounds, the smallest annual increase since 1988,
which I think illustrates our determination to keep costs under control.
Tax - not much to say there really - other than to note that we paid five million
pounds, or twenty-five per cent more than in 1989, taking us, in fact, up to twenty five
million pounds.
Dividends remained unchanged over the previous year at five million pounds,
as the major part of the year’s profit was retained to expand our consolidated capital
base. Our balance sheet footings have been growing steadily over recent years and
this was in fact the first year in which they passed the three billion pounds mark.
After allocation of the dividends, there remained a net undistributed balance
for the year of nine million pounds which was transferred to reserves.

Vocabulary:

Outgoings-amount of money spend.

Staf costs-money involved in paying employees.
Fee generating activities-services for which charges can be made.
Depreciation on leased assets- the decline in value of property which is hired.
Premises-buildings and the land on which they stand.
Expenses- money spent on the running of the bank.
Dividents- the part of the company’s profits which is paid to the shareholders.
Retained-kept by the company and not paid to the shareholders.
Footings-totals.
To allocate- togive money in certain proportions
Allocation- setting aside money for.
Undistributed balance- amount of money kept by the company and not paid to
shareholders.
Reserves-amount of money set aside from profits for a special purpose.
To grow- to become larger.
To transfer- tom ove from one place to another.
Transfer pricing- adjustment of price son sales made between parts of a
multinational company.

* Note down what you think it can be said instead of the words in italics.
1 ... let’s now look at the (amount of money spent)
2 The largest of these is... (money involved in paying the employees)

345
 3 ... to handle the expansion of the bank’s (services for which charges can be
made)
4. …………. increased to eight million pounds ... (money put aside to cover
possible credit losses)
5. ………….(the decline in value of property which is hired) and on..... and
equipment ... (buildings and the land on which they stand)
6. Other increased by ... (money spent on the running of the bank)
7. ... the smallest increase ... (yearly)
8. ……………remained unchanged ... (the part of the company’s profits
which is paid to shareholders)
9. …as the major part of the year’s profit was……. (kept by the company and
not paid to shareholders)
10. Our balance sheet…………. (totals)
11. After………. of the dividends ... (setting aside money for)
12. …there remained a net…………… (amount of money kept by the
company and not paid to shareholders).
13. …nine million pounds, which was…………… (moved over to funds put
aside to cover unexpected events).

Foreign exchange

Foreign exchange dealing is, as its name implies, the exchange of the
currency of one country for the currency of another. The rate of exchange is the value
of one unit of the foreign currency expressed in the other currency concerned.
With the growth of global trade, many companies need foreign
currencies to pay producers in other countries. A British company with a supplier in
Germany, for example, will probably use sterling to buy Deutschmarks from its bank
in order to pay an invoice from the German company. The bank buys the
Deutschmarks from another bank at a particular rate and provides them to its
customer at a higher rate, thus making a profit. Similarly, a bank may make gains on
buying and selling currencies on the inter-bank market. Making a profit on the
transaction is the basic idea of foreign exchange dealing.
Currencies can be bought or sold in the foreign exchange market either for
immediate delivery, that is at the spot rate, or for delivery later (e.g. two weeks, three
months, etc.) at a forward rate. The forward market is useful for companies, since if a
company knows that it will need a particular foreign currency to pay a bill in four
weeks’ time, for example, a forward deal enables it to protect itself against future
adverse movements in the exchange rate which would have otherwise had the effect
of making the foreign goods more expensive.
When dealing in foreign exchange, normally by telephone, the bank quotes
both the selling and buying rate of a currency at which it is prepared to transact
business. Settlement for a spot transaction is two working days later. Thus if a
contract is made on Monday, the seller delivers the amount sold and receives payment
on Wednesday. Similarly if the contract is made on Tuesday, value is Thursday.
Currency traded in this way is delivered to the buyer’s account with a bank in
the main centre, or one of the main centres, for the currency in question. In the case of
sterling, for example, this is London, for Dutch guilders it is Amsterdam and

346
Rotterdam, and for Belgian francs it is Brussels and Antwerp. The buyer decides the
bank where his or her account is to be credited.
The foreign exchange dealer fills in a dealing slip containing basic information
such as the date and time of the deal, the contracting party, the amount and rate agreed
on, the date of settlement, and the place of delivery of the currency dealt in. As soon
as a foreign exchange transaction has been carried out, both banks send a written
confirmation containing the basic information mentioned above. Any discrepancies
may thus be detected quickly.
A bank holding debts or claims in a foreign currency is itself exposed to an
exchange risk, unless the debts and claims neutralize each other by being of equal size
and by having roughly the same maturity dates. Dealers therefore aim for a balanced
total position. If the amount of a bank’s claims in dollars, for example, is larger than
the total debts in dollars, then the bank has a long position, but if the debts are larger
than the claims, the bank is short in dollars. As long as the total position balances,
there is no risk for the bank.

TEXT 7

Ken Williams explains some of the basic principles of foreign exchange

dealing.
Ken: We’re accounted in sterling, but generally all dealings are based on the
dollar. So, for instance, your spot prices are dollar Deutschmark, OK? That’s the big
market really, dollar Deutschmark. And it’s the movement in the dollar which is
really moving the market. I mean, for instance, yesterday the dollar rates firmed up a
little. They went up about a sixteenth to an eighth of a per cent. So people buy dollars
because the interest differential between dollars and Deutschmarks is widening. So I
mean, if you buy dollars, OK, you, you can lend them out on the next day at, say,
eleven and a half per cent. You’re short of Deutschmarks that day, and you have to
purchase, borrow those for one day, and that’s about five and a half per cent. So
you’re talking about six per cent difference. The basic idea of spot dealing is to buy
dollars low and sell high. That’s the basis of making a profit.
Interviewer: So why would you need Deutschmarks on a particular day? You
said you’d be short in Deutschmarks so you’d have to borrow them.
Ken: Well, to square the account for that day. We’re dealing ahead all the
time. The spot market is dealing two working days forward. So, for instance, if I
bought dollars against Deutschmarks, I would come in tomorrow and find that on the
seventeenth I’m short in Deutschmarks and long in dollars. So then I would go into
the market and say ‘What’s your tom/next dollar mark?’
Interviewer: What’s your what?
Ken: Tom/next dollar mark. They’re dealing terms, OK?
We have spot which is normal buying and selling of currencies. Then we have
a tom/next. Now a tom/next simply means tomorrow to the next day. Then we have a
spot/next which is your two days’ forward dealing value date to the next day. Then
you have a spot a week, a spot a fortnight. Then you go one, two, three months and so
on. We also have outrights. So someone can ask ‘What is your spot dollar mark
outright tomorrow?’ It’s just that you’re quoting a spot rate but it’s from tomorrow,

347
and you adjust the price, depending what the price is for the tom/ next swap. It’s
always, it’s always relative to the two day forward dealing rate.
Interviewer: So the ... yeah, yeah, OK. I don’t, I don’t see what an outright is.
Ken: Well, an outright is simply ... we also have the term swaps, in forward
dealing which is when you lend one currency and borrow another for a certain period
time. There are two related contracts, one sale and one purchase, and you’re taking
into consideration different interest rates, trading on the movement in two currencies.
By using a simple calculation these swaps can calculate into another currency’s
deposits, so that the relationship between the two currencies determines the forward
pricing. Now an outright is if someone wants to buy Deutschmark and sell dollars on
any particular day. It’s not, it’s not connected to a corresponding spot transaction.
Say, for instance, two month’s time, a company has to cover its Deutschmark
payments, so they cover their foreign exchange exposure by buying Deutschmarks
from tomorrow to that day. So they would ring us and say ‘What is your price spot
dollar mark outright to the tenth of October?’ And that is an outright.
Presenter: So now we know a little about the principles and terminology of
foreign exchange dealing.

Vocabulary:

Spot prices- prices for funds which will be exchanged two working days later.
To firm up-to increase.
Interest differencial-difference in interest rates.
To purchase- to buy.
Profit-a result where the income is higher than the costs.
To square- to balance.
Spot a fortnight- a period of two weeks beginning two working days from
now.
Outrights- deals where someone buys one currency and sells another on any
particular day.
To quote- to state the price that you will charge for a spot rate.
Swap- an exchange of one currency for another,for a certain period of time.
Deal- a business agreement.
To deal- to buy and sell.
* Write down the words that are used in place of those printed in italics.
1. We’re accounted in (British pounds.)
2. So, for instance, your( prices for funds which will be exchanged two
working days later) are dollar Deutschmark.
3. I mean, for instance, yesterday the dollar rates (increased slightly).
4. So people buy dollars because the (difference in interest rates) between
dollars and Deutschmarks is (increasing).
5. You’re short of Deutschmarks that day and you have (to buy), borrow those
for one day...
6. That is the basis of making (a result where the income is higher than the
costs).
7. Well, (to make totals equal, to balance) the account for that day.

348
 8. …….and find that on the 17th that I am (in a position where I have sold
more Deutschmarks than I have bought, and bought more dollars than I have sold.)
9. Then you have spot a week,( a period of two weeks beginning two working
days from now.)
10. We also have (deals where someone buys currency and sells another on
any particular one day).
11. It’s just that you’re (stating the price that you will charge for) a spot rate.
12 ... depending what the price is for the tom/next (exchange of one currency
for another, for a certain period of time.)
13 ... so that the relationship between the two currencies (fixes, decides) the
forward pricing.
14 ... so they cover their foreign exchange (risk or possibility of loss) by
buying Deutschmarks

Meetings

Banks provide a wide variety of services to companies, and a company

operating internationally is likely to use several banks around the world to meet its
various needs. Banks keep in touch with these customers by telephone and perhaps
with regular meetings, to maintain the relationship and to market new services.
Most companies use banks at one time or another to finance their operations.
As with any other type of loan, banks charge interest on corporate loans. Interest rates
for loans in Britain, for example, can be charged in one of three ways:
• at a margin above the bank’s base rate. Each bank decides its own base rate,
and then charges the company a rate of interest which is related to this. A big
customer with a very good reputation may be charged the bank’s base rate plus 0.5%,
for example, while a smaller company might be charged the base rate plus 3%.
• at a margin above LIBOR, the margin again depending on the bank’s
assessment of the corporate customer.
• at a fixed rate of interest for the period of the loan.
The first two ways are variable and are adjusted periodically to reflect
movements in interest rates on the market. They may also be negotiable. The third
may be dangerous for the bank when market rates are erratic.
A company involved in a business where income and expenditure are subject
to constant changes needs a variable borrowing facility. This is met most simply by an
overdraft facility. The company opens an account with the bank, and an overdraft
with a specified limit is granted on the account.
Many companies make a profit not only from the goods or services which they
sell, but also from the money that they have. Cash managers utilize funds at their
disposal, buying and selling shares, treasury bills and so on, to generate profit in the
form of investment income. Rather than move valuable foreign shares and securities
around the world by post, a company will deposit them for safe keeping with a bank
in the foreign country. A company in Sweden which buys shares on the American
market, for example, will use the custodian services of a US bank. Banks naturally
charge fees and/or commissions for custodian services.

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 TEXT 8

Presenter: Simon Stillman meets Oliver Richardson .

Simon: Could we take up the question of the interest rate charged for this
overdraft facility?
Oliver: Yes, of course.
Simon: It seems to be rather high: one per cent over Wallers base rate. First of
all, what is the base rate?
Oliver: It’s our basic lending rate which at the moment is eleven per cent.
Simon: Yes, I see. It’s more or less the overnight rate, then, as I understand it,
your base rate.
Oliver: Yes.
Simon: But a mark-up of one per cent seems rather high. As you know, we
work with a lot of banks, and, quite frankly, one per cent is just too expensive for us.
Oliver: Yes, I see.
Simon: I think you’ll have to think about this, Oliver, because we’re not
interested in having the facility if it is going to be so expensive for us to use it. We
work with Key Commercial Bank too, and just for your information there we pay zero
point two per cent above LIBOR, more or less the same as Wallers base rate.
Oliver: What kind of reduction did you have in mind?
Simon: Well, a margin more in line with what we can get from the other
banks. Say zero point two five per cent above your base rate.
Oliver: Zero point two five.
Simon: Yes, at the very highest. We’d be prepared to pay that little bit extra
simply to maintain our working relationship. But one per cent is just too high for a
company like Denavian.
Oliver: Yes, the...
Simon: By the way, I haven’t told you, but it could be useful for you when
you take this up in the credit committee in the bank. We have been rated now by
Alibright and Rich, and for short-term debt we have A one plus, and as you know
that’s the best you can get.
Oliver: That’s credit rating?
Simon: Yes, credit rating, and for the long-term we have triple A. And that’s
also the best. There’s no risk involved for you, so one per cent for the overdraft
facility ... we’d really like you to review that.
Oliver: Fine, I’ve made a note of it. I’ll take it up when I get back to London,
and I’ll get in touch with you. All right?
Simon: Yes, do that. Then you can confirm it. If it’s positive. Otherwise,
there’s not much point in us keeping this facility.

Vocabulary:

Overdraft - amount of money which a person or company withdraws from a

bank account and which is more than is in the account.
Overdraft facility- arrangements with a bank for an overdraft to a certain limit;
Overnight rate-the rate of interest charged for a loan at call from one day to
another.
Mark-up- the gross profit margin or an increase in price.

350
 Margin- the relation between profit and selling price.
Libor-London Inter-Bank Offered Rate, the rate of interest between London
banks on some deposits.
Credit committee- a group of bank staff who control the lending of the bank.
Credit rating- a formal and detailed examination of the financial strength of a
company.
To confirm- to give agreement.
Debt- money owed.

*Match the words with the correct definition:

1) credit rating,
2) confirm,
3) overnight rate,
4) credit committee,
5) review,
6) overdraft facility,
7) LIBOR,
8) mark up,
9) margin,
10) quite frankly

a. the rate of interest charged for a loan at call from one day to another.
b. a bank service providing for borrowing on current account up to an
agreed maximum limit.
c. the gross profit margin or an increase in price.
d. honestly and directly, without wishing to hide anything.
e. London Inter-Bank Offered Rate, the rate of interest between London
banks on some deposits.
f. the relation between profit and selling price.
g. a group of bank staff who control the lending of the bank.
h. a formal and detailed examination of the financial strength of a
company.
i. to look at or examine again.
j. to give agreement.

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 Financial news

Modern information technology has led to news being transmitted worldwide

quicker than ever before. Time differences around the world mean that financial news
is being made twenty-four hours a day, and it is this barrage of readily accessible
information that serves as a basis for many of the business decisions that are made
concerning international banking and financing. Techniques of analysis are applied to
information to determine its implications and to try to discern trends in the future.
Many prices are determined by a complex interaction of factors. With regard
to currencies, it may be said that one factor governing prices is the interaction of
supply and demand. Interest rates prevailing in different countries affect currency
exchange rates. If interest rates rise in the UK for example, US investors may move
funds to the UK to earn higher interest income. They will then sell dollars for sterling,
and the demand for sterling will rise, while at the same time the supply of dollars will
rise too. The dollar will therèfore fall in value, while the price of sterling will rise.
Trade between countries may also affect currency rates. If, say, Japanese
exports to Germany rise, and German exports to Japan remain the same, there will be
an increase in the supply of Deutschmarks as Japanese exporters sell them for dollars.
This will normally increase the value of the Yen in relation to Deutschmarks.
Government intervention may also affect exchange rates. If sterling is weak,
for instance, the Bank of England may enter the market to buy sterling with some of
its reserves of other currencies. This will reduce the supply of sterling, thereby
increasing its value.
Stock market prices in a particular country are often affected by stock market
prices elsewhere in the world, and markets tend to move together, as indicated by the
worldwide crash in the autumn of 1987. The share price of any one company will
obviously tend to be influenced by the financial performance of the company, details
of which are released at various times during the financial year.
The factor of supply and demand mentioned ealier will also tend to affect
commodity prices. A bad coffee harvest in Brazil will increase the price of coffee
because demand will exceed supply. The over-production of oil, on the other hand,
will lead to a fall in the price of the commodity, since there will be a glut of oil
available on the market.

TEXT 9

Presenter: The financial news headlines, and more detailed news of the
currency markets.
Newsreader: Here is the Financial News, read by Margret Sinclair. The dollar
recovered after a weak start. The pound strengthened. Gold was slightly stronger, and
silver slightly weaker. London share prices were steady, but New York prices drifted
down.
A survey published in London yesterday states that over the past five years
trading on the world’s foreign exchanges has more than doubled in size. It estimates
that Forex volume now stands at almost fifty-five thousand billion dollars a year.
London remains the leading centre, with nearly fifty billion dollars traded here every
day. Despite increasing competition from the Far Eastern market, New York is in
second place and Zurich third.

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 In the European foreign exchanges the dollar closed yesterday little changed,
after recovering from early weakness. Trading was thin, with dealers waiting for US
economic indicators due on Friday, when US consumer prices and durable goods
orders will be released. In London the dollar closed at two marks sixty-three point
seven pfennigs, and later in New York at two marks sixty-three point nine. That’s a
gain of two and three quarters on the previous close there.
In Tokyo today the dollar slipped back a little, ending at two hundred and
fifteen point eight five yen, against a previous close of two hundred and sixteen point
two. Some selling by the Bank of Japan was noted, but the dollar was helped by the
covering of short positions.
The pound yesterday was stronger against most currencies, aided by firmer
spot oil prices.
In the latest currency prices in London this morning, the pound is at one dollar
forty-four point five cents, that’s one and a quarter cents up on the closing price
yesterday. The German mark is two marks sixty-three point eight pfennigs to the
dollar. The Swiss franc is unchanged at two francs sixteen point six. The French franc
is eight francs forty, and the Dutch guilder is weaker at two guilders ninety- seven
point five. The Japanese yen is unchanged at two hundred and fifteen point eight five
yen to the dollar.
Presenter: So now we know about the currency exchange rates for the day in
question.

Vocabulary:

To recover- to get better after a downturn.

Survey-a report based on inspection.
To drift- to fall slightly.
Forex volume- the volume of foreign exchange.
Gain- an increase in volume.
To slip back- fall slightly.

Choose the one best answer

1. If prices drifted down they:
a) fell heavily; b) fell slightly; c) fell quickly; d) rose then fell.
2. A survey is:
a) a report based on inspection; b) a document that describes what is expected
in the future; c) a detailed description of goods; d) an official list of things or events.
3. Forex volume is:
a) a sum of money that is borrowed; b) a sum of money that is invested; c) the
volume of money in a country; d) the volume of foreign exchange.
4. If trading was thin:
a) buying and selling was not very successful; b) there was a lot of buying and
selling; c) there was not much buying or selling; d) there was no buying or selling at
all.
5. US economic indicators are:

353
 a) the index of retail prices produced by the US government; b) figures that
show the difference between the amount of money flowing into and out of the USA;
c) figures dealing with economic activities in the USA; d) the total amount of money
that other countries owe to the USA.
6. US consumer prices are:
a) a list of prices to be paid for goods imported into the USA; b) the index of
retail prices produced by the US government; c) the prices charged for goods exported
from the USA; d) the prices charged for US dollars expressed in the money unit of
another country.
7. Durable goods orders are:
a) orders for goods which are intended to be used over a period of time;
b) orders for goods which are used up soon after they are bought;
c) orders for any type of goods; d) orders for goods to be exported.
8. If information is released, it:
a) is for sale; b) is kept secret from the public; c) is made known to the public;
d) is written down and recorded.
9. A gain is:
a) a change in value; b) an increase in value; c) a fall in value; d) a value that
stays the same.
10. If the dollar slipped back a little, it:
a) fell slightly; b) fell unexpectedly; c) fell quickly; d) rose then fell.
11. The covering of short positions is:
a) banks buying a currency because they had previously sold more than they
had bought; b) banks selling a currency because they had previously bought more
than they had sold; c) banks buying and selling currencies so as to make a profit; d)
banks buying a currency and selling it soon.
12. If the pound was aided by firmer spot oil prices, it was:
a) helped by higher spot oil prices; b) not helped by higher spot oil prices; c)
helped by lower spot oil prices; d) not helped by lower spot oil prices.

TEXT 10

Presenter: Now we will hear news relating to companies and stock markets.
Newsreader: The company headlines today are that Lewhill is to open a thirty
million pound production centre in Birmingham. It will employ around fifteen
hundred people. Welby Engines have landed a twenty-five million pound order from
Air Texas, and the latest bid for Basterfields by the Canadian giant Garvin has been
rejected.
On the interim results front, Luxdon’s third quarter profit of three hundred
thousand pounds came as a setback, after first half profits of two and a half million
pounds. Another company reporting was Fisher Hogg, who pleased the market,
however, with a fifty per cent profits rise compared with last quarter.
On the London stock market yesterday, shares remained close to last week’s
record highs. Financial and discount houses were a firm sector, with United Alverson
advancing twenty pence to seven pounds sixty-eight. Banks too made further gains,
and Key Commerce rose twelve to six seventy-six.

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 Among the other features, Ainscough and Lee were up nine at four thirty-
seven on bid hopes, and Sheldon jumped thirty to two forty-five on their Monday sale
of their Quinton stake. Hale and Owen stuck at two oh four, despite reporting treble
interim profits which in fact conceal a setback, if one disregards the proceeds from the
sale and leaseback of their Birmingham headquarters. Berry Sugar were down eight at
one seventy one, on doubts about the commodity price.
On Wall Street on Tuesday, leading stocks were moderately firmer, though the
market was mixed. Falling stocks outnumbered rising ones by seven hundred and
ninety-eight to seven hundred and twenty-eight, on a moderate volume of one
hundred and one million shares. Bonds were strong.
In Tokyo today there were heavy falls for many shares, especially among the
market leaders. Hong Kong shares slipped back a little. In Australia, shares fell
sharply across the board although trading was subdued.
Presenter: Some specific news about British companies and share prices
there, followed by stock market news from other parts of the world.

-Vocabulary-

Market- place where products and services can be bought and sold.
Capital market- place where companies can look for investment capital.
To land- to succeed in obtaining.
Bid- price offered
Setback- diappointment and difficulty.
On the interim results front-in the area of news dealing with the outcome of a
company’s trading during only part of the year.
Shares- the parts into which the ownership of a company is divided.
Financial and discount houses- finance companies and finance organizations
which buy and sell bills of exchange.
A firm sector- an area of business activity tending to rise.
Bid hopes- hopes of an offer to buy.
To conceal- to hide.
Doubt- uncertainty.
Commodity price- price of the raw material.
Bonds- documents promising to pay sums of money at specified times.
To fall across the board- to move downwards suddenly.
Trading was subdued- there was a lot of buying and selling.

Write down the words used instead of those in italics:

**they have (succeeded in obtaining) a very important order.

**this is the latest( price offered) for Grandfields.
**(in the area of news dealing with the outcome of a company's trading
during only part of the year) Luxdon's third profit of $ 300 000 came as a (
disappointment and difficulty).
**(the parts into which the ownership of a company is divided) remained close
to last week's record highs.
**(finance companies and finance organizations which buy and sell bills of
exchange) were an (area of business activity tending to rise ).

355
 **on Wall Street (major shares were slighty higher in price).
**(documents promising to pay sums of money at specified times) were strong.
**in Australia ( all share prices moved downwards suddenly) although (there
was not a lot of buying and selling).

TEST -1-

*Chose from the words in brackets to complete the sentences.

(Bank of England, bearer,base rate,Stock Exchange,stock, bear, shares, bond,
bull,asset).
1.The American central bank is the equivalent of ................ in Britain.
2.The units of ownership of a company allowing the holder to receive a
proportion of the company’s profits are the .........
3.In the U. K.a fixed amount of a paid –up capital held by a stockholder is
a ............
4.If the market is thought to be good and prices on the Stock Exchange are
thought to be likely to rise the market is called a .........market.
5.If the market is thought to be poor and prices on the Stock Exchange are
likely to fall the market is called a ..........market.
6.A promise to pay a sum of money over an agreed time by anyone licensed to
do so such as a government insurance firm is a .....
7.Certificates of ownership of bond that can be tranferred from seller to buyer
without any formalities are ...........bonds.
8.Something that is owned by an individual or a company has monetary value
and can be sold to pay debts is an .........

TEST-2

*Match the following sentences with the words or phrases (a-k).

1.The holder of these has lent the company money but has no voting rights.
2 A group of six accountants have decided to form an association to carry on
business in common and make a profit.
3.The investors give these people the power to run the company .
4.This company holds more than 50% of the voting shares in another
company.
5.Members of the public can only invest in this company if they are invited to
do so.
6.Investments in many companies can be made by buying shares on this
market.
7.The public at large can be shareholder in this company.
8.The golf club was set up with the intention of not making a profit.
9.Fifty one per cent of the voting shares of this company are held by another
company.

10.This is the meeting which is held once a year for the shareholders.

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 a.subsidiary
b.group
c.non-profit-making
d.stock exchange
e.partnership
f.directors
g.private limited
h.debentures
i.public limited
j.holding company
k.annual general meeting

TEST-3-

Choose the correct answer in each of the following:

1.Funds coming into a firm are known as ................of funds.
a.springs
b.sources
c.origination
d.income
2.The ways these funds are used are known as the ....................of funds.
a.application

b.delegation
c.disposal
d.consumption.
3.................funds include money in our hands and in the bank.
a.working
b.current
c.profit
d.cash
4.When you take away current liabilities from current assets you have the
amount of .............funds.
a.liability
b.working capital
c.asset
d.flow
5.Financial statements about cash funds are usually known
as.....................statements.
a.cash flow
b.cash resource

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 c.cash outflow
d.cash loss
6.An item which doesn’t involve flow of funds is .........................
a.sales of fixed assets
b.drawings
c.depreciation
d.loan repayment
7.An item which involves flow of funds is...............
a.provision for bad debts
b.book loss on sale of fixed assets
c.sale of fixed asset
d.book profit on sale of fixed asset.
8.After making adjustment for items which dont’t involve the flow of funds
the net profit or loss is known as...............
a.gross profit
b. outflow of funds
c. cash movements
d.total generated from operations..
TEST-4-

*Fill in the missing words in each of the following sentences.Chose from

the alternatives beneath each sentence:

1.The Board of .......is responsible for deciding on and controlling the strategy
of a corporation or company.
a.workers
b.directors
c.control
2.Small businesses depend on investors providing .........capital.
a.venture
b.individual
c.cooperative
3.Investors are influenced by the projected.........on their capital.
a.market
b.return
c.rate
4.The capital needed to run a business is provided by............
a.gain b.risk c.investment
5.Rent and rates which do not change as turnover volume changes make up
the...........costs of a company.
a.fixed
b.contribution
c.variable
6.Every company must watch its...........carefully if it is to avoid banrupcy.
a.market managers
b.cash flow
c.production lines.
7.The..........account shows whether the company is profitable or not.
a.profit and loss
b.volume

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 c.shareholders
8.Banks require.........to guarantee a loan.
a.accounts
b.shares
c.securities
9.Insurance companies may use .............to negotiate the amount of insurance
to be paid.
a.claim forms
b.tariff companies
c.insurance adjusters.
10.The Stock Exchange deals with the purchase and sale of...........
a.stocks and shares
b.bulls and bears
c.statements and invoices.

TEST-5-

Choose the correct words from the following: bookkeeping, interest,

creditor, company, profit, current, capital, net, shares, debtor, divident, statement, to
complete the definitions.

1.Recording financial transactions is...........

2.A legal organisation,formally registered in one of three ways and having a
life independent of its members is a ............
3.A person or organisation that owes money is a................
4.A person or organisation to whom money is owed is a.....................
5.The assets,including cash, debtors and stocks used in a company’s trading
available at the present moment are its...................assets
6.The equal parts into which the ownership of a company is divided are
its..................
7.The money paid to shareholders out of a company’s profits is
the ..................
8.A company’s turnover, less its cost of sales,is its gross......................
9.A company’s turnover after the cost of sales, tax,rent and other liabilities
are deducted is its.................profit.
10.The sum of money paid by a borrower to a lender for the use of the
lender’s money is the.............on the loan.
11.The document send to the debtor by the creditor, showing how much is
owed and for what, is the .............of account.
12.The shareholders’ investment in a company is the share..............

TEST-6-

1. I have been requested to... a deposit

a) leave
b)let

359
 c) put
d) do
2. An I.O.U...
a) is a small loan
b) is the same as a cheque
c) is a bill exchange
d) is a promise to pay on the part of the debtor
3. Your payment is ... and your account is now in the red.
a) overtime
b) overdue
c) overtaxed
d) overcome
4. The bank does not want to lend me any money. I shall have to go to the...
a) borrower
b) hireling
c) pawnbroker’s
d) cash-register
5. Counterfoil is a synonym for...
a) stub
b) ticket
c) coupon
d)draft
6. A bad cheque may be referred to as a ... check
a) red
b) black
c) dud
d) void
7. A bill of exchange is drawn up by...
a) the payer
b) the debtor
c) the creditor
d) the drawee
8. When the acceptor stipulates some special condition, the acceptance of a
bill is said to be...
a) particular

360
 b) qualified
c) specialized
d) peculiar
9. A hire purchase transaction involves payment by...
a) scattering
b) instalments
c) settlements
d) periods
10. The contract provides for the ... to leave 10% of the loan on deposit.
a) lender
b) depositor
c) borrower
d) creditor
11. Most foreign bills are payable 30, 60 or 90 days after...
a) record
b) sight
c) fill in
d) signature
12. Deeds of property may be ... as security for loans.
a) hedged
b) dredged
c) pledged
d) fledged
13. You are supposed to give a few days’... before withdrawing the balance of
your deposit account.
a) period
b) delay
c) warning
d) notice
14. The bill will ... due on January 30th.
a) fall
b) come
c) get
d) reach
15. The acceptor of a bill of exchange is the...

361
 a) drawer
b) lender
c) payee
d) drawee
16. When making a deposit you have to fill in the...
a) folder
b) paying-in-slip
c) application form
d) statement of account
17. Banks collect ... and lend them out again.
a) coins
b) bookings
c) savings
d) ratings
18. Owing to the credit ... it is increasingly hard to obtain cash.
a) squeeze
b) loan
c) back
d) stop
19. We grant loans to our clients and arrange for ... facilities.
a) overdrive
b) overdraft
c) overdone
d) overpaid
20. The ... system is the British equivalent to the French Cheques Postaux.
a) Biro
b) Giro
c) Tiro
d) Barrow

Translate into English:

1. Am vrea sa vă rugăm să deschideţi un cont curent pe numele Mateescu and
Co.
2.Credeti ca putem sa deschidem un cont current pe numele Stanculescu and
Co.?

362
 3. Pentru a deschide contul, anexăm un cec emis de banca Carpatica în
valoarea de 200.000 000 lei.
4. Acest cec în valoare 500 000 000 lei tras asupra bãncii Carpatica va
constitui depozitul nostru iniţial.
5.Vreau sa anexez cecul meu in valoare de
20 000 000 lei, plătibil la ordinul dumneavoastrã.
6.Credeam ca ştiţi că trebuie sã plătiţi taxe bancare pentru cecurile
internaţionale.
7. Puteţi plăti prin cec, ordin de platã sau cashier’s check. Această plată
trebuie să fie trasă asupra unei bănci din SUA.
8. Plata se va face prin transfer bancar.
9. Anexăm cecurile noastre în valoare de 600000000 lei, ca plată
corespunzătoare următoarelor facturi...
10. La care bancă sunteţi?
11.Eu ştiu că nu puteţi achita cecuri fãrã acoperire.
12. Pentru creditarea corectă am dori să indicaţi întotdeauna numărul
dumneavoastră de cont.
13. Am aprecia dacã aţi plăti imediat.
14. Va rugäm să plătiţi astăzi, deoarece procesarea cecului durează .
15.Cum doriţi să plătiţi: în numerar sau cu carte dc credit?
16 Trebuie să andosati cecul pe verso inainte de a-l incasa or depune.
17. Vă cerem permisiunea sã depãsim limita contulul nostru cu pânã la 7 000 $
intre martie 25 si iulie 25.
18. Ne-aţi face un mare serviciu dacă ne-aţi susţine în acest moment.
19. Contul dumneavoastrã este descoperit cu 1000 $.
20. Suntem de acord sã vă aprobăm o depăşire a contulul în valoare de 500 $
până în martie anul curent.
21. Suntem gata sã vă acordăm un împrumut, cu condiţia să fie garantat.
22. Va trebui sã asiguraţi garanţii pentru acoperirea avansului.
23. Suntem dispuşi să fim garantul dumneavoastrã.
24. Ca o garanţie, vă vom oferi titluri de valoare.
25. Va rugăm sã ne remiteţi garantiile.
26 Din cauza tranzacţiilor sale financiare dubioase, i-am blocat contul.
27. Noi oferim credite clientilor nostri si le acordăm conditii avantajoase de
rambursare.
28. Rata de bazã (de referinţă) este rata pe care băncile o aplică celor mai
solvabili clienţi.
29. Ei nu au întocmit documente care să precizeze condiţiile împrumutului.

363
 30. Graficul de rambursare este prezentat in contractul de împrumut.
31. Care este cursul de schimb al zilei pentru €uro în raport cu dolarul SUA?
32. Va oferim dolari la cel mai bun curs posibil .
33. Acestea sunt variaţii ale cursului de schimb, rata de bază, cursul de schimb
actual (curent).
34 Bancnotele şi cecurile de călătorie în dolari SUA pot fi convertite în lire
dacă prezentaţi paşaportul la ghişeul din colţ.
35. Păstraţi borderoul, care vă va fi de folos pentru a schimba yenii în moneda
ţării dumneavoastră la sfârşitul excursiei.
36 Agentul de schimb este cel care vă va spune cursul la care veţi putea
schimba valuta dumneavoastră.
37. Cotaţiile monedelor echivalente dolarilor SUA sunt doar aproximative.
Pentru cursurile exacte ar fi bine să vă adresaţi băncii dumneavoastră.
38. Pentru remiteri de fonduri în alte valute decât dolari veţi fi creditaţi cu
echivalentul valorii primite pentru remiterea dumneavoastră.
39. Alăturat vă trimitem cecul în valoare de 8000$ reprezentând plata
corespunzătoare facturii anexate. Am convenit suma datorată,considerând că la data
plăţii cursul de schimb pentru €uro era destul de ridicată.
40.Vrem să vă inştiinţăm că cererea dumneavoastrá de cumpărare a fost
refuzată deoarece aţi depăşit limita creditulul acordat.
41. Documentele care trebuie prezentate sunt următoarele:
• o trată la vedere pentru valoarea creditulul
• un certificat de origine
• un certificat (o poliţă ) de asigurare.
42. După cum am convenit, documentele de expediţie vă vor fi înmânate de
agenţii (reprezentanţii) Băncii Carpatica la plata tratei, la scadenţă.
43 Am tras asupra dumneavoastră valoarea facturii de 400 $, la 6o de zile de
la prezentare, prin banca de care am vorbit, căreia i-am remis documentele de
expediţie.
44.Puteţi să vindeţi creanţele dumneavoastra unei societaţi de factoring.
45.Ar fi bine să oferiţi garanţie sub forma de obligaţiune.
46.Vă vom pregăti comanda atunci când vom primi confirmarea creditului de
la Banca Bucuresti.
47.Contul meu este deja descoperit aşa că evit emiterea de cecuri in clipa de
faţă.
48.Cecurile descoperite îi fac pe majoritatea vânzătorilor cu amănuntul să
refuze acest instrument de plată şi să solicite plăţi in numerar pentru valori mici.
48.Banca Centrala şi-a diminuat rata de baza pentru a evita o criză severă.
49.Trebuie să aflu care este rata dobănzii la banca despre care mi-ai vorbit.

364
 50.Ai un cont la o bancă de stat?
51.Ce garanţie oferiţi pentru acest împrumut?
52.Vreau să aflu mai mult despre creditul încrucişat .
53.Nu ştiu prea multe despre metoda numită compensare.
54.Dacă preţurile nu vor fi susţinute ele se vor prăbuşi vertiginos deoarece
piaţa este saturată.
55.Am vrea să cumpărăm 100 de acţiuni ale societăţii amintite cu condiţia ca
detaliile tranzacţiei să ne parvină prin avocatul firmei noastre.

1.Translate into Romanian:

Modern banking appeared in England and Scotland at the end of the XVIIIth
century-1694 and 1695.We certainly know that the Bank of England held a dominant
position for about two centuries and enjoyed a monopoly on overseas operations and
acting as the government’s banker’s;in 1946 it was nationalized and we can consider
it today as a typical central bank.
It was in 1760 when Scotland was the first country to have set up a modern
banking system with seven banks which carried out transactions through a clearing
house
In 1826 the first joint stock banks were set up in England and in the XVIIIth
century there were 100 clearing banks. The English banking system became a highly
concentrated system with the great banks :Lloyd’s, Barclays, Midland, Wesminster
and National Provincial.
Today there are four major banks:Lloyd’s, Midland, Natwest, Barclays which
are involved in wholesale banking activities through diferrent subsidiaries.
The U.S Banking system is quite peculiar today having more than 10
000banks .Unfortunately none of them among the top ten in the world.

2-Translate into Romanian:

Deferred shares do not take part in profits until the preferred share and
ordinary share dividents have already been paid. Founder’s shares are issued to the
promoters of the company.Ranking after other shares they may yield nothing during
the early years.They may bring huge dividends later.Industrials are the shares of
industrial companies. Blue chips are the shares of particularly well known and sound
companies.
An investor who buys stocks gets tangible shares of a corporation, which can
be held for a long term.The person who buys or sells stock index futures is making a
short term bet on which direction the market is going towards the near future usually a
month or less.The investor buying into futures –buying shares on credit- has to put up
only a fraction or percentage of the amount of the investment.And this is called the

365
margin .Stock index futures contracts represent an obligation to buy or sell an index at
a stated price before a stated date.

3.Translate into Romanian:

Attempts to introduce other costs and benefits of development, which would

move GNP toward a broader welfare measure, lack a logical basis and tend instead to
result in a confusion of concepts. Research on ‘social’ indicators has failed to produce
an alternative which is as readily accepted and com prehended as GNP per head ...
Systems of social accounts which could integrate social indicators through some
unifying concept have not been able to overcome successfully all the difficult
problems encountered.
The search for a composite index of social welfare, analogous to GNP as an
index of production, has been a fruitless one so far, since it has proved virtually
impossible to translate every aspect of social progress into money values or some
other readily accepted common denominator. The great deal of work devoted to
composite indices, however, suggests the need for a single number which, like GNP
per head, can be quickly grasped and gives a rough indication of “social”
development.

4.Translate into Romanian:

Many firms lay down definite terms of payment and expect their customers to
abide by these terms, but special arrangements may be made in certain cases. The
purchaser should, however, pay his accounts at due date whatever is arranged, as it is
unwise to gain a reputation for slow payment. Promptitude in payment in normal
circumstances makes it easier to obtain consideration when actual need to delay
payment for a time arises.
In general, terms of payment may be classified into cash on or before delivery
of the goods and credit. By far the greater number if transactions are on credit, and
generally longer periods of credit are given by wholesalers to retail customers than by
manufacturers to wholesalers.
5.Translate into Romanian:

The primary need when starting a business, whether a retail firm, a wholesale
warehouse, or manufacturing concern, is money. Goods have to be bought for stock,
premises leased or bought and fitted out to suit the requirements of the business, and
some money retained for current expenditure such as wages. A small retail business
may he set up by a person with very small financial resources; more ambitious
concerns will entail great expense before they are able to commence operations.

366
 The money which must be got together to start the enterprise is called the
capital of the firm. How the original capital is provided depends upon the form the
business unit takes.
6.Translate into Romanian:

Classes of Shares. The shares into which a company’s capital is divided may
be of different classes according to the rights given to their holders in respect of them.
They may also be of different amounts, for example £1, £5, £10, or £25 shares, but
the £1 share is most general. Shares in a public company are freely transferable and,
unless a further issue of shares is made, the only way in which a person may become a
shareholder in a going concern is to purchase the shares of a present holder.
Preference Shares are those which have a prior claim to the profits of the
company.
Ordinary Shares are generally entitled to the remainder of the profits after the
preference share dividends have been paid.
If Deferred Shares exist, then the ordinary shares have a limited dividend and
the deferred shareholders are entitled to the remainder of the profits.
When joint-stock companies raise loans, they usually give to the lenders a
form of security, named a debenture, which gives to the holder a right to a fixed
interest.
A company may make application for its fully-paid shares to be converted into
stock, which may be transferred in fractions of a pound, whereas shares cannot be
subdivided. Shares must each bear a distinctive number; stock is unnumbered.

7.Translate into Romanian:

Bills of Exchange put debts into tangible form. A creditor receiving one has a
legal acknowledgement of the debt, and if the amount is not paid when due he can sue
on a bill without proving that he has delivered goods. He may sell or discount the bill
at the bank, which makes a profit called discount for the accommodation; or he may,
in payment of one of his own debts, endorse the bill to one of his creditors. The debtor
gets longer time in which to pay and so he may take advantage of special
opportunities for buying. Thus it will be seen that Bills of Exchange are very useful
commercial documents.

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Vocabulary
agreement- contract
as agreed- după cum ne-am înţeles
bank run- panică bancară
bearer- bond- titlu la purtător
bill of exchange-trata,cambie
clearing bank-banca de compensaţie
clearing-compensare
closing- încheiere
collateral- garanţie
counterfoil- talon,matcă,cotor
debtor-debitor
deferred shares-acţiune cu plata ulterioară
draft- trata
exchange rate- cursul de schimb
face value-valoare nominală
fall due to- a ajunge la scadenţă
fee-comision
financial dealings- tranzacţii financiare.
floatations- emisiuni de titluri
founder’s share-acţiune de fondator
funding-finanţare
futures- contracte la termen
glutted-saturat
gilt-edged securities- titluri de valoare
hedging- acoperire financiară
Giro- serviciu de cecuri postale
instalment- plată parţială,rată
invoice- factură
lender-creditor,
loan agreement-contract de împrumut
loan on mortgage-împrumut ipotecar
loan repayable-împrumut rambursabil
margin-marjă,coeficient de siguranţă.
no effects/uncovered-fără acoperire
order-comandă
outstanding -restant
overdraft- suma cu care s-a depăşit contul
overdrawn account- cont descoperit
overdrawn- descoperit
overdue- restant,neachitat
pawnbroker- propietarul unei case de amanet
payee- beneficiar
premises -sediu
prime rate-rata de bază
rate shift- variaţii ale cursului de schimb

368
remittance-remitere
repayment-rambursare
securities-garanţii
security-garanţie
settlement-reglementare,decontare
share certificates- titluri de acţiuni
shipping documents- documente de expediţie
standing order- ordin de plată
statement of account-extras de cont
stub-matcă,cotor
swap agreement-acord de swap, acord de credit încrucişat
swap- credit încrucişat
swift- sistemul de transfer electronic al fondurilor
tax shelter- paradis fiscal
teller- casier
term deposit- depozit la termen
terms -condiţii
to acknowledge- a confirma
to be over - a depăşi
to comply with- a fi în concordanţă cu
to deem- a considera,a estima
to default- a nu-si plati datoriile
to deny- a refuza
to enclose- a anexa
to grant-a acorda
to incur- a atrage asupra sa
to pawn- a amaneta
to providea - asigura
to recocile- a face să concorde
to set out –a preciza
to settle- a achita
to stand surety -a fi garantul
to underwrite securities- a subscrie titluri de valoare
unsecured credit- credit negarantat
to abide- a rămâne,a sta,a suporta,a respecta,a se conforma
due- datorat,cuvenit, scadent
to retail- a vinde cu amănuntul
instalment- plată parţială, rată
to entitle- a da dreptul la
expenditure- cheltuială,consum
joint- comun,asociat, mixt, colectiv
joint stock company- societate anonimă pe acţiuni
debenture- obligaţiune, împrumut pe termen lung
tangible- concret, palpabil
to acknowledge- a recunoaşte, a confirma
acknowledgement- constatare, confirmare, certificare, recipisă,chitanţă
bill- titlu de valoare, poliţă, factură
to discount- a reduce, a diminua
to endorse- a andosa, a gira, a subscrie
wholesaler- angrosist

369
warehouse- depozit de mărfuri, magazie
premises- local
lease- contract de închiriere
to set up a business- a porni o afacere
lender- împrumutător
lessor- propietar care dă cu chirie
lessee- chiriaş
to claim- a pretinde, a revendica
issue- emisiune, punere în circulaţie
to issue- a emite, a pune în circulaţie

Tourism - The Worlds Biggest Industry

The Business of Hotels
♦ The Importance of Hotels
♦Travel and Hotels
♦Two Centuries of Hotelkeeping
♦Hotel Location
♦Types of Hotel
Hotel Products and Markets
♦ The Hotel as a Total Market Concept
♦ Hotel Facilities and Services as Products
♦ Hotel Accommodation Markets
♦ Hotel Catering Markets
♦ Hotel Demand Generating Sources
♦ Hotel Market Areas
♦ Hotel Market Segmentation
♦ Buying and Paying for Hotel Services
♦ Hotel Marketing Orientation
♦ Special Features of Hotel Marketing
♦ Property Ownership
♦ Property Operation and Maintenance

Hotel Organization
♦ Rooms
♦ Food and Beverage
♦ Miscellaneous Guest Services
♦ Hotel Support Services
♦ The Management Structure
Hotel Services
♦Rooms and Beds
♦Room Sales
♦Mail and Other Guest Services
♦ Uniformed Services

370
♦ Hotel Housekeeping
♦ Food and Drink
♦ Restaurants
♦ Miscelaneous Guest Services
Tourist Attractions
♦Tourism Today
♦Local Tours
Paris
♦Foreign Tours
The Bahamas

371
 Tourism - The Worlds Biggest Industry

Against the background. of unparalleled growth in the latter half of the

twentieth century, tourism now finds itself at a crossroads in its development. On the
one hand, it is heralded as ‘the world’s biggest industry’ by a number of global
organisations including the World Travel and Tourism Council (WTTC) and the
World Tourism Organisation (WTO), which highlights the fact that tourism overtook
both crude petroleum and motor vehicles to become the world’s number one export
earner in 1994. Its economic significance is also illustrated by the fact that tourism
receipts were greater than the world’s exports of other selected product groups,
including electronic equipment, clothing, textiles and raw materials.
In addition, receipts from international tourism have achieved growth rates in
excess of exports of commercial services and merchandise exports during the period
1984 to 1994. For the period 1985 to 1995 the trend is similar, with the following
average annual percentage growth rates:
• Tourism l2per cent
• Commercial services 12 per cent
• Merchandise exports 10 per cent
WTO data also indicate rapid and sustained growth in international tourist
arrivals and receipts from tourism over the last 30 years. Today, tourism is seen as a
major contributor to global economic development, creating employment and
generating wealth on a truly international scale. An increasing number of countries
rely heavily on receipts from tourism for their economic and social well-being.
In direct contrast to this very positive outlook for the industry, many national
governments are reluctant to invest public funds in tourism development and
promotion, with tourism spending often being cut when more pressing social and
economic needs arise. The decisions, in 1997, by the governments of Canada, the
United States of America and Belgium to transfer responsibility, for tourism to private
sector enterprises or regional authorities serve to illustrate this point well. In Britain,
the funding of the English Tourist Board has been cut drastically since the early
1990s, the decision of a government that considered the industry to he sufficiently
mature and able to fund its own expansion with diminishing public financial support.
At a time of increasing corrcern for the environment and the retention of cultural
identities, tourism is also viewed by governments and consumers alike as a potentially
destructive force, causing harmful environmental and socio-cultural impacts in
destination areas and on host communities. Paradoxically, it is not difficult to argue
that the withdrawal of public funding and control from tourism development may well
accelerate the industry’s harmful environmental and socio-cultural effects.

372
 It is against this background of a complex and rapidly expanding industry
seeking to maintain its credibility and promote its economic benefits, often in the face
of declining governmental and host community support.

The Business of Hotels

I The Importance of Hotels

Hotels play an important role in most countries in providing facilities for the
transaction of business, for meetings and conferences, for recreation and
entertainment. In that sense hotels are as essential to economies and societies as are

373
adequate transport, communication and retail distribution systems for various goods
and services. Through their facilities hotels contribute to the total output of goods and
services, which makes up the material well-being of nations and communities.
In many areas hotels are important attractions for visitors who bring to them
spending power and who tend to spend at a higher rate than they do when they are at
home. Through visitor spending hotels thus often contribute significantly to local
economies both directly, and indirectly through the subsequent diffusion of the visitor
expenditure to other recipients in the community.
In areas receiving foreign visitors, hotels are often important foreign currency
earners and in this way may contribute significantly to their countries’ balance of
payments. Particularly in countries with limited export possibilities, hotels may be
one of the few sources of foreign currency earnings.
Hotels are important employers of labour. Thousands of jobs are provided by
hotels in the many occupations that make up the hotel industries in most countries;
many others in the industry are self—employed and proprietors of smaller hotels. The
role of hotels as employers is particularly important in areas with few alternative
sources of employment, where they contribute to regional development.
Hotels are also important outlets .for the products of other industries. In the
building and modernization of hotels business is provided for the construction
industry and related trades. Equipment, furniture and furnishings are supplied to
hotels by a wide range of manufacturers. Food, drink and other consumables are
among the most significant daily hotel purchases from farmers, fishermen, food and
drink suppliers, and from gas, electricity and water undertakings. In addition to those
engaged directly in hotels, much indirect employment is, therefore, generated by
hotels for those employed in industries supplying them.
Last but not least, hotels are an important source of amenities .for local
residents. Their restaurants, bars and other facilities often attract much local custom
and many hotels have become social centres of their communities.

Travel and Hotels

Staying away from home is a function of travel and three main phases may be
distinguished in the development of travel in the northern hemisphere.
Until about the middle of the nineteenth cenruiy the bulk of journeys were
undertaken for business and vocational reasons, by road, by people travelling mainly
in their own countries. The volume of travel was relatively small, confined to a small
fraction of the population in any country, and most of those who did travel, did so by
coach. Inns and similar hostelries along the highways and in the principal towns
provided the means of accommodation well into the nineteenth century.
Between about 1850 and about 1950 a growing proportion of travellers went
away from home for other than business reasons and holidays came to represent
gradually an important reason for a journey. For a hundred years or so, the railway
and the steamship dominated passenger transportation, and the new means of
transport gave an impetus to travel between countries and between continents.

374
Although the first hotels date from the eighteenth century, their growth on any scale
occurred only in the nineteenth century, when first the railway and later the steamship
created sufficiently large markets to make the larger hotel possible. Hotels together
with guest houses and boarding houses dominated the accommodation market in this
period.
By about the middle of the twentieth century in most developed countries of
the world (a little earlier in North America and a little later in Europe) a whole cycle
was completed and most traffic returned to the road, with the motor car increasingly
providing the main means of passenger transportation. Almost concurrently the
aircraft took over unmistakably both from the railways and from shipping as the
principal means of long-distance passenger transport. On many routes holiday traffic
came to match and often greatly exceed other traffic. A growing volume of travel
away from home became international. Hotels entered into competition with new
forms of accommodation — holiday centres and holiday villages in Europe, motels in
North America, and various self—catering facilities for those on holiday.

Two Centuries of Hotelkeeping

Hotels are some two hundred years old. The word ‘hotel’ itself came into use
in England with the introduction in London, after 1760 , of the kind of establishment
then common in Paris, called ‘hotel garni’, or a large house, in which apartments were
let by the day, week or trench. Its appearance signified a departure from the
customary method of accommodating guests in inns and similar hostelries, into
something more luxurious and even ostentatious. Hotels with managers, receptionists
and uniformed staff arrived generally only at the beginning of the nineteenth century
and until the middle of that century their development was relatively slow. The
absence of good inns in Scotland to someextent accelerated the arrival of the hotel
there; by the end of the eighteenth century Edinburgh, for example, had several hotels
where the traveller could get elegant and comfortable rooms. Hotels are also known to
have made much progress in other parts of Europe in the closing years of the
eighteenth and early years of the nineteenth century, where at the time originated the
idea of a resort hotel.
In North America early accommodation for travellers followed a similar
pattern as in England, with most inns originating in converted houses, but by the turn
of the eighteenth century several cities on the eastern seaboard had purpose—built
hotels and in the first half of the nineteenth century hotel building spread across
America to the Pacific Coast. The evolution from innkeeping to hotelkeeping,
therefore, proceeded almost in parallel in the Old and in the New Worlds and the rise
of the hotel industries on both sides of the Atlantic had probably more in common
than is generally recognized. What America might have lacked in history and
tradition, it more than made up in pioneering spirit, in intense rivalry between cities
and entrepreneurs, and in the sheer size and growth of the travel market.
In the last century hotels became firmly established not only as centres
commercial hospitality for travellers, but often also as important social centres of their
communities. Their building, management and operation became specialized
activities, with their own styles and methods. The present century brought about
growing specialization and increased sophistication in the hotel industries of most
countries, as well as their growth and expansion. But the growth and the diversity of

375
hotel operations has been also matched by the growth and diversity of competition in
the total accommodation
market.
Information about accommodation facilities in individual countries essentially
reflects the designations used for them by the countries concerned and the coverage of
various types in the available statistics. Only very broad inter-country comparisons
are possible. One source is the annual report of the Tourism Committee of the
Organisation for Economic Co-operation and Development (OECD), which
distinguishes between beds available in hotels and similar establishments, and in what
is described as supplementary accommodation.
The ratio of beds in hotels and similar establishments to beds in supplementary
accommodation gives an indication of the relative importance of the hotel sector in
the total accommodation market of individual countries. In most countries the
accommodation profile tends to reflect the relative importance of foreign and
domestic users, of leisure and business travel, and of other influences. In many
countries hotels and similar establishments appear to be minority providers of
accommodation.

Hotel Location

Hotel services are supplied to their buyers direct in person; they are consumed
at the point of sale, and they are also produced there.
Hotel services must be, therefore, provided where the demand exists and the
market is the dominant influence on hotel location. In fact, location is part of the hotel
product. In turn, location is the key influence on the viability of the business, so much
so that a prominent entrepreneur could have said with conviction and with much
justification that there are only three rules for success in the hotel business: location,
location, location.
We have seen earlier that from the early days all accommodation units
followed transport modes, Inns and other hostelries were situated along the roads and
at destinations, serving transit and terminal traffic. The rapid spread of railways
marked the emergence of railway hotels in the nineteenth century. In the twentieth
century motor transport created a new demand for accommodation along the
highways and the modern motel and motor hotel have been distinctive responses to
the new impetus of the motor car. A similar but les pronounced influence was
passenger shipping, which stimulated hotel development in ports, and more recently
air transport, which brought about a major growth of hotels in the vicinity of airports
and air terminals.
Secondly, although this is closely related to transport, many hotels are located
to serve first and foremost holiday markets. In their areas of highest concentration,
holiday visitors are accommodated in hotels in localities whcre the resident
population may represent only a small proportion of those present at the time, as is the
case in many resorts.
The third major influence on hotel location is the location of economic activity
and of industry and commerce in particular. Whilst again not separable from transport

376
development, industrial and commercial activities create demand for transit and
termInal accommodation in industrial and commercial centres, in locations not
frequented by holiday visitors.
Different segments of the travel market give rise to distinctive patterns of
demand for hotel accommodation and often distinctive types of hotels. In business
and industrial centres hotels normally achieve their highest occupancies on weekdays
and in resorts in the main holiday seasons; their facilities and services reflect the
requirements of businessmen and of holiday visitors respectively. Between these
clearly defined segments come other towns and areas, such as busy commercial
centres with historical or other attractions for visitors, which may achieve a more even
weekly and annual pattern of business.

Types of Hotels

The rich variety of hotels can be seen from the many terms in use to denote
particular types. Hotels are referred to as luxury, resort, commercial, residential,
transit, and in many other ways. Each of these terms may give an indication of
standard or location, or particular type of guest who makes up most of the market of a
particular hotel, but it does not describe adequately its main characteristics. These can
be only seen when a combination of terms is applied to an hotel, each of which
describes a particular hotel according to certain criteria. It is helpful to appreciate at
this stage what the main types of hotels are, by adopting particular criteria for
classifying them, without necessarily attaching precise meanings to them.
• Thus according to location hotels are in cities and in large and small towns,
in inland, coastal and mountain resorts, and in the country.
• According to the actual position of the hotel in its location it may be in the
city or town centre or in the suburbs, along the beach of a coastal resort, along the
highway.
• By reference to its relationship with particular means of transport_there are
motels and motor hotels, railway hotels, airport hotels (the terms also indicating
location).
• According to the purpose of visit and the main reason for their guests’ stay,
hotels may become known as business hotels, holiday hotels, convention hotels,
tourist hotels.
• Where there is a pronounced tendency to a short or long duration of guests’
stay it may be an important hotel characteristic, so that the hotel becomes a transit or a
residential hotel.
• According to the range of its facilities and services a hotel may be open to
residents and non-residents, or it may restrict itself to providing overnight
accommodation and at most offering breakfast to its guests, and be a hotel garni or
apartment hotel.

377
 • Whether a hotel holds a licence for the sale of alcoholic liquor or not, is an
important dimension in the range of available hotel services, and the distinction
between licensed and unlicensed hotels is, therefore, of relevance in describing a hotel
in most countries.
• There is no universal agreement on how hotels should he described
according to size, but by reference to their room or bed capacities we normally apply
the term small hotel to one with a small amount of sleeping accommodation, the term
large hotel to one with several hundred beds or bedrooms, and the term medium size
hotel to one somewhere between the two, according to the size structure of the hotel
industry in a particular country.
• Whatever the criteria used in hotel guides and in classification and grading
systems in existence in many countries, normally at least four or five classes or grades
have been found necessary to distinguish adequately in the standards of hotels and
these have found some currency among hotel users. The extremes of luxury and basic
standards, sometimes denoted by five stars and one star respectively are not difficult
concepts; the mid point on any such scale denotes the average without any particular
claims to merit. The intervening points are then standards above average but falling
short of luxury (quality hotels) and standards above basic (economy).
Last but not least comes the ownership and management. Individually owned
independent hotels, which may he managed by the proprietor or by a salaried
manager, have to he distinguished from chain or group hotels, invariably owned by a
company. Independent hotels may belong to a hotel consortium or cooperative. A
company may operate its hotels under direct management or under a franchise
agreement.
The above distinctions then enable us to describe a particular hotel in broad
terms, concisely, comprehensively and meaningfully, e.g.:
• Terminus Hotel is a medium-sized economy town centre unlicensed hotel,
owned and managed by a small company, catering mainly for tourists visiting the
historic town and the surrounding countryside.
• Hotel Excelsior is a large independent luxury hotel on the main promenade
of the coastal resort, with holiday visitors as its main market.
• The Crossroads Hotel is a small licensed quality transit motor hotel, operated
as a franchise, on the outskirts of the city, which serves mainly traveling

Hotel Products and Markets

The aim of this subject is to outline the facilities and services provided by
hotels, who are the people who use hotels, why they use hotels, and what influences
their choice of particular hotels. In providing answers to these questions, we can
formulate a conceptual model of a hotel, which attempts to explain in simple terms
how particular hotel products meet the needs of particular hotel markets, and establish
a basis for a more detailed examination of the hotel business.

The Hotel as a Total Market Concept

378
 From the point of view of its users, a hotel is an institution of commercial
hospitality, which offers its facilities and services for sale, individually or in various
combinations, and this concept is made up of several elements.
Its location places the hotel geographically in or near a particular city, town or
village; within a given area location denotes accessibility and the convenience this
represents, attractiveness of surroundings and the appeal this represents, freedom from
noise and other nuisances, or otherwise.
Its facilities which include bedrooms, restaurants, bars, function rooms,
meeting rooms and recreation facilities such as tennis courts and swimming pools
represent a repertoire of facilities for the use of its customers, and these may be
differentiated in type, size, and in other ways.
I ts service comprises the availability and extent of particular hotel
services provided through its facilities, the style and quality of all these in such terms
as formality and informality, degree of personal attention, and speed and efficiency.
Its image may he defined as the way in which the hotel portrays itself to
people and the way in which it is perceived as portraying itself by them. It is a
byproduct of its location, facilities and service, but it is enhanced by such factors as
its name, appearance; its associations by who stays there and who eats there; by what
it says about itself and what other people say about it.
Its price expresses the value given by the hotel through its location, facilities,
service and image, and the satisfaction derived by its users from these elements of the
hotel concept. The individual elements assume greater or lesser importance for
different people. One person may put location as paramount and be prepared to accept
basic facilities and service for an overnight day, ignoring the image, as long as the
price is within a limit, to which he is willing to go. Another may be more concerned
with the image of the hotel, its facilities and service. However, all the five elements
are related to each other, and in a situation of choice most hotel users tend either to
accept or reject as a whole, that is the total concept.
There are varying degrees of adaptability and flexibility in the hotel concept,
ranging from the complete fixity of its location to the relative flexibility of price, with
facilities, service and image lending themselves to some adaptation in particular
circumstances with time.

Hotel Facilities and Services as Products

In the early days of innkeeping the traveller often had to bring his own food to
places where he stayed the night-bed for the night was the only product offered But
soon most establishments extended their hospitality to providing at least some food
and refreshments. Today many apartment hotels, hotels gami, and motels confine their
facilities to sleeping accommodation, with little or no catering provision. But the
typical hotel as we know it today, normally provides not only accommodation, but
also food and drink, and sometimes other facilities and services, and makes them
available not only to its residents but also to non-residents.
Although the range of hotel facilities and services may extend as far as to cater
for all or most needs of their customers, however long their stay, and for a hotel to
become a self-contained community with its own shops, entertainments and recreation

379
facilities, it is helpful at this stage to describe the hotel concept in a simpler form, by
including only the main customer needs typically met by most hotels.
The main customer demand in most hotels is for sleeping accommodation,
food and drink, and for food and drink for organized groups. These four requirements
then relate to accommodation, restaurants, bars and functions, as the principal hotel
products.
Sleeping accommodation is provided for hotel residents alone. Restaurants and
bars meet the requirements of hotel residents and non-residents alike, even though
separate facilities may be sometimes provided for them. Functions are best seen as a
separate hotel product bought by organized groups; these groups may be resident in
the hotel as, for example, participants in a residential conference, or be non-residents,
such as a local club or society, or the group may combine the two. The total hotel
concept — of location, facilities, service, image and price - can he, therefore, sub-
divided according to the needs of the customer and the particular facilities brought
into play to meet them. The cluster of elements of the total hotel concept is then
related to each particular hotel product. Each hotel product contains the elements of
the location, facilities, services, image and price, to meet a particular customer need
or set of needs. The first approach to the segmentation of the hotel market is,
therefore, taken by dividing hotel users according to the products bought.
Corresponding to each hotel product there are the buyers of that product who
constitute a market for it.

Hotel Accommodation Markets

Hotel users who are buyers of overnight accommodation may be classified

according to the main purpose of their visit to a particular location into three main
categories as holiday, business and other users.
Holiday users include a variety of leisure travel as the main reason for their
stay in hotels, ranging from short stays in a particular location on the way to
somewhere else to weekend and longer stays when the location represents the end of a
journey. Their demand for hotel accommodation tends to be resort oriented, seasonal
and sensitive to price.
Business users are employees and others travelling in
the course of their work, people visiting exhibitions, trade fairs, or coming
together as members of professional and commercial organizations for meetings and
conferences. Their demand for hotel accommodation tends to be town- and city-
oriented, non-seasonal and less price-sensitive, except in the case of some event
attractions such as conferences and exhibitions, which may he usefully regarded as a
separate category.
Other hotel users comprise visitors to a particular location for a variety of
reasons other than holiday or business, e.g. those attending such family occasions as
weddings, parents visiting educational institutions, visitors to special events, and
common interest groups meeting for other than business and vocational reasons, re-
locating families and individuals seeking permanent accommodation in an area and
staying temporarily in an hotel, people living in an hotel permanently. The
characteristics of this type of demand are more varied than those of the first and
second group, and it is, therefore, often desirable to sub-divide it further for practical
purposes.

380
 Within and between the three main groups, which comprise the total market
for hotel accommodation, there are several distinctions important to individual hotels.
We have noted already that some hotel users give rise to demand for transit and short
—stay accommodation; others are terminal visitors with a longer average stay.
Also, for example, much business demand is generated by a relatively
small number of travellers who are frequent hotel users; most holiday and other
demand comes from a very large number of people who use hotels only occasionally.
Moreover, business users often book accommodation at short notice, whilst holiday
and other users tend to do so longcr in advance. And in allthree groups some people
are individual hotel users, and others stay in hotels in groups.

Hotel Catering Markets

Hotel restaurants, bars and function rooms may be conveniently grouped

together as its food and beverage or catering facilities, and the meals and refreshments
they provide as the hotel food and beverage or catering products. Corresponding to
them there are again buyers of these products who constitute the hotel catering
markets and who may be classified in various ways. For our purposes there is a basic
distinction between the demand exercised by hotel residents, by non-residents, and by
organized groups.
The first category of users of hotel restaurants and bars is related to the basic
function of the hotel in providing overnight sleeping accommodation, and consists of
hotel residents, whom we have classified earlier as holiday, business and other users
Their use of hotel catering facilities tends to be influenced by the reason for their
hotel stay and by the terms on which they stay. Breakfast is their common hotel
purchase, but otherwise a hotel resident may have his meals in his hotel or elsewhere,
and he is more likely to be a hotel restaurant or bar customer in the evenings than at
midday.
The second category is non-residents, individually or in small groups, when
eating out. They may, in fact, be staying at other hotels or accommodation
establishments or with friends or relative or be day visitors to the area, for holiday,
business or other reasons Alternatively they are local residents, for whom the hotel
restaurants and bars represent outlets for meals and refreshments, as a leisure activity
or as part of their business activities. This category tends to represent important hotel
users at midday as well as in the evenings, particularly at weekends.
The third category of users of hotel catering facilities is organized groups who
make advance arrangements for functions at the hotel, which may call for separate
facilities and organizational arrangements. They include local clubs, societies,
business and professional groups, as well as participants in meetings and conferences
originating from outside the area.
Hotel catering products represent a greater diversity than its accommodation
products and it is often correspondingly more difficult to classify them and the
markets for them in practice. Moreover, hotels are not alone in supplying them. In the
market for meals and refreshments for individuals and groups a hotel competes not
only with other hotels, but also with restaurants outside hotels, pubs and clubs, to
name but a few other types of outlet.
Therefore, catering in hotels is a separate hotel function, with its own
objectives, policies and strategies, and with its own organization.

381
 Hotel Demand Generating Sources

For most people the use of hotels represents what is known as derived demand
because few stay or eat in hotels for its own sake; their primary reasons for doing so
lie in their reasons for visiting an area or for spending their time there in particular
ways. When describing hotel accommodation and catering markets we have seen that
hotel users have different degrees of freedom and choice as to whether they buy hotel
services or not. Some have
few or no alternatives; for them only hotels provide the facilities and services
which they require in a particular area in pursuit of their business, vocational and
other interests; the incidence of their hotel usage arises to a great extent from their
working circumstances. For many others the use of hotels is a matter of choice; they
do so in their pursuit of leisure and recreation; for them hotel usage involves a
discretionary use of their time and money. This distinction helps us identify the
demand generating sources for hotels in a given area, which are of three main types-
institutional, recreational and transit.
Institutional sources include industrial and commercial enterprises,
educational institutions, government establishments and other organizations in the
private and public sector, whose activities are involved in the economic life of the
community and in its administration. These institutions generate demand for hotels
through their own visitors and their other requirements for hotel facilities and
services.
Recreational sources include historical, scenic and other site attractions and
event attractions, which generate demand for hotels from tourists; local events and
activities in the social and cultural life of the community, which generate demand
from clubs, societies and other organizations; happenings of significance to
individuals and families.
The third source of demand stems from individuals and groups with no
intrinsic reason for spending time in a particular locality, other than being on the way
somewhere else and the need to break a journey. This source of demand is closely
related to particular forms of transport; it expresses itself on highways, at ports and at
airports, and may be described as transit.
It will be readily apparent that this view of demand generating sources for
hotels is closely related to several aspects of the hotel business considered earlier —
for example, to the three-fold classification of the hotel accommodation market into
holiday, business and other users; to the three main influences on hotel location —
travel, holidays and economic activity; and to the types of hotel. By adopting in each
case a somewhat different viewpoint, it is possible to highlight the interdependence
between the location, markets and products of hotels.

Hotel Market Areas

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 We can define a hotel market in several ways by reference to the people who
buy hotel services, as a network of dealings between the hotel and its users, or as an
area which a hotel serves. In the first two approaches hotel users may come from
within the area, from various parts of the country, and from abroad; we then refer to
the local, domestic and foreign markets, and subdivide them in appropriate ways. In
the third approach described below we view the hotel market area as a physical area
served by the hotel.
For hotel accommodation it is necessary to identify all the institutional and
recreational sources of demand, which may be served by a particular hotel. The area
drawn in this way round the hotel may extend from its immediate vicinity to a radius
of several miles or more. How far it does extend depends on the geographical
distribution of the demand generating sources, the mode of transport used by the hotel
users of each source, and the availability of other facilities in the area. The head office
of a large firm, a university, a historic castle, and a town which is a festival centre,
may be all within a market area of a hotel, if the hotel is reasonably accessible from
these points, and if its location at least matches the location of other hotels. The
market area may coincide for a number of hotels within close proximity of each other,
which offer a similar concept in terms of facilities, service, image and price. On the
periphery the market area for a hotel may overlap with the market areas of other
hotels some distance away. At periods of peak demand it may extend further than at
times of low demand. For transit the accommodation market area is related to the
journeys undertaken through the area — their origin and destination, the method of
transportation, the time of day, the time of year and other circumstances of the
journeys.
For hotel catering services the market area depends on market density — the
availability of spending power within an area, as well as on the accessibility of the
hotel to the different sources of demand, and on the availability of other catering
services in the area. In this there is a close analogy with the concept of a catchment
area for other retail outlets, as far as the resident population is concerned. How far do
people go from where they live to do their shopping? The distance may vary
according to the purchase they are to make. Similarly there may be a smaller market
area for hotel lunches than for hotel dinners and functions, because close proximity to
the hotel may he a more important consideration for a midday meal than for an
evening out.

Hotel Market Segmentation

The market for hotel products may be divided into several components or
segments and this enables individual hotels to identify their actual and potential users
according to various criteria. Segmentation then provides a basis for the marketing of
hotel products, for paying close attention to the requirements of different users, and
for monitoring the performance in the markets chosen by a hotel.
We divided hotel users, according to the product bought by them, into buyers
of accommodation, food, drink and functions. We divided the accommodation market,
according to the reasons for the users’ stay, into holiday, business and other users, and
the hotel catering market into hotel residents, non-residents and functions. According
to the origin of demand we also identified institutional, recreational and transit
sources of demand.

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 Another basis for segmentation is the needs of hotel users and the means_they
have to pay for their satisfaction, by dividing them according to their socio economic
characteristics. Socio-economic classifications seek to group people according to their
occupation and employment status. For example, the British Joint Industry Committee
for National Readership Surveys (JICNARS) defines social grades as shown in the
following table:

Social Grade Definitions

Social grade Social status Occupation
A Upper middle Higher
class managerial,
administrative
or professional
B Middle class Intermediate
managerial,
adminisniative or
professional
C1 Lower middle Supervisory or
class clerical, and
juniormanagerial,
administrative or
professional
C2 Skilled working Skilled manual
class workers
D Working class Semi- and
unskilled manual
E Those at the State pensioners
lowest level of or widows (no
subsistence other earner),
casual or lowest
grade workers

Social grade A might be expected to stay in luxury and quality hotels, B in

medium hotels, C in economy hotels. However, this is an oversimplification, because
the same people may interchange between segments according to the circumstances in
which they find themselves. A businessman on an expense account may stay in a
quality hotel, but travelling for pleasure with his family he may stay in a lower grade
hotel. Moreover, the incidence of hotel usage among DE groups is minimal.
Nevertheless, segmentation by socio-economic criteria is an important approach to
market segmentation. For some purposes age, family composition, life cycle stage, or
other criteria may be more appropriate.
A concomitant of market segmentation is product branding, with a view to
differentiating an hotel from others in the minds of buyers, long established in other
consumer industries. Some hotel groups have focused on branded segments
distinguished by levels of service; examples include Holiday Inn upmarket Crowne
Plaza, core brand Holiday Inn and limited service Garden Court.
Other brands have been created by grouping like operations, such as Forte
Posthouses and Whitbread Lanshury Hotels, or by acquisition, such as Porte Crest and
Mount Charlotte Thistle.

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 We anticipate that product segmentation will assume even greater significance
in the future development of hotel companies. It is an effective method for hotel
companies to maintain or expand market share and in some instances create new
markets.
Product branding will become more focussed and will reflect increasing levels
of segmentation.
In the light of this, the future of the ‘all purpose hotel’ is doubtful in terms of
its competitiveness in the market place.
Buying and Paying for Hotel Services
It is important to understand how a buying decision is made, who makes it,
and who pays for the hotel services bought.
The buying decision itself may be basically of two kinds —deliberate or
impulsive. Before embarking on journeys, business people may ask secretaries to
reserve hotel rooms in the towns they are to visit for specified nights. A family may
arrive at their choice of holiday hotel after a scrutiny of hotel guides. A society may
make several inquiries before choosing the venue for their annual dinner dance. These
are deliberate buying decisions made with some _advance planning and with advance
reservations. A tourist looking for somewhere to stay when travelling by car, or on
arrival at the railway station or airport, is likely to make an impulse decision, in much
the same way as a couple walking through the streets of a town and ‘discovering’ a
restaurant which appears to be to their liking. Purchases of hotel products are both
deliberate and impulse purchases and most hotels respond to both, although different
operational policies and procedures normally apply to each.
Many people make their own arrangements for travelling and for staying in
hotels. However, many hotel bookings are made by people who do it for others: the
secretary for the boss, the travel agent for the client, the business travel department of
a large company for its employees. In these circumstances it is important to know
who the buying agent is and where that person is located, if the knowledge derived
from the analysis of the hotel demand generating sources is to be applied to bringing
about sales. Most hotels can no longer hope to fill their beds, restaurants and bars by
simply waiting for the guest.
According to the source of payment for hotel services, hotel users are also of
two basic kinds — those who pay themselves and those whose hotel bills are covered
or reimbursed for them. Most leisure use of hotels represents personal expenditure out
of disposable incomes, the bulk of business use of hotels in the wide sense is paid for
directly or indirectly by third parties — employers and other agencies on behalf of the
guest. Although many business users have no fixed limits as to the charges they incur
in hotels, many tend to observe what they and their organizations regard as
acceptable. The understanding of these practices is important to hotels too. The
decision on the market segments to be catered for is closely related to decisions on
pricing and we have seen that price is an integral element of each hotel’s total
concept.

Hotel Marketing Orientation

Hotels serve people and their success depends on how well they serve them in
places where they wish to be served. This is only a way of stating in the simplest of

385
tenns the application to hotel operations of the marketing concept, which is concerned
with the consumer as a starting point in the conduct of business.
The marketing concept is beginning to be understood by hoteliers. Although
some continue to regard sales andmarketing as synonymous, most hotels no longer
operate in the seller’s market and even massive sales effort is not likely to generate a
sustained high volume of business, if consumer needs are not genuinely met in the
planning, design and subsequent operation of an hotel.
The basic hotel concept stresses the view of the hotel, as it is seen by the hotel
user rather than the hotel operator, as a business to meet the needs of hotel users.
Some of these needs are basic and physical, such as sleeping in clean beds or eating
wholesome meals; others such as those met by the image of the hotel are acquired
needs, which reflect what a person aims to be as an individual. A successful hotel
must seek to meet both sets of needs. So that an hotel can meet the needs of hotel
users, individual hotel services have to be seen as hotel products sold to particular
markets. A hotel cannot be all things to all people. Each hotel has to achieve a match
between its particular products and particular market segments, i.e. groups of people
with more or less similar characteristics and requirements for hotel services. In this
there is a difference between the hotel accommodation and catering products, in that
each may to some extent cater for different markets. But this difference only
reinforces the need for harmony in the total hotel concept. In order to achieve the
match between hotel products and markets, there is a need for a careful analysis of the
sources of demand for hotel services in the market area served by the hotel and an
understanding of how hotel services are bought and paid for.
From this model of a hotel a translation can be made to particular operations.
This takes the form of hotel policies, philosophies and strategies.

Special Features of Hotel Marketing

Marketing is first and foremost about matching products and markets and in
this sense the marketing of hotel services is in principle no different from the
marketing of other consumer products. But there are special features of hotel products
and markets and hence of hotel marketing.
For most users hotel rooms are a means to an end and not an end in itself and
the demand for them is what is known as derived demand - the reason for their use
may be a business visit or a holiday or something else but rarely the room itself, and
the same applies to some extent to other hotel services.
The availability of the most important hotel product, the hotel room, is fixed in
time and place. In the short term the number of rooms or beds on offer cannot be
significantly changed and location is part of the highly perishable product, which
cannot be stored for future sale or follow the customer. The demand for hotel
accommodation and other services fluctuates from day to day, from week to week and
from one part of the year to another. A waste occurs when demand falls and there is a
definite upper limit to the volume of business in a period of peak demand.
Hotel investment is primarily an investment in land and buildings and interior
assets. The bulk of the capital invested in the fixed assets of the hotel, combined with
the continuity of hotel activity, gives risc to high fixed costs, which have to be
covered irrespective of the volume of business. Three key factors are, therefore,
critical to a successful hotel operation — the right location, correct capacity, and a

386
high level of utilization, all of them imply marketing decisions — first in the
conception of the hotel and in its operation subsequently.
In the conception of the hotel, marketing can contribute first through a market
feasibility study to assess the demand. A study may identify the best market
opportunity for a hotel, a gap in the market, a location or choice between alternative
locations, for a particular hotel concept; or, given a particular location, a study can
determine the most appropriate hotel concept. The translation of the concept into an
operational facility then takes place through product formulation and development. In
the operation of the hotel, marketing can contribute through a continuous process of
market research, product development, promotion, selling, monitoring and review —
the stages of a marketing cycle.
In the planning of a new hotel, there is full scope for the adherence to the
marketing concept from the outset. In an existing hotel, there is often an important
distinction between the short-and long-term marketing tasks. In the short term the
marketing task may be to adjust customers’ wants to available facilities and services,
but the long-term task is to modify the facilities and services to the customers’ wants.
In the short run our existing facilities and services are given within narrow
limits. We may research the market to see which market segments are or could be
attracted to them, make such adjustments to our products as are possible, but the main
effort is likely to focus on promotion and selling. With low occupancies and low
utilization of restaurants, bars and function rooms, in the short run the sales effort
becomes dominant. But it is no excuse for doing just that; it is both necessary and
possible to proceed with changing the products: toestablish who our customers could
be and what their needs are (market research), and to formulate and develop products
meeting their needs (product formulation and development). This approach ultimately
calls for less sales effort, which is then designed to demonstrate to people that their
needs can be met; it is of particular importance in hotels.
Marketed commodities and articles are concrete, physical and capable of
measurement; most of them can be inspected and many of them even tried out before
purchase. Services are less tangible and hotel services particularly so. Hotel services
cannot be easily defined and described in terms of clearly measurable products and
their qualities. They are often bought individually or as part of a package, and they
may be bought directly by the user or through an intermediary, for example, a travel
agent. In hotels, as in other walks of life, it is necessary to make it easy to buy only
more so.

Property Ownership

An investment in hotels is first and foremost an investment in land and

buildings, which represent the dominant assets of hotels. Other fixed assets are:
• plant and equipment, including such major items as air conditioning, boilers,
lifts, and heavy kitchen equipment;
• furniture, furnishings, and small equipment;
• china, glass, linen and cutlery.
Accordingly there is a dual nature of investment in hotels — as an investment
in land and buildings and an investment in interior assets. This distinction has been
recognized in three principal ways in recent years.

387
 First, the building shell may be owned by a developer, sometimes as part of
some larger project, and leascd to anhotel operator on a rental basis. This is also
implied by some hotel groups, which apply internal rentals to hotels owned by them;
in this way the hotel profits are assessed after taking into account the notional rental
of the land and building.
Secondly, hotel companies make use of sale-and-lease- back arrangements as
a means of financing the investment, which reduces the capital requirement for the
hotel operator.
Thirdly, interior assets may be also leased by the hotel operator rather than
bought, thereby also reducing the capital requirement.
There are, therefore, various arrangements as to who is involved in property
ownership and in hotel management. A hotel operator may invest in the property
represented by land and buildings or enter into a leasing arrangement and invest only
in the interior assets, or an operator may enter into a management contract without
any direct capital investment.

Property Operation and Maintenance

In large hotels and in hotel groups normally a senior person is ultimately

responsible for technical services who may be variously described as the technical
services, buildings and services, or works director, officer, or superintendent, or
simply as chief engineer, or by some such title. In large organizations the technical
services may be subdivided between those responsible for buildings, for engineering,
and for other services.
Although technical considerations may be the direct concern of hotel
management in smaller hotels, they arespecialist activities normally entrusted to
specialist staff and sometimes ‘contracted out’.
Property operation, maintenance and energy costs are costs of hotel operation,
as distinct from the capital investment outlay on the assets. They are, therefore,
appropriately included in hotel profit and loss statements.
In the Uniform System of Accounts for Hotels property operation and
maintenance includes costs of repairs and maintenance of buildings, plant and
equipment, furniture and furnishings, as well as the maintenance of grounds, related
wages and salaries, and work let out on contract. The costs incurred by hotels
contributing to Horwath International reports in the early 1990.

388
 III.Hotel Organization

Organization is the framework in which various activities operate. It is

concerned with such matters as the division of tasks within firms and establishments,
positions of responsibility and authority, and relationships between them. It introduces
such concepts as the span of control (the number of subordinates supervised directly
by an individual), levels of management (the number of tiers through which
management operates), delegation (the allocation of responsibility and authority to
designated individuals in the line of ‘command’).
Until not so long ago — about the middle of this century and even later than
that the typical hotel of almost any size was characterized by a large number of
individuals and departments directly responsible to the hotel manager who was
closely concerned with his guests and with all or most aspects of the hotel operation.
Theremight have been one or more assistant managers who had little or no authority
over such key individuals as the chef, the head waiter or the housekeeper. The hotel
manager usually combined the ‘mine host’ concept of hotel keeping with a close
involvement in the operation. He normally had all or most of the technical skills that
enter into the business of accommodating and catering for guests. Although he might
have given more attention to departments in which he felt confident about his
expertise, and less to those in which his knowledge and skills might have been
lacking, his approach was essentially that of a technician rather than the manager of a
business. Hotels served those who chose to use them. The financial control was
exercised by the owners or by accountants on their behalf. Personnel management
rarely extended beyond the ‘hiring and firing’ of staff. Hotel buildings and interiors
were not often viewed as business assets required to produce a return comparable to
other commercial investments; maintenance and energy were cheap.
Several influences have tended to change this profile generally and the
approach to hotel organization in particular in the second half of the twentieth
century. The market for hotels, the number of hotels, and the size of individual
operations have grown, against the background of economic and social conditions in
most parts of the world. Business and management thought and practice have found
their way into hotels, with the entry into the hotel business of firms engaged in other
industries, development of hotel education and training, and higher quality of
management. Innovation in hotel organization, at first largely confined to a few firms
in North America, has spread to others in other countries. These and other influences
have brought about changesin the ways in which hotels organize their activities today.
Three particular developments illustrate the changes in hotel organization in
post-war Britain. One relates to the grouping of functions. In the early I 950s hotel
reception, uniformed services and housekeeping were invariably regarded as separate

389
departments, each reporting directly to the hotel manager; twenty years later many
large hotels had front hall managers, rooms managers, or assistant managers with
specific responsibilities in this area. Similarly, over the same period in most large
hotels food and beverage managers came to be appointed, responsible for all the hotel
activities previously organized in restaurants, bars and kitchens under the direct
control of the hotel manager. Secondly, there has been a growth in specialists. In the
early 1950s only a few large hotels had a staff manager, a public relations officer or a
buyer; by the early 1970s personnel, sales and marketing, and purchasing departments
were common features of the large hotels and of hotel groups. Thirdly, where each
hotel used to be more or less self-sufficient in the provision of its various guest
services and supporting requirements, many of these are now provided through
internal rentals and concessions and through specialist suppliers and operators such as
outside bakeries, butcheries and laundries.
The accommodation function may be described in terms of reception,
uniformed services and housekeeping. Several typical organizational approaches may
be identified in respect of these activities in practice:
- all three activities operate as separate departments with their own heads of
department;
-reception and uniformed services are grouped together as the front hail or
front house of the hotel under an assistant manager for whom this is the sole or main
responsibility;
- reception and uniformed services are grouped together as a front hail or front
house department with its own head of department.
- all three activities are grouped together as the rooms department under an
assistant manager for whom this is the sole or main responsibility;
- all three activities are grouped together as the rooms department with its own
head of department.
The first approach provides for a direct line of responsibility and authority
between each separate head

390
 Rooms

The accommodation function may be described in terms of

reception,uniformed services and housekeeping. Several typical organizational
approaches may be identified in respect of these activities in practice:
- all three activities operate as separate departments with their own heads of
department;
-reception and uniformed services are grouped together as the front hail or
front house of the hotel under an assistant manager for whom this is the sole or main
responsibility;
- reception and uniformed services are grouped together as a front hail or front
house department with its own head of department.
- all three activities are grouped together as the rooms department under an
assistant manager for whom this is the sole or main responsibility;
- all three activities are grouped together as the rooms department with its own
head of department.
The first approach provides for a direct line of responsibility and authority
between each separate head of department and the hotel manager and hence for a
close contact between the two levels of management; however, it extends the hotel
manager’s span of control and he is required to coordinate the separate departments.
The other four approaches are designed to reduce the hotel manager’s span of control
and provide for a coordination of related activities at an intermediate level but
increase the number of levels through which management has to operate, and reduce
the amount of direct contact between the hotel manager and the departments
concerned.
Several activities were described in connection with rooms, which may be
arranged differently in large hotels:
In most hotels advance reservations form an integral part of hotel reception
and the same employees deal with them and with other reception tasks. But advance
reservations may be dealt with in a separate section of the reception office or in a
separate department, to enable employees to concentrate on the respective tasks
without conflicting demands on their time and attention. Sometimes all advance

391
reservations are concentrated in the sales department, which has a responsibility for
maximizing hotel occupancy.
In smaller hotels guest accounts are normally handled by book-
keeper/receptionists, but strictly speaking guest accounts represent an extension of the
accounting function of the hotel. Therefore, where guest accounting is handled by bill
office clerks and cashiers, they normally form a part of the accounts department.
• In some hotels room service is provided by housekeeping staff, but room
service is clearly part of the food and beverage function of the hotel.

Food and Beverage

Several typical organizational approaches identified in respect of this function

in practice:
● may be each sales outlet and supporting service operates as a separate
department with its own head of department;
• several departments are grouped together under an assistant manager for
whom they represent the sole or main responsibility, e.g. purchasing and storage, bars
and cellars, the ‘back-of-the-house’ activities including the kitchen, and so on;
• several of these departments are grouped together as one department under
its own head of department;
• all food and beverage activities are grouped together under an assistant
manager for whom they represent the sole or main responsibility; • all food and
beverage activities are grouped together as a food and beverage department with its
own head of department.
The same observations apply to these approaches as are made above in
relation to rooms, regarding lines of responsibility and authority, span of control and
levels of management; the size of the span of control and the number of management
levels are conflicting considerations.
Several aspects of the food and beverage function are closely related to each
other but also to other parts of the hotel operation:
• Most hotels have facilities serving both food and beverages, although in
some of them food or beverages may predominate. Whilst it is usually relatively easy
to separate the revenue from each, it is often impractical to separate accurately all the
costs of operation other than the cost of sales, because the same employees may
handle both products, and because other goods and services provided in the same

392
outlet may not be readily identifiable as either food or beverages. In these
circumstances food and beverages are treated together, analysed by sales outlet, and
the related responsibilities are reflected in the organization structure.
• Food and beverage control based on the food and beverage cycles may be
appropriately seen as part of the total accounting function of the hotel. In these
circumstances such employees as restaurant cashiers and cost control clerks are
included on the staff of the hotel accountant. • ‘Where there is a separate sales
department, food and beverage sales are usually closely monitored by that
department, and such arrangements as reservations for functions may form part of the
responsibilities of the sales department.

Miscellaneous Guest Services

Miscellaneous guest services are illustrated in terms of such activities as

telephones and laundry and the typical organizational approaches for most of term are
shown to be of two main kinds:
• the services are operated under direct management of the hotel as minor
operated departments;
• the services are operated under rental and concession arrangements with the
hotel by another firm.
The alternative arrangements may apply in the provision of the following main
services to guests:

beauty shop and secretarial services

hairdressing
florist squash courts and
tennis courts
garage gifts and souvenirs
laundry and dry cleaning swimming pool
newspapers and magazines tobacconist

Direct management of these services normally provides for a closer direct

control and supervision by the hotel and for greater flexibility in operation. In many
hotels the services are merely grouped as residuary hotel activities for accounting and
control purposes and are in practice provided as part of the services of other hotel
departments, e.g. reception, uniformed services, housekeeping or general
administration, and are not separate departments in the organizational sense. Only
when the volume of a particular service is sufficiently large, it may be organized as a
separate department. And it is only then that the option arises for the service to be
provided for the guests by another operator, because it warrants his involvement,
under a rental or concession arrangement. Such arrangement then relieves the hotel
from operating what is often to the hotel operator an unfamiliar service and allows it
to concentrate on its primary activities.
Therefore, major deciding factors are the size of the operation, the availability
of suitable operators of particular services, and the operational philosophies of the
hotel or hotel group, as well as the quality of service and the financial return to the
hotel, which may result from one or the other approach.

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 Hotel Support Services

In practice the non-revenue service activities are organized in one of three

main ways:
• retained among the hotel manager’s own responsibilities;
• assigned to an assistant manager as one of his or her responsibilities;
• assigned to a separate department with its own head of department.
To a greater or lesser extent each of these activities may also draw for its
performance on external specialist advice and assistance.
The main specialist activities, which may be organized in one of these ways,
and examples of the external sources of advice and assistance available to the hotel in
respect of each, can be summarized as follows:

Accounting and finance Hotel accountants and

consultants
Public accountants and
auditors
Professional stock-takers
Personnel services Personnel recruitment and
selection specialists
Work study, personnel and
industrial relations advisers
Training boards and other
agencies
Purchasing Hotel accountants and
consultants
Furniture and equipment
specialists
Various suppliers
Sales and marketing Market research agencies
Advertising agencies
Public relations consultants
Property operation, Architects, builders,
maintenance, energy designers
Consulting engineers
Utility undertakings

Advisory services are also sometimes provided by professional bodies, trade

associations for their members, the technical press and other agencies.

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 Apart from any operational philosophies, the adoption of the organizational
approaches, in respect of a particular activity, is largely determined by the size of
operation: the first is normally associated with a small hotel; the second with medium
size; and the third with large operations, but no hard and fast rules apply. Each of
these activities comprises specialist knowledge and skills, as distinct from normal
operational know-how inherent in the primary operating activities.

The Management Structure

Following the discussion of the division and grouping of operated and service
activities into departments, it is next necessary to consider the total management
structure of the hotel; this comprises all positions of responsibility and authority
below top management, which is represented in a hotel company by the board of
directors. The management team consists of the hotel manager, one or more deputy or
assistant managers, and the heads of departments. A discussion of the management
structure is concerned with these posts and with the relationships between them.
According to the size of the hotel and the particular arrangement in operation,
the hotel chief executive may be variously designated as managing director, general
manager or simply hotel manager. He or she may to agreater or lesser extent
participate in the formulation of the hotel policies and strategies, and will invariably
be responsible for their implementation and for the hotel performance. In larger hotels
this level may be subdivided betweena managing director or general manager and the
hotel manager or a resident manager. The former then reports to the board and
normally coordinates the work of the specialist departments and of the hotel or
resident manager, who is in turn responsible for the day-to-day management of the
hotel activities.
The complexity and continuity of the hotel activities normally give rise to the
need for one or more deputy or assistant managers. A deputy hotel manager normally
has authority over the heads of departments. But there is much variation in the role,
authority and responsibilities of hotel assistant managers.
In some instances they are the hotel manager’s deputies in all but name, in
respect of the whole operation or some parts of it, e.g. food and beverages, front hall,
‘back of the house’, and so on; in other cases they have these specific responsibilities
in addition to their general role as the manager’s deputies. But many so-called
assistant managers perform roles, which are more appropriately described as those of
general assistants (assisting where required throughout the hotel) or of personal
assistants to the manager (acting on his behalf as he directs them to do). Yet in other
cases their main role is guest contact.
All the roles described above may be appropriate in particular circumstances,
but effective hotel management calls for a clear definition of responsibility and
authority. The relationships with heads of departments are especially important in this
context. Titles, which describe the particular roles, can be helpful in this direction.
In order to provide clear-cut lines of responsibility and authority and an
effective coordination of related activities, some hotels function without assistant
managers as such: those who would normally be in such positions are allocated
specific responsibilities and appropriate titles to describe them.
Those in positions of heads of departments fall into two distinct categories.
Heads of operated departments are known as line managers, with direct lines of

395
responsibility and authority to their superiors and to their subordinates in respect of
each operated department. Heads of service departments are specialists who provide
advice and service to line management, and relieve them of such specialist tasks as
are considered to be more effectively discharged through the appointment of
specialists; they have no direct authority over employees other than those of their own
departments. Line management includes, for example, head receptionists, head
housekeepers, head chefs and restaurant managers. Specialists include accountants,
buyers, personnel and purchasing officers and similar posts. In order to draw a
distinction between the two, it is helpful to confine the designation ‘manager’ to
operated departments.
It is also relevant to refer in this context to a confusion, which often arises
with various trainee positions. It is difficult to justilt such titles as ‘trainee manager’
unless its holder has been designated to fill a specific post, for which he is training. A
person who is undergoing training with a view to an ultimate unspecified position of
responsibility is more appropriately described as a management trainee.

IVHotel Services

Rooms and Beds

The primary function of a hotel is to accommodate those away from home and
sleeping accommodation is the most distinctive hotel product. In most hotels room
sales are the largest single source of hotel revenue and in many, more sales are
generated by rooms than by all the other services combined. Room sales are
invariably also the most profitable source of hotel revenue, which yield the highest
profit margins and contribute the main share of the hotel operating profit.
Hotels contributing to annual reports of Horwath International earned on
average the proportions of their total revenue shown in the following from room sales
in the early 1990s.

Room Sales as a Ratio of Hotel Revenue in Main Regions

1990 1991 1992
(%) (%) (%)

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 Africa and the Middle East 46.0 43.6 45.2
Asia mid Australia 54.1 56.0 57.9
Europe 49.2 49.1 47.0
North America 63.9 62.9 71.6
Latin ArnericalCaribbean 53.8 58.5 56.

Three main hotel activities are earning the room revenue: hotel reception,
uniformed services and Room Sales
A large proportion of hotel guests reserve their rooms from a few hours to
several weeks or months before they actually arrive at the hotel. They do so in person,
by telephone, telegram, Telex or Fax, by mail, through travel agents, and in a growing
number of cases through central reservations systems. Hotel reservations create a
multitude of contractual relationships between the hotel and its guests, which begin at
the time each reservation is made and continue until the departure of the guests or
until their accounts are settled after their stay. Advance reservations are an important
responsibility on the part of the hotel, both in the legal and in the business sense, and
call for a system which enables room reservations to be converted into room revenue.
When guests arrive in hotels, they are asked to register by providing the receptionist
with certain particulars about themselves. The hotel register, in which the particulars
are entered, has two main functions; one is to satisfy the law, which makes hotel
registration of guests a legal requirement in most countries. The second function is to
provide an internal record of guests, from which data are obtained for other hotel
records.
In most hotels room allocations of accommodation reserved in advance are
made before the guests’ arrival and only guests registering without a previous
reservation are allocated rooms on arrival, but in some hotels all room allocations are
made only when guests arrive. The registration and room allocation are then the
starting point for guests’ stay and a signal for the opening of their accounts, as well as
for notifying uniformed staff, the housekeeping department, telephonists, and others,
of arrivals.
Several main records document the room sale in the reception office:
• reservation form or card standardizes the details of each booking, forms the
top sheet of any documents relating to it, and enables a speedy reference to any
individual case;
• reservation diamy or daily arrival list records all bookings by date of arrival
and shows all arrivals for a particular day at a glance;
• reservation chart provides a visual record of all reservations for a period and
shows at a glance rooms reserved and those remaining to he sold;
• hotel register records all arrivals as they occur and gives details of all current
and past guests;
• reception or room status board shows all rooms by room number and floor
and gives the current and projected status of all rooms on a particular day, with details
of occupation;
• guest index lists all current guests in alphabetical order with their room
numbers and provides an additional quick point of reference in larger hotels.

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 Mall and Other Guest Services

A combined key and mail rack is a standard feature of most hotel reception
offices and reflects two typical responsibilities of the office room keys and guest mail,
Arranged by room number and floor, it corresponds in layout to the reception or room
status board and is complementary to it.
In the course of a day’s business room keys arc issued from the rack to
arriving guests and to residents who call for them; keys are returned to the rack by
guests going out of the hotel or departing at the end of their stay. The rack is a point
of reference regarding the occupation of rooms and the whereabouts of guests.
Mail may arrive for guests before, during and after their stay at the hotel, and
may consist ç.f ordinary or registered mail, packets and parcels, cables and’
telegrams, Telex messages, Fax transmissions, express mail and personal messages
left for guests. Mail awaiting guests’ arrival should be handed to them when they are
registering; mail arriving after a guest has left the hotel, should be forwarded. During
the guest’s stay speed is the essence of Fax transmissions, security is the essence of
registered mail, bulkiness is the essence of parcels; each calls for standard procedures
of their own. But the key and mail rack is the focus; it accommodates much of the
mail the guest collects when collecting the room key; it can serve to alert the
receptionist to items such as parcels or registered mail, stored elsewhere.
Three basic aids are, therefore, related and complementary in the provision of
key, mail and other guest services:
• guest index shows whether a particular person is resident and that person’s
room number;
• reception or room status board shows who is occupying a particular room;
• key and mail rack indicates whether the guest is in the hotel and whether
there is any mail for that person.
In many hotels the reception office or a separate section of it also acts as a
source of information to guests
— about hotel facilities and services, about the locality, about transport and
other matters. In other hotels the keys, mail and information to guests are provided by
uniformed staff, and there are usually good reasons for one or the other arrangement.
But who does what and to whom the guest can turn, should be made clear to the guest
in terms of individual needs and requirements rather than in terms of the hotel
organization structure, particularly in larger hotels. Such notices as ‘Reception’ and
‘Hall Porter’have different connotations in different hotels and are not necessarily
self-explanatory even for experienced hotel users. Counters and sections of the front
hall of the hotel clearly labelled ‘Registration’, ‘Keys’, ‘Mail’, ‘information’, ‘Guest
Accounts’, and so on, are more meaningful to guests.

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 Uniformed Services

The second component of the accommodation function is uniformed services,

which form an integral part of the front hail ftmnctions of the hotel and provide a
variety of personal services to guests.
Servicing arrivals and departures are the most common uniformed services.
The meeting and greeting of arriving guests, their luggage and the parking of their
ears, are the first responsibilities, which extend from the hotel entrance and car park to
the hotel bedrooms. On departure, guests, luggage and transportation are again their
primary responsibilities. In an hotel with a hundred departing guests in the morning,
followed by a similar volume of arrivals in the afternoon and evening, uniformed staff
attend in a day’s business to some two hundred people, handle several hundred pieces
of luggage, park several doPzen cars, and arrange several dozen taxis. The guests,
their luggage, and their vehicles, therefore, play a major part in the provision of
uniformed services.
During the guest’s stay uniformed staff are often the main source of
informatinn about the hotel and the locality, and the guest’s main source of such
arrangements as theatre tickets, tours, car hire and other services. The hail porter’s
desk or an enquiry counter in the front hail are then the information centres of hotels,
which contribute much to the range of guest services and to their integration.
In some hotels other guest services may be provided by uniformed staff.
Newspapers, as well as other small articles, may be supplied to guests by uniformed
staff who may also act as messengers, lift operators and men’s cloakroom attendants.
In many hotels uniformed staff are the only people on duty during the night and
particularly in smaller hotels maintain a whole range of hotel services provided by
other departments in day time: to receive and register late arrivals, to serve light
refreshments, to operate the hotel switchboard, to arrange early morning calls, as well
as to clean public rooms and to ensure the security of the hotel.
The provision of uniformed services varies greatly between hotels of different
sizes, types and standards, and their organization tends to be influenced by all these
factors, as well as by established practices, As mentioned earlier, information to
guests may he provided by the reception office or as part of uniformed services or by
both. The cleanliness of public rooms may be the responsibility of uniformed staff,
the housekeeping department, or outside contractors. What hotel services are available
during the night and by whom they are provided, is another source of variation. These
differences are legitimate, as long as they reflect the particular requirements of guests
and the particular circumstances of each hotel, and as long as the respective functions
are defined and understood by staff and made clear to guests where they affect them.

Hotel Housekeeping

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 The basic housekeeping function of the hotel is the servicing of guest rooms.
In its scope, guest bedrooms may be the sole or main responsibility of the hotel
housekeeping department, but it may extend to other areas of the hotel.
Normally hotel guests spend at least one-third of their stay in their room. The
design, layout, decor, furniture and furnishings of the hotel bedroom are fundamental
to meeting their needs and in creating customer satisfaction, and these may be
significantly influenced by the housekeeping department. The cleanliness and good
order, the linen and other room supplies, and the smooth functioning of the room are
the focus of the department. This may include other guest services, such as early
morning teas, guest laundry, baby sitting and other personal services. The main
housekeeping records are made up of arrival and departure lists and notifications
received from the reception office and the housekeeping own room status report,
together with separate records in respect of additional services provided by the
department.
The extension of the housekeeping function outside the hotel bedroom
normally includes the cleaning of bedroom floors and may include staircases, public
cloakrooms and other public areas of the hotel. However, it is quite common for such
public rooms as hotel lounges to be cleaned by uniformed staff, for the responsibility
for the men’s and women’s cloakrooms to be divided between uniformed staff and the
housekeeping department, and for restaurants and bars to be cleaned by the staff of
those departments. More recently, hotels have been engaging outside contract firms
for the cleaning of public rooms.
Other housekeeping services often include the provision of first aid to guests
and staff, dealing with lost property, and floral arrangements throughout the hotel.
When staff accommodation is provided by the hotel, it may be included as part of the
head housekeeper’s responsibilities. Although in many countries hotels increasingly
use outside laundries and dry cleaning firms for their requirements, many hotels
operate their own dry cleaning and laundry facilities. These ‘in-house’ facilities may
be then organized as separate departments of the hotel or as sections of the
housekeeping department.
This outline of the hotel housekeeping function illustrates three organizational
approaches. One seeks to integrate a number of related functions within a major
housekeeping department. The second assigns certain functions to the housekeeping
department and others to other departments of the hotel, largely on the basis of
physical areas. The third consists of ‘buying in’ certain services from outside
suppliers rather than operating them directly as hotel facilities. Food and Drink
The food and drink service is the second major activity of most hotels and in
many of them it accounts for a larger proportion of employees than the provision of
sleeping accommodation and related services. This is due to two main factors:
• in contrast to hotel rooms, meals and refreshments in hotels may be supplied
to non-residents as well as to resident guests and include substantial functions sales;
• the provision of meals and refreshments is relatively labour intensive.
The provision of sleeping accommodation is a service activity, in which there
is a negligible use of materials, and there is no cost of sales. The provision of meals
and refreshments results in composite products made up of commodities and of
service, and the use of materials represent the cost of sales. Food and drink enter into
meals and refreshments served in hotels in several stages from their purchase by the
hotel to their sale in the same or altered form to the hotel customer. According to the

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size and diversity of the hotel markets there may be more than one restaurant and bar
and also food and drink service in rooms and through functions.

