BBNG3103 International Business PDF

BBNG3103
INTERNATIONAL
BUSINESS
Dr Abdul Jumaat Mahar
Mohd Shah Kassin
Mohd Sobri Don
Jannatul Firdaus
Ahmad Bashawir Haji Abd Ghani
Dr Teo Boon Chui
Copyright © Open University Malaysia (OUM)

Project Directors: Prof Dato’ Dr Mansor Fadzil
Prof Dr Wardah Mohamad
Open University Malaysia
Module Writers: Dr Abdul Jumaat Mahar

Mohd Shah Kassin
Mohd Sobri Don
Jannatul Firdaus
Ahmad Bashawir Haji Abd Ghani
Universiti Utara Malaysia
Dr Teo Boon Chui

Universiti Teknologi MARA
Moderator: Ayub Nasir
Developed by: Centre for Instructional Design and Technology

Open University Malaysia
Printed by: Meteor Doc. Sdn. Bhd.

Lot 47-48, Jalan SR 1/9, Seksyen 9,
Jalan Serdang Raya, Taman Serdang Raya,
43300 Seri Kembangan, Selangor Darul Ehsan
First Edition, May 2007

Second Edition, December 2013 (rs)
Copyright © Open University Malaysia (OUM), December 2013, BBNG3103
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).

Table of Contents
Course Guide xi–xvii
Topic 1 Introduction to International Business 1

1.1 Background 1
1.2 Why Study International Business? 3
1.3 Main Terminologies in International Business 4
1.4 Evolution of International Business 6
1.4.1 Early Era of International Business 6
1.4.2 Development of International Business Since
World War II 7
1.4.3 Golden Era of American Business: 1945 to 1960 7
1.4.4 Emergence of Europe and Japan: 1960 to 1980 8
1.4.5 New Global Market: 1980 Until Present 9
1.5 Development of International Business 10
1.5.1 Market Development 10
1.5.2 Purchasing of Resources 11
1.5.3 Competition Pressures 11
1.5.4 Technological Changes 11
1.5.5 Social Changes 11
1.5.6 Changes in Government Trade and Investment
Policy 12
1.6 International Business Activities 12
1.7 Internationalisation 14
1.8 External Influences in International Business 15
1.8.1 Law and Political Policy 16
1.8.2 Cultural Factor 16
1.8.3 Economic Power 17
1.8.4 Geographical Influence 17
Summary 19
Key Terms 20

iv  TABLE OF CONTENTS
Topic 2 Economic Environment and Systems 21

2.1 Background 22
2.2 Overview of the WorldÊs Economy 23
2.3 Country Classification by Income 24
2.4 Country Classification by Geographic Areas 26
2.5 Country Classification by Economic System 26
2.6 Market Economy 28
2.7 Command Economy 29
2.8 Mixed Economy 29
2.9 Changes in Macroeconomic Environment and Indicators 30
2.9.1 Economic Growth 30
2.9.2 Inflation 31
2.9.3 Trade Surplus and Deficit 32
2.10 Transition towards Market Economy 32
2.11 Effects of the Transition Process 33
2.11.1 Transition in Russia 33
2.11.2 Transition in Central and Eastern Europe 34
2.11.3 Transition in China and Vietnam 34
2.11.4 Effects of Transition on International Business 35
2.12 Major Changes in the Macroeconomic Environment 35
2.12.1 The Asian Financial Crisis of 1997/1998 36
2.12.2 The Global Financial Meltdown of 2008/2009 36
Summary 40
Key Terms 40
Topic 3 Cultural Environment 41

3.1 Concept of Culture 42
3.2 Cross-Cultural Risks and International Business 43
3.3 Cultural Elements 44
3.3.1 Language 45
3.3.2 Religion 44
3.3.3 Social Structure and Interaction 49
3.3.4 Aesthetics 52
3.3.5 HofstedeÊs Cultural Value Dimensions 53
3.4 Overcoming Cultural Challenges 57
Summary 61
Key Terms 62

TABLE OF CONTENTS  v
Topic 4 Political and Legal Environment 63

4.1 Political Environment 64
4.1.1 Effects of Political System 65
4.2 Effects of Political Ideology Differences 65
4.3 Political Risks 67
4.3.1 Types and Causes of Political Risks 68
4.4 Micro and Macro Political Risks 70
4.5 Managing Political Risk 71
4.6 Multinational Corporation – Government Relationship 72
4.7 Legal Environment 73
4.8 Types of Legal Systems 73
4.8.1 Common Law 74
4.8.2 Civil Law 74
4.8.3 Theocratic Law 74
4.9 Legal Issues in International Business 75
Summary 79
Key Terms 79
Topic 5 Regional Economic Integration 80

5.1 Forms of Regional Economic Integration 81
5.1.1 Preferential Trade Agreement (PTA) 81
5.1.2 Free Trade Area 82
5.1.3 Customs Union 82
5.1.4 Common Market 83
5.1.5 Economic Union 83
5.1.6 Political Union 83
5.2 Reasons for the Formation of Regional Economic
Integration 84
5.2.1 Economic Reasons 84
5.2.2 Political Reasons 85
5.3 Obstacles in the Formation of Regional Economic
Integration 85
5.4 Effects of Regional Economic Integration on Firms 86
5.5 Economic Integration in Europe 88
5.5.1 European Union 88
5.6 Economic Integration in the American Continent 90
5.6.1 North American Free Trade Agreement (NAFTA) 91
5.6.2 Andean Pact 92
5.6.3 Mercosur 92
5.6.4 Central American Common Market and
Caribbean Community and Common Market 92

vi  TABLE OF CONTENTS
5.7 Economic Integration in the Asia Pacific Region 93

5.7.1 Association of South East Asian Nations
(ASEAN) 93
5.7.2 Asia Pacific Economic Cooperation (APEC) 94
Summary 96
Key Terms 96
Topic 6 International Trade Theories 97

6.1 International Trade Theories 98
6.2 Country-Based Theories 99
6.2.1 Mercantilism 99
6.2.2 Absolute Advantage Theory 101
6.2.3 Comparative Advantage Theory 104
6.2.4 Heckscher-Ohlin Theory 107
6.3 Firm-Based Theories 108
6.3.1 International Product Life-Cycle Theory 108
6.3.2 PorterÊs Diamond Theory of NationsÊ
Competitive Advantage 111
6.4 Foreign Direct Investment Theories 112
6.4.1 Firm-Specific Advantage 113
6.4.2 Location-Specific Advantage 114
6.4.3 Internalisation Advantage 115
6.4.4 DunningÊs Eclectic Model 116
Summary 119
Key Terms 120
Topic 7 Foreign Direct Investment (FDI) 121

7.1 Foreign Direct Investment (FDI) 122
7.2 Foreign Direct Investment (FDI) Pattern 123
7.3 Major Motives of Foreign Direct Investment (FDI) 125
7.4 Impact of Foreign Direct Investment (FDI) 126
7.5 Types of Foreign Direct Investment (FDI) 128
7.5.1 Horizontal Foreign Direct Investment 128
7.5.2 Vertical Foreign Direct Investment 129
7.6 Foreign Direct Investment (FDI) Theory 132
Summary 134
Key Terms 135

TABLE OF CONTENTS  vii
Topic 8 International Financial Environment 136

8.1 Foreign Exchange Market 137
8.1.1 Functions of Foreign Exchange Market 138
8.1.2 Features of Foreign Exchange Market 139
8.1.3 Foreign Exchange Rate Quotations 140
8.1.4 Foreign Exchange Market Players 141
8.1.5 Factors Influencing Foreign Exchange Market 142
8.2 International Monetary System 144
8.2.1 The Gold Standard (1876 to 1914) 145
8.2.2 Interwar Years (1914 to 1944) 146
8.2.3 The Bretton Woods System (1944 to 1973) 146
8.2.4 The Floating Exchange Rate System
(1973 until present) 148
8.2.5 Contemporary Exchange Rate System 148
8.3 International Money Market 149
8.3.1 International Capital Market 150
8.3.2 International Bond Market 150
8.3.3 International Equity Market 151
Summary 154
Key Terms 154
Topic 9 Country Selection and Entry Strategies 155

9.1 Selecting Suitable Marketing and Production Location 156
9.2 Scanning for Alternative Locations 159
9.3 Choosing and Comparing Opportunities and Risks 159
9.3.1 Investment Opportunities 159
9.3.2 Investment Risks 162
9.4 Collecting and Analysing Data 167
9.4.1 External Sources of Information 168
9.5 Using Comparison Tools 169
9.5.1 Grids 169
9.5.2 Matrices 171
9.6 Modes of Entry 174
9.7 Trade-Related Entry Modes–Exporting 175
9.8 Transfer-Related Entry Modes 177
9.8.1 International Licensing 177
9.8.2 International Franchising 178
9.8.3 Management Contract 180
9.8.4 Turnkey Operation 180

viii  TABLE OF CONTENTS
9.9 Foreign Direct Investment (FDI)-Related Entry Modes 181

9.9.1 Equity Joint Ventures (EJV) 182
9.9.2 Wholly-Owned Subsidiary 183
Summary 188
Key Terms 189
Topic 10 Managing the Global Marketing Environment 190

10.1 Market Analysis 191
10.2 Standardisation and Adaptation in Global Markets 192
10.3 Global Product and Global Brand 194
10.4 Global Promotion 197
10.4.1 Standardisation vs Adaptation Strategies in
Global Promotion 197
10.5 Global Pricing 199
10.6 Global Distribution 200
10.6.1 Global Distribution Channels 201
10.6.2 Global Retailing 202
Summary 205
Key Term 206
Answers 207
References 233

COURSE GUIDE

COURSE GUIDE  xi
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBNG3103 International Business is one of the courses offered by Faculty of
Business and Management at Open University Malaysia (OUM). This course is
worth three credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This course is offered to all students taking the Bachelor of Business
Administration programme. This module aims to impart the basic foundation on
the understanding of international business environment and its influence on the
role of the business manager. Relevant to all learners is the Âreal-worldÊ feel that
conveys the complexity yet excitement of cross-border business.
As an open and distance learner, you should be acquainted with learning

independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please confirm the course material,
the course requirements and how the course is conducted.

xii  COURSE GUIDE
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
Table 1: Estimation of Time Accumulation of Study Hours
STUDY
STUDY ACTIVITIES
HOURS
Briefly go through the course content and participate in initial 3
discussions
Study the module 60
Attend three to five tutorial sessions 10
Online Participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS ACCUMULATED 120
COURSE OUTCOMES
By the end of this course, you should be able to:
1. Describe what is international business, underlying trade theories and why

firms engage in foreign investment;
2. Describe the cultural, economic, political, legal and financial environment

facing multinational companies in foreign markets;
3. Summarise the developments in global markets in terms of economic

integration and monetary system; and
4. Discuss international business strategies in terms of country selection, entry

modes and marketing.

COURSE GUIDE  xiii
COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic is listed as
follows:
Topic 1 describes what is international business, why it is important and

the differences between international and domestic business. Multinational
enterprise and international firms are also distinguished. Lastly, the factors that
drive international trade are discussed.
Topic 2 focuses on the economic environment facing firms in foreign markets.

Country classification according to economic system with major macroeconomics
changes are explained with examples of economic events.
Topic 3 deals with the issues on the cultural environment facing firms in terms of
cultural risk, cultural elements and strategies to cope with cultural differences
when entering foreign markets.
Topic 4 discusses the political and legal environment that firms encounter in
international business.
Topic 5 focuses on the development of regional economic integration in the

global marketplace.
Topic 6 describes the underlying traditional and new international trade theories
to explain why and how international trade occurs.
Topic 7 examines foreign direct investment (FDI) in terms of types, motives,

effects and theories.
Topic 8 discusses the international monetary and exchange rate system in which
international business transaction operates.
Topic 9 examines where and how multinational firms select locations to operate
the business and the modes of entry into the foreign markets.
Topic 10 deals with strategies to manage marketing efforts in the global business
environment.

xiv  COURSE GUIDE
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one sub-section or a few sub-
sections. It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.
Activity: Like Self-Check, the Activity component is also placed at various

locations or junctures throughout the module. This component may require you
to solve questions, explore short case studies, or conduct an observation or
research. It may even require you to evaluate a given scenario. When you come
across an Activity, you should try to reflect on what you have gathered from the
module and apply it to real situations. You should, at the same time, engage
yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.

COURSE GUIDE  xv
References: The References section is where a list of relevant and useful

textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.
PRIOR KNOWLEDGE
Learners of this course are required to pass BBPP1103 Principle of Management
course.
ASSESSMENT METHOD
Please refer to myVLE.
REFERENCES
Balcerowicz, L. (1994). Economic transition in Eastern and Central Europe:
Comparisons and lessons. The Australian Economic Review, 27(1), pp. 47–59.
Bartlett, C. A., & Ghoshal, S. (1989). Managing across borders: The transnational
solution. Boston, MA: Harvard Business School Press.
Cordenillo, R. L. (2005). The economic benefits to ASEAN of the ASEAN-China

Free Trade Area (ACFTA). Retrieved from http://www.aseansec.org/
17310.htm
Daniels, J. D., & Radebaugh, L. H. (2009). International business: Environments

and operations. New Jersey: Prentice Hall.
Economist, T. (2007). Over the hill? Foreign investment in Eastern Europe may be
at a peak. Retrieved from http://www.economist. com/node/9392733
Guo, S. (2004). Economic transition in China and Vietnam: A comparative

perspective. Asian Profile, 32(5), pp. 393–410.
Hoang, T. T. (2006). Determinants of foreign direct investment in Vietnam.

Retrieved from www.thailandnce.eco.ku.ac.th

xvi  COURSE GUIDE
Holden, M. (2003). Stages of economic integration: From autarky to economic

union. Retrieved from http://dsppsd.pwgsc.gc.ca/Collection-R/LoPBdP/
EB-e/prb0249-e.pdf
Johnson, A. (2005). Host country effects of foreign direct investment [Electronic

version]. JIBS Dissertation Series, 31.
Kotabe, M., & Helsen, K. (2011). Global marketing management (5th ed.).
New Jersey: John Wiley & Sons (Asia) Pte Ltd.
Lin, J. Y. (2010). ChinaÊs miracle demystified [Electronic version]. Retrieved from

https://blogs.worldbank.org/africacan/team
Maher, M., & Christiansen, H. (2001). New horizons and policy challenges
for foreign direct investment in the 21st century. OECD Paper. Paper
presented at the Global Forum on International Investment, Mexico City.
Moran, T. H. (2003). FDI and development: What is the role of international rules
and regulations? Transnational Corporations, 12(2), pp. 1–44.
Ouchi, W. G. (1981). Theory Z: How American business can meet the Japanese
Challenge. New York: Avon Books.
Shenkar, O., & Luo, Y. (2004). International business. New Jersey: John Wiley &
Sons, In.
Sun, X. (2002). How to promote FDI? The regulatory and institutional

environment for attracting FDI. Foreign Investment Advisory Service,
United Nations.
UkraineÊs Business Culture. (2005). Retrieved from http://www.tryukraine.com/

society/business_culture.shtml

COURSE GUIDE  xvii
TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL

LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for
the use of its learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books247, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.

xviii  COURSE GUIDE

Topic  Introduction to
1 International
Business
LEARNING OUTCOMES
k
By the end of this topic, you should be able to:
1. Explain the meaning of international business;
2. Define the main terminologies used in international business;
3. List the types of multinational firms;
4. Discuss the evolution of international business; and
5. Describe the activities involved in international business.
 INTRODUCTION
The first part of Topic 1 summarises the meaning of international business, why
we study international business, the activities involved in international business
and the types of multinational firms. In the latter part of this topic, we will
be looking at the evolution of international business, which includes the
development of international business from the early era until the present. At the
end of this topic, we will discuss the factors contributing to the development of
international business and external influences of international business activities,
and also common terminologies used in international business.
1.1 BACKGROUND
Let us first start our lesson by looking at the meaning of international business.
International business consists of all transactions between one country and

another country.

2  TOPIC 1 INTRODUCTION TO INTERNATIONAL BUSINESS
For example, international business includes buying raw materials from one
country and then transporting them to another country for processing, exporting
products to other countries to be sold and building a factory at a foreign country to
get cheap labour. The parties which handle international transactions consist of
individuals, private companies and corporations as well as government agencies.
ACTIVITY 1.1
Name a few organisations that engaged in international business.
Domestic business involves commercial transactions within oneÊs own country

whereas international business takes place across borders. Normally it is between
two or more countries.
International business differs from domestic business in a few aspects. Let us

now take a look at each aspect (refer to Table 1.1).
Table 1.1: Differences between International and Domestic Businesses
Aspect International Business Domestic Business

Use of For customers who purchase goods and For domestic business, a
Currency services from foreign countries, they customer should use the official
have to do transactions in the currency local currency of the country.
which has been agreed in the trade For example, if someone living
contract; for example, US Dollars or in Malaysia wants to buy things
Japanese Yen. in the country, he/she has to
use the Malaysian Ringgit.
Legal The legal system is important in For domestic business, firms
System international business transactions. For need to abide by the domestic
firms who want to export or import a laws with regards to buying
certain product from foreign countries, and selling transactions.
they have to abide by the Custom Act
and Trade Act established by the host
country as well as the international laws.
Culture Culture plays a vital role in international For domestic business, a firm
business transactions. If a local firm has to only understand the local
wants to make a direct investment in a culture in an effort to gain its
foreign country, it has to understand the customerÊs interest in buying
local culture of the people in the host the product.
country. This is because cultural
differences influence the behaviour in
the use and purchase of products and
services in that particular foreign market.

TOPIC 1 INTRODUCTION TO INTERNATIONAL BUSINESS  3
Raw Each country is endowed with different For domestic business, the
Materials raw materials due to differences in production of a product depends
climatic and land conditions. Most on the availability of raw
advanced countries invest in developing materials that can be easily
countries to obtain the cheap and sourced in the country.
abundant raw materials not available in
their own country.
Basically, the skills and knowledge required to achieve success are the same as
transactions done either domestically or internationally. However, other risks
and uncertainties tend to make international business more difficult to operate
and manage. Those involved in international business should understand the
culture, legal system, political situation and social background which are
different amongst countries. They have to consider the buying of raw materials
and market conditions in order to gain optimum outcome.
1.2 WHY STUDY INTERNATIONAL BUSINESS?
ACTIVITY 1.2
Take a moment to reflect on how the knowledge of international
business can help someone who is involved in business. Discuss with
your coursemates.
Every big organisation which has international operations will be influenced by

the global environment. Knowledge about international business can assist us in
enhancing our careers as well as enable effective interaction between managers
and subordinates around the world.
Small businesses are also involved in international business. Knowledge about

international business is important because we may work with an organisation
which has its headquarters abroad. We need to have knowledge about
international business in order to compete and learn the methods as well as
techniques that are used by advanced countries. With knowledge in international
business, we will be able to learn and understand the cultures of other countries.
SELF-CHECK 1.1
List four differences between international business and domestic

business. Why are there such differences?

1.3 MAIN TERMINOLOGIES IN

INTERNATIONAL BUSINESS
Let us now take a look at some of the common terminologies used in
(a) Multinational Company

A multinational company uses a globalisation approach in a foreign
market. It has foreign direct investments and business operations across
multiple markets. The size of a multinational company, be it big or small,
will determine its competing capability in international business. A
multinational company, its headquarters is in the home country, while its
subsidiaries are in the host countries, for example, Motorola, Siemens, Dell,
Toyota and Petronas. A multinational company can operate at three
different levels. Let us take a look at Figure 1.1.
Figure 1.1: Three levels of multinational company
(b) Multidomestic Company

Have you ever heard of the word „multidomestic‰? What is the difference
between multidomestic companies, global companies and transnational
companies?
A multidomestic company is a company with many subsidiaries which

operates freely from its headquarters.

Each subsidiary focuses on a domestic market. That particular subsidiary is

free to plan its own marketing campaign and production technique to
enhance its production. For example, a multidomestic company in Malaysia
will concentrate on its marketing effort in enhancing customersÊ needs
toward product development while its subsidiary in London will focus on
marketing strategy for the local market.
(c) Global Company

Another level of multinational company that we need to know is global
company. To a global company, the world is its market. It will try to fulfil
the needs and requirements of global customers by offering standardised
services and products. It also develops global advertising strategies across
different countries in order to achieve economies of scale through an
integrated productive production system.
A global company uses a centralised approach to control its production

and marketing strategies of its business operations overseas unlike a
multidomestic company in which authority and decision-making is left to
each subsidiary.
(d) Transnational Company

Now, let us move on to transnational company. A transnational company
combines the characteristics of both a global company and multidomestic
company. Let us look at the definition by Barlett and Ghoshal (1983).
A transnational company operates a business which embarks on

activities according to the needs of local customers. Decisions therefore,
do not necessarily depend on the headquartersÊ requirements but more
on local needs.
Each subsidiary has its own planning and focuses towards customer needs.
This requires the company to make use of strategies that combine global
effectiveness and local requirement. The management system of a
transnational company is more complex with regards to the way
coordination and two-way communication between headquarters and
subsidiaries are practised. Typically, this type of company uses a
centralised decision-making process especially for its production and
development department which requires parallelism in its activities.

ACTIVITY 1.3
Provide two examples of organisations in Malaysia that implement the
following approaches:
(a) Multidomestic company;
(b) Global company; and
(c) Transnational company.
1.4 EVOLUTION OF INTERNATIONAL

BUSINESS
Although international business has just begun to advance only a few years ago,
it actually existed thousands of years ago. Let us look at the evolution of
international business from the time it existed until the present. The evolution of
international business can be divided into various levels as shown in Figure 1.2.
Figure 1.2: Evolution of international business
1.4.1 Early Era of International Business

In the beginning, international business consisted of international trade. Trading
in the society has existed since 2000 years ago where people of Northern Africa
started trading dates and clothes in exchange for spices and olive oil from the
Middle East. Such trades started to expand years after that.

1.4.2 Development of International Business since

World War II
The activities of international business have rapidly developed since five
centuries ago. World exports have developed tremendously. In 1992, world
exports achieved more than $3.6 trillion compared to $53 billion in 1950. The
figure has since been increasing.
Foreign direct investments have also shown an increasing trend. In 1967, the
overall share of foreign direct investment received by other countries is about
$105 billion, but the figure doubled in 1973 and again in 1980. The development
of trade and international investment portrays economic power, politics and
technology as drivers of the global market and industry.
1.4.3 Golden Era of American Business: 1945 to 1960

At the end of World War II in 1945, the war launched by air, land and water
destroyed most of the infrastructure in European countries and Japan. However,
the infrastructure in the United States was not harmed. Therefore, the US did not
have to rebuild their nation and as such faced minimum challenges and was able
to focus on building their industrial business success internationally.
In the 1950s, American Motors (now part of Chrysler), Chrysler, Ford and
General Motors were successful in selling all their cars. General Electric and RCA
became renowned electronic producers. Companies like US Steel and Bethlehem
Steel did not face any competition. Boeing, McDonnel Douglas and Lockheed
dominated the market for commercial flights.
The US army also influenced the foreign economy during that period. For
example, during the conflict in Korea, the US funded many supply operations in
Japan. This helped in capital emergence, employment and technology in Japan.
Most industrial countries like France, Italy and Japan received full support from
the US either directly or indirectly. At the end of the 1950s, the process of re-
building the infrastructure in the European countries and Japan was completed.

1.4.4 Emergence of Europe and Japan: 1960 to 1980

At the beginning of the 1960s, companies in Europe and Japan were preparing to
enter international markets. These companies wanted to take advantage of the
new market potential and expand their operations abroad.
For example, in 1958, Nissan Motor exported their cars to the US under the
brand, Datsun. Nissan Motor was incorporated in Los Angeles in 1960 and a
factory was built in Mexico in 1961. In the same year, a Canadian company,
Alcan Aluminium, built its first foreign factory in the US. In 1962, Fuji
collaborated with Xerox to produce photocopy machines. The effort by the
companies from Europe and Asia was the basis for the present growth of a more
sophisticated and greater competition faced by present companies.
In the 1970s, a few events weakened the position of the US in the world economy.
Such events included greater competition and uncertain conditions of the world.
Japan, who had concentrated on quality and cost, was more ready to compete
compared to the US.
Another economic shock which occurred in the 1970s was the hike in oil price
and raw materials. At that time, the oil exporting countries had established a
cartel known as OPEC (Organisation of Petroleum Exporting Countries). OPEC
controlled the production of oil and increased its price sharply. Such actions by
OPEC had provided a negative impact on other countries and companies all
around the world and had transferred the wealth from oil consuming countries
to oil producing countries.
Companies had to change their business mindsets in order to overcome the

increased production costs. The problem was made worse due to the
inconsistency of the labour policy in the US. The situation worsened for
industries where resources such as electricity and natural gas were depended on.
These industries such as the airline and production industry became victims of
the change in government policy. After the war, the automobile industry in the
US suffered a great loss due to their poor quality products which were not
comparable to products produced in Japan. This situation had facilitated
companies from Europe, Japan and others to extend their market into the US and
the world market. As a result, these companies also increased their quality of
their products through research and development.

Similarly in the 1970s, the structure of world market had changed. For example,
Japan had conquered the market share for the industry of steel and electronics.
Europe and Japan had captured the automobile industry and replaced General
Motors, Ford and Chrysler in the medium-priced and low-priced automobile
markets.
1.4.5 New Global Market: 1980 Until Present

At the end of 1970s, managers of companies in the US had realised that they had
to work hard in order to compete in the global market. Most of the managers
realised that the emergence of new competitors in the global market were a
threat, but they also saw the opportunity to gain entry to a new market.
Theory Z scholar, William Ouchi (1981), found that in Japanese organisations

each worker was highly committed in producing high quality products. On the
other hand, workers in most companies in the US were given only minimal
understanding on the operations of organisations. As such, the products
produced were of lesser quality in comparison. Companies in the US then began
to undertake a more competitive method of management, following the footsteps
as those being practised by Japanese companies. For example, US companies
started emulating practices such as quality circles, just-in-time and other policies
to enhance quality control.
US companies also realised that they could not totally follow the business practices
of Japanese companies because they needed to maintain their own organisational
and business culture. Hence US companies only followed the business practices of
their competitors in specific areas. For example, Ford and Chrysler followed
Honda and Toyota in terms of product quality enhancement. Electronic companies
such as Motorola and Texas Instruments followed Hitachi and Toshiba in research
and development as well as cost control.
Tight competition among the companies in international business have driven

most of the companies to become innovative and thus produce high quality
products in order to fulfil customer needs around the world.
When multinational companies in Europe and Japan developed in terms of size and
wealth, they also increased direct investment in the US. Such investments enabled
these companies to operate in the US market and increased their property values. In
the early 1990s, the worldÊs economy was controlled by industrial nations of the US,
the European Union and Japan (also known as the Triads).

1.5 DEVELOPMENT OF INTERNATIONAL

BUSINESS
The contributing factors for the development of international business are market
development, purchasing of resources, competition pressures, technological
changes, social changes, and changes in government trade and investment
policy, as shown in Figure 1.3.
Figure 1.3: Six contributing factors to the development of international business
ACTIVITY 1.4
What are the policies of the Malaysian government that could
encourage and contribute towards international business? Discuss with
your coursemates in myVLE.
Let us look at the following explanations of these six factors.
1.5.1 Market Development

Market development is the main catalyst towards the development of
international business. When the production capacity has outgrown the size of
the local market, companies will find new market opportunities overseas.
Companies from countries with a small market size such as Singapore,
Switzerland and Netherlands will find that they need to expand their market
outside the borders of their countries. For example, in 1975, Nestle marketed
their milk products to sixteen countries.

1.5.2 Purchasing of Resources

The purchasing of resources by advanced countries from developing countries
have developed the activities of international business. Such resources are not
found in advanced countries. In most cases, these companies depend on foreign
resources due to the lack of resources in their own countries. For example, the US
buys coffee and banana from South America, Japan buys forestry products from
Canada while companies around the world buy oil from the Middle East.
Companies also find that such resources could be cheaper and easily available
abroad. For instance, companies in most countries buy telecommunication tools
from Nortel because it is cheaper and easier if these tools are purchased from one
company rather than from several companies.
1.5.3 Competition Pressures

Due to the efficiency of economies of scale and wealth found in big companies,
small companies find it hard to compete with them. For example, Mazda suffered
a great loss because of lack of resources that hindered them from competing with
Nissan and Toyota. Hence, in the early 1990s, Mazda introduced new models
such as the „Miatra Convertible‰ and increased the production of its
automobiles. It practised such tactics to enhance its market, purchases,
profitability and thus competing at the same level as its competitors. Competition
pressures contribute to the development of current international business.
1.5.4 Technological Changes

Technological changes especially in the areas of communication, transportation
and information processing are the main reasons for the development of
international business. Technological development eases the management of
business today. Due to the rapid technological changes such as the Internet and
e-commerce, international business transactions can be done faster and easier.
1.5.5 Social Changes

Social changes have also enabled international business to expand. The society
nowadays is more open and easily accepts products and services produced by
foreign countries. The borderless international business enables consumers from
various countries to easily obtain and enjoy products of high quality.

1.5.6 Changes in Government Trade and

Investment Policy
Changes in the governmentÊs trade and investment policy have also contributed
to the development of international business. With trade liberalisation many
governments have reduced their import tariffs and abolished foreign investment
obstacles to their countries. Such actions have helped ease the transaction of
international business between countries. It cannot be denied that international
business is increasingly important in the worldÊs economy.
1.6 INTERNATIONAL BUSINESS ACTIVITIES

There are seven international activities: import/export, foreign direct investment,
licensing, franchise, management contract, manufacturing contract and turnkey
project. Let us now discuss each of these activities.
(a) Export/Import
Export, whether in the form of goods or services, is important for a
company. At present, the service sector contributes more than 60% of the
gross domestic production of industrial countries. Import involves products
which are bought by other countries to be used by them.
(b) Foreign Direct Investment (FDI)

Foreign direct investment is an activity in international business where the
capital of a country is invested in other countries. It was reported that FDI
made up 50% of world trade of which was participated by 500 top
companies in the world. (Rugman & Hodgetts, 2006) It is divided into two
types:
(i) Foreign direct investment is an investment implemented to control

properties or operation of a company based in other countries.
(ii) Portfolio investment involves the purchasing of financial instruments

or securities (shares, bonds and savings certificates) for certain
reasons other than controlling. One main reason would be to increase
its worth in these financial instruments or securities.

(c) Licensing
Licensing happens when a company in a country (licensor) leases licenses
to enable a company from other countries (licensee) to use their intellectual
property such as patent, trading mark, brand, technology copyrights or
trading secret in return for a royalty. For example, Walt Disney Company
allows other companies to display the picture of Mickey Mouse on their
clothes and thus, gain payment from the sale of the clothes.
(d) Franchise
The two parties that are involved in franchising are franchisor and
franchisee. The franchisor allows the franchisee to use their products in
their brand, logo as well as operational techniques of a product or services.
The franchisee will then pay royalties to the franchisor. For example,
McDonalds sells its franchised restaurants all over the world.
(e) Management Contract

A management contract is signed when a company with skills agrees to
handle the operation or management in other countries for a certain charge.
For example, in the hotel industry, Marriot and Hilton normally do not own
hotels outside of the US even though these hotels in other countries operate
with their brand name. They are said to operate under a management
contract.
(f) Manufacturing Contract

A manufacturing contract is signed when a firm contracts the production of
their products to other firms to produce the products. The purpose of a
manufacturing contract is to reduce production cost and human resource.
For example, Proton gives out its manufacturing contracts to other firms to
produce the windscreen of Proton cars in Selangor and the other states in
Malaysia.
(g) Turnkey Project

A turnkey project kicks off when a country signs a contract with a firm
from another country to complete a project such as the construction of a
flyover or building. Once the project is completed, then it will be handed
over to the company who is initially offered the project. For example, the
Penang Bridge was built by a company from South Korea and when the
bridge was completed, it was handed over to the company who was
initially offered the project. The company from South Korea was then paid
according to the content found in terms of reference that was agreed upon
before they started the project.

To test your understanding, try the following exercises:
EXERCISE 1.1
1. Explain the term „international business‰ and identify the parties
involved in the international transaction. Provide examples.
2. Briefly describe the following international business activities:
(a) Licensing; and
(b) Franchising.
1.7 INTERNATIONALISATION
Internationalisation happens when an organisation gets involved in commercial
activities outside its border through foreign direct investment. The purpose is to
own and control the operation, to enhance the production value and eventually
gain optimum profit. For example, an organisation engaged in
internationalisation activities is a multinational company (MNC) involved
extensively in international business.
A multinational company is defined as a company that is involved in foreign

direct investment and owns or controls value-added activities in more than one
country.
Characteristics of a multinational company are:
(i) A multinational company purchases cheap materials from several countries

and produces products and services at other countries to gain maximum
profit;
(ii) A multinational firm controls the activities of its subsidiaries in other

countries other than their headquarters; and
(iii) At the same time, it also allows the subsidiaries to operate according to
local situations.

IBM (International Business Machines) is an example of a multinational company

which practises internationalisation. This computer company imports electronic
components to the US from more than 50 foreign countries. It exports its
computers to more than 130 foreign countries and has foreign direct investment
in 45 countries.
ACTIVITY 1.5
Provide examples of multinational organisations.
1.8 EXTERNAL INFLUENCES IN

Each company involved in international business will face external influences
that will affect their international business. There are four main external
influences, as shown in Figure 1.4.
Figure 1.4: Four external influences in international business
Let us discuss these external influences further.

1.8.1 Law and Political Policy

The political system of each country is different. A multinational company which
invests in a foreign country must adhere to the political system which is
practised in the host country. For example, Malaysian companies are not allowed
to trade with Israel. Meanwhile other countries which face similar political
conflicts would not invest in companies owned by the countries concerned.
When a company wants to invest in foreign countries, it has to also understand
the legal system of the country. For example, there are countries that impose
legal requirements on multinational companies that are operating in their
country, such as to employ more than 50% of their local citizens. Others would
give exemption in terms of payment of tariff and quota in order to encourage
more multinational countries to invest in their country.
1.8.2 Cultural Factor

Understanding the culture of a country is important for an international
company. Each country has its own unique culture. Cultural differences can pose
a barrier to international business. By understanding a countryÊs cultural system
such as the lifestyle, attitude, social values and beliefs would help a manager of
an international business to plan the products that would be of interest to the
local people. Due to cultural differences, it is necessary for foreign companies to
adapt their products and strategies to suit the local market. For example,
McDonalds had to adapt their menu to meet halal standards when operating
their restaurants in Muslim countries.
ACTIVITY 1.6
Think of a few examples of the changes or adaptations by companies
that are made on foreign products in order to suit our Malaysian
culture. Discuss this issue with your coursemates.

1.8.3 Economic Power

By understanding the economic environment of a country, it would give us an
explanation of how economics affects international business operations. For
example, economics explain why many countries trade products and services
with one another, and why advanced countries enhance their productivity of
agricultural production, while small countries still use machines which are
outdated and cheap. Recent developments such as the rise of emerging economy
of China as the new supereconomic power clearly explains MNCsÊ foreign
investment decisions to expand into the Chinese market. China is the second
largest economy after the US.
1.8.4 Geographical Influence

Physical and geographical factors influence companiesÊ decision to invest abroad.
Factors such as good climate and availability of natural resources in a country are
sources of natural advantage that MNCs consider when investing. There are
companies that do not want to invest in a particular country due to poor location
which can increase the cost of transportation. Hence, strategic location is an
important geographical influence on foreign direct investment. Natural disasters
also provide indications on international business development. For example,
when the earthquake and tsunami hit Japan in March 2011, it had widespread
economic impact on the worldÊs economies. The adverse impact through trade,
finance and international business development in East Asia and the world is
affected as Japan was the worldÊs third largest economy.
EXERCISE 1.2
State and describe the external influences in international business.
Now, try the following questions to check your understanding of the topic.

