International Business and Trade 1st Sem SY 2020-2021

Module
International
Business and
Trade
Chriselda Saniata G. Niala

Elsa S. Pinzon
International Business
and Trade
T
his course is designed to help students develop the
appreciation, knowledge, skills, and abilities needed
to live and work in a global marketplace. It takes a
global view on business, investigating why and how
companies go international and are more interconnected.
The course further provides students a conceptual tool by
which to understand how economic, social, cultural,
political and legal factors influence both domestic and
cross-border business. This is drawn upon international
business theory and practice for understanding the
international business context. It aims to provide students
with practical tools and theoretical knowledge related to
international trade and the exploration of practical issues
faced by business managers in international business
situations.
Page
COURSE DESCRIPTION
TABLE OF CONTENTS
INTRODUCTION TO INTERNATIONAL BUSINESS 1

Introduction 1
The Importance of International Business 1
International Business Activities 7
Concepts and Challenges in International Business 10
Motivations and Restrictions in International Business 13
Summary 15
Exercises 17
CULTURAL, POLITICAL, LEGAL, AND ECONOMIC

SYSTEMS 21
Introduction 21
Culture 21
Politics and Legal Environment 27
Economic Environment 32
Summary 37
Exercises 39
INTERNATIONAL TRADE THEORIES AND INSITUTIONS 42

Introduction 42
Theories of International Trade 43
International Trade Strategies and Organization 50
Regional Economic Integration 51
Summary 60
Exercises 61
THE FINANCIAL ENVIRONMENT OF INTERNATIONAL

BUSINESS 64
Introduction 64
The International Monetary System 64
The Foreign Market Exchange 69
Currency Convertibility 74
Summary 76
Exercises 77
MARKET RESEARCH, MODE OF ENTRY, AND ETHICAL

ISSUES IN INTERNATIONAL BUSINESS 80
Introduction 80
Market Research 80
Foreign Market Entry Strategies 85
International Business Ethics and Social
Responsibility 91
Summary 94
Exercises 96
Page
OPERATIONAL AND FUNCTIONAL CONSIDERATIONS
IN INTERNATIONAL BUSINESS 99
Introduction 99
Organizational Design and Control 99
International Marketing Management 106
International Financial Management 111
Human Resource Management 116
Summary 121
Exercises 123
INTERNATIONAL LOGISTICS AND SUPPLY CHAIN

MANAGEMENT 127
Introduction 127
International Logistics 127
Issues in International Logistics 129
International Transportation 136
Supply Chain Management 138
Summary 148
Exercises 150
REFERENCES AND OTHER RESOURCES

References:
• Daniels J., Radebaugh, L., and Sullivan D. (2015), International Business
Environments and Operations 15th Edition, Pearson
• Hill, C. W. L. (2014), Global Business Today 8th Edition, McGraw-Hill/Irwin
• Wardtrope, W. (2016), Introduction to International Business: People,
Places, and Ideas (1st Edition), Wardtrope Communication Development
Inc. and www.bookboon.com
• Ayub N. (2016), Introductory International Business 2nd Edition, OUM
• Carpenter M. and Dunung S. (2012), Challenges and Opportunities in
International Business v. 1.0, Creative Commons
• Suranovic S. (2012), Theory and Policies of International Trade v. 1.0,
Creative Commons
• Steiner J. and Steiner G. (2012), Business, Government, and Society A
Managerial Perspective, Text and Cases 13th Edition, McGraw-Hill/Irwin
• Peng M. and Meyer K. (2011), International Business, Cengage Learning
• Mondejar R., Onishi J., Lim, F. Jr., and De Castro S.(2010), Introduction to
International Business and Globalization: Text & Cases, Sinag-Tala
Publishers
Other Resources:
• www.wto.org
• www.worldbank.org
• www.imf.org
• www.weforum.org
• www.theeconomist.com
• www.csis.org
• www.hbr.org
• www.businessinsider.com
• www.investopedia.com
Chapter
1
1
Introduction to
International Business
LEARNING OBJECTIVES LEARNING CONTENTS
After this chapter, the student must be able to: In this chapter, you will learn about:
LO1. Define the term globalization; LC1. The Importance of International

LO2. Describe the scope of activities in Business
international business; LC2. International Business Activities
LO3. Explain the role played by international LC3. Concepts and Challenges in
business especially in the economic International Business
development of a country, a particular LC4. Motivations and Restrictions
region as well as the world in general; in International Business
LO4. Explain important concepts which
underline the activities of the
international firm; and
LO5. Discuss the reasons firms engage in
international business and the
challenges the firms have to face.
Introduction
In this chapter, we will discuss the term “globalization” and the scope of activities in
international business. We will also discuss the roles played by international business especially in
the economic development of a country, a particular region as well as the world in general.
International business consists of business transactions between parties from more than one
country. For example, firms buy materials from one country, ship them to another country for
processing or assembly and then ship the finished products to another country to be sold. Firms also
build manufacturing plants in a foreign country to take advantage of lower labor costs or borrow money
from banks in other countries. Those involved in these transactions may include private individuals,
firms and government agencies.
International business differs from domestic business due to several reasons. As international
business involves other countries, its activities are carried out using different currencies, different legal
systems and practices and in different cultures. Countries also differ in the availability of their natural
or labor resources, resulting in varying production capabilities.
Finally, this topic shall include discussions on the types of international business activities and
its importance to countries’ economies, the reasons for its tremendous growth, the concept of
globalization and its effects. This topic shall also explain the major factors that motivate firms to
engage in international business and the challenges they face in today’s highly competitive
environment.
THE IMPORTANCE OF INTERNATIONAL BUSINESS

International Business and Trade | First Semester S.Y. 2020 – 2021 | CSGN & ESP
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The field of international business has become increasingly important not only as a subject of academic
study but also how it affects our daily lives as individuals, employees and citizens of a particular country.
Most large corporations today engage in international activities or may be affected by events taking
place around the world. As employees of these firms, a basic understanding of international business would
help us understand why some of our colleagues from foreign countries are recruited and how we might interact
more effectively with them. The business firm we work for may be foreign-owned or the Philippine-owned firm
we work for may need to buy foreign made materials and equipment or even expand their operations outside
the country.
Besides keeping abreast of the latest business techniques and tools which are developed in other
countries in North America, Europe and Japan, the knowledge and skills of managing in foreign markets would
also assist in our career development. Managers who remain unaware of the innovations of their international
competitors may be doomed to failure in the global market place.
We will often meet colleagues, customers, suppliers and competitors from different countries with
different cultural backgrounds. Being culture literate would help us understand their countries’ and their
companies’ position in the context of the global economy. Our ability to recognize and appreciate these
differences may earn their respect, confidence as well as provide us with a competitive edge. Thus, whether we
are managers, consumers or just observers of global events, international business is very much a relevant
subject.
ACTIVITY 1.1
Let us say you work for a large corporation which engages in international business.
As an employee, what can you do in order to enhance your company’s future?
Discuss with your classmates in our group page.
A. The Growth of International Business
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Self-Assessment Question 1.1

Nowadays, business firms are very eager to conduct business internationally.
What do you think drives them to do so?
PLEASE READ: This is a Self-Assessment Question (SAQ) box, where you answer given questions to
gauge your understanding of a given topic. Thus, your answers must be constructed in your own words.
You must create a word file with the following format: “<YourSurname>IBTSAQ” (e.g. NialaIBTSAQ).
This will serve as your journal for your SAQs to be submitted every time we accomplish a chapter. Preferred
submission is through E-mail. For questions/concerns, please inform your instructor.
Although it is difficult to determine how much international business has occurred at the different
times in history, world trade has grown at a much faster pace than world production.
According to data from the World Trade Organization, the volume of world trade has increased by 20 times
from 1950 until 2000 while world production grew by 6.5 times. The rate of growth, however, slowed down
significantly in 2001 due partly to the global economic slowdown and the aftermath of the September 11
terrorist attacks on the United States.
The figure above illustrates the four factors that bring about the increased growth in
international business. These factors are sometimes interrelated and they are as follows:
(a) Expansion of Technology
Developments in communications and transportation technology have enabled people in

one part of the world to know and demand for products and services developed in another part of
the world. Increasing demand for these new products and services has increased the number of
international business transactions.
The Internet phenomenon has not only facilitated business-to-customer transactions but
also more business-to-business transactions. About 48% of the world’s population uses the
Internet. In 2015, the International Telecommunication Union estimated about 3.2 billion people, or
almost half of the world’s population, would be online by the end of the year, of which, about 2 billion
would be from developing countries, including 89 billion from least developed countries.
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Several major innovations have also occurred in transportation technology since World War
II. The development of commercial jet aircraft and super freighters and containerization have made
trans-shipment of goods simpler and more efficient.
Although the costs of improved communications and transportation have increased, it has
risen more slowly than the operating costs of international businesses.
(b) Government Deregulation
Every country restricts the movement of goods and services, as well as resources such as
labor and capital across its borders. Many of these barriers are in the form of tariffs on the import
of manufactured goods, which are imposed to protect domestic industries from foreign competition.
Such restrictions make international business more expensive to undertake. As regulations may be
changed at any time, international business is also risky.
Generally, governments today have gradually reduced these trade barriers and allow
greater movement of trade and investments into their countries for several reasons. Their citizens’
desire for access to greater variety of goods and services at lower prices, the increased efficiency
of domestic producers as a result of foreign competition and the need to encourage other countries
to reduce their trade barriers have led to the deregulation of restrictions. This has enabled firms to
gain access to more markets.
(c) Supporting Services
The development of banking, insurance and postal services by governments and

companies also helped to ease international business. Through banks, payments to exporters for
the goods and services sold abroad and arrangements to convert currencies can easily be made.
Insurance companies cover for damage en route or non-payment by the buyer. Postal agreements
among countries enable us to mail a letter to any place in the world using stamps from the country
where we mail it.
(d) Increase in Global Competition
Foreign competition can also persuade companies to expand its business into international
markets to maintain competitiveness. Companies today can respond quickly to take advantage of
foreign sales opportunities. International firms can shift production among countries quickly
because of their experience in foreign markets and their ability to transport goods to many places
efficiently. When a few companies respond to foreign market and production opportunities, other
companies also follow suit.
B. Globalization
Countries are moving away from being self-contained and isolated entities separated by:
(a) Trade and investment barriers;

(b) Distance, time zones and language; and
(c) Differences in government regulation, culture and business practices.
Trade and investment barriers are falling, transportation and telecommunications technology
make vast distances accessible and material culture looks similar all over the world. No nation can
afford to exist without interacting with other nations. A country’s successful participation in international
business and international markets should lead to a better life for its citizens.
This process of merging into one interdependent global economic system is commonly called
“globalization”.
Two important facets of globalization are:

(a) Globalization of markets; and
(b) Globalization of production.
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(a) Globalization of Markets

The reduction in trade restrictions has made it easier to sell goods and services
internationally. Tastes and preferences of consumers in different countries are beginning to
converge, helping to create a global market.
Examples of Global Brands
Products like McDonald’s burgers, Coca-Cola soft drinks, Levi’s jeans and Citigroup
credit cards are some examples of this trend. These companies offer standardized products
worldwide, thus creating a global market.
However, we shall learn in later topics that there are significant differences in consumer
tastes and preferences, distribution channels, cultural values, business practices and the law
requiring companies to customize their marketing strategies, product features and operations
in order to match the conditions in different countries.
Most global markets currently are not markets for consumer products but markets for
industrial goods and materials that serve a universal need, such as microprocessors, computer
software and for commodities like oil, aluminum and rice.
As companies expand their operations and compete with each other, they bring along
their products, operating and marketing strategies and brand names into other markets, thus
also creating some uniformity across different markets. Therefore, Coca-Cola’s rivalry with
Pepsi, Ford with Toyota, and Boeing with Airbus are examples of such markets.
(b) Globalization of Production
International firms source for goods and services from all around the world to take
advantage of differences in the cost and the quality of factors of production, such as labor,
capital, energy and land. In doing so, they are able to lower their overall cost and improve the
quality of the products they offer. For example, Boeing’s 777 jet airliner has parts supplied by
a global network of suppliers. Fuselage, doors and wings are obtained from Japan, landing
gears from Singapore and wing flaps are from Italian manufacturers.
Outsourcing is a practice used by different companies to reduce costs by transferring portions of work
to outside suppliers rather than completing it internally.
We shall also learn from subsequent topics that substantial obstacles still exist which make it difficult
for firms to optimize their production activities around the world. These obstacles include barriers to trade and
foreign direct investments, transportation costs as well as the issue of economic and political risks.
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Nowadays, business firms are very eager to conduct business internationally.
What do you think drives them to do so?
REMINDER: Place your answer in your SAQ file as instructed in SAQ 1.1.
C. The Globalization Debate

So far, we have looked at the positive aspects of globalization.
What do you think are the negative aspects?
REMINDER: Place your answer in your SAQ file as instructed in SAQ 1.1.
As globalization is dependent on the concept of free trade without restrictions or barriers being
imposed by national governments, several arguments have emerged in support as well as in opposition.
While many economists, politicians and business leaders view globalization positively, there were also
street demonstrations held protesting it. These arguments mainly arose from the following issues:
a. Loss of Jobs and Income
Jobs in the manufacturing sector of the wealthy and advanced economies would be
destroyed when declining trade and investment barriers allow firms to shift their manufacturing
activities to countries where labor costs are much lower.
However, supporters of globalization argue that the benefits are greater than its costs.
Free trade will encourage countries to specialize in the production of goods that they can
produce most efficiently while importing the goods that they cannot produce as efficiently. This
will result in the whole economy being better off. For example, the US imports textiles from
China where it can be produced at a lower cost and this will lead to lower prices for clothes in
the US. This would enable consumers to spend more of their money on other items. At the
same time, the increased income in China from textile exports would increase the income levels
in the country which would allow the Chinese to purchase more products produced in the US.
b. Labor Policies and the Environment
Firms may move their manufacturing operations to less developed countries which do
not have adequate laws and regulations to protect labor and the environment from abuse, thus
relieving them from the burden of the cost of complying with such regulations. This might lead
to an increase in environmental pollution and exploitation of labor. Firms from the advanced
countries might also ignore workplace safety and health issues in an attempt to reap higher
profits.
However, supporters of globalization believe that free trade enables developing

countries to increase their economic growth rates to become richer countries, thus, enabling
them to make and enforce tougher environmental and labor laws. Wealth creation and
incentives would encourage enterprises to produce technological innovations that would reduce
or make it easier to cope with the problems of pollution and population growth.
Supporters also argue that business firms are generally committed to behave ethically
and not move production to countries where they can easily pollute the atmosphere or exploit
labor.
c. Loss of National Sovereignty

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Critics of globalization are also concerned that the increasing interdependence

between economies would shift economic power from national governments to supranational
governments like the World Trade Organization (WTO) and the United Nations (UN). They may
impose policies that undermine the sovereignty of elected governments and limit government
authority to make their own decisions.
Many economists and politicians however, maintain that the power of bodies such as
the WTO and the UN depends on their ability to persuade member countries to follow certain
actions in the interest of members. If they fail, these countries will withdraw their support which
eventually will lead to the collapse of the supranational organizations.
d. Widening Gap between the Rich and Poor Nations
Critics point out that despite the supposed benefits of free trade and investment, the
gap between the rich and the poor nations of the world has become wider. Although some
nations like South Korea, Thailand and Malaysia are capable of economic transformation, the
average per capita income of the world’s 17 richest nations in 1990 was 4.5 times that of all
other countries. The income gap was only 2.4 times in 1870. If globalization is such a positive
development, this divergence should not have occurred.
Several factors other than free trade or globalization could have been the cause.
Totalitarian governments and destructive economic policies which provide little protection for
property rights and war such as in the countries of Africa have failed to improve the economic
level of their citizens. The rapid rate of population growth further complicates the issue.
Another factor is the large debt burdens held by the poor countries. The servicing of
these debts result in very little left for these countries to spend on building important
infrastructures, such as roads, power generation plants, education and health care. Large scale
debt-relief programs could provide these poor countries with the opportunity to restructure their
economies and invest wisely in public projects that facilitate economic growth and free trade
and investment.
ACTIVITY 1.2
Based on your opinion, how can the Philippines obtain the benefits of globalization?
Format: Word | Submit via:  E-mail  Online Classroom  Others (Please notify your instructor.)
Deadline of submission: _______________________ Date of discussion: _____________________
Task Reminder
Assess your understanding by answering Exercise 1.1 at the end of this chapter.
INTERNATIONAL BUSINESS ACTIVITIES