Restaurants

Restaurants establishment where refreshments or meals may be procured by

the public. The public dining room that came ultimately to be known as the restaurant
originated in France, and the French have continued to make major contributions to
the restaurant’s development.
The first restaurant proprietor is believed to have been one A. Boulanger, a
soup vendor, who opened his business in Paris in 1765. The sign above his door
advertised restoratives, or restaurants, referring to the soups and broths available
within. The institution took its name from that sign, and “restaurant” now denotes a
public eating place in English, French, Dutch, Danish, Norwegian, Romanian, and
many other languages, with some variations. For example, in Spanish and Portuguese
the word becomes restaurante, in Italian it is ristorante; in Swedish, restaurang; in
Russian, restoran; and in Polish, restauracia. Although inns and hostelries often served
paying guests meals from the host’s table, or table d’hôte, and beverages were sold in
cafés, Boulanger’s restaurant was probably the first public place where any diner
might order a meal from a menu offering a choice of dishes.

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 Boulanger operated a modest establishment; it was not until 1782 that La
Grande Taverne de Londres, the first luxury restaurant, was founded in Paris. The
owner, Antoine Beauvilliers, a leading culinary writer and gastronomic authority,
later wrote L ‘Art du cuisinier (1814), a cookbook that became a standard work on
French culinary art.
The most illustrious of all 19th-century Paris restaurants was the Café Anglais,
on the Boulevard des Italiens at the corner of the rue Marivaux, where the chef,
Adoiphe Dugléré, created classic dishes such as sole Dugléré (filets poached with
tomatoes and served with a cream sauce having a fish stock base) and the famous
sorrel soup potage Germiny. On June 7, 1867, the Café Anglais served the now-
famous “Three Emperors Dinner” for three royal guests visiting Paris to attend the
Universal Exposition. The diners included Tsar Alexander 11 of Russia; his son the
tsarevich (later the tsar Alexander III); and King William I of Prussia, later the first
emperor of Germany. The meal included souffles with creamed chicken (a Ia reine),
fillets of sole, escalloped turbot, chicken a la portugaise (cooked with tomatoes,
onions, and garlic), lobster a la parisienne (round, flat medallions glazed with a
gelatin-mayonnaise mixture and elaborately decorated), ducklings a Ia rouennaise (the
carcasses stuffed with liver and pressed, presented on a platter with boned slices of
the breast and the grilled legs, and served with a red wine sauce containing pureed
liver), ortolans (small game birds) ontoast, and eight different wines.
Toward the end of the 19th century, in the gaudy and extravagant era known
as ia belie époque, the luxurious Maxim’s, on the rue Royale, became the social and
culinary centre of Paris. The restaurant temporarily declined after World War I but
recovered under new management, to become an outstanding gastronomic shrine.
France produced many of the world’s finest chefs, including Georges-Auguste
Escoffier, who organized the kitchens for the luxury hotels owned by César Ritz,
developing the so-called brigade de cuisine, or kitchen team, consisting of highly
trained experts each with clearly defined duties. These teams included a chef, or gros
bonnet, in charge of the kitchen; a sauce chef, or deputy; an entremettier, in charge of
preparation of soups, vegetables, and sweet courses; a rótisseur to prepare roasts and
fried or grilled meats; and the garde manger, in charge of all supplies and cold dishes.
In Escoffier’s time, the duties and responsibilities of each functionary were sharply
defined, but in modern times, rising labour costs and the need for faster service have
broken down such rigidly defined duties. In the kitchens of even the leading modern
restaurants, duties at the peak of the dinner-hour preparations are likely to overlap
widely, with efficiency maintained amid seeming chaos and confusion.
I n the 20th century, with the development of the automobile, country
dining became popular in France, and a number of fine provincial restaurants were
established. The Restaurant de la Pyramide, in Vienne, regarded by many as the
world’s finest restaurant, wasfounded by Fernand Point and after his death, in 1955,
retained its high standing under the direction of his widow, Madame “Mado” Point.
Other leading French provincial restaurants have included the Troisgros in Roanne;
the Paul Bocuse Restaurant near Lyon; the Auberge de 1’Ill in Illhaeusern, Alsace;
and the hotel Côte d’Or, at Saulieu.
French restaurants today are usually in one of three categories: the bistro, or
brasserie, a simple, informal, and inexpensive establishment; the medium-priced
restaurant; and the more elegant grand restaurant, where the most intricate dishes are
executed and served in luxurious surroundings.
Other nations have also made many significant contributions to the
development of the restaurant.

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 In Italy the botteghe (coffee shop) of Venice originated in the 16th century, at
first serving coffee only, later adding snacks. The modern trattorie, or taverns, feature
local specialities. The osterie, or hostelries, are informal restaurants offering home-
style cooking. In Florence small restaurants below street level, known as the buca,
serve whatever foods the host may choose to cook on a particular day.
Austrian coffeehouses offer leisurely, complete meals, and the diner may
linger to sip coffee, read a newspaper, or even to write an article. Many Austrians
frequent their own “steady restaurants,” known as Stain,nbe
In Hungary the csárda, a country highway restaurant, offers menus usually
limited to meat courses and fish stews.
The beer halls of the Czech Republic, especially in Prague, are similar to
coffeehouses elsewhere. Food is served, with beer replacing coffee.
The German Weinstube is an informal restaurant featuring a large wine
selection, and the Weinhaus, a food and wine shop where customers may also dine,
offers a selection of foods ranging from delicatessen fare to full restaurant menus. The
Schenke is an estate-tavern or cottage pub serving wine and food. In the cities a
similar establishment is called the Stadischenke.
In Spain the bars and cafés of Madrid offer widely varied appetizers, called
tapas, including such items as shrimp cooked in olive oil with garlic, meatballs with
gravy and peas, salt cod, eels, squid, mushrooms, and tuna fish. The tapas are taken
with sherry, and it is a popular custom to go on a chateo, or tour of bars, consuming
large quantities of tapas and sheny at each bar. Spain also features the marisco bar, or
marEs querIa, a seafood bar; the asadoro, a Catalan rotisserie; and the tasca, or pub-
wineshop.
In Portugal, cervejarias are popular beer parlours also offering shellfish. Fado
taverns serve grilled sausages and wine, accompanied by the plaintive Portuguese
songs called fados (meaning “fate”).
In Scandinavia sandwich shops offer open-faced, artfully garnished
sandwiches called smorrebrod. Swedish restaurants feature the smorgasbord, which
literally means “bread and butter table” but actually is a lavish, beautifully arranged
feast of herring, shrimp, pickles, meatballs, fish, salads, cold cuts, and hot dishes,
served with aquavit or beer.
The Netherlands has broodjeswinkels, serving sandwich open-faced shops,
called sandwiches, seafoods, hot and cold dishes, and cheeses from a huge table.
English city and country pubs have three kinds of bars: the public bar, the
saloon, and the private bar. Everyone is welcome in the public bar or saloon, but the
private bar is restricted to habituës of the pub. Pub food varies widely through
England, ranging from sandwiches and soups to pork pies, veal and ham pies, steak
and kidney pies, bangers (sausages) and a pint (beer), bangers and mash (potatoes),
toad in the hole (sausage in a Yorkshire pudding crust), and Cornish pasties, or pies
filled with meat and vegetables.
In the tavérnas of Greece, customers are served such beverages as retsina, a
resinated wine, and ouzo, an anise-flavoured aperitif, while they listen to the music of
the bou:ouki. Like other Mediterranean countries, Greece has the groceiy-tavérna
where one can buy food or eat.
The Turkish iskembeci is a restaurant featuring tripe soup and other tripe
dishes; muhalleb icE shops serve boiled chicken and rice in a soup and milk pudding.
Characteristic of Japan are sushi bars that serve sashimi (raw fish slices) and
sushi (fish or other ingredients with vinegared rice) at a counter. Other food bars serve
such dishes as noodles and tempura (deep- fried shrimp and vegetables). Yudofu

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restaurants build their meals around varieties of tofu (bean curd), and the elegant tea
houses serve formal Kaiseki table d’hôte meals.
In China, restaurants serving the local cuisine are found, and noodle shops
offer a wide variety of noodles and soups. The dim-sum shops provide a never-ending
supply of assorted steamed, stuffed dumplings and othersteamed or fried delicacies.
A common sight in most parts of Asia is a kind of portable restaurant,
operated by a single person or family from a wagon or litter set up at a particular
street location, where specialties are cooked on the spot. Food and cooking utensils
vary widely in Asia.
The cafeteria, an American contribution to the restauranfs development,
originated in San Francisco during the 1849 gold rush. Featuring self-service, it offers
a wide variety of foods displayed on counters. The customer makes his selections,
paying for each item as he chooses it or paying for the entire meal at the end of the
line. Other types of quick-eating places originating in the United States are the
drugstore counter, serving sandwiches or other snacks; the lunch counter, where the
diner is served a limited quick-order menu at the counter; and the drive-in, “drive-
thru,” or drive-up restaurant, where patrons are served in their automobiles. So-called
fast-food restaurants, usually operated in chains or as franchises and heavily
advertised, offer limited menus-- typically comprising hamburgers, hot dogs, fried
chicken, or pizza and their complements--and also offer speed, convenience, and
familiarity to diners who may eat in the restaurant or take their food home. Among
fast-food names that have become widely known are White Castle (one of the first,
originating in Wichita, Kan., in 1921), McDonald’s (which grew from one
establishment in Des Flames, Ill., in 1955 to more than 15,000 internationally within
40 years), Kentucky Fried Chicken (founded in 1956), and Pizza Hut (1958). Many
school, work, and institutional facilities provide space for coin-operated vending
machines that offer snacks and beverages. The specialty restaurant, serving one or two
special kinds of food, such as seafood or steak, is another distinctive American
establishment.
The Pullman car diner, serving full-course meals to long distance railroad
passengers, and the riverboat steamers, renowned as floating gourmet palaces, were
original American conceptions. They belong to an earlier age, when dining out was a
principal social diversion, and restaurants tended to become increasingly lavish in
food preparation, decor, and service. In many modern restaurants, customers now
prefer informal but pleasant atmosphere and fast service. The number of dishes
available, and the elaborateness of their preparation, has been increasingly curtailed as
labour costs have risen and the availability of skilled labour decreased. The trend is
toward such efficient operations as fast-food restaurants, snack bars, and coffee shops.
The trend in elegant and expensive restaurants is toward smaller rooms and intimate
atmosphere, with authentic, highly specialized and limited menus.

Miscelaneous Guest Services

Accommodation, food and drink services are the major activities of hotels,
which generate all or most hotel revenue, account for all or most of their employees,
and represent the principal products provided by the major hotel departments.
But the present-day hotel guest normally also expects other facilities and
services. In addition to a comfortable room, and meals and refreshments in a

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restaurant or bar or in the room, a guest may want to use the telephone or have clothes
laundered or dry cleaned. In a large modern hotel a guest may anticipate to be able to
buynewspapers, magazines and souvenirs, have a haircut, obtain theatre tickets, and
book an airline ticket for the next stage of a trip.
The hotel services other than accommodation, food and drink may be provided
to the guest by the hotel or by other operators on the hotel premises. The revenue-
earning activities provided directly by the hotel are variously described as ancillary or
subsidiary revenue- earning, and are grouped for accounting and control purposes in
what are known as minor operated departments, to distinguish them from major
operated departments concerned with rooms, food and beverages. Both are
distinguished from rental and concession arrangements, under which some of these
and other services may be provided to guests by outside firms operating in the hotel.
The three basic components of the accommodation function are present in
most hotels and are normally organized in separate departments. But their
organization and staffmg often differ in hotels of different sizes, types and standards.
In smaller hotels only a few people may be engaged in each and cover a wide range of
duties; as the hotel increases in size, each activity may be subdivided into separate
departments or sections, in which those engaged in them perform more specialized
tasks.
A transit city hotel with a short average length of stay calls for a somewhat
different approach from that of a resort hotel, which accommodates guests for longer
and often such regular periods as one or two weeks. There is also a relationship
between prices, the range and quality of facilities and services provided, and the way
they are organized. For all these and other reasons it is possible to describe the hotel
activities related to the accommodation of guests only in broad and general terms.

V. Tourist Attractions

Tourist attractions have an important role to play in world tourism since they
often provide the motivating force for travel, thereby energising the many components
of the tourist industry. The scope of the attractions sector is immense; logically
anything that has the power to draw visitors to it can be considered an attraction.
Moreover an attraction may not be a readily identifiable place or feature, but a
visitor’s overall perception of a destination as an attractive place to visit, distilled
from a variety of surces and images. London’s current popularity as a tourist
destination with young visitors from around the world is a good case; they are not
attracted primarily by the traditional Big Ben, Buckingham Palace, Houses of
Parliament but rather by the image of the capital as a “cool” place to hear good music
and have an enjoyable time.
Touristic attractions occur at a variety of scales. Many internationally famous
attractions such as:
San Francisco’s Golden Gate Bridge
Red Square in Moscow
The Ponipidou Centre in Paris are household names on many tourists’ “must
see” lists.

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 Domestic tourists travel within their own countries to a variety of attractions,
some of which are provided free of charge while others charge admission. These may
be day visits or a part of a long holiday or short break.
Tourist attraction are provided by both commercial and non-commercial
organizations. Many historic buildings, areas of landscape or wildlife interest,
museums and ancient monuments are in the care of public bodies and voluntary
groups which aim to preserve or conserve vital parts of a country’s heritage while at
the same time making facilities available to tourists.

Types of tourist attractions

Tourist attractions are generally classified into one of

two categories:
Natural attractions
Man made attractions such as:
Heritage attractions (e.g. Williamsburg)
Museums and ancient monuments (‘e.g Louvre in Paris)
Theme parks (e.g. Walt Disney World in Florida)
Entertainments (e.g The Sydney Opera House)
Sport facilities (e.g Winter Olimpic Gaines)
Leisure shopping venues (‘e.gThe Metro Center in Englanc
Wildlife areas (e.g Busch Garden in Florida)

Tourism today

The mass tourism that exists in the world today is a phenomenon of the post-
industrial society of the latter half of the twentieth century. Tourism has become an
integral part of the move away from economies based on heavy engineering and
manufacturing to a rapidly expanding service sector. The growth in international and
domestic tourism since the 1950s has been nothing short of dramatic, with
international tourist arrivals climbingfrom 25 million in 1950 to a record 592 million
in 1996 (World Tourism Organisation, 1997). When we add to this the fact that the
volume of domestic tourism worldwide is estimated by the World Tourism
Organisation to be approximately ten times greater than that of international tourism
(World Tourism Organisation. 1983), the scale of the tourism phenomenon can begin
to be appreciated. Greater wealth, higher educational standards, increased mobility
and more leisure time have all contributed to unparalleled demand for holidays and
excursions at home and abroad. Overseas travel is no longer the preserve of the
privileged few, but is available to the majority, as developments in transportation,
increased competition and global communications technology have reduced the real
cost of holidays. Private and public sector organisations have responded to the
increased demand by providing a wide range of facilities and products to meet the
needs of an increasingly discerning travelling public. It must be remembered,
however, that tourism is a very recent phenotnenon that has hitherto been allowed to

406
grow in a business environment relatively free of regulation and trade restrictions.
Such an unrestricted environment is unlikely to continue in years to come.
The current scale and scope of the international tourism industry is illustrated
in recent data from the World Travel and Tourism Council (1996), which indicate that
in 1996 the world travel and tourism industry is estimated to have:
• Gmployed 255 million people
• Generated an output of US $3.6 trillion
• Contributed 10.7 per cent of global gross domestic product (.GDP) o
invested US $766 billion in capital projects
• Generated( US $761 billion in world exports
• Paid US $653 billion in taxes worldwide
Such figures demonstrate the economic significance of the tourism industry on
a global scale and confirm that the age of mass tourism has truly arrived in
spectacular fashion.

Local Tours

Paris

Paris is the capital of France and one of Europe’s largest conurbations. The
city was founded more than 2,000 years ago on an island in the Seine River, some
233 miles (375 kilometres) upstream from the river’s mouth on the English
Channel. The modern city has spread from the island (the lie de la Cite) and far
beyond both banks of the Seine. The City of Paris itself covers an area of 41 square
miles (105 square kilometres); the Greater Paris conurbation, formed of suburbs and
other built-up areas, extends around it in all directions to cover approximately 890
square miles. Paris occupies a central position in the rich agricultural region known as
the Paris Basin, and it constitutes one of eight départements of theIle-de-France
administrative region. It is by far the nation’s most important centre of commerce and
culture.

NEIGHBOUR FlOODS AND SIGHTS

Paris’ many old buildings, monuments, gardens, plazas, boulevards, and

bridges compose one of the world’s grandest cityscapes. An impressive spot from
which to view the city is the Chaillot Palace, which stands on a rise on the Right Bank
of the Seine to the west, where the river begins its southwestward curve.

The Chaillot Palace.

The Chaillot Palace dates from the International Exposition of 1937. It

replaced the Trocadéro Palace, a structure left over from the 1878 International
Exposition. The Chaillot Palace is made up of two separate pavilions, from each of
which extends a curved wing. The Musée de I’Homme, the Naval Museum, the
Museum of French Monuments, and the Cinema Museum are located there. Under the
terrace that separates the two sections are two theatres, the National Theatre of

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Chaillot and a small hall that serves as one of the two motion- picture houses of the
national film library.
The terrace, which is lined by statues, gives a splendid view across Paris. The
slope descending to the river has been made into a terraced park, the centre of which
is alive with fountains, cascades, and pools. The Trocadéro Aquarium is in a grotto a
few steps away in the park.
From the bottom of the slope the five-arched Jena Bridge (Pont d’Iéna) leads
across the river. It was built for Napoleon in 1813 to commemorate his victory at
theBaffle of Jena in 1806. On the Left Bank rises the Eiffel Tower, an unclad metal
truss tower designed by Gustave Eiffel. The tower was built for the International
Exposition of 1889, against the strident opposition of national figures who thought it
unsafe or ugly or both. When the exposition concession expired in 1909, the 984-foot
(300-metre) tower was to have been demolished, but its value as an antenna for radio
transmission saved it. Additions made for television transmission have added 56 feet
to the height. From the topmost of the three platforms the view extends for more than
40 miles.

From the two-acre base of the tower the Champ-de Mars (“Field of Mars”), an
immense field, stretches to the Military Academy (Ecole Militaire), which was built
from 1769 to 1772 and is still used by the War College (Ecole Supérieure de Guerre).
The Champ-de-Mars, which originally served as the school’s parade ground, was the
scene of two vast rallies during the French Revolution: that of the Federation (1790)
and that of the Supreme Being (1794). From 1798 there were annual national
expositions of crafts and manufactures, which were followed by world’s fairs between
1855 and 1900. Behind the Military Academy stands the headquarters of the United
Nations Educational, Scientific and Cultural Organization (UNESCO). The building,
erected in 1958, was designed by an international trio of architects and decorated by
artists of member nations.

The Invalides.

One street to the northeast is the Hotel des Invalides, founded by Louis XIV to
shelter 7,000 aged or invalid veterans. The enormous range of buildings was
completed in five years (1671-76). The gold-plated dome (1675-1706) that rises

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above the hospital buildings belongs to the church of Saint-Louis. The dome was
designed by Jules Ilardouin-Mansart, who employed a style known in France as
“Jesuit” because it derives from the Jesuits’ first church in Rome, built in 1568. The
churches of the French Academy (Académie Francaise), the Val-de-Grâce Hospital,
and the Sorbonne, as well as three others in Paris, all of the 17th century, followed
this style. By using the classical elements more freely than had been done in Rome,
the French made it something recognizably Parisian.
In the chapels of Saint-Louis are the tombs of Napoleon’s brothers Joseph and
Jérôme, of his son (whose body was returned from Vienna in 1940 by Adolf Hitler),
and of the marshals of France. Immediately beneath the cupola is a red porphyry
sarcophagus that covers the six coffins, one inside the other, enclosing the remains of
Napoleon, which were returned from St. Helena in 1840 through the efforts of King
Louis Philippe. Napoleon’s uniforms, personal arms, and deathbed are displayed in
the Army Museum at the front of the Invalides. A portion of the Invalides still serves
as a military hospital; facilities have been modernized since World War II.
The vast, tree-lined Invalides Esplanade slopes gently to the Quai d and the
Alexandre III Bridge. The first stone for the bridge, which commemorates the Russian
tsar Alexander III, was laid in 1897 by Alexander’s son, Tsar Nicholas II. The bridge
was finished in time for the International Exposition of 1900, and it leads to two other
souvenirs of that year’s fair, the Grand Palais and the Petit Palais. The buildings are
still used for annual shows and for major visiting art exhibits.

The Louvre.

Vikings camped on the Right Bank across from the western tip of the lie de la
Cite in their unsuccessful siege of Paris in 885, and in about 1200 King Philip II had a
square crusader’s castle built on the same site, just outside the new city wall, to
buttress the western defenses. Over the following centuries many additions and
renovations were made, and from the castle grew one of the world’s largest palaces,
completed only in 1852. From the original square, known as the Cour Carrëe (“Square
Court”), two galleries extend westward for 1,640 feet, one along the river, the other
along the rue de Rivoli. In 1871, only 19 years after the huge oblong was completed,
its western face, the Tuileries Palace (begun 1563), was destroyed by the
insurrectionists of the Commune.
Two of the facades of the Cour Carrée had strong influence on French
architecture. Pierre Lescot began his inner courtyard facade in 1546, adapting the
Renaissance rhythms and orders he had observed in Italy and adding purely French
decoration to the classical motifs. The physician and architect Claude Perrault
collaborated with Louis Le Vau, architect to the king, to design the outer east face of
the palace in 1673. It, too, employs classic elements, making especially graceful use
of coupled columns and a pediment.
The Louvre Museum occupies the four sides of the palace around the Cour
Carrée as well as the south gallery, which stretches along the river. Among the
treasures of the museum are the Victory of Samothrace, the Venus de Milo, and the
Mona Lisa. The enormous collections contain works from the 7th century BC to the
mid-l9th century, with a huge cultural and geographic spread. The north gallery, along
the rue de Rivoli, houses a separate museum, the Museum of Decorative Arts, as well
as the Ministry of Finance.

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 Extensive remodeling has been undertaken throughout the Louvre to increase
space for art works. Construction began in the early 1980s to create a new main
entrance and underground reception hail in the vast Napoleon Courtyard, between the
two galleries; the 70-foot-high glass pyramid designed by I.M. Pei to cover the
entrance aroused both strong support and spirited criticism.
The Arts Bridge (Pont des Arts), which crosses the Seine from the Louvre to
the Left Bank, is one of the most charming of all the Parisian bridges. It was the first
(1803) to be made of iron, and it has always been reserved for pedestrians: it provides
an intimate view of riverside Paris and of the Seine itself.

Ile de la Cite.

Downstream and just below the bridge is the tip of the Ile de la Cite, fashioned
into a triangular gravel-pathed park bordered by flowering bushes, with rustic benches
under the ancient trees. It is surrounded by a wide cobbled quay that is especially
popular with sunbathers and lovers. Where the steps come onto the bridge from the
park there is a bronze equestrian statue of King Henry W, who insisted on completion
of the Pont-Neuf The statue is an 1818 reproduction of the 1614 original, which was
the first statue to stand on a public way in Paris. Opposite is the narrow entrance to
the Place Dauphine (1607), named for Henry’s heir, the future Louis XIII. The place
was formerly a triangle of uniform red-brick houses pointed in white stone, but the
row of houses along its base was ripped out in 1871 to make room for construction of
part of the Palace of Justice.
The ship-shaped lie de la Cite is 10 streets long and five wide. Eight bridges
link itto the riverbanks and a ninth leads to the scow-shaped lie Saint-Louis, which
lies to the southeast.
The palace of the early Roman governor (now the Palace of Justice) was
rebuilt on the same site by Louis IX (St. Louis) in the 13th century and enlarged 100
years later by Philip IV the Fair, who added the grim, gray turreted Conciergerie, with
its impressive Gothic chambers. The Great Hail, which, under the kings, was the
meeting place of the Pariement (the high court of justice), was known throughout
Europe for its Gothic beauty. Fires in 1618 and 1871 destroyed much of the original
room, however, and most of the rest of the palace was devastated by flames in 1776.
The Great Hall now serves as a waiting room for the courts, in one of which, the
adjoining first Civil Chamber, the Revolutionary Tribunal sat from 1793, condemning
2,600 persons to the guillotine. After sentencing, the victims were taken back down
the stone stairs to the dungeons of the Conciergerie to await the tumbrils. The
Conciergerie still stands and is open to visitors.

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 In the palace courtyards is found one of the great monuments of France, the
13th-century Sainte-Chapelle (‘Chapel”). Built at Louis IXs direction between 1243
and 1248, it is a masterpiece of Gothic Rayonnant style. With great daring, the
architect (possibly Pierre de Montreuil) poised his vaulted ceilings on a trellis of
slender columns, the walls between being made of stained glass. The exquisite chapel
was designed to hold the Crown of Thorns, thought to be the very one worn by Jesus
at his crucifixion. Louis IX had purchased the relic from the Venetians, who held it in
pawn from Baldwin, the Latin king of Byzantium. Other holy relics, such as nails and
pieces of wood from the True Cross, were added to the chapel’s collection, the
remnants of which are now in the treasury of Notre-Dame.
Under King Louis-Philippe (1830-48), the “sanitization” of the island was
begun, and it was continued for his successor, Napoleon III, by Baron Georges
Haussmann. The project involved a mass clearing of antiquated structures, widening
of streets and squares, and the erection of massive new government offices, including
parts of the Palace of Justice. The portion of the palace that borders the Quai des
Orfêvres- formerly the goldsmiths’ and silversmiths’ quay—became the headquarters
of the Paris municipal detective force, the Police Judiciaire (“Judicial Police”), which
keeps a small museum on the fourth floor.
Across the boulevard du Palais is the Police Prefecture, another 19th-century
structure. On the far side of the prefecture is the Place du Parvis-Notre-Dame, an open
space enlarged six times by Haussmann, who also moved the Hôtel-Dieu, the first
hospital in Paris, from the riverside to the inland side of the square. Its present
buildings date from 1868.

Notre-Dame de Paris.

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 At the east end of the square is the cathedral of Notre Dame de Paris, which is
situated on a spot that Parisians have always reserved to the practice of religious rites.
The Gallo-Roman boatmen of the cite erected their altar to Jupiter there (it is now in
the Cluny Museum), and, when Christianity was established, a church was built on the
temple site. The first bishop of Paris, St. Denis, became its patron saint. The red in the
colours of Paris represents the blood of this martyr who, in popular legend, after
decapitation, picked up his head and walked.
When Maurice de Sully became bishop in 1159 he decided to replace the
decrepit cathedral of Saint-Etienne and the 6th-century Notre-Dame with a church in
the new Gothic style. The style was conceived in France, and a new structural
development, the flying buttress, which added to the beauty of the exterior and
permitted interior columns to soar to new heights, was introduced in the building of
Noire-Dame. Construction began in 1163 and continued until 1345.
After being damaged during the French Revolution, the church was sold at
auction to a building-materials merchant. Napoleon came to power in time to annul
the sale, and he ordered that the edifice be redecorated for his coronation as emperor
in 1804. Louis-Philippe later initiated restoration of the neglected church. The
architect Eugene Viollet-le-Duc worked from 1845 to 1864 to restore the monument.
Like all cathedrals in France, Notre-Dame is the property of the state, although its
operation as a religious institution is left entirely to the Roman Catholic Church.
A few 16th- and 17th-century buildings survive north of the cathedral. They
are what remain of the Cloister of the Cathedral Chapter, whose school was famous
long before the new cathedral was built. Early in the 12th century, one of its
theologians, Peter Abelard, left the cloister with his disciples, crossed to the Left
Bank, and set up an independent school in the open air in the Convent of the Paraclete
near the present Place Maubert. After a prolonged struggle with the monks of Saint-
Denis the followers of Abelard in 1200 won the right, from both the king and the
pope, to form and govern their own community. This was the beginning of the
University of Paris.

Rue de Rivoli.

The Louvre and the Tuileries Gardens take up the south side of this street, and
on the other side runs an arcade more than a mile long. Opposite the middle of the
Louvre, the Place du Palais-Royal leads to the palace of Cardinal de Richelieu, which
he willed to the royal family. Louis XIV lived there as a child, and during the
minority of Louis XV the kingdom was ruled from there by the debauched but gifted
regent Philippe II, duc d’Orléans from 1715 to 1723. Late in the 18th century Louis-
Philippe d’Orléans, who was popularly renamed Philippe-Egalité during the
Revolution for his radical opinions, undertook extensive building around the palace
garden. It was a commercial operation, and the Prince hoped to pay his debts from the
property rents. Around the garden he built a beautiful oblong of colonnaded galleries
and at each end of the gallery farthest from his residence a theatre. The larger
playhouse has been the home of the Comédie-Française, the state theatre company,
since Napoleon’s reign. The princely apartments now shelter high state bodies such as
the Council of State.
Just behind the courtyard is the Bibliothêque Nationale (National Library), the
national library of deposit, with an enormous collection of books and prints.
Haussrnann greatly enlarged the Place du Palais-Royal in 1852, and he was careful to

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preserve the palace when he laid out the avenue de l’Opéra. At the top of the avenue,
where the Grands Boulevards crossed an enormous new place, the new opera house
was built from 1825 to 1898. The Paris Opera House, a splendid monument to the
Second Empire, was designed in the neo-Baroque style by Charles Gamier. It is
known especially for its decorative embellishments, chief among them the Grand
Staircase. Just behind the Opera House are various large department stores.

The next place along the rue de Rivoli is the Place des Pyramides. The gilded
equestrian statue of Joan of Arc stands not far from where she was wounded at the
Saint Honoré Gate (Porte Saint-Honoré) in her unsuccessful attack on Paris (at that
time held by the English), on Sept. 8, 1429.
Farther along toward the Place de la Concorde the rue de Castiglione leads to
the Place Vendôme, an elegant octagonal place, little changed from the 1698 designs
of Jules Hardouin-Mansart. In the centre, the Vendôme Column bears a statue of
Napoleon. It was pulled down during the Commune and put back up under the Third
Republic (187 1-1940). The place and the rue de la Paix have lost none of their
discreet distinction, nor have their shops.

The “Triumphal Way.”

From the Arc de Triomphe du Carrousel, in the courtyard between the open
arms of the Louvre, extends one of the most remarkable perspectives to be seen in any
modern city. It is sometimes called la Voie Triomphale ( Triumphal Way!!). From
the middle of the Carrousel arch the line of sight runs the length of the Tuileries
Gardens, lines up on the obelisk in the Place de Ia Concorde, and goes up the
Champs-Elysees to the centre of the Arc de Triomphe and beyond to the skyscrapers
of La Defense, in the western suburbs.
The Louvr&s modest triumphal arch stands in the open
space where costumed nobles performed in an equestrian
display-- carrousel--to celebrate the Dauphin’s birth in
1662. The design of the arch, an imitation of that of the
Arch of Septimius Severus in Rome, was conceived in
1808 by Charles Percier and Pierre Fontaine. The flanks of the Carrousel arch
are incised with a record of Napoleon’s victories.

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 The Tuileries Gardens, which fronted the Tuileries Palace (looted and burned
in 1871 during the Commune), have not altered much since André Le Nôtre
redesigned them in 1664. Le Nôtre was born and died in the gardener’s cottage in the
Tuileries; he succeeded his father there as master gardener. His design carried the line
of the central allée beyond the gardens and out into the countryside by tracing a path
straight along the wooded hill west of the palace. On this hilltop, 170 years later, the
Arc de Triomphe was erected.
The Place de la Concorde was designed as a moated octagon in 1755 by
Jacques-Ange Gabriel. The river end was left open, and on the inland side two
matching buildings were planned. Viewed clockwise starting from the Navy Ministry
(Ministère de la Marine), the statues are Lille, Strasbourg, Lyon, Marseille, Bordeaux,
Nantes, Brest, and Rouen. Louis-Philippe also had the Luxor Obelisk, a gift from
Egypt, installed in the centre and flanked by two fountains
Between the twin buildings on the northeastern side of the place, the broad rue
Royale mounts to the Church of Sainte-Marie-Madeleine, consecrated in 1842.
The church is a stern oblong, fenced with columns 60 feet high. Its design, supposedly
that of a Greek temple, is actually closer to the Roman notion of Greek.
The Place de la Madeleine is the western terminus of the Grands Boulevards,
which imitate the arch of the river from there north and east to the Place de la
Republique and the Bastille.
To the west off the rue Royale runs the rue du Faubourg Saint-Honoré, which,
in addition to the British Embassy and the Elysee Palace (residence of the French
president), has on its shop windows some of the most prestigious names in the Paris
fashion trade.
Along the first 2,500 feet of the Champs-Elysées, between Concorde and the
Rond-Point des Champs Elysées (a roundabout, or traffic circle), little has changed for
a century: the avenue is bordered with chestnut trees, behind which on both sides are
gardens, usually full of children at play. The pavilions in the gardens are used as
tearooms, restaurants, and theatres. From the Rond-Point up to the Arc de Triomphe,
however, the avenue has changed with the times. Under the Second Empire this was a
street of luxurious town houses. They were supplanted by cafés, nightclubs, luxury
shops, and cinemas, but the Street retained its feeling of luxury, and the tree-shaded
sidewalks (wide as a normal Street) offered promenades that were the pride of Paris.
Since the 1950s, however, banks, automobile showrooms, airline offices, and fast-
food eateries have taken over much of the space.
At the top of the Champs-Elysëes is a circular place from which 12 imposing
avenues radiate to form a star (étoile). It was called Place de l’Etoile from 1753 until
1970, when it was renamed Place Charles de Gaulle. In the centre of the place is the

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Arc de Triomphe, commissioned by Napoleon in 1806. It is twice as high and as wide
as the Arch of Constantine, in Rome, which inspired it. Jean Chaigrin was the
architect and François Rude sculpted the frieze and the spirited group, ‘The Departure
of the Volunteers of 1792” (called “La Marseillaise”). On Armistice Day in 1920, the
Unknown Soldier was buried under the centre of the arch, and each evening the flame
of remembrance is rekindled by a different patriotic group.

The Latin Quarter (Quartier Latin).

At the Concorde Bridge the boulevard Saint-Germain begins, curving

eastward to join the river again at the Sully Bridge. A little less than halfway along
the boulevard is the pre-Gothic church of Saint-Germain des-Prés. The old church,
which belonged to a Benedictine abbey founded in the 8th century, was sacked four
times by Vikings and was rebuilt between 990 and 1201. Parts of the present church
date from that time.
Beyond the boulevard Saint-Michel is the university precinct, self-governing
under the kings, where, in class and out, students and teachers spoke Latin until 1789.
At the junction of the boulevards Saint-Germain and Saint Michel are the remains of
one of the three baths of the Roman city. These are in the grounds of the Cluny
Museum, a Gothic mansion built 1485-1500, which now houses a collection of
medieval works of art, including the renowned six-panel unicorn tapestry “La Dame a
Ia licorne.”
The wide, straight boulevard Saint-Michel is the main street of the student
quarter. It is lined with bookshops, cafés, cafeterias, and movie houses. The buildings
of the university are found on smaller streets. The university was built up of colleges,
each founded and supported by a donor, often a prelate or a religious order. In about
1257 Robert de Sorbon, chaplain to Louis LX, established a college, known as the
Sorbonne, that eventually became the centre of theological study in France. The oldest
part of the Sorbonne is the chapel (1635-42), the gift of Richelieu, who is buried
there. Designed by Lemercier, it was one of a number of new domed Jesuit-style
churches of the period.
The Sorbonne served for centuries as the administrative seat of the University
of Paris. In 1968-71 the university was divided into a number of entirely separate
universities, and the Sorbonne building proper continues to serve as premises for
some of these.
At the top of the hill rising from the river the boulevard skirts the Luxembourg
Gardens, the remains of the park of Marie de Médicis’ Luxembourg Palace (1616-
21), which now houses the French Senate. The gardens are planted with chestnuts and
are enhanced with a pond for toy sailboats, a marionette theatre, and statuary.
Across the boulevard at the end of the rue Soufflot stands the Pantheon (1755-
92), designed by Jacques Germain Soufflot. It was commissioned by Louis XV, after
his recovery from an illness, as a votive offering to St. Genevieve and was to replace
the mouldering 5th- century abbey in her name. Though intended as the principal
church in Paris, it was renamed the Pantheon by the Revolutionary authorities, who
made it the last resting place for heroes of the Revolution. The walling up of a number
of its windows and removal of much interior decoration replaced the intended effect
of light interior space with a gloomy dignity. Among those buried under the
inscription “Aux grands bommes, la Patrie reconnaissante” (“To great men, [ their

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grateful land”) are the authors Victor Hugo, Voltaire, Rousseau, and Zola and Jean
Moulin, chief of the Resistance in World War II.

The Buttes.

The river valley of Paris is almost entirely circled by high ground. Upon the
heights of Passy, on the Right Bank between the western city limits and the Arc de
Triomphe, perch the wealthy neighbourhoods of the 16th arrondissement. The
Butte-Montmartre (18th arrondissement) and the Buttes-
Chaumont( 19th arrondissement), which rise along the northern rim of the city, are
still working-class. The 18th arrondissement has broad avenues, but it also has
winding lanes, some of which become stairways on the steeper hills, From the early
19th century until the migration in the 1920s to Montparnasse, Montmartre was the
major art colony of Paris. Some sections are highly commercialized for the tourist
trade; others, however, are unself-consciously picturesque. Montmartre is known for
its nightclubs and entertainment.
The most noted landmark of Montmartre was built only in 1919: the Sacred
Heart Basilica (Basilique du Sacrd-Coeur), paid for by national subscription after the
French defeat by the Prussians in 1870. The work began in 1876 but was delayed by
the death of the architect, Paul Abadie, who took inspiration from the 12th-century
five-domed Romanesque church of Saint-Front in Périgueux, itself inspired by either
Venetian or Byzantine churches.

Basilique du Sacré-Coeur

Foreign Tours

The Bahamas

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 Officially COMMONWEALTH OF THE BAHAMAS, archipelago and state
on the northwestern edge of the West Indies, consisting of about 700 islands and cays
and more than 2,000 low, barren rock formations, located off the southeastern coast of
Florida, U.S. The archipelago is spread across the Tropic of Cancer and about 90,000
square miles (233,000 square km) of ocean in the western Atlantic. Andros (104 miles
long and 40 miles wide {167 km long and 64 km wide] is the largest of the islands.
The capital is Nassau on New
Providence--the most important island. Area 5,382 square miles (13,939
square km). Pop. (1993 est.) 266,000.

The land.

New Providence has the majority of the archipelago’s population. The rest of
the islands, chief among which are Abaco, Andros, and Eleuthera, are called the
Family, or Out, Islands. All the islands of the archipelago are composed of coraline
limestone, lie mostly only a few feet above sea level, and are generally flat. The
highest point, Mount Alvemia (formerly Como Hill), rises 206 feet (63 m) on Cat
Island. Most of the islands are long and narrow, each rising from its eastern shore to a

417
low ridge, beyond which lie lagoons and mangrove swamps; coral reefs mark the
shorelines. There are no rivers in The Bahamas.
The mild subtropical climate of The Bahamas, with two seasons (winter and
summer is greatly influenced by the Gulf Stream and Atlantic Ocean breezes. The
average temperature varies from 70°F (21°C) during the winter to 81° F (27° C)
during the summer; average annual rainfall is about 44 inches (1,120 mm), though
there is some variation between the islands. The hurricane season lasts from mid-July
to mid-November.
The islands abound in tropical flora, including bougainvillea, jasmine, orchid,
and oleander. Caribbean pine forests occur on some islands, such as Andros, Great
Abaco, and Grand Bahama. Native trees include the black olive, cork tree, and several
species of palm; mahogany, casuarina, and cedar trees have been planted on some
islands. Animal life is dominated by frogs, lizards, and snakes; mosquitoes, sandflies,
and termites are widespread. There are numerous species of birds, including the
flamingo, the national bird. The Inagua National Park on Great Inagua Island is the
home of more than 50,000 West Indian flamingos, the largest such flock in the world.
Salt, aragonite, and limestone are the only commercially important minerals. Salt is
produced largely by solar evaporation from salt beds on Great Inagua.

The people.

The people of The Bahamas are a blend of European and African ancestry, the
latter a legacy of the slave trade. English is the official language, and almost all of the
population is Christian. Baptists account for about one-third of the population, and
Anglicans and Roman Catholics each constitute approximately one-fifth of the total.
Only about 30 of the islands and cays are inhabited. During the 1970s there
was significant rural-to-urban interisland migration, mostly directed to the already
densely populated islands of New Providence (where two-thirds of the populace
lives), Grand Bahama, and Great Abaco. Long Cay, on the other hand, had only a few
dozen inhabitants. Average population density for the country is relatively low.
The population growth rate of The Bahamas was relatively high during the late
1970s (a trend that continued intermittently through the 1980s), mostly because of a
substantial birth rate; consequently, almost two-fifths of the populace is younger than
15 years of age. The death rate is relatively low.

The Economy.

The Bahamas has a predominantly market economy that is heavily dependent

on tourism and international financial services. The gross national product (GNP) is
growing much more rapidly than the population. The GNP per capita is similar to
those of other developed countries.
Agriculture accounts for about one-twentieth of the GNP and employs a
comparable fraction of the workforce. Only about 1 percent of the land is arable, and
soils are shallow. The government has had only limited success in increasing

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agricultural output, and nearly all of the country’s foodstuffs are imported, largely
from the United States. The sunny climate favours the cultivation of tomato,
pineapple, banana, mango, guava, sapodilla, soursop, grapefruit, and sea grape. Some
pigs, sheep, and cattle are raised. The small fishing industry’s catch is dominated by
crayfish, groupers, and conchs.
Mineral industries are limited to the production of salt and cement. Grand
Bahama has several petroleum transshipment terminals. Manufacturing industries
centre on the production of rum and other liquors, cement, pharmaceuticals (including
hormones), canned tomatoes and pineapples, and frozen crayfish. The Industries
Encouragement Act offers manufacturers relief from tariffs and various taxes.
Electricity is generated entirely from imported fuels.
Tourism accounts for as much as two-thirds of the GNP and employs about
two-fifths of the workforce. It centres on New Providence and Grand Bahama; most
tourists come from the United States. Several hundred banks and trust companies
have been attracted to The Bahamas because there are no income or corporation taxes
and because the secrecy of financial transactions is guaranteed. Public expenditures
are constrained by the government’s dependence on indirect taxes, which are levied
primarily on tourism and external trade. The United States is The Bahamas’ principal
trading partner and exempts certain Bahamian products from duties under the
generalized system of preferences. Nassau and Freeport, the latter on Grand Bahama
Island, are the country’s two main ports and also have international airports.

Cultural life.

Outstanding among traditional group activities is the “Junkanoo” parade on

Boxing Day and New Year’s Day. The main thoroughfare is given over to hundreds
of gaily bedecked celebrants who, with clanging cowbells and beating drums, march
and dance to a rhythm of African origin. In Nassau, amateur choral, dramatic, and
dancing groups provide entertainment with much local flavour.

History.

The Bahamas were originally inhabited by a group of Arawak Indians known

as Lucayan. Originally from the South American continent, some of the Arawak had
been driven north into the Caribbean by the Carib Indians. Unlike their Carib
neighbours, the Lucayan were generally peaceful, more involved in fishing than
agriculture, and noncannibalistic.
When Columbus reached the New World in 1492, he is thought to have landed
on San Salvador (also called Watling Island) or possibly Sarnana Cay, both in the
Bahamas. The Spaniards made no attempt to settle but operated slave raids on the
peaceful Arawak that depopulated the islands, and by the time the English arrived the
Bahamas were uninhabited.
In 1629 Charles I of England granted the islands to one of his ministers, but no
attempt at settlement was made. In 1648 William Sayle led a group of English
Puritans from Bermuda to, it is thought, Eleuthera Island. This settlement met with

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extreme adversity and did not prosper, but other Bermudian migrants continued to
arrive. New Providence was settled in 1656. By 1670 the Bahamas were given to the
Duke of Albemarle and five others as a proprietary colony. The proprietors were
mostly uninterested in the islands, and few of the settlements prospered. Piracy
became a way of life for many.
The colony reverted to the crown in 1717, and serious efforts were made to
end the piracy. The first royal governor, Woodes Rogers, succeeded in controlling the
pirates but mostly at his own expense. Little monetary and military support came from
England. Consequently, the islands remained poor and susceptible to Spanish attack.
Held for a few days by the U.S. Navy in 1776, and for almost a year by Spain
in 1782-83, the islands reverted to England in 1783 and received a boost in population
from loyalists and their slaves who fled the United States after the American
Revolution. For a time, cotton plantations brought some prosperity to the islands, but
when the soil gave out and slavery was abolished in 1834, the Bahamas’ endemic
poverty returned.
Two other periods of prosperity followed: the years 1861-65, when the
Bahamas became a centre for blockade runners during the American Civil War, and in
1920-33, when bootlegging became big business during the years of American
Prohibition. But these were economic accidents; not until the tourist industry was
developed after World War II did any form of permanent prosperity come to the
islands.

Som e cases as Possible Entertainm ent

N ew Y or k : B ro a d w a y

The term Broadway is applied to about 38 theatres in Manhattan,

New York, which are either on the street Broadway itself or in the surrounding
streets. Broadway refers more to commercial orientation and to the size of
theatre than to location. Broadway theatres usually have over 1100 seats and operate
for profit. MostBroadway theatres are not on the street but in the TimesSquare area.
The Broadway area including Times Square has had a reputation in the past as
being rather seedy though Mayor' Giuliani’s clean-up campaigns have changed.
Broadway is commercial. for-profit. theatre whereas the not-for-profit theatre is
old-Broadway. There is commercial theatre old-Broadway but it is small
compared with either Broadway itself or the non-profit sector. There is a
particular concentration of off-Broadway theatres in the Greenwich Village area.
Off -Broadway theatres are associated with neweravant-garde productions and new
American productions are more likely lo be found here than on Broadway. Some
productions do though move from off- B roa dw ayto B roadw ay.

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 New York's dominance of theatre in the USA has reduced as regional
theatre, especially in Chicago and Los Angeles, has become more important in the
development of new productions. Many of these then go on to Broadway.
Attendances at Broadway theatres were nearly 12 million in 1998 99
compared with 7 million in 1984 85 but this has not been an uninterrupted growth.
There was for instance, a decline in numbers for most of the 1980s. Playing weeks
have risen from 1078 in 1984 -85 lo 1441 in 1998-99 with a low of 905 in 1991- 92.
The composition of Broadway audiences is similar to that in many oilier places.
Two-thirds are aged 35 or older, three-quarters are Caucasian and over half
(compared with 14 per cent of the US population) have an annual income of $7.5000
or more. 'There has, however, been a doubling,between 1991 and 1997 of the number
of Broadway theatre-goers under the age of 18 partly due to the number of "youth-
friendly' productions. Whilst personal recommendation is the single most important
reason for choosing to see a show, one inl i v e of audiences indicated th at newspaper
reviews were important.
As in London's West End, new openings andexisting playing weeks
on Broadway hav e been dominated by musicals. Broadway isassociated with large
musical and drama productions. The name Broadway has become closely associated
w ith a particular typ e of production such asthe older musicals 'A Chorus Line' and
"42nd Street', which ran for many years. As w i t h main theatrical districts, there is
a v i e w that the nature of productions has changedcompared w i t h the early part of the
t w e n t i e t h cen tu ry . Whereas New York wasregarded as a place where many new
productions occurred each year. Broadway theatres now concentrate on long-running
plays and musicals in particular. Other productions do not get theopportunity to be
seen; th is c ritic ism is lev e lle d at London's West End also. By producing classic
plays and musicals, risk is reduced especially as it is believedthat many peopledesire
th e technological spectacle and d iv e rs io n of m usicals in particular.B ro ad w a y has
become increasingly a place for 'a special e v e n t ' complete with merchandising.
Often productions rely on famous name film or televisionstars to increase ticket
sales. The name Broadway has been used as a term of abuse critics.
by A review . in the
British Sunday Times (April 2000). of the London West End production of 'The
Graduate" included the comment 'the show is like the worst of Broadway, shallow
and celebrity-driven, with ghastly merchandise being sold in thefo y er'.
New York is a major tourist destination including some of the most
famous landmarks in the w orld such as the EmpireState Building and the S ta tu e of
Liberty. In 1999. there were ov er 34 million visit ors to New York city and of these,
nearly 6 million were international, mostly from Canada (0.9 million) and the UK
(0.8 million). Broadway is regarded as atourist attraction of the c it y and the name
has become universally recognized as being 'theatre in New York'. To fac ilitate
booking, there is a charge freeinformation and booking 'hot-line' and the Broadway
Picket Center located in the busy v i s i t o r area of Tim es Square.
Despite this the proportion of audiences who are visitors from the
rest of the USA continues to fall though there has been a slight increase in the
proportion of international v is ito rs (to one in ten of audiences). An increasing
proportion of audiences areresident in New York c i t y or the surrounding suburbs. 'The
suburban elem en t has sh o w n the g rea tes t g ro w th. About 17 % of 'locals' go to a
Broadway show at least once a year and there is a core of regular theatre goers 6 %, who
account for o v e r 30 % of all tickets sold.
There are shows such as"C ats" (running since 1952 making it th e
longest running musical in Broadway history). "Les Miserables". 'Chicago'.
'Phantom of the Opera' and 'Fosse' which are being performed in New

421
York and London (and other c itie s ) at the sametime. In recent y e ar s there has been a
large number of 'imports' of productions from abroad especially from Britain.
These h ave included a new production of"Cabaret" ( 1 9 9 8 ) by Sam Mendes, later th e
Oscar-w inning director of the film 'A m erican B e a u ty ' as w e l l as in 1999, plays
such as Eugene O'Neill's 'The Iceman Cometh` and David Hare's `Via Dolorosa'.
'This is partly a matter of economics, being cheaper to bring in an established play
or musical instead of starting the production process from the beginning. Some
originated in the more heavily subsidized theatre of Europe and, in a sense, the
USA is capitalizing on that inv estm ent of public funds. The risk of new and
'straight" plays is reduced by buying in from elsewhere. 'There is an argument
too that American 'classics' are limited in number compared w i t h those from
Europe. There is however, also a reverse transfer with productions such as
"Chicago and 'Kent" originating in the U SA and then being produced in London.
The economic impact of Broadway on New York city was estimated
at $ 2724 million in 1996-97 and as seen inChapter 8, $ 1719 million of this w a s due
to v i s i t o r spending. T h e total impact w a s calculated by adding the initial visitor
spending other than on tickets to the set-up andoperating costs of Broadway
companies and the spending oncapital improvements to theatres. This w a s subject
to a multiplier effect. Comparedw i t h 1991 92. there w a s a 37 per cent increase in
impact (after allowing for inf la tio n) . The spending of locals was not included as
such. In the case ofv is ito r s from outside the c i t y , the only spending that was
included was that of people who indicated dial Broadway was the main reason for
the visit. In addition, a part of the spending of v i s i t o r s w h o extend ed th eir v is it in
order lo go loB ro ad w ayth ea tre w a s included. The proportions of visitors for whom
Broadway w as the main reason, or was a reason forextending the visit, were not
estimated at the same lime as the audience surveys were undertaken ( 1996-97 ) but
from the earlier Port Authority surveys in 1992.
These Port Authority surveys also estimated economic impact and
included commercial off-Broadway theatre and also 'Road productions'. These are
Broadway shows that are performed elsewhere but which have an economic impact in
New York in the form, for instance, of royalty payments. This impact has been
declining partly because of local financing, because of touring productions originating
elsewhere including the rest of the USA and the influx of productions from the UK.

L on d o n : W est E n d

London, apart from being the centre of government in the UK and a

major international commercial and financial centre, is also the most important tourist
destination in the country. Total tourist visits to London are over 20 million and over
half of these are international. The attractions of London are mostly 'heritage' though
'pop' culture, clubs, fashion, restaurants and lifestyle are claimed to be of increasing

422
importance. London also has a large number of theatres which act as a tourist
attraction. Over a quarter of all professional theatres in the UK are in London and there is
a particular concentration within London's West End. Many of the more significant
theatres in London are members of the Society of London Theatre (SOLT) known, until
1994, as the Society of West End Theatre (SWET). SOLT is a trade association with a
membership of about 50 of London's theatres most of which are 'West End' theatres.
They are located in central London with several distinct, but close,
theatre clusters contributing to the leisure zone of the city. The concentration is itself
considered to have a positive influence on attracting visitors to the city. SOLT
theatres range in size from the relatively small at 250 capacity through to a few larger
theatres at over 2000 seats. Most are operated as commercial concerns and few are
subsidized. Attendances at SOLT theatres during 1997 were about 11.5 million
compared with 10.5 million on Broadway the previous year though Broadway does
include fewer theatres.
It was seen in Chapter 6 how important the West End is in attracting
tourists to London and how the proportion of tourists in audiences has fluctuated. The
share of international tourists in audiences is currently much less than it has been
during the 1980s.
One of the most noticeable recent features of the West End is the
increased importance of musicals and the reduced importance of plays and this has been
linked with the tourist market (domestic and international). Nearly two-thirds of all
attendances in West End theatres in 1997 were at 'modern musicals'. This is
markedly different from the situation outside London. Tourists are a higher
proportion of musical audiencesthan they are for other productions. For main
observers, the tourist audiences are believednot to be particularly) discerning and
want little more than a 'g litzy night out". One theatre c ritic was disappointed, in
1997, that the stage version of Disney’s 'Beauty and the Beast' at the Dominion
theatre was welcomed as favourable for West End jobs and tourism, and not seen as a
threat to national heritage. Another critic condemned as undesirable and a sell-out
to 'West End' values, the programming (in 1998) of the musical 'Oklahoma!' at the
National Theatre. This had been created as 'a radical a lt ern a tiv e to a complacent
commercial theatre .
Not only are musicals denigrated but also then impact on the rest of
theatre is considered undesirable. Musicals and other 'tourist' productions have
long-runs ( ' t h e Mousetrap' since 1952. 'Cats' since 1981 and "Les Miserable*'since
1985) and so-called serious plays are squeezed out and the tu rn o v e r of new p lays is
restricted. It is not ju st musicals th a t are seen as the problem but also r e v i v a l s of
popular p lays, and associated long runs ofmany of these. Access to theatres and to
finance and artistic talent is restricted for the non-musical and the new play. There
are several reported instances of productions, such as the award-winning "the Fate
Middle Classes", being unable to find a West Endven ue because of the desire to
produce musicals, in th at case a musical about a boy band which closed after a few
weeks (I999). The actor and playwright Steven Berkoff complained, a l t e r his
controversial new play 'Messiah' w a s turned down by the NationalTheatre in 2000,
t h a t theatres w e re too sale and w e re u n w illin g to lake risks. It is obviously less
risky for large commercial theatres to produce blockbuster musicals orplays than it
is to put on experim ental,innov a tiv e or controversial productions th a t may not sell
on a large scale. Thetou rist market is onethat is large and co n tin ua lly turning o v e r
and renew ing i t s e l f e v e r y few days or weeks, an ideal scenario for investment in
large-scale spectaculars. Corporat ions are able to absorb early losses and to subsidize
the early days of one production from the revenue of another until the break-even
point is reached.

423
 There are however, some West End theatres, usually subsidized.
which are some of the mosta d v e n tu ro u s and prestigious thea tres in the country: the
Donmar Warehouse, the Royal Court, the Royal National Theatre and the Barbican
until recently a London base for the Royal Shakespeare Company. There have been
a number of successful transfers, such as "Les Miserables' and 'the Herbal Bed', from
the subsidized sector to the commercial sector. In addition to these theatres many of the
more innovative and limited interest productions take place off-West End in smaller
theatres or in regional theatre. It is claimed that a 'significant proportion' of West End
productions have originated in regional or non-SOLT theatre before transfer.
West End productions also transfer to regional theatres often as a
national tour and also to other countries. In 1997, 'Phantom of the Opera' was
performed in Australia, New Zealand and 17 cities in the USA and 'Buddy' in Japan,
Germany, Canada, South Africa and USA. Earnings from international performances
such as these were estimated at between £40 to £60 million in 1997.
The concentration of theatre ownership and of influence over productions
is likely to have had a direct impact on the pattern of programming. Ownership of the
commercial theatres is diverse but certain organizations and individuals appear
dominant. By early 2000, there were two large corporations dominating ownership of
London theatres. The Ambassador Theatre Group, which is part owned by the US
corporation SFX, owned eleven after purchasing nine smaller theatres in February and
the Really Useful Group owned thirteen having purchased ten from Stoll Moss the
previous month. As seen in Chapter 2, SFX had already purchased the large national
Apollo group in 1999, four of whose theatres are in London. The Really Useful Group
is owned by the composer Andrew Lloyd Webber (Cats, Starlight Express, Phantom
of the Opera and many others). The producer Cameron Mackintosh bought two
theatres in 1999 to join the three that his company currently co-owned. The impresario
Bill Kenwright has also been responsible for a large number of West End productions
in recent years. Theatre ownership is therefore being combined in the same organiza-
tion with composition, production, play and concert promotion. There is, in addition, a
concentration of influence into fewer hands including, for instance, through joint
Mackintosh-Webber productions. All of this could lead to significant control and
influence over the programming of theatres in the West End. For the firms concerned,
such integration yields economies and spreads risks.

L as V egas

Las Vegas (Nevada. USA) is perhaps the best-known instance of a

tourist centre with an 'entertainment core'. The main attraction of Las Vegas is
gaming and until recently Nevada was the only stale to legalize casino gaming in
the USA (legalized in 1931). Las Vegas receives over 30 million visitors a year
( 1 99 8 ) of whom 70 percent werethere for vacation, pleasure or traveling. It is also a
major centre for conventions. It claims to have more hotel and motel rooms (at
109.000) than any oilier resortdestination in the world and 19 of the 20 largest
hotels in the world. The MGM Grand, for instance, has o v e r 5000 rooms. At
A tla ntic C i t y most gamblers are day tri
ppers bill Las Vegas is more a destination for
the staying tourists. Most visitors do not have children with them and the average
age is late forties. A high proportion(three-quarters) are repeat visitors and nearly
all gamble during the ir stay. The averagestay is short or ju s t o v e r three n ig h ts but
nearly a third of visitors are from neighboring California, half from the Western

424
states and one in ten is international. Thecity has its own international airport w i t h
direct flights from countries such as the UK and Japan.
The key attraction of Vegas has been gambling but it has a l w a y s been
associated w ith live entertainment. Casinos areusually based in hotels that also
provide a variety of live entertainment in order to attract and retain gaming
customers. Most Las Vegas entertainment is associated with hotels rather than with
separate theatres or concert halls. The musical"Starlight Express' was, for instance,
staged al the Las Vegas Hilton. The entertainment ranges from musicians in bar
and lounge settings through circus and illusionists to national and international
stars in large purpose-built theatres and concert arenas. Some of these operations are
so huge that effectively they operate as separate enterprises. Caesar's Palace (1500
rooms) has a 4500 seat indoor theatre and a 15.300 seat outdoor events stadium and
MGM Grand has a similar size events centre as well as its own 33 acre theme park.
At Circus Circus there is live circus in addition to a 5 acre indoor theme park.
There is a style of show, the glitzy spectacular floor-show with
dancers and singers, that is referred to universally as a 'Las Vegas-type show".
The 'Official Visitors Guide' to Las Vegas refers to 'other parts of the casinos
(w here) entertainers adorned in glittering costumes join forces in lavish stage
spectaculars . . . Extravaganzas costing millions to produce surround visitors in a
fantasy of shapely dancers, intricate choreographs and special effects'. Las Vegas is
also a centre for manyassociated spectaculareven ts including boxing».

Just under half of Las Vegas visitors attend a show during their visit
though spending on shows only accounts for about 8% of expenditure per visitor
compared, for instance, with 38% on food and drink and 22% on shopping.
Entertainment has been regarded as an incidental attraction and has been justified by
its ability to attract people to gamble. It was initially regarded as a loss-leader in order
to attract high-spending gamblers. There is now, however, more emphasis on
entertainment as a profit centre. This, in conjunction with rising costs, has resulted
in a shift from the star-centred shows towards smaller-scale variety (or revue) shows
and musicals.
The city has long had a reputation for being an adult destination with
gaming associated not only with adult entertainment but also organized crime and
prostitution. It has in recent years sought to re-position itself as a tourist destination.
Casino gaming is now legal in more places in the USA, including Atlantic City and
many Native American reservations, and Las Vegas can no longer rely on its virtual
monopoly to attract visitors. It is therefore developing as a family holiday destination.
In order to do this, more family-oriented entertainment has been offered in the form of
virtual reality experiences, theme parks and free open-air events such as an erupting
volcano outside the Mirage hotel and a pirate battle performed outside the Treasure
Island hotel. The emphasis on Las Vegas as a gaming centre has been reduced but it
is still the hotels that maintain a connection with entertainment, albeit in a different
form.
These developments have had mixed fortunes and, whilst such enter-
tainment has undoubtedly broadened the appeal of Las Vegas, some gaming operators
have found that certain forms of entertainment compete with, rather than complement,
gaming. There are several other concerns associated with this re-positioning, such as the
increased number of 'non-gamblers' and 'low-roller' gamblers in the city and the loss of
its distinctive character. In addition some casino executives are not skilled in providing
these types of experience and there have been some noticeable failures. There has been
a concern that the city has gone too far along the route of a family-friendly destination
and some business people have been anxious to maintain the reputation as an adult

425
destination. This is partly due to the lower gaming spend of tourists with children.
Nonetheless some of the more recent developments, such as the New York, New York
with its own rollercoaster and the Venetian Casino Resort complete with upscale
shopping mall and Grand Canal, have continued the wider appeal.
Las Vegas is very much a one-industry city with just over half of the
labour force in southern Nevada being employed in the city's tourist and gaming
sector. It has been pointed out that this means low-skill, low-wage and un-
unionized employment for many and also an excessive influence of the 'Mining and
hold corporations on the political and development process. Since the l950s there
arc now fewer individuals and more corporations owning and operating casinos in
the city. The needs of the industry may have been prioritized over the social
community and welfare needs of the local population and the sustainability of the
local natural environment. There would appear lo he a coalition of interests between
local hotel-casino operators, other business people, development agencies, the
visitor bureau, airlines and local government that exerts a powerful influence in
encouraging free- enterprise and gro w th.

B r itish se a sid e r e so r ts: e a r ly d ev e lo p m en ts

There are features of the seaside resort in Britain in the past that have
been unique features of the entertainment industry. The significance of this lies in
the fact that their influence lingers on to the present-day. As seaside resorts became
more popular during the kilter part of the nineteenth century there was considerable
investment in theatres, pavilions, concert halls and 'pleasure palaces'. Some of
these, such as the Winter Gardens in Blackpool (1878), initially represented a
more serious purpose by including gardens and library. The Winter Gardens in R hyl
(North Wales) built in 1876 included a zoo, theatre, seal pond and skating rink. At
this time music hall w a s flourishing and halls were built in resorts, firmly
establishing the tradition of the variety show al the seaside.
As th e seaside began loa t t r a c t th e w o rk in g classes there w a s a need to
change what wa s on offer and from the end of the nineteenth century investment in
entertainmentrose dramatically. Theatres and hallsexisted in many resorts offering
variety, melodrama and farce and more "serious" plays, drama and musicals during
the season lo a predominantly middle class audience alongside a more informal,
often out-door and beach entertainment. These included circuses, fairgrounds,
"black-face' minstrels. Pierrots and Punch and Judy shows geared to a more
working class audience. The Punch and Judy Show has been synonymous with the
seaside though it had originated al inland fairs. The "black-lace' minstrels were a
prominent feature of English seaside resorts, dominating popular entertainment
until the "more refined' Pierrots, originating in France, appeared.
Entertainment became increasingly commercial.
Some of the attractions became more bizarre and included waxworks
and freak shows as well as an assortment offortune tellers and healers and talks,
lectures and lantern slides by dubious 'experts'. A major attraction in several
resorts during the l930s was the "Rector of Stiffkey' who had been dismissal from
the church for sexual misconduct. He earned a living in a sideshow in Blackpool
which included him living in a barrel and also being "devoured in the flames of

426
hell", lie later appeared in a show in Skegness only to he killed by one of the lions
in l938.
Piers were also particularly associated with entertainment. Although
most were originally intended for the arrival and departure of ships, they soon
became geared towards entertainment. Holiday-makers were able to extend their
walking and display from the promenade itself to a promenade over the sea. Piers
often included money-generating facilities such as pavilions and concert halls,
refreshment rooms, machines and mechanical devices, booths and kiosks. There
was often an 'end-of-the-pier show' performed by concert parties of small groups
of artists all of whom sang, danced, told jokes and performed short sketches. They
were particularly popular from the l920s through to the late l930s.
Military and brass bands also played in open-air bandstands and in
pier pavilions. Most resorts also had an orchestra, however small, which
invariably played in pavilions on piers. Most resorts had an orchestra at some time
during the late nineteenth and early twentieth centuries and the continuing existence
of orchestras owes a great deal to the holiday-maker. The conductors, musicians and
singers were among the most able and famous of the day. They included (S i r)
Malcolm Sargent at the seaside town of Llandudno (Wales) who was later
conductor of many famous orchestras and chief conductor of the annual BBC Proms
festival 1948-66 and Granville Bantock ( at New Brighton, a resort near Liverpool)
who was later Professor of Music at Birmingham University. As employment in
such orchestras w as usually seasonal, musicians from non-tourist area orchestras
were able to find year-round employment. In the early part of the twentieth century
the Pier Orchestra at Llandudno was made up largely of members of the Halle
Orchestra (Manchester), which is Britain's longest established professional
symphony orchestra (founded 1858). The seaside resort of Bournemouth, on the
south coast of England, had the distinction of having the first year-round permanent
orchestra in England (1893) and it has since become an important touring symphony
orchestra. Musical programmes were usually short and light for background or
promenading, but most orchestras endeavoured to provide symphony concerts in
addition and to work the 'more serious' works into their programmes.
The holiday camp is also of particularsignificance in the history of
holidays and entertainment. All-inclusive centres for a holiday had existed for
some lime. Some originated in the early twentieth century as a form of sell help,
sell-improvement movement where a sense of community in a healthy
environment could he fostered. These holidays, often in tents, included organized
games and entertainments that were often self-entertainment. Commercial camps
emerged during the 1930s and of particular significance were the holiday camps
established by Bill Butlin (initially in Skegness in 1937 for 1000 campers and in
Clacton in 1939). Holiday-makers did not need to leave the holiday camps during
their slay as apart from the chalet-type accommodation, there were catering halls,
swimming pools, games and sports areas , theatres and dance halls. Access to all of
these was without further charge. In the seaside tradition, entertainment followed
the variety revue pattern and also dance bands and children's entertainers. There
was also an emphasis on holiday-makers making their own entertainment.
Organizers variously known as Red Coats (Butlins) or Blue Coats (Pontius)
organized games and competitions for campers and entertainment by campers as
w ell pulling on shows themselves. The holiday camp was particularly popular
during the l950s. They were major providers of seaside entertainment and were a
significant 'breeding-ground' for new performing talent.

ENGLISH COURSE FOR ECTS AND MANAGEMENT

427
 Marketing and merchandising

Marketing is a process whose principal function is to promote and facilitate

exchange. Through marketing, individuals and groups obtain what they need and want
by exchanging products and services with other parties. Such a process can occur only
when there are at least two parties, each of whom has something to offer. In addition,
exchange cannot occur unless the parties are able to communicate about and to deliver
what they offer. Marketing is not a coercive process: all parties must be free to accept
or reject what others are offering. So defined, marketing is distinguished from other
modes of obtaining desired goods, such as through self-production, begging, theft, or
force. Marketing is not confined to any particular type of economy, because goods
must be exchanged and therefore marketed in all economies and societies except
perhaps in the most primitive. Furthermore, marketing is not a function that is limited
to profit-oriented business; even such institutions as hospitals, schools, and museums
engage in some forms of marketing. Within the broad scope of marketing,
merchandising is concerned more specifically with promoting the sale of goods and
services to consumers (i.e., retailing) and hence is more characteristic of free-market
economies. Based on these criteria, marketing can take a variety of forms: it can be a
set of functions, a department within an organization, a managerial process, a
managerial philosophy, and a social process.
THE EVOLVING DISCIPLINE OF MARKETING
The marketing discipline had its origins in the early 20th century as an
offspring of economics. Economic science had neglected the role of middlemen and
the role of functions other than price in the determination of demand levels and
characteristics. Early marketing economists examined agricultural and industrial
markets and described them in greater detail than the classical economists. This
examination resulted in the development of three approaches to the analysis of
marketing activity: the commodity, the institution, and the function.
Commodity analysis studies the ways in which a
product or product group is brought to market. A commodity analysis of milk, for
example, traces the ways in which milk is collected at individual dairy farms,
transported to and processed at local dairy cooperatives, and shipped to grocers and
supermarkets for consumer purchase. Institutional analysis describes the types of
businesses that play a prevalent role in marketing, such as wholesale or retail
institutions. For instance, an institutional analysis of clothing wholesalers examines
the ongoing concerns that wholesalers face in order to ensure both the correct supply
for their customers and the appropriate inventory and shipping capabilities. Finally, a
functional analysis examines the general tasks that marketing performs. For example,
any marketing effort must ensure that the product is transported from the supplier to
the customer. In some industries, this transportation function may be handled by a
truck, while in others it may be done by mail, facsimile, television signal, or airline.
All these institutions perform the same function.
As the study of marketing became more prevalent throughout the 20th century,
large companies--particularly mass consumer manufacturers--began to recognize the
importance of market research, better product design, effective distribution, and
sustained communication with consumers in the success of their brands. Marketing
concepts and techniques later moved into the industrial-goods sector and subsequently
into the services sector. It soon became apparent that organizations and individuals

428
market not only goods and services but also ideas (social marketing), places (location
marketing), personalities (celebrity marketing), events (event marketing), and even
the organizations themselves (public relations).

ROLES OF MARKETING
As marketing developed, it took a variety of forms. It was noted above that
marketing can be viewed as a set of functions in the sense that certain activities are
traditionally associated with the exchange process. A common but incorrect view is
that selling and advertising are the only marketing activities. Yet, in addition to
promotion, marketing includes a much broader set of functions, including product
development, packaging, pricing, distribution, and customer service.
Many organizations and businesses assign responsibility for these
marketing functions to a specific group of individuals within the organization. In this
respect, marketing is a unique and separate entity. Those who make up the marketing
department may include brand and product managers, marketing researchers, sales
representatives, advertising and promotion managers, pricing specialists, and
customer service personnel.
As a managerial process, marketing is the way in which an organization
determines its best opportunities in the marketplace, given its objectives and
resources. The marketing process is divided into a strategic and a tactical phase. The
strategic phase has three components--segmentation, targeting, and positioning (STP).
The organization must distinguish among different groups of customers in the market
(segmentation), choose which group(s) it can serve effectively (targeting), and
communicate the central benefit it offers to that group (positioning). The marketing
process includes designing and implementing various tactics, commonly referred to as
the "marketing mix," or the "4 Ps": product, price, place (or distribution), and
promotion. The marketing mix is followed by evaluating, controlling, and revising the
marketing process to achieve the organization's objectives The
managerial philosophy of marketing puts central emphasis on customer satisfaction as
the means for gaining and keeping loyal customers. Marketers urge their
organizations to carefully and continually gauge target customers' expectations and to
consistently meet or exceed these expectations. In order to accomplish this, everyone
in all areas of the organization must focus on understanding and serving customers; it
will not succeed if all marketing occurs only in the marketing department. Marketing,
consequently, is far too important to be done solely by the marketing department.
Marketers also want their organizations to move from practicing transaction-oriented
marketing, which focuses on individual exchanges, to relationship-driven marketing,
which emphasizes serving the customer over the long term. Simply getting new
customers and losing old ones will not help the organization achieve its objectives.
Finally, marketing is a social process that occurs in all economies, regardless of their
political structure and orientation. It is the process by which a society organizes and
distributes its resources to meet the material needs of its citizens. However, marketing
activity is more pronounced under conditions of goods surpluses than goods
shortages. When goods are in short supply, consumers are usually so desirous of
goods that the exchange process does not require significant promotion or facilitation.
In contrast, when there are more goods and services than consumers need or want,
companies must work harder to convince customers to exchange with them.
THE MARKETING PROCESS
The marketing process consists of four elements: strategic marketing analysis,
marketing-mix planning, marketing implementation, and marketing control.

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 Strategic marketing analysis

MARKET SEGMENTS

The aim of marketing in profit-oriented organizations is to meet needs

profitably. Companies must therefore first define which needs--and whose needs--
they can satisfy. For example, the personal transportation market consists of people
who put different values on an automobile's cost, speed, safety, status, and styling. No
single automobile can satisfy all these needs in a superior fashion; compromises have
to be made. Furthermore, some individuals may wish to meet their personal
transportation needs with something other than an automobile, such as a motorcycle, a
bicycle, or a bus or other form of public transportation. Because of such variables, an
automobile company must identify the different preference groups, or segments, of
customers and decide which group(s) they can target profitably.

MARKET NICHES

Segments can be divided into even smaller groups, called subsegments or

niches. A niche is defined as a small target group that has special requirements. For
example, a bank may specialize in serving the investment needs of not only senior
citizens but also senior citizens with high incomes and perhaps even those with
particular investment preferences. It is more likely that larger organizations will serve
the larger market segments (mass marketing) and ignore niches. As a result, smaller
companies typically emerge that are intimately familiar with a particular niche and
specialize in serving its needs.

MARKETING TO INDIVIDUALS

A growing number of companies are now trying to serve "segments of one."

They attempt to adapt their offer and communication to each individual customer.
This is understandable, for instance, with large industrial companies that have only a
few major customers. For example, The Boeing Company (United States) designs its
747 planes differently for each major customer, such as United Airlines, Inc., or
American Airlines, Inc. Serving individual customers is increasingly possible with the
advent of database marketing, through which individual customer characteristics and
purchase histories are retained in company information systems. Even mass-
marketing companies, particularly large retailers and catalog houses, compile
comprehensive data on individual customers and are able to customize their offerings
and communications.

POSITIONING

A key step in marketing strategy, known as positioning, involves creating and

communicating a message that clearly establishes the company or brand in relation to
competitors. Thus, Volvo Aktiebolaget (Sweden) has positioned its automobile as the
"safest," and Daimler-Benz AG (Germany), manufacturer of Mercedes-Benz vehicles,
has positioned its car as the best "engineered." Some products may be positioned as

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"outstanding" in two or more ways. However, claiming superiority along several
dimensions may hurt a company's credibility because consumers will not believe that
any one offering can excel in all dimensions. Furthermore, although the company may
communicate a particular position, customers may perceive a different image of the
company as a result of their actual experiences with the company's product or through
word of mouth.
Marketing-mix planning
Having developed a strategy, a company must then decide which tactics will
be most effective in achieving strategy goals. Tactical marketing involves creating a
marketing mix of four components--product, price, place, promotion--that fulfills the
strategy for the targeted set of customer needs.

PRODUCT

Product development.
The first marketing-mix element is the product, which refers to the offering or
group of offerings that will be made available to customers. In the case of a physical
product, such as a car, a company will gather information about the features and
benefits desired by a target market. Before assembling a product, the marketer's role is
to communicate customer desires to the engineers who design the product or service.
This is in contrast to past practice, when engineers designed a product based on their
own preferences, interests, or expertise and then expected marketers to find as many
customers as possible to buy this product. Contemporary thinking calls for products to
be designed based on customer input and not solely on engineers' ideas.

In traditional economies, the goods produced and consumed often remain the
same from one generation to the next--including food, clothing, and housing. As
economies develop, the range of products available tends to expand, and the products
themselves change. In contemporary industrialized societies, products, like people, go
through life cycles: birth, growth, maturity, and decline. This constant replacement of
existing products with new or altered products has significant consequences for
professional marketers. The development of new products involves all aspects of a
business--production, finance, research and development, and even personnel
administration and public relations.

Packaging and branding.

Packaging and branding are also substantial components in the marketing of a
product. Packaging in some instances may be as simple as customers in France
carrying long loaves of unwrapped bread or small produce dealers in Italy wrapping
vegetables in newspapers or placing them in customers' string bags. In most
industrialized countries, however, the packaging of merchandise has become a major
part of the selling effort, as marketers now specify exactly the types of packaging that
will be most appealing to prospective customers. The importance of packaging in the
distribution of the product has increased with the spread of self-service purchases--in
wholesaling as well as in retailing. Packaging is sometimes designed to facilitate the
use of the product, as with aerosol containers for room deodorants. In Europe such
condiments as mustard, mayonnaise, and ketchup are often packaged in tubes. Some
packages are reusable, making them attractive to customers in poorer countries where
metal containers, for instance, are often highly prized.

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 Marketing a service product.
The same general marketing approach about the product applies to the
development of service offerings as well. For example, a health maintenance
organization (HMO) must design a contract for its members that describes which
medical procedures will be covered, how much physician choice will be available,
how out-of-town medical costs will be handled, and so forth. In creating a successful
service mix, the HMO must choose features that are preferred and expected by target
customers, or the service will not be valued in the marketplace.

PRICE

The second marketing-mix element is price. Ordinarily companies determine

a price by gauging the quality or performance level of the offer and then selecting a
price that reflects how the market values its level of quality. However, marketers also
are aware that price can send a message to a customer about the product's presumed
quality level. A Mercedes-Benz vehicle is generally considered to be a high-quality
automobile, and it therefore can command a high price in the marketplace. But, even
if the manufacturer could price its cars competitively with economy cars, it might not
do so, knowing that the lower price might communicate lower quality. On the other
hand, in order to gain market share, some companies have moved to "more for the
same" or "the same for less" pricing, which means offering prices that are consistently
lower than those of their competitors. This kind of discount pricing has caused firms
in such industries as airlines and pharmaceuticals (which used to charge a price
premium based on their past brand strength and reputation) to significantly reevaluate
their marketing strategies.

PLACE

Place, or where the product is made available, is the third element of the
marketing mix and is most commonly referred to as distribution. When a product
moves along its path from producer to consumer, it is said to be following a channel
of distribution. For example, the channel of distribution for many food products
includes food-processing plants, warehouses, wholesalers, and supermarkets. By
using this channel, a food manufacturer makes its products easily accessible by
ensuring that they are in stores that are frequented by those in the target market. In
another example, a mutual funds organization makes its investment products available
by enlisting the assistance of brokerage houses and banks, which in turn establish
relationships with particular customers. However, each channel participant can handle
only a certain number of products: space at supermarkets is limited, and investment
brokers can keep abreast of only a limited number of mutual funds. Because of this,
some marketers may decide to skip steps in the channel and instead market directly to
buyers through direct mail, telemarketing, door-to-door selling, shopping via
television (a growing trend in the late 20th century), or factory outlets.

PROMOTION

Promotion, the fourth marketing-mix element, consists of several methods of

communicating with and influencing customers. The major tools are sales force,
advertising, sales promotion, and public relations.

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 Sales force.
Sales representatives are the most expensive means of promotion, because
they require income, expenses, and supplementary benefits. Their ability to
personalize the promotion process makes salespeople most effective at selling
complex goods, big-ticket items, and highly personal goods--for example, those
related to religion or insurance. Salespeople are trained to make presentations, answer
objections, gain commitments to purchase, and manage account growth. Some
companies have successfully reduced their sales-force costs by replacing certain
functions (for example, finding new customers) with less expensive methods (such as
direct mail and telemarketing).

Advertising.
Advertising includes all forms of paid, nonpersonal communication and
promotion of products, services, or ideas by a specified sponsor. Advertising appears
in such media as print (newspapers, magazines, billboards, flyers) or broadcast (radio,
television). Print advertisements typically consist of a picture, a headline, information
about the product, and occasionally a response coupon. Broadcast advertisements
consist of an audio or video narrative that can range from short 15-second spots to
longer segments known as infomercials, which generally last 30 or 60 minutes.
Sales promotion.
While advertising presents a reason to buy a product, sales promotion offers a
short-term incentive to purchase. Sales promotions often attract brand switchers
(those who are not loyal to a specific brand) who are looking primarily for low price
and good value. Thus, especially in markets where brands are highly similar, sales
promotions can cause a short-term increase in sales but little permanent gain in
market share. Alternatively, in markets where brands are quite dissimilar, sales
promotions can alter market shares more permanently. The use of promotions has
risen considerably during the late 20th century. This is due to a number of factors
within companies, including an increased sophistication in sales promotion techniques
and greater pressure to increase sales. Several market factors also have fostered this
increase, including a rise in the number of brands (especially similar ones) and a
decrease in the efficiency of traditional advertising due to increasingly fractionated
consumer markets.
Public relations.
Public relations, in contrast to advertising and sales promotion, generally
involves less commercialized modes of communication. Its primary purpose is to
disseminate information and opinion to groups and individuals who have an actual or
potential impact on a company's ability to achieve its objectives. In addition, public
relations specialists are responsible for monitoring these individuals and groups and
for maintaining good relationships with them. One of their key activities is to work
with news and information media to ensure
appropriate coverage of the company's activities and products. Public relations
specialists create publicity by arranging press conferences, contests, meetings, and
other events that will draw attention to a company's products or services. Another
public relations responsibility is crisis management--that is, handling situations in
which public awareness of a particular issue may dramatically and negatively impact
the company's ability to achieve its goals. For example, when it was discovered that
some bottles of Perrier sparkling water might have been tainted by a harmful
chemical, Source Perrier, SA's public relations team had to ensure that the general
consuming public did not thereafter automatically associate Perrier with tainted water.

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Other public relations activities include lobbying, advising management about public
issues, and planning community events.
Because public relations does not always seek to impact sales or
profitability directly, it is sometimes seen as serving a function that is separate from
marketing. However, some companies recognize that public relations can work in
conjunction with other marketing activities to facilitate the exchange process directly
and indirectly. These organizations have established marketing public relations
departments to directly support corporate and product promotion and image
management.
Marketing implementation.
Companies have typically hired different agencies to help in the development
of advertising, sales promotion, and publicity ideas. However, this often results in a
lack of coordination between elements of the promotion mix. When components of
the mix are not all in harmony, a confusing message may be sent to consumers. For
example, a print advertisement for an automobile may emphasize the car's exclusivity
and luxury, while a television advertisement may stress rebates and sales, clashing
with this image of exclusivity. Alternatively, by integrating the marketing elements, a
company can more efficiently utilize its resources. Instead of individually managing
four or five different promotion processes, the company manages only one. In
addition, promotion expenditures are likely to be better allocated, because differences
among promotion tools become more explicit. This reasoning has led to integrated
marketing communications, in which all promotional tools are considered to be part
of the same effort, and each tool receives full consideration in terms of its cost and
effectiveness.
Marketing evaluation and control
No marketing process, even the most carefully developed, is guaranteed to
result in maximum benefit for a company. In addition, because every market is
changing constantly, a strategy that is effective today may not be effective in the
future. It is important to evaluate a marketing program periodically to be sure that it is
achieving its objectives.

MARKETING CONTROL

There are four types of marketing control, each of which has a different
purpose: annual-plan control, profitability control, efficiency control, and strategic
control.
Annual-plan control.
The basis of annual-plan control is managerial objectives--that is to say,
specific goals, such as sales and profitability, that are established on a monthly or
quarterly basis. Organizations use five tools to monitor plan performance. The first is
sales analysis, in which sales goals are compared with actual sales and discrepancies
are explained or accounted for. A second tool is market-share analysis, which
compares a company's sales with those of its competitors. Companies can express
their market share in a number of ways, by comparing their own sales to total market
sales, sales within the market segment, or sales of the segment's top competitors.
Third, marketing expense-to-sales analysis gauges how much a company spends to
achieve its sales goals. The ratio of marketing expenses to sales is expected to
fluctuate, and companies usually establish an acceptable range for this ratio. In
contrast, financial analysis estimates such expenses (along with others) from a
corporate perspective. This includes a comparison of profits to sales (profit margin),
sales to assets (asset turnover), profits to assets (return on assets), assets to worth

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(financial leverage), and, finally, profits to worth (return on net worth). Finally,
companies measure customer satisfaction as a means of tracking goal achievement.
Analyses of this kind are generally less quantitative than those described above and
may include complaint and suggestion systems, customer satisfaction surveys, and
careful analysis of reasons why customers switch to a competitor's product.

Profitability control.
Profitability control and efficiency control allow a company to closely monitor
its sales, profits, and expenditures. Profitability control demonstrates the relative
profit-earning capacity of a company's different products and consumer groups.
Companies are frequently surprised to find that a small percentage of their products
and customers contribute to a large percentage of their profits. This knowledge helps a
company allocate its resources and effort.

Efficiency control.
Efficiency control involves micro-level analysis of the various elements of the
marketing mix, including sales force, advertising, sales promotion, and distribution.
For example, to understand its sales-force efficiency, a company may keep track of
how many sales calls a representative makes each day, how long each call lasts, and
how much each call costs and generates in revenue. This type of analysis highlights
areas in which companies can manage their marketing efforts in a more productive
and cost-effective manner.

Strategic control.
Strategic control processes allow managers to evaluate a company's marketing
program from a critical long-term perspective. This involves a detailed and objective
analysis of a company's organization and its ability to maximize its strengths and
market opportunities. Companies can use two types of strategic control tools. The
first, which a company uses to evaluate itself, is called a marketing-effectiveness
rating review. In order to rate its own marketing effectiveness, a company examines
its customer philosophy, the adequacy of its marketing information, and the efficiency
of its marketing operations. It will also closely evaluate the strength of its marketing
strategy and the integration of its marketing tactics.

MARKETING AUDIT

The second evaluation tool is known as a marketing audit. This is a

comprehensive, systematic, independent, and periodic analysis that a company uses to
examine its strengths in relation to its current and potential market(s). Such an
analysis is comprehensive because it covers all aspects of the marketing climate
(unlike a functional audit, which analyzes one marketing activity), looking at both
macro-environment factors (demographic, economic, ecological, technological,
political, and cultural) and micro- or task-environment factors (markets, customers,
competitors, distributors, dealers, suppliers, facilitators, and publics). The audit
includes analyses of the company's marketing strategy, marketing organization,

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marketing systems, and marketing productivity. It must be systematic in order to
provide concrete conclusions based on these analyses. To ensure objectivity, a
marketing audit is best done by a person, department, or organization that is
independent of the company or marketing program. Marketing audits should be done
not only when the value of a company's current marketing plan is in question; they
must be done periodically in order to isolate and solve problems before they arise.

THE MARKETING ACTORS

The elements that play a role in the marketing process can be divided into
three groups: customers, distributors, and facilitators. In addition to interacting with
one another, these groups must interact within a business environment that is affected
by a variety of forces, including governmental, economic, and social influences.
Customers
In order to understand target customers, certain questions must be answered:
Who constitutes the market segment? What do they buy and why? And how, when,
and where do they buy? Knowing who constitutes the market segment is not simply a
matter of knowing who uses a product. Often, individuals other than the user may
participate in or influence a purchasing decision. Several individuals may play various
roles in the decision-making process. For instance, in the decision to purchase an
automobile for a small family business, the son may be the initiator, the daughter may
be an influencer, the wife may be the decider, the purchasing manager may be the
buyer, and the husband may be the user. In other words, the son may read in a
magazine that businesses can save money and decrease tax liability by owning or
leasing company transportation. He may therefore initiate the product search process
by raising this issue at a weekly business meeting. However, the son may not be the
best-qualified to gather and process information about automobiles, because the
daughter worked for several years in the auto industry before joining the family
business. Although the daughter's expertise and research efforts may influence the
process, she may not be the key decision maker. The mother, by virtue of her position
in the business and in the family, may make the final decision about which car to
purchase. However, the family uncle may have good negotiation skills, and he may be
the purchasing agent. Thus, he will go to different car dealerships in order to buy the
chosen car at the best possible price. Finally, despite the involvement of all these
individuals in the purchase process, none of them may actually drive the car. It may
be purchased so that the father may use it for his frequent sales calls. In other
instances, an individual may handle more than one of these purchasing functions and
may even be responsible for all of them. The key is that a marketer must recognize
that different people have different influences on the purchase decision, and these
factors must be taken into account in crafting a marketing strategy.
In addition to knowing to whom the marketing efforts are targeted, it is
important to know which products target customers tend to purchase and why they do
so. Customers do not purchase "things" as much as they purchase services or benefits
to satisfy needs. For instance, a conventional oven allows users to cook and heat food.
Microwave oven manufacturers recognized that this need could be fulfilled--and done
so more quickly--with a technology other than conventional heating. By focusing on
needs rather than on products, these companies were able to gain a significant share in
the food cooking and heating market. Knowledge of
when, where, and how purchases are made is also useful. A furniture store whose
target customers tend to
make major purchases in the spring may send its mailings at the beginning of
this season. A food vendor may set up a stand near the door of a busy office complex
so that employees must pass the stand on their way to lunch. And a jeweler who
knows that customers prefer to pay with credit cards may ensure that all major credit

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cards are accepted at the store. In other cases, marketers who understand specifics
about buying habits and preferences also may try to alter them. Thus, a remotely
situated wholesale store may use deeply discounted prices to lure customers away
from the more conveniently located shopping malls.
Customers can be divided into two categories: consumer customers, who
purchase goods and services for use by themselves and by those with whom they live;
and business customers, who purchase goods and services for use by the organization
for which they work. Although there are a number of similarities between the
purchasing approaches of each type of customer, there are important differences as
well.

CONSUMER CUSTOMERS

Factors influencing consumers.

Four major types of factors influence consumer buying behaviour: cultural,
social, personal, and psychological.

Cultural factors.

Cultural factors have the broadest influence, because they constitute a stable
set of values, perceptions, preferences, and behaviours that have been learned by the
consumer throughout life. For example, in Western cultures consumption is often
driven by a consumer's need to express individuality, while in Eastern cultures
consumers are more interested in conforming to group norms. In addition to the
influence of a dominant culture, consumers may also be influenced by several
subcultures. In Quebec the dominant culture is French-speaking, but one influential
subculture is English-speaking. Social class is also a subcultural factor: members of
any given social class tend to share similar values, interests, and behaviours.

Social factors.

A consumer may interact with several individuals on a daily basis, and the
influence of these people constitutes the social factors that impact the buying process.
Social factors include reference groups--that is, the formal or informal social groups
against which consumers compare themselves. Consumers may be influenced not
only by their own membership groups but also by reference groups of which they
wish to be a part. Thus, a consumer who wishes to be considered a successful white-
collar professional may buy a particular kind of clothing because the people in this
reference group tend to wear that style. Typically, the most influential reference group
is the family. In this case, family includes the people who raised the consumer (the
"family of orientation") as well as the consumer's spouse and children (the "family of
procreation"). Within each group, a consumer will be expected to play a specific role
or set of roles dictated by the norms of the group. Roles in each group generally are
tied closely to status.

Personal factors.

Personal factors include individual characteristics that, when taken in

aggregate, distinguish the individual from others of the same social group and culture.

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These include age, life-cycle stage, occupation, economic circumstances, and
lifestyle. A consumer's personality and self-conception will also influence his or her
buying behaviour.

Psychological factors.

Finally, psychological factors are the ways in which human thinking and
thought patterns influence buying decisions. Consumers are influenced, for example,
by their motivation to fulfill a need. In addition, the ways in which an individual
acquires and retains information will affect the buying process significantly.
Consumers also make their decisions based on past experiences--both positive and
negative.
Consumer buying tasks.
A consumer's buying task is affected significantly by the level of purchase
involvement. The level of involvement describes how important the decision is to the
consumer; high involvement is usually associated with purchases that are expensive,
infrequent, or risky. Buying also is affected by the degree of difference between
brands in the product category. The buying task can be grouped into four categories
based on whether involvement is high or low and whether brand differences are great
or small.

High-involvement purchases.

Complex buying behaviour occurs when the consumer is highly involved with
the purchase and when there are significant differences between brands. This
behaviour can be associated with the purchase of a new home or of an advanced
computer. Such tasks are complex because the risk is high (significant financial
commitment), and the large differences among brands or products require gathering a
substantial amount of information prior to purchase. Marketers who wish to influence
this buying task must help the consumer process the information as readily as
possible. This may include informing the consumer about the product category and its
important attributes, providing detailed information about product benefits, and
motivating sales personnel to influence final brand choice. For instance, realtors may
offer consumers a book or a video featuring photographs and descriptions of each
available home. And a computer salesperson is likely to spend

time in the retail store providing information to customers who have questions.
Dissonance-reducing buying
behaviour occurs when the consumer is highly involved but sees little difference
between brands. This is likely to be the case with the purchase of a lawn mower or a
diamond ring. After making a purchase under such circumstances, a consumer is
likely to experience the dissonance that comes from noticing that other brands would
have been just as good, if not slightly better, in some dimensions. A consumer in such
a buying situation will seek information or ideas that justify the original purchase.

Low-involvement purchases.

There are two types of low-involvement purchases. Habitual buying behaviour

occurs when involvement is low and differences between brands are small.
Consumers in this case usually do not form a strong attitude toward a brand but select

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it because it is familiar. In these markets, promotions tend to be simple and repetitive
so that the consumer can, without much effort, learn the association between a brand
and a product class. Marketers may also try to make their product more involving. For
instance, toothpaste was at one time purchased primarily out of habit, but Proctor and
Gamble Co. introduced a brand, Crest toothpaste, that increased consumer
involvement by raising awareness about the importance of good dental hygiene.

Brand differences.

Variety-seeking buying behaviour occurs when the consumer is not involved

with the purchase, yet there are significant brand differences. In this case, the cost of
switching products is low, and so the consumer may, perhaps simply out of boredom,
move from one brand to another. Such is often the case with frozen desserts, breakfast
cereals, and soft drinks. Dominant firms in such a market situation will attempt to
encourage habitual buying and will try to keep other brands from being considered by
the consumer. These strategies reduce customer switching behaviour. Challenger
firms, on the other hand, want consumers to switch from the market leader, so they
will offer promotions, free samples, and advertising that encourage consumers to try
something new.
The consumer buying process.
The purchase process is initiated when a consumer becomes aware of a need.
This awareness may come from an internal source such as hunger or an external
source such as marketing communications. Awareness of such a need motivates the
consumer to search for information about options with which to fulfill the need. This
information can come from personal sources, commercial sources, public or
government sources, or the consumer's own experience. Once alternatives have been
identified through these sources, consumers evaluate the options, paying particular
attention to those attributes the consumer considers most important. Evaluation
culminates with a purchase decision, but the buying process does not end here. In fact,
marketers point out that a purchase represents the beginning, not the end, of a
consumer's relationship with a company. After a purchase has been made, a satisfied
consumer is more likely to purchase another company product and to say positive
things about the company or its product to other potential purchasers. The opposite is
true for dissatisfied consumers. Because of this fact, many companies continue to
communicate with their customers after a purchase in an effort to influence post-
purchase satisfaction and behaviour.
For example, a plumber may be motivated to consider buying a new set of
tools because his old set of tools is getting rusty. To gather information about what
kind of new tool set to buy, this plumber may examine the tools of a colleague who
just bought a new set, read advertisements in plumbing trade magazines, and visit
different stores to examine the sets available. The plumber then processes all the
information collected, focusing perhaps on durability as one of the most important
attributes. In making a particular purchase, the plumber initiates a relationship with a
particular tool company. This company may try to enhance post-purchase loyalty and
satisfaction by sending the plumber promotions about new tools.

BUSINESS CUSTOMERS

Business customers, also known as industrial customers, purchase products or

services to use in the production of other products. Such industries include

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agriculture, manufacturing, construction, transportation, and communication, among
others. They differ from consumer markets in several respects. Because the customers
are organizations, the market tends to have fewer and larger buyers than consumer
markets. This often results in closer buyer-seller relationships, because those who
operate in a market must depend more significantly on one another for supply and
revenue. Business customers also are more concentrated; for instance, in the United
States more than half of the country's business buyers are concentrated in only seven
states. Demand for business goods is derived demand, which means it is driven by a
demand for consumer goods. Therefore, demand for business goods is more volatile,
because variations in consumer demand can have a significant impact on business-
goods demand. Business markets are also distinctive in that buyers are professional
purchasers who are highly skilled in negotiating contracts and maximizing efficiency.
In addition, several individuals within the business usually have direct or indirect
influence on the purchasing process.
Factors influencing business customers.
Although business customers are affected by the same cultural, social,
personal, and psychological factors that influence consumer customers, the business
arena imposes other factors that can be even more influential. First, there is the
economic environment, which is characterized by such factors as primary demand,
economic forecast, political and regulatory developments, and the type of competition
in the market. In a highly competitive market such as airline travel, firms may be
concerned about price and therefore make purchases with a focus on saving money. In
markets where there is more differentiation among competitors--e.g., in the hotel
industry--many firms may make purchases with a focus on quality rather than on
price.
Second, there are organizational factors, which include the objectives,
policies, procedures, structures, and systems that characterize any particular company.
Some companies are structured in such a way that purchases must pass through a
complex system of checks and balances, while other companies allow purchasing
managers to make more individual decisions. Interpersonal factors are more salient
among business customers, because the participants in the buying process--perhaps
representing several departments within a company--often have different interests,
authority, and persuasiveness. Furthermore, the factors that affect an individual in the
business buying process are related to the participant's role in the organization. These
factors include job position, risk attitudes, and income.
The business buying process.
The business buying process mirrors the consumer buying process, with a few
notable exceptions. Business buying is not generally need-driven and is instead
problem-driven. A business buying process is usually initiated when someone in the
company sees a problem that needs to be solved or recognizes a way in which the
company can increase profitability or efficiency. The ensuing process follows the
same pattern as that of consumers, including information search, evaluation of
alternatives, purchase decision, and post-purchase evaluation. However, in part
because business purchase decisions require accountability and are often closely
analyzed according to cost and efficiency, the process is more systematic than
consumer buying and often involves significant documentation. Typically, a
purchasing agent for a business buyer will generate documentation regarding product
specifications, preferred supplier lists, requests for bids from suppliers, and
performance reviews.

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 Marketing intermediaries:the distribution channel
Many producers do not sell products or services directly to consumers and
instead use marketing intermediaries to execute an assortment of necessary functions
to get the product to the final user. These intermediaries, such as middlemen
(wholesalers, retailers, agents, and brokers), distributors, or financial intermediaries,
typically enter into longer-term commitments with the producer and make up what is
known as the marketing channel, or the channel of distribution. Manufacturers use
raw materials to produce finished products, which in turn may be sent directly to the
retailer, or, less often, to the consumer. However, as a general rule, finished goods
flow from the manufacturer to one or more wholesalers before they reach the retailer
and, finally, the consumer. Each party in the distribution channel usually acquires
legal possession of goods during their physical transfer, but this is not always the
case. For instance, in consignment selling, the producer retains full legal ownership
even though the goods may be in the hands of the wholesaler or retailer--that is, until
the merchandise reaches the final user or consumer.
Channels of distribution tend to be more direct--that is, shorter and
simpler--in the less industrialized nations. There are notable exceptions, however. For
instance, the Ghana Cocoa Marketing Board collects cacao beans in Ghana and
licenses trading firms to process the commodity. Similar marketing processes are used
in other West African nations. Because of the vast number of small-scale producers,
these agents operate through middlemen who, in turn, enlist sub-buyers to find
runners to transport the products from remote areas. Japan's marketing organization
was, until the late 20th century, characterized by long and complex channels of
distribution and a variety of wholesalers. It was possible for a product to pass through
a minimum of five separate wholesalers before it reached a retailer.
Companies have a wide range of distribution channels
available to them, and structuring the right channel may be one of the company's most
critical marketing decisions. Businesses may sell products directly to the final
customer, as Land's End, Inc., does with its mail-order goods and as is the case with
most industrial capital goods. Or they may use one or more intermediaries to move
their goods to the final user. The design and structure of consumer marketing channels
and industrial marketing channels can be quite similar or vary widely. The
channel design is based on the level of service desired by the target consumer. There
are five primary service components that facilitate the marketer's understanding of
what, where, why, when, and how target customers buy certain products. The service
variables are quantity or lot size (the number of units a customer purchases on any
given purchase occasion), waiting time (the amount of time customers are willing to
wait for receipt of goods), proximity or spatial convenience (accessibility of the
product), product variety (the breadth of assortment of the product offering), and
service backup (add-on services such as delivery or installation provided by the
channel). It is essential for the designer of the marketing channel--typically the
manufacturer--to recognize the level of each service point that the target customer
desires. A single manufacturer may service several target customer groups through
separate channels, and therefore each set of service outputs for these groups could
vary. One group of target customers may want elevated levels of service (that is, fast
delivery, high product availability, large product assortment, and installation). Their
demand for such increased service translates into higher costs for the channel and
higher prices for customers. However, the prosperity of discount and warehouse
stores demonstrates that customers are willing to accept lower service outputs if this
leads to lower prices.

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 Channel functions and flows.

In order to deliver the optimal level of service outputs to their target

consumers, manufacturers are willing to allocate some of their tasks, or marketing
flows, to intermediaries. As any marketing channel moves goods from producers to
consumers, the marketing intermediaries perform, or participate in, a number of
marketing flows, or activities. The typical marketing flows, listed in the usual
sequence in which they arise, are collection and distribution of marketing research
information (information), development and dissemination of persuasive
communications (promotion), agreement on terms for transfer of ownership or
possession (negotiation),
intentions to buy (ordering), acquisition and allocation of funds (financing),
assumption of risks (risk taking), storage and movement of product (physical
possession), buyers paying sellers (payment), and transfer of ownership (title).
Each of these flows must be performed by a marketing intermediary
for any channel to deliver the goods to the final consumer. Thus, each producer must
decide who will perform which of these functions in order to deliver the service
output levels that the target consumers desire. Producers delegate these flows for a
variety of reasons. First, they may lack the financial resources to carry out the
intermediary activities themselves. Second, many producers can earn a superior return
on their capital by investing profits back into their core business rather than into the
distribution of their products. Finally, intermediaries, or middlemen, offer superior
efficiency in making goods and services widely available and accessible to final users.
For instance, in overseas markets it may be difficult for an exporter to establish
contact with end users, and various kinds of agents must therefore be employed.
Because an intermediary typically focuses on only a small handful of specialized tasks
within the marketing channel, each intermediary, through specialization, experience,
or scale of operation, can offer a producer greater distribution benefits.