EXERCISE 1.3
1. International business is different from domestic business because

of the following factors, EXCEPT:
A. the use of currency
B. legal system
C. culture
D. raw materials
E. advanced countries
2. _____________ is an investment implemented to control properties

or operation of a company located in a foreign country.
A. Foreign direct investment
B. Licensing
C. Franchising
D. Management contract
E. Export
3. One of the contributing factors of the international business

development is _______________.
A. changes in the top management of a company.
B. changes in the administration of a company.
C. changes in the culture practised by the society of a country.
D. changes in the legal system of a country.
E. market development.

5. ___________ is when an organisation gets involved in commercial

transactions out of the border with individuals, private companies
and/or public organisations.
A. Internationalisation
B. Multidomestic firm
C. Transnational firm
D. Global firm
E. Local firm
 International business consists of all commercial transactions between one

country with another country and the rest of the world.
 The multinational firms that engage in international business are

multidomestic, global, multinational and transnational firms.
 Companies with an increasing participation in the global market will enhance

their business income, widen their market, obtain raw materials easily as well
as human resources and other cheap production factors from foreign
countries.
 International business begins with domestic business in the home market and
expands across borders from multidomestic business to global and
transnational business.
 Some of the activities of international business include exporting, licensing,

franchising, contract manufacturing and turnkey projects.
 The contributing factors that have led to the growth of international business
are market development, resource seeking, competition pressures,
technological changes, social changes, and changes in government trade
investment policy.

 The external influences that have a direct impact on international business

consist of cultural, law and political and geographical factors as well as
economic forces.
Cultural factor Legal system

Economic power Multidomestic company
Geographical influence Multinational company
Global company Political policy
International business Transnational company
Internationalisation

Topic  Economic
2 Environment
and Systems
LEARNING OUTCOMES
1. Discuss the differences in the economic environment of countries
according to geographical factors;
2. Differentiate between market, command and mixed economies;
3. Identify the main macroeconomic indicators that affect international
business such as economic growth, inflation, trade surplus and
deficit; and
4. Explain major economic events such as economic transitions and
financial crisis that affect international business.
 INTRODUCTION
In this topic, we will discuss the different ways of categorising the economy of a
country according to geographical regions and classifying the economic systems
into market economy, command economy and mixed economy. We will also
discuss the main macroeconomic issues that affect business strategies, AsiaÊs
economic crisis and the current global financial meltdown. Besides that, we will
look at problems in economic growth which include inflation, balance of
payment surplus and deficit and internal debts. This topic also covers the
transition process of the economic system in Russia, China and East Europe and
we will see the differences found in countries that practise democracy and
socialism. We will then look at the importance of using the privatisation policy in
the development of the economy of developing countries.

22  TOPIC 2 ECONOMIC ENVIRONMENT AND SYSTEMS
ACTIVITY 2.1
Malaysia is classified as a developing country. In your opinion, what

are the criteria used for this classification.
2.1 BACKGROUND
Understanding the economic environment of the foreign market will help
managers predict the direction and forces that can affect the future performance
of the company. A multinational company would have to consider the following
questions when developing their business ventures in a foreign country for the
first time:
(a) What type of economic system would the company be operating under?
(b) What is the market size, potential growth and market stability?
(c) Is the industry in the country in the private or public sector?
(d) If the company is in the public sector, will the government allow
competition from the private sector?
(e) If the company is in the private sector, will it move towards public
ownership?
(f) Does the government look at foreign capital as a competition or public and
private collaboration?
(g) How does the government control the situation and development of private
business?
(h) How much contribution is expected from the private sector in helping the
government in the economic environment?
Although the questions above seem simple, the answers are complicated because
of the political situation and economic complexities that economies face today.
For example, foreign investors are not interested to invest in Hong Kong after it
was handed over to China in 1997. The economic system in China is different
from the British system. Is China going to continue with the freedom of a market
economy as practised in Hong Kong while under British authority? Doubts
towards such situations may cause many businessmen to transfer their
businesses to other countries like Singapore.

TOPIC 2 ECONOMIC ENVIRONMENT AND SYSTEMS  23
ACTIVITY 2.2
Based on the earlier scenario, is a global company able to follow and

adapt to the changes in the current economic situation?
Physical and societal factors influence economic stability, the existence and
influence of market capital, market size, and infrastructure such as public
transportation and communication. A manager should understand the economic
condition of the worldÊs economy when making decisions. A manager also
should obtain the latest information regarding national income of the country
and the economic system practised by a foreign country. The economic growth,
inflation as well as surplus and deficit influence the decisions made on the use of
resources and dynamic capabilities of a multinational business. Figure 2.1
summarises how physical and societal factors influence the international
business.
Figure 2.1: Influences toward international business
2.2 OVERVIEW OF THE WORLD’S ECONOMY

There are 196 countries around the world with a total population of over 7 billion
people (About.com, 2013). To which country should a manager distribute the
companyÊs resources? Although the answer is different from country to country,
a company must consider various factors when operating their business in their
chosen country. Production factors include human resources, physical location,
knowledge, capital and physical infrastructure. Geographical factors such as

climate, water availability, access to raw materials such as steel and agricultural
production as well as transportation of products from one market to another, and
finally knowledge through research and development implemented by the
company and government must be considered.
2.3 COUNTRY CLASSIFICATION BY INCOME

The main measures used in comparing one country to another are by the size of
market demand or gross national product (GNP). We can categorise a country
accurately through GNP per capita that is the size of GNP divided by the total
population. A country with a large population and high GNP per capita has
bigger market potential.
On the other hand, a country with low per capita GNP and low population is a
favourite of advanced countries to invest in. For example, China has a low GNP
per capita due to its high population, however its market size and demand is
huge and this has attracted many MNCs to invest to gain market share in the
Chinese market.
What does gross national product mean?
Gross national product is a measure of total economic activities of a country.
It is also the total value of finished goods of the market and the services
produced by the factors of production at home and abroad. The alternative to
gross national product is gross domestic product (GDP). GDP is the total
production value of goods and services produced in the country whether it is
produced by a local or foreign company.
SELF-CHECK 2.1
Why must we use the gross national product to explain the economic
growth of a country?

The World Bank consists of 184 member countries which use the gross national
income (previously referred to as Gross National Product) as the basis for
releasing loans. The World Bank was founded in 1944 at Bretton Woods
Monetary Conference. Its objective is to provide loan and economic advising
assistance to middle-income and low-income countries. It uses the Gross
National Income per capita to determine which country has the most need for the
loans. Its programmes also include:
(a) Invest in the development of health and education of a country and

protection of the environment;
(b) Encourage the development of private business;
(c) Establish governmentÊs stability in providing quality, efficient and honest

service; and
(d) Enhance the stability of macroeconomic environment that is suitable for

investment and other long-term plans.
The main focus of the World Bank is to improve the social development of
people as well as other development institutions as the main element to eradicate
poverty. The activities of the World Bank are important to multinational
businesses because they help develop the infrastructure and enhance the growth
and stability of the economy, quantity and also quality of demands
World Bank classifies economies into various categories according to Gross

National Income per capita, as shown in Table 2.1.
Table 2.1: Classification of Economies According to

Gross National Income (GNI) Per Capita
Income Level GNI Per Capital

Low income $1005 or less in 2010
Lower middle income $1006–$3,975
Upper Middle income $3976–$12,275
High income $12,276 or more
Source: http://www.worldbank.org

The World Bank classifies low and middle income countries as developing
countries, (now also called emerging economies) although it is identified that
developing countries are not all the same and not all are at the same stage of
development. Developing countries are also known as enhancing countries. Such
a term is also used to explain the capital market (debts and equity market) of the
country which is different from the capital market of advanced countries. The
World Bank does not state that high income countries have reached the peak of
development. High income countries are known as advanced countries or
industrial countries. The term „industrial country‰ exists because the percentage
of production and gross national income is high. At present, the percentage of the
gross national income is focused on services and no longer on industry.
However, the term industrial country is still used.
2.4 COUNTRY CLASSIFICATION BY

GEOGRAPHIC AREAS
Most of the World Bank data is based on geographical region and the data is
important to discuss economic growth. However, the countries listed are those in
the developing countries list. It is clearly stated that Japan, Australia and New
Zealand are included in the area of East Asia and the Pacific, even though these
countries are high income countries and highlighted differently in the map. This
is the same with Europe whereby West Europe is highlighted differently from
the rest of Europe and the Middle Asia.
The location of the countries is important for multinational businesses. For

example, IBM organises its business by region: Africa, US, Asia Pacific and
Middle East. Siemens, the biggest German electronics company, strategise their
sales according to region such as Africa, Middle East, Commonwealth countries
and ex-Soviet Union countries; Asia Pacific, US, Europe and Germany. A
manager can use the data from World Bank to identify the location of their main
market. Besides that, investors can use the data to analyse the development
potential and risks that exist in the area which they operate.
2.5 COUNTRY CLASSIFICATION BY ECONOMIC

SYSTEM
A country can also be classified according to the type of economic system. In an
economic system, economic activities are organised according to ownership and
control. Ownership and control of resources and economic activities are owned
by individuals in the private sector or public sector or both.

Ownership of economic activities by the public sector refers to the businesses

which belong to the state.
Control of economic activity means resources are distributed and controlled

either by the public or private sector. The best example is during ChinaÊs early
economic transition saw local businesses run by many state-owned enterprises.
The private sector was discouraged and restricted. The same situation occurred
during RussiaÊs economic transformation where production was by the public
sector via state-owned monopolies. However, the last decade saw the number of
state-owned enterprises decreased and China encouraged the growth of the
private sector. However, public sector business ownership is not just a
phenomenon in communist countries. Countries like Brazil, India and France
also have large state-owned companies. Hong Kong and United States of The US
are examples of countries which have limited state ownership in their main
economic activity. Many governments today have embarked on privatisation
policies where state-owned enterprises have been turned into privately-owned
companies.
Each year, the Heritage Foundation and Wall Street Journal publish the economic
freedom index. The index is for a country to evaluate another countryÊs economic
freedom based on principles of economic freedom such as individual
empowerment, equitable treatment and the promotion of competition. The index
is determined using 10 indicators:
(a) Trade freedom
(b) Fiscal freedom
(c) Government spending
(d) Financial freedom
(e) Investment freedom
(f) Monetary freedom
(g) Labour freedom
(h) Property rights
(i) Business freedom
(j) Freedom from corruption

Research such as this helps in identifying how far is the involvement of the
government in controlling the economic activities. The 2010 Index of Economic
Freedom classifies economic freedom of countries based on economic openness,
regulatory efficiency, rule of law and competitiveness. Table 2.2 shows some
examples of country classification by economic freedom index.
Table 2.2: Country Classification by Economic Freedom
Category Country
Free Hong Kong, Singapore, US
Mostly free Czech Republic, Japan, Germany
Mostly not free Zambia, Indonesia, China
Not free at all Zimbabwe, Cuba, North Korea
Source: http://www.heritage.org/index
ACTIVITY 2.3
List three countries classified according to economic activity.
2.6 MARKET ECONOMY

In a market economy, the countryÊs resources are owned or controlled by the
private sector. The main factor which makes the economy successful is the power
of consumer, where the consumers have the freedom in determining what they
want to buy based on the ability to spend to maximise their satisfaction. Firms
have freedom of enterprise to decide which business and market to operate and
maximise profits. Decision making is decentralised. Price mechanism exists to
allocate the resources among competing wants. Price is determined by the free
market forces of demand and supply. For example, in the market for oil, when
demand exceeds supply, price rises. At a higher price, consumers will spend less
causing the demand to decrease until excess demand is eliminated and market is
in equilibrium.
There is little or no government intervention. The government plays a limited

role and provides a legal framework for businesses to operate and to protect
citizen rights to own property. MNCs find it favourable to operate in a market
economy as there are fewer constraints on investments.

2.7 COMMAND ECONOMY
Command economy or centrally planned economy is a system whereby the

economic activities, prices and production decisions are determined by the
central government.
The government owns and controls all the countryÊs resources. The government
also sets the goals of each business effort in the country, the total production and
distribution. Under this economy, the government assumes that they are more
qualified in determining the distribution of resources compared to the people or
businessmen.
There is absence of a price mechanism to allocate resources. The central planning

authority decides on what to produce, how much and how to produce and
ensures equal distribution of wealth among its people. Such planned systems
have resulted in frequent shortages of essential goods like food. Rationing of
goods is commonly practised and this leads to development of black markets.
The consequence is government failure to meet the peopleÊs needs. The collapse
of the Soviet Union economy in the early 1990s is testimony of the shortcomings
of planned economies. By then, other economies such as China and Vietnam
have also started to adopt market reforms to shift from socialism to a socialist
market economy. Since 1980s the countries that follow the centrally planned
economy have reduced tremendously. Currently, Russia, North Korea and Cuba
still follow this economic system.
2.8 MIXED ECONOMY

In the real world, there is no economic system that is purely free market or
purely command economy practised by a country. In practice, most countries
adopt a mixture of both types of economic systems. An example of a mixed
economy is market socialism where private individuals own significant resources
but distribution is determined by the price mechanism. Although the
government owns some of the economic resources, the price is determined by the
free market forces of demand and supply. The government plays an active role to
regulate economic activities and ensure competition in the private sector. The
state may own key sectors of the economy such as utilities and railways. A
manager must understand the role of the company and government in the
economic system where they conduct their business. A company must be aware
of any economic changes in a country. Therefore, it is important for a manager to
understand the cycle of the economic changes and how it affects their company.

Countries like Western Europe, Asia, Latin America and South Africa are
examples of mixed economy. To further stimulate their economy, some countries
like Malaysia, Britain, Spain and France embarked on privatisation programmes.
In this programme, government owned companies were sold to private
corporations.
EXERCISE 2.1
Describe the features of each economy:
(a) Market economy; and
(b) Command economy.
2.9 CHANGES IN MACROECONOMIC

ENVIRONMENT AND INDICATORS
Changes in macroeconomic environment of the global economy can affect profit
and operational strategy of foreign investment of a company. The management
must monitor and analyse the macroeconomic indicators where they operate
their business. We will discuss three indicators – economic growth, inflation and
trade surplus and deficit. Then, we will discuss the challenges faced by countries
in transition from a command economy to free market economy. In addition, two
major economic events that have affected international business operation and
strategies will also be discussed: Asia Financial crisis of 1997/1998 and the recent
Global Financial Meltdown of 2008/2009.
2.9.1 Economic Growth

Let us now look into economic growth. What does it mean?
Economic growth indicates the health and performance of an economy.

Economic growth of a country represents an increase in the countryÊs GNP per

capita. An increase in GNP per capita indicates that the countryÊs standard of
living has improved. Hence, the MNCs are interested in a countryÊs economic
growth as it reflects potential economic capacity. How the MNCs invest in a
country is affected by economic growth factors. Recent developments indicate
developing economies with high economic growth rates such as the BRIC (Brazil,
Russia, China and India) countries and this has attracted foreign direct
investment into these emerging economies.
2.9.2 Inflation
Another indicator that we should look into is inflation. What do you understand
by inflation?
Inflation refers to the rate of change in general price level of a country.
Consumer price index (CPI) or in some countries it is called Retail Price Index is
often used to measure the rate of inflation. CPI measures consumer prices based
on a basket of goods. Inflation affects:
(a) Interest rate;
(b) Currency exchange rate;
(c) Cost of living; and
(d) General confidence of companies, consumers and economy.
Generally, interest rates as inflation increase occur for two reasons.
(a) The first reason is that the interest rate should be higher than the inflation
rate so that investments on money asset will continue to enjoy the actual
profit.
(b) Second, the financial authority, such as the Federal Reserve Bank in the
USA, would raise interest rate to reduce inflation. When the interest rate is
high, companies and consumers will be reluctant to borrow money due to
the high cost of borrowings. High interest rates have deflationary effects on
the economy and in the long run weakens the economic growth.

Inflation influences a countryÊs exchange rate. When there is inflation, the value
of currency falls. In other words, the purchasing power of currency is reduced.
Generally, a country with low inflation rate will have a relatively stable and
strong currency. MNCs prefer to invest in economies with low and stable
inflation rate which are conducive for economic growth while high inflation
indicates economic instability, rising costs and poor control of the economy by
the government. Goods produced in the country will be expensive and this leads
to high export prices. This may have a negative impact on FDI.
2.9.3 Trade Surplus and Deficit

Another way for us to measure the stability of an economy and potential
investment location is through deficit and surplus, internally or externally. A
manager must monitor trade and debt balances as a sign of the countryÊs
economic position and performance. External trade deficit occurs when the
outflow of money on expenditure on imports exceeds inflow of money receipts
from sale of exports. Internal deficit occurs when government expenditure
exceeds its revenue. A country with large external deficit and/or internal deficit
denotes a debtor country. For example, the debt crisis in Europe and the US in
2010/2011 have sparked fears of falling FDI inflows.
Let us try the following exercise:
EXERCISE 2.2
1. How does inflation affect the FDI decision?
2. Why are internal deficit and external deficit of a country

important to MNC managers?
2.10 TRANSITION TOWARDS MARKET

ECONOMY
In the 1980s and 1990s, countries such as China and Russia have embarked on the
process of transition from command system to market-oriented economy mainly
due to government failure in managing the economy. Economic reforms also
took place in Eastern Europe. The process of economic transition of these
economies has great impact on international business throughout the world.

ACTIVITY 2.4
How has the economic transition process affected international

business?
This economic transition or transformation differs from one country to another.

Success in the transition depends on several factors:
(a) Maintaining the economic stability of the macro environment such as

control of inflation;
(b) Speed of transformation process;
(c) Implementation of market reforms; and
(d) Support of effective legal framework.
2.11 EFFECTS OF THE TRANSITION PROCESS

In this subtopic, we will look into the effects of the transition process. The
transition process has actually provided opportunities to multinational
businesses. Hence, when these countries opened their doors to foreign
companies, their exports have grown tremendously.
2.11.1 Transition in Russia

In Russia, the transition to market economy is difficult because the government
tries to simultaneously change their economic and political system. Russia is a
country that is rich with natural resources. It has highly educated people, cheap
labour and also huge consumer population. However, Russia has not been able
to attract foreign investors especially in the manufacturing sector. It has to
compete by increasing the industrial growth internally without foreign
investment.

2.11.2 Transition in Central and Eastern Europe
Within three years of the communist downfall in the years 1989–1990,

economic growth in East Europe has stopped. From 1990 to 1992, the gross
national product has dropped to 40% in Czechoslovakia, 32% in Hungary and
32% in Poland. Transitions in Poland, Hungary and the Czech Republic
moved faster than Russia because these countries joined the European Union,
which required them to change into market economy. However, countries in
East Europe that hold a strong national identity are influenced by the Catholic
Church, have strong ownership tradition and a strong workers' union.
(Balcerowics, 1994)
Three features of Eastern and Central EuropeÊs economic transition are:
(a) Macroeconomic stabilisation;
(b) Microeconomic liberalisation and privatisation; and
(c) Institutional changes in both economic and political systems.
2.11.3 Transition in China and Vietnam

The approach to the Asian economic transformation practised by China and
Vietnam is different from that of Russia and East Europe. They practised a
gradualist approach compared to a radicalist approach by Russia and Eastern
Europe. The gradualist approach uses gradual, experimental, phased and partial
market reforms (Guo, 2004). Chinese leaders are not interested to change to a
democratic system. They continuously practise totalitarianism. They allow
private investment but they still fully control their economy. Similarly in
Vietnam, economic transition involved liberalisation of the state sector and little
privatisation. The state remains dominant in the economy.
ACTIVITY 2.5
Compare the transitions in the three regions that you have just read
about. State the strengths and weaknesses for each transition. Then,
choose the type of transition which you think is suitable to be
implemented in Malaysia.

2.11.4 Effects of Transition on International Business

Overall economies in transitions provide new market opportunities to MNCs for
their expansion of business operations and FDIs. Two decades after the economic
transition process, it has brought much impact on international business. China
has been lauded for its success in economic development. Average growth rate of
GDP peaked 9.8% (Lin, 2010). Non-state enterprises are encouraged to develop
alongside an improved state sector. ChinaÊs growth as the new supereconomic
power is testimony to its successful market reforms during the process of
economic transformation. China surpassed Japan to become the second largest
economy in the world. Many MNCs have taken advantage of ChinaÊs open
policy to engage FDI there. China is attractive for FDI because of its strategic
location, large market demand, cheap labour and land as well as natural
resources.
Similarly, Vietnam has charted much success since economic reforms in 1986. It is
one of the fastest emerging countries in ASEAN attracting FDI inflows because of
its openness to trade, high GDP growth, market size and infrastructure
development (Hoang, 2006).
However, FDI to Central and Eastern Europe have declined since its peak in
2006. Poland, Russia and Romania are the top three FDI locations. FDI inflows
were the result of large privatisation sales, investments in commodities, and
property boom (The Economist, 2007).
2.12 MAJOR CHANGES IN THE

MACROECONOMIC ENVIRONMENT
There are two major changes in the macroeconomic environment that brought
economic shocks on the global market, which are:
(a) The Asian Financial Crisis on 1997/1998; and
(b) The Global Financial Meltdown of 2008/2009.
What do you understand by economic shock?
An economic shock is defined as an economic event that produces significant

change within an economy, despite occurring outside of it.

It is unpredictable and its impact has effects on demand and supply throughout
the global market (Investopedia, 2012).
Now, let us move on to the next section which explains about the Asian Financial
Crisis in 1997/1998.
2.12.1 The Asian Financial Crisis of 1997/1998

On 2 July, 1997, Thailand had to devalue its currency, the baht, by 17% against
the US dollar. This was due to market pressures to protect the falling baht. The
crisis was made worse by currency speculators, ThailandÂs falling reserves and
pessimistic market confidence. Speculators are people or firms that try to make
some profits from currency rate changes without any protection or hedging
(Rugman & Collinson, 2006). The crisis quickly spread to South Korea, Malaysia
and Indonesia.
The currency crisis led to a sharp rise in interest rates and this caused the share
market to collapse. The contagion effect of the crisis led to Indonesia having to
devalue its Rupiah by 90% against the US dollar causing major collapse in its
financial market and political system.
These economic shocks were felt throughout the world notably countries like
Russia and Eastern Europe, and it spread to China and Japan. Competition from
cheap exports from ASEAN countries after large devaluation of currencies were
the main reasons. However, US and European economies were less affected.
Even though the International Monetary Fund (IMF) intervened to provide tight
financial reforms in Thailand and Indonesia, this did not mitigate the contagion
effect rather caused those countries' economy to shrink further as a result of its
tight monetary and fiscal policies.
2.12.2 The Global Financial Meltdown of 2008/2009

In mid 2007 and into 2008, a global financial crisis had loomed into a global
recession with adverse impact across all markets. It was believed to be the worst
crisis since the depression of 1930s. Also called the Credit Crunch, the meltdown
originated from the US sparked mortgage crisis in real estate especially the
housing market. The developed and rich economies were not spared. Financial
markets across the world collapsed. Large, old and established financial
institutions in the US such as Lehman Brothers went bankrupt and triggered a
chain reaction on other major banks such as Citibank and AIG. Governments had
to provide fiscal packages to restore confidence in the financial system by buying
up the ailing banks.

The contagion effects of this crisis are still being felt today and the problems are
not over. Both economic shocks have brought about tremendous negative impact
on the global business. Some negative impacts of economic shocks are:
(a) Falling exchange rates of important currencies such as the US dollar affect
profits;
(b) Falling world demand for goods and services affects countryÊs exports;
(c) Lack of credit facilities for business development;
(d) Decline in the global FDI leads to general slowdown in world growth with
developing economies most affected; and
(e) Global recession leading to business closures and unemployment.
Although such economic shocks are unpredictable, managers must be aware of

the economic risks. Lessons can be learnt from the economic turmoil to minimise
risks. Suggested strategies include:
(a) Targeting new markets especially in emerging economies;
(b) Exploring new business opportunities with new products or e-business;
(c) Expanding customer base;
(d) Cost-cutting strategies to sustain business;
(e) Starting small business or entrepreneurial ventures; and
(f) Limiting business expansion plans.
ACTIVITY 2.6
Explain how economic shocks such as the Asian financial crisis and the
global financial meltdown affect international business. You can visit
the following websites for further information:
(a) International Monetary Fund at http://www.imf.org
(b) World Economic Forum at http:// www.weforum.org
(c) ASEAN at http://www.asean.org
(d) World Trade Group at http://www.worldbank.org

Now, try the following exercise.
EXERCISE 2.3
1. What does gross national product mean? Gross national product

is __________.
A. the value of final market trade and services produced by

production factors
B. the value of trade market and services which have no

competition in the market
C. high market value compared to domestic market value
D. zero market value and could be taken into account in

classifying countries
E. market value that must be used in determining the

calculation of national income
2. Mixed economy is ____________.
A. capitalism market where the government owns specific

sources
B. socialism market where the government states its own

specific sources but the distribution is controlled by market
price mechanism
C. capitalism and socialism market where the government

determines the distribution of specific sources
D. socialism market where the government will determine what

is produced and how much to produce
E. socialism and capitalism market practised by countries

which practise communism

3. The main characteristics to differentiate between one country and

another is ____________.
A. demand size or gross national production
B. demand size or total annual export of a country
C. gross national production and inflation rate
D. market size or gross national production
E. gross national production or the total of population
4. The main purpose of the World Bank is to_____________.
A. abolish poverty
B. abolish bribery
C. abolish poverty and bribery
D. provide loans to poor countries
E. provide loans to advanced countries
5. Most of the data in the World Bank are obtained from

________________.
A. advanced countries
B. developing countries
C. advanced and developing countries
D. socialism countries
E. geographical area

 Understanding the economic environments of the foreign markets can help a

manager to predict the direction of the company.
 Countries in the world economy are classified according to income or GNP

per capita, geography by regions and the economic systems such as the
market, command and mixed systems that exist.
 Companies make foreign investment decisions based on environmental and

market factors such as the market demand, size and its potential.
 In market economy, the private sector controls and owns the resources,
whereas in a command economy, the government owns and controls the
resources. Mixed economy is a hybrid of market and command economic
systems.
 Economic freedom of an economy refers to the degree of government

intervention in the economic activities.
 Information on macroeconomic environment such as inflation rate, economic

growth and internal and external balance helps foreign investors to decide in
choosing the country as the location for their business operation.
 The economic transformation of China and Russia affected the pattern and
development of international business.
 Financial crisis can bring about economic shocks and adversely impact
Command economy Market economy

Economic growth Mixed economy
Economic shocks Surplus and deficit
Economic system Transition process
Inflation WorldÊs economy

Topic  Cultural
3 Environment
LEARNING OUTCOMES
1. Define culture and cross-cultural risk;
2. Explain the importance of culture in international business;
3. Determine in what ways cultural differences influence international
business;
4. Determine how cultural elements such as language, religion, social
structure and interaction, aesthetics and cultural values influence
international business; and
5. Discuss how to overcome cultural challenges.
 INTRODUCTION
In this topic, we address the concept of culture and what constitute cultural
elements. The importance of culture to international business is discussed as well
as the risks that culture can pose in international business encounters. It cannot
be denied that today, developing an appreciation of, and sensitivity for, cultural
differences have become imperative for any manager, even more in cross-cultural
boundaries. Different cultural environments are characterised by foreign
languages and different beliefs and values. Hence, global managers need to
develop understanding and skills in dealing with other cultures to avoid cultural
blunders and mistakes. The influence of culture on international business is
discussed together with ways to overcome these cultural challenges.

42  TOPIC 3 CULTURAL ENVIRONMENT
3.1 CONCEPT OF CULTURE

Culture has been defined in many ways. In modern management, Hofstede
viewed culture as „the cultural programming of the human mind,‰ (Cavusgil
et al., 2008) whereas in business-oriented terms, Terpstra and David (1991)
defined culture as „a learned, shared, compelling, interrelated set of symbols
whose meanings provide a set of orientations for members of a society.‰
The working definition of culture used throughout this topic is by Whitely and
England (1977) who described culture as „the knowledge, beliefs, art, law,
morals, customs and other capabilities of one group distinguishing it from the
other groups.‰
Despite the different definitions, culture has four common features, as shown in
Figure 3.1.
Figure 3.1: Four features of culture

TOPIC 3 CULTURAL ENVIRONMENT  43
Now let us have a look at the explanation of each feature in Table 3.1.
Table 3.1: Explanation of Four Common Features of Culture
No Features Explanation
1 Culture is learned It is a learned behaviour and transmitted through
the process of learning and interacting with oneÊs
environment and not inherited.
2 Culture is intangible It is not about „things‰ such as products or values. It is
concerned about meanings which are intangible or not
visible in nature and must be inferred.
3 Culture is shared It does not belong to an individual but is shared by
individuals who are members of a group or society.
Culture is identified with a nation, firm or society.
4 Culture is interrelated It consists of different parts that are interrelated. For
example, a personÊs culture such as language or
religion has an impact on another part.
3.2 CROSS-CULTURAL RISKS AND

Culture matters in international business. Culture is a key ingredient in the
management of international business. Often multinational corporations (MNCs)
operate in different cultural environments characterised by foreign languages,
beliefs, values and lifestyles. Culture can be a liability of foreignness and could
pose as a risk to the MNCÊs success abroad.
Cross-cultural risk refers to a situation or event where a cultural

miscommunication puts some human value at stake.
Cavusgil et al., 2008

The impact of culture at the business level ranges from strategy formulation and
communication to foreign investment operations and organisational structure.
Effective cross-cultural management of the firmÊs resources and operations is a
critical source of competitive advantage. Culture can impact managerial tasks in
various ways such as:
(a) Marketing strategies that involve development of products and services

and advertising;
(b) FDI strategies such as communicating and interacting with foreign business
partners, screening and selecting foreign distributors and other partners,
negotiating and structuring international business ventures;
(c) Business practices such as interacting with current and potential customers
from abroad;
(d) International management of human resources; and
(e) Organisational design and behaviour such as motivation, leadership and

perception.
ACTIVITY 3.1
When working in a global business environment, knowledge of the

impact of cultural differences is vital to business success. To find out
more about the cultural profile of different countries, visit the website
http://www.worldbusinessculture.com and share your findings with
your coursemates.
3.3 CULTURAL ELEMENTS

Moving on, we will now discuss cultural elements. Culture has many
components that are correlated with many variables, for example, language and
religion. Some cultural elements are visible attributes that have objective
dimensions (such as symbols, colour, art and music) while some have invisible
attributes (such as values, attitudes, norms and religion). International business
managers need to have knowledge and deep understanding of the different
components of culture. The basic elements of culture that are important in
international business are language, religion, education, social structure and
interaction, aesthetics and cultural values.

3.3.1 Language
Let us continue our discussion by looking at the first cultural element which is
language. Language is one of the key dimensions of culture. Language is
construed as the „mirror‰ of culture and provides insights into culture. It is
essential for communication and basic socialisation in which values and norms
are expressed and communicated. Language is both a unifying and dividing
force. There exists diversity in language across and within national boundaries.
At present, the world has nearly 7,000 active languages. India alone has more
than 200 spoken languages. Table 3.2 highlights the major languages of the
world.
Table 3.2: WorldÊs Main Languages
Number of Speakers
Language Family Principal Locations
(estimated in millions)
Chinese Sino-Tibetan China 885
English Indo-European North America, Great 450
(Germanic group) Britain, Australia, South
Africa
Hindi- Indo-European India, Pakistan 333
Urdu (Indo-Iranian group)
Spanish Indo-European South America, Spain 266
(Romance group)
Portuguese Indo-European Brazil, Portugal 175
(Romance group)
Bengali Indo-European Bangladesh, India 162
(Indo-Iranian group)
Russian Indo-European Former Soviet Union 153
(Slavic group)
Arabic Afro-Asiatic North Africa, Middle 150
East
Japanese Altaic Japan 126
French Indo-European France, Canada, 122
(Romance group) Belgium, Switzerland,
West and North Africa
German Indo-European Germany, Austria, 118
(Germanic group) Switzerland
Source: alis.isoc.org/languages/grandes.en.htm

Because of differences between language structure and in the use of slang and
dialects, language blunders are common in business settings. Translation,
meaning and expressions differ across the language spectrum. The concept and
meaning of a word are not universal, even though the word can be translated
into another language. Language mistakes and blunders are embarrassing and
often unnecessary, for example, careless translation in advertising slogans or
products labels. The following examples of language mistakes in cross-cultural
marketing illustrate how crucial language is in international business.
(a) Marketing executives were disappointed to learn that the brand name of
the cooking oil they were promoting in a Latin American country translated
into Spanish as „Jackass Oil‰.
(b) In Chinese, the Kentucky Fried Chicken slogan „finger-lickinÊ good‰ came
out as „eat your fingers off.‰
(c) In Taiwan, the translation of the Pepsi slogan „Come alive with the Pepsi
Generation‰ came out as „Pepsi will bring your ancestors back from the
dead.‰
(d) In Italy, a campaign for Schweppes Tonic Water translated the name into
„Schweppes Toilet Water.‰
As a communication medium, language has two parts: verbal (spoken) and non-
verbal (silent language such as space, facial expressions and gestures). Linguistic
proficiency is a great asset in international business because it facilitates cross-
cultural understanding especially in business negotiation. For example, it is
important for investors to be proficient in Mandarin Chinese and it will be of
great advantage to know the native Chinese language while doing business in
China. For non-verbal language, facial expressions and hand gestures can have
different interpretations in different cultures and often complicate international
communication. Not only may the person you are dealing with be
unintentionally sending non-verbal signals that you do not comprehend or you
misunderstand, you may be unconsciously sending your own signals. Some
examples of silent language blunders and lack of cultural awareness are as
below:
(a) One company printed the „OK‰ finger sign on each page of its catalogue. In
many parts of Latin America this is considered an obscene gesture. The
entire catalogue had to be re-printed.
(b) An American executive refused an offer of a cup of coffee from a Saudi
businessman. Such a rejection is considered very rude and the business
negotiations were terminated.

It is important to remember that for language to be truly useful for business

people, they must understand the uses, distances, gestures and interpretations
that accompany verbal communication. Global business managers must be
familiar with the foreign culturesÊ hidden language. Marketers of MNCs should
decide which language to use in product labels and advertisement copy.
EXERCISE 3.1
Why is silent (non-verbal) language important for international
business?
Provide several examples of how it differs across cultures.
3.3.2 Religion
Our next discussion will be on religion.
Religion can be defined as a system of common beliefs, attitudes and rituals

that people consider to be sacred.
Religion directly influences culture, and therefore business and consumer

behaviour. While there are thousands of religions worldwide, four dominant
religions around the world are Christianity, Islam, Hinduism and Buddhism.
Table 3.3 shows the major religions of the world and the percentage of each
religion.
Table 3.3: Major Religions of the World
Religion Members Percentage

Christianity 2.1 billion 33
Islam 1.5 billion 21
Hinduism 900 million 14
Buddhism 376 million 6
Source: www.infoplease.com

The impact of religion is evident in international business. Religion influences

attitudes towards consumption, business practices and social organisation.
Global managers must be sensitive towards religious differences and beliefs not
only among the major religions but also within the subgroups. Examples of how
religion can influence international business are:
(a) McDonaldÊs in India faced religious challenges. The cow is considered

sacred in IndiaÊs Hindu culture prompting McDonaldÊs to alter its menu to
offer mutton, chicken and vegetarian alternatives to its traditional beef
burgers.
(b) The case of Nike Air brings back another classic example of cultural
blunder. In 1998, Nike Air Bakin made national headlines when Arab-
American groups thought that the way „Air‰ was written on the shoe
looked too similar to „Allah‰ written in Arabic. Nike recalled thousands of
shoes, covered the logos with patches and the shoes made their way to the
outlets. Unfortunately for Nike, there were hundreds of thousands of shoes
fresh out of the factories that had the same logo (Nicekicks, 2012).
(c) In the Islamic market, Nokia launched a mobile phone that shows Muslims
the direction towards Mecca, IslamÊs holiest site. Heineken, the Dutch
brewing giant, rolled out the non-alcoholic malt drink, Fayrouz.
(d) Major holidays in many countries are tied to religion. Almost 90 percent of
Brazilians are Catholic, making Brazil the largest Catholic population in the
world. Catholic holidays, consequently, affect Brazilian work schedules and
are widely celebrated. MNCs operating there must keep this in mind when
planning marketing events, scheduling meetings or operating in local
offices.
(e) In Islamic countries, which prohibit the consumption of alcohol, gambling,

usury and „immodest‰ exposure, firms that deal in alcoholic beverages,
resorts, entertainment, and womenÊs clothing, as well as ad agencies, and
banks and other institutions that lend money are affected.
SELF-CHECK 3.1
Identify the dominant religion in each of the following countries:

(a) China, (b) India, (c) Brazil, (d) Russia, (e) South Korea, (f) Indonesia
and (g) Japan.

