Aleshia Akers Yoonah Hahn, J.D.

February 22, 2016 International Business

Chapters 7 & 8

Chapter 7

1. What is the difference between foreign direct investment and portfolio investment?

A foreign direct investment (FDI) is an investment in stock in a company in another country that
gives the shareholder a measurement of management control. This is different from a portfolio
investment which is an investment in stock in a company that does not involve any control of the
company.

2. What factors influence global flows of FDI?

The two main factors that influence global flows of FDI are globalization and mergers and
acquisitions (M&As). Globalization is a big influence on global flows of FDI because as
countries began to reduce barriers to trade, thanks to the Uruguay Round of GATT negotiations,
companies realized that they could move their production facilities to the cheapest and most
efficient countries, thereby increasing FDI flows into emerging markets. However, the main way
that countries undertake FDI is through mergers and acquisitions. This activity is also increasing
in emerging markets rather than being in mainly developed nations. Companies engage in
M&As to enter new geographic markets, increase competitiveness, improve their product line,
and to reduce costs across the board. However, the rising and declining M&A activity is largely
based on the success or failure of global markets. Though globalization and M&As are the main
factors of influence on global flows of FDI, entrepreneurs and small businesses also play a role,
though there is currently no record on the portion of FDI they contribute. "Unhindered by many
of the constraints of a large company, entrepreneurs investing in other markets often demonstrate
an inspiring can-do spirit mixed with ingenuity and bravado (pg. 179)."

3. Identify the main destinations of FDI. Is the pattern shifting?

Currently, developed countries account for 49 percent of FDI inflows worldwide, with the U.S.,
European Union, and Japan largely responsible. But the trend is changing from only these
countries having the most FDI inflows, to include many more developing countries, mostly in
Asia and South America, due to reductions in barriers to trade.

4. Explain the international product lifecycle theory of FDI.

The international product lifecycle theory has three stages. First, a company, uncertain of
demand, produces a good in their home country, where R&D takes place, so that they may alter
the product quickly and efficiently if needed. Once consumers begin buying the product and
demand increases, the company will build production facilities in countries that have the highest
demand. In the third stage, there is an increase in competition which drives the company to
lower production costs by moving production to the lowest-cost, developing nations. However,
while some companies follow this model in order to enter new markets, there is no proof in the
model to suggest that FDI is the best choice for market entry.

5. How does the theory of market imperfections (internalization) explain FDI?

"Market imperfections theory states that when an imperfection in the market makes a transaction
less efficient than it could be, a company will undertake FDI to internalize the transaction and
thereby remove the imperfection (pg. 181)." The two major imperfections that occur are trade
barriers and specialized knowledge. Trade barriers can force international companies to
undertake FDI in order to avoid things like tariffs. Companies also undertake FDI in order to
gain special knowledge, like technical expertise or employee ability, from foreign countries.

6. Explain the eclectic theory, and identify the three advantages necessary for FDI to occur.

"The eclectic theory states that firms undertake FDI when the features of a particular location
combine with ownership and internalization advantages to make a location appealing for
investment (pg. 182)." With location advantage, companies benefit from engaging in specific
business activities in a location with ideal characteristics for those activities to take place. The
internalization advantages come from companies avoiding certain markets in favor of
internalizing particular business practices.

7. How does the theory of market power explain the occurrence of FDI?

The theory of market power assumes that businesses will want to undertake FDI in order to gain
a dominant presence in their market. This is because having this dominant status will allow them
better control over their costs and prices. Companies can achieve this dominance through either
vertical integration, "the extension of company activities into stages of production that provide a
firm's inputs (backward integration) or that absorb its output (forward integration) (pg. 182)," or
by integrating forward to increase control over their output.

8. Why is control important to companies considering the FDI decision?

Control is important to companies considering the FDI decision because companies believe that
the more they invest in the foreign markets they operate in, the more control they will have over
things like marketing, production costs, and selling price. However, some governments can
upset this theory by requiring shared ownership of subsidiaries operating in their countries or by
forcing companies to export their products so as to not compete with local businesses. Though
some governments have relaxed these practices because many companies avoided investments in
those countries because of their own policies about maintaining control, and those countries did
not want their inward investment flow to dry up.