Although international business activity was first carried out in the form of exporting and importing,
business today can be divided into the following three broader categories.
A. Exports and Imports
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Exporting and importing of goods and services are the most common methods used
compared to any other international mode. The export of goods or merchandise consist of tangible
products such as televisions, automobiles, machineries, chemicals and other items sent out of a
country; imports are goods brought into a country.
Services include all types of non-product sales (export) and purchases (import) such as travel
and tourism, transportation, communications, banking, insurance, education and distribution rights for
motion pictures.
B. International Investments
International investments are the second major form of international business activity and can
be divided into:
(a) Foreign direct investments (FDI); and
(b) Portfolio investments.
FDI is an investment that gives the investor a controlling interest in a foreign company. Companies
may choose FDI as a way to gain access to certain resources or to reach a market in a foreign
country. Many small firms also engage themselves in FDIs.
A portfolio investment is a non-controlling interest in a company. Firms may purchase foreign

financial assets such as shares, bonds and certificates of deposits which are not for the purpose of
gaining control. Firms use them for short-term gain and move funds among countries to earn higher
returns.
Examples of portfolio investment
C. Other Forms of International Activities and Companies
International firms may also use their assets such as trademarks, patents, copyrights or
expertise under contracts known as licensing agreements. Under these contracts, the licensor allows
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the foreign licensee the use of their assets and receive royalty payments in return. Franchising is a
specialized form of licensing in which the firm (franchisor) allows another firm (franchisee) in a foreign
country to utilize its complete operating systems as well as brand names, trademarks and logos in return
for royalties. In a management contract, the firm agrees to operate facilities or provide management
services to a firm in another country for an agreed fee.
A firm that is involved in any of these types of transactions can be called an international
business firm. An international firm can therefore be formally defined as “any organization that engages
in cross-border commercial transactions with individuals, private firms and/or public sector
organizations.”
The term “multinational corporation (MNC)” is often used to identify a firm “that engages in
foreign direct investment and owns or controls value-adding activities in more than one country”. They
also typically buy resources in several countries, make goods and services in several countries and sell
those goods and services in several countries.
The term “transnational company (TNC)” is often used today in its strategic context which
refers to a company whose “capabilities and contributions may differ by country but is developed and
integrated into its worldwide operations”. For example, Caterpillar Inc. learns from all its different
operating environments and uses the knowledge throughout its global operations. This means that the
company combines global coordination to attain efficiency with flexibility to meet the specific needs in
various countries. Its main location of power within the organization may be geographically dispersed.
A global company also integrates its operations that are located in different countries. For
example, it may design a product or service to market it to a global segment or it may rely on its other
country operations to produce the components used in its products and services. In contrast to the TNC,
the development of capabilities and decisions to utilize them globally are mainly made at the company’s
home country.
A multidomestic company or sometimes called a locally responsive company allows each of

its foreign country operations called subsidiaries to act more independently. For example, products and
services are designed in India for the Indian market and in Japan for the Japanese market. This
encourages marketing, advertising and product decisions to be modified and adapted to the specific
needs of each country.
ACTIVITY 1.3
Based on your understanding, name some companies in the Philippines which engage in
international business. Then, determine the forms of international business activities that they are
involved in.
Philippine Company Forms of International Business Activities
1.
2.
3.
4.
5.
Task Reminder
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CONCEPTS AND CHALLENGES IN INTERNATIONAL

BUSINESS
The international firm of the 21st century faces many more challenges compared to previous periods in history.
The global economy is rapidly changing, becoming more integrated and interdependent as barriers to the free
flow of goods, services and capital are reduced. More nations are joining the ranks of the developed world and
more firms from the developing countries are now major players in many global industries. On the other hand,
greater globalization also brings various risks of its own. The manager, therefore, needs to examine closely the
external environment in which the firm operates before forming and implementing any strategy to exploit the
available opportunities.
A. The External Influences on International Business
Within a firm’s external environment, there are several factors, some of which are beyond the
managers’ control. In addition to knowledge of business operations, managers should have a working
knowledge of political science, societal, economics and geography.
The figure below highlights the four external factors which influence international business.
Now let us discuss each of the four external factors which influence international business:
a. Politics shape business when political leaders control when and how international business should
take place. Political disputes or conflicts can disrupt trading and investment activities. Domestic laws
govern how firms operate within the country while international laws determine the relationship between
governments and may affect the respective firms from the countries concerned, such as tax laws and
trade sanctions.
b. Societal factor concerns a society’s values, attitudes and beliefs about themselves and others. The
international manager’s knowledge of foreign culture would lead to a better understanding and help
them function more effectively in other countries.
c. Economics is about why countries exchange goods and services with one another why capital and
people travel among different countries and why different countries’ currencies have different values.
By studying economics, the international manager can better understand which country can produce
goods or services at a lesser cost than others and why. The manager can also learn how to analyze
and determine the effect of a country’s economic policies and conditions on the firm and how the firm
impacts the host and home country.
d. Geography helps ascertain the locations, quantity and quality and availability of resources in different
parts of the world and how to exploit them best. Mountains, jungles, deserts and climate pose as
geographical barriers that affect communications and distribution channels.
The external environment affects how firms operate and firms need to make adjustments as to how it
produces and market its products and services, recruit employees and maintain its accounts in a particular
country.
B. The Competitive Environment

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The competitive environment in which a firm operates varies by industry, company and country.
Thus, firms in industries where products are homogeneous in nature may compete more on price. Strategies
would therefore be influenced by cost savings, such as producing on a larger scale to achieve lower average
unit costs and locating sources of cheaper labor and materials. Firms in other industries may compete more
on differentiated and innovative products, thus, placing more emphasis on research and product
development to gain competitive edge.
Another competitive factor is the size of the company and the resources it possesses compared to
competitors. Large firms like Coca-Cola has much more resources and international options to choose from,
compared to smaller firms, allowing it to vary its strategies according to different markets.
The size of the firm’s domestic markets, like the US compared to Switzerland, also creates different
competitive environments. Swiss producers are more highly dependent on sales to foreign markets than
the US producers in order to achieve economies of scale in product development and production.
Yet another factor which shapes this environment is whether there is international or local
competition in the home country and in foreign markets. Firms that compete with each other everywhere
they try to sell their products, such as Boeing and Airbus, learn more about each other and use the
knowledge to anticipate each other’s actions and strategies in other countries.
Other firms such as Carrefour may face different retailers as competitors in each of the foreign
countries where they operate.
The mentioned factors help to generally describe the competitive environment within which
international firms operate.
ACTIVITY 1.4
In your opinion, how do hypermarkets such as SM remain competitive
when faced with different retailers as competitors?
C. Global Standardization
A global strategy is one that implements highly standardised practices among the countries they
operate. For example, a firm may design and produce a product or service suitable to be marketed to
many countries. In doing so, the firm is able to avoid duplicating product development costs and reduce
manufacturing costs by serving many markets from a single production location. The firm gains from
economies of scale. A Boston Consulting Group (BCG) study showed that when output is doubled,
production costs can be reduced by up to 30%.
Thus, when firms are faced with competitive pressures for cost reduction, they respond by mass
producing and offering a standardised product to the global marketplace. Production is carried out at
the most optimal location in the world where they can realise location as well as experience curve
economies. Some examples of such industries are commodity-type products like petroleum, sugar,
steel and industrial chemicals where price is the main competitive weapon.
The increasing liberalization of international trade and investment which facilitates greater
international competition has also generally increased pressures for cost reduction.
D. Local Responsiveness
Pressures to be locally responsive require the firm to differentiate its product, practices and
marketing strategies in response to the different country preferences. The sources of this pressure are
indicated in the figure below.
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a. Differences in Consumer Tastes and Preferences
Consumers in different countries may significantly differ in their tastes and preferences
due to historical or cultural reasons. Products and/or marketing programmes have to be
customised in order to appeal to each country’s consumers.
Although modern communication and transportation have created some convergence

in consumer tastes and preferences for products like Coca-Cola or Pepsi, Levis and
McDonald’s, consumers of certain electronic products, television programs and four-wheel
drive vehicles have shown a preference for products that are differentiated to suit local
conditions.
b. Differences in Infrastructure and Traditional Practices
Differences in electrical systems (110-volt/240-volt) infrastructure and traditional

driving practices (left-hand/right-hand drive practices) which are rooted in history, would require
products to be customised to suit the local differences. More recently, arising differences are
the technical standards in the wireless telecommunications industry between Global System
for Mobile Communication (GSM) and Code Division Multiple Access (CDMA).
c. Differences in Distribution Channels
An international firm’s marketing strategies may have to be varied according to different

distribution channels among countries. There may be a few but powerful food retailers in
Germany dominating the market but they are smaller and larger in number in Italy. Distribution
systems in Japan may not favour American-style high pressure sales.
d. Host Government Demands
Host country governments may impose stringent regulations such as food or drug testing
procedures, pricing restrictions or rules requiring a higher percentage of local content in
products. These demands would require foreign products to be locally responsive.
The firm therefore has to customise their product and service offerings and marketing
programmes to meet local requirements and it may not be possible for the firm to realise the
full benefits of location and experience curve economies.
E. National Sovereignty
Sovereignty refers to a country’s ability to decide and implement policies free from any external
influences and control. It provides a government with the right and responsibility to shape the country’s
environment and citizens. Governments seek to improve or maintain the standard of living and the
quality of life of its citizens and stimulate development through its domestic policies.
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However, these policies may indirectly influence international trade and investment while other
policies are imposed with a more direct and specific intention. Accumulation of large quantities of debt
which may threaten the economy and the citizens’ future standard of living is an example of the former.
Import restrictions to protect infant domestic industries are more direct policies.
Governments also institute foreign policies and the major goal is national security. They may
develop alliances and agreements to protect their borders and improve trade and investment
opportunities.
As each country develops its own policies with varying intentions from country to country,
conflicts and disputes may arise. A country’s policies to achieve full employment may directly affect the
employment policies of another country and development policies of one country may reduce the
development capabilities of another country. Firms operating or seeking to operate in foreign countries
would therefore need to be wary of these uncertainties and risk possibilities.
Task Reminder
MOTIVATIONS AND RESTRICTIONS IN

INTERNATIONAL BUSINESS
Firms engage in international business for a variety of reasons. While to expand their markets and to
acquire resources can be quite obvious, another major motive is to minimize the risk of competition. Against
these aspirations, foreign country governments may impose restrictions on imports and exports as measures
to protect the interest of their countries. Thus, the international firm needs to develop and vary their business
strategies country by country to achieve their aspirations. Both these topics are discussed in detail next.
A. Why do Companies Engage in International Business?
The following figure illustrates the three objectives which influence firms to engage in
international business.
The three major objectives are to:
a. Expand Sales
Firms search international markets to increase sales. However, sales depend on

consumers’ interest in the firm’s products or services and their willingness to buy them. Firms
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therefore pursue international markets because of their size and purchasing power which as a
whole are greater compared to a single country.
Coca-Cola, for example, derives 80% of its income from international operations while
McDonald’s foreign activities generate about 65% of its revenue. Jollibee and ABS-CBN are
examples of Philippine firms venturing into international markets to increase sales.
b. Acquire Resources
Firms venture abroad seeking materials, components, capital, new technologies and
information that they can also use in their home countries, to reduce costs or to acquire
resources that are not available at home. These resources would enable the firm to improve
the quality of its products and differentiate it from competitors. Foreign resources and
experience can also be used to improve their domestic operations. Mars Inc., the producer of
M&M’s, snickers, etc., has been sourcing its cacao from the Ivory Coast, Ghana, and other
cacao producing countries since the main ingredient in making chocolates does not grow in the
U.S.
c. Minimize Risk
Different country markets often face different stages in the business cycle, such as
recessions and growth. Decreasing sales in countries facing recessions may be offset by
increasing sales in another country which is expanding economically. Firms are also able to
avoid price increases or shortages of supplies of raw materials, components and products in
any one country by obtaining them from different countries.
Firms also engage in international business to counter and prevent the advantages that
competitors gain in foreign markets and use in the home market. For example, a competitor
firm may make higher profits from a foreign market. These additional funds are then used to
increase its advertising or develop better products in its domestic market, giving them an
advantage over domestic firms. In order to gain similar or higher capabilities, the domestic firm
will also need to venture abroad.
B. Trade Protectionism
Protectionism is government measures that affect competition, prohibit exports or imports thus
limiting a firm’s ability to buy or sell abroad. The more common instruments used to control trade flows are
explained next.
a. Tariffs or duty, are taxes levied on exports (export tariff) and imports (import tariff).
b. Non-tariff barriers are as follows:
■ Subsidies are assistance provided to offset high domestic production costs to assist
exporters to make selling prices cheaper or more profitable when selling abroad. They
may be in the form of research and development aid or loans or direct payments to
compensate domestic firms for the losses incurred from exporting.
■ Quotas are limits imposed on the quantity of products that can be imported or exported
during a certain period of time.
■ Administrative barriers are regulations, rulings, standards and testing procedures
which may make exports to a foreign country difficult, costly or even impossible.
■ Local content regulations require that a specified portion of a product be produced
locally using locally sourced materials or components.
There are various reasons for government intervention in trade flows, primarily for the purpose of
protecting the country and its citizens’ interest. Among the major ones are to:
a. Maintain Essential Industries

This is to promote the country’s self-sufficiency and avoid dependence on other
countries for supplies of critical raw materials, machinery or technology. A country may ban the
import of certain commodities to promote home production or restrict exports of commodities
which are in short supply for home consumption.
b. Protect Infant Industries
15
Governments may implement import restrictions or export subsidies to protect young

domestic industries from fierce competition until they are able to thrive independently in
international markets.
c. Prevent Unemployment
Domestic firms and their workers may lose jobs if their employer firms are not able to
compete with more efficiently produced imports. Governments would impose tariffs, quotas and
other barriers to restrict imports.
d. Promote Local Industrialisation

A government may intervene to help develop their country’s industrial base by
regulating imports from foreign producers. The unregulated importation of lower priced products
may prevent the development of the domestic industry.
Import restrictions also increase foreign direct investment when foreign firms shift their
manufacturing facilities into the country to overcome import restrictions and avoid the loss of a
potential market.
e. Maintain National Security

The export of strategic defence goods, such as sophisticated computer hardware and
software and materials with a nuclear potential which can be used to threaten national security
if placed in the wrong hands, are also restricted. The United States government, for example,
prevents these exports unless prior approval has been granted.
For non-defence goods, trade controls may be imposed as a matter of foreign policy to
prevent another country from meeting its political objectives. For example, the United States
may impose trade sanctions on the sale of technology or chemicals to North Korea who would
use them in their defence development programmes.
f. Maintain Spheres of Influence

A country may put in place trade restrictions to force other countries to follow certain
political actions or punish those who do not. The United States may threaten to restrict Chinese
products because of China’s controversial human rights records.
g. Preserve National Identity
This concerns those industries which a country believes must be protected to preserve
their cultural identity. Thus, France protects its cinema industry to prevent the invasion of the
English language films, while Japan and South Korea bans the import of rice to preserve rice
farming as a historical identity.
ACTIVITY 1.5
Ready to make a stand between FREE TRADE and PROTECTIONISM?
Research on the two topics and be prepared for a modified debate.
Further instructions will be given by your instructor.
Task Reminder
SUMMARY
 This opening topic introduced and explained the basic and current concepts underlying the activity of
 First, we learned about the increasing role and importance of international business in line with its
tremendous growth in recent years and the reasons for its growth.
16
 Next, we learned that globalisation can be viewed as comprising two aspects of production and of
marketing.
 The activities conducted in international markets are categorised as the export and import of goods and
services and investments. The other activities which we briefly learned are licensing, franchising and
management contracts, all of which will be dealt with in greater detail in later topics.
 In order to have a better understanding of international competition, we learned about external factors
that interact within which the international firm operates.
 We also learned about the reasons that drive firms to engage in businesses abroad which are mainly
to expand their sales, to acquire needed resources and/or to minimise the risk of competition.
 Finally, we learned about the practice of trade protectionism by country governments to restrict the free
flow of trade into or out of their countries based on seven major reasons.
17
EXERCISES
EXERCISE 1.1
1. The two areas of technology which have helped contribute to the tremendous growth of
international business are in ____________.
A. research and manufacturing
B. communications and transportation
C. agriculture and manufacturing
D. production and processes
2. When a firm designs a product in one country, produces it in another country and exports the
product to other countries, this is known as the globalization of:
A. Management
B. Marketing
C. Production
D. Finance
3. Firms that do not participate in international business will more likely be:
A. Forced to go out of business.
B. Too small to export their goods successfully.
C. Better positioned for unlimited domestic expansion.
D. Affected by the economic but not political developments that is occurring in the global
markets.
4. Although there are many benefits to globalization, there is a general agreement that increased
international trade and investment will result in higher prices for goods and services.
A. True
B. False
5. Government deregulation means the increase in barriers imposed by foreign country
governments to encourage trade and investment.
A. True
B. False
6. Is the isolation of specific countries from the international markets possible? Why or why not?
7. In what way has the increase in competition contributed to the growth of international
business?
18
EXERCISE 1.2
1. International tourism and transportation are important sources of revenue for the following
companies, EXCEPT:
A. Airlines
B. Travel agencies
C. Hotels
D. Shopping centers
2. A ____________ company allows each of its foreign subsidiary to operate independently,
such as in designing and producing a product or service for the local market.
A. transnational
B. global
C. multidomestic
D. multinational
3. The Disney Company which allows other firms to use their brand names, logos and characters
in return for royalty payment, is involved in:
A. Exporting of goods
B. Importing of goods
C. Licensing
D. Franchising
4. International business does not include the purchase of financial assets such as shares and
bonds.
A. True
B. False
5. Companies use portfolio investments usually for short-term financial profits.
A. True
B. False
6. What are the types of international business activities that a firm can engage in?
7. How is a global company different from a transnational company?
19
EXERCISE 1.3
1. The external environment of international business includes all of the following factors, EXCEPT:
A. Country’s geography.
B. Economic factors.
C. Societal factors.
D. Company management.
2. When firms produce and market homogeneous (similar in nature) products, they tend to compete
more on the basis of:
A. Uniqueness of products.
B. Price.
C. Quality.
D. After sales service.
3. All the following factors are reasons for firms to employ globally standardised procedures, EXCEPT:
A. To gain from economies of scale.
B. To reduce the cost of manufacturing.
C. To improve the infrastructures and traditions.
D. To save on product development costs.
4. Adapting to the environment is important in domestic business but it is not that important in
A. True
B. False
5. National sovereignty also means the right of a country to impose their laws on other countries.
A. True
B. False
6. What are the reasons that may require a firm to be locally responsive in their operations?
7. What are the features that can describe the competitive environment of international business?
20
EXERCISE 1.4
1. Both the Coca-Cola Company and McDonald’s derive more than ____________ % of their total
revenue from international markets.
A. 30
B. 40
C. 50
D. 60
2. Subsidies will help ____________ to become better international competitors.
A. domestic producers
B. foreign competitors
C. importers
D. both importers and international businesses
3. Subsidies, quotas and local content requirements are all forms of tariff barriers.
A. True
B. False
4. Malaysian export restrictions to China may increase foreign direct investments by China’s
companies into Malaysia.
A. True
B. False
5. The Malaysian government used the „Infant Industry‰ argument to support the national car
manufacturer, Proton.
A. True
B. False
6. Why do firms need to venture abroad to acquire resources?
7. How does the maintaining of national security justify government intervention in trade flows?
Chapter 21
2 Cultural, Legal, Political,