3.3.3 Social Structure and Interaction

We will now continue with the third cultural element which is social structure
and interaction.
Social structure refers to a societyÊs basic social organisation.
Social structure affects business decisions ranging from production site selection,
negotiation and marketing to the costs of doing business in a country. One
important dimension of social structure that differs across cultures is social group
interaction.
Social group interaction refers to how people of different cultures associate

themselves and interact with one another.
Two important social group interactions affecting business activities everywhere

are family unit and gender.
(a) Role of Family Unit

Family unit varies dramatically across societies. The two different types of
family units are:
(i) Nuclear family which comprises parents and children and is found
mainly in Western countries; and
(ii) Extended family which comprises a wider group of family members

that includes relatives and is prevalent in developing countries.
The way in which families are structured present interesting situations for
business people who are unfamiliar with the culture. For example, in
extended family cultures, managers and other employees often try to find
jobs for relatives inside their own companies. This can pose a challenge for
human resource management. In some cultures, business is owned with
family and relatives. Owners and managers buy supplies and materials
only from companies owned by relatives or in which someone from the
extended family works. In cultures where extended families are the norm,
major purchase decisions are influenced by members of an extended family.

In Chinese cultures, guanxi is one of the most important elements involving

social interaction in the business context. Guanxi literally means
relationship. Building relationships is vital when establishing business
networks in China such as when negotiating a deal, setting up a joint
venture and during formal business meetings. A Chinese company will feel
far more comfortable doing business with a company which they have
strong guanxi with because they believe it will make it far easier for them
to trust their business counterpart. It is equally important for foreign
companies to develop strong guanxi with Chinese companies and
government organisations. This guanxi will help your company in case you
run into problems doing business in China. In addition, Chinese companies
will feel more comfortable doing business with you if they have strong
guanxi with you either because you have built a strong relationship with
them or you were introduced to them by someone in their network
(www.businessinsider.com). Table 3.4 provides some tips on doing
business in China.
Table 3.4: Some Tips on Doing Business in China
1. Do your homework to know about the Chinese market before making any
concrete move. China is a huge country with diverse cultures and peoples. Each
region possesses unique demographics and consumer preferences that are crucial
to any business plan. What works in one city may not necessarily work in another
city.
2. Do your communications in Chinese. Hire a Chinese-speaking employee to
handle communications in China or use the services of an interpreter for the job.
The Chinese place a premium on good relationships (guanxi).
3. Do your best to locate a good local partner. Existing Chinese laws prohibit foreign
representative offices from signing contracts directly in China. Use a reliable local
agent to sign all sales contracts and send billing statements to customers when
needed. A good local partner is also in the best position to sell and distribute your
products in China.
4. Do not sign contracts without first seeking legal advice. Do not sacrifice short-
term profits for so-called long-term gains. The economic climate in China is
always changing and may be unpredictable.
5. Do not use unsecured channels for payment. Make it a policy to receive or make
payments using only established banking institutions and by asking for Letters of
Credit and other financial instruments.
6. Protect your intellectual property rights. Profitable or well-known brands usually
become the subject of copyright infringement or piracy.
Source: www.chineseewhispers.com

(b) Role of Gender

Now let us find out more on the role of gender in business activities.
Gender in the cultural context refers to socially learned behaviours and

attitudes associated with the role of men or women.
This includes behaviours and attitudes such as style of dress, activity

preferences and decision-making authority. Each culture handles gender
roles more or less differently and this has a great impact on international
business. The economic role of women varies from culture to culture. For
example, business in global marketing in Islamic countries should find out
what is the role of women. Marketing to women is driven by local religions
and beliefs.
In AsiaÊs management style, women in general have less opportunity than

men in the workplace and hence are less involved in decision-making. For
example, women in China are still mainly responsible for caring for the
family and home. Women in China work hard but they do not get positions
which would be adequate for their knowledge and level of education. There
is an obvious problem when working in a Chinese company where men do
not report to women about business matters. It is unacceptable in China for
women to take managerial positions or have a higher status in jobs than
their male colleagues. Today, women in China are playing an increasingly
important role but they are still far from having achieved equal rights
(Hofman, 2009).
EXERCISE 3.2
Define social structure. How does social group interaction affect

international business?

3.3.4 Aesthetics
We will now continue with another element, which is aesthetics. What do you
understand by the word „aesthetics‰?
Aesthetics refer to sense and perception of beauty and good taste of a culture.
Aesthetic is the objective dimensions in culture that includes symbolic and

material productions, meaning of tools, architecture, art forms, music and use of
brand names. Cultures differ sharply in terms of their aesthetic preferences.
Colour and form (design and shape) are used as symbols with specific meanings.
Colour and symbols have different meanings – religious, symbolic, patriotic
reasons and aesthetic appeal and its significance vary from culture to culture.
Colour as a brand identity has become a big legal issue recently as trademark law
protected distinctive colours that had become strongly associated with a
particular product or manufacturer. Colour and symbols would be of interest in
international business due to trademark infringement lawsuits that allow
companies to appropriate a single colour, colour combination or symbol. Global
marketers need to know the significance of colour psychology and the symbolic
meanings of colours in planning products, packaging, branding and advertising.
Table 3.5 highlights some pitfalls when creating universal symbols.
Table 3.5: Pitfalls when Creating Universal Symbols
 Avoid Hand Gestures in Graphic Symbols – In some countries, icons using the
thumbs up, „V‰ for victory or „OK‰ sign would indicate that something is good
but these can be vulgar gestures in other countries.
 Avoid Animals in Graphic Symbols – Owls symbolise wisdom in the United
States but they symbolise stupidity in some Asian countries. Other animals could
cause offence because of their religious significance. For example, dogs and pigs
to Muslims, cows to Hindus, elephants to Thais.
 Avoid Text Requiring Translation in Graphic Symbols – Words or even single
letters will likely not be universal because of the translation required.
 Avoid Humour and Slang in Graphic Symbols – Humour cannot always be
translated.
 Avoid Culturally Sensitive Topics in Graphic Symbols – Examples are
race/ethnicity, politics, religion and sex/gender.
 Avoid Region-Specific Elements in Graphic Symbols – Currency, time/date, and
flags (i.e. in website language selectors) will not share universal meaning across
borders.
Source: www.globalization-group.com

ACTIVITY 3.2
Find out what the following colours symbolise in the countries stated
below.
(a) Orange for India and Egypt;
(b) Purple for Brazil and Thailand; and
(c) Red for China and Russia.
3.3.5 Hofstede’s Cultural Value Dimensions

By far the most widely used work on national culture is from Geert Hofstede,
who surveyed the values of attitudes of more than 100,000 IBM employees
worldwide. HofstedeÊs survey revealed four underlying dimensions of national
culture: power distance, individualism/collectivism, uncertainty avoidance and
masculinity/femininity.
(a) Power Distance (PD)
Power distance is the extent to which society deals with differences in

power that exists among people.
Examples of countries with high PD are Japan, India, Brazil and Malaysia
while United States, Denmark, and Sweden exhibit low PD. Societies with
high PD tend to tolerate and accept relatively high social inequalities. Status
symbols play an important role. Organisations with high PD are more
centralised, with more layered and hierarchical structure with more
supervisory personnel and larger wage differentials. In societies with low
PD, the gaps between the powerful and weak are minimal and status
symbols are less emphasised. Organisations with low PD are characterised
by flatter structure and less centralisation.
(b) Individualism/Collectivism (I/C)
Individualism/collectivism describes the degree to which people

function primarily as an individual or within a group.

It is also referred to as the „I‰ and „we‰ societies. In individualistic

societies, the focus is on peopleÊs own interests while societies high in
collectivism tend to pursue group interest and group harmony.
Competition is important among individualists while group conformity is
highly emphasised in collectivists. The United States, Australia and United
Kingdom are individualist countries. Collectivist countries are South Korea,
Mexico, China and Indonesia. Organisations from highly collectivistic
cultures practise group loyalty, sense of duty and group participation. The
organisation is more paternalistic (the organisation is viewed as a family)
while individualistic organisations are more impersonal and encourage
individual initiative.
(c) Uncertainty Avoidance (UA)
Uncertainty avoidance refers to the extent to which uncertainty and

ambiguity are tolerated.
People from a strong UA culture feel threatened by uncertainty and attempt

to standardise rules and behaviour that structure life. In weak uncertainty
avoidance cultures, people are more risk-taking, easygoing and
entrepreneurial. Countries that score high on UA are Japan, France and
Spain. Malaysia, India, the United Kingdom and Hong Kong are examples
of countries that exhibit low uncertainty avoidance. UA is one of the most
critical dimensions for foreign investment because of its implications for
risk taking and investment. Multinational corporations from cultures high
in UA are likely to take a more incremental approach to internationalisation
of their business expansion.
(d) Masculinity/Femininity (M/F)
The masculinity/femininity dimension describes the importance of male

values such as competitiveness, assertiveness, status and success.
They are emphasised against female values like caring, people orientation,
quality of life and nurturing. Typical examples of masculine cultures are
Australia, Japan and Italy while Thailand, Sweden and Finland are low in
the masculinity trait. MNCs from feminine cultures tend to minimise
gender roles with more women in more qualified jobs. Such organisations
tend to value social rewards and benefits to employees.

Table 3.6 shows country comparison of work-related values. The index

score roughly ranged from 0 to 100. The higher the score, the more that
dimension is exhibited in society. Western nations like the United States,
Canada and the United Kingdom score high on the individualism scale and
low on the power distance scale. Asian countries score high on power
distance but emphasise on collectivism. Japan has strong uncertainty
avoidance and high masculinity. Malaysia scores high on power distance.
Sweden and Denmark has both low uncertainty avoidance and masculinity.
Table 3.6: Country Comparison on Work-Related Values for 15 Selected Countries
Power Distance Uncertainty Individualism Masculinity

Country
(PD) Avoidance (UA) (IDV) (MAS)
Australia 36 51 90 61
Canada 39 46 80 52
China 80 40 20 66
Denmark 18 23 74 16
Germany 35 65 67 66
India 77 40 48 56
Indonesia 78 48 14 46
Japan 54 92 46 95
Malaysia 104 36 26 50
Saudi 95 80 25 60
Arabia
Sweden 31 29 71 5
Thailand 64 64 20 34
Turkey 66 85 37 45
United 35 35 89 66
Kingdom
United 40 46 91 62
States
Source: http://geert-hofstede.com

ACTIVITY 3.3
Find more information on national culture and organisational culture,

at http://www.geert-hofstede.com.
Let us move on by looking at Table 3.7. Table 3.7 provides a summary of the
characteristics of HofstedeÊs cultural dimension and tips to deal with each value
orientation.
Table 3.7: HofstedeÊs Cultural Value Dimension – Characteristics and Tips
Value Characteristics Tips

High  Centralised companies.  Acknowledge a leaderÊs power.
PD  Strong hierarchies.  Be aware that you may need to go
 Large gaps in compensation, to the top for answers.
authority and respect.
Low  Flatter organisations.  Use teamwork.
PD  Supervisors and employees are  Involve as many people as possible
considered almost as equals. in decision making.
High  High valuation on peopleÊs time  Acknowledge accomplishments.
IDV and their need for freedom.  Do not ask for too much personal
 An enjoyment of challenges and an information.
expectation of rewards for hard  Encourage debate and expression
work. of own ideas.
 Respect for privacy.
Low  Emphasis on building skills and  Show respect for age and wisdom.
IDV becoming masters of something.  Suppress feelings and emotions to
 Work for intrinsic rewards. work in harmony.
 Harmony more important than  Respect traditions and introduce
honesty. change slowly.
High  Men are masculine and women are  Be aware that people may expect
MAS feminine. male and female roles to be
 There is a well-defined distinction distinct.
between menÊs work and womenÊs  Advise men to avoid discussing
work. emotions or making emotionally-
based decisions or arguments.

Low  A woman can do anything a man  Avoid an „old boysÊ club‰

MAS can do. mentality.
 Powerful and successful women  Ensure job design and practices are
are admired and respected. not discriminatory to either
gender.
 Treat men and women equally.
High  Very formal business conduct  Be clear and concise about your
UAI with lots of rules and policies. expectations and parameters.
 Need and expect structure.  Plan and prepare, communicate
 Sense of nervousness spurns high often and early, provide detailed
levels of emotion and expression. plans and focus on the tactical
aspects of a job or project.
 Differences are avoided.
 Express your emotions through
hands gestures and raised voices.
Low  Informal business attitude.  Do not impose rules or structure
UAI  More concerned with long-term unnecessarily.
strategy than what is happening  Minimise your emotional response
on a daily basis. by being calm and contemplating
 Accepting of change and risk. situations before speaking.
 Express curiosity when you
discover differences.
Source: www.mindtools.com
3.4 OVERCOMING CULTURAL CHALLENGES

Cultural differences between countries have a direct impact on international
business activity. Cultural blunders and misunderstandings encountered by big
companies in our examples have proven the importance of local cultural
knowledge. As globalisation becomes more prominent in international business,
there is greater need for companies to understand local culture in order to
enhance their competitive advantage.
(a) Avoid Cultural Bias

One of the main causes of culture-related blunders made by managers is
ethnocentrism. This is a form of cultural bias based on the belief that oneÊs
own cultural group is superior to that of others. International business
managers should be sensitive to cultural biases that influence oneÊs
thinking or avoid ethnocentricity so as to not disregard the positive and
beneficial aspects of other cultures. At the same time, managers should
develop cultural literacy to appreciate cultural diversity and respect for

cultural identities. Cultural literacy is detailed knowledge about a culture

which enables one to function effectively within it (Wild et al., 2008).
Companies operating in local markets and in working environments
with employees from diverse cultures should promote intercultural
communication sensitivity and multiculturalism. This is a critical step to
avoid cultural bias and overcome ethnocentric reactions (Dong & Collaco,
2009).
(b) Avoid Cultural Stereotypes
A cultural stereotype is an assumption or generalisation made about an

individual based on oneÊs own superficial criteria, for instance, cultural
assumptions of a personÊs gender, age, habits and behaviour.
Such stereotyping can affect our attitudes and expectations when

communicating with people from other cultures. Hence, managers involved
directly in international business should develop business literacy through
cross-cultural training and pay attention to significant subcultures within
countries. This is particularly important especially in working environments
with colleagues and counterparts from other cultures and also in
international business relationships. Table 3.8 presents various forms of
business literacy that managers and executives must learn in order to do
business in the global marketplace.
Table 3.8: Forms of Business Literacy
Form Description
Personal Understanding and valuing yourself such as self-awareness, self-
literacy renewal, and having strong values, being flexible enough to know
that people from other cultures have different values and ethics.
Social Engaging and challenging other people such as learning what gets
literacy said is non-verbal, and learning to read environments, contexts and
circumstances.
Business Learning and building new things, building and rebuilding, tearing
literacy down what donÊt work, engaging in problem solving, navigating
through chaos and leading people through change.
Cultural Valuing and leveraging cultural differences, understanding own
literacy cultural heritage, recognising own strengths and shortcomings and
building bridges across cultures. Cultural literacy in marketing, work
attitudes, expatriates and gender are important.
Source: Rosen & Digh (2001)

(c) Understanding Business Culture and Practices

Apart from having a general understanding of the historical and cultural
background of the foreign country a company is dealing with, it is
important that managers be aware of and are sensitive to significant
features of the business culture. It is imperative for managers to not only
have a general appreciation for other cultures but acquire knowledge on
specific details of how to conduct oneself in various business situations.
Some of the major guidelines necessary for understanding business
practices include appropriate conduct during conversations, business
meetings and social gatherings as well as physical appearance, including
how to dress and facial expressions. Such cultural awareness and
knowledge are vital for the success of business dealings. However, business
practices vary across countries. Companies should offer international
business managers training in cross-cultural communication.
SELF-CHECK 3.2
Visit Executive Planet website for guidelines on business culture and
etiquette when meeting with business associates from other cultures, at
www.executiveplanet.com/
EXERCISE 3.3
1. _________ consists of people with shared beliefs, values and
attitudes.
A. Moral
B. Culture
C. Identity
D. Self-concept
2. Silent language includes all of the following EXCEPT

A. Handshake
B. Body language
C. Colour symbols and associations
D. Facial expressions

4. Which of the following religion prohibits paying or receiving

interest on business transactions?
A. Christianity
B. Buddhism
C. Islam
D. Hinduism
5. _________ pis the belief that oneÊs own culture is superior to

others.
A. Geocentrism
B. Polycentrism
C. Ethnocentrism
D. Regiocentrism
5. Which of the following statements regarding culture is TRUE?
A. Building cultural awareness is an easy task.
B. International business managers are expected to understand

the variations of business practices in every country.
C. All companies have the same degree of cultural awareness.
D. Companies that are new to international business may need

only a minimum level of cultural understanding and
sensitivity.
6. In which of the following situations do companies find their best

marketing successes when emphasising advertisements that
express group values?
A. High individualism
B. High collectivism
C. High masculinity

7. Which of the following is NOT a cultural variable?
A. Career choice
B. Aesthetics
C. Social interaction in family unit
D. Religion
8. Which of the following is NOT a masculine value?
A. Quality of life
B. Assertiveness
C. Achievement
D. Status
 Culture is a vital force in international business.
 Lack of cultural understanding and sensitivity towards foreign cultures when

doing cross-border business can lead to cultural blunders.
 Language and religion are two major cultural elements that exert a direct
impact on international business operations and strategies.
 Hofstede classified national culture into four major cultural value

dimensions: power distance, individualism-collectivism, uncertainty avoidance
and masculinity-femininity.
 The family unit and gender are two components of social group interactions
that influence cultural behaviour in particular situations.
 Colour as a form of aesthetic appeal plays an important role in advertising,

packaging and branding strategies.
 Key cultural challenges facing MNCs include cultural bias, ethnocentrism,

cultural stereotypes and cross-cultural miscommunication.

 Cultural literacy which forms part of understanding the business culture and
practices of local markets is key to MNCsÊ success abroad.
Aesthetics Individualism
Business practices Masculinity
Collectivism Non-verbal language
Colour symbol Power distance
Cultural awareness Religion
Cultural bias Social group interaction
Cultural literacy Social structure
Culture Uncertainty avoidance
Ethnocentrism Value orientation
Femininity Verbal language

Topic  Political and
4 Legal
Environment
LEARNING OUTCOMES
1. Discuss the functions of a political system;
2. Compare between three political ideologies and how each of them
influences government policy decisions on investments;
3. Explain political risks and how companies formulate and
implement political strategies to overcome such risks; and
4. Examine three types of legal systems in international business.
 INTRODUCTION
Welcome to Topic 4 on International Business. Before we proceed with the
discussion on the political and legal environment, let us take a moment to think
about political issues in international business. In your opinion, how do political
issues affect international business? Do you think that political issues can
exacerbate economic challenges? Can a company which implements different
business practices from Malaysia operate successfully in China?
You must remember that multinational companies operate in the political and
legal environment of their host countries. Therefore, international business
managers must analyse in detail whether their corporate policies and objectives
are in line with the political environment and legal system of the host country.
If you would like to have better knowledge of the political and legal systems
which managers have to deal with and the factors to consider when operating a
business in a foreign country, read through this topic. Happy reading!

64  TOPIC 4 POLITICAL AND LEGAL ENVIRONMENT
4.1 POLITICAL ENVIRONMENT
SELF-CHECK 4.1
Explain how an organisation operates in a different political and legal

environment.
Did you know that most of the major obstacles to the operations of a foreign firm
relate to the political and legal environment? In todayÊs fast-changing political
environment, changes in a countryÊs political system can have dramatic and
widespread impact on businesses, both domestically and internationally. For
example, Malaysian managers may be familiar with a relatively stable political
system but this is sometimes not the case in other countries. For instance, since
2008, Thailand has been experiencing political instability due to anti-government
protests. Civil unrest and riots have affected tourism, consumer spending and
investor confidence not only in Thailand but also in its neighbouring Association
of Southeast Asian Nations (ASEAN) countries (Euromonitor, 2010).
Figure 4.1 shows political and legal factors that form part of the external
environment influencing management decisions.
Figure 4.1: Political and legal influences on international business

TOPIC 4 POLITICAL AND LEGAL ENVIRONMENT  65
4.1.1 Effects of Political System

Let us now discuss the effects of a political system. A political system integrates
parts of a society into viable and functioning units. The main challenge for a
political system is to unite a society of various races and cultural backgrounds as
well as encourage cooperation. Figure 4.2 illustrates the political system and its
functions.
Figure 4.2: The political system and its functions

Source: Daniels & Radebaugh (2001)
A political policy is formed by combining various suggestions from influential

parties such as politicians, individuals, traders and other important people. The
government identifies the alternatives on a policy and which policy decision
should be made. A policy is implemented and changed depending on feedback
from politicians, bureaucracy, law, court and other institutions.
4.2 EFFECTS OF POLITICAL IDEOLOGY

DIFFERENCES
How do differences in political ideology influence international business? What
do you understand about political ideology?
A political ideology, which forms part of a political system, is a body of

theories or ideas and its purpose is to achieve socio-political goals.

Examples of political ideologies are the Democratic and Republican parties in the
United States; and the Conservative and Labour parties in the United Kingdom.
A country with a pluralistic society is likely to have many political ideologies.
Most of modern society is pluralistic politically because there is no ideology that
could be fully accepted. Pluralism exists because groups in a country are often
significantly different from each other in terms of language, race and religion (for
example, India).
The main purpose of any political system is to unite the society even with
pressures from various ideologies. The more different the ideas the more difficult
it is for the government to form ideologies that can be accepted by all. In sum,
whatever types of ideology the host government supports, the number of
political parties and the ideology of the main political party in the country are
major concerns of multinational corporations (MNCs). Political instability is the
result of transcending differences in ideas and ideologies. Political instability
makes it difficult for foreign investment and any operation that uses the
resources in a country. A political ideology determines the direction of a host
governmentÊs policy towards foreign direct investment (FDI).
ACTIVITY 4.1
What is the political ideology of Malaysia? How does this ideology

affect the governmentÊs attitude towards foreign investment?
As you can see in Figure 4.3, there are three different political ideologies on
foreign investment.
Figure 4.3: Different political ideologies towards foreign investment

Source: Hill (1998)

The three approaches of political ideologies that can influence government

policies towards MNCs and foreign investments are explained as follows:
(a) The radical view, based on Marxism, adopts a hostile stance towards FDI. It
sees MNCs as a tool for exploiting a host country. The host government
restricts foreign investment and is more likely to nationalise MNCs. The
radical view declined due to the collapse of communism in the late 1980s.
(b) The free market view sees MNCs as an important tool for efficient
allocation of resources and production. Based on this view, no restrictions
are placed on FDI and it is allocated to countries where it will be produced
most efficiently.
(c) Pragmatic nationalism is the most practical approach whereby a host

government views FDI as having both benefits and costs. Hence, countries
that adopt the pragmatic approach have policies that aggressively attract
foreign investments that aim to maximise benefits and minimise costs of
FDI.
ACTIVITY 4.2
1. List three approaches of political ideologies which influence
government policies towards MNCs.
2. In your opinion, which approach is ideal for a developing country

like Malaysia?
4.3 POLITICAL RISKS

Let us now discuss political risk. By now, you should have an idea of what it is
all about. Let us first define political risk.
Political risk is defined as disruptions to an MNCÊs operations due to changes

in political environments.

Politics that affect international trade and foreign investment can stem from
political changes in the home country, host country or the rest of the world.
Table 4.1 shows a list of countries ranked according to the risk of political
instability.
Table 4.1: Risk of Political Instability, 2010
Ranking Country Rating

1 Norway 9.49
2 Switzerland 9.49
3 Chile 9.48
4 New Zealand 9.41
5 Finland 9.18
14 Singapore 8.50
15 USA 8.47
20 Hong Kong 7.57
22 China Mainland 7.15
23 Malaysia 7.09
29 India 6.71
32 Taiwan 6.47
47 Indonesia 4.95
55 Japan 3.89
56 Iceland 3.29
57 Ukraine 3.03
58 Thailand 2.67
59 Venezuela 1.07
Note: Rating of 1 = very high political instability risk, rating of 10 = very low political instability
risk
Source: The IMD World Competitiveness Yearbook (2011)
4.3.1 Types and Causes of Political Risks

MNCs are often exposed to a range of political risks when making investments in
foreign countries. There are three types of political risks that can affect a
companyÊs FDI operations (refer to Table 4.2).

Table 4.2: Three Types of Political Risks that Affect FDI Operations
Types of Political
No Causes Examples
Risk
1 Ownership risks (a) Change in political Change in political
associated with ideology of a country. leadership when China took
change in the (b) Change in political over Hong Kong in 1997 –
structure of foreign leadership. many MNCs which invested
ownership and in Hong Kong had to
(c) Change in opinions of
control of assets and identify new risks
political leaders.
properties. associated with changes in
the political system,
ideology, government
leadership and rules of the
game between the
communist system of the
government of Mainland
China and Hong KongÊs
democratic system.
2 Operational risks (a) Political instability in a  Violent political riots in
occur when there is host country or region Egypt, Libya and
change in the „rules arising from riots, civil neighbouring countries
of the game‰ by the war, terrorism and have a negative impact
government or the natural disaster disrupt on tourism FDI, airline
political climate, MNCÊs local operations. operations and oil
affecting daily (b) Host or home industries.
operations of the government introduce  Venezuelan President
foreign business. changes in rules of Hugo Chavez
investment on FDI and confiscated the oil fields
limit foreign ownership of foreign oil companies
of equity. operating in Venezuela
(c) Host government and made new oil
actions such as contracts.
confiscation,
expropriation (seizure
of property without
compensation) and
nationalisation of
foreign business and
assets interrupt MNCs
daily operations causing
FDI losses, closure and
even exit the country.

3 Transfer risks arise (a) Host government During the Asian Financial
from barriers to imposes foreign Crisis, Malaysia and other
transfer of FDI exchange controls on ASEAN countries impose
capital, profits and MNCs that restrict capital controls to protect
human resources by outflow of their FDI their local currency.
MNCs. profits back to their Increasing levels of capital
home country. controls reduce the life-span
(b) Host government of FDI and foreign
restricts placement of investorsÊ willingness to
expatriates in key undertake new investment
positions at foreign (Siddiqui, 2012).
companies.
ACTIVITY 4.3
Identify the major sources of political risks. Compare whether the

political risks are different between developed and developing
countries.
4.4 MICRO AND MACRO POLITICAL RISKS

If a political action is focused on a certain foreign investment, for example a
particular foreign company, business or industry it is called micro political risks.
Companies that face micro political risks are those with obvious position due to
their size, monopoly influences and brand icon. In 2007, Venezuelan President
Hugo ChavezÊs sudden takeover of 60 oil fields belonging to foreign companies
had an impact on the oil industry.
If political actions affect a wide spectrum of foreign investors, such as when

political actions of a host country affect all foreign operations, these are termed
macro political risks. For example, the terrorism disaster of 11 September 2001
affected both the American and global economies.

4.5 MANAGING POLITICAL RISK

Although political risks declined in the 1990s, recent changes in the political
environment witnessed a rise in political risks after the terrorist attacks of 11
September 2001. Many countries have relaxed FDI restrictions and rules to attract
more FDI inflow into their countries. However, political uncertainties caused by
war, racial riots and natural disasters such as tsunami continue to impact FDI
and global business. Hence, it is vital for MNCs to take into account political
risks in their international business strategies. Managers must have knowledge
about political risk and find ways to manage it.
According to Shenkar and Luo (2004), a few strategies available to managers for
managing political risk are as follows:
(a) Opt for collaboration such as joint venture with a local partner to gain local
acceptance for a foreign investorÊs presence, product and brand.
(b) Use local materials in production to support local industriesÊ products or

even market the local products.
(c) Hire local workers and managers.
(d) Build political support at home and in host countries through lobbying,
public relations and implementation of corporate social responsibility.
(e) Reduce exposure by utilising host country financing.
(f) Avoid high-visibility acquisitions or mergers especially of firms or assets

viewed as local icons.
(g) Constant monitoring of political development.
(h) Minimise outright investment, use leasing or collaborate projects with host
governments.
(i) Use risk management measures to insure and protect properties and
intellectual property.

4.6 MULTINATIONAL CORPORATION –

GOVERNMENT RELATIONSHIP
One of the main political challenges faced by MNCs is managing their
relationship with governments in host and home countries. The various roles of
governments in an economy include the following:
(a) Economic Role – through economic policies, for example, tax, monetary,
price controls and employment (this has been discussed in Topic 2).
(b) Legal Role – through laws and legislations, for example, environmental,
trade and investment policies (this will be discussed further in subtopic 4.7).
(c) Political Role – through government intervention in the business

environment. The degree of government intervention depends on two
ideology paradigms (refer to Figure 4.4).
There are two ideology paradigms namely individualistic and communitarian as

shown in the following Figure 4.4.
Figure 4.4: Ideology paradigms
Now let us look at the explanation in Table 4.3.
Table 4.3: Explanation of Individualistic and Communitarian Paradigm
Individualistic Paradigm Communitarian Paradigm

Based on the belief that the government The government has total power and gives
should not interfere in the economy or priority to its people. The government
should keep the intervention to a plays a larger role with centralised
minimum. Individuals have more bureaucracy. Japan is the best example of
flexibility and economic freedom. The how a communitarian paradigm can affect
government aims to lessen trade obstacles businesses. For example, an MNC that
and enhance knowledge of international operates in Japan may have to establish
business. partnerships or relationships with
government, suppliers, customers and
even business rivals.

MNCs have to establish good relationships with the government in the host
country. The main political objective of MNCs in a host country is to establish
favourable trade and investment conditions. MNCs seek from the host
government for:
(a) Foreign ownership rules to be relaxed.
(b) Easier entry and access to local markets.
(c) Removal of tariff and non-tariff barriers to locate, manufacture, sell

products and expand business to gain maximum profits.
(d) Government investment support such as investment grants and allowances.
ACTIVITY 4.4
If you were a manager in a multinational organisation, what type of

paradigm would you prefer to do your business with and why?
4.7 LEGAL ENVIRONMENT

The legal environment of a country is closely related to its political system. The
legal system forms part of the external environment dimension which influences
businesses. Managers must have knowledge of the legal system of a country in
which they operate as well as the institutional background of those who practise
the law, either at national or international level, and the legal relationships that
exist between countries.
4.8 TYPES OF LEGAL SYSTEMS

A legal system is different in terms of its institutional context. There are three
legal systems practised by countries as depicted in Figure 4.5.
Figure 4.5: Types of legal systems

4.8.1 Common Law

Common law is based on tradition, precedent and custom. The court plays an
important role in interpreting common law. For example, common law is
administered in the courts of the United Kingdom and the United States.
4.8.2 Civil Law

Civil law, known as codified law, is based on a detailed set of laws that are
written into code. Its origins can be traced back to Roman law and it is the most
common type of legal system practised in the world. Business law is part of civil
codes. More than 70 countries, including Germany, France and Japan, practise
civil law.
Common and civil laws differ. Common law is based on the courtÊs
interpretation of the case, while civil law is based on how the law is applied
based on information. An example of how it is practised in both systems is a
contract. For countries that practise common law, a contract sets out in detail the
terms that govern the contractual relationships between the parties whereas in a
civil law country, contracts are often shorter and have limited legal provisions.
4.8.3 Theocratic Law

Theocratic law is based on religious tenets and beliefs such as those practised in
Iran and the Vatican City. The most common example is Islamic law (Shariah)
which is based on the following:
(a) Al-Quran;
(b) Sunnah from the Prophet; and
(c) Writings of Muslim scholars based on the principles found in the Al-Quran
and Sunnah.
Considering that 25 percent of the worldÊs population is Muslim, it is important

to understand the Islamic law that governs economic transactions. One of the
major influences of Islamic law on international businesses can be found in
Islamic finance. For example, the Islamic Banking Act, 1983 ensures the Islamic
banking system in Malaysia is enforced under this law. Under this Act, banks are
not supposed to charge any interest or gain benefit from the interest. However,
banks must structure their fees in the form of loans to enable them to gain profit.

There is a strong relationship between the legal systems and MNCsÊ investment
operations. MNCs have to abide by the legal systems practised by host countries.
MNCs are concerned about legal jurisdiction or legal authority levels that govern
MNC operations. MNCs are subject to a multitude of laws under international
laws, regional laws and national laws of home and host countries and also third
countries.
ACTIVITY 4.5
Name three banks in Malaysia which implement Islamic banking.
4.9 LEGAL ISSUES IN INTERNATIONAL

BUSINESS
Laws and regulations that affect trade and business are important and relevant to
MNCs. Figure 4.6 provides some of the key legal issues that are of particular
interest to MNCs.
Figure 4.6: Legal influences on international business
These include:
(a) Product safety and consumer protection such as product liability laws;
(b) Competition laws such as antitrust laws; and
(c) Intellectual property laws such as patent laws.

Let us now have a look at the key legal issues in detail.
(a) Product liability issues are a major concern and challenge for MNCs.
Different legal systems provide different protection for consumers. One
example is the case of melamine milk contamination in China which
prompted the government to introduce product liability and recall laws.
Civil liability suits can be brought against manufacturers and sellers of
goods, enabling consumers to seek compensation and damages. China also
imposed criminal sanctions on the production and sale of fake, counterfeit
and defective products (CECC, 2009). Following that, the US Food and
Drug Administration Act issued health warnings on infant formula in
China to protect consumers.
(b) Competition laws such as legislations on antitrust and takeovers prevent

unfair competition in the market. Antitrust enforcement is stringent in the
United States, European Union (EU) and Japan. For example, EUÊs antitrust
investigation on Microsoft in 1998 and 2001 was settled when US courts
required Microsoft to make changes in its current business model in which:
(i) Customers must have a choice about what Windows components are
mandatory in any installation of the operating system; and
(ii) Microsoft must disclose certain information to allow third party

developers to create software that better interoperates with Windows
(Weiss, 2006).
(c) Intellectual property (IP) refers to creations of the mind: inventions, literary
and artistic works, and symbols, names, images, and designs used in
commerce. MNCs often face the problem of intellectual property theft and
increasing difficulty in protecting their IP in their FDI. Examples of IP laws
administered by the World Intellectual Property organisation (WIPO) are
Patent Law Treaty and Trademark Law Treaty. WIPO is specialised agency
of the United Nations aimed at developing a balanced and accessible IP
system, which rewards creativity, stimulates innovation and contributes to
economic development while safeguarding the public interest (http://
www.wipo.int/). For example, the top five pharmaceutical MNCs – Pfizer,
Bayer, Roche, Schering and Bristol Myers Squibb – have been accused of
violating patent laws with regard to top-selling patented anti-cancer and
hepatitis drugs sold in India (Mukherjee, 2011).
Legal issues are more complex in the context of international business than in
domestic business; hence, MNCs must study, adapt and leverage national and
international differences in product liability, competition, intellectual property
laws as well as labour, marketing and distribution laws.