9. What is the role of production costs in the FDI decision? Define rationalized production.

Production costs can affect whether or not companies choose to undertake FDI because they can
change at the drop of a hat. Cost of land, taxes on profits, increased wage and benefit package
regulations, investment in R&D, and the costs of employee development can increase as
countries become more developed or industrialized. Companies can attempt to curb production
costs by using a system of rationalized production where companies produce each of their
products' components in locations where their production is the cheapest. The downside to this
system occurs when a work-stoppage occurs in one of the locations because it puts a stop to the
final production process.

10. Explain the need for customer knowledge, following clients, and following rivals in the
FDI decision.

A desire in an increase in customer knowledge can encourage companies to undertake FDI

because a local presence can help them to better understand customer preferences in foreign
markets. They can also choose to engage in FDI in order to produce their final products in
countries that have status in certain product categories. Companies sometimes choose to follow
client companies undertaking FDI, resulting in geographical clusters of companies because they
supply each other's imports. This helps all companies involved to improve sustainability.
Companies can also choose to follow their competition for fear of being locked out of potentially
lucrative markets.

11. What is a country's balance of payments? Briefly explain its usefulness.

"A country's balance of payments is a national accounting system that records all receipts
coming into the nation and all payments to entities in other countries (pg. 187)." The balance of
payments in the United States includes the current account and the capital account, which should
be equal in value. This balance is what most countries use to determine the appropriate amount
of FDI they should allow or encourage. Paying attention to the current account surpluses or
deficits can help to determine whether a country is producing enough exports.

12. Explain the difference between the current account and the capital account.

The current account tracks national imports and exports as well as accounts received from and
paid to foreign countries. On the other hand, the capital account tracks purchases and sales of
assets, such as FDI.

13. For what reasons do host countries intervene in FDI?

Host countries sometimes intervene in FDI, mostly to either control the balance of payments or
to obtain resources and benefits. They wish to improve the balance of payments through FDI
inflows, imposing local content requirements, and through exports generated by the new
production operation. Countries may also attempt to do this by restricting foreign companies
from returning profits to their home countries. Other than to control the balance of payments,
governments may intervene in FDI flows to encourage technological imports or inflows of
workforce talent.

14. For what reasons do home countries intervene in FDI?

Home countries can intervene in FDI by discouraging it if foreign investments are detracting
from home resources or if the government believes that outgoing FDI can negatively affect the
balance of payments. Countries will encourage FDI to increase long-term competitiveness or to
move away from "sunset" industries. "Sunset industries are those that use outdated and obsolete
technologies or that employ low-wage workers with few skills (pg. 190)." Moving away from
these types of industries by allowing those positions move abroad and further training workers
that were in those positions will help improve a country's economy.

15. Identify the main methods host countries use to promote and restrict FDI.

The main ways host countries can promote and restrict FDI are through financial incentives,
infrastructure improvements, ownership restrictions, and performance demands. Host nations
will attempt to promote FDI through financial incentives such as reduced or waived taxes or low-
interest loans. However, this can result in intense competition for certain locations which can
then cost taxpayers more than it was work to attempt to attract FDI in the first place.
Improvements to infrastructure can also help countries encourage inflows of FDI because it gives
companies the opportunity to operate in locations with advanced and superior infrastructure
which will give them a competitive advantage. Host countries will attempt to limit FDI flows by
establishing ownership restrictions which puts limits or bans on foreign companies investing in
certain industries or types of businesses, although this practice has dwindled as countries realize
that FDI will still flow elsewhere. Nations will also attempt to limit FDI by enforcing
performance demands. "Performance demands include insuring that a portion of a product's
content originates locally, stipulating that a portion of the output must be exported, or requiring
that certain technologies be transferred to local businesses (pg. 191)."