Management of channel systems.

Although middlemen can offer greater distribution economy to producers,

gaining cooperation from these middlemen can be problematic. Middlemen must
continuously be motivated and stimulated to perform at the highest level. In order to
gain such a high level of performance, manufacturers need some sort of leverage.
Researchers have distinguished five bases of power: coercive (threats if the
middlemen do not comply), reward (extra benefits for compliance), legitimate (power
by position--rank or contract), expert (special knowledge), and referent (manufacturer
is highly respected by the middlemen). As new institutions emerge or
products enter different life-cycle phases, distribution channels change and evolve.
With these types of changes, no matter how well the channel is designed and
managed, conflict is inevitable. Often this conflict develops because the interests of
the independent businesses do not coincide. For example, franchisers, because they
receive a percentage of sales, typically want their franchisees to maximize sales, while

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the franchisees want to maximize their profits, not sales. The conflict that arises may
be vertical, horizontal, or multichannel in nature. When General Motors Corporation
comes into conflict with its dealers, this is a vertical channel conflict. Horizontal
channel conflict arises when a franchisee in a neighbouring town feels a fellow
franchisee has infringed on its territory. Finally, multichannel conflict occurs when a
manufacturer has established two or more channels that compete against each other in
selling to the same market. For example, a major tire manufacturer may begin selling
its tires through mass merchandisers, much to the dismay of its independent tire
dealers.

WHOLESALERS

Wholesaling includes all activities required to sell goods or services to other

firms, either for resale or for business use, usually in bulk quantities and at lower-
than-retail prices. Wholesalers, also called distributors, are independent merchants
operating any number of wholesale establishments. Wholesalers are typically
classified into one of three groups: merchant wholesalers, brokers and agents, and
manufacturers' and retailers' branches and offices.
Merchant wholesalers.
Merchant wholesalers, also known as jobbers, distributors, or supply houses,
are independently owned and operated organizations that acquire title ownership of
the goods that they handle. There are two types of merchant wholesalers: full-service
and limited-service.

Full-service wholesalers.

Full-service wholesalers usually handle larger sales volumes; they may

perform a broad range of services for their customers, such as stocking inventories,
operating warehouses, supplying credit, employing salespeople to assist customers,
and delivering goods to customers. General-line wholesalers carry a wide variety of
merchandise, such as groceries; specialty wholesalers, on the other hand, deal with a
narrow line of goods, such as coffee and tea, cigarettes, or seafood.

Limited-service wholesalers.

Limited-service wholesalers, who offer fewer services to their customers

and suppliers, emerged in order to reduce the costs of service. There are several types
of limited-service wholesalers. Cash-and-carry wholesalers usually handle a limited
line of fast-moving merchandise, selling to smaller retailers on a cash-only basis and
not delivering goods. Truck wholesalers or jobbers sell and deliver directly from their
vehicles, often for cash. They carry a limited line of semiperishables such as milk,
bread, and snack foods. Drop shippers do not carry inventory or handle the
merchandise. Operating primarily in bulk industries such as lumber, coal, and heavy
equipment, they take orders but have manufacturers ship merchandise directly to final
consumers. Rack jobbers, who handle nonfood lines such as housewares or personal
goods, primarily serve drug and grocery retailers. Rack jobbers typically perform such
functions as delivery, shelving, inventory stacking, and financing. Producers'
cooperatives--owned by their members, who are farmers--assemble farm produce to
be sold in local markets and share profits at the end of the year.

In less-developed countries, wholesalers are often the sole or primary

means of trade; they are the main elements in the distribution systems of many

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countries in Latin America, East Asia, and Africa. In such countries the business
activities of wholesalers may expand to include manufacturing and retailing, or they
may branch out into nondistributive ventures such as real estate, finance, or
transportation. Until the late 1950s, Japan was dominated by wholesaling. Even
relatively large manufacturers and retailers relied principally on wholesalers as their
intermediaries. However, in the late 20th century, Japanese wholesalers have declined
in importance. Even in the most highly industrialized nations, however, wholesalers
remain essential to the operations of significant numbers of small retailers.
Brokers and agents.
Manufacturers may use brokers and agents, who do not take title possession of
the goods, in marketing their products. Brokers and agents typically perform only a
few of the marketing flows, and their main function is to ease buying and selling--that
is, to bring buyers and sellers together and negotiate between them. Brokers, most
commonly found in the food, real estate, and insurance industries, may represent
either a buyer or a seller and are paid by the party who hires them. Brokers often can
represent several manufacturers of noncompeting products on a commission basis.
They do not carry inventory or assume risk. Unlike
merchant wholesalers, agent middlemen do not take legal ownership of the goods they
sell; nor do they generally take physical possession of them. The three principal types
of agent middlemen are manufacturers' agents, selling agents, and purchasing agents.
Manufacturers' agents, who represent two or more manufacturers' complementary
lines on a continuous basis, are usually compensated by commission. As a rule, they
carry only part of a manufacturer's output, perhaps in areas where the manufacturer
cannot maintain full-time salespeople. Many manufacturers' agents are businesses of
only a few employees and are most commonly found in the furniture, electric, and
apparel industries. Sales agents are given contractual authority to sell all of a
manufacturer's output and generally have considerable autonomy to set prices, terms,
and conditions of sale. Sometimes they perform the duties of a manufacturer's
marketing department, although they work on a commission basis. Sales agents often
provide market feedback and product information to the manufacturers and play an
important role in product development. They are found in such product areas as
chemicals, metals, and industrial machinery and equipment. Purchasing agents, who
routinely have long-term relationships with buyers, typically receive, inspect, store,
and ship goods to their buyers.

Manufacturers' and retailers' branches and offices.

Wholesaling operations conducted by the sellers or buyers themselves rather
than by independent wholesalers comprise the third major type of wholesaling.
Manufacturers may engage in wholesaling through their sales branches and offices.
This allows manufacturers to improve the inventory control, selling, and promotion
flows. Numerous retailers also establish purchasing offices in major market centres
such as Chicago and New York City that play a role similar to that of brokers and
agents. The major difference is that they are part of the buyer's own organization.

RETAILERS

Retailing, the merchandising aspect of marketing, includes all activities

required to sell directly to consumers for their personal, nonbusiness use. The firm
that performs this consumer selling--whether it is a manufacturer, wholesaler, or
retailer--is engaged in retailing. Retailing can take many forms: goods or services may

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be sold in person, by mail, telephone, television, or computer, or even through
vending machines. These products can be sold on the street, in a store, or in the
consumer's home. However, businesses that are classified as retailers secure the vast
majority of their sales volume from store-based retailing.
The history of retailing.
For centuries most merchandise was sold in marketplaces or by peddlers. In
many countries, hawkers still sell their wares while traveling from one village to the
next. Marketplaces are still the primary form of retail selling in these villages. This
was also true in Europe until the Renaissance, when market stalls in certain localities
became permanent and eventually grew into stores and business districts.
Retail chains are known to have existed in China several centuries before
the Christian era and in some European cities in the 16th and 17th centuries.
However, the birth of the modern chain store can be traced to 1859, with the
inauguration of what is now the Great Atlantic & Pacific Tea Company, Inc.
(A&P), in New York City. During the 15th and 16th centuries the Fugger family of
Germany was the first to carry out mercantile operations of a chain-store variety. In
1670 the Hudson's Bay Company chartered its chain of outposts in Canada.

Department stores also were seen in Europe and Asia as early as the 17th
century. The famous Bon Marché in Paris grew from a large specialty store into a full-
fledged department store in the mid-1800s. By the middle of the 20th century,
department stores existed in major U.S. cities, although small independent merchants
still constitute the majority of retailers. Shopping malls, a late 20th-century
development in retail practices, were created to provide for a consumer's every need
in a single, self-contained shopping area. Although they were first created for the
convenience of suburban populations, they can now also be found on main city
thoroughfares. A large branch of a well-known retail chain usually serves as a mall's
retail flagship, which is the primary attraction for customers. In fact, few malls can be
financed and built without a flagship establishment already in place.
Other mall proprietors have used recreation and entertainment
to attract customers. Movie theatres, holiday displays, and live musical performances
are often found in shopping malls. In Asian countries, malls also have been known to
house swimming pools, arcades, and amusement parks. Hong Kong's City Plaza
shopping mall includes one of the territory's two ice rinks. Some malls, such as the
Mall of America in Bloomington, Minn., U.S., may offer exhibitions, sideshows, and
other diversions. Although there is a great variety of retail enterprises, with new types
constantly emerging, they can be classified into three main types: store retailers,
nonstore retailers, and retail organizations.
Store retailers.
Several different types of stores participate in retail merchandising. The
following is a brief description of the most important store retailers.

Specialty stores.

A specialty store carries a deep assortment within a narrow line of goods.

Furniture stores, florists, sporting-goods stores, and bookstores are all specialty stores.
Stores such as Athlete's Foot (sports shoes only) and Tall Men (clothing for tall men)
are considered superspecialty stores because they carry a very narrow product line.

Department stores.

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 Department stores carry a wider variety of merchandise than most stores but
offer these items in separate departments within the store. These departments usually
include home furnishings and household goods, as well as clothing, which may be
divided into departments according to gender and age. Department stores in western
Europe and Asia also have large food departments, such as the renowned food court at
Harrods in the United Kingdom. Departments within each store are usually operated
as separate entities, each with its own buyers, promotions, and service personnel.
Some departments, such as restaurants and beauty parlours, are leased to external
providers. Department stores generally account for less than 10 percent of a country's
total retail sales, but they draw large numbers of customers in urban areas. The most
influential of the department stores may even be trendsetters in various fields, such as
fashion. Department stores such as Sears, Roebuck and Company have also spawned
chain organizations. Others may do this through mergers or by opening branch units
within a region or by expanding to other countries.

Supermarkets.

Supermarkets are characterized by large facilities (15,000 to 25,000 square

feet [1,394 to 2,323 square metres] with more than 12,000 items), low profit margins
(earning about 1 percent operating profit on sales), high volume, and operations that
serve the consumer's total needs for items such as food (groceries, meats, produce,
dairy products, baked goods) and household sundries. They are organized according
to product departments and operate primarily on a self-service basis. Supermarkets
also may sell wines and other alcoholic beverages (depending on local licensing laws)
and clothing. The first true supermarket was opened in the United States by Michael
Cullin in 1930. His King Kullen chain of large-volume food stores was so successful
that it encouraged the major food-store chains to convert their specialty stores into
supermarkets. When compared with the conventional independent grocer,
supermarkets generally offered greater variety and convenience and often better prices
as well. Consequently, in the two decades after World War II, the supermarket drove
many small food retailers out of business, not only in the United States but throughout
the world. In France, for example, the number of larger food stores grew from about
50 in 1960 to 4,700 in 1982, while the number of small food retailers fell from
130,000 to 60,000.

Convenience stores.

Located primarily near residential areas, convenience stores are relatively

small outlets that are open long hours and carry a limited line of high-turnover
convenience products at high prices. Although many have added food services,
consumers use them mainly for "fill-in" purchases, such as bread, milk, or
miscellaneous goods.

Superstores.

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 Superstores, hypermarkets, and combination stores are unique retail
merchandisers. With facilities averaging 35,000 square feet, superstores meet many of
the consumer's needs for food and nonfood items by housing a full-service grocery
store as well as such services as dry cleaning, laundry, shoe repair, and cafeterias.
Combination stores typically combine a grocery store and a drug store in one facility,
utilizing approximately 55,000 square feet of selling space. Hypermarkets combine
supermarket, discount, and warehousing retailing principles by going beyond
routinely purchased goods to include furniture, clothing, appliances, and other items.
Ranging in size from 80,000 to 220,000 square feet, hypermarkets display products in
bulk quantities that require minimum handling by store personnel.

Discount stores.

Selling merchandise below the manufacturer's list price is known as

discounting. The discount store has become an increasingly popular means of
retailing. Following World War II, a number of retail establishments in the United
States began to pursue a high-volume, low-profit strategy designed to attract price-
conscious consumers. A key strategy for keeping operating costs (and therefore
prices) low was to locate in low-rent shopping districts and to offer minimal service
assistance. This no-frills approach was used at first only with hard goods, or consumer
durables, such as electrical household appliances, but it has since been shown to be
successful with soft goods, such as clothing. This practice has been adopted for a wide
variety of products, so that discount stores have essentially become department stores
with reduced prices and fewer services. In the late 20th century, discount stores began
to operate outlet malls. These groups of discount stores are usually located some
distance away from major metropolitan areas and have facilities that make them
indistinguishable from standard shopping malls. As they gained popularity, many
discount stores improved their facilities and appearances, added new lines and
services, and opened suburban branches. Coupled with attempts by traditional
department stores to reduce prices in order to compete with discounters, the
distinction between many department and discount stores has become blurred.
Specialty discount operations have grown significantly in electronics, sporting goods,
and books.

Off-price retailers.

Off-price retailers offer a different approach to discount retailing. As discount

houses tried to increase services and offerings in order to upgrade, off-price retailers
invaded this low-price, high-volume sector. Off-price retailers purchase at below-
wholesale prices and charge less than retail prices. This practice is quite different
from that of ordinary discounters, who buy at the market wholesale price and simply
accept lower margins by pricing their products below retail costs. Off-price retailers
carry a constantly changing collection of overruns, irregulars, and leftover goods and
have made their biggest forays in the clothing, footwear, and accessories industries.
The three primary examples of off-price retailers are factory outlets, independent

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carriers, and warehouse clubs. Stocking manufacturers' surplus, discontinued, or
irregular products, factory outlets are owned and operated by the manufacturer.
Independent off-price retailers carry a rapidly changing collection of higher-quality
merchandise and are typically owned and operated by entrepreneurs or divisions of
larger retail companies. Warehouse (or wholesale) clubs operate out of enormous,
low-cost facilities and charge patrons an annual membership fee. They sell a limited
selection of brand-name grocery items, appliances, clothing, and miscellaneous items
at a deep discount. These warehouse stores, such as Wal-Mart-owned Sam's, Price
Club, and Costco (in the United States), maintain low costs because they buy products
at huge quantity discounts, use less labour in stocking, and typically do not make
home deliveries or accept credit cards.

Nonstore retailers.
Some retailers do not operate stores, and these nonstore businesses have
grown much faster than store retailers. With some market observers predicting that by
the year 2000 nonstore retailing will handle 30 percent of all general merchandise
sold, nonstore channels may become a powerful force in the retailing industry. The
major types of nonstore retailing are direct selling, direct marketing, and automatic
vending.

Direct selling.

This form of retailing originated several centuries ago and has mushroomed
into a $9 billion industry consisting of about 600 companies selling door-to-door,
office-to-office, or at private-home sales meetings. The forerunners in the direct-
selling industry include The Fuller Brush Company (brushes, brooms, etc.),
Electrolux (vacuum cleaners), and Avon (cosmetics). In addition, Tupperware
pioneered the home-sales approach, in which friends and neighbours gather in a home
where Tupperware products are demonstrated and sold. Network marketing, a direct-
selling approach similar to home sales, is also gaining prevalence in markets
worldwide. Network marketing companies such as Amway and Shaklee reward their
distributors not only for selling products but also for recruiting others to become
distributors.

Direct marketing.

Direct marketing is direct contact between a seller (manufacturer or retailer)

and a consumer. Generally speaking, a seller can measure response to an offer
because of its direct addressability. Although direct marketing gained wide popularity
as a marketing strategy only in the late 20th century, it has been successfully utilized
for more than a hundred years. The world's largest catalog houses--Sears, Roebuck
and Company and Montgomery Ward & Co.--began as direct marketers in the late
1880s, selling their products solely by mail order. A century later, however, both
companies were conducting most of their business in retail stores. Some department
stores and specialty stores may supplement their store operations with direct-
marketing transactions by mail or telephone. Mail-order firms grew rapidly in the
1950s and '60s in continental Europe, Great Britain, and certain other highly
industrialized nations. Modern direct marketing is generally supported by advanced
database technologies that track each customer's purchase behaviour. These

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technologies are used by established retail firms, such as Quelle and Neckermann in
Germany, and are the foundation of mail-order businesses such as J. Crew, The
Sharper Image, and L.L. Bean (all in the United States). Direct marketing is not a
worldwide business phenomenon, however, because mail-order operations require
infrastructure elements that are still lacking in many countries, such as efficient
transportation networks and secure methods for transmitting payments. Direct
marketing has expanded from its early forms, among them direct mail and catalog
mailings, to include such vehicles as telemarketing, direct-response radio and
television, and electronic shopping. Unlike many other forms of promotion, a direct-
marketing campaign is quantitatively measurable.

Automatic vending.

Automatic vending is a unique area in nonstore merchandising because the

variety of merchandise offered through automatic vending machines continues to
grow. Initially, impulse goods with high convenience value such as cigarettes, soft
drinks, candy, newspapers, and hot beverages were offered. However, a wide array of
products such as hosiery, cosmetics, food snacks, postage stamps, paperback books,
record albums, camera film, and even fishing worms are becoming available through
machines. Vending-machine operations are usually offered in sites owned by
other businesses, institutions, and transportation agencies. They can be found in
offices, gasoline stations, large retail stores, hotels, restaurants, and many other
locales. In Japan, vending machines now dispense frozen beef, fresh flowers,
whiskey, jewelry, and even names of prospective dating partners. In Sweden, vending
machines have developed as a supplementary channel to retail stores, where hours of
business are restricted by law. High costs of manufacturing, installation, and operation
have somewhat limited the expansion of vending-machine retailing. In addition,
consumers typically pay a high premium for vended merchandise.

Retail organizations.
While merchants can sell their wares through a store or nonstore retailing
format, retail organizations can also structure themselves in several different ways.
The major types of retail organizations are corporate chains, voluntary chains and
retailer cooperatives, consumer cooperatives, franchise organizations, and
merchandising conglomerates.

Corporate chains.

Two or more outlets that have common ownership and control, centralized
buying and merchandising operations, and similar lines of merchandise are considered
corporate chain stores. Corporate chain stores appear to be strongest in the food,
drug, shoe, variety, and women's clothing industries. Managed chain stores have a
number of advantages over independently managed stores. Because managed chains
buy large volumes of products, suppliers are willing to offer cost advantages that are
not usually available to other stores. These savings can be passed on to consumers in
the form of lower prices and better sales. In addition, because managed chains operate
on such a large scale, they can hire more specialized and experienced personnel, who
may be better able to take full advantage of purchasing and promotion opportunities.
Chain stores also have the opportunity to take advantage of economies of scale in the

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areas of advertising, store design, and inventory control. However, a corporate chain
may have disadvantages as well. Its size and bureaucracy often weaken staff
members' personal interest, drive, creativity, and customer-service motivation.

Voluntary chains and retailer cooperatives.

These are associations of independent retailers, unlike corporate chains.

Wholesaler-sponsored voluntary chains of retailers who engage in bulk buying and
collective merchandising are prevalent in many countries. True Value hardware stores
represent this type of arrangement in the United States. In western Europe in the
1980s there were several large wholesaler-sponsored chains of retailers, each
including more than 15,000 stores. These retail stores were located across 18
countries, each store using the same name and, as a rule, offering the same brands of
products but remaining an independent enterprise. Wholesaler-sponsored chains offer
the same types of services for their clients as do the financially integrated retail
chains. Retailer cooperatives, such as ACE hardware stores, are grouped as
independent retailers who establish a central buying organization and conduct joint
promotion efforts.

Consumer cooperatives.

Consumer cooperatives, or co-ops, are retail outlets that are owned and
operated by consumers for their mutual benefit. The first consumer cooperative store
was established in Rochdale, Eng., in 1844, and most co-ops are modeled after the
same, original principles. They are based on open consumer membership, equal
voting among members, limited customer services, and shared profits among
members in the form of rebates generally related to the amounts of their purchases.
Consumer cooperatives have gained widespread popularity throughout western and
northern Europe, particularly in Denmark, Finland, Iceland, Norway, Sweden, and
Great Britain. Co-ops typically emerge because community residents believe that
local retailers' prices are too high or service is substandard.

Franchise organizations.

Franchise arrangements are characterized by a contractual relationship

between a franchiser (a manufacturer, wholesaler, or service organization) and
franchisees (independent entrepreneurs who purchase the right to own and operate
any number of units in the franchise systems). Typified by a unique product, service,
business method, trade name, or patent, franchises have been prominent in many
industries, including fast foods, video stores, health and fitness centres, hair salons,
auto rentals, motels, and travel agencies. McDonald's Corporation is a prominent
example of a franchise retail organization, with franchises all over the world.

Merchandising conglomerates.

Merchandising conglomerates combine several diversified retailing lines and

forms under central ownership, as well as integrate distribution and management of
functions. Merchandising conglomerates are relatively free-form corporations. In the
United States, Woolworth Corporation is considered a merchandising conglomerate

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because it operates Kinney shoe stores, Herald Square Stationers, Frame Scene, and
Kids Mart.

Marketing facilitators
Because marketing functions require significant expertise, it is often both
efficient and effective for an organization to use the assistance of independent
marketing facilitators. These are organizations and consultants whose sole or primary
responsibility is to handle marketing functions. In many larger companies, all or some
of these functions are performed internally. However, this is not necessary or
justifiable in most companies, which usually require only part-time or periodic
assistance from marketing facilitators. Also, most companies cannot afford to support
the salaries and operating expenses required to maintain marketing facilitators as a
permanent part of their staff. Furthermore, independent marketing contractors can be
more effective than an internal department because nonemployee facilitators can have
broader expertise and more objective perspectives. In addition, independent
contractors often are more motivated to perform at high standards, because
competition in the facilitator market is usually aggressive, and poor performance
could mean lost business. There are four major types of marketing
facilitators: advertising agencies, market research firms, transportation firms, and
warehousing firms.

ADVERTISING AGENCIES

Advertising agencies are responsible for initiating, managing, and

implementing paid marketing communications. In addition, some agencies have
diversified into other types of marketing communications, including public relations,
sales promotion, interactive media, and direct marketing. Agencies typically consist
of four departments: account management, a creative division, a research group, and a
media planning department. Those in account management act as liaisons between the
client and the agency, ensuring that client needs are communicated to the agency and
that agency recommendations are clearly understood by the client. Account managers
also manage the flow of work within the agency, making sure that projects proceed
according to schedule. The creative department is where advertisements are
conceived, developed, and produced. Artists, writers, and producers work together to
craft a message that meets agency and client objectives. In this department, slogans,
jingles, and logos are developed. The research department gathers and processes data
about the target market and consumers. This information provides a foundation for the
work of the creative department and account management. Media planning personnel
specialize in selecting and placing advertisements in print and broadcast media.

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 MARKET RESEARCH FIRMS

Market research firms gather and analyze data about customers, competitors,
distributors, and other actors and forces in the marketplace. A large portion of the
work performed by most market research firms is commissioned by specific
companies for particular purposes. However, some firms also routinely collect a wide
spectrum of data and then attempt to sell some or all of it to companies that may
benefit from such information. For example, the A.C. Nielsen Co. in the United States
specializes in supplying marketing data about consumer television viewing habits, and
Information Resources, Inc. (IRI), has an extensive database regarding consumer
supermarket purchases. Marketing research may
be quantitative, qualitative, or a combination of both. Quantitative research is
numerically oriented, requires significant attention to the measurement of market
phenomena, and often involves statistical analysis. For example, when a restaurant
asks its customers to rate different aspects of its service on a scale from 1 (good) to 10
(poor), this provides quantitative information that may be analyzed statistically.
Qualitative research focuses on descriptive words and symbols and usually involves
observing consumers in a marketing setting or questioning them about their product or
service consumption experiences. For example, a marketing researcher may stop a
consumer who has purchased a particular type of detergent and ask him why that
detergent was chosen. Qualitative and quantitative research each provides different
insights into consumer behaviour, and research results are ordinarily more useful
when the two methods are combined. Market research can be thought of as the
application of scientific method to the solution of marketing problems. It involves
studying people as buyers, sellers, and consumers, examining their attitudes,
preferences, habits, and purchasing power. Market research is also concerned with the
channels of distribution, with promotion and pricing, and with the design of the
products and services to be marketed.

TRANSPORTATION FIRMS

As a product moves from producer to consumer, it must often travel long

distances. Many products consumed in the United States have been manufactured in
another area of the world, such as Asia or Mexico. In addition, if the channel of
distribution includes several firms, the product must be moved a number of times
before it becomes accessible to consumers. A basic home appliance begins as a raw
material (iron ore at a steel mill, for example) that is transported from a processing
plant to a manufacturing facility. Transportation
firms assist marketers in moving products from one point in a channel to the next. An
important matter of negotiation between companies working together in a channel is
whether the sender or receiver of goods is responsible for transportation. Movement
of products usually involves significant cost, risk, and time management. Thus, when
firms consider a transportation option, they carefully weigh its dependability and
price, frequency of operation, and accessibility. A firm that has its own transportation
capabilities is known as a private carrier. There are also contract carriers, which
are independent transportation firms that can be hired by companies on a long- or
short-term basis. A common carrier provides services to any and all companies
between predetermined points on a scheduled basis. The U.S. Postal Service is a
common carrier, as are Federal Express and the Amtrak railway system.

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 WAREHOUSING FIRMS

Because products are not usually sold or shipped as soon as they are produced
or delivered, firms require storage facilities. Two types of warehouses meet this need:
storage warehouses hold goods for longer periods of time, and distribution
warehouses serve as way stations for goods as they pass from one location to the next.
Like the other marketing functions, warehouses can be wholly owned by firms, or
space can be rented as needed. Although companies have more control over wholly
owned facilities, warehouses of this sort can tie up capital and firm resources.
Operations within warehouses usually require inspecting goods, tracking inventories,
repackaging goods, shipping, and invoicing.
MARKETING IN DIFFERENT SECTORS
Although the basic principles of marketing apply to all industries, the ways in
which these principles are best applied can differ considerably based on the kind of
product or service sold, the kind of buying behaviour associated with the purchase,
and the sector (government, consumer goods, services, etc.).

The government market

This market consists of federal, state, and local governmental units that
purchase or rent goods to fulfill their functions and responsibilities for the public.
Government agencies purchase a wide range of products and services, including
helicopters, paintings, office furniture, clothing, alcohol, and fuel. Most of the
agencies manage a significant portion of their own purchasing.

THE CIVILIAN ESTABLISHMENT

One prominent sector of the government market is the federal civilian buying
establishment. In the United States this establishment consists of six categories:
departments (e.g., the Department of Commerce), administration (e.g., the General
Services Administration), agencies (e.g., the Federal Aviation Administration), boards
(e.g., the Railroad Retirement Board), commissions (e.g., the Federal
Communications Commission), and the executive office (e.g., the Office of
Management and Budget). In addition there are several miscellaneous civilian buying
establishments, such as, for example, the Tennessee Valley Authority.

THE MILITARY ESTABLISHMENT

Another governmental purchasing sector is the federal military buying

establishment, represented in the United States by the Department of Defense, which
purchases primarily through the Defense Supply Agency and the army, navy, and air
force. The Defense Supply Agency operates six supply centres, which specialize in
construction, electronics, fuel, personnel support, and industrial and general supplies.

PURCHASING PROCEDURES

Government purchasing procedures fall into two categories: the open bid and
the negotiated contract. Under open-bid buying, the government disseminates very
specific information about the products and services required and requests bids from
suppliers. Contracts generally are awarded to the lowest bidder. In negotiated-contract
buying, a government agency negotiates directly with one or more companies

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regarding a specific project or supply need. In most cases, contracts are negotiated for
complex projects that involve major research-and-development costs and in matters
where there is little effective competition.
Consumer-goods marketing
Consumer goods can be classified according to consumer shopping habits.

CONVENIENCE GOODS

Convenience goods are those that the customer purchases frequently,

immediately, and with minimum effort. Tobacco products, soaps, and newspapers are
all considered convenience goods, as are common staples like ketchup or pasta.
Convenience-goods purchasing is usually based on habitual behaviour, where the
consumer will routinely purchase a particular product. Some convenience goods,
however, may be purchased impulsively, involving no habit, planning, or search
effort. These goods, usually displayed near the cash register in a store in order to
encourage quick choice and purchase, include candy, razors, and batteries. A slightly
different type of convenience product is the emergency good, which is purchased
when there is an urgent need. Such goods include umbrellas and snow shovels, and
these are usually distributed at a wide variety of outlets so that they will be readily
available when necessary.

SHOPPING GOODS

A second type of product is the shopping good, which usually requires a more
involved selection process than convenience goods. A consumer usually compares a
variety of attributes, including suitability, quality, price, and style. Homogeneous
shopping goods are those that are similar in quality but different enough in other
attributes (such as price, brand image, or style) to justify a search process. These
products might include automobile tires or a stereo or television system.
Homogeneous shopping goods are often sold strongly on price.
With heterogeneous shopping goods,
product features become more important to the consumer than price. Such is often the
case with the purchase of major appliances, clothing, furniture, and high-tech
equipment. In this situation, the item purchased must be a certain size or colour and
must perform very specific functions that cannot be fulfilled by all items offered by
every supplier. With goods of this sort, the seller has to carry a wide assortment to
satisfy individual tastes and must have well-trained salespeople to provide both
information and advice to consumers.

SPECIALTY GOODS

Specialty goods have particularly unique characteristics and brand

identifications for which a significant group of buyers is willing to make a special
purchasing effort. Examples include specific brands of fancy products, luxury cars,
professional photographic equipment, and high- fashion clothing. For instance,
consumers who favour merchandise produced by a certain shoe manufacturer or
furniture maker will, if necessary, travel considerable distances in order to purchase
that particular brand. In specialty-goods markets, sellers do not encourage
comparisons between options; buyers invest time to reach dealers carrying the product

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desired, and these dealers therefore do not necessarily need to be conveniently
located.

UNSOUGHT GOODS

Finally, an unsought good is one that a consumer does not know about--or
knows about but does not normally think of buying. New products, such as new
frozen-food concepts or new communications equipment, are unsought until
consumers learn about them through word-of-mouth influence or advertising. In
addition, the need for unsought goods may not seem urgent to the consumer, and
purchase is often deferred. This is frequently the case with life insurance, preventive
car maintenance, and cemetery plots. Because of this, unsought goods require
significant marketing efforts, and some of the more sophisticated selling techniques
have been developed from the challenge to sell unsought goods.
Services marketing
A service is an act of labour or a performance that does not produce a tangible
commodity and does not result in the customer's ownership of anything. Its
production may or may not be tied to a physical product. Thus, there are pure services
that involve no tangible product (as with psychotherapy), tangible goods with
accompanying services (such as a computer software package with free software
support), and hybrid product-services that consist of parts of each (for instance,
restaurants are usually patronized for both their food and their service).
Services can be distinguished from products because
they are intangible, inseparable from the production process, variable, and
perishable. Services are intangible because they can often not be seen, tasted, felt,
heard, or smelled before they are purchased. A person purchasing plastic surgery
cannot see the results before the purchase, and a lawyer's client cannot anticipate the
outcome of a case before the lawyer's work is presented in court. To reduce the
uncertainty that results from this intangibility, marketers may strive to make their
service tangible by emphasizing the place, people, equipment, communications,
symbols, or price of the service. For example, consider the insurance slogans "You're
in good hands with Allstate" or Prudential's "Get a piece of the Rock."
Services are inseparable from their production because they are typically
produced and consumed simultaneously. This is not true of physical products, which
are often consumed long after the product has been manufactured, inventoried,
distributed, and placed in a retail store. Inseparability is especially evident in
entertainment services or professional services. In many cases, inseparability limits
the production of services because they are so directly tied to the individuals who
perform them. This problem can be alleviated if a service provider learns to work
faster or if the service expertise can be standardized and performed by a number of
individuals (as H&R Block, Inc., has done with its network of trained tax consultants
throughout the United States).
The variability of services comes from their significant human component.
Not only do humans differ from one another, but their performance at any given time
may differ from their performance at another time. The mechanics at a particular auto
service garage, for example, may differ in terms of their knowledge and expertise, and
each mechanic will have "good" days and "bad" days. Variability can be reduced by
quality-control measures. These measures can include good selection and training of
personnel and allowing customers to communicate dissatisfaction (e.g., through
customer suggestion and complaint systems) so that poor service can be detected and.

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corrected Finally, services are perishable because they cannot be stored. Because
of this, it is difficult for service providers to manage anything other than steady
demand. When demand increases dramatically, service organizations face the problem
of producing enough output to meet customer needs. When a large tour bus
unexpectedly arrives at a restaurant, its staff must rush to meet the demand, because
the food services (taking orders, making food, taking money, etc.) cannot be
"warehoused" for such an occasion. To manage such instances, companies may hire
part-time employees, develop efficiency routines for peak demand occasions, or ask
consumers to participate in the service-delivery process. On the other hand, when
demand drops off precipitously, service organizations are often burdened with a staff
of service providers who are not performing. Organizations can maintain steady
demand by offering differential pricing during off-peak times, anticipating off-peak
hours by requiring reservations, and giving employees more flexible work shifts.
Business marketing
Business marketing, sometimes called business-to-business marketing or
industrial marketing, involves those marketing activities and functions that are
targeted toward organizational customers. This type of marketing involves selling
goods (and services) to organizations (public and private) to be used directly or
indirectly in their own production or service-delivery operations. Some of the major
industries that comprise the business market are construction, manufacturing, mining,
transportation, public utilities, communications, and distribution. One of the key
points that differentiates business from consumer marketing is the magnitude of the
transactions. For example, in the mid-1990s, a Boeing 747 airliner, selling for about
$155 million, could take up to four years to manufacture and deliver once the order
was placed. Often, a major airline company will order several aircraft at one time,
making the purchase price as high as a billion dollars. Customers for industrial
goods can be divided into three groups: user customers, original-equipment
manufacturers, and resellers. User customers make use of the goods they purchase in
their own businesses. An automobile manufacturer, for example, might purchase a
metal-stamping press to produce parts for its vehicles. Original-equipment
manufacturers incorporate the purchased goods into their final products, which are
then sold to final consumers (e.g., the manufacturer of television receivers buys tubes
and transistors). Industrial resellers are middlemen--essentially wholesalers but in
some cases retailers--who distribute goods to user customers, to original-equipment
manufacturers, and to other middlemen. Industrial-goods wholesalers include mill-
supply houses, steel warehouses, machine-tool dealers, paper jobbers, and chemical
distributors.
Nonprofit marketing
Marketing scholars began exploring the application of marketing to nonprofit
organizations in 1969. Since then, nonprofit organizations have increasingly turned to
marketing for growth, funding, and prosperity.
Although it is difficult to define "nonprofit" organizations because of the
existence of a number of quasi-governmental organizations, a study in the mid-1990s
found more than one million private, nonprofit organizations in the United States.
Some experts believe that the way to distinguish between organizations is according
to their sources of funding. The three major sources are profits, government revenues
(such as grants or taxes), and voluntary donations. In addition, a legally defined
nonprofit organization is one that has been granted tax-exempt status by the Internal
Revenue Service. However, while nonprofit groups can be defined legally, it is more
helpful to focus on the specific marketing activities that need to be performed within
the organization's environment. Museums, hospitals, universities, and churches are all

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examples of nonprofit organizations. Although many individuals may believe that
nonprofit organizations have only a small impact on the economy, the operating
expenditures of private nonprofit organizations now represent a significant percentage
of the U.S. gross national product. In addition, many of these are substantial
enterprises. For example, Girl Scout cookies, sold by Girl Scouts of America,
constitute 10 percent of all cookies sold in the United States.
Social marketing
Social marketing employs marketing principles and techniques to advance a
social cause, idea, or behaviour. It entails the design, implementation, and control of
programs aimed at increasing the acceptability of a social idea or practice that would
benefit the adoptors or society. Social ideas can take the form of beliefs, attitudes, and
values, such as human rights. Whether social marketers are promoting ideas or social
practices, their ultimate goal is to alter behaviour. In order to accomplish this
behaviour change, social marketers set measurable objectives, research their target
group's needs, target their "products" to these particular "consumers," and effectively
communicate their benefits. In addition, social-marketing organizations have to be
constantly aware of changes in their environments and must be able to adapt to these
changes.
Place marketing
Place marketing employs marketing principles and techniques to advance the
appeal and viability of a place (town, city, state, region, or nation) to tourists,
businesses, investors, and residents. Among the "place sellers" are economic
development agencies, tourist promotion agencies, and mayors' offices. Place sellers
must gain a deep understanding of how place buyers make their purchasing decisions.
Place-marketing activities can be found in both the private and public sectors at the
local, regional, national, and international levels. They can range from activities
involving downtrodden cities trying to attract businesses to vacation spots seeking to
attract tourists. In implementing these marketing activities, each locale must adapt to
external shocks and forces beyond its control (intergovernmental power shifts,
increasing global competition, and rapid technological change) as well as to internal
forces and decline cycles.

ECONOMIC AND SOCIAL ASPECTS OF MARKETING

Sometimes criticized for its impact on personal economic and social well-
being, marketing has been said to affect not only individual consumers but also
society as a whole. This section briefly examines some of the criticisms raised and
how governments, individuals, and marketers have addressed them.
Marketing and individual welfare
Criticisms have been leveled against marketers, claiming that some of their
practices may damage individual welfare. While this may be true in certain
circumstances, it is important to recognize that, if a business damages individual
welfare, it cannot hope to continue in the marketplace for long. As a consequence,
most unfavourable views of marketing are criticisms of poor marketing, not of
strategically sound marketing practices.
Others have raised concerns about marketing by saying that it increases
prices by encouraging excessive markups. Marketers recognize that consumers may
be willing to pay more for a product--such as a necklace from Tiffany and Co.--

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simply because of the associated prestige. This not only results in greater costs for
promotion and distribution, but it allows marketers to earn profit margins that may be
significantly higher than industry norms. Marketers counter these concerns by
pointing out that products provide not only functional benefits but symbolic ones as
well. By creating a symbol of prestige and luxury, Tiffany's offers a symbolic benefit
that, according to some consumers, justifies the price. In addition, brands may
symbolize not only prestige but also quality and functionality, which gives consumers
greater confidence when they purchase a branded product. Finally, advertising and
promotions are often very cost-effective methods of informing the general public
about items and services that are available in the marketplace.
A few marketers have been accused of using deceptive
practices, such as misleading promotional activities or high-pressure selling. These
deceptive practices have given rise to legislative and administrative remedies,
including guidelines offered by the Federal Trade Commission (FTC) regarding
advertising practices, automatic 30-day guarantee policies by some manufacturers,
and "cooling off" periods during which a consumer may cancel any contract signed.
In addition, professional marketing associations, such as the Direct Marketing
Association, have promulgated a set of professional standards for their industry.
Marketing and societal welfare
Concern also has been raised that some marketing practices may encourage
excessive interest in material possessions, create "false wants," or promote the
purchase of nonessential goods. For example, in the United States, children's Saturday
morning television programming came under fire for promoting materialistic values.
The Federal Communications Commission (FCC) responded in the early 1990s by
regulating the amount of commercial time per hour. In many of these cases, however,
the criticisms overstate the power of marketing communications to influence
individuals and portray members of the public as individuals unable to distinguish
between a good decision and a bad one. In addition, such charges cast marketing as a
cause of social problems when often the problems have much deeper societal roots.
Marketing activity also has been sometimes criticized
because of its control by strong private interests and its neglect of social and public
concern. While companies in the cigarette, oil, and alcohol industries may have
significant influence on legislation, media, and individual behaviour, organizations
that focus on environmental, health, or education concerns are not able to wield such
influence and often fail to receive appropriate recognition for their efforts. While
there is clearly an imbalance of power between private interests and public ones, in
the late 20th century, private companies have received more praise for their marketing
efforts for social causes.
Marketing's contribution to individuals and society
Although some have questioned the appropriateness of the marketing
philosophy in an age of environmental deterioration, resource shortages, world hunger
and poverty, and neglected social services, numerous firms are commendably
satisfying individual consumer demands as well as acting in the long-term interests of
the consumer and society. These dual objectives of many of today's companies have
led to a broadening of the "marketing concept" to become the "societal marketing
concept." Generating customer satisfaction while at the same time attending to
consumer and societal well-being in the long run are the core concepts of societal
marketing.
In practicing societal marketing, marketers try to balance company profits,
consumer satisfaction, and public interest in their marketing policies. Many
companies have achieved success in adopting societal marketing. Two prominent

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examples are The Body Shop International PLC, based in England, and Ben & Jerry's
Homemade Inc., which produces ice cream and is based in Vermont. Body Shop's
cosmetics and personal hygiene products, based on natural ingredients, are sold in
recycled packaging. The products are formulated without animal testing, and a
percentage of profits each year is donated to animal rights groups, homeless shelters,
Amnesty International, rain-forest preservation groups, and other social causes. Ben
& Jerry's donates a percentage of its profits to help alleviate social and environmental
problems. The company's corporate concept focuses on "caring capitalism," which
involves the product as well as social and economic missions. Marketing has
had many other positive benefits for individuals and society. It has helped accelerate
economic development and create new jobs. It has also contributed to technological
progress and enhanced consumers'

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 TOURISM

Tourism - The Worlds Biggest Industry

Against the background. of unparalleled growth in the latter half of the

twentieth century, tourism now finds itself at a crossroads in its development. On the
one hand, it is heralded as ‘the world’s biggest industry’ by a number of global
organisations including the World Travel and Tourism Council (WTTC) and the
World Tourism Organisation (WTO), which highlights the fact that tourism overtook
both crude petroleum and motor vehicles to become the world’s number one export
earner in 1994. Its economic significance is also illustrated by the fact that tourism
receipts were greater than the world’s exports of other selected product groups,
including electronic equipment, clothing, textiles and raw materials.
In addition, receipts from international tourism have achieved growth rates in
excess of exports of commercial services and merchandise exports during the period
1984 to 1994. For the period 1985 to 1995 the trend is similar, with the following
average annual percentage growth rates:
• Tourism l2per cent
• Commercial services 12 per cent
• Merchandise exports 10 per cent
WTO data also indicate rapid and sustained growth in international tourist
arrivals and receipts from tourism over the last 30 years. Today, tourism is seen as a
major contributor to global economic development, creating employment and
generating wealth on a truly international scale. An increasing number of countries
rely heavily on receipts from tourism for their economic and social well-being.
In direct contrast to this very positive outlook for the industry, many national
governments are reluctant to invest public funds in tourism development and
promotion, with tourism spending often being cut when more pressing social and
economic needs arise. The decisions, in 1997, by the governments of Canada, the
United States of America and Belgium to transfer responsibility, for tourism to private
sector enterprises or regional authorities serve to illustrate this point well. In Britain,
the funding of the English Tourist Board has been cut drastically since the early
1990s, the decision of a government that considered the industry to he sufficiently
mature and able to fund its own expansion with diminishing public financial support.
At a time of increasing corrcern for the environment and the retention of cultural
identities, tourism is also viewed by governments and consumers alike as a potentially
destructive force, causing harmful environmental and socio-cultural impacts in
destination areas and on host communities. Paradoxically, it is not difficult to argue
that the withdrawal of public funding and control from tourism development may well
accelerate the industry’s harmful environmental and socio-cultural effects.
It is against this background of a complex and rapidly expanding industry
seeking to maintain its credibility and promote its economic benefits, often in the face
of declining governmental and host community support.

The Business of Hotels

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 I The Importance of Hotels

Hotels play an important role in most countries in providing facilities for the
transaction of business, for meetings and conferences, for recreation and
entertainment. In that sense hotels are as essential to economies and societies as are
adequate transport, communication and retail distribution systems for various goods
and services. Through their facilities hotels contribute to the total output of goods and
services, which makes up the material well-being of nations and communities.
In many areas hotels are important attractions for visitors who bring to them
spending power and who tend to spend at a higher rate than they do when they are at
home. Through visitor spending hotels thus often contribute significantly to local
economies both directly, and indirectly through the subsequent diffusion of the visitor
expenditure to other recipients in the community.
In areas receiving foreign visitors, hotels are often important foreign currency
earners and in this way may contribute significantly to their countries’ balance of
payments. Particularly in countries with limited export possibilities, hotels may be
one of the few sources of foreign currency earnings.
Hotels are important employers of labour. Thousands of jobs are provided by
hotels in the many occupations that make up the hotel industries in most countries;
many others in the industry are self—employed and proprietors of smaller hotels. The
role of hotels as employers is particularly important in areas with few alternative
sources of employment, where they contribute to regional development.
Hotels are also important outlets .for the products of other industries. In the
building and modernization of hotels business is provided for the construction
industry and related trades. Equipment, furniture and furnishings are supplied to
hotels by a wide range of manufacturers. Food, drink and other consumables are
among the most significant daily hotel purchases from farmers, fishermen, food and
drink suppliers, and from gas, electricity and water undertakings. In addition to those
engaged directly in hotels, much indirect employment is, therefore, generated by
hotels for those employed in industries supplying them.
Last but not least, hotels are an important source of amenities .for local
residents. Their restaurants, bars and other facilities often attract much local custom
and many hotels have become social centres of their communities.

Travel and Hotels

Staying away from home is a function of travel and three main phases may be
distinguished in the development of travel in the northern hemisphere.

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 Until about the middle of the nineteenth cenruiy the bulk of journeys were
undertaken for business and vocational reasons, by road, by people travelling mainly
in their own countries. The volume of travel was relatively small, confined to a small
fraction of the population in any country, and most of those who did travel, did so by
coach. Inns and similar hostelries along the highways and in the principal towns
provided the means of accommodation well into the nineteenth century.
Between about 1850 and about 1950 a growing proportion of travellers went
away from home for other than business reasons and holidays came to represent
gradually an important reason for a journey. For a hundred years or so, the railway
and the steamship dominated passenger transportation, and the new means of
transport gave an impetus to travel between countries and between continents.
Although the first hotels date from the eighteenth century, their growth on any scale
occurred only in the nineteenth century, when first the railway and later the steamship
created sufficiently large markets to make the larger hotel possible. Hotels together
with guest houses and boarding houses dominated the accommodation market in this
period.
By about the middle of the twentieth century in most developed countries of
the world (a little earlier in North America and a little later in Europe) a whole cycle
was completed and most traffic returned to the road, with the motor car increasingly
providing the main means of passenger transportation. Almost concurrently the
aircraft took over unmistakably both from the railways and from shipping as the
principal means of long-distance passenger transport. On many routes holiday traffic
came to match and often greatly exceed other traffic. A growing volume of travel
away from home became international. Hotels entered into competition with new
forms of accommodation — holiday centres and holiday villages in Europe, motels in
North America, and various self—catering facilities for those on holiday.

Two Centuries of Hotelkeeping

Hotels are some two hundred years old. The word ‘hotel’ itself came into use
in England with the introduction in London, after 1760 , of the kind of establishment
then common in Paris, called ‘hotel garni’, or a large house, in which apartments were
let by the day, week or trench. Its appearance signified a departure from the
customary method of accommodating guests in inns and similar hostelries, into
something more luxurious and even ostentatious. Hotels with managers, receptionists
and uniformed staff arrived generally only at the beginning of the nineteenth century
and until the middle of that century their development was relatively slow. The
absence of good inns in Scotland to someextent accelerated the arrival of the hotel
there; by the end of the eighteenth century Edinburgh, for example, had several hotels
where the traveller could get elegant and comfortable rooms. Hotels are also known to
have made much progress in other parts of Europe in the closing years of the
eighteenth and early years of the nineteenth century, where at the time originated the
idea of a resort hotel.
In North America early accommodation for travellers followed a similar
pattern as in England, with most inns originating in converted houses, but by the turn
of the eighteenth century several cities on the eastern seaboard had purpose—built
hotels and in the first half of the nineteenth century hotel building spread across
America to the Pacific Coast. The evolution from innkeeping to hotelkeeping,
therefore, proceeded almost in parallel in the Old and in the New Worlds and the rise
of the hotel industries on both sides of the Atlantic had probably more in common

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than is generally recognized. What America might have lacked in history and
tradition, it more than made up in pioneering spirit, in intense rivalry between cities
and entrepreneurs, and in the sheer size and growth of the travel market.
In the last century hotels became firmly established not only as centres
commercial hospitality for travellers, but often also as important social centres of their
communities. Their building, management and operation became specialized
activities, with their own styles and methods. The present century brought about
growing specialization and increased sophistication in the hotel industries of most
countries, as well as their growth and expansion. But the growth and the diversity of
hotel operations has been also matched by the growth and diversity of competition in
the total accommodation
market.
Information about accommodation facilities in individual countries essentially
reflects the designations used for them by the countries concerned and the coverage of
various types in the available statistics. Only very broad inter-country comparisons
are possible. One source is the annual report of the Tourism Committee of the
Organisation for Economic Co-operation and Development (OECD), which
distinguishes between beds available in hotels and similar establishments, and in what
is described as supplementary accommodation.
The ratio of beds in hotels and similar establishments to beds in supplementary
accommodation gives an indication of the relative importance of the hotel sector in
the total accommodation market of individual countries. In most countries the
accommodation profile tends to reflect the relative importance of foreign and
domestic users, of leisure and business travel, and of other influences. In many
countries hotels and similar establishments appear to be minority providers of
accommodation.

Hotel Location

Hotel services are supplied to their buyers direct in person; they are consumed
at the point of sale, and they are also produced there.
Hotel services must be, therefore, provided where the demand exists and the
market is the dominant influence on hotel location. In fact, location is part of the hotel
product. In turn, location is the key influence on the viability of the business, so much
so that a prominent entrepreneur could have said with conviction and with much
justification that there are only three rules for success in the hotel business: location,
location, location.
We have seen earlier that from the early days all accommodation units
followed transport modes, Inns and other hostelries were situated along the roads and
at destinations, serving transit and terminal traffic. The rapid spread of railways
marked the emergence of railway hotels in the nineteenth century. In the twentieth
century motor transport created a new demand for accommodation along the
highways and the modern motel and motor hotel have been distinctive responses to
the new impetus of the motor car. A similar but les pronounced influence was
passenger shipping, which stimulated hotel development in ports, and more recently
air transport, which brought about a major growth of hotels in the vicinity of airports
and air terminals.
Secondly, although this is closely related to transport, many hotels are located
to serve first and foremost holiday markets. In their areas of highest concentration,
holiday visitors are accommodated in hotels in localities whcre the resident

463
population may represent only a small proportion of those present at the time, as is the
case in many resorts.
The third major influence on hotel location is the location of economic activity
and of industry and commerce in particular. Whilst again not separable from transport
development, industrial and commercial activities create demand for transit and
termInal accommodation in industrial and commercial centres, in locations not
frequented by holiday visitors.
Different segments of the travel market give rise to distinctive patterns of
demand for hotel accommodation and often distinctive types of hotels. In business
and industrial centres hotels normally achieve their highest occupancies on weekdays
and in resorts in the main holiday seasons; their facilities and services reflect the
requirements of businessmen and of holiday visitors respectively. Between these
clearly defined segments come other towns and areas, such as busy commercial
centres with historical or other attractions for visitors, which may achieve a more even
weekly and annual pattern of business.

Types of Hotels

The rich variety of hotels can be seen from the many terms in use to denote
particular types. Hotels are referred to as luxury, resort, commercial, residential,
transit, and in many other ways. Each of these terms may give an indication of
standard or location, or particular type of guest who makes up most of the market of a
particular hotel, but it does not describe adequately its main characteristics. These can
be only seen when a combination of terms is applied to an hotel, each of which
describes a particular hotel according to certain criteria. It is helpful to appreciate at
this stage what the main types of hotels are, by adopting particular criteria for
classifying them, without necessarily attaching precise meanings to them.
• Thus according to location hotels are in cities and in large and small towns,
in inland, coastal and mountain resorts, and in the country.
• According to the actual position of the hotel in its location it may be in the
city or town centre or in the suburbs, along the beach of a coastal resort, along the
highway.
• By reference to its relationship with particular means of transport_there are
motels and motor hotels, railway hotels, airport hotels (the terms also indicating
location).
• According to the purpose of visit and the main reason for their guests’ stay,
hotels may become known as business hotels, holiday hotels, convention hotels,
tourist hotels.
• Where there is a pronounced tendency to a short or long duration of guests’
stay it may be an important hotel characteristic, so that the hotel becomes a transit or a
residential hotel.
• According to the range of its facilities and services a hotel may be open to
residents and non-residents, or it may restrict itself to providing overnight
accommodation and at most offering breakfast to its guests, and be a hotel garni or
apartment hotel.
• Whether a hotel holds a licence for the sale of alcoholic liquor or not, is an
important dimension in the range of available hotel services, and the distinction
between licensed and unlicensed hotels is, therefore, of relevance in describing a hotel
in most countries.

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 • There is no universal agreement on how hotels should he described
according to size, but by reference to their room or bed capacities we normally apply
the term small hotel to one with a small amount of sleeping accommodation, the term
large hotel to one with several hundred beds or bedrooms, and the term medium size
hotel to one somewhere between the two, according to the size structure of the hotel
industry in a particular country.
• Whatever the criteria used in hotel guides and in classification and grading
systems in existence in many countries, normally at least four or five classes or grades
have been found necessary to distinguish adequately in the standards of hotels and
these have found some currency among hotel users. The extremes of luxury and basic
standards, sometimes denoted by five stars and one star respectively are not difficult
concepts; the mid point on any such scale denotes the average without any particular
claims to merit. The intervening points are then standards above average but falling
short of luxury (quality hotels) and standards above basic (economy).
Last but not least comes the ownership and management. Individually owned
independent hotels, which may he managed by the proprietor or by a salaried
manager, have to he distinguished from chain or group hotels, invariably owned by a
company. Independent hotels may belong to a hotel consortium or cooperative. A
company may operate its hotels under direct management or under a franchise
agreement.
The above distinctions then enable us to describe a particular hotel in broad
terms, concisely, comprehensively and meaningfully, e.g.:
• Terminus Hotel is a medium-sized economy town centre unlicensed hotel,
owned and managed by a small company, catering mainly for tourists visiting the
historic town and the surrounding countryside.
• Hotel Excelsior is a large independent luxury hotel on the main promenade
of the coastal resort, with holiday visitors as its main market.
• The Crossroads Hotel is a small licensed quality transit motor hotel, operated
as a franchise, on the outskirts of the city, which serves mainly traveling

F Hotel Products and Markets

The aim of this subject is to outline the facilities and services provided by
hotels, who are the people who use hotels, why they use hotels, and what influences
their choice of particular hotels. In providing answers to these questions, we can
formulate a conceptual model of a hotel, which attempts to explain in simple terms
how particular hotel products meet the needs of particular hotel markets, and establish
a basis for a more detailed examination of the hotel business.

The Hotel as a Total Market Concept

From the point of view of its users, a hotel is an institution of commercial

hospitality, which offers its facilities and services for sale, individually or in various
combinations, and this concept is made up of several elements.
Its location places the hotel geographically in or near a particular city, town or
village; within a given area location denotes accessibility and the convenience this
represents, attractiveness of surroundings and the appeal this represents, freedom from
noise and other nuisances, or otherwise.
Its facilities which include bedrooms, restaurants, bars, function rooms,
meeting rooms and recreation facilities such as tennis courts and swimming pools

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represent a repertoire of facilities for the use of its customers, and these may be
differentiated in type, size, and in other ways.
I ts service comprises the availability and extent of particular hotel
services provided through its facilities, the style and quality of all these in such terms
as formality and informality, degree of personal attention, and speed and efficiency.
Its image may he defined as the way in which the hotel portrays itself to
people and the way in which it is perceived as portraying itself by them. It is a
byproduct of its location, facilities and service, but it is enhanced by such factors as
its name, appearance; its associations by who stays there and who eats there; by what
it says about itself and what other people say about it.
Its price expresses the value given by the hotel through its location, facilities,
service and image, and the satisfaction derived by its users from these elements of the
hotel concept. The individual elements assume greater or lesser importance for
different people. One person may put location as paramount and be prepared to accept
basic facilities and service for an overnight day, ignoring the image, as long as the
price is within a limit, to which he is willing to go. Another may be more concerned
with the image of the hotel, its facilities and service. However, all the five elements
are related to each other, and in a situation of choice most hotel users tend either to
accept or reject as a whole, that is the total concept.
There are varying degrees of adaptability and flexibility in the hotel concept,
ranging from the complete fixity of its location to the relative flexibility of price, with
facilities, service and image lending themselves to some adaptation in particular
circumstances with time.

Hotel Facilities and Services as Products

In the early days of innkeeping the traveller often had to bring his own food to
places where he stayed the night-bed for the night was the only product offered But
soon most establishments extended their hospitality to providing at least some food
and refreshments. Today many apartment hotels, hotels gami, and motels confine their
facilities to sleeping accommodation, with little or no catering provision. But the
typical hotel as we know it today, normally provides not only accommodation, but
also food and drink, and sometimes other facilities and services, and makes them
available not only to its residents but also to non-residents.
Although the range of hotel facilities and services may extend as far as to cater
for all or most needs of their customers, however long their stay, and for a hotel to
become a self-contained community with its own shops, entertainments and recreation
facilities, it is helpful at this stage to describe the hotel concept in a simpler form, by
including only the main customer needs typically met by most hotels.
The main customer demand in most hotels is for sleeping accommodation,
food and drink, and for food and drink for organized groups. These four requirements
then relate to accommodation, restaurants, bars and functions, as the principal hotel
products.
Sleeping accommodation is provided for hotel residents alone. Restaurants and
bars meet the requirements of hotel residents and non-residents alike, even though
separate facilities may be sometimes provided for them. Functions are best seen as a
separate hotel product bought by organized groups; these groups may be resident in
the hotel as, for example, participants in a residential conference, or be non-residents,
such as a local club or society, or the group may combine the two. The total hotel
concept — of location, facilities, service, image and price - can he, therefore, sub-

466
divided according to the needs of the customer and the particular facilities brought
into play to meet them. The cluster of elements of the total hotel concept is then
related to each particular hotel product. Each hotel product contains the elements of
the location, facilities, services, image and price, to meet a particular customer need
or set of needs. The first approach to the segmentation of the hotel market is,
therefore, taken by dividing hotel users according to the products bought.
Corresponding to each hotel product there are the buyers of that product who
constitute a market for it.

Hotel Accommodation Markets

Hotel users who are buyers of overnight accommodation may be classified

according to the main purpose of their visit to a particular location into three main
categories as holiday, business and other users.
Holiday users include a variety of leisure travel as the main reason for their
stay in hotels, ranging from short stays in a particular location on the way to
somewhere else to weekend and longer stays when the location represents the end of a
journey. Their demand for hotel accommodation tends to be resort oriented, seasonal
and sensitive to price.
Business users are employees and others travelling in
the course of their work, people visiting exhibitions, trade fairs, or coming
together as members of professional and commercial organizations for meetings and
conferences. Their demand for hotel accommodation tends to be town- and city-
oriented, non-seasonal and less price-sensitive, except in the case of some event
attractions such as conferences and exhibitions, which may he usefully regarded as a
separate category.
Other hotel users comprise visitors to a particular location for a variety of
reasons other than holiday or business, e.g. those attending such family occasions as
weddings, parents visiting educational institutions, visitors to special events, and
common interest groups meeting for other than business and vocational reasons, re-
locating families and individuals seeking permanent accommodation in an area and
staying temporarily in an hotel, people living in an hotel permanently. The
characteristics of this type of demand are more varied than those of the first and
second group, and it is, therefore, often desirable to sub-divide it further for practical
purposes.
Within and between the three main groups, which comprise the total market
for hotel accommodation, there are several distinctions important to individual hotels.
We have noted already that some hotel users give rise to demand for transit and short
—stay accommodation; others are terminal visitors with a longer average stay.
Also, for example, much business demand is generated by a relatively
small number of travellers who are frequent hotel users; most holiday and other
demand comes from a very large number of people who use hotels only occasionally.
Moreover, business users often book accommodation at short notice, whilst holiday
and other users tend to do so longcr in advance. And in allthree groups some people
are individual hotel users, and others stay in hotels in groups.

Hotel Catering Markets

Hotel restaurants, bars and function rooms may be conveniently grouped

together as its food and beverage or catering facilities, and the meals and refreshments

467
they provide as the hotel food and beverage or catering products. Corresponding to
them there are again buyers of these products who constitute the hotel catering
markets and who may be classified in various ways. For our purposes there is a basic
distinction between the demand exercised by hotel residents, by non-residents, and by
organized groups.
The first category of users of hotel restaurants and bars is related to the basic
function of the hotel in providing overnight sleeping accommodation, and consists of
hotel residents, whom we have classified earlier as holiday, business and other users
Their use of hotel catering facilities tends to be influenced by the reason for their
hotel stay and by the terms on which they stay. Breakfast is their common hotel
purchase, but otherwise a hotel resident may have his meals in his hotel or elsewhere,
and he is more likely to be a hotel restaurant or bar customer in the evenings than at
midday.
The second category is non-residents, individually or in small groups, when
eating out. They may, in fact, be staying at other hotels or accommodation
establishments or with friends or relative or be day visitors to the area, for holiday,
business or other reasons Alternatively they are local residents, for whom the hotel
restaurants and bars represent outlets for meals and refreshments, as a leisure activity
or as part of their business activities. This category tends to represent important hotel
users at midday as well as in the evenings, particularly at weekends.
The third category of users of hotel catering facilities is organized groups who
make advance arrangements for functions at the hotel, which may call for separate
facilities and organizational arrangements. They include local clubs, societies,
business and professional groups, as well as participants in meetings and conferences
originating from outside the area.
Hotel catering products represent a greater diversity than its accommodation
products and it is often correspondingly more difficult to classify them and the
markets for them in practice. Moreover, hotels are not alone in supplying them. In the
market for meals and refreshments for individuals and groups a hotel competes not
only with other hotels, but also with restaurants outside hotels, pubs and clubs, to
name but a few other types of outlet.
Therefore, catering in hotels is a separate hotel function, with its own
objectives, policies and strategies, and with its own organization.
Hotel Demand Generating Sources

For most people the use of hotels represents what is known as derived demand
because few stay or eat in hotels for its own sake; their primary reasons for doing so
lie in their reasons for visiting an area or for spending their time there in particular
ways. When describing hotel accommodation and catering markets we have seen that
hotel users have different degrees of freedom and choice as to whether they buy hotel
services or not. Some have
few or no alternatives; for them only hotels provide the facilities and services
which they require in a particular area in pursuit of their business, vocational and
other interests; the incidence of their hotel usage arises to a great extent from their
working circumstances. For many others the use of hotels is a matter of choice; they
do so in their pursuit of leisure and recreation; for them hotel usage involves a
discretionary use of their time and money. This distinction helps us identify the
demand generating sources for hotels in a given area, which are of three main types-
institutional, recreational and transit.

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 Institutional sources include industrial and commercial enterprises,
educational institutions, government establishments and other organizations in the
private and public sector, whose activities are involved in the economic life of the
community and in its administration. These institutions generate demand for hotels
through their own visitors and their other requirements for hotel facilities and
services.
Recreational sources include historical, scenic and other site attractions and
event attractions, which generate demand for hotels from tourists; local events and
activities in the social and cultural life of the community, which generate demand
from clubs, societies and other organizations; happenings of significance to
individuals and families.
The third source of demand stems from individuals and groups with no
intrinsic reason for spending time in a particular locality, other than being on the way
somewhere else and the need to break a journey. This source of demand is closely
related to particular forms of transport; it expresses itself on highways, at ports and at
airports, and may be described as transit.
It will be readily apparent that this view of demand generating sources for
hotels is closely related to several aspects of the hotel business considered earlier —
for example, to the three-fold classification of the hotel accommodation market into
holiday, business and other users; to the three main influences on hotel location —
travel, holidays and economic activity; and to the types of hotel. By adopting in each
case a somewhat different viewpoint, it is possible to highlight the interdependence
between the location, markets and products of hotels.

Hotel Market Areas

We can define a hotel market in several ways by reference to the people who
buy hotel services, as a network of dealings between the hotel and its users, or as an
area which a hotel serves. In the first two approaches hotel users may come from
within the area, from various parts of the country, and from abroad; we then refer to
the local, domestic and foreign markets, and subdivide them in appropriate ways. In
the third approach described below we view the hotel market area as a physical area
served by the hotel.
For hotel accommodation it is necessary to identify all the institutional and
recreational sources of demand, which may be served by a particular hotel. The area
drawn in this way round the hotel may extend from its immediate vicinity to a radius
of several miles or more. How far it does extend depends on the geographical
distribution of the demand generating sources, the mode of transport used by the hotel
users of each source, and the availability of other facilities in the area. The head office
of a large firm, a university, a historic castle, and a town which is a festival centre,
may be all within a market area of a hotel, if the hotel is reasonably accessible from
these points, and if its location at least matches the location of other hotels. The
market area may coincide for a number of hotels within close proximity of each other,
which offer a similar concept in terms of facilities, service, image and price. On the
periphery the market area for a hotel may overlap with the market areas of other
hotels some distance away. At periods of peak demand it may extend further than at
times of low demand. For transit the accommodation market area is related to the
journeys undertaken through the area — their origin and destination, the method of
transportation, the time of day, the time of year and other circumstances of the
journeys.

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 For hotel catering services the market area depends on market density — the
availability of spending power within an area, as well as on the accessibility of the
hotel to the different sources of demand, and on the availability of other catering
services in the area. In this there is a close analogy with the concept of a catchment
area for other retail outlets, as far as the resident population is concerned. How far do
people go from where they live to do their shopping? The distance may vary
according to the purchase they are to make. Similarly there may be a smaller market
area for hotel lunches than for hotel dinners and functions, because close proximity to
the hotel may he a more important consideration for a midday meal than for an
evening out.

Hotel Market Segmentation

The market for hotel products may be divided into several components or
segments and this enables individual hotels to identify their actual and potential users
according to various criteria. Segmentation then provides a basis for the marketing of
hotel products, for paying close attention to the requirements of different users, and
for monitoring the performance in the markets chosen by a hotel.
We divided hotel users, according to the product bought by them, into buyers
of accommodation, food, drink and functions. We divided the accommodation market,
according to the reasons for the users’ stay, into holiday, business and other users, and
the hotel catering market into hotel residents, non-residents and functions. According
to the origin of demand we also identified institutional, recreational and transit
sources of demand.
Another basis for segmentation is the needs of hotel users and the means_they
have to pay for their satisfaction, by dividing them according to their socio economic
characteristics. Socio-economic classifications seek to group people according to their
occupation and employment status. For example, the British Joint Industry Committee
for National Readership Surveys (JICNARS) defines social grades as shown in the
following table:
Social Grade Definitions
Social grade Social status Occupation
A Upper middle Higher
class managerial,
administrative
or professional
B Middle class Intermediate
managerial,
adminisniative or
professional
C1 Lower middle Supervisory or
class clerical, and
juniormanagerial,
administrative or
professional
C2 Skilled working Skilled manual
class workers
D Working class Semi- and
unskilled manual
E Those at the State pensioners

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 lowest level of or widows (no
subsistence other earner),
casual or lowest
grade workers

Social grade A might be expected to stay in luxury and quality hotels, B in

medium hotels, C in economy hotels. However, this is an oversimplification, because
the same people may interchange between segments according to the circumstances in
which they find themselves. A businessman on an expense account may stay in a
quality hotel, but travelling for pleasure with his family he may stay in a lower grade
hotel. Moreover, the incidence of hotel usage among DE groups is minimal.
Nevertheless, segmentation by socio-economic criteria is an important approach to
market segmentation. For some purposes age, family composition, life cycle stage, or
other criteria may be more appropriate.
A concomitant of market segmentation is product branding, with a view to
differentiating an hotel from others in the minds of buyers, long established in other
consumer industries. Some hotel groups have focused on branded segments
distinguished by levels of service; examples include Holiday Inn upmarket Crowne
Plaza, core brand Holiday Inn and limited service Garden Court.
Other brands have been created by grouping like operations, such as Forte
Posthouses and Whitbread Lanshury Hotels, or by acquisition, such as Porte Crest and
Mount Charlotte Thistle.
We anticipate that product segmentation will assume even greater significance
in the future development of hotel companies. It is an effective method for hotel
companies to maintain or expand market share and in some instances create new
markets.
Product branding will become more focussed and will reflect increasing levels
of segmentation.
In the light of this, the future of the ‘all purpose hotel’ is doubtful in terms of
its competitiveness in the market place.
Buying and Paying for Hotel Services
It is important to understand how a buying decision is made, who makes it,
and who pays for the hotel services bought.
The buying decision itself may be basically of two kinds —deliberate or
impulsive. Before embarking on journeys, business people may ask secretaries to
reserve hotel rooms in the towns they are to visit for specified nights. A family may
arrive at their choice of holiday hotel after a scrutiny of hotel guides. A society may
make several inquiries before choosing the venue for their annual dinner dance. These
are deliberate buying decisions made with some _advance planning and with advance
reservations. A tourist looking for somewhere to stay when travelling by car, or on
arrival at the railway station or airport, is likely to make an impulse decision, in much
the same way as a couple walking through the streets of a town and ‘discovering’ a
restaurant which appears to be to their liking. Purchases of hotel products are both
deliberate and impulse purchases and most hotels respond to both, although different
operational policies and procedures normally apply to each.
Many people make their own arrangements for travelling and for staying in
hotels. However, many hotel bookings are made by people who do it for others: the
secretary for the boss, the travel agent for the client, the business travel department of
a large company for its employees. In these circumstances it is important to know
who the buying agent is and where that person is located, if the knowledge derived

471
from the analysis of the hotel demand generating sources is to be applied to bringing
about sales. Most hotels can no longer hope to fill their beds, restaurants and bars by
simply waiting for the guest.
According to the source of payment for hotel services, hotel users are also of
two basic kinds — those who pay themselves and those whose hotel bills are covered
or reimbursed for them. Most leisure use of hotels represents personal expenditure out
of disposable incomes, the bulk of business use of hotels in the wide sense is paid for
directly or indirectly by third parties — employers and other agencies on behalf of the
guest. Although many business users have no fixed limits as to the charges they incur
in hotels, many tend to observe what they and their organizations regard as
acceptable. The understanding of these practices is important to hotels too. The
decision on the market segments to be catered for is closely related to decisions on
pricing and we have seen that price is an integral element of each hotel’s total
concept.

Hotel Marketing Orientation

Hotels serve people and their success depends on how well they serve them in
places where they wish to be served. This is only a way of stating in the simplest of
tenns the application to hotel operations of the marketing concept, which is concerned
with the consumer as a starting point in the conduct of business.
The marketing concept is beginning to be understood by hoteliers. Although
some continue to regard sales andmarketing as synonymous, most hotels no longer
operate in the seller’s market and even massive sales effort is not likely to generate a
sustained high volume of business, if consumer needs are not genuinely met in the
planning, design and subsequent operation of an hotel.
The basic hotel concept stresses the view of the hotel, as it is seen by the hotel
user rather than the hotel operator, as a business to meet the needs of hotel users.
Some of these needs are basic and physical, such as sleeping in clean beds or eating
wholesome meals; others such as those met by the image of the hotel are acquired
needs, which reflect what a person aims to be as an individual. A successful hotel
must seek to meet both sets of needs. So that an hotel can meet the needs of hotel
users, individual hotel services have to be seen as hotel products sold to particular
markets. A hotel cannot be all things to all people. Each hotel has to achieve a match
between its particular products and particular market segments, i.e. groups of people
with more or less similar characteristics and requirements for hotel services. In this
there is a difference between the hotel accommodation and catering products, in that
each may to some extent cater for different markets. But this difference only
reinforces the need for harmony in the total hotel concept. In order to achieve the
match between hotel products and markets, there is a need for a careful analysis of the
sources of demand for hotel services in the market area served by the hotel and an
understanding of how hotel services are bought and paid for.
From this model of a hotel a translation can be made to particular operations.
This takes the form of hotel policies, philosophies and strategies.
Special Features of Hotel Marketing

Marketing is first and foremost about matching products and markets and in
this sense the marketing of hotel services is in principle no different from the
marketing of other consumer products. But there are special features of hotel products
and markets and hence of hotel marketing.

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 For most users hotel rooms are a means to an end and not an end in itself and
the demand for them is what is known as derived demand - the reason for their use
may be a business visit or a holiday or something else but rarely the room itself, and
the same applies to some extent to other hotel services.
The availability of the most important hotel product, the hotel room, is fixed in
time and place. In the short term the number of rooms or beds on offer cannot be
significantly changed and location is part of the highly perishable product, which
cannot be stored for future sale or follow the customer. The demand for hotel
accommodation and other services fluctuates from day to day, from week to week and
from one part of the year to another. A waste occurs when demand falls and there is a
definite upper limit to the volume of business in a period of peak demand.
Hotel investment is primarily an investment in land and buildings and interior
assets. The bulk of the capital invested in the fixed assets of the hotel, combined with
the continuity of hotel activity, gives risc to high fixed costs, which have to be
covered irrespective of the volume of business. Three key factors are, therefore,
critical to a successful hotel operation — the right location, correct capacity, and a
high level of utilization, all of them imply marketing decisions — first in the
conception of the hotel and in its operation subsequently.
In the conception of the hotel, marketing can contribute first through a market
feasibility study to assess the demand. A study may identify the best market
opportunity for a hotel, a gap in the market, a location or choice between alternative
locations, for a particular hotel concept; or, given a particular location, a study can
determine the most appropriate hotel concept. The translation of the concept into an
operational facility then takes place through product formulation and development. In
the operation of the hotel, marketing can contribute through a continuous process of
market research, product development, promotion, selling, monitoring and review —
the stages of a marketing cycle.
In the planning of a new hotel, there is full scope for the adherence to the
marketing concept from the outset. In an existing hotel, there is often an important
distinction between the short-and long-term marketing tasks. In the short term the
marketing task may be to adjust customers’ wants to available facilities and services,
but the long-term task is to modify the facilities and services to the customers’ wants.
In the short run our existing facilities and services are given within narrow
limits. We may research the market to see which market segments are or could be
attracted to them, make such adjustments to our products as are possible, but the main
effort is likely to focus on promotion and selling. With low occupancies and low
utilization of restaurants, bars and function rooms, in the short run the sales effort
becomes dominant. But it is no excuse for doing just that; it is both necessary and
possible to proceed with changing the products: toestablish who our customers could
be and what their needs are (market research), and to formulate and develop products
meeting their needs (product formulation and development). This approach ultimately
calls for less sales effort, which is then designed to demonstrate to people that their
needs can be met; it is of particular importance in hotels.
Marketed commodities and articles are concrete, physical and capable of
measurement; most of them can be inspected and many of them even tried out before
purchase. Services are less tangible and hotel services particularly so. Hotel services
cannot be easily defined and described in terms of clearly measurable products and
their qualities. They are often bought individually or as part of a package, and they
may be bought directly by the user or through an intermediary, for example, a travel

473
agent. In hotels, as in other walks of life, it is necessary to make it easy to buy only
more so.

Property Ownership

An investment in hotels is first and foremost an investment in land and

buildings, which represent the dominant assets of hotels. Other fixed assets are:
• plant and equipment, including such major items as air conditioning, boilers,
lifts, and heavy kitchen equipment;
• furniture, furnishings, and small equipment;
• china, glass, linen and cutlery.
Accordingly there is a dual nature of investment in hotels — as an investment
in land and buildings and an investment in interior assets. This distinction has been
recognized in three principal ways in recent years.
First, the building shell may be owned by a developer, sometimes as part of
some larger project, and leascd to anhotel operator on a rental basis. This is also
implied by some hotel groups, which apply internal rentals to hotels owned by them;
in this way the hotel profits are assessed after taking into account the notional rental
of the land and building.
Secondly, hotel companies make use of sale-and-lease- back arrangements as
a means of financing the investment, which reduces the capital requirement for the
hotel operator.
Thirdly, interior assets may be also leased by the hotel operator rather than
bought, thereby also reducing the capital requirement.
There are, therefore, various arrangements as to who is involved in property
ownership and in hotel management. A hotel operator may invest in the property
represented by land and buildings or enter into a leasing arrangement and invest only
in the interior assets, or an operator may enter into a management contract without
any direct capital investment.

Property Operation and Maintenance

In large hotels and in hotel groups normally a senior person is ultimately

responsible for technical services who may be variously described as the technical
services, buildings and services, or works director, officer, or superintendent, or
simply as chief engineer, or by some such title. In large organizations the technical
services may be subdivided between those responsible for buildings, for engineering,
and for other services.
Although technical considerations may be the direct concern of hotel
management in smaller hotels, they arespecialist activities normally entrusted to
specialist staff and sometimes ‘contracted out’.
Property operation, maintenance and energy costs are costs of hotel operation,
as distinct from the capital investment outlay on the assets. They are, therefore,
appropriately included in hotel profit and loss statements.
In the Uniform System of Accounts for Hotels property operation and
maintenance includes costs of repairs and maintenance of buildings, plant and
equipment, furniture and furnishings, as well as the maintenance of grounds, related
wages and salaries, and work let out on contract. The costs incurred by hotels
contributing to Horwath International reports in the early 1990.

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 III.Hotel Organization

Organization is the framework in which various activities operate. It is

concerned with such matters as the division of tasks within firms and establishments,
positions of responsibility and authority, and relationships between them. It introduces
such concepts as the span of control (the number of subordinates supervised directly
by an individual), levels of management (the number of tiers through which
management operates), delegation (the allocation of responsibility and authority to
designated individuals in the line of ‘command’).
Until not so long ago — about the middle of this century and even later than
that the typical hotel of almost any size was characterized by a large number of
individuals and departments directly responsible to the hotel manager who was
closely concerned with his guests and with all or most aspects of the hotel operation.
Theremight have been one or more assistant managers who had little or no authority
over such key individuals as the chef, the head waiter or the housekeeper. The hotel
manager usually combined the ‘mine host’ concept of hotel keeping with a close
involvement in the operation. He normally had all or most of the technical skills that
enter into the business of accommodating and catering for guests. Although he might
have given more attention to departments in which he felt confident about his
expertise, and less to those in which his knowledge and skills might have been
lacking, his approach was essentially that of a technician rather than the manager of a
business. Hotels served those who chose to use them. The financial control was
exercised by the owners or by accountants on their behalf. Personnel management
rarely extended beyond the ‘hiring and firing’ of staff. Hotel buildings and interiors
were not often viewed as business assets required to produce a return comparable to
other commercial investments; maintenance and energy were cheap.
Several influences have tended to change this profile generally and the
approach to hotel organization in particular in the second half of the twentieth
century. The market for hotels, the number of hotels, and the size of individual
operations have grown, against the background of economic and social conditions in
most parts of the world. Business and management thought and practice have found
their way into hotels, with the entry into the hotel business of firms engaged in other
industries, development of hotel education and training, and higher quality of
management. Innovation in hotel organization, at first largely confined to a few firms
in North America, has spread to others in other countries. These and other influences
have brought about changesin the ways in which hotels organize their activities today.
Three particular developments illustrate the changes in hotel organization in
post-war Britain. One relates to the grouping of functions. In the early I 950s hotel
reception, uniformed services and housekeeping were invariably regarded as separate
departments, each reporting directly to the hotel manager; twenty years later many
large hotels had front hall managers, rooms managers, or assistant managers with
specific responsibilities in this area. Similarly, over the same period in most large
hotels food and beverage managers came to be appointed, responsible for all the hotel
activities previously organized in restaurants, bars and kitchens under the direct
control of the hotel manager. Secondly, there has been a growth in specialists. In the
early 1950s only a few large hotels had a staff manager, a public relations officer or a
buyer; by the early 1970s personnel, sales and marketing, and purchasing departments
were common features of the large hotels and of hotel groups. Thirdly, where each
hotel used to be more or less self-sufficient in the provision of its various guest
services and supporting requirements, many of these are now provided through

475
internal rentals and concessions and through specialist suppliers and operators such as
outside bakeries, butcheries and laundries.
The accommodation function may be described in terms of reception,
uniformed services and housekeeping. Several typical organizational approaches may
be identified in respect of these activities in practice:
- all three activities operate as separate departments with their own heads of
department;
-reception and uniformed services are grouped together as the front hail or
front house of the hotel under an assistant manager for whom this is the sole or main
responsibility;
- reception and uniformed services are grouped together as a front hail or front
house department with its own head of department.
- all three activities are grouped together as the rooms department under an
assistant manager for whom this is the sole or main responsibility;
- all three activities are grouped together as the rooms department with its own
head of department.
The first approach provides for a direct line of responsibility and authority
between each separate head

Rooms

The accommodation function may be described in terms of

reception,uniformed services and housekeeping. Several typical organizational
approaches may be identified in respect of these activities in practice:
- all three activities operate as separate departments with their own heads of
department;
-reception and uniformed services are grouped together as the front hail or
front house of the hotel under an assistant manager for whom this is the sole or main
responsibility;
- reception and uniformed services are grouped together as a front hail or front
house department with its own head of department.
- all three activities are grouped together as the rooms department under an
assistant manager for whom this is the sole or main responsibility;

476
 - all three activities are grouped together as the rooms department with its own
head of department.
The first approach provides for a direct line of responsibility and authority
between each separate head of department and the hotel manager and hence for a
close contact between the two levels of management; however, it extends the hotel
manager’s span of control and he is required to coordinate the separate departments.
The other four approaches are designed to reduce the hotel manager’s span of control
and provide for a coordination of related activities at an intermediate level but
increase the number of levels through which management has to operate, and reduce
the amount of direct contact between the hotel manager and the departments
concerned.
Several activities were described in connection with rooms, which may be
arranged differently in large hotels:
In most hotels advance reservations form an integral part of hotel reception
and the same employees deal with them and with other reception tasks. But advance
reservations may be dealt with in a separate section of the reception office or in a
separate department, to enable employees to concentrate on the respective tasks
without conflicting demands on their time and attention. Sometimes all advance
reservations are concentrated in the sales department, which has a responsibility for
maximizing hotel occupancy.
In smaller hotels guest accounts are normally handled by book-
keeper/receptionists, but strictly speaking guest accounts represent an extension of the
accounting function of the hotel. Therefore, where guest accounting is handled by bill
office clerks and cashiers, they normally form a part of the accounts department.
• In some hotels room service is provided by housekeeping staff, but room
service is clearly part of the food and beverage function of the hotel.
Food and Beverage

Several typical organizational approaches identified in respect of this function

in practice:
● may be each sales outlet and supporting service operates as a separate
department with its own head of department;
• several departments are grouped together under an assistant manager for
whom they represent the sole or main responsibility, e.g. purchasing and storage, bars
and cellars, the ‘back-of-the-house’ activities including the kitchen, and so on;
• several of these departments are grouped together as one department under
its own head of department;

477
 • all food and beverage activities are grouped together under an assistant
manager for whom they represent the sole or main responsibility; • all food and
beverage activities are grouped together as a food and beverage department with its
own head of department.
The same observations apply to these approaches as are made above in
relation to rooms, regarding lines of responsibility and authority, span of control and
levels of management; the size of the span of control and the number of management
levels are conflicting considerations.
Several aspects of the food and beverage function are closely related to each
other but also to other parts of the hotel operation:
• Most hotels have facilities serving both food and beverages, although in
some of them food or beverages may predominate. Whilst it is usually relatively easy
to separate the revenue from each, it is often impractical to separate accurately all the
costs of operation other than the cost of sales, because the same employees may
handle both products, and because other goods and services provided in the same
outlet may not be readily identifiable as either food or beverages. In these
circumstances food and beverages are treated together, analysed by sales outlet, and
the related responsibilities are reflected in the organization structure.
• Food and beverage control based on the food and beverage cycles may be
appropriately seen as part of the total accounting function of the hotel. In these
circumstances such employees as restaurant cashiers and cost control clerks are
included on the staff of the hotel accountant. • ‘Where there is a separate sales
department, food and beverage sales are usually closely monitored by that
department, and such arrangements as reservations for functions may form part of the
responsibilities of the sales department.

Miscellaneous Guest Services

Miscellaneous guest services are illustrated in terms of such activities as

telephones and laundry and the typical organizational approaches for most of term are
shown to be of two main kinds:
• the services are operated under direct management of the hotel as minor
operated departments;
• the services are operated under rental and concession arrangements with the
hotel by another firm.
The alternative arrangements may apply in the provision of the following main
services to guests:

beauty shop and secretarial services

hairdressing
florist squash courts and
tennis courts
garage gifts and souvenirs
laundry and dry cleaning swimming pool
newspapers and magazines tobacconist

Direct management of these services normally provides for a closer direct

control and supervision by the hotel and for greater flexibility in operation. In many
hotels the services are merely grouped as residuary hotel activities for accounting and
control purposes and are in practice provided as part of the services of other hotel

478
departments, e.g. reception, uniformed services, housekeeping or general
administration, and are not separate departments in the organizational sense. Only
when the volume of a particular service is sufficiently large, it may be organized as a
separate department. And it is only then that the option arises for the service to be
provided for the guests by another operator, because it warrants his involvement,
under a rental or concession arrangement. Such arrangement then relieves the hotel
from operating what is often to the hotel operator an unfamiliar service and allows it
to concentrate on its primary activities.
Therefore, major deciding factors are the size of the operation, the availability
of suitable operators of particular services, and the operational philosophies of the
hotel or hotel group, as well as the quality of service and the financial return to the
hotel, which may result from one or the other approach.

Hotel Support Services

In practice the non-revenue service activities are organized in one of three

main ways:
• retained among the hotel manager’s own responsibilities;
• assigned to an assistant manager as one of his or her responsibilities;
• assigned to a separate department with its own head of department.
To a greater or lesser extent each of these activities may also draw for its
performance on external specialist advice and assistance.
The main specialist activities, which may be organized in one of these ways,
and examples of the external sources of advice and assistance available to the hotel in
respect of each, can be summarized as follows:

Accounting and finance Hotel accountants and

consultants
Public accountants and
auditors
Professional stock-takers
Personnel services Personnel recruitment and
selection specialists
Work study, personnel and
industrial relations advisers
Training boards and other
agencies
Purchasing Hotel accountants and
consultants
Furniture and equipment
specialists
Various suppliers
Sales and marketing Market research agencies
Advertising agencies
Public relations consultants
Property operation, Architects, builders,
maintenance, energy designers
Consulting engineers
Utility undertakings

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 Advisory services are also sometimes provided by professional bodies, trade
associations for their members, the technical press and other agencies.
Apart from any operational philosophies, the adoption of the organizational
approaches, in respect of a particular activity, is largely determined by the size of
operation: the first is normally associated with a small hotel; the second with medium
size; and the third with large operations, but no hard and fast rules apply. Each of
these activities comprises specialist knowledge and skills, as distinct from normal
operational know-how inherent in the primary operating activities.

The Management Structure

Following the discussion of the division and grouping of operated and service
activities into departments, it is next necessary to consider the total management
structure of the hotel; this comprises all positions of responsibility and authority
below top management, which is represented in a hotel company by the board of
directors. The management team consists of the hotel manager, one or more deputy or
assistant managers, and the heads of departments. A discussion of the management
structure is concerned with these posts and with the relationships between them.
According to the size of the hotel and the particular arrangement in operation,
the hotel chief executive may be variously designated as managing director, general
manager or simply hotel manager. He or she may to agreater or lesser extent
participate in the formulation of the hotel policies and strategies, and will invariably
be responsible for their implementation and for the hotel performance. In larger hotels
this level may be subdivided betweena managing director or general manager and the
hotel manager or a resident manager. The former then reports to the board and
normally coordinates the work of the specialist departments and of the hotel or
resident manager, who is in turn responsible for the day-to-day management of the
hotel activities.
The complexity and continuity of the hotel activities normally give rise to the
need for one or more deputy or assistant managers. A deputy hotel manager normally
has authority over the heads of departments. But there is much variation in the role,
authority and responsibilities of hotel assistant managers.
In some instances they are the hotel manager’s deputies in all but name, in
respect of the whole operation or some parts of it, e.g. food and beverages, front hall,
‘back of the house’, and so on; in other cases they have these specific responsibilities
in addition to their general role as the manager’s deputies. But many so-called
assistant managers perform roles, which are more appropriately described as those of
general assistants (assisting where required throughout the hotel) or of personal
assistants to the manager (acting on his behalf as he directs them to do). Yet in other
cases their main role is guest contact.
All the roles described above may be appropriate in particular circumstances,
but effective hotel management calls for a clear definition of responsibility and
authority. The relationships with heads of departments are especially important in this
context. Titles, which describe the particular roles, can be helpful in this direction.
In order to provide clear-cut lines of responsibility and authority and an
effective coordination of related activities, some hotels function without assistant
managers as such: those who would normally be in such positions are allocated
specific responsibilities and appropriate titles to describe them.
Those in positions of heads of departments fall into two distinct categories.
Heads of operated departments are known as line managers, with direct lines of

480
responsibility and authority to their superiors and to their subordinates in respect of
each operated department. Heads of service departments are specialists who provide
advice and service to line management, and relieve them of such specialist tasks as
are considered to be more effectively discharged through the appointment of
specialists; they have no direct authority over employees other than those of their own
departments. Line management includes, for example, head receptionists, head
housekeepers, head chefs and restaurant managers. Specialists include accountants,
buyers, personnel and purchasing officers and similar posts. In order to draw a
distinction between the two, it is helpful to confine the designation ‘manager’ to
operated departments.
It is also relevant to refer in this context to a confusion, which often arises
with various trainee positions. It is difficult to justilt such titles as ‘trainee manager’
unless its holder has been designated to fill a specific post, for which he is training. A
person who is undergoing training with a view to an ultimate unspecified position of
responsibility is more appropriately described as a management trainee.

IVHotel Services

Rooms and Beds

The primary function of a hotel is to accommodate those away from home and
sleeping accommodation is the most distinctive hotel product. In most hotels room
sales are the largest single source of hotel revenue and in many, more sales are
generated by rooms than by all the other services combined. Room sales are
invariably also the most profitable source of hotel revenue, which yield the highest
profit margins and contribute the main share of the hotel operating profit.
Hotels contributing to annual reports of Horwath International earned on
average the proportions of their total revenue shown in the following from room sales
in the early 1990s.

Room Sales as a Ratio of Hotel Revenue in Main Regions

1990 1991 1992
(%) (%) (%)
Africa and the Middle East 46.0 43.6 45.2
Asia mid Australia 54.1 56.0 57.9
Europe 49.2 49.1 47.0
North America 63.9 62.9 71.6
Latin ArnericalCaribbean 53.8 58.5 56.

Three main hotel activities are earning the room revenue: hotel reception,
uniformed services and Room Sales
A large proportion of hotel guests reserve their rooms from a few hours to
several weeks or months before they actually arrive at the hotel. They do so in person,
by telephone, telegram, Telex or Fax, by mail, through travel agents, and in a growing
number of cases through central reservations systems. Hotel reservations create a

481
multitude of contractual relationships between the hotel and its guests, which begin at
the time each reservation is made and continue until the departure of the guests or
until their accounts are settled after their stay. Advance reservations are an important
responsibility on the part of the hotel, both in the legal and in the business sense, and
call for a system which enables room reservations to be converted into room revenue.
When guests arrive in hotels, they are asked to register by providing the receptionist
with certain particulars about themselves. The hotel register, in which the particulars
are entered, has two main functions; one is to satisfy the law, which makes hotel
registration of guests a legal requirement in most countries. The second function is to
provide an internal record of guests, from which data are obtained for other hotel
records.
In most hotels room allocations of accommodation reserved in advance are
made before the guests’ arrival and only guests registering without a previous
reservation are allocated rooms on arrival, but in some hotels all room allocations are
made only when guests arrive. The registration and room allocation are then the
starting point for guests’ stay and a signal for the opening of their accounts, as well as
for notifying uniformed staff, the housekeeping department, telephonists, and others,
of arrivals.
Several main records document the room sale in the reception office:
• reservation form or card standardizes the details of each booking, forms the
top sheet of any documents relating to it, and enables a speedy reference to any
individual case;
• reservation diamy or daily arrival list records all bookings by date of arrival
and shows all arrivals for a particular day at a glance;
• reservation chart provides a visual record of all reservations for a period and
shows at a glance rooms reserved and those remaining to he sold;
• hotel register records all arrivals as they occur and gives details of all current
and past guests;
• reception or room status board shows all rooms by room number and floor
and gives the current and projected status of all rooms on a particular day, with details
of occupation;
• guest index lists all current guests in alphabetical order with their room
numbers and provides an additional quick point of reference in larger hotels.

Mall and Other Guest Services

A combined key and mail rack is a standard feature of most hotel reception
offices and reflects two typical responsibilities of the office room keys and guest mail,
Arranged by room number and floor, it corresponds in layout to the reception or room
status board and is complementary to it.
In the course of a day’s business room keys arc issued from the rack to
arriving guests and to residents who call for them; keys are returned to the rack by
guests going out of the hotel or departing at the end of their stay. The rack is a point
of reference regarding the occupation of rooms and the whereabouts of guests.
Mail may arrive for guests before, during and after their stay at the hotel, and
may consist ç.f ordinary or registered mail, packets and parcels, cables and’
telegrams, Telex messages, Fax transmissions, express mail and personal messages
left for guests. Mail awaiting guests’ arrival should be handed to them when they are
registering; mail arriving after a guest has left the hotel, should be forwarded. During
the guest’s stay speed is the essence of Fax transmissions, security is the essence of

482
registered mail, bulkiness is the essence of parcels; each calls for standard procedures
of their own. But the key and mail rack is the focus; it accommodates much of the
mail the guest collects when collecting the room key; it can serve to alert the
receptionist to items such as parcels or registered mail, stored elsewhere.
Three basic aids are, therefore, related and complementary in the provision of
key, mail and other guest services:
• guest index shows whether a particular person is resident and that person’s
room number;
• reception or room status board shows who is occupying a particular room;
• key and mail rack indicates whether the guest is in the hotel and whether
there is any mail for that person.
In many hotels the reception office or a separate section of it also acts as a
source of information to guests
— about hotel facilities and services, about the locality, about transport and
other matters. In other hotels the keys, mail and information to guests are provided by
uniformed staff, and there are usually good reasons for one or the other arrangement.
But who does what and to whom the guest can turn, should be made clear to the guest
in terms of individual needs and requirements rather than in terms of the hotel
organization structure, particularly in larger hotels. Such notices as ‘Reception’ and
‘Hall Porter’have different connotations in different hotels and are not necessarily
self-explanatory even for experienced hotel users. Counters and sections of the front
hall of the hotel clearly labelled ‘Registration’, ‘Keys’, ‘Mail’, ‘information’, ‘Guest
Accounts’, and so on, are more meaningful to guests.

Uniformed Services

The second component of the accommodation function is uniformed services,

which form an integral part of the front hail ftmnctions of the hotel and provide a
variety of personal services to guests.
Servicing arrivals and departures are the most common uniformed services.
The meeting and greeting of arriving guests, their luggage and the parking of their
ears, are the first responsibilities, which extend from the hotel entrance and car park to
the hotel bedrooms. On departure, guests, luggage and transportation are again their
primary responsibilities. In an hotel with a hundred departing guests in the morning,
followed by a similar volume of arrivals in the afternoon and evening, uniformed staff
attend in a day’s business to some two hundred people, handle several hundred pieces
of luggage, park several doPzen cars, and arrange several dozen taxis. The guests,
their luggage, and their vehicles, therefore, play a major part in the provision of
uniformed services.
During the guest’s stay uniformed staff are often the main source of
informatinn about the hotel and the locality, and the guest’s main source of such
arrangements as theatre tickets, tours, car hire and other services. The hail porter’s
desk or an enquiry counter in the front hail are then the information centres of hotels,
which contribute much to the range of guest services and to their integration.
In some hotels other guest services may be provided by uniformed staff.
Newspapers, as well as other small articles, may be supplied to guests by uniformed
staff who may also act as messengers, lift operators and men’s cloakroom attendants.
In many hotels uniformed staff are the only people on duty during the night and
particularly in smaller hotels maintain a whole range of hotel services provided by
other departments in day time: to receive and register late arrivals, to serve light

483
refreshments, to operate the hotel switchboard, to arrange early morning calls, as well
as to clean public rooms and to ensure the security of the hotel.
The provision of uniformed services varies greatly between hotels of different
sizes, types and standards, and their organization tends to be influenced by all these
factors, as well as by established practices, As mentioned earlier, information to
guests may he provided by the reception office or as part of uniformed services or by
both. The cleanliness of public rooms may be the responsibility of uniformed staff,
the housekeeping department, or outside contractors. What hotel services are available
during the night and by whom they are provided, is another source of variation. These
differences are legitimate, as long as they reflect the particular requirements of guests
and the particular circumstances of each hotel, and as long as the respective functions
are defined and understood by staff and made clear to guests where they affect them.

Hotel Housekeeping

The basic housekeeping function of the hotel is the servicing of guest rooms.
In its scope, guest bedrooms may be the sole or main responsibility of the hotel
housekeeping department, but it may extend to other areas of the hotel.
Normally hotel guests spend at least one-third of their stay in their room. The
design, layout, decor, furniture and furnishings of the hotel bedroom are fundamental
to meeting their needs and in creating customer satisfaction, and these may be
significantly influenced by the housekeeping department. The cleanliness and good
order, the linen and other room supplies, and the smooth functioning of the room are
the focus of the department. This may include other guest services, such as early
morning teas, guest laundry, baby sitting and other personal services. The main
housekeeping records are made up of arrival and departure lists and notifications
received from the reception office and the housekeeping own room status report,
together with separate records in respect of additional services provided by the
department.
The extension of the housekeeping function outside the hotel bedroom
normally includes the cleaning of bedroom floors and may include staircases, public
cloakrooms and other public areas of the hotel. However, it is quite common for such
public rooms as hotel lounges to be cleaned by uniformed staff, for the responsibility
for the men’s and women’s cloakrooms to be divided between uniformed staff and the
housekeeping department, and for restaurants and bars to be cleaned by the staff of
those departments. More recently, hotels have been engaging outside contract firms
for the cleaning of public rooms.
Other housekeeping services often include the provision of first aid to guests
and staff, dealing with lost property, and floral arrangements throughout the hotel.
When staff accommodation is provided by the hotel, it may be included as part of the
head housekeeper’s responsibilities. Although in many countries hotels increasingly
use outside laundries and dry cleaning firms for their requirements, many hotels
operate their own dry cleaning and laundry facilities. These ‘in-house’ facilities may
be then organized as separate departments of the hotel or as sections of the
housekeeping department.
This outline of the hotel housekeeping function illustrates three organizational
approaches. One seeks to integrate a number of related functions within a major
housekeeping department. The second assigns certain functions to the housekeeping
department and others to other departments of the hotel, largely on the basis of

484
physical areas. The third consists of ‘buying in’ certain services from outside
suppliers rather than operating them directly as hotel facilities. Food and Drink
The food and drink service is the second major activity of most hotels and in
many of them it accounts for a larger proportion of employees than the provision of
sleeping accommodation and related services. This is due to two main factors:
• in contrast to hotel rooms, meals and refreshments in hotels may be supplied
to non-residents as well as to resident guests and include substantial functions sales;
• the provision of meals and refreshments is relatively labour intensive.
The provision of sleeping accommodation is a service activity, in which there
is a negligible use of materials, and there is no cost of sales. The provision of meals
and refreshments results in composite products made up of commodities and of
service, and the use of materials represent the cost of sales. Food and drink enter into
meals and refreshments served in hotels in several stages from their purchase by the
hotel to their sale in the same or altered form to the hotel customer. According to the
size and diversity of the hotel markets there may be more than one restaurant and bar
and also food and drink service in rooms and through functions.