SELF-CHECK 4.2
What are some national laws that MNCs must comply with in order to
make FDI in Malaysia?
EXERCISE 4.1
1. Political risks can happen because of _____________.
A. privatisation policy
B. inflation
C. war
D. export pricing downfall
E. opinions of political leaders
2. Macro political risk is _____________.
A. political action which affects foreign investorsÊ spectrum
B. political action which affects the country
C. political action which affects export of local firms
D. political action which affects collaboration between local and

foreign firms
E. government policy that does not encourage foreign investors

to invest in its country

3. An individualistic paradigm believes that a government should

_____________.
A. interfere with its economic system
B. not interfere with its economic system
C. attract the attention of foreign investors to invest in its

country
D. protect local firms from competing with international firms
E. protect local workers from being fired by foreign firms
4. Legal environment is closely related to the_____________ system

of a country.
A. political
B. social
C. economic
D. industrial
E. cultural
5. The main legal challenge facing global companies is dealing with

the issue of _____________.
A. product liability
B. marketing and promotion
C. technology
D. employee recruitment
E. local resources

 The political ideologies of host governments can impact foreign investments

in many ways.
 The three views of political ideologies which affect government policies

towards foreign investments are radical, free market and pragmatic
nationalism.
 Political risk is the possibility of disruption to MNC operations caused by

political events or changes in political environment.
 The three types of political risks are operational, ownership and transfer
risks.
 Managers from multinational companies should have knowledge of the

various legal systems that exist in foreign countries.
 In executing international business, it is important to know the legal system

of a country because it affects taxation, ownership, tariff and issues related to
national laws.
 Some of the legal issues facing foreign companies are product liability,
competition and intellectual property laws.
Civil law Micro political risks

Common law Political environment
Consumer safety protection Political ideology
Free market view Political risks
Intellectual property Pragmatic nationalism
Legal environment Radical view
Macro political risks Theocratic law

Topic  Regional
5 Economic
Integration
LEARNING OUTCOMES
1. State five types of regional economic integration;
2. Discuss the importance of regional economic integration in
international business and trade;
3. Evaluate the political and economic reasons for the formation of
regional economic integration;
4. Discuss the advantages and disadvantages of economic
integration; and
5. Discuss regional economic integration that has been formed.
 INTRODUCTION
In Topic 2, we discussed the importance of free trade, investment and capital to
the worldÊs economy. There are fewer obstacles to trade and investment today
than before, however, one of the main developments in the international market
is the increasing economic integration of countries.
Regional economic integration (REI) has greatly altered global economic patterns
and influenced trade activities.
Regional economic integration is an agreement between two or more countries

towards establishing economic cooperation and coordination among them.
The main concern of REI is the removal of tariff and non-tariff barriers.

TOPIC 5 REGIONAL ECONOMIC INTEGRATION  81
REI has become important as it helps to foster good interrelationships between

countries worldwide. REI has also been responsible for helping to drive many
countries and the world towards globalisation. According to Shenkar and Luo
(2004), globalisation is the cross-border transaction of goods, services, capital and
labour. This has led to increasing economic interdependence among countries. In
turn, the markets have gained from faster diffusion of technology and
information. Hence, international managers of MNCs must not only understand
the influence and benefits of such integration for their global operations but
respond strategically.
5.1 FORMS OF REGIONAL ECONOMIC

INTEGRATION
Regional economic integration can be categorised into six levels. These levels differ
according to the degree of economic integration. The integration level follows from
the lowest to the highest level: preferential trade agreement (PTA), free trade area,
customs union, common market, economic union and political union. Let us have
at look at Figure 5.1.
5.1.1 Preferential Trade Agreement (PTA)

In preferential trade agreement, affiliated members receive reduced tariffs on
certain products. In PTA, usually the trade pact made between WTO countries is
subject to Most Favoured Nation (MFN) principle. In this principle, neither
favouritism nor prejudice treatment is allowed to be applied on certain countries.
At PTA level, it is characterised by a unilateral relationship where tariff reduction
is given in one direction (Hashim & Jedin, 2007).
Figure 5.1: Stages of regional economic integration
Now let us discuss the integration level one by one.

82  TOPIC 5 REGIONAL ECONOMIC INTEGRATION
5.1.2 Free Trade Area

In a free trade area, all tariff barriers on products and services between member
countries are abolished. In theory, under free trade conditions, tariff
discrimination, quota, subsidies or other non-tariff barriers to trade between
countries are not allowed. However, each member is allowed to determine its
own trade and tariff policy with non-member countries.
An example of a free trade area is the European Free Trade Association (EFTA).
EFTA was established in 1960 by West European countries which were not in the
European Community. The main objective of EFTA is to ensure free trade and
market access among its members. Agricultural products, however, are not
included in the agreement and each member is allowed to determine its own
tariff when trading with countries which are not EFTA members. Other examples
of free trade areas are North America Free Trade Area (NAFTA) and ASEAN
Free Trade Area (AFTA). These will be discussed in the last section of this topic.
ACTIVITY 5.1
Use a search engine like http://www.google.com and type the

keywords EFTA, NAFTA and AFTA. Get additional information on
these unions and discuss with your coursemate in myVLE.
5.1.3 Customs Union

A customs union involves a higher stage of integration compared to that of a free
trade area. A customs union abolishes trade barriers between members and each
country must use a common external trade policy. The formation of a common
external trade policy needs a form of administrative machine that is able to
monitor the trade relationship between member and non-member countries. An
example of a customs union is South African Customs Union (SACU).

5.1.4 Common Market

A common market is formed by groups of countries within the same
geographical area to take advantage of tariff-free trade among member countries.
It also imposes a common external trade policy with non-member countries.
However, common market allows free movement of production factors between
countries. Production factors such as labour and capital are free to move among
its member countries. MERCOSUR is an example of a common market.
5.1.5 Economic Union

Economic union involves a higher level of integration than a common market.
An economic union shares the common features of a common market and each
member country adheres to common economic, social and fiscal as well as
monetary policies such as the use of a single currency, harmonisation in taxation
and a common central bank. Due to its complexity, an economic union is difficult
to achieve because it needs a standardised body or bureaucracy. An example of
economic union is the European Union.
ACTIVITY 5.2
Describe briefly the success stories of the European Union as an

economic and monetary union.
5.1.6 Political Union

Political union is the last stage in the multinational integration process. Political
union is a full integration of politics and economy between member countries. A
full political union involves common home and judicial policies and a common
foreign and security policy (europedia).
In sum, one form of economic integration may shift from one level to a higher
level over time provided the participating member countries agree. For example,
the European Union started out as a common market (Single European Market)
and evolved into an economic union and now can be regarded as a partial
political union.

We have discussed the five stages of regional economic integration. Table 5.1
shows the basic features of the different stages of regional economic integration.
Table 5.1: Different Stages of Regional Economic Integration

Stages of Economic Integration Basic Features
Free Trade Area(FTA) Zero tariffs and reduced non-tariff barriers among
member countries
Customs Union (CU) FTA + common external tariff
Common Market (CM) CU + free movement of capital, labour
Economic Union (EU) CM + common economic, social, fiscal, monetary
and institutions
Political Union Political cooperation among member countries
with common home and judicial policies and a
common foreign and security policy
Source: Holden (2003)
EXERCISE 5.1
1. Explain the meaning of regional economic integration.
2. List the stages of regional economic integration.
5.2 REASONS FOR THE FORMATION OF

REGIONAL ECONOMIC INTEGRATION
The reasons for the formation of economic integration can be divided into
economic and political reasons. However, there are certain groups who disagree
with such formation and it shows that not all regional economic integration can
achieve success. In the next section, we will discuss the supporting reasons for
and against such formation.
5.2.1 Economic Reasons

The main economic reason for the formation of regional economic integration is
to increase economic cooperation and free trade agreements to the benefit of
member countries. With reduction and removal of tariff and non-tariff barriers,
this will lead to the increase of intra-regional trade among member countries.
It allows free flow of products, people or capital among member countries.
Generally, economic theory suggests that trade and investment which are free
from obstacles are beneficial to all countries. This condition can be achieved by
forming economic integration areas. Free trade leads a country to specialise in the
production of a product or service which will be produced more efficiently.
Based on the law of comparative advantage, economic efficiency is enhanced.
The result is an increase in regional output and gain in regional welfare.
Another economic reason for economic integration is to gain access to larger

markets. With larger markets, production is increased and this allow firms to
reap economies of scale and reduce production costs. Increased output is the
result of growth in intra-regional trade among members. The benefits to
consumers and producers of member countries are access to a wider choice of
goods and services and lower domestic prices.
The member countries not only gain increased market power but also increased
collective bargaining power with non-member countries. They are more
successful in getting better terms of trade for their exports and imports with non-
member countries.
You may visit the World Trade Organisation website at http://www.wto.org for
additional information.
5.2.2 Political Reasons

The formation of regional economic integration is encouraged by political
pressures. Economic relationships and cooperation between neighbouring
countries through regional economic integration will encourage easier political
cooperation. Conflicts will also be reduced too.
5.3 OBSTACLES IN THE FORMATION OF

REGIONAL ECONOMIC INTEGRATION
Although there are strong reasons for such a formation, it has failed to obtain full
agreement from all parties. Two arguments against such a formation are as
follows:
(a) Regional economic integration may make it restricted for national

governments to develop and implement policies based on their internal
needs. Member countries are bound by rules of origin in trade agreements
and adherence to common monetary and fiscal policies. Economists argue
such loss of flexibility in national policies may bring about richer member

nations having to finance poorer member nations. For example, the 2010–
2011 EuropeÊs financial debt crisis in Greece, Ireland, Portugal and Spain
could have negative domino effects on the European Union. It remains to
be seen how the EU will tackle this debt crisis.
(b) Economists argue that governments fear the loss of decision-making power
and sovereignty. Such fear is caused by close economic cooperation among
member countries and governments lose control and decision making in
some policies. For example, in the UK, some sovereign power is transferred
from London to Brussels as headquarters of the EU.
It should be noted, however, that the economic benefits of economic integration

are not equally distributed among member countries nor are all economic gains
guaranteed. The impact of the integration on member countries differs
depending on the different levels of economic development and economic
growth experienced.
ACTIVITY 5.3
What are the disadvantages of regional economic integration?
5.4 EFFECTS OF REGIONAL ECONOMIC

INTEGRATION ON FIRMS
Regional economic integration brings two main effects on firmsÊ operations.
Removal of tariff walls causes the markets to be opened to free trade to all
member countries. Firms will be able to reduce their production and distribution
cost through the economies of scale gained from the larger production base as a
result of such economic integration. The low cost of production will enable firms
to compete more competitively.
On the other hand, removal of tariffs protection will expose firms to competition
from other member countries. This results in negative effects on local firms
which are less cost efficient. Economic integration areas are also the preferred
location of investments from advanced countries. These firms invest in such
areas in order to gain entry and market share into the region.

The formation of regional economic integration also causes controversy because

of the instability of effects on the global economy. Formation of a unified trading
bloc enhances productive efficiency if it causes the transfer of production from a
high cost producer to a low cost producer in the regional trading bloc. Such a
phenomenon is known as trade creation. However, if a trading bloc causes a
production transfer from low cost to higher cost producer, efficiency will
decrease. This situation is known as trade diversion and has negative effects on
member countries and the regional economy as a whole.
In brief,
Production from high cost producer Low cost producer

= Trade Creation
Production from high cost producer Low cost producer

= Trade Diversion
Assume that before the formation of the European Union, an apple from France
cost $1.00 per kilogramme. Price per kilogramme for the apple in Germany is
$1.20. If, for instance, Germany uses an import tariff of $0.25 per kilogramme on
apples imported from France, those apples from France will be expensive and
could not compete in the Germany market ($1.00 + $0.25 = $1.25 per
kilogramme). When the European Union is formed, this import tariff will be
abolished. „Trade creation‰ will happen because the apple production will move
from a high cost producer (Germany) to a low cost producer (France) within the
European Union territory. However, if Chile can produce apples with a lower
price ($0.85 per kilogramme) compared to France and Germany, then „trade
diversion‰ will happen. Since Chile is not a member of the European Union,
apples from Chile will be imposed import tax by Germany resulting in apples
from Chile to be expensive ($0.85 + $0.25 = $1.10).
Tariff abolition on apples from France will make it cheaper compared to the
apples from Chile. This shows a trade diversion from a low cost producer (apple
farmer from Chile) out of the European Union to a high cost producer (apple
farmer from France) in the European Union. In sum, trade diversion occurs when
cheaper imports of member countries from lower cost countries outside the
formation are replaced by less efficient and higher cost member countries. While
trade creation contributes positively to welfare in the home country, trade
diversion results in a welfare loss (Tangermann, 2002).

EXERCISE 5.2
1. List the reasons that support the formation of regional economic
integration.
2. Explain the following effects of regional economic integration:
(a) Trade creation; and
(b) Trade diversion.
You may visit the Institute for International Economics website at

http://www.iie.com for additional information.
5.5 ECONOMIC INTEGRATION IN EUROPE

In this section, we will discuss the initiatives and success of economic integration
in Europe.
5.5.1 European Union

Brief History of European Union
The early history of the European Union started with the formation of the
European Coal and Steel Community (ECSC) in 1951. ECSC consists of France,
Germany, Italy, Belgium, Holland and Luxembourg. The purpose of ECSC is to
abolish tariff and non-tariff barriers on trading of coal, mines and steel among the
member countries. The effort in forming a bigger economic community achieved
success when ECSC members signed the Treaty of Rome in 1957. From the
agreement, the European Economic Community (EEC) and Atomic Energy
Committee (Euratom) were formed. These three entities combined were known
as the European Community. This community fulfilled two main goals, which
are to:
(a) Form a basis for a tighter union among European economies; and
(b) Form a common market among the members through abolishment of trade
obstacles.
The European Community provides a bureaucracy framework and institutions

which have the role of supervising the formation of a common market and
economic union.

ACTIVITY 5.4
1. Use the Internet to get additional information on ECSC, EEC and

Euratom by typing the terminologies as the keywords.
2. Use the Financial Times website (www.ft.com) to get the latest

articles on the discussion whether the British government should
use the euro currency to replace the pound. Then, answer the
following questions:
(a) From the British perspective, what are the strengths and
weaknesses of the euro?
(b) What are the actions taken to be considered by the British

government on the euro?
(c) What can you predict will happen in the future?
You can discuss the questions above with your friends on myVLE.
European Community, Internal Market and Creation of European Union

In 1987, all countries of the European Community agreed to adhere to the Single
European Act. This Act is important because it led to the formation of a single
common market. The Single European Act was formed based on dissatisfaction
among members of the European Community. In 1985, as a result of pressures
and efforts of the members of the European Community, member countries
agreed to abolish all obstacles of single markets and form a single common
market on 31 December 1992.
In 1993, the Maastricht Treaty or Treaty of European Union established the

European Union (EU). There are 27 member states that form the EU. The treaty
promotes economic cooperation and trade expansion within a common market.
In addition, it embraces the formation of a monetary union called European
Monetary Union (EMU). A common European currency called the Euro or
European Currency Unit (ECU) was created in 1999. The EMU and ECU, shared
by 15 European countries, remain the key success features of the EU.
Political Structure in European Union

The economic policy of the European Union was formed and implemented
through a complex political process. The five important institutions are the
Council of the European Union, Council of Ministers, European Commission,
European Parliament and European Court of Justice.

(a) Council of European Union

The council consists of governments from the European Union and
president of the European Commission. The council holds meetings twice a
year to determine the direction of the union policy and solve arising issues.
(b) European Commission

The commission as the executive body is responsible for suggesting,
implementing and monitoring the law. The headquarters is in Brussels,
Belgium, and consists of more than 10,000 workers. It is administered by a
group of 20 authorities appointed by the members of the union.
(c) Council of Ministers

The rights and importance of each member will be defended in the Council
of Ministers. It is an authoritative body of great importance to the European
Union. The members of the Council of Ministers consist of a government
representative of each member country.
(d) European Parliament

The parliament consists of 630 members elected by the people of the
European Union member states. The period of service is five years. Each
member will debate and make the necessary legislation before approving
the bill suggested by the European Commission.
(e) Court of Justice

Court of Justice is the highest court in the European Union and consists of
a judge from each country. Just like the commissioner in the European
Commission, these judges are officers who are free and carry no functions
as representatives from any country.
ACTIVITY 5.5
Explain the difference between a free trade area and an economic union.
What are the key success factors to the EU as an integration model?
5.6 ECONOMIC INTEGRATION IN THE

AMERICAN CONTINENT
The American continent is another region where effort towards the economic
integration formation happens rapidly. Among the important integration success
is the formation of the North American Free Trade Agreement (NAFTA).

5.6.1 North American Free Trade Agreement

(NAFTA)
The effort in the formation of a free trade area in North America was inspired by
George Bush, the former president of the United States (US). The effort was
carried on by Bill Clinton and only became a reality when NAFTA was formed.
This agreement was signed by the US, Mexico and Canada in 1992. Basically, it
was an agreement of trade and investment which stresses on removal of trade
obstacles to free flow of goods and services. This agreement was established on 1
January 1994.
Among others, the agreement consists of reduction of tariffs and non-tariffs

barriers, free movement of professional members, finance and foreign direct
investment as well as consumer safety. NAFTA also comprises of other issues
such as labour and environment protection. Among the main objectives of
NAFTA are:
(a) Abolish 99 percent of tariff on trading between the US, Canada and Mexico
in 10 years.
(b) Abolishment of a big part of obstacles on free trade and services in 2000.
(c) Intellectual property ownership protection.
(d) Abolishment of a big part of obstacles on international investment between

the three countries although benefits are given to the industry in the energy
and rail sector in Mexico, and aviation industry and audio in the US and
Canada.
In short, NAFTA is an effort to move the economy of North America towards a

bigger market. Firms which are operating in the member countries can execute
their business across borders without high trade obstacles. However, some of the
contending issues in NAFTA are the potential loss of jobs and industries in both
the US and Mexico, economic and political stability in Mexico and protecting and
stimulating US investment.
ACTIVITY 5.6
Find additional information on http://www.naftanow.org/ and

discuss with your coursemates the success of NAFTA as one of the
worldÊs largest free trade areas.

5.6.2 Andean Pact

The Andean Pact, one of the oldest free trade movements, was formed in 1969
through the Cartagena Agreement between Bolivia, Chile, Ecuador, Colombia
and Peru. Subsequently, Venezuela joined the pact on 1973 and Chile withdrew
from the pact in 1976. In 2006, Venezuela withdrew as a member of the pact. The
Andean Pact was based on the formation of the European Union but failed to
achieve its goals.
During the mid-1980s, the Andean Pact remained a failure. However, things
began to change by the end of the 1980s when the American Latin government
began to accept an open market policy. In 1990, leaders of the five countries had a
meeting and formed the Galapagos Declaration. The Andean Pact countries
agreed to proceed with the Andean Pact initiatives to form free trade areas in
stages by 1992, a customs union by 1994 and a common market by 1995.
Today, the Andean Community integration has strengthened and extended from
purely economic and commercial matters to a wide variety of sectors, such as
social cohesion, job creation, fight against drugs and protection of the
environment (EEAS, n.d.).
5.6.3 Mercosur
In March 1991, Brazil, Paraguay, Argentina and Uruguay signed an agreement
known as the Mercusor Accord. This agreement was aimed at forming a common
market among the four countries with free movement of goods, services, capital
and labour. The common market was fully implemented in 1995 with a common
tariff structure and common external tariff rates. In 2006, Venezuela was accepted
and is in the process of being integrated as a member. In 2009, EU-Mercosur
trade represented nearly as much as EU trade with the rest of Latin America
taken together. In 2008, the EU was Mercosur's first largest trading partner
(EEAS, n.d.).
5.6.4 Central American Common Market and

Caribbean Community and Common Market
The Central American Common Market (CACM), which started out in the 1960s,
reactivated its objectives and was established as a customs union in 1993. The
Caribbean Community and Common Market (CARICOM) was started by
countries in the Caribbean region in 1973 with the objective of achieving
efficiency in regional production of services and obtaining investment and

financial resources in a regional development bank. Both areas are still in

progress and great effort is being made to ensure its success. Efforts in enhancing
trade activities often face difficulties due to a lack of commitment from the
members and low economic status of the members.
ACTIVITY 5.7
What are the common challenges faced by economic integration across

many regions?
5.7 ECONOMIC INTEGRATION IN THE ASIA

PACIFIC REGION
Initiatives are being made towards making the Asia Pacific region a formal
integrated area. Two established political and economic arrangements in the
region are ASEAN and APEC.
5.7.1 Association of South East Asian Nations

(ASEAN)
ASEAN was formed in August 1967 to encourage political and economic
cooperation in the region. The countries involved were Brunei, Indonesia,
Malaysia, Philippines, Singapore and Thailand. Vietnam was accepted as a
member in 1995 and Myanmar in 1997. The South East Asian economy has
grown rapidly due to supply of cheap labour and attractive investment
incentives. Most products are given special priority under the Generalised
System of Preferences scheme.
In order to encourage trading, ASEAN formed AFTA on 1 January 1993. With

such initiatives, members of AFTA aimed to reduce tariff rates to 0%-5% on
manufactured products by 2005 and on all products by 2010. They aim to create a
customs union by 2020. With AFTA, the growth of trading activities can be
quickened and thus increase economic strength in ASEAN. Recent developments
in economic cooperation in ASEAN such as ASEAN +1 and ASEAN +3 have
advanced to include China, Japan, India, New Zealand, Australia and South
Korea.

More recent development saw the formation of the China-Asean Free Trade Area
(ACFTA) in 2010. ACFTA is expected to create an economic region with
1.7 billion consumers, a regional Gross Domestic Product (GDP) of about US$2
trillion and total trade estimated at US$1.23 trillion. This makes it the biggest
FTA in the world in terms of population size (Cordenillo, 2005).
ACTIVITY 5.8
Search the Internet on China-Asean Free Trade Area (ACFTA). What

are the economic benefits of the ACFTA to ASEAN?
5.7.2 Asia Pacific Economic Cooperation (APEC)

Do you know what is APEC? It stands for Asia Pacific Economic Cooperation
and was formed in 1989. Currently, APEC has 21 member countries including the
US, Japan and China. The economies of these countries account for 57 percent of
the worldÊs gross domestic product (GDP) and nearly half of the worldÊs trade
volume and population (APEC, 2013). APECÊs objectives rest on two main pillars,
which are:
(a) Liberalisation and facilitation of trade and investment; and
(b) Development cooperation.
EXERCISE 5.3
1. Agreement between countries in the same geographical area in
order to lessen tariff and non-tariff barriers on trade flow, services
and production factor is known as:
A. regional economic integration
B. cross-cultural economy
C. geography and trade integration
D. less tariff and non-tariff integration

2. The following countries are members of the North American Free

Trade Agreement:
A. Panama, Mexico and the United States
B. Mexico, the United States and Canada
C. Panama, Honduras and El Salvador
D. The United States, Jamaica and Canada
3. In a free trade area, _____________.
A. trade obstacles between member countries are abolished
B. a single currency is used
C. a common trade policy is used
D. a single parliament determines political and external policies
4. European Union is now at this stage of integration:
A. free trade area
B. custom union
C. common market
D. economic union
5. _____________ is formed when production shifts from a high cost

producer to a low cost producer within the free trade area.
A. Trade diversion
B. Trade creation
C. Trade modification
D. Trade separation

 Economic integration involves trade agreement between countries to allow

free trade movement, services and production factor across borders.
 The strengths or weaknesses of economic cooperation depend on the stage of

economic integration. Among the benefits gained from economic integration
include trade creation, economies of scale and reduction of trade barriers.
 Economic integration also has disadvantages such as trade diversion, loss of

sovereignty and flexibility over control of economy and policies.
Andean Pact Economic union

Asia Pacific Economic Cooperation Free trade area
(APEC)
North American Free Trade Agreement
Association of South East Asian Nation (NAFTA)
(ASEAN)
Regional economic integration
Common market
Trade creation
Customs union
Trade diversion
European Union

Topic  International
6 Trade Theories
LEARNING OUTCOMES
1. Identify six main theories of international trade;
2. Explain the benefits of free trade;
3. Apply the various international trade theories to explain world
trade patterns;
4. Differentiate between four foreign direct investment (FDI) theories.
 INTRODUCTION
Welcome to a new topic titled International Trade Theories. In this topic, we will
discuss various international trade theories which have existed since the 19th
century. These theories include Mercantilism Theory, Absolute Advantage
Theory, Comparative Advantage Theory, Heckscher-Ohlin Theory, International
Product Life-Cycle Theory and Competitive Advantage Nations Theory. Then,
the challenges and application of these theories are discussed.
We will also look at free trade briefly to determine its relationship with
international trade theories.
Lastly, we will look at firm-specific advantage, location-specific advantage,

internationalisation advantage and DunningÊs Eclectic Model. Let us get started!

98  TOPIC 6 INTERNATIONAL TRADE THEORIES
6.1 INTERNATIONAL TRADE THEORIES

We will begin this topic with the Mercantilism Theory. Mercantilism, founded in
the 16th century and widely used in the 17th century, suggests that each country
should increase its exports and decrease imports at the same time. Even though
many people think that the mercantilism doctrine is outdated and is not
applicable for trade today, it is still popular and used in some countries. Next, we
will go through the theory founded by Adam Smith, which is the Absolute
Advantage Theory. Introduced in 1776, the theory first explains how free trade
can benefit countries. Can you define free trade?
Free trade means there is no government intervention in international trade,

whether through tariffs or non-tariffs that will affect trade flow.
In other words, free trade is hindered when governments impose trade barriers
through tariff, quota, subsidy and other commercial trade instruments, and this
will cause free trade to be restricted. Smith said a governmentÊs trade should not
affect the world commerce trend but it should be determined by market control.
We will also look at other theories such as the Comparative Advantage Theory
by David Ricardo, Heckscher-Ohlin Theory, International Product Life-Cycle
Theory and other international investment theories.
In this section, we will discuss thoroughly each of the International Trade

Theories as simplified in Figure 6.1.

TOPIC 6 INTERNATIONAL TRADE THEORIES  99
Figure 6.1: International trade theories
6.2 COUNTRY-BASED THEORIES

Country-based theories are classic theories that were evolved in the 16th century.
They were economic driven theories.
6.2.1 Mercantilism
Mercantilism was the first international commerce theory formulated in England
in the middle of the 16th century. At that time, silver and gold were the source
of wealth for each country and played a major role in international trade
transactions. They were the main currencies used in trading and businesses
among the countries. A country would receive inflow of gold and silver by
exporting their products to other countries, while outflow of gold and silver was

through purchase of imported products. The main concept of mercantilism was

that a country would incur trade surplus in the balance of payment account
because the trade surplus would result in inflow of gold and silver, and the
country would gain wealth and prestige.
To gain wealth, the government would be involved in trade to get trade surplus
in the balance of payment account. For this reason, mercantilism theorists
suggest that the application of trade is aimed at maximising export trade
activities and minimising import activities. The import activities could be
decreased by trade restrictions such as tariff and quota, while export activities are
encouraged through subsidies given to the domestic companies. Subsidies would
make the products of the domestic companies more competitive in the foreign
market and hence, increase their export activities. The use of import duty or tax
would make the imported products more expensive and less competitive in the
local market. The high price of the imported products would then lead to a fall in
the demand for imports, resulting in the low volume of imported products.
In 1752, David Hume (Figure 6.2), a classical economist, said that the
mercantilism doctrine was not consistent in explaining the real situation of a
countryÊs balance of payment. For example, if England had trade surplus with
France, this meant the products exported were more than the imported products
and the inflow of gold and silver into England would result in an increase of
money supply in the market. This in turn would cause inflation in England.
Then, France would have insufficient gold and silver because of their import
activities and the price of the products in France would decrease. The price of
exports of England would increase and it becomes less competitive. France
would not import any products from England. In contrast, England would
import products from France because of the low price. As a result, the trade
balance in England would decrease while in France, it would increase. In the
long run, none of the countries would gain from the trade surplus.
Figure 6.2: David Hume

Source: http://www.iep.utm.edu/wp-content/media/hume.jpg

However, there are weaknesses in this theory. The main weakness of the
mercantilism view is that trade benefits the country which has trade surplus in
the balance of payment account. The exporter will gain more profit while the
importer will incur losses. The zero sum game situations occur with trade when
one country gains while the other loses.
On the other hand, other trade theories by Adam Smith and David Ricardo have
proven that trade is beneficial and both countries can benefit from exchange of
goods.
SELF-CHECK 6.1
State the main shortcoming of Mercantilism.
6.2.2 Absolute Advantage Theory

The theory of absolute advantage was founded by Adam Smith (Figure 6.3), a
Scottish economist, in his book entitled „An Inquiry into the Nature and Causes
of Wealth of Nations‰ (1776). Smith disagreed with the nature of mercantilism
trade and proved that it would have a bad impact on the economy and the
nation.
Figure 6.3: Adam Smith

Source: http://upload.wikimedia.org

SmithÊs theory was based on the view that each country aims to maximise the
wealth of the people. The mercantilism doctrine is inefficient as it reduces the
wealth of the country as a whole. It is most likely that only certain groups of
people will benefit from it. From SmithÊs observation, mercantilism will prevent
individuals from engaging in free trade. The nation will experience wastage of
resources due to inefficient production.
Smith then suggested that free trade will benefit countries. Free trade would
determine the level of products or services that should be imported or exported
by a country. He propounded the absolute advantage theory. This theory states
that a country should export the products that it is able to produce efficiently
(absolute advantage) and import the products from other countries in which they
can produce more efficiently in their own country. In other words, the country
should specialise in producing products productively and efficiently before
exporting them to other countries. On the other hand, that country would import
products that they cannot produce productively and efficiently. By specialising
and trading, the countries will increase total world output.
Let us look at an example for absolute advantage – trade transaction between

Malaysia and Ghana (Refer to Table 6.1). The production of each product
requires resources. Assume that Malaysia and Ghana have 200 units of resources
each and these resources are used to produce either rice or cocoa. Ghana needs 10
units of resources to produce one tonne of cocoa and another 20 units of
resources to produce one tonne of rice. Therefore, Ghana can produce 20 tonnes
of cocoa without producing rice or 10 tonnes of rice without producing cocoa or
any combination between rice and cocoa depending on the resource combination.
Malaysia needs 40 units of resources to produce one tonne of cocoa and 10 units
of resources to produce one tonne of rice. Thus, Malaysia can produce five tonnes
of cocoa without producing rice, 20 tonnes of rice without producing cocoa or
any combination between cocoa and rice. This example clearly shows that Ghana
has absolute advantage in producing cocoa while Malaysia has absolute
advantage in producing rice.

Table 6.1: Absolute Advantage and Gains from Trade
Resource Needed to Produce One Tonne of Rice and One Tonne

of Cocoa
Ghana Cocoa Rice
Malaysia 10 20
40 10
Production Before Trade

Cocoa Rice
Ghana 10.0 5.0
Malaysia 2.5 10.0
Total Output 12.5 15.0
Production with Specialisation
Cocoa Rice
Ghana 20.0 0.0
Malaysia 0.0 20.0
Total Output 20.0 20.0
Consumption After Six Tonnes of Cocoa with Six Tonnes of Rice
Traded
Cocoa Rice
Ghana 14.0 6.0
Malaysia 6.0 14.0
Gains from Specialisation and Trade
Cocoa Rice
Ghana 4.0 1.0
Malaysia 3.5 4.0
If both countries do not trade with each other, each country is assumed to use
half of its resources to produce cocoa and another half to produce rice. Each
country is expected to use all products that have been produced. In this situation,
Ghana will produce 10 tonnes of cocoa and five tonnes of rice, while Malaysia
will produce 10 tonnes of rice and 2.5 tonnes of cocoa. Without trade, the total
amount of cocoa produced by both countries is 12.5 tonnes and 15 tonnes of rice.
If both countries choose to specialise production in accordance to the absolute
advantage theory and trade, this scenario will change. Through specialisation,
Ghana will produce 20 tonnes of cocoa and Malaysia will produce 20 tonnes of
rice. By specialising, the total output for both countries will be 20 tonnes,
increasing from 12.5 tonnes without specialisation. The production of rice will
increase from 15 tonnes to 20 tonnes. Basically, with specialisation in production
based on natural advantage and trade between the two countries, both countries
will gain from an increase of output by 7.5 tonnes of cocoa and five tonnes of rice.

Both countries benefited from the trading. Assume that both countries agree to
trade on the range of 1:1 (one tonne of rice with one tonne of cocoa). If Ghana
exports six tonnes of cocoa to Malaysia and imports six tonnes of rice from
Malaysia, the amount of cocoa in Ghana will be 14 tonnes while the rice will
increase to six tonnes. Therefore, the total amount of cocoa will be four tonnes
more than the production if Ghana does not practise specialisation. Malaysia will
have 14 tonnes of rice and six tonnes of cocoa. As a result of specialisation and
trading, output will increase and both countries will benefit from a larger output.
In a nutshell, a positive sum game is achieved that will benefit and profit both
countries.
SELF-CHECK 6.2
1. What are the limitations of the Absolute Advantage Theory?
2. Explain the meaning of free trade.
3. How will the Absolute Advantage Theory help increase trade and
world output?
6.2.3 Comparative Advantage Theory

We have discussed Absolute Advance Theory in the last section. Can you spot
the disadvantages of this theory? Well, the main disadvantage of the absolute
advantage theory is that it fails to explain the situation when a country has
absolute advantage in producing all products. If this happens, trade cannot take
place and world output will be stagnant. Then came David Ricardo (Figure 6.4), a
British economist, who introduced the theory of comparative advantage in the
early 19th century.
Figure 6.4: David Ricardo

Source: http://en.wikipedia.org

The theory states that a country will produce and export products or services that
it can produce more efficiently relative to other countries. Both countries would
gain even if one country were more efficient in producing all goods. The
difference between the two theories lies in the concept that the Absolute
Advantage Theory is based on absolute productivity difference while the
Comparative Advantage Theory focuses on the relative productivity difference
between countries. This distinction occurs because Comparative Advantage
Theory uses the opportunity cost concept to identify which products a country
should specialise in.
Again, using the example of Ghana and Malaysia, assume that Ghana has
absolute advantage in producing both products, cocoa and rice, and needs
10 resources to produce one tonne of cocoa and 13.3 resources to produce one
tonne of rice. With 200 resources, Ghana can produce 20 tonnes cocoa without
producing any rice and 15 tonnes rice without producing cocoa or any
combination between the two products according to resource distribution.
Malaysia needs 40 resources to produce one tonne of cocoa and 20 resources to
produce one tonne of rice. Malaysia can produce five tonnes of cocoa without
producing rice, 10 tonnes of rice without producing cocoa or any combination
according to resource distribution. Without trade, each country will use half of its
resources to produce rice and another half to produce cocoa. As a result, Ghana
will produce 10 tonnes of cocoa and 7.5 tonnes of rice, while Malaysia will
produce 2.5 tonnes of cocoa and 5 tonnes of rice (refer to Table 6.2).
Based on the absolute advantage theory, Ghana does not have to trade with
Malaysia. In contrast, the Comparative Advantage Theory shows that that even if
Ghana has absolute advantage in producing both products, it has comparative or
relative advantage in producing cocoa only. Ghana can produce four times more
cocoa than Malaysia but only 1.5 times more rice compared to Malaysia. In
relative terms, Ghana is more efficient in producing cocoa compared to rice.
Without trade, the total amount of cocoa produced by both countries is
12.5 tonnes and the total amount of rice is 12.5 tonnes. The countries are assumed
to use both products they produce. If they trade, both countries will increase the
production of both products and consumers will have more of the products.

Table 6.2: Comparative Advantage and Gains from Trade
Resource Needed to Produce One Tonne of Rice and One Tonne

of Cocoa
Cocoa Rice
Ghana
10 13.3
Malaysia
40 20
Production Before Trade
Ghana Cocoa Rice
Malaysia 10.0 7.5
Total of Production 2.5 5.0
12.5 12.5
Production with Specialisation
Ghana Cocoa Rice
Malaysia 15.0 3.75
Total of Production 0.0 10.0
15.0 13.75
Consumption After Six Tonnes of Cocoa with Six Tonnes of Rice
Traded
Ghana Cocoa Rice
Malaysia 11.0 7.75
4.0 6.0
Gains from Specialisation and Trade
Cocoa Rice
Ghana 1.0 0.25
Malaysia 1.5 1.0
Assume that Ghana exploits comparative advantage through specialisation. Then

the production of cocoa will increase from 10 tonnes to 15 tonnes if it uses
150 resources and the other 50 resources will be used in producing rice
(3.75 tonnes of rice). Subsequently, Malaysia will specialise in producing rice
using all 200 resources (10 tonnes of rice). The total world production of cocoa
will be 15 tonnes and the production of rice will be 13.75 tonnes. Specialisation
has increased production for 2.5 tonnes cocoa and 1.25 tonnes rice.
Comparative Advantage Theory shows that the world production potential will
increase if there is no trade barrier. RicardoÊs theory suggests that consumers in
all countries will gain from more output if there is no trade barrier. This takes
place even if a country does not have absolute advantage in any production. The
Comparative Advantage Theory asserts that trade is a positive sum game in
which all countries will benefit from free trade. Therefore, this theory sets a
strong basis towards promoting policies for freer trade.