16. What methods do home countries use to promote and restrict FDI?

Home countries can promote FDI by offering insurance on investments abroad, granting loans to
businesses looking to increase their foreign presence, offering tax breaks on profits earned
abroad or special tax incentives for companies looking to increase foreign investments, or by
encouraging foreign nations to relax their investments so that businesses in the home country
will have more opportunity to undertake FDI. Countries can restrict FDI by either charging
higher tax rates for foreign earnings or imposing sanctions banning FDI in certain markets
abroad.

Chapter 8

1. What is the ultimate goal of regional economic integration?

Regional economic integration is the process where several geographically close nations work
together to curb trade barriers. "The goal of nations pursuing economic integration is not only to
increase cross-border trade and investment but also to raise living standards for their people (pg.
200)."
 2. Define each of the five levels, or degrees, of regional integration.

The five levels of regional economic integration include, from the lowest extent of integration to
the highest, are a free trade area, customs union, common market, economic union, and political
union. A free trade area allows all member countries to trade freely, without barriers amongst
themselves, but then also allows each country to determine their own level of barriers against any
nonmembers. A customs union differs slightly in that in addition to eliminating barriers among
member countries, it also determines the trade policy that all members will follow when
engaging with nonmember countries. A common market combines both of the previous levels of
regional integration and also includes the removal of barriers to the movement of labor and
capital among members. However, a common market is difficult to attain and can result in
uneven benefits among member countries. "An economic union goes beyond the demands of a
common market by requiring member nations to harmonize their tax, monetary, and fiscal
policies and to create a common currency (pg. 201)." And finally, the highest level of regional
economic integration comes in the form of a political union. This occurs when countries have
gone through all the other levels of regional integration and then also opt to coordinate their
political systems in regards to nonmember nation relations as well.

3. Identify several potential benefits and several potential drawbacks of regional integration.

Regional economic integration can result in several benefits as well as several drawbacks.
Regional integration can result in trade creation which is important because it gives consumers a
wider selection of goods and services to choose from. The resulting competition creates lower
prices and the lower prices increase consumer demand. With regional integration the elimination
of trade barriers is made easier among member countries because consensus is more likely within
smaller groups. Member countries also tend to have more power in negotiations with other
countries and more willingness to avoid military conflict with other members. Citizens of
member countries benefit from the increase in employment opportunities as they are able to seek
more pay or better jobs across borders. Drawbacks to economic integration include the diversion
of trade toward member nations. This move away from potentially more efficient companies in
other countries can end up costing their citizens more money. Employment changes are claimed
to be a negative effect because unskilled labor positions move to the countries in the bloc with
the lowest wages, but others believe that this move can create the opportunity for workforce to
become more skilled and receive more advanced training which will attract higher paying jobs to
the trade bloc. Finally, some believe that a loss of sovereignty coming from the trade bloc is
enough to take a second look before becoming involved.

4. What is meant by the term trade creation and trade diversion? Why are these concepts
important?

Trade diversion is the move toward trading with countries only inside the trading bloc and away
from foreign countries. Trade creation in the term for the increase in the level of trade within the
trading bloc. They are important because the first can increase aggregate demand through a
wider selection of goods and services but the second can reduce quality among those goods and
services causing an increase in price.
 5. Why did Europe initially desire to form a regional trading bloc?

Europe initially chose to form regional trading bloc because they wanted to avoid future military
conflict and to keep in competition with the United States.