Restaurants

Restaurants establishment where refreshments or meals may be procured by

the public. The public dining room that came ultimately to be known as the restaurant
originated in France, and the French have continued to make major contributions to
the restaurant’s development.
The first restaurant proprietor is believed to have been one A. Boulanger, a
soup vendor, who opened his business in Paris in 1765. The sign above his door
advertised restoratives, or restaurants, referring to the soups and broths available
within. The institution took its name from that sign, and “restaurant” now denotes a
public eating place in English, French, Dutch, Danish, Norwegian, Romanian, and
many other languages, with some variations. For example, in Spanish and Portuguese
the word becomes restaurante, in Italian it is ristorante; in Swedish, restaurang; in
Russian, restoran; and in Polish, restauracia. Although inns and hostelries often served
paying guests meals from the host’s table, or table d’hôte, and beverages were sold in
cafés, Boulanger’s restaurant was probably the first public place where any diner
might order a meal from a menu offering a choice of dishes.
Boulanger operated a modest establishment; it was not until 1782 that La
Grande Taverne de Londres, the first luxury restaurant, was founded in Paris. The

485
owner, Antoine Beauvilliers, a leading culinary writer and gastronomic authority,
later wrote L ‘Art du cuisinier (1814), a cookbook that became a standard work on
French culinary art.
The most illustrious of all 19th-century Paris restaurants was the Café Anglais,
on the Boulevard des Italiens at the corner of the rue Marivaux, where the chef,
Adoiphe Dugléré, created classic dishes such as sole Dugléré (filets poached with
tomatoes and served with a cream sauce having a fish stock base) and the famous
sorrel soup potage Germiny. On June 7, 1867, the Café Anglais served the now-
famous “Three Emperors Dinner” for three royal guests visiting Paris to attend the
Universal Exposition. The diners included Tsar Alexander 11 of Russia; his son the
tsarevich (later the tsar Alexander III); and King William I of Prussia, later the first
emperor of Germany. The meal included souffles with creamed chicken (a Ia reine),
fillets of sole, escalloped turbot, chicken a la portugaise (cooked with tomatoes,
onions, and garlic), lobster a la parisienne (round, flat medallions glazed with a
gelatin-mayonnaise mixture and elaborately decorated), ducklings a Ia rouennaise (the
carcasses stuffed with liver and pressed, presented on a platter with boned slices of
the breast and the grilled legs, and served with a red wine sauce containing pureed
liver), ortolans (small game birds) ontoast, and eight different wines.
Toward the end of the 19th century, in the gaudy and extravagant era known
as ia belie époque, the luxurious Maxim’s, on the rue Royale, became the social and
culinary centre of Paris. The restaurant temporarily declined after World War I but
recovered under new management, to become an outstanding gastronomic shrine.
France produced many of the world’s finest chefs, including Georges-Auguste
Escoffier, who organized the kitchens for the luxury hotels owned by César Ritz,
developing the so-called brigade de cuisine, or kitchen team, consisting of highly
trained experts each with clearly defined duties. These teams included a chef, or gros
bonnet, in charge of the kitchen; a sauce chef, or deputy; an entremettier, in charge of
preparation of soups, vegetables, and sweet courses; a rótisseur to prepare roasts and
fried or grilled meats; and the garde manger, in charge of all supplies and cold dishes.
In Escoffier’s time, the duties and responsibilities of each functionary were sharply
defined, but in modern times, rising labour costs and the need for faster service have
broken down such rigidly defined duties. In the kitchens of even the leading modern
restaurants, duties at the peak of the dinner-hour preparations are likely to overlap
widely, with efficiency maintained amid seeming chaos and confusion.
I n the 20th century, with the development of the automobile, country
dining became popular in France, and a number of fine provincial restaurants were
established. The Restaurant de la Pyramide, in Vienne, regarded by many as the
world’s finest restaurant, wasfounded by Fernand Point and after his death, in 1955,
retained its high standing under the direction of his widow, Madame “Mado” Point.
Other leading French provincial restaurants have included the Troisgros in Roanne;
the Paul Bocuse Restaurant near Lyon; the Auberge de 1’Ill in Illhaeusern, Alsace;
and the hotel Côte d’Or, at Saulieu.
French restaurants today are usually in one of three categories: the bistro, or
brasserie, a simple, informal, and inexpensive establishment; the medium-priced
restaurant; and the more elegant grand restaurant, where the most intricate dishes are
executed and served in luxurious surroundings.
Other nations have also made many significant contributions to the
development of the restaurant.
In Italy the botteghe (coffee shop) of Venice originated in the 16th century, at
first serving coffee only, later adding snacks. The modern trattorie, or taverns, feature

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local specialities. The osterie, or hostelries, are informal restaurants offering home-
style cooking. In Florence small restaurants below street level, known as the buca,
serve whatever foods the host may choose to cook on a particular day.
Austrian coffeehouses offer leisurely, complete meals, and the diner may
linger to sip coffee, read a newspaper, or even to write an article. Many Austrians
frequent their own “steady restaurants,” known as Stain,nbe
In Hungary the csárda, a country highway restaurant, offers menus usually
limited to meat courses and fish stews.
The beer halls of the Czech Republic, especially in Prague, are similar to
coffeehouses elsewhere. Food is served, with beer replacing coffee.
The German Weinstube is an informal restaurant featuring a large wine
selection, and the Weinhaus, a food and wine shop where customers may also dine,
offers a selection of foods ranging from delicatessen fare to full restaurant menus. The
Schenke is an estate-tavern or cottage pub serving wine and food. In the cities a
similar establishment is called the Stadischenke.
In Spain the bars and cafés of Madrid offer widely varied appetizers, called
tapas, including such items as shrimp cooked in olive oil with garlic, meatballs with
gravy and peas, salt cod, eels, squid, mushrooms, and tuna fish. The tapas are taken
with sherry, and it is a popular custom to go on a chateo, or tour of bars, consuming
large quantities of tapas and sheny at each bar. Spain also features the marisco bar, or
marEs querIa, a seafood bar; the asadoro, a Catalan rotisserie; and the tasca, or pub-
wineshop.
In Portugal, cervejarias are popular beer parlours also offering shellfish. Fado
taverns serve grilled sausages and wine, accompanied by the plaintive Portuguese
songs called fados (meaning “fate”).
In Scandinavia sandwich shops offer open-faced, artfully garnished
sandwiches called smorrebrod. Swedish restaurants feature the smorgasbord, which
literally means “bread and butter table” but actually is a lavish, beautifully arranged
feast of herring, shrimp, pickles, meatballs, fish, salads, cold cuts, and hot dishes,
served with aquavit or beer.
The Netherlands has broodjeswinkels, serving sandwich open-faced shops,
called sandwiches, seafoods, hot and cold dishes, and cheeses from a huge table.
English city and country pubs have three kinds of bars: the public bar, the
saloon, and the private bar. Everyone is welcome in the public bar or saloon, but the
private bar is restricted to habituës of the pub. Pub food varies widely through
England, ranging from sandwiches and soups to pork pies, veal and ham pies, steak
and kidney pies, bangers (sausages) and a pint (beer), bangers and mash (potatoes),
toad in the hole (sausage in a Yorkshire pudding crust), and Cornish pasties, or pies
filled with meat and vegetables.
In the tavérnas of Greece, customers are served such beverages as retsina, a
resinated wine, and ouzo, an anise-flavoured aperitif, while they listen to the music of
the bou:ouki. Like other Mediterranean countries, Greece has the groceiy-tavérna
where one can buy food or eat.
The Turkish iskembeci is a restaurant featuring tripe soup and other tripe
dishes; muhalleb icE shops serve boiled chicken and rice in a soup and milk pudding.
Characteristic of Japan are sushi bars that serve sashimi (raw fish slices) and
sushi (fish or other ingredients with vinegared rice) at a counter. Other food bars serve
such dishes as noodles and tempura (deep- fried shrimp and vegetables). Yudofu
restaurants build their meals around varieties of tofu (bean curd), and the elegant tea
houses serve formal Kaiseki table d’hôte meals.

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 In China, restaurants serving the local cuisine are found, and noodle shops
offer a wide variety of noodles and soups. The dim-sum shops provide a never-ending
supply of assorted steamed, stuffed dumplings and othersteamed or fried delicacies.
A common sight in most parts of Asia is a kind of portable restaurant,
operated by a single person or family from a wagon or litter set up at a particular
street location, where specialties are cooked on the spot. Food and cooking utensils
vary widely in Asia.
The cafeteria, an American contribution to the restauranfs development,
originated in San Francisco during the 1849 gold rush. Featuring self-service, it offers
a wide variety of foods displayed on counters. The customer makes his selections,
paying for each item as he chooses it or paying for the entire meal at the end of the
line. Other types of quick-eating places originating in the United States are the
drugstore counter, serving sandwiches or other snacks; the lunch counter, where the
diner is served a limited quick-order menu at the counter; and the drive-in, “drive-
thru,” or drive-up restaurant, where patrons are served in their automobiles. So-called
fast-food restaurants, usually operated in chains or as franchises and heavily
advertised, offer limited menus-- typically comprising hamburgers, hot dogs, fried
chicken, or pizza and their complements--and also offer speed, convenience, and
familiarity to diners who may eat in the restaurant or take their food home. Among
fast-food names that have become widely known are White Castle (one of the first,
originating in Wichita, Kan., in 1921), McDonald’s (which grew from one
establishment in Des Flames, Ill., in 1955 to more than 15,000 internationally within
40 years), Kentucky Fried Chicken (founded in 1956), and Pizza Hut (1958). Many
school, work, and institutional facilities provide space for coin-operated vending
machines that offer snacks and beverages. The specialty restaurant, serving one or two
special kinds of food, such as seafood or steak, is another distinctive American
establishment.
The Pullman car diner, serving full-course meals to long distance railroad
passengers, and the riverboat steamers, renowned as floating gourmet palaces, were
original American conceptions. They belong to an earlier age, when dining out was a
principal social diversion, and restaurants tended to become increasingly lavish in
food preparation, decor, and service. In many modern restaurants, customers now
prefer informal but pleasant atmosphere and fast service. The number of dishes
available, and the elaborateness of their preparation, has been increasingly curtailed as
labour costs have risen and the availability of skilled labour decreased. The trend is
toward such efficient operations as fast-food restaurants, snack bars, and coffee shops.
The trend in elegant and expensive restaurants is toward smaller rooms and intimate
atmosphere, with authentic, highly specialized and limited menus.

Miscelaneous Guest Services

Accommodation, food and drink services are the major activities of hotels,
which generate all or most hotel revenue, account for all or most of their employees,
and represent the principal products provided by the major hotel departments.
But the present-day hotel guest normally also expects other facilities and
services. In addition to a comfortable room, and meals and refreshments in a
restaurant or bar or in the room, a guest may want to use the telephone or have clothes
laundered or dry cleaned. In a large modern hotel a guest may anticipate to be able to
buynewspapers, magazines and souvenirs, have a haircut, obtain theatre tickets, and
book an airline ticket for the next stage of a trip.

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 The hotel services other than accommodation, food and drink may be provided
to the guest by the hotel or by other operators on the hotel premises. The revenue-
earning activities provided directly by the hotel are variously described as ancillary or
subsidiary revenue- earning, and are grouped for accounting and control purposes in
what are known as minor operated departments, to distinguish them from major
operated departments concerned with rooms, food and beverages. Both are
distinguished from rental and concession arrangements, under which some of these
and other services may be provided to guests by outside firms operating in the hotel.
The three basic components of the accommodation function are present in
most hotels and are normally organized in separate departments. But their
organization and staffmg often differ in hotels of different sizes, types and standards.
In smaller hotels only a few people may be engaged in each and cover a wide range of
duties; as the hotel increases in size, each activity may be subdivided into separate
departments or sections, in which those engaged in them perform more specialized
tasks.
A transit city hotel with a short average length of stay calls for a somewhat
different approach from that of a resort hotel, which accommodates guests for longer
and often such regular periods as one or two weeks. There is also a relationship
between prices, the range and quality of facilities and services provided, and the way
they are organized. For all these and other reasons it is possible to describe the hotel
activities related to the accommodation of guests only in broad and general terms.

V. Tourist Attractions

Tourist attractions have an important role to play in world tourism since they
often provide the motivating force for travel, thereby energising the many components
of the tourist industry. The scope of the attractions sector is immense; logically
anything that has the power to draw visitors to it can be considered an attraction.
Moreover an attraction may not be a readily identifiable place or feature, but a
visitor’s overall perception of a destination as an attractive place to visit, distilled
from a variety of surces and images. London’s current popularity as a tourist
destination with young visitors from around the world is a good case; they are not
attracted primarily by the traditional Big Ben, Buckingham Palace, Houses of
Parliament but rather by the image of the capital as a “cool” place to hear good music
and have an enjoyable time.
Touristic attractions occur at a variety of scales. Many internationally famous
attractions such as:
San Francisco’s Golden Gate Bridge
Red Square in Moscow
The Ponipidou Centre in Paris are household names on many tourists’ “must
see” lists.
Domestic tourists travel within their own countries to a variety of attractions,
some of which are provided free of charge while others charge admission. These may
be day visits or a part of a long holiday or short break.
Tourist attraction are provided by both commercial and non-commercial
organizations. Many historic buildings, areas of landscape or wildlife interest,
museums and ancient monuments are in the care of public bodies and voluntary
groups which aim to preserve or conserve vital parts of a country’s heritage while at
the same time making facilities available to tourists.

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 Types of tourist attractions

Tourist attractions are generally classified into one of

two categories:
Natural attractions
Man made attractions such as:
Heritage attractions (e.g. Williamsburg)
Museums and ancient monuments (‘e.g Louvre in Paris)
Theme parks (e.g. Walt Disney World in Florida)
Entertainments (e.g The Sydney Opera House)
Sport facilities (e.g Winter Olimpic Gaines)
Leisure shopping venues (‘e.gThe Metro Center in Englanc
Wildlife areas (e.g Busch Garden in Florida)

Tourism today

The mass tourism that exists in the world today is a phenomenon of the post-
industrial society of the latter half of the twentieth century. Tourism has become an
integral part of the move away from economies based on heavy engineering and
manufacturing to a rapidly expanding service sector. The growth in international and
domestic tourism since the 1950s has been nothing short of dramatic, with
international tourist arrivals climbingfrom 25 million in 1950 to a record 592 million
in 1996 (World Tourism Organisation, 1997). When we add to this the fact that the
volume of domestic tourism worldwide is estimated by the World Tourism
Organisation to be approximately ten times greater than that of international tourism
(World Tourism Organisation. 1983), the scale of the tourism phenomenon can begin
to be appreciated. Greater wealth, higher educational standards, increased mobility
and more leisure time have all contributed to unparalleled demand for holidays and
excursions at home and abroad. Overseas travel is no longer the preserve of the
privileged few, but is available to the majority, as developments in transportation,
increased competition and global communications technology have reduced the real
cost of holidays. Private and public sector organisations have responded to the
increased demand by providing a wide range of facilities and products to meet the
needs of an increasingly discerning travelling public. It must be remembered,
however, that tourism is a very recent phenotnenon that has hitherto been allowed to
grow in a business environment relatively free of regulation and trade restrictions.
Such an unrestricted environment is unlikely to continue in years to come.
The current scale and scope of the international tourism industry is illustrated
in recent data from the World Travel and Tourism Council (1996), which indicate that
in 1996 the world travel and tourism industry is estimated to have:
• Gmployed 255 million people
• Generated an output of US $3.6 trillion
• Contributed 10.7 per cent of global gross domestic product (.GDP) o
invested US $766 billion in capital projects
• Generated( US $761 billion in world exports
• Paid US $653 billion in taxes worldwide

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 Such figures demonstrate the economic significance of the tourism industry on
a global scale and confirm that the age of mass tourism has truly arrived in
spectacular fashion.

Local Tours

Paris

Paris is the capital of France and one of Europe’s largest conurbations. The
city was founded more than 2,000 years ago on an island in the Seine River, some
233 miles (375 kilometres) upstream from the river’s mouth on the English
Channel. The modern city has spread from the island (the lie de la Cite) and far
beyond both banks of the Seine. The City of Paris itself covers an area of 41 square
miles (105 square kilometres); the Greater Paris conurbation, formed of suburbs and
other built-up areas, extends around it in all directions to cover approximately 890
square miles. Paris occupies a central position in the rich agricultural region known as
the Paris Basin, and it constitutes one of eight départements of theIle-de-France
administrative region. It is by far the nation’s most important centre of commerce and
culture.

NEIGHBOUR FlOODS AND SIGHTS

Paris’ many old buildings, monuments, gardens, plazas, boulevards, and

bridges compose one of the world’s grandest cityscapes. An impressive spot from
which to view the city is the Chaillot Palace, which stands on a rise on the Right Bank
of the Seine to the west, where the river begins its southwestward curve.

The Chaillot Palace.

The Chaillot Palace dates from the International Exposition of 1937. It

replaced the Trocadéro Palace, a structure left over from the 1878 International
Exposition. The Chaillot Palace is made up of two separate pavilions, from each of
which extends a curved wing. The Musée de I’Homme, the Naval Museum, the
Museum of French Monuments, and the Cinema Museum are located there. Under the
terrace that separates the two sections are two theatres, the National Theatre of
Chaillot and a small hall that serves as one of the two motion- picture houses of the
national film library.
The terrace, which is lined by statues, gives a splendid view across Paris. The
slope descending to the river has been made into a terraced park, the centre of which
is alive with fountains, cascades, and pools. The Trocadéro Aquarium is in a grotto a
few steps away in the park.
From the bottom of the slope the five-arched Jena Bridge (Pont d’Iéna) leads
across the river. It was built for Napoleon in 1813 to commemorate his victory at
theBaffle of Jena in 1806. On the Left Bank rises the Eiffel Tower, an unclad metal
truss tower designed by Gustave Eiffel. The tower was built for the International
Exposition of 1889, against the strident opposition of national figures who thought it
unsafe or ugly or both. When the exposition concession expired in 1909, the 984-foot
(300-metre) tower was to have been demolished, but its value as an antenna for radio
transmission saved it. Additions made for television transmission have added 56 feet

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to the height. From the topmost of the three platforms the view extends for more than
40 miles.

From the two-acre base of the tower the Champ-de Mars (“Field of Mars”), an
immense field, stretches to the Military Academy (Ecole Militaire), which was built
from 1769 to 1772 and is still used by the War College (Ecole Supérieure de Guerre).
The Champ-de-Mars, which originally served as the school’s parade ground, was the
scene of two vast rallies during the French Revolution: that of the Federation (1790)
and that of the Supreme Being (1794). From 1798 there were annual national
expositions of crafts and manufactures, which were followed by world’s fairs between
1855 and 1900. Behind the Military Academy stands the headquarters of the United
Nations Educational, Scientific and Cultural Organization (UNESCO). The building,
erected in 1958, was designed by an international trio of architects and decorated by
artists of member nations.

The Invalides.

One street to the northeast is the Hotel des Invalides, founded by Louis XIV to
shelter 7,000 aged or invalid veterans. The enormous range of buildings was
completed in five years (1671-76). The gold-plated dome (1675-1706) that rises
above the hospital buildings belongs to the church of Saint-Louis. The dome was
designed by Jules Ilardouin-Mansart, who employed a style known in France as
“Jesuit” because it derives from the Jesuits’ first church in Rome, built in 1568. The
churches of the French Academy (Académie Francaise), the Val-de-Grâce Hospital,
and the Sorbonne, as well as three others in Paris, all of the 17th century, followed
this style. By using the classical elements more freely than had been done in Rome,
the French made it something recognizably Parisian.
In the chapels of Saint-Louis are the tombs of Napoleon’s brothers Joseph and
Jérôme, of his son (whose body was returned from Vienna in 1940 by Adolf Hitler),
and of the marshals of France. Immediately beneath the cupola is a red porphyry
sarcophagus that covers the six coffins, one inside the other, enclosing the remains of
Napoleon, which were returned from St. Helena in 1840 through the efforts of King
Louis Philippe. Napoleon’s uniforms, personal arms, and deathbed are displayed in
the Army Museum at the front of the Invalides. A portion of the Invalides still serves
as a military hospital; facilities have been modernized since World War II.

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 The vast, tree-lined Invalides Esplanade slopes gently to the Quai d and the
Alexandre III Bridge. The first stone for the bridge, which commemorates the Russian
tsar Alexander III, was laid in 1897 by Alexander’s son, Tsar Nicholas II. The bridge
was finished in time for the International Exposition of 1900, and it leads to two other
souvenirs of that year’s fair, the Grand Palais and the Petit Palais. The buildings are
still used for annual shows and for major visiting art exhibits.

The Louvre.

Vikings camped on the Right Bank across from the western tip of the lie de la
Cite in their unsuccessful siege of Paris in 885, and in about 1200 King Philip II had a
square crusader’s castle built on the same site, just outside the new city wall, to
buttress the western defenses. Over the following centuries many additions and
renovations were made, and from the castle grew one of the world’s largest palaces,
completed only in 1852. From the original square, known as the Cour Carrëe (“Square
Court”), two galleries extend westward for 1,640 feet, one along the river, the other
along the rue de Rivoli. In 1871, only 19 years after the huge oblong was completed,
its western face, the Tuileries Palace (begun 1563), was destroyed by the
insurrectionists of the Commune.
Two of the facades of the Cour Carrée had strong influence on French
architecture. Pierre Lescot began his inner courtyard facade in 1546, adapting the
Renaissance rhythms and orders he had observed in Italy and adding purely French
decoration to the classical motifs. The physician and architect Claude Perrault
collaborated with Louis Le Vau, architect to the king, to design the outer east face of
the palace in 1673. It, too, employs classic elements, making especially graceful use
of coupled columns and a pediment.
The Louvre Museum occupies the four sides of the palace around the Cour
Carrée as well as the south gallery, which stretches along the river. Among the
treasures of the museum are the Victory of Samothrace, the Venus de Milo, and the
Mona Lisa. The enormous collections contain works from the 7th century BC to the
mid-l9th century, with a huge cultural and geographic spread. The north gallery, along
the rue de Rivoli, houses a separate museum, the Museum of Decorative Arts, as well
as the Ministry of Finance.
Extensive remodeling has been undertaken throughout the Louvre to increase
space for art works. Construction began in the early 1980s to create a new main
entrance and underground reception hail in the vast Napoleon Courtyard, between the
two galleries; the 70-foot-high glass pyramid designed by I.M. Pei to cover the
entrance aroused both strong support and spirited criticism.
The Arts Bridge (Pont des Arts), which crosses the Seine from the Louvre to
the Left Bank, is one of the most charming of all the Parisian bridges. It was the first
(1803) to be made of iron, and it has always been reserved for pedestrians: it provides
an intimate view of riverside Paris and of the Seine itself.

Ile de la Cite.

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 Downstream and just below the bridge is the tip of the Ile de la Cite, fashioned
into a triangular gravel-pathed park bordered by flowering bushes, with rustic benches
under the ancient trees. It is surrounded by a wide cobbled quay that is especially
popular with sunbathers and lovers. Where the steps come onto the bridge from the
park there is a bronze equestrian statue of King Henry W, who insisted on completion
of the Pont-Neuf The statue is an 1818 reproduction of the 1614 original, which was
the first statue to stand on a public way in Paris. Opposite is the narrow entrance to
the Place Dauphine (1607), named for Henry’s heir, the future Louis XIII. The place
was formerly a triangle of uniform red-brick houses pointed in white stone, but the
row of houses along its base was ripped out in 1871 to make room for construction of
part of the Palace of Justice.
The ship-shaped lie de la Cite is 10 streets long and five wide. Eight bridges
link itto the riverbanks and a ninth leads to the scow-shaped lie Saint-Louis, which
lies to the southeast.
The palace of the early Roman governor (now the Palace of Justice) was
rebuilt on the same site by Louis IX (St. Louis) in the 13th century and enlarged 100
years later by Philip IV the Fair, who added the grim, gray turreted Conciergerie, with
its impressive Gothic chambers. The Great Hail, which, under the kings, was the
meeting place of the Pariement (the high court of justice), was known throughout
Europe for its Gothic beauty. Fires in 1618 and 1871 destroyed much of the original
room, however, and most of the rest of the palace was devastated by flames in 1776.
The Great Hall now serves as a waiting room for the courts, in one of which, the
adjoining first Civil Chamber, the Revolutionary Tribunal sat from 1793, condemning
2,600 persons to the guillotine. After sentencing, the victims were taken back down
the stone stairs to the dungeons of the Conciergerie to await the tumbrils. The
Conciergerie still stands and is open to visitors.
In the palace courtyards is found one of the great monuments of France, the
13th-century Sainte-Chapelle (‘Chapel”). Built at Louis IXs direction between 1243
and 1248, it is a masterpiece of Gothic Rayonnant style. With great daring, the
architect (possibly Pierre de Montreuil) poised his vaulted ceilings on a trellis of
slender columns, the walls between being made of stained glass. The exquisite chapel
was designed to hold the Crown of Thorns, thought to be the very one worn by Jesus
at his crucifixion. Louis IX had purchased the relic from the Venetians, who held it in
pawn from Baldwin, the Latin king of Byzantium. Other holy relics, such as nails and
pieces of wood from the True Cross, were added to the chapel’s collection, the
remnants of which are now in the treasury of Notre-Dame.
Under King Louis-Philippe (1830-48), the “sanitization” of the island was
begun, and it was continued for his successor, Napoleon III, by Baron Georges

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Haussmann. The project involved a mass clearing of antiquated structures, widening
of streets and squares, and the erection of massive new government offices, including
parts of the Palace of Justice. The portion of the palace that borders the Quai des
Orfêvres- formerly the goldsmiths’ and silversmiths’ quay—became the headquarters
of the Paris municipal detective force, the Police Judiciaire (“Judicial Police”), which
keeps a small museum on the fourth floor.
Across the boulevard du Palais is the Police Prefecture, another 19th-century
structure. On the far side of the prefecture is the Place du Parvis-Notre-Dame, an open
space enlarged six times by Haussmann, who also moved the Hôtel-Dieu, the first
hospital in Paris, from the riverside to the inland side of the square. Its present
buildings date from 1868.

Notre-Dame de Paris.

At the east end of the square is the cathedral of Notre Dame de Paris, which is
situated on a spot that Parisians have always reserved to the practice of religious rites.
The Gallo-Roman boatmen of the cite erected their altar to Jupiter there (it is now in
the Cluny Museum), and, when Christianity was established, a church was built on the
temple site. The first bishop of Paris, St. Denis, became its patron saint. The red in the
colours of Paris represents the blood of this martyr who, in popular legend, after
decapitation, picked up his head and walked.
When Maurice de Sully became bishop in 1159 he decided to replace the
decrepit cathedral of Saint-Etienne and the 6th-century Notre-Dame with a church in
the new Gothic style. The style was conceived in France, and a new structural
development, the flying buttress, which added to the beauty of the exterior and
permitted interior columns to soar to new heights, was introduced in the building of
Noire-Dame. Construction began in 1163 and continued until 1345.
After being damaged during the French Revolution, the church was sold at
auction to a building-materials merchant. Napoleon came to power in time to annul
the sale, and he ordered that the edifice be redecorated for his coronation as emperor
in 1804. Louis-Philippe later initiated restoration of the neglected church. The
architect Eugene Viollet-le-Duc worked from 1845 to 1864 to restore the monument.
Like all cathedrals in France, Notre-Dame is the property of the state, although its
operation as a religious institution is left entirely to the Roman Catholic Church.

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 A few 16th- and 17th-century buildings survive north of the cathedral. They
are what remain of the Cloister of the Cathedral Chapter, whose school was famous
long before the new cathedral was built. Early in the 12th century, one of its
theologians, Peter Abelard, left the cloister with his disciples, crossed to the Left
Bank, and set up an independent school in the open air in the Convent of the Paraclete
near the present Place Maubert. After a prolonged struggle with the monks of Saint-
Denis the followers of Abelard in 1200 won the right, from both the king and the
pope, to form and govern their own community. This was the beginning of the
University of Paris.

Rue de Rivoli.

The Louvre and the Tuileries Gardens take up the south side of this street, and
on the other side runs an arcade more than a mile long. Opposite the middle of the
Louvre, the Place du Palais-Royal leads to the palace of Cardinal de Richelieu, which
he willed to the royal family. Louis XIV lived there as a child, and during the
minority of Louis XV the kingdom was ruled from there by the debauched but gifted
regent Philippe II, duc d’Orléans from 1715 to 1723. Late in the 18th century Louis-
Philippe d’Orléans, who was popularly renamed Philippe-Egalité during the
Revolution for his radical opinions, undertook extensive building around the palace
garden. It was a commercial operation, and the Prince hoped to pay his debts from the
property rents. Around the garden he built a beautiful oblong of colonnaded galleries
and at each end of the gallery farthest from his residence a theatre. The larger
playhouse has been the home of the Comédie-Française, the state theatre company,
since Napoleon’s reign. The princely apartments now shelter high state bodies such as
the Council of State.
Just behind the courtyard is the Bibliothêque Nationale (National Library), the
national library of deposit, with an enormous collection of books and prints.
Haussrnann greatly enlarged the Place du Palais-Royal in 1852, and he was careful to
preserve the palace when he laid out the avenue de l’Opéra. At the top of the avenue,
where the Grands Boulevards crossed an enormous new place, the new opera house
was built from 1825 to 1898. The Paris Opera House, a splendid monument to the
Second Empire, was designed in the neo-Baroque style by Charles Gamier. It is
known especially for its decorative embellishments, chief among them the Grand
Staircase. Just behind the Opera House are various large department stores.

The next place along the rue de Rivoli is the Place des Pyramides. The gilded
equestrian statue of Joan of Arc stands not far from where she was wounded at the

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Saint Honoré Gate (Porte Saint-Honoré) in her unsuccessful attack on Paris (at that
time held by the English), on Sept. 8, 1429.
Farther along toward the Place de la Concorde the rue de Castiglione leads to
the Place Vendôme, an elegant octagonal place, little changed from the 1698 designs
of Jules Hardouin-Mansart. In the centre, the Vendôme Column bears a statue of
Napoleon. It was pulled down during the Commune and put back up under the Third
Republic (187 1-1940). The place and the rue de la Paix have lost none of their
discreet distinction, nor have their shops.

The “Triumphal Way.”

From the Arc de Triomphe du Carrousel, in the courtyard between the open
arms of the Louvre, extends one of the most remarkable perspectives to be seen in any
modern city. It is sometimes called la Voie Triomphale ( Triumphal Way!!). From
the middle of the Carrousel arch the line of sight runs the length of the Tuileries
Gardens, lines up on the obelisk in the Place de Ia Concorde, and goes up the
Champs-Elysees to the centre of the Arc de Triomphe and beyond to the skyscrapers
of La Defense, in the western suburbs.
The Louvr&s modest triumphal arch stands in the open
space where costumed nobles performed in an equestrian
display-- carrousel--to celebrate the Dauphin’s birth in
1662. The design of the arch, an imitation of that of the
Arch of Septimius Severus in Rome, was conceived in
1808 by Charles Percier and Pierre Fontaine. The flanks of the Carrousel arch
are incised with a record of Napoleon’s victories.

The Tuileries Gardens, which fronted the Tuileries Palace (looted and burned
in 1871 during the Commune), have not altered much since André Le Nôtre
redesigned them in 1664. Le Nôtre was born and died in the gardener’s cottage in the
Tuileries; he succeeded his father there as master gardener. His design carried the line
of the central allée beyond the gardens and out into the countryside by tracing a path
straight along the wooded hill west of the palace. On this hilltop, 170 years later, the
Arc de Triomphe was erected.
The Place de la Concorde was designed as a moated octagon in 1755 by
Jacques-Ange Gabriel. The river end was left open, and on the inland side two
matching buildings were planned. Viewed clockwise starting from the Navy Ministry
(Ministère de la Marine), the statues are Lille, Strasbourg, Lyon, Marseille, Bordeaux,
Nantes, Brest, and Rouen. Louis-Philippe also had the Luxor Obelisk, a gift from
Egypt, installed in the centre and flanked by two fountains

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 Between the twin buildings on the northeastern side of the place, the broad rue
Royale mounts to the Church of Sainte-Marie-Madeleine, consecrated in 1842.
The church is a stern oblong, fenced with columns 60 feet high. Its design, supposedly
that of a Greek temple, is actually closer to the Roman notion of Greek.
The Place de la Madeleine is the western terminus of the Grands Boulevards,
which imitate the arch of the river from there north and east to the Place de la
Republique and the Bastille.
To the west off the rue Royale runs the rue du Faubourg Saint-Honoré, which,
in addition to the British Embassy and the Elysee Palace (residence of the French
president), has on its shop windows some of the most prestigious names in the Paris
fashion trade.
Along the first 2,500 feet of the Champs-Elysées, between Concorde and the
Rond-Point des Champs Elysées (a roundabout, or traffic circle), little has changed for
a century: the avenue is bordered with chestnut trees, behind which on both sides are
gardens, usually full of children at play. The pavilions in the gardens are used as
tearooms, restaurants, and theatres. From the Rond-Point up to the Arc de Triomphe,
however, the avenue has changed with the times. Under the Second Empire this was a
street of luxurious town houses. They were supplanted by cafés, nightclubs, luxury
shops, and cinemas, but the Street retained its feeling of luxury, and the tree-shaded
sidewalks (wide as a normal Street) offered promenades that were the pride of Paris.
Since the 1950s, however, banks, automobile showrooms, airline offices, and fast-
food eateries have taken over much of the space.
At the top of the Champs-Elysëes is a circular place from which 12 imposing
avenues radiate to form a star (étoile). It was called Place de l’Etoile from 1753 until
1970, when it was renamed Place Charles de Gaulle. In the centre of the place is the
Arc de Triomphe, commissioned by Napoleon in 1806. It is twice as high and as wide
as the Arch of Constantine, in Rome, which inspired it. Jean Chaigrin was the
architect and François Rude sculpted the frieze and the spirited group, ‘The Departure
of the Volunteers of 1792” (called “La Marseillaise”). On Armistice Day in 1920, the
Unknown Soldier was buried under the centre of the arch, and each evening the flame
of remembrance is rekindled by a different patriotic group.

The Latin Quarter (Quartier Latin).

At the Concorde Bridge the boulevard Saint-Germain begins, curving

eastward to join the river again at the Sully Bridge. A little less than halfway along
the boulevard is the pre-Gothic church of Saint-Germain des-Prés. The old church,
which belonged to a Benedictine abbey founded in the 8th century, was sacked four
times by Vikings and was rebuilt between 990 and 1201. Parts of the present church
date from that time.
Beyond the boulevard Saint-Michel is the university precinct, self-governing
under the kings, where, in class and out, students and teachers spoke Latin until 1789.
At the junction of the boulevards Saint-Germain and Saint Michel are the remains of
one of the three baths of the Roman city. These are in the grounds of the Cluny
Museum, a Gothic mansion built 1485-1500, which now houses a collection of
medieval works of art, including the renowned six-panel unicorn tapestry “La Dame a
Ia licorne.”
The wide, straight boulevard Saint-Michel is the main street of the student
quarter. It is lined with bookshops, cafés, cafeterias, and movie houses. The buildings
of the university are found on smaller streets. The university was built up of colleges,

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each founded and supported by a donor, often a prelate or a religious order. In about
1257 Robert de Sorbon, chaplain to Louis LX, established a college, known as the
Sorbonne, that eventually became the centre of theological study in France. The oldest
part of the Sorbonne is the chapel (1635-42), the gift of Richelieu, who is buried
there. Designed by Lemercier, it was one of a number of new domed Jesuit-style
churches of the period.
The Sorbonne served for centuries as the administrative seat of the University
of Paris. In 1968-71 the university was divided into a number of entirely separate
universities, and the Sorbonne building proper continues to serve as premises for
some of these.
At the top of the hill rising from the river the boulevard skirts the Luxembourg
Gardens, the remains of the park of Marie de Médicis’ Luxembourg Palace (1616-
21), which now houses the French Senate. The gardens are planted with chestnuts and
are enhanced with a pond for toy sailboats, a marionette theatre, and statuary.
Across the boulevard at the end of the rue Soufflot stands the Pantheon (1755-
92), designed by Jacques Germain Soufflot. It was commissioned by Louis XV, after
his recovery from an illness, as a votive offering to St. Genevieve and was to replace
the mouldering 5th- century abbey in her name. Though intended as the principal
church in Paris, it was renamed the Pantheon by the Revolutionary authorities, who
made it the last resting place for heroes of the Revolution. The walling up of a number
of its windows and removal of much interior decoration replaced the intended effect
of light interior space with a gloomy dignity. Among those buried under the
inscription “Aux grands bommes, la Patrie reconnaissante” (“To great men, [ their
grateful land”) are the authors Victor Hugo, Voltaire, Rousseau, and Zola and Jean
Moulin, chief of the Resistance in World War II.

The Buttes.

The river valley of Paris is almost entirely circled by high ground. Upon the
heights of Passy, on the Right Bank between the western city limits and the Arc de
Triomphe, perch the wealthy neighbourhoods of the 16th arrondissement. The
Butte-Montmartre (18th arrondissement) and the Buttes-
Chaumont( 19th arrondissement), which rise along the northern rim of the city, are
still working-class. The 18th arrondissement has broad avenues, but it also has
winding lanes, some of which become stairways on the steeper hills, From the early
19th century until the migration in the 1920s to Montparnasse, Montmartre was the
major art colony of Paris. Some sections are highly commercialized for the tourist
trade; others, however, are unself-consciously picturesque. Montmartre is known for
its nightclubs and entertainment.
The most noted landmark of Montmartre was built only in 1919: the Sacred
Heart Basilica (Basilique du Sacrd-Coeur), paid for by national subscription after the
French defeat by the Prussians in 1870. The work began in 1876 but was delayed by
the death of the architect, Paul Abadie, who took inspiration from the 12th-century
five-domed Romanesque church of Saint-Front in Périgueux, itself inspired by either
Venetian or Byzantine churches.

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 Basilique du Sacré-Coeur

Foreign Tours

The Bahamas

Officially COMMONWEALTH OF THE BAHAMAS, archipelago and state

on the northwestern edge of the West Indies, consisting of about 700 islands and cays
and more than 2,000 low, barren rock formations, located off the southeastern coast of
Florida, U.S. The archipelago is spread across the Tropic of Cancer and about 90,000
square miles (233,000 square km) of ocean in the western Atlantic. Andros (104 miles
long and 40 miles wide {167 km long and 64 km wide] is the largest of the islands.
The capital is Nassau on New

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 Providence--the most important island. Area 5,382 square miles (13,939
square km). Pop. (1993 est.) 266,000.

The land.

New Providence has the majority of the archipelago’s population. The rest of
the islands, chief among which are Abaco, Andros, and Eleuthera, are called the
Family, or Out, Islands. All the islands of the archipelago are composed of coraline
limestone, lie mostly only a few feet above sea level, and are generally flat. The
highest point, Mount Alvemia (formerly Como Hill), rises 206 feet (63 m) on Cat
Island. Most of the islands are long and narrow, each rising from its eastern shore to a
low ridge, beyond which lie lagoons and mangrove swamps; coral reefs mark the
shorelines. There are no rivers in The Bahamas.
The mild subtropical climate of The Bahamas, with two seasons (winter and
summer is greatly influenced by the Gulf Stream and Atlantic Ocean breezes. The
average temperature varies from 70°F (21°C) during the winter to 81° F (27° C)
during the summer; average annual rainfall is about 44 inches (1,120 mm), though
there is some variation between the islands. The hurricane season lasts from mid-July
to mid-November.
The islands abound in tropical flora, including bougainvillea, jasmine, orchid,
and oleander. Caribbean pine forests occur on some islands, such as Andros, Great
Abaco, and Grand Bahama. Native trees include the black olive, cork tree, and several
species of palm; mahogany, casuarina, and cedar trees have been planted on some
islands. Animal life is dominated by frogs, lizards, and snakes; mosquitoes, sandflies,
and termites are widespread. There are numerous species of birds, including the
flamingo, the national bird. The Inagua National Park on Great Inagua Island is the
home of more than 50,000 West Indian flamingos, the largest such flock in the world.
Salt, aragonite, and limestone are the only commercially important minerals. Salt is
produced largely by solar evaporation from salt beds on Great Inagua.

The people.

The people of The Bahamas are a blend of European and African ancestry, the
latter a legacy of the slave trade. English is the official language, and almost all of the

501
population is Christian. Baptists account for about one-third of the population, and
Anglicans and Roman Catholics each constitute approximately one-fifth of the total.
Only about 30 of the islands and cays are inhabited. During the 1970s there
was significant rural-to-urban interisland migration, mostly directed to the already
densely populated islands of New Providence (where two-thirds of the populace
lives), Grand Bahama, and Great Abaco. Long Cay, on the other hand, had only a few
dozen inhabitants. Average population density for the country is relatively low.
The population growth rate of The Bahamas was relatively high during the late
1970s (a trend that continued intermittently through the 1980s), mostly because of a
substantial birth rate; consequently, almost two-fifths of the populace is younger than
15 years of age. The death rate is relatively low.

The Economy.

The Bahamas has a predominantly market economy that is heavily dependent

on tourism and international financial services. The gross national product (GNP) is
growing much more rapidly than the population. The GNP per capita is similar to
those of other developed countries.
Agriculture accounts for about one-twentieth of the GNP and employs a
comparable fraction of the workforce. Only about 1 percent of the land is arable, and
soils are shallow. The government has had only limited success in increasing
agricultural output, and nearly all of the country’s foodstuffs are imported, largely
from the United States. The sunny climate favours the cultivation of tomato,
pineapple, banana, mango, guava, sapodilla, soursop, grapefruit, and sea grape. Some
pigs, sheep, and cattle are raised. The small fishing industry’s catch is dominated by
crayfish, groupers, and conchs.
Mineral industries are limited to the production of salt and cement. Grand
Bahama has several petroleum transshipment terminals. Manufacturing industries
centre on the production of rum and other liquors, cement, pharmaceuticals (including
hormones), canned tomatoes and pineapples, and frozen crayfish. The Industries
Encouragement Act offers manufacturers relief from tariffs and various taxes.
Electricity is generated entirely from imported fuels.
Tourism accounts for as much as two-thirds of the GNP and employs about
two-fifths of the workforce. It centres on New Providence and Grand Bahama; most
tourists come from the United States. Several hundred banks and trust companies
have been attracted to The Bahamas because there are no income or corporation taxes
and because the secrecy of financial transactions is guaranteed. Public expenditures
are constrained by the government’s dependence on indirect taxes, which are levied
primarily on tourism and external trade. The United States is The Bahamas’ principal
trading partner and exempts certain Bahamian products from duties under the
generalized system of preferences. Nassau and Freeport, the latter on Grand Bahama
Island, are the country’s two main ports and also have international airports.

Cultural life.

Outstanding among traditional group activities is the “Junkanoo” parade on

Boxing Day and New Year’s Day. The main thoroughfare is given over to hundreds
of gaily bedecked celebrants who, with clanging cowbells and beating drums, march
and dance to a rhythm of African origin. In Nassau, amateur choral, dramatic, and
dancing groups provide entertainment with much local flavour.

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 History.

The Bahamas were originally inhabited by a group of Arawak Indians known

as Lucayan. Originally from the South American continent, some of the Arawak had
been driven north into the Caribbean by the Carib Indians. Unlike their Carib
neighbours, the Lucayan were generally peaceful, more involved in fishing than
agriculture, and noncannibalistic.
When Columbus reached the New World in 1492, he is thought to have landed
on San Salvador (also called Watling Island) or possibly Sarnana Cay, both in the
Bahamas. The Spaniards made no attempt to settle but operated slave raids on the
peaceful Arawak that depopulated the islands, and by the time the English arrived the
Bahamas were uninhabited.
In 1629 Charles I of England granted the islands to one of his ministers, but no
attempt at settlement was made. In 1648 William Sayle led a group of English
Puritans from Bermuda to, it is thought, Eleuthera Island. This settlement met with
extreme adversity and did not prosper, but other Bermudian migrants continued to
arrive. New Providence was settled in 1656. By 1670 the Bahamas were given to the
Duke of Albemarle and five others as a proprietary colony. The proprietors were
mostly uninterested in the islands, and few of the settlements prospered. Piracy
became a way of life for many.
The colony reverted to the crown in 1717, and serious efforts were made to
end the piracy. The first royal governor, Woodes Rogers, succeeded in controlling the
pirates but mostly at his own expense. Little monetary and military support came from
England. Consequently, the islands remained poor and susceptible to Spanish attack.
Held for a few days by the U.S. Navy in 1776, and for almost a year by Spain
in 1782-83, the islands reverted to England in 1783 and received a boost in population
from loyalists and their slaves who fled the United States after the American
Revolution. For a time, cotton plantations brought some prosperity to the islands, but
when the soil gave out and slavery was abolished in 1834, the Bahamas’ endemic
poverty returned.
Two other periods of prosperity followed: the years 1861-65, when the
Bahamas became a centre for blockade runners during the American Civil War, and in
1920-33, when bootlegging became big business during the years of American
Prohibition. But these were economic accidents; not until the tourist industry was
developed after World War II did any form of pennanent prosperity come to the
islands

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 International Trade

International trade includes all economic transactions that are made between
countries. Among the items commonly traded are consumer goods, such as television
sets and clothing; capital goods, such as machinery; and raw materials and food.
Other transactions involve services, such as travel services and payments for foreign
patents. International trade transactions are facilitated by international financial
payments, in which the private banking system and the central banks of the trading
nations play important roles.
International trade and the accompanying financial transactions are
conducted generally toward the purpose of providing a nation with commodities it
lacks in exchange for those that it produces in abundance; such transactions,
functioning with other economic policies, generally improve the standard of living of
a nation. This article provides a historical and contemporary overview of the structure
of international trade, of the classic controversy over free versus controlled trade,
and of the problems that arise in transactions between nations.

The theory of international trade

HISTORY
Accounts of barter of goods or of services among different peoples can be
traced back almost as far as the record of human history. International trade, however,
is specifically an exchange between members of different nations, and accounts and
explanations of such trade begin (despite fragmentary earlier discussion) only with the
rise of the modern nation-state at the close of the European Middle Ages. As political
thinkers and philosophers began to examine the nature and function of the nation,
trade with other nations became a particular topic of their inquiry. It is, accordingly,
no surprise to find one of the earliest attempts to describe the function of international
trade within that highly nationalistic body of thought now known as "mercantilism."
Mercantilist analysis, which reached the peak of its influence upon European thought
in the 16th and 17th centuries, focused directly upon the welfare of the nation. It
insisted that the acquisition of wealth, particularly wealth in the form of gold, was of
paramount importance for national policy. Mercantilists took the virtues of gold
almost as an article of faith; consequently, they never undertook to explain adequately
why the pursuit of gold deserved such a high priority in their economic plans.
The trade policy dictated by mercantilist philosophy was accordingly simple:
encourage exports, discourage imports, and take the proceeds of the resulting export
surplus in gold. Because of their nationalistic bent, mercantilist theorists either
brushed aside or else did not realize that, from an international viewpoint, this policy
would necessarily prove self-defeating. The nation that successfully gains an export
surplus must ordinarily do so at the expense of one or more other nations that record a
matching import surplus. Mercantilists' ideas often were intellectually shallow, and
indeed their trade policy may have been little more than a rationalization of the
interests of a rising merchant class that wanted wider markets--hence the emphasis on
expanding exports--coupled with protection against competition in the form of
imported goods. Yet mercantilist policies, as will be noted later, are by no means
completely dead today.

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 COMPARATIVE-ADVANTAGE ANALYSIS
The British school of "classical economics" began in no small measure as a
reaction against the inconsistencies of mercantilist thought. Adam Smith was the
18th-century founder of this school; his famous work, The Wealth of Nations (1776),
is in part an antimercantilist tract. In The Wealth of Nations, Smith emphasized the
importance of specialization as a source of increased output, and he treated
international trade as a particular instance of specialization: in a world where
productive resources are scarce and human wants cannot be completely satisfied, each
nation should specialize in the production of goods it is particularly well equipped to
produce; it should export part of this production, taking in exchange other goods that
it cannot so readily turn out. Smith did not expand these ideas at much length; but
David Ricardo, the second great classical economist, developed them into the
"principle of comparative advantage," a principle still to be found, much as Ricardo
spelled it out, in every textbook on international trade.

Simplified theory of comparative advantage.

For clarity of exposition, the theory of comparative advantage is usually first

outlined as though only two countries and only two commodities were involved,
although the principles are by no means limited to such cases. Again for clarity, the
cost of production is usually measured only in terms of labour time and effort; the
cost of a unit of cloth, for example, might be given as two hours of work. The two
countries will here be A and B; and the two commodities produced, wine and cloth.
The labour time required to produce a unit of either commodity in either country is as
follows:
cost of production (labour time)
country A country B
wine (1 unit) 1 hour 2 hours
cloth (1 unit) 2 hours 6 hours As
compared with country A, country B is productively inefficient. Its workers need
more time to turn out a unit of wine or a unit of cloth. This relative inefficiency may
result from differences in climate, in worker training or skill, or in the amount of
available tools and equipment, or from numerous other possible reasons. Ricardo took
it for granted that such differences do exist, and he was not concerned with their
origins. Country A is said to have an absolute advantage in the production of both
wine and cloth because it is more efficient in the production of both goods.
Accordingly, A's absolute advantage seemingly invites the conclusion that country B
could not possibly compete with country A, and indeed that if trade were to be opened
up between them, country B would be competitively overwhelmed. Ricardo insisted
that this conclusion is false. The critical factor is that country B's disadvantage is less
pronounced in wine production, in which its workers require only twice as much time
for a single unit as do the workers in A, than it is in cloth production, in which the
required time is three times as great. This means, Ricardo pointed out, that country B
will have a comparative advantage in wine production. Both countries will profit, in
terms of the real income they enjoy, if country B specializes in wine production,
exporting part of its output to country A, and if country A specializes in cloth
production, exporting part of its output to country B. Paradoxical though it may seem,
it is preferable for country A to leave wine production to country B, despite the fact
that A's workers can produce wine of equal quality in half the time that B's workers
can do so. To illustrate this conclusion, it can be considered that country

505
A's total labour force consists of 300 workers. Disregarding the possibility of trade
with B, A then has a choice of various outputs of cloth and of wine, depending on the
number of workers engaged in each of the two occupations. This range of choices is
illustrated by the line DEF in the accompanying diagram. If all 300 labourers work on
cloth production, total hourly cloth output will be 150 units (point D in the diagram),
since each such unit requires two hours' labour. At the other extreme, if all labour
works on wine production, wine output will be 300 units per hour (point F). Any
intermediate point on the line DEF is possible. Point E, for example, indicates 80
units of cloth produced each hour (160 workers so employed) and 140 units of wine
(employing the other 140 workers). DEF is country A's "production possibility" line.
If it does not trade with country B and so can consume only what it produces itself,
DEF will also be country A's "consumption possibility" line; it will choose some point
thereon, depending on the preferences of its citizens for wine and cloth. DEF
represents the limit of production and consumption possibilities; points above and to
the right of DEF are unattainable. In
the right-hand diagram, the line GHJ has exactly the same production and
consumption significance for country B--assuming its total force to be 600 workers
(so as to make it roughly equal to A in total output capacity). The position of the line
GHJ reflects the fact that labour in country B requires two hours to produce a unit of
wine, and six hours for a unit of cloth.
One may consider that A and B are initially isolated from one
another. Country A has chosen point E (80 cloth, 140 wine) as its production-
consumption point. Country B has chosen point H (55 cloth, 135 wine). The
opportunity of free trade between the two countries is now opened up. If both
countries want to attain the higher levels of production and consumption available to
them through specializing on and trading of the product for which they have a
comparative advantage, Country A will shift its entire labour force to cloth
production, and Country B will shift its entire labour force to wine production. A
possible barter rate (setting aside the detail of how this would be worked out) might
be one cloth for two and one-half wine. Country A might then choose to export 60
units of its hourly cloth output of 150, keeping the other 90 for domestic
consumption. In exchange for this 60 cloth (at the 1-for-2 1/2 exchange rate) it would
receive 150 wine. A's real income position is thus improved in comparison with
pretrade point E: cloth for domestic consumption has risen from 80 to 90, and wine
consumption has risen from 140 to 150. Country B enjoys a similar gain. In
comparison with pre-trade point H, its cloth consumption has risen from 55 to 60, and
wine consumption has risen from 135 to 150.
The incentive to export and to import can be explained in price terms. In
country A (before international trade), the price of cloth ought to be twice that of
wine, since a unit of cloth requires twice as much labour effort. If this price ratio is
not satisfied, one of the two commodities will be overpriced and the other
underpriced. Labour will then move out of the underpriced occupation and into the
other, until the resulting shortage of the underpriced commodity drives up its price. In
country B (again, before trade), a cloth unit should cost three times as much as a wine
unit, since a unit of cloth requires three times as much labour effort. Hence, a typical
before-trade price relationship, matching the underlying real cost ratio in each
country, might be as follows: country A country B
Price of wine per unit $ 5 1
Price of cloth per unit $10 3

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 The absolute levels of price do not matter. All that is necessary is that in each
country the ratio of the two prices should match the labour-cost ratio.
As soon as the opportunity of exchange between the two
countries is opened up, the difference between the wine-cloth price ratio in country A
(namely, 5:10, or 1:2) and that in country B (which is 1:3) provides the opportunity of
a trading profit. Cloth will begin to move from A to B, and wine from B to A. A
trader in A, starting with a capital of $10 for example, would buy a unit of cloth, sell
it in B for £3, buy 3 units of B's wine with the proceeds, and sell this in A for $15.
(This example assumes, for simplicity, that costs of transporting goods are negligible
or zero. The introduction of transport costs complicates the analysis somewhat, but it
does not change the conclusions, unless these costs are so high as to make trade
impossible.) So long as the
ratio of prices in country A differs from that in country B, the flow of goods between
the two countries will steadily increase as traders become increasingly aware of the
profit to be obtained by moving goods between the two countries. Prices, however,
will be affected by these changing flows of goods. The wine price in country A, for
example, can be expected to fall as larger and larger supplies of imported wine
become available. Thus A's wine-cloth price ratio of 1:2 will fall. For comparable
reasons, B's price ratio of 1:3 will rise. When the two ratios meet, at some
intermediate level (in the example earlier, at 1:2 1/2), the flow of goods will stabilize.

Amplification of the theory.

At a later stage in the history of comparative-advantage theory, the English

philosopher and political economist John Stuart Mill showed that the determination
of the exact after-trade price ratio was a supply-and-demand problem. At each
possible intermediate ratio (within the range of 1:2 and 1:3), country A would want to
import a particular quantity of wine and export a particular quantity of cloth. At that
same possible ratio, country B would wish to import and export particular amounts of
cloth and of wine. For any intermediate ratio taken at random, however, A's export-
import quantities probably will not match those of B. Ordinarily, there will be just one
intermediate ratio at which the quantities correspond; that is the final trading ratio at
which quantities exchanged will stabilize. (Once they have stabilized, there is no
longer any profit in exchanging goods. Even with such profits eliminated, however,
there is no reason why A producers should want to stop selling part of their cloth in B,
since the return there is as good as that obtained from domestic sales. Any falloff in
the amounts exported and imported would reintroduce profit opportunities.) In
the elementary labour-cost example used above, there will be complete specialization:
country A's entire labour force will move to cloth production and country B's to wine
production. More elaborate comparative-advantage models recognize production costs
other than labour (that is, the costs of land and of capital). In such models, part of
country A's wine industry may survive and compete effectively against imports, as
may also part of B's cloth industry. The models can be expanded in other ways: to
take account of more than two countries, or more than two commodities, and of
transport costs. The essential conclusions, however, come from the elementary model
used above, so that this model, despite its simplicity, still provides a workable outline
of the theory. (It should be noted that even the most elaborate comparative-advantage
models continue to rely on certain simplifying assumptions without which the basic
conclusions do not necessarily hold. These assumptions are discussed below.) As
noted earlier, the effect of this analysis is to correct any false first impression that

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low-productivity countries are at a hopeless disadvantage in trading with high-
productivity ones. The impression is false, that is, if one assumes, as comparative
advantage theory does, that international trade is an exchange of goods between
countries. It is pointless for country A to sell goods to country B, whatever its labour-
cost advantages, if there is nothing that it can profitably take back in exchange for its
sales. With one exception, there will always be at least one commodity that a low-
productivity country such as B can successfully export. Country B must of course pay
a price for its low productivity, as compared with A; but that price is a lower per
capita domestic income and not a disadvantage in international trading. For trading
purposes, absolute productivity levels are unimportant; country B will always find one
or more commodities in which it enjoys a comparative advantage; that is, a
commodity in the production of which its absolute disadvantage is least. The one
exception is that case in which productivity ratios, and consequently pre-trade price
ratios, happen to match one another in two countries. Such would have been the case
had country B required four labour hours (instead of six) to produce a unit of cloth. In
this particular circumstance, there would be no incentive for either country to engage
in trade, and no gain from trading. In a two-commodity example such as that
employed, it might not be unusual to find matching productivity and price ratios. But
as soon as one moves on to cases of three and more commodities, the statistical
probability of encountering precisely equal ratios becomes very small indeed.
The major purpose of the theory of comparative
advantage is to illustrate the gains from international trade. Each country can gain by
specializing in those occupations in which it is relatively efficient; it should export
part of that production and take in exchange those goods in whose production it is, for
whatever reason, at a comparative disadvantage. The theory of comparative advantage
thus provides a strong argument for free trade--and indeed for a laissez-faire attitude
with respect to trade. The supporting argument is simple: specialization and free
exchange among nations yield higher real income for the participants.
The fact that a country will enjoy higher
real income as a consequence of the opening up of trade does not mean, of course,
that every family or individual within the country must share in that benefit. Producer
groups affected by import competition obviously will suffer, to at least some degree.
Comparative-advantage theorists concede that free trade would affect the relative
income position of such groups, and perhaps even their absolute income level. But
they insist that the special interest of these groups clashes with the total national
interest, and the most that they are usually willing to concede is the possible need for
temporary protection against import competition, in order that the persons affected
may have sufficient time to move to another occupation. Nations do, of course,
maintain tariffs and other barriers to imports.

SOURCES OF COMPARATIVE ADVANTAGE

As already noted, British classical economists simply accepted the fact that
productivity differences exist between countries; they made no concerted attempt to
explain which commodities a country would export or import. During the 20th
century, international economists have offered a number of theories in an effort to
explain why countries have differences in productivity, the factor that determines
comparative advantage and the pattern of international trade.

Natural resources.

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 First, countries can have an advantage because they are richly endowed with a
particular natural resource. For example, countries with plentiful oil resources can
generally produce oil inexpensively. Thus, Saudi Arabia produces oil very cheaply,
giving it a comparative advantage in oil, and it exports oil in order to finance its
purchases of imports. Similarly, countries with large forests generally are the major
exporters of wood, paper, and paper products. The supply available for export also
depends on domestic demand. Canada, for example, has large quantities of lumber
available for export to the United States, not only because of its large areas of forest
but also because its small population consumes little of the supply, leaving much of
the lumber available for export. Climate is another natural resource that provides an
export advantage. Thus, for example, bananas are exported by Central American
countries, not Iceland or Finland.

Factor endowments: the Heckscher-Ohlin theory.

The proposition that countries with plentiful natural resources generally have a
comparative advantage in products using those resources is obvious and
straightforward. A related, but much more subtle, explanation was put forward by two
Swedish economists, Eli Heckscher and Bertil Ohlin. Ohlin's work was built upon that
of Heckscher. In recognition of his ideas as described in his path-breaking book,
Interregional and International Trade (1933), Ohlin shared the Nobel Prize for
Economics in 1977. The Heckscher-
Ohlin theory focuses on the two most important factors of production, labour and
capital. Some countries are relatively well-endowed with capital; the typical worker
has plenty of machinery and equipment at his disposal. In such countries, wage rates
generally are high. Products requiring much labour--such as textiles, sporting goods,
and simple consumer electronics--tend as a result to be more expensive than in
countries with plentiful labour and low wage rates. On the other hand, goods requiring
much capital and only a little labour (automobiles and chemicals, for example) tend to
be relatively inexpensive in countries with plentiful and cheap capital. Thus, countries
with abundant capital should generally be able to produce capital-intensive goods
relatively inexpensively, exporting them in order to pay for imports of labour-
intensive goods. In the Heckscher-Ohlin
theory it is not the absolute amount of capital that is important; rather, it is the amount
of capital per worker. A small country like Luxembourg has much less capital in total
than India, but Luxembourg has more capital per worker. Accordingly, the
Heckscher-Ohlin theory predicts that Luxembourg will export capital-intensive
products to India and import labour-intensive products in return. Despite its
plausibility the Heckscher-Ohlin theory is frequently at variance with the actual
patterns of international trade. As an explanation of what countries actually export
and import, it is much less accurate than the more obvious and straightforward natural
resource theory. One early study of the
Heckscher-Ohlin theory was carried out by Wassily Leontief, a Russian-born U.S.
economist. Leontief observed that the United States was relatively well-endowed with
capital. According to the theory, therefore, the United States should export capital-
intensive goods and import labour-intensive ones. He found that the opposite was in
fact the case: U.S. exports are generally more labour intensive than the type of
products that the United States imports. Because his findings were the opposite of
those predicted by the theory, they are known as the Leontief Paradox.

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 Economies of large-scale production.

Even if countries have quite similar climates and factor endowments, they may
still find it advantageous to trade. Indeed, economically similar countries often carry
on a large and thriving trade. The prosperous industrialized countries have become
one another's best customers. A main reason for this situation lies in what is called the
economies of large-scale production.
For many products, there are advantages in producing on a large scale;
costs become lower as more is produced. Thus, for example, automobiles can be made
more cheaply in a factory producing 100,000 units than in a small factory producing
only 1,000 units. This means that countries have an incentive to specialize in order to
reduce costs. To sell a large volume of output, they may have to look to export
markets. The smaller the country, and the more limited its domestic market, the
more incentive it has to look to international trade as a way of gaining the advantages
of large-scale production. Thus, Luxembourg or Belgium has much more to gain
relatively than does the United States. Indeed, the advantages of large-scale
production have been one of the major sources of gain from the establishment of the
European Economic Community (EEC), which was formed for the purpose of
providing free trade between most western European countries.
Even a large country such as the United States, however, can gain in some
cases by exporting in order to lengthen production lines. For example, the Boeing
Company has been able to produce airplanes more cheaply because it is able to sell
large numbers of aircraft to other countries. The importing countries also gain because
they can buy aircraft abroad more cheaply than they could produce them at home.

Technology.

Technological development can also provide a distinctive trade advantage.

The relatively advanced countries--particularly the United States, Japan, and those of
western Europe--are the principal exporters of high-technology products such as
computers and precision machinery. One important
aspect of technology is that it can change rapidly. Such rapid changes present several
challenges. For the countries that are not in the front rank, it raises the question of
whether they should import high-technology products or attempt to enter the circle of
the most advanced nations. For the countries that have held the technological lead in
the past, there is always the possibility that they will be successfully overtaken by
newcomers. This occurred in the second half of the 20th century when Japan
advanced technologically in its automobile production to the point where it could
challenge the automobile leadership of North America and Europe. Japan quickly
became the world's foremost producer of automobiles.

The product cycle.

The spread of technology across national boundaries means that comparative

advantage can change. The most technologically advanced countries generally have
the advantage in making new products, but as time passes other countries may gain
the advantage. For example, many television sets were produced in the United States
during the 1950s. As time passed, however, and technological change in the television
industry became less rapid, there was less advantage in producing sets in the United
States. Producers of television sets had an incentive to look to other locations, with
lower wage rates. In time, the manufacturers established overseas operations in

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Taiwan, Hong Kong, and elsewhere. Concurrently, the United States turned to new
activities, such as the manufacture of large mainframe computers and the
development of computer software.

State interference in international trade

METHODS OF INTERFERENCE
Regardless of what comparative-advantage theory may say about the virtues of
unrestricted trade, all nations interfere with international transactions to at least some
degree. Tariffs may be imposed on imports--in some instances making them so costly
as to bar completely the entry of the good involved. Quotas may limit the permissible
volume of imports. State subsidies may be offered to encourage exports. Money-
capital exports may be restricted or prohibited. Investment by foreigners in domestic
plant and equipment may be similarly restrained.
These interferences may be simply the result of special-interest
pleading, because particular groups suffer as a consequence of import competition. Or
a government may impose restrictions because it feels impelled to take account of
factors that comparative advantage sets aside. It is of interest to note that insofar as
goods and services are concerned, the general pattern of interference follows the old
mercantilist dictum of discouraging imports and encouraging exports. A
company that finds itself barred from an attractive foreign market by tariffs or quotas
may be able to leapfrog the barrier simply by establishing a manufacturing plant
within that foreign country. This policy of foreign plant investment has expanded
enormously since the end of World War II. U.S. companies have taken the lead,
investing particularly in western Europe, Canada, and South America. Industry in
other developed countries has followed a similar pattern--some foreign companies
establishing plants within the United States as well as in other areas of the world.
The governments of countries subject to this new investment
find themselves in an ambivalent position. The establishment of new foreign-owned
plants may mean more than simply the creation of new employment opportunities and
new productive capacity; it may also mean the introduction of new technologies and
superior business-control methods. But the government that welcomes such benefits
must also expect complaints of "foreign control," an argument that will inevitably be
pressed by domestic owners of older plants who fear a new competition that cannot be
blocked by tariffs. This has been a pressing problem for many governments,
particularly insofar as investment by U.S. firms is involved. Countries such as the
United Kingdom and Canada have been liberal in their admissions policy; others,
notably Japan, impose tight restrictions on foreign-owned plants.

Tariffs.

A tariff, or duty, is a tax levied on a commodity when it crosses the boundary

of a customs area. The boundary may be that of a nation or a group of nations that
have agreed to impose a common tax on goods entering their territory. Tariffs are
often classified as either protective or revenue. Protective tariffs are designed to
shield domestic production from foreign competition by raising the price of the
imported commodity. Revenue tariffs are designed to obtain revenue rather than to
restrict imports. The two sets of objectives are, of course, not mutually exclusive.
Protective tariffs, unless they are so high as to keep out imports, yield revenue.

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Revenue tariffs give some protection to any domestic producer of the duty-bearing
goods. A transit duty, or transit tax, is a tax levied on commodities passing through a
customs area en route to another country. Similarly, an export duty, or export tax, is a
tax imposed on commodities leaving a customs area. Finally, some countries provide
export subsidies; import subsidies are rarely used.
How tariffs work.
Tariffs on imports may be applied in several ways. If they are imposed
according to the physical quantity of an import (so much per ton, per yard, per item,
etc.), they are called specific tariffs. If they are levied according to the value of the
import, they are known as ad valorem tariffs. Tariffs
may differentiate among the countries from which the imports are obtained. They
may, for instance, be lower between countries that have previously entered into
special arrangements, such as the trade preferences accorded to each other by
members of the Commonwealth. Tariffs may affect the
economy of the country imposing them in a number of ways. By raising the prices of
imported goods, tariffs may encourage domestic production. As expenditures on
domestic products rise, domestic employment tends to do likewise. This is why tariffs
are favoured by industries that find themselves pressed by foreign competitors. The
tariff may also encourage tendencies toward a monopolistic market structure to the
extent that it lessens foreign competition, with a resulting decrease in the incentive to
modernize or innovate. By increasing the price of an imported commodity a tariff may
also reduce its consumption. The decrease in demand could be large enough in
relation to the world market to force the price of the import down.
Measuring the effects of tariffs.
It is difficult to gauge the effect of tariff barriers among countries. First of all,
how import demand responds to changes in tariffs depends on a variety of factors--the
reaction of producers and consumers to price changes, the share of imports in
domestic production and consumption, the substitutability of imports for domestic
products, and so on. And the responsiveness to tariff levels will differ from country to
country as well as from commodity to commodity. Thus, the amount of a tariff does
not necessarily determine its restrictive effect. For another thing, such comparisons
also must be restricted to commodities for which tariffs are the major protective
device. This is generally true for nonagricultural commodities in developed countries,
but other devices are often employed to protect agricultural production. In the third
place, a tariff levied upon imports of raw materials will protect domestic raw material
producers but will increase the costs of manufacturers using those raw materials. It is
necessary, therefore, to distinguish between nominal and effective rates of protection.
The nominal rate of
protection is the percentage tariff imposed on a product as it enters the country. For
example, if a tariff of 20 percent of value is collected on clothing as it enters the
country, then the nominal rate of protection is that same 20 percent. The
effective rate of protection is a more complex concept: consider that the same
product--clothing--costs $100 on international markets. The material that is imported
to make the clothing (material inputs) sells for $60. In a free trade situation, a firm can
charge no more than $100 for a similar piece of clothing (ignoring transportation
costs). Importing the fabric for $60, the clothing manufacturer can add a maximum of
$40 for labour, profit markup, rents, and the like. This $40 difference between the $60
cost of material inputs and the price of the product is called the value added. The
same situation may be considered with tariffs--say, 20 percent on clothing and 10
percent on fabric. The 20 percent tariff on clothing would raise the domestic price by
$20 to $120, while a 10 percent tariff on fabrics would increase material costs to the
domestic producer by $6 to $66. Protection would thus enable the firm to operate with
a value-added margin of $54--the difference between the domestic price of $120 and

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the material cost of $66. The difference between the value added of $40 without tariff
protection and that of $54 with it provides a margin of $14. This means that the
effective rate of protection of the domestic processing activity--the ratio of $14 to
$40--would be 35 percent. The effective rate of protection derived--35 percent--is
greater than the nominal rate of only 20 percent. This will be the case whenever the
tariff rate on the final product is greater than the tariff on inputs. Because countries
generally do levy higher tariffs on final products than on inputs, effective rates of
protection are generally higher than nominal rates--often much higher.
The effective rate of protection also depends on the share of
value added in the product price. Effective rates can be very high if value added to the
imported commodity is a small percentage or very low if value added is a large
percentage of the total price. Thus, effective protection in one country may be much
higher than that in another even though its nominal tariffs are lower, if it tends to
import commodities of a high level of fabrication with correspondingly low ratios of
value added to product price.

Nontariff barriers.

Other government regulations and practices may also act as barriers to trade.
Quotas or quantitative restrictions may prohibit the importation of certain
commodities or limit the amounts imported. Such quotas are usually administered by
requiring importers to have licenses to bring in particular commodities. Quotas raise
prices just as tariffs do, but, being set in physical terms, their impact on imports is
direct, with an absolute ceiling set on supply. Increased prices will not bring more
goods in. There is also a difference between tariffs and quotas in their effect on
revenues. With tariffs, the government receives the revenue: under quotas, the import
license holders obtain a windfall in the form of the difference between the high
domestic price and the low international price of the import. Another barrier,
which has become increasingly common during the past several decades, is the
"voluntary" export restraint (VER). For example, in the 1980s the Japanese (under
pressure from the United States) "voluntarily" limited their exports of automobiles to
the U.S. market. Like quotas, VERs limit the quantity of trade and therefore tend to
raise the prices of imported goods. In this case the VER made Japanese automobiles
less available in the United States and raised the prices that U.S. consumers had to
pay for such automobiles. VERs are usually not voluntary in any meaningful sense. In
this example, the Japanese agreement to a VER on automobiles was an attempt to
avoid a U.S. import quota. For the Japanese, a VER was preferable to a U.S. import
quota because Japanese exporters could charge higher prices. The Japanese exporters,
rather than U.S. importers, reaped much of the windfall from the VER. A VER is also
easier to get rid of. In addition, a VER has a less damaging effect on the political
relations between countries.
Still other barriers include state trading organizations and government
procurement practices that may be used preferentially. In the United States, "buy
American" legislation requires government procurement agencies to favour domestic
goods. Customs classification and valuation procedures, health regulations, and
marking requirements may also have a restrictive effect on trade. Finally, excise taxes
may act as a barrier to trade if they are levied at higher rates on imports than on
domestic goods.

Protectionism in the less-developed countries.

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 The industrialization that has taken place in the late decades of the 20th
century in some developing countries has been characterized by the expansion of
import-competing industries behind high tariff walls. In many of those countries
tariffs and various quantitative restrictions on manufactured goods are great. The
effective rates of protection may be even greater, because the goods tend to be highly
fabricated and the proportion of value added in production after importation is low.
While some places such as Taiwan and North Korea have oriented their
manufacturing industries mainly toward export trade, those are exceptional cases in
the developing world. More commonly the new industries seek to compete with
foreign-made goods for the domestic market. High protection in these countries has
often contributed to a slowdown in the production and export of primary commodities
and has discouraged expansion of exports of manufactured goods. Furthermore, while
domestic production of nondurable consumer goods has permitted rapid economic
growth at an early stage, developing countries have encountered considerable
difficulties in producing more sophisticated commodities. They suffer all of the
disadvantages of small domestic markets, in addition to a lack of incentives for
technological improvement.
ARGUMENTS FOR AND AGAINST INTERFERENCE

Revenue.

Developing nations in particular often lack the institutional machinery needed

for effective imposition of income or corporation taxes. The governments of such
nations may then finance their activity by resort to tariffs on imported goods, since
such levies are relatively easy to administer. The amount of tax revenue obtainable
through tariffs, however, is always limited. If the government tries to increase its tariff
income by imposing higher duty rates, this may choke off the flow of imports and so
reduce tariff revenue instead of increasing it.

Economic development.

Protection of domestic industry.

Probably the most common argument for tariff imposition is that particular
domestic industries need tariff protection for survival. Comparative-advantage
theorists will of course argue that the industry in need of such protection ought not to
survive and that the resources so employed ought to be transferred to occupations
having greater comparative efficiency. The welfare gain of citizens taken as a whole
would more than offset the welfare loss of those groups affected by import
competition; that is, total real national income would increase. An opposing argument
would be, however, that this welfare gain would be widely diffused, so that the
individual beneficiaries might not be conscious of any great improvement. The
welfare loss, in contrast, would be narrowly and acutely felt. Although resources can
be transferred to other occupations, just as comparative-advantage theory says, the
transfer process is sometimes slow and painful for those being transferred. For such
reasons, comparative-advantage theorists rarely advocate the immediate removal of
all existing tariffs. They argue instead against further tariff increases--since increases,
if effective, attract still more resources into the wrong occupation--and they press for
gradual reduction of import barriers.

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 The infant-industry argument.
Advocates of protection often argue that new and growing industries,
particularly in less-developed countries, need to be shielded from foreign competition.
They contend that costs decline with growth and that some industries must reach a
minimum size before they are able to compete with well-established industries
abroad. Tariffs can protect the domestic market until the industry becomes
internationally competitive and, it is often argued, the costs of protection can be
recouped after the industry has reached maturity. In short, the infant-industry
argument is based principally on the idea that there are economies of large-scale
production in many industries and that developing countries have difficulty in
establishing such industries. Advocates
of such protection, however, can have their arguments turned against them. While an
individual country can, in some circumstances, gain from protecting its infant
industries, this protection is particularly costly for the international community as a
whole. Where there are major advantages in large-scale production, there are also
large advantages in relatively free international trade. By closing off markets,
protection reduces the ability of firms to gain economies of large-scale by exporting.
If a group of countries imposes infant-industry protection, it will split up the market;
each country may end up with small-scale, localized, inefficient production, thus
reducing the prosperity of all of the countries. One way in which developing nations
have tried to deal with this problem has been through the establishment of customs
unions or other regional groupings Infant-industry
tariffs have been disappointing in other ways; the infant-industry argument is often
abused in practice. In many developing countries, industries have failed to attain
international competitiveness even after 15 or 20 years of operation and might not
survive if protective tariffs were removed. The infant industry is probably better aided
by production subsidies than by tariffs. Production subsidies do not raise prices and
therefore do not curtail domestic demand; and the cost of the protection is not
concealed in higher prices to consumers. Production subsidies, however, have the
disadvantage of drawing upon government revenue rather than adding to it, which
may be a serious consideration in countries at lower levels of development.

Unemployment.

Tariffs or quotas are also sometimes proposed as a way to maintain domestic

employment--particularly in times of recession. There is, however, near-unanimity
among modern-day economists that proposals to remedy unemployment by means of
tariff increases are misguided. Insofar as a higher tariff is effective for this purpose, it
simply "exports unemployment"; the rise in domestic employment is matched by a
drop in production in some foreign country. That other country, moreover, is likely to
impose a retaliatory tariff increase. Finally, the tariff remedy for unemployment is a
poor one because it is usually ineffective and because more suitable remedies are now
available. It has come to be generally recognized that unemployment is far more
efficiently dealt with by the implementation of proper fiscal and monetary policies.

National defense.

A common appeal made by an industry seeking tariff or quota protection is

that its survival is essential in the national interest: its product would be needed in

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wartime, when the supply of imports might well be cut off. The verdict of economists
on this argument is fairly clear: the national-defense argument is frequently a red
herring, an attempt to "wrap oneself in the flag," and insofar as an industry is
essential, the tariff is a dubious means of ensuring its survival. Essential industries
ought instead to be given a direct subsidy to enable them to meet foreign competition,
with explicit recognition of the fact that the subsidy is a price paid by the nation in
order to maintain the industry for defense purposes.

Autarky, or self-sufficiency.

Many demands for protection, whatever their surface argument may be, are
really appeals to the autarkic feelings that prompted mercantilist reasoning. (Autarky
is defined as the state of being self-sufficient at the level of the nation.) A proposal for
the restriction of free international trade can be described as autarkic if it appeals to
those half-submerged feelings that the citizens of the nation share a common welfare
and common interests, whereas foreigners have no regard for such welfare and
interests and might even be actively opposed to them. And it is quite true that a
country that has become heavily involved in international trade has given hostages to
fortune: a part of its industry has become dependent upon export markets for income
and for employment. Any cutoff of these foreign markets (brought about by recession
abroad, by the imposition of new tariffs by some foreign country, or by numerous
other possible changes) would be acutely serious; and yet it would be a situation
largely beyond the power of the domestic government involved to alter. Similarly,
another part of domestic industry may rely on an inflow of imported raw materials,
such as oil for fuel and power. Any restriction of these imports could have the most
serious consequences. The vague threat implicit in such possibilities often results in a
yearning for autarky, for national self-sufficiency, for a life free of dependence on the
hazards of the outside world. There is general agreement that no
modern nation, regardless of how rich and varied its resources, could really practice
self-sufficiency, and attempts in that direction could produce sharp drops in real
income. Nevertheless, protectionist arguments--particularly those made "in the
interests of national defense"--often draw heavily on the strength of such autarkic
sentiments.

The terms-of-trade argument.

When a country imposes a tariff, foreign exporters have greater difficulty in

selling their products. As their exports decline, they may cut prices in order to keep
their sales from falling drastically. Thus, for example, when a tariff of $10.00 is
imposed, foreign exporters may cut their price by, say, $6.00. The foreign exporter is
being "taxed" when the tariff is imposed; the other $4.00 is reflected in a higher price
to the consumer. The use of tariffs to tax foreign exporters in this way is known as the
terms-of-trade argument for protection. The terms of trade represent the relative price
of what a nation is exporting, compared with the price paid to foreigners for imported
goods. When the price of what is being exported rises, or when the price paid to
foreigners for imported goods falls (as it may when a nation imposes a tariff), terms of
trade improve.

Balance-of-payments difficulties.

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 Governments may interfere with the processes of foreign trade for a reason
quite different from those thus far discussed: shortage of foreign exchange. Under the
international monetary system established after World War II and in effect until the
1970s, most governments tried to maintain fixed exchange rates between their own
currencies and those of other countries. Even if not absolutely fixed, the exchange rate
was ordinarily allowed to fluctuate only within a narrow range of values.
If balance-of-payments difficulties arise
and persist, a nation's foreign exchange reserve runs low. In a crisis, the government
may be forced to devalue the nation's currency. But before being driven to this, it may
try to redress the balance by restricting imports or encouraging exports, in much the
old mercantilist fashion. The
problem of reserve shortages became acute for many countries during the 1960s.
Although the total volume of international transactions had risen steadily, there was
not a corresponding increase in the supply of international reserves. By 1973 payment
imbalances led to an end of the system of fixed, or pegged, exchange rates and to a
"floating" of most currencies.
International trade arrangements
Many efforts have been made in modern times to promote trade among
nations. The ways in which this may be attempted range from agreements among
governments to reduce or eliminate trade barriers to more ambitious attempts to
harmonize economic policies, as in the European Economic Community (EEC)
established by the nations of western Europe.
HISTORY OF MODERN TRADE POLICIES

Mercantilism.

Much of the modern history of international relations concerns efforts to

promote freer trade among nations. The 17th century saw the growth of restrictive
policies that later came to be known as mercantilism. The mercantilists held that
economic policy should be nationalistic and aim to secure the wealth and power of the
state. The concept was based on the conviction that national interests are inevitably in
conflict--that one nation can increase its trade only at the expense of other nations.
Thus, governments were led to impose price and wage controls, foster national
industries, promote exports of finished goods and imports of raw materials, and
prohibit the exports of raw materials and the import of finished goods. The state
endeavoured to provide its citizens with a monopoly of the resources and trade outlets
of its colonies. A typical illustration of the mercantilist
spirit is the famous English Navigation Act of 1651, which reserved for the home
country the right to trade with the colonies and prohibited the import of goods of non-
European origin unless transported in ships flying the English flag. This law lingered
on until 1849. A similar policy was followed in France.

Liberalism.

A strong reaction against mercantilist attitudes began to take shape toward the
middle of the 18th century. In France, the economists known as Physiocrats
demanded liberty of production and trade. In England, as discussed above, Adam
Smith demonstrated in his The Wealth of Nations (1776) the advantages of removing
trade restrictions. Economists and businessmen voiced their opposition to excessively
high and often prohibitive customs duties and urged the negotiation of trade

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agreements with foreign powers. This change in attitudes led to the signing of a
number of agreements embodying the new liberal ideas, among them the Anglo-
French Treaty of 1786, which ended what had been an economic war between the two
countries. After Adam Smith, the basic tenets of
mercantilism were no longer considered defensible. This did not, however, mean that
nations abandoned all mercantilist policies. Restrictive economic policies were now
justified by the claim that, up to a certain point, the government should keep foreign
merchandise off the domestic market in order to shelter national production from
outside competition. To this end, customs levies were introduced in increasing
number, replacing outright bans on imports, which became less and less frequent.
In the middle of the 19th century, customs walls effectively sheltered
many national economies from outside competition. The French tariff of 1860, for
example, charged extremely high rates on British products: 60 percent on pig iron; 40
to 50 percent on machinery; and 600 to 800 percent on woolen blankets. Transport
costs between the two countries provided further protection.
A triumph for liberal ideas was the Anglo-French trade
agreement of 1860, which provided that French protective duties were to be reduced
to a maximum of 25 percent within five years, with free entry of all French products
except wines into Britain. This agreement was followed by other European trade
pacts.

Resurgence of protectionism.

A reaction in favour of protection spread throughout the Western world in the

latter part of the 19th century. Germany adopted a systematically protectionist policy
and was soon followed by most other nations. Shortly after 1860, during the Civil
War, the United States raised its duties sharply; the McKinley Tariff Act of 1890 was
ultraprotectionist. England was the only country to remain faithful to the principles of
free trade. But the
protectionism of the last quarter of the 19th century was mild by comparison with the
mercantilist policies that had been common in the 17th century and were to be revived
between the two world wars. Extensive economic liberty prevailed by 1913.
Quantitative restrictions were unheard of, and customs duties were low and stable.
Currencies were freely convertible into gold, which in effect was a common
international money. Balance-of-payments problems were few. People who wished to
settle and work in a country could go where they wished with few restrictions; they
could open businesses, enter trade, or export capital freely. Equal opportunity to
compete was the general rule, the sole exception being the existence of limited
customs preferences between certain countries, most usually between a home country
and its colonies. Trade was freer throughout the Western world in 1913 than it was in
Europe in 1970.

The "new" mercantilism.

World War I wrought havoc with these orderly trading conditions. By the
end of hostilities, world trade was in a straitjacket that made recovery very difficult.
The first five years of the postwar period were marked by the dismantling of wartime
controls proper. The 1920 crisis and the commercial advantages accruing to countries
whose currencies had depreciated, as had Germany's, rapidly led to fresh measures in
restraint of trade. The protectionist tide engulfed the world economy, not because

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policymakers consciously adhered to any specific theory but because of nationalist
ideologies and the pressure of economic conditions. In an attempt to end the continual
raising of customs barriers, the League of Nations organized the first World
Economic Conference in May 1927. Twenty-nine states, including the main
industrial countries, subscribed to an international convention that was the most
minutely detailed and balanced multilateral trade agreement ever approved until that
time. It was a precursor of the arrangements made under the General Agreement on
Tariffs and Trade of 1947. The 1927
agreement remained practically without effect. During the Great Depression of the
1930s, unemployment in major countries reached unprecedented levels and
engendered an epidemic of protectionist measures. Countries attempted to shore up
their balance of payments by raising their customs duties and introducing a range of
import quotas or even import prohibitions, accompanied by exchange controls.
From 1933 onward, the recommendations of all the postwar economic
conferences based on the fundamental postulates of economic liberalism were
ignored. The planning of foreign trade came to be considered a normal function of the
state. Mercantilist policies dominated the world scene until after World War II.
TRADE AGREEMENTS
The term trade agreement or commercial agreement can be used to describe
any contractual arrangement between states concerning their trade relationships.
Trade agreements may be bilateral or multilateral--that is, between two states or
between more than two states.

Bilateral trade agreements.

A bilateral trade agreement usually includes a broad range of provisions

regulating the conditions of trade between the contracting parties. These include
stipulations governing customs duties and other levies on imports and exports,
commercial and fiscal regulations, transit arrangements for merchandise, customs
valuation bases, administrative formalities, quotas, and various legal provisions. Most
bilateral trade agreements, either explicitly or implicitly, provide for (1) reciprocity,
(2) most-favoured-nation treatment, and (3) "national treatment" of nontariff
restrictions on trade.
Reciprocity.
In a trade agreement, the parties make reciprocal concessions to put their
trade relationships on a basis deemed equitable by each. The principle of reciprocity is
extremely old, and in one form or another it is to be found, implicitly at least, in all
trade agreements. The concessions may, however, be in different areas. In the Anglo-
French Agreement of 1860, for example, France pledged itself to reduce its duties to
20 percent by 1864. In return, Britain granted duty-free imports of all French
products except wines and spirits. The principle of reciprocity implies only that the
gains arising out of foreign trade are distributed fairly.
The most-favoured-nation clause.
The most-favoured-nation clause binds a country to apply to its partner
country any lower rate of import duties that it may later grant to imports from some
other country. The clause may cover a list of specified products only, or specific
concessions yielded to certain foreign countries. Alternatively, it may cover all
advantages, privileges, immunities, or other favourable treatment granted to any third
country whatever. The clause is intended to provide each signatory with the assurance
that the advantages obtained will not be attenuated or wiped out by a subsequent

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agreement concluded between one of the partners and a third country. It guarantees
the parties against discriminatory treatment in favour of a competitor.
The effect of the most-favoured-nation clause on customs duties is to
amalgamate the successive trade agreements concluded by a state. If the rates in
different agreements are fixed at varying levels, the clause reduces them to the lowest
rate specified in any agreement. Thus, goods imported from a country benefiting from
most-favoured-nation treatment are charged the rate of duty applicable to imports
from another country which, in a subsequent trade agreement, has negotiated a lower
rate of duty. The coverage of the most-
favoured-nation clause can be considerably reduced by a minute definition of a
particular item so that a concession, while general in form, applies in practice to only
one country. The best-known illustration of this technique is to be found in the
German Tariff of 1902, which admitted at a special rate

large dappled mountain cattle, reared at a spot at least 300 metres

above sea level, and which have at least one month's grazing each year at a
spot at least 800 metres above sea level.

The advantages granted under the most-favoured-nation clause may be

conditional or unconditional. If unconditional, the clause operates automatically
whenever appropriate circumstances arise. The country drawing benefit from it is not
called on to make any fresh concession. By contrast, the partner invoking a
conditional most-favoured-nation clause must make concessions equivalent to those
extended by the third country. A typical wording was that of the 1911 treaty between
the United States and Japan, which stated that

in all that concerns commerce and navigation, any privilege, favour or

immunity . . . to the citizens or subjects of any other State shall be extended to
the citizens or subjects of the other Contracting Party gratuitously, if the
concession in favour of that other State shall have been gratuitous, and on the
same or equivalent conditions, if the concession shall have been conditional.

The conditional form of the clause may at first sight seem more equitable. But
it has the major drawback of being liable to raise dispute each time it is invoked, for it
is by no means easy for a country to evaluate the compensation it is being offered as
in fact being equivalent to the concession made by the third country.
The effect of the unconditional form of
the most-favoured-nation clause is, finally, to wipe out any relevance that the
principle of reciprocity may have had to the purely bilateral preoccupations of the
negotiating parties, since the results of the bargaining process, instead of being limited
to the participants, influence their relationships with other states. In practice,
therefore, a country negotiating a trade agreement must measure the advantages it is
willing to concede in terms of the benefits these concessions will provide collaterally
to that third country which is the most competitive. In other words, the concessions
that may be granted are determined by the minimum protection that the negotiating
state deems indispensable to protect its home producers. This sets a major limitation
on the scope of bilateral negotiations. Protagonists of free trade consider that the
unconditional most-favoured-nation clause is the only practical way by which to
obtain the progressive reduction of customs duties. Apologists for protectionism are
resolutely against it, preferring the conditional form of the clause or some equivalent

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mechanism. The conditional most-favoured-nation clause was generally in use in
Europe until 1860, when the so-called Cobden-Chevalier Treaty between Great
Britain and France established the unconditional form as the pattern for most
European treaties. The United States used the conditional most-favoured-nation
clause from its first trade agreement, signed with France in 1778, until the passage of
the Tariff Act of 1922, which terminated the practice. (The Trade Reform Bill of
1974, however, in effect restored to the U.S. president the authority to designate
preferential tariff treatment, subject to approval by Congress.)
The Genoa conference in May 1922 and the
World Economic Conference in May 1927 both recommended that trade agreements
should include the most-favoured-nation clause whenever possible. But the Great
Depression of the 1930s led instead to a rise of restrictions in world trade. Imperial or
regional systems of preference came into being: the Ottawa Agreement of 1932 for
the British Commonwealth, similar arrangements for the French empire, and a series
of tariff and preference agreements negotiated in eastern and central Europe from
1931 on.

The "national treatment" clause.

The "national treatment" clause in trade agreements is designed to ensure that
internal fiscal or administrative regulations are not used to introduce discrimination of
a nontariff nature. It forbids discriminatory use of the following: taxes or other
internal levies; laws, regulations, and decrees affecting the sale, offer for sale,
purchase, transport, distribution, or use of products on the domestic market; valuation
of products for purposes of assessment of duty; legislation on prices of imported
goods; warehousing and transit regulations; and the organization and operation of
state trading corporations.

Multilateral agreements since World War II.

When World War II ended, the lessons learned from the growth of
protectionism since 1871, and most of all from the resurgence of trade restrictions in
the interwar years, spurred the development of multilateral trade agreements and other
forms of international economic cooperation. These developments culminated in the
General Agreement on Tariffs and Trade (GATT).
The General Agreement on Tariffs and Trade.
The General Agreement on Tariffs and Trade was signed at Geneva on Oct.
30, 1947, by 23 countries, which among them accounted for four-fifths of world trade.
On the same day 10 of them, including the United States, the United Kingdom,
France, Belgium, and The Netherlands, signed a protocol bringing the agreement into
force on Jan. 1, 1948. GATT takes the form of a multilateral trade
agreement setting forth the principles under which the signatories, on a basis of
"reciprocity and mutual advantage," shall negotiate "a substantial reduction in
customs tariffs and other impediments to trade, and the elimination of discriminatory
practices in international trade." With the adherence of additional countries, GATT
has become a charter governing almost all world trade except for that of the
Communist countries. The main principles underlying
GATT are as follows: (1) There shall be no trade discrimination. The unconditional
most-favoured-nation clause is regarded as fundamental. (2) As a rule, there is to be
no protection other than that provided by the customs tariff (the "national treatment"
principle). (3) Customs unions and free trade groupings are considered legitimate

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means of trade liberalization, provided that, taken as a whole, such arrangements do
not discriminate against third countries. (4) Members of GATT are entitled to levy the
following charges on imports: (a) an import tax equal in amount to internal taxes on
the product concerned, subject only to the general principle embodied in (2) above,
(b) "antidumping" duties in the case of imported products that are being sold at less
than the price in the home market, or at less than cost, (c) countervailing duties to
offset the effects of export subsidies, and (d) fees and other proper charges for
services rendered. These, however, are only the basic principles. The agreement
also contains a variety of clauses providing exceptions from the rules in special
situations. These include balance-of-payments disequilibrium; serious and unexpected
damage to domestic production; the requirements of economic development or,
subject to very broad reservations, of agricultural policy; the need to protect domestic
raw material production; and the interests of national security. In addition the GATT
rules permit countries entering a customs union to depart from the most-favoured-
nation principle. For example, within the European Economic Community, France
can permit duty-free entry of goods from its fellow members--such as Germany and
Italy--without extending such duty-free treatment to the products of outside nations.
Periodically, major multilateral trade
conferences, called rounds, are held by GATT countries to work out trade problems.
Most of these have been held at Geneva, site of GATT headquarters. The formula for
multilateral tariff bargaining applied in negotiations held under GATT auspices is a
major innovation in intergovernmental cooperation. In appraising the concessions that
they could afford to make, governments have been able to take account of the indirect
advantages that they could expect to accrue to them from the full set of bilateral
negotiations. Over the years since GATT's inception, it has been successful far
beyond its creators' expectations; its contribution to the growth of world trade has
been major. Two GATT sessions of particular historic importance were the Kennedy
Round and the Tokyo Round. As the economic integration of western Europe
progressed, opinion in the United States became concerned at the prospect of
remaining outside. Pres. John F. Kennedy pursued the goal of an Atlantic partnership
and secured special negotiating powers under the Trade Expansion Act of 1962. The
act authorized tariff reductions of up to 50 percent, subject to reciprocal concessions
from the European partners. This marked a fundamental shift away from the
traditional protectionist posture of the United States and led to the so-called Kennedy
Round negotiations in the GATT, held in Geneva from May 1964 to June 1967.
The Kennedy Round negotiations concerned four types of
problems: (1) progressive reduction, to amount finally to 50 percent, in the duties on
all but a few products, in place of the item-by-item bargaining that had prevailed in
earlier GATT conferences; (2) inclusion of agricultural as well as industrial products
in the scope of the negotiations; (3) discussion of nontariff obstacles as well as of
customs duties; and (4) nonreciprocity for economically less-developed countries.
Fifty-four countries participated in the negotiations, which covered 400,000 tariff
headings. The final result was an average reduction of 35
percent in the duties levied on industrial products, to be implemented over a five-year
period. This was less than the 50 percent originally envisaged. Further, the reductions
were not geographically uniform: U.S., European, and Japanese duties were to fall by
an average of 35 percent, British duties by 38 percent, and Canadian by 24 percent.
Little change was made in steel and textile tariffs, since the participants felt that
reductions in those industries would create intolerable political and social tensions in
most of the industrial countries. Problems arose with regard to chemicals because of a

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so-called American Selling Price that was used for appraising the dutiable value of
some products, based on prices ruling in the U.S. market; in return for a reduction of
50 percent in the rates of duty charged by the United States, Great Britain and the
European countries agreed to lower their duties by 22 percent, with a further 24
percent reduction to become effective upon abrogation of the American Selling Price.
Rather less spectacular results were achieved for agricultural commodities. These
included the setting of a minimum price for wheat and a weighted reduction of
between 15 and 18 percent in the duties charged on other agricultural and food
products. In the area of nontariff barriers to trade the most significant result was the
adoption of a uniform antidumping code.
The Kennedy Round continued the process of tariff reduction begun two
decades earlier by the industrial countries. While developing countries drew little
immediate advantage from the Kennedy Round negotiations, they were able to obtain
the addition of a new part titled "Trade and Development" to the GATT charter,
calling for stabilization, as far as possible, of raw material prices; reduction or
abolition of customs duties or other restrictions that differentiate unreasonably
between products in their primary state and the same products in finished form; and
renunciation by the advanced countries of the principle of reciprocity in their relations
with less-developed countries. The next ministerial meeting of GATT opened in
Tokyo on Sept. 12, 1973, and was attended by representatives of ministerial or
comparable level from 102 countries. On September 14 the meeting closed with the
adoption of what came to be called the Tokyo Declaration. The declaration differed
markedly from previous GATT documents in the inordinately large portion of its
language devoted to strengthening the negotiating position of the less-developed
countries. One of the general aims of the negotiations was said to be the securing of
additional trade benefits for less-developed countries. Specifically, the trade
negotiations would aim at improving the conditions of access for products of interest
to such countries and ensuring stable, equitable, and remunerative prices for primary
products. Tropical products would be given special and priority treatment. The
principle of nonreciprocity in negotiations between developed and less-developed
countries, an established principle in GATT, was reaffirmed: the importance of
maintaining and improving the Generalized System of Preferences granted by
developed countries to less-developed countries, as well as the need for special
measures and the importance of providing special, differential, and more favourable
treatment for less-developed countries, were recognized. Special attention was to be
given to the trade interests of the least-developed countries.
The Tokyo Declaration was followed by several years of multinational
trade negotiations that came to be called the Tokyo Round, concluding in 1979 with
the adoption of a series of tariff reductions to be implemented generally over an eight-
year period beginning in 1980. Further progress was also made in dealing with
nontariff issues. Most notably, a Code on Subsidies and Countervailing Duties was
negotiated. This code had two main features: it listed a number of unacceptable
subsidy practices, and it introduced a requirement that formal procedures be followed
before the imposition of countervailing duties on imports subsidized by foreign
nations. Specifically, before the imposition of a countervailing duty, an investigation
had to establish that competing domestic firms were being injured. The code was not
signed by all of the members, however, and the signing nations agreed only to follow
the prescribed rules before applying countervailing duties to the exports of other
signatories. Thus, while the code represented progress in dealing with a new topic, it
also represented a departure from the most-favoured-nation principle: signatories

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were not required to extend the benefits of the code to GATT members who did not
sign the code. A new set of negotiations was initiated at
a conference in Uruguay in 1986. Because traditional tariffs were becoming much less
important, most of the attention was focused on other impediments to international
transactions. The United States was particularly eager that the new negotiations
include international transactions in services and an attack on the problems of
international agricultural trade, which had been severely distorted by domestic price
support programs and subsidized exports of surplus production.

The Organisation for Economic Co-operation and Development.

On April 16, 1948, 16 European countries responded to a U.S. offer of
economic aid under the European Recovery Program by setting up the Organisation
for European Economic Co-operation (OEEC). Although the immediate aim was to
coordinate the distribution of U.S. credits, the OEEC convention was also designed to
foster free trade between the members and allow their participation in customs unions
or similar institutions. The members by 1955 consisted of Britain, France, West
Germany, Italy, Spain, the Benelux countries, Austria, Denmark, Sweden, Norway,
Switzerland, Portugal, Greece, Ireland, Turkey, and Iceland. The
Organisation for European Economic Co-operation did much to facilitate the recovery
of intra-European trade and particularly to abolish most of the quantitative restrictions
on imports within the area. On Sept. 30, 1961, the OEEC was converted into a new
institution, the Organisation for Economic Co-operation and Development (OECD),
and its membership was expanded to include the United States and Canada. Japan
became a member in 1964, Finland joined in 1969, Australia in 1971, and New
Zealand in 1973. The three fundamental aims of
the OECD are to promote the economic growth of member countries in conditions of
financial stability, to contribute to the economic growth of less-developed countries,
and to foster the growth of world trade on a multilateral, nondiscriminatory basis.
Having little power to enforce its decisions, the OECD has served mostly as a
consultative body, influencing trade through its studies and communications.
ECONOMIC INTEGRATION

Forms of integration.

The economic integration of several countries or states may take a variety of

forms. The term covers preferential tariffs, free-trade associations, customs unions,
common markets, economic unions, and full economic integration. The parties to a
system of preferential tariffs levy lower rates of duty on imports from one another
than they do on imports from third countries. For example, Great Britain and its
Commonwealth countries operated a system of reciprocal tariff preferences after
1919. In free-trade associations no duty is levied on imports from other member
states, but different rates of duty may be charged by each member on its imports from
the rest of the world. The European Free Trade Association is an example. A further
stage is the customs union, in which free trade among the members is sheltered
behind a unified schedule of customs duties charged on imports from the rest of the
world. The 19th-century German Zollverein (see below) was a customs union. A
common market is an extension of the customs union concept, the additional feature
being that it provides for the free movement of labour and capital among the

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members; an example was the Benelux common market until it was converted into an
economic union in 1959. The term economic union denotes a common market in
which the members agree to harmonize their economic policies generally, as is the
case with the European Economic Community (often referred to as the Common
Market). Finally, total economic integration implies the pursuit of a common
economic policy by the political units involved; examples are the states of the United
States or the cantons of the Swiss confederation. Economic
integration may be brought about by the political will of a state powerful enough to
impose it, as under the Roman Empire or the European colonial systems of the 19th
century, or it may result from freely negotiated agreement between sovereign states,
as has been more common in the 20th century.
The attempts at economic integration made after World War II
can be appraised only by reviewing them against the background of the long process
through which, over the centuries, the nations of the world have progressively
achieved economic integration. Thus, for instance, the world's greatest power in the
17th century, France, was divided into a number of provinces separated from one
another by various customs barriers involving a multitude of duties, tolls, and
prohibitions. Trade regulations and fiscal charges differed from one region to the
next; there was not even a single system of weights and measures. Not until after the
Revolution did the economic integration of France really get under way.

Integration between the states of federations.

The United States.

The economic integration of the United States was not achieved all at once,
but as the result of a long process during which the powers of the federal authorities
were constantly reinforced. The Constitution empowered the federal government to
regulate the conditions of trade with other countries and to set up a single system of
duties. It also abolished the right of individual states to maintain separate customs
legislation and to issue their own currencies. It authorized the federal government
alone to issue currency and established the principle of free movement of persons,
merchandise, and capital between the federated states. But the conflict of interest
between North and South was settled only by the American Civil War. Almost 200
years were to elapse before the economies of the states could be considered as
integrated for practical purposes, and even today many economic and fiscal disparities
still exist among them. The difficulties faced by the 13 original states
should not be underestimated. During the years prior to the adoption of the
Constitution there were bitter trade disputes among the states, which imposed tariffs
against each other and refused to accept each other's currencies. Everything seemed to
justify the words of a contemporary liberal philosopher, Josiah Tucker, Dean of
Gloucester (England):

As to the future grandeur of America, and its being a rising empire

under one head, whether republican or monarchical, it is one of the idlest and
most visionary notions that ever was conceived even by writers of romance.
The mutual antipathies and clashing interests of the Americans, their
differences of governments, habitudes, and manners, indicate that they will
have no centre of union and no common interest. They never can be united
into one compact empire under any species of government whatever; a
disunited people till the end of time, suspicious and distrustful of each other,

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they will be divided and sub-divided into little commonwealths or
principalities, according to natural boundaries, by great bays of the sea, and
by vast rivers, lakes, and ridges of mountains.

Switzerland.
The Swiss example is no less instructive. Although the Helvetic
Confederation emerged as a political entity in the 14th century, its economic
integration was achieved, only after many vicissitudes, with the constitution of 1848.
The terms of this document established a common currency, set forth the principle of
a common protective system for the cantons, and provided for free movement of
goods and Swiss citizens throughout the national territory. Swiss economic
integration is all the more remarkable in that it comprises peoples who speak four
different languages.

The economic integration of colonial empires.

When the great colonial powers of Europe founded their empires from the
16th century onward, they attempted to monopolize trade with the colonies and to turn
it to their own profit. This policy involved four main restrictions: (1) The colonies
were to trade exclusively with the mother country. (2) They were not to undertake
manufacturing; transformation of raw materials into finished goods remained a
monopoly right of the mother country. (3) Imports and exports of the colonies were to
be carried only in ships flying the mother country's flag. (4) The mother country
exempted colonial products from duty, or imposed lower rates.
This system, although progressively attenuated, applied in
various forms from the 16th to the 19th century. Based on force, it was to the benefit
of the home countries and detrimental to the economic growth of their colonies.

The Zollverein.

The best known of the early customs unions is the German Zollverein
(literally, "customs union"). Even though Napoleon had reduced the number of
German states from 300 to 40 at the beginning of the 19th century, those that
remained were isolated from each other by their own customs systems. In addition,
numerous internal customs barriers hampered trade within each state. At the same
time there was no single external tariff, and the German industries that had sprung up
during the Napoleonic Wars were being crushed by English competition. These
difficulties were at the root of the creation of the Zollverein.
The starting point was Prussia's abolition of all
internal duties and its adoption of an external tariff in 1818. In the next few years a
number of other German states followed the Prussian example. Bavaria and
Württemberg set up a customs union in 1828, and by 1830 four separate customs
unions were in existence. Prussia then sought to break up the local customs unions
and attach them to a general customs union, the Zollverein. The coverage of the
Zollverein increased until, by 1871, it included all the German states.
In its first phase, from 1834 to 1867, the Zollverein was administered
by a central authority, the Customs Congress, in which each state had a single vote. A
common tariff, the Prussian Tariff of 1818, shielded the member states from foreign

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competition, but free trade was the rule internally. During a second phase,
from 1867 to 1871 (following Prussia's victory over Austria at Sadowa), executive
power was wielded by a federal council (Bundesrat) composed of governmental
delegates, in which decisions were taken by an absolute majority. Prussia was entitled
to 17 of the 58 votes and held the chair of the council. Legislative power lay with a
"customs parliament" (Zollparlament) composed of deputies directly elected by
popular vote, and, like the council, taking decisions by a majority vote. This
arrangement transformed what had been a confederation into a federal state.
After the victory over France and the proclamation of the German
empire in 1871, the customs parliament and the federal council were replaced by the
parliament and the executive council of the empire. The federal state had become a
nation. The progressive destruction of a tangled maze of regulations, prohibitions,
and controls set the stage for the subsequent rapid development of the German
economy. Although economic integration occurred before political unification, it
would not have been possible had not many difficulties been swept away by
irresistible pressure from Prussia with its military victories.

The Benelux Economic Union.