SELF-CHECK 6.3
What is the difference between Comparative Advantage Theory and
Absolute Advantage Theory?
6.2.4 Heckscher-Ohlin Theory

Now, we are going to look at Heckscher-Ohlin Theory. Before we proceed, let us
recall the last two theories. The Absolute Advantage and Comparative
Advantage Theories focus on the natural advantages of production and trade at
different levels of productivity. One example is to determine whether Japan is
efficient in producing bulbs or shoes. Well, the answer depends on how
productive Japan is in the use of its resources.
Two Swedish economists, Eli Heckscher (in 1919) and Bertil Ohlin (in 1933)
explained different perspectives in a countryÊs comparative advantage. You can
see their pictures in Figure 6.5 and Figure 6.6.
Figure 6.5: Eli Hechscher

Source: http://upload.wikimedia.org
Figure 6.6: Bertil Ohlin

Source: http://www.nobel-winners.com
Comparative advantage is the result of different endowments in production

factors of a country. Heckscher and Ohlin defined factor endowments as natural
resources such as land, labour and capital. Each country has different natural
resources and these differences affect production cost. More abundant factors

will reduce input cost. The Heckscher-Ohlin Theory suggests that a country with
relatively abundant factor endowment will export products that use those
abundant factors and import products that use factor endowments in which the
country does not have in abundance. Unlike Ricardo, Heckscher-Ohlin explains
that the international trade pattern is determined by a countryÊs differences in
factor endowments and not differences in productivity.
The Heckscher-Ohlin Theory has a strong basis in explaining modern

international trade pattern. For example, the United States is more abundant in
capital relative to labour than other countries, hence it will export commodities
such as cars whose production requires a greater use of capital than other
products do and in turn will import labour-intensive products such as garments.
ACTIVITY 6.1
How does the Heckscher-Ohlin Theory differ from the Comparative

Advantage Theory?
6.3 FIRM-BASED THEORIES

Firm-based theories are other international trade theories that attempt to discuss
business related issues.
6.3.1 International Product Life-Cycle Theory

The next theory is International Product Life-Cycle Theory by Raymond Vernon
(Figure 6.7).
Figure 6.7: Raymond Vernon

Source: http://www.harvardsquarelibrary.org

Vernon describes the international trade pattern through the Product Life-Cycle
Theory. This theory is different from the earlier theories discussed as it focuses
on the product and not the firmÊs productivity or factor endowment. This theory
which was developed in the mid-1960s suggests that most new products are
initially produced by firms in the United States and other developed countries
and are sold there. Vernon comments that the wealth and market size of
developing countries provide big incentives to firms to develop and produce
new products. Moreover, expensive labour cost has caused firms in the United
States to develop innovation processes to reduce production cost.
The product life-cycle can be divided into three phases as simplified in Figure 6.8.
Figure 6.8: Three phases of International Product Life-Cycle Theory
Now, let us look at further details of these three phases.
(a) Phase I: New Product

Innovation demands highly-skilled workers and higher capital for the
purpose of product research and development. Normally, product
innovation and new products are developed and produced in a
sophisticated market in the firmÊs own country.
In this phase, the new product that has been produced is not yet a standard
product. The production process needs the use of skilled workers.
Therefore, the production cost is high. For example, the United States as the
innovating country has the status of monopoly over a new product and
enjoys a high profit margin arising from the monopoly power. In this first
stage, US producers have export monopoly over the new product and will
continue to sell and export with no concern for foreign competition.

(b) Phase II: Growth Product

The second phase is the growth-product stage with the start of foreign
production. As more producers from other industrial countries start to
manufacture the product, production becomes more standardised. The
need for flexibility in design and manufacturing as well as skilled workers
decreased. Product-innovating countries will start to export more of their
product to other countries. As more competitors emerge, this will cause
product prices to fall and the firmÊs profit to decline. The manufacturing
firms will start to worry about production cost.
The increasing number of competitors and pressures on the prices will

cause difficulty for innovating firms in the US to maintain their market
share. In this phase, a firm may lose its market share or need to invest in
other markets (to take advantage of the factor cost) to maintain their
market. Hence, this is the first theory that explains how trade and
investment work in parallel.
(c) Phase III: Standardised Product

During the final phase, the production of products becomes standardised to
ensure low production costs. Other foreign producers with lower labour
costs and economies of scale displaced US exports. Therefore, with the
already established world model market, the production countries consist
of those that have cheap labour. The margin of profit is getting smaller and
the competition is greater.
The location for the production of products will be shifted from the
innovating (United States) to other countries that have cheap labour. The
country that acts as the facilitator will enjoy the benefit of trade overflow.
Exports come to an end as the United States becomes an importer of this
no-longer-new product. The Theory of Product Life-Cycle explains clearly
how international trade and foreign direct investment is conducted by
multinational firms.
ACTIVITY 6.2
Explain how International Product Life-Cycle theory can be used to

explain foreign direct investment made by multinational companies.

6.3.2 Porter’s Diamond Theory of Nations’

Competitive Advantage
In 1990, Michael E. Porter (Figure 6.9) of Harvard Business School presented a
research on how to determine the success or failure of a nation in international
competition. The findings of his research are published in his book entitled „The
Competitive Advantage of Nations‰. Porter was not satisfied with the theories
produced as they were only able to explain some parts of activities and the
pattern of international trade. Questions like why Japan is very successful in its
automobile industry and Switzerland is established in the high-quality watch
industry while Germany and the United States are successful in their respective
chemical industries were not fully explained by earlier classical trade theories.
These questions were not answered by the Heckscher-Ohlin Theory either and
were partially answered by the Theory of Comparative Advantage.
Figure 6.9: Michael E. Porter

Source: http://drfd.hbs.edu
Porter emphasised that there are four main attributes of a country that can shape
a nationÊs competitive nature. The existence and non-existence of these attributes
will determine whether a country would have competitive advantage. These
attributes are further explained in Table 6.3.
Table 6.3: Four Main Attributes of Competitive Advantage
Attribute Description
Factor Conditions Factors of production such as supply for skilled workers,
land, natural resources, capital and the infrastructure needed
to compete in an industry.
Demand Conditions The market conditions of demand towards products or
services that are produced.
Supporting and Related The existence or non-existence of the local industries and
Industries competitive supporting industries at an international level.
Firm Strategy, Local conditions that affect the shaping, structuring of
Structure and Rivalry strategy as well as rivalry.

Porter perceives these attributes as a Diamond (refer to Figure 6.10). He suggests

that a firm will be more successful if it is located in an industry or an industrial
segment that has suitable attributes. Porter used the diamond framework to
illustrate the forces of national advantage. The Diamond is a system in which the
forces reciprocally reinforce each other. For instance, good demand condition
cannot give a country competitive advantage if there is insufficient rivalry.
Figure 6.10: PorterÊs Diamond of National Competitive Advantage
6.4 FOREIGN DIRECT INVESTMENT THEORIES

Before we begin with new theories, let us stop for a while to ponder about this –
Why does a company make a foreign direct investment? Well, a firmÊs decision to
invest overseas can be explained from several advantages of international
investment. There are four theories to explain Foreign Direct Investment Theory,
as shown in Figure 6.11.

Figure 6.11: Foreign direct investment theories
6.4.1 Firm-Specific Advantage

What can we say to describe firm-specific advantage? Firm-specific advantage
states that a company should have a specific advantage, even if it is small but
exclusive, to enable it to invest and compete competitively in the international
market. The firm-specific advantage will be the competitive tool that enables a
multinational company to compete with local and international companies, and
produce larger profits.
Firm-specific advantages consist of two assets:
(a) Intangible assets, such as expertise in management, marketing advantages

and technology; and
(b) Tangible assets such as source of capital and modern machinery.

A firm-specific advantage has become a pre-requirement for a company before it

takes the initiative to invest in the international market. Figure 6.12 simplified
firm-specific advantage and its assets.
Figure 6.12: Firm-specific advantage
6.4.2 Location-Specific Advantage

Location-specific advantages arise from assets which exist in certain locations
(countries) and usually this advantage is specific elements belonging to that
place. Some of the location advantages are:
(a) No trade restrictions on import;
(b) Skilled and cheap labour;
(c) Wealth of natural resources;
(d) Proximity to markets and consumers;
(e) Good transportation and communication network;
(f) Free from government interference; and
(g) Differences in culture.

These advantages are simplified in Figure 6.13.
Figure 6.13: Location-specific advantage
6.4.3 Internalisation Advantage

Internalisation advantage suggests that foreign direct investments occur when
transaction costs (negotiation, observation and enforcement of the contract cost)
with the second company are high. In this situation, the company would gain a
higher profit controlling their own resources compared to contracting these
factors to a second party (via licensing contract or franchising). The
internalisation advantage enables a company to cross-subsidise its product or
operation to evade technology cost and to control the input supplies and sales.
The advantages of internalisation answer the question why companies choose to

enter the foreign market through foreign direct investments. The company has to
make the decision whether it is more profitable to build the foreign factory by
themselves or negotiate a tender with a foreign company to produce the product,
whether through franchising or licensing agreement.
Let us look at an example. The Toyota Motor Corporation is a good example of

transaction cost. Toyota Motor Corporation has the reputation of a high quality
manufacturer. The sophisticated techniques in producing cars made it hard for
them to have a production contract with other companies. Toyota Motor
Corporation chose to retain the ownership of its foreign factory due to the high
transaction cost (production process and technology).

6.4.4 Dunning’s Eclectic Model

Lastly, let us look at DunningÊs Eclectic Model. John H. Dunning, through the
Eclectic Model, offers a framework for explaining production in a foreign
country. It has three advantages – ownership advantage (O), location advantage
(L) and internalisation (I) advantages – and they are integrated.
Did you know that the Eclectic Model is also known as the OLI paradigm? You
can see this as it is shown in Figure 6.14. All three factors (OLI) are important in
determining the extent and pattern of FDI.
Figure 6.14: DunningÊs Eclectic Paradigm
Now, let us look at further descriptions for these advantages.
(a) Ownership Advantage (O)

Ownership advantage includes tangible assets such as natural endowment
resources, manpower and financial assets. Intangible assets include
communication technology, information, management expertise, marketing
and entrepreneur skills as well as organisational systems.
(b) Location Advantage (L)

A host country can offer location advantages such as natural advantages in
terms of factor endowments the county possess as well as the cultural,
legal, political and institutional environments in which foreign direct
investment is undertaken. Profits are bigger when made in a foreign
location compared to a domestic location, if the location provides
advantages in trading and investments. For example, Caterpillar produces
heavy machinery in Brazil to take advantage of location-specific factors,
such as the low cost labour and also to exclude the high tariff for the
products imported from American factories.

(c) Internalisation Advantage (I)

What can you say about internalisation? Do you have any idea?
Internalisation refers to the firmÊs capability and flexibility to produce and
market through its own internal subsidiaries. The company gains
advantages from controlling and owning the foreign production compared
to contracting it out to foreign companies. By internalising its activities
across national borders, a company becomes multinational. Hence,
companies internalise activities to benefit from internal integration such as
to ensure product quality from forward integration and supplies of raw
materials from backward integration.
ACTIVITY 6.3
1. Using your knowledge of the theories of foreign investments

discussed above, discuss with your coursemates why so many
organisations fail at the international level.
2. Visit the Financial Times website at http://www.ft.com. Choose

„industries‰ and select one industry from the list. Read the news
about the industry selected. Then, discuss your answers, online if
necessary, for the problems below:
(a) Why is the international market important for the selected

industry?
(b) Why is it important to have a Foreign Direct Investment?
(c) What can be learnt from the competition stages?
3. Please visit these websites for additional information:
(a) United States International Commission: http://ita.doc.gov
(b) Japan Information Network: http://www.nippon‐jin.com
(c) Nokia: http://www.nokia.com

As your revision, try this exercise by selecting the correct answer.
EXERCISE 6.1
1. Used widely in the 16th and 17th century, the theory of

_____________ suggested increasing exports and decreasing
imports at the same time.
A. ethnocentrism
B. capitalism
C. mercantilism
D. natural advantage
2. Adam Smith introduced the Theory of _____________ in the year

1776 through his book entitled The Wealth of Nations.
A. Absolute Advantage
B. Comparative Advantage
C. Competitive Advantage
D. PorterÊs Diamond
3. The weakness of mercantile theory is that it sees trading as

_____________.
A. a zero sum game
B. economic needs
C. a threat to the country
D. a positive sum game
4. The theory of comparative advantage ___________.
A. is influential in promoting freer trade
B. is not influential in encouraging international trade
C. did not encourage foreign direct investment
D. provides a weak foundation for international trading

5. Theory of International Product Life-Cycle was introduced by

__________.
I. Adam Smith
J. David Ricardo
K. David Hume
L. Raymond Vernon
 Trade theories such as Mercantilism, Absolute Advantage Theory,

Comparative Advantage Theory, Hecksher-Ohlin Theory and International
Product Life-Cycle Theory provide insight into how international trade takes
place, although none of the theories is capable of explaining the whole
motives for international trade.
 Free trade can benefit countries because there is no government intervention

in international trade, whether through tariffs or non-tariffs that will affect
the trade flow.
 The main concept of mercantilism is that a country would incur trade surplus
in the balance of payment account because the trade surplus would result in
inflow of gold and silver, and the country would gain wealth and prestige.
 SmithÊs Theory of Absolute Advantage states that a country should specialise

in the production and export of goods in which it has acquired or natural
advantage.
 The Theory of Comparative Advantage by Ricardo is accepted by most

economists and is influential in promoting policies for freer trade.
 The International Product/Life-Cycle Theory by Vernon is more useful in

explaining why foreign production in the form of foreign direct investment
takes place among multi-national companies.
 Differences in natural factor endowments as propounded in the Hecksher-

Ohlin Theory explain why trade in labour-intensive or capital-intensive takes
place in some countries.

 PorterÊs Competitive Advantage Theory emphasises factor conditions,

demand conditions, supporting industries and firm rivalry as the four main
attributes of a country that can shape a nationÊs competitive nature.
 Firm-specific advantage states that a company should have a specific

advantage, even if it is small but exclusive, to enable it to invest and compete
competitively in the international market.
 Location-specific advantages arise from assets which exist in certain locations

(countries) and usually these advantages are specific elements belonging to
that place.
 Internalisation advantage suggests that foreign direct investments occur

when the transaction costs (negotiation, observation and enforcement of the
contract cost) with the second company are high.
 The Eclectic Model by Dunning provides a specific framework of analysing

determinants of foreign direct investment based on a countryÊs ownership
(O) and location (L) advantages in determining a firmÊs internalisation
decisions to invest abroad.
Absolute Advantage Theory Location advantage

Comparative Advantage Theory Location-specific advantage
DunningÊs Eclectic Model Mercantilism
Firm-specific advantage Ownership advantage
Foreign Direct Investment Theory PorterÊs Diamond Theory of Nation
Competitive Advantage
Heckscher-Ohlin Theory
Product Life-Cycle Theory
Internalisation advantage

Topic  Foreign Direct
7 Investment
(FDI)
LEARNING OUTCOMES
1. Explain the meaning of foreign direct investments (FDI);
2. Identify the motives of foreign direct investments (FDI);
3. Analyse the impact of foreign direct investments (FDI) on host
countries;
4. Differentiate between two types of foreign direct investments (FDI);
and
5. Summarise how International Product Life-Cycle Theory is used to
describe multinational corporationsÊ engagement in foreign direct
investment.
 INTRODUCTION
Hello and welcome to Topic 7 titled Foreign Direct Investment (FDI). What will
you learn in this topic? We will first discuss the concept of foreign direct
investments (FDI) made by multinational companies (MNC). This will be
followed by a section on the pattern of FDI since the early 1980s to the late 20th
century.

122  TOPIC 7 FOREIGN DIRECT INVESTMENT (FDI)
A major part of this topic will focus on the major motives of MNCs in FDI. One of
the major motives is to gain the main resources of a particular country. For
example, Goodyear invested in Malaysia to control the supply of rubber that can
be found in abundance in Malaysia. The company also invested in other foreign
countries to expand its market, which can supplement its small domestic market.
Other motives include low production cost, gaining major sales and market share
to supplement the high cost of research and development, and the short product
life cycle as a result of technological advancement.
The positive and negative aspects of the impact of FDI will also be discussed.
Then, types of foreign direct investments, vertical investment and horizontal
investment, and reasons why MNCs opt for either type of investment are also
discussed.
Lastly, before we end this topic, we will look at International Product Life-Cycle
Theory to better understand FDI activities. Are you ready? Let us start the
journey of FDI!
7.1 FOREIGN DIRECT INVESTMENT (FDI)

What can we say about foreign direct investment? How do we define it?
Foreign direct investment occurs when an entity invests directly in production

or other physical facilities in a foreign country.
For instance, Lehel Company in Hungary was acquired by the Electrolux

Company in 1991 as a type of foreign direct investment.
Meanwhile, the United States International Trade Commission defines FDI as

individual(s), organisation or affiliation that owns or controls at least 10% of the
equity of the foreign company. These companies are known as multinational
companies (MNCs). As for the overseas entities, they are called foreign
subsidiaries. The country in which a foreign subsidiary operates is the host
country. There are two terms that you should know with regard to FDI:
(a) Outward FDI is outflow of FDI out of a home country where firms
undertake FDI in foreign countries.
(b) Inward FDI is inflow of FDI into a host country by firms.

TOPIC 7 FOREIGN DIRECT INVESTMENT (FDI)  123
ACTIVITY 7.1
Distinguish between inward and outward FDI. Give an example of a

multinational company that has FDI in Malaysia and a Malaysian
company that has undertaken FDI abroad.

PATTERN
Did you know that for industrialised countries, FDI forms a larger part of the
business than international trade? Most of the worldÊs FDI is in the United States,
the European Union (EU) and Japan. Over 50% of world trade and over 80% of
FDI is conducted by three regional economic hubs: the United States, the
European Union and Japan. Together, these three major regions are referred to as
the „Triad‰. The Triad forms a group of three major trading and investment blocs
in the global market. Table 7.1 shows you the top 10 countries with the highest
FDI in 2008.
Table 7.1: Highest FDI Countries (2008)
2008 (USD in billion) 2007 (USD in billion)

Rank Country
Inflow Outflow Inflow Outflow
1 United 316.11 (18.6%) 311.79 (16.8%) 271.18 (13.7%) 378.36 (17.6%)
States
2 France 117.51 (6.9%) 220.05 (11.8%) 157.97 (7.9%0 224.65 (10.4%)
3 China 108.31 (6.4%) 52.15 (2.8%) 83.52 (4.2%) 22.47 (1%)
4 UK 96.94 (5.7%) 111.41 (6%) 183.39 (9.3%) 275.48 (12.8%)
5 Russian 70.32 (4.1%) 52.39 (2.8%) 55.07 (2.8%) 45.92 (2.1%)
Federation
6 Spain 65.54 (3.9%) 77.32 (4.2%) 28.18 (1.4%) 96.06 (4.5%)
7 Hong 63 (3.7%) 59.92 (3.2% 54.37 (2.7%) 61.12 (2.8%)
Kong
8 Belgium 59.68 (3.5%) 68.79 (3.7% ) 110.77 (5.6%) 93.90 (4.4%)
9 Australia 46.77 (2.8%) 35.93 (1.9% ) 44.33 (2.2% ) 16.81 (0.78%)
10 Brazil 45.06 (2.7%) 20.46 (1.1%) 34.59 (1.7% ) 7.07 (0.33% )
(Figures in parentheses show % of total world FDI)

Source: http://www.cnbc.com

A recent survey of transnational corporations found that companies see China

and India as the worldÊs first and second most important destinations for foreign
direct investment over the 2010 to 2012 period, respectively. As for Figure 7.1, it
shows you the top priority host economies for FDI for the 2010 to 2012 period
(the number of times that the country is mentioned as a top priority for FDI by
transnational corporations). The number in parenthesis is the countryÊs rank in
last yearÊs UNCTAD survey. Developing countries are now generally growing
sources of FDI, especially the emerging BRIC nations (Brazil, Russia, India and
China).
Figure 7.1: Top priority host economies for FDI for 2010 to 2012 period
Source: World Prospectus Survey 2010–2012 by United Nations Conference on Trade and
Development (UNCTAD)
ACTIVITY 7.2
1. How has the foreign direct investment pattern in the major

economies changed? Provide reasons why a large proportion of the
worldÊs FDI is concentrated in the „Triad‰ region.
2. Can you think of the main reasons why firms undertake foreign
direct investments?

7.3 MAJOR MOTIVES OF FOREIGN DIRECT

INVESTMENT (FDI)
What are motivations for firms to do FDI? Firstly, the major motive why firms
undertake FDI is resource-seeking. Firms aim to gain control of the natural
resources of a host country such as minerals and oil supply. For example, an
aluminium company needs to invest in raw materials in order to get enough
bauxite, a petroleum company needs to dig new oil wells in Canada and the
Middle East to get quality oil supply; and tyre manufacturers invest in countries
near the equator region to get their supplies of quality latex. Since the early
20th century, large companies such as Standard Oil, Alcoa, Goodyear, Anaconda
Copper and International Nickel have opted for foreign direct investment to gain
control and ownership of the required natural resources.
Figure 7.2 shows the four major motives of foreign direct investment.
Figure 7.2: Four major motives of foreign direct investment
The second motive is market-seeking. This motive is obvious for companies

which have internal advantages, such as technology expertise and popular
brands. These advantages provide the competitive edge when entering foreign
markets. Market-seeking motive is one of the major motives for many MNCs
because of the small domestic market. MNCs such as Amway, Avon and Nokia
seize market opportunities in China because of its strong market size and
demand. Firms use foreign direct investment to expand their market overseas in
order to secure market share and to generate sales growth. Another reason for
market-seeking FDI is because the firmÊs main suppliers or customers have set
up foreign operations abroad. Bridgestone, the tyre maker from Japan, entered
the US market when Japanese car makers such as Honda and Toyota exported
cars to the United States.

Another motive is cost-seeking or efficiency-seeking motive. Firms seek FDI to

take advantage of the low production cost in the host country. Most of the
companies from developed countries aim to take advantage of the different
factor endowments, labour supply, government policies and economic systems to
become efficient in their production. The main determinant of inward FDI into
China and India is mainly due to their cheap labour cost and other location
advantages that enable FDI to keep production costs low and competitive.
Other new motives for FDI include the rapid advancement in technology which
has forced companies to develop and sell their products faster. New technologies
tend to shorten the life cycle of products in the market. This has also caused
companies to search for new buyers in other countries for their products. In
addition, the increase in research and development costs has compelled these
companies to seek FDI in foreign countries as the main alternative to market their
products.
For additional information, please visit these websites:
(a) The Asia Society: http://www.asiasociety.org
(b) Wal-Mart: http://www.wal-mart.com
(c) Honda: http://www.honda.com
7.4 IMPACT OF FOREIGN DIRECT

INVESTMENT (FDI)
Foreign direct investment is a complex, costly and lengthy method and has high
risks compared to other entry methods such as exporting or licensing. The reason
is because a company would have to build its own facilities or buy other existing
companies. This is high risk investment as many problems can occur in countries
with different cultural and economic backgrounds. On the other hand, FDI gives
the firm full and tight control of the operations in different countries. At the same
time, FDI reduces the risk of losing control of a firmÊs technological expertise.
Host countries who are recipients of foreign direct investment tend to benefit
substantially from FDI. Can you think of what the benefits are?


The main benefits of FDI to host countries are:
(a) FDI brings about creation of new jobs and employment in the host country.
Foreign subsidiaries employ local workers in their domestic operations.
Employment is not only created in the FDI industry by MNCs but also in
upstream and downstream businesses that provide goods and services to
the FDI industry (Sun, 2002). Hence, more employment is created in FDI-
related industries. As FDI-related industries expand, the demand for local
workers also increases and this leads to higher wages.
(b) The host country benefits from transfer of technology. Foreign MNCs with
technology advantage via their FDI result in a positive effect in the form of
technology spillover to domestic firms. The domestic firms are thereby able
to improve their level of technology and become more productive. Such
technology spillovers provide the strongest potential for FDI to enhance
economic growth of the host country (Johnson, 2005).
(c) FDI affects the economic development of the host country. FDI can
contribute to host country development in many ways which enhances the
host countryÊs economic growth and improvement in standard of living of
its people. MNCs via FDI bring in new products, improved quality and
lower prices to consumers in the host country. New resources provided
through FDI such as technology, capital and human resources and
management techniques help raise domestic output (Moran, 2003). All
these benefits add to the competitive advantage of the host country in the
international business arena.
In sum, FDI enhances economic growth in the host country especially among the
developing countries who are the main recipients of FDI from MNCs.
On the other hand, FDI can have a negative impact on a host country. The
possible negative impacts are:
(a) FDI exposes host countries and leads them and their resources to
exploitation by the foreign company. In some situations, host governments
fear the FDI can lead to loss of sovereignty and control over domestic
policies. The risks of overdependency on FDI remain an issue of debate
among many developing economies. They have tried to restrict and resist
FDI because of national sentiments over foreign economic and political
influence (Economy Watch, 2010).

(b) There is a risk of FDI firms leaving the host country when other emerging
countries become more attractive with location advantages. Hence, host
governments fear outflow of FDI can adversely affect the net capital
outflow and unemployment. This happens when MNCs close their
domestic operations when other host governments offer attractive FDI
incentives. Or when during economic recession, when demand declines,
MNCs withdraw FDI from a host country.
SELF-CHECK 7.1
List the positive and negative impacts of FDI on host countries.
7.5 TYPES OF FOREIGN DIRECT INVESTMENT

(FDI)
There are two types of direct foreign investments. These are horizontal foreign
direct investment and vertical foreign direct investment. Now, let us look at these
FDI further in the next section.
7.5.1 Horizontal Foreign Direct Investment

What does horizontal foreign direct investment stand for?
Horizontal foreign direct investment stands for investment in the same

industry as the parent company in the home country.
In other words, the investment is made by operating a similar business in a

foreign country, thus representing geographical diversification and international
expansion of the parent company to other markets. Can you think of any
example? Here are two examples in the automobile industry:
(a) Toyota, a Japanese car maker, has factories in the United States.
(b) Renault has purchase and controlling interest in Nissan, a Japanese car
maker.

7.5.2 Vertical Foreign Direct Investment

Now, let us look at the second type of FDI which is vertical FDI. How do we
define vertical FDI?
Vertical FDI occurs when an MNC operates in a foreign country at different

stages of production.
Note that vertical foreign direct investment is divided into two categories:
(a) Backward vertical FDI; and
(b) Forward vertical FDI.
How do we differentiate between these two vertical FDIs?
Backward FDI happens when a MNC enters an industry to produce inputs to the
production process of the companyÊs products.
Examples of companies that undertake backward vertical FDI are Royal Dutch
Shell, British Petroleum and Alcoa that build or acquire oil refineries to secure
the supply of petroleum. A car manufacturer that acquires a foreign steel or tyre
supplier is another example of backward vertical FDI to ensure supply or lower
cost of raw materials.
Forward vertical FDI occurs when investment is made towards the source of
distribution of a firmÊs output. An MNC decides to buy or build its own
distribution network to secure distributors or sell its finished products.

You can refer to Figure 7.3 which illustrates the types of FDI.
Figure 7.3: Types of foreign direct investment
Here is an interesting question for us to ponder: Why do companies make

vertical or horizontal FDI even though it is easier to import resources into their
own country?
(a) Horizontal FDI is more common than vertical FDI while backward FDI is
more common than forward FDI. According to the economic theory, a
company can control resources such as minerals in foreign countries and it
helps to block other companies from entering the industry. For example, in
the 1930s, Alcoa and Alcan Aluminium Ltd in North America monopolised
a huge bauxite mine in the Caribbean Island of Trinidad. At that time, the
bauxite mine was the only mine that had aluminium material to be
processed and both companies made huge profits because they blocked
their rivals from entering the industry.
(b) Another reason for forward vertical FDI is the difficulty of finding
distributors for a market. This situation influenced Volkswagen to build up
its car selling network while entering the US market. The company thought
the quickest way to enter the US market would be by acquiring a large
number of car dealers.

There are also other factors that lead to vertical and horizontal FDI. They are:
(a) Transportation Cost

Transporting products to a distant country is not profitable if transportation
costs form a large part of the production cost. Products which have a lower
oblique of weight, such as cement, soft drinks and sugar, would be more
profitable through foreign direct investment. On the other hand, products
which have a higher oblique of weight should generally be exported
because it is more profitable. The rule of thumb for this factor is
summarised in Table 7.2.

Table 7.2: Weight versus Methods
Oblique of Weight Methods

Low Foreign Direct Investment
High Export

Products such as electrical components, computer microchips and medical
appliances have a high value whereby its transportation cost forms a small
part of the overall production cost. Transportation cost is less important in
industries which have a high number of products with a high oblique of
weight.
(b) Barriers towards Knowledge and Technology Transfer

FDI allows easier and quicker way for the transfer of technology and
management techniques. Multinational enterprises as the main drivers of
FDI are a powerful and effective means to disseminate technology and
management expertise from developed to developing countries. FDI is
often the only source of new and innovative technologies that are usually
not available through the market. Technology disseminated through FDI
generally includes the „entire package‰ including experts, skills and the
financial resources to exploit the technology appropriately. Where barriers
to technology and knowledge transfer exist in host countries, FDI are often
a faster entry method compared to licensing (OECD, 2001).
SELF-CHECK 7.2
Distinguish between horizontal FDI and vertical FDI.


THEORY
Note that foreign direct investment activities can be explained by using the
International Product Life-Cycle Theory. Can you recall this theory? The theory,
developed by Raymond Vernon, explains why MNCs shift from exporting their
products overseas to foreign direct investment in host countries. According to
this theory, a company makes foreign direct investments to satisfy the demand of
the foreign market and also to take advantage of low-cost production in low-
wage countries. For example, Nokia expanded a mobile phone factory in
Dongguan, China, and subsequently in Chennai, India. This was aimed at
gaining export advantage from product inventions developed for the Finnish
market.
Production goes through various stages. Let us look at Table 7.3 for these stages
with their examples.
Table 7.3: Various Stages of Production
Stages What Happened Example

New Product Product innovation and invention Nokia in Finland: To cater home
Stage initially take place in home and export demand
country.
Growth Export demand increases and Nokia has an incentive to
Product Stage production becomes standardised. manufacture abroad to cut cost of
production and prevent loss of
market to local and other new
foreign competitors. Hence,
Nokia investment will be shifted
to a low-wage country with
expanding local market demand
– building a factory in China to
take advantage of cheap labour
supply and other factor
endowments.
Standardisation Production becomes standardised. NokiaÊs further expansion into
and Mature other emerging markets such as
Product Stage India to compete with rivals in
terms of cost competition and to
serve IndiaÊs market.
Before we conclude this topic and move on to the next topic, let us do Exercise 7.1
to enhance our understanding of FDI.

EXERCISE 7.1
1. Foreign direct investment is _____________.

A. investment in a foreign country that is made by individuals,
companies or public organisations
B. investment that is made by a voluntary organisation in its

own country
C. a low-risk investment but makes lots of profit
D. investment of monetary instrument in foreign market to gain

profit
2. Horizontal direct foreign investment is _____________.
A. foreign investment in a different industry from the industry

that is managed by the company in its own country
B. foreign investment in the same industry as the industry that

is managed by the company in its own country
C. local investment in a different industry from the industry

that is managed by the company in its own country
D. local investment in the same industry as the industry that is

managed by the company in its own country
3. Forward vertical foreign direct investment means _____________.
A. foreign direct investment that enters a foreign market and

competes with other companies in that foreign country
B. foreign direct investment that enters a foreign market and

collaborates with other companies in that foreign country
C. foreign direct investment that enters a foreign market with

the purpose of collaborating with other companies in that
foreign country
D. foreign direct investment that enters a foreign market with

the purpose of selling and distributing its products

 Foreign direct investment (FDI) occurs when an entity invests directly in

production or other physical facilities in a foreign country.
 The main motives behind FDI are resource-seeking, market-seeking and cost-
seeking.
 Host countries benefit from FDI in terms of increase in jobs and employment,
transfer of technology and human resource training for the local people as
well as enhancement of economic development. These benefits add to the
economic growth of the host economy.
 Some negative impacts of FDI include the fear that host governments might
lose sovereignty and control over domestic economic policies as well as risks
of overdependency on FDI such as exploitation of resources and adverse
effects when MNCs exit or withdraw FDI out of the country.
 MNCs can enter a foreign market via two forms of FDI: horizontal FDI and
vertical FDI.
 Horizontal FDI allows firms to expand to multiple markets similar to its

operation in the home country. This is often regarded as a safe and fast way
of entering a foreign market.
 Vertical FDI can either be backward towards the source of supply of

resources or forward vertical FDI towards the distribution network.
 The International Product Life-Cycle Theory explains why companies with a

new product become MNCs and engage in FDI via the product stages from
new to growth and standardisation stage and finally, mature stage. FDI is
shifted from the home country where product innovation originated to low-
wage countries where manufacturing plants are set up to gain cost advantage
and access to market their exports.

Advancement in technology Horizontal FDI

Backward vertical FDI Market-seeking motive
Cost-seeking motive Multinational Corporations (MNCs)
Efficiency-seeking motive Resource-seeking motive
Foreign direct investment Vertical FDI
Forward vertical FDI

T op i c  International
8 Financial
Environment
LEARNING OUTCOMES
1. Describe the functions of a foreign exchange market and how it
works;
2. Determine the conditions influencing the foreign exchange market;
3. Explain how international monetary systems determine exchange
rates; and
4. Summarise the features and roles of international capital, bond and
equity markets.
 INTRODUCTION
Welcome to Topic 8 on international financial environment. We start off this
topic by defining the functions and conditions that influence foreign exchange
markets. This is followed by a discussion on the evolution of international
monetary systems such as the Gold Standard (1876–1914), Bretton Woods System
(1944–1971) to present day fixed and floating exchange rate regimes.
Lastly, we will look at the money markets such as the capital, bond and equity
markets. These are also the key components of the international financial system.
Therefore, it is important to understand their roles and functions in the world of
financial market. Are you ready? Let us start the topic.