& Economic System
LEARNING OBJECTIVES
After this chapter, the student must be able to:
LO1.Explain the diversity of culture and how

LEARNING CONTENTS
In this chapter, you will learn about:
LC1. The Importance of

the various elements of culture impact the International Business
international firm’s decisions; LC2. International Business
LO2. Describe the basic political ideologies Activities
that exist; LC3. Concepts and Challenges in
LO3. Examine the types of political risks International Business
faced by international firms operating in LC4. Motivations and Restrictions in
countries with differing systems; International Business
LO4. Assess the basic legal systems of the
world and how they influence the
international firm; and
LO5. Appraise several types of economic
systems and their impact on firms.
INTRODUCTION
In this topic, we will shift our attention to study in greater depth on the differences among
countries in the aspects of their culture, political and legal, and economic systems of which we have
briefly mentioned in the first topic.
For the international business manager, an awareness of each of these external

environmental factors would help towards a useful understanding and appreciation of foreign markets
and how their firm’s business can be conducted more effectively and successfully in foreign country
environments. The type of products to be sold, how they are promoted and distributed, and pricing
strategies will all be strongly influenced by these factors.
Finally, in this topic, the concept of culture is analyzed to help us understand how diverse
cultural values and attitudes shape the demands of consumers, their tastes and preferences. The
different political and legal systems regulate how businesses can operate in foreign countries while
economic systems indicate their differing emphasis on economic development.
CULTURE
The following subtopics explain the elements that constitute culture and how the activities of
international business can be affected when cultures differ among foreign countries.
A. What is Culture?
22
Culture is the characteristics and knowledge of a particular group of people, defined by

everything from language, religion, cuisine, social habits, music and arts.
The Center for Advance Research on Language Acquisition goes a step further, defining
culture as shared patterns of behaviors and interactions, cognitive constructs, and
understanding that are learned by socialization. Thus, it can be seen as the growth of a group
identity fostered by social patterns unique to the group.
Let us look at the following terms:
Culture Culture can be defined as a system of values and norms that are
shared among a group of people (such as in a society) and when
taken together, they constitute a design for living.
Values Values are shared assumptions about how things ought to be, for
example, about what a group believes to be good, right and
desirable.
Norms Norms mean the social rules and guidelines that prescribe the
appropriate behavior in particular situations within the society. A
society may be equivalent to a country.

What should a business firm do to adjust itself to a specific culture in a particular country?
REMINDER: Place your answer in your SAQ file as instructed in SAQ 1.1 in Chapter 1.
.
The process of adjusting and adapting to a specific culture other than our own is known as
acculturation, a key success factor in international operations.
Definition of Acculturation
(a) Cultural modification of an individual, group, or people by adapting to or borrowing traits
from another culture.
(b) A merging of culture as a result of prolonged contact.
(c) The process by which a human being acquires the culture of a particular society from
infancy.
Source: www.Merriam-Webster.com/dictionary/acculturation
A society’s culture determines the rules that govern how firms operate in the society.
Firms must build awareness of the cultural diversity of international markets to operate
effectively. Problems may arise when a person from one culture has to adjust to another
culture.
The basic elements that determine culture are social structure, religion and ethics,
values and attitudes, language and education, as seen in the figure on the right.
 ELEMENTS OF CULTURE
23
a. Social Structure
Every society has a
social structure that
determines the roles of
individual members, the
stratification of the society
(division of population into
classes) and the individual’s
mobility within the society.
Although all societies

involve individuals living in
family units and work
groups, they define family
and groups differently and
place different importance
on the role of the individual.
Americans define the basic
family unit as comprising
parents and their children. The Arabs consider uncles, cousins and in-laws as part
of the family unit, while the Somalian society is organized into clans comprising
individuals of the same tribe. American societies therefore promote individualism
and encourage the development of individual talents. Japanese societies are
group-focused and the individual’s role is to serve the group. As employees, their
work attitudes will also be similarly focused.
Social stratification systems exist because each culture values some people
more highly than others and distinguish a person by their social class or status.
The caste system in India and the British class structure are examples of this
system. Firms operating in such societies need to take class differences, for
example between supervisors and workers, into account when hiring and
promoting employees. This is to avoid assigning jobs traditionally performed by
members of one group to another group as it may lower the morale and productivity
of the groups concerned.
Social mobility refers to the ability of individuals to move from one class to
another within society. In a rigid system like in India, a lower caste member may
face difficulty interacting and gaining the cooperation of colleagues when they are
promoted to higher supervisory roles.
Apart from workplace relations, the international firm may also need to tailor
promotional messages more carefully so as not to offend groups not targeted.
b. Religion and Ethics
Religion can be defined as a system of shared beliefs and rituals that are
concerned with the realm of the sacred. Ethical systems are sets of moral principles
or values that are used to guide and shape behavior. Most ethical systems are
based on religious principles.
There are numerous religions in the world today, some of which are very
influential in certain parts of the world. The major ones, in terms of number of
followers are Christianity with 1.7 billion followers, Islam with 1 billion, Hinduism
with 750 million and Buddhism with 350 million followers. Although Confucianism
24
is more a set of guiding principles than a religion, it also has an important ethical
influence on culture and behaviour in certain parts of Asia.
Christianity has three main branches which are Roman Catholic, Orthodox and
Protestant. According to the German sociologist Max Weber, Protestant ethics
emphasizes on the importance of individual hard work, achievement and frugality
for the glory of God. They strive constantly for efficiency, savings and reinvestment
of profits for future productivity, all of which are necessary in a capitalist economy
and entrepreneurial activity.
Hinduism and Buddhism stress the afterlife and spiritual achievement rather
than involvement in this world. Hinduism believes that the way to achieve spiritual
perfection is by leading a severe ascetic lifestyle of material and physical self-
denial. However, Buddhism does not support the Hindu caste system and may be
more encouraging towards entrepreneurial activity than Hinduism.
While Islam supports entrepreneurship, it strongly prohibits exploitation and

discrimination. The role of women managers in business may also be limited
compared to Western countries and products have to abide by the halal ruling.
Islam also regards interest payment as usury. However, these restrictions have
also revealed opportunities as evidenced by the successful marketing of non-
alcoholic beverages and interest-free banking products.
Confucianism has 150 million followers throughout Asia. It has been

characterized more as a code of conduct rather than a religion with the emphasis
on loyalty and relationships. The economic success of Japan, South Korea,
Singapore and China could be a result of loyalty to central authority and placing
the good of the group before that of the individual.
The impact of religion on international business varies from country to country,

depending on the similarity of religious beliefs and tolerance of other religious view
points.
c. Values and Attitudes
Values Values are the principles and standards that have been
internalized and accepted by members of society.
Attitude Attitudes are the thoughts, feelings, and actions
resulting from those values.
Thus, cultural attitudes towards time, age, and status may reflect these values and
influence the opportunities available to international business in a given society.
(a) Time
Attitude towards time differ greatly among cultures. In western cultures,

time means an opportunity to produce more and increase one’s income and
is not to be wasted. In Latin America, it is not unusual if meetings begin 45
minutes late and meetings may be interrupted by the host entertaining
unscheduled visitors like family and friends. Westerners may wrongly
interpret the hospitality of the host as a sign of rudeness and disrespect.
In other cultures like the Japanese and the Arabs, meetings may start
on time but initial meetings would focus on establishing relationships and
determining whether the parties can trust and work with each other
25
comfortably. In contrast, Westerners expect to get down to business

immediately after exchanging a few pleasantries and follow a set agenda.
(b) Age
While youthfulness is considered a virtue in a society like the United

States and may send young “high achievers” to negotiate with international
partners, the Asian and Arab cultures respect age and correlates a
manager’s stature with age. Similarly, the Chinese would prefer to deal with
older and more senior members of a firm and may feel offended when
dealing with young counterparts.
In the Japanese culture where group-based decisions are important,

senior managers will not approve projects unless they have obtained a
consensus among junior managers. Foreign firms often commit the mistake
of focusing their attention in negotiations to the senior managers, when they
should be persuading the junior managers.
(c) Status
Values and attitudes towards the means by which a person achieves

his status also vary across the different cultures. In some societies, status
may be inherited through the wealth or rank of a person’s ancestors, such
as the noble class in some European countries. In the United States,
however, hardworking entrepreneurs are held in high regard and their
children would not be similarly respected if they fail to match their parent’s
achievements.
In Japan, a person’s status is linked to the status of the group to which

he belongs. Thus, attending elite universities such as the Tokyo University
or employment in elite organizations such as Toyota Motor Corporation or
the Ministry of Finance would grant a high status.
d. Language
Language shapes the way people perceive the world and helps define culture.
In countries with more than one language, we may also find more than one culture,
such as the “English-speaking” and the “French-speaking” cultures in Canada.
Language may be verbal and messages are conveyed by the words used and how
they are spoken, for example, the tone of the voice. Messages may also be
communicated through non-verbal means by way of gestures, body position and
eye contact.
In international business, language serves four important purposes which are:
(a) Information Gathering and Evaluation
Language is important in information gathering and evaluation. Market

intelligence is best obtained by becoming part of the market rather than
observing it from the outside. The capable manager is therefore personally
able to see and hear what is going on, rather than relying on the opinions
of others.
(b) Easier Access to Society
26
Language is also able to provide the manager with easier access to

society. The ability to speak the local language means better acceptance
and higher willingness of the locals to openly communicate with the
manager, at the same time fostering cordial relationships.
(c) Ability to Communicate
The capability to speak a common language within the firm or with

diverse distributors has also become increasingly important. A foreign
manager needs to communicate with employees of a subsidiary in another
country and would otherwise require an interpreter.
(d) Ability to Interpret Different Contexts of Culture
Besides the ability to communicate, language also provides the

manager with the ability to interpret different contexts of culture. For
example, the use of English in different countries carries different
meanings. When the British say “Negotiations Bombed”, it means it was a
huge success, which conveys exactly the opposite to the Americans.
Firms also need to exercise more care in the use of language in conveying
advertising messages. There often is a need for advertisements originally in the
language of the home country to be accurately translated into the local language
and words used have to be carefully selected to avoid difficulty in pronouncing
them.
e. Education
A country’s education system, both public and private, plays an important role
in the transmitting and sharing of culture. Countries’ education systems have
varying emphasis on the quality of their education, whether based on particular
skills or the overall level of the education. Japan and South Korea emphasize on
the sciences more than the Western countries and Germany on apprenticeship
programs for craftsmen and machinists. The United States’ system stresses on the
development of self-reliance, creativity and self-esteem, and provides widespread
access to higher education.
In employment, the international firm has to provide employees with training

programs taking into account their educational background, skills and literacy
levels.
ACTIVITY 2.1
Let us say you work for a large corporation which engages in international business.
As an employee, what can you do in order to enhance your company’s future?
Task Reminder
27
POLITICS AND LEGAL ENVIRONMENT

The two subjects of law and politics are considered as a pair because they are both
intertwined in the sense that political decisions may change laws and laws may regulate the power of
politicians. The system of government in a country is known as the political system. It brings together
people of different backgrounds and allows them to work together to govern themselves. A country’s
political system influences how business is conducted domestically and internationally.
We shall now learn about the political ideologies upon which countries base their political
systems and the risks associated with doing business in different countries.
A. Basic Political Ideologies
Political systems can be assessed according to two related dimensions. Firstly, the
degree to which collectivism is emphasized against individualism. Secondly, the degree to
which they are democratic or totalitarian. These two dimensions are interrelated because
systems that emphasize on collectivism tend to be totalitarian while systems that value
individualism tend to be democratic. The figure below illustrates the types of political
ideologies.
a. Collectivism
This refers to a political system that places primary importance on collective goals
rather than individual goals. The needs of society as a whole are generally held as more
important than individual freedom. Collectivism was firstly advocated by Plato (427-347
BC), who believed that individual rights should be sacrificed for the good of the majority,
property should be commonly owned and society should be divided into classes with
philosophers and soldiers who would rule for the benefit of all.
Modern socialism was based on the teachings of Karl Marx (1818-1883), who believed
that in a capitalist society where individual freedom is not restricted, the few will benefit at
the expense of the many. Therefore, to correct this situation he advocated that the state
should own all enterprises and means of production, and ensure that workers are fully
compensated for their labor.
In the 20th century, the socialist ideology can be divided into the communists, who
believed that socialism can be achieved only through violent revolutions and totalitarian
dictatorship, and the social democrats, who strived to achieve socialism by democratic
means. Communism has weakened with the collapse of the Soviet Union and in the
countries of Eastern Europe in 1989, as well as other nations such as Cambodia, Laos,
Vietnam, Angola and Mozambique. Many believe that it is now only a matter of time before
communism in China will also collapse. In Great Britain, France, Germany, India and
Brazil, social democratic parties have held power from time to time, where private
28
companies in certain industries have been nationalized into state-owned enterprises to be

run for the good of the public. However, it has been shown that state-run companies
performed poorly and has become inefficient, counter to public interest. As a
consequence, many social democratic parties were voted out of office and the state-owned
enterprises were sold to private investors. Britain’s Conservative Party and Germany’s
Christian Democratic Party are more committed to private ownership and free market
economics.
b. Individualism
Individualism refers to a philosophy that the individual should have the freedom to
pursue his own economic and political beliefs. It stresses that the interest of the individual
should take precedence over the interest of the state. This ideology can be traced to
another Greek philosopher, Aristotle (384-322 BC). He argued that private property
receive the greatest care and is therefore more highly productive.
The central message of individualism is that individual economic and political freedoms
should be the ground rules upon which society should be based. It emphasizes the
importance of individual freedom and self- expression, and believes that the welfare of
society is best served by letting people pursue their own self-interest. These ideas can
also be found in the writings of economists Adam Smith and John Stuart Mill.
Individualism can be viewed as advocating democratic political systems and free

market economies championed by the United States, and collectivism as championed by
the now defunct communist Soviet Union.
c. Democracy
Democracy refers to a political system by which a country is governed by the people,

exercised directly or through elected representatives. It goes hand- in-hand with
individualism.
In ancient Greece, the pure form of democracy was practiced with the citizens’ direct
involvement in government decision making. However, the large populations of modern
societies have made this impractical. Today’s democratic countries practice what is known
as representative democracy, where the citizens elect individuals to represent them in
government. If the elected representatives fail to perform his job adequately, they will be
voted out at the next election. An ideal representative democracy is indicated by the
following basic characteristics:
 An individual’s right to freedom of expression, opinion and freedom to organize;