In 1921 Luxembourg, a former member of the Zollverein, signed the

Convention of Brussels with Belgium, creating the Belgium-Luxembourg Economic
Union. Since 1921 Belgium and Luxembourg have, then, had the same customs tariff
and a single balance of payments. The union
was expanded after World War II to include The Netherlands. At the beginning of
1948 most import duties within the Benelux area were abolished, and a common
external tariff was put into operation. Exceptions were made, nevertheless, for a few
agricultural products, and it was also felt necessary to introduce a system of quotas.
It was rapidly perceived that a simple customs union
was inadequate, and a treaty on Oct. 15, 1949, set as its target the progressive and
complete liberalization of trade between the partners, systematic coordination of their
international commercial and monetary policies, and the adoption of a joint
bargaining position in negotiations with other countries. Though the experiment was
optimistically viewed everywhere as the precursor of a wider European economic
integration, it faced difficulties arising from the very different postwar situations of
Belgium and The Netherlands. The two economies were competitive rather than
complementary. Other problems arose in connection with the free access of Dutch
agricultural products to the Belgian market. Moreover, the Belgian economic system
was more liberal than the Dutch, where rigorous price control had long been a
standard practice. The development of Benelux received strong impetus
from the formation of the European Economic Community in the 1950s. The Treaty
of Rome in 1957 creating the EEC, or Common Market, spurred the members of
Benelux to confirm and strengthen their own integration in the Benelux Treaty of
Economic Union signed at The Hague on Feb. 3, 1958. The Hague treaty, however,
contained little that was new, and in outline it was no more than the codification of
results already achieved. The
Benelux Economic Union makes all of its decisions unanimously. The union has
executive organs (the Committee of Ministers, the Council of the Economic Union, a
number of commissions, and a Secretariat General); consultative organs (the Inter-
Parliamentary Council and the Economic and Social Advisory Council); and legal
organs (the Court of Justice).

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 The European Coal and Steel Community.

An important step in European integration was taken in May 1950 when the
French foreign minister, Robert Schuman, proposed that a common market for coal
and steel be set up by countries willing to delegate powers over these sectors of their
economies to an independent authority. The motive behind the plan was the belief that
a new economic and political framework was needed if European unity was to be
achieved and if the threat of a future Franco-German conflict was to be avoided. In
April 1951 France, West Germany, Italy, and the three Benelux countries signed a
treaty in Paris setting up the European Coal and Steel Community (ECSC).
The signatories bound themselves to abolish all customs barriers and other
restrictions on the movement of coal and steel between their countries; to renounce all
discriminatory practices among producers, purchasers, or users (with respect to price
and delivery conditions, transport charges, selection of suppliers, etc.); to end
government subsidies or grants-in-aid; and to eliminate all practices interfering with
the operation of markets.
The constitution of the community.
When first promulgated, the constitution of the Coal and Steel Community
allowed that it be governed by a High Authority, assisted by a Consultative
Committee, a Common Assembly, a Special Council of Ministers, and a Court of
Justice. The High Authority was
the permanent executive organ of the community. Its decisions, taken by a majority
vote, were fully binding on all member countries, each of which was pledged to
respect the "supranational character" of the High Authority. The authority was to refer
important substantive matters to the Consultative Committee before taking a decision.
The latter was composed of coal and steel industry representatives, including
producers, workers, users, and traders.
The assembly was empowered to exercise only parliamentary control
but could overrule the High Authority by a two-thirds majority. Its delegates were
composed of deputies of national parliaments.
The function of the Council of Ministers was to "harmonise the actions of
the High Authority and the governments responsible for the economic policy of
respective countries." It was composed of representatives of member countries, each
of which delegated a member of its government. Most decisions of the council were
valid if voted by a majority of representatives. Unanimous agreement was required
only on decisions concerning production questions and shortages. Taken as a whole,
the treaty was similar to a federal constitution, embodied in a long and complex
document. There is, however, a basic incompatibility between the
community's provenance, limited to the coal and steel industries, and the sovereignty
of the member countries, each of which is responsible for its own general economic
policy. As a practical matter, during the first 17 years of the community's existence,
authority on all substantive issues remained vested in the national governments. The
High Authority was autonomous only in matters of secondary importance. Thus, the
coal crisis of 1958--when West German, Belgian, and French stocks of unsold coal
rose to unmanageable proportions--was resolved at the national level. All the High
Authority could do was to confirm the measures taken, even when they were contrary
to the provision of the treaty. Similarly, the reduction of the labour force in coal
mining from 650,000 persons at the end of 1957 to 300,000 10 years later was
effected by individual countries; there was no community-wide action.
The treaty reserved for member countries responsibility for their own trade

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policies toward third countries. This hindered the establishment of an effective
common market since a common market requires a unified system of protection from
foreign competition. At the height of the coal crisis, for example, when stocks of coal
rose in Belgium, West Germany, and France, Italy nonetheless continued to buy
cheap supplies from the United States.
Later developments.
Despite such difficulties much has been accomplished by the community. The
markets for steel and coal have been liberalized to a considerable degree; the
community has been a useful forum in which questions of common interest could be
examined; and it has fostered the growth of an international spirit, which did much to
facilitate the negotiation of the Treaty of Rome, establishing the European Economic
Community and the European Atomic Energy Community (Euratom). In
1957 the Coal and Steel Community's assembly and Court of Justice were replaced by
parallel institutions established by the European Economic Community. In 1967 its
executive organs were merged with those of the European Economic Community and
Euratom in what is now called the European Communities. The other provisions of
the treaty remained unchanged.

The European Economic Community.

The European Coal and Steel Community was only the initial step in the
movement for European integration. On March 25, 1957, its six member governments
signed the Treaty of Rome, under which they agreed to establish the European
Economic Community, or Common Market, which came into being on Jan. 18, 1958.
In 1973 it was enlarged with the entry of Great Britain, Ireland, and Denmark. Since
that time, Greece (1981), Spain (1986), and Portugal (1986) have become members.
The EEC is the most far-reaching attempt at economic integration among sovereign
countries. Its founding treaty has been the model, in whole or part, for all subsequent
attempts at economic integration. The Treaty of
Rome aimed to "establish a common market" and "progressively bring the economic
policies of members into alignment" so as to

promote the harmonious growth of economic activity in the

Community as a whole, regular and balanced expansion, augmented stability,
a more rapidly rising standard of living, and closer relations between the
participating states.

The treaty pledged the signatories to

abolish customs duties and quantitative restrictions on the entry and

outflow of merchandise, to abrogate all other measures having an equivalent
effect, and to fix a common customs tariff for imports from non-member states.

They also agreed to "abolish, as between members, all barriers to the free
movement of persons, services and capital." This was to be accomplished during a
transition period of 12 years. The transition period ended on Jan. 1, 1970, and the
community then entered into its definitive phase.
Formation of a customs union.
The treaty set a timetable for the abolition of customs duties between member
states. On balance, this timetable was met and in some areas exceeded so that, by the
middle of 1968, tariff barriers had been abolished for agricultural as well as industrial

529
products. By that date also, most quota restrictions had been lifted. The customs posts
had not disappeared, however; they were still needed for such tasks as assessing and
collecting the compensatory taxes that equalized the differences in taxes between
member countries. Tariffs on imports from
outside the community were gradually brought closer, and on July 1, 1970, a common
community tariff was put into effect.
Development of a common agricultural policy.
When the treaty took effect at the beginning of 1958, agriculture was
subsidized in all six member countries. The various price-support mechanisms
differed substantially, as did foreign-trade policies and tariff levels. The cumulative
impact of governmental intervention of various kinds over the years had led to major
differences among the members in agricultural price levels. With the average price of
wheat in the six countries in 1959 indexed at 100, the relative price levels in
individual countries were as follows: Germany, 108; France, 78; Italy, 108; Belgium,
101; Luxembourg, 119; and The Netherlands, 86. The achievement of common
policies in agriculture appeared to be so difficult that the treaty limited itself to setting
forth a number of general provisions on which agreement seemed feasible. Despite
this, a common agricultural policy was achieved: all tariff and quota restrictions on
trade in farm products among member countries were abolished; a common set of
tariffs on agricultural imports from non-EEC countries was established; and a
common system of price supports took the place of the former national systems.
The price supports required difficult compromises among the member
governments because of the differences in their domestic price levels for farm
products. The EEC wheat price, for example, was set roughly halfway between the
prices of the lowest-cost suppliers in the community, France and The Netherlands,
and those of West Germany, which was the highest. France exerted considerable
political pressure to persuade West Germany to accept a substantial lowering of the
returns to its wheat producers. The community prices are supported by purchases
from a common fund. The fund begins buying in any area where the price of a crop
drops to a fixed intervention level. The cost of the price support program is financed
by contributions from the members. Since its inception, the common
agricultural policy has experienced several fundamental problems, especially
recurrent surpluses and conflicts of interest between large- and small-scale producers.
Surpluses have originated as a result of the price support system. While this system
has helped marginal farmers stay in business, it has often encouraged more productive
farmers to overproduce, creating surpluses that must be purchased with EEC funds.
Recurrent surpluses of butter and sugar have become a particular problem. Conflicts
of interest have arisen between countries that are net food importers (e.g., the United
Kingdom), which make large contributions to the common policy but receive little
return in export subsidies and price supports, and those countries that are net food-
exporting countries (like France and Italy), which receive greater relative support.
Toward a harmonization of policies.
Another fundamental aim of the Treaty of Rome was to achieve a general
harmonization of national economic policies. The treaty envisaged the working out of
common rules covering such matters as competition, taxation, and other economic
legislation. It also called for the development of common policies in such areas as
foreign trade and transportation. Members were asked to concert their economic
policies in the fields of fiscal and monetary policy, balance-of-payments policy, and
social welfare.

530
 Relations with other countries.
The treaty provides that overseas countries and territories having a special
relationship with Belgium, France, The Netherlands, and Italy may be granted
associate membership. The purpose of this was to eliminate preferential tariff
arrangements by any member with outside countries by extending the same
preferential terms to all of the members. The treaty also provides for a European
Development Fund to assist the economic development of these countries.

New members.
Any European state may request membership in the EEC. Acceptance requires
a unanimous decision by the present members after "the conditions for entry and the
modifications to be made to the Treaty as a result" have been agreed upon by the
member states and the would-be entrant.
Associates.
The EEC may also conclude an agreement of association with a nonmember
country, a union of states, or an international organization. The associate is entitled to
special terms in its trade with the EEC and can send representatives to its meetings.
Associate status providing for a customs union after a 12-year transitional period was
granted to Greece in 1962, prior to its accession as a full member, and to Turkey in
1964. Partial association agreements have been signed with other countries.
Constitution of the EEC.
As mentioned above, since 1967 the governing bodies for the EEC, the ECSC,
and Euratom have been integrated. These bodies include the Council of Ministers, the
Commission, the European Parliament, and the Court of Justice. The Council of
Ministers and Commission are assisted by the Economic and Social Committee with
advisory functions. Headquarters are in Brussels, Luxembourg, and Strasbourg.
The council has decision-making power in all matters falling within the sphere
of competence of the communities. Each member sends one delegate. During the
transition period before 1970, all important decisions had to be taken unanimously;
they may now be taken by either absolute majority or "qualified" majority (i.e., with
weighted voting rights) or unanimously. Either a qualified majority or unanimity are
required on certain matters by the treaty. Decisions must be taken unanimously on a
very large number of issues. The Commission members are "selected by
reason of their general competence and offering the utmost guarantees of
independence." They are appointed by agreement among the member countries, not
more than two being of the same nationality. Members serve a four-year term and
may be reappointed. They are expected to act in the general interest of the
communities, without deference to any government or other organization.
The Commission's basic function is to
watch over the application of the Treaty of Rome and other treaties and to assist the
council with recommendations or advice. Its powers for the most part are delegated to
it by the council. The European Parliament is formed of
delegates selected from the parliaments of the members. In principle the parliament
meets once a year. It passes recommendations and resolutions and discusses the
Commission's annual report. It may pass a resolution of no confidence in the
Commission by a two-thirds majority, resulting in immediate dismissal of the
Commission members. The Court of
Justice is charged with the interpretation and application of the treaties. It is
composed of 11 judges appointed by mutual agreement of the governments of the
member states for six-year terms. Actions may be brought in the court by any member
state or by any physical or legal person. The court's powers are considerable since

531
community law takes precedence over the national laws of each member country. The
Economic and Social Committee is a consultative body composed of representatives
of various economic and social strata, including manufacturing, agriculture,
transportation, trade, handicrafts, the liberal professions, wage earners, and the public.
Its members are appointed for a four-year term by unanimous decision of the council
and may be reappointed.

The European Free Trade Association.

When the European Economic Community was being organized, Great Britain
sought to organize a free-trade area that would include 17 member countries of the
Organization for European Economic Co-operation. This would have given Britain
access to the benefits of the industrial common market on the Continent while
avoiding possible infringements of British sovereignty. The effort failed, mainly
because of French opposition. Britain then undertook the formation of a free-trade
area in association with Austria, Denmark, Norway, Portugal, Sweden, and
Switzerland. The convention setting up the European Free Trade Association
(EFTA) was signed at Stockholm on Jan. 4, 1960. The preamble stated that one of the
main purposes of the organization was to "facilitate the future establishment of a
wider multilateral association for abolition of customs barriers." More specifically, it
was intended as a mechanism for freeing trade with the six Common Market countries
without subscribing to the commitments of political character embodied in the Treaty
of Rome. In the meantime, EFTA gave its seven members a stronger bargaining
position vis-à-vis the other six, as well as the means of creating a large market of their
own.
Operation of the EFTA.
The European Free Trade Association is governed by a council composed of
one member from each participating state. The council found it useful to set up a joint
consultative committee composed of representatives of industry, business, and labour;
a set of six permanent technical committees (on customs, trade, economic
development, agriculture, economics, and budget); and working parties dealing with
special topics. The EFTA treaty, like that of the EEC, provided for a transitional
period, set forth rules governing competition, and called for the abolition of all
indirect protection and trade discrimination.
The EFTA had one special problem arising from its nature as a free-trade area.
Since the duties charged on imports from outside countries might differ from one
member to another, traders could take advantage of the differences by channeling
imports through the country levying the lowest rates and delivering them to customers
in another member country. Rules were established to prevent this by classifying
merchandise according to whether it was produced or fabricated in one of the member
countries. In the case of goods made from imported raw materials, the rules required
that the import content not exceed 50 percent of the export price of the finished
product.
The EFTA's record.
Although a 10-year transitional period was originally envisaged, internal
customs barriers on industrial goods were eliminated on Jan. 1, 1967, three years
ahead of schedule. Bilateral trade agreements have also been negotiated to increase
trade in agricultural products. The EFTA passed
through two grave crises in the 1960s. The first was in 1961 when Britain, acting

532
unilaterally, informed its partners that it had applied for membership in the EEC. The
upshot was a joint declaration in which the EFTA members committed themselves to
"coordinate their action and remain united throughout the negotiations." The second
crisis occurred in October 1964, when, to shore up the pound sterling, Britain
suddenly introduced a surcharge of 15 percent on all its industrial imports--an act that
was in violation of the treaty. Finland became an associate member of EFTA in July
1961, and Iceland was admitted to full membership in March 1970. In 1973 Britain
and Denmark left the association when they were accepted as members in the
European Economic Community--Britain, after two previous unsuccessful tries. Since
that time agreements have been reached between EFTA and EEC promoting trade
between the two groups.

Economic integration in Latin America.

Progress toward economic integration in Europe encouraged the Latin-

American republics to make similar attempts. By the late 20th century several
organizations had been established to work toward such integration; they include the
Central American Common Market; the Latin American Free Trade Association; the
Andean Group; and the Caribbean Community and Common Market.
The Central American Common Market.
On June 10, 1958, El Salvador, Guatemala, Honduras, Nicaragua, and Costa
Rica signed a multilateral treaty aiming at free trade and economic integration. It
provided for the establishment of a free-trade area within 10 years. The participating
countries also agreed to the industrial integration of the region. These arrangements
were completed by the signature on Dec. 13, 1960, of the Treaty of Managua. Its aims
were similar to those of the EEC in Europe, namely, the establishment of a common
market within five years and the organization of integrated industrial development.
Most barriers on the region's internal trade have since been removed or reduced, and a
single customs tariff has been introduced for most products imported from outside the
area. Economic integration in Central America has been hampered
by disagreements and military conflicts in the area. Following a dispute with El
Salvador in 1970, Honduras in effect withdrew from common market membership
by implementing tariffs on imports from other member countries. In 1980, however,
Honduras signed a treaty with El Salvador, settling their dispute and restoring
Honduran participation in the common market trade agreements. During the 1980s,
tensions between the revolutionary government of Nicaragua and its neighbours, as
well as other disorders, have disrupted trade among the nations of Central America.
The Latin American Integration Association.
On Feb. 18, 1960, Argentina, Brazil, Chile, Mexico, Paraguay, Peru, and
Uruguay signed a treaty setting up the Latin American Free Trade Association
(LAFTA), predecessor to the Latin American Integration Association. By 1970 the
seven signatories had been joined by Ecuador, Colombia, Venezuela, and Bolivia.
The treaty provided for a 12-year transition period during which all obstacles to trade
were to be eliminated. It was based on the principle of reciprocity and most-favoured-
nation treatment. Member states also committed themselves to progressive
coordination of their industrialization policies. Special treatment was provided for
agriculture and for the relatively least-developed member countries.
Liberalization of trade between the member countries
was carried out initially through negotiation of product-by-product concessions. In
1967, however, the negotiations failed; they were postponed to 1968, when agreement
was reached on a system of across-the-board automatic tariff reductions similar to

533
those of the European Economic Community. The eventual aim was that LAFTA be
the first step in a process that would lead to a common Latin-American market; but
during the 1970s it became apparent that the geographic diversity and varying levels
of economic development exhibited by the member countries were handicapping the
formation of a true common market within the association's existing framework. In
the late 1970s negotiations were begun to establish a new framework for economic
integration, and in 1980, 20 years after the creation of LAFTA, the Latin American
Integration Association (LAIA; Asociación Latino-Americana de Integración) was
formed. Unlike its predecessor, LAIA adopted an alternative to the concept of a free-
trade area in that it opted for the establishment of bilateral preference agreements that
would take into account the varying stages of economic development of the member
countries. In order to best negotiate bilateral preference agreements the member
nations were divided into three categories: most developed countries (Argentina,
Brazil, and Mexico), intermediate developed countries (Chile, Colombia, Peru,
Uruguay, and Venezuela), and least-developed countries (Bolivia, Ecuador, and
Paraguay). Cuba was admitted to LAIA in 1986 with observer status.
The Andean Group.
In 1966 Bolivia, Chile, Colombia, Ecuador, Peru, and Venezuela, all members
of the Latin American Free Trade Association, agreed to form a regional subgroup.
The Andean Group finally began its official existence in June 1969 without
Venezuela, which had withdrawn. By 1973 Venezuela had decided to join, but Chile
withdrew in 1976. (The Andean Judicial Tribunal was established in 1980 to monitor,
interpret, and resolve problems resulting from Andean Group decisions. The tribunal
is composed of one judge from each country, serving a six-year term.) Among the
group's aims are the acceleration of economic integration between member countries,
the coordination of regional industrial development, the regulation of foreign
investment in member countries, and the maintenance of a common external tariff.
The Caribbean Community and Common Market.
Established in 1973 by 12 Caribbean countries, the Caribbean Community
and Common Market (Caricom) is the successor to the Caribbean Free Trade
Association, which was founded in 1968 by five former British colonies (Antigua,
Barbados, Guyana, Jamaica, and Trinidad and Tobago), all of whom joined the new
organization. The organization attempts to encourage economic integration in the
Caribbean region and achieved partial agreement to a common external tariff and
protective policy for the community in 1978. Caribbean
economic integration was curtailed between 1976 and 1978, in part because of import
restrictions imposed by Jamaica and Guyana, and in part because of dissatisfaction
among the less-developed countries, who claimed that they were not receiving their
fair share of trading revenues. By 1980 Jamaica and Guyana had removed their import
restrictions, and the Caricom Council had endorsed several measures to improve the
status of the less-developed countries within Caricom. The less-developed countries,
however, remained dissatisfied, and in 1981 the seven former members of the West
Indies Associated States (Antigua and Barbuda, Dominica, Grenada, Montserrat,
Saint Kitts-Nevis, Saint Lucia, and Saint Vincent) formed a subregional economic
integration organization, the Organization of Eastern Caribbean States. They retained
their Caricom membership.

The Council for Mutual Economic Assistance (1949-90).

534
 A Soviet-sponsored effort to integrate the economies of eastern Europe began
as early as Jan. 25, 1949, in response to the Marshall Plan. The founding states were
Bulgaria, Hungary, Poland, Romania, Czechoslovakia, and the Soviet Union. Albania
joined in 1949, the German Democratic Republic in 1950, and the Mongolian
People's Republic in 1962. Albania ceased to participate after 1961. In its early years
the activities of the Council for Mutual Economic Assistance (or Comecon) were
limited mainly to the registration of bilateral trade and credit agreements among the
member countries. After Stalin's death in 1953 it made efforts to promote industrial
specialization and to reduce "parallelism" in the economies of its members. In 1956
and 1957, when most of its standing commissions began to operate, attempts were
made to harmonize the long-term plans of the members. The
establishment of the European Economic Community in 1958, together with pressures
from the eastern European countries for a greater degree of independence, induced the
Soviet leadership to rethink the organization. A new charter was signed by the
members in Sofia on Dec. 14, 1959. The council's economic objectives were
to coordinate each member country's efforts for development in technology and
industrialization, growth of labour productivity, and specialization in industry.
However, the democratic revolutions throughout eastern Europe in 1989-90 left the
organization defunct. In 1991 the Council for Mutual Economic Assistance was
renamed the Organization for International Economic Cooperation, under which each
member country was free to develop its own foreign trade. After the collapse of the
communist governments, member countries moved toward private enterprise and
market-based price systems. Comecon's original objectives had been
hindered by certain political and economic constraints. One of the most serious was
the absence of flexible and realistic price systems in the member countries. This made
it impossible to base trade on relative prices; instead it was conducted mainly on a
barter basis through bilateral agreements between governments. In negotiating such
agreements, the parties were led to use "world prices"--i.e., prices prevailing in the
trade of countries outside the Council for Mutual Economic Assistance. Another
hindrance to economic integration was the highly centralized economic planning in
the member countries, which had only limited success in coordinating their plans.
There were also serious nationalistic tensions within the
council. The Romanian government, for example, announced its intention to pursue
all-around industrialization, including the development of its heavy industries, in
opposition to the policy of specialization in raw materials and agricultural products
that was said to have been the Council for Mutual Economic Assistance's policy for
Romania. Among the practical achievements of the Council for
Mutual Economic Assistance, however, were the organization of railroad coordination
(1956); construction of a high-voltage electricity grid (1962); creation of the
International Bank for Economic Cooperation (1963); the pooling of 93,000 railway
freight cars (1964); and construction of the "Friendship" oil pipeline from Russia's
Volga region to the eastern European countries. Comecon initially was composed of
the old Soviet Union's eastern European satellites, but in 1972 Cuba became a
member and in 1978 Vietnam joined. The highest
authority of the organization was the council-in-session. It was composed of
delegations from all member countries, the composition of each delegation being
fixed by the government concerned. The conference of representatives of member
countries, composed of one representative of each country, could issue
recommendations and decisions. It could also submit proposals for examination by the
council-in-session. Various

535
permanent commissions were composed of experts and officials of member countries.
Some were general economic commissions; others dealt with specific industries. The
headquarters of the various commissions were located in the capital cities of member
countries. The central secretariat was in Moscow.
The Council for Mutual Economic Assistance was often called the
eastern European counterpart of western Europe's EEC. Although the general aims
were indeed the same, the two organizations differed radically in their approach to the
problems involved. The EEC aims to achieve integration on a decentralized basis by
means of an economic market in which goods, services, capital, and persons have full
freedom of movement--a market regulated by uniform economic legislation. The
Council for Mutual Economic Assistance sought to achieve cooperation among
national economies each of which was centrally planned and administered.

GATT rules regarding regional arrangements.

When countries join regional trading groups such as the European Economic
Community, they provide preferences to one another. For example, German producers
can export duty-free to France, whereas U.S. or Japanese exporters still have to pay
duties on products shipped to France. Thus, German producers are preferred over U.S.
or Japanese suppliers; a customs union represents a departure from most-favoured-
nation treatment. Nevertheless, countries entering a customs union or free-trade
association are not in violation of their commitments under the General Agreement on
Tariffs and Trade; customs unions and free-trade associations are permitted under
GATT. GATT article XXIV
allows countries to grant special treatment to one another by establishing a customs
union or free-trade association, provided that (1) duties and other trade restrictions are
"eliminated on substantially all the trade" among the participants, (2) the elimination
of internal barriers occurs "within a reasonable length of time" (commonly interpreted
as permitting a phase-in period of not more than 10 years), and (3) duties and other
barriers to imports from nonmember countries "shall not on the whole be higher or
more restrictive" than those preceding the establishment of the customs union or free-
trade association. The third condition was explicitly aimed at protecting the rights of
outside countries. The first
condition disapproves partial preferential arrangements covering only some products,
while accepting broad arrangements covering (substantially) all products. It was
supported on the ground that large, unrestricted markets--most notably, that within the
United States--provide substantial benefits. Such benefits should also be available to
others. For example, when the GATT articles were being drafted, consideration was
being given to an integration of the nations of western Europe.
Shortly after article XXIV was written, it received
substantial support in the classic study of Jacob Viner, The Customs Union Issue
(1950). Viner, a Canadian-born U.S. economist, saw efficiency as the main gain from
international trade, since trade encourages production in a less costly location. He
contended that a customs union works to increase efficiency in one way, but decreases
it in another. To explain, Viner drew a distinction between two forces at work when a
customs union is established. As two (or more) countries cut tariffs on each other's
products, new trade is created. Some goods previously bought from domestic
producers are now bought from lower-cost producers in the trading partner, whose
goods now come in duty-free, improving efficiency. When, however, a
country removes tariffs on its partner's goods but not on the goods of outside

536
countries, the partner has preferred access. As a result, some purchases are switched--
goods are bought from the partner nation, rather than from the outside world. Such
trade diversion reduces efficiency; purchases are switched from the efficient outside
country to the less efficient partner nation. A customs union (or free-trade area) may
be predominantly trade-creating, which is desirable, or it may be predominantly trade-
diverting, which is not. Viner's book thus introduced a skeptical note
into the discussion of customs unions, which had previously been given broad
approval. Viner's work also supported the distinctions made in article XXIV of the
General Agreement on Tariffs and Trade. Clearly, if barriers on imports from
nonmember countries are kept down, then trade diversion is less likely. Furthermore,
the provision to disapprove partial preferential arrangements covering only some
products, while accepting broad arrangements covering virtually all products found
support within Viner's framework. Because of the political dynamics of trade
negotiations, partial preferential arrangements generally cause more trade diversion
than trade creation. This can
be illustrated in a hypothetical situation in which countries (say, France and Germany)
are permitted to get together to make whatever preferential agreements they wish. A
natural way for France to open negotiations would be to say to Germany: "We'll cut
tariffs on your automobiles and buy from you rather than Japan, if you will cut tariffs
on our sugar and buy from us rather than from the Caribbean nations." In other words,
negotiators tend to pick and choose those items previously imported from outside
countries; they tend to cut tariffs where trade diversion is greatest. By requiring a
comprehensive approach, article XXIV ensures that trade-creating tariff cuts will be
made, too.
Patterns of trade
DEGREES OF NATIONAL PARTICIPATION
Nations vary considerably in the extent of their foreign trade. As a very rough
generalization, it may be said that the larger a country is in physical size and
population, the less its involvement in foreign trade, mainly because of the greater
diversity of raw materials available within its borders and the greater size of its
internal market. Thus, the participation of the United States is relatively low, as
measured by percentage of gross national product, and that of the former Soviet
Union was even lower. The U.S. gross national product, however, is so immense by
world standards that the United States still ranks as one of the world's most important
trading countries. Some of the smaller countries of western Europe (such as The
Netherlands) have export and import totals that approximate half of their gross
national products.

TRADE AMONG DEVELOPED COUNTRIES

The greatest volume of trade occurs among the developed, capital-rich
countries, especially among industrial leaders such as Australia, Belgium, Canada,
France, Germany, Italy, Japan, The Netherlands, Spain, Sweden, the United Kingdom,
and the United States. Generally, as a country matures economically, its participation
in foreign trade grows more rapidly than its gross national product.
The European Economic Community (EEC)
affords an impressive instance of the gains to be derived from freer trade. A major
part of the increases in real income in EEC countries is almost certainly attributable to
the removal of trade barriers. The EEC's formation cannot, however, be interpreted as
reflecting an unqualified dedication to the free-trade principle, since EEC countries
maintain tariffs against goods from outside the Community.

537
 TRADE BETWEEN DEVELOPED AND DEVELOPING COUNTRIES

Difficult problems frequently arise out of trade between developed and

developing countries. Many less-developed countries are tropical, frequently relying
heavily for income upon the proceeds from export of one or two crops, such as coffee,
cacao, or sugar. Markets for such goods are highly competitive (in the sense in which
economists use the term competitive)--that is, prices are extremely sensitive to every
change in demand or in supply. Prices of manufactured goods, the typical exports of
developed countries, are commonly much more stable. Hence, as the price of its
export commodity fluctuates, the tropical country experiences large fluctuations in its
"terms of trade," the ratio of export prices to import prices, often with painful effects
on the domestic economy. With respect to almost all important primary commodities,
efforts have been made at price stabilization and output control. These efforts have
met with varied success. Comparable problems arise when
the developing country exports a mineral resource such as petroleum or copper. The
initiative in developing such a resource has often been taken by a foreign company
from a developed country that owns (in part if not in full) the extracting capital
facilities. Particularly since the mineral resource is exhaustible, charges of
exploitation are common. The matter is a continuing source of political strife and may
on occasion lead to expropriation of the mineral properties. Several groups of
developing countries have joined in creating organizations for the promotion of trade
between themselves. Notable examples include the Central American Common
Market (1961), the Organisation Commune Africaine et Mauricienne (1965), the
Association of Southeast Asian Nations (1967), the Caribbean Community and
Common Market (1973), and the Latin American Integration Association (1980).
International commodity trade
Goods that are traded internationally fall into two broad categories--primary
goods and manufactured products. Manufactured products, such as machinery and
clothing, comprise products whose value reflects largely the cost of manufacturing
processes. Such manufacturing processes contribute relatively little to the value of
primary goods, such as crude petroleum and cotton, which undergo little processing
before they are traded. Commodities and commodity markets are terms used as
synonyms for primary goods and the markets in such goods.
PRIMARY COMMODITY MARKETS
Trade in primary goods may take the form of a normal exchange of goods for
money as in any everyday transaction (referred to technically as trade in "actuals"),
or it may be conducted by means of futures contracts. A futures contract is an
agreement to deliver or receive a certain quantity of a commodity at an agreed price at
some stated time in the future. Trade in actuals has declined considerably and in many
cases (such as the Liverpool markets in cotton and grain) has even come to a halt.

Operation of the market.

The great bulk of commodity trading is in contracts for future delivery. The
purpose of trading in futures is either to insure against the risk of price changes
(hedging) or to make a profit by speculating on the price trend. If a speculator
believes that prices will rise, he buys a futures contract and sells it when he wishes
(e.g., at a more distant delivery date). The speculator either gains (if prices have risen)
or loses (if they have fallen), the difference being due to the change in price.
"Hedging" means the offsetting of commitments in the market in
actuals by futures contracts. A producer who buys a commodity at spot (current)

538
prices but does not normally resell until three months later can insure himself against
a decline in prices by selling futures: if prices fall he loses on his inventories but can
purchase at a lower price; if prices rise he gains on his inventories but loses on his
futures sales. Since price movements in the actuals market and the futures market are
closely related, the loss (or gain) in actual transactions will normally be offset by a
comparable gain (or loss) in the futures market.
The operation of futures markets requires commodities of
uniform quality grades in order that transactions may take place without the buyer
having to inspect the commodities themselves. This explains why there is no futures
market, for example, in tobacco, which varies too much in quality. A steady,
unfluctuating supply also is needed; this is referred to technically as "low elasticity of
supply," meaning that the amount of a commodity that producers supply to the market
is not much affected by the price at which they are able to sell the commodity. If
supply could be adjusted relatively quickly to changes in demand, speculation would
become too difficult and risky because exceptionally high or low prices, from which
speculators are able to profit, are eliminated as soon as supply is adjusted.
Monopolistic control of demand and supply is also unfavourable to the operation of a
futures market because price is subject to a large extent to the control of the
monopolist and is thus unlikely to fluctuate sufficiently to provide the speculator with
an opportunity for making profits. There is, for example, no market in diamonds,
because there is only one marketing cooperative. In 1966 the London market in
shellac ceased to function after the Indian government applied control of exporters'
prices at the source. Before World War II London
was the centre of international trade in primary goods, but New York City has
become at least as important. It is in these two cities that the international prices of
many primary products are determined. Although New York often has the bigger
market, many producers prefer the London market because of the large fluctuations in
local demand in the United States that influence New York market prices. In some
cases international commodity agreements have reduced the significance of certain
commodity markets. There are markets
in both New York and London for numerous primary goods, including cotton, copper,
cocoa, sugar, rubber, coffee, wool and wooltops, tin, silver, and wheat. Tea, wool, and
furs are auctioned in London, but in the case of many other commodities, auctions
have been superseded by private sales. In London the metal market is much more a
"spot" or delivery market than other futures markets. Many countries have their own
markets: Australia for wool, Sri Lanka and India for tea, and Malaysia for rubber and
tin.

The terms of trade.

The relation between the price of primary goods and that of manufactures has
long intrigued economists. The relationship is known as the "terms of trade" and
may be defined as the ratio of the average price of a country's or a group of countries'
exports to the average price of its imports. The long-range trend of the terms of trade
between primary products and manufactures has been the subject of diametrically
opposed conclusions: some theorists hold that the trend is favourable to the less-
developed countries, others that it is unfavourable. Faulty statistical material and
methods in various countries are responsible for this lack of agreement.
Any comparison of the terms of trade over a long period of time is very
difficult and may be misleading because the structure of trade changes, as does the

539
quality of the groups of goods studied. Many economists believe that the terms of
trade were adverse for less-developed countries from 1870 to 1938. They point to the
fact that as developed countries become more technologically advanced there is a
tendency for them to require relatively less in the way of primary products. A
downward influence is thus exercised on primary product prices. Another factor is
that in the industrial countries the benefits of progress find expression not in lower
prices but in higher wages. This, together with inflationary pressures, means that
prices of manufactured goods produced by the developed countries tend to rise
steadily. There is thus a tendency, it is argued, for the less-developed countries to
receive relatively less for what they have to sell and to have to pay more for what they
need to buy. But the statistical problems posed by any attempt to verify this
hypothesis are considerable. The countries selected, the relative weight assigned to
the various goods, changes in transport costs, and the fact that the quality of
manufactured goods has improved much more than that of primary goods make the
statistics unreliable. There is also the problem that the terms of trade between primary
commodities and manufactures do not necessarily coincide with the terms of trade
between less-developed and industrial areas. Even if it were
established that the terms of trade have moved against the less-developed, largely
primary-producing countries, this would not necessarily mean that their balance-of-
payments situation has been adversely affected. A decline in the terms of trade may in
fact improve a country's balance-of-payments, because, although the prices of that
country's exports have fallen, it may, as a consequence of this fall in price, be able to
sell a far larger quantity. Total revenue from exports may thus increase. Similarly,
although imports may become more expensive, the result may be that the country's
demand for imports drops very steeply, so that less is spent on them than when they
were cheaper. These problems make it extremely
difficult to generalize about the effects of commodity price changes on the economic
situation of one or a group of countries.
PRICE MOVEMENTS
Prices usually vary widely in commodity markets, not only in the short run but
also in the long run. In the short run there are frequent changes in supply because of
varying climatic conditions (for agricultural products) and because of political and
other events on the international scene (such as the closure of the Suez Canal) and in
individual countries (such as strikes). As a rule, price changes do not give rise in the
short run to substantial changes in the supply of or demand for primary goods (low
elasticity of supply and demand). Business cycles in the importing countries,
however, have an influence on demand. Market conditions differ, of course, from
product to product. In the case of sugar and wheat, demand is fairly stable, but
supply is not; as regards tin, and, indeed, the majority of metals, the converse is true.
In the case of industrial commodities, such as cotton, there are fluctuations in both
supply and demand. In the long run the
extent of changes in demand and supply is usually greater. A considerable and
sustained price increase, for example, may result in a fall in demand and the
appearance of substitute products. After a number of years, supply may increase in
response to a higher level of demand reflected by higher prices. The length of time
required to adjust supply to demand varies from commodity to commodity. Tree
crops, for example, need a long growth period, and mineral reserves are tapped only if
expectations about the price trend are favourable.

Effect on economic development.

540
 Through their repercussion on export earnings, price fluctuations are often
held responsible for the variations in the growth rate of countries producing primary
goods, especially since exports of a single primary good account for a large part of the
total exports of many countries. But apart from the fact that, as described above,
quantities exported influence export earnings as much as prices, there are many other
factors that determine export earnings. Such factors include the type and destination
of exports and, above all, the economic policies of the countries concerned.
It is thus difficult to generalize about the
relation of foreign trade to economic growth. Many countries with very unstable
exports have relatively stable national incomes; others whose exports are stable have
highly unstable national incomes. The stimulus from exports will usually be stronger,
for example, if the rate of demand for these exports is growing rapidly. Often,
however, the transmission of growth to the nonexporting sector of the economy is
impeded in less-developed countries by the economic, social, and political
organization of the economy. It is important, for example, for some countries to try to
decrease exports of goods that have a slowly growing demand and at the same time to
try to increase exports of goods, such as minerals, for which world demand is growing
more rapidly.

Efforts to stabilize prices.

The uncertainty both for private producers and for governments resulting from
sharp and sudden commodity price changes has resulted in many efforts to achieve
greater stability on the market in primary goods.
Action in individual countries.
In theory a country could insulate domestic producers against international
price fluctuations through variable charges and subsidies, but politically it is difficult
to tax away producers' profits during a period of rising prices and to hold the resulting
revenue in order to redistribute it should prices and profits fall.
In Nigeria, Ghana, Sierra Leone, and The Gambia,
for instance, national marketing boards that attempted to even out price fluctuations of
cocoa, cotton, and peanuts (groundnuts) were in operation before those countries
became independent. In the former French territories in Africa, stabilization funds
fixed producer prices and controlled margins and profits. The main dangers inherent
in national stabilization schemes are inconsistent government policies and the
excessive operating costs of the public bodies concerned. These factors explain the
unsatisfactory results of many national price agencies.
International cooperation.
In the 1920s international cartels were created for rubber, sugar, tin, and tea,
but they yielded no lasting results. Nor did cooperation between the governments of
exporting and importing countries (such as in the International Wheat Agreement of
1933 and the International Sugar Agreement of 1937) serve to attain the desired goals
during the Great Depression. Of special significance among more recent attempts to
raise and stabilize a commodity price has been the one made by the Organization of
Petroleum Exporting Countries (OPEC). (The special features of the oil market are
considered below.) Other attempts to stabilize commodity prices since World War II
have mainly assumed three forms--the multilateral contract agreement, the quota
agreement, and the buffer-stock agreement. Transactions are effected at world market
prices. When a minimum or a maximum price is reached or approached, efforts are
made to ensure that prices remain within the two limits. Each of the three systems

541
achieves this in a different way. In the multilateral
contract system, consumers and producers undertake to buy or sell a specified
quantity of the commodity at agreed minimum and maximum prices, or at a price
within the agreed range. In
the quota method, the quantity negotiated is determined by a previously fixed quota
when a minimum or maximum price is exceeded. When there is a surplus, the
producers restrict their exports or production; when there is a shortage, quotas are
allotted to the consumer countries. With the buffer-stock method, stability is ensured
by a combination of an export control arrangement and a buffer-stock arrangement. In
certain circumstances exports are restricted by the controlling body. The buffer-stock
agency buys when the market price is in the lower sector or at the floor price set out in
the agreement; the buffer-stock agency sells when the market price is in the upper
sector or at the ceiling price.
Results.
The utility of commodity agreements in general can hardly be judged on past
experience. Experience with wheat, sugar, and tin agreements, which cover a
comparatively long period, is not conducive to generalization. Some degree of
stability, though at a high price level, was achieved in the case of wheat, but this was
due to the dominant influence of U.S. and Canadian policies. In the case of tin, too,
transactions for the U.S. strategic stockpile exerted an influence. Political factors
(including the Cuban revolution) underlay the de facto suspension from 1962 to 1969
of the sugar agreement, which had covered, and still covers, only a limited share of
the world market. The value
of world transactions in tin, wheat, coffee, and sugar amounts to only a small part of
the value of the world's entire commodity trade. Furthermore, the agreements in
question do not cover all transactions. It is, in a way, understandable that only a few
such agreements have been concluded; during a boom the producer countries are not
inclined to conclude them, and during a depression there is little incentive for
consumer countries to enter into them.
Conditions for success.
A prerequisite for the success of commodity agreements is that they should
embrace the vast majority of producers and especially the largest of them. No
transactions should be excluded, and substitute commodities should be covered by the
agreements. The most
intractable of the difficulties in concluding commodity agreements lies in the fixing of
the price range. Neither unduly high nor unduly low price scales are tenable. Future
market conditions are not easily foreseeable, so the possibility of errors cannot be
ruled out; regular adjustment of the price ranges is necessary.
When it comes to determining the price range, the importing and exporting
countries, respectively, do not systematically advocate low and high prices. Certain
importing countries are not opposed to a relatively high price because the difference
between the international price and the tariff-protected price of domestic producers is
thereby reduced; exporting countries in a favourable competitive position are often in
favour of lower prices so that they will be able to increase their share of the market at
the expense of less-competitive countries. In
concluding an agreement, the parties have to bear in mind that complete price
stabilization is impossible. It would in fact be undesirable, because in the long run
supply and demand need to remain in equilibrium, and the necessary adjustments in
the economies concerned must not be precluded. Price fluctuations do not necessarily
imply failure, because the fluctuations might well have been larger had the agreement
not been concluded. The method of
stabilization needs to be chosen carefully, with due regard for the characteristics of

542
the commodities concerned. The multilateral purchase contract and buffer-stock
systems offer the advantage of not requiring any restrictions on production; new
producers with improved technical equipment may participate.
A buffer stock needs to be sufficiently large if it is to
achieve its purpose. Wider financing facilities are necessary; this is something to
which the importing countries could contribute. Even then the buffer stock is better
used together with other methods of stabilization. Because of the perishable nature of
certain commodities or their bulk and high storage costs, however, a buffer stock is
not always feasible. Buffer stocks alone often are not sufficient for the control of
prices, and it is sometimes necessary for producers to restrict exports in order to
reduce supply, thus pushing prices up.
INTERESTS OF THE LESS-DEVELOPED COUNTRIES
So far as the producer countries are concerned, stabilization of incomes, rather
than of prices, is the most important factor. Although commodity agreements may
contribute to this, their relatively limited success has caused other proposals to be
advanced. Compensatory financing
refers to international financial assistance to a country whose export earnings have
suffered as a result of a decline in primary commodity prices. Such a system was
instituted in 1963 by the International Monetary Fund (IMF). In 1969 the IMF also
began making loans available to countries having a balance-of-payments need in
relation to the financing of buffer stocks under international commodity agreements.

EEC stabilization fund.

The European Economic Community has established a stabilization fund for

its associated overseas countries; prices must fall by a specified percentage before the
mechanism of the fund goes into effect, and the richer beneficiary countries must
repay the aid received. Other proposals
involve the introduction of simultaneous negotiations for a whole range of
commodities. These discussions, however, and more particularly the administration of
the resulting multicommodity agreement, would be highly complex. It may also be
argued that the significance of export instability has been exaggerated and that most
of the economies involved have suffered no serious damage. Thus, the resources
devoted to countering price fluctuations and compensatory financing might be better
employed in investments or technical assistance.
As to the possibility of the less-developed countries themselves
influencing prices, circumstances vary from commodity to commodity. In the case of
primary goods, such as coffee, that are produced only in the less-developed countries
and for which practically no substitutes exist, action to increase prices can easily be
taken if demand is not too much affected by price increases. A simple way to raise
prices would be for the governments of producing countries to levy a duty on exports.
Attempts by some developing countries to raise prices, however, can induce other
developing countries to increase their output. For example, African coffee production
was stimulated when Latin-American countries took steps to raise the price of their
coffee.

Limitations on pricing.

The fact that there are substitutes for a few primary goods (such as cotton,
wool, and rubber) limits the extent to which primary-goods producers can raise their
prices. Also, most commodities produced by less-developed countries face
competition from the developed countries, which may produce the same commodities

543
(such as petroleum, sugar, rice, and tobacco) or goods substitutable in varying degrees
(such as soybean oil for peanut oil). Many
agricultural commodities are protected in the developed countries by tariffs, which
means that their requirements are often met entirely from domestic production. Some
developed countries produce surpluses that are sold abroad at low, subsidized prices.
Such commodities are therefore traded to a relatively small extent on world markets.
The sales of the less-developed countries are thus influenced by the developed
countries' national policies and by the price at which these countries sell their
surpluses on the residual markets. The less-developed countries that produce minerals
and metals seemingly have the most favourable export prospects because demand for
such finite commodities is expanding among the developed countries, many of which
are concerned over the depletion of their domestic resources.
OPEC AND OIL
Of the multinational organizations aimed at affecting the price of a
commodity, one of the most significant is the Organization of Petroleum Exporting
Countries (OPEC). It was founded in 1960 by Middle Eastern countries and
Venezuela, although its membership has come to include developing nations in other
parts of the world. Some major oil-exporting nations have remained outside the
organization, notably Mexico and Russia. The
principal objective of OPEC has been to raise the price received by the oil-exporting
countries. During its early years, it was notably unsuccessful: plentiful supplies of oil
kept the price low throughout the 1960s. In the early 1970s, however, major changes
took place. The rapid economic expansion, which was simultaneously occurring in
many countries, put upward pressure on the demand for oil. At the same time, the
production of oil was leveling out and beginning to decline in the United States, with
the result that U.S. demand for imported oil was rising rapidly.
In 1973 OPEC seized the opportunities offered by the changing
market conditions--and by the political and economic disruptions associated with the
war between Israel and its Arab neighbours--to raise prices sharply, from about $3 to
more than $12 per barrel. Between 1974 and 1979 the international price of oil
remained quite stable, but then OPEC was once again successful in pushing the price
up sharply--to more than $30 per barrel in 1980. These price increases caused a huge
transfer in revenues from the oil-importing nations to the oil-exporting countries.
They also contributed to a major increase in inflation in the importing countries.
The large increase in revenues in the OPEC
nations allowed many of them to embark on major development programs. On the
other side, the loss of revenues, combined with the inflationary impact, precipitated
major recessions in many of the oil-importing countries in 1974-75 and 1980-82. The
higher oil price also has been suggested as a cause of a decline in productivity in
many countries after 1973, although the causes of the decline are not well understood.
OPEC has often been called an international cartel, but
it lacked the standard enforcement mechanism of a cartel during the two periods
(1973 and 1979-80) when prices rose spectacularly. That is, it did not have a
mechanism for sharing the market among the oil-exporting nations. Saudi Arabia
played a key role in enforcing the organization's price increases.
In the 1970s Saudi Arabia had proven reserves
in excess of 150 billion barrels, more than twice as much as any other nation, and five
or six times the proven reserves of such major non-OPEC producers as the United
States and Mexico. Because of its huge reserves and productive capacity, Saudi
Arabia was able to act as the residual supplier, cutting back on production when
demand slackened, thus reducing downward pressures on prices. Saudi Arabia's

544
willingness to act as the residual supplier was partly the result of its limited
population; even when producing at much less than capacity, it had a very large oil
income per capita. During the early
and middle 1980s, the oil market softened markedly. Oil consumption grew much
more slowly, partly as a result of the major U.S. recession of 1982 and sluggish
growth in western Europe, and partly as a result of increased conservation measures, a
reaction to the upward spiral of fuel prices in the 1970s. At the same time, oil output
increased in a number of non-OPEC areas such as the North Sea. The result was
downward pressure on prices through the mid-1980s. In order to maintain sales and
revenues, OPEC members had an incentive to undercut the posted price. As its oil
production fell sharply and the bills from its ambitious development projects
continued to increase, Saudi Arabia became less willing to act as the residual supplier.
In order to relieve the downward pressure on prices, OPEC members attempted to
transform the organization into a more formal cartel, with production quotas for each
member. However, these efforts faced the classic problem of cartels: each member
had an incentive to cheat on the organization by producing more than its quota and by
offering secret price concessions to buyers.

International payments and exchange

Economic life does not stop at national boundaries but flows back and forth
across them. The money of one country, however, cannot as a rule be used in another
country; the flow of payments must be interrupted at national boundaries by exchange
transactions in which one national money is converted into another. These
transactions serve to cover payments so long as there is a balance between them: local
money can be exchanged against foreign money only insofar as there is a
counterbalancing offer of foreign money in exchange. In China and other
countries with centralized economic planning, there are no legal private markets for
foreign exchange; in those countries the state has a monopoly of the business of
foreign trade, which is generally conducted through formal agreements on a country-
by-country basis. While the currencies of the Communist countries have official par
values, these bear no particular relationship to their purchasing power or to the prices
at which goods are exchanged. The international economic relationships of those
countries therefore fall outside the scope of this discussion.
BALANCE-OF-PAYMENTS ACCOUNTING
The balance-of-payments accounts provide a record of transactions between
the residents of one country and the residents of foreign nations. The two types of
accounts used are the current account and the capital account.

The current account.

When using balance-of-payments statistics, it is important to understand their

basic concepts. The balance of payments includes, among other things, payments for
goods and services; these are often referred to as the balance of trade, but the
expression has been used in a variety of ways. In order to be more specific, some
authorities have taken to using the expression "merchandise balance," which
unmistakably refers to trade in goods and excludes services and other occasions of
international payment. Figures for the

545
merchandise balance often quote exports valued on an FOB (free on board) basis
and imports valued on a CIF basis (including cost, insurance, and freight to the
point of destination). This swells the import figures relative to the export figures by
the amount of the insurance and freight included. The reason for this practice has been
that in many countries the trade statistics have been based on customs house data,
which naturally include insurance and freight costs for imports but not for exports.
The authorities have more recently made a point of providing estimates of imports
valued on an FOB basis. Another
expression, "balance of goods and services," is often used. The British, however,
continue to use the term invisibles for current services entering into international
transactions. For many years the "visible" balance was taken to be equivalent to
exports quoted FOB and imports CIF as explained above. The British authorities have
more recently instituted another linguistic usage by which the visible balance is
equivalent to the true merchandise balance. The old usage still lingers on in the less-
expert literature. And so the total current account is the
balance of goods (merchandise) and services. The United Kingdom includes unilateral
transfers among invisibles and in the current account. The United States statistics,
more correctly, show them under a separate heading.
Services include such items as payments for shipping and civil
aviation, travel, expenditures (including military) by the home government abroad and
expenditures by foreign governments at home, interest and profits and dividends on
investments, payments in respect of insurance, earnings of banking, merchanting,
brokerage, telecommunications and postal services, films and television, royalties
payable by branches, subsidiaries and associated companies, agency expenses in
regard to advertising and other commercial services, expenditures by journalists and
students, construction work abroad for which local payment is made and, conversely,
earnings of temporary workers such as entertainers and domestic workers, and
professional consultants' fees. This list contains the more important items but is not
comprehensive. Among unilateral transfers the more important are outright aid
by governments, subscriptions to international agencies, grants by charitable
foundations, and remittances by immigrants to their former home countries.

The capital account.

There is also the capital account, which includes both long-term and short-
term capital movements.
Long-term flows.
Long-term capital movement divides into direct investments (in plant and
equipment) and portfolio investments (in securities). In the 19th century direct
investment in plant and equipment was preponderant. The United Kingdom was by
far the most important contributor to direct investment overseas. In the early part of
the century it even contributed to the industrial development of the United States;
later its attention shifted to South America, Russia, other European countries, and
India. Investment in what came to be called the "Commonwealth" and "Empire," not
prominent at that time, became very important in the 20th century. The other

546
countries of western Europe also made important contributions to direct investment
overseas. The most important items of direct investment were railways and other
basic installations. In early stages direct investment may help developing countries to
balance their payments, but in later stages there will have to be a flow of interest and
profit in the opposite direction back to the investing country. The United Kingdom is
frequently cited as the country whose overseas investments were most helpful for
developing countries because its rapidly growing population and small cultivable land
area permitted it to develop large net imports of food and to run corresponding
deficits on its merchandise account. The complementary surplus this generated in the
developing countries from which the imports came enabled them to pay the interest
and profit on British capital without straining their balances of payments.
Between World War I and World War II the United
States began to take a more active interest in overseas investment, but this was not
always well-advised. After the great world slump, which started in 1929, international
investment almost ceased for lack of profit opportunities.
After World War II the United States began to build up a leading position
as overseas investor. The process accelerated in 1956 and afterward, both on direct
investment and on portfolio investment accounts. This may have been partly due to
the desire of U.S. firms to have plants inside the European Economic Community.
Other countries also found more opportunities for capital export than there had been
in the interwar period. The United Kingdom gave special attention to the
Commonwealth. During the 1970s and 1980s Japan became a major overseas
investor, financing its foreign investments with the funds accumulated with its large
current account surpluses. The U.S. international position changed sharply in the
1980s. As a result of its large current account deficits, the United States accumulated
large overseas debts. Its position changed from that of major net creditor (it had larger
investments abroad than foreign nations had in the United States) to that of the largest
debtor nation. Its liabilities to foreign nations came to exceed its foreign assets by
hundreds of billions of dollars.

Short-term flows.
A very important distinction must be drawn between the short-term capital
that flows in the normal course of industrial and commercial development and that
which flows because of exchange-rate movements. The first class of short-term
capital may be thought of as going in the train of direct long-term investment. A
parent company may desire from time to time to supply its branch or affiliate with
working capital. There may also be repayments from time to time. The second type of
short-term capital flow occurs because of expectations of changes in exchange rates.
For example, if people expect that the price of the dollar will fall in terms of the
Japanese yen, they have an incentive to sell dollars and buy yen. An
international capital market developed in the 1960s dealing in what are known as
Eurocurrencies, of which much the most important was the Eurodollar. The prefix
Euro is used because initially the market largely centred on the countries of Europe,
but it has by no means been confined to them. Japan and the Middle Eastern oil states
have been important dealers. While these short-term lendings normally move across
national frontiers, they do not directly involve foreign exchange transactions. They
may, however, indirectly cause such transactions to take place.
The nature of the market is as follows: In the ordinary course of affairs, an
Italian, for example, acquiring dollars--say from exports or from a legacy--would sell
these dollars for his own currency. But he may decide to deposit the dollars at his

547
bank instead, with an instruction not to sell them for cash but to repay him in dollars
at a later date. Thus the bank has dollars in hand and a commitment to pay them out
in, say, three months. It may then proceed to lend these dollars to another bank,
anywhere in the world. Since the lending and borrowing is done in dollars, no foreign
exchange transaction is directly involved. The sum total of all operations of this sort is
the Eurodollar market. It is not centred on any particular place and has no formal rules
of procedure or constitution. It consists of a network of deals conducted by telephone
and telex around the world. U.S. residents themselves lend to and borrow from this
market. One may ask why lenders
and borrowers use this market in preference to more conventional methods of lending
and borrowing. Ordinarily the answer is because they can get more favourable terms,
since the market works on very narrow margins between lending and borrowing rates.
This involves expertise; London has played the most important part in the creation of
the market. The lender hopes to get a better rate of interest than he would on a time
deposit in the United States (restrictions limiting interest payable on U.S. time
deposits are said to have been a contributing cause of the growth of the market during
the 1960s). At the same time, normally, the borrower will find that he has to pay a
lower rate than he would on a loan from a commercial bank in the United States.
This has not always been the case. In 1969 Eurodollar interest rates went
to very high levels. One reason for this was the set of restrictions imposed by the
United States on its commercial banks lending abroad. The second was that although
the prime lending rates of the principal U.S. banks might be below Eurodollar rates,
many individuals, including U.S. citizens, found that they could not get loans from
their banks because of the "credit squeeze." Because this form
of international lending does not involve the sale of one currency for another, it does
not enter into balance-of-payments accounts. Nonetheless it may have a causal effect
on the course of the exchanges. For instance, the Italian cited above might have
chosen to sell his dollars had he not been tempted by the more attractive Eurodollar
rate of interest. In this case, the market causes dollars not to be sold that otherwise
would have been. Others who have liquid cash at their disposal for a time may even
buy dollars in order to invest them in the market at short term. That would be helpful
to the dollar. There are countercases. An individual who has to make a payment in
dollars but lacks cash may borrow the dollars in the Eurodollar market, when
otherwise he would have got credit in his own country and used that to buy dollars; in
this case the market is damaging to the dollar because its existence prevents someone
from buying dollars in the regular way.

Assessing the balance.

To summarize, the overall balance of payments comprises the current account

(merchandise and services), unilateral transfers (gifts, grants, remittances, and so on),
and the capital account (long-term and short-term capital movements). If payments
due in exceed those due out, a country is said to be in overall surplus; and when
payments due out exceed payments due in, it is in overall deficit. The surplus or
deficit must be balanced by a monetary movement in the opposite direction, and
consequently the overall balance including monetary movements must always be
equal. In practice, great difficulties have been found in
assessing whether a country is in deficit or in surplus. It is often important to establish
this with a view to possible corrective measures. The United Kingdom stresses the
combined balance of current and long-term capital account--i.e., excluding short-term

548
capital. Such a balance, however, omits short-term movements that occur in the
ordinary course of business, which may be called "normal" and which ought in
principle to be included. On the other hand it is not desirable to include equilibrating
or disequilibrating capital movements. These occur in consequence of a deficit (or
surplus), actual or anticipated. But there may be great statistical difficulty in
distinguishing between the normal short-term capital flows and those that are
consequential on a surplus or deficit. It has been noted that the overall
balance, including monetary movements, must be equal, but it usually happens that
the figures do not in fact balance. U.S. statisticians call the residual figure that has to
be inserted to square the account "errors and omissions." If the average value of this
figure over a substantial period, such as 10 years--an even longer period may have to
be taken if a country is in persistent surplus or deficit--has a positive or negative value
of substantial amount, then it may be taken to constitute genuine items that have
escaped the statistical net. These may legitimately be included in assessing whether a
country is in genuine surplus or deficit and whether corrective measures are needed.
The "errors and omissions" item is extremely volatile from year
to year and often very large. Such movements up and down are probably caused by
precautionary short-term capital movements. There have been periods when a minus
item in the U.S. account was rather strikingly associated with a plus item in the U.K.
account, and conversely. Accordingly, in the short term, the "errors and omissions"
item should not be included in assessing whether a country is in surplus or deficit.
It has been noted that the United Kingdom stresses the balance of
current and long-term capital accounts (which include unilateral transfers). The U.S.
position is less clear. It traditionally published two overall balance-of-payments
measures: the "Liquidity Balance" and the "Official Settlements Balance."
In distinguishing between monetary and
nonmonetary items, the Liquidity Balance included any increase in the holding of
short-term dollar securities abroad as part of the U.S. deficit during the period; but it
did not include as counterweight any increase in short-term foreign claims held by
U.S. resident banks or others (apart from official holdings). Thus, in this respect the
treatment was asymmetrical. The rationale for this was precautionary. The argument
was that short-term dollar assets held abroad outside the central banks might at any
time be sold in the market or turned in to the central banks of the respective countries
and thus constitute a drain, or the threat of a drain, on U.S. reserves. On the other
hand the corresponding foreign short-term assets held by U.S. resident banks or others
were not readily mobilizable by U.S. authorities for making payments. Thus by this
reckoning, if during a period non-central-bank foreign holdings of short-term dollar
securities and resident non-central-bank U.S. holdings of short-term foreign securities
went up by an equal amount, the situation would be shown as having deteriorated,
since the former class (liabilities) were a threat to U.S. reserves, while the latter class
(assets) could not be mobilized by U.S. authorities to meet such a threat. Thus, though
the motive for this asymmetrical treatment may have been understandable, it was
statistically unsatisfactory and also unsatisfactory as a guide to corrective action. This
balance is thus mainly of historical interest, and it has not been commonly used since
1971. The U.S. Official Settlements Balance reckoned an
increase in non-central-bank foreign holdings of short-term dollar assets as an inflow
of short-term capital into the United States; similarly an increase in U.S. resident
holdings of short-term foreign assets was an outflow of short-term capital. This was a
logical treatment. But the balance thus defined proved in the 1960s to be extremely
volatile. This was due to large movements of funds between foreign central banks and

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non-central-bank foreign holders, associated with the rise of the Eurodollar market.
Oscillations of this kind do not represent changes in the fundamental balance that are
needed in order to determine whether corrective measures are required. It may well be
that the British method of omitting short-term capital movements altogether in the
assessment of surplus or deficit is, although imperfect, the most practical available.
Since exchange rates began to float in the early 1970s, the major industrial countries
have paid much less attention to overall balance-of-payments measures. The current
account and the trade account are the two measures that are now most commonly used
in developing countries.

ADJUSTING FOR FUNDAMENTAL DISEQUILIBRIUM

A "fundamental disequilibrium" exists when outward payments have a
continuing tendency not to balance inward payments. A disequilibrium may occur for
various reasons. Some may be grouped under the head of structural change (resulting
from changes in tastes, habits, institutions, technology, etc.). A fundamental
imbalance may occur if wages and other costs rise faster in relation to productivity in
one country than they do in others. Imbalance may also result when aggregate demand
runs above the supply potential of a country, forcing prices up or raising imports. A
war may have a profoundly disturbing effect on a country's economy.

The classical view.

In the traditional "classical" view no intervention by the authorities was

necessary to maintain external equilibrium, except for their readiness to convert
currency into gold (or silver) upon demand. The system was supposed to work
automatically. If a country had a deficit, gold would flow out, and the consequent
reduction in the domestic money supply would cause prices to move downward. This
would stimulate exports and tend to reduce imports. The process would continue until
the deficit was eliminated. Classical doctrine did not embody a clear-cut theory about
international capital movements. It was usually assumed that the trade balance (more
strictly, balance on goods and services) would be tailored to accommodate any capital
movement that occurred. Thus, if the country was exporting capital, gold flows would
cause prices to move to such a level that exports minus imports would be equal to the
capital flow; equilibrium in the overall balance was automatically secured.
In due course the classical scheme of
thought came under criticism. Some critics asked if an outflow or inflow of specie
would necessarily have a sufficient effect on the price level to ensure an equal balance
of payments. More important, a reduction in the money supply, it was pointed out,
might have a side effect on the level of economic activity. Some critics went further
and argued that this side effect would be stronger than the effect on prices to such a
degree as to cause unemployment to rise to an undesirable level.

Contemporary views.

Monetary and fiscal measures.

The belief grew that positive action by governments might be required as well.
The doctrine was first related to monetary policy in particular. The idea was that
interest-rate adjustments should be combined with open-market operations by a
central bank to ensure that the domestic money supply and borrowing facilities were
conducive to external long-period equilibrium. After World War II the idea came to

550
be widely held that government budget policy (usually called fiscal policy) should be
brought in to assist monetary policy. For instance, if aggregate domestic demand was
running so high as to cause rising prices, this should be reduced both by having a tight
monetary policy and by increasing taxation more than expenditure or reducing
expenditure without reducing taxation. The correct apportionment of this task
between the monetary and fiscal arms is still a subject of discussion.
Nor is there yet agreement about the scope of these policies or their ability
to secure fundamental equilibrium in all cases. There is probably agreement that when
overall demand is running in excess of the supply potential of the economy, it should
be reduced by monetary and fiscal policies. There is difference of opinion, however,
as to whether the reduction of aggregate demand will bring external payments into
balance in all cases. For instance, a country may have a deficit owing to some
underlying economic change (such as a shift in the pattern of world trade), even if
domestic demand is not above the supply potential and prices are not rising. In this
case, policies designed to reduce domestic demand (commonly called deflationary
policies) would cause unemployment. Some hold that, if there is an external deficit,
deflationary policies should be pursued to whatever extent may be needed to eliminate
the deficit. Others hold that such a policy is socially unacceptable. Opinions differ
also about how deflationary measures work to improve the external balance. Some
hold that they work mainly by reducing domestic activity and thereby the amount of
imported materials that a country needs and the amount of income that people can
afford to spend on imported goods. If this were the whole effect of a deflationary
policy, it would improve the external balance only in proportion to the amount by
which it increases unemployment. Those who hold that this is the only manner in
which deflation affects the external balance are especially opposed to relying on
deflationary policies alone to eliminate a deficit in conditions in which aggregate
domestic demand is not running above the supply potential. Some hold that a
reduction of home demand also helps because it makes producers look around more
eagerly for export markets (and increase their selling efforts in the home market). This
appears to be doubtful, however. There is further disagreement on the extent to which
deflationary policies influence the course of prices. If aggregate demand is running
above the supply potential of the economy, it is highly probable that deflationary
policies will slow the increase of prices and thus make a country more competitive
with foreign suppliers. There is not the same agreement about the effects when
demand is initially running below the supply potential of the economy. Some hold
that a deflationary policy, if pushed hard enough, will infallibly slow up price
increases and so help the country's external balance. Others hold that it will not, and
some even argue that higher interest rates and higher taxes (weapons of deflation) can
cause prices to rise. Thus, it is not absolutely clear that monetary and fiscal policies
will in all cases suffice to cure an external deficit, at least without socially
unacceptable results. There is also the opposite
case of countries with a trade surplus. It is clear that these countries will be unwilling
to encourage policies that cause domestic prices to rise. Price inflation is a social evil
and politically unpopular. In the case of surplus countries, the same
distinction must be made between the situation in which aggregate demand is fully up
to or above the supply potential of the economy and that in which it is not. In the
former case a further increase in demand would almost certainly have an inflationary
effect; accordingly, surplus countries in this condition will be unwilling to use
monetary and fiscal policies to eliminate their external surpluses. On the other hand, if
aggregate demand is running below supply potential, then a surplus country might

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reasonably be asked to increase aggregate demand by monetary and fiscal policies on
the view that the increase will not cause inflation but will tend to remove the external
surplus by inducing more imports and possibly causing producers to be less active in
their selling efforts abroad.
Incomes policy.
Prices may rise even when aggregate demand is not in excess of the supply
potential. This may be due to wage increases and other factors. Some hold that this
can be dealt with through efforts to discourage excessive wage increases by a direct
approach, which may consist of a propaganda campaign on the evil effects of wage-
price inflation, together with guidelines governing rates of wage increases. This direct
attempt to deal with the problem is generally known as "incomes policy."
Changes in exchange rates.
Exchange-rate movements work by making the products of a deficit country
more price competitive or those of a surplus country less price competitive. Any
program that seeks to rectify an imbalance by changing the level of prices will be
effective only if demand is "price elastic." In other words, if the offer of an article at a
lower price does not cause an increase in demand for it more than in proportion to the
fall in price, the proceeds from its export will fall rather than increase. Economists
believe that price elasticities are sufficiently great for most goods so that price
reductions will increase revenues in the long run. The outcome is not quite so certain
in the short run. A
fast means of changing relative price levels is devaluation, which is likely to have a
quick effect on the prices of imported goods. This will raise the cost of living and may
thereby accelerate demands for higher wages. If granted, these will probably cause
rises in the prices of domestically produced goods. A "wage-price spiral" may follow.
If this spiral moves too quickly it may frustrate the intended effect of the devaluation,
namely that of enabling the country to offer its goods at lower prices in terms of
foreign currency. This means that if the beneficial effects of a devaluation are not
gathered in quickly, there may be no beneficial effect at all. The
authorities of a country that has just devalued must therefore be especially active in
preventing or moderating domestic price increases. They will need to use the other
policy measures discussed above. Devaluation (or the downward movement of a
flexible rate) is thus not a remedy that makes other forms of official policy
unnecessary. Some have argued that, if exchange rates were allowed to float, nothing
further would have to be done officially to bring the external balance into equilibrium,
but this is a minority view. One further point must be made
regarding exchange-rate movements. It has been found in practice that governments
resist upward valuation more than they do devaluation. Under the IMF system prior to
1973, devaluations in fact were larger and more frequent than upward valuations. This
had an unfortunate consequence. It meant that the aggregate amount of price inflation
in deficit countries resorting to devaluation as a remedy was not offset by equivalent
price decreases in the surplus countries. Therefore this system had a bias toward
worldwide inflation.
Trade restrictions.
Since World War II the major industrial countries have attempted to reduce
interferences with international trade. This policy, by extending the international
division of labour, should increase world economic welfare. An exception has had to
be allowed in favour of the less-developed countries. In the early stages of the
development of a country, the effectiveness and feasibility of the three types of
adjustment mechanism discussed above, particularly monetary and fiscal policies,

552
may be much less than in the more advanced countries. The less-developed countries
may therefore be driven to protection or the control of imports, for lack of any other
weapon, if they are to stay solvent. It has already been noted that, even in the case of a
more advanced country, the effectiveness and appropriateness of the above-mentioned
adjustment mechanisms are not always certain. Thus, there is no certainty that some
limitation on foreign trade and on the international division of labour may not be a
lesser evil than the consequences that might follow from a vigorous use of the other
adjustment mechanisms, such as unemployment.

Restrictions on capital exports.

Interference with capital movements is generally considered a lesser evil than
interference with the free flow of trade. The theory of the optimum international
movement of capital has not yet been thoroughly developed, but there may be a
presumption in favour of absolutely free movement. The matter is not quite certain;
for instance, it might be desirable from the point of view of the world optimum to
channel the outflow of capital from a high-saving country into the less-developed
countries, although the level of profit obtainable in other high-saving countries might
be greater. Or it might be expedient to restrain wealthy individuals in less-developed
countries, where domestic saving was in notably short supply, from sending their
funds to high-saving countries. While there may be good reasons
for interfering with the free international flow of capital in certain cases, it is not
obvious that the outflow of capital from, or inflow of capital into, a country should be
tailored to surpluses or deficits in current external accounts. It may be that in some
cases the sound remedy for a deficit (or surplus) is to adopt adjustment measures such
as those discussed above, bearing upon current items, rather than taking the easier
way of adjusting capital movements to the de facto balance on current account.

FOREIGN EXCHANGE MARKETS

Buying and selling currencies.

A foreign exchange market is one in which those who want to buy a certain
currency in exchange for another currency and those who want to move in the
opposite direction are able to do business with each other. The motives of those
desiring to make such exchanges are various. Some are concerned with the import or
export of goods between one country and another, some with the purchase and sale of
services. Some wish to move capital from one area to the other, and some wish to
make gifts (the latter including government aid and gifts by charitable foundations).
In any organized market there must be intermediaries
who are prepared to "quote a price," in this case a rate of exchange between two
currencies. These intermediaries must move the price quoted in such a way to permit
them to make the supply of each currency equal to the demand for it and thus to
balance their books. In an important foreign exchange market the price quoted is
constantly on the move. An exchange rate is the
price of one currency in terms of another. For example, in the market for the British

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pound sterling ( ) in exchange for U.S. dollars ($), the exchange rate might be 1 =
$2. This price may also be quoted the other way around; that is, $1 = 0.50.

Determination of exchange rates.

In a foreign exchange market, there may be a standard, government-

determined price, or par value. This par value may be quoted in terms of another
currency; for example, the par value of the pound was 1 = $2.80 between 1949 and
1967. In 1973 many governments abandoned their par values and let their exchange
rates be determined by the forces of demand and supply. An exchange rate determined
in this way, without being tied to an official par, is called a flexible or floating
exchange rate; in contrast, an exchange rate is said to be pegged if the government ties
it to par value. Historically, countries often tied their
currencies to gold, setting their official parities in terms of that metal. Under this
historical gold standard, the gold equivalence of currencies determined exchange
rates. For example, the British pound was worth 4.86 times as much gold as the U.S.
dollar during the period prior to World War I. The exchange rate remained at or quite
close to the mint parity of 1 = $4.86. Nobody would pay much more than $4.86 for a
British pound, nor take much less. Historically, there were also periods of
bimetallism, when the gold standard was combined with a silver standard, and
currencies were fixed in terms of both gold and silver. The bimetallic standard was
given up by most of its adherents (the United States, France, Italy, Switzerland, The
Netherlands, and Belgium) in the 1870s.

THE GOLD STANDARD

The function of gold.

If the demand by those holding a particular currency, say sterling, for another
currency, say the dollar, exceeds the demand of dollar holders for sterling, the dollar
will tend to rise in the foreign exchange market. Under the gold standard system there
was a limit to the amount by which it could rise or fall. If a sterling holder wanted to
make a payment in dollars, the most convenient way for him to procure the dollars
would be in the foreign exchange market. But under the gold standard he had another
option; i.e., he had a legal right to obtain gold from the authorities in exchange for
paper currency at the established par value of that currency and remit the gold to the
other country, where he would have a legal right to obtain its currency in exchange for
bars of gold at the official valuation. Thus, it would not be advantageous for a sterling
holder to obtain dollars in the foreign exchange market if the quotation for a dollar
there exceeded parity by more than the cost of remitting gold. The exchange rate at
which it became cheaper to remit gold rather than use the foreign exchange market
was known as the "gold-export point." There was also a "gold-import point"
determined on similar lines . Most of those seeking dollars, however, did not
undertake to remit gold even if the dollar quotation was at the gold-export point. The
remission of gold was handled by arbitrageurs. These are people who buy and sell

554
currencies simultaneously on different exchanges in order to profit by small
differences in the quoted rates. Their action would reduce the supply of sterling, since
they would be selling sterling for gold to the British authorities, and increase the
supply of dollars, since they would acquire dollars in exchange for gold from the U.S.
authorities. The arbitrageurs would carry out these operations to the extent needed to
prevent the scarcity of the dollar from raising its sterling price above the gold-export
point for the United Kingdom, and conversely. At the same time, the gold reserve of
the British authorities would be diminished, and the gold reserve of the U.S.
authorities increased. The
international gold standard provided an automatic adjustment mechanism, that is, a
mechanism that prevented any country from running large and persistent deficits or
surpluses. It worked in the following manner. A country running a deficit would see
its currency depreciate to the gold-export point. Arbitrage would then result in a gold
flow from the deficit to the surplus country. In other words, the deficit would be
settled in gold. The gold
flow had an effect on the money system. When gold flowed into the banking system
of the surplus country, its money stock rose as a consequence. On the other side, when
a deficit country lost gold, its money stock fell. The falling money stock caused
deflation in the deficit country; the rising money stock caused inflation in the surplus
country. Thus, the goods of the deficit country became more competitive on world
markets. Its exports rose, and its imports declined, correcting the balance-of-payments
deficit.

Problems with the gold standard.

Although this adjustment process worked automatically, it was not problem-

free. The adjustment process could be very painful, particularly for the deficit
country. As its money stock automatically fell, aggregate demand fell. The result was
not just deflation (a fall in prices) but also high unemployment. In other words, the
deficit country could be pushed into a recession or depression by the gold standard. A
related problem was one of instability. Under the gold standard, gold was the ultimate
bank reserve. A withdrawal of gold from the banking system could not only have
severe restrictive effects on the economy but could also lead to a run on banks by
those who wanted their gold before the bank ran out. These twin
problems materialized during the Great Depression of the 1930s; the gold standard
contributed to the instability and unemployment of that decade. Because of the strains
caused by the gold standard, it was gradually abandoned. In 1931, faced with a run on
its gold, Britain abandoned the gold standard; the British authorities were no longer
committed to redeem their currency with gold. In early 1933 the United States
followed suit. Although the tie of the dollar to gold was partially restored at a later
date, one very important feature of the old gold standard was omitted. The public was
not permitted to exchange dollars for gold; only foreign central banks were allowed to
do so. In this way the U.S. authorities avoided the risk of a run on their gold stocks by
a panicky public.

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 THE INTERNATIONAL MONETARY FUND
The International Monetary Fund (IMF), founded at the Bretton Woods
Conference in 1944, is the official organization for securing international monetary
cooperation. It has done useful work in various fields, such as research and the
publication of statistics and the tendering of monetary advice to less-developed
countries. It has also conducted valuable consultations with the more developed
countries. Of particular interest to this discussion is the Fund's system of
Drawing Rights, which permits countries in temporary deficit to draw supplies of
foreign currency according to predetermined quotas. These extra supplies of currency
give a country more time in which to adjust its balance of payments and so avoid
taking unsound or unneighbourly measures like import restrictions for lack of enough
reserves to tide it over a difficulty. The mechanism is as follows: members of the
Fund are required to make initial deposits according to their quotas, which are based
on the country's national income, monetary reserves, trade balance, and other
economic factors. Quotas are payable partially in Special Drawing Rights and
partially in a country's own currency. A country's quota closely approximates its
voting power, the amount of foreign exchange it may purchase (Drawing Rights), and
its allotment of Special Drawing Rights. The Fund makes its stock of members'
currencies available to member countries that wish to draw upon their quotas. When
creditor countries are presented with their own currencies previously deposited by
them with the Fund, they are obliged to take them in final discharge of debts owed by
other member countries. Since they previously deposited these currencies themselves
they are in effect getting nothing from the debtor countries in respect of the debts
owed to them, and their willingness to accept payment in this way is their contribution
to the overall liquidity of the world system. Later the creditor countries may
themselves become debtors and partake of the benefits. The debtors have to repay the
Fund usually in three to five years. A country with more serious financial problems
may draw as much as 140 percent of its quota during a three-year period, and
repayment must be made between four to 10 years afterward.
The exercise of Drawing Rights is subject to discussion and sometimes
to conditions, except for drawings on what are called the reserve tranches (sums equal
to the member's original deposits in its own currency and Special Drawing Rights),
which are given "the overwhelming benefit of the doubt." Countries are also free to
draw without discussion up to the net amount to which they have previously been
drawn upon by other countries. The
quotas paid by members of the IMF are the primary source of income for the
organization. Quotas for member countries are periodically reviewed and reevaluated
according to the country's financial situation. General increases in quotas normally
occur following the periodic reviews, although special reviews and increases
sometimes occur for specific countries, such as Saudi Arabia in 1981. The IMF also
borrows to supplement its quota resources. In 1981, for example, Saudi Arabia agreed
to loan the Fund more than $8,000,000,000 over a two-year period, and an additional
$1,300,000,000 was loaned by a group of countries. Between 1976 and 1980 about
one-third of the Fund's gold holdings were sold at public auction to benefit the
member developing countries. More than $4,600,000,000 was received from the gold
sale; part of the revenue was made available to members according to their quotas,
and part of the revenue was placed in a trust fund to dispense low-interest loans to
developing countries. The International Monetary Fund as it finally emerged
from the wartime discussions was a much more modest undertaking than had
originally been conceived by the British. An early British proposal would have

556
required creditor countries to receive payment in paper money up to the total amount
of all the quotas of all the debtor countries. This seemed to many to be more than it
was fair to ask creditors to do. The United States claimed that for a number of years
after the war it was likely to be in credit against the whole of the rest of the world, and
so it was. Under the British plan they would have had to give an unconscionably large
amount of credit, with no certainty of repayment. At that time it did not seem at all
likely that the United States would ever go into deficit, which, of course, it eventually
did.
THE IMF SYSTEM OF PARITY (PEGGED) EXCHANGE RATES
When the IMF was established toward the end of World War II, it was based
on a modified form of the gold standard. The system resembled the gold standard in
that each country established a legal gold valuation for its currency. This valuation
was registered with the International Monetary Fund. The gold valuations served to
determine parities of exchange between the different currencies. As stated above, such
fixed currencies are said to be pegged to one another. It was also possible, as under
the old gold standard, for the actual exchange quotation to deviate somewhat on either
side of the official parity. There was agreement with the International Monetary Fund
about the range, on either side of parity, within which a currency was allowed to
fluctuate. But there was a difference in the technical mode of operation. The service
of the arbitrageurs in remitting physical gold from country to country as needed was
dispensed with. Instead the authorities were placed under an obligation to ensure that
the actual exchange rates quoted within their own territories did not go outside the
limits agreed upon with the International Monetary Fund. This they did by intervening
in the foreign exchange market. If, for instance, the dollar was in short supply in
London, the British authorities were bound to supply dollars to the market to whatever
extent was needed to keep the sterling price of the dollar from rising above the
agreed-upon limit. The same was true with the other currencies of the members of the
International Monetary Fund. Thus, the obligation of the monetary authorities to
supply the currency of any Fund member at a rate of exchange that was not above the
agreed-upon limit took the place of the obligation under the old gold standard to give
actual gold in exchange for currency. It would be inconvenient for the
monetary authorities of a country to be continually watching the exchange rates in its
market of all the different currencies. Most authorities confined themselves to
watching the rate of their own currency against the dollar and supplying from time to
time whatever quantity of dollars might be required. At this point the arbitrageurs
came into service again. They could be relied upon to operate in such a way that the
exchange rates between the various currencies in the various foreign exchange
markets could be kept mutually consistent. This use of the dollar by many monetary
authorities caused it to be called a currency of "intervention." The official fixing of
exchange rates as limits on either side of parity, outside of which exchange-rate
quotations were not allowed to fluctuate, bears a family resemblance to the gold
points of the old gold standard system. The question naturally arose why, in devising
a somewhat different system, it was considered desirable to keep this range of
fluctuation. In the old system it arose necessarily out of the cost of remitting gold.
Since there was no corresponding cost in the new system, why did the authorities
decide not to have a fixed parity of exchange from which no deviation would be
allowed? The answer was that there was convenience in having a range within which
fluctuation was allowed. Supply and demand between each pair of currencies would
not be precisely equal every day. There would always be fluctuations, and if there
were one rigidly fixed rate of exchange the authorities would have to supply from

557
their reserves various currencies to meet them. In addition to being inconvenient, this
would require each country to maintain much larger reserves than would otherwise be
necessary. Under a system of pegged
exchange rates, short-term capital movements are likely to be equilibrating if people
are confident that parities will be maintained. That is, short-term capital flows are
likely to reduce the size of overall balance-of-payments deficits or surpluses. On the
other hand, if people expect a parity to be changed, short-term capital flows are likely
to be disequilibrating, adding to underlying balance-of-payments deficits or surpluses.

Equilibrating short-term capital movements.

Commercial banks and other corporations involved in dealings across

currency frontiers are usually able to see some (but not necessarily all) of their needs
in advance. Their foreign exchange experts will watch the course of the exchanges
closely and, if a currency is weak (i.e., below parity), advise their firms to take the
opportunity of buying it, even if somewhat in advance of need. Conversely, if the
currency is above parity but not expected to remain so indefinitely, they may
recommend postponing purchases until a more favourable opportunity arises. These
adjustments under the influence of common sense and self-interest have an
equilibrating influence in foreign exchange markets. If a currency is temporarily
weak, it is presumably because of seasonal, cyclical, or other temporary factors. If on
such an occasion private enterprise takes the opportunity to buy the currency while it
is cheap, that tends to bring demand up to equality with supply and relieves the
authorities from the need to intervene in order to prevent their currency from falling
below the lower point whenever there is a temporary deficit in the balance of
payments. As previously noted, when confidence in the fixed parity exchange rate
drops and market participants expect a change in parity, short-term capital movements
may be disequilibrating. Another equilibrating influence arises from the
movements of short-term interest rates. When the authorities have to supply foreign
currencies in exchange for the domestic currency, this causes a decline in the money
supply in domestic circulation--unless the authorities deliberately take offsetting
action. This decline in the money supply, which is similar to that occurring under the
gold standard, tends to raise short-term interest rates in the domestic money market.
This will bring an inflow of money from abroad to take advantage of the higher rates
or, what amounts to the same thing, will discourage foreigners from borrowing in that
country's money market since borrowing will have become more expensive. Thus, the
interest-rate differential will cause a net movement of short-term funds in the
direction required to offset the temporary deficit or, in the opposite case, to reduce a
temporary surplus that is embarrassing to others. It must be stressed again that this
equilibrating interest-rate mechanism implies confidence that the parity will not be
altered in the near future. The helpful movement of interest rates may be
reinforced by action of the monetary authorities, who by appropriate open-market
operations may cause short-term interest rates to rise above the level that they would
have attained under market forces and thus increase the equilibrating movement of
short-term funds. The Bank of England provided the most notable example of the
smooth and successful operation of this policy under the old gold standard during
many decades before World War I.

Forward exchange.

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 The transactions in which one currency is exchanged directly for another are
known as spot transactions. There can also be forward transactions, consisting of
contracts to exchange one currency for another at a future date, perhaps three months
ahead, but at a rate determined now. For instance, a German firm may have a
commitment to pay a U.S. firm in dollars in three-months' time. It may not want to
take the risk that the dollar will rise relative to the mark during the three months, so
that it would have to surrender more marks in order to honour its commitment. It
could of course buy the dollars right away and thus obviate this risk, but it may not
have any spare cash and borrowing may be inconvenient. The firm has the alternative
of buying dollars at a rate agreed upon now for which it does not have to surrender
marks until three months have passed. Some firms have a regular routine procedure
for covering all future commitments to be paid for in a foreign currency as soon as
these are entered into. Of course, even a firm that does this may combine its routine
procedure with a little judgment, for instance, if there are good reasons for believing
that the foreign currency will become cheaper during the relevant period. And firms
with multinational commitments will vary the distribution of their assets among
different currencies in accordance with changing conditions. The forward-exchange
rate will, like the spot rate, be continually varying. It is not usually identical with the
spot rate but in normal times has a regular relation to it. This relation is determined as
follows: Dealers in forward exchange usually balance
their commitments; for instance, a contract to deliver forward marks can be offset
against one to deliver forward dollars, and nothing more has to be done about it. If a
particular dealer cannot manage this he will be in communication with another who
may be in the opposite position. It may not, however, always be possible to offset
every transaction. If this is not done, the dealer must make a spot purchase of the
currency--say marks--in excess demand in the forward market. If he did not do this he
would risk an exchange loss on some of his forward transactions. For the purpose of
evaluating the forward-exchange rate to be asked in a particular deal, it is always
correct to suppose that the deal is one that cannot be offset. If the dealer has to
purchase marks on the spot, he can earn the rate of interest prevailing in Frankfurt
until the time comes when he has to deliver the marks. Whether this is advantageous
or not depends on whether the rate of interest in Frankfurt is higher or lower than that
in New York City. If it is higher in Frankfurt, the dealer will normally quote a rate per
forward mark that is lower than the spot rate; but if the rate of interest in Frankfurt is
lower, then the forward mark will normally stand above the spot mark to compensate
the dealer for having to employ his liquid funds in a less remunerative market. When
the relation of the forward rate to the spot rate is determined by a comparison of the
short-term interest rates in the two centres in the manner just described, the forward
rate is said to be at "interest parity." The
question arises as to what particular interest rates are used to calculate the interest
parity. There is a variety of practice. In previous times the rate of interest on U.S.
Treasury bills and the rate of interest on British Treasury bills were used to determine
the interest parity of the sterling price for forward dollars. More recently the interest
rates on Eurodollars and Eurosterling have been used--that is, the interest on dollar
and sterling accounts held by European banks. In normal
times arbitrage may be expected to hold forward rates to their interest parities. There
have been times, and even rather prolonged periods, in which the forward rate for a
currency has fallen below (or risen above) its interest parity. This may happen when
there is a large one-way movement of funds (such as when there is a lack of
confidence in a particular currency). In some cases, such as a simultaneous multiple

559
swapping of currencies, the arbitrager does not have to commit any funds, but in
forward arbitrage funds have to be committed for a period of three months. It is true
that an arbitrageur who had bought three-months' sterling could resell the sterling
before the three months had elapsed, but if he did so he might have to accept a loss. If
the one-way movement is very heavy there may be a shortage of funds available for
forward arbitrage. Nonetheless the demand for forward sterling has to be kept equal to
the supply of it, and if there is insufficient arbitrage for this purpose then a positive
profit has to appear on the purchase of forward sterling; in other words, its price has
to fall below the interest parity. If dealers
in a forward currency cannot offset contracts for sale with contracts for purchase and
find an excess of customers wishing to sell, the excess supply causes immediate
pressure on the spot market, since arbitrageurs and others who supplement the
forward demand for the weak currency must cover their positions by selling an
equivalent amount spot. The only way in which the authorities can prevent an excess
offer of their currency forward from causing an immediate drain on their reserves is
by offering to buy it forward themselves, without simultaneously selling it spot.
British authorities engaged in such operations during periods when sterling was weak,
and similar operations have been conducted by other central banks in connection with
swap agreements for mutual accommodation.
The foregoing descriptions of the equilibrating movements of short-
term funds have not applied when there has been a serious lack of confidence that a
given parity will be maintained. Occasions of lack of confidence occurred much more
frequently under the modified gold standard (International Monetary Fund) than they
did under the old gold standard. The reason for this is simple. Under the old gold
standard it was not expected that a country of good standing would alter the gold
valuation of its currency (although in much earlier days "debasement" was common
enough). A devaluation of the official gold content was regarded as not far removed
from a declaration of bankruptcy, and it was assumed that a country would avoid it at
all costs and in all times short of a major war or revolution. Under the International
Monetary Fund this position was altered quite deliberately to allow a country whose
payments were in "fundamental disequilibrium," to propose a change of parity. This
remedy was proposed at the Bretton Woods Conference (1944), which set up the
International Monetary Fund, because it was thought to be better than alternative
remedies, such as domestic deflation.

Disequilibrating capital movements.

Whatever its merits from a long-term point of view, the idea that it is quite
respectable for a country to alter the par value of its currency in certain circumstances
had disturbing effects on the movements of short-term funds--effects that may not
have been clearly foreseen at the time of Bretton Woods. Such movements of funds
were sometimes very large indeed. These movements were not equilibrating, like
those described in relation to a parity in which there is confidence; on the contrary,
they were disequilibrating. If a currency became weak--if the demand for it fell below
the supply--this could give rise to the idea that the authorities having the weak
currency might in due course decide to devalue it, as they were perfectly entitled,
under International Monetary Fund principles, to do.

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 Covering.
Foreign exchange advisers to corporations had to watch for such possibilities
and propose a readjustment of assets entailing a movement out of the weak currency.
It was not necessary that there be, on an objective assessment, a probability (more
than a 50 percent chance) that the currency in question had to be devalued. To
provoke a disequilibrating movement of funds it was enough that there should be a
small chance (much less than 50 percent) that it would be devalued. In strict theory,
funds should be moved out of a given currency whenever the probability that it will
be devalued outweighs the cost of moving the funds.
If a firm or its affiliate has foreseeable commitments to make
payments in a currency other than that of the area in which it operates, it may think it
wise to "cover" its position by buying the currency at once, in either the spot or the
forward market. Covering may take other forms also. If a contract to pay abroad is in
the currency of the home, or paying, country, then the prospective foreign receiver of
these funds will have to consider whether he should not cover his own position by
selling the currency of the paying country forward. Payments in the opposite direction
have also to be considered. If these are in the currency of the home country, the
foreigner due to make the payment will consider whether he should cover his position
by buying the currency of the home country forward. If the payment is in the foreign
currency, then the firm in the home country due to receive it will consider whether to
cover itself by selling the foreign currency forward. Thus, there are four main classes
of covering. In normal times it is probable that not all positions are covered in these
four ways, although it is not impossible that they should be.
If a suspicion arises that a particular currency, say that of the home
country, may be devalued, then the position is radically changed. The following
arguments apply in reverse to the case when it is believed that a particular currency
may be valued upward. It is necessary to go through the four classes of cases.
Members of the home country who normally cover their commitments to make
payments in a foreign currency would clearly continue to do so. And those, if any,
who do not habitually do so would be strongly advised to do so when there is a
possibility that the home currency may be devalued. To take the second case--that of
outward payments to be made in the home currency--the same applies: foreigners who
normally sell it forward should continue to do so, and those who do not normally sell
it forward would be strongly advised to do so lest the currency be devalued before the
payment is made. Coming to the payments due to the home country, in the case of
those to be made in the home currency, the foreigners who normally cover themselves
by buying forward or spot should be advised to cease doing so immediately, since
they may get the currency cheaper before the payment has to be made. Thus, in this
case the fear of devaluation causes those concerned to stop covering their positions.
The same applies to inward payments to be made in foreign currencies; residents of
the home country would be advised to cease from such covering, since in the interval
their currency may be devalued, and therefore it would be foolish to sell the foreign
currency due to come, in advance of payment.
Thus, the prospect of devaluation may cause both additional
covering and uncovering. Both types of change are adverse to the currency under
suspicion. It is notable that the total value of the appropriate covering plus that of the
uncovering when a currency becomes suspect is independent of the proportion of
positions that are normally covered. If all positions are normally covered then the
adverse effect will consist of an uncovering of about half of all positions. If all
positions are not normally covered, then the adverse effect will be equal to the sum of

561
the amount of extra covering and the amount of uncovering. The movement of funds
under these heads can be very large in relation to a country's normal balance of
incoming and outgoing payments. It makes no difference whether the changed action
by the firms relates to the spot or to the forward markets. This is because, when there
is a big one-way movement in the forward market, the whole of it is thrown, through
the actions of the dealers, arbitrageurs, and the like, onto the spot market.

Hedging.
Whereas the word "covering" relates to payments foreseen or possible, the
term hedging is used for operations related not to prospective payments but to
existing assets. Thus, a non-British firm may need to have a sterling balance for an
indefinite period ahead. It may think it desirable in this case to protect its position
against the possibility of sterling being devalued in the near future by selling sterling
forward at the existing quoted rate. If sterling is devalued before the forward contract
matures, the operator will get a foreign currency--say the franc--at the old rate and can
rebuy sterling at a cheaper rate. The profit that he makes recoups him for the loss in
the franc value of his sterling due to the devaluation. If there is no devaluation he can
renew his hedge at the date due, if sterling is still suspect, or he can terminate it
without loss except for the actual cost, or service charge, of the hedging transaction.
An even more important use of hedging is to protect the international
value of real assets such as securities, real estate, and industrial buildings and plants.
If a non-British person conducts business and has assets in Britain, he may think it
wise to protect the international value of these assets by selling a certain amount of
sterling forward. A devaluation, if it occurs, will reduce the foreign exchange value of
the sterling assets; but the profit that the owner makes from selling sterling forward
and buying it back at a cheaper rate will be an offset to this loss.

Speculation.
The movements so far considered are of a precautionary nature. It is
sometimes suggested, when there is a big movement of funds out of a currency, that
those prompting it are actuated by some motive hostile to the suspect currency. This is
usually quite wrong. Such large movements of funds are often referred to incorrectly
as "speculative." This gives a false impression of what is happening. Speculation
can, and often does, occur when a currency becomes suspect; but the word speculative
should be confined to movements of funds made not to protect positions but purely in
the hope of gain. A person may believe that the Deutsche Mark is likely to be valued
upward and decide to buy Deutsche Marks, not because he has any commitments
denominated in Deutsche Marks but because he wants to resell them afterward at a
profit. He will probably buy the Deutsche Marks forward. Such speculation plays only
a minor role in the early movements of funds in anticipation of a change of parity. It
may, however, mount up very strongly in the last stages when an upward or
downward revaluation has become almost certain. A big
outward movement of funds may precipitate a change of parity, desirable or
undesirable in itself, simply because there are not enough reserves to finance the
withdrawals. Even if the country in trouble is assisted by international credits, in
certain cases these may not be large enough to avert the need for devaluation. A great
movement of funds from a particular country may occur because it is thought likely

562
that it will have to devalue. There may also be a great movement into a country
thought likely to value upward. The latter kind of movement will cause difficulties for
other countries, since the funds must come from somewhere. This adverse effect may
be concentrated on one other currency, as in the classic crisis centred on a possible
upward valuation of the Deutsche Mark in November 1968, where the drain was
mainly from the French franc; or it may be more widely diffused, as in the crisis of
the mark in September 1969.

Stresses in the IMF system.

The International Monetary Fund system of pegged-but-adjustable exchange

rates came under increasing pressures during the 1960s. The system suffered from
three major, interrelated problems: inadequate adjustment, confidence, and liquidity.
Changes actually made in exchange rates were inadequate to deal with the major
disturbances occurring in international payments. Because the adjustment
mechanisms in the system were inadequate, a number of countries ran large and
persistent imbalances in their international payments. This led to a lack of confidence
that existing par values could be maintained and to periodic speculative rushes into
strong currencies and away from weak ones. Deficit countries were not in a position
to meet large speculative attacks because of their limited quantities of liquid reserves.
Traditionally, there had been two major methods of international
reserve creation: the mining of gold and the acquisition of reserves in the form of key
currencies (mainly dollars). Gold mining did not keep up with the rapid increase in
international trade; gold reserves became less and less adequate as a means for
covering balance-of-payments deficits. The alternative method for acquiring
reserves--the accumulation of U.S. dollars by central banks--had one major
disadvantage. For countries such as the United Kingdom, West Germany, or Brazil to
accumulate dollars, the United States had to run a balance-of-payments deficit. But
when the United States ran large deficits, doubts arose regarding the ability of the
United States to maintain the convertibility of the dollar into gold. In other words,
there was a fundamental inconsistency in the design of the IMF system, which created
something of a paradox: if the United States did run large deficits, the dollar would
sooner or later be subject to a crisis of confidence; if it did not run large deficits, the
rest of the world would be starved for dollar reserves.

Special Drawing Rights.

To deal with the inability of the existing system to create an adequate quantity
of reserves without requiring the United States to run large deficits, a new kind of
reserve called Special Drawing Rights (SDRs) was devised by the International
Monetary Fund. Members of the Fund were to be allocated SDRs, year by year, in
prearranged quantities to be used for the discharge of international indebtedness. At
the IMF meeting in 1969, agreement was reached for an issue extending over three
years. These Special Drawing Rights differed from ordinary Drawing Rights in three
important respects: (1) The use of Special Drawing Rights was not to be subject to
negotiations or conditions. (2) There was to be only a very much modified form of
repayment obligation. A member who used more than 70 percent of all the Special
Drawing Rights allotted in a given period had to repay to the extent needed to reduce
its average use of the rights during that period to 70 percent of the total. Thus, 70
percent of all Special Drawing Rights issued could be thought of as reserves in the
fullest sense, since a member who limited its use to this amount would have no

563
repayment obligation. (3) In the case of Drawing Rights, the Fund uses currencies as
subscribed by members to provide the medium of payment. By contrast, the Special
Drawing Rights were to be accepted in final discharge of debt without being
translated into any particular currency. Though currencies would still have to be
subscribed by members receiving Special Drawing Rights, these would be in the
background and would not be used, except in the case of a member in net credit on
Special Drawing Rights account who wished to withdraw from the scheme.
Initially, the total amount of Special Drawing Rights allocated was
equivalent to more than U.S. $9,000,000,000, but additional allocations to IMF
members during the 1970s more than doubled the total. The value of the Special
Drawing Rights is based on the currencies of the largest exporting IMF members. The
use of SDRs was altered and expanded in 1978, allowing agencies other than the IMF
to use SDRs in monetary exchange. Subsequently SDRs have been used by the Andes
Reserve Fund, the Arab Monetary Fund, the Bank for International Settlements, and
others.

Other efforts at financial cooperation.

The Group of Ten.

As early as 1961 there were signs of a crisis in the IMF system. The United
States had been running a heavy deficit since 1958, and the United Kingdom plunged
into one in 1960. It looked as if these two countries might need to draw upon
continental European currencies in excess of the amounts available. Per Jacobssen,
then managing director of the IMF, persuaded a group of countries to provide standby
credits amounting to $6,000,000,000 in all, so that supplementary supplies of their
currencies would be available. The plan was not confined to the countries that
happened to be in credit at that time but was extended to other important countries,
the currencies of which might run short at some future time. This plan was known as
the "General Arrangements to Borrow." The adhering countries were 10 in
number: the United States, the United Kingdom, Canada, France, West Germany,
Italy, The Netherlands, Belgium, Sweden, and Japan. They became known as the
"Group of Ten."
The arrangement was subject to the agreement that countries actually
supplying additional currency would have the right to take cognizance of how the
Fund used it. This put them in a power position as against the International Monetary
Fund itself. Since then the Group of Ten has worked together in deliberating on
international monetary problems. The dominant position gained by
the Group of Ten has been due not only to their provision of standby credit but also to
the manner in which they do their business. The ultimate authority of the Group
resides in the finance ministers of the countries concerned, who meet from time to
time. Their deputies meet more frequently for detailed work on particular problems.
These deputies consist of high-ranking persons in their respective treasuries and
central banks; they are resident in their own countries and have day-to-day knowledge
of their problems and of what is politically feasible. In this respect they are in a much
more advantageous position than the executive directors of the International Monetary
Fund, who live in Washington, D.C., and have less contact with their home
governments; they also tend to be persons of higher standing and authority.

564
 The Basel Group.
In 1930 a Bank for International Settlements was established at Basel,
Switz.; its main duty was to supervise and organize the transfer of German
reparations to the recipient countries. This "transfer problem" had caused much
trouble during the 1920s. There may also have been a hope in the minds of some that
this institution might one day develop into something like a world central bank.
Not long after it was set up the Germans gained a moratorium
on their reparations payments. By then, however, the Bank for International
Settlements had become a convenient place for the heads of the European central
banks to meet together and discuss current problems. This practice was resumed after
the war, and the United States, although not a member, was invited to join in the
deliberations. When Marshall Plan aid was furnished by the United
States to help European countries in their postwar reconstruction, a European
Payments Union was established to facilitate multilateral trade and settlements in
advance of the time when it might be possible to reestablish full multilateralism on a
world scale. The war had left a jumble of trade restrictions that could not be quickly
abolished. The European Payments Union also contained a plan for the provision of
credit to European debtors. The United Kingdom was a member, and with it was
associated the whole sterling area. Responsibility for working the machinery of the
European Payments Union was assigned to the Bank for International Settlements.
The European Payments Union was ultimately wound up after the countries of Europe
were able to eliminate the last restrictions and make their currencies fully convertible
in 1958. In January and February
1961 there was a serious sterling crisis, due partly to the British deficit of 1960 and
partly to a large movement of funds in anticipation of an upward valuation of the
West German mark, which happened, and thereafter in anticipation of a second
upward valuation, which did not happen at that time. To help the British, the Basel
Group of central banks provided substantial credits. These were liquidated when the
United Kingdom transferred its indebtedness to the International Monetary Fund the
following July. The Basel Group has provided further credits from time to time. The
problems involved have continued to be discussed at the monthly meetings.
The arrangement made for the support of the
sterling area in 1968 is noteworthy. After the devaluation of sterling in 1967 it was
feared that the monetary authorities of the countries composing the sterling area might
wish to reduce their holdings of sterling. Because there was a continuing problem of
world liquidity and sterling played an important part as a reserve currency, the
international consensus was that any substantial reduction in the holding of sterling as
a reserve currency would be damaging to the international monetary system. Under
the arrangement made in 1968 the United Kingdom on its side agreed to give a dollar
guarantee to the value of the greater part of the sterling-area reserves; there were
slightly different arrangements with each monetary authority. On its side the Bank for
International Settlement agreed to organize credits to finance payments deficits for
some countries of the sterling area, should these occur at times when the United
Kingdom might find it difficult to handle them.
The OECD.
The Organisation for European Economic Co-operation (OEEC) was set
up in 1948 to make arrangements for the distribution of Marshall Aid among the
countries of Europe. When its tasks in this connection were accomplished, it remained
in existence, was broadened to include the United States, Canada, and Japan, and it
was renamed the Organisation for Economic Co-operation and Development

565
(OECD). It has a permanent staff and headquarters in Paris. It undertakes research on
a substantial scale and affords a forum for the discussion of international economic
problems. The Working Party No. 3 of the organization's Economic Committee,
which is concerned with problems of money and exchange, has made significant
contributions; it issued a very important report on balance-of-payments adjustment
problems in 1966. At times the personnel of the Working Party has been much the
same as that of the deputies of the Group of Ten. The Organisation for Economic Co-
operation and Development has also set up an organization called the Development
Assistance Committee, concerned with problems of assistance to the developing
countries.
Swap agreements.
The informal system of swap agreements provides a mutual arrangement
between central banks for standby credits designed to see countries through
difficulties on the occasions of large movements of funds. These are intended only to
offset private international flows of capital on precautionary or speculative account,
not to finance even temporary deficits in countries' balance of payments. Arranged ad
hoc and informally, they depend on the mutual goodwill and trust of the central banks
involved. The system of credits, although informal, must be reckoned as important,
because they are of large amount.