TOPIC 8 INTERNATIONAL FINANCIAL ENVIRONMENT  137
8.1 FOREIGN EXCHANGE MARKET

Let us start this topic on basic knowledge of foreign exchange market. What do
you know about foreign exchange market? Well, let us look at its definition.
A foreign exchange market is a place where the foreign currencies of different

countries are bought and sold and the exchange rates are determined.
Now what does exchange rate means?
The exchange rate is simply the price of a currency. It measures the rate at
which one currency is converted into another currency.
Foreign exchange markets play an important role in facilitating cross-border

trade, investment and financial transactions. With increased growth in global
economic activity, trade, and investment, foreign exchange markets have become
even more significant. Foreign exchange markets enable companies to convert
local currencies into foreign currencies to facilitate trade and financial
transactions.
Let us look at Table 8.1 which shows you the exchange rates of major currencies.
Table 8.1: Foreign Exchange Rates

USD EUR GBP JPY CHF CAD AUD NZD HKD SGD
USD 1 0.7411 0.6208 100.216 0.9149 1.0447 1.0669 1.1992 7.7537 1.2464
EUR 1.34907 1 0.83723 135.197 1.23432 1.4094 1.4394 1.6179 10.4604 1.6813
GBP 1.61138 1.1944 1 161.4865 1.4743 1.6834 1.7193 1.9325 12.4945 2.0082
JPY 0.01 0.7395 0.0062 1 0.9129 1.0422 0.0107 0.012 0.0774 0.0124
CHF 1.093 0.8101 0.6783 109.538 1 1.1416 1.1662 1.3105 8.4745 1.362
CAD 0.9572 0.7095 0.5942 95.9275 0.8757 1 1.0219 1.148 7.4223 1.193
AUD 0.93715 0.6947 0.5816 93.923 0.8575 0.9791 1 1.124 7.267 1.1681
NZD 0.8337 0.618 0.5174 83.552 0.7628 0.871 0.8895 1 6.4645 1.039
HKD 0.129 0.0956 0.08 12.925 11.7995 0.1347 0.1376 0.1547 1 0.1607
SGD 0.8023 0.5947 0.498 80.415 0.734 0.8388 0.8563 0.9623 6.2216 1
Source: http://www.fxstreet.com/rates-charts/exchange-rates/

138  TOPIC 8 INTERNATIONAL FINANCIAL ENVIRONMENT
ACTIVITY 8.1
List the major currencies of other countries that are used to facilitate
trade in the world market.
8.1.1 Functions of Foreign Exchange Market

In the previous section, you have learnt the definition of foreign exchange
market. Now, let us look at its function. A foreign exchange market serves three
major functions: conversion of currency, provision of credit for foreign trade and
insurance for foreign exchange risk. Let us look at further descriptions of these
functions:
(a) Conversion of Currency

Each country has its own currency in terms of its purchasing power.
Foreign exchange transactions normally involve participants in countries
who want to facilitate transactions of their own currency with different
currencies. The foreign exchange market provides a mechanism for the sale
or purchase of foreign currency thereby facilitating international trade. The
commonly traded currencies in the foreign exchange market are US Dollar
(USD), Japanese Yen (JPY) and Euro (EUR).
(b) Provision of Credit for Foreign Trade

Do you know that the movement of goods from one country to another in
international trade takes time? Most of the settlement of an international
trade transaction is done after the date of agreement. Because of the
transition in the movement of goods, trade must be financed. It supplies
short-term credits, for example, a letter of credit is the instrument used as a
source of credit to finance trade and the payment will be made at a future
stipulated date.
(c) Insurance for Foreign Exchange Risk

The foreign exchange market provides foreign exchange instruments to
minimise foreign exchange risk. The foreign exchange market provides
facilities of buying and selling at spot or forward exchange market, and
enables exporters and importers to hedge their exchange risks arising from
change in the foreign exchange rate.
Hedging facilities insure against potential losses arising from the transfer of
exchange risk to another party who is willing to carry the risk.

Speculation involves the purchase and sale or vice-versa of a currency is

undertaken for a profit. Currency speculation involves short-term fund
movements in a currency to another currency in return for a profit.
Lastly, have you ever heard about arbitrage? Arbitrage is the simultaneous
purchase and sale of a currency is undertaken in different markets for a
profit.
SELF-CHECK 8.1
What are the major functions of a foreign exchange market?
8.1.2 Features of Foreign Exchange Market

Now, let us look at the features of the foreign exchange market. The foreign
exchange market has unique features. There are four features of foreign exchange
market and these are explained further in Table 8.2.
Table 8.2: Four Features of Foreign Exchange Market
Features Description
Whole world is It is the largest financial market in the world. It is primarily an over-
its market the-counter market which means that transactions occur through
online exchanges and via electronic means (by phone or Internet) and
not on the trading floor of an exchange.
Leverage Leverage foreign exchange trading takes place at the market.
trading Leverage refers to trading on margin. In other words, in leverage
trading, a small amount of funds can be used to gain control of a
bigger amount. The funds are the source of credit for speculative
activity in the foreign exchange market with the risk of making
profits or losses.
Large trading The whole world is its market. Large sums of money are traded daily
volume on the currency market. Global foreign exchange market turnover
totalled US$4 trillion in 2010 (taken from www.goforex.net).
The American dollar is the most traded currency, followed by Yen
and the Euro.
Trading opens Currencies in the foreign exchange market are traded 24 hours a day,
24 hours a day five days a week in most financial markets.


These four features of foreign exchange market are simplified in Figure 8.1.
Figure 8.1: Features of foreign exchange market
8.1.3 Foreign Exchange Rate Quotations

Can you recall the definition of exchange rate? How about foreign exchange rate?
Do you know what it stands for?
A foreign exchange rate is a statement of willingness to buy or sell at an

announced rate.
Let us look at an example. The price of Malaysian Ringgit (MYR) against the US
dollar ($) is quoted as MYR3.2000/$.
Foreign exchange rates follow specific quoting conventions. Since most of the
foreign exchange rate transactions are done in US dollars, the exchange rate
quotes are in US Dollar prices. There are several pairs of quotations used in
foreign exchange businesses, two of which are as follows:
(a) Direct and Indirect Quote

A direct quote is a home currency price of a foreign currency unit
(e.g. MYR3.2/US$1) in Malaysia.
An indirect quote is a foreign currency price of a home currency unit

(US$0.31/MYR1) in Malaysia.

(b) Spot and Forward Rates

Spot rate is the exchange rate used to conduct foreign exchange transactions
that occur on the spot (quoted for immediate settlement).
Forward rate is the exchange rate for a transaction that requires delivery of
a foreign exchange at a specified future date.
For example, the MYR is quoted against U.S$, a single spot rate and two
different forward rates are:
(i) Spot rate for MYR/$3.155
(ii) 3-month forward rate – 3.202
(iii) 6-month forward rate – 3.344
ACTIVITY 8.2
What are the exchange rates for Malaysian Ringgit to other foreign
currencies such as the US dollar, Singapore dollar and Indonesian
rupiah?
8.1.4 Foreign Exchange Market Players

Foreign exchange market players can be categorised into four major players as
shown in Figure 8.2.
Figure 8.2: Four major market players

Now, let us look at further descriptions of these four major market players.
(a) Central banks – The role of a central bank in the foreign exchange market is
not over the profitability of currency trading but to support the value of
their own currencies. It ensures adequate trading conditions and intervenes
in economic or financial imbalance in the foreign exchange market. In
Malaysia, we have Bank Negara that act as Malaysia's central bank.
(b) Banks – Commercial and investment banks are natural players in foreign
exchange. All other foreign exchange trading players must deal with them.
Major banks also known as market makers invest in currencies for a return
or keep currencies as their inventories. As market makers, they can
influence exchange rate quotations. As for medium-sized banks, they
participate in currency markets to facilitate international trade on behalf of
their customers. Some examples include Bank Islam, Bank Rakyat and
Maybank.
(c) Firms/Individuals – They comprise exporters, importers, tourists and

immigrants who use local currency to purchase foreign-made products and
services. Individuals as investors are high net-worth individuals who
engage in foreign exchange by accessing commercial and investment banks.
Recently, new players in the currency market called hedge funds have
emerged in the form of partnership of high net-worth individuals who
invest large sums in foreign exchange trading.
(d) Speculators/Arbitrageurs – They act as foreign exchange traders who

directly buy and sell currencies to make profit from the speculation and
arbitrage activities. Can you differentiate between them? Well, speculators
seek to make short-term profit from currency price appreciation (based on
rumours with high risk) while arbitrageurs seek to make profit from
currency price differences in different markets.
8.1.5 Factors Influencing Foreign Exchange Market

The forex market is the most liquid market in the world now and accounted for
almost $4 trillion as daily turnover in 2010 (finance.mapsofworld, 2013). Like any
other market, the foreign exchange market is subject to volatility due to changes
in external environment such as political conditions, economic factors and
market psychology.

As stated before, political stability plays an important role as one of the major
factors influencing foreign exchange market volatility. Any political disruption in
one country may affect the neighbouring countriesÊ currency exchange rates. For
example, political crisis such as civil war can cause loss of confidence in a
currency and it may subsequently fall in currency value.
Economic factors have significant impact on a countryÊs exchange rate and in

turn cause widespread repercussions on the exchange rates of other countries in
the rest of the world. Differentials in inflation, interest rates, balance of trade,
public debt and economic growth rates directly affect exchange rates.
For example, a country with higher inflation rate generally experiences

depreciation in its currency relative to the currencies of its trading partners. A
country with balance of trade deficit indicates that spending on imports exceed
sale of exports, hence, the country requires more foreign currency to pay for its
imports than it receives through sales of exports. Excess demand for foreign
currency leads to depreciation in the countryÊs exchange rates.
Major economic events in countries or regions can spark massive fluctuations in

exchange rates of countries in surrounding regions and the rest of the world. Let
us recall some of the events:
(a) The Asian financial crisis of 1997–98 found changes in the Thai baht
exchange rate which had an impact on prices, trading activities and fund
liquidity. This in turn triggered contagious effects and caused volatility of
exchange rates of Asian and even in Western countries.
(b) The recent global financial meltdown of 2008–2009 and current European
Debt Crisis too had tremendous impact on exchange rates of almost all
countries in the world.
Lastly, let us look at market psychology. Market psychology factors influence the
foreign exchange market in a variety of ways. Any destabilising international
events or crisis can change market expectations and perceptions including trader
and investor perceptions. This can lead to flight-to-quality and investors seeking
safe options. As a result there will be greater demand, hence a higher price, for
perceived currencies.

In sum, many situational factors can cause currency movements. For instance, the
US budget deficits, Japanese recession, the rise of China as the new super
economic powerhouse and the debt crisis in Greece have an effect on the price of
currencies. Everyone can feel the impact of currency price movements directly or
indirectly. Do you agree with that?
SELF-CHECK 8.2
1. Do you think major political disasters such as the terrorist attacks

of 11 September 2001 and the war in Iraq in 2003 had an impact to
foreign exchange markets?
2. Where is the foreign exchange market located? What is the

original form of this market? What is the major advantage and
disadvantage of using the US dollar as the international trading
currency to facilitate trade and transactions?
Please visit these websites for additional information on the Asian Financial
Crisis:
(a) www.ifg.org/imf_asia.html
(b) www.imf.org/external/np/exr/facts/asia.HTM
8.2 INTERNATIONAL MONETARY SYSTEM

Have you ever heard about the international monetary system? What does it
refer to?

This system comprises currencies from individual countries and exchange rate
systems adopted by countries. The foreign exchange rate market forms the
primary institution for determining exchange rates based on the demand and
supply of any two currencies. There are three monetary systems that determine
exchange rates:
(a) Fixed exchange rate system in which the government of a country regulates
the rate at which a local currency is exchanged for other currencies.
(b) Pegged exchange rate system in which a countryÊs currency is tied to

another country currency.
(c) Floating or flexible exchange rate system in which the government does not
interfere in the valuation of its currency.
Next, we are going to look at a brief review of the evolution and history of the
international monetary system. This can give you a better understanding of the
present monetary system.
8.2.1 The Gold Standard (1876 to 1914)

Did you know that the gold standard gained acceptance as an international
monetary system in the 1970s? Under this system, each country pegged its
money to gold. In other words, the currency issued by a country is backed by
gold reserves. For example, the US dollar ($) is priced at $20.67 per ounce of gold,
while the British pound (£) is priced at £4.2472 per ounce of gold and the
exchange rate is simply the ratio of two prices. Hence, the exchange rate of US
dollar against British pound is $20.67/£4.2472 which means an exchange rate of
$4.866/£.
The government of each country agrees to buy or sell gold on demand at its own
fixed parity rate. Under this system, it is necessary for governments to maintain
sufficient supply of gold reserves to back up its currencyÊs value. The gold
standard operated until the outbreak of WW1 when movement of trade and gold
were restricted and it was then suspended.

8.2.2 Interwar Years (1914 to 1944)

During the interwar years, currencies were allowed to fluctuate over fairly wide
ranges in terms of both gold and another currency. This caused widespread
speculation and fluctuations in exchange rates. World trade was hampered in the
1920s, thereby contributing to the Great Depression in the 1930s. The US returned
to a modified gold standard in 1934. This further devalued the currency. During
World War II and its aftermath, many of the major trading currencies lost their
convertibility into other currencies. The dollar was the major trading currency
that remained convertible.
8.2.3 The Bretton Woods System (1944 to 1973)

By the end of World War II in 1944, the governments of 44 Allied Powers
including Great Britain and the United States gathered in Bretton Woods, New
Hampshire, United States, to create a new international monetary system called
the Bretton Woods Agreement. This system was characterised by a fixed
exchange rate system in which the government of each member country pledged
to establish a pegged exchange rate for its currency (US dollar-based) or gold
price fixed at US$35 for each ounce of gold. This system implies that all
currencies are convertible with the US dollar which means the currency market
performance is dependent on the value of the US dollar and the state of the US
economy. In addition, under the agreement, two new institutions were set up,
namely, the International Monetary Fund (IMF) and the World Bank, to help
supervise and maintain stability in the international monetary system.
Unfortunately during this period, the US economy suffered from persistent

deficits in its balance of payments. This required a large amount of dollars to
finance the deficits and resulted in rising demand for dollars. There was lack of
confidence in the ability of the United States to meet its commitment to convert
dollars to gold. Hence in 1971, the US dollar was no longer convertible to gold. In
1973, many of the major currencies were allowed to float against the dollar which
led to the collapse of the Bretton Woods System. Figure 8.3 depicts the
development of the international monetary system from 1971 onwards.

Figure 8.3: Global trade and the currency market: The big picture matters
Source: www.fxstreet.com
ACTIVITY 8.3
Visit the IMF (www.imf.org/) and the World Bank

(www.worldbank.org/) websites to learn more about IMF and World
Bank.
Can you find out the primary roles of the IMF and World Bank?

8.2.4 The Floating Exchange Rate System

(1973 until present)
Since 1973, the worldÊs major currencies have floated their values against
each other. The floating exchange rate system was formally adopted after the
Jamaica Agreement in 1976. Under the agreement, floating rates were declared
acceptable, gold was no longer a reserve asset and more countries became IMF
members.
Under the flexible exchange rate system, governments can intervene directly and
take part in the currency market by buying and selling their own currency using
their reserves to stabilise their exchange rate. Capital inflows can be increased by
raising interest rates. However under such a system, exchange rates have become
more volatile and less predictable than the fixed exchange rate system. Floating
exchange rates can increase exposure to speculative activities that may result in
currency devaluation.
8.2.5 Contemporary Exchange Rate System

Lastly, let us look at the contemporary exchange rate system. In most
contemporary economies, exchange rates are managed in relation to monetary
policy. How are exchange rates determined? Exchange rates are determined by
market forces but a central bank can actively intervene in the foreign exchange
market in order to keep the exchange rate within a certain range. This is called
managed floater where the float is monitored by governments. This is to ensure
an orderly pattern of exchange rate changes against a predetermined rate but
allows the rate to vary.
The 1985 Plaza Accord, an agreement among G-5 countries (United States,
France, Germany, Japan, and the United Kingdom), was set up to work together
to deliberately weaken the US dollar's exchange rate. The objective of this
strategy was to help the United States improve its huge trade deficit (especially
against Japan) and to spur its economy to climb out of the 1980sÊ long recession.
The Louvre Accord of February 1987 was agreed by the G-6 nations (West
Germany, France, Great Britain, Japan, Canada and the United States) to stop the
United StatesÊ dollar depreciation.
Under the revived Bretton Woods II system which started in 2003 and lasted
until 2007, the new international system involves interdependency between
states with generally high savings in Asia (lending and exporting) to Western
states with generally high spending. This system was in response to the 1997
Asian financial crisis.

Although most major currencies float in value against one another, some of the
developing countries pegged (fixed) their exchange rates to one of the major
currencies or to a basket of currencies. For example, the European UnionÊs Euro
under the European Monetary System (EMS) is pegged to a basket of chosen
currency mix and the Chinese currency (yuan) has been pegged to the US dollar
for a decade. Hence, todayÊs global economy is increasingly dominated by
currency blocs especially by the US dollar, EUÊs Euro and the Japanese Yen.
Have you ever heard of the European Monetary System (EMS)? Launched in
1979, it was the forerunner of the Economic and Monetary Union (EMU) which
led to the establishment of the Euro. It created an area of currency stability
throughout the European community by encouraging countries to co-ordinate
their monetary policies. It used an Exchange Rate Mechanism (ERM) to create
stable exchange rates in order to improve trade between EU member states and
thus help the development of the single market. The Euro was introduced in
practice in 2001 (Civitas, 2011).
8.3 INTERNATIONAL MONEY MARKET

Let us start this section by looking at the definition of international money
market. Have you ever heard about it? What does it stand for?
The international money market is a network of people, firms, financial

institutions and governments borrowing and investing internationally in
money market instruments.
There are three types of international money market:
(a) International capital market;
(b) International bond market; and
(c) International equity market.
Let us look at these types of market further in the next section.

8.3.1 International Capital Market

What happens in this kind of market? This is the money market where foreign
capital such as Euro dollars is financed or invested. Euro dollars are US dollar
deposits in non-US banks.
For example, Sony and Hitachi borrowed US dollars from several banks in Tokyo
to finance their worldwide operations. Capital markets provide long-term debt
and equity finance for the government and corporate sector. Multinational
companies (MNCs) occasionally source foreign capital from international money
markets to finance global operations at a lower cost than is possible domestically.
Domestic capital markets tend to be illiquid and segmented, hence, at a higher

cost due to limited availability of capital. How about the international capital
market? The international capital market is liquid due to a large pool of funds
and market participants. The Euro currency market is a largely short-term
(usually less than one year of maturity) market for bank deposits and loans
denominated in any currency, except the currency of the country where the
market is located.
For example, in London, the Euro currency market is a market for bank deposits
and loans denominated in dollars, yen, franc, marks and any other currency
except British pounds. The main instruments used in this market are certificate of
deposits (CDs), time deposits and bank loans.
8.3.2 International Bond Market

What does international bond market stand for?
International bond markets are a place where company stocks are listed and
traded on foreign stock exchanges.
For example, some recent issuers of bonds are Google and Apple. Tencent
Holdings, China's largest Internet company by revenue, became the first Asian
borrower from the sector to issue global bonds. Can you define bonds?
Bonds are debt instruments used to finance long-term investments.

The approximate worth of bond markets worldwide is more than $45,000 billion,
of which the US bond market, comprises a significant portion of the total value
(finance.mapsofworld.com). The Euro bond market is a long-term market for
bonds denominated in any currency outside the country in whose currency the
bond is denominated. A foreign bond is sold outside a borrowerÊs country and
denominated in the currency of the country in which it is sold.
8.3.3 International Equity Market

Lastly, let us look at international equity market. What happens in this kind of
market?
International equity market is a place where corporate and government bonds

are issued and traded in foreign countries.
For example, Google of the United States issued stocks on the New York Stock
Exchange. These markets provide financing for global operations but can also
improve organisational recognition and portfolio performance. MNCs that are in
need of financing use foreign stock markets as their additional sources of funds.
The Euro equity market issues US dollar-denominated stocks on non-US
exchanges for distribution among foreign markets. The stocks are underwritten by
investment banks and purchased by institutional investors in several countries.
SELF-CHECK 8.3
The average world inflation rate grew to 5.5% in 2008, the highest since
1999. How does rising inflation affect exchange rate and international
business?
ACTIVITY 8.4
1. For more information on bond market development in Malaysia,

visit www.sc.com.my.
2. Visit the website www.imf.org/external/pubs/ft/wp/2004/

wp04222.pdf for more information on currency bloc formation.
Share your findings with your coursemates.

Before we conclude this topic, let us complete the following exercise. Good luck!
EXERCISE 8.1
1. _____________ is a market to convert one nationÊs currency to

another currency.
A. Foreign exchange market
B. Culture diagonal market
C. Open currency market
D. Currency exchange market
2. Foreign exchange market has two important functions which are

_____________.
A. to collect taxes of imported merchandise and to change a

nationÊs currency to another currency
B. to protect a company from foreign trading risks and to

determine the rate of benefit to the international investor
C. to collect taxes of imported merchandise and to determine

the rate of benefit to the international investor
D. to convert a nationÊs currency to another currency and to

protect the nation from foreign exchange trading risks
3. The value of one currency is determined by _____________.
A. demands and bidding interaction that is relative to the

demands and bidding of another currency
B. the international consortium of currency traders
C. the World Trade Organisation (WTO)
D. negotiations between the main banks from the top five

industrial supremacy countries

4. The process of buying one unit of currency at a lower price and

selling at a higher price is known as _____________.
A. swapping
B. crawling
C. profit
D. arbitrage
5. Between two major currencies, the spot exchange rate is the rate
__________ and the forward exchange rate is the rate ___________.
A. today; on that date
B. at some specified future date; today
C. on that date; today
D. on that date; at some specified future date
6. Foreign bonds are sold primarily in ______________________.
A. the United States
B. Japan
C. Europe
D. the country of the currency of issue
7. The _____________ established a par value, or benchmark value,

for each currency initially quoted in terms of gold and the US
dollar.
A. Bretton Woods Agreement
B. Jamaican Agreement
C. World Trade Agreement
D. International Monetary Agreement

 The foreign exchange market is a market to convert the currency of one

country to another country.
 Exchange rate is the rate at which one currency can be converted into other
currencies.
 The three main functions of foreign exchange markets are: currency

conversion, provision of credit for foreign trade and insurance for foreign
exchange risk.
 Foreign exchange market participants comprise central banks, commercial

and investment banks, corporations and individuals who buy or sell
currencies.
 Political conditions, economic factors and market psychology are factors that
can influence the foreign exchange market.
 There are five international monetary systems that determine exchange rates.
They are the gold standard, interwar years, Bretton Woods System, floating
exchange rate system and contemporary exchange rate system.
 There are three international money markets that borrow and invest
internationally in money market instruments – international capital market,
international bond market and international equity market.
Bretton Woods System International capital market

Currency bloc International equity market
Fixed exchange rate International Monetary System
Floating exchange rate Managed float
Foreign exchange market Speculation
Foreign exchange rate Spot rate
Forward rate Swap rate
International bond market

Topic  Country
9 Selection and
Entry
Strategies
LEARNING OUTCOMES
1. Describe how a manager selects suitable markets and production
locations overseas;
2. Explain the important factors of opportunities and risks when
deciding to develop business in a foreign country;
3. Describe how to collect and analyse the data of the potential
country;
4. Compare two tools used in determining a global location strategy;
and
5. Differentiate between three available entry modes to invest in a
foreign country.
 INTRODUCTION
If I want to expand my business internationally, what should I

do? How do I select the potential country and what are the
strategies to enter it?

156  TOPIC 9 COUNTRY SELECTION AND ENTRY STRATEGIES
In this era of globalisation, we can feel how small the world can be. You can
travel easily to another country for a lot of reasons. Sometimes the reason can be
about business. But how do we make business with another country? This topic
will give the answers to such questions as we are going to learn about country
selection and entry strategies.
Companies are faced with several important decisions when entering a foreign
market. One major decision that companies should consider during international
expansion is the entry strategies. International entry strategies concern two major
decisions:
(a) Where (country selection); and
(b) How (mode of entry).
This topic deals with how foreign companies allocate their scarce resources
among different countries when selecting where they might operate. The focus is
on major variables to consider when evaluating and comparing countries based
on opportunities and risk factors. This is followed by a discussion on how to
collect and analyse data. After that, you will learn how to use two comparison
tools on selecting potential countries to enter. Lastly, three modes of entry
strategies will be explained so that you know how companies decide which entry
mode to use for specific markets. Let us begin our lesson!
9.1 SELECTING SUITABLE MARKETING AND

PRODUCTION LOCATION
In everyday life, we always have to make decisions. One of the ways to come up
with decisions is by making selections. How do we select a suitable marketing
and production location? Who is the person in charge of doing it? The person in
charge for this job is the manager. In order to select the location of production
and marketing, a manager needs to answer these two basic questions:
1. Which market to explore; and

2. Which location would be suitable for production .

TOPIC 9 COUNTRY SELECTION AND ENTRY STRATEGIES  157
Did you know that the factors to consider in the selection of production and
marketing locations are usually interdependent? Production sites are often
located close to the market when transportation costs are high or when host
government regulations require local production. For example, in service
industries, they need to be close to their customers.
Companies may also need to search for location advantages to minimise

production cost. Location advantages of a foreign production such as supply of
labour, raw materials, supplier's network and infrastructure can prolong a
companyÊs competitiveness.
The process of determining the overall location strategy must be flexible due to
the ever-changing situation in certain countries. A good strategy must enable a
company to respond to new opportunities in alternative locations. Hence, a
company must take into account existing factors in the foreign environment, such
as future cost, price, rivalsÊ reaction and technology.
Figure 9.1 demonstrates what managers should consider when making decisions
on market and production location.

Figure 9.1: Chart of location selection for operation
SELF-CHECK 9.1
Explain the main reasons why managers should give attention to a

country when making decisions on the market and location of
production.

9.2 SCANNING FOR ALTERNATIVE LOCATIONS

What happens when a manager cannot find a suitable place for his business
operation? Well, there is always another solution for this problem which is
scanning for alternative locations. But how do we do it?
When making comparison between countries, managers use various techniques

of scanning based on the broad variables that indicate opportunities and risks. A
thorough analysis on alternative locations will prevent companies from making
biased decisions so as to maximise sales or ensuring choice of least-cost
production location.
9.3 CHOOSING AND COMPARING

OPPORTUNITIES AND RISKS
As explained in the previous section, managers use various techniques of
scanning to find alternative locations. The scanning technique involves
determining the opportunities which are then weighed against risks of doing
business in the host country. Moreover, managers need to evaluate the host
countryÊs external factors that could significantly affect the success and failure of
the foreign operations.
9.3.1 Investment Opportunities

How do we determine investment opportunities?
Opportunities are determined by the profitability of investments.
There are four factors that need to be considered when assessing opportunities:
(a) Size of market;
(b) Infrastructure and operation suitability;
(c) Resource availability and costs; and
(d) Bureaucracy.

Figure 9.2 simplifies these opportunities in a diagram. Note that these factors also
affect both the market location and production decisions.
Figure 9.2: Four factors to consider in investment opportunities
These factors are further explained as follows:

(a) Market Size
Sales potential is one of the most important variables used by managers to
determine a suitable location to make an investment. This is because market
size determines sales potential.
Companies rely on past and present information on sales figures on a

country-by-country basis for the type of products they want to sell.
However, in certain countries where sales figures are not available, other
data such as Gross National Product (GNP), market growth, population,
middle-class consumer size and stage of industrial development can be
used to estimate demand.
(b) Infrastructure and Suitability of Operation

Basically, most companies prefer to select locations where they perceive it
as easier for them to operate. For example, American companies rank
Canada and Mexico as suitable because of their geographical location and
ease of control on their subsidiary operations. Other factors such as
similarities in culture and economic systems determine a countryÊs
attractiveness as choice of location. Infrastructure such as accessibility to
communication and transportation network is examined by companies in
their feasibility studies in alternative country selection.

(c) Availability of Resources and Cost

Companies also consider the availability of the resources that they need.
They seek resources that do not exist or are more expensive in their home
country. For example, local people who have the market knowledge and
technical skills are sought after. Most of the time, companies decide
whether to make the product or component for sale in the countries where
they are made or to export them to another market. They also seek low
labour cost, raw materials, land, local tax rates and transfer pricing costs
that are suitable with the production. When seeking low-production sites,
companies also consider other factors such as ease of entry and regulations
and presence of suppliers.
(d) Bureaucracy
Companies usually compare the level of bureaucracy that is needed to
operate in certain countries as this can increase their operating costs.
Bureaucracy includes the administrative work in getting a licence to
operate, produce and sell certain products, bringing in expatriates and
abiding by host government policies such as taxes, labour laws, working
conditions and environmental rules.
For example, in Ukraine, different government bodies often have

overlapping spheres of responsibility and have conflicting instructions and
policies. Controlling and regulating bodies often act unpredictably, based
on rules that no one else is aware of (taken from UkraineÊs Business
Culture, 2005). It is difficult to measure the level of bureaucracy and red
tape of a country that can hinder investment opportunities significantly and
hence, companies need to evaluate this factor towards other countries
subjectively.
ACTIVITY 9.1
1. Read more about „Investment Opportunities in China‰ by

Dr Burton G. Malkiel (http://www.youtube.com/watch?v=
uVcV0H4qtgw).
2. Read „The McDonalds Case: Strategies for Growth‰ by

L. Siehoyono and L. E. Giang (http://puslit2.petra.ac.id/
ejournal/index.php/hot/article/view/16310) and
„Why McDonalds Wins in Every Economy‰ at (http://

management.fortune.cnn.com/2011/08/23/why–mcdonalds–
wins –in–any–economy/).

9.3.2 Investment Risks

Can you think of the types of risks that may directly affect business investment in
a foreign environment? Well, there are many risks that companies are exposed to
when operating their business in certain countries even though each country has
its potential. Let us look at Figure 9.3 that shows you the types of risks in
investment.
Figure 9.3: Four types of risks
These four types of risks are further explained as follows:
(a) Uncertainty and Risk

Companies use various monetary techniques in comparing potential
projects such as discounted cash flows, economic add value, payback
period, present total value, sales return, return on asset employed, internal
return value, account return and return on equity. Even though the
differences between the techniques are better explained in a monetary
course, the international implication is the same. As for that, we can only
refer to return of investment (ROI) to explain risks consideration in

If the expected return is the same, most decision makers prefer a certain
gain than an uncertain one. In order to estimate the ROI, a company will
count the different average return for an investment. Table 9.1 shows you
two same lines of ROI but they have clear differences in terms of
achievement and possibilities. In Table 9.1, at the 10 percent level of
certainty, the ROI lines are higher for investment B compared to investment
A (40% to 30%). Next, the 10% of customersÊ possibilities are also higher for
B (.40 +.30 = .70 or 70%) compared to A (.30 +.20 = .65 or 65%). Experience
shows that most (not all) investors will prefer alternative B as compared to
alternative A. Moreover, when doubt increases, investors will need a higher
estimation of ROI.
Table 9.1: Two same lines of ROI
Investment A Investment B
Weighted Weighted
ROI as Percentage Possibilities Possibilities
Value Value
0 0.15 0 0 0
5 0.20 1.0 0.30 1.5
10 0.30 3.0 0.40 4.0
15 0.20 3.0 0.30 4.5
20 0.15 3.0 0 0.0
Estimation of ROI 10.0% 10.0%
Companies can frequently decrease the risk or doubt by taking insurance.

However, insuranceÊs cost towards funds which its currency is not
exchangeable or cannot be moved is high. During the early process of
precision to set the desired amount that can be managed, a company must
give consideration to the elements of risk and doubt. During a more specific
level of feasibility study, the manager must determine whether the level of
risk can be accepted without involving additional costs. Otherwise, the
manager has to calculate the ROI including expenses, such as insurance, to
increase the level of confirmation operation.

How do we determine the Return of Investment (ROI)? We can determine

the Return of Investment (ROI) as follows:
(i) Multiply ROI as a percentage with its „possibilities‰ to get the

weighted value.
(ii) Total up all the weighted value.
Weighted value = Possibilities  Percentage
Usually, when a company operates overseas, it will have a higher level of

doubt as compared to operating only in its own country due to the different
environment. A company can alter its impression towards the consumer,
competition and governmentÊs action through the experience of operating
in certain countries or countries with similarities, which will eventually
decrease the level of doubt.
In addition, in the beginning years of operation, foreign companies have

lower success rates as compared to local companies. This situation is known
as „liability of foreignness‰. However, foreign companies, which are able to
adapt to new situations and overcome early problems, are capable of
having the same level of success with local companies in the following
years. The process of learning explains why companies always consider
reinvestment or expanding their investment in a particular country in a
totally different perspective compared to countries in which they do not
have any experience. We will discuss reinvestment in another topic.
ACTIVITY 9.2
If two projects have a similar ROI (7%), does that mean that both
projects have an equal risk and opportunity to be successful?
(b) Competition Risk

Now we move on to the second risk – competition risk. The competitive
advantage of innovation of a particular company may not last forever.
Although it has the advantage of competition as an apprentice, its period as
an apprentice may differ according to the market. A strategy being used to
exploit this temporary advantage of innovation is known as „imitation lag‰.

In order to implement this strategy, a particular company will need to enter

a country which they can easily adapt to and accept the advantage of
innovation, before going to other countries. Countries which receive
innovation at a faster mode will be countries with their companies
investing a lot in technology and offer minimum protection to intellectual
property rights (IPR). Hence, a companyÊs innovation advantage is
threatened in countries that offer little protection on the firmÊs IPR.
Companies can also form a strategy by searching for countries which do not
have any apparent competition. For example, you might be familiar with
Kao. Kao is a manufacturer of goods for household cleaners and bath
toiletries. The company has already focused its international expansion in
South East Asia because its market is expanding and also lack of
competition from America and Europe.
As for Chrysler, it is vice-versa. Chrysler gained approval to build an

assembly factory in Vietnam because it is one of the only four automobile
manufacturers in the market. However, Chrysler quit when it heard that
there are already 12 companies that have gained the same approval.
ChryslerÊs decision to quit is because there was too much competition as
compared to the market size.
However, there are also cases where a company can benefit if it operates in
places where there are competitors. Companies that operate in a cluster
location can gain better information about the latest development and
technologies.
(c) Financial Risk

The third risk of investment is financial risk. Did you know that often
foreign investors prefer some of their holdings to be liquid?
„Liquidity preference‰ is a theory whereby investors usually require part

of their investment in liquid asset.
They are also willing to receive a lower income. Liquidity is needed to

make payment in a short period of time, such as paying for dividends and
accommodating unexpected contingencies such as „stockpiling‰ materials
in times of emergencies.

Sometimes, companies intend to sell all or part of their equity in a foreign

country so that the funds can be used for other developments. However,
the ability to find local buyers is different between the countries depending
on the availability of the local capital market. For example, Vitro glass
manufacturer decided to sell Anchor Glass, their American subsidiary. The
capital market of America is more developed and the move eased the
selling and transferring of product to Mexico.
If the fund is not convertible, the seller has to spend the fund in the host
country. Another concern that worries most of the foreign investors is the
ability and cost to convert overseas operation profits. Investors are more
willing to receive a lower ROI in a country that has a stable currency as
compared to those with unstable exchange rates.
There are two variables that affect the financial risk of operating in a foreign
country: capital control and exchange rate stability. Changes in exchange
rates may decrease investment liquidity and increase financial risk. A
countryÊs balance of trade, savings, interest rates, inflation and government
budget are other useful indicators to predict the financial situation of a
particular country.
(d) Political Risk

Lastly, let us look at the final risk which is political risk. What are the
sources of political risk and how can it be predicted? Sources of political
risks include change in opinion of political leaders, policy, civil disorder
and hostility between host countries and other countries, and such risks can
disrupt foreign operations.
Furthermore, threats of takeover of property by host government, damage

of property, operational failure and changes in law can directly affect
business operations.
There are three methods that a manager can use to predict a countryÊs
political risks. These are:
(i) Analysis of past patterns;
(ii) Consultation with professionals; and
(iii) Inspection of social and economic situation which may lead to such
risks.

These methods are summarised in Figure 9.4.
Figure 9.4: Three ways to predict political risk
SELF-CHECK 9.2
1. What are the types of risks that may directly affect business
investment in a foreign environment?
2. What is political risk and how can it be predicted?
9.4 COLLECTING AND ANALYSING DATA

When making decisions on foreign market selection and entry, one of the main
questions concerning market information is how data should be collected and
analysed. Companies have to determine what national and international sources
of information are available. Companies rely on both internal and national
sources of information that are normally easily available, however, companies
may face problems with external sources of data about an international market.
For example, problems associated with the source, quality, and comparability of
available information used to increase understanding of foreign markets
(including access to data, ability to retrieve data quickly and the cost of obtaining
data).