 Freedom of the press;
 A regular election in which all eligible citizens are allowed to vote;
 Universal adult suffrage;
 Limited terms for elected representatives;
 A fair court system that is independent of the political system;
 A non-political state bureaucracy
 A non-political police force and armed service; and
 Relatively free access to government information.
d. Totalitarianism
Totalitarianism is a form of government in which one person or one political party

exercises absolute control over all areas of human life and prohibits opposing political
parties. The individual’s right to freedom of expression and organization, free media and
regular elections are denied to the citizens.
29
There are four major forms of totalitarianism in the world today. Up to the demise of
the Soviet Union, the most widespread form was communist totalitarianism, which is a
version of collectivism advocating that socialism can only be achieved through totalitarian
dictatorship.
The second form is called theocratic totalitarianism, where political power is

controlled by a party or individual who governs according to religious principles. This is
practiced in Iran and Saudi Arabia based on Islamic principles and freedom of political and
religious expression is limited.
Thirdly, tribal totalitarianism, which arose in the African countries such as Zimbabwe,
Tanzania, Uganda and Kenya. A typical country consists of several different tribes and
one political party, which is not always the majority tribe that represents the interest of a
particular tribe monopolizing power.
The fourth major form is known as right-wing totalitarianism, which generally allows
some individual economic freedom but restricts individual political freedom in order to
prevent the rise of communism. They are hostile to socialist or communist ideologies and
many are backed by the military. Some examples of right-wing totalitarianism were the
fascist regimes of Germany and Italy during 1930-1940 and the right-wing dictatorships in
Latin America. Most of these countries, however, are now multi-party democracies.
Although collectivism and individualism are at the opposite ends of political systems,
as is democracy and totalitarianism, there are also gray areas that exist in between.
Democratic nations may practice collective values, while totalitarian nations may allow
some degree of individualism. China, for example, is a totalitarian state but is economically
moving towards greater individual freedom.
ACTIVITY 2.2
Visit China’s web site at www.chinatoday.com and Taiwan’s website at www.sinica.edu.tw/taiwan/.
Study and compare these two nations who share a common history and tradition yet have opposing
political ideologies. Discuss the similarities and the differences in their approach to business.
B. Political Risks
The political climate in a foreign country may change and affect the viability of a firm’s
operations. Tax and minimum wage laws affect the firm’s profitability and the cost of labor
respectively, and environmental protection laws affect the production technology and the cost
of waste disposal. Civil wars, kidnappings of foreign personnel and government take-over of
foreign assets may threaten foreign operations.
Most political risks can be divided into three categories:
a. Ownership risks, whereby the property of the firm is threatened through expropriation
or confiscation.
Expropriation is the taking-over of foreign-owned properties by the government with

compensation being provided. However, these compensations are often unsatisfactory
to the owners. Confiscation also means the taking over of foreign-owned assets, but it
does not involve compensation for the firm.
30
b. Operating risks, in which changes in laws, environmental standards, tax regulations,

terrorism and armed uprisings threaten the on-goings of the firm and the safety of its
employees.
c. Transfer risks, when the government interferes with a firm’s ability to shift funds into
and out of the country.
Political risks may be the result of government actions through passing of laws. It may
also arise from non-governmental actions, such as kidnappings, extortion and terrorism.
Although political risks may occur in democratic as well as in totalitarian political regimes,
they are more likely to happen in totalitarian countries.
C. Types of Legal Systems
An international firm faces a complex task of not only having to obey the laws of its
own home country but also the laws of all the host countries in which it operates. Laws
determine which markets firms can enter, the prices of their products or services, and the cost
of labor, raw materials or technology. Managers, therefore, need to be aware of the different
countries’ legal systems, which may differ in terms of the nature of the system and the degree
of the judiciary’s independence from the political system.
Legal systems differ based on their historical, cultural, political and religious
backgrounds. There are three basic systems of law:
a. Common Law
It is a system of law that relies on the rulings of previous cases (called

precedents), custom and traditions, and common usage as the basis for court
decisions. Its origins can be traced to England hundreds of years ago. It is now
found in the United States and most of the United Kingdom’s former colonies, such
as Hong Kong.
b. Civil Law
The civil law system, sometimes known as code law, is a compilation of laws
organized into codes. It has its origins in the Roman code of law dating back to 450
BC. More than 70 countries, including Germany, France, Japan and Russia
operate with a civil law system.
Common law and civil law differ because the former is based on the courts’
interpretation of events, whereas civil law is based on how the law is applied to the
facts of the case. For example, contracts in a common law country tend to be
detailed, with all the terms and conditions spelled out. In a civil law country, they
tend to be shorter and less specific because many of the issues detailed in a
common law contract are already included in the civil code. The courts will interpret
civil law with reference to these codes.
c. Theocratic Law
A theocratic law system is based on the established rules governing the faith
and practice of a particular religion. Although both Hindu and Jewish laws are still
being practiced, Islamic law is the most widely implemented legal system in the
modern world. Islamic law, or the Sharia (also known as "Shariah" or "Shari'a"), is
based on the Holy Quran, and the Sunnah, or decisions and teachings of the
Prophet Muhammad.
31
Islamic law not only concerns moral behavior but it also extends to cover
commercial activities. It is intended to govern all aspects of life. Several Islamic
countries such as Iran, Sudan, Pakistan and Saudi Arabia, for example, have adopted
Islamic banking systems and banned traditional commercial banking. They have
pronounced interest to be non-Islamic and illegal. Banks therefore cannot charge
interest or benefit from interest and instead structure fees into their loans to allow them
to make a profit.
The underlying principle is that money can earn a return by being employed
productively, but not by being earned in financial markets.
ACTIVITY 2.3
Different countries have different kinds of legal systems in relation to business operations. List down and
discuss the importance of law in international businesses.
D. The Legal Profession
As international trade expands, legal services are increasingly required by firms, such
as in the area of contract negotiations and intellectual property protection. As such, the legal
profession itself is also experiencing internationalization.
However, the international practice of law is not without barriers. Cultural and political
differences between countries which influence the law still remain. Apart from the law itself,
rules and procedures pertaining to the practice of law also varies from country to country.
There are different professional codes governing lawyers’ standards of conduct regarding
issues such as confidentiality, fees, conflicts of interest and publicity.
Law firms also face barriers in extending their services due to government restrictions
on foreign firms from hiring local lawyers, forming partnerships with local law firms or entering
the country to practice law. Other countries may allow foreigners to open offices within their
borders to offer their services. For example, until 1986 the Japanese market for legal services
was closed to foreign lawyers who wanted to practice in Japan. Germany blocks the practice
of foreign lawyers and the establishment of foreign firms within their country until very recently.
Hong Kong and Singapore, however, welcome foreign law firms, while the European
Community (EC) countries are beginning to relax their rules for lawyers from other EC member
countries.
For the international business firm, its need for legal services can be obtained through
several ways. The larger firms may set up its in-house legal department by recruiting trained
lawyers. When it is necessary to have local representation, they may choose a law firm that
has overseas connections who can represent them through their foreign branch offices,
affiliates or correspondent relationships. However, smaller international business firms still rely
on outside legal counsel for their needs.
Task Reminder
32
ECONOMIC ENVIRONMENT
In connection with the political system, we are more likely to find free market economic
systems where individualism is given prominence. In collectivist political systems, the government
may have control over enterprises and markets may be more restricted.
The international manager’s ability to anticipate economic trends and events in foreign
countries may affect the firm’s future performance. Important dynamic issues such as the size, growth
potential, market stability, how governments view foreign competition and their economic objectives
may assist firms to assess their viability of doing business.
A. Economic Systems
Let us now learn about the three broad types of economic systems. They are:
(a) Market Economy/Capitalism
In a pure market economy, resources and all productive activities are owned
and controlled by the private sector. Production is determined by the interaction
between supply and demand through the price system. If demand for a product
exceeds supply, prices will rise encouraging producers to produce more. If supply
exceeds demand, prices will fall and producers will produce less. In this system,
consumers are sovereign, which means that consumers decide what to buy, and
companies face no restrictions in how they operate.
The role of the government in a market economy is to encourage competition

and efficiency between producers. Private ownership ensures that entrepreneurs
have the right to earn profits for their efforts, which provides the incentive for them
to find better ways to serve consumer needs. This constant striving for
improvement in products and processes can be considered as a major positive
impact on economic growth and development.
In most market economies, monopolies are against the law, such as the anti-
trust laws in the United States. Monopolies emerge when they are allowed to
restrict supply. Rather than increasing output when demand increases, the
monopolist restricts output and let prices increase. Since they have no competitors,
they have no incentive to look for better ways to lower their production costs.
Although this situation is good for the monopoly firm, it is bad for consumers and
society as a whole.
(b) Command Economy/Socialism
Command economies can be found in the communist countries, such as

Myanmar and North Korea. It is also known as centrally planned economies,
whereby all economic activities such as goods and services that the country
produces, the quantity produced and the prices at which they are sold, are all
planned by the government. In pure command economies, all enterprises are
owned by the state, the rationale being that the government can direct investments
in the best interest of the nation.
Other socialist-inclined governments like France and India also practice some
elements of a command economy, although it has declined.
(c) Mixed Economy
33
In reality, there is no purely market or completely command economy being

practiced. Most market economies have some degree of government ownership
and control. At the other end of the spectrum, command economies are shifting to
a more market oriented economy.
Between free market economies on one hand, and command economies on

the other, are mixed economies. In mixed economies, governments may tend to
take ownership of troubled firms which are considered vital to national interests.
Renault, the automobile company, was at one time taken over by the French
government to prevent its collapse and the resulting unemployment. Some
governments may own significant resources, but it allows supply and demand to
set prices, while other countries without much resources levy high taxes for funds.
Governments may also control economic activity through their fiscal policies.
ACTIVITY 2.4
What type of economic system does the Philippines practice? Explain your answer.
B. Differences in Economic Development
Different countries have different levels of economic development, which international

business firms should be aware of in making their expansion and investment decisions or
strategies.
(a) Economic Classification by Income
In measuring economic development, a country’s Gross Domestic Product (GDP) is

commonly used as a yardstick. GDP is the final value of goods and services produced by
a certain country within a certain period of time. This value includes goods and services
produced by the citizens and people of other nationalities living in the country. Per capita
income is the total income of an individual in a country. As examples, Table 2.1
summarizes the GDP (Purchasing Power Parity, PPP) per capita growth rate of some of
the world’s nations in the year 1990–2014.
List of Countries by GDP (PPP) Per Capita Growth Rate from 1990 - 2014
GDP Per
GDP Per Capita GDP Growth Rate
COUNTRY Capita
(USD) in 1990 (%) 1990 - 2014
(USD) in 2014
 Brazil 6,622 15,893 140.00
 China 980 13,206 1247.62
 Germany 19,033 46,401 143.79
 India 1,146 5,701 397.43
 Japan 19,230 36,619 90.43
 Nigeria 1,959 5,911 201.8
 Poland 5,996 25,262 321.33
 Russia 8,013 22,990 186.91
 Switzerland 26,734 59,540 122.71
 United Kingdom 17,446 40,233 130.61
Source: World Bank, World Development Indicators (1990 – 2014)
34
From Table 2.1, among the richest countries are Japan, Switzerland, Germany
and the United Kingdom. Switzerland, one of the world’s richest nations had a GDP
per capita (per head of population) of USD 59,540 (2014), whereas Mozambique (not
shown in table), with a GNP per capita of only USD 1,129 (2014), is one of the world’s
poorest. Large countries such as India and China are among the poorest and very
dynamic countries. Large nations such as China and India achieved USD 13,206 and
USD 5,701 with 1247.62% and 397.43% GDP growth rates respectively from 1990–
2014.
GDP per capita figures, however, can be misleading because it does not
consider the differences in the cost of living between countries. For example, although
the GDP of Switzerland showed USD 59,540 (2014) exceeding that of the United
States at USD 54,629 (2014) (not shown in table), the higher cost of living in
Switzerland meant that American citizens could actually afford more goods and
services than the Swiss.
The Purchasing Power Parity (PPP) method adjusts the GDP of countries
with the cost of living and allows a more direct comparison of living standards between
countries. Let us use the cost of living in the United States as a base for comparison
with India. While the GDP per capita for India was USD 5,701, the PPP per capita was
USD 5,610 (2014) (not shown in table). This may indicate that the cost of living in India
was lower than in the United States, and that USD5,701 in India could buy as much as
USD5,610 worth of goods and services in the United States, as much as USD 55,837
(2014) and PPP as USD55,140 (2014).
The above figures further suggest that the standard of living among countries
also differ drastically. The average Indian citizen can afford to consume only about
(5,610 55,140 100%) 10.17% of the goods and services that the average US citizen
can. Therefore, despite having a population of 1 billion, India does not appear to be an
attractive market for consumer goods. This conclusion, however, may not be accurate
because India has a wealthy middle class, although the majority may be poor.
The GDP and PPP figures are also a static picture of a country’s economic
development. We will need to further rely on the rate of growth in Gross Domestic
Product (GDP). For example, India may be shown as poorer than the United States,
but it does not tell us whether the income gap is closing. They may currently be poor
but it is growing at a much quicker rate than the advanced countries. With their
potential, they may in future become more advanced and be huge markets for the
international firm’s products. Currently, they may contribute little to revenues, but their
future contributions could be much higher and firms may want to gain a foothold in the
market now.
Another wider approach to measuring development is called the Human

Development Index (HDI) which was developed by the United Nations and used to
measure the quality of human life in different countries. The three criteria used are:
 Life expectancy at birth, which depends on the quality level of health care
accorded;
 Educational attainment, which is measured through combining the adult

literacy rate and enrolment in primary, secondary and tertiary education; and
 Average incomes, which are based on PPP estimates, to measure whether

incomes are sufficient to meet the basic life necessities in a country such as
food, shelter and health care.
35
(b) Economic Classification by Regions
World Bank reports on developing countries are usually provided according to

geographical regions. International corporations find this classification important
because their activities tend to be organized along geographical lines as well.
The major regions are as follows:
1. East Asia and the Pacific countries such as Korea, China and Japan;
2. Latin America and the Caribbean, such as Brazil, Argentina and Chile;
3. The Middle East and North African countries such as Saudi Arabia, Egypt,
Algeria and Libya;
4. South Asia includes countries on the Indian continent;
5. Sub-Saharan Africa such as Ethiopia, Sudan, Nigeria, Mozambique,

Namibia and South Africa; and
6. Eastern Europe and Central Asia, such as the Czech Republic, Ukraine,
Poland and the countries of Russia.
The regions of North America, Western Europe and Australia, and Japan are
categorised as high income countries, or members of the Organization for Economic
Cooperation and Development (OECD) countries.
It is also important to note that although these countries are located within
similar regions, they may be very different from each other in terms of ethnic origin,
history, politics and economics.
The following image provides a clearer picture of these regions.
36
ACTIVITY 2.5
What is the difference between “Economic Classification by Income”
and “Economic Classification by Regions”?
C. The Emerging Market Economies
Since the late 1980s, two trends have radically changed the world’s government. Firstly, a
wave of democratic revolutions took place when totalitarian governments in Eastern Europe
and the Soviet Union collapsed and were replaced by democratically elected ones. Secondly,
there has been a strong shift from centrally planned or mixed economies to a more free market
system. Many countries in Asia, Latin America and Western Europe began selling state-owned
enterprises to private investors and deregulated their economies to promote greater
competition. These are the so-called emerging economies of the world today.
The major underlying reason for economic transition was that command and mixed
economies have revealed weaknesses that generally failed to deliver the kind of economic
achievement that was achieved by free market-based systems, such as the United States,
Switzerland and Taiwan.
The process of shifting towards a free market-based system requires several steps as
explained in the following.
(a) Deregulation
In the command economies, deregulation of the markets means the removing of legally
imposed restrictions to allow the free play of market forces, the formation of private
enterprises and how they operate, uplifting controls over prices and outputs and
international trade.
In the mixed economies where the role of the government is more limited, deregulation
is much easier to implement because a private sector already exists. India, for example,
has reformed their industrial licensing system that made it difficult for new private
enterprises to be established and opened up sectors such as electricity generation, steel
making, air transport and some areas of the telecommunications industry to the private
sector. India has also removed limitations placed on foreign ownership of Indian assets
and lowered the barriers to international trade.
(b) Privatization
Privatization is the transfer of ownership of state-owned properties to private

individuals. It was first implemented by the British government in 1979 when 20 state firms
were converted into privately owned companies.
This is an economic strategy usually used by the government as a way to reduce their
burden of the cost of operating these enterprises. Funds raised from the effort can then be
utilized to finance other government projects. At the same time, the companies can
become more productive, efficient and innovative, and can expand the choices for the
private sector. Privatization is also intended to attract new foreign capital into their
countries.
37
For international firms, a country’s privatization exercise may offer opportunities to

acquire the properties for sale at a low cost and allow the expansion of their operations
from an established base provided by these properties.
(c) Legal Systems
Many countries that are emerging from the communist bloc, where all properties were
government-owned, lacked the legal structure needed to protect private property rights
and enforcement of contracts that are required for the smooth functioning of a market
economy.
Foreign capital may be hesitant due to the weak system of law which cannot offer
adequate protection for their investments. In the event of contract disputes, procedures for
resolving them are either insufficient or poorly developed.
In the long-term, major changes in the flow of trade and investments will take place as these
emerging economies continue their effort to become major players in global trade.
Task Reminder
SUMMARY
● In this topic, we have focused on the existing issues of culture, politics, legal and economic
systems in the external environment of the international business firm.
● We have learned that although international markets are increasingly facing globalisation, the
world remained strongly multi-cultural.
● Culture has a greater impact on consumer goods tastes and preferences compared to
industrial goods, which are more universal in nature.
● We also learned that political and legal systems tend to differ from country to country, even
among those sharing similar political ideologies.
● Based on these different systems, governments determine how businesses are carried out in
relation to their respective countries.
● The area of business contracts and settlement of disputes is another important area that gives
direct impact to the international firm.
● Finally, we learned about the three major economic systems practised by countries today,
which are broadly categorized as the free market system, command economy and mixed
economic system. These different systems are also related to political systems.
● The economic success of democratic countries indicates a strong positive relationship with
the free market economic system.
38
● Thus, the desire to be as economically-developed drove many communist countries to convert