The end of pegged exchange rates.

The crisis of the dollar.

The monetary system established by the IMF in 1944 underwent profound
changes in the 1970s. This system had assumed that the dollar was the strongest
currency in the world because the United States was the strongest economic power.
Other countries were expected to have difficulty from time to time in stabilizing their
exchange rates and would need assistance in the form of credits from the IMF, but the
dollar was expected to remain stable enough to function as a substitute for gold in
international transactions. In the second half of the 1960s these assumptions came into
question. The war in Vietnam led to inflation. The flood of dollars into other countries
caused difficulty for the European central banks, which were forced to increase their
dollar holdings in order to maintain their currencies at the established exchange rates.
As the flood continued in 1971, the West German and Dutch governments decided to
let their currencies float--that is, to let their exchange rates fluctuate beyond their
assigned parities. Austria and Switzerland revalued their currencies upward in relation
to the dollar. These measures helped for a time, but in August the outflow of dollars
resumed. On August 15 Pres. Richard M. Nixon suspended the U.S. commitment
made in 1934 to convert dollars into gold, effectively ending the postwar monetary
system established by the IMF. Most of the major trading countries decided to
abandon fixed exchange rates temporarily and let their currencies find their own
values in relation to the dollar.
The Smithsonian Agreement and after.
On Dec. 17 and 18, 1971, representatives of the Group of Ten met at the
Smithsonian Institution in Washington, D.C., and agreed on a realignment of
currencies and a new set of pegged exchange rates. The dollar was devalued in terms
of gold, while other currencies were appreciated in terms of the dollar. On the whole,
the dollar was devalued by nearly 10 percent in relation to the other Group of Ten
currencies (those of the United Kingdom, Canada, France, West Germany, Italy, The
Netherlands, Belgium, Sweden, and Japan). Several months after the Smithsonian

566
Agreement, the six members of the European Economic Community (EEC) agreed
to maintain their exchange rates within a range of 2.25 percent of parity with each
other. The Smithsonian Agreement proved to
be only a temporary solution to the international currency crisis. A second devaluation
of the dollar (by 10 percent) was announced in February 1973, and not long afterward
Japan and the EEC countries decided to let their currencies float. At the time, these
were thought of as temporary measures to cope with speculation and capital shifts; it
was, however, the end of the system of established par values.
FLOATING EXCHANGE RATES
The floating exchange-rate system emerged when the old IMF system of
pegged exchange rates collapsed. The case for the pegged exchange rate is based
partly on the deficiencies of alternative systems. The IMF system of adjustable pegs
proved unworkable in a world in which there were huge volumes of internationally
mobile financial capital that could be shifted out of countries in balance-of-payments
difficulties and into the stronger nations. The earlier gold standard system had
likewise contained substantial defects. Under some circumstances, it required
countries to go through a painful deflation. The gold standard, it is widely held, made
the Great Depression of the 1930s even deeper than it might otherwise have been.
Three major, interrelated hopes were expressed when flexible exchange rates
replaced the collapsing IMF system of pegged exchange rates in the early 1970s.
First, flexible exchange rates would allow currencies to hold at or near their
fundamental equilibrium values; national authorities would not feel obliged to defend
exchange rates that were severely out of line. Second, deficit countries would be able
to reestablish their international competitiveness without going through the painful
deflationary process required by the old gold standard and without facing the political
embarrassment of abandoning an established par value. Finally, the national monetary
authorities would have a substantial degree of independence to pursue the most
appropriate domestic monetary and fiscal policies, without being severely constrained
by balance-of-payments pressures. In practice, exchange-rate flexibility turned out to
be more complicated than its proponents had anticipated.

Exchange-rate fluctuations.

The pegged exchange-rate system collapsed in two speculative flurries against

the U.S. dollar in 1971 and 1973. In each case, the dollar depreciated about 10 percent
in terms of an average of other currencies. (In calculating an average exchange rate
for the dollar, the currencies of each other nation is weighted according to the volume
of trade of that nation with the United States.) After these initial adjustments,
exchange rates of the major trading nations were generally quite stable for the next
four years (late 1973-77), although there were some fluctuations. The dollar
strengthened following the first oil shock, which occurred in 1973-74; because the
United States still produced most of the oil it consumed, it was expected to be less
severely shaken by high oil prices than would its major trading partners, especially
West Germany and Japan. In the 1973-77 period, the major exchange-rate change was
a fall in the British pound sterling by about 30 percent when measured in terms of
dollars. In late 1977 the dollar
entered a period of instability. As the U.S. economy expanded and inflation increased,
U.S. goods became less competitive on world markets. In response, the dollar began
to slide downward. This raised the price of imported goods in the United States,
adding to inflationary pressures. The United States seemed in danger of entering a
wage-price-exchange rate spiral. Anticipating worse to come, speculators began to
unload dollars, moving the exchange value of the dollar even lower. During the 1977-

567
79 period, the average exchange value of the dollar declined by about 15 percent.
Faced with a rapidly deteriorating
situation, the United States tightened its domestic policies sharply. In particular,
monetary policy was tightened in order to combat the rapid inflation. This experience
provided one early, important lesson about flexible exchange rates. Even though
flexible exchange rates provide some independence for domestic monetary policies,
domestic policies cannot be made without concern for international complications.
This is true even for a large, prosperous economy, such as that of the United States.
During the late 1970s, the U.S. dollar was threatened with a collapse.
By the mid-1980s the opposite had occurred: the dollar had soared--rising about 80
percent. A number of forces contributed to this rise. One was U.S. fiscal policy: tax
rates were cut sharply, and budgetary deficits ballooned. Large-scale government
borrowing added to the demands on financial markets, leading to high interest rates.
This encouraged foreign asset holders to buy U.S. bonds. To do so, they bought
dollars, creating upward pressure on the exchange value of the dollar. In turn, the high
dollar made it difficult for U.S. producers to compete on world markets. U.S. imports
rose briskly; exports were relatively sluggish, and the U.S. trade deficit soared.
Because of strong competition from imports, U.S. producers of automobiles,
textiles, and a number of other products lobbied for protection. Under the threat of
unilateral U.S. actions, the government of Japan was persuaded to impose "voluntary"
limits on exports of cars to the United States. There were concerns--both in the United
States and in its trading partners--that the United States might adopt a much more
protectionist policy because the high exchange value of the dollar was making it so
difficult for U.S. producers to compete. Faced with this unwelcome prospect,
senior officials of the "Group of Five" (France, West Germany, Japan, the United
Kingdom, and the United States) met at the Plaza Hotel in New York City in 1985. In
the "Plaza Agreement," they declared their intention to bring the dollar down to a
more competitive level, if necessary by official sales of dollars on exchange markets.
This episode raised
fundamental questions about flexible exchange rates, leading some financial experts
to suggest an intermediate system between freely flexible exchange rates and the old
IMF system of adjustable pegs. With sizable exchange-market interventions by
governments and central banks, exchange rates were not freely flexible. They were
being managed by the authorities. (Such a managed floating rate is sometimes called a
"dirty" float.) Some experts supported more active
exchange-rate management in order to prevent currencies from becoming severely
misaligned. Governments were advised to declare "target zones" for exchange rates
and to buy or sell currencies whenever needed to keep exchange rates within these
zones--moving the target zones as fundamental economic conditions changed. The
concept was to avoid large exchange-rate swings.
THE INTERNATIONAL DEBT CRISIS
Developing nations have traditionally borrowed from the developed nations to
support their economies. In the 1970s such borrowing became quite heavy among
certain developing countries, and their external debt expanded at a very rapid,
unsustainable rate. The result was an international financial crisis. Countries such as
Mexico and Brazil declared that they could not keep up with the schedule of interest
and principal payments, causing severe reactions in the financial world. Cooperating
with creditor nations and the IMF, these countries were able to reschedule their
debts--that is, delay payments to remove financial pressure. But the underlying
problem remained--developing countries were saddled with staggering debts that
totaled more than $800,000,000,000 by the mid-1980s. For the less-developed
countries as a whole (excluding the major oil exporters), debt service payments were

568
claiming more than 20 percent of their total export earnings. The
large debts created huge problems for the developing countries and for the banks that
faced the risk of substantial losses on their loan portfolios. Such debts increased the
difficulty of finding funds to finance development. In addition, the need to acquire
foreign currencies to service the debt contributed to a rapid depreciation of the
currencies and to rapid inflation in Mexico, Brazil, and a number of other developing
nations. The wide fluctuations in the price
of oil were one of the factors contributing to the debt problem. When the price of oil
rose rapidly in the 1970s, most countries felt unable to reduce their oil consumption
quickly. In order to pay for expensive oil imports, many went deeply into debt. They
borrowed to finance current consumption--something that could not go on
indefinitely. As a major oil importer, Brazil was one of the nations adversely affected
by rising oil prices. Paradoxically, however, the oil-importing
countries were not the only ones to borrow more when the price of oil rose rapidly.
Some of the oil exporters--such as Mexico--also contracted large new debts. They
thought that the price of oil would move continually upward, at least for the
foreseeable future. They therefore felt safe in borrowing large amounts, expecting that
rapidly increasing oil revenues would provide the funds to service their debts. The
price of oil drifted downward, however, making payments much more difficult. The
debt reschedulings, and the accompanying policies of demand restraint, were built on
the premise that a few years of tough adjustment would be sufficient to get out of such
crises and to provide the basis for renewed, vigorous growth. To the contrary,
however, some authorities believed that huge foreign debts would act as a continuing
drag on growth and could have catastrophic results.

569
 Political Parties and Interest Groups

A political party is a group organized to achieve and exercise power

within a political system. An interest group (or special-interest group) is an aggregate
of individuals who, bound by one or more concerns or wants, makes claims upon
other groups or upon society in general in order to maintain or promote its position or
objectives. An interest group that attempts to influence government becomes a
"pressure group." It is distinguished from a political party in that, whereas a party puts
up candidates for election to public office and carries out activities to secure their
election, a pressure group seeks to influence both the government and the parties. The
Roman Catholic interest in Italy, for instance, is served by the Christian Democratic
Party and also by the Catholic Action Society. The first is a party, and the second is a
pressure group. Again the ethnic Swedes in Finland is served by the Swedish People's
Party; this is clearly a special-interest group, yet it puts up candidates and is
represented in the legislature because it thinks its members think their constituents'
interest is best served by exerting pressure as part of a governmental coalition. Thus,
what begins as a pressure group may eventually become a political party. The British
Labour Party, for example, had its origins in 1900, when trade unionists formed a
Labour Representation Committee in order to elect working-class MPs to Parliament;
later it broadened its membership and program to become the Labour Party. In
France, Pierre Poujade's pressure group, the Union of Small Shopkeepers, was
involved in the 1956 elections and won more than 40 seats, thus becoming a political
party, before reverting to pressure-group status in 1958. The reverse process can also
occur, as when a political party engenders pressure groups; thus, Communist parties
set up interest groups for women, youth, workers, and the like.

Political parties
Political parties originated in their modern form in Europe and the United
States in the 19th century, along with the electoral and parliamentary systems, whose
development reflects the evolution of parties. The term party has since come to be
applied to all organized groups seeking political power, whether by democratic
elections or by revolution. In earlier, prerevolutionary, aristocratic and monarchical
regimes, the political process unfolded within restricted circles in which cliques and
factions, grouped around particular noblemen or influential personalities, were
opposed to one another. The establishment of parliamentary regimes and the
appearance of parties at first scarcely changed this situation. To cliques formed
around princes, dukes, counts, or marquesses there were added cliques formed around
bankers, merchants, industrialists, and businessmen. Regimes supported by nobles
were succeeded by regimes supported by other elites. These narrowly based parties
were later transformed to a greater or lesser extent, for in the 19th century in Europe
and America there emerged parties depending on mass support. The 20th century saw
the spread of political parties throughout the entire world. In Africa large parties have
sometimes been formed in which a modern organization has a more traditional ethnic
or tribal basis; in such cases the party leadership is frequently made up of tribal chiefs.
In certain areas of Asia, membership in modern political parties is often determined
largely by religious factors or by affiliation with ritual brotherhoods. Many political

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parties in the developing countries are partly political, partly military. Certain
Socialist and Communist parties in Europe earlier experienced the same tendencies.
These last-mentioned European parties have demonstrated an equal aptitude for
functioning within multiparty democracies and as the sole political party in a
dictatorship. Developing originally within the framework of liberal democracy in the
19th century, political parties have been used in the 20th century by dictatorships for
entirely undemocratic purposes.

TYPES OF POLITICAL PARTY

A fundamental distinction can be made between cadre parties and mass-

based parties. The two forms coexist in many countries, particularly in western
Europe, where Communist and Socialist parties have emerged alongside the older
conservative and liberal parties. Many parties do not fall exactly into either category
but combine some characteristics of both.
Cadre parties.

Cadre parties--i.e., parties dominated by politically elite groups of

activists--developed in Europe and America during the 19th century. Except in some
of the states of the United States, France from 1848, and the German Empire from
1871, the suffrage was largely restricted to taxpayers and property owners, and, even
when the right to vote was given to larger numbers of people, political influence was
essentially limited to a very small segment of the population. The mass of people
were limited to the role of spectators rather than that of active participants.
The cadre parties of the 19th century reflected a fundamental conflict between
two classes: the aristocracy on the one hand and the bourgeoisie on the other. The
former, composed of landowners, depended upon rural estates on which a generally
unlettered peasantry was held back by a traditionalist clergy.
The bourgeoisie, made up of industrialists, merchants, tradesmen, bankers,
financiers, and professional people, depended upon the lower classes of clerks and
industrial workers in the cities. Both aristocracy and bourgeoisie evolved its own
ideology. Bourgeois liberal ideology developed first, originating at the time of the
English revolution of the 17th century in the writings of John Locke, an English
philosopher. It was then developed by French philosophers of the 18th century. In its
clamouring for formal legal equality and acceptance of the inequities of circumstance,
liberal ideology reflected the interests of the bourgeoisie, who wished to destroy the
privileges of the aristocracy and eliminate the lingering economic restraints of
feudalism and mercantilism. But, insofar as it set forth an egalitarian ideal and a
demand for liberty, bourgeois classical liberalism expressed aspirations common to all
men.
Conservative ideology, on the other hand, never succeeded in defining themes
that would prove as attractive, for it appeared to be more closely allied to the interests
of the aristocracy. For a considerable period, however, conservative sentiment did
maintain a considerable impact among the people, since it was presented as the
expression of the will of God. In Catholic countries, in which religion was based upon
a hierarchically structured and authoritarian clergy, the conservative parties were
often the clerical parties, as in France, Italy, and Belgium.
Conservative and liberal cadre parties dominated European politics in the 19th
century. Developing during a period of great social and economic upheaval, they

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exercised power largely through electoral and parliamentary activity. Once in power,
their leaders used the power of the army or of the police; the party itself was not
generally organized for violent activity. Its local units were charged with assuring
moral and financial backing to candidates at election time, as well as with maintaining
continual contact between elected officials and the electorate. The national
organization endeavoured to unify the party members who had been elected to the
assemblies. In general, the local committees maintained a basic autonomy and each
legislator a large measure of independence. The party discipline in voting established
by the British parties--which were older because of the fact that the British Parliament
was long established--was imitated on the Continent hardly at all.
The first United States political parties of the 19th century were not
particularly different from European cadre parties, except that their confrontations
were less violent and based less on ideology. The first United States form of the
struggle between the aristocracy and the bourgeoisie, between conservative and
liberal, was carried out in the form of the Revolutionary War, in which Great Britain
embodied the power of the king and the nobility, and the insurgents that of
bourgeoisie and liberalism. Such an interpretation is, of course, simplified. There
were some aristocrats in the South and, in particular, an aristocratic spirit based on the
institutions of slaveholding and paternalistic ownership of land. In this sense, the Civil
War could be considered as a second phase of violent conflict between the
conservatives and the liberals. Nevertheless, the United States was from the beginning
an essentially bourgeois civilization, based on a deep sense of equality and of
individual freedom. Federalists and Anti-Federalists, Republicans and Democrats--all
belonged to the liberal family since all shared the same basic ideology and the same
system of fundamental values and differed only in the means by which they would
realize their beliefs.
In terms of party structure, United States parties in the beginning differed little
from their European counterparts. Like them, the United States parties were
composed of local notables. The ties of a local committee to a national organization
were even weaker than in Europe. At the state level there was some effective
coordination of local party organizations, but at the national level such coordination
did not exist. A more original structure was developed after the Civil War--in the
South to exploit the vote of the blacks and along the East Coast to control the votes of
immigrants. The extreme decentralization in the United States enabled a party to
establish a local quasi-dictatorship in a city or county by capturing all of the key posts
in an election. Not only the position of mayor but also the police, finances, and the
courts came under the control of the party machine, and the machine was thus a
development of the original cadre parties. The local party committee came typically to
be composed of adventurers or gangsters who wanted to control the distribution of
wealth and to ensure the continuation of their control. These men were themselves
controlled by the power of the boss, the political leader who controlled the machine at
the city, county, or state levels. At the direction of the committee, each constituency
was carefully divided, and every precinct was watched closely by an agent of the
party, the captain, who was responsible for securing votes for the party. Various
rewards were offered to voters in return for the promise of their votes. The machine
could offer such inducements as union jobs, trader's licences, immunity from the
police, and the like. Operating in this manner, a party could frequently guarantee a
majority in an election to the candidates of its choosing, and, once it was in control of
local government, of the police, the courts, and public finances, etc., the machine and
its clients were assured of impunity in illicit activities such as prostitution and

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gambling rings and of the granting of public contracts to favoured businessmen.
The degeneration of the party mechanism was not
without benefits. The European immigrant who arrived in the United States lost and
isolated in a huge and different world might find work and lodging in return for his
commitment to the party. In a system of almost pure capitalism and at a time when
social services were practically nonexistent, machines and bosses took upon
themselves responsibilities that were indispensable to community life. But the moral
and material cost of such a system was very high, and the machine was often purely
exploitative, performing no services to the community.
By the end of the 19th century the excesses of the machines and
the bosses and the closed character of the parties led to the development of primary
elections, in which party nominees for office were selected. The primary movement
deprived party leaders of the right to dictate candidates for election. A majority of the
states adopted the primary system in one form or another between 1900 and 1920.
The aim of the system was to make the parties more democratic by opening them up
to the general public in the hope of counterbalancing the influence of the party
committees. In practice, the aim was not realized, for the committees retained the
upper hand in the selection of candidates for the primaries. In its original form the
British Labour Party constituted a new type of cadre party, forming an intermediate
link with the mass-based parties. It was formed with the support of trade unions and
left-wing intellectuals. At the base, each local organization sent representatives to a
district labour committee, which was in turn represented at the national congress.
The early (pre-1918) Labour Party was thus structured of many local and
regional organizations. It was not possible to join the party directly; membership
came only through an affiliated body, such as a trade union. It thus represented a new
type of party, depending not upon highly political individuals brought together as a
result of their desire to acquire and wield power but upon the organized
representatives of a broader interest--the working class. Certain Christian Democrat
parties--the Belgian Social Christian Party between the two world wars and the
Austrian Popular Party, for example--had an analogous structure: a federation of
unions, agricultural organizations, middle class movements, employers' associations,
etc. After 1918, the Labour Party developed a policy of direct membership on the
model of the continental Socialist parties, individual members being permitted to join
local-constituency branches. The majority of its membership, however, continued to
be affiliated rather than direct.

Mass-based parties.

Cadre parties normally organize a relatively small number of party

adherents. Mass-based parties, on the other hand, unite hundreds of thousands of
followers, sometimes millions. But the number of members is not the only criterion of
a mass-based party. The essential factor is that such a party attempts to base itself on
an appeal to the masses. It attempts to organize not only those who are influential or
well known or those who represent special interest groups but rather any citizen who
is willing to join the party. If such a party succeeds in gathering only a few adherents,
then it is mass based only in potential. It remains, nevertheless, different from the
cadre-type parties. At the end of the 19th century the
Socialist parties of continental Europe organized themselves on a mass basis in order
to educate and to organize the growing population of labourers and wage earners,
which industrialization was making increasingly large and which was becoming more

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important politically because of extensions of the suffrage, and to gather the money
necessary for propaganda by mobilizing in a regular fashion the resources of those
who, although poor, were numerous. Membership campaigns were conducted, and
each member paid party dues. If its members became sufficiently numerous, the party
emerged as a powerful organization, managing large funds and diffusing its ideas
among an important segment of the population. Such was the case with the German
Social Democratic Party, which by 1913 had more than 1,000,000 members.
Such organizations were necessarily rigidly structured. The party required
an exact registration of membership, treasurers to collect dues, secretaries to call and
lead local meetings, and a hierarchical framework for the coordination of the
thousands of local sections. A tradition of collective action and group discipline, more
developed among workers as a result of their participation in strikes and other union
activity, favoured the development and centralization of party organization. A
complex party organization tends to give a great deal of influence to those who have
responsibility at various levels in the hierarchy, resulting in certain oligarchical
tendencies. The Socialist parties made an effort to control this tendency by developing
democratic procedures in the choice of leaders. At every level those in responsible
positions were elected by members of the party. Every local party group would elect
delegates to regional and national congresses, at which party candidates and party
leaders would be chosen and party policy decided.
The type of mass-based party described above was imitated by many non-
Socialist parties. Some cadre-type parties in Europe, both conservative and liberal,
attempted to transform themselves along similar lines. The Christian Democrat parties
often developed organizations copied even more directly from the mass-based model.
But non-Socialist parties were generally less successful in establishing rigid and
disciplined organizations. The first Communist parties were splinter groups of
existing Socialist parties and at first adopted the organization of these parties. After
1924, as a result of a decision of the Comintern (the Third International, or federation
of working class parties), all Communist parties were transformed along the lines of
the Soviet model, becoming mass parties based on the membership of the largest
possible number of citizens, although membership was and is limited to those who
embraced and espoused the ideology of Marxism-Leninism.
The Communist parties developed a new
structural organization: whereas the local committees of cadre and Socialist parties
focussed their organizing efforts and drew their support from a particular
geographical area, Communist groups formed their cells in the place of work. The
work-place cell was the first original element in Communist party organization. It
grouped together all party members who depended upon the same firm, workshop, or
store or the same professional institution (school or university, for example). Party
members thus tended to be tightly organized, their solidarity, resulting from a
common occupation, being stronger than that based upon residence.
The work-place-cell system proved to be effective, and other parties tried to
imitate it, generally without success. Such an organization leads each cell to concern
itself with problems of a corporate and professional nature rather than with those of a
more political nature. These basic groups, however, smaller and, therefore, more
numerous than the Socialist sections, tend to go their separate way. It is necessary to
have a very strong party structure and for party leaders to have extensive authority if
the groups are to resist such centrifugal pressure.
This has resulted in a second distinctive characteristic of the
Communist parties: a high degree of centralization. Although all mass-based parties

574
tend to be centralized, Communist parties are more so than others. There is, in
principle, free discussion, which is supposedly developed at every level before a
decision is made, but afterward all must adhere to the decision that has been made by
the central body. The splintering that has from time to time divided or paralyzed the
Socialist parties is forbidden in Communist parties, which have generally succeeded
in maintaining their unity. A further distinctive characteristic of Communist parties is
the importance given to ideology. All parties have a doctrine or at least a platform.
The European Socialist parties, which were doctrinaire before 1914 and between the
two wars, later became more pragmatic, not to say opportunistic. But, in Communist
parties, ideology occupies a much more fundamental place, a primary concern of the
party being to indoctrinate its members with Marxism. The 1920s and
'30s saw the emergence of Fascist parties that attempted, as do the Communist and
Socialist parties, to organize the maximum number of members but that did not claim
to represent the great masses of people. Their teaching was authoritarian and elitist.
They thought that societies should be directed by the most talented and capable
people--by an elite. The party leadership, grouped under the absolute authority of a
supreme head, constituted such an elite. Party structure had as its goal the assurance
of the obedience of the elite.
This structure resembled that of armies, which are also organized in such a
way as to ensure, by means of rigorous discipline, the obedience of a large number of
men to an elite leadership. The party structure, therefore, made use of a military-type
organization, consisting of a pyramid made up of units that at the base were very tiny
but that, when joined with other units, formed groups that got larger and larger.
Uniforms, ranks, orders, salutes, marches, and unquestioning obedience were all
aspects of Fascist parties. This similarity rests upon another factor; namely, that
Fascist doctrine taught that power must be seized by organized minorities making use
of force. The party thus made use of a militia intended to assure victory in the struggle
for control over the unorganized masses. Large parties built upon the Fascist
model developed between the two wars in Italy and Germany, where they actually
came into power. Fascist parties appeared also in most other countries of western
Europe during this period but were unable to achieve power. The less-developed
nations of eastern Europe and Latin America were equally infected by the movement.
The victory of the Allies in 1945, as well as the revelation of the horrors of Nazism,
stopped the growth of the Fascists and provoked their decline, but Fascist-type party
organization and doctrine remain a potent means of exercising power.

PARTIES AND POLITICAL POWER

Whether they are conservative or revolutionary, whether they are a

union of notables or an organization of the masses, whether they function in a
pluralistic democracy or in a monolithic dictatorship, parties have one function in
common: they all participate to some extent in the exercise of political power,
whether by forming a government or by exercising the function of opposition, a
function that is often of crucial importance in the determination of national policy.

The struggle for power.

It is possible in theory to distinguish revolutionary parties, which

attempt to gain power by violence (conspiracies, guerrilla warfare, etc.), from those
parties working within the legal framework of elections. But the distinction is not

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always easy to make, because the same parties may sometimes make use of both
procedures, either simultaneously or successively, depending upon the circumstances.
In the 1920s, for example, Communist parties sought power through elections at the
same time that they were developing an underground activity of a revolutionary
nature. In the 19th century, liberal parties were in the same situation, sometimes
employing the techniques of conspiracy, as in Italy, Austria, Germany, Poland, and
Russia, and sometimes confining their struggles to the ballot box, as in Great Britain
and France. Revolutionary methods vary greatly. Clandestine plots
by which minority groups seize the centres of power presuppose monarchies or
dictatorships in which the masses of people have little say in government. But terrorist
and disruptive activity can serve to mobilize citizens and to demonstrate the
powerlessness of any government. At the beginning of the 20th century leftist trade
unionists extolled the revolutionary general strike, a total stoppage of all economic
activity that would paralyze society completely and put the government at the
revolutionaries' mercy. Rural guerrilla activity has often been used in countries with a
predominantly agrarian society; urban guerrilla warfare was effective in the European
revolutions of the 19th century, but the development of techniques of police and
military control has made such activity more difficult. Revolutionary parties are
less numerous than parties that work within the law: the contest at election time is the
means normally used in the struggle for power. Such activity corresponds, morever, to
the original nature of political parties and involves three factors: the organization of
propaganda, the selection of candidates, and the financing of campaigns. The first
function is the most visible. The party first of all gives the candidate a label that
serves to introduce him to the voters and to identify his position. Because of

this party label the voters are better able to distinguish the candidates. The
promises and declarations of individuals are seldom taken with too much seriousness,
and it means more to indicate that one candidate is a Communist, another a Socialist,
a third a Fascist, and a fourth a liberal. Finally, the party also furnishes the candidate
with workers to raise funds, put up his posters, distribute his literature, organize his
meetings, and canvass from door to door. The function of selecting candidates is
exercised in three ways. In cadre parties, candidates are selected by committees of the
party activists who make up the party -- the caucus system, as it is known in the
United States. In general, local committees play essential roles in this regard. In some
countries, however, the selection is centralized by a national caucus, as, for example,
by the Conservative Party in Britain and the Union of Democrats in France. In mass-
based parties, selection is made by members of the regional and national congresses
according to apparently democratic procedures; in actual practice, the governing
committees play an essential role, the local constituency members generally ratifying
their choice. Thirdly, in the United States the mechanism of primary elections has
established a system for selecting candidates by means of the votes of all party
members or all voters within a particular electoral district. The various processes of
selecting candidates do not, however, differ significantly in their results, for it is
almost always the party leaders who play the essential role. This introduces an
oligarchical tendency into party politics, a tendency that has not been overcome by the
congresses of the mass-based parties or the United States primaries, which provide
only a partial limitation on the power of the governing committees. An
important aspect of the struggle for power between political parties is the financing of
campaigns. Cadre parties always have in their committees some key figure having
connections with businessmen who is responsible for collecting gifts from them. In

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mass-based parties, rather than looking for large sums of money from a few people,
leaders gather smaller sums from a large number of people who usually give on a
monthly or annual basis. This method has been viewed as one of the distinguishing
characteristics of mass-based parties. Sometimes the law intervenes in the financing
of elections and of parties. Laws often limit campaign expenses and attempt to restrict
the resources of the parties, but they are generally inoperative because it is quite easy
to circumvent them. In some countries the state contributes public funds to the parties.
At first, such financial participation was limited to expenses for campaigns and was
based on the uniform treatment of candidates (as in France), but in Sweden and
Finland the state contributes to the general finances of parties.

Participation in power.

Only the functions of parties in democratic regimes will be considered

at this time. The role of the single party in a dictatorship will be analyzed separately.
Once a political party has achieved electoral victory, the
question arises of how much influence the party is to have on the government. The
influence of the party on members in elective office is frequently quite weak. It
defines the general lines of their activity, but these lines can be quite hazy, and few
decisions are taken in the periodic meetings between officeholders and their party.
Each member of the legislature retains personal freedom of action in his participation
in debates, in his participation in government, and, especially, in his voting. The party
may, of course, attempt to enforce the party line, but parliamentary or congressional
members cannot be compelled to vote the way the party wants them to. Such is the
situation in the United States, within most of the liberal and conservative European
parties, and within cadre parties in general. The question of how disciplined a
party is, of the extent to which it will always present a united front, enables a
distinction to be made between what may be termed rigid and flexible parties; that is,
between those that attempt always to be united and disciplined, following what is
most often an ideologically based party line, and those that, representing a broader
range of interests and points of view, form legislatures that are assemblies of
individuals rather than of parties. Whether
the parties operating within a particular system will be rigid or flexible depends
largely on the constitutional provisions that determine the circumstances in which a
government may continue in office. This is clearly illustrated by comparing the
situation in the United States with that in Great Britain. In the United States the
president and his government continue in office for the constitutionally defined period
of four years, regardless of whether a majority in the legislature supports him or not.
Since a united party is thus not crucial to the immediate survival of the government,
both major parties are able to contain broad coalitions of interests, and votes on issues
of major importance frequently split each party. In the United Kingdom the situation
is quite different. There, government can continue in office only so long as it
commands a majority in the legislature. A single adverse vote can result in the

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dissolution of Parliament and a general election. Party discipline and unity are thus of
crucial importance, and this fact has far-reaching consequences for the composition,
organization, and policies of each party. The consequences of party disunity within
such a constitutional framework are well illustrated by the weakness and instability of
the governments of the Third and Fourth French republics.
The distinction between flexible and rigid parties applies equally to
parties in power and to those forming the opposition. Votes of censure or of lack of
confidence, votes on proposed legislation or on the budget, questions put to ministers
or challenges made to them--in short, all the functions of an opposition party--are
worked out differently in flexible and rigid party systems.
In flexible party systems the absence of strong discipline is
often of great consequence to the opposition party because only rigid parties can
constitute an opposition force sufficiently strong to counterbalance the strength of the
party in power. At the same time, party discipline permits the opposition to present
the public with an alternative to the majority party; the logical consequence of such a
situation is Britain's "shadow cabinet," which accustoms the electorate to the idea that
a new group is ready to take over the reins of government.
Parties provide, moreover, a channel of
communication between opposition legislators and the public. The governing party
performs a similar service for the government, although it is less necessary, since the
government has at its disposal numerous means of communicating with the public.
Opposition parties thus provide a means of expressing negative reaction to decisions
of government and proposing alternatives. This role justifies the official recognition
given to opposition parties, as is the case in Great Britain and Scandinavia.

Power and representation.

It is difficult to envisage how representative democracy could function

in a large industrialized society without political parties. In order for citizens to be
able to make an intelligent choice of representative or president, it is necessary for
them to know the real political orientation of each candidate. Party membership
provides the clearest indication of this. The programs and promises of each individual
candidate are not too significant or informative, because most candidates, in their
attempt to gain the most votes, try to avoid difficult subjects; they all tend to speak the
same language; that is, to camouflage their real opinions. The fact that one is a
Socialist, another a conservative, a third a liberal, and a fourth a Communist provides
a far better clue as to how the candidate will perform when in office. In the legislature
the discipline of the party limits the possibility that elected representatives will change
their minds and their politics, and thus the party label acts as a sort of guarantee that
there will be at least some correspondence between promise and performance. Parties
make possible the representation of varying shades of opinion by synthesizing
different positions into a stance that each representative adopts to a greater or lesser
extent. But
parties, like all organizations, tend to manipulate their members, to bring them under
the control of an inner circle of leaders that often perpetuates itself by cooptation. In
cadre parties, members are manipulated by powerful committees containing cliques of
influential party leaders. In mass-based parties, leaders are chosen by the members,
but incumbents are very often re-elected because they control the party apparatus,
using it to ensure their continuation in power.
Democratic political systems, while performing the function of

578
representation, thus rest more or less on the competition of rival oligarchies. But these
oligarchies consist of political elites that are open to all with political ambition. No
modern democracy could function without parties, the oligarchical tendencies of
which are best regarded as a necessary evil.

PARTY SYSTEMS

Party systems may be broken down into three broad categories: two-
party, multiparty, and single-party. Such a classification is based not merely on the
number of parties operating within a particular country but on a variety of distinctive
features that the three systems exhibit. Two-party and multiparty systems represent
means of organizing political conflict within pluralistic societies and are thus part of
the apparatus of democracy. Single parties usually operate in situations in which
genuine political conflict is not tolerated. This broad statement is, however, subject to
qualification, for, although single parties do not usually permit the expression of
points of view that are fundamentally opposed to the party line or ideology, there may
well be intense conflict within these limits over policy within the party itself. And
even within a two-party or a multiparty system, debate may become so stymied and a
particular coalition of interests so entrenched that the democratic process is seriously
compromised. The distinction between two-party and
multiparty systems is not as easily made as it might appear. In any two-party system
there are invariably some tiny parties in addition to the two major parties, and there is
always the possibility that such small parties might prevent one of the two main
parties from gaining a majority of seats in the legislature. This is the case with regard
to the Liberal Party in Great Britain, for example. Other countries do not fall clearly
into either category; thus, Austria and the Federal Republic of Germany only
approximate the two-party system. It is not simply a question of the number of parties
that determines the nature of the two-party system; many other elements are of
importance, the extent of party discipline in particular.

Multiparty systems.

In Anglo-Saxon countries there is a tendency to consider the two-party

system as normal and the multiparty system as the exceptional case. But, in fact, the
two-party system that operates in Great Britain, the United States, and New Zealand is
much rarer than the multiparty system, which is found in almost all of western
Europe. In western Europe, three major categories of parties
have developed since the beginning of the 19th century: conservative, liberal, and
Socialist. Each reflects the interests of a particular social class and expounds a
particular political ideology. After World War I other categories of parties developed
that were partly the result of divisions or transformations of older parties. Communist
parties began as splinter groups of Socialist parties, and Christian Democrat parties
attempted to weld together moderate Socialists and conservatives and some liberals.
Other distinctive types of party emerged in some countries. In Scandinavia, liberal
rural parties developed in the 19th century, reflecting a long tradition of separate
representation of the rural population. In many countries ethnic minorities formed the
basis of nationalist parties, which then either joined existing parties or divided them.

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 The appearance of
Socialism in the 19th century upset the earlier lines of battle between conservatives
and liberals and tended to throw the latter two groups into a common defense of
capitalism. Logically, this situation should have led to the fusion of conservatives and
liberals into one bourgeois party that would have presented a united stand against
Socialism. This is, in fact, what happened in Great Britain after World War I.
One of the most important factors determining the number of parties
operating within a particular country is the electoral system. Proportional
representation tends to favour the development of multiparty systems because it
ensures representation in the legislature for even small parties. The majority, single-
ballot system tends to produce a two-party system, because it excludes parties that
may gain substantial numbers of votes but not the majority of votes necessary to elect
a representative within a constituency. The majority system with a second ballot
favours a multiparty system tempered by alliances between parties. Such a system is
very rare, found only in the German Empire (1871-1914) and in the French Third
(1870-1940) and Fifth (since 1958) republics. Voters choose between the parties that
did best in a first ballot. This leaves small parties at a disadvantage but, nevertheless,
gives them opportunity to strengthen their role during the second balloting as long as
they are willing to enter into alliances with the leading parties.
Another factor
producing multiparty systems is the intensity of political conflicts. If, within a given
political movement, extremists are numerous, then it is difficult for the moderates in
that party to join with them in a united front. Two rival parties are likely to be formed.
Thus, the power of the Jacobins among 19th-century French liberals contributed to the
inability of the moderates to form one great liberal party, as was successfully achieved
in Great Britain. Likewise, the power of the extremists among the conservatives was
an obstacle to the development of a strong conservative party. The
distinction between the multiparty system and the two-party system corresponds
largely to a distinction between two types of Western political regime. In a two-party
situation the administration has, in effect, an assurance of a majority in the legislature,
deriving from the predominance of one party; it has, therefore, a guarantee of
continuance and effectiveness. Such a system is often referred to as majority
parliamentarianism. In a multiparty situation, on the other hand, it is quite rare for one
party to have a majority in the legislature; governments must, therefore, be founded
on coalitions, which are always more heterogeneous and more fragile than a single
party. The result is less stability and less political power. Such systems may be
referred to as nonmajority parliamentarianism.
In practice, majority and nonmajority
parliamentary systems do not coincide exactly with two-party systems and multiparty
systems. For, if each of the two parties is flexible and does not control the voting
patterns of its members (as is the case in the United States), the numerical majority of
one of the parties matters little. It can happen, moreover, that one party in a multiparty
system will hold an absolute majority of seats in the legislature so that no coalition is
required. Such a situation is unusual but did occur in West Germany, Italy, and
Belgium at various times after 1945. Ordinarily, however, a
coalition will be the only means of attaining a parliamentary majority within the
framework of the multiparty system. Coalitions are by nature more heterogeneous and
more unstable than a grouping made up of one party, but their effectiveness varies
greatly according to the discipline and organization of the parties involved. In the case
of flexible parties that are undisciplined and that allow each legislator to vote on his

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own, the coalition will be weak and probably short-lived. The instability and
weakness of governments is at its maximum in such situations, of which the Third
French Republic provides a good example. If, on the
other hand, the parties involved in a coalition are rigid and disciplined, it is possible
for a system quite similar to the two-party system to develop. This is often the case
when two opposing alliances are formed, one on the left and one on the right, and
when both are strong enough to endure through the legislative session. This type of
coalition, referred to as bipolarized, introduces elements of the two-party system into
a multiparty framework. A situation of this type has developed in Sweden, where
conservative, liberal, and agrarian parties have been aligned against the Social
Democrat Party, which eventually allied itself with the Communist Party (1970).
The system of bipolar alliances may be contrasted with the
system of a centrist alliance. Rather than the parties on the right forming a centre-right
coalition to oppose a centre-left coalition, there is the possibility that the centre-left
and the centre-right will join forces and reject the extremes at both ends of the
political spectrum. Such a situation occurred in Germany during the Weimar
Republic, when the government rested on a majority formed of a coalition of Catholic
Centrists and Social Democrats, with opposition coming from the Communists and
the nationalists on the extreme left and right.
Centrist coalitions all tend
to give the average citizen a sense of political alienation. In rejecting both extremes,
coalitions may well be isolating the radical, unstable elements, but the governing
coalition may tend to be unresponsive to new ideas, uninspiringly pragmatic, and too
ready to compromise. This situation gives rise to a more or less permanent breach
between practical politics and political ideals. An advantage of bipolarization or of the
two-party system is that the moderates of both sides must collaborate with those who
are more extreme in their views, and the extremists must be willing to work with
those who are more moderate; the pressure from the extremists prevents the
moderates from getting bogged down, while collaboration with the moderates lends a
touch of realism to the policies of the extremists.

Two-party systems.

A fundamental distinction must be made between the two-party

system as it is found in the United States and as it is found in Great Britain.
Although two major parties dominate political life in the two countries, the system
operates in quite different ways.

The American two-party system.

The United States has always had a two-party system, first in the
opposition between the Federalists and the Anti-Federalists, then in the competition
between the Republicans and the Democrats. There have been frequent third-party
movements in the history of the country, but they have always failed. Presidential
elections seem to have played an important role in the formation of this type of two-
party system. The mechanism of a national election in so large a country has
necessitated very large political organizations and, at the same time, relatively
simplified choices for the voter. American parties are different from their
counterparts in other Western countries. They are not tied in the same way to the great
social and ideological movements that have so influenced the development of political

581
life in Europe during the last two centuries. There have been Socialist parties at
various times in the history of the United States, but they have never challenged the
dominance of the two major parties. It can be argued that the main reason for the
failure of Socialist parties in America has been the high degree of upward mobility
permitted by a rich and continually expanding economy. The consequence of this
mobility has been that class consciousness has never developed in the United States in
a manner that would encourage the formation of large Socialist or Communist parties.

In comparison with European political movements, therefore,

American parties have appeared as two varieties of one liberal party, and within each
party can be found a wide range of opinion, going from the right to the left.
The American parties have a flexible and
decentralized structure, marked by the absence of discipline and rigid hierarchy. This
was the structure of most of the cadre-type parties of the 19th century, a structure that
most liberal parties have retained. Federalism and a concern for local autonomy
accentuate the lack of rigid structure and the weakness of lines of authority in the
parties. Organization may be relatively strong and homogeneous at the local level, but
such control is much weaker on the state level and practically nonexistent on the
national level. There is some truth to the observation that the United States has not
two parties but 100--that is, two in each state. But it is also true that each party
develops a certain degree of national unity for the presidential election and that the
leadership of the president within his party gives the victorious party some cohesion.

In voting, Republicans and Democrats are usually found on both sides.

An alliance between liberal Republicans and Democrats against conservative
Republicans and Democrats tends to develop. But neither bloc is stable, and the
alignment varies from one vote to another. As a consequence, despite the existence of
a two-party system, no stable legislative majority is possible. In order to have his
budget adopted and his legislation passed, the president of the United States must
carefully try to gather the necessary votes on every question, bearing the wearisome
task of constantly forming alliances. The American two-party system is thus a
pseudo-two-party system, because each party provides only a loose framework within
which shifting coalitions are formed.

The British two-party system.

Another form of the two-party system is operative in Great Britain and
in New Zealand. The situation in Australia is affected somewhat by the presence of a
third party, the Country Party. A tight alliance between the Australian Liberal Party
and the Country Party introduces, however, a rather rigid bipolarization with the
Labour Party. The system thus tends to operate on a two-party basis. Canada also
possesses what is essentially a two-party system, Liberals or Conservatives usually
being able to form a working majority without the help of the small, regionally based
parties. Great Britain has had two successive
two-party alignments: Conservative and Liberal prior to 1914 and Conservative and
Labour since 1935. The period from 1920 to 1935 constituted an intermediate phase
between the two. Britain's Conservative Party is actually a Conservative-Liberal
Party, resulting from a fusion of the essential elements of the two great 19th-century
parties. Despite the name Conservative, its ideology corresponds to political and
economic liberalism. A similar observation could be made about the other major

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European conservative parties, such as the German Christian Democratic Party and
the Belgian Social Christian Party. The British two-
party system depends on the existence of rigid parties; that is, parties in which there is
effective discipline regarding parliamentary voting patterns. In every important vote,
all party members are required to vote as a bloc and to follow to the letter the
directives that they agreed upon collectively or that were decided for them by the
party leaders. A relative flexibility may at times be tolerated, but only to the extent
that such a policy does not compromise the action of the government. It may be
admissible for some party members to abstain from voting if their abstention does not
alter the results of the vote. Thus, the leader of the majority party (who is at the same
time the prime minister) is likely to remain in power throughout the session of
Parliament, and the legislation he or she proposes will likely be adopted. There is no
longer any real separation of power between the executive and legislative branches,
for the government and its parliamentary majority form a homogeneous and solid bloc
before which the opposition has no power other than to make its criticisms known.
During the four or five years for which a Parliament meets, the majority in power is
completely in control, and only internal difficulties within the majority party can limit
its power. Since each party is made up of a disciplined group with a
recognized leader who becomes prime minister if his or her party wins the legislative
elections, these elections perform the function of selecting both the legislature and the
government. In voting to make one of the party leaders the head of the government,
the British assure the leader of a disciplined parliamentary majority. The result is a
political system that is at once stable, democratic, and strong; and many would argue
that it is more stable, more democratic, and stronger than systems anywhere else.
This situation presupposes that
both parties are in agreement with regard to the fundamental rules of a democracy. If
a Fascist party and a Communist party were opposed to one another in Great Britain,
the two-party system would not last very long. The winner would zealously suppress
the opponent and rule alone. The system, of course, does have
its weak points, especially insofar as it tends to frustrate the innovative elements
within both parties. But it is possible that this situation is preferable to what would
happen if the more extreme elements within the parties were permitted to engage in
unrealistic policies. The risk of immobility is in fact a problem for any party in a
modern industrial society, and not just for those in a two-party situation. The problem
is related to the difficulties involved in creating new organizations capable of being
taken seriously by an important segment of the population and in revitalizing long-
standing organizations encumbered by established practices and entrenched interests.

Single-party systems.

There have been three historical forms of the single-party system:

Communist, Fascist, and that found in the developing countries.

The Communist model.

In Communist countries the party is considered to be the spearhead of
the urban working class and of other workers united with it (peasants, intellectuals,
etc.). Its role is to aid in the building of a Socialist regime during the transitory phase
between capitalism and pure Socialism, called the dictatorship of the proletariat. An

583
understanding of the exact role of the party requires an appreciation of the Marxist
conception of the evolution of the state. In countries based on private ownership of
the means of production, the power of the state, according to the Marxist point of
view, is used to further the interests of the controlling capitalists. In the first stage of
revolution the power of the state is broken. Power, however, still has to be wielded to
prevent counterrevolution and to facilitate the transition to Communism, at which
stage coercion will no longer be necessary. Thus, the party, in effect, assumes the
coercive functions of the state during the dictatorship of the proletariat or, to be more
accurate, during the dictatorship of the party in the name of the proletariat.
In all Communist
countries, the structure of the party has been determined largely by the need for it to
govern firmly while at the same time maintaining its contact with the masses of the
people. Party members are a part of the general public, of which they are the most
active and most politically conscious members. They remain in contact with the
masses by means of a network of party cells that are present everywhere. Party
leaders are thus always "listening in on the masses," and the masses are always
informed of decisions of party leaders, as long as the communication network is
working in both directions.
The party is not only a permanent means of contact
between the people and party leaders but also a propaganda instrument. Political
indoctrination is essential to the survival of Communist parties, and many resources
are devoted to it. Indoctrination is accomplished in training schools, by means of
"education" campaigns, by censorship, and through the untiring efforts of militants,
who play a role similar to that of the clergy in organized religion. The party is thus the
guardian of orthodoxy and has the power to condemn and to excommunicate.
In the traditional
Communist model, the party hierarchy, then, and not the official state hierarchy, has
the real power. The first secretary of the party is the most important figure of the
regime, and, whether the party leadership is in the hands of one man or several, the
party remains the centre of political power. Near the end of the 20th century,
however, the Communist model began to change as the centre of power began shifting
toward a popularly elected state hierarchy. A younger generation of Communist
leaders, openly critical of the party's inefficient, unresponsive, and domineering
management of the government--particularly the economy--sought a return to Lenin's
original concepts of democratic centralism and socialism. In some countries,
democratic concepts were emphasized, and constitutional amendments eliminated the
party's official control, clearing the way for a multiparty system.

The Fascist model.

Fascist parties in a single-party state have never played as important a
role as Communist parties in an analogous situation. In Italy, the Fascist party was
never the single most important element in the regime, and its influence was often
secondary. In Spain the Falange never played a crucial role, and in Portugal the
National Union was a very weak organization even at the height of dictator António
Salazar's strength. Only in Germany did the National Socialist Party have a great
influence on the state. But, in the end, Hitler's dictatorship was dependent on his
private army, the SS (Schutzstaffel), which formed a separate element within the party
and which was closed to outside influences, and on the Gestapo, which was a state
organization and not an organization of the party. The Fascist party in the single-party

584
state has a policing or military function rather than an ideological one.
After their rise to power,
the Fascist parties in both Germany and Italy gradually ceased to perform the function
of maintaining contact between the people and the government, a function that is
usually performed by the party in a single-party situation. It was possible to observe a
tendency for the party to close in upon itself while suppressing its deviant members.
The renewal of the party was then assured through recruitment from youth
organizations, from which the most fanatical elements, the products of a gradual
selection process starting at a very early age, entered the party. The party tended,
therefore, to constitute a closed order.

The single party in the developing countries.

Some of the Communist parties in power in developing countries do
not differ significantly from their counterparts in industrialized countries. This is
certainly true of the Communist Party of the Socialist Republic of Vietnam and the
Workers' Party of North Korea. There have always been, however, countries in which
the single party in power could not be characterized in terms of a traditional European
counterpart. This observation applies to, for example, the former Arab Socialist Union
in Egypt, the Neo-Destour Party in Tunisia (renamed the Destour Democratic Rally),
and the National Liberation Front in Algeria, as well as many other parties in black
Africa. Most of these parties claimed to be more or less Socialist or at
least progressive, while remaining far removed from Communism and, in some cases,
ardent foes of Communism. President Nasser attempted to establish a moderate and
nationalistic Socialism in Egypt. In Tunisia the Neo-Destour Party was more
republican than Socialist and was inspired more by the example of the reforms in
Turkey under Kemal Atatürk than by Nasserism. In black Africa, single parties have
often claimed to be Socialist, but with few exceptions they rarely are in practice.
Single parties in developing countries are
rarely as well organized as Communist parties. In Turkey the Republican People's
Party was more a cadre party than a mass-based party. In Egypt it has been necessary
to organize a core of professional politicians within the framework of a pseudoparty
of the masses. In sub-Saharan Africa the parties are most often genuinely mass based,
but the membership appears to be motivated primarily by personal attachment to the
leader or by tribal loyalties, and organization is not usually very strong. It is this
weakness in organization that explains the secondary role played by such parties in
government. Some regimes, however,
have endeavoured to develop the role of the party to the fullest extent possible. The
politics of Atatürk in Turkey were an interesting case study in this regard. It was also
Nasser's goal to increase the influence of the Arab Socialist Union, thereby making it
the backbone of the regime. This process is significant in that it represents an attempt
to move away from the traditional dictatorship, supported by the army or based on
tribal traditions or on charismatic leadership, toward a modern dictatorship, supported
by one political party. Single-party systems can institutionalize dictatorships by
making them survive the life of one dominant figure.

FUTURE OF POLITICAL PARTIES

It has often been said in the West that political parties are in a state of
decline. Actually, this has been a long-standing opinion in certain conservative

585
circles, arising largely out of a latent hostility to parties, which are viewed as a
divisive force among citizens, a threat to national unity, and an enticement to
corruption and demagoguery. In certain European countries--France, for example--
right-wing political organizations have even refused to call themselves parties, using
instead such terms as movement, union, federation, and centre. And it cannot be
denied that to some extent the major European and American parties of the late 20th
century do appear old and rigid in comparison with their condition at the turn of the
century or immediately following World War I. Even relatively new parties, such as
the Christian Democratic parties of Germany and Italy (founded in 1945), seem
somewhat lifeless. In terms of size
and number, however, political parties are not declining but growing. At the turn of
the century they were confined mainly to Europe and North America; elsewhere they
were quite weak or nonexistent. In the late 20th century, parties are found practically
everywhere in the world. And in Europe and North America there are generally far
more people holding membership in parties than prior to 1914. Parties of the late 20th
century are larger, stronger, and better organized than those of the late 19th century.
In the industrialized nations, especially in western Europe, parties have become less
revolutionary and innovative, and this factor may explain the rigid and worn-out
image that they sometimes present. But even this phenomenon is found only in a
limited area and may, perhaps, pass.
The growth of parties into very large organizations may be responsible
for the feelings of powerlessness on the part of many individuals who are involved in
them. This is a problem experienced by people who find themselves part of any large
organization, whether it be a political party, business enterprise, corporation, or union.
The difficulties involved in reforming or changing political parties that have become
large and institutionalized, coupled with the next-to-impossible task of creating new
parties likely to reach sufficient strength to be taken seriously by the electorate, have
resulted in much frustration and impatience with the party system. But it is difficult to
imagine how democracy could function in a large industrialized country without
political parties. In the modern world, democracy and political parties are two facets
of the same reality, the inside and outside of the same fabric.
Interest groups
TYPES OF INTEREST GROUP

Categories defined by purpose.

Within the broad definition of interest groups, two polar types are
recognizable: first, interest groups proper, such as trade unions, farmers' unions, and
employers' associations, which have as their primary purpose the enhancement of the
advantage of their members; and, second, promotional groups, such as the societies
for the prevention of cruelty to children or various voluntary relief agencies, which
exist primarily or entirely to enhance the advantage not of their own members but of
the population, even perhaps to the discomfort or disadvantage of their own members.
Some of these, such as churches or various evangelizing groups, exist to promulgate a
distinctive set of values to be applied to society as a whole.
The distinction between interest groups proper
and promotional groups is not sharp for two reasons. In the first place, most interest
groups proper sincerely believe that in furthering their own material advantage they
are also serving that of society as a whole--by promoting "free enterprise" or a healthy
and wealthy body of farmers or a well-paid and enthusiastic corps of schoolteachers.

586
But the propagation of such beliefs is certainly not the primary purpose of such
organizations, thus distinguishing them from promotional groups. The second reason
is that some groups--for instance, organized churches--fall between the two types;
they can simultaneously pursue advantages for their own sect and seek to inculcate a
distinctive set of values in a whole society.

Categories defined by structure.

In primitive or developing societies, the most prominent type of

interest group is the natural (i.e., primordial or communal) one--that is, one based on
kinship, lineage, neighbourhood, or religious confession. In Western, industrialized
societies, though such groups do sometimes retain influence (as do the nationalities in
Latvia and Belgium), the most prominent interest group is the associational (i.e.,
secondary or factitious) type, like the trade union or Campaign for Nuclear
Disarmament, which is deliberately created to serve defined purposes. Often,
associational (or factitious) groups are created for the sake of the specialized purposes
of the first type; the Indian Workers Union, for instance, was created from the
community of Indian persons in Britain.
Within the class of associational groups, further qualifications must be made:
1. Not all associational groups possess formal structure. "Wall Street" in the
United States, or the "City" in London, though consisting of a loose network of
persons or functions, may nevertheless exert powerful collective pressures.
2. Some associational groups are collectivities; but others are single, discrete
organizations. Thus General Motors Corporation exerts its own strong influence vis-
ŕ-vis the U.S. government irrespective of the influence of the more general employers'
organization to which it possibly belongs, like the National Association of
Manufacturers.
3. Some associational groups are temporary or ad hoc. Such are the so-called
anomic groups, such as enraged French farmers who come together briefly to put logs
across roads in order to draw governmental attention to their grievances.
4. Some associational groups are "latent." There may be a common interest
among certain members of the public even though these individuals may not have
combined into a formal or informal organization. The individuals may be unaware
that they have a common interest or, if aware, see no reason to defend or promote it.
Or, even if the members consciously wish to defend or promote an interest, the laws
may restrict or control their ability to associate for such a purpose.

Categories defined by political activity.

If or when any interest group tries to influence the government in the

pursuit of its aims, it becomes a "pressure group." Not all interest groups proper try to
exert influence on governments; many (such as businesses and trade unions) do so
only as a part of their more general activities of promoting their own interests.
Promotional groups, on the other hand, spend much or all their time precisely in
trying to influence the government to favour their aims. Groups such as an anglers'
association may, therefore, turn into pressure groups for a time--the time when they
seek to influence the government for one of their purposes--and then revert to simple
interest-group status. A pressure group is therefore definable as "any interest group
that is not a part of the government and does not itself seek to govern the country in

587
its own name, but does seek to influence that government for its own purposes."
Difficulties of
definition arise, however. Some groups are neither a governmental agency nor
entirely a private group. In autocratic states, Communist or otherwise, for instance,
trade unions are often controlled by the government or the governing party. In the
Western liberal democracies, again, agencies like the Tennessee Valley Authority (in
the U.S.) or the British Broadcasting Corporation, though subject to the overriding
control of the government, enjoy substantial autonomy in certain broad areas.
Also, as noted at the beginning of this article, some pressure
groups eventually turn into political parties, or vice versa.

CHARACTERISTICS OF PRESSURE GROUPS

Power elements.

Even in the most pluralistic of the Western liberal democratic states, it

is wrong to picture public policy as simply the result of a parallelogram of group
forces. The groups are themselves restrained by institutions, procedures, and public
beliefs. Among the institutions, the most important are the public bureaucracy, the
political parties, and the independent branches of the government (the executive,
legislature, and judiciary--or some combination of these, depending on the structure
of government). To the extent that each or all of these institutions have strong
traditions, no interest group supplants them but instead has to deal with them. The
governmental procedures in force also affect groups' performance. To the extent that
public issues are traditionally subject to publicity and wide discussion, groups are
limited in the kind of activities that they can pursue. They are constrained by public
beliefs as to what is in "the public interest," by what is a proper or improper
procedure, or by what causes are respectable and what are not. If any of these three
entities--institutions, procedures, or public beliefs--become feeble, interest groups can
intrude into them. By allying with or gaining power over the parties, the legislature, or
the bureaucracy, for instance, groups can tend to substitute themselves for such organs
in the decision-making process.
Inside every country the power that pressure groups wield against the
government and that each group wields relative to its rivals depends on a combination
of the following variables, some of which are mutually dependent:
1. Density is the ratio of actual membership to potential membership. The
higher the density, the more "representative" is the group of all the people whose
interests it purports to represent and the greater will be the inclination for
governments to recognize and consult it. On the other hand, too wide a membership
brings with it internal cleavages, so that on certain issues the organization may not be
able to tender clear-cut advice or, indeed, may have to refrain from offering advice
altogether.
2. Wealth not only helps a group to develop a skilled management and
bureaucracy but also enables it to propagandize and to finance political parties.
3. Prestige lends a group the ability to get a favourable initial hearing from
government and public, even though its numbers may be small and its wealth meagre.
4. Organization consists notably of the ability to brief legislators and
administrators well and quickly, to mobilize members and the public rapidly, and to
receive advance intelligence of likely trends in policy.

588
 5. Socioeconomic leverage is strong among some groups (such as trade
unions) that can disrupt social life and low among others (such as consumers
associations).
6. Militancy consists of making an effective nuisance of oneself, so that,
hopefully, governments will be willing to "buy" time or peace.
7. Specialized information and skills add the weight of authority.
8. Electoral strength refers to the power of some groups that, though poorly
organized or having a low density, nevertheless command wide support in the
electorate and so find themselves courted by rival political parties.
Strategy and tactics.

Although all groups seek out the most influential agencies of government, the
most influential may not be accessible; and resort must be had to the next most
influential organ that is accessible. Because the Communist trade unions in Italy, for
instance, are not welcome at the Roman Catholic controlled Ministry of Labour, they
try to penetrate the legislature through political election. Indeed, in any system the
influence of the various organs of government varies. In France the president and
bureaucracy are more influential than the majority party and Parliament; in the United
States, the president and Congress balance each other, with control of the bureaucracy
shared between the two. Strategy, for an interest group, consists of determining and
going to the most influential organ that is accessible.
The tactics of an interest group range
from the constitutional to the unconstitutional (or "direct action"), the legal to the
illegal--all subject, as noted above, to the restraints of institutions, public procedures,
and public beliefs. When the target of the tactics is the executive and the
governmental bureaucracy, the following are the prime methods: Constitutional
operations include (1) advice via advisory bodies attached to the ministries (as in
Britain and France), (2) official hearings outside the ministries (as in Royal
Commissions in the U.K. and presidential commissions in the U.S.) or inside the
ministries (as in Germany or Sweden), and (3) ad hoc consultations and cooperation.
Semiconstitutional operations include (1) recruitment of state civil servants into the
private bureaucracies of the interest groups, or vice versa, and (2) bribery and favours,
which need not necessarily mean passing of money but can take the form of providing
entertainment, gifts, or meals. Semidirect operations include such measures as
refusing to provide information or to cooperate in administering legislation and thus
generally withdrawing from advisory functions. Direct action includes such measures
as the withdrawal of labour (the British Medical Association, for instance, advised its
members to withdraw from the state medical service in 1965 unless its demands were
met) or even violence such as the roadblocking activities of enraged French farmers in
the 1960s). When the target is the legislature, the following are the chief
kinds of tactics used by interest groups: Constitutional operations include (1)
testimony before legislative committee hearings (extremely important in the U.S. and
somewhat important in Sweden, the German Federal Republic, Japan, and Italy); (2)
direct representation in the legislature, which involves having individual businessmen,
financiers, farmers, school teachers, journalists, and other professionals representing
the larger interests of their profession or sponsoring group (in Great Britain in 1955
some 30 percent of Labour's MP's were trade-union sponsored); and (3) lobbying,
which refers to the activities of salaried or nonsalaried persons who try to promote
their interest groups' aims by seeking personal contacts with legislators, by sending
communications or information to legislators or persuading others to do so, and by

589
rendering campaign assistance to favoured legislators. (In the U.S., lobbying is
conducted not only by private interest groups but also by certain members of the
executive branch and the bureaucracy.) Semiconstitutional operations include
subvention or payment of retainers as well as providing campaign contributions,
secretarial help, office accommodations, and the like, which are restricted but not
forbidden by law. Semidirect action includes mass lobbying, such as promoting mass
demonstrations before legislators, ostensibly to relate grievances but in fact to impress
public opinion. Direct action includes threatening legislators with a withdrawal of
financial assistance, with physical violence, or with riots (as in Japan, where snake
dances and riots become a means of protest).
When political parties are powerful, they may prove a highly preferred
target. Tactics in such cases include the following: Constitutional operations, such as,
(1) exacting election pledges, which is most important and fruitful in countries (such
as the U.S.) where there is relatively little national-party discipline, where
representatives owe a certain allegiance to local-party groups and constituents, and
where, most important, representatives do possess legislative power; (2) financing the
party, which in all systems is perhaps the most effective operation and which in most
Western parliaments--and in Western-style parliaments like Japan's--is systematically
done by trade unions, employers associations, and individual firms; and (3) lobbying
the party machinery, a method that is virtually nonexistent in the United States but is
significant in such countries as Great Britain and Germany.
A final target of interest groups is
public opinion. The general opinion of the public at large can be of importance in
issues where questions of "fairness" or "justice" arise (on which most people feel they
can pronounce). These questions involve such matters as capital punishment, the use
of nuclear weapons, or certain wars, about which large numbers of people feel very
strongly.

ROLE OF INTEREST GROUPS IN VARIOUS POLITICAL SYSTEMS

The Anglo-American and Swedish patterns.

In the United States, Great Britain, and Sweden, the general population is
not irreparably divided on ideological or cultural lines. Although there arise from time
to time some small extremist groups, the population at large is not split into
irreconcilable blocks. Given this situation, the most influential and prominent groups
are "secondary" associations that have highly specialized objectives, form freely
without the requirement of prior governmental permission, and carry out their
activities autonomously. With the exception of the affiliation of the trade-union
movement to the Labour Party in Britain and in Sweden, the groups are politically
neutral; and even the alignment of British and Swedish trade unions and cooperatives
does not prevent them from cooperating with other parties nor hinder their free access
to government departments. Latent groups are few, since freedom of speech and
association and the right to petition the government permit most interests to organize,
while good communication media facilitate such organization. Public participation in
such groups is, by world standards, high. The pressure groups play highly specialized
roles and are sharply differentiated from the political parties. Although American and
British means of influencing the executive are similar (by advisory committees,
special inquiries, and day-to-day consultation and mutual assistance), these relations
are more institutionalized in Britain than in the U.S. British groups seek to influence
the parties by affiliation or by securing their members' nomination as candidates,

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neither mode being employed in the U.S., and by financial assistance, which occurs in
both states but in quite different ways owing to the very different legislation on this
matter in the two countries. British groups seek to influence the legislature by
securing direct representation through participation in party caucuses and by
promoting amendments in the committee stage. In the U.S. the methods employed
consist of lobbying influential congressmen and appearing at committee hearings,
which are far more important in Congress than in the House of Commons. In
influencing public opinion, American groups spend far more than their British
counterparts--one reason being that purchase of time on radio and television networks
is permissible in the U.S., whereas in Britain it is not. In addition, access to the
presidency can prove decisive in the U.S.; and some groups such as the National
Association for the Advancement of Colored People have scored notable successes by
seeking court action. In Sweden the tactics are
somewhat different, owing to three factors: the existence of a multiparty system and
the existence of coalition cabinets, the structure of the bureaucracy, and the much
greater institutionalization of pressure groups. Sweden, Denmark, and Norway each
possess a multiparty system; but when coalitions are formed, they are highly stable.
Consensus is achieved in a three-tier operation--first at interparty (electoral) level,
then at the interparty-coalition (legislative) level, and finally at the bureaucratic level.
In Sweden groups seek to influence the parties by affiliation (the trade unions being
affiliated to the Labour Party), by financing them (trade unions giving to the Labour
Party, employers groups to the antisocialist parties), and by securing direct
representation through the nomination of members as parliamentary candidates. The
parties respond by trying to compose a balanced ticket of the spectrum of interests.
Hence the groups can affect the legislature through their representatives inside each of
the parties and may, on occasion, form a cross-party legislative pressure group in
defense of their common interest; and they also seek access to the party caucus and
influence the committee stage of legislation. In the latter case they are assisted by the
standard Swedish procedure by which the "comments" of outside interests are
attached to the government's bill, even if they contradict the bill's purposes. Groups
have ready access to the legislature in the same ways that Anglo-American groups do,
except that the procedure is highly institutionalized; the "Royal Commission" with
representatives of the bureaucracy, the parties, and the interest groups seek to reach
initial agreement on a bill to be presented to the legislature; and when this device is
not used, "comments" appended to the bill serve to put the measure in the context of
the avowed interests of various groups. Not unlike the system in Britain, the
U.S., and Sweden is the system in Japan, which, despite sharp ideological divisions,
has a strong and stable two-party arrangement. This has led to the emergence of a
pattern of highly institutionalized pressure groups of the "secondary" type, the most
influential of these being business and organized labour. Business, on the whole, is
aligned with the conservative Liberal-Democratic party, supplies the bulk of its funds,
and has a large say in policy formation. Organized labour constitutes a powerful
element within the Japanese Socialist Party. In an earlier day, rural farm groups
carried considerable political weight--for the conservatives--but the increasing
industrialization and urbanization of the country have tended to reduce its importance.

The French and Italian patterns.

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 In France and Italy the political pattern is characterized by deep ideological
cleavages. The Roman Catholic Church, for example, operates through both its own
political party and its own interest groups, such as the Catholic Action Society and
Catholic youth and women's group. By the same token, the highly ideological and
sectarian Communist Party establishes its own pressure groups, such as trade unions,
farmers associations, and youth movements. Several rival groups thus compete for the
same clientele aligned or affiliated with rival political parties. Under France's Fifth
Republic, the executive branch currently controls the majority party in the legislature,
and the role of the legislature has been reduced; whereas, under Italy's current system,
feeble and fragile coalition cabinets have weakened executive leadership of the
legislature, and the legislature itself is highly fragmented among numerous parties.
Because contacts between interest groups on the one hand and the parties, civil
service departments, and legislature on the other are poorly institutionalized,
semidirect action or even direct action against the executive and the legislature are
more common, and lawless activities of crowds and violent organizations have proved
more widespread. The means of influencing the chosen targets also vary.
In France attention has shifted from the legislature (under the Fourth Republic) to the
president and bureaucracy (under the Fifth); interest groups now act through the
numerous advisory bodies, private contacts, and such official institutions as the
Economic and Social Council. Interest groups secure contacts by putting former civil
servants on their own payrolls. The fact that many civil servants and business
executives come from the same schools facilitates private collusion.
In Italy interest
groups direct their attention mainly to three targets. First, the bureaucracy, even
though it is highly fragmented and provides few formal advisory channels of
communication, is open to ad hoc and personal consultations (except to groups
deemed ideologically distasteful, such as the Communists). Second, the parties are
often twinned to interest groups, as noted earlier; and thus the groups seek and
achieve direct representation in the legislature. Third, the legislature, because it is
composed of interest groups, is heavily influenced in specialized legislative
committees. In general, therefore, interest groups have tended to "intrude" into the
organs of government, forming close alliances with certain departments and
legislative commissions and inserting themselves into others via their membership in
political parties. In short, interest groups are not "contained" as they are in Anglo-
American and Scandinavian countries--political institutions are fragmented and weak,
procedures are irregular or personal and not formal, and public beliefs are polarized
into uncompromising ideologies.

Patterns in developing countries.

Although there is no one typical pattern for all developing countries, which
of course embrace more than two-thirds of the world's sovereign states, there are a
few common characteristics that can be suggested.
First, political culture in each of these countries is fragmented,
sometimes because of ideological differences, sometimes because of the mutual
hostility of "natural" groupings based on kinship, lineage, tribe, or language. Second,
nascent interest groups representing new modernizing and industrializing forces tend
to range against rural natural groupings. The modernizers have defined and
specialized objectives, whereas the traditionalists usually represent a spectrum of
attitudes, beliefs, values, and interests. Both, in any case, tend to sponsor or generate

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their own political parties. Third, during preindependence days in some countries,
trade unions and other movements (such as the Somali Youth League) carried on
activities that would otherwise have been carried on by political parties; when
independence came, these groups continued such activities, thus blurring the
functional distinctions between parties and interest groups. Fourth, associations in
these countries tend to have low membership densities; and in most of these countries
the principal "interest"--that is, the peasantry--is hardly organized at all. Attempts to
develop widely represented peasant movements have had only limited success. Fifth,
although organization and established procedures may be poor, latent interest is
usually high. In a particularly divisive and administratively feeble country, this
interest latency may reveal itself in lawless and violent group activity--such as strikes,
riots, guerrilla movements, and assassinations.
In some countries "parties" in elections are not really parties but
simply electoral coalitions of various interest groups--the most influential groups
consisting of cliques of landlords; leaders of religious, ethnic, or linguistic groups;
and the like. Legislatures tend to reflect these divisions and temporary arrangements
in society and so enjoy only feeble authority.
In countries that have had single-
party regimes, such as Kenya and Tanzania, the parties tended to lose their mass
following and fairly well-defined organization in the years after independence. To
enhance their authority, the party leaders tried to limit or abolish the autonomy of
such interest groups as trade unions, cooperative movements, and youth and women's
movements and tried to turn these groups into ancillaries of the party.
In
some countries the military has taken over, either alone or with civilian elements, and
imposed an authoritarian rule. In such cases, the most prominent groups are
governmental--the military and the executive. Unless interest groups enjoy a long
history of organization (as does the Roman Catholic hierarchy in Latin America), they
are often turned into governmental ancillaries or suppressed. In these countries ruled
by the military or single parties, the political process turns into a highly informal
medley of pressures and personal contacts between the government, the military
forces, the various "natural" groups, and some of the more strategically placed groups
(such as the church hierarchy or private industry). The "system" is constantly
threatened with government coercion or violent outbreaks by sections of the
population.

Patterns in former Communist states.

From World War II to 1989, most of the Communist nations in eastern Europe
were ruled by a single Communist party (as in Albania, Hungary, Romania, and the
Soviet Union), or by a Communist party that dominated one or more satellite parties
in a hegemonic multiparty system (as in Bulgaria, Poland, Czechoslovakia, and East
Germany). Falling somewhere between these categories was Yugoslavia, which was
governed by a League of Communists composed of Communist parties based in its
several ethnic republics. Following the fall of the Berlin Wall in November 1989,
these party systems were entirely transformed. By 1990, each country (Albania in
1991) quickly held relatively free elections that shattered the old regime. In most
cases, power was transferred to those with little connection to the old leadership or
who were dissident Communists. In most cases, the former Communist parties soon
disbanded or reformed under different names to compete with new parties for votes

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and political influence. The parties and party systems in these countries are not yet
institutionalized and will need time, perhaps decades, to achieve stability and acquire
popular value. This slow process is common to countries seeking democratic
government after authoritarian rule. The first wave of elections (1989-
90) tended to go heavily against Communist candidates and toward candidates backed
by mass popular movements. In Poland, for example, Lech Walesa's labour-based
Solidarity movement swept nearly all the offices it contested in 1989. In
Czechoslovakia, Václav Havel's Civic Forum (and its Slovak counterpart) decisively
defeated the Communist candidates in the 1990 assembly elections. Old-line
Communist rulers were also ousted that year in Hungary and East Germany. Although
Communist governments were reelected in Albania and Bulgaria, even these hard-line
regimes were defeated by opposition forces in the second round of elections--Bulgaria
in 1991 and Albania in 1992. In Russia only the Communist Party was allowed to
participate as a party in the 1990 elections for the 1,068 seats in the Congress of
People's Deputies. Nevertheless, many candidates were backed by popular fronts,
interest groups, and political clubs that had arisen under glasnost (the Soviet policy of
"openness" that began in the late 1980s). Democratic Russia, an organization of
progressive forces, claimed 190 seats after the election. In Russia's historic popular
election for president of the republic in 1991, Boris Yeltsin won 57 percent of the vote
against five other candidates, some of whom were backed by the Communist Party of
the Soviet Union. Only in Romania did voters keep former Communists in power
through 1992, although old-line Communists also won power in most of the former
Soviet republics. This was particularly true in the Asian republics, where elections
were less free and marked by a high turnout of government-mobilized voters, but old-
line Communists also won elections in Ukraine, the largest republic after Russia.
However, three small Baltic republics (Estonia, Latvia, and Lithuania) ousted their
former Communist leaders, most convincingly in Lithuania, where the mass popular
movement Sajudis won about 65 percent of the parliamentary seats in early elections.
Despite the initial landslides toward mass-based
democratic movements in some cases, the most characteristic feature of free elections
in these former Communist nations was the proliferation of political parties, as
political entrepreneurs sought to take advantage of an uprooted electorate. For
example, Poland soon had more than 100 registered parties, Romania more than 80,
and Bulgaria more than 50. A survey of parties in eastern Europe and the Soviet
Union published in 1991 listed more than 500 different parties. Most of these were
known as "couch" parties (the entire membership would fit on a sofa), and they had
little structure or staff. The proliferation of ephemeral parties produced political
confusion as voters faced a bewildering array of choices in an unfamiliar market. In
Romania, for instance, citizens who were new to free elections could choose among
the National Democrats, Romanian Democrats, Free Democrats, Social Democrats,
Liberal Democrats, Constitutional Democrats, and Christian Democrats--to name a
few. One consequence was disillusionment with the electoral process and low voter
turnout. In Poland, for example, only 43 percent of the eligible electorate voted in the
parliamentary elections of 1991, which saw 29 different parties elected to the lower
house, including the Polish Party of the Friends of Beer (Beer Lovers' Party), which
won 16 seats in the lower parliament in 1991. In
general terms, the nascent parties that sprouted in the former Communist countries
can be classified into seven types. First, there were the parties of mass democratic
movements--Solidarity in Poland, Civic Forum in Czechoslovakia, and Sajudis in
Lithuania, for instance--that were often instrumental in forcing the Communist

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authorities to schedule free elections. However, most parties of this type dramatically
lost support in the second wave of elections. (Civic Forum had split into two wings by
then.) Second were the remnants of the former Communist Party operating with
names like the Socialist Party (Albania, Bulgaria, and Hungary) or the National
Salvation Front (Romania). These parties may change their names as they develop.
For instance, the Democratic National Salvation Front in Romania became the Party
for Social Democracy in July 1993. In Lithuania, the former Communists--
reorganized as the Democratic Labour Party--actually outpolled the Sajudis in the
November 1992 parliamentary election and regained the government.
A third type consisted of parties that took
up the mantles of pre-World War II parties, such as various farmers' and liberal
parties. A fourth kind represented nationalist parties promoting ethnic interests, as, for
example, the Hungarian Democratic Union in Romania. Fifth were religious parties,
typically Christian Democrats. A sixth category consisted of parties modeled after
Western political values, such as environmentalism, feminism, and capitalism.
Finally, there were the frivolous parties, like the Beer Lovers' and Volcano parties in
Poland. As explained
above, the nature of the electoral system affects the number of parties that win
representation to parliament. Countries using proportional representation and having
few electoral barriers to discourage minor parties sustained severely fragmented party
systems. Poland, for example, did not require parties to achieve any minimum vote
(threshold) to gain representation in 1991, and none of its 29 parliamentary parties
had more than 13 percent of the vote. This fragmentation in the Polish parliament
made it difficult to form a governing coalition. Hungary, on the other hand, required
that parties win 4 percent of the national vote in 1990, and only six out of more than
65 registered parties entered parliament. Countries that did not use proportional
representation, such as Russia, usually required that candidates win an absolute
majority of the vote or face a runoff election. This two-ballot system, also used in
France, favours party fragmentation by encouraging minor parties to form for the
purpose of denying the leading candidate a majority on the first ballot and thus
costing him the election. Minor parties can then bargain their support, in exchange for
favours, on the second ballot, often held one week after the first. The alternative
system, used in most Anglo-American democracies, requires only a simple plurality
of the vote and tends to produce two-party rather than multiparty systems. The new
democracies that have emerged from the former Communist countries are certain to
experiment with different electoral systems as they seek to develop institutionalized
parties and stable party systems.

2. The History of Western Political Philosophy.

The central problem of political philosophy is how to deploy or limit public

power so as to maintain the survival and enhance the quality of human life. Like all
aspects of human experience, it is conditioned by environment and by the scope and
limitations of mind; and the answers given by successive political philosophers to
perennial problems reflect the knowledge and the assumptions of their times. Political
philosophy, as distinct from the study of political and administrative organization, is
more theoretical and normative than descriptive. It is inevitably related to general

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philosophy and is itself a subject of social anthropology, sociology, and the sociology
of knowledge. As a normative discipline it is thus concerned with what ought, on
various assumptions, to be and how this purpose can be promoted, rather than with a
description of facts--although any realistic political theory is necessarily related to
these facts. The political philosopher is thus not concerned so much, for example,
with how pressure groups work or how, by various systems of voting, decisions are
arrived at, as with what the aims of the whole political process should be in the light
of a particular philosophy of life. There is thus a distinction
between political philosophy, which reflects the world outlook of successive theorists
and which demands an appreciation of their historical settings, and modern political
science proper, which, insofar as it can be called a science, is empirical and
descriptive. Political philosophy, however, is not merely unpractical speculation,
though it may give rise to highly impractical myths: it is a vitally important aspect of
life, and one that, for good or evil, has had decisive results on political action; for the
assumptions on which political life is conducted clearly must influence what actually
happens. Political philosophy may thus be viewed as one of the most important
intellectual disciplines, for it sets standards of judgment and defines constructive
purposes for the use of public power. Such consideration of the purposes for which
power should be used is in a sense more urgent today than it has been in earlier
periods, for mankind has at its disposal the power either to create a world civilization
in which modern technology can benefit the human race or to destroy itself in pursuit
of political myths. The scope for political philosophy is thus great, the clarification of
its purpose and limitations urgent--an aspect, indeed, of civilization's survival.

The history of political philosophy in the West to the end of the 19th century
ANTIQUITY

Although in antiquity great civilizations arose in Egypt and Mesopotamia, in

the Indus Valley, and in China, there was little speculation about the problems of
political philosophy as formulated in the West and since predominant. The laws of
Hammurabi of Babylon (c. 1750 BC) are rules propounded by the monarch as a
representative of God on Earth and are mainly concerned with order, trade, and
irrigation; the Admonitions of the Egyptian vizier Ptahhotep (c. 2300 BC) are shrewd
advice on how to prosper in a bureaucracy; and the Arthashastra of Kautilya, grand
vizier to the Indian Candragupta Maurya in the late 4th century BC, are Machiavellian
precepts on how to survive under an arbitrary power. To be sure, the Buddhist concept
of dharma (social custom and duty), which inspired the Indian emperor Ashoka in the
3rd century BC, implies a moralization of public power, and the teachings of
Confucius in the 6th century BC are a code of conduct designed to stabilize society;
but there is not, outside Europe, much speculation about the basis of political
obligation and the purpose of the state, with both of which Western political
philosophy is mainly concerned. An authoritarian society is taken for granted, backed
by religious sanctions, and a conservative and arbitrary power is generally accepted.
In
contrast to this overwhelming conservatism, paralleled by the rule of custom and
tribal elders in most primitive societies, the political philosophers of ancient Greece

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question the basis and purpose of government; and, though they do not separate
political speculation from shrewd observations that today would be regarded as
empirical political science, they created the vocabulary of Western political thought.

Plato

The first elaborate work of European political philosophy is The Republic of

Plato (c. 378 BC), a masterpiece of insight and feeling, superbly expressed in
dialogue form and probably meant for recitation. Further development of Plato's ideas
is undertaken in his Statesman and Laws, the latter prescribing the ruthless methods
whereby they might be imposed. Plato grew up during the great war between Athens
and Sparta in which Athens suffered defeat and, like many political philosophers,
tried to find remedies for prevalent political injustice and decline. Indeed, The
Republic is the first of the utopias, though not one of the more attractive; and it is the
first classic attempt of a European philosopher to moralize political life.
Cast as a lively discussion between
Socrates, whose wisdom Plato is recounting, and various leisured Athenians, Books
V, VII-VIII, and IX of The Republic state the major themes of political philosophy
with poetic power. Plato's work has been criticized as static and class bound,
reflecting the moral and aesthetic assumptions of an elite in a slave-owning
civilization and bound by the narrow limits of the city-state. The work is indeed a
classic example of a philosopher's vivisection of society, imposing by relatively
humane means the rule of a high-minded minority. The
Republic is a criticism of current Hellenic politics--often an indictment. It is based
upon a metaphysical act of faith, for Plato believes that a world of permanent Forms
exists beyond the limitations of human experience and that morality and the good life,
which the state should promote, are reflections of these ideal Forms. The point is best
made in the famous simile of the cave, in which men are chained with their faces to
the wall and their backs to the light, so that they see only the shadows of reality. So
constrained, they shrink from what is truly "real" and permanent and need to be
forced to face it. This idealistic doctrine, known misleadingly as Realism (in
nontechnical language it is hardly realistic), pervades all Plato's philosophy: its
opposite doctrine, Nominalism, declares that only particular and observed "named"
data are accessible to the mind. On his Realist assumption, Plato, who was perhaps
influenced by Indian thought, regards most ordinary life as illusion and the current
evils of politics as the result of men pursuing brute instinct. It follows that unless
philosophers bear kingly rule in cities or those who are now called kings and princes
become genuine and adequate philosophers, and political power and philosophy are
brought together . . . there will be no respite from evil for cities.
Only philosopher-statesmen can apprehend permanent and
transcendant Forms and turn to "face the brightest blaze of being" outside the cave,
and only philosophically minded men of action can be the saviours and helpers of the
people. Plato is thus indirectly the pioneer of modern
beliefs that only a party organization, inspired by correct and "scientific" doctrines,
formulated by the written word and interpreted by authority, can rightly guide the
state. His rulers would form an elite, not responsible to the mass of the people. Thus,
in spite of his high moral purpose, he has been called an enemy of the open society
and the father of totalitarian lies. But he is also an anatomist of the evils of unbridled
appetite and political corruption and insists on the need to use public power to moral
ends. Having described his utopia,

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Plato turns to analyze the existing types of government in human terms with great
insight. Kingly government is the best but impracticable; in oligarchies the rule of the
few and the pursuit of wealth divide societies--the rich become demoralized and the
poor envious, and there is no harmony in the state. In democracy, in which the poor
get the upper hand, demagogues distribute "a peculiar kind of equality to equals and
unequals impartially," and the old flatter the young, fawning on their juniors to avoid
the appearance of being sour or despotic. The leaders plunder the propertied classes
and divide the spoils among themselves and the people until confusion and corruption
lead to tyranny, a worse form of government. For the tyrant becomes a wolf instead of
a man and "lops off" potential rivals and starts wars to distract the people from their
discontent. "Then, by Zeus," Plato concludes, "the public learns what a monster they
have begotten." In the
Statesman Plato admits that, although there is a correct science of government, like
geometry, it cannot be realized, and he stresses the need for the rule of law, since no
man can be trusted with unbridled power. He then examines which of the current
forms of government is the least difficult to live with, for the ruler, after all, is an
artist who has to work within the limits of his medium. In the Laws, purporting to be a
discussion of how best to found a polis in Crete, he presents a detailed program in
which a state with some 5,000 citizens is ruled by 37 curators of laws and a council of
360. But the keystone of the arch is a sinister and secret Nocturnal Council to be "the
sheet anchor of the state," established in its "central fortress as guardian." Poets and
musicians will be discouraged and the young subjected to a rigid, austere, and
exacting education. The stark consequence of Plato's political philosophy here
becomes apparent. He had, nonetheless, stated, in the dawn of European political
thought, the normative principle that the state should aim at promoting the good life
and social harmony and that the rule of law, in the absence of the rule of philosopher-
kings, is essential to this purpose.

Aristotle.

Aristotle, who was a pupil in the Academy of Plato, remarks that "all the
writings of Plato are original: they show ingenuity, novelty of view and a spirit of
enquiry. But perfection in everything is perhaps a difficult thing." Aristotle was a
scientist rather than a prophet, and his Politics (c. 335-322 BC), written while he was
teaching at the Lyceum at Athens, is only part of an encyclopaedic account of nature
and society, in which he analyzes society as if he were a doctor and prescribes
remedies for its ills. Political behaviour is here regarded as a branch of biology, as
well as of ethics; in contrast to Plato, Aristotle was an empirical political philosopher.
He criticizes many of Plato's ideas as impracticable, but, like Plato, he admires
balance and moderation and aims at a harmonious city under the rule of law. The
book is composed of lecture notes and is arranged in a confusing way--a quarry of
arguments and definitions of great value but hard to master. The first book, though
probably the last written, is a general introduction; Books II, III, and VII-VIII,
probably the earliest, deal with the ideal state; and Books IV-VII analyze actual states
and politics. The treatise is thus, in modern terms, a mixture of political philosophy
and political science Like Plato,
Aristotle naturally thinks in terms of the city-state, which he regards as the natural
form of civilized life, social and political, and the best medium in which men's
capacities can be realized. Hence his famous definition of man as a "political animal,"
distinguished from the other animals by his gift of speech and power of moral

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judgment. "Man, when perfected," he writes, is the best of animals, but when
separated from law and justice he is the worst of all, since armed injustice is the most
dangerous, and he is equipped at birth with the arms of intelligence and wit, moral
qualities which he may use for the worst ends.
Since all nature is pervaded by purpose and since men "aim at the good," the
city-state, which is the highest form of human community, aims at the highest good.
Like sailors with their separate functions, who yet have a common object in safety in
navigation, citizens, too, have a common aim--in modern terms survival, security, and
the enhancement of the quality of life. In the context of the city-state, this high quality
of life can be realized only by a minority, and Aristotle, like Plato, excludes those
who are not full citizens or who are slaves; indeed, he says that some men are "slaves
by nature" and deserve their status. Plato and Aristotle aim at an aristocratic and
exacting way of life, reflecting, in more sophisticated forms, the ideas of the warrior
aristocracies depicted by Homer.
Having stated that the aim of the city-state is to
promote the good life, Aristotle insists that it can be achieved only under the rule of
law.
The rule of law is preferable to that of a single citizen; if it be the better
course to have individuals ruling, they should be made law guardians or
ministers of the laws.
The rule of law is better than that even of the best men, for "he who bids law
rule may be deemed to bid God and reason alone rule, but he who bids men rule adds
the element of the beast; for desire is a wild beast, and passion perverts the minds of
rulers, even if they are the best of men." This doctrine, which distinguishes between
lawful government and tyranny, survived the Middle Ages and, by subjecting the ruler
to law, became the theoretical sanction of modern constitutional government.
Aristotle also vindicates the rule of custom and justifies the obligations accepted by
members of society: the solitary man, he writes, "is either a beast or a God." This
outlook at once reflects the respect for custom and solidarity that have promoted
survival in primitive tribal societies, even at the price of sacrificing individuals, and
gives a theoretical justification for the acceptance of political obligation.
Like Plato, Aristotle analyzes the different kinds
of city-states. While states are bound, like animals, to be different, he considers a
balanced "mixed" constitution the best--it reflects the ideal of justice (dike) and fair
dealing, which gives every man his due in a conservative social order in which
citizens of the middle condition preponderate. And he attacks oligarchy, democracy,
and tyranny. Under democracy, he argues, demagogues attain power by bribing the
electorate and waste accumulated wealth. But it is tyranny that Aristotle most detests;
the arbitrary power of an individual above the law who is "responsible to no-one and
who governs all alike with a view to his own advantage and not of his subjects, and
therefore against their will. No free man can endure such a government."
The Politics
contains not only a firm statement of these principles but also a penetrating analysis of
how city-states are governed, as well as of the causes of revolutions, in which
"inferiors revolt in order that they may be equal, and equals that they may be
superior." The treatise concludes with an elaborate plan for educating the citizens to
attain the "mean," the "possible," and the "becoming." The first implies a balanced
development of body and mind, ability and imagination; the second, the recognition
of the limits of mind and the range and limitations of talent; the third, an outcome of
the other two, is the style and self-assurance that come from the resulting self-control

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and confidence.
While, therefore, Aristotle accepts a conservative and hierarchic social
order, he states firmly that public power should aim at promoting the good life and
that only through the rule of law and justice can the good life be attained. These
principles were novel in the context of his time, when the great extra-European
civilizations were ruled, justly or unjustly, by the arbitrary power of semidivine rulers
and when other peoples, though respecting tribal custom and the authority of tribal
elders, were increasingly organized under war leaders for depredation.

Cicero and the Stoics.

Both Plato and Aristotle had thought in terms of the city-state. But Aristotle's
pupil Alexander the Great swamped the cities of old Greece and brought them into a
vast empire that included Egypt, Persia, and the Levant. Though the civilization of
antiquity remained concentrated in city-states, they became part of an imperial power
that broke up into kingdoms under Alexander's successors. This imperial power was
reasserted on an even greater scale by Rome, whose empire at its greatest extent
reached from central Scotland to the Euphrates and from Spain to eastern Anatolia.
Civilization itself became identified with empire, and the development of eastern and
western Europe was conditioned by it.
Since the city-state was no longer self-
sufficient, universal philosophies developed that gave men something to live by in a
wider world. Of these philosophies, Stoicism and Epicureanism were the most
influential. The former inspired a rather grim self-sufficiency and sense of duty, as
exemplified by the writings of the Roman emperor Marcus Aurelius; the latter, a
prudent withdrawal from the world of affairs. The setting for
political philosophy thus became much wider, relating individuals to universal
empire, thought of, as in China, as coterminous with the civilization itself. Its
inspiration remained Hellenic; but derivative Roman philosophers reinterpreted it, and
Roman legists enclosed the old concepts of political justice in a carapace of legal
definitions, capable of surviving their civilization's decline.
Cicero lived in a time of political confusion during which the old institutions
of the republic were breaking down before military dictators. His De republica and
Laws are both dialogues and reflect the classical sense of purpose: "to make human
life better by our thought and effort." Cicero defined the res publica (commonwealth)
as an association held together by law; he further asserted, as Plato had maintained
with his doctrine of Forms manifest in the just city, that government was sanctioned
by a universal natural law that reflected the cosmic order. Cicero expresses the pre-
Christian Stoic attempt to moralize public power, apparent in the exacting sense of
public responsibility shown by Hadrian and Marcus Aurelius in the 2nd century AD.

St. Augustine.

With the conversion of the emperor Constantine (AD 312), when

Christianity, long influential, became the predominant creed of the empire, and,
under Theodosius (379-395), the sole official religion, political philosophy changed
profoundly. St. Augustine's City of God (413-426), written when the empire was
under attack by barbarians within and without, sums up and defines a new division

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between church and state and a conflict between "matter" and "spirit" resulting from
the Fall of man and original sin.
St. Augustine, whose Confessiones are a record
of a new sort of introspection, combined a classical and Hebraic dualism. From the
Stoics and Virgil he inherited an austere sense of duty, from Plato and the
Neoplatonists a contempt for the illusions of appetite, and from the Pauline and
patristic interpretation of Christianity a sense of the conflict between Light and
Darkness that reflects Zoroastrian and Manichaean doctrines emanating from Iran. In
this context worldly interests and government itself are dwarfed by the importance of
attaining salvation and of escaping from an astrologically determined fate and from
the demons who embody the darkness. Life becomes illuminated for the elect
minority by the prospect of eternal salvation or, for those without grace, shrivels
under the glare of eternal fires. St. Augustine
regarded salvation as predestinate and the cosmic process as designed to "gather" an
elect to fill the places of the fallen angels and so "preserve and perhaps augment the
number of the heavenly inhabitants." The role of government and indeed of society
itself becomes subordinated into a "secular arm," part of an earthly city, as opposed to
the "City of God." The function of government is to keep order in a world intrinsically
evil.
Since Christianity had long played the main role in defense of the
veneer of a precarious urban civilization in antiquity, this claim is not surprising.
Constantine came of crude Balkan origins, a soldier putting to rights a breakdown in
government that would continue in the West with the abdication of the last Western
emperor in 476, though in the East the empire would carry on with great wealth and
power, centred in the new capital of Constantinople (Byzantium).
St. Augustine thus no longer assumed, as did
Plato and Aristotle, that a harmonious and self-sufficient good life could be achieved
within a properly organized city-state; he projected his political philosophy into a
cosmic and lurid drama working out to a predestinate end. The normal interests and
amenities of life became insignificant or disgusting, and the Christian Church alone
exercised a spiritual authority that could sanction government. This outlook,
reinforced by other patristic writings, would long dominate medieval thought, for with
the decline of civilization in the West the church became more completely the
repository of learning and of the remnants of the old civilized life.
THE MIDDLE AGES

The decline of ancient civilization in the West was severe; not, indeed, in
technology, for the horse collar, the stirrup, and the heavy plow now came in; but
political philosophy, like other intellectual interests, became elementary. In the
Byzantine Empire, on the other hand, Justinian's lawyers in 529-533 produced the
Codex Constitutionum, the Digest, the Institutes, which defined and condensed
Roman law, and the Novels. The Byzantine basileus, or autocrat, had moral
responsibility for guarding and harmonizing an elaborate state, a "colony" of heaven
in which reason and not mere will ought to rule. And this autocracy and the orthodox
form of Christianity were inherited by the Christianized rulers of the Balkans, of
Kievan Russia, and of Muscovy. In the West, two essential principles of
Hellenic and Christian political philosophy were transmitted, if only in elementary
definitions, in rudimentary encyclopaedias. Isidore of Seville in his 7th-century
Etymologiae, for example, asserts that kings rule only on condition of doing right and
that the rule reflects a Ciceronic law of nature "common to all people and mankind

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everywhere by natural instinct." Further, the barbarians respected the civilization they
took over and exploited. When converted, they revered the papacy, and in 800 the
Frankish Charlemagne even revived the Western Empire as holy and Roman. The
idea of Christian empire coterminous with civilization thus survived in Western as
well as Eastern Christendom.

Aquinas.

It is a far cry from this practical 12th-century treatise by a man of affairs to the
elaborate justification of Christian kingship and natural law created by St. Thomas
Aquinas in the 13th century, during the climax of medieval Western civilization. His
political philosophy is only part of a metaphysical construction of Aristotelian range--
for Aristotle had now been assimilated from Arabic sources and given a new Christian
content, with the added universality of the Stoic and Augustinian world outlook.
Aquinas' Summa theologiae purports to answer all the major questions of existence,
including those of political philosophy. Like Aristotle, Aquinas thinks in terms of an
ethical purpose. Natural law is discussed in the first part of the second book as part of
the discussion of original sin and what would now be termed psychology, while war
comes under the second part of the second book as an aspect of virtue and vice. Law
is defined as "that which is regulation and measure." It is designed to promote the
"felicity and beatitude" that are the ends of human life. Aquinas agrees with Aristotle
that "the city is the perfection of community" and that the purpose of public power
should be to promote the common good. The only legitimate power is from the
community, which is the sole medium of man's well being. In his De regimine he
compares society to a ship in need of a helmsman and repeats Aristotle's definition of
man as a social and political animal. Again following Aristotle, he considers oligarchy
unjust and democracy evil. Rulers should aim to make the "life of the multitude good
in accordance with the purpose of life which is heavenly happiness." They should also
create peace, conserve life, and preserve the state--a threefold responsibility. Here is a
complete program for a hierarchical society within a cosmic order. It combines the
Hellenic sense of purpose with Christian aims and asserts that, under God, power
resides in the community, embodied in the ruler but only for so long as he does right.
Hence the comment that "St. Thomas Aquinas was the first Whig"--a pioneer of the
theory of constitutional government. The society he envisages, however, is medieval,
static, hierarchical, conservative, and based on limited agriculture and even more
limited technology. Nonetheless, Thomism remains the most complete and lasting
political doctrine of the Catholic Church, since modified and adapted but not in
principle superseded.

Dante.

By the early 14th century the great European institutions, empire and papacy,
were breaking down through mutual conflict and the emergence of national realms.
But this conflict gave rise to the most complete political theory of universal and
secular empire formulated in the medieval West. Dante's De monarchia (c. 1313),
still in principle highly relevant, insists that only through universal peace can human
faculties come to their full compass. But only "temporal Monarchy" can achieve this:
"a unique princedom extending over all persons in time." The aim of civilization is to
actualize human potentialities, and to achieve that "fullness of life which comes from
the fulfillment of our being."

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 Monarchy, Dante argues, is necessary as a means to this end.
The imperial authority of the Holy Roman emperor, moreover, comes direct from God
and not through the pope. The empire is the direct heir of the Roman Empire, a
legitimate authority, or Christ would not have chosen to be born under it. In
subjecting the world to itself, the Roman Empire had contemplated the public good.
This high-flown argument, part of the political warfare between the
partisans of the emperor and pope that was then affecting Italy, drives to essentials:
that world peace can be secure only under a world authority. That Dante's argument
was impractical did not concern this medieval genius, who was writing more the
epitaph than the prospectus of the Holy Roman Empire; he was concerned, like St.
Thomas, to create a political philosophy with a clear-cut aim and a universal view.
Out of the grand but impractical
visions of the High Middle Ages in the 13th-century climax of Christian civilization
there emerged by early modern times the idea of a well-governed realm, its authority
derived from the community itself, with a program designed to ensure the solvency
and administrative efficiency of a secular state. In spite of the decline of the
civilization of antiquity in the West, the Greco-Roman sense of purpose, of the rule of
law, and of the responsibility of power survived in Christian form.

THE 16TH TO THE 18TH CENTURIES

Machiavelli.

In the thought of the Italian political philosopher Niccolň Machiavelli may be

seen a complete secularization of political philosophy. Machiavelli was an
experienced diplomat and administrator, and, since he stated flatly how the power
struggle was conducted in Renaissance Italy, he won a shocking reputation. He was
not, however, without idealism about the old Roman republic, and he admired the
independent spirit of the German and Swiss cities. This idealism made him all the
more disgusted with Italian politics, of which he makes a disillusioned and objective
analysis. Writing in retirement after political disgrace, Machiavelli states firmly that,
Since this is to be asserted in general of men, that they are ungrateful,
fickle, false, cowards, covetous, and as long as you succeed they are yours
entirely: they will offer you their blood, property, life, and children . . . when
the need is far distant; but when it approaches they turn against you.
And again,
since the desires of men are insatiable, nature prompting them to desire
all things and fortune permitting them to enjoy but few, there results a constant
discontent in their minds, and a loathing of what they possess.
This view of human nature, already expressed by Plato and St. Augustine, is
here unredeemed by Plato's doctrine of form and illusion or by St. Augustine's dogma
of salvation through grace. Machiavelli accepts the facts and advises the ruler to act
accordingly. The prince, he states, must combine the strength of the lion with the
cunning of the fox: he must always be vigilant, ruthless, and prompt, striking down or
neutralizing his adversaries without warning. And when he does an injury it must be
total. For "men ought to be either well treated or crushed, because they can avenge
themselves of lighter injuries, of more serious ones they cannot." Moreover,
"irresolute princes who follow a neutral path are generally ruined." He advises that it
is best to come down at the right moment on the winning side and that conquered
cities ought to be either governed directly bythe tyrant himself residing there or

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destroyed. Princes, furthermore, unlike private men, need not keep faith: since politics
reflects the law of the jungle, the state is a law unto itself, and normal moral rules do
not apply to it. Machiavelli had stated
with unblinking realism how, in fact, tyrants behave; and, far from criticizing their
conduct or distinguishing between the just prince who rules by law and the tyrant
whose laws are in his own breast, he considers that the successful ruler has to be
beyond morality since the safety of and expansion of the state are the supreme
objective. In this myopic view, the cosmic visions of Aquinas and Dante are
disregarded, and politics becomes a fight for survival. Within his terms of reference,
Machiavelli made a convincing case, although as an experienced diplomat he might
have realized that dependability in fact pays and that systematic deceit, treachery, and
violence usually bring about their own nemesis.

Hobbes.