9.4.1 External Sources of Information

How do companies get external information about certain countries? Companies
have multiple sources of country information that can be sourced externally.
These sources can be from:
(a) Individualised reports from marketing and business consulting companies

that conduct research and studies covering many countries for a fee;
(b) Specialised reports from research organisations that provide data on

specific studies to potential/interested company. For example, a specific
study done on certain products or market for a much lower fee than
individualised reports;
(c) Service firms that provide services to international clients such as banks,
accounting firms, rating agencies publish reports on subjects such as
taxation and legislation;
(d) Government agencies that publish statistical reports on country indicators

and trends;
(e) International organisations and agencies such as United Nations (UN),

World Trade Organisation (WTO), International Monetary Fund (IMF),
Organisation for Economic Co-operation and Development (OECD) and
European Union (EU). They collect and disseminate country information to
those who are interested;
(f) Trade associations that publish trade journals that provide industry
information related to product lines with technical and competitive factors;
(g) Information service companies that manage and sell online databases from
multiple sources. Companies can obtain such computerised data from
library sources; and
(h) The Internet which provides a host of current information via World Wide
Web. However care must be taken to ensure reliability of information.

EXERCISE 9.1
1. Discuss how companies can choose and weigh variables before

deciding to invest in foreign countries.
2. List and describe three external sources of country information

that is available in terms of completeness, reliability and cost.
9.5 USING COMPARISON TOOLS

What should a firm do after it has collected and analysed data? After the firm has
identified potential locations overseas and the necessary data has been collected,
analysis and comparing information across countries is undertaken. The two
instruments commonly used in comparing data are grid and matrix. Let us look
at how to use these two instruments.
9.5.1 Grids
A firm can use grids to make comparisons between countries based on factors
that they deem important. Values and weights are assigned to each country-
related variable in order to rank each country according to factors identified as
important. Table 9.2 shows you how grid analysis is done based on information
which is divided into three categories: equity, income and risk.

Table 9.2: Simple Grid for Comparison of Countries for Penetration of Market
Country
Variables Leverage
I II III IV V
1. Accepted factor (A), unaccepted (U)
1.0 Allow 100% equity hold – U A A A A
2.0 Allow licensing to subsidiaries – A A A A A
which are owned by majority
2. Income (higher score = higher
choice)
1.0 Size of investment needed 0–5 – 4 3 3 3
2.0 Direct cost 0–3 – 3 1 2 2
3.0 Tax rate 0–2 – 2 1 2 2
4.0 Market size, current 0–4 – 3 2 4 1
5.0 Market size, 3–10 coming years 0–3 – 2 1 3 1
6.0 Market share, in a short time, 0–2 – 2 1 2 1
0–2 years
7.0 Market share, 3–10 future years 0–2 – 2 1 2 0
Total 18 10 18 10
3. Risk (lower score, higher choice)
(a) Loss of market, 3–10 coming 0–4 – 2 1 3 2
years
(b) Problem of foreign exchange 0–3 – 0 0 3 3
(c) Potential political problem 0–3 – 0 1 2 3
(d) Business law, current 0–4 – 1 0 4 3
(e) Business law, 3–10 coming 0–2 – 0 1 2 2
years
Total 3 3 14 13
Companies can ignore non-potential countries based on the first category (U).
They will determine the weight or value for each variable according to
importance. High income will be assigned a high score, while high risk will be
assigned a low score.

In this example (Table 9.2), country II is seen as a country that has high income
and low risk (total of income = 18, total of risk = 3), country III has low income
and low risk (total of income = 10, total of risk = 3), country IV is a country that
has high income and high risk (total of income = 18, total of risk = 14) and
country V with low income and high risk (total of income = 10, total of risk = 13).
Both variables and weights differ between product and company, and it depends
on the companyÊs situation and objective. Grid technique is not only useful for
comparisons across countries, but it can also help to analyse if a company needs
to add further investment or deeper analysis into feasibility research after
fulfilling the minimal criteria of the company. However, grids tend to become
cumbersome and limited as the number of variables for comparison increases.
SELF-CHECK 9.3
What are the advantages and disadvantages of using the grid technique
to determine investment across countries?
9.5.2 Matrices
Now, let us look at the second instrument of comparison tools – matrices. In
general, there are two types of matrices that managers can use when comparing
countries. They are:
(a) Opportunity-risk matrix; and
(b) Country attractiveness-firm strength matrix.

These two types of matrices are further explained as follows.
(a) Opportunity-risk Matrix

This method provides an overall picture of the data that has been gathered
by comparing opportunities and risk. An example of this matrix is
illustrated in Figure 9.5.
Figure 9.5: Opportunity-risk matrix

The matrix shows a company with operations in six countries. Countries E

and F are the most desirable because they have a combination of high
opportunity and low risk. In country A, the opportunity level is not that
high but risk is low which makes it attractive. Country B has a high level of
opportunity but high risk. Countries C and D are less appealing than E and
F. Hence, the decision between A and B will depend on the companyÊs risk
tolerance.
How are the scores determined using this matrix? First, the factors that are
considered as good indicators of companiesÊ risk and opportunity are
determined and then we weigh them to reflect their importance. For
example, in risk axis, a company can determine 40 percent (0.4) for takeover
risk, 25 percent (0.25) for foreign exchange control, 20 percent (0.2) for riot
and 15 percent (0.15) for exchange rate. The total is 100 percent. The
company will then assess every country based on a scale of 1 until 10 for
every variable (by giving 10 as the best and 1 as the worst) and multiply
every variable with weights that has been determined.

For example, the company may give 8 marks to takeover risk for country A
and multiply 8 with 0.4 to get 3.2. The company will total up all of the risk
variablesÊ scores at the risk axis. The same method is used to determine the
position in the opportunity axis. When the scores for each country are
determined, the management can determine the average risk and
opportunity scores among the countries and divide the matrix into four
quadrants.
(b) Country Attractiveness-firm Strength Matrix

This matrix is used for making comparisons between a firmÊs strengths and
country attractiveness, as shown in Figure 9.6.
Figure 9.6: Country attractiveness-firm strength matrix

Based on Figure 9.6, we can see that a company should try to focus on its
activities in countries which are situated in the upper left corner of the
matrix and try to hold onto as many equities as possible. In this situation,
the level of attractiveness of a country and ability to compete are at the
highest level. At the upper right corner, the level of attractiveness is also
high but the ability to compete is weak, probably due to unsuitable
strategy. If the cost is not too high, the company can try to gain advantage
and alter its weakness. If not, it may have to liquidate its investment or try

to strengthen its position through collaboration with other companies. A

company may liquidate its operation with companies that are located at the
lower right corner. It may also need to license its operation to gain income
without the need to do extra investment. In another situation, a company
needs to analyse its position and take action subsequently because it
involves marginal places that need specific analysis.
SELF-CHECK 9.4
1. List two tools and their major components that can be used to
analyse and compare information on market location.
2. What is the difference between these two tools?
9.6 MODES OF ENTRY

Next item to consider when selecting a country is mode of entry. Multi-national
enterprises (MNEs) must make an important strategic decision concerning the
choice of entry mode when investing in a foreign market. There are various
modes of entry choices and each mode selected by the company depends on the
level of resource commitment, risks, control and ownership as well as expected
returns from investment. There are three forms of entry mode choices available
to choose from:
(a) Trade-related entry modes via direct and indirect exporting;
(b) Transfer-related entry modes involve transfer of ownership of property,

usually intellectual property such as use of technology, from one party to
the other in return for royalty fees. For example, licensing, franchising and
turnkey operations; and
(c) Foreign direct investment-related entry modes via joint venture and
wholly-owned subsidiary.

Figure 9.7 summarises these three types of entry modes and their components.
Figure 9.7: Different modes of entry
9.7 TRADE-RELATED ENTRY MODES–EXPORTING
Most firms start their international expansion through exporting. Exporting as an

entry mode involves the firm maintaining its production facilities at home and
selling its products overseas. However, there are some advantages and
disadvantages of exporting (see Table 9.3).
Table 9.3: Advantages and Disadvantages of Exporting
EXPORTING
Advantages Disadvantages
 Suitable for small firms to sell surplus  Firm is subject to government
production abroad. regulations on exports into a country in
 Low costs involved with low the form of trade barriers such as tariffs
commitment of financial and human and non-tariff barriers.
resources.  Firm is subject to high transportation
 Low risks. costs of bringing goods abroad making
it uneconomical.
 Does not require substantial presence
in foreign countries.  Problems associated with export agent
who carries many brands and types of
 Allows firms to expand new products and firm has no control over
knowledge and experience about marketing activities of export agent.
going overseas.

There are three broad options of exporting available to companies that plan to
enter a market. They are:
(a) Indirect exporting involves the firm using export intermediaries as

middleman or third parties based in its home market to handle
transportation, documentation and customs claims or sometimes to the
extent of handling marketing and financing exports. Export intermediaries
in the form of an export merchant, export agent or export management
company (EMC) are popular among small businesses. These three
intermediaries have their own specific role as follows:
(i) An export merchant is a trading company that buys a firmÊs exports

directly and resells them in foreign markets.
(ii) An export agent acts for local manufacturers carrying a number of

non-competing exports of manufacturers.
(iii) An EMC is an independent firm that acts as an exclusive distributor

for a number of non-competing exports.
(b) Direct exporting occurs when a company sets up its own export
organisation and uses a foreign distributor based in a foreign market to
handle its exports.
(c) Cooperative exporting, also known as piggyback exporting, happens when

a company uses the overseas distribution network of another company to
sell its goods in a foreign market. For example, Wrigley (the US chewing
gum company) entered India by piggybacking on ParrysÊ (a local
confectionary firm) distribution network.
ACTIVITY 9.3
Why do companies export? Explain the potential pitfalls of exporting.

9.8 TRANSFER-RELATED ENTRY MODES

In this section, we will look at three transfer-related entry modes, namely,
international licensing, international franchising and management contract.
9.8.1 International Licensing

What does international licensing stand for?
International licensing is an entry mode in which a foreign licensor grants a

local licensee the right to use intangible property rights such as patents,
trademarks, technology or management skills in return for a royalty fee.
The licensor does not have to start or build a new operation overseas as the local
licensee is allowed to produce, manufacture and market the licensorÊs product.
For example, Coca Cola Company has a trademark licensing agreement with
Fraser & Neave Holdings Berhad (F&N) Malaysia giving F&N rights to bottle
and distribute cola in Malaysia, Thailand and Brunei. How about the advantages
and disadvantages of licensing? Let us look at Table 9.4 to find out the answers.


Table 9.4: Advantages and Disadvantages of Licensing
LICENSING
 Offers benefits to both parties involved.  The licensor bears the risk of creating
The licensee gets to enjoy products or a new competitor once the licensing
technology that involves development agreement expires as production
cost and high production. technology is already known and
 The licensor gains entry into the exposed to the foreign licensee. For
international market quickly with example, the case in 2008 between
minimal investment, effort or risk New Balance (NB) and HK Yangtian
especially entry into established (former authorised manufacturer of
markets that have been closed or NB) for imitating the package and
restricted by high tariffs. intentionally used the good reputation
of „NB‰ to mislead consumers and to
 The licensor can expand its limited promote its products after termination
capacity at home to overseas markets of use of trademark.
and develop market outlets for its
products via the licensee.  Cultural clashes between licensor and
licensee due to differences in language
 The licensor is able to prevent possible and political risks may affect and
infringement, imitation or loss of cause termination of licensing
patents or trademarks by granting agreement.
licensing rights.
 The licensor has little or no control
 Considered a globalisation strategy over the manufacture, quality and
that allows multinational companies to marketing of its goods in the foreign
grow and build their core business for country. For example in 2007, Mattel
example license agreements between which license its brands to toy
mass merchandisers and licensors for manufacturers in China had to recall
toys, games, and children's apparel Barbie dolls due high lead paint.
such as Barbie, Mickey Mouse, Harry
Potter and many others.
9.8.2 International Franchising

Are you familiar with international franchising? What can you say about it?
International franchising is an entry mode in which the foreign franchisor grants

a local franchisee to use specified intangible property rights usually a trademark
or brand name or operation method to execute its business operation. In return,
the franchisor receives royalty fee.

Franchising is widely used in the fast food and hotel/motel industries. The
franchising concept can be easily adapted to fulfil the needs of the local market
and produce high profits to the company. Can you think of any examples? Fast
food companies such as KFC, McDonaldÊs and Burger King use franchising to
widen their markets. In the hotel industry, Holiday Inn is among the
international franchise businesses which have been effective and successful.
Franchising normally requires a deposit and annual royalty based on the

percentage of annual sales. As a reward, the franchisor will help in purchasing
raw materials and even in marketing to ensure that the quality is the same at all
outlets. Franchising provides benefits to both parties. It also provides
opportunity for a new source of income to the franchisee and makes it easy for
the franchisee to venture into new markets.
However, there are some disadvantages of franchising as explained in Table 9.5.
Table 9.5: Advantages and Disadvantages of Franchising
FRANCHISING
 Offers a fast and easy opportunity for  More difficult to execute at the
the franchisor to explore international international level as all franchisees use
markets with low cost and risk. the same name, image and product. The
 The franchisee gets to start a business franchisor must ensure uniformity and
using a product and operation system quality in the production process. There
that is already established in the might be conflicts and disagreements
international market. between the franchisor and franchisee
over control of operations and also due
 Involves longer commitments, offers to cultural clashes and differences in
greater control over foreign operations opinion.
and receives more rights and
resources. This may be the reason why  The franchisor bears the risk that the
service MNEs such as KFC and franchisee may damage the companyÊs
McDonalds prefer franchising. image if the franchisee fails to meet
quality standards.
 Franchisees often have access and
assistance from franchisors such as
production equipment, operating
procedures, advertising, management
systems and even financing funds.

ACTIVITY 9.4
1. List the main differences between international licensing and

international franchising.
2. What problems might arise in the international licensing

agreement between a licensor and licensee?
3. Visit the Malaysian Franchise Association at www.mfa.org.my/

and Franchise Malaysia at www.franchisemalaysia.org/ to find
out more about franchising opportunities in Malaysia.
9.8.3 Management Contract

Now, we move on to management contract. Do you know its definition?
A management contract is an agreement made between a company with other

companies that provides technical expertise or specific managerial services such
as training, marketing accounting and personnel management in return for a fee
until the contract expires.
Through this approach, the entry risk in the international market is low and is
suitable when there is lack of local skills to manage the project or when a host
government restricts other entry methods.
9.8.4 Turnkey Operation

Lastly, let us take a look at turnkey operation. How does turnkey operation
work?
Turnkey operation involves a contractual

agreement in which a foreign company as
the investor will design and build an
operation facility and upon the completion
of the facility hands the project and
management over to the local owner.

In return, the investor is guaranteed periodic payments for the project. The
turnkey investment is also called Build-Operate-Transfer (BOT) which is useful
especially for large scale and long-term infrastructure projects, usually for
government agencies such as building airports, highways and rail transportation.
The main advantage of the turnkey method is that the host government and local
companies gain the technology transfer as well as training and expertise from the
foreign investor that has agreed to complete and manage the entire project. BOT
allows the foreign investor to enter the market easily. The method involves low
risk as the foreign investor normally gets support from the host government to
complete the entire project. However, the main disadvantage of turnkey
operation is that the foreign investor can become a leading competitor in the
future after the BOT.
ACTIVITY 9.5
1. Find out the successful turnkey projects that have been

undertaken in Malaysia.
2. Identify the factors that contribute to a successful turnkey project.
3. Read „Managing Mega Projects: The Experiences of KLIA‰ by Tan

Sri DatoÊ Prof. Ir. Jamilus Hussein and Prof. Dr. Shafie Karimin at
http://www.mbam.org.my/mbam/images/MBJ4Q06(pdf)/@Me
gaProjects.pdf
9.9 FOREIGN DIRECT INVESTMENT (FDI)-

RELATED ENTRY MODES
Before we end this topic, let us look at related entry modes for FDI. Can you
recall what are the forms of FDI? The two common forms of FDI-related entry
modes are joint ventures and wholly-owned subsidiaries. Let us look at them
further in the next section.

9.9.1 Equity Joint Ventures (EJV)

Did you know that equity joint ventures (EJV) are one of the most common forms
of entry for MNEs? It involves setting up a new entity that is jointly owned and
managed by two or more companies in different countries. The partners involved
agree to contribute capital in proportion to the equity stakes which can be
majority, equal or minority share ownership. In addition, both parties contribute
facilities, materials, labour, training and even intellectual property rights.
For example, ChinaÊs law requires a foreign venture partner to contribute at least
25% of capital to the EJV. While there is no upper limit on the foreign partnerÊs
contributions (maximum 99%), however, host governments may limit majority
ownership for foreign JV partners in restricted sectors. The main factor behind a
successful international joint ventures is by choosing a suitable partner.
Let us look at Starbucks Coffee as an example for EJV.
Starbucks CoffeeÊs Criteria in Selecting Suitable Partners

 Shared values and corporate culture
 Strategic fit
 Sufficient financial and human resources
 Real estate knowledge and access
 Local busines leader
 Strong track record in developing new ventures
 Food and beverage experience
 Involved and committed management
Source: Kotabe & Helsen (2011)

What are the advantages and disadvantages of EJV? Let us look at the answers in
Table 9.6.
Table 9.6: EJV Advantages and Disadvantages
EQUITY JOINT VENTURES (EJV)

 Allows foreign partner greater control  Foreign partner runs the risk of giving
over operations. control of technology to the local
 Sharing of operation and set-up costs partners and this could create a future
or capital as well as risks with local competitor.
partner.  Disagreement may cause a break-up
 Foreign partner benefits from local due to differences in culture and
partnerÊs knowledge of competitive management styles or lack of trust
conditions, culture, language, legal among the partners. Conflicts of control
and political system and business on operations and shared ownership
system. Foreign partner also gain from arrangements may arise between the
local partnerÊs access to distribution investing partners.
network, supplier contact and host
government relationships. Hence, EJV
creates synergy between the two
partners.
 A safer and only feasible entry mode
in some countries with high political
risks.
Read Starbucks CoffeeÊs joint venture success in China at www.starbucks.com.
9.9.2 Wholly-Owned Subsidiary

Last but not least, let us learn about wholly-owned subsidiary (WOS). Wholly-
owned subsidiary (WOS) involves a company which invests and owns 100% of
the new entity in a host country.
There are two strategies of setting up a new entity in the host country:
(a) Build Strategy

This is also known as Greenfield investment in which the investing
company builds a new subsidiary ground usually in the form of Greenfield
projects such as building, new plants, manufacturing factories, assembly
and bio-diesel plants. For example, in 2002, Ford Motor Company was the

first automaker to set up a manufacturing facility in Russia. Some recent

examples of Chinese Greenfield are investments in the United States such
as Tianjin PipeÊs steel pipe mill in Texas and Suntech PowerÊs solar panel
assembly plant in Arizona.
(b) Buy Strategy

This is also called Brownfield investment in which the investing company
buys or acquires an existing or established local company in the host
country. For example, Wal-Mart, the world's leading retailer, acquired
Asda, the United Kingdom's third largest supermarket group to enter the
UK market.
Before we come to the end, can you think of the advantages and disadvantages of
a wholly-owned subsidiary? Let us look at Table 9.7 to find out the answers.
Table 9.7: Advantages and Disadvantages of Wholly-Owned Subsidiary
WHOLLY-OWNED SUBSIDIARY (WOS)

 Allows the parent company to have  WOS projects can be complex and
tight control over its operations of usually involve a lengthy process.
subsidiaries in different countries to
take advantage of global integration.
 Reduces the risk of losing control of a  The investing company has to bear full
firmÊs technological expertise to a risk and cost of setting up the
competitor. operations overseas.
 Builds the business from ground up to
gain experience and realise learning
curve and reap benefits of location
advantages of host country.
ACTIVITY 9.6
1. List some of the criteria in selecting suitable joint venture

partners.
2. What are the possible causes of break-up and failures in

international joint ventures?
3. For more information about FDI in Malaysia, visit http://www.

tradechakra.com/economy/malaysia/fdi-in-Malaysia-198.php.

As a conclusion, let us look at Table 9.8 which shows a comparison between the
foreign market entry modes.
Table 9.8: Comparison of Foreign Market Entry Modes
Conditions Favouring
Mode Advantages Disadvantages
this Mode
Exporting  Limited sales  Minimises risk  Trade barriers and
potential in target and investment. tariffs add to costs.
country; little  Speed of entry.  Transport costs.
product
adaptation  Maximises scale;  Limits access to
required. uses existing local information.
facilities.  Company viewed
 Distribution
channels close to as an outsider.
plants.
 High target
country
production costs.
 Liberal import
policies.
 High political risk.
Licensing  Import and  Minimises risk  Lack of control
investment and investment. over use of assets.
barriers.  Speed of entry.  Licensee may
 Legal protection  Able to become
possible in target circumvent trade competitor.
environment. barriers.  Knowledge
 Low sales  High ROI. spillovers.
potential in target  License period is
country. limited.
 Large cultural
distance.
 Licensee lacks
ability to become a
competitor.

Joint Ventures  Import barriers.  Overcomes  Difficult to

 Large cultural ownership manage.
distance. restrictions and  Dilution of
cultural distance. control.
 Assets cannot be
fairly priced.  Combines  Greater risk than
resources of two exporting and
 High sales companies.
potential. licensing.
 Potential for  Knowledge
 Some political learning.
risk. spillovers.
 Viewed as insider.  Partner may
 Government
restrictions on  Less investment become a
foreign required. competitor.
ownership.
 Local company
can provide skills,
resources,
distribution
network, brand
name, etc.
Wholly-  Import barriers.  Greater  Higher risk than
Owned  Small cultural knowledge of other modes.
Subsidiary distance. local market.  Requires more
 Assets cannot be  Can better apply resources and
fairly priced. specialised skills. commitment.
 High sales  Minimises  May be difficult to
potential. knowledge manage the local
spillover. resources.
 Low political risk.
 Can be viewed as
an insider.
Source: http://www.quickmba.com
Before we move on to the next topic, let us do Exercise 9.2 to enhance our
knowledge about this topic.

EXERCISE 9.2
1. One of the tools that can be used to make comparisons between

countries is ______________.
A. grid
B. matrix
C. subsidy
D. quota
2. Generally, which are the two types of matrix that are usually used
by managers when making comparisons between countries?
A. SWOT matrix and environmentÊs observation matrix
B. Subsidy matrix
C. Opportunity-risk matrix and countryÊs attractiveness-
companyÊs strength matrix
D. Industrial-non industrial company matrix and companyÊs
strength matrix
3. All of the following are considered as good indicators of market

size potential and future sales EXCEPT:
A. Gross national product (GNP)
B. Population growth
C. Income per capita
D. Cultural values
4. Companies are more likely to pursue joint ventures as an entry

strategy in countries where ___________________________.
A. the political environment is highly unstable
B. the domestic companies are competitive
C. the cultural value of trust is high
D. the exchange rate is unpredictable

5. The fastest growing area of international franchising for Western

companies can be found in _____________________.
A. Automobile dealerships
B. Banking services
C. Food services
D. Petrol service stations
 There are two important decisions that should be made by a manager:

determine the best country/market to be selected to locate production site
and the mode of entry into the market.
 There are a few techniques that can be used to help the manager in making
country selection and evaluation decision. The techniques are the
environmental scanning technique, ranking technique, published data and
using professional expertise of consultants.
 The most important factors in country selection should take into account
initiatives that maximise the companyÊs profit and opportunities and
minimise cost and risks simultaneously.
 There are two tools used in determining a global location strategy: grids and
matrices.
 Grid technique is used by companies to make comparisons between countries

based on the countryÊs opportunity and risk factors deemed as important to
the company.
 The two types of matrix used for country comparison are opportunity-risk
matrix and countryÊs attractiveness-companyÊs strength matrix.
 Opportunity-risk matrix studies the opportunity to invest and risk that will
be faced in a particular situation.
 CountryÊs attractiveness-companyÊs strength matrix, on the other hand,

relates the attractiveness of a country and the strength of the company to
compete.

 If a firm has a low level of competition and high level of countryÊs

attractiveness, the domination of liquidation or collaboration can be
conducted.
 However, if the strength to compete is high and the countryÊs attractiveness is

also high, an investment strategy can be considered.
 There are three available entry modes to invest in a foreign country: trade-
related, transfer-related and foreign direct investment-related.
 Trade-related entry modes are direct and indirect exporting.
 Transfer-related entry modes include licensing, franchising, turnkey projects

and management contract.
 FDI-related entry modes involve higher commitment and risks such as joint
ventures and wholly-owned subsidiaries.
Bureaucracy Indirect exporting

Competition risk Investment opportunity
Country selection Licensing
Direct exporting Liquidity preference
Entry mode Management contract
Equity joint venture Matrix
Financial risk Political risk
Franchising Turnkey project
Grid Wholly-owned subsidiary
Investment risk

Topic  Managing the
10 Global
Marketing
Environment
LEARNING OUTCOMES
1. Summarise market analysis for the global marketing environment;
2. Describe how companies standardise or adapt their marketing mix
strategies to global marketing;
3. Explain how companies do their global product brand;
4. Summarise global promotion for international marketing;
5. Describe how global pricing is set; and
6. Explain the importance of global distribution in the growth and
development of world trade.
 INTRODUCTION
Hello and welcome to the last topic of International Business. In this last topic,
we will discuss how to manage the global marketing environment as global
markets offer vast potential opportunities and threats for companies to market
their products or services abroad.
The global marketing environment of a company is influenced by various

external factors and forces beyond the control of the company. Globalisation has
brought about intense competition in domestic and foreign markets. Success in
global markets depends on many skills such as accurate analysis of market

TOPIC 10 MANAGING THE GLOBAL MARKETING ENVIRONMENT  191
potential, selection of right product mix and appropriate marketing strategies,

which is under the first section of this topic entitled Market Analysis. Then, you
will learn how companies do standardisation and adaptation of their products or
services at the global markets.
In the next section, we will talk about global products and brands in multiple
markets. This is followed by an explanation on how to promote the products and
brands globally. As the promotion has been set, how about the pricing? You will
find the answer on how to set the global pricing in the following section.
Lastly, we will look at global distribution as it is very important in the growth

and development of world trade with further descriptions on global distribution
channels and global retailing. So, are you ready now? Let us start this topic!
10.1 MARKET ANALYSIS

To be or not to be? Should I take my company to
the international level? What should I do?

Can you think of what is the first thing a company should do before deciding to
operate internationally? Well, before deciding to operate internationally, a
company must understand the global marketing environment.
A company must determine its objectives and policies of global marketing.

Decisions on market analysis include targeted-foreign sales, the foreign countries
they want to venture into and commitment of resources. The global market must
be evaluated based on market size, market growth, cost of executing the
business, competitiveness and risks.

192  TOPIC 10 MANAGING THE GLOBAL MARKETING ENVIRONMENT
How do we do that? Well, to assess market potential, global marketers need to

determine which market offers a profitable return on investment and estimate
the costs and risks associated with marketing mix variables. Market
attractiveness depends on production factors, geography, income, population
growth, cultural attractiveness, political climate and consumption patterns.
Population growth provides a rough estimate of future market potential. For

example, Europe and Japan encounter low and negative population growth
whereas most Asian countries face rapid increase in population. This suggests,
for instance, big emerging markets like China, India and Indonesia. They can be
potential markets but it depends on the purchasing power and ability of
consumers to purchase products and services. Economic development and
income per capita or even disposable income are indeed important indicators of
market potential.
Market potential is also influenced by consumption patterns. Consumption

patterns are dynamic and driven by factors different from those in domestic
markets. Hence, current consumption patterns must be interpreted with care.
For instance, Saint Martin, an island in the Caribbean, has the highest per
capita Coca Cola consumption while America ranks as the fifth (taken from
wiki.answers.com).
10.2 STANDARDISATION AND ADAPTATION

IN GLOBAL MARKETS
Like other functional areas of international business, striking a balance between
standardisation and adaptation is a key challenge. Global marketers need to align
the key elements of the firmÊs marketing programme (also known as marketing
mix variables) to the standardisation or adaptation decision. There are four key
elements in global marketing as listed in Figure 10.1.
Figure 10.1: Four key elements in global marketing

Let us look at standardisation first. What does it stand for?

Standardisation refers to a firmÊs efforts to make its marketing mix variables
uniform to a regional or global marketplace, with a similar product or service
(Cavusgil et al., 2008).

Standardisation involves global integration of marketing strategies and it is

normally undertaken by large multinational corporations (MNCs). Examples of
MNCs that use standardised marketing strategies with success are Intel, Apple
Inc, Louis Vuitton and Canon. Do you know that there are five factors that favour
standardised marketing strategy? These are:
(a) Common and similar customer needs in different countries;
(b) Universal market segments exist across countries;
(c) Products that have universal specifications;
(d) Regional market agreements such as EU and AFTA; and
(e) Cost savings to gain economies of scale.
How about adaptation?
Adaptation concerns the firmÊs efforts to modify or localise its marketing

programme to suit local market needs and local regulations (Kotabe & Helsen,
2011).
Did you know that adaptation has other names? Adaptation is also called
customisation or localisation. It involves firms in multidomestic industries who
make minor alterations of their product offerings or marketing programmes.
MNCs such as McDonaldÊs, Coca Cola and Pepsi do standardising where they
can, which means they need to engage in adaptation to meet local responsiveness
of each foreign market.

For example, McDonaldÊs customises its menu to meet halal requirements in

Malaysia and substitute lamb burgers in India. There are five forces that favour
adaptation in certain markets. These are:
(a) Differences in laws and regulations;
(b) Differences in cultural norms and values;
(c) Niche and small markets exist;
(d) Customers preference for local goods; and
(e) Differences in living standards (such as income levels).
Table 10.1 summarises standardisation versus adaptation in global marketing.

Table 10.1: Standardisation versus Adaptation in Global Marketing
Standardisation Adaptation
Involves global integration and is suitable Involves local responsiveness and it is
among MNCs. suitable in multidomestic industries.
Undertaken when: Undertaken when there are:
 Similar market segments exist across  Niche or small market segments
countries  Customers who have national
 Customers have similar preferences preferences
 Products have universal specifications  Distinct laws and regulations
 Regional market agreements  Different cultural needs
 Gains from economies of scale  Different living standards
10.3 GLOBAL PRODUCT AND GLOBAL BRAND

Now, let us move on to global products and brands. Companies that are
operating in foreign markets with different characteristics may choose to extend
the same product offered in the home market to other markets or adapt a product
to suit regional or country requirements. In developing new products for
multiple markets, managers emphasise on commonalities across countries rather
than differences between them. For instance, Honda and Toyota design models
such as Accord and Camry using a standardised platform to which modular
components and accessories are added or modified to suit local market needs,
tastes and regulations. Another example is McDonaldÊs. We knew from the
previous section that McDonaldÊs customises its menu based on the country it
operates. Table 10.2 shows you the product adaptation at McDonaldÊs.

Table 10.2: Product Adaptation at McDonaldÊs
Country Modification
Saudi Arabia  Halal menus
 Separate floors: first floor conventional, second floor family section
 All Muslim employees
Hong Kong  Curry potato pie
 Sake fries
 Red bean sundae
Malaysia  Halal menus
 Porridge
 Fried chicken
India  Lamb burger
 Vegetarian burgers
 Veggie McNuggets
Japan  Teriyaki burger
Source: Shenkar & Luo (2005)
There are three strategies available to marketers for adapting products to a global
market. Do you have any ideas what these are? They are explained in Table 10.3.
Table 10.3: Three Strategies for Adapting Products to a Global Market
Strategy Description Example

1. Product The same product in the home Apple products like iPad.
Extension country is introduced in a new
country without modifying it.
2. Product The product is modified to McDonaldÊs adapts its menu
Adaptation suit local market tastes and according to location.
requirements.
3. Product A new product is developed to Tata Nano car has been
Invention serve needs and requirements designed to be small and
for a specific country and to be inexpensive for the Indian
marketed there. market.
The development of a global brand offers a unique challenge in the global

positioning strategy. Global branding is complex given the varying demands
among sophisticated consumers and changing market conditions. Companies
pursue a global branding strategy because of the advantages of economies of

scale in which costs can be spread over large volumes of products. In addition, it
creates brand awareness and brand loyalty as global brands are more visible than
local brands. Global branding enhances the companyÊs competitive advantage in
the global market and enable charging of premium prices. Consumers prefer
products that are global brands as it provides a sense of status, quality and trust
in their purchase decision. Table 10.4 shows you top global brands by region.
How about you? Do you prefer global brands or local ones?
Table 10.4: Top Global Brands by Region in 2011
Brand Value Main Product/

Company Country of Origin
(USD billion) Service
U.S. Brands
Coca Cola 71.9 United States Beverages
IBM 69.9 United States Business Services
Microsoft 59.1 United States Computer Software
Google 55.3 United States Internet Services
General Electric 42.8 United States Diversified
European Brands
Mercedes Benz 27.4 Germany Automotive
Nokia 25.1 Finland Electronics
BMW 24.6 Germany Automotive
Louis Vuitton 23.2 France Luxury
H&M 16.5 Sweden Apparel
Asian Brands
Toyota 27.8 Japan Automotive
Samsung 23.4 South Korea Electronics
Honda 19.4 Japan Automotive
Canon 11.7 Japan Electronics
Sony 9.9 Japan Electronics
Source: www.interbrand.com/

SELF-CHECK 10.1
Explain the strategies used for adapting product strategies to a global

market. Which strategy is the best?
10.4 GLOBAL PROMOTION

What can you say about global promotion? Global promotion involves the
management of marketing communication such as advertising and promotional
activities at the multi-country level. Keep in mind that global advertising is an
important part of international marketing. The issue of whether to standardise or
adapt global advertising remains one of the most daunting challenges facing
international marketers. Managers are often compelled to adapt advertising to
local tastes, norms and regulations. A company can adopt promotional strategies
with minor modifications for each external market.
For instance, in advertisement messages and positioning themes, some global

organisations use one universal theme such as NikeÊs „Just Do It‰ and LorealÊs
„Because You are Worth It‰. As for Coca Cola Inc., it adapts its communication
strategy by translating its brand name into 15 languages and has themes such as
„Open Happiness‰ for the Asian market.
10.4.1 Standardisation vs Adaptation Strategies in

Global Promotion
Did you know that in order for global advertising to be successful, multinational
companies must be creative in their adaptation and customisation of
communication strategies? Promotional strategies in the global market place can
misfire because of cultural differences. Cultural barriers pose the biggest
stumbling block in international advertising. Cultural barriers to advertising
include language and religion. Hence, the question is to determine to what
degree the advertising strategy should be standardised at pan-regional or global
level.

Standardisation of advertising strategies in multiple markets has benefits to

companies such as:
(a) Savings in cost from a single advertising campaign. It is cheaper to produce

a single commercial, less time consuming and requires fewer resources.
(b) Company enjoys consistent brand image and identity thereby creating
brand awareness and a similar positioning theme worldwide.
(c) Serve and target global consumer segments that are similar across markets.
This enables an integrated and standardised approach. Thus, this creates a
global village that is culturally binding with similar taste, convergence in
advertising and media.
(d) Development and sourcing of creative talent in advertising from

subsidiariesÊ staff can be handled with pooling of skills and resources.
However, companies face restrictions and barriers which can limit

standardisation strategies in global advertising. Barriers to standardisation can be
in the following forms:
(a) Cultural differences which can persist for many product categories such as
language and religion.
(b) Local advertising regulations affect the execution of commercials. For

example in Malaysia, foreign-made commercials or advertising featuring
Caucasians are not allowed.
(c) Level of market maturity differs across countries and may require
advertising to create brand awareness or educate consumers by giving
product information.
ACTIVITY 10.1
Visit the company website of Nestle at http://www.nestle.com/Pages/

Nestle.aspx and find out how Nestle adapts its products into Popularly
Positioned Products (PPP) varieties of the brand.