6. Describe the evolution of the European Union. What are its five primary institutions?

The European Union began by moving trade barriers that affected the production of coal and
steel so that they may control the postwar arms industry. Then over the years their goals
increased, adding transportation, atomic energy, and agricultural policies among members, and
their number of member nations rose from six to twenty-seven. The Single European Act was
established in the late 1980s to remove trade barriers, increase consensus, and enhance
competitiveness. In the early 90s, the Maastricht Treaty was implemented to call for a common
currency among member nations, monetary and fiscal targets for countries wishing to participate,
and for the development of a common defense, citizenship, and foreign policy which will only be
implemented after examining the success of the first two parts of the treaty. The monitoring and
enforcement of economic and political integration is taken care of by five primary institutions.
The European Parliament supervises the rest of the EU institutions and debates and amends
legislation proposed by the European Commission. The Council of the EU, made up of different
groups of ministers (representatives) depending on the topic of discussion, votes legislation into
laws. The European Commission is made up of commissioners, appointed by each country and
approved by the European Parliament, who work in the best interest of the EU as a whole. "The
commission has the right to draft legislation, is responsible for managing and implementing
policy, and monitors member nations’ implementation of, and compliance with, EU law (pg.
210)." The Court of Justice consists of one judge from each nation of the EU and hears cases
about failures to meet treaty agreements by member countries, the council, or the commission.
The Court of Auditors is also made up of 27 members and audits EU accounts, implements its
budget, improves financial management of the EU, and supplies citizens of member nations
about the use of public funds.

7. What is European monetary union? Explain its importance to business in Europe.

The European monetary union was the plan, based off the goals and outlines of the Maastricht
Treaty, that established its own central bank and currency for 17 member nations. In order to be
a member, consumer price inflation needs to be less than 3.2 percent and to not exceed the top
three countries by 1.5 percent, government debt must be below or really close to being below 60
percent of GDP, the deficit has to be less than or really close to being less than 3 percent of GDP,
and interest rates on long-term government securities can't exceed that of the three countries with
the lowest inflation rates by more than 2 percent. By establishing their own currency, the EU
eliminates financial barriers that come from the use of multiple currencies such as exchange rate
risk and high transaction costs. It also makes it significantly easier to compare prices across
countries without having to worry about exchange rate calculations.

8. Briefly describe the European Free Trade Association.

The European Free Trade Association (EFTA) is made up of countries that were not interested in
joining the European Union who banded together to improve trade of industrial goods among
members. Together with the EU the EFTA created the European Economic Area in order to
encourage the free movement of goods, services, persons, and capital and to improve
environmental, social, and educational policies among members.

9. What was the impetus for the formation of the North American Free Trade Agreement
(NAFTA)?

With the increasing unification of Europe, Canada, Mexico, and the United States realized the
need for an official trading bloc agreement. The goal of the creation of NAFTA was to eliminate
all tariffs and other non-trade barriers between these countries

10. What effect has NAFTA had on trade among its member nations?

" Overall, NAFTA has helped trade among the three countries to grow from $297 billion in 1993
to around $1.6 trillion (pg. 213)." However, there are claims of serious losses of jobs and job
opportunities in the United States. There is also an ongoing issue with environmental impact,
especially on the United States-Mexico border, but these countries continue to invest billions of
dollars on environmental protection efforts to combat these issues.

11. List the main benefits the United States obtains from the Central American Free Trade
Agreement.

The Central American Free Trade Agreement holds several benefits for the United States. It has
a goal of trade barriers against U.S. exports to Costa Rica, El Salvador, Guatemala, Honduras,
Nicaragua, and the Dominican Republic. Other benefits come from the insurance that those
countries will not disadvantage the US when trading with nonmember countries and that they
will support U.S. national security efforts. "The agreement also requires the Central American
nations and the Dominican Republic to reform their legal and business environments to
encourage competition and investment, protect intellectual property rights, and promote
transparency and the rule of law (pg. 214)."

12. What is the Andean Community? Identify why its progress is behind schedule.

The Andean Community is a trading bloc in the Andes mountain range which includes the
countries of Bolivia, Columbia, Ecuador, and Peru. "The main objectives of the group include
tariff reduction for trade among member nations, a common external tariff, and common policies
in both transportation and certain industries (pg. 215)." Progress in their objective to establish a
common market has been stunted for several reasons. For one, governments in these countries
have difficulty accepting the concept of free markets. These governments also find difficulty in
trusting each other which makes any cooperation more difficult. The Andean Community
currently allows for too many exceptions in each of their tariff structures with nonmember
nations. Their members also harm their goal of becoming a common market because they
continue to make independent agreements with nonmember nations which hurt their credibility.
 13. Identify the members of the Southern Common Market (MERCOSUR). How has it
performed?