The 17th-century English political philosopher Thomas Hobbes, who spent

his life as a tutor and companion to great noblemen, was a writer of genius with a
greater power of phrase than any other English political philosopher. He was not, as
he is sometimes misrepresented, a prophet of "bourgeois" individualism, advocating
free competition in a capitalistic free market. On the contrary, he was writing in a
preindustrial, if increasingly commercial, society and did not much admire wealth as
such but rather "honours." He was socially conservative and anxious to give a new
philosophical sanction to a hierarchical, if businesslike, commonwealth in which
family authority was most important.
Philosophically, Hobbes was influenced by
nominalist scholastic philosophy, which had discarded Thomist metaphysics and had
accepted a strict limitation of mind. He therefore based his conclusions on the
rudimentary mathematical physics and psychology of his day and aimed at practical
objectives--order and stability. He believed that the fundamental physical law of life
was motion and that the predominant human impulses were fear and, among those
above the poverty level, pride and vanity. Men, Hobbes argued, are strictly
conditioned and limited by these laws, and he tried to create a science of politics that
would reflect them. "The skill of making, and maintaining Common-wealths,"
therefore, "consisteth in certain Rules, as doth Arithmetique and Geometry; not (as
Tennis play) on Practise onely: which Rules, neither poor men have the leisure, nor
men that have had the leisure, have hitherto had the curiosity, or the method to find
out."
Hobbes ignores the classical and Thomist concepts of a transcendent
law of nature, itself reflecting divine law, and of a "chain of being" whereby the
universe is held harmoniously together and, following Descartes's practical method of
investigation, states plainly that power creates law, not law power. For law is law only
if it can be enforced, and the price of security is one supreme sovereign public power.
For, without it, such is the competitive nature of men, that once more than subsistence
has been achieved they are actuated by vanity and ambition, and there is a war of all
against all. The true law of nature is self-preservation, he argues, which can be
achieved only if the citizens make a compact among themselves to transfer their
individual power to the "leviathan" (ruler), who alone can preserve them in security.
Such a commonwealth has no intrinsic supernatural or moral sanction: it derives its
original authority from the people and can command loyalty only so long as it
succeeds in keeping the peace. He thus uses both the old concepts of natural law and

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contract, often invoked to justify resistance to authority, as a sanction for it.
Hobbes, like Machiavelli, starts
from an assumption of basic human folly, competitiveness, and depravity, and
contradicts Aristotle's assumption that man is by nature a "political animal." On the
contrary, he is naturally antisocial; and, even when men meet for business and profit,
only "a certain market-fellowship" is engendered. All society is only for gain or glory,
and the only true equality among men is their power to kill each other. Hobbes sees
and desires no other equality. Indeed, he specifically discouraged "men of low degree
from a saucy behaviour towards their betters." The Leviathan
horrified most of his contemporaries; Hobbes was accused of atheism and of
"maligning the Human Nature." But, if his remedies were tactically impractical, in
political philosophy he had gone very deep by providing the sovereign nation-state
with a pragmatic justification and directing it to utilitarian ends.
Spinoza.

The 17th-century Dutch philosopher Benedict de Spinoza also tried to make a

scientific political theory, but it was more humane and more modern. Hobbes assumes
a preindustrial and economically conservative society, but Spinoza, a Portuguese Jew
born in Amsterdam, assumes a more urban setting. Like Hobbes, he is Cartesian,
aiming at a scientific basis for political philosophy; but, whereas Hobbes was
dogmatic and authoritarian, Spinoza desired toleration and intellectual liberty, by
which alone human life achieves its highest quality. Spinoza, reacting against the
ideological wars of religion and skeptical of both metaphysics and religious dogma,
was a scientific humanist who justified political power solely by its usefulness. If state
power breaks down and can no longer protect him or if it turns against him, frustrates,
or ruins his life, then any man is justified in resisting it, since it no longer fulfills its
purpose. It has no intrinsic divine or metaphysical authority.
In Tractatus Theologico-
Politicus and the Tractatus Politicus Spinoza develops this theme. He intends, he
writes, "not to laugh at men or weep over them or hate them, but to understand them."
In contrast to St. Augustine, he glorifies life and holds that governments should not
try to "change men from rational beings into beasts or puppets, but enable them to
develop their minds and bodies in security and to employ their reason unshackled."
The more life is enjoyed, he declares, the more the individual participates in the
divine nature. God is immanent in the entire process of nature, in which all creatures
follow the laws of their own being to the limit of their powers. All are bound by their
own consciousness, and man creates his own values.
It seems that Spinoza thought good government approximated
to that of the free burgesses of Amsterdam, a city in which religious toleration and
relative political liberty had been realized. He is thus a pioneer of a scientific
humanist view of government and of the neutrality of the state in matters of belief.

Richard Hooker's adapted Thomism.

While out of the breakup of the medieval social order there emerged the
humanist but sceptical outlook of Machiavelli, then the scientific humanist principles
of Descartes, Hobbes, and Spinoza, from which the utilitarian and pragmatic outlook
of modern times derives, another influential and politically important strain of
political philosophy also emerged. During the Reformation and Counter-
Reformation, Protestant and Catholic dogmatists denounced each other and even

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attacked the authority of princes who, from interest or conviction, supported one side
or the other. Political assassination became endemic, for both Protestant and Catholic
divines declared that it was legitimate to kill an heretical ruler. Appeal was made to
rival religious authority as well as to conscience. Men would resist authority and
suffer execution rather than risk damnation, and in the resulting welter Hobbes and
Spinoza advocated a sovereign state as the remedy. But other political philosophers
salvaged the old Thomist concept of a divine cosmic order and of natural and human
laws sanctioning the state. They also put forth the classical and medieval idea of the
derivation of public power from the commonwealth as a whole and the responsibility
of princes to the law. When Hobbes wrote that might makes right, he outraged such
critics, who continued to assert that public power was responsible to God and the laws
and that it was right to resist a tyrant who declared that the laws were in his own
breast. This political theory was most influentially developed in England, where it
inspired the constitutionalism that would also predominate in the United States.
Richard Hooker, an Anglican divine who wrote Of the lawes of
ecclesiasticall politie (1593-1662), reconciled Thomist doctrines of transcendent and
natural law, binding on all men, with the authority of the Elizabethan Anglican
Church, which he defended against the Puritan appeal to conscience. Society, he
argued, is itself the fulfillment of natural law, of which human and positive law are
reflections, adapted to society. And public power is not something personal, for it
derives from the community under law. Thus,
The lawful power of making laws to command whole politic societies
of men belongeth so properly unto the same entire societies, that for any
prince . . . to exercise the same of himself . . . is no better than mere tyranny.
Such power can derive either directly from God or else from the people. The
prince is responsible to God and the community; he is not, like Hobbes's ruler, a law
unto himself. Law makes the king, not the king law.
Hooker, indeed, insisted that "the prince has a delegated
power, from the Parliament of England, together with the convocation (of clergy)
annexed thereto . . . whereupon the very essence of all government doth depend." This
is the power of the crown in parliament in a balanced constitution. Hence an idea of
harmonious government by consent. The Thomist medieval universal harmony had
been adapted to the nation-state.

Locke.

It was John Locke, politically the most influential English philosopher, who
further developed this doctrine. His Two Treatises of Government (1690) were
written to justify the Glorious Revolution of 1688-89, and his Letter Concerning
Toleration (1689) was written with a plain and easy urbanity, in contrast to the
baroque eloquence of Hobbes. Locke was a scholar, physician, and man of affairs,
well-experienced in politics and business. As a philosopher he accepted strict
limitations for mind, and his political philosophy is moderate and sensible, aimed at a
balance among executive, judicial, and legislative powers, although with a bias
toward the last. His first Treatise was devoted to confuting the Royalist
doctrine of patriarchal divine right by descent from Adam, an argument then taken
very seriously and reflecting the idea of government as an aspect of a divinely
ordained chain of being. If this order were broken, chaos would come about. The
argument was part of the contemporary conflict of the ancients and the moderns.
Locke tried to provide an answer by defining a limited purpose for political power,

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which purpose he considered to be "a right of making laws with penalties of death,
and consequently all less penalties, for the regulating and preserving of property, and
of employing the force of the community in execution of such laws, and in the
defense of the commonwealth from foreign injury, and all this only for the public
good." The authority of government derives from a contract between the rulers and
the people, and the contract binds both parties. It is thus a limited power, proceeding
according to established laws and "directed to no other end but the peace, safety, and
public good of the people."
Whatever its form, government, to be legitimate,
must govern by "declared and reasoned laws," and, since every man has a "property"
in his own person and has "mixed his labour" with what he owns, government has no
right to take it from him without his consent. It was the threat of attack on the laws,
property, and the Protestant religion that had roused resistance to James II. Locke is
expressing the concerns and interests of the landed and moneyed men by whose
consent James's successor, William III, came to the throne, and his commonwealth is
strictly conservative, limiting the franchise and the preponderant power to the
propertied classes. Locke was thus no democrat in the modern sense and was much
concerned to make the poor work harder. Like Hooker, he assumes a conservative
social hierarchy with a relatively weak executive power and defends the propertied
classes both against a ruler by divine right and against radicals. In advocating
toleration in religion he was more liberal: freedom of conscience, like property, he
argued, is a natural right of all men. Within the possibilities of the time, Locke thus
advocated a constitutional mixed government, limited by parliamentary control of the
armed forces and of supply. Designed mainly to protect the rights of property, it was
deprived of the right of arbitrary taxation or imprisonment without trial and was in
theory responsible to all the people through the politically conscious minority who
were thought to represent them.
Though he was socially conservative, Locke's writings
are very important in the rise of liberal political philosophy. He vindicates the
responsibility of government to the governed, the rule of law through impartial
judges, and the toleration of religious and speculative opinion. He is an enemy of the
totalitarian state, drawing on medieval arguments and deploying them in practical,
modern terms.

Burke.

The Irishman Edmund Burke, while elaborating Whig constitutional

doctrine expressed with such common sense by Locke, wrote with more emotion and
took more account of time and tradition. While reiterating that government is
responsible to the governed and distinguishing between a political society and a mere
mob, he thought that governments were trustees for previous generations and for
posterity. He made the predominant political philosophy of the 18th-century
establishment appear more attractive and moral, but he wrote no great single work of
political philosophy, expressing himself instead in numerous pamphlets and speeches.
In his early Vindication of Natural Society
Burke is critical of the sufferings imposed by government, but his " Thoughts on the
Cause of the Present Discontents" defines and defends the principles of the Whig
establishment. He invoked a transcendent morality to sanction a constitutional
commonwealth, but he detested abstract political theories in whose name men are
likely to vivisect society. He set great store by ordered liberty and denounced the

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arbitrary power of the Jacobins who had captured the French Revolution. In his
Reflections on the Revolution in France (1790) and An Appeal from the New to the
Old Whigs (1791), he discerned in the doctrine of sovereignty of the people, in whose
name the revolutionaries were destroying the old order, another and worse form of
arbitrary power. No one generation has the right to destroy the agreed and inherited
fabric of society, and "Neither the few nor the many have the right to govern by their
will." A country is not a mere physical locality, he argued, but a community in time
into which men are born, and only within the existing constitution and by the consent
of its representatives can changes legitimately be made. Once the frame of society is
smashed and its law violated, the people become a "mere multitude told by the head,"
at the mercy of any dictator who can seize power. He was realistic in predicting the
consequences of violent revolution, which usually ends up in some kind of
dictatorship. Burke, in sophisticated accents, spoke for the ancient and worldwide rule
of custom and conservatism and supplied a needed romanticism to the calculating
good sense of Locke.
Vico.

The political philosophies hitherto surveyed contained little idea of progress.

In antiquity the idea of cyclic recurrence predominated, and even 18th-century
Christians believed that the world had been created in 4004 BC and would end in the
Second Coming of Christ and a judgment. The 14th-century Arab philosopher of
history Ibn Khaldun of Tunis, in the Muqaddimah to his Kitab al-'ibar, had pioneered
a vast sociological view of the historical process; but in western Europe it was a
neglected Neapolitan philosopher, Giambattista Vico (1668-1744), who first
interpreted the past in terms of the changing consciousness of mankind. His Scienza
nuova (1725; revised edition 1744) interpreted history as an organic process involving
language, literature, and religion and attempted to reveal the mentality or ethos of
earlier ages: the age of the gods, the heroic age, and the human age, its climax and
decadence. These ages recur, and each is distinguished by mythology, heroic poetry,
and rational speculation respectively. In contrast to the legalistic, contractual, and
static political philosophies then prevalent, Vico had discerned new horizons.

Montesquieu.

This sort of vision was developed and elegantly popularized by the

cosmopolitan French savant Montesquieu, whose work The Spirit of Laws (Eng.
trans. 1750) won immense influence. It was an ambitious treatise on human
institutions and a pioneer work of anthropology and sociology. Believing in an
ordered universe--for "how could blind fate have produced intelligent beings?"--
Montesquieu examined the varieties of natural law, varying customs, laws, and
civilizations in different environments. He made the pedestrian good sense of Locke
seem provincial, although he admired him and the British constitution. Unfortunately,
he overemphasized the separation of executive, judicial, and legislative powers,
considerable in Locke's day but by his own time tending to be concentrated in the
sovereignty of Parliament. This doctrine much influenced the founders of the United
States and the early French Revolutionaries.

Rousseau.

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 The revolutionary romanticism of the Swiss-French philosopher Jean-Jacques
Rousseau may be interpreted in part as a reaction to the analytic rationalism of the
Enlightenment. He was trying to escape the aridity of a purely empirical and
utilitarian outlook and attempting to create a substitute for revealed religion.
Rousseau's Émile (1762) and Du contrat social (1762) proved revolutionary
documents, and his posthumous Considérations sur le gouvernement de Pologne
("Considerations on the Government of Poland") contains desultory but often valuable
reflections on specific problems. There had been radical political slogans coined in
medieval peasant revolts and in the 17th century, as in the Putney debates (1647) in
the Cromwellian army, when a Puritan officer declared that "the poorest hee that is in
England hath a life to live as the greatest hee," but the inspiration of these movements
had been religion. Now Rousseau proclaimed a secular egalitarianism and a romantic
cult of the common man. His famous sentence, "man is born free, but he is
everywhere in chains," called into question the traditional social hierarchy: hitherto,
political philosophers had thought in terms of elites, but now the mass of the people
had found a champion and were becoming politically conscious
Rousseau was a romantic,
given to weeping under the willows on Lake Geneva, and the Social Contract and
Discourses are hypnotically readable, flaming protests by one who found the hard
rationality of the 18th century too exacting. But man is not, as Rousseau claims, born
free. Man is born into society, which imposes restraints on him. Casting about to
reconcile his artificial antithesis between man's purported natural state of freedom and
his condition in society, Rousseau utilizes the old theories of contract and transforms
them into the concept of the "general will." This general will, a moral will that aims
at the common good and in which all participate directly, reconciles the individual
and the community by representing the will of the community as deriving from the
will of moral individuals, so that to obey the laws of such a community is in a sense to
follow one's own will, assuming that one is a moral individual. Similar ideas to
that of the general will became accepted as a basis for both the social-democratic
welfare state and for totalitarian dictatorships. And, since the idea was misapplied
from small village or civic communities to great sovereign nation-states, Rousseau
was also a prophet of a nationalism that he never advocated. Rousseau himself wanted
a federal Europe. He never wrote the proposed sequel to the Du contrat social in
which he meant to deal with international politics, but he declared that existing
governments lived in a state of nature, that their obsession with conquest was
imbecilic, and that "if we could realize a European republic for one day, it would be
enough to make it last for ever" (Political Writings I, pp. 365-388). But, with a flash
of realism, he thinks the project impracticable, owing to the folly of men.
The incursion of this
revolutionary romantic into political philosophy changed the climate of political
opinion, for it coincided with the breakdown of the old dynastic order and the
emergence first of the middle classes and then of the masses to political consciousness
and power. That the
concept of general will was vague only increased its adaptability and prestige: it
would both make constitutionalism more liberal and dynamic and give demagogues
and dictators the excuse for "forcing people to be free" (that is, forcing people to
follow the general will, as interpreted by the ruling forces). Rousseau could inspire
liberals, such as the 19th-century English philosopher T.H. Green, to a creative view
of a state helping people to make the best of their potential through a variety of free

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institutions. It could also play into the hands of demagogues claiming to represent the
general will and bent on molding society according to their own abstractions.
THE 19TH CENTURY
Utilitarianism.

A major force in the political and social thought of the 19th century was
Utilitarianism, the doctrine that the actions of governments should be judged simply
by the extent to which they promoted the "greatest happiness of the greatest number."
The founder of the Utilitarian school was Jeremy Bentham, an eccentric Englishman
trained in the law.
Bentham judged all laws and institutions by their utility thus defined.
"The Fabric of Felicity," he wrote, "must be reared by the hands of reason and Law."
Bentham's Fragment, on Government (1776)
and Introduction to the Principles of Morals and Legislation (1789) elaborated a
Utilitarian political philosophy. Bentham was an atheist and an exponent of the new
laissez-faire economics of Adam Smith and David Ricardo, but he inspired the spate
of legislation that, after the Reform Bill of 1832, had tackled the worst consequences
of 18th-century inefficiency and of the Industrial Revolution. His influence,
moreover, spread widely abroad. At first a simple reformer of law, Bentham attacked
notions of contract and natural law as superfluous, "The indestructible prerogatives of
mankind," he wrote, "have no need to be supported upon the sandy foundation of a
fiction." The justification of government is pragmatic, its aim improvement and to
release the free choice of individuals and the play of market forces that will create
prosperity. Bentham thought men far more reasonable and calculating than they are
and brushed aside all the Christian and humanist ideas rationalizing instinctive loyalty
and awe. He thought society could advance by calculation of pleasure and pain, and
his Introduction even tries to work out "the value of a lot of pleasure and pain, how
now to be measured." He compared the relative gratifications of health, wealth,
power, friendship, and benevolence, as well as those of "irascible appetite" and
"antipathy." He also thought of punishment purely as a deterrent, not as retribution,
and graded offenses on the harm they did to happiness, not on how much they
offended God or tradition.
If Bentham's psychology was naďve, that of his
disciple James Mill was philistine. Mill postulated an economic man whose
decisions, if freely taken, would always be in his own interest, and he believed that
universal suffrage, along with Utilitarian legislation by a sovereign parliament, would
produce the kind of happiness and well-being that Bentham desired. In his Essay on
Government (1828) Mill thus shows a doctrinaire faith in a literate electorate as the
means to good government and in laissez-faire economics as a means to social
harmony. This Utilitarian tradition was humanized by James Mill's son, John Stuart
Mill, one of the most influential of mid-Victorian liberals.
Whereas James Mill had
been entirely pragmatic, his son tried to enhance more sophisticated values. He
thought that civilization depended on a tiny minority of creative minds and on the free
play of speculative intelligence. He detested conventional public opinion and feared
that complete democracy, far from emancipating opinion, would make it more
restrictive. Amid the dogmatic and strident voices of mid-19th-century nationalists,
utopians, and revolutionaries, the quiet, if sometimes priggish, voice of mid-Victorian
liberalism proved extremely influential in the ruling circles of Victorian England.
Accepting democracy as inevitable, J.S. Mill expressed the still optimistic and

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progressive views of an intellectual elite. Without complete liberty of opinion, he
insisted, civilizations ossify. The quality of progress results not merely from the blind
forces of economic competition but from the free play of mind. The worth of the state
in the long run is only the worth of the individuals composing it, and without men of
genius society would become a "stagnant pool." This militant humanist, unlike his
father, was aware of the dangers of even benevolent bureaucratic power and declared
that a state that "dwarfs its men" is culturally insignificant.
Mill also advocated the legal and social
emancipation of women, holding that ability was wasted by mid-Victorian
conventions. He believed that the masses could be educated into accepting the values
of liberal civilization, but he defended private property and was as wary of rapid
extensions of the franchise as of bureaucratic power.

Tocqueville.

Mill's friend Alexis de Tocqueville, whose De la démocratie en Amérique (

Democracy in America) appeared in 1835-40, was a French civil servant also
concerned with maintaining the standards and creativeness of civilization in face of
the rising tide of mass democracy. Since the United States was then the only large-
scale democracy extant, Tocqueville decided to go there, and as a result of his visit
wrote a classic account of early 19th-century American civilization. "We cannot," he
wrote, "prevent the conditions of men from becoming equal, but it depends upon
ourselves whether the principle of equality will lead them to servitude or freedom, to
knowledge or barbarism, to prosperity or wretchedness." He feared the possible abuse
of power by centralized government, unrestrained by the power of the old privileged
classes, and thought it essential to "educate democracy" so that, although it would
never have the "wild virtues" of the old regimes, it would have its own dignity, good
sense, and even benevolence. Tocqueville greatly admired American representative
institutions and made a penetrating analysis of the new power of the press. He
realized, as few people then did, that the United States and Russia would become
world powers, and he contrasted the freedom of the one and the despotism of the
other. He also foresaw that under democracy education would be respected more as a
ladder to success than for its intrinsic content and might thus become mediocre. He
was alive to the dangers of uniform mediocrity but believed, like Mill, that democracy
could be permeated by creative ideas.

T.H. Green.

This kind of humanism was given a more elaborate philosophical content by

the English philosopher T.H. Green, whose Lectures on the Principles of Political
Obligation (1895; reprinted from Philosophical Works, vol. 2, 1885) greatly
influenced the Liberals in the British governments of the period 1906-15. Green, like
J.S. Mill and Tocqueville, wished to extend the minority culture to the people and
even to use state power to "hinder hindrances to the good life." He had absorbed from
Aristotle, Spinoza, Rousseau, and Hegel an organic theory of the state. The latter, by
promoting the free play of spontaneous institutions, ought to help individuals both to
"secure the common good of society [and] enable them to make the best of
themselves." While hostile to the abuse of landed property,
Green was not a Socialist. He accepted the idea that property should be private and

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unequally distributed and thought the operation of the free market the best way to
benefit the whole society; for free trade would, he thought, diminish the inequalities
of wealth in a common prosperity. But Green would have extended the power of the
state over education, health, housing and town planning, and the relief of
unemployment--a new departure in Liberal thought. These recommendations are
embedded in the most elaborate and close-knit intellectual construction made by any
modern British political philosopher, and they laid the foundation of the British
welfare state.

Liberal nationalism.

Whereas Green shirked the extension of liberal and constitutional principles

into international affairs, the Italian patriot and revolutionary prophet Giuseppe
Mazzini made it his vision and became the most influential prophet of liberal
nationalism. In his The Duties of Man and Essays he envisaged a harmony of free
peoples--a "sisterhood of nations," in which the rule of military empires would be
thrown off, the destruction of clerical and feudal privileges accomplished, and in
which the emancipated peoples would be regenerated by means of education and
universal suffrage. This vision inspired the more idealistic aspects of the Italian
Risorgimento (national revival or resurrection) and of nationalistic revolts in Europe
and beyond. Though, in fact, fervid nationalism often proved destructive, Mazzini
advocated a united Europe of free peoples, in which national singularities would be
transcended in a pan-European harmony. This sort of liberal democratic idealism was
catching, and even if it frequently inspired Machiavellian policies, it also inspired
President Woodrow Wilson of the United States, who, had he not been thwarted by
domestic opposition, might well have made a Mazzinian-type League of Nations a
success. Moreover, the Europe of the Common Market owes much to the apparently
impractical liberal idealism of Mazzini.

American constitutionalism.

The United States was founded by men deeply influenced by

republicanism, by Locke, and by the optimism of the French Enlightenment. George
Washington, John Adams, and Thomas Jefferson all concurred that laws, rather than
men, should be the final sanction and that government should be responsible to the
governed. But the influence of Locke and the Enlightenment was not entirely happy.
John Adams, who followed Washington as president, prescribed a constitution with a
balance of executive and legislative power checked by an independent judiciary. The
federal constitution, moreover, could be amended only by a unanimous vote of the
states. Anxious to safeguard state liberties and the rights of property, the founding
fathers gave the federal government insufficient revenues and coercive powers, as a
result of which the constitution was stigmatized as being "no more than a Treaty of
Alliance." Yet the federal union was preserved. The civil power controlled the
military, and there was religious toleration and freedom of the press and of economic
enterprise. Most significantly, the concept of natural rights had found expression in
the Declaration of Independence and was to influence markedly political and legal
developments in the ensuing decades, as well as inspire the French Declaration of the
Rights of Man.

Anarchism and utopianism.

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 While a liberal political philosophy within a framework of capitalistic free
trade and constitutional self-government dominated the greatest Western powers,
mounting criticism developed against centralized government itself. Radical utopian
and anarchist views, previously expounded mainly by religious sects, became
secularized in such works as William Godwin's Political Justice (1793), Robert
Owen's New View of Society (1813), and Pierre-Joseph Proudhon's voluminous
and anticlerical writings. The English philosopher William
Godwin, an extreme individualist, shared Bentham's confidence in the reasonableness
of mankind. He denounced the wars accepted by most political philosophers and all
centralized coercive states. The tyranny of demagogues and of "multitudes drunk with
power" he regarded as being as bad as that of kings and oligarchs. The remedy, he
thought, was not violent revolution, which produces tyranny, but education and
freedom, including sexual freedom. His was a program of high-minded, atheistic
anarchy. The English Socialist
Robert Owen, a cotton spinner who had made a fortune, also insisted that bad
institutions, not original sin or intrinsic folly, caused the evils of society, and he
sought to remedy them by changing the economic and educational system. He thus
devised a scheme of model cooperative communities that would increase production,
permit humane education, and release the naturally benevolent qualities of mankind.

The French moralist and advocate of social reform Pierre-Joseph

Proudhon attacked the "tentacular" nation-state and aimed at a classless society in
which major capitalism would be abolished. Self-governing producers, no longer
slaves of bureaucrats and capitalists, would permit the realization of an intrinsic
human dignity, and federation would replace the accepted condition of war between
sovereign states. Proudhon tried to transform society by rousing the mass of the
people to cooperative humanitarian consciousness.

Saint-Simon and Comte.

Another revolt against the prevalent establishment, national and international,

was made by the French social philosopher Henri de Saint-Simon. Saint-Simon
wanted to develop the Industrial Revolution so as to ameliorate the condition of the
poorest class. This would be achieved not through political revolution, but through a
government of bankers and administrators who would supersede kings, aristocrats,
and politicians. If France were suddenly deprived of three thousand leading scientists,
engineers, bankers, painters, poets, and writers, he argued, the result would be
catastrophic; but if all the courtiers and bishops and 10,000 landowners vanished, the
loss, though deplorable, would be much less severe. Saint-Simon also demanded a
united Europe, superseding the warring nation-states, with a European parliament and
a joint development of industry and communication. He also invented a synthetic
religion appropriate to a scientific phase of history, with a cult of Newton and the
great men of science. Saint-Simon's disciple Auguste Comte
went further. His Course of Positive Philosophy (1830-42) and System of Positive
Polity (1851-54) elaborated a "religion of humanity," with ritual, calendar, and a
priesthood of scientists, and secular saints, including Julius Caesar, Dante, and Joan of
Arc. Society would be ruled by bankers and technocrats and Europe united into a
Western republic. This doctrine, backed by pioneering sociology, won much influence
among intellectuals. Comte, like Saint-Simon, tackled the essential questions: how to

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deploy the power of modern technology for the benefit of all mankind; how to avoid
wars between sovereign states; and how to fill the void left by the waning of Christian
beliefs.

Hegel.

Whereas the utopian reformers had discarded metaphysical arguments, the

German philosopher G.W.F. Hegel claimed to apprehend the totality of the cosmos by
speculative cognition. Like Vico, he saw the past in terms of changing consciousness,
but he viewed the historical process as one of "becoming" rather than as one of eternal
recurrence. Hegel had no adequate historical data for his intuitions, since the whole of
world history was even less known then than it is today, but his novel sweep and
range of theory proved an intoxicating substitute for religion. He divided world
history into four epochs: the patriarchal Eastern empire, the brilliant Greek boyhood,
the severe manhood of Rome, and the Germanic phase after the Reformation. The
"Absolute," like a conductor, summons each people to their finest hour, and neither
individuals nor states have any rights against them during their historically
determined period of supremacy. Many felt some sense of anticlimax, however, when
he claimed that the Prussian state embodied the hitherto highest self-realization of the
"Absolute" Not since St. Augustine had so compelling a drama been adumbrated.
Hegel's drama, moreover, culminates in this world, for "the state is the divine idea as
it exists on earth."

Marx and Engels.

Hegel was a conservative, but his influence on the revolutionaries Karl Marx
and his collaborator Friedrich Engels was profound. They inherited the Hegelian
claim to understand the "totality" of history and life as it progressed through a
dialectic of thesis, antithesis, and synthesis. But, whereas Hegel envisaged a conflict
of nation-states, Marx and Engels thought that the dynamism of history was generated
by inevitable class conflict economically determined. This was an idea even more
dynamic than Hegel's and more relevant to the social upheavals that were a
consequence of the Industrial Revolution. Marx was a formidable prophet whose
writings lead up to an apocalypse and redemption. A deeply learned humanist, his
ideal was the fullest development of the human personality. But, whereas Plato was
concerned with an elite, Marx cared passionately for the elevation of whole peoples.
The Marxist credo was all
the more effective as it expressed with eloquent ferocity the grievances of the poor,
while prophesying retribution and a happy ending. For the state, once captured by the
class-conscious vanguard of the proletariat, would take over the means of production
from the capitalists, and a brief "dictatorship of the proletariat" would establish a truly
communist society. The state would then wither away and man at last become "fully
human" in a classless society. The powerful
slogans of Marx and Engels were a natural result of the unbridled capitalism of
laissez-faire, but politically they were naďve. In classical, medieval, and humanistic
political philosophy the essential problem is the control of power, and to imagine that
a dictatorship, once established, will wither away is utopian. As even Marx's fellow
revolutionary the Russian anarchist M.A. Bakunin observed,
The revolutionary dictatorship of the doctrinaires who put science
before life would differ from the established state only in external trappings.

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The substance of both are a tyranny of the minority over the majority--in the
name of the many and the supreme wisdom of the few.
The revolutionaries would vivisect society in the name of dogmas and
"destroy the present order, only to erect their own rigid dictatorship among its ruins."

Political philosophy in the 20th century

Nineteenth-century European civilization had been the first to dominate and
pervade the whole world and to create a new self-sustaining productivity in which all
eventually might share. But, as Saint-Simon had pointed out, this civilization had a
fatal flaw. The rule of law, accepted within the politically advanced states, had never
been achieved among them. Heavily armed nations and empires remained in a
Hobbesian "posture of war," and classical and medieval ideals of world order had
long been discarded. Within states, also, laissez-faire capitalism had exacerbated class
conflicts, while the decline of religious belief had undermined traditional solidarity.
And in 1914, when a general European war broke out, the peoples, contrary to the
hopes of cosmopolitan revolutionaries, rallied behind their national governments.
When the victorious powers failed to promote world order through the League of
Nations, a second global conflict followed, during which were developed weapons so
destructive as to threaten life everywhere.
In the aftermath of these catastrophes and the
worldwide revulsion they occasioned, not least against the European colonial powers,
three mainstreams of mid-20th-century political philosophy may be discerned.
In liberal-constitutional states, with
modified, managerial capitalism and various degrees of public welfare, a political
pragmatism has emerged, still maintaining the Aristotelian distinction between the
rule of law and government by consent, on the one hand, and tyranny on the other.
Second, there has been a reaffirmation of religious or quasi-religious values appealing
to conscience and the inner man, expressed persuasively in Existentialist writings.
Third, revolutionary ideas have also developed, most of them along Marxist lines.
Other revolutionary doctrines appeal to anarchist traditions and are elaborated with
neo-Marxist and neo-Freudian insights. Within these categories many shades of
opinion are expressed, and only a sampling of representative views is presented here.

POLITICAL PRAGMATISM

The first, pragmatist approach probably has been most powerfully asserted
in the United States and Great Britain. The American writer Lewis Mumford, for
example, has advocated a militant humanism, defending people against the alienations
of megalopolitan life and attacking mechanization and materialism. Like the Greek
philosophers and like Tocqueville, whom he admires, Mumford declares, "In the end,
all our contrivances have but one object; the continued growth of human personalities
and the cultivation of the best life possible." The American philosopher and
educationist John Dewey, on the other hand, sought to counteract the dehumanization
of industrial mass society by a freer form of education, liberating the personality.
Both these writers criticize the existing structure of society and its modified
capitalism, but try to work within it. Another humanist, the English philosopher
Bertrand Russell, was more radical. Russell carried into political philosophy an
aristocratic individualism, campaigning for toleration, sexual freedom, compassion,
and common sense. He broadcast elite values to a mass society and attacked

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materialism, crass bureaucracy, and war. He twice went to prison in pacifist protest
and was obsessed with the universal menace of nuclear weapons. He denounced
warlike political theories: "Remember your humanity," he said, "and forget the rest."
On political tactics often inept, Russell won wide influence as a man of principle,
concerned to adapt archaic institutions to the changed environment of mankind.
The Austrian-born
British philosopher Sir Karl Popper has demonstrated the pretensions of the 19th-
century determinist philosophies such as those of Hegel and Marx, while an English
historian and philosopher, Sir Isaiah Berlin, has ridiculed the idea of a supposedly
objective march of histoy. Berlin also rejects the Marxist belief that all values are
conditioned by the place men occupy on the "moving stair of time." Marx, he points
out, was as romantic as Hegel in envisaging a "world which moves from explosion to
explosion in order to fulfil the great cosmic design." Moral values, he insists, are not
just a "subjective gloss unworthy of consideration on the great hard edifice of
historical construction." No single formula can be found, Berlin argues, whereby the
various objectives of men can be harmoniously realized. There are many human
goals, which may well be in conflict with one another.
This empirical, pluralist, and liberal political philosophy
has much in common with the approach of the Frenchman Émile Durkheim and the
Englishman Graham Wallas, both founding fathers of modern sociology. Statesmen
and political philosophers, they contend, should not play the part of prophets but
rather confine themselves to investigating social patterns and the ideas that are part of
them. Ways might thus be found of promoting the survival and vitality of a given
society in its particular setting.
Graham Wallas was concerned to adapt constitutional
societies by consent. He wanted to nationalize many essential means of production,
including transport and communications, and through increased taxation strengthen
social democracy by greater economic and social equality. He was not a revolutionary
but a reformer, who understood the precariousness of civilization and the dangers of
nationalism, which could only bring, he prophesied, centuries of warfare and
regression. He advocated a worldwide and constitutionalist scientific humanism,
inspired by the idea of the solidarity of the whole species, for "the master task of
civilized mankind is to promote the conditions leading to the good life."
Other political
sociologists who accepted the established order did not expect to improve it. The
Italian Vilfredo Pareto, and Gaetano Mosca, a Sicilian-born lawyer, set themselves
not to state what they wanted but to record what occurs in society. Pareto's Mind and
Society (1916) is an elaborate, quasi-mathematical classification of nonlogical
political myths. Its form is daunting, but its insights are penetrating, especially a
hilarious dissection of Rousseau's General Will, of which, Pareto concludes, "the
intrinsic logico-experimental value . . . is zero." Ranging sardonically over history,
Pareto insists that elites will always manipulate society, power merely shifting from
one set of rulers to another.
Mosca, in The Ruling Class (1939), analyzed how
political myths are exploited. He also concluded that elites everywhere are bound to
rule and that the least bad government occurs when abuse of power is checked by
legal means; that is, by the rule of law. Mosca admired the liberal constitutionalism of
the 19th century, although he was aware of its precariousness and limitations. He
argued that there is no total explanation of history, which has always been the
unpredictable outcome of competing and interacting interests. One thing is certain,

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nevertheless: in various forms there will always be a struggle for predominance.
Mosca's views, more clearly set out than Pareto's, have a salutary realism.
The
American philosopher and critic James Burnham also analyzed shifts of power. In
The Managerial Revolution (1941) he propounded a theory of bureaucratic revolution:
the rulers of the new society, the class with power and privilege, will be the
bureaucratic managers of "super states." In The Machiavellians, Defenders of
Freedom (1943), he reinterprets Machiavelli and cites Mosca as a modern
Machiavellian. Following Pareto's idea of the "circulation of elites," he asserts that,
when a ruling class becomes inadequate, frivolous, or bored, loses confidence in itself
and its myths, and becomes irresolute in deploying necessary force, new elites are
bound to take over--as in the managerial revolution of the 20th century.

RELIGIOUS AND EXISTENTIALIST APPROACHES

In the second religious and quasi-religious group of political philosophies, the

Catholic hierarchy has reiterated its ancient neo-Thomist doctrine of original sin and
redemption. Pope Leo XIII, in the encyclicals Inscrutabili Dei Consilio (1878),
Immortale Dei (1885), and Rerum Novarum (1891), dismissed all anthropocentric
political philosophies as new versions of old heresies. The world, "through an
insatiable craving for things perishable," was "rushing wildly upon the straight road to
destruction." Society is intelligible only in the light of the Christian revelation and a
future life:
exclude the idea of futurity and forthwith the very notion of what is
good and right would perish, nay, the whole scheme of the universe would
become a dark and unfathomable mystery.
Such is the human condition that visionary innovations are fruitless, and
"venomous" teachings can only bring "death-bearing fruit." Society, as St. Augustine
had declared, if organized without God, can only be a present hell. Hierarchy,
authority, and censorship can alone "control the excesses of the unbridled intellect,
which unfailingly end in the oppression of the untutored multitude." Property is
essential to the family, on which the social order depends, and inequality is inherent in
all human societies. Only a harmonious Christian commonwealth can assuage the
consequences of sin, and within that social order the state should therefore encourage
Christian trade unions and promote the welfare of the poor. Thus, with these views the
papacy, maintaining its monopoly of revelation, tried to come to terms with the
demands of industrial civilization. During the rise of 19th-century
nationalism and of Communist, Fascist, and Nazi dictatorships, and in face of the
increasing dominance of governments and large-scale industry in all mass societies,
the importance of individual responsibility with regard to moral issues was
emphasized by a divergent group of thinkers who have come to be described as
Existentialists. Sřren Kierkegaard (died 1855), a Danish philosopher, declared that
"truth is subjectivity" and that only by means of inward revelation can man know
God. Jean-Paul Sartre, a brilliant French Existentialist, tried to come to terms with
dialectical Materialism. His Existentialism and Humanism (1948) comprises an
affirmation of human dignity. "If," he writes, "I have excluded God the Father, there
must be someone to invent values." Man, who has abandoned God, "must liberate
himself by some practical commitment," for only then can he become fully human.
Sartre's elaborate L'Etre et le néant (1943; Eng. trans., Being and Nothingness, 1956)
is at once Cartesian and laborious, complete with a "key" to its special and pedantic

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terms. It investigates the loneliness of the human condition, attitudes to others, love,
masochism, indifference, desire, and hate. This intense introspection is even more
vividly expressed in his fiction and drama. The Algerian-born Albert Camus in The
Myth of Sisyphus (1942) and The Rebel (1951) also agonizes brilliantly over the
current human condition, and in Man in Revolt he discards hope of pragmatic
improvement.

REVOLUTIONARY DOCTRINES

The third stream of contemporary political philosophy is Marxist-Leninist

totalitarian and neo-Marxist anarchist. Many of Marx's original insights into the
socio-economic process and its effect on ideas are now generally accepted. His
prophecies, on the other hand, have not been fulfilled. The proletarian revolution, for
example, came not in an economically advanced country but in one of the most
backward; and the state, far from withering away or being diminished by inexorable
economic trends, has in fact become more powerful both in Communist and in social-
democratic countries. Those who have accepted the total Marxist revelation as
superseding all else have had thus to adapt and revise it. Hence, much tortuous and
artificial debate has ensued. All orthodox Marxists accept the Hegelian position that
one can get beyond empirical knowledge and perceive the historically revealed
installments of a total explanation. They also start from Marx's 19th-century belief
that economically determined conflicts among feudal, bourgeois, and proletarian
classes are the dynamic of history and that the rule of law is not a safeguard for the
whole society against arbitrary power but merely the expression of class interest.

Lenin.
The first and by far the most significant interpretation of Marx's doctrine as
realized in the Soviet Union was made by Lenin and developed by Stalin and is
entirely authoritarian. According to Marx and Engels, the revolution could occur only
after the bourgeois phase of production had "contradicted" the tsarist order, but Lenin
determined to take advantage of the opportunities provided by World War I and settle
accounts directly with the "accursed heritage of serfdom, of Asiatic barbarism . . . an
insult to mankind," and in 1917 he engineered a coup that secured the support of the
peasantry and the industrial workers. He also adopted the revolutionary theorist Leon
Trotsky's idea of a "permanent revolution" from above by a small revolutionary elite.
Already in What Is To Be Done? (1902), Lenin had
argued that an educated elite must direct the proletarian revolution, and when he came
to power he dissolved the constituent assembly and ruled through a "revolutionary
and democratic dictatorship supported by the state power of the armed workers." In
asserting the need for an elite of professional revolutionaries to seize power, Lenin
reverted to Marx's program in The Communist Manifesto rather than conforming to
the fated pattern of economic development worked out in Das Kapital. In 1921 he
further adapted theory to the times. His new economic policy sanctioned the
development of a class of prosperous "kulak" peasantry to keep the economy viable.
For Lenin always thought in terms of world revolution; and, in spite of the failure of
the Marxists in central Europe and the defeat of the Red armies in Poland, he died in
the expectation of a global sequel. Thus, in Imperialism, the Highest Stage of
Capitalism (1917), he had extended the class war into an inevitable conflict between

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European imperialism and the colonial peoples involved. He had been influenced by
the English historian J.A. Hobson's Imperialism, a Study (1902), which alleged that
decadent capitalism was bound to turn from glutted markets at home to exploit the toil
of "reluctant and unassimilated peoples." But, as observed by classical, medieval, and
modern constitutionalist political philosophers, authoritarian regimes suffer the
tensions of all autocracies. Marx himself might have thought that such planned
autocracies had made the worst of his revelation.

Other Marxist approaches.

Many Marxist revisionists tend toward anarchism, stressing the Hegelian and
utopian elements of his theory. The Hungarian György Lukács, for example, and the
German Herbert Marcuse, who fled from the Nazis to the United States, have won
some following among those in revolt against both authoritarian "peoples'
democracies" and the diffused capitalism and meritocracy of the managerial welfare
state. Lukács' Geschichte und Klassenbewusstsein (1923; Eng. trans., History and
Class Consciousness, 1971), a neo-Hegelian work, claims that only the intuition of
the proletariat can properly apprehend the totality of history. But world revolution is
contingent, not inevitable, and Marxism is an instrument, not a prediction. Lukács
renounced this heresy after residence in the Soviet Union under Stalin, but he
maintained influence through literary and dramatic criticism. After Khrushchev's
denunciation of Stalin, Lukács advocated peaceful coexistence and intellectual rather
than political subversion. In The Meaning of Contemporary Realism (trans. 1963), he
again relates Marx to Hegel and even to Aristotle, against the Stalinist claim that
Marx made a radically new departure. Lukács' neo-Marxist literary criticism can be
tendentious, but his neo- Hegelian insights, strikingly expressed, have appealed to
those anxious to salvage the more humane aspects of Marxism and to promote
revolution, even against a modified capitalism and social democracy, by intellectual
rather than by political means. Marcuse also
reached back to the more utopian Marx. Now that most of the proletariat has been
absorbed into a conformist managerial capitalism or has been regimented into
bureaucratic peoples' democracies, freedom, argues Marcuse, is in retreat. In Western
affluent societies most employers and workers are equally philistine, dominated by
the commercialized mass media, or "cogs in a culture machine." The former Soviet
Union had reverted to an even more philistine monolithic repression, distorting art
and literature. This enslavement of man by his own industrial productivity had been
clinched by the colossal power of governments, which rendered the old brief and brisk
class warfare a romantic, impracticable idea. Marcuse attacked all establishments and
transferred the redeeming mission of the proletariat to a fringe of alienated
minorities--radical students and the exponents of the "hippie" way of life--as well as
to Viet Cong guerrillas and Black Power militants. Such groups, he declared, could
apparently form liberating elites and destroy the managerial society. Thus reappeared
the old Marxist-Hebraic pattern of redemption through struggle by a chosen people.

The Italian Communist Antonio Gramsci deployed a vivid rhetorical

talent in attacking existing society. Like Marcuse, Gramsci was alarmed that the
proletariat was being assimilated by the capitalist order. He took his stand on the
already obsolescent Marxist doctrine of irreconcilable class war between bourgeois
and proletariat. He aimed to unmask the bourgeois idea of liberty and to replace
parliaments by an "implacable machine" of workers' councils, which would destroy

619
the current social order through a dictatorship of the proletariat. "Democracy," he
wrote, "is our worst enemy. We must be ready to fight it because it blurs the clear
separation of classes." Not only would
parliamentary democracy and established law be unmasked, but culture, too, would be
transformed. A workers' civilization, with its great industry, large cities, and
"tumultuous and intense life," would create a new civilization with new poetry, art,
drama, fashions, and language. Gramsci insisted that the old culture should be
destroyed and that education should be wrenched from the grip of the ruling classes
and the church. But this militant revolutionary was also a utopian. He turned
bitterly hostile to Stalin's regime, for he believed, like Engels, that the dictatorship of
the workers' state would wither away. "We do not wish," he wrote, "to freeze the
dictatorship." Following world revolution, a classless society would emerge, and
mankind would be free to master nature instead of being involved in a class war.
Since World War II, Gramsci's notions have enjoyed a minor revival.
They appeal to the fringe of revolutionaries who admire Marcuse and detest the
embourgeoisement of an idealized proletariat. But, in a civilization in which, if total
war can be avoided, material prospects are good, the destruction of the old culture out
of rage, envy, and naďve idealism appears to be a pointless program. Like Marcuse's
doctrine, it is a cry of pain, typical of the 1920s in Italy.

Conclusion
The history of political philosophy from Plato until the present day
makes plain that modern political philosophy is still faced with the basic problems
defined by the Greeks. The need to redeploy public power in order to maintain the
survival and enhance the quality of human life, for example, has never been so
essential. And, if the opportunities for promoting well-being are now far greater, the
penalties for the abuse of power are nothing less than the destruction or gross
degradation of all life on the planet. In these circumstances it is of no great
importance that some analytical philosophers have declared themselves neutral; they
have at least often discredited pretentious metaphysical myths. On the empirical
evidence, constitutionalism and the rule of law, with the ancient classic, medieval, and
humanist traditions behind them, have proved themselves a more successful response
to the environment than tyranny and repression. In the current and more sophisticated
view, there are no shortcuts to the millennium. As Mosca points out, utopian ideas
become
dangerous when they succeed in bringing a large mass of intellectual
and moral energies to bear upon an end that can never be achieved, and that in
the day of purported achievement can mean nothing more than the triumph of
the worst people and distress and disappointment for the good.
There will perhaps always be a struggle for preeminence in any society, and
public laws are necessary to regulate it. Too much cannot be hoped of government,
and the best society is that in which tyranny and caprice of power are prevented and in
which men are free to create diverse and spontaneous institutions within the
framework of law. Only within such a framework of a tolerably well-organized
constitutionalism, gradually extended to relations between states, can the swiftly
mounting opportunities provided by applied science be taken and the pattern of social
life adjusted, so that the human species, instead of being thwarted and deformed by its
institutions, can realize its full potentialities.
Political Systems

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 The term political system may be used narrowly or broadly. Narrowly
defined, it is the set of formal legal institutions that constitute a "government" or a
"state." This is the definition adopted by many studies of the legal or constitutional
arrangements of advanced political orders. More broadly defined, it comprehends
actual as well as prescribed forms of political behaviour, not only the legal
organization of the state but also the reality of how the state functions. Still more
broadly defined, the political system is seen as a set of "processes of interaction" or as
a subsystem of the social system interacting with other nonpolitical subsystems, such
as the economic system. This points to the importance of informal sociopolitical
processes and emphasizes the study of political development.
Traditional legal or
constitutional analysis, using the first definition, has produced a huge body of
literature on governmental structures, many of the specialized terms that are a part of
the traditional vocabulary of political science, and several instructive classifying
schemes. Similarly, empirical analysis of political processes and the effort to identify
the underlying realities of governmental forms have yielded a rich store of data and an
important body of comparative theory. The third definition has inspired much
scholarly work that employs new kinds of data, new terms, and some new concepts
and categories of analysis. The discussion that follows draws on all three approaches
to the study of political systems.

Typologies of government
The most important type of political system in the modern world is the nation-
state. The world today is divided territorially into more than 175 states, in each of
which a national government claims to exercise sovereignty--or the power of final
authority--and seeks to compel obedience to its will by its citizens. This fact of the
world's political organization suggests the distinction employed in the following
section among supranational, national, and subnational political systems.

SUPRANATIONAL POLITICAL SYSTEMS

The formation of supranational relationships is a principal result of the

division of the world into a number of separate national entities, or states, that have
contact with one another, share goals or needs, and face common threats. In some
cases, as in many alliances, these relationships are short-lived and fail to result in
significant institutional development. In other cases, they lead to interstate
organizations and supranational systems. The discussion below examines several
types of supranational political systems, together with historical and contemporary
examples of each.
Empires.

Because they are composed of peoples of different cultures and ethnic

backgrounds, all empires are ultimately held together by coercion and the threat of
forcible reconquest. Imposing their rule on diverse political structures, they are
characterized by the centralization of power and the absence of effective
representation of their component parts. Although force is thus the primary instrument
of imperial rule, it is also true that history records many cases of multiethnic empires
that were governed peaceably for considerable periods and were often quite
successful in maintaining order within their boundaries. The history of the ancient

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world is the history of great empires--Egypt, China, Persia, and imperial Rome--
whose autocratic regimes provided relatively stable government for many subject
peoples in immense territories over many centuries. Based on military force and
religious belief, the ancient despotisms were legitimized also by their achievements in
building great bureaucratic and legal structures, in developing vast irrigation and road
systems, and in providing the conditions for the support of high civilizations.
Enhancing and transcending all other political structures in their sphere, they could
claim to function as effective schemes of universal order. In
contrast to the empires of the ancient world, the colonial empires of recent times fell
far short of universal status. In part, these modern European empires were made up of
"colonies" in the original Greek sense; peopled by immigrants from the mother
country, the colonies usually established political structures similar to those of the
metropolitan centre and were often able to exercise a substantial measure of self-
government. In part, also, the European empires were composed of territories
inhabited by native populations and administered by imperial bureaucracies. The
government of these territories was generally more coercive than in the European
colonies and more concerned with protection and supervision of the commercial,
industrial, and other exploitative interests of the imperial power. The disintegration of
these empires occurred with astonishing speed. The two world wars of the 20th
century sapped the power of the metropolitan centres, while their own doctrines of
democracy, equality, and self-determination undermined the principle of imperial
rule. Powers such as Britain and France found it increasingly difficult to resist claims
to independence couched in terms of the representative concepts on which their home
governments were based, and they lacked the military and economic strength to
continue their rule over restive native populations. In the two decades after 1945,
nearly all the major colonial territories won their independence; the great colonial
empires that had once ruled more than half the world were finally dismembered.

Leagues.

One of the commonest forms of supranational organization in history is that of

leagues, generally composed of states seeking to resist some common military or
economic threat by combining their forces. This was the case with the early city
leagues, such as the Achaean and Aetolian leagues in ancient Greece and the
Hanseatic and the Swabian leagues in Europe; and to a great extent it was the case
with the League of Nations. Other common features of leagues include the existence
of some form of charter or agreement among the member states, an assembly of
representatives of the constituent members, an executive organ for the implementation
of the decisions of the assembly of representatives, and an arbitral or judicial body for
adjudicating disputes. The League of Nations was one of the great
experiments in supranational organization of the 20th century and the predecessor in
several important respects of the United Nations. The Covenant of the League was
drafted by a special commission of the Peace Conference after World War I, with
Pres. Woodrow Wilson of the United States as its leading advocate, and approved by
a plenary conference of the victorious powers in 1919. The initial membership of the
League consisted of 20 states. The United States failed to take membership in the
League, but by 1928 the organization had a total membership of 54. The machinery of
the League consisted of an Assembly of all the member nations, acting through agents
of their governments; a council on which the great powers were permanently
represented and to which the other member powers were elected by the Assembly for

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three-year terms; a Secretariat to administer the internal affairs of the League; and a
number of specialized agencies, such as the International Labour Organisation, that
were responsible for implementing various economic and humanitarian programs on
an international basis. The Covenant required that international disputes be submitted
to peaceful settlement with a provision for adjudication or arbitration by the
Permanent Court of International Justice or for intervention by the Council of the
League. The Covenant also provided for the use of financial and economic penalties,
such as embargoes, to enforce the decisions of the League and for joint military action
against convicted aggressors. In practice, however, the League failed its most
important tests and was unable to master the crises that led to World War II and its
own collapse.

Confederations.

Confederations are voluntary associations of independent states that, to

secure some common purpose, agree to certain limitations on their freedom of action
and establish some joint machinery of consultation or deliberation. The limitations on
the freedom of action of the member states may be as trivial as an acknowledgment of
their duty to consult with each other before taking some independent action or as
significant as the obligation to be bound by majority decisions of the member states.
Confederations usually fail to provide for an effective executive authority and lack
viable central governments; their member states typically retain their separate military
establishments and separate diplomatic representation; and members are generally
accorded equal status with an acknowledged right of secession from the
confederation. Historically, confederations have often proved to be a first or second
step toward the establishment of a national state, usually as a federal union. Thus, the
federal union of modern Switzerland was preceded by a confederation of the Swiss
cantons; Germany's modern federal arrangements may be traced to the German
Confederation of the 19th century (the Deutsche Bund); and the federal constitution of
the United States is the successor to the government of the Articles of Confederation.
In some other cases, confederations have replaced more centralized arrangements, as,
for example, when empires disintegrate and are replaced by voluntary associations of
their former colonies. The British Commonwealth, or Commonwealth of Nations, and
the French Community are cases of this type. An example of confederal
arrangements that gave birth to a federal union is the Articles of Confederation
(1781-89) that preceded the Constitution of the United States. The Articles established
a Congress of the confederation as a unicameral assembly of ambassadors from the 13
states, each possessing a single vote. The Congress was authorized to appoint an
executive committee of states
to execute, in the recess of Congress, such of the powers of Congress
as the United States, in Congress assembled, by the consent of nine States,
shall from time to time think expedient to vest them with;
in turn, the committee of states could appoint a presiding officer or president
for a term of one year. The Congress could also appoint such other committees and
"civil officers as may be necessary for managing the general affairs of the United
States" and was given the authority to serve as "the last resort or appeal in all disputes
and differences, now subsisting or that hereafter may arise between two or more
states." Although the Congress was given authority in important areas such as the
regulation of foreign affairs, the establishment of coinage and weights and measures,
the appointment of officers in the confederation's land and naval forces, and the

623
issuance of bills of credit, all its powers were in fact dependent for their enforcement
upon the states. The Congress lacked both an independent source of revenue and the
executive machinery to enforce its will directly upon individuals. As the language of
the Articles summarized the situation,
each State retains its sovereignty, freedom and independence, and
every power, jurisdiction and right, which is not by this Confederation
expressly delegated to the United States in Congress assembled.
The Commonwealth of Nations is an example of a confederation born as the
result of the decentralization and eventual disintegration of an empire. The original
members were the United Kingdom, Australia, Canada, the Irish Free State,
Newfoundland, New Zealand, and the Union of South Africa. In 1949 Newfoundland
became a province of Canada, and the Irish Free State became an independent
republic; South Africa became an independent republic in 1961. New commonwealth
members in the latter half of the 20th century were newly independent former British
colonies, such as Malaysia (1957), Cyprus (1961), and Kiribati (1979), and numbered
well over 40. The Statute of Westminster (1931) established that all members
were equal in status, although all recognized the British monarch as head of the
commonwealth. Commonwealth governments were represented in the capitals of
other commonwealth countries by high commissioners equal in status to ambassadors.
In 1965 the commonwealth established its Secretariat to organize meetings, keep the
membership informed, and implement its collective decisions. The Commonwealth
Fund for Technical Cooperation, which is financed by all member states, was
implemented to provide technical assistance to less-developed states. The nations of
the commonwealth rarely acted in concert on the international scene, and, despite
fairly regular meetings of the commonwealth prime ministers, there were at times
severe strains in the relations among several of the member states. The fairly general
use of the English language and of English common law, together with some common
symbols and remaining cultural affinities, appeared to be the major ties binding
together this loose association.

Federations.

The term federation is used to refer to groupings of states, often on a regional

basis, that establish central executive machinery to implement policies or to supervise
joint activities. In some cases such groupings are motivated primarily by political or
economic concerns; in others, military objectives are paramount. Examples of the
former include the European Communities (EC), actually a combination of three main
structures -- the European Coal and Steel Community, established in 1952; the
European Economic Community (Common Market), established in 1958; and the
European Atomic Energy Community (Euratom), established in 1958. The
Communities quickly developed executive machinery exercising significant
regulatory and directive authority over the governments and private business firms of
the member countries. Although each of the member governments retains a
substantial measure of sovereignty, and a systematic effort by one or more of the
governments to resist the authority of the Communities' agencies could endanger the
whole fabric of cooperative effort, the Communities have developed significant
supranational features. These include the staffing of executive organs with persons
other than governmental representatives, the making of binding decisions on
important matters by majority vote, and the capability of the Communities' agencies
to deal directly and authoritatively with individuals and companies within the member

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states. For example, the high authority of the Coal and Steel Community acts by
majority vote of its members, without instruction from any of the governments, to
"assure the achievement of the purposes stated in the Treaty"; and in pursuing this
function it involves itself deeply in the economies of each of the member nations.
The
North Atlantic Treaty Organization (NATO), established in April 1949, is an
example of a modern military alliance endowed with complex and permanent
executive machinery, employing multilateral procedures, and involving the
continuous elaboration of plans for the conduct of joint military action by its member
states (Belgium, Canada, Denmark, France, Germany, Greece, Iceland, Italy,
Luxembourg, The Netherlands, Norway, Portugal, Spain, Turkey, the United
Kingdom, and the United States). As stated in its treaty, the purpose of NATO is to
maintain the security of the North Atlantic area by exercise of the right of collective
security recognized in the Charter of the United Nations. An impressive array of
institutional mechanisms was established, including a secretary-general and a
permanent staff, a council, a military command structure, and liaison staffs; and an
ongoing system of collaboration in planning and joint military exercises was brought
into being. With the continued development of its organization, NATO gradually
added a number of economic and cultural activities to its functions until it came to
possess several of the features of a multipurpose supranational organization.

The United Nations organization.

A supranational political system that does not fit precisely any of the
conventional classifications of such systems is the United Nations, a voluntary
association of most of the world's nation-states. Its membership had grown from an
original 51 states to more than 175 by the late 20th century. (The government of the
People's Republic of China was admitted in place of the government of Taiwan in
1971.) The United Nations was founded in 1945 at a conference in San Francisco that
was attended by representatives of all the nations that had declared war on Germany
or Japan. The purposes of the organization are declared in its Charter to be the
maintenance of international peace and security, the development of friendly relations
among states, and international cooperation in solving the political, economic, social,
cultural, and humanitarian problems of the world. Its organizational structure consists
of a Security Council of five permanent members (China, France, Russia, the United
Kingdom, and the United States) and 10 nonpermanent members elected for two-year
terms, a General Assembly, a secretary-general and a Secretariat, an Economic and
Social Council, a Trusteeship Council, and the International Court of Justice.
Attached to the United Nations are a number of specialized agencies, including the
Food and Agriculture Organization, the International Atomic Energy Agency, the
International Civil Aviation Organization, the International Labour Organisation, the
International Monetary Fund, the International Telecommunications Union, the
Universal Postal Union, the United Nations Educational, Scientific and Cultural
Organization, the World Health Organization, and the International Bank for
Reconstruction and Development (World Bank). Aside from
the rather generally stated and decidedly elusive aims of the Charter, the member
states of the United Nations cannot be said to have any common goal, and they have
often failed to unify in the face of common external threats to security. There also has
been difficulty in reaching and implementing decisions. Two different formulas are
employed for voting in the two principal organs, the General Assembly and the

625
Security Council. In the General Assembly a two-thirds majority decides on important
matters, but, since the Assembly's decisions are not binding and are merely
recommendations, this qualified majority principle must be viewed as of little
significance. Although, on the other hand, the decisions of the Security Council may
be binding, a unanimous vote of all five of the permanent members joined by the
votes of at least four of the nonpermanent members is required; whenever important
questions of peace and security are at stake, it has rarely been possible to achieve
agreement among the five great powers of the council. Although these difficulties
might be fatal to the survival of many supranational organizations, they are not in fact
totally debilitating for the United Nations. The United Nations continues to serve as a
very important forum for international debate and negotiation, and its specialized
agencies play an important role in what is sometimes referred to as "the functional
approach to peace."

NATIONAL POLITICAL SYSTEMS

The term nation-state is used so commonly and yet defined so variously that
it will be necessary to indicate its usage in this article with some precision and to give
historical and contemporary examples of nation-states. To begin with, there is no
single basis upon which such systems are established. Many states were formed at a
point in time when a people sharing a common history, culture, and language
discovered a sense of identity. This was true in the cases of England and France, for
example, which were the first nation-states to emerge in the modern period, and of
Italy and Germany, which were established as nation-states in the 19th century. In
contrast, however, other states, such as India, the Soviet Union, and Switzerland,
came into existence without a common basis in race, culture, or language. It must also
be emphasized that contemporary nation-states are creations of different historical
periods and of varied circumstances. Before the close of the 19th century, the
effective mobilization of governmental powers on a national basis had occurred only
in Europe, the United States, and Japan. It was not until the 20th century and the
collapse of the Ottoman, Habsburg, French, and British empires that the world could
be fully organized on a national basis. This transformation was completed in 1991
with the dissolution of the U.S.S.R. In 1920 the League of Nations recognized seven
nation-states as "Great Powers" (Britain, France, the United States, Germany, Italy,
Japan, and Russia) and eventually admitted more than 40 other states to membership;
the United Nations had more than 175 member states in the late 20th century. States
in the post-Cold War world include the United States as the preeminent power; the
established powers of Britain, France, China, Japan, Germany, and Russia; emerging
powers such as Ukraine and Brazil; and a host of old and new states such as Denmark,
Namibia, Kazakstan, Switzerland, Egypt, Turkey, Malaysia, and Chile.
The characteristics that qualify these variously
composed and historically differing entities as nation-states and distinguish them from
other forms of social and political organization amount in sum to the independent
power to compel obedience from the populations within their territories. The state is,
in other words, a territorial association that may range in size from Russia to
Singapore, in population from China to Luxembourg, and that claims supremacy over
all other associations within its boundaries. As an association, the state is peculiar in
several respects: membership is compulsory for its citizens; it claims a monopoly of
the use of armed force within its borders; and its officers, who are the government of
the state, claim the right to act in the name of the land and its people.

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 A
definition of the state in terms only of its powers over its members is not wholly
satisfactory, however. Although all states make a claim to supremacy within their
boundaries, they differ widely in their ability to make good their claims. States are, in
fact, often challenged by competing associations within their boundaries; their
supremacy is often more formal than real; and they are sometimes unable to maintain
their existence. Moreover, a definition in terms of power alone ignores the fact that
there are great differences among states in the structures they employ for the exercise
of power, in the ways they use power, and in the ends to which they turn their power.
Some of these differences are explored in the discussion that follows of two general
categories of nation-states: the unitary state and the federal state. Partly from
administrative necessity and partly because of the pressures of territorial interests,
nearly all modern states provide for some distribution of governmental authority on a
territorial basis. Systems in which power is delegated from the central government to
subnational units and in which the grant of power may be rescinded at the will of the
central government are termed unitary systems. Systems in which a balance is
established between two autonomous sets of governments, one national and the other
provincial, are termed federal. In federal systems, the provincial units are usually
empowered to grant and take away the authority of their own subunits in the same
manner as national governments in unitary systems. Thus, although the United States
is federally organized at the national level, each of the 50 states is in a unitary
relationship to the cities and local governments within its own territory.

Unitary nation-states.

A great majority of all the world's nation-states are unitary systems, including
Belgium, Bulgaria, France, Great Britain, The Netherlands, Japan, Poland, Romania,
the Scandinavian countries, Spain, and many of the Latin-American and African
countries. There are great differences among these unitary states, however,
specifically in the institutions and procedures through which their central
governments interact with their territorial subunits.
In one type of unitary system,
decentralization of power among subnational governments goes so far that in
practice, although not in constitutional principle, they resemble federal arrangements.
In Great Britain, for example, there are important elements of regional autonomy in
the relationship between Northern Ireland, Wales, and Scotland and the national
government in London; and the complex system of elected local governments,
although in constitutional theory subject to abrogation by Parliament, is in practice a
fixed and fairly formidable part of the apparatus of British government. In other
unitary systems of this type, decentralization on a territorial basis is actually provided
for constitutionally, and the powers of locally elected officials are prescribed in detail.
Thus, the Japanese constitution, for example, specifies certain autonomous functions
to be performed by local administrative authorities. A second
type of unitary system makes substantially less provision for territorial
decentralization of authority and employs rather strict procedures for the central
supervision of locally elected governments. The classic example of this type is
France. Until March 1982, when a law on decentralization went into effect, the
French administrative system was built around départements, each headed by a
préfet, and subdivisions of the départements, termed arrondissements, each headed
by a sous-préfet. The préfets and sous-préfets were appointed by the government in

627
Paris to serve as agents of the central government and also as the executives of the
divisional governments, the conseils généraux, which were composed of elected
officials. The system thus combined central supervision of local affairs through
appointed officials with territorial representation through locally elected governments.
(Following the passage of the decentralization law, the executive powers of the
préfets were transferred to the conseils généraux.)
Yet a third type of unitary system
provides for only token decentralization. In such cases, the officials responsible for
managing the affairs of the territorial subdivisions are appointees of the central
government, and the role of locally elected officers is either minimal or nonexistent.
Examples of this kind of arrangement include Germany under Adolf Hitler and also
several formerly Communist countries. The Third Reich was divided into 42 Gaue,
each headed by a gauleiter chosen for his personal loyalty to Hitler. In eastern Europe,
the people's councils or people's committees were named by the centrally organized
Communist parties; their appointment was confirmed by elections with one slate of
candidates.

Federal systems.

In federal systems, political authority is divided between two autonomous sets

of governments, one national and the other subnational, both of which operate directly
upon the people. Usually a constitutional division of power is established between the
national government, which exercises authority over the whole national territory, and
provincial governments that exercise independent authority within their own
territories. Of the eight largest countries in the world, seven--Argentina, Australia,
Brazil, Canada, India, Russia, and the United States--are organized on a federal basis.
Federal states also include Austria, Germany, Malaysia, Mexico, Nigeria,
Switzerland, and Venezuela. The governmental structures and
political processes found in these federal systems show great variety. One may
distinguish, first, a number of systems in which federal arrangements reflect rather
clear-cut cultural divisions. A classic case of this type is Switzerland, where the
people speak four different languages--German, French, Italian, and Romansh--and
the federal system unites 26 historically and culturally different entities, known as
cantons and demicantons. The Swiss constitution of 1848, as modified in 1874,
converted into the modern federal state a confederation originally formed in the 13th
century by the three forest cantons of Uri, Schwyz, and Unterwalden. The principal
agencies of federal government are a bicameral legislature, composed of a National
Council representing the people directly and a Council of States representing the
constituent members as entities; an executive branch (Bundesrat) elected by both
houses of the legislature in joint session; and a supreme court that renders decisions
on matters affecting cantonal and federal relations. The Russian Federation's
arrangements, although of a markedly different kind, also reflect the cultural and
linguistic diversity of the country. Depending on their size and on the territories they
have historically occupied, ethnic minorities may have their own autonomous
republic, province, or district. These divisions provide varying degrees of autonomy
in setting local policies and provide a basis for the preservation of the minorities'
cultures. Some of these areas were integrated into the Russian Empire centuries ago,
after the lands were taken from the Mongols of the Golden Horde, and others resisted
occupation even late in the 19th century. It is not uncommon for Russians to
constitute a plurality of the population in these areas. The national government

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consists of the executive branch, led by the nationally elected president; the
parliament; and a judicial branch that resolves constitutional matters.
In other systems, federal
arrangements are found in conjunction with a large measure of cultural homogeneity.
The Constitution of the United States delegates to the federal government certain
activities that concern the whole people, such as the conduct of foreign relations and
war and the regulation of interstate commerce and foreign trade; certain other
functions are shared between the federal government and the states; and the remainder
are reserved for the states. Although these arrangements require two separate bodies
of political officers, two judicial systems, and two systems of taxation, they also allow
extensive interaction between the federal government and the states. Thus, the
election of Congress and the president, the process of amending the Constitution, the
levying of taxes, and innumerable other functions necessitate cooperation between the
two levels of government and bring them into a tightly interlocking relationship.

SUBNATIONAL POLITICAL SYSTEMS

Although national government is the dominant form of political

organization in the modern world, an extraordinary range of political forms exists
below the national level--tribal communities, the intimate political associations of
villages and towns, the governments of regions and provinces, the complex array of
urban and suburban governments, and the great political and administrative systems
of the cities and the metropolises. These subnational entities are, in a sense, the basic
political communities--the foundation on which all national political systems are built.

Tribal communities.
The typical organization of mankind in its early history was the tribe. Today,
in many parts of the world, the tribal community is still a major form of human
political organization. Even in advanced systems, traces can still be found of its
influence. Some of the Länder of modern Germany, such as Bavaria, Saxony, or
Westphalia, have maintained their identity since the days of the Germanic tribal
settlements. In England, too, many county boundaries can be explained only by
reference to the territorial divisions in the period after the end of the Roman
occupation. In many African states, the tribe is still an
effective community and a vehicle of political consciousness. Most of these states are
the successors to the administrative units established by colonial regimes and owe
their present boundaries to the often arbitrary decisions of imperial bureaucracies or to
the territorial accommodations of rival colonial powers. The result was often the
splintering of the tribal communities or their aggregation in largely artificial entities.
Tribal loyalties continue to hamper nation-building efforts in some parts of the world
where tribes were once the dominant political structure. Tribes may act through
formal political parties like any other interest group. In some cases they simply act out
their tribal bias through the machinery of the political system, and in others they
function largely outside of formal political structures. In its primary
sense, the tribe is a community organized in terms of kinship, and its subdivisions are
the intimate kindred groupings of moieties, gentes, and totem groups. Its territorial
basis is rarely defined with any precision, and its institutions are typically the
undifferentiated and intermittent structures of an omnifunctional social system. The
leadership of the tribe is provided by the group of adult males, the lineage elders
acting as tribal chiefs, the village headmen, or the shamans, or tribal magicians. These

629
groups and individuals are the guardians of the tribal customs and of an oral tradition
of law. Law is thus not made but rather invoked; its repository is the collective
memory of the tribal council or chief men. This kind of customary law, sanctioned
and hallowed by religious belief, nevertheless changes and develops, for each time it
is declared something may be added or omitted to meet the needs of the occasion.

Rural communities.

The village has traditionally been contrasted with the city: the village is the
home of rural occupations and tied to the cycles of agricultural life, while the
inhabitants of the city practice many trades, and its economy is founded on commerce
and industry; the village is an intimate association of families, while the city is the
locus of a mass population; the culture of the village is simple and traditional, while
the city is the centre of the arts and sciences and of a complex cultural development.
The village and the city offer even sharper contrasts as political communities.
Historically, the village has been ruled by the primitive democracy of face-to-face
discussion in the village council or by a headman whose decisions are supported by
village elders or by other cooperative modes of government; urban government has
never been such a simple matter, and monarchical, tyrannical, aristocratic, and
oligarchic forms of rule have all flourished in the city. In the village, the boundaries
among political, economic, religious, and other forms of action have not been as
clearly drawn as in cities. The
origins and development of the apparatus of government can be seen most clearly in
the simple political society of the rural community. The transformation of kin-bound
societies with their informal, folk-sustained systems of sociopolitical organization into
differentiated, hierarchical societies with complex political structures began with the
enlargement of the rural community--an increase in its population, the diversification
of its economy, or its interaction with other communities. The rudimentary organs of
communal government were then elaborated, the communal functions received more
specialized direction, and leadership roles were institutionalized. This was sometimes
a process that led by gradual stages to the growth of cities. Elsewhere, however, as in
the case of ancient Attica, the city was established as the result of a process of
synoikismos, or the uniting of a number of tribal or village communities. This was
undoubtedly the origin of Athens, and, according to its legendary history, Rome also
was established as a result of the forcible unification of the tribes that dwelt on the
hills surrounding the Palatine Hill.
Even in the nation-states of today's
world, the contrasts between the village or the town and the city as centres of human
activity are readily apparent. In the country, life is more intimate, human contacts
more informal, the structure of society more stable. In the city, the individual becomes
anonymous, the contacts between people are mainly formal, and the standing of the
individual or the family in society is subject to rapid change. In many contemporary
systems, however, the differences in the forms of government of rural and urban
communities appear to be growing less pronounced. In the United States, for example,
rural institutions have been seriously weakened by the movement of large numbers of
people to the city. The township meeting of New England and other forms of direct
citizen participation in the affairs of the community have declined in importance and
have often been displaced by more formal structures and the growth of local
governmental bureaucracies.
Cities.

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 Cities first emerged as complex forms of social and political organization in
the valleys of the Euphrates and the Tigris, the Nile, the Huang Ho, and the Yangtze.
These early cities broke dramatically with the patterns of primitive life and the rural
societies from which they sprang. Kinship as the basis of society was replaced by
status determined by class and occupation; the primitive magical leaders of the tribe
were displaced by temple priesthoods presiding over highly developed religious
institutions and functioning as important agencies of social control; earlier systems of
rule by the tribal chieftains and the simple forms of communal leadership gave way to
kingships endowed with magical powers and important religious functions; and
specialized functionaries in the royal courts became responsible for supervising new
kinds of governmental activity. Many other developments contributed to the growing
centralization of power in these city civilizations. Barter was replaced by more
effective systems of exchange, and the wealth generated in commerce and the
specialized city trades became both an object of taxation and an instrument of power.
Class distinctions emerged as the result of a division of labour and advances in
technical development. A military order and a professional soldiery were created and
trained in new techniques of warfare, and a slave class provided the work force for
large-scale projects of irrigation, fortification, and royal architecture. As these
developments proceeded, the city was able to project its power even further into the
surrounding countryside, to establish its rule over villages and other cities in its
sphere, and finally to become the centre of such early empires as those of Sumeria,
Egypt, China, Babylonia, Assyria, and Persia. A very different form of
city life emerged among the Greeks. The Greek polis also broke with the folkways of
primitive society, but its political development was in striking contrast to the
despotism of the Oriental city empires and their massive concentrations of power in
the hands of king and priest. As the polis transcended its origins in village life, the
powers of the tribal chief dwindled and passed into the hands of aristocratic families.
The kingship of Homeric tradition vanished, the "kings" who remained became mere
dignitaries in the religious and ceremonial life of the city, and new magistracies and
other civic offices were founded. These offices became the focus of factional struggle
among the aristocratic families and later, with the weakening of aristocratic rule, the
chief prizes in a contest of power between the nobility and the common citizens.
Eventually, these developments issued in the characteristic form of Greek city
government. A citizen body, always a much narrower group than the total population
but often as numerous as the population of freeborn males, acquired power in the
direction of the city government through the election of its officers and direct
participation in the city councils. Although often interrupted by episodes of oligarchic
or tyrannical rule and by periods of civic dissension and class rivalry, the main theme
of governmental development in the Greek city was the elaboration of structures that
permitted the control of political affairs by its citizens.
Autonomous cities also sprang up in Europe in the later Middle
Ages. Medieval city life, although it differed from that of the polis and was coloured
by the forms of feudal society, also emphasized the principle of cooperative
association. Indeed, for the first time in the history of city civilization, the majority of
the inhabitants of the city were free. The development of trades, the growth of
commerce, and the mobilization of wealth emancipated the city from its feudal
environment, and the merchant and craft guilds became the matrices of a new kind of
city democracy. In time, the guilds were transformed into closed corporations and
became a basis for oligarchic control; and the city's independence was threatened by

631
the rise of the new nation-states. Tempting targets for the ambition of kings, Venice,
Genoa, Florence, Milan, Cologne, Amsterdam, Hamburg, and other free cities of
Europe eventually succumbed to monarchical control. Theirs was an important
legacy, however, for the political order of the medieval city was a powerful influence
in the development of the constitutional structures of the modern democratic state.

Although cities are no longer independent, the almost universal

increase in urban population has made them more important than ever before as
centres of human activity. The political organization of modern cities differs from
country to country. Even within the same nation-state, there are often important
contrasts in the structures of city government. In the United States, for example,
three principal types of city government are usually distinguished: the council-
manager form, the mayor-council form, and the commission form.
More than half of all
American cities with populations between 25,000 and 250,000 operate under council-
manager governments. In council-manager systems the council is generally small,
elected at large on a nonpartisan ballot for overlapping four-year terms; no other
offices are directly elected, and the mayor, who presides at council meetings and
performs mainly ceremonial functions, is chosen by the council from among its
members. The manager, a professional city administrator, is selected by the council,
serves at the council's pleasure, and is responsible for supervising the city departments
and municipal programs, preparing the budget, and controlling expenditures.
Mayor-council governments are found in two basic forms, the "weak"
mayor and the "strong" mayor. The former was typical of the 19th-century municipal
organization and is now mainly confined to cities of less than 25,000 population; the
latter is a common arrangement in cities with significantly larger populations. In
weak-mayor-council governments, a number of officials, elected or appointed for
lengthy terms, wield important administrative powers; the council, typically elected
by divisions of the city called wards, is responsible for the direction of the major city
agencies; and the mayor's powers of appointment and removal and his control over
the city budget are severely limited. In many cases, strong-mayor-council
governments evolved from weak-mayor-council systems as an independently elected
mayor won the power of veto over council ordinances, strengthened his control over
appointment and removal, and established himself as the city's chief budgetary
officer; at the same time, also, the elective administrative officers and the semi-
autonomous appointive boards and commissions were often eliminated and the
number of councilmen reduced. The commission
plan, which is now found in fewer than 200 cities of more than 10,000 population,
concentrates legislative and executive powers in the hands of a small group of
commissioners. The commissioners serve individually as the heads of administrative
departments and choose one of their number to act as a ceremonial mayor without
executive authority. The
variety in the governmental structures of American cities is paralleled in many other
countries, for everywhere in the modern world the government of the city continues to
challenge man's political invention. Although no longer sovereign, cities are the
centres of modern civilization and--both in terms of the services demanded of them
and the range and importance of the functions they exercise--the most important of
contemporary subnational political systems. Moreover, it is in the cities that most of
the problems of modern industrial society seem to have their focus. These problems
are not only governmental but also technological, cultural, and economic. They are

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found in their most acute form in the great metropolitan centres and in that vast urban
agglomeration known as the megalopolis. In political terms, the issue that is posed
appears to be whether these huge centres of population can continue as effective
communities with democratically manageable governments.

Regions.

In many contemporary national political systems the forces of history and

administrative necessity have joined to produce regional communities at an
intermediate level between the local and the national community. In some cases--the
Swiss canton, the English county, the German Land, and the American state--these
regional communities possess their own political institutions and exercise
governmental functions. In other cases, however, the territorial community is a
product of ethnic, cultural, linguistic, physiographic, or economic factors and
maintains its identity without the support of political structures. As subnational
political systems, regional communities are sometimes based in tradition, even tracing
their origin to a period prior to the founding of the nation; in other cases, they are
modern administrative units created by national governments for their own purposes.
Examples of both types may be found in the history of regionalism in France and its
complex pattern of internal territorial divisions. Before the French Revolution, France
was divided into ancient provinces--Burgundy, Gascony, Brittany, Normandy,
Provence, Anjou, Poitou, and others. After the Revolution, in what seems to have
been an effort to discourage regional patriotism and threats of separatism, the
Napoleonic government superimposed a new regional structure of départements on
the old provincial map. More than a century and a half later, in the era of rapid
communications and national economic planning, the French national government
announced a regrouping of the Napoleonic départements into much larger Gaullist
régions. Recognizing, perhaps, the continuing strength of the provincial attachments
of Gascon, Breton, Norman, and Provençal and the survival of old regional folk
cultures with their distinctive patterns of speech, the new régions were given
boundaries similar in many cases to the traditional provincial boundaries of pre-
republican France. The history of the French regional communities
is not a special case, for political, administrative, economic, and technical forces have
led many other national governments to replace traditional territorial divisions with
new regional units. In England, for example, the traditional structure of county
governments (52 in number) was replaced by a system of administrative counties (61
plus London); and, in 1969, a royal commission proposed a further reform that would
abolish 39 counties. Attempts have also been made to use older regional communities
as the infrastructure for new systems of regional government. Thus, the Italian
constitution provides for semi-autonomous government in five special regions--Valle
d'Aosta, Sardinia, Sicily, Trentino-Alto Adige, and Friuli-Venezia Giulia--which, in
different ways, are historically distinct from the rest of Italy. In yet other cases the
fear of competition from regional governments or of separatist movements has led
national governments to make various efforts to resist the development of regional
political structures. Again, Italy provides a convenient example, for its constitution
requires the establishment of 14 other autonomous regions, but Italian governments
refused to implement this provision of the 1947 constitution until recently. It should
be noted that the Italian republic of 1870-1922 and its Fascist successor state also
made similar efforts to combat regional political development, the former by the
creation of a large number of administrative provinces and the latter by establishing

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corporazione to represent occupations regardless of geographic location.
In several modern states the growth of vast conurbations and
the rise of the megalopolis have prompted the development of new kinds of regional
governmental structures. The Port of London Authority, the Port of New York
Authority, and the San Francisco Bay Area Transit Authority are examples of regional
systems designed to serve the needs of urban communities that have outgrown the
boundaries of existing city governments. New regional structures have also resulted
from the increased responsibility of national governments for the administration of
comprehensive social and economic programs. The Tennessee Valley Authority, for
example, is both a national agency and a regional government whose decisions affect
the lives of the inhabitants of all the states and cities in its sphere. Other examples of
new regional administrative structures include the zonal councils established in India
for social and economic planning purposes, the districts of the Interstate Commerce
Commission in the United States, and the governmental and economic units
established in Britain to deal with the problems of industrially depressed areas.

ISSUES OF CLASSIFICATION
Types of classification schemes.

The almost infinite range of political systems has been barely suggested in this
brief review. Confronted by the vast array of political forms, political scientists have
attempted to classify and categorize, to develop typologies and models, or in some
other way to bring analytic order to the bewildering variety of data. Many different
schemes have been developed. There is, for example, the classical distinction between
governments in terms of the number of rulers--government by one man (monarchy or
tyranny), government by the few (aristocracy or oligarchy), and government by the
many (democracy). There are schemes classifying governments in terms of their key
institutions (for example, parliamentarism, cabinet government, presidentialism).
There are classifications that group systems according to basic principles of political
authority or the forms of legitimacy (charismatic, traditional, rational-legal, and
others). Other schemes distinguish between different kinds of economic organization
in the system (the laissez-faire state, the corporate state, and Socialist and Communist
forms of state economic organization) or between the rule of different economic
classes (feudal, bourgeois, and capitalist). And there are modern efforts to compare
the functions of political systems (capabilities, conversion functions, and system
maintenance and adaptation functions) and to classify them in terms of structure,
function, and political culture. Although none is comprehensive, each of these
principles of analysis has some validity, and the classifying schemes that are based on
them, although in some cases no longer relevant to modern forms of political
organization, have often been a major influence on the course of political
development. The most influential of such classifying schemes is undoubtedly the
attempt of Plato and Aristotle to define the basic forms of government in terms of the
number of power holders and their use or abuse of power. Plato held that there was a
natural succession of the forms of government: an aristocracy (the ideal form of
government by the few) that abuses its power develops into a timocracy (in which the
rule of the best men, who value wisdom as the highest political good, is succeeded by
the rule of men who are primarily concerned with honour and martial virtue), which
through greed develops into an oligarchy (the perverted form of government by the
few), which in turn is succeeded by a democracy (rule by the many); through excess,
the democracy becomes an anarchy (a lawless government), to which a tyrant is

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inevitably the successor. Abuse of power in the Platonic typology is defined by the
rulers' neglect or rejection of the prevailing law or custom ( nomos); the ideal forms
are thus nomos observing (ennomon), and the perverted forms are nomos neglecting
(paranomon). Although disputing the character of this implacable succession of the
forms of government, Aristotle also based his classification on the number of rulers
and distinguished between good and bad forms of government. In his typology it was
the rulers' concern for the common good that distinguished the ideal from perverted
forms of government. The ideal forms in the Aristotelian scheme are monarchy,
aristocracy, and polity (a term conveying some of the meaning of the modern concept
of "constitutional democracy"); when perverted by the selfish abuse of power, they
are transformed respectively into tyranny, oligarchy, and ochlocracy (or the mob rule
of lawless democracy). The concept of the polity, a "mixed" or blended constitutional
order, fascinated political theorists for another millennium. To achieve its advantages,
innumerable writers from Polybius to St. Thomas Aquinas experimented with the
construction of models giving to each social class the control of appropriate
institutions of government.
Another very influential classifying scheme was
the distinction between monarchies and republics. In the writings of Machiavelli and
others, the tripartism of classical typologies was replaced by the dichotomy of
princely and republican rule. Sovereignty in the monarchy or the principality is in the
hands of a single ruler; in republics, sovereignty is vested in a plurality or collectivity
of power holders. Reducing aristocracy and democracy to the single category of
republican rule, Machiavelli also laid the basis in his analysis of the exercise of
princely power for a further distinction between despotic and nondespotic forms of
government. In the work of Montesquieu, for example, despotism, or the lawless
exercise of power by the single ruler, is contrasted with the constitutional forms of
government of the monarchy and the republic. As a result of the decline of
monarchies and the rise of new totalitarian states terming themselves republics, this
traditional classification is now, of course, of little more than historical interest.

Modern classifying systems.

The usefulness of all the traditional classifications has been undermined by the
momentous changes in the political organization of the modern world. Typologies
based on the number of power holders or the formal structures of the state are
rendered almost meaningless by the standardization of "democratic" forms, the
deceptive similarities in the constitutional claims and governmental institutions of
regimes that actually differ markedly in their political practices, and the rise of new
political orders in the non-Western world. A number of modern writers have
attempted to overcome this difficulty by constructing classifying schemes that give
primary importance to social, cultural, economic, or psychological factors. The most
influential of such schemes is the Marxist typology, which classifies types of rule on
the basis of economic class divisions and defines the ruling class as that which
controls the means of production in the state. A monistic typology that also
emphasized the importance of a ruling class was developed by an Italian theorist of
the early 20th century, Gaetano Mosca. In Mosca's writings all forms of government
appear as mere facades for oligarchy or the rule of a political "elite" that centres
power in its own hands. Another classification, which distinguishes between
"legitimate" and "revolutionary" governments, was suggested by Mosca's
contemporary Guglielmo Ferrero. Using a sociopsychological approach to the

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relations between rulers and ruled, Ferrero held that a legitimate government is one
whose citizens voluntarily accept its rule and freely give it their loyalty; in
revolutionary systems, the government fears the people and is feared by them.
Legitimacy and leadership are also the basis of a typology developed by the German
sociologist Max Weber. In Weber's scheme there are three basic types of rule:
charismatic, in which the authority or legitimacy of the ruler rests upon some genuine
sense of calling and in which the followers submit because of their faith or conviction
in the ruler's exemplary character; traditional, in which, as in hereditary monarchy,
leadership authority is historically or traditionally accepted; and rational-legal, in
which leadership authority is the outgrowth of a legal order that has been effectively
rationalized and where there is a prevailing belief in the legality of normative rules or
commands. The Weberian typology has been elaborated by a number of recent writers
who have found it particularly useful for comparing and classifying the emergent
political orders of the non-Western world. A serviceable
classification of political systems must penetrate beneath formal appearances to
underlying realities; these realities, however, do not consist only of the facts of social
and economic organization. Important differences often exist between political
systems having very similar socioeconomic structures. That is why some recent
sociological classifications and schemes of analysis fail as tools of political inquiry:
they cannot effectively distinguish between certain societies whose political orders are
full of contrasts. The political system itself must be the primary focus of inquiry and
the phenomena of politics the principal facts of investigation. Such an approach may
involve many different kinds of analysis, but it must begin with an examination of the
ways in which power is acquired and transferred, exercised, and controlled. This is
important for comparing advanced political orders and also for drawing important
distinctions between regimes in the underdeveloped areas of the world.

GOVERNMENTS CLASSIFIED BY MODE OF SUCCESSION

A key problem of all political orders is that of succession. "The king is dead;
long live the king" was the answer, not always uncontested, of European hereditary
monarchy to the question of who should rule after the death of the king. A second,
closely related problem is in what manner and by whom a present ruler may be
replaced or deprived of power. To this second question hereditary monarchy gave no
definite answer, although the concept of diffidatio, or the severance of the bond of
allegiance between king and feudal lord, was invoked more than once in the medieval
period. Political systems, even those of primitive tribal societies, have approached
both problems in a variety of ways. Anthropological records show that tribal chiefs or
kings were sometimes selected as a result of ritual tests or the display of magical signs
and proofs of divine origin, usually as determined by the tribal elders or magical
leaders; in other cases, a principle of heredity, often diluted by a choice among heirs
in terms of physique or warrior ability, was applied; in still other cases, the chief was
elected, often from among the adult males of a select group of families. Techniques
for the removal of tribal rulers were equally varied. Sometimes the ruler would be
killed after a specified period or when his magical powers weakened or when his
physical prowess or health failed; in other cases the chief was exposed to periodic
tests of his magical powers or required to accept challenges to combat from other
qualified candidates for rule; and in some cases the elders could remove him from
office. Techniques for assuring the succession are also varied in the modern world.
Succession procedures range from the complex hieratic process of identifying a

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reincarnated Dalai Lama, which was practiced until quite recently in Tibet, to the
subtle, informal procedures by which parliamentary majorities choose a successor to
the office of prime minister in Britain. In fact, however, the succession practices of
modern political systems appear to be of four main types: (1) heredity, (2)
constitutional prescription, (3) election, and (4) force.

Hereditary succession.

Although dictators still occasionally seek to establish their sons as their heirs,
they usually rely on force rather than the claims of heredity to achieve their object.
Apart from a few states, mostly in the Arab world, where the dynastic ruler is the
effective head of the government, the hereditary principle of succession is now almost
exclusively confined to the constitutional monarchies of western Europe. There is
some irony in the fact that the line of succession is more securely established in these
monarchies now than at any point in their earlier history: intradynastic struggle, it
appears, is much less likely when kingship is mainly ceremonial. Heredity may be
reinforced or modified by constitutional prescription: this was the case, for example,
of the famous Act of Settlement that secured the Hanoverian succession in Britain.

Succession by constitutional prescription.

A leading example of succession by constitutional prescription is the United

States. Article II, Section 1, of the Constitution of the U.S. provides:
In case of the removal of the President from office, or of his death,
resignation, or inability to discharge the powers and duties of the said office,
the same shall devolve on the Vice President, and the Congress may by law
provide for the case of removal, death, resignation, or inability, both of the
President and Vice President, declaring what officer shall then act as
President, and such officer shall act accordingly, until the disability be
removed, or a President shall be elected.
A constitutional amendment was ratified in 1967 elaborating these procedures
to include further arrangements for dealing with the problem of presidential disability.
The original language of the Constitution has been the basis for the peaceful
succession of Vice Presidents John Tyler, Millard Fillmore, Andrew Johnson, Chester
Arthur, Theodore Roosevelt, Calvin Coolidge, Harry S. Truman, and Lyndon
Johnson. Constitutionally prescribed arrangements for assuring the succession are not
always so successful, and many states whose constitutions contain very similar
provisions have experienced succession crises that were resolved only by violence.

Succession by election.

Election is a principle of succession also frequently combined with

force. In cases of closely contested elections or where there is doubt as to the validity
or proper form of the election, the result is often a disputed succession. The Great
Schism in the papacy in the 14th century and the disputed succession to the elective
kingship of Hungary in the 16th century are examples of the failure of elective
systems to assure an orderly succession. Force is the effective basis of succession in
several contemporary states in which pro forma electoral confirmation is given to a
ruler who seizes power.
The problem of succession imposes great

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strains on any political order: the continuity of rule is broken, established patterns of
action are interrupted, and the future suddenly becomes uncertain. This political crisis
tests the character of regimes in ways that are of some importance for comparative
political analysis. A number of interesting comparisons may be drawn from the study
of succession practices, but perhaps the most important is the distinction between
those systems in which the problem is resolved primarily by force and those systems
in which heredity, constitutional prescription, or election assure a peaceful and
orderly succession. Political orders are subjected to another
kind of strain when the rule of their present power holders is challenged and the
question arises of depriving them of authority. This is the problem of the transfer of
power: whether, in what way, and by whom a present ruler may be displaced. Like
succession, it is a recurrent problem in all political systems, and, as in the case of
succession practices, the ways in which political systems respond to the strains
involved offer important clues to their character. It is, in a sense, the fundamental
political crisis, for all systems are in some way shaken, often violently, sometimes to
the point of destruction, by the struggles between established rulers and their rivals.
Succession by force.

Revolutions, which are the result of the crisis in its most extreme form,
involve the overthrow not merely of the government but of the political order itself.
Typically, a revolution is preceded by a series of strains within the system: challenges
to the authority of the government mount, and its legitimacy is increasingly
questioned; the exercise of power becomes coercive, and the challenge to rule
assumes ever more violent forms; eventually, the struggle comes to a dramatic climax
in the destruction of the old order. The coup d'etat is another form of violent
response to the crisis of rule, but it is distinguished from the revolution in that it
involves the overthrow only of the government: the political order is not immediately
affected, for the coup is managed by an individual or group within the government or
within the ruling class. In some cases, however, the coup d'etat is merely a
preliminary stage to revolution. Sometimes this happens when the new ruler leads a
governmentally imposed revolution: this was the role played by Napoleon I, Napoleon
III, Mussolini, and Hitler. At other times, coups are actually prompted by fear of
revolution but succeed only in further weakening the claims to legitimacy of the
existing order: this has recently been the case in some countries in the non-Western
world where conservative-led coups were quickly overthrown by revolutionary
movements. In addition to revolutions and coups d'etat, the crisis of rule may prompt
other forms of violent political reaction, including civil war and secession, resistance
movements and rebellions, guerrilla warfare and terrorism, class warfare, and peasant
revolts.
`The causes of internal conflict leading to the forcible
overthrow of governments are extremely varied. They include tensions created by
rapid social and economic development; the rise of new social classes and the refusal
of established elites to share their power; problems of the distribution of wealth and
the grievances of different economic groups and interests; the rise of corrosive social
and political philosophies and the estrangement of intellectuals; conflict of opinions
over the ends of government; factional struggles among power holders or within the
ruling class; the rise of a charismatic leader; oppressive rule that alienates powerful
groups; weak rule that tolerates antigovernmental or revolutionary movements; and
many different combinations of these and other social, economic, and political factors.
All political systems experience some of these conditions with some frequency. Yet

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there are a number of modern states that have avoided internal wars and the forcible
overthrow of their governments for considerable periods. It
appears that rulers in the contemporary world are generally safe from violent
challenges if they possess an effective monopoly of military, economic, and political
power, linked with certain important social controls; or, alternatively, if they are
obliged to exercise limited powers for specified periods and are required to yield
office to rivals who meet certain qualifications. The first is the definition of a modern
totalitarian regime, fully and efficiently organized; the second describes the
governments of several contemporary constitutional democracies. In the first case, the
government secures itself by force combined with social and psychological means of
preventing the formation of opposition. In the second case, alternatives to internal war
are provided by the opportunities for oppositions to influence the exercise of power
and ultimately to replace the government. The great achievement of constitutional
democracy has been to give reasonable security to governments from forcible
overthrow by compelling them to accept limitations on their power, by requiring them
to forgo the use of force against rivals who agree to accept the same limitations, and
by establishing well-known legal procedures through which these rivals may
themselves constitute the government.

Autocratic versus nonautocratic rule.

The foregoing discussion has suggested a distinction among political systems

in terms of the role played by force in the acquisition and transfer of power. The role
of force is vital, also, in distinguishing among political systems in terms of the
exercise and control of power. Here the contrast is essentially between "autocratic"
and "nonautocratic" governments, for totalitarianism is only a recent species of
autocracy, to which constitutionalism is the principal contemporary antithesis.
Autocracy is characterized by the concentration of power in a single centre, be it an
individual dictator or a group of power holders such as a committee or a party
leadership. This centre relies on force to suppress opposition and to limit social
developments that might eventuate in opposition. The power of the centre is not
subject to effective controls or limited by genuine sanctions: it is absolute power. In
contrast, nonautocratic government is characterized by the existence of several
centres, each of which shares in the exercise of power. Nonautocratic rule allows the
development of social forces that generate a variety of interests and opinions. It also
subjects the power holders to reciprocal controls and to effective sanctions of law.
In appearance, autocracy may sometimes be difficult to
distinguish from nonautocratic rule. Often, autocracies attempt to borrow legitimacy
by adopting the language of the constitutions of nonautocratic regimes or by
establishing similar institutions. It is a common practice, for example, in many
modern totalitarian states to establish institutions--parliaments or assemblies,
elections and parties, courts and legal codes--that differ little in appearance from the
institutional structures of constitutional democracies. Similarly, the language of
totalitarian constitutions is often couched in terms of the doctrines of popular rule or
democracy. The difference is that in totalitarian regimes neither the institutions nor
the constitutional provisions act as effective checks on the power of the single centre:
they are essentially facades for the exercise of power through hierarchical procedures
that subject all the officials of the state to the commands of the ruling individual or
group. The underlying realities of autocratic rule are always the concentration of
power in a single centre and the mobilization of force to prevent the emergence of

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opposition. Totalitarianism, as already noted, has been a chief form of autocratic
rule; it is distinguished from previous forms in its use of state power to impose an
official ideology on its citizens. Nonconformity of opinion is treated as the equivalent
of resistance or opposition to the government, and a formidable apparatus of
compulsion, including various kinds of state police or secret police, is kept in being to
enforce the orthodoxy of the proclaimed doctrines of the state. A single party,
centrally directed and composed exclusively of loyal supporters of the regime, is the
other typical feature of totalitarianism. The party is at once an instrument of social
control, a vehicle for ideological indoctrination, and the body from which the ruling
group recruits its members. In the
modern world, constitutional democracy is the chief type of nonautocratic
government. The minimal definition in institutional terms of a constitutional
democracy is that it should provide for a regularized system of periodic elections with
a free choice of candidates, the opportunity to organize competing political parties,
adult suffrage, decisions by majority vote with protection of minority rights, an
independent judiciary, constitutional safeguards for basic civil liberties, and the
opportunity to change any aspect of the governmental system through agreed
procedures. Two features of constitutional democracy require emphasis in contrasting
it with modern totalitarian government: the constitution, or basic law, and the political
party. A constitution, as the example of British constitutional
democracy suggests, need not be a single written instrument; indeed, the essence of a
constitution is that it formalizes a set of fundamental norms governing the political
community and determining the relations between the rulers and the people and the
interaction among the centres of power. In most modern constitutional democracies,
however, there is a constitutional document providing for fixed limitations on the
exercise of power. These provisions usually include three major elements: an
assignment of certain specified state functions to different state organs or offices, the
delimitation of the powers of each organ or office, and the establishment of
arrangements for their cooperative interaction; a list of individual rights or liberties
that are protected against the exercise of state power; and a statement of the methods
by which the constitution may be amended. With these provisions a concentration of
power in the hands of a single ruler is prevented, certain areas of political and social
life are made immune to governmental intervention, and peaceable change in the
political order is made possible. The political party is the other chief instrument of
constitutional democracy, for it is the agency through which the electorate is involved
in both the exercise and transfer of power. In contrast with the centralized, autocratic
direction of the totalitarian single-party organization, with its emphasis on ideological
conformity and restricted membership, the political parties of constitutional
democracy are decentralized, concerned with the integration of many interests and
beliefs, and open to public participation. In constitutional democracies there is usually
some measure of competition among two or more parties, each of which, if it cannot
hope to form a future government, has some ability to influence the course of state
action. The party in a constitutional democracy is at once a means of representing a
mass electorate in the exercise of power and also a device for allowing the peaceful
replacement of one set of power holders with another.
The distinction between autocratic and nonautocratic rule
should not conceal the existence of intermediate types that combine elements of both.
In these cases, also, the best procedure for comparative purposes is to investigate the
power configurations underlying the formal structures and to examine the extent to
which power is concentrated in a single centre or the role that is played by force in the

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maintenance of the regime. It is a type of analysis that, by guiding attention to the
relative weight of coercive and consensual power and the scope of individual freedom
in the political order, allows comparisons between systems in terms of their most
important attributes.

GOVERNMENTS CLASSIFIED BY STAGE OF DEVELOPMENT

Analyzing political change.

Political life is shaped by a wide variety of factors, including social and

cultural conditions, economic organization, intellectual and philosophical influences,
geography or climate, and historical circumstance. Recurrent attempts have been
made to reduce this range of variables to analytically manageable dimensions. This is
partly the motive, for example, of Marxist and other efforts to relate specific types of
political systems to stages of economic development or particular kinds of
socioeconomic organization. Although interesting interrelations between political and
economic development have been discovered, such monistic, or single-factor,
approaches are inadequate to the task of explaining political change. The problem is
not only that there are many factors that should be examined but also that they are
found in different combinations from one society to another. All political orders are
unique as products of history and creations of the peculiar forces and conditions of
their environment. A second problem that confronts comparative analysis is the
difficulty of devising measures of political development. The definition of what is
modern or what constitutes an advanced or developed political system has troubled
many recent writers. Clearly, the older notions of development toward the goals of
constitutionalism or democracy must now be seriously questioned, and to judge the
maturity of a political system in terms of the extent to which it adopts any particular
set of institutions or techniques of rule is an equally doubtful procedure. Another
difficulty is that political change is not simply a reaction to "objective" factors such as
economic forces but also the product of conscious manipulation. In explaining the
growth and development of political systems it is impossible to ignore the fact that
men, having considered the advantages and disadvantages of different forms of
government, often decide to adopt one form rather than another. A similar problem
arises from the fact that the nature of the interaction between political systems and
their environment is extremely complex. For example, to treat the political system as
merely the outgrowth of particular patterns of social or economic organization is to
ignore the fact that changes in social and economic structures are often the product,
sometimes the intended product, of governmental action.

Emergence of advanced nation-states.