10.5 GLOBAL PRICING

Did you know that global pricing is one of the most critical and complex issues
in international marketing? This is because price is the only marketing mix
instrument that creates revenues. All other elements entail costs. Many mistakes
are often made in the international environment with respect to pricing policies
and practices. There are two common mistakes in global pricing. These are:

Pricing the product too high – Customers avoid using or trying the product
and therefore limit market expansion.
Pricing the product too low – Customers see the low price of the product as a
signal for low quality.
As for pricing strategies, there are three pricing strategies that a company may
choose when establishing a price for a product in the global market. They are:
Ethnocentric or – The headquarters set the price for its subsidiaries in

extension policy which a uniform or same price is charged for its
products across all markets. This strategy is suitable for
companies selling standardised products and in
smaller markets.
Polycentric or – The headquarters allow local subsidiaries to set the

adaptation policy price. The price is adapted and localised to suit
conditions in the local market. This strategy is suitable
in markets where price sensitivities are evident. This
also may involve additional costs to adapt price.
Geocentric policy – The headquarters set a global price but there is an

added mark-up that is tailored to each market. This
added mark-up varies specifically on market demand
and competition the company faces in the country. If
demand is high and competition is weak, the mark-up
will be high. If competition increases, the mark-up is
decreased to increase competitive pricing advantage.
SELF-CHECK 10.2
List the factors that affect pricing of products in a global market.

10.6 GLOBAL DISTRIBUTION

What does global distribution means? Can you define it? Let us look at its
definition.
Global distribution is defined as the design and management of a system that directs
and controls the flows of materials into, through and out of the firm across national
boundaries. It aims to achieve its corporate objectives at a minimum total cost.
Global distribution, like domestic distribution, encompasses materials

management and physical distribution. Global distribution/logistics have played
a critical role in the growth and development of world trade and in the
integration of manufacturing on a worldwide scale.
The use of appropriate distribution channels in international markets increases

the chances of success dramatically. As firms start operating on a global basis,
logistic managers need to manage shipping of raw materials, components and
supplies among various manufacturing sites at the most economical and reliable
rates.
Global distribution also involves managing international sourcing strategy. What

does sourcing strategy refer to? Sourcing strategy refers to an operational link
between materials management and physical distribution. Materials can be
sourced by procurement through:
(a) Intra-firm sourcing either by buying within oneÊs corporate system,

domestic purchase arrangement or off-shore outsourcing; or
(b) Outsourcing by buying from outside contractors.
Materials management refers to the inflow of raw material, parts and supplies
through the firm.
How about physical distribution? Physical distribution refers to the movement of

the firmÊs finished products to its customers, consisting of transportation,
warehousing, inventory, customer service/order entry and administration. These
functions can be affected by tradition, culture, economic infrastructure, laws and
geographical expanse which can shift the orientation of these functions.

Did you know that today many companies have adopted international sourcing?
These are the reasons for that:
(a) Intense international competition;
(b) Pressure to reduce costs;
(c) The need for manufacturing flexibility;
(d) Shorter product development cycles;
(e) Stringent quality standards; and
(f) Continually changing technology.
Let us look at IKEA as an example. Approximately 10,000 IKEA products are

manufactured by 1,600 suppliers and transported to 186 IKEA stores around the
world via one of the companyÊs 27 central warehouses and distribution centres.
The hallmarks of IKEA distribution are a global distribution network, large
volumes, flat packages and low costs (taken from www.ikea.com).
ACTIVITY 10.2
Visit the IKEA website at www.ikea.com and find out how the
companyÊs competitive advantage is developed in its global logistics
and sourcing strategies.
10.6.1 Global Distribution Channels

What can we say about global distribution channels? Distribution channels
involve physical movement of goods and services through channels. Channels
consist of a coordinated group of individuals or firms that perform functions that
add utility to a product or service. Global distribution channels include:
(a) Selling direct to geographically homogeneous customers with similar

consumption patterns and to relatively small markets such as peer-to-peer
selling via Internet and other related media. Examples are EBay, Dell and
Amazon.

(b) Using intermediaries such as agent intermediaries who negotiate

transactions between two or more parties but do not take the title to the
goods being purchased or sold, or merchant intermediaries who take the
title to the goods. Global channel management involves selection of
intermediaries. There are guidelines for selection of foreign intermediaries
and they are:
(i) Intermediaries should be able to develop markets.
(ii) Intermediaries should be long-term partners.
(iii) Choose the partner, do not let them choose you.
(iv) Support them with marketing, funds and know-how.
(v) Control marketing strategy as much as possible.
(vi) Seek national intermediaries as soon as possible after entry.
10.6.2 Global Retailing

Next, we move on to global retailing. Do you know that global retailing remains
one of the major consumer channel intermediaries? Retailing involves very
locally entrenched activities, including stocking of an assortment of products that
local consumers prefer and seasonal promotion. In developed countries, retailing
employs between 7% and 12% of the workforce (Kotabe & Helsen, 2011).
As a potential market for global expansion, Asia is an attractive region for the
global retail industry expansion growing at a rate of 9% per year. The Asian retail
industry is worth $1 trillion USD (Farfan, 2012). Retailers have grown into some
of the worldÊs largest international businesses. The list showing the top 10
countries for global retail expansion in 2011 based on A.T. Kearney Global Retail
Development Index is summarised in Table 10.5:

Table 10.5: Top 10 Countries for Global Retail Expansion in 2011
Rank Country
1 Brazil
2 Uruguay
3 Chile
4 India
5 Kuwait
6 China
7 Saudi Arabia
8 Peru
9 U.A.E.
10 Turkey
Table 10.6 lists the top five global retailers in 2011. Are you familiar with some of
the names?

Table 10.6: Top Five Global Retailers in 2011
Countries of Revenue
Rank World Country Format
Operation (USD billion)
1 Wal-Mart Stores USA Discount store 16 404
2 Carrefour France Hypermarket 36 122
3 Metro AG Germany Diversified 33 91
4 Tesco UK Supermarket/ 13 90.43
hypermarket
5 Schwarz Germany Hypermarket 25 77.22
Unternehmens
Treuhand KG
Source: http://ecobuildertoday.com

Global Retailing Strategies

Before we end global retailing, let us look at its strategies. Recent development in
the retailing indicates a real shift in power to the retailer. The traditional supply
chain powered by the manufacturing push is becoming a demand chain
driven by consumer pull, especially in the developed countries. The old system
of top-down stimulation (push) is now giving way to bottom-up to (pull)
merchandising, promotion and stimulation.
Now, let us look at some of the strategies used by global retailers:
(a) Branding strategy with the use of private labels or store brands. These
brands appeal to price-conscious customers and are attractive to MNCs
facing strong local competition. The share of store brands is increasing
globally and is particularly attractive to MNCs competing with local
brands.
(b) Entry strategy using company resources to open a store on a green field site
(for example Carrefour Hypermarket in Malaysia) or chain acquisition of a
company with multiple existing outlets in a foreign country (for example,
Dairy Farm from Hong Kong acquired GiantÊs hypermarket chain) or joint
venture in markets that are culturally distant and difficult-to-enter (for
example, TescoÊs joint venture with Sime Darby).
(c) Innovation strategy to adapt innovations to its level of economic

development. Adaptation is a key success factor in the global retailing
environment that is conducive to change due to differences in local
demographic factors, cultural factors, geographic factors, government
action and competitive pressures.

ACTIVITY 10.3
Did you know that the top three trends in the world on retail marketing
are mobile marketing, mobile service and green products? Visit the
website www.deloitte.com to find out the global powers of retailing.

Before we conclude this module, let us do some revision by doing this exercise.
All the best!
EXERCISE 10.1
1. What are the market factors in terms of threats and opportunities

that global marketers need to monitor and assess in the marketing
environment?
2. Do a market analysis on China and India as emerging markets.

What are the market attractiveness of these two countries?
3. State the differences between a domestic and a global marketing

plan.
4. What environmental factors in the market influence the

development of the global retailing industry?
 Before the new century, companies in the United States gave more attention
to the international trade.
 The environmental factors that influence global marketing are determined by

market size, market growth, cost of operation, level of competitiveness and
risks.
 A marketÊs attractiveness is assessed in terms of production factors,

geography, income, population growth, cultural attractiveness, political
climate and consumption patterns.
 The main concern faced by global marketers is the ability to determine the
need as well as the degree to adapt or standardise marketing strategies.
 Three strategies available to marketers for adapting products to a global

market are product extension, product adaptation and product invention.

 The toughest issue facing marketers in developing global communication

strategy is the choice of appropriate and proper advertising theme in which
the marketer must determine what degree of advertising campaign should be
standardised or localised.
 When establishing a price for its products in the global market, companies
can opt for ethnocentric, polycentric or geocentric pricing policy.
 Strategies on global distribution are focused on sourcing strategy of materials

as well as customer channel management in global retailing.
Adaptation Global product

Global branding Global promotion
Global distribution Global retailing
Global marketing Market analysis
Global pricing Standardisation

ANSWERS  207
Answers
TOPIC 1: INTRODUCTION TO INTERNATIONAL
BUSINESS
Activity 1.1
A few organisations that implement international business include:
 Malaysian MNCs: Petronas, Genting Group, Maybank, Axiata
 Foreign MNCs: Intel, IKEA, McDonalds, HSBC
Activity 1.2
Knowledge of international business can assist an individual involved in
business through the following:
 Providing information on the real-world perspective to meet the current
challenges in the global business arena;
 Gaining learning benefits from the participants involved in international
business;
 Enhancing careers and enabling effective interaction between managers and
subsidiaries; and
 Learning and understanding the cultures of other countries.
Self-Check 1.1
Four differences between international business and domestic business:
(a) Use of currency;
(b) Legal systems;
(c) Economic and political systems; and
(d) Cultural differences.
Differences occur due to differences in global environment and trade systems,

complexities and uncertainties that exist in international business.
208  ANSWERS
Activity 1.3
Examples of organisations in Malaysia that implement:
(a) Multi domestic company: CIMB, Air Asia
(b) Global company: Petronas, Genting, Armada
(c) Transnational company: Axiata, IJM
Activity 1.4
Policies of the Malaysian Government that could encourage and contribute
towards international business include:
 Providing financial incentives and grants;
 Tax exemption and tax allowances;
 Free trade zones or free enterprise zones;
 Relaxing foreign ownership policies; and
 Reducing tariff and non-tariff barriers.
Exercise 1.1
1. International business is cross-border commercial/business transactions
between individuals and businesses. Examples are Samsung, Toyota and
Subway Sandwich.
2. Description of the following international business activities:
(a) Licensing: contractual agreement over the right to use brandname,

trademark or intellectual property owned by licensor to licensee in
return for royalty.
(b) Franchising: agreement in which owner of an existing company

(franchisor) gives right to other businesses (franchisee) to operate
business using its trademark or brandname in exchange for royalty.

ANSWERS  209
Activity 1.5
Examples of multinational organisations:
 Apple Incorporation (US);
 Petronas (Malaysia);
 Samsung (South Korea); and
 Toyota (Japan).
Activity 1.6
Examples of the changes or adaptations by companies that are made on foreign
products in order to suit our Malaysian culture:
 McDonalds adapted its menu to meet halal food standards and to suit
Malaysian taste and culture; and
 Coca-Cola adapted its advertising strategy using local language and local
theme to target the Malaysian youth market.
Exercise 1.2
The external influences in international business include:
 Political influences: change in government leadership, change in political

ideology, political risk arising from nationalisation, war and terrorism.
 Legal influences: change in FDI policies, taxation, and international trade

rules and treaties.
 Economic shocks: financial crises and oil shocks.
Exercise 1.3
1. E
2. A
3. E
4. B
5. A

210  ANSWERS
TOPIC 2: ECONOMIC ENVIRONMENT AND SYSTEMS

Activity 2.1
The criteria used to classify Malaysia as a developing country include:
 Gross Domestic Product per capita to reflect income level;
 Share of manufacturing in total GDP;
 Stock of human assets; and
 Adult literacy rate.
Activity 2.2
A global company must understand the need to constantly adapt to changing
economic conditions to keep abreast of the latest economic developments as
businesses change with times or it can become extinct.
Firms adapt to a changing economic environment by changing product/service

to serve the growing markets. E.g. IBM was quick to adapt its business to a space
service-based company while Kodak was slow to adapt its digital camera
business to changes in market conditions.
Self-Check 2.1
We use the gross national product to explain the economic growth of a country
because GNP measures the market value of output produced by residents of a
country. In addition, GNP per capita is used to measure economic growth of a
country as it reflects productive potential output that a country can produce.
Activity 2.3
The countries classified according to economic activities include:
 Free market economy – Hong Kong, U.S.A and Canada.
 Planned economy – North Korea.
 Mixed economy – Malaysia and South Korea.

ANSWERS  211
Exercise 2.1
The features of these economies:
(a) Market economy: freedom of enterprise, freedom of consumer choice, profit

motive and little or no government intervention.
(b) Command economy: resources owned by government, planning and

distribution by central planning authority, equal distribution of income and
wealth, no freedom of enterprise and customer choice.
Exercise 2.2
1. Inflation affects FDI decision as FDI decision not to invest somewhere is
affected by rising cost of production and exports in the country due to
inflation in the host country. Inflation causes an increase in cost of
production and increase pressure on domestic prices. This will cause price
of exports to rise and make country exports less competitive.
2. Internal deficit and external deficit of a country are important to MNC

managers because:
 Internal deficit reflects on governmentÊs management of budget and

could mean increase in demand for goods and services, increasing the
pressure on domestic prices and on the countryÊs external balance of
payments.
 External deficit reflects on a countryÊs balance of payment problems and

has effects on exchange rates and poor trade performance.
Activity 2.4
The economic transition of economies such as China and Russia has transformed
these economies into big emerging markets:
 From command economy to open market economy driven by exports and

consumption; and
 The rise of middle-class population has increased international business

opportunities for foreign direct investment and trade.

212  ANSWERS
Activity 2.5
China used a step-by-step approach to carry out its economic transition by
started restructuring in rural areas and slowly introducing it to urban cities
Russia used shock therapy or rapid transition. Transition of eastern Germany
was quick and easily merged with a more stable western Germany.
The weaknesses of ChinaÊs and RussiaÊs economic transition are the relatively
weak regulatory systems and corruption.
Activity 2.6
Economics shocks especially financial crises have affected the socio-economic
and political changes in many countries. Financial crises have brought about a
slowdown of the world economy as many countries experience a fall in
consumption, investment and trade.
Exercise 2.3
1. A
2. B
3. A
4. D
5. E
TOPIC 3: CULTURAL ENVIRONMENT

Exercise 3.1
Silent (non-verbal) language is important for international business because there
are many different interpretations across different cultures. Often it can
complicate international communication. The person you are dealing with might
be unintentionally sending non-verbal signals that you may misinterpret and
vice versa. For example the hand gesture, bending the thumb and index finger to
form the letter „O‰ for „okay‰ is normally accepted in English-speaking countries
but in Brazil it is generally considered rude and offensive.

ANSWERS  213
Self-Check 3.1
The dominant religion in each of these countries:
(a) China – Taoism
(b) India – Hinduism
(c) Brazil – Roman Catholic and Protestant
(d) Russia – Russian Orthodox
(e) South Korea – no affiliation
(f) Indonesia – Islam
(g) Japan – Shintoism and Buddhism
Exercise 3.2
Social structure refers to a societyÊs basic social organisation. Social group
interaction can influence international business decisions as it is a cultural
element. It refers to how people of different cultures associate themselves and
interacts with one another, such as the structure of the family unit and role of
gender in society.
Activity 3.2
What the following colours symbolise in different countries:
Colour Country Symbolise

(a) Orange India Sacred
Egypt Mourning
(b) Purple Brazil Mourning
Thailand Mourning
(c) Red China Luck and happiness
Russia Communism

214  ANSWERS
Exercise 3.3
1. B
2. B
3. C
4. C
5. B
6. B
7. A
8. A
TOPIC 4: POLITICAL AND LEGAL ENVIRONMENT

Self-Check 4.1
An organisation first needs to assess the possible impact of political and legal
influences upon its policies, operations and programmes. This assessment is
necessary in order to diagnose the key issues it needs to address and understand
the political-legal environment it is operating in and the opportunities and
threats that lie within.
Activity 4.1
Malaysia is moving towards a more pragmatic nationalism approach where the
government views FDI as having both benefits and costs. Hence the Malaysian
government is open to FDI and implements policies that aggressively attract
foreign investments that aim to maximise benefits and minimise costs of FDI.

ANSWERS  215
Activity 4.2
1. Three approaches of political ideologies influencing government policy
towards MNCs:
 Radical view;
 Free market view; and
 Pragmatic nationalism.
2. Pragmatic nationalism approach is ideal for a developing country like

Malaysia.
Activity 4.3
Major sources of political risks that can bring about ownership, transfer and
operation risks are:
 Change in government leadership;
 Change in political ideology;
 Change on government trade and FDI policies;
 Government intervention – nationalism, confiscation, expropriation; and
 Natural disasters, war and terrorism.
All countries whether developing or developed are subject to political risks.

However, the degree varies across countries and environment in the country.
Generally, developing countries tend to have higher political risks than
developed countries due to its stage of development and external influences in
certain developing countries.

216  ANSWERS
Activity 4.4
If I was a manager in a multinational organisation, my organisation would prefer
an individualistic paradigm as this system is more open to trade and business.
There is more economic freedom with little government intervention to restrict
trade.
Activity 4.5
Some banks in Malaysia that implement Islamic banking are Maybank, CIMB,
HSBC Amanah and AmBank.
Self-Check 4.2
Some national laws that MNCs must comply with in order to make FDI in
Malaysia:
 Local Authority/Local Council laws;
 FDI guidelines by Ministry of Domestic Trade, Cooperatives and

Consumerism; and
 Intellectual Property Protection Laws.
Exercise 4.1
1. C or E
2. A
3. C
4. A
5. A

ANSWERS  217
TOPIC 5: REGIONAL ECONOMIC INTEGRATION

Activity 5.2
EU has achieved one step further in its process of economic integration forming a
European Monetary Union (EMU). The integration brings benefits of greater size,
internal efficiency and development to the EU economy as a whole and to the
economies of the individual member countries. This, in turn, offers opportunities
for economic stability, higher growth and more employment as outcomes of
direct benefit to EU citizens.
Advantages of EMU include:
 Coordination of economic policy-making between member countries;
 Coordination of fiscal policies;
 An independent monetary policy run by the European Central Bank; and
 The single currency and the Eurozone.
Exercise 5.1
1. The meaning of regional economic integration: it is a formal agreement
among member countries in a particular region to foster economic and
political cooperation. Main objective is to abolish barriers to trade.
2. The stages of regional economic integration:

Regional economic integration takes place in stages beginning from
lowering/removal of tariff barriers and finally the creation of an economic
union. The four stages are: Free Trade Area, Customs Union, Common
Market and Economic Union.
Activity 5.3
Disadvantages of REI:
 Trade diversion effects;
 Increased competition due to cheaper imports; and
 Increased interdependency among member countries; if one member country

suffers economic crisis it could triggering a domino effect on the whole
region as REI means member countries giving up protectionism and could
cause the disadvantage of job losses.
218  ANSWERS
Exercise 5.2
1. The reasons that support the formation of regional economic integration:
 Reduces trade and nontrade barriers to promote free trade;
 Boosts higher share of trade in world trade and enhance economic

growth in the region from increased intraregional trade; and
 Political cooperations ensure stability, safety and security in the region.
2. The effects of regional economic integration:
(a) Trade creation: production shifts from a high cost producer to a low
cost producer within the economic integration leading to increased
economic efficiency.
(b) Trade diversion: production transfers from low cost to higher cost
producer through REI.
Activity 5.5
The difference between a free trade area and an economic union:
 Free trade area: economic agreement to abolish trade obstacles (tariff and
nontariff barriers) between member countries but each member country is
allowed to establish its own external tariff policy with non members.
 Economic union: economic agreement at the high level which involves free
trade among member countries, common external tariff policy, common
market agreements such as free movement of capital and labour as well as
common monetary and fiscal policies.
The key success factors to the EU as an integration model:

 Effective leadership;
 Commitment from member countries;
 Common goals and ability to recognise value added benefits from
integration; and
 Managing financial integration.

ANSWERS  219
Activity 5.7
The common challenges faced by economic integration across many regions:
 Political differences: internal political instability and security;
 Cultural differences;
 Barriers to coordination and harmonisation of regulations; and
 Problems in integrating regulations on investment rules and domestic
industrial policy.
Activity 5.8
The economic benefits of the ACFTA to ASEAN:
 Enlarged market size, trade and production base;
 Access to wider consumer base and choice of products;
 Removal of trade barriers, specialisation and enhanced economic efficiency;
and
 Improved FDI prospects.
Exercise 5.3
1. A
2. B
3. A
4. D
5. B

220  ANSWERS
TOPIC 6: INTERNATIONAL TRADE THEORIES

Self-Check 6.1
The theory is not consistent in explaining the real situation of a countryÊs balance
of payment and leads to zero sum game when trade with one country gains
while the other loses.
Self-Check 6.2
1. The limitations of the Absolute Advantage Theory:
 The theory fails to explain the situation when a country has absolute
advantage in producing all products;
 It does not take into account transportation costs involved in

international trade; and
 It assumes that resources (labour) are perfectly mobile and easily

interchangeable between productions.
2. Free trade occurs when there is no government restriction to trade, that is

there are no barriers to trade such as tariff or non-tariff barriers that could
hinder free trade.
3. Absolute Advantage Theory states that a country will specialise in the

production of goods in which it can produce most efficiently i.e. it can
produce at a lower unit cost. The country will increase its wealth by
specialising in this way and engaging in international trade to export these
products and import those that it does not make. Specialisation and trade
will lead to an increase in world output.
Self-Check 6.3
A country has absolute advantage over another in a particular good when it can
produce that good at a lower cost resulting in the country having greater output.
A country has a comparative advantage in the production of a good if it can

produce that good at a lower opportunity cost relative to another country.

ANSWERS  221
Activity 6.1
Heckscher-Ohlin Model of Comparative Advantage explains how trade occurs
based on differences in factor endowment while Ricardian Comparative
Advantage theory focuses on the natural advantages of production and trade at
different levels of productivity.
Activity 6.2
International Product Life-Cycle Theory seeks to explain how a company will
begin by exporting its products and eventually undertake FDI as the product
moves through its life cycle. A countryÊs export could eventually become its
import.
Activity 6.3
1. Reasons why some organisations fail at the international level:
 Lack of research and analysis on the nature of the international market;
 Failure to account for operating costs in an international market.
 Late entry and the too competitive nature of the international market.
2. (a) Understanding the international market at both micro and macro

levels is important for an industry that intends to expand its business
overseas. The industry must analyse the market size and growth
prospects of the host country before FDI is undertaken.
(b) FDI is a direct method of international expansion for a company as

well as a major contributor of income and growth for the company. To
a country, FDI means higher exports and job creation leading to
economic growth.
(c) Competition at the global level is inevitable for firms making FDI.

222  ANSWERS
Exercise 6.1
1. C
2. A
3. A
4. A
5. D
TOPIC 7: FOREIGN DIRECT INVESTMENT (FDI)

Activity 7.1
Difference between inward and outward FDI:
 Inward FDI: inflow of foreign capital into local resource or into host countries
from MNCs.
 Outward FDI: outflow of foreign capital or direct investment abroad.
MNCs that have FDI in Malaysia – Dell, Toyota, National Panasonic, Samsung, Intel.
Malaysian companies that have undertaken FDI abroad – Petronas, AirAsia,

Proton, CIMB Bank.
Activity 7.2
1. FDI pattern in major economies have changed in terms of:
 Growth of services sector;
 Increase in FDI inflows into emerging economies;
 FDI growth via mergers and acquisitions, joint venture and strategic
alliances; and
 High technology transfer.

ANSWERS  223
Reasons why a large proportion of the worldÊs FDI is found in the "Triad"
region:
 Developed economies with stable currency;
 Services FDI concentrated in TRIAD region;
 High disposable income and market size; and
 Good infrastructure and communication technology.
2. The main reasons why firms undertake foreign direct investments:
 Resource seeking;
 Efficiency seeking;
 Market expansion; and
 Strategic seeking for competitive advantage.
Self-Check 7.1
The likely positive and negative impact of FDI on host countries:
Positive Impact Negative Impact

 Creation of new jobs and employment  Loss of sovereignty and control over
for locals; domestic policies;
 Economic growth, development and  Domestic industries face competition
infrastructure; and from MNCs; and
 Transfer of technology, skills and  Overuse of resources leading to
expertise to locals. depletion.
Self-Check 7.2
Difference between horizontal FDI and vertical FDI:
 Horizontal FDI refers to investment in the same industry as the parent

company in the home country.
 Vertical FDI occurs when MNC operates in a foreign country at different

stages of production. It can be backward or forward vertical integration.

224  ANSWERS
Exercise 7.1
1. A
2. B
3. D
TOPIC 8: INTERNATIONAL FINANCIAL ENVIRONMENT

Activity 8.1
The major currencies of other countries that are used to facilitate trade in the
world market: US Dollar, Euro Dollar and Japanese Yen.
Self-Check 8.1
The major functions of a foreign exchange market include:
 Transfer of purchasing power for currency conversion;
 Provision of credit to facilitate international trade and financial transactions;

and
 Minimising foreign exchange risk.
Activity 8.2
The exchange rates for Malaysian Ringgit to other foreign currencies such as the
U.S. dollar, Singapore dollar and Indonesia rupiah:
 Exchange rate for RM to USD; 1 MYR = 0.3138 USD
 Exchange rate for RM/ Singapore dollar; 1 MYR = 0.400031161 SGD
 Exchange rate for RM/ Indonesian rupiah; 1 MYR = 2970.1515 IDR

ANSWERS  225
Self-Check 8.2
1. Yes, major disruptions caused by political disasters have major impact and
repercussions on almost all economies in the world. The impact can be
seen when changes or fluctuations in major foreign exchange rates cause
foreign exchange markets to be active.
2. The foreign exchange (FOREX) market is a decentralised worldwide

financial market for currency trading. This means that it has no specific
location or source. Most transactions are done either electronically or over
the phone. However, the majority of FX volume is handled in London.
The major advantage of using the US dollar as the international currency

trading is that it is the dominant currency and is regarded as a strong and
stable foreign currency. This invokes greater confidence among
international trade and investment.
The major disadvantage of using the US dollar as the international currency

trading is a countryÊs exchange rate, international trade and investment are
linked to the US dollar. Any repercussion in the US dollar can influence
countryÊs economy.
Activity 8.3
The primary roles of the IMF and World Bank:
Primary Role
IMF World Bank
IMFÊs main focus is to encourage countries World Bank provides development loans,
to correct macroeconomic imbalances, grants and aids for specific projects, such
reduce inflation, and undertake key trade, as the building of dams, roads, harbours
exchange, and other market reforms and so on which are considered necessary
needed to improve efficiency and support for „economic growth‰ in a developing
sustained economic growth. country.

226  ANSWERS
Self-Check 8.3
Inflation causes an increase in the general price level of a domestic economy. This
in turn causes production costs to rise and hence raise price of exports. Increase
in export prices reduces export competitiveness and demand for countryÊs
exports. Reduced demand for exports leads to a fall or depreciation in the
countryÊs exchange rate.
Exercise 8.1
1. A
2. D
3. A
4. D
5. D
6. D
7. A
TOPIC 9: COUNTRY SELECTION AND ENTRY STRATEGIES

Self-Check 9.1
The main reasons why managers should give attention to a country when
making decisions on market and location of production:
 Minimise production costs. Example, transportation cost;
 Location of production are near to markets; and
 Access to other resources. Example, labour, raw materials and facilities.
Activity 9.2
ROI is just the expected net income that a firm can earn from a project that it
invested in. Risk and opportunity to be successful for a project depends on
financial, political and economic conditions in the market and these risks vary
across markets in which the project is undertaken.

ANSWERS  227
Self-Check 9.2
1. Financial risk, political risk, legal risk and economic risk.
2. Political risk is defined as disruptions to foreign operations of a company

due to changes in political environments of the host country, home country
or the world. It is normally difficult to predict or calculate political risk.
However companies in an attempt to predict such risk use:
 Analysis of past patterns;
 Consultation with professionals; and
 Inspect and scan the social and economic situation which may lead to
such risk.
Exercise 9.1
1. Decide on important and potential country variables – market opportunity
versus risks and assign weights to determine the importance of each
variable to the company.
2. Three external sources of country information that is available in terms of

accuracy, reliability and cost are:
 Government agencies;
 International organisations such as WTO, World Bank, IMF; and
 Individualised and specialised reports from marketing and business

consulting companies and research companies.
Self-Check 9.3
Advantage: Grid technique is useful for comparisons across countries and
helps a company to analyse if it needs to add further
investment or deeper analysis into feasibility research after
fulfilling the minimal criteria of the company.
Disadvantage: Grids tend to become cumbersome and limited as the number

of variables for comparison increases.

228  ANSWERS
Self-Check 9.4
1. Two tools and their major components that can be used to analyse and
compare information on market location:
 Grid technique using potential/accepted country variables, income and

risk factors; and
 Matrices using opportunity-risk matrix and country attractiveness-firm

strength matrix.
2. The main difference is in the variables/factors selected for comparison.

Grid technique is based on a countryÊs opportunity and risk factors deemed
as important to the company while opportunity-risk studies the
opportunity to invest and risk that will be faced in a particular situation.
CountryÊs attractiveness-companyÊs strength on the other hand, relates the
attractiveness of a country and the strength of the company to compete.
Activity 9.3
Companies export to sell surplus production abroad, and exporting allows low
cost and low risk method of entry into a foreign market.
Potential pitfalls in exporting are: exporting company has to face trade barriers,
high transportation costs of bringing goods abroad making it uneconomical, face
problems associated with export agent who carries many brands and types of
products and firm has no control over marketing activities of export agent.
Activity 9.4
1. The main differences between international licensing and international
franchising include:
 International franchising involves higher cost of establishing and

operating the business (franchise fees and ongoing royalties) than
licensing (licensing fee is a one time payment up front but with no
royalties).
 International franchising involves tight control by franchisor (parent

company) in every aspect of the business and they provide much
assistance in marketing and management of the business to the
franchisee while there is more freedom in business operation in
licensing.

ANSWERS  229
2. Quality problems when licensee does not perform as anticipated and

licensor bears the risk of creating a competitor in the future.
Activity 9.5
1. Express Rail Link in Kuala Lumpur and Kuala Lumpur International
Airport Express.
2. The factors that contribute to a successful turnkey project:
 Host government and local companies must gain the technological

transfer as well as training and expertise from the foreign investor that
has agreed to complete and manage the entire project;
 Hiring a reliable outside contractor to handle the entire project as full

responsibility for the project rests upon the contractor; and
 Commitment and support from the host government.
Activity 9.6
1. Some of the criteria in selecting suitable joint venture partners:
 Shared values and corporate culture;
 Strategic fit;
 Sufficient financial and human resource;
 Marker knowledge and access;
 Local business leader;
 Strong track record in developing new ventures;
 Business experience; and
 Involved and committed management.

230  ANSWERS
2. The possible causes of break-up and failures in international joint ventures

include:
 Disagreements that may cause a break-up in JV due to differences in
culture and management styles or lack of trust among the partners; and
 Conflicts of control on operations and shared ownership arrangements
between the investing partners.
Exercise 9.2
1. A
2. C
3. D
4. C
5. C
TOPIC 10: MANAGING THE GLOBAL MARKETING

ENVIRONMENT
Self-Check 10.1
The strategies used for adapting product strategies to a global market:
 Product extension;
 Product adaptation; and
 Product invention.
Which strategy is the best? The best strategy depends on the companyÊs goals
and objectives, the intended market to enter and the nature of the product.
Self-Check 10.2
The factors that affect pricing of products in a global market include:
 Standardising or adapting pricing policy: which pricing strategy to use –
ethnocentric, polycentric or geocentric;
 Price sensitivities of consumers in various markets; and
 Competitive pricing from the competitors in the markets.
ANSWERS  231
Exercise 10.1
1. The market factors in terms of threats and opportunities that

global marketers need to monitor and assess in the marketing environment
are:
Threats Opportunities
 Rising costs of raw materials and  Large market size
wages  Rise of emerging markets
 Large and increasing global  Rising income per capita
competition
 Rising spending power of middle
 Political risks class consumers
 Cultural differences  Technological advancement
 Economic shocks
2. Based on a market analysis on China and India as emerging markets, these

are the market attractiveness:
Market attractiveness of China Market attractiveness of India

 Large population = large market  Large population = large market
size and market demand potential size and demand potential
 Ample supply of resources =  Cheap labour resources
availability of cheap labour, land  Growing consumer and retail
and natural resources market
 Rising income of middle class  Less competitive nature of industry
population = high purchasing
power of consumers  Early mover advantages
 Open and deregulated economy =  Technical and IT skills of Indian

government relaxed controls on labour
foreign ownership and taxation
3. The differences between a domestic and global marketing plan include:
 Target market: local consumer tastes and demands differ from foreign
target markets due to cultural differences and levels of sophistication.
 Entry strategy: how to enter foreign market via exporting or wholly

owned subsidiary or collaboration strategies such as joint ventures and
licensing.

232  ANSWERS
 External influences of marketing environment in foreign markets are

more complex, uncertain and riskier than domestic marketing
environment, such as political risks, economic risks, financial and
cultural risks.
 Strategies for 4Ps differ between foreign and domestic market; need for
standardisation or adaptation of 4Ps in foreign market.
4. The environmental factors in the market that influence the development of

the global retailing industry include:
 Consumer spending: level of domestic consumption of essential goods

and consumer durables such as food, clothing and electronic gadgets.
 Economic performance: affects consumer confidence which in turn

affects retail spending and access to credit for retail spending such as
global economic recession.
 Technological development: affects innovation of goods and spending

trends, retailers have to keep up with these trends and develop high-
tech innovations to reach their customers.

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BBNG3103

Copyright © Open University Malaysia (OUM)

Module Writers: Dr Abdul Jumaat Mahar

Dr Teo Boon Chui

Moderator: Ayub Nasir

Developed by: Centre for Instructional Design and Technology

Printed by: Meteor Doc. Sdn. Bhd.

First Edition, May 2007

Copyright © Open University Malaysia (OUM)

Topic 1 Introduction to International Business 1

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Topic 2 Economic Environment and Systems 21

Topic 3 Cultural Environment 41

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Topic 4 Political and Legal Environment 63

Topic 5 Regional Economic Integration 80

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5.7 Economic Integration in the Asia Pacific Region 93

Topic 6 International Trade Theories 97

Topic 7 Foreign Direct Investment (FDI) 121

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Topic 8 International Financial Environment 136

Topic 9 Country Selection and Entry Strategies 155

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9.9 Foreign Direct Investment (FDI)-Related Entry Modes 181

Topic 10 Managing the Global Marketing Environment 190

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Copyright © Open University Malaysia (OUM)

COURSE GUIDE DESCRIPTION

As an open and distance learner, you should be acquainted with learning

Copyright © Open University Malaysia (OUM)

Table 1: Estimation of Time Accumulation of Study Hours

1. Describe what is international business, underlying trade theories and why

2. Describe the cultural, economic, political, legal and financial environment

3. Summarise the developments in global markets in terms of economic

4. Discuss international business strategies in terms of country selection, entry

Copyright © Open University Malaysia (OUM)

Topic 1 describes what is international business, why it is important and

Topic 2 focuses on the economic environment facing firms in foreign markets.

Topic 5 focuses on the development of regional economic integration in the

Topic 7 examines foreign direct investment (FDI) in terms of types, motives,

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TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

Activity: Like Self-Check, the Activity component is also placed at various

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References: The References section is where a list of relevant and useful

Cordenillo, R. L. (2005). The economic benefits to ASEAN of the ASEAN-China

Daniels, J. D., & Radebaugh, L. H. (2009). International business: Environments

Guo, S. (2004). Economic transition in China and Vietnam: A comparative

Hoang, T. T. (2006). Determinants of foreign direct investment in Vietnam.

Copyright © Open University Malaysia (OUM)

Holden, M. (2003). Stages of economic integration: From autarky to economic

Johnson, A. (2005). Host country effects of foreign direct investment [Electronic

Lin, J. Y. (2010). ChinaÊs miracle demystified [Electronic version]. Retrieved from

Sun, X. (2002). How to promote FDI? The regulatory and institutional

UkraineÊs Business Culture. (2005). Retrieved from http://www.tryukraine.com/

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TAN SRI DR ABDULLAH SANUSI (TSDAS) DIGITAL

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

International business consists of all transactions between one country and

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