to democracies such as in Russia and Eastern Europe.
● The topic ends with a discussion on these former communist countries which are now termed
as the emerging market economies.
39
EXERCSISES
EXERCISE 2.1
1. The Japanese culture places very high importance on:
A. Group Membership
B. Individualism
C. Personal Achievement
D. Individual Preferences
2. Which of the following religious beliefs are most likely to support economic development and
growth?
A. Christianity and Buddhism
B. Hinduism and Buddhism
C. Confucianism and Islam
D. Islam and Christianity
3. Culture includes all the following elements, EXCEPT:
A. Language
B. Religion
C. Geography
D. Social Institutions
4. Culture is a system of values and norms that are shared among a group of people and shapes
their way of life.
A. True
B. False
5. Hinduism is the most widely practiced religion in the world.
A. True
B. False
6. How does education impact culture?
7. Why is knowing the local language important to the international business manager?
Deadline of submission: _______________________ Date of discussion:
_____________________
40
EXERCISE 2.2
1. More than 70 countries, including France, Germany, and Japan operate on this legal system.
A. Common law system
B. Theocratic law system
C. Civil law system
D. Socialist law system
2. A country’s ________ influences how business is conducted domestically as well as
internationally.
A. Political system
B. Economic system
C. Legal system
D. Financial system
3. China is an example of _________ totalitarian government.
A. Fascist
B. Theocratic
C. Communist
D. Tribal
4. In theocratic totalitarianism, the government imposes law and order through the use of military
power.
A. True
B. False
5. Common law is based on customs and traditions, usage and precedents.
A. True
B. False
6. What are the three types of political risks? How may they affect the international business firm?
7. Describe the various sources on which Islamic theocratic law is based.
_____________________
41
EXERCISE 2.3
8. Which of the following is NOT a developing country?
E. China
F. France
G. India
H. Malaysia
9. Among the countries of the emerging market economies are the countries of:
E. Argentina and Brazil
F. Russia and Eastern Europe
G. Malaysia and Thailand
H. Germany and Italy
10. Which method adjusts the national income of countries with the cost of living and allows a more
direct comparison of living standards between countries?
C. Gross National Product (GNP)
D. Gross Domestic Product (GDP)
E. Purchasing Power Parity (PPP)
F. GDP Growth Rate
11. A centrally planned economy is one in which the country’s resources are primarily owned and
controlled by the private sector, not the public sector.
C. True
D. False
12. Privatization means the selling of privately owned companies to the government to settle their
debts.
C. True
D. False
13. What are the major features that differentiates between the three economic systems of the
world today?
14. What are the three steps that need to be taken by the emerging market economies in their
efforts to transform to a free market-based system?
Chapter 42
3 International Trade
Theoris and Institutions
LEARNING OBJECTIVES
LO1.Explain why countries trade with each

LEARNING CONTENTS
LC1. Theories of International

other; Trade
LO2. Distinguish between the different LC2. International Trade Strategies
theories and the pattern of trade flows and Organization
between countries; LC3. Regional Economic
LO3. Examine the four basic strategies of Integration
international firms according to different
marketing environments abroad; and
LO4. Discuss the meaning of regional
economic integration, the arguments
supporting or opposing economic
integration and its impact on the
international business firm.
INTRODUCTION
In this chapter, we will discuss the international trade as the exchange of goods, services,
assets or money between persons or organizations of two countries. It occurs when parties involved
in the transaction believe that they will benefit from the exchange. In this topic, we will look into the
significance of international trade to businesses, consumers and workers, which have led to the
development of several theories to explain and predict the factors that motivate international trade.
We shall trace several theories from the period of the 1500s up to the modern theories of the 20th
century.
Chapter 3 also explains in detail and compares the four basic strategies employed by
international firms when they compete in the international environment, namely an international
strategy, a multi-domestic strategy, a global strategy and a transnational strategy. Each has its own
advantages and disadvantages in which its appropriateness varies with the environment.
The final section of the topic studies the institution of regional economic trading blocs, called
economic integration, among countries to promote trade among country members and develop their
economies. The different levels of economic integration shall be explained, each with its own
distinctive features and issues. We shall also study in greater depth selected trading blocs existing
today to assess its development.
43
THEORIES OF INTERNATIONAL TRADE
In the following subtopics, we shall review six theories that explain why a country benefits by
engaging in international trade as well as explain the pattern of exports and imports of products
between different countries.
A. Age of Mercantilism
Mercantilism emerged in England and was propagated during the period 1500- 1800,
when gold and silver were the medium of exchange and considered as a measure of a nation’s
wealth. Gold and silver could be earned by exporting goods.
It advocates that countries should therefore encourage and maintain more exports
than imports which would then result in a trade surplus position. A country could then
accumulate wealth and prestige.
As a result, governments would practice intervention to achieve a surplus balance of trade.

Exports were subsidized while tariffs and quotas were imposed on imports.
Towards the late 1700s, weaknesses began to emerge with this practice, as pointed
out by the classical economist, David Hume (1711–1776). According to Hume, the resulting
inflow of gold and silver would increase domestic money supply and cause inflation in England.
In France, to which England exports, money supply would decrease, thus demand and prices
of goods would also fall. This change in relative prices would cause France to buy fewer
English goods (because they have become more expensive), while England would buy more
French goods (because they have become cheaper). England’s balance of trade would
deteriorate and France’s balance of trade would improve. Hume further argues that no country
could sustain a surplus trade balance in the long run by accumulating gold and silver, as
advocated by the mercantilists.
B. The Theory of Absolute Advantage
In 1776, another classical economist, Adam Smith, argued that the real wealth of a
country should not be measured in the amount of gold or silver that it accumulates, but consists
of the goods and services available to its citizens. This means that the more goods and
services that a country could produce the wealthier it would become.
He developed the Theory of Absolute Advantage which holds that different countries
produce some goods more efficiently than other countries. Countries should therefore
specialize in producing those products that they were most efficient at. Specialization could
increase a country’s efficiency due to three reasons:
1. Workers become more skilled by repeatedly doing the same tasks;

2. Workers would not lose time switching from the production of one type of product
to another; and
3. More effective working methods could be developed from the experience and
incentives provided by long production runs.
Excess from the specialized production could then be used to pay for more imports
than the country could themselves produce.
The sources for a country to obtain efficiency advantage can be natural or acquired.
Natural advantage can be due firstly to climatic conditions which allow a country to produce
certain agricultural products efficiently. For example, the Philippine’s climate is suitable for the
production of coffee, bananas, and mangoes. Malaysia’s climate is suitable for the production
44
of palm oil and Sri Lanka’s for the production of tea. Secondly, a country can obtain natural
advantage from natural resources that it has access to. Oil, ores and metals are natural
resources which no single country possesses sufficiently to be independent of the rest of the
world except for short periods of time. Lastly, it can be due to the availability of labor or skills
in particular industries. Sri Lanka could instead process tea into instant tea to reduce bulk and
transport costs on tea exports.
Next, advantage can be acquired such as in product or process technology. Product

technology enables a country to produce a unique product that can be distinguished from the
products of competitors. For example, Denmark exports silver tableware because Danish
companies have developed distinctive products, not because they have rich silver mines.
Process technology would enable a country to produce a homogeneous product efficiently.
Japan, for example, employs new labor-saving and material-saving processes to process and
export steel, although they import the iron and coal needed for steel production. Therefore,
these new product and process technology is able to create an advantage for the countries
where they are developed.
C. The Theory of Comparative Advantage
Although the Theory of Absolute Advantage can be easily understood, it has a

weakness.
Adam Smith’s theory seems to suggest that no trade would then take place. However,
David Ricardo expanded on the Theory of Absolute Advantage.
Ricardo’s Theory of Comparative Advantage states that a country should produce

and export those goods and services which it is relatively more efficient at producing than
other countries, and import those goods and services which other countries are relatively more
efficient in producing. All the countries concerned would then still be economically better off
by engaging in trade.
We shall assume an example between Germany and Italy.
Table 3.1 Production of Machine Tools and Trucks between Germany and Italy
Production
Machine Tools Trucks Trade Off Ration
Possibilities
Germany 60 60 1:1
Italy 15 30 1:2
Germany is equally efficient in the production of both machine tools and trucks and has
absolute advantage in the production of both products. With the available resources, it can out
produce Italy in both products. Italy on the other hand, is relatively more efficient in the production of
trucks than Germany. It can produce 2 trucks for each machine tool while Germany can only produce
1 truck. Thus, Italy has a comparative advantage in the production of trucks.
Table 3.2 Assumed Production and Consumption Before

Trade of Machine Tools and Trucks between Germany and Italy
Assumed Production/ Consumption
Machine Tools Trucks
Before Trade
Germany 44 16
Italy 12 6
45
Total 56 22
Table 3.2 shows the assumed production and consumption of each country before any trading and
specialization. Each country exists self-sufficiently.
Table 3.3 Production Before Trade, with Specialization

of Machine Tools and Trucks between Germany and Italy
Production Before Trade,
Machine Tools Trucks Trading Rate
with Specialization
Germany 60 Nil 1:1.5
Italy Nil 30 1:1.5
Total 60 30
As per Table 3.3, Germany would concentrate on machine tools. Italy should concentrate in
producing trucks where it is more efficient. The surplus production is not needed for its own
consumption and would be traded for the product needed. It is assumed that both countries have
agreed to exchange their products needed. It is assumed that both countries have agreed to exchange
their products at a trading rate of 1:1:5, i.e. 1 machine tool is exchanged for 1.5 trucks.
Table 3.4 Assumed Consumption After Trade of

Machine Tools and Trucks between Germany and Italy
Assumed Consumption After Trade Machine Tools Trucks
Germany 44 24
Italy 16 6
Total 60 30
In Table 3.4, Germany required 44 machine tools for its own internal consumption, and Italy
required 6 trucks for its own consumption. The surplus unit of each country is traded. Table 3.5 shows
the number of units of both machine tools gained after trading the surplus production with each other.
Thus, total consumption of machine tools and trucks can increase in both countries as a result of
specialization and trade.
Table 3.5 Number of Units (Machine Tools and Trucks)

Gained After Trade between Germany and Italy
No. of Units Gained After Trade
Machine Tools Trucks
(1d – 1b = 1e)
Germany - 8
Italy 4 -
The basic message of the theory of comparative advantage is that potential world production
is greater with unrestricted trade than it is when trade is restricted. Consumers in all nations can
consume more if there are no trade restrictions, even in countries that lack an absolute advantage in
the production of any good.
ACTIVITY 3.1
What is the weakness of the theory of absolute advantage? How does the theory of comparative
advantage help to improve on the theory of absolute advantage?
46
D. The International Product Life Cycle Theory
The International Product Life Cycle (PLC) theory was introduced by Raymond
Vernon in the 1960s. It was based on an observation that in the 20th century a very large
proportion of the world’s new products had been developed by American firms and sold first
in the United States, such as televisions, instant cameras, photocopiers and personal
computers.
The international PLC

theory states that the location of
production of certain kinds of
products shifts as they go through
three different stages called the
new product, maturing product and
standardized product stages as
shown in Figure 3.1.
(a) Stage 1: New Product
From the following figure

on the right, the United States is
shown as the innovating country.
Innovation requires highly skilled
labor and large quantities of capital
for research and development,
which are normally available in
highly industrialized countries. The
products would be non-
standardized and require close
communication among the
different components of skills.
Product design and manufacturing
would therefore be most effective
when it is located near the parent
company. Due to the high cost of
production and the uncertainty of
the market size, the firm will initially
sell most of the product in the
domestic market. Export sales will
be limited.
(b) Stage 2: Maturing Product
As demand for the product increases, production expands and the innovating country
increases its sales to other countries. As competitors increase and production processes
become more standardized (i.e. requiring less use of skilled labor), the firm faces strong
pressures to reduce cost. Product variations also begin to develop.
The innovating firm has to decide whether to lose their market share to other countries’
lower cost manufacturers, or relocate production abroad where costs are lower and maintain
their market share.
Source: Charles W.L. Hill (2014)
(c) Stage 3: Standardized
Product
47
The product manufacturing process becomes completely standardized. Competition is

fierce and profit margins are small. Production would be located in a country that can offer the
cheapest unskilled labor. As production in the low-cost countries increases, they eventually
export the product.
At this stage the innovating country continues to reduce its domestic production. The
mass-produced products may even be exported back to the innovating country. Production in
the other advanced countries will also reduce.
It should be noted that throughout the PLC, the countries of production, consumption,
export and import depends on the availability of their labor and capital. Vernon pointed out
that it could very well be the same innovator firms that are moving production from the United
States, firstly to other advanced countries and then to the less developed countries. Thus,
although the pattern of trade changes, the same firms continue their operations to secure
market share, profits and competitiveness.
The international PLC theory is also the first theory explaining how international trade
and investment are interrelated. However, it is limited and more appropriate for technology-
based products only.
ACTIVITY 3.2
Think of other types of products that follow the pattern of the international PLC. List them down.
E. Theory of Economies of Scale and Imperfect Competition
This is the first of two major new trade theories developed in the 1980s in attempts to
analyze international trade more in line with the real issues of the time, such as economies of
scale and imperfect competition. Paul Krugman focused on two types of economies of scale:
internal economies of scale and external economies of scale.
(a) Internal Economies of Scale
According to Krugman, the larger the firm the greater will be the benefits of
economies of scale, and the lower the cost of production per unit. A firm that possesses
this internal economies of scale could monopolize an industry domestically and
internationally, thus creating an imperfect market. With the lower cost advantage, the
firm can set lower prices and sell more products.
In order for the firm to achieve its economies of scale, it must take resources
away from other domestic industries to expand production. As the firm expands, the
country will narrow its range of products in the industry it specializes, thus providing an
opportunity for other countries to specialize in the products that it has abandoned.
Internal economies of scale therefore leads a firm to specialized in a narrow product
range to produce the larger volume necessary to enjoy the benefits of economies of
scale.
Other firms in other countries may also produce similarly narrow product ranges
but with product differentiation. This further explains why countries’̂ firms in similar
industries buy and sell similar but differentiated products. For example, Europe and
48
the United States both produce cars, yet they also import cars from each other. This is
known as intra-industry trade.
(b) External Economies of Scale
The achievement of external economies of scale depends not on the size of

the firm but on the size of the industry. A country may not have one massive firm
producing large quantities of a particular product, but it has many small firms that
interact to create one large and competitive industry. Such a country can also dominate
world markets in the particular product. Firms in other countries may find they are not
being competitive enough to enter that industry.
External economies of scale may result in industry maintaining its dominance

in world markets. It also explains why certain industries do not shift to countries with
lower cost resources or labor. How these small firms interact will be partially explained
by the next theory that we shall study.
ACTIVITY 3.3
Are there industries in the Philippines which are either internal or external?
F. Porter’s Diamond Theory of National Competitive Advantage
The “Diamond” is the second new trade theory, which was developed by Michael E.
Porter in his book called The Competitive Advantage of Nations. It was based on a survey of
100 companies in 10 nations that attempted to explain why a nation can achieve success in a
particular industry and other nations fail.
The figure shows the four attributes or components that shape a nation’s environment
in which firms compete. The existence of each component may promote the creation of
competitive advantage.
Porter’s Diamond Theory of National Competitive Advantage