The Southern Common Market (MERCOSUR) is a trading bloc made up of Argentina, Brazil,
Paraguay, and Uruguay. There are also associate members including Bolivia, Chile, Columbia,
Ecuador, and Peru, and Mexico has been granted observer status. MERCOSUR has been
exceptionally successful, increasing trade among members by four times what they started with,
and is quickly becoming the strongest trading block in Latin America.

14. Characterize economic integration efforts throughout Central America and the Caribbean.

Economic integration efforts throughout Central America and the Caribbean had less impact than
other efforts in the Americas. The Caribbean Community and Common Market (CARICOM)
has fifteen members, five associates, and eight observers with a combined GDP of almost $30
billion. "A key CARICOM agreement calls for the establishment of a CARICOM Single
Market, which would permit the free movement of factors of production including goods,
services, capital, and labor (pg. 215)." However, CARICOM has issues because, more often,
members will trade with nonmembers because they can't find the imports they need within the
trading block. The Central American Common Market (CACM) was formed between Costa
Rica, El Salvador, Guatemala, Honduras, and Nicaragua, but due to ongoing conflict between
those countries, neither a common market or customs unit we ever established.

15. What is the objective of the Free Trade Area of the Americas? What are its current
prospects for success?

The Free Trade Area of the Americas has been negotiated on since 1994. "The objective of the
FTAA (www.alca-ftaa.org) is to create the largest free trade area on the planet, stretching from
the northern tip of Alaska to the southern tip of Tierra del Fuego, in South America (pg. 216)."
Three summits have taken place so far, involving every nation in the Americas except for Cuba,
but because of the huge task of making this work, it is likely to take many years before anything
is formally agreed on.

16. Identify the three main objectives of the Association of Southeast Asian Nations.

The Association of Southeast Asian Nations (ASEAN) is made up of Indonesia, Malaysia, the
Philippines, Singapore, Thailand, Brunei, Vietnam, Laos, Myanmar, and Cambodia. "The three
main objectives of the alliance are to (1) promote economic, cultural, and social development in
the region; (2) safeguard the region’s economic and political stability; and (3) serve as a forum in
which differences can be resolved fairly and peacefully (pg. 216)."

17. How do the goals of the Asia Pacific Economic Cooperation forum differ from those of
other regional blocs?

While most regional blocs are formed with a main goal of eliminating barriers to trade within the
region, the Asia Pacific Economic Cooperation forum is a bit different. "The stated aim of
APEC is not to build another trading bloc. Instead, it desires to strengthen the multilateral trading
system and expand the global economy by simplifying and liberalizing trade and investment
procedures among member nations (pg. 217)." It is trying to make it easier to do business or find
employment across member nations through establishing a common universal business visa,
mutual recognition agreements on professional qualifications, and a unified customs procedure.

18. What is the Gulf Cooperation Council? Identify its members.

The Gulf Cooperation Council's members include the Middle East nations of Bahrain, Kuwait,
Oman, Qatar, Saudi Arabia, and the United Arab Emirates. It was created to help cooperate with
the EU and the EFTA, but has moved to be more of a political bloc that helps its members travel
freely or own land, property, or businesses across member nations.

19. List the aims of both the Economic Community of West African States and the African
Union.

The Economic Community of West African States (ECOWAS) was formed with the goal of
creating a customs union, a common market, and a monetary union. It has made great gains in
the free movement of people, international road construction, and telecommunication
development, but has made little to no progress with market integration. The African Union is
comprised of 53 member nations and has the goal of establishing a more unified and strong
African continent. "Specifically, the stated aims of the AU are to (1) rid the continent of the
remaining vestiges of colonialism and apartheid, (2) promote unity and solidarity among African
states, (3) coordinate and intensify cooperation for development, (4) safeguard the sovereignty
and territorial integrity of members, and (5) promote international cooperation within the
framework of the United Nations (pg. 218)."

Resource:

Wild, J. J., & Wild, K. L. (n.d.). International business: The challenges of globalization
(7th ed.). Pearson Education.