These difficulties of analysis have prevented the emergence of any

satisfactory theory to explain the processes of political change or growth. In the
absence of such a theory, however, several writers have recently attempted to identify
certain basic phases in the development of national political systems. For example,
five major steps in the emergence of the advanced nation-states of the modern world
are often distinguished: (1) unification and independence or autonomy; (2)
development and differentiation of political institutions and political roles; (3) transfer

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of power from traditional elites; (4) further institutional and political role
differentiation accompanied by the development of a number of organized social
interests and growth in governmental functions; and (5) use of state power in attempts
to guide or control social and economic activity, extensive exploitation of resources as
the result of technological development, and full participation in the international
political system.
Other writers distinguish among "traditional," "transitional," and
"modern" societies in an effort to identify differences and regularities in social,
economic, cultural, and political development. The social structure of the traditional
society is described as hierarchical, class bound, based on kinship, and divided into
relatively few effectively organized social groupings; its economic basis is primarily
agricultural, and industry and commerce are relatively undeveloped; its political
institutions are those of sacred monarchy, rule by a nobility, and various forms of
particularism. The social system of the transitional society is typified by the formation
of new classes, especially a middle class and a proletariat, and conflict among ethnic,
religious, and cultural groupings; its economic system experiences major tensions as
the result of technological development, the growth of industry, urbanization, and the
use of rapid communications; its political institutions are typically authoritarian,
although constitutional forms also make their appearance. Modernity is seen as the
age of high social mobility, equality, universal education, mass communications,
increasing secularism, and sociocultural integration; in its economic system, the
modern society experiences a further technological revolution, massive urbanization,
and the development of a fully diversified economy; its political institutions are those
of democracy and modified totalitarianism, and, in either case, a specialized
bureaucracy is used to carry on the expanding functions of government.
These efforts to identify stages of
"modernization" are poor substitutes for a general theory of political change, but they
serve to emphasize the increasing complexity of all the structures--social, economic,
and political--of the modern state. The elaboration of the institutions and procedures
of modern government appears to be partly a reflection of the social and economic
forces at work in the contemporary world and partly the result of efforts to control
these forces through governmental action. The complex structures of advanced
political orders are treated in the discussion that follows.

The structure of government

The study of governmental structures must be approached with great caution,
for political systems having the same kind of legal arrangements and using the same
type of governmental machinery often function very differently. A parliament, for
example, may be an important and effective part of a political system; or it may be no
more than an institutional facade of little practical significance. A constitution may
provide the framework within which the political life of a state is conducted; or it may
be no more than a piece of paper, its provisions bearing almost no relationship to the
facts of political life. Political systems must never be classified in terms of their legal
structures alone: the fact that two states have similar constitutions with similar
institutional provisions and legal requirements should never, by itself, lead to the
conclusion that they represent the same type of political system.
To be useful, the study of
governmental structures must always proceed hand in hand with an investigation of
the actual facts of the political process: the analyst must exercise the greatest care in

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distinguishing between form and reality and between prescription and practice.
Approached in this way, an examination of the organizational arrangements that
governments use for making decisions and exercising power can be a valuable tool of
political inquiry.

CONTEMPORARY FORMS OF GOVERNMENT

Few states in the modern world have constitutional arrangements that

are more than a century old. Indeed, the vast majority of all the world's states have
constitutions written in the 20th century. This is true of states, such as Germany, Italy,
and Japan, that were defeated in World War II and of other states, such as the
successor states of the Soviet Union, Spain, and China, that have experienced civil
war and revolutions in the course of the century. Great Britain and the United States
are almost alone among major contemporary nation-states in possessing constitutional
arrangements that predate the 20th century.
Even in Britain and the United States, the 20th century has seen
much change in the governmental system. In the United States, for example, the
relationship of legislature and executive at both the national and the state levels has
been significantly altered by the growth of bureaucracies and the enlargement of the
executive's budgetary powers. In Britain, even more far-reaching changes have
occurred in the relationship between the prime minister and Parliament and in
Parliament's role in supervising the executive establishment. In both countries, the
appearance of the welfare state, the impact of modern technology on the economy,
and international crises have resulted in major alterations in the ways in which the
institutions of government function and interact.
The modern
student of constitutional forms and institutional arrangements confronts an endlessly
changing world. In many parts of the world, in countries as different as France,
Pakistan, Argentina, and Tanzania, there have been continuing experiments with new
constitutions. The adoption of new constitutions is also a major aspect of political
change in almost all of the states of eastern Europe and in the successor states of the
Soviet Union. All systems, moreover, even without formal constitutional change,
undergo a continual process of adjustment and mutation as their institutional
arrangements respond to and reflect changes in the social order and the balance of
political forces.

Monarchy.

The ancient distinction among monarchies, tyrannies, oligarchies, and

constitutional governments, like other traditional classifications of political systems,
is no longer very descriptive of political life. A king may be a ceremonial dignitary in
one of the parliamentary democracies of western Europe, or he may be an absolute
ruler in one of the emerging states of North Africa, the Middle East, or Asia. In the
first case his duties may be little different from those of an elected president in many
republican parliamentary regimes; in the second his role may be much the same as
that of countless dictators and strongmen in autocratic regimes throughout the less-
developed areas of the world.
It may be said of the reigning dynasties
of modern Europe that they have survived only because they failed to retain or to
acquire effective powers of government. Royal lines have been preserved only in

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those countries of Europe in which royal rule was severely limited prior to the 20th
century or in which royal absolutism had never firmly established itself. More
successful dynasties, such as the Hohenzollerns in Germany, the Habsburgs in
Austria-Hungary, and the Romanovs in Russia, which continued to rule as well as to
reign at the opening of the 20th century, have paid with the loss of their thrones.
Today in countries such as Great Britain or The Netherlands or Denmark the monarch
is the ceremonial head of state, an indispensable figure in all great official occasions
and a symbol of national unity and of the authority of the state, but is almost entirely
lacking in power. Monarchy in the parliamentary democracies of modern Europe has
been reduced to the status of a dignified institutional facade behind which the
functioning mechanisms of government--cabinet, parliament, ministries, and parties--
go about the tasks of ruling. The 20th century has also seen the
demise of most of the hereditary monarchies of the non-Western world. Thrones have
toppled in Turkey, in China, in most of the Arab countries, in the principates of India,
in the tribal kingdoms of Africa, and in several countries of Southeast Asia. The kings
who maintain their position do so less by the claim of legitimate blood descent than
by their appeal as popular leaders responsible for well-publicized programs of
national economic and social reform or as national military chieftains. In a sense,
these kings are less monarchs than monocrats, and their regimes are little different
from several other forms of one-man rule found in the modern world.
Dictatorship.

While royal rule, as legitimized by blood descent, had almost vanished as an

effective principle of government in the modern world, monocracy--a term that
comprehends the rule of the remaining non-Western royal absolutists, of the generals
and strongmen of Latin America and Asia, of the messianic leaders of postcolonial
Africa, and of the totalitarian heads of Communist states--still flourished. Indeed, the
20th century, which has witnessed the careers of Atatürk, Benito Mussolini, Adolf
Hitler, Joseph Stalin, Francisco Franco, Mao Tse-tung, Juan Perón, Tito, Gamal
Abdel Nasser, Sukarno, Kwame Nkrumah, and Charles de Gaulle, could appear in
history as the age of plebiscitary dictatorship.
In many of the states of Africa
and Asia, for example, dictators quickly established themselves on the ruins of
constitutional arrangements inherited from Western colonial powers. In some of these
countries, presidents and prime ministers captured personal power by banning
opposition parties and building primitive replicas of the one-party systems of the
Communist world. In other new countries, the armies seized power, and military
dictatorships were established. Whether as presidential dictatorships or as military
dictatorships, the regimes that came into being appear to have had common roots in
the social and economic problems of the new state. The constitutional
systems inherited from the colonial powers proved unworkable in the absence of a
strong middle class; local traditions of autocratic rule retained a powerful influence;
the army, one of the few organized forces in society, was also often the only force
capable of maintaining order; and a tiny intellectual class was impatient for economic
progress, frustrated by the lack of opportunity, and deeply influenced by the example
of authoritarianism in other countries. The dictatorships that resulted proved
highly unstable, and few of the individual dictators were able to satisfy for long the
demands of the different groups that supported their bids for power.
Although similar in some respects to the dictatorships of the new
nations, the caudillos of 19th- and 20th-century Latin America represent a very

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different type of monocratic rule. In its 19th-century form, caudillismo was the result
of the breakdown of central authority. After a brief period of constitutional rule, each
of the former Spanish colonies in the Americas experienced a collapse of effective
national government. A self-proclaimed leader, usually an army officer, heading a
private army typically formed from the peasantry with the support of provincial
landowners, established his control over one or more provinces, and then marched
upon the national capital. The famous 19th-century caudillos--Antonio López de
Santa Anna of Mexico or Juan Manuel de Rosas of Argentina, for example--were thus
essentially provincial leaders who seized control of the national government to
maintain the social and economic power of provincial groups. The 20th-century
dictatorships in Latin-American countries have had different aims. The modern
caudillo is less a provincial than a national leader. The Perón regime, for example,
was established by nationalistic army officers committed to a program of national
reform and ideological goals. Often, too, recent dictators in Latin America have allied
themselves with a particular social class, attempting either to maintain the interests of
established economic groupings or to press social reforms.
Dictatorship in the
technologically advanced, totalitarian regimes of modern Communism is distinctively
different from the authoritarian regimes of either Latin America or the new states of
Africa and Asia. Nazi Germany under Hitler and the Soviet Union under Stalin are the
leading examples of modern totalitarian dictatorships. The crucial elements of both
were the identification of the state with the single mass party and of the party with its
charismatic leader, the use of an official ideology to legitimize and maintain the
regime, the employment of a terroristic police force and a controlled press, and the
application of all the means of modern science and technology to control the economy
and individual behaviour. The two systems, however, may be distinguished in several
ways. Fascism, in its National Socialist form, was primarily a counterrevolutionary
movement that mobilized middle- and lower middle-class groups to pursue
nationalistic and militaristic goals and whose sole principle of organization was
obedience to the Führer. By contrast, Soviet Communism grew out of a revolutionary
theory of society, pursued the goal of revolutionary overthrow of capitalist systems
internationally, and employed the complex bureaucratic structures of the Communist
Party as mechanisms of governmental organization.
Western constitutional democracies have provided examples of another
type of contemporary dictatorship. At various points in the 20th century, during
periods of domestic or foreign crisis, most constitutional regimes have conferred
emergency powers on the executive, suspending constitutional guarantees of
individual rights or liberties or declaring some form of martial law. Indeed, the
constitutions of some Western democracies explicitly provide for the grant of
emergency powers to the executive in a time of crisis to protect the constitutional
order. In many cases, of course, such provisions have been the instruments with which
dictators have overthrown the regime. Thus, the proclamation of emergency rule was
the beginning of the dictatorships of Mussolini in Italy, of Kemal Atatürk in Turkey,
of Józef Pilsudski in Poland, of António de Olveira Salazar in Portugal, of Franz von
Papen and Hitler in Germany, and of Engelbert Dollfuss and Kurt von Schuschnigg in
Austria. In other democracies, however, constitutional arrangements have survived
quite lengthy periods of crisis government. After World War II, for example, in both
the United States and Britain, the use of extraordinary powers by the executive came
to a halt with the end of the wartime emergency. Similarly, although the 1958
constitution of the Fifth Republic of France contained far-reaching emergency powers

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conferred on the president--"when the institutions of the Republic, the independence
of the nation, the integrity of its territory or the fulfillment of its international
obligations are threatened with immediate and grave danger, and when the regular
functioning of the constitutional authority is interrupted"--their implicit threat to the
constitutional order has not been realized.
Many forces at work in the 20th century appear
to lend impetus to the rise of monocratic forms of rule. In nearly all political systems,
the powers of chief executives have increased in response to the demanding social,
economic, and military crises of the age. The complex decisions required of
governments in a technological era, the perfectionist impulses of the great
bureaucratic structures that have developed in all industrialized societies, and the
imperatives of national survival in a nuclear world continue to add to the process of
executive aggrandizement. The question for many constitutional regimes is whether
the limitation and balance of power that are at the heart of constitutional government
can survive the growing enlargement of executive power.

Oligarchy.

In the Aristotelian classification of government, there were two forms of rule

by the few: aristocracy and its debased form, oligarchy. Although the term oligarchy
is rarely used to refer to contemporary political systems, the phenomenon of
irresponsible rule by small groups has not vanished from the world.
Many of the
classical conditions of oligarchic rule were found until recently in those parts of Asia
in which governing elites were recruited exclusively from a ruling caste--a hereditary
social grouping set apart from the rest of society by religion, kinship, economic status,
prestige, and even language. In the contemporary world, in some countries that have
not experienced the full impact of industrialization, governing elites are still often
recruited from a ruling class--a stratum of society that monopolizes the chief social
and economic functions in the system. Such elites have typically exercised power to
maintain the economic and political status quo. The
simple forms of oligarchic rule associated with pre-industrial societies are, of course,
rapidly disappearing. Industrialization produces new, differentiated elites that
replace the small leadership groupings that once controlled social, economic, and
political power in the society. The demands of industrialization compel recruitment on
the basis of skill, merit, and achievement rather than on the basis of inherited social
position and wealth. New forms of oligarchic rule have also made their appearance in
many advanced industrial societies. Although governing elites in these societies are
no longer recruited from a single class, they are often not subjected to effective
restraints on the exercise of their power. Indeed, in some circumstances, the new elites
may use their power to convert themselves into a governing class whose interests are
protected by every agency of the state. Oligarchic tendencies of a lesser degree have
been detected in all the great bureaucratic structures of advanced political systems.
The growing complexity of modern society and its government thrusts ever greater
power into the hands of administrators and committees of experts. Even in
constitutional regimes, no fully satisfactory answer has been found to the question of
how these bureaucratic decision makers can be held accountable and their powers
effectively restrained without, at the same time, jeopardizing the efficiency and
rationality of the policy-making process.

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 Constitutional government.

Constitutional government is defined by the existence of a constitution--

which may be a legal instrument or merely a set of fixed norms or principles generally
accepted as the fundamental law of the polity--that effectively controls the exercise of
political power. The essence of constitutionalism is the control of power by its
distribution among several state organs or offices in such a way that they are each
subjected to reciprocal controls and forced to cooperate in formulating the will of the
state. Although constitutional government in this sense flourished in England and in
some other historical systems for a considerable period, it is only recently that it has
been associated with forms of mass participation in politics. In England, for example,
constitutional government was not harnessed to political democracy until after the
Reform Act of 1832 and subsequent 19th-century extensions of the suffrage. In the
contemporary world, however, constitutional governments are also generally
democracies, and in most cases they are referred to as constitutional democracies or
constitutional-democratic systems. The
contemporary political systems that combine constitutionalism and democracy share a
common basis in the primacy they accord to the will of the majority of the people as
expressed in free elections. In all such systems, political parties are key institutions,
for they are the agencies by which majority opinion in a modern mass electorate is
mobilized and expressed. Indeed, the history of the political party in its modern form
is coincidental with the development of contemporary constitutional-democratic
systems. In each case, the transition from the older forms of constitutionalism to
modern constitutional democracy was accompanied by the institutionalization of
parties and the development of techniques of party competition. The essential
functions of political parties in a constitutional democracy are the integration of a
multitude of interests, beliefs, and values into one or more programs or proposals for
change and the nomination of party members for elective office in the government. In
both functions, the party serves as a link between the rulers and the ruled: in the first
case by allowing the electorate to register an opinion on policy and in the second by
giving the people a chance to choose their rulers. Of course, the centralized,
autocratically directed, and ideologically orthodox one-party systems of totalitarian
regimes perform neither of these functions.
The two major types of constitutional
democracy in the modern world are exemplified by the United States and Great
Britain. The United States is the leading example of the presidential system of
constitutional democracy; Britain, although its system is sometimes referred to as a
cabinet system in recognition of the role of the Cabinet in the government, is the
classic example of the parliamentary system. The U.S. presidential system is based
on the doctrine of separation of powers and distinguishes sharply between the
personnel of the legislature and the executive; the British parliamentary system
provides for the integration or fusion of legislature and executive. In the U.S. system
the separation of legislature and executive is reinforced by their separate election and
by the doctrine of checks and balances that provides constitutional support for
routine disagreements between the branches; in the British system the integration of
legislature and executive is reinforced by the necessity for their constant agreement,
or for a condition of "confidence" between the two, if the normal processes of
government are to continue. In the U.S. system reciprocal controls are provided by
such devices as the presidential veto of legislation (which may be overridden by a
two-thirds majority in Congress), the Senate's role in ratifying treaties and confirming

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executive nominations, congressional appropriation of funds and the exclusive ability
to declare war, and judicial review of legislation; in the British system the major
control device is the vote of "no confidence" or the rejection of legislation that is
considered vital. The prestige of constitutional democracy was once so great that
many thought all the countries of the world would eventually accede to the examples
of the United States or Britain and establish similar arrangements. However, the
collapse of the Weimar Constitution in Germany in the 1930s and the recurrent
political crises of the Fourth Republic in France after World War II suggested that
constitutional democracy carries no guarantee of stability. The failure of both
presidential and parliamentary systems to work as expected in less-advanced countries
that modelled their constitutions on those of the United States and Britain resulted in a
further diminution in the prestige of both systems. Functioning examples are located
throughout the world, though these are generally poorly institutionalized outside of
those countries with direct historical ties to western Europe. Japan is a notable
exception to this generalization, as are Costa Rica, India, and several other states to a
lesser degree.

CONTEMPORARY LEVELS OF GOVERNMENT

Most national societies have passed through a stage in their social and
political development, usually referred to as feudalism, in which a weak and
ineffectively organized national government competes for territorial jurisdiction with
local power holders. In medieval England and France, for example, the crown was
perennially threatened by the power of the feudal nobles, and a protracted struggle
was necessary before the national domain was subjected to full royal control.
Elsewhere, innumerable societies continued to experience this kind of feudal conflict
between local magnates and the central government well into the modern era. The
warlords of 19th- and 20th-century China, for example, were just as much the
products of feudal society as the warring barons of 13th-century England and
presented the same kind of challenge to the central government's claim to exercise
sovereign jurisdiction over the national territory. By the 1970s, feudalism was almost
extinct. The social patterns that had formerly supported the power of local landowners
were rapidly disappearing, and central governments had generally acquired a near
monopoly of communications and military technology, enabling them to project their
power into areas once controlled by local rulers.
In nearly
all national political systems, central governments are better equipped than ever
before to exercise effective jurisdiction over their territories. In much of the
developing world, nationalist political movements and a variety of modern economic
forces have swept away the traditional structures of local government, and the quasi-
autonomous governments of village and tribe and province have been replaced by
centrally directed systems of subnational administration. Even in the heavily
industrialized states of the modern world, there has been an accelerating tendency
toward greater centralization of power at the national level. In the United States, for
example, the structure of relationships among the governments at the national, state,
and local levels has changed in a number of ways to add to the power of the federal
government in Washington. Even though the system of national grants-in-aid appears
to have been designed as a means of decentralizing administration, the effect has been
decidedly centralist, for the conditional character of the grants has allowed the federal

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government to exercise influence on state policies in fields that were once
invulnerable to national intervention.

National government.

The nation-state is the dominant type of political system in the contemporary

world, and nationalism, or the creed that centres the supreme loyalty of the people
upon the nation-state, is the dominating force in international politics. The national
ideal triumphed as a result of the wars of the 19th and 20th centuries. The Napoleonic
Wars, which spread the doctrines of the French Revolution, unleashed nationalism as
a force in Europe and led to the Risorgimento in Italy and the emergence of
Bismarck's Germany. The two world wars of the 20th century carried the principles of
national self-determination and liberal democracy around the world and gave birth to
the independence movements that resulted in the foundation of new states in eastern
Europe in 1919 and the emergence from colonial status of countries in Asia and
Africa after 1945. The collapse of the Warsaw Pact and the Soviet Union itself
completed this process of moving from multinational empires to truly sovereign
national states. All
the major forces of world politics-- e.g., war, the development of national economies,
and the demand for social services--have reinforced the national state as the primary
focus of people's loyalties. Wars have played the major part in strengthening national
governments and weakening political regionalism and localism. The attachments that
people have to subnational political communities are loosened when they must
depend for their security on the national power. Even in the new age of total war--
which few nations are capable of waging and even fewer of surviving--people look
for their security to national governments rather than to international organizations. In
nearly all contemporary states, the national budget is dominated by expenditures for
defense, the military employs the largest fraction of the work force, and questions of
national security pervade the discussion of politics.
One of the lessons of the late 20th century is that
national sovereignty continues to be the most important obstacle not only to the
emergence of new forms of supranational government but to effective international
cooperation as well. Almost everywhere, attempts to achieve federation and other
forms of multinational communication have foundered on the rocks of nationalism.
The collapse of the Federation of Rhodesia and Nyasaland and the Federation of
Malaya, for example, were paralleled by the seeming ineffectiveness of the
Organization of American States and the Arab League. On another level is the
collapse of the Warsaw Pact when the nations of eastern Europe reclaimed their
sovereignty in the late 1980s, after decades of domination by the Soviet Union. In
western Europe, nations have joined together to form a confederation known as the
European Union (EU). These countries are united not only by a long history and a
common cultural inheritance but also by the expectation of mutual economic
advantage. Even in this case, nationalism has proved to be an obstacle to the most
ambitious goals of unification, which would severely limit national sovereignty in
some spheres. At the international level,
anarchy is the principal form of contemporary rule, for the nation-state's freedom of
action is limited only by its power. While the state's freedom of action may not be
directly threatened, the effectiveness of the state's action in the economic realm is
increasingly being called into question. The development of national industries in the
19th and early 20th centuries played a major part in strengthening national as against

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regional and local political entities, but the scale of economic activity has now
outgrown national markets. Industrial combines and commercial groupings have
emerged that cross national frontiers and require international markets. This tight
integration of the world economy has limited the effectiveness of some traditional
instruments used to influence national trends in capitalist economies.
It is increasingly clear that some aspects of traditional
sovereignty may be affected by serious efforts to confront some issues that act on the
entire international system. National frontiers can no longer be adequately defended in
an era of intercontinental ballistic missiles, especially with the rapid diffusion of the
technology required for delivery systems as well as for nuclear weapons themselves.
Action in this area is, by definition, an attempt to shape the national security policy of
states, something very near the core of a state's sovereignty. Concern over
environmental matters could lead to more restrictive regimes than any arms-control
provisions, ultimately shaping the way in which nations evolve economically.
Destruction of major ecosystems, wasteful use of energy, and industrialization based
on the use of fossil fuels are all national policies with international repercussions. As
technology empowers more countries to directly affect the state of the planet as well
as other nations, there are increasing incentives to limit the domestic policy choices of
all nations.
Although the failure of efforts to achieve world government
and to develop an effective system of international law may be regretted, it should
perhaps be remembered that the nation-state continues to function as an extremely
effective system for maintaining order within its boundaries. In some cases, this is
achieved with remarkably little coercion and in such a way that the progress of
civilization is encouraged. Under present-day conditions, world government might
well involve much higher levels of coercion and much less civilization.

Regional and state government.

The 18th-century political philosopher Montesquieu wrote that governments

are likely to be tyrannical if they are responsible for administering large territories, for
they must develop the organizational capacity characteristic of despotic states. It was
partly this fear that led the American founding fathers to provide for a federal system
and to divide governmental functions between the government in Washington and the
state governments. Modern technology and mass communication are often said to
have deprived Montesquieu's axiom of its force. Yet the technology that makes it
possible for large areas to be governed democratically also holds out the spectre of an
even greater tyranny than Montesquieu foresaw. In all political systems the
relationships between national and regional or state governments have been affected
by technology and new means of communication. In the 18th century Thomas
Jefferson--in arguing that local government, or the government closest to the people,
was best--could claim that citizens knew most about their local governments,
somewhat less about their state governments, and least about the national government.
In the present-day United States, however, the concentration of the mass media on the
issues and personalities of national government has made nonsense of this
proposition. As several recent studies have demonstrated, people know much less
about local government than national government and turn out to vote in much larger
numbers in national elections. The necessity for employing systems for the devolution
of political power is reduced when a central government can communicate directly
with citizens in all parts of the national territory, and the vitality of subnational levels

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of government is sapped when public attention is focussed on national problems.
Another general
development that has lessened the importance of regional or state government is the
rise of efficient national bureaucracies. In nearly all political systems, there has been
some tendency toward bureaucratic centralization, and in some cases national
bureaucracies have almost completely replaced older systems of regional and
provincial administration. In the United States, for example, complex programs of
social security, income taxes, agricultural subsidies, and many others that bear
directly on individuals are centrally administered. Even in systems in which a
division of functions between national and subnational governments is
constitutionally prescribed, the prevailing trend in intergovernmental relations is
toward increasing involvement of the national government in areas once dominated
by regional or state governments. Thus, the original constitutional arrangements
prescribed by the Allied powers for the West German republic in 1949 won general
acclaim at the time because they provided for greater decentralization than had the
Weimar Constitution; but, as soon as Germany was free to amend its own
constitution, several state functions were reassigned to the national government. In the
United States, also, the collapse of the doctrine of "dual federalism," according to
which the powers of the national government were restricted by the powers reserved
to the states, signalled the end of an era in which the states could claim exclusive
jurisdiction over a wide range of functions. Today, forms of cooperative federalism
involving joint action by national and state governments are increasingly common.
Such cooperative relationships in the United States include programs of public
assistance, the interstate highway system, agricultural extension programs, and aid to
education. In some areas, such as school desegregation, the national government has
used broad powers to compel states to conform to national standards. Efforts
made to halt the trend toward centralization and to reinvigorate regional or state
governments have met with little success. In the United States a Commission on
Intergovernmental Relations established by President Eisenhower in 1953 concluded
that it could recommend no major reversion of functions to state governments.
Similarly, efforts in France and Italy to decentralize parts of the national
administrations have had few practical results. Political regionalism appears to be in
steep decline almost everywhere, whether in China or in the American South. The
attachments that bind people to localities and allow the growth of genuine subnational
political communities have weakened under the impact of technology and the growth
of national economies. Only where political regionalism has always been in reality a
cloak for movements of national independence--for example, in Scotland, Wales,
Northern Ireland, Quebec, and Brittany--are there popular attempts to reverse the
trend toward national centralization.
City and local government.

Political scientists since Aristotle have recognized that the nature of political
communities changes when their populations grow larger. One of the central problems
of contemporary government is the vast increase in urban population and the
progression from "polis to metro-polis to mega-polis." The catalog of ills that have
resulted from urban growth includes political and administrative problems of
extraordinary complexity. Aging
infrastructure has become an issue of pressing national importance in the United
States, with the major cities obviously suffering in this area. Grave social problems--
for example, violent crime (especially that committed by youths in poverty-stricken

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areas), drug trafficking, unemployment, and homelessness--are concentrated to such a
degree that they directly shape the environment in many large urban areas. The
majority of cities are ill equipped to handle these problems without significant
assistance from the national government. The tax base of U.S. cities has dwindled
with the flight of the middle classes to the suburbs and the relocation of industry.
Largely as a result of this, political power has begun to follow wealth out of the cities
and into adjoining suburbs. These outlying areas have not only increased significantly
in population, but, compared with that of many large cities, it is a population more
likely to vote and otherwise lobby for its interests. This has served to reduce the
national government's activism in the cities at the very time when most cities are
suffering from a drastically reduced capacity to act. Aside from such fiscal and
political pressures, however, the national government is inevitably concerned with the
threats posed by racial conflict, ghetto violence, and other kinds of social chaos in the
cities. The metropolis suffers from several acute governmental and
administrative failures. Responsibility for the issues that transcend the boundaries of
local governments has not been defined, for representative institutions have failed to
develop at the metropolitan level. In most cases, there are no effective governmental
structures for administering area-wide services or for dealing comprehensively with
the common problems of the metropolitan community. The result has been the
appearance of a new class of problems created by government itself, including uneven
levels of service for metropolitan residents, inequities in financing government
services and functions, and variations in the democratic responsiveness of the
governments scattered through the metropolitan area. The tangled pattern of local
governments, each operating in some independent sphere, does not allow the
comprehensive planning necessary to deal with the escalating problems of urban life.

Efforts to create new governing structures for metropolitan

communities are among the most interesting developments in contemporary
government. In the United States these efforts include the creation of special districts
to handle specific functions, area-wide planning agencies, interstate compacts,
consolidated school and library systems, and various informal intergovernmental
arrangements. Although annexation of outlying areas by the central city and city-
county consolidations have been attempted in many cases, the reluctance of urban
areas to surrender their political independence or to pay for central-city services has
been an obstacle. The Los Angeles plan, by which the county has assumed
responsibility for many area-wide functions, leaving the local communities with
substantial political autonomy, may represent a partial solution to the problem of
urban-suburban tensions. In other cases, "metropolitan federation" has been
attempted. One of the earliest and most influential examples of a federated system of
metropolitan government is the Greater London Area in Britain, which encompasses
32 London boroughs and places effective governing powers in the hands of an elected
city council. In Canada the city of Toronto and its suburbs adopted a metropolitan
"constitution" in 1953 under which mass transit, highways, planning, and several
other functions are controlled by a council composed of elected officials from the
central city and surrounding governments. In 1957 Miami and Dade County in Florida
chose "metro" government: Miami and 27 suburban cities retained control of local
functions, while area-wide functions such as fire and police protection and
transportation were allocated to the new federal structure. In 1962 Nashville,
Tennessee, combined with Davidson County to form a single metropolitan
government; and in 1968 Jacksonville, Florida, joined with Duval County in a similar

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arrangement. Other examples of various degrees of area-wide consolidation in the
United States include Baton Rouge, Louisiana; Seattle, Washington; Portland,
Oregon; and Indianapolis, Indiana. Most of the major problems of contemporary
politics seem to have found their focus in the metropolis, and there is almost universal
agreement that new governing systems must be devised for the metropolitan
community if the problems are ever to be resolved.

CONTEMPORARY DIVISIONS OF GOVERNMENT

In his Politics, Aristotle differentiated three categories of state activity--

deliberations concerning common affairs, decisions of executive magistrates, and
judicial rulings--and indicated that the most significant differences among
constitutions concerned the arrangements made for these activities. This threefold
classification is not precisely the same as the modern distinction among legislature,
executive, and judiciary. Aristotle intended to make only a theoretical distinction
among certain state functions and stopped short of recommending that they be
assigned as powers to separate organs of government. Indeed, since Aristotle held that
all power should be wielded by one man, pre-eminent in virtue, he never considered
the concept of separated powers. In the 17th century the English political philosopher
John Locke also distinguished the legislative from the executive function but, like
Aristotle, failed to assign these to separate organs or institutions. Montesquieu was
the first to make the modern division among legislative, executive, and judiciary.
Arguing that the purpose of political association is liberty, not virtue, and that the very
definition of liberty's great antagonist, tyranny, is the accumulation of all power in the
same hands, he urged the division of the three functions of government among three
separate institutions. After Montesquieu, the concept of separation of powers became
one of the principal doctrines of modern constitutionalism. Nearly all modern
constitutions, from the document written at Philadelphia in 1787 through the French
Declaration of the Rights of Man and of the Citizen of August 1789 up to the
constitutions of the new states of Africa and Asia, provide for the separate
establishment of legislative, executive, and judiciary. The functional division among
the branches of government is never precise. In the American system, for example,
the doctrine of checks and balances justifies several departures from the strict
assignment of functions among the branches. Parliamentary forms of government
depart even further from the concept of separation and integrate both the personnel
and the functions of the legislature and the executive. Indeed, the principle of shared
rather than separated powers is the true essence of constitutionalism. In the
constitutional state, power is controlled because it is shared or distributed among the
divisions of government in such a way that they are each subjected to reciprocal
checks and forced to cooperate in the exercise of political power. In the
nonconstitutional systems of totalitarianism or autocracy, although there may be
separate institutions such as legislatures, executives, and judiciaries, power is not
shared but rather concentrated in a single organ. Because this organ is not subjected to
the checks of shared power, the exercise of political power is uncontrolled or
absolute.
The legislature.

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 The characteristic function of all legislatures is the making of law. In most
systems, however, legislatures also have other tasks, such as selection and criticism of
the government, supervision of administration, appropriation of funds, ratification of
treaties, impeachment of executive and judicial officials, acceptance or refusal of
executive nominations, determination of election procedures, and public hearings on
petitions. Legislatures, then, are not simply lawmaking bodies. Neither do they
monopolize the function of making law. In most systems the executive has a power of
veto over legislation, and, even where this is lacking, the executive may exercise
original or delegated powers of legislation. Judges, also, often share in the lawmaking
process, through the interpretation and application of statutes or, as in the U.S.
system, by means of judicial review of legislation. Similarly, administrative officials
exercise quasi-legislative powers in making rules and deciding cases that come before
administrative tribunals. Legislatures differ
strikingly in their size, the procedures they employ, the role of political parties in
legislative action, and their vitality as representative bodies. In size, the British House
of Commons is among the largest; the Icelandic lower house, the New Zealand House
of Representatives, and the Senate of Nevada are among the smallest. Most
legislatures are bicameral, although New Zealand, Denmark, the state of Queensland,
in Australia, and Nebraska, in the United States, have all abolished their second
chambers. The procedures of the United States House of Representatives, which
derive from a manual of procedure written by Thomas Jefferson, are among the most
elaborate of parliamentary rules, requiring study and careful observation over a
considerable period before members become proficient in their manipulation. Voting
procedures range from the formal procession of the division or teller vote in the
British House of Commons to the electric voting methods employed in the California
legislature and in some other American states. Another point of difference among
legislatures concerns their presiding officers. These are sometimes officials who stand
above party and, like the speaker of the British House of Commons, exercise a neutral
function as parliamentary umpires; sometimes they are the leaders of the majority
party and, like the speaker of the United States House of Representatives, major
political figures; and sometimes they are officials who, like the vice president of the
United States in his role as presiding officer of the Senate, exercise a vote to break
ties and otherwise perform mainly ceremonial functions.
Legislative parties are of various
types and play a number of roles or functions. In the United States House of
Representatives, for example, the party is responsible for assigning members to all
standing committees; the party leadership fills the major parliamentary offices, and
the party membership on committees reflects the proportion of seats held by the party
in the House as a whole. The congressional party, however, is not disciplined to the
degree found in British and some other European legislative parties, and there are
relatively few "party line" votes in which all the members of one party vote against all
the members of the other party. In the House of Commons, party-line voting is
general; indeed, it is very unusual to find members voting against their party
leadership, and, when they do, they must reckon with the possibility of penalties such
as the "withdrawal of the whip" or the loss of their official status as party members.
It is often said that the 20th century has dealt
harshly with legislatures and that this is an age of executive aggrandizement.
Certainly, executives in most countries have assumed an increasingly large role in the
making of law, through the initiation of the legislation that comes before parliaments,
assemblies, and congresses, through the exercise of various rule-making functions,

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and as a result of the growth of different types of delegated legislation. It is also true
that executives have come to predominate in the sphere of foreign affairs and, by such
devices as executive agreements, which are frequently used in place of treaties, have
freed themselves from dependence upon legislative approval of important foreign-
policy initiatives. Moreover, devices such as the executive budget and the rise of
specialized budgetary agencies in the executive division have threatened the
traditional fiscal controls of legislatures. This decline in legislative power, however, is
not universal. The United States Congress, for example, has preserved a substantial
measure of its power. Indeed, congressional oversight of the bureaucracy is an area in
which it has added to its power and has developed new techniques for controlling the
executive. The difficulties of presidents in the late 20th century with legislative
programs of foreign aid and the perennial congressional criticism of executive
policies in foreign affairs also suggest that Congress continues to play a vital role in
the governing process.
The executive.

Political executives are government officials who participate in the

determination and direction of government policy. They include heads of state and
government leaders-- presidents, prime ministers, premiers, chancellors, and other
chief executives--and many secondary figures, such as cabinet members and
ministers, councillors, and agency heads. By this definition, there are several thousand
political executives in the U.S. national government, including the president, dozens
of political appointees in the Cabinet departments, in the agencies, in the
commissions, and in the White House staff, and hundreds of senior civil servants. The
same is true of most advanced political systems, for the making and implementation
of government policy require very large executive and administrative establishments.
The crucial
element in the organization of a national executive is the role assigned to the chief
executive. In presidential systems, such as in the United States, the president is both
the political head of the government and also the ceremonial head of state. In
parliamentary systems, such as in Great Britain, the prime minister is the national
political leader, but another figure, a monarch or elected president, serves as the head
of state. In mixed presidential-parliamentary systems, such as that established in
France under the constitution of 1958, the president serves as head of state but also
wields important political powers, including the appointment of a prime minister and
Cabinet to serve as the government.
The manner in which the chief executive is elected or selected is often
decisive in shaping his role in the political system. Thus, although he receives his
seals of office from the monarch, the effective election of a British prime minister
usually occurs in a private conclave of the leading members of his party in
Parliament. Elected to Parliament from only one of more than 630 constituencies, he
is tied to the fortunes of the legislative majority that he leads. By contrast, the
American president is elected by a nationwide electorate, and, although he leads his
party's ticket, his fortunes are independent of his party. Even when the opposition
party controls the Congress, his fixed term and his independent base of power allow
him considerable freedom of manoeuvre. These contrasts explain many of the
differences in the roles of the two chief executives. The British prime minister
invariably has served for many years in Parliament and has developed skills in debate
and in political negotiation. His major political tasks are the designation of the other
members of the Cabinet, the direction of parliamentary strategy, and the retention of

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the loyalty of a substantial majority of his legislative party. The presidential chief
executive, on the other hand, often lacks prior legislative and even national-
governmental experience, and his main concern is with the cultivation of a majority in
the electorate through the leadership of public opinion. Of course, since the president
must have a legislative program and often cannot depend on the support of a
congressional majority, he may also need the skills of a legislative strategist and
negotiator. Another important area of contrast between different national
executives concerns their role in executing and administering the law. In the U.S.
presidential system, the personnel of the executive branch are constitutionally
separated from the personnel of Congress: no executive officeholder may seek
election to either house of Congress, and no member of Congress may hold executive
office. In parliamentary systems the political management of government ministries is
placed in the hands of the party leadership in parliament. In the U.S. system the
president often appoints to Cabinet positions persons who have had little prior
experience in politics, and he may even appoint members of the opposition party. In
the British system, Cabinet appointments are made to consolidate the prime minister's
personal ascendancy within the parliamentary party or to placate its different factions.
These differences extend even further into the character of the two systems of
administration and the role played by civil servants. In the U.S. system a change in
administration is accompanied by the exodus of a very large number of top
government executives--the political appointees who play the vital part in shaping
day-to-day policy in all the departments and agencies of the national government. In
Britain, when political control of the House of Commons changes, only the ministers,
their parliamentary secretaries, and one or two other top political aids are replaced.
For all practical purposes, the ministries remain intact and continue under the
supervision of permanent civil servants.
In nearly all political systems, even in constitutional
democracies where executive responsibility is enforced through free elections, the
20th century has seen an alarming increase in the powers of chief executives. The
office of the presidency in the United States, like the office of prime minister in
Britain, has greatly enlarged the scope of its authority. One of the challenges of
representative government is to develop more constitutional restraints on the abuse of
executive powers while retaining their advantages for effective rule.
The judiciary.

Like legislators and executives, judges are major participants in the policy-
making process; and courts, like legislatures and administrative agencies, promulgate
rules of behaviour having the nature of law. The process of judicial decision making,
or adjudication, is distinctive, however, for it is concerned with specific cases in
which an individual has come into conflict with society by violating its norms or in
which individuals have come into conflict with one another, and it employs formal
procedures that contrast with those of parliamentary or administrative bodies.
Established court systems are found in all advanced political
systems. Usually there are two judicial hierarchies, one dealing with civil and the
other with criminal cases, each with a large number of local courts, a lesser number at
the level of the province or the region, and one or more courts at the national level.
This is the pattern of judicial organization in Britain, for example. In some countries--
for example, in France--although there is a double hierarchy, the distinction is not
between courts dealing with criminal cases and other courts dealing with civil cases
but rather between those that handle all civil and criminal cases and those that deal

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with administrative cases or challenges to the administrative authority of the state.
Reflecting the federal organization of its government, the United States has two court
systems: one set of national courts and 50 sets of state courts. By contrast, Germany,
which is federal in governmental organization, possesses only a single integrated
court system. Local courts are found in all systems and are usually of two types. The
first type deals with petty offenses and may include a traffic court, a municipal court,
a small-claims court, and a court presided over by a justice of the peace or a local
magistrate. The second type, sometimes called trial courts, are courts of first instance
in which most cases of major importance are begun. These are the state superior
courts in the United States, the county courts and quarter sessions in Britain, the
tribunal de grande instance in France, and the district courts, or Landgerichte, in
Germany. In some systems there is a level above the local court, usually referred to as
assize courts, in which exceptionally serious crimes, such as homicide, are tried.
Courts of appeal review the procedures and the law in the lower court and, in some
instances, return the case for a new trial. In all systems there are national supreme
courts that hear appeals and exercise original jurisdiction in cases of the greatest
importance, such as those involving conflict between a state and a national
government. Outside the regular court systems, there are sometimes found specialized
judicial tribunals, such as administrative courts, or courts of claims that deal with
special categories of cases.

The functions of government

In all modern states, governmental functions have greatly expanded with the
emergence of government as an active force in guiding social and economic
development. In Socialist countries, government has a vast range of responsibilities
for many types of economic behaviour. Even in the United States, where there
remains a much greater attachment than in most societies to the idea that government
should be only an umpire adjudicating the rules by which other forces in society
compete, such governmental activities as the Tennessee Valley Authority or the use of
credit controls to prevent economic fluctuations are now accepted with relatively little
question. Government has thus become the major or even the dominant organizing
power in all contemporary societies.
The historical stages by which
governments have come to exercise their contemporary functions make an interesting
study in themselves. The scope of government in the ancient polis involved the
comprehensive regulation of the ends of human existence. As Aristotle expressed it,
what was not commanded by government was forbidden. The extent of the functions
of government in the ancient world was challenged by Christianity and its insistence
on a division of those things that belong separately to Caesar and to God. When the
feudal world succeeded the Roman Empire, however, the enforcement of the
sanctions of religion became one of the first objects of political authority. The
tendencies that began in the 18th century separated church from state and state from
society, and the modern concept of government came into being. The American
colonies' Declaration of Independence expresses the classic modern understanding
of those ends that governmental functions exist to secure. The first aim of government
is to secure the right to life; this comprehends the safety of fellow citizens as regards
one another and the self-preservation of the nation as regards foreign powers. Life
exists for the exercise of liberty, in terms of both natural and civil rights, and these,
along with other specific functions of government, provide those conditions upon

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which men may pursue happiness, an end that is finally entirely private and beyond
the competence of government.
With the advent of the Marxist conception of the state, the ends
of human existence once again became the objects of comprehensive government
regulation. Marxism sees the state as a product of class warfare that will pass out of
existence in the future age of perfect freedom. Aristotle believed human perfection to
be possible only within political society; Marx believed that the perfection of man
would follow upon the abolition of political society. Before the final disposal of the
state, however, many Marxists believe that forceful use of governmental power is
justified in order to hasten mankind's progress toward the last stage of history.

THE TASKS
Self-preservation.

The first right of men and nations is self-preservation. The task of

maintaining the nation, however, is more complex than the individual's duty of self-
preservation, for the nation must seek to command the attachment of a community of
citizens as well as to preserve itself from external violence. As Thomas Hobbes
insisted, civil war constitutes the greatest threat to governments, for it represents the
dissolution of the "sovereign power." In modern terms, civil war signifies that the
government has lost one of the basic attributes of political authority: its monopoly of
force and its control over the use of violence. In a fundamental sense, political
authority may be preserved from the threat of civil war only when there exists in the
political community an agreement on the basic principles of the regime. Such a
consensus is the result, among other things, of a shared " ideology" that gives fellow
citizens a sense of communal belonging and recognizes interlocking values, interests,
and beliefs. Ideology, in this sense, may be the product of many different forces.
Sometimes it is associated with ancient customs, sometimes with religion, sometimes
with severe dislocations or the sort of common need that has led to the formation of
many nation-states, and sometimes with the fear of a common enemy. The ideological
commitment that people call patriotism is typically the product of several of these
forces. Governments neglect at their peril the
task of strengthening the ideological attachment of their citizens to the regime. In this
sense, civic education should be counted among the essential functions of the state,
for it is primarily through systems of education that citizens learn their duties. Indeed,
as a number of sociological studies have shown, the process of political socialization
that transforms people into citizens begins in kindergarten and grade school. Even
more than this, education is the instrument by which governments further the
cohesion of their societies and build the fundamental kinds of consensus that support
their authority. It is not surprising, therefore, that national systems of education are
often linked to central elements of the regimes. In France public education was
traditionally mixed with the teachings of the Roman Catholic church; in Great Britain
a private system of education supported the class divisions of society; and in the
United States a primarily secular form of public education traditionally used
constitutional documents as the starting point of children's training in patriotism.
The preservation of the authority
of the state also requires a governmental organization capable of imposing its
jurisdiction on every part of the national territory. This involves the maintenance of
means of communication, the use of administrative systems, and the employment of
police forces capable of controlling domestic violence. The police function, like

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education, is often a key to the character of a regime. In Nazi Germany, Hitler's
Brownshirts took over the operation of local and regional police systems and often
supervised the administration of law in the streets. In the Soviet Union the security
police acted to check any deviation from the policy of the party or state. In the United
States the police powers are left in the hands of the 50 states and the local agencies of
government. With the exception of certain offenses created by the McCarran Act and
some parallel statutes, political crimes as such are unknown. In addition, there are
state militias that act, under the control of the governors of the various states, in
moments of local emergency, such as riots or natural catastrophes. The Federal
Bureau of Investigation (FBI), the only equivalent of a national police force, is an
agency established to carry out specific assignments dealing with a limited but
important class of crimes. Since there is no comprehensive federal criminal code,
there is not, strictly speaking, a federal police.
Governments must preserve themselves against external
as well as domestic threats. For this purpose they maintain armed forces and carry on
intelligence activities. They also try to prevent the entry of aliens who may be spies or
saboteurs, imprison or expel the agents of foreign powers, and embargo the export of
materials that may aid a potential enemy. The ultimate means of preserving the state
against external threats, of course, is war. In war, governments usually enlarge the
scope of their domestic authority; they may raise conscript forces, imprison
conscientious objectors, subject aliens to internment, sentence traitors to death,
impose extraordinary controls on the economy, censor the press, compel settlement of
labour disputes, impose internal-travel limitations, withhold passports, and provide for
summary forms of arrest. Many forces
generate clashes between nations, including economic rivalry and disputes over trade,
the desire to dominate strategic land or sea areas, religious or ideological conflict, and
imperialistic ambition. All national governments develop organizations and policies to
meet these and other situations. They have foreign ministries for the conduct of
diplomatic relations with other states, for representing them in international
organizations, and for negotiating treaties. Some governments conduct programs
such as foreign aid, cultural exchange, and other activities designed to win goodwill
abroad.
In the 20th century, relationships among governments have been
affected by a developing awareness that world peace and prosperity depend on
multinational and international cooperation. The League of Nations and the United
Nations, together with their associated agencies, have represented major efforts to
establish substitutes for traditional forms of diplomacy. Regional alliances and joint
efforts, such as the Organization of American States, the North Atlantic Treaty
Organization, the European Economic Community, and the Organization of African
Unity, represent another type of cooperation among nations.

Supervision and resolution of conflicts.

The conflict of private interest is the leading characteristic of the political

process in constitutional democracies, and the supervision, mediation, arbitration, and
adjudication of such conflicts are among the key functions of their governments.
Representative institutions are themselves a device for the resolution of conflict.
Elections in constitutional democracies provide opportunities for mass participation in
a process of open debate and public decision; assemblies, congresses, and other
parliamentary institutions provide for public hearings on major issues of policy and

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require formal deliberative procedures at different stages of the legislative process;
and political parties integrate a variety of interests and effect compromises on policy
that win acceptance from many different groups.
If the interests that compete in the political
process are too narrow or restricted, efforts may be made to control or change the
rules of competition. Thus, laws have been enacted that seek to prevent discrimination
from locking racial and other minorities out of the democratic process; the franchise
has been extended to all groups, including minorities such as women, blacks, and 18-
year-olds; and government bodies such as courts and administrative agencies enforce
legislation against groups considered to be too large or monopolistic.
Judicial processes offer a means by
which some disputes in society are settled according to rule and legal authority, rather
than by political struggle. In all advanced societies, law is elaborated in complex
codes governing rights and duties and procedural methods, and court systems are
employed that adjudicate disputes in terms of the law. In constitutional systems such
as the United States, the judiciary is deeply involved in the process of public decision
making; the courts actually produce much of the substantive law that bears on private
individuals and economic groups in society.
Regulation of the economy.

Government regulation of economic life is not a new development.

The national mercantilist systems of the 18th century provided for regulation of the
production, distribution, and export of goods by government ministries; even during
the 19th century, governments continued to intervene in the economy. The
government of the United States, for example, from its inception in 1789, allotted
funds or subsidies for the support of agriculture, maintained a system of tariffs for its
own revenue and the support of domestic manufacturers, patronized the arts and
sciences, and engaged in various kinds of public works to advance commerce and
promote the general welfare. In France even more elaborate governmental schemes of
economic regulation were practiced throughout the 19th century, including a variety
of Socialist experiments such as the Public Workshops that Louis Blanc established in
Paris in 1848. In Britain the various factory acts of the 19th century represented an
effort by government to improve slightly the working conditions in industry.

After World War II the ability of a government to regulate or control

the economy became one of the chief tests of its success, and regulatory agencies
multiplied to the point at which they are now often referred to as "the fourth branch of
government." The extent of the controls imposed on the economy is one of the
principal distinctions among capitalist, Socialist, and Communist systems. In
Communist countries it is a matter of doctrine that the means of production should be
owned and therefore controlled by the state. In Britain the Labour governments
nationalized some major industries, including coal, steel, and the railroads, prompted
partly by Socialist doctrine and partly by the failure of British industry to remain
competitive in international markets. This process was then reversed when the
Conservative Party became ascendent. In the United States the government has
involved itself in the economy primarily through its regulatory powers. In France the
government has gone further and has engaged in national economic planning in
cooperation with private business organizations.
The regulation of industrial conditions
and of labour-management relations has been a major concern of most Western

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governments. In the United States the first regulatory efforts in this field were made
during the Progressive era at the turn of the 20th century, when the wages, hours, and
working conditions of women and children in industry became a matter of public
scandal. A little later the conditions, hours, food, and wages of merchant seamen were
brought under government regulation; an eight-hour day was set for railway crews;
and workmen's compensation laws were instituted. With the Great Depression in the
1930s, minimum wages were introduced for workers in many industries, hours of
work were set, and the right to collective bargaining was given legal sanction.

Regulation of transportation has been another major activity in most

Western political systems, beginning with the railroads. In the United States their
monopolistic practices attracted the criticism of agricultural interests and led
eventually to the Interstate Commerce Act of 1887, which regulated railroad rates;
subsequent legislation covered the hours, conditions, and wages of railroad
employees, among other things. Other modes of land and air transportation have since
been brought under regulatory controls implemented by government agencies.
In most European countries, facilities of
communication--the telegraph, telephone, radio, and television--are owned and
operated by the government. In the United States, most of these facilities have
remained in private ownership, although they are regulated by the Federal
Communications Commission. The regulation by government of important
instruments of public opinion such as radio, television, and newspapers has important
implications for the freedoms of speech and press and other individual rights. In the
United States and Great Britain, government censorship of the press and other media
has been restricted to matters of national security. This is also generally true of other
Western constitutional democracies, although the celebrated Der Spiegel affair in
Germany in 1962 and some extraordinary controls imposed on the media in France
have been widely criticized. In many of the less-developed nations with authoritarian
governments, very extensive controls are imposed on the press, and government-
owned newspapers are often the principal sources of political news.
Other forms of
government regulation of the economy involve the use of taxes and tariffs, the
regulation of weights and measures, and the issuance of money.

Protection of political and social rights.

To some extent, all modern governments assume responsibility for

protecting the political and social rights of their citizens. The protection of individual
rights has taken two principal forms: first, the protection of liberty in the face of
governmental oppression; second, the protection of individual rights against hostile
majorities and minorities. From the 1960s to the mid-1980s the sphere of public
discussion in the Soviet Union was gradually, though erratically, widened. While this
widening never extended to the purely political, some of the sociological discussion
allowed served to set the intellectual stage for the Gorbachev period of radical reform.
Although the Soviet Union suppressed most expression of political opinion until the
late 1980s, domination by a central authority protected the basic human rights of
some groups from violent rival minorities. On a larger scale, this is also what
suppressed many long-standing rivalries in eastern Europe during the Cold War. The
degree of repression in the former Communist states varied from country to country
and changed with time after the death of Stalin.

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 In the United States the Supreme Court expanded the
rights of the criminally accused; and after 1954 the national government acted to bar
legal discrimination against ethnic minorities. Indeed, almost all the freedoms detailed
in the first 10 amendments to the Constitution have been extended since World War
II. Another
type of government regulation bearing on the individual concerns the law of
immigration and emigration. The great mass migrations of the 19th and early 20th
centuries came to an abrupt halt after 1914 with the proliferation of government
controls on the freedom of movement across national boundaries. After some later
liberalization, immigration to the industrialized states again saw increased restrictions
near the end of the 20th century.

Provision of goods and services.

All modern governments participate directly in the economy, purchasing

goods, operating industries, providing services, and promoting various economic
activities. One of the indispensable functions of government--national defense--has
made governments the most important consumers of goods, and they have not
hesitated to use their resulting pricing, purchasing, and contracting powers to achieve
various economic aims. In efforts to avoid dependence on private sources of strategic
goods and defense materials, some governments have taken a further step and
established their own military production plants. In wartime, governments have
assumed control over entire industries and have subjected the work force to military
direction in addition to rationing goods and regulating prices.
In nearly
all political systems, certain functions are recognized as public, or belonging to the
government. In addition to national defense, these include the maintenance of
domestic peace, public education, fire protection, traffic control, aid to the indigent,
conservation of natural resources, flood control, and postal services. But governments
have assumed responsibility for many other commercial operations, even in non-
Socialist countries. The sale of electric power, for example, is one of the established
enterprising functions of national, state, and local governments in the United States
and Canada. Municipally owned power utilities exist in about 2,000 cities in North
America; 14 states of the U.S. have public power districts; and the U.S. government
markets power through the Tennessee Valley Authority, the Bureau of Reclamation,
and several other agencies. Another range of functions is performed by other national
agencies, including the Rural Electrification Administration, which loans money to
rural cooperatives to finance local power projects; the Export-Import Bank of
Washington, which makes loans to finance export and import trade; the Maritime
Administration, which holds mortgages on ships; and the Veterans Administration,
which makes loans for farm or home purchases to military veterans. The United States
government, acting through agencies such as the Social Security Board, the Federal
Deposit Insurance Corporation, and the Federal Housing Administration, is also the
largest insurer in the nation. Through other agencies, such as the Housing and Home
Finance Agency, the Urban Renewal Administration, and the Public Works
Administration, the national government has also developed a major role in the
construction and rental of residential housing for low-income persons. Other
miscellaneous enterprises in which governments are involved include the provision of
health care, the operation of public transport facilities, the development of public
works, airport and port maintenance, and water-supply systems. In Great Britain the

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government operates hospitals and provides medical care under the National Health
Service. In the United States many state and local governments operate hospitals on a
commercial basis, although providing some charity care. At the local level in the
United States the Port of New York Authority constructs and operates bridges,
terminals, and airports. The states in the Delaware Basin have joined in a compact to
establish an agency to control the use of water from the basin, institute programs to
prevent pollution, provide recreation facilities, transmit and sell hydroelectric power,
and provide watershed management. Cities in the United States and Canada operate
more than 70 urban transit systems, 600 municipal gas utilities, and more than 4,000
water-supply systems. Cities are also generally responsible for garbage disposal and
sometimes operate commercial slaughterhouses, coal yards, laundries, ice plants, and
golf courses. Finally, packaged liquor sales, either wholesale or retail or both, are
often made by the state governments.
PUBLIC ADMINISTRATION

While the functional objectives of government administration vary from

system to system, all countries that are technologically developed have evolved
systems of public administration. A number of common features may be detected in
all such systems. The first is the hierarchical, or pyramidal, character of the
organization by which a single chief executive oversees a few subordinates, who in
turn oversee their chief subordinates, who are in turn responsible for overseeing other
subordinates, and so on until a great structure of personnel is integrated and focussed
on the components of a particular program. A second common feature is the division
of labour or specialization within the organization. Each individual in the hierarchy
has specialized responsibilities and tasks. A third feature is the maintenance of
detailed official records and the existence of precise paper procedures through which
the personnel of the system communicate with each other and with the public. Finally,
tenure of office is also characteristic of all public bureaucracies.
The
various national civil services, despite their similarities, also show important
differences, particularly in the way in which individuals are recruited and in the status
accorded them in the political system. The British civil service, for example, has
traditionally been composed of three classes, or grades--clerical, executive, and
administrative. Administrative civil servants, the highest grade, are recruited by
examination from among recent university graduates. The top managers of the
different government ministries are drawn from this elite group. They remain in office
despite changes in government and are accorded immense prestige. The U.S. civil
service is organized into 18 grades. Although promotion from the lower grades is the
typical means by which positions in the top grades are filled, there is also a flow of
individuals into senior positions from private business and the professions. The U.S.
equivalent of the administrative civil servant in Britain is usually a political appointee
recruited by each new administration from private life or from a position in politics.

Development and change in political systems

The student of political systems grapples with a subject matter that is today in
constant flux. He must deal not only with the major processes of growth, decay, and
breakdown but also with a ceaseless ferment of adaptation and adjustment. The
magnitude and variety of the changes that occurred in the world's political systems

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between the second and eighth decades of the 20th century suggest the dimensions of
the problem. Great empires disintegrated; nation-states emerged, flourished briefly,
and then vanished; world wars twice transformed the international system; new
ideologies swept the world and shook established groups from power; all but a few
nations experienced at least one revolution and many nations two or more; domestic
politics in every system were contorted by social strife and economic crisis; and
everywhere the nature of political life was changed by novel forms of political
activity, new means of mass communication, the enlargement of popular participation
in politics, the rise of new political issues, the extension of the scope of governmental
activity, the threat of nuclear war, and innumerable other social, economic, and
technical developments.

CAUSES OF STABILITY AND INSTABILITY

Although it is possible to identify a number of factors that obviously have a

great deal to do with contemporary development and change in the world's political
systems--industrialization, population growth, the "revolution of rising expectations"
in the less developed countries, and international tensions--there is no agreed theory
to explain the causes of political change. Some social scientists have followed
Aristotle's view that political instability is generally the result of a situation in which
the distribution of wealth fails to correspond with the distribution of political power
and have echoed his conclusion that the most stable type of political system is one
based on a large middle class. Others have adopted Marxist theories of economic
determinism that view all political change as the result of changes in the mode of
production. Still others have focussed on governing elites and their composition and
have seen in the alienation of the elite from the mass the prime cause of revolutions
and other forms of violent political change. In the
discussion that follows, a distinction is drawn between unstable and stable political
systems, and an attempt is made to suggest ways of understanding the processes of
political development and change.

Unstable political systems.

In modern times the great majority of the world's political systems have
experienced one form or another of internal warfare leading to violent collapse of the
governments in power. Certain crisis situations seem to increase the likelihood of this
kind of breakdown. Wars and, more particularly, national military defeats have been
decisive in prompting many revolutions. The Paris Commune of 1871, the Russian
revolutions of 1905 and 1917, Hitler's overthrow of the Weimar Constitution in
Germany, and the revolutions in China all occurred in the aftermath of national
military disasters. Many factors in such a situation, including the cheapening of
human life, the dislocation of population, the ready availability of arms, the
disintegration of authority, the discrediting of the national leadership, material
scarcities, and a sense of wounded national pride, contribute to the creation of an
atmosphere in which radical political change and violent mass action are acceptable to
large numbers of people. Economic crises are another common stimulus to
revolutionary outbreaks, for they produce not only the obvious pressures of material
scarcity and deprivation but also a threat to the individual's social position, a sense of
insecurity and uncertainty as to the future, and an aggravation of the relationships
among social classes. A severe national economic crisis works, in much the same way

664
as a military disaster, to discredit the existent leadership and the present regime.
Another triggering factor is the outbreak of revolutions in other political systems.
Revolutions have a tendency to spread: the Spanish Revolution of 1820 had
repercussions in Naples, Portugal, and Piedmont; the French Revolution of July 1830
provoked similar outbreaks in Poland and Belgium; the Russian Revolution of 1917
was followed by a dozen other revolutions; and the colonial liberation movements in
Africa, Southeast Asia, and elsewhere after World War II appear to have involved a
similar chain reaction. Crisis situations test the
stability of political systems in extremely revealing ways, for they place extraordinary
demands on the political leadership and the structure and processes of the system.
Since the quality of the political leadership is often decisive, those systems that
provide methods of selecting able leaders and replacing them possess important
advantages. Although leadership ability is not guaranteed by any method of selection,
it is more likely to be found where there is free competition for leadership positions.
The availability of established methods of replacing leaders is equally, if not more,
important, for the result of crises is often to disgrace the leaders in power, and, if they
cannot be replaced easily, their continued incumbency may discredit the whole
regime. The stamina and resolve of the ruling elite are also important. It is often said
that a united elite, firmly believing in the justice of its own cause and determined to
employ every measure to maintain its power, will not be overthrown. Most
revolutions have gotten under way not when the oppression was greatest but only
after the government had lost confidence in its own cause.
Other
conditions of the survival of political systems relate to the effectiveness of the
structures and processes of government in meeting the demands placed on them.
Political systems suffer violent breakdown when channels of communication fail to
function effectively, when institutional structures and processes fail to resolve
conflicts among demands and to implement acceptable policies, and when the system
ceases to be viewed as responsive by the individual and groups making demands on it.
Usually, a system has failed over a period of some time to satisfy persistent and
widespread demands; then, exposed to the additional strains of a crisis situation, it is
unable to maintain itself. Revolutions and other forms of violent collapse are thus
rarely sudden catastrophes but rather the result of a process of considerable duration
that comes to its climax when the system is most vulnerable.
Unstable political systems are those that
prove vulnerable to crisis pressures and that break down into various forms of internal
warfare. The fundamental causes of such failures appear to be the lack of a
widespread sense of the legitimacy of state authority and the absence of some general
agreement on appropriate forms of political action. Governments suffer their gravest
handicap when they must govern without consent or when the legitimacy of the
regime is widely questioned. This is often the case in systems that have experienced
prolonged civil war, that are torn by tensions among different national or ethnic
groups, or in which there are divisions along sharply drawn ideological or class lines.
The problem is often most acute where there is a pretender to the throne, a
government in exile, a neighbouring state sympathetic to a rebel cause, or some other
focus for the loyalty of dissidents. To some degree, also, the problem of legitimacy
confronts all newly established regimes. Many of the new states of Africa and Asia,
for example, have found it a source of great difficulty. Often they have emulated the
form of Western institutions but failed to achieve their spirit: borrowing eclectically
from Western political philosophies and systems of law, they have created

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constitutional frameworks and institutional structures that lack meaning to their
citizens and that fail to generate loyalty or a sense that government exercises rightful
powers. Closely related to the problem of legitimacy as a cause of the
breakdown of political systems is the absence of a fundamental consensus on what is
appropriate political behaviour. A regime is fortunate if there are well-established,
open channels of political action and settled procedures for resolving grievances.
Although the importance of such "rules of the game" is that they allow change to
occur in mainly peaceful ways, stable political systems often show surprising
tolerance for potentially violent forms of political behaviour, such as strikes, boycotts,
and mass demonstrations. Such forms of political behaviour are not permitted in
systems where there are no agreed limits to the role of violence and where there is a
high risk that violence may escalate to the point of actual warfare. If the government
cannot count upon widespread support for peaceful political procedures, it must
restrict many kinds of political action. Such restriction, of course, inhibits still more
the development of open methods of citizen participation in politics and adds to
tension between the government and the people.

Stable political systems.

The simplest definition of a stable political system is one that survives

through crises without internal warfare. Several types of political systems have done
so, including despotic monarchies, militarist regimes, and other authoritarian and
totalitarian systems. After 1868, in the period of the restoration regime under the
Meiji emperor, Japan succeeded, without major political breakdowns, in building an
industrial state and developing commercial structures that transformed traditional
Japanese society. This achievement was based on the development of centralized
patterns of political control and the growth of a type of authoritarianism involving the
rule of a military elite. Similarly, some of the totalitarian regimes of the contemporary
world have demonstrated an impressive capability for survival. The key to their
success is their ability to control social development, to manage and prevent change,
and to bring under governmental direction all the forces that may result in innovations
that are threatening to the system. In some systems,
survival does not depend on the detailed management of the society or close
governmental control over social processes but is the result of sensitive political
response to the forces of change, of flexible adjustment of the structures of the system
to meet the pressures of innovation, and of open political processes that allow gradual
and orderly development. Much of the Western democratic world has achieved
peaceful progress in this way, despite new political philosophies, population
increases, industrial and technological innovations, and many other social and
economic stresses.
Such evolutionary change is possible when representative institutions
provide effective channels for the communication of demands and criticisms to
governments that rely upon majority support. The election of legislators and executive
officials, competition between political parties, constitutional guarantees of freedom
of speech and press, the right of petition, and many other structures and procedures
perform this function in contemporary constitutional democracies. In such systems,
social and economic problems are quickly transformed into issues in the open arenas
of politics; governments are obliged to shape policies that reflect a variety of
pressures and effect compromises among many conflicting demands.
The representative mechanisms

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that have produced evolutionary change in Western constitutional democracies are
themselves subject to a continuous process of adjustment and mutation. Indeed,
representative institutions must develop in ways that reflect social and economic
developments in the society or they will lose their legitimacy in the minds of the
people. In political systems such as the United States, for example, subtle shifts in the
function and relative power of different institutions are continuously being made and,
over time, produce entirely new structures and very different patterns of institutional
behaviour. It is as a result of this process that the presidency has accumulated a range
of new powers that have given it primacy among the branches of American
government. This process also explains the growth of administrative agencies that
perform both legislative and judicial functions. This process of dynamic adjustment is
crucial, for institutions that remain static in a changing society are unable to serve as
agencies of evolutionary change.

TYPES OF POLITICAL CHANGE

The study of political change is difficult, for change occurs in many different
ways and at many different points in the political system. One may distinguish several
major types of change.

Radical revolution.

First are changes of the most fundamental type--transformations not only of

the structure of government but of the whole polity. Such change is not limited to
political life but transforms also the social order, the moral basis, and the values of the
whole society. Drastic change of this kind occurred in the four great revolutions of the
modern era--the English Revolution of the 17th century, the American Revolution, the
French Revolution, and the Russian Revolution. These movements had the most
profound effect on social and political life, permanently altering the beliefs by which
men live. Their consequences were felt not only in the societies in which they
occurred but also in many other political systems, in which, as a result of their
example, revolutions of an equally fundamental character occurred.
Each of these major revolutions
was something of a world revolution, for it resulted in a basic change in the ways in
which men in all political systems viewed the nature of politics and the purpose of
political life. The independence movements in the colonial empires after World War
II, for example, were fuelled by those principles of individual liberty and
representative government that were once the slogans of 18th-century American and
French revolutionaries. Marxist revolutionary concepts emphasizing economic
progress and radical social change have shaped the development of many of the new
nations. The continuing impact of such ideas is an example of another way in which
fundamental political change occurs. The nature of a political system may be
transformed not suddenly or violently in the course of revolution but by the gradual,
corrosive influence of ideas and by the accumulating impact of different political
philosophies.

Structural revision.

A second type of change involves alterations to the structure of the political

system. Such change is not fundamental, in the sense of a basic transformation of the

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nature of the regime, but it may produce great shifts in policy and other political
outcomes. Because the structure of a political system--that is, its formal and informal
institutional arrangements--is a major determinant of policy outcomes, it is frequently
the target of political action of various kinds. The political activist, the reformer, and
the revolutionary share the recognition that the policies of a government may be
effectively changed by adjusting the institutional forms through which the
government acts. In some systems, structural change has been accomplished by legal
means. In the United States, for example, such major institutional reforms as the
direct election of the Senate and the limitation on presidential terms were made by
constitutional amendment; and in Britain the various reforms of Parliament were
accomplished by statute. In other systems, structural changes are often achieved by
revolution and other violence.
Change of leaders.

A third type of political change involves the replacement of leaders. Again,

the recognition that to change the personnel of a government may be an effective way
of changing government policy prompts many kinds of political action, ranging from
election contests to political assassination and various forms of coup d'etat. In some
systems the existence of established means of changing political leaderships works to
prevent violent types of political action. In the United States the quadrennial contests
for the presidency afford a constitutional opportunity to throw the whole executive
leadership out of office. At the other extreme, the coup d'etat leads to the abrupt,
often violent replacement of national executives. Although it is a type of revolution,
the coup d'etat usually does not involve prolonged struggle or popular participation;
after seizing office, the principal aim of the leaders of the coup is usually the
restoration of public order. The coup d'etat occasionally develops into much more
than the replacement of one set of governmental leaders by another and may prove to
be the initial stage of a truly revolutionary process; e.g., the coups d'etat that initiated
Communist rule in Czechoslovakia in 1948 and ended King Farouk I's regime in
Egypt in 1952.
Change of policies.

Government policy itself may be an important agency of political change.

The social and economic policies of Franklin D. Roosevelt's New Deal and the
Socialist programs implemented by the British Labour Party after 1945 are examples.
In both cases, government policies resulted in far-reaching modifications to the
functioning of the political system: a vast expansion in the role of government in the
economy, the use of taxes to redistribute wealth, an increase in the political influence
of organized labour, and the implementation of national programs of social welfare.
Major policy change of this type, of course, is often a response to widespread
pressures and demands that, if not satisfied by the system, may intensify and lead to
various forms of violent political action. At other times, however, policy changes are
imposed by a government to achieve the political, social, and economic goals of a
single class, of an elite, or of the political leadership itself.
Many
important questions remain as to the reasons for change, the ways in which change
occurs, and the effects of change. Political scientists are still not completely certain,
for example, why some systems have managed to avoid violent political change for
considerable periods, while in other systems change is typically accomplished through
coups d'etat, revolutions, and other forms of internal warfare. As suggested above, the

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explanation may have much to do with the existence in countries such as the United
States and Great Britain of well-established political institutions that permit peaceful
change, the presence in the population of widely shared attitudes toward the
government, and the existence of basic agreement on the legitimacy of state authority.
Clearly, however, other factors are also involved. Perhaps one of the chief goals of the
study of political systems should be to determine as exactly as possible the conditions
and prerequisites of those forms of change that permit the peaceful and evolutionary
development of human society.

ELECTORAL PROCESSES

Elections provide a means of making political choices by voting. They are

used in the selection of leaders and in the determination of issues. This conception of
elections implies that the voters are presented with alternatives, that they can choose
among a number of proposals designed to settle an issue of public concern. The
presence of alternatives is a necessary condition, for, although electoral forms may be
employed to demonstrate popular support for incumbent leaders and their policies, the
absence of alternatives disqualifies such devices as genuine elections. The
widespread use of elections in the modern world is due in large part to the gradual
emergence of representative government from the 17th century on. For proper
appraisal, however, it is important to distinguish between the form and substance of
elections. Electoral forms may be present but the substance may be missing. The
substance is, of course, that the voter has a free and genuine choice between at least
two alternatives. In a purely formal sense, the great majority of the more than 150
contemporary nations have what are called "elections," but probably only about a
third of these have more or less competitive elections; perhaps a fifth have one-party
elections; and in some others the electoral situation may be highly ambiguous.
The discovery of the individual as the
unit to be counted was, from the 17th century on, the critical factor in the emergence
of modern electoral processes. The counting of individuals, in turn, was a by-product
of the change from the holistic conception of representation in the Middle Ages to an
individualistic conception. The British Parliament, for instance, was seen no longer as
representing estates, corporations, and vested interests but rather as standing for actual
human beings. The movement abolishing " rotten boroughs"--boroughs of small
population controlled by a single person or family--that culminated in the Reform Act
of 1832 was a direct consequence of the individualistic conception of representation.
Once governments were not only believed to derive their powers from the consent of
the governed but were expected to seek consent, the only remaining problem was to
decide who was to be included among the governed whose consent was to be sought.
The democratic answer was, of course, universal adult suffrage.
Although it is common to equate representative government, elections,
and democracy and although competitive elections under universal suffrage are in
many respects a defining characteristic of political democracy, universal suffrage is
not a necessary condition of competitive electoral politics. An electorate may be
limited by formal legal requirements--as was the case before universal adult suffrage--
or it may be limited by citizens' failure to take advantage of the vote, as is often the
case in American municipal and other elections. Although such legal or self-imposed
exclusion affects the democratic quality of elections and may ultimately affect the
legitimacy of government, it does not impede decision making by election, provided
the voter is presented with alternatives among which to choose.

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 Access to the political arena during the 18th
century depended largely on membership in some aristocracy, and participation in
elections was regulated mainly by local customs and arrangements. With the
American and French revolutions, every citizen was declared formally equal to every
other citizen, but the vote remained an instrument of political power possessed by
very few.
Even with the arrival of universal suffrage, the ideal of "one
man, one vote" was not achieved. Systems of plural voting were maintained in some
countries, giving certain social groups an electoral advantage. In Great Britain, for
example, university graduates and owners of businesses in constituencies other than
those in which they lived continued to have an extra vote until 1948. Before World
War I both Austria and Prussia had three classes of weighted votes that effectively
kept electoral power in the hands of the upper social strata.
Whereas in the Western nations of the 19th and 20th centuries the
increasing use of competitive mass elections in selecting governments had the
purpose and the effect of institutionalizing the diversity of modern societies, in the
Eastern, one-party, Communist regimes mass elections came to have quite different
purposes and consequences. They differed from competitive elections in that each
voter usually had only the choice of voting for or against the official candidate.
Indeed, they were in the nature of the 19th-century Napoleonic plebiscites, in that
they were intended to demonstrate the unity rather than the diversity of the people.
Dissent could be registered by crossing out the name of
the candidate on the ballot, as several million Soviet citizens did in each election
before 1989. As voting was not private, however, this invited reprisals. It may well be
that some portion of dissenting votes were cast not so much because of dislike of
Communism but because of grievances involving the conduct of minor officials. This
may have served to weed out some of the worst officials at the very lowest levels.
Even not voting was a form of protest, especially because local Communist Party
activists were under extreme pressure to get nearly a 100 percent turnout. Before the
revolutions of 1989, not all elections in eastern Europe followed the Soviet model
exactly. In Poland, for instance, more names appeared on the ballot than there were
offices to fill, and some degree of electoral choice was possible.
Many
authoritarian regimes throughout the world have attempted to gain some level of
legitimacy through the holding of elections. This may be done when it is clear that,
because of repression, no substantive opposition is remotely feasible. Often, however,
the process is more subtle in order to maximize the regime's gains. Elections may be
scheduled when economic factors favour the regime and, more importantly, when
election laws have been written to the severe disadvantage of competing parties. The
opposition may be given little time to prepare, while the government already has
various networks of supporters in place. Challengers also may be forced to campaign
in an atmosphere of intimidation that precludes the effective organization of many
potential supporters. A regime may cite unrelated reasons for postponing an election
if it perceives a significant chance of losing. Also, it is not uncommon for government
intervention to occur once balloting has begun, either in the form of voter intimidation
(not infrequently actually attacking voters) or manipulating the count of votes freely
cast.

Functions of elections.

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 Fundamental to the use of elections is the contribution that they make to
democratic government. Where the members of the body politic cannot themselves
govern and must entrust government to representatives, elections serve not only to
select leaders acceptable to the voters but also to hold the leaders accountable for their
performance in office. Accountability, however, is greatly jeopardized in electoral
situations in which elected leaders, for want of ambition, do not care whether or not
they are re-elected or in situations in which, for historical or other reasons, one party
is so predominant as to preclude effective choice among alternate candidates or
policies. Nevertheless, the possibility of controlling leaders by requiring them to
submit to regular and periodic elections contributes to solving the problem of
succession in leadership and, thereby, to the continuation of democracy. Moreover,
where the electoral process is competitive and forces candidates or parties to expose
their record of accomplishment and future intentions to popular scrutiny in election
campaigns, elections serve as forums for the discussion of public issues, facilitate the
expression of public opinion, and, more generally, permit an exchange of influence
between governors and governed.
Elections also serve to reinforce the stability and legitimacy of
the political community in which they take place. Like national holidays
commemorating common experiences, elections serve to link the members of a body
politic to each other and thereby confirm the viability of the political community. By
mobilizing masses of voters in a common act of governance, elections lend authority
and legitimacy to the acts of those who wield power in the name of the people.
Elections can also confirm the worth and dignity of the individual
citizen as a human being. Whatever other needs he may have, participation in an
election serves to gratify the voter's sense of self-esteem and self-respect. It gives him
an opportunity to have his say, and he can, through expressing partisanship and even
through nonvoting, satisfy his sense of belonging to or alienation from the political
community. It is for just this reason that the age-long battle for the right to vote and
the demand for equality in electoral participation can be seen as the manifestation of a
profound human craving for personal fulfillment.
In all forms of government, from the most democratic
to the most totalitarian alike, elections have a ritualistic aspect. Elections and the
campaigns preceding them are dramatic events which, depending on cultural or
historical circumstances, may exude the gay atmosphere of a circus or the sombre
atmosphere of a funeral. Rallies, banners, posters, buttons, headlines, and television
call attention to the importance of participation in the event. Candidates and parties,
from right to left, in addition to propagating their policy objectives through rhetoric
and slogans, invoke the symbols of nationalism or patriotism, reform or revolution,
past glory or future promise. Whatever the peculiar national, regional, or local
variations, elections are events that, by arousing emotions and channelling them
toward collective symbols, break the monotony of daily life and focus attention on the
common fate.
Systems of counting votes.

Individual votes are totalled into collective decisions by a wide variety of

rules of counting that voters and leaders have accepted as legitimate prior to the
election. These decision rules may call for plurality voting, which requires that,
among three or more alternatives, the winner need have only the highest number of
votes; simple majority voting, which requires that the winner receive more than 50

671
percent of the vote; extraordinary majority voting, which requires some higher
proportion for the winner, such as a two-thirds vote; or unanimity.

Plurality and majority decision.

The simplest means of deciding an election is the plurality rule. To win, a
candidate need only poll more votes than any other single opponent; he need not, as
required by the majority formula, poll more votes than the combined opposition. The
more candidates contesting a constituency seat, the greater the probability that the
winning candidate will receive less than 50 percent of the vote. The plurality formula
is used in the national elections of such countries as Great Britain, Canada, and New
Zealand. One-half of the former West German Bundestag was elected according to
the plurality system, while the other half was elected according to a proportional
representation formula (see below).
Under the majority rule, the party or candidate winning more
than 50 percent of the vote in a constituency is awarded the contested seat. The
winning party or candidate must poll more votes than the combined opposition. This
system thus ensures that the elected representative has the support of the majority of
the voters. The majority formula is employed in Australia and France. It is usually
applied only within single-member electoral constituencies.
Both the plurality and the majority-decision rules are employed
in the election of U.S. presidents. The composition of the electoral college, which
actually elects the president, is determined by a plurality vote taken within each state.
Voters choose between the names of the presidential candidates, but they are in effect
choosing the electors who will elect the president by means of a majority vote in the
electoral college. All of a state's electoral votes (which are equal in number to its seats
in Congress) are given to the presidential candidate who gains a plurality of the vote
in the state election. It is thus possible for a president to be elected on the basis of a
minority of the popular vote.
A critical difficulty with the majority formula is
that, in a multiparty political system, the formula may produce an electoral deadlock
if no candidate secures 50 percent of the total vote. In order to break such deadlocks a
second round of elections ( second ballot) is required, if no candidate obtains a
majority on the first round. In Australia, voters rank the candidates on an alternate
preference ballot. If a majority is not achieved on the first round of elections, the
weakest candidate is eliminated, and the votes he accrued are distributed to the other
candidates according to the second preference on the ballot. This redistributive
process is repeated until one candidate collects a majority of the votes. If no candidate
secures a majority in the first round of the French National Assembly elections,
another round of elections is required. In this second round, the candidate securing a
plurality of the popular vote is declared winner. Neither the
majority nor the plurality formulas distribute legislative seats in proportion to the
share of the popular vote won by the competing parties. Both formulas tend to award
the strongest party disproportionately and to handicap the weaker parties. The latter is
particularly true if small parties are rooted in ethnic, religious, or social minorities;
small parties escape the inequities of the electoral system only if they have a
regionally concentrated base. The plurality formula distorts the distribution of seats
more than the majority system.

Proportional representation.

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 Proportional representation requires that the distribution of offices be
proportional to the distribution of the popular vote among competing political parties
or candidates. It seeks to overcome the distribution imbalances that result from
majority and plurality formulas and to create a representative body that reflects the
distribution of opinion within the electorate. Because of the use of multimember
constituencies in proportional representation, parties with neither a majority nor
plurality of the popular vote can still win legislative representation.
Proportional representation is an ideal that is sought
after, but only approximated: the size of electoral districts is the critical factor; the
larger the electoral district in terms of seats, the more proportional the representation
will be. The number of seats assigned to a constituency is in fact a greater determinant
of the proportionality of the outcome than is the specific type of proportional formula
used. The different formulas of proportional representation are basically similar in
their effect on the conversion of votes to political representation.
Developed in the 19th century in Denmark and in Britain, the
single transferable vote formula--or Hare system (after one of its English developers,
T. Hare)--employs a ballot that allows the voter to rank the competing candidates in
order of preference. When the ballots are counted, any candidate receiving the
necessary quota of first preference votes is awarded a seat. In the electoral
calculations, votes received by a winning candidate in excess of the quota are
transferred to other candidates according to the second preference marked on the
ballot. Any candidate who then has the necessary quota is also awarded a seat. This
process is repeated, with subsequent surpluses also being transferred, until all the
remaining seats have been awarded. Five-member constituencies are considered
optimal for the working of the Hare system. The single transferable
vote formula, because it involves the aggregation of ranked preferences, necessitates
complex electoral computations. This factor, plus the fact that the Hare system limits
the influence of political parties, probably accounts for its infrequent use; it has been
used in Northern Ireland, Ireland, and Malta in the selection of the Australian and
South African senates. The characteristic of the Hare formula that distinguishes it
from other proportional representation formulas is its emphasis on candidates, not
parties. The party affiliation of the candidates has no bearing on the computations.
The basic
difference between the transferable vote formula and the list systems is that, in the
latter, voters choose among party-compiled lists of candidates rather than among
individual candidates. Although voters may have some limited choice among
individual candidates, electoral computations are on the basis of party affiliation; seats
are awarded in respect to party rather than candidate totals. The seats that a party wins
are allocated to its candidates in the order in which they appear on the party list.
Several types of electoral formulas are used, although they fall into two main
categories: largest average formulas and greatest remainder formulas. All employ
some type of electoral quota.
In the largest average formula, the number of
votes won by each party is divided by the number of seats held by the party, plus one.
The first seat is awarded to the party with the highest number of votes, since, no seats
yet having been allocated, the initial denominator is one. When a party wins a seat, its
formula denominator is increased by one and hence the party's chances of winning the
next seat are reduced. The available seats are awarded one at a time to the party with
the greatest average. Party totals, not candidate totals, are used in the calculations. No
transfer of ballots takes place. Frequently named after its Belgian inventor, Victor

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d'Hondt, the largest average formula is used in Austria, Belgium, Finland, and
Switzerland. The d'Hondt formula has a slight
tendency to over-reward large parties and to reduce the chance of small parties
gaining legislative representation. The so-called Lague variation of the d' Hondt
formula--used in Denmark, Norway, and Sweden--reduces the reward to large parties
but increases further the handicap to small parties. By adjusting the denominator of
the d'Hondt formula, the Lague formula increases both the cost of the initial seat of a
party and that of additional seats. The Lague formula thus aids middle-size political
parties and reduces the number of legislatively represented small parties.
The greatest remainder
method establishes a vote quota for each seat in an electoral district by dividing the
total vote in the district by the number of competing parties. The total popular vote
won by each party is then divided by the quota, and a seat is awarded as many times
as the party total contains the full quota. If all the seats are awarded in this manner,
the election is complete. Such an outcome is unlikely, however. Seats that were not
won by full quotas are subsequently awarded to the parties with the largest remainder
of votes after the quota has been subtracted from each party's total vote for each seat it
was awarded. Seats are awarded sequentially to the parties with the largest remainder
until all the district's allocated seats have been awarded. Of all the
proportional representation formulas, the greatest remainder formula, given large
enough constituencies, yields results closest to the proportional ideal. Small parties
fare better when the greatest remainder formula is used than when the largest average
formula is employed. The greatest remainder formula is used in Israel, Italy, and
Luxembourg and in some elections in Denmark. Italy, however, uses a special variety
of the formula, called the Imperiali formula, whereby the electoral quota is established
by dividing the total popular vote by the number of parties plus two. This
modification increases the legislative representation of small parties but leads to a
greater distortion of the proportional ideal.
The choice of majority and plurality or proportional systems is,
of course, not simply a matter of pure theory. Different methods of counting, just as
different conceptions of representation, usually reflect cultural, social-structural, and
political circumstances in a particular jurisdiction. Majority or plural methods of
voting are most likely to be acceptable in relatively stable political cultures. In such
cultures, fluctuations in electoral support, given to one party or another from one
election to the next, reduce polarization and make for political centrism. Thus the
"winner take all" implications of the majority or plurality formulas are not
experienced as unduly deprivational or restrictive. Proportional representation, on the
other hand, is more likely to be found in societies with traditional ethnic, linguistic,
and religious cleavages or in societies experiencing pervasive class and ideological
conflicts.

Voting practices.

There is a direct relation between the size of an electorate and the

formalization and standardization of its voting practices. In very small voting groups,
in which political encounters are face-to-face and the members are bound together by
ties of friendship or common experience, voting is mostly informal and may not even
require counting, because the "sense of the meeting" emerges from the group's
deliberations. The consensus of the Quaker meeting is of this order. An issue is
discussed until a solution emerges to which all participants can agree or, at least, from

674
which any one participant will not dissent.
By way of contrast, in modern mass electorates, in
which millions of individual votes are aggregated into the collective choice,
formalization and standardization of voting practices and vote counting are the rule.
This is necessary in order to guarantee that the outcome can be considered valid,
reliable, and legitimate. Validity means that the collective choice in fact expresses the
sense of the electorate. Reliability means that each vote is accurately recorded and
effectively counted into the total. Legitimacy means that the criteria of validity and
reliability have been met, so that the result of the voting is acceptable and provides
authoritative guidelines in subsequent political conduct.
The
development of routinized and standardized electoral practices in mass electorates is a
surprisingly recent phenomenon, not much older than 100 years. It is as much a
corollary of the growth of rapid communication through telephone and telegraph as of
the growth of the electorate and rational insistence on making electoral processes fair
and equitable. Nevertheless, even today electoral practices around the world differ a
great deal, depending not just on formal institutional arrangements, but even more on
a country's political culture.

Secret voting.
Once suffrage rights had been extended to masses of voters who, in theory,
were assumed to be equal but who, in fact, were unequal (in order of birth, in
intellectual endowment and educational accomplishment, in social status and the
possession of property, and so on), open voting was no longer tolerable precisely
because it could and often did involve undue influence, ranging from hidden
persuasion and bribery to intimidation, coercion, and punishment. Equality, at least in
voting, was not something given but something that had to be engineered; the secrecy
of the vote was a first and necessary administrative step toward the one man, one vote
principle. Equality in voting was possible only if each vote was formally independent
of every other vote, and this suggested the need for strict secrecy.
The slow progress made in
introducing secret voting, from the French Revolution well into the 20th century,
attests to the fact that social engineering, no matter how desirable or lofty in purpose,
depends on favourable conditions for success. One need not assume that the obstacles
placed in the way of secret voting were the result of some conspiracy on the part of
those who recognized, quite accurately, that the mobilization of large numbers of
voters fundamentally changed the distribution of political power and who, through
opposing the secret vote, hoped to maintain a stranglehold on the newly enfranchised
electorates. Rather, the success of secret voting depended on the reduction of illiteracy
and, at the cultural level, on the spread of the individualistic norms of privacy and
anonymity to certain classes of the population, notably peasants and workers.
Traditionally these groups took their cues from those accepted as superior in status, or
from their peers. Secret voting required learning to free oneself as a citizen from one's
customary associations and from pressures for conformity. The difficulty of
introducing and practicing the secret vote in today's politically and economically less
developed nations mirrors the tortuous advance of the secret ballot in the Western
nations during the 19th and early 20th centuries. Secret
voting reduces drastically the possibility of undue influence on the voter. Without it,
influence can range from outright purchase of votes to social chastisement or

675
economic sanctions. This is not to say that bribery in voting is automatically
eliminated by secret voting. Laws prohibiting and punishing the purchase of votes are
on the statute books of many countries and undoubtedly contribute to discouraging the
practice. Although informal social
pressures on the voter are probably unavoidable and, in some respects, useful in
reducing political rootlessness and contributing to political stability, secrecy in voting
permits voters to break away from their social moorings and gives them a
considerable degree of independence if they wish to take advantage of this electoral
freedom. As a result it becomes ever more difficult for interest groups, whether
labour unions, farmers' organizations, commercial or industrial associations, ethnic
leadership groups, or even criminal syndicates, to "deliver the vote." The extent to
which "deviant voting" occurs depends partly on the degree of rigidity in the social
structure. In countries where caste or class barriers are high or where traditional
social, economic, religious, or regional cleavages remain strong, deviant voting is less
likely than in countries where social mobility is possible and where political conflicts
cut across traditional social cleavages. In Western nations the increasing difficulties of
labour, farm, religious, or ethnic leaders in influencing the voter attests to the success
that secret voting seems to have had on freeing the individual from electoral bondage
to his traditional or economic affiliations.

Balloting.
The ballot makes secret voting possible. Its initial use seems to have been a
means to reduce irregularities and deception in elections. This objective, however,
could be achieved only if the ballot was not supplied by the voter himself, as was the
case in much early voting by secret ballot, or by political parties, as is still the case in
some countries. Ballot procedures differ widely, ranging from marking the names of
preferred candidates to crossing out those not preferred or writing in the names of
persons who are not formal candidates. Ballots also differ according to the type of
voting system employed. Where plurality or majority voting is practiced, most
elections employ classified ballots whereby the voter casts his vote for only one
candidate or list of candidates. Where proportional methods are used, election is by
ballots that enable the voter to rank the candidates according to his preferences.
Though evidence is hard to come by, it is commonly believed that the nature of the
ballot influences the voter's choice. In jurisdictions where electors are called upon to
vote not only for higher offices but also for a multitude of local positions and where,
in addition, the election may include propositions in the nature of referenda, the
length of the ballot seems to be a factor affecting vote outcomes. Overwhelmed by the
length of the ballot, voters may be discouraged from expressing their preferences for
candidates of whom they have not heard, or from deciding on propositions that they
do not understand. Breaking up of the single ballot into separate short ballots helps
overcome this problem but does not eliminate it. Election data show a rapid decline
from votes cast for higher offices to those cast for lower offices and referendum-type
propositions. Ballot
position also seems to have an effect on the votes cast for particular candidates,
especially in the absence of cues as to party affiliation or other identifications. The
first position on the ballot may be favoured, and in the case of a long ballot both first
and last names may benefit, with candidates in the middle of the ballot suffering a
slight handicap. Ballot position is likely to have its greatest impact in nonpartisan
elections, primaries, and elections for minor offices. Finally, the

676
manner in which candidates are listed--by party column or office bloc--is likely to
affect election outcomes. On party-column ballots it is possible to vote a "straight
ticket" for all of a party's candidates by entering a single mark, although voting for
individual candidates is usually possible. On the other hand, on the office-bloc ballot,
voting is for individual candidates grouped by office rather than party. This
discourages, though it does not eliminate, voting exclusively for members of one
party. This can have important consequences for the structure of government,
especially in systems with separated powers and federal territorial organization. If
different offices are controlled by different parties, the governmental process may be
marked by greater conflict than would otherwise be the case, and governmental
decision-making often will be more difficult. The introduction of voting
machines has not substantially changed the balloting process, although it has made it
faster, more accurate and economical, and virtually tamper-proof. The voting machine
is not without some minor problems of its own, in that it may marginally depress the
level of voting. In candidate elections the dampening effect is accounted for by
improper use of the machine, a problem that is being overcome through improved
machines and voter education.

Compulsory voting.

In some nations, notably Australia and Belgium, electoral participation is

legally required of all citizens, and nonvoters without legitimate excuses face money
fines. The concept of compulsory voting reflects a strain in democratic theory in
which voting is considered not merely a right but a duty. Its purpose is to ensure the
electoral equality of all social groups. Whether made
compulsory in law or through social pressure, it is doubtful that high voter turnout as
such is a good indication of an electorate's capability for intelligent social choice. On
the other hand, high rates of abstention or differential rates of abstention by different
social classes are not necessarily signs of satisfaction with governmental processes
and policies and may in fact indicate the contrary.

Electoral abuses.
Corruption of electoral practices is, of course, not limited to bribery or
intimidation of the individual voter. The possibilities are endless, ranging from the
dissemination of scurrilous rumours about candidates, and deliberately false campaign
propaganda, to tampering with the election machinery by stuffing the ballot box with
fraudulent returns, dishonest counting or reporting of the vote, and total disregard of
electoral outcomes by incumbent officeholders. The existence of these practices
depends more on a population's adherence to political civility and the democratic
ethos than on the prohibitions and sanctions written into the law.
The integrity of the electoral process is maintained by a
variety of devices and practices. Permanent and up-to-date registries of voters are
maintained to guarantee easy identification of those eligible to participate in elections,
and procedures are designed to make the registration process as simple as possible. In
most jurisdictions, elections are now held on a single day rather than staggered.
Polling hours in all localities are the same, and opening and closing hours are fixed
and announced, so that voters have an equal opportunity to participate. Polling
stations are manned by presumably disinterested government officials or polling

677
clerks under governmental supervision; and political party agents or party workers are
given an opportunity to observe the polling process, enabling them to challenge
irregularities and prevent abuses. Efforts are made to maintain order in polling
stations, directly through police protection or indirectly through such practices as
closing bars and liquor stores. The act of voting itself takes place in voting booths that
protect privacy. Votes are counted and often recounted by tellers, watched by party
workers to assure an honest count. The transmission of voting results from local
polling stations to central election headquarters is safeguarded and checked.
Participation in elections.

The rate at which individuals participate in the electoral process depends on

many factors, including the type of electoral system, the social groupings to which
voters belong, the voters' personality and beliefs, their place of residence, and a host
of other idiosyncratic factors. The level and type of election has a great
impact on the rate of electoral participation. Electoral turnout is greater in national
than in state or provincial elections, and greater in the latter than in local elections.
Because of this, scheduling has an impact on the turnout for local elections. If local
elections are held concurrently with provincial or national elections, a higher voter
turnout is achieved than for nonconcurrent elections. Whether an election is
partisan or nonpartisan also affects voter turnout--lighter participation occurring in the
nonpartisan elections. Participation is also greater in candidate elections than in
noncandidate elections such as referenda. There is some evidence that elections based
on proportional representation, in which in some cases every vote counts, have higher
electoral turnouts than majority or plurality elections. Noncompetitive or safe
electoral districts tend to depress the level of voter turnout, whereas marginal
elections increase the turnout. Technicalities in electoral law involuntarily
disenfranchise many potential voters. As a result of moving, people may temporarily
lose their vote because of residence requirements for voters in their new electoral
district. Complicated voter registration procedures, combined with a high level of
geographical mobility, significantly reduce the size of the active electorate in the
United States, whereas in Canada and Great Britain the size of the electorate is
maximized by government-initiated registration immediately prior to elections. Voter
registration in the United States is left to the initiative of individuals and political
parties. Relatively low levels of electoral participation
are associated with rural residence, and also with low levels of education,
occupational status, and income. The groups in society that have been most recently
enfranchised also tend to vote less. Hence women vote less than men, American
blacks less than whites, and working class people less than those of the middle class.
Young people who have just turned of age, and have therefore just been enfranchised,
are less likely to vote than people who are middle-aged. It is important to note that the
nonparticipation of certain groups in elections has important implications; if everyone
were to vote, the balance of electoral power would shift toward the recently
enfranchised and less privileged members of the society. Some people are
conscientious nonvoters, although such people are rare. Others, perceiving the vote
more as an instrument of censure than of support, may not vote because they are
satisfied with the present government. This group of voluntary nonvoters is also
small, however. In fact, nonvoters have been shown to be generally less satisfied with
the political status quo than are voters. The vote is a rather blunt and ineffectual
instrument for expressing dissatisfaction, and nonvoting is more likely to be
symptomatic of alienation from, than of satisfaction with, the political system.

678
 Supporters of political parties vote more often than nonsupporters; to
party supporters the vote becomes a pledge of party loyalty as well as a political
instrument. Those who feel that government policies have
some direct relevance to their lives are more likely to vote than those who are
disinterested or who sense the government as being more remote. Finally, a
great number of random factors may determine individual participation in specific
elections. Election campaigns vary in their intensity. A crisis atmosphere may induce
an unusually large number of people to vote on one occasion, whereas on another the
chance to vote for an extremist candidate may increase the participation of the
normally disinterested. Even the weather has a substantial impact on election turnout.

Influences on the direction of voting.

The electoral choice of voters is largely influenced by their

membership in social groups or by the social groups with which they identify, and, to
a much lesser extent, by campaign issues and party promises. The determinants of
party membership or party identification are the most crucial factors behind the voting
decision. Membership in social and occupational classes, regional, religious, or ethnic
groupings, and so on, are thus important influences on the direction of the vote.
Because the electoral choice appears to be largely determined by long-
standing group and party identifications, the voting decision may appear to be
irrational, in that it is not based on a careful calculation of the immediate benefits
expected to accrue to the voter from each electoral outcome. Group-determined voting
does not preclude rationality, however, for individual self-interest may well be tied to
the destiny of the social groups to which the voter belongs. The
independent voter, contrary to much common belief, is likely to be poorly informed
politically and relatively uninterested and uninvolved in politics. Paradoxically,
however, by switching their support, independent voters represent an important factor
in democratic politics. In most countries the relatively permanent party
alignments are based on social and cultural cleavages. But if elections are to be
competitive, and if control of the government is to alternate between parties or
coalitions of parties, then some voters must switch party support from election to
election. New voters and independent voters, therefore, provide a vital source of
change in democratic politics.

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7. WILLIAM H. BAUGHN, THOMAS I. STORRS, and CHARLES E.
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Insurance

1. BERNARD L. WEBB et al., Principles of Reinsurance, 2 vol. (1990).

2. ARTHUR E. BRUNCK, VICTOR P. SIMONE, and C. ARTHUR
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3. BERNARD L. WEBB, STEPHEN HORN II, and ARTHUR L.
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4. DANI L. LONG and GENE A. MORTON, Principles of Life and
Health Insurance, 2nd ed. (1988)
5. EMMETT J. VAUGHAN, Fundamentals of Risk and Insurance, 6th
ed. (1992)
6. MARK R. GREENE and JAMES S. TRIESCHMANN, Risk &
Insurance, 8th ed. (1992)
7. PAT MAGARICK, Casualty Insurance Claims: Coverage,
Investigation, Law, 3rd ed. (1988)
8. ROBERT I. MEHR and SANDRA G. GUSTAVSON, Life Insurance:
Theory and Practice, 4th ed. (1987)
9. ROBERT I. MEHR, EMERSON CAMMACK, and TERRY ROSE,
Principles of Insurance, 8th ed. (1985)
10. RODERICK McNAMARA, ROBERT A. LAURENCE, and GLENN
L. WOOD, Inland Marine Insurance, 2 vol. (1987)
11. WILLIAM H. RODDA et al., Commercial Property Risk Management
and Insurance, 3rd ed., 2 vol. (1988)

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5. PAUL A. SAMUELSON, Foundations of Economic Analysis,
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6. J. HÜSLER and R.-D. REISS (eds.), Extreme Value Theory (1989),
7. MARC R. TOOL, Essays in Social Value Theory: A Neo-
Institutionalist Contribution (1986),
8. JOHN WEEKS, Capital and Exploitation (1981
9. DAVID M. KREPS, Notes on the Theory of Choice (1988);
10. BILL GERRARD (ed.), The Economics of Rationality (1993).
11. DAVID D. FRIEDMAN, Price Theory, 2nd ed. (1990),
12. DAVID M. KREPS, A Course in Microeconomic Theory (1990),
13. HAL R. VARIAN, Microeconomic Analysis, 3rd ed. (1992), and
Intermediate Microeconomics, 3rd ed. (1993)
14. GEORGE J. STIGLER, The Theory of Price, 4th ed. (1987);
15. DAVID ROSS, Industrial Market Structure and Economic
Performance, 3rd ed. (1990),
16. PAUL A. SAMUELSON and WILLIAM D. NORDHAUS,
Economics, 14th ed. (1992);
17. WILLIAM J. BAUMOL and ALAN S. BLINDER, Economics, 6th ed.
(1994), and Macroeconomics, 6th ed. (1994).
18. WILLIAM G. SHEPHERD and CLAIR WILCOX, Public Policies
Toward Business, 6th ed. (1979)
19. JOSEPH A. SCHUMPETER, Capitalism, Socialism, and Democracy,
6th ed. (1987),
20. MORTON I. KAMIEN and NANCY L. SCHWARTZ, Market
Structure and Innovation (1982),
21. RICHARD E. QUANDT and DUSAN TRISKA (eds.), Optimal
Decisions in Markets and Planned Economies (1990),
22. ELHANAN HELPMAN and PAUL R. KRUGMAN, Trade Policy and
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23. RICHARD SCHMALENSEE and ROBERT D. WILLIG (eds.),
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24. DENNIS W. CARLTON and JEFFREY M. PERLOFF, Modern
Industrial Organization, 2nd ed. (1994),
25. ROLF FÄRE, Fundamentals of Production Theory (1988),
26. GERHARD ROSEGGER, The Economics of Production and
Innovation: An Industrial Perspective, 2nd ed. (1986);
27. FERNANDO J. CARDIM DE CARVALHO, Mr. Keynes and the Post
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28. ALAN S. BLINDER, Toward an Economic Theory of Income
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682
 31. E.J. MISHAN, The Costs of Economic Growth, rev. ed. (1993),
32. ANGUS DEATON, Understanding Consumption (1992).
33. DENNIS C. MUELLER, Public Choice II (1989), JAMES E. ALT and
KENNETH A. SHEPSLE (eds.), Perspectives on Positive Political Economy (1990).
34. GEORGE T. McCANDLESS, JR., Macroeconomic Theory (1991
35. JOSEPH STIGLITZ, Economics (1993),
36. ROBERT J. BARRO and VITTORIO GRILLI, European
Macroeconomics (1994),
37. RUDIGER DORNBUSCH and STANLEY FISCHER,
Macroeconomics, 6th ed. (1994),
38. DOUGLASS C. NORTH, Institutions, Institutional Change, and
Economic Performance (1990).
39. NEIL DE MARCHI and MARK BLAUG (eds.), Appraising Economic
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40. MARK BLAUG, The Methodology of Economics; or, How
Economists Explain, 2nd ed. (1992).

683