Source: Charles W. L. Hill (2014)
The four attributes are:
(a) Factor Endowments or Factor Conditions
49
Factor endowments or factor conditions refer to the nation’s position in terms of the
presence of the factors of production. Factors may be naturally endowed (called basic factors)
such as natural resources, climate, location and demographics, or advanced factors such as
communication infrastructure, skilled labor, research facilities and technology. Advanced
factors, which are a product of investment by individuals, companies or governments, are the
most significant for competitive advantage.
While basic factors can provide an initial advantage, it has to be strengthened and
extended by investment in advanced factors. A country lacking in basic factors, such as Japan
and Singapore, need to invest more in the advanced factors to build competitive advantage.
(b) Demand Conditions
This refers to the role of domestic demand in building competitive advantage. The
sophisticated and demanding domestic consumers would pressure local firms to produce
innovative and high standards of product quality, thus shaping the attributes of domestically
made products. For example, Japan’s sophisticated and knowledgeable camera buyers
helped to stimulate the Japanese camera industry to continuously improve product quality and
introduce innovative models.
(c) Related and Supporting Industries
The third attribute of a country’s competitive advantage is the presence of

internationally competitive suppliers or related industries. Suppliers will compete to produce
lower priced higher quality products and technology innovations to meet the needs of the
particular industry. Thus, an industry or firm located close to suppliers will enjoy better
exchange of ideas and inventions to save cost.
When Steve Jobs introduced the Apple personal computer and demand for personal
computers exploded, suppliers of software, disk drives and computer chips located in the
Silicon Valley to be closer to Apple and other personal computer manufacturers. This local
availability of suppliers strengthened the United States’ competitive advantage in world
markets.
(d) Firm Strategy, Structure and Rivalry
The domestic environments in which firms compete shape their ability to compete in
international markets. Firstly, different nations are characterized by different management
ideologies, which either help them or do not help them to build competitive advantage. For
example, the United States firms’ focus on finance and lack of attention to improving
manufacturing processes and product design in the 1970s and 1980s led to an over emphasis
on short- term financial returns. As a consequence, the United States lost their
competitiveness in engineering-based industries where manufacturing and product design is
very important (e.g. automobile industry) to Japan and Germany.
Secondly, strong domestic competition pushes firms to look for ways to improve
efficiency, which makes them better international competitors. They are pressured to innovate,
improve quality, reduce costs and invest in upgrading advanced factors.
Porter’s theory combines the findings of previous theories and argues that the
presence and interactions of all four components is usually required to boost competitive
performance. Governments also influence each of the four components, such as providing
subsidies for factors, setting product standards for consumer goods, regulate suppliers and
competition.
50
Task Reminder
INTERNATIONAL TRADE STRATEGIES AND ORGANIzATIONS
Firms may use four basic strategies

to enter and compete in international
markets, namely an international strategy,
a multidomestic strategy, a global strategy
and a transnational strategy. Each of these
strategies has its own advantages and
disadvantages and the use of each varies
with the degree of pressure for cost
reduction or local responsiveness. Figure
3.3 illustrates these strategies.
We shall now study the four basic

strategies in detail.
A. International Strategy
Firms following an
international strategy centralize the
development of products in their
home country and offer
differentiated products to new overseas markets, where competitors do not possess those
skills and products. They face little pressure for local responsiveness, such that they do not
need to customize their products to meet local requirements, as well as pressures for cost
reduction. Although these firms may establish manufacturing and marketing facilities in foreign
markets, it is rather limited. Some examples of these firms are IBM, Microsoft and Toys “R”
Us.
B. Multidomestic Strategy
A multidomestic firm (i.e. those pursuing multidomestic strategies) strives to achieve

maximum local responsiveness. The products they offer and marketing strategies are
customised to match the different country conditions. Thus, they establish subsidiaries in
produce, market and conduct R & D activities independently in each major market that they
do business.
These firms usually face high pressure for local responsiveness and little pressure to
reduce costs. This strategy may not be appropriate if cost is major competitive factor.
Multidomestic firms also face weak global coordination capabilities being highly autonomous.
Unilever previously pursued this strategy.
C. Global Strategy
The global strategy is a low cost strategy, where firms concentrate production,
marketing and R & D activities in a few favorable locations. They are able to enjoy the benefits
of economies of scale. Global firms tend to look for similarities between different markets and
51
offer a standardized product to avoid customizing their products because customization

increases costs.
Firms employing this strategy, such as Intel, Texas Instruments and Motorola in the
semiconductor industry, face strong pressures for cost reduction but pressures for local
responsiveness are minimal.
D. Transnational Strategy
Transnational firms encounter strong pressures for cost reduction and pressures for
local responsiveness simultaneously which is typical of some industries in today’s competitive
environment. Such firms need to utilize and transfer skills and competencies developed in any
of their worldwide operations in order to simultaneously achieve cost and differentiation
advantages.
Caterpillar, for example, had to compete with low-cost producers Komatsu and Hitachi.
Caterpillar needed to obtain economies of scale to reduce their cost. At the same time,
construction practices and government regulations which differ between countries meant that
Caterpillar had to remain locally responsive. Caterpillar reacted by redesigning its products to
use many identical components and built a few large-scale component manufacturing facilities
and assembly plants at favorable locations. The firm also added local product features,
tailoring the finished product to suit different local needs. By pursuing this strategy, Caterpillar
was able to reduce costs through large scale manufacturing while simultaneously responding
to pressures for local responsiveness.
Task Reminder
REGIONAL ECONOMIC INTEGRATION

Regional economic integration means an agreement among countries within a particular
geographic region to reduce or remove tariff and non-tariff barriers to the free flow of goods, services
and factors of production between each other.
Since the last few years there have been an increasing number of such regional trade
agreements. We shall focus our discussion on the more notable economic integrations that has
occurred in North America, Europe and Asia.
A. Levels of Economic Integration
Regional economic integration can be categorized 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.
52
Levels of Regional Economic Integration
a. 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 Favored Nation (MFN) principle. In this principle, neither favoritism nor
prejudice treatment is allowed to be applied on certain countries. At PTA level, it is
characterized by a unilateral relationship where tariff reduction is given in one direction
(Hashim & Jedin, 2007).
b. 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.
53
Activity 3.4
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 this with your classmates in our group page.
c. 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).
d. 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 labor and capital are free to move among its member
countries. MERCOSUR is an example of a common market.
e. 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, harmonization in taxation and a common
central bank. Due to its complexity, an economic union is difficult to achieve because
it needs a standardized body or bureaucracy. An example of economic union is the
European Union.
f. 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.
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.
54
Self-Assessment Questions 3.1

Explain the meaning of regional economic integration.
Is regional economic integration similar to the concept of free trade?
List and describe briefly the levels of regional economic integration.
B. Arguments on Economic Integration
There have been several arguments surrounding the issue of economic integration. They
focus on the following:
(a) Trade Creation and Trade Diversion
Trade creation occurs when high-cost domestic producers are replaced by low-cost
producers in other countries within the economic integration. Thus, consumers can gain
access to more goods at a lower price than would have been possible without integration. The
elimination of tariff has also created more trade within the economic integration.
However, the effect of trade diversion, which occurs when lower-cost external
producers (from non-member countries) are replaced by higher-cost producers from countries
within the economic integration, is negative. On the whole, a regional economic integration
would benefit the world only if the amount of trade it creates is greater than the amount it
diverts.
For example, let us suppose that the United States and Mexico, both impose tariffs on
imports from all countries. They then set up a free trade area, eliminating all trade barriers
between them but maintaining tariffs on imports from all other countries. If the United States,
which previously produced all its own textiles, starts to import textiles from Mexico which can
produce it at a lower cost, then trade is said to have been created. Trade with all other
countries would also not decrease. However, if the United States had previously imported
textiles from Costa Rica, which can produce them cheaper than both Mexico and the United
States (but has now become more expensive than Mexico’s due to the import duties
maintained with non- member countries), then trade has been diverted from a lower-cost
producer to a higher-cost producer.
(b) Reduced Import Prices
The lower demand for imported goods, due to the higher prices to cover the cost of
tariff imposed by the bloc of countries in the integration, may be substantial. The exporting
country may then be forced to reduce the prices of their goods. The trade position of member
countries may improve, but this would be offset by the deteriorating trade position of the non-
member exporting country.
(c) Increased Competition and Economies of Scale
There may be a lower degree of monopoly in the production of certain goods and
services due to the increased market size resulting from integration. The larger market
increases the number of firms competing, improves efficiency and lower prices for consumers.
55
Many industries may also gain the advantage from economies of scale as a result of the larger
volume of production.
(d) Higher Factor Productivity
The free mobility of factors of production would likely increase the aggregate wealth of
the common market countries. Labor and capital, for example, would move from low
productivity countries to countries with higher productivity. It will also lead to higher degree of
cross-cultural understanding among member countries.
However, a poorer country may lose their most talented workers as well as badly
needed capital to richer countries where opportunities appear to be more profitable.
(e) Regionalism versus Nationalism
The biggest obstacle to achieving economic integration is the reluctance of member

countries to sacrifice a certain degree of their national sovereignty. In the spirit of nationalism,
they may not be willing to surrender, for example, their independence to decide in the better
interest of the country’s citizens at the expense of regional interest.
C. Economic Integration in Europe
Europe consists of two trade blocs, i.e. the European Union (EU) and the European
Free Trade Association (EFTA). The EU, on which our discussion will focus, has 27 members,
and EFTA has 3. The EU is also far more influential economically and politically.
(a) The Development of the European Union
The two World Wars which devastated Western Europe, left the European countries
with the desire for lasting peace and greater cooperation to rebuild their nations and potential
economies.
The EU originated from the European Coal and Steel Community formed in 1951 to
remove barriers to the shipments of coal, iron, steel and scrap metal within the industry. In
1957, a common market called the European Economic Community (EEC) was established
under the Treaty of Rome. With the signing of the Maastricht Treaty in 1992, the European
Union was established. The total number of member countries is 15, with 10 more scheduled
to join in May, 2004. With a total population of 350 million and a GDP greater than the United
States, the EU is a potential global superpower.
(b) The Organizational Structure of the European Union

56
International firms need to understand the governance of the EU just as they need to
understand the governing process of the individual European countries so as to understand
how they make decisions that may affect the firm’s strategy. The EU is made up of several
agencies which are the European Commission, European Council and the European Court of
Justice.
The European Commission provides the political leadership and direction for the EU.
Its major functions are to formulate proposals for legislation; safeguards the treaties signed by
member countries, and manage and execute EU policies and budgets as well as international
trade relations.
The European Council, or Council of Ministers, comprises different ministers of

member countries representing their countries in the more than 25 different councils such as
Foreign Affairs, Economy and Finance, and Agriculture. The Council has the final say in
legislative matters, whether to adopt, amend or ignore laws proposed by the Commission.
The European Parliament is made up of 626 members who are elected every five
years. Membership is based on the population of each country. The Parliament is responsible
for legislation, budget control and supervision of executive decisions. Laws proposed by the
Commission must be approved by Parliament before submitting it to the Council for adoption.
The European Court of Justice is an appeals court where individuals, firms and
organizations are fined by the Commission for violating EU laws. It deals mostly with economic
matters and is relevant to international firms.
(c) The Single European Act, 1987
It was adopted by member countries in 1987 and commits them to work towards a
single market. Among other things, the act was to remove the remaining barriers to free trade
and investment among member countries and to harmonize the technical and legal standards
for doing business, such as customs checkpoints, certification procedures, tax rates and
excise duties.
(d) The Treaty of Maastricht, 1992
This treaty, among others, committed member countries to:
(i) Adopt a common currency by January 1, 1999;
(ii) Establish a common foreign and defense policy;

(iii) A common citizenship; and
(iv) A stronger EU parliament “with teeth”.
The euro currency is now being

used by 19 member countries
(Denmark and Sweden not included),
often referred to as the European
Monetary Union (EMU), or the Euro
Zone. Its implementation required
member country governments to give
up their own currencies and their
control over monetary policies. The
Euro is administered by the European
Central Bank (ECB) which was
established in 1998.
57
There is one concern among Asian countries and the United States as to
whether the EU will implement protectionist policies towards external trade, although
the Single European Act laid down a free market philosophy. The economic union of
the EU is also seen as moving towards the formation of a political union among
member countries.
D. Economic Integration in the Americas
Among the notable regional economic integration in the American continent are the Andean
Pact, MERCOSUR and the North American Free Trade Area (NAFTA). We shall focus our discussion
on the North America Free Trade Agreement and its revamped version the, USMCA, comprising the
countries of Mexico, Canada and the United States with a combined population of about 400 million.
The NAFTA took effect in January 1, 1994 and is the first time that industrialized countries
formed an economic cooperation with a developing country (Mexico). The United States and
Canadian firms would be able to take advantage of Mexico’s cheap labor and benefit from the large
and growing Mexican market. Consumers would benefit from its lower-cost agricultural products.
However, there was concern about the potential loss of jobs in Canada and the United States
as firms might close down factories and set them up in Mexico as a result of Mexico’s cheaper wages,
poor working conditions and weak enforcement of environmental regulations. The United States labor
unions lobbied for new labor standards and environmentalists pushed for environmental standards to
be upgraded and complied.
Canada-US trade in goods and services in 2015 reached close to CA$881 billion. Canada is
the second largest market for US services exports with Canada-US services trade nearly reaching
over CA$122.8 billion in 2015, a 205.1 per cent increase since 1993. The United States was the
number one destination for Canadian merchandise exports in 2015, and was Canada’s largest
supplier of merchandise imports. Canada is the main foreign supplier of energy to United States
(Mexico is 4th), and was the largest cumulative source of foreign direct investment (FDI) into the
United States.
Between 1993 and 2015, Mexico-Canada merchandise trade grew eight-fold to almost
CA$37.8 billion in 2015, showing an average annual growth rate of 10.1 per cent. Services trade
between Canada and Mexico has increased six-fold during the NAFTA period, to nearly $3.9 billion
in 2015. In 2015, Mexico was Canada’s third largest trade partner and was Canada’s third largest
supplier and fifth largest export market for merchandise trade.
As the Mexican economy and the Mexican peso strengthened, firms left Mexico and relocated
to cheaper countries such as China, Vietnam and Guatemala.
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.
 United States-Mexico-Canada Agreement (USMCA)

The United States-Mexico-Canada Agreement, also known as the USMCA, is a trade
deal between the three nations which was signed on November 30, 2018. The USMCA
replaced the North American Free Trade Agreement (NAFTA), which had been in effect since
January of 1994. Under the terms of NAFTA, tariffs on many goods passing between North
America's three major economic powers were gradually phased out. By 2008, tariffs on various
agricultural and textiles products, automobiles, and other goods were reduced or eliminated .
58
E. Economic Integration in Asia
Due to political differences and low level of economic development among many countries,
economic integration efforts in Asia were less successful. The more significant forms are the
Association of South East Asian Nations (ASEAN) and the Asia Pacific Economic Cooperation
(APEC).
(a) Association of South East Asian Nations (ASEAN)
ASEAN was formed in 1967 which includes the 10 countries of Brunei, Indonesia, Laos,
Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam. It has a total
population of about 500 million and holds potential market and investment opportunities.
In January, 1993, the ASEAN Free Trade Area (AFTA) was officially formed with the
intention of reducing tariffs to a maximum of 5% on all trade within the area by January,
2008. However, progress has been limited due to several reasons. Some countries such
as Malaysia, Singapore and Thailand continue to implement protectionist measures and
the economic development gap with Laos, Myanmar and Vietnam complicates matters.
Several ASEAN countries were also hard hit by the financial crisis in 1997.
59
As the countries’ economies recover, we may be able to see better progress being
made.
(b) Asia Pacific Economic Cooperation (APEC)
APEC was founded in 1989 to promote multilateral economic cooperation in trade and
investment among the 21 member countries Asia and the Americas that border the Pacific
Rim. The industrialized countries are scheduled to achieve free and open trade by 2010,
while the other members by 2020.
While APEC has the potential to become a significant economic bloc because of its
large volume of output and trade, its size poses a problem. Unlike the EU and NAFTA,
which are located closely with a unity of purpose, APEC has too many countries with
diverse interests.
Although progress towards forming a free trade area is slow, the member countries’
heads of government continue to meet regularly to chart and propose developments. If it
succeeds in establishing an FTA, it may be the world’s largest.
Task Reminder
60
SUMMARY
● There are several theories in international business.
● The classical trade theories of Adam Smith and David Ricardo strongly argue that firms
should specialize in the production of goods that they are absolutely or relatively efficient in
producing and buy the goods that they cannot produce as efficiently as other countries.
● The IPLC theory suggests that the production location of goods shifts from the innovating
country, firstly to other advanced countries and finally to developing countries in search of
lower costs as the product becomes more standardized and the requirement for skilled labor
reduces. The IPLC is also the first theory that explains a link between international trade and
international investment.
● The latest group of theories are the new trade theories of Paul Krugman and Michael Porter
which focus on economies of scale and national competitive advantage respectively. These
theories to a large extent explain why countries trade with each other and the benefits that
can be obtained from free trade.
● We also learned about the four basic strategies that international firms can implement and the
degree of each strategy’s appropriateness in different marketing environments abroad.
● Each strategy is distinguished by the different degrees of pressures for either, or both, cost
reduction and/or local responsiveness. These strategies are known as the international, multi-
domestic, global and transnational strategies.
● The end of the topic explained the meaning of regional economic integration, which is an
agreement among a group of countries to allow a freer flow of trade within the group by
removing or minimizing tariff or non-tariff barriers.
● Economic integration exists on four levels of differing strengths of cooperation beginning from
the FTA, the custom union, the common market and finally the economic union.
● We have also seen the various arguments put forth that support and oppose the concept of
economic integration and learned how it impacts on the international business firm.
● The more prominent regional trading blocs, namely the EU, NAFTA, ASEAN and APEC were
also highlighted, tracing their development and success until recent times.
61
EXERCISES
EXERCISE 3.1
1. According to the theory of __________, a country’s wealth is measured by its holding of gold
and silver.
A. Mercantilism
B. Absolute Advantage
C. Comparative Advantage
D. Merchandise
2. The theory of comparative advantage was developed by:
A. Adam Smith
B. David Ricardo
C. Raymond Vernon
D. Michael Porter
3. The Theory of _________ says that countries should specialize in goods that they can produce
more efficiently than others and import the goods that they cannot.
A. Mercantilism
B. Absolute Advantage
C. Comparative Advantage
D. National Competitive Advantage
4. Michael Porter believed that countries who wish to improve their capabilities to compete on a
global basis should restrict the exports of goods and services.
A. True
B. False
5. The lesser the volume of production, the easier it is for firms to achieve economies of scale in
production.
A. True
B. False
6. What is the basic message of theories of absolute advantage and comparative advantage with
regards to international trade?
7. Briefly describe the stages of the international product life cycle theory.
_____________________
62
EXERCISE 3.2
1. The _________ strategy places more emphasis on lowering cost than the other basic
international business strategies.
A. International
B. Multidomestic
C. Global
D. Transnational
2. Which of the following is NOT a factor in making it necessary for local responsiveness?
A. Similar distribution channels
B. Demands of host country governments
C. Differences in infrastructure and traditions
D. Different consumer tastes and preferences.
3. IBM, Toys “R” Us and Microsoft are examples of companies pursuing a/an :
A. International strategy
B. Multidomestic strategy
C. Global strategy
D. Transnational strategy
4. All multinational corporations must pursue a multidomiestic strategy to succeed in international
markets.
A. True
B. False
5. A multidomestic firm typically try to establish R&D, marketing, and production facilities in each
major market they do business.
A. True
B. False
6. When a firm encounters strong pressures for cost reduction, while simultaneously facing
pressures for local responsiveness, which would be the most appropriate strategy to employ?
7. Draw a diagram to show the different positions of the four basic strategies (international,
multidomestic, global, transnational) in response to pressures for cost reduction and pressures
for local responsiveness.
_____________________
63
EXERCISE 3.3
1. The Pacific Rim countries:
A. Are a group of poor Asian countries and is not relevant to international business.
B. Account for a small volume of world output.
C. Include countries like Japan, China, Hong Kong and South Korea.
D. Are members of MERCOSUR.
2. All of the following countries are members of the European Union, EXCEPT:
A. Germany
B. Sweden
C. France
D. Norway
3. Which of the following would indicate a favorable balance of trade position?
A. When a country exports more than it imports.
B. When a country imports more than it exports.
C. When the country’s government is democratic.
D. When a country is in economic recession.
4. Economic integration among groups of countries in Asia has been more successful than in other parts
of the world due to the high degree of cooperation between governments.
A. True
B. False
5. There is total agreement that regional economic integration benefits all countries and firms that are
involved in international business.
A. True
B. False
6. What is the difference between a free trade area and a customs union?
7.What is meant by the terms “trade creation” and “trade diversion”?
_____________________
Chapter 64
4 The Financial Environment

of International Business
LEARNING OBJECTIVES
LO1. Discuss the historical development of

LEARNING CONTENTS
LC1. The International Monetary

international monetary system; System
LO2. Identify the role of the international LC2. The Foreign Market
monetary system in international trade Exchange
and investment; LC3. Currency Convertibility
LO3. Differentiate between fixed and floating
exchange rates;
LO4. Explain how currencies are traded and
quoted on world financial markets; and
LO5. Examine the risks and implications of the
international monetary system for
managing currency transactions and
business strategy.
INTRODUCTION
In this topic, we shall learn about the history of the modern international monetary system,
from the period when gold and silver were the medium of exchange, the systems that were practiced
before and after the two World Wars, until the current floating exchange rate system. These systems
exist because most countries have their own currencies. Since international business is conducted
between different
countries, there is a need for a mechanism to exchange these different currencies.
Examples of foreign currency transactions, such as the “spot and forward transactions” are
provided to assist us in understanding the foreign exchange risks faced by international business
firms in their daily operations and its implications on the firms’ decisions and strategies.
THE INTERNATIONAL MONETARY SYSTEM

The present international monetary system has its origin in the ancient trading system of
exchanging goods and services for gold or silver which were the mediums of exchange then.
However, this system has evolved through what is known as the Gold Standard, followed by the
Bretton Woods, a fixed exchange rate system and the present floating exchange rate system.
A. The Gold Standard

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In the early times when international trade was limited in volume, goods purchased from
another country were typically paid for in gold and silver. However, as the volume of trade expanded
with the Industrial Revolution in the 1800s, a more convenient method of payment was required. It
was not practical to ship large quantities of gold or silver around the world. Thus, resulting in the
emergence of arrangements for payments to be made in paper currency that can be converted into
gold on demand at a fixed rate.
This system of pegging currencies to gold and guaranteeing its convertibility into gold is known
as the Gold Standard.
Great Britain was the first country to use the gold standard in 1821, followed by the other major
trading nations such as Germany, the United States and Russia.
(a) Rates of Exchange under the Gold Standard
Under a common gold standard, the value of any currency was determined by their
value in terms of gold. For example, if one US dollar (USD) was equivalent 23.22 grains of
pure gold, and there are 480 grains to an ounce, therefore, an ounce of gold would cost
USD20.67 (480/23.22). This is known as the “gold par value”, i.e. the amount of currency
needed to purchase one ounce of gold.
The gold par value of other currencies can be similarly worked out. Based on these
gold par values, the exchange rates can thus be determined. As an example, if one United
Kingdom Pound (GBP) as a currency code from www.xe.com/1804217.php is equivalent to
113 grains of gold, one ounce of gold would cost GBP4.25 (480/113). Thus, the implied
exchange rate for converting pounds into dollars would be GBP1 = USD4.87 (USD20.67/
GBP4.25). This system was preferred by many firms and individuals as long as they had faith
that they can exchange their currency for gold at the promised rates at any time upon request.
(b) The Collapse of the Gold Standard
From 1821–1918, the most important currency in international trade was the British
sterling pound as most firms worldwide accepted gold or the pound in the settlement of
transactions. The international monetary system also became known as the sterling-based
gold standard. The expansion of the British empire throughout the world also reinforced its
influence, and London became a dominant international financial center until today.
When World War I broke out, normal commercial transactions ceased. Several
governments printed money to finance their military expenditures, resulting in inflation. The
economic pressures of war also caused countries to suspend buying and selling gold at their
currencies’ par value. Although several countries attempted to readopt the gold standard up
to 1933, they were not successful. Great Britain was pushed into depression. Those who held
pounds lost confidence in its value and began converting their holdings into gold. The British
government could not satisfy these demands without seriously depleting their gold reserves,
66
so it suspended its convertibility in 1931. This was followed by the United States which
abandoned the gold standard in 1933.
The United States devalued (i.e. reducing the value) its dollar price of gold from
USD20.67 per ounce to USD35.00 per ounce, effectively making its exports cheaper and
increasing the price of imports. This step was taken to boost output and create employment.
However, other countries also adopted a similar tactic and devalued their currencies at will
and the gold par value of currencies was no longer certain. As more people lost confidence in
currencies and preferred to change them into gold, other countries suspended their currency
convertibility into gold. By 1939, when World War II broke out, the gold standard was no longer
in practice.
B. The Bretton Woods System
In 1944, representatives from 44 countries met at a resort in Bretton Woods, New Hampshire,
to design a new international monetary system. In order to overcome the weaknesses under the gold
standard such as the competitive devaluations of currencies, the Bretton Woods agreement
established two new institutions the International Monetary Fund (IMF) to oversee the international
monetary system, and the International Bank for Reconstruction and Development (IBRD or popularly
known as the World Bank) to finance long-term economic development.
Under the Bretton Woods agreement, all countries were to fix the value of their own currencies
in terms of gold but were not required to exchange their currencies for gold. Only the US dollar (USD)
remained convertible to gold at a price of USD35.00 per ounce, but only at the request of foreign
governments. Currency par values could then be translated into US dollars. Thus, the US dollar (USD)
became the key currency of post-war commerce. The Bretton Woods system was effectively a fixed
exchange rate system.

According to the Bretton Woods agreement, what is the task of the IMF and the task of the World Bank?
(a) The International Monetary Fund (IMF)
The IMF was officially established on 27

December 1945 and commenced operations on
1 March 1947. Initially consisting of 29 member
countries, it has grown to include 189 countries
by the end of May 10, 2016. The IMF was
created to oversee the functioning of the
international monetary system with the following
major purposes:
(i) Promote international monetary

cooperation;
(ii) Facilitate the expansion and balanced growth of international trade;
(iii) Promote exchange stability, to maintain orderly exchange arrangements among

members, and to avoid competitive exchange depreciation;
(iv) Assist in the establishment of a multilateral system of payments; and
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(v) Make its resources temporarily available to members experiencing balance of

payment difficulties.
All participating countries agreed to maintain the value of their currencies within 1% of
the par value by buying or selling currencies (or gold) as necessary. If, for example, foreign
exchange dealers were selling more of a country’s currency than is demanded, the country’s
government would have to buy its currency from the foreign exchange markets to increase
demand and maintain its gold par value.
If the government concerned was unable to maintain its value within the 1% of par
value, they are allowed to devalue their currency up to 10%. Devaluations of larger than 10%
would require the IMF’s approval.
The IMF also extends foreign currency loans to participating countries to help them
maintain stability. Large borrowers, however, would have to comply with the IMF’s monetary
and fiscal policies.
The overall aim was to try to avoid the chaos experienced between the two world wars,
maintain stability in the world trade environment and impose a monetary discipline on
countries to curb inflation.
ACTIVITY 4.1
Visit www.imf.org for information on the monetary issues of the world.
Discuss this with your classmates in our group page.
(b) The World Bank
The official name for the World Bank is the International Bank
for Reconstruction and Development (IBRD). The World Bank was
created to help in the reconstruction of the economies of Europe by
providing low- interest loans. However, this role was overshadowed by
the United States’ Marshall Plan, under which the United States lent
money directly to European nations. So the bank turned its attention to
the development of Third World countries, such as in building power
stations, roads and transportation, agriculture, education, population
control and urban development.
The World Bank has two loan schemes. The first, called the IBRD Scheme, raised
money through the sale of bonds in the international money markets. These low interest loans
are usually offered to risky customers whose credit rating is poor. The second scheme is
supervised by the International Development Agency (IDA), an arm of the bank established in
1960. Funds for these loans are obtained from the subscriptions of the rich member countries
such as United States, Germany and Japan. Borrowing countries have 50 years to pay at an
interest rate of 1% a year.
ACTIVITY 4.2
Visit www.worldbank.org to get the full details on the organization.
Discuss this with your classmates in our group page.
(c) The Collapse of the Fixed Exchange Rate System
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The Bretton Woods fixed exchange rate system was dependent on the US dollar (USD)
and the stability of the United States’ economy. As long as the United States’ inflation rate
remained low and the country is not in a deficit trade balance (i.e. imports exceeds exports),
the system would work well.
However, several events in the United States in 1965-1968 led to the ultimate collapse
of the fixed exchange rate system. The United States government had increased their money
supply to finance the Vietnam war and welfare programs without increasing their taxes,
causing price inflation and stimulated higher imports, resulting in a deficit trade balance. It
gave rise to speculation that the US dollar (USD) would be devalued setting off massive
purchases of the German deutsche marks, which was expected to be revalued (i.e. to increase
in value). Despite the German central bank, the Bundesbank, buying up to 2 billion US dollars
from the foreign exchange market, they failed to increase demand for the US dollar. The
United States also did not have sufficient gold reserves in the event the foreign governments
demanded gold in exchange for their US dollar
(USD) holdings (in 1970 the United States
government had gold reserves valued at USD11
billion against the USD47 billion held by foreign
governments and individuals).
On August 15, 1971, President Richard Nixon

(see photo) announced that the US dollar was no
longer convertible into gold. Most of the world’s
major currencies were allowed to float (i.e. no
longer fixed in value), thus effectively ending the
fixed exchange rate system established at Bretton
Woods.
ACTIVITY 4.3
Research and read about the collapse of the Bretton Woods system in 1971, and how it was reluctantly
replaced with a regime of floating exchange rates. Write a short discussion essay.
C. The Floating Exchange Rate System
Following the collapse of the fixed exchange rate system, member countries of the IMF met
in Jamaica in 1976 to formalize new rules for the international monetary system.
(a) The Jamaica Agreement
The main elements of the Jamaica agreement include the following:
I. Acceptance of floating rates and allowing IMF member countries to intervene

in the foreign exchange markets to stabilize their currencies.
II. Gold was abandoned as a reserve asset. Gold deposited with the IMF as
reserves were returned to member countries at market price.
69
III. Amount of contribution to the IMF by member countries was increased to

USD41 billion (since increased to USD300 billion and membership has now
increased to 189 countries). More countries were also given greater access to
IMF funds.
Thus, the IMF continued in its role of assisting countries to cope with their economic
and exchange rate problems, although within the context of a different exchange rate system.
The floating (or flexible, or managed) exchange rate system poses many new and
different problems for the participating countries. The value of currencies is determined
primarily by the interaction between the forces of supply and demand for the currency in the
world market place. Each country was free to adopt whatever exchange rate system which
met its requirements best. Thus, the United States adopted a floating exchange rate system,
while other countries adopted a fixed exchange rate by pegging their currencies to the US
dollar (USD), the French franc (FF), or some other currencies.
ACTIVITY 4.3
Which foreign exchange rate system has the Philippine government adopted?
Give some reasons for the choice.
Task Reminder
THE FOREIGN EXCHANGE

MARKET
This subtopic explains the nature and functions of the
foreign exchange market. We shall also focus on some of the
risks encountered by international business firms in
international financial transactions. Photo below displays
samples of a foreign currencies.
A. The Nature of the Foreign Exchange Market
The worldwide volume of foreign exchange being traded is estimated at USD1.5 trillion per
day, compared to about USD200 billion per day in 1986. The largest trading centers are in London
(31% of activity), followed by New York (16%), Tokyo (9%) and Singapore (6%). Zurich, Frankfurt,
Paris, Hong Kong, San Francisco and Sydney are the major secondary trading centers. London’s
dominance in the foreign exchange market was due firstly to its position as the capital of the world’s
first major trading nation since the 19th century. Secondly, its central position between Tokyo and
New York made it a critical link between the Asian and the American markets.
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The foreign exchange “market” has no formal structure. It is not located in any one place, or
floor like the stock exchange where trading takes place. It is a global network of banks, brokers and
foreign exchange dealers linked by electronic communications systems. It is also described as “a
market that never sleeps” because trading continues for 24 hours a day. Due to time zone differences,
London opens soon after Tokyo closes and is still open for the first few hours of trading in New York.
These three centers closes for only 3 hours per day, during which time the minor centers such as San
Francisco and Sydney continues trading.
Buyers and sellers convert the currencies of countries into that of other countries through the
foreign exchange market. As examples, Malaysian tourists utilize the foreign exchange market when
they exchange the Malaysian ringgit (MYR) for Philippine Peso (PHP), and the Toyota Company
exchanges Canadian dollars for Japanese yen when it exports automobiles to Canada. The British
government also uses the foreign exchange market to arrange a multi-million pound loan to monsoon-
ravaged Bangladesh for the rebuilding of their economy. Brokers, central banks and commercial
banks participate in the foreign exchange market by buying and selling currencies on behalf of
governments, businesses and individuals. Approximately 90% of the transactions involve the US
dollar, a dominant role carried down from the Bretton Woods system.
B. Functions of the Foreign Exchange Market
The foreign exchange market serves two major functions. The first function is to
convert the currency of one country into the currency of another country, and secondly it is to
protect or insure against the negative consequences of unpredictable changes in exchange
rates (foreign exchange risks).
ACTIVITY 4.4
Take a few minutes to read and learn the currencies of the countries around the globe. Do you
know the name of several global currencies? Name the currencies for Algeria, Bolivia, Chile, Denmark,
Egypt, Finland, Germany, Holland, India, Jordan, Kenya, Libya, Madagascar, Nepal, Oman, Panama,
Qatar, Singapore, Taiwan, Uganda, Vatican City, and Zaire.
(a) Currency Conversion
The price of goods and services are quoted in each country’s currency, such as – dollar in the
United States, pound in Great Britain, francs in France, marks in Germany, yen in Japan and the euro
in the member countries of the euro zone. While the countries’ currency must be used within the
respective countries’ borders, they are not recognized as "legal tender" outside their own countries.
Japanese must exchange their yen to US dollars (USD) when they travel and spend in New York,
using a specific exchange rate quoted by a commercial bank or a broker. International business firms,
as the major participants, use the foreign exchange market for four main reasons as follows:
i. Convert the payments that they receive for their exports or income from foreign
investments into the currency of their home country;
71
ii. Convert the amount of their country’s currency into the currency of the country from
where they buy goods and services as payment;
iii. Invest their spare cash for short-terms by placing deposits in the currency of another
country so as to earn interest; and
iv. Speculate in the currency of another country for short-terms by investing in the
currency of a country that they anticipate will rise in value against the home country
currency and profit from the difference or change in exchange rates.
An exchange rate is the rate at which one currency is converted into another currency. We
can look at exchange rate as being the price of foreign exchange, just like the price of other
commodities. As examples, Table 4.1 shows some foreign exchange rates quoted against the US
dollar (USD).
ACTIVITY 4.5
Using the rates provided in Table 4.1, calculate how much of each foreign currency is required
to purchase USD100,000.00.
(b) Insuring against Foreign Exchange Risks
Firms that conduct international trade are exposed to and may be adversely affected by foreign
exchange risks that occur as a result of the fluctuation in exchange rates from the period a contract
72
is signed until it is fulfilled. In order to explain how the foreign exchange market performs this function,
we must first understand the difference between spot rates and forward rates.
ACTIVITY 4.6
Visit this website to know all about the foreign market exchange: https://www.fxstreet.com/
C. Spot and Forward Exchange Rates
Let us now turn our attention to spot and forward exchange rates.
(a) Spot Exchange Rates
The spot exchange rate is the rate at which two parties agree to exchange currency and execute the
deal immediately.
It is the rate at which a foreign exchange dealer converts one currency into another currency
on a particular day. For example, when a French tourist goes to bank in Kuala Lumpur to convert her
francs into ringgit, the exchange rate is the spot rate for that particular day. Such a transaction is
referred to as a spot exchange.
Spot exchange rates can be quoted in two ways. Let us use the exchange rates between the
US dollar (USD) and the Japanese yen (JPY) as our examples.
(i) As the price of Japanese yen in terms of the US dollar: USD0.008095 per yen
(USD0.008095/JPY1).
(ii) As the price of US dollar in terms of the Japanese yen: Yen123.54 per dollar
(JPY123.54/USD1).
Spot rates change continually, determined by the interaction between the demand and supply
of a currency relative to the demand and supply of other currencies. Assuming the spot exchange
rate when the market opens on a particular day is GBP1 = USD1.50. As the day progresses, many
people want US dollars and dollars are in short supply, and few people want the British pound and
supply is plentiful. By the end of the day, the spot rate may change to GBP1 = USD1.48. The US
dollar (USD) is said to have appreciated in value and the British pound has depreciated.
Such continual change in the spot rates can pose problems for an international firm. For
example, a United States company that imports notebook computers from Japan has entered into a
purchase agreement and must pay its Japanese supplier JPY 200,000 for each computer when it
arrives in 30 days time. The current dollar/yen spot exchange rate is USD1 = JPY120, and the
computer’s selling price is USD 2,000 each. At this rate, each computer would cost USD1,667 (i.e.
JPY 200,000/JPY 120), yielding a gross profit of USD333 (USD2,000 – USD1,667). However, the
importer has no funds presently and has 30 days to sell all the computers. Over the next 30 days, the
dollar unexpectedly depreciates against the yen say to USD1 = JPY95, but the importer still has to
pay the Japanese supplier JPY 200,000 which is now equivalent to USD 2,105 (JPY 200,000/JPY
95). The change in the spot rates has transformed into a loss of USD 105 per computer (USD 2,000
– USD 2,105) for the importer.
In order to avoid this risk, the US company can engage in a forward exchange as explained
in the following section.
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ACTIVITY 4.7
Let us suppose a French visitor is trying to convert his 500 Swiss francs (CHF) into Philippine
Peso (PHP). Can you help him to find the spot exchange rate? You may visit this website:
http://www.canadianforex.ca/exchange-rate and use the currency tools to help you.
(b) Forward Exchange Rates
A forward exchange occurs when two parties agree to exchange currency and execute the deal at
some specific time in the future.
The rates used in such future transactions are known as forward exchange rates. They are
usually quoted for 30 days, 90 days and 180 days into the future.
Using the same computer importer example, let us assume that the 30-day USD/JPY forward
exchange rate is USD1 = JPY110. The importer can enter into a forward exchange contract (FEC)
with a banker/foreign exchange dealer at the said forward rate guaranteed and pay USD1,818.18
(JPY200,000/JPY110) for each computer. It can now make a profit of USD181.82 (USD2,000 –
USD1,818.18). The firm has thus insured itself against the possibility of a profitable deal turning into
an unprofitable one.
D. Foreign Exchange Risks
There are three types of foreign exchange risks or exposures that international firms have to
confront. Each has to be managed quite differently from the other and they are as follows:
(a) Transaction Exposure
Any contract, agreement, purchase or sale that is denominated in a foreign currency to be

settled sometime in the future poses a transaction exposure. Thus, this refers to the extent to which
the proceeds from a transaction is affected by fluctuations in foreign exchange values.
Firms can manage this type of exposure either by contractual hedging, which is by entering
into a FEC as illustrated in earlier example, or by natural hedging. Natural hedging refers to a firm’s
arrangement to have foreign currency cash inflows (receipts) and outflows (payments) roughly at the
same times and in the same amounts. Foreign currency cash flows can then be matched by offsetting
outflows against inflows.
(b) Translation Exposure
International firms must integrate the financial accounts of all its foreign subsidiaries into a set
of consolidated financial statements. Problems arise when financial statements of foreign subsidiaries
denominated in the foreign countries’ currency are consolidated into the parent company’s currency.
Fluctuations in exchange rates may change the value of the foreign subsidiaries when measured in
the parent company’s currency. It is also known as accounting exposure. It does not result in any
cash flow impact unless liquidation or sale of the foreign subsidiary is anticipated.
(c) Economic Exposure
74
The Economic exposure is the impact of unexpected changes in exchange rates that change the value
of an international firm’s operations, such as an economic or a financial crisis.
While transaction exposure is concerned with the effect of short-term changes in exchange
rates on individual transactions, economic exposure is concerned with the long-term effect of
exchange rate changes on future prices, sales and costs. Firms may manage this situation by
diversifying their operations over several countries to remain prepared for such an occurrence. For
example, Hewlett-Packard produces the same products in their manufacturing facilities in Singapore,
United States, Puerto Rico and Europe.

Which type of foreign exchange risk would most international companies be commonly exposed to? How
can the company protect itself from such risks?
Task Reminder
CURRENCY CONVERTIBILITY
Many countries restrict the conversion of their domestic currency into a foreign currency
making international trade and investment difficult. Restrictions range from a minor one such as
restricting the amount of foreign currency the country’s resident may take with them on trips out of the
country, to major restrictions such as restricting business firms’ ability to take foreign currency out of
the country. These restrictions can be classified by three different levels of currency convertibility.
(a) Freely Convertible
When a government allows both residents and non-residents of its country to purchase
unlimited amounts of a foreign currency with the domestic currency, the currency is said to be
freely convertible.
(b) Externally Convertible
When only non-residents may convert domestic currency into a foreign currency
without any limitation, a currency is said to be externally convertible.
(c) Non-convertible
When both residents and non-residents are not allowed to convert domestic currency
into a foreign currency, it is known as non-convertible.
Foreign firms face serious problems if the currency of the country where they operate is non-
convertible. The firm may generate profits but it may not be able to convert those profits into a foreign
currency and take it out of the country
A. Government Policies
75
Governments may impose policies restricting the convertibility of the local currency
into a foreign currency to preserve their foreign exchange reserves. These reserves are
needed to service its foreign denominated borrowings and to pay for imports.
When a country’s economy is facing a downturn and the value of the domestic currency
is depreciating rapidly, residents and non-residents may believe that the value of their money
is better preserved if invested abroad and held in a foreign currency. They may rush to convert
their domestic currency into a foreign currency a phenomenon known as capital flight. If the
government allows free convertibility, not only will its foreign exchange reserves be depleted,
but it will also lead to depreciation in the exchange rate (due to the increase in the supply of
the country’s currency as it is sold off in the foreign exchange market). The price of imports
would also increase leading to a rise in inflation, thus further weakening the economy.
ACTIVITY 4.7
What restrictions on convertibility did the Philippines impose during the financial crisis in 2008?
Was the government’s policy successful in meeting its objective? Discuss.
B. Countertrading
Countertrade refers to the exchange of goods and services with other goods and services (like barter
trading), with or without some amount of money involved.
This can be used as an alternative method of exchange when a country’s currency is non-
convertible.
For example, in 1984 General Electric was awarded a contract for a generator project in
Romania for USD150 million. As the Romanian government had imposed a policy of non-convertibility
of its currency, General Electric agreed to take payment in the form of Romanian goods that could be
sold for USD150 million on international markets.
Countries are increasingly becoming aware of the benefits of countertrading. Up to 20% of

world trade has been conducted involving some form of countertrade arrangements.
ACTIVITY 4.9
What are the potential problems in countertrading? Discuss your answer.
Task Reminder
76
SUMMARY
● We have discussed the financial environment of international business. Firstly, we read about the
development of the world’s international monetary system during the period of the Gold Standard, by
which the currency values of all countries’ participating in international trade was linked to gold (known
as gold par values).
● Any party who prefers to hold gold may freely exchange their paper money into gold.
● The gold standard, however, came to end after the World Wars and was replaced by the Bretton Woods
system of fixed exchange rates in 1944. Under this system, only the US dollar (USD) was convertible
into gold, while all other currencies are linked to the US dollar (USD).
● The dependence of the US dollar (USD) meant that the United States’ economy must always remain
stable with low inflation rates and not suffer any deficit in its trade balance.
● However, as the United States’ economy weakened during 1960-1970 and was not able to maintain its
position, the Bretton Woods system also failed. It was abandoned in 1973 and a system of floating
exchange rates was formally implemented and in force until today.
● We have also learned about the nature and functions of the foreign exchange market together with its
risks (foreign exchange risks) brought about by the uncertainty in the fluctuation of exchange rates
under the floating exchange rate system.
● We have also worked through some examples of the spot and forward exchanges and how forward
exchange can be used to protect a firm from losses in a foreign exchange transaction.
● Finally, we have learned that not all countries allow free convertibility of their domestic currency as a
result of government imposed policies.
● An international firm may face problems in a country whose domestic currency is non-convertible.
● However, firms may resort to a method called countertrade to overcome this problem.
● Countertrading is a barter like arrangement, whereby goods and services can be exchanged with other
goods and services, with or without some amount of money involved. This method is increasingly
gaining acceptance as more countries become aware of its benefits.
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EXERCISES
EXERCISE 4.1
1. Which of the following organizations was formed as a result of the Bretton Woods Agreement?
A. United Nations
B. World Trade Organization
C. World Bank
D. Organization for Economic Cooperation and Development
2. Under the floating exchange rate system, exchange rates of each country’s currency is determined
mainly by:
A. The forces of supply and demand.
B. The respective country governments.
C. The World Bank.
D. The world’s most powerful economic nations.
3. The World Bank was created to oversee the management of the Bretton Woods fixed exchange
rate system.
A. True
B. False
4. Under the gold exchange standard, all currencies are convertible into gold.
A. True
B. False
5. The Bretton Woods exchange rate system collapsed due to the expected weakening of the
Japanese yen.
A. True
B. False
6. What are the purposes for which the International Monetary Fund (IMF) was established?
7. What are the two loan schemes available under the International Bank for Reconstruction and
Development?
78
EXERCISE 4.2
1. The ____________ is the most widely traded currency in the world.

A. US dollar (USD)
B. Philippine peso (PHP)
C. Japanese yen (JPY)
D. British pound (GBP)
2. If Importer A has to pay USD 3,000 for each unit of digital camera and Importer A’s
selling price is RM11,000, what would be the USD/RM exchange rate that would be
just sufficient to cover costs (rounded to 2 decimal places)?
A. USD1/RM3.67
B. USD3.67/RM1
C. USD1/RM0.27
D. USD3.80/RM1
3. When a firm’s operations exposure encounter unexpected changes in exchange rates,
such as during a financial crisis that reduces its value, it is known as:
A. Transaction
B. Translation
C. Economic
D. Accounting
4. The three largest financial centers are in Zurich, Washington and Singapore.
A. True
B. False
5. Transaction exposure is also known as accounting exposure.
A. True
B. False
6. Explain the differences between a spot and a forward exchange rate.
7. For what reasons do international firms convert currencies?
79
EXERCISE 4.3
1. When residents are not allowed to convert domestic currency into a foreign currency, but
non-residents are allowed to the domestic currency is said to be:
A. Freely convertible
B. Internally convertible
C. Externally convertible
D. Non-convertible
2. One important purpose for governments to impose restrictions on the convertibility of
local currency into a foreign currency is to:
A. Pay for the country’s imports
B. Pay for the country’s exports
C. Pay higher returns to investors
D. Pay higher salaries to government personnel
3. Countertrading is the exchange of goods or services with gold.
A. True
B. False
Chapter 80
5 Market Research,
Mode of Entry & Ethical Issues
in International Business
LEARNING OBJECTIVES

LEARNING CONTENTS
LO1. Explain the importance of conducting LC1. Market Research

global marketing research; LC2. Foreign Market Entry
LO2. Examine the several methods used by Strategy
international firms in entering foreign LC3. International Business
markets; Ethics and Social
LO3. Discuss the appropriateness of Responsibility
choosing a particular foreign market
mode of entry;
LO4. Describe the current issues in
international business ethics; and
LO5. Assess the impact of international
ethics on business firms and social
responsibility.
INTRODUCTION
This topic focuses on the importance of doing market research before making a decision as
to which market(s) to enter or to set up its operations. Firms that venture abroad without prior research
may be unprepared and are exposed to risks due to the various differences in the foreign environment.
It has been reported that failure to conduct such a research on foreign markets has been the major
cause of many firm’s international business losses. Although exporting remains as the most widely
used strategy in foreign market expansion, there are other methods such as licensing, franchising,
turnkey operations, joint ventures, wholly owned subsidiaries and forms of strategic alliances that we
shall also study.
The final subtopic discusses the issue of business ethics in international markets, such as
human rights, product safety and environmental protection. These issues may have a serious long-
term impact on the international firm if not properly managed. In this context, we shall also study the
benefits that can be gained by the international firm from a strategy of social responsibility.
MARKET RESEARCH
Given the opportunities and challenges in the international market place a firm would seldom
have sufficient resources to take advantage of all the opportunities. Thus, international managers
must formulate and implement a strategic plan to match their products and resources (whether
human, physical or financial) to markets. In order to pick the best location in the best interest of their
business, managers need to engage in global market research to gather information for the purpose
of making these decisions.
81
For example, firms must determine where to sell, where to produce and who are their
competitors are. These will depend on a wide range of information, such as the size of the market, its
growth potential, competition, government regulations and economic as well as political stability,
before firms are able to select a target country or market segment. As firms have limited resources,
these foreign market requirements must be appropriately matched with their human resources
capabilities, available physical and financial resources and the level of management commitment to
venture into international markets. The information obtained would then be utilized towards
developing an international marketing program.
ACTIVITY 5.1
Similar to a well-built house, marketing organizations also need a strong foundation (product and
services) to sustain in the business world. Therefore, a good market research is critical in helping
management to support this effort. Explain some of the importance of market research from an
international business perspective.
(a) Sources of Data Collections
There are two types of data collections.

Primary data is the collection of original facts and figures. Being original and not having done
before, primary data collection can be costly and time-consuming.
Secondary data is the data that has been collected by others and is usually less expensive and
easier to collect.
For this market research reason, international business researchers usually attempt to gather
secondary data first, before spending their time and money collecting primary data. The raw data,
which are raw facts and figures, collected are then analyzed and compiled into useful information.
Secondary data can be obtained from external sources such as the following:
i. Individualized reports and studies prepared by market research and business consulting
companies for a fee;
ii. Reports provided by service companies such as banks, accounting firms, transportation
agencies for their international clients;
iii. Government agencies’ statistical reports, news and regulations on individual foreign countries
such as those from the Philippine Statistics Authority (PSA), Philippine International Trade
Corporation (PITC) and Center for International Trade Expositions and Missions (CITEM);
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iv. Reports and recommendations on common trends and problems provided by international
organizations and agencies such as the United Nations (UN), the World Trade Organization
(WTO), the International Monetary Fund (IMF), the Organization for Economic Co-operation
and Development (OECD) and the European Union (EU);
v. Journals of trade associations which contain a wide variety of data dealing with technical and
competitive factors in their industries;
vi. Information service companies that maintain databases from different sources provide
information for a fee, or public libraries for free; and
vii. Material available on the Internet and World Wide Web (WWW). However, these information
need to be checked for reliability.
viii. Primary data are collected when more specific information is required, and can be collected
through several methods such as:
o Experimentation, which is carried out under a controlled environment to establish

precise cause-and-effect relationships;
o Observation, which requires the researcher to observe the activities and behaviors of
users;
o Surveys can be carried out through personal interviews, the mail or the telephone; and
o Focus groups involve gathering a group of knowledgeable people for a limited period
of time and given a specific topic to discuss. It is helpful in providing information about
perceptions, emotions and attitudes. The ideal size for a focus group is between 7–10
participants. The figure highlights some examples of primary and secondary data.

What is primary and secondary data? Explain in your own words.
NOTE: Please follow the format as instructed in Chapter 1.
A. The Need for Market Research
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As illustrated in the preceding subtopic, a wide range of information is required towards

formulating and implementing an effective strategic plan. Doing business abroad without
conducting a proper research places the firm, their assets and their future international
business at risk.
Research allows management to identify markets and develop appropriate international business
strategies. It provides feedback about business activities and information to anticipate events, take
appropriate action and adequately prepare for changes in the international market place.
Despite this, many firms conduct very little research before they enter a foreign market.
They tend to view it as relatively unimportant for four major reasons:
a. Managers lack sensitivity to the differences in culture, consumer tastes and market
demands.
b. Managers have a limited appreciation for the different marketing environments in

foreign countries. There may be different labor regulations, distribution systems and
media regulations and availability, compared to their home country markets.
c. Managers are not familiar with the sources of data and may also lack the ability to use
the data that they are able to obtain. Thus, they perceive that the cost of conducting
global research as not a worthwhile investment compared to the benefits to be gained.
d. Firms may rely on what little actual experience they have had in dealing with a foreign
country as a substitute for organized research.
B. Problems with Research
While firms undertake business research to assist them in their decision process, they
are seldom able to gather all the information that they like due to time and cost constraints.
The lack, obsolescence and inaccuracy of data on many countries make research difficult and
expensive to undertake. Comparability problem adds to the problems in market research.
a. Reasons for Inaccuracies
i. Published data may be incomplete or inaccurate as a result of the governments’

inability to collect the information required. Poor countries may have limited
resources and such data may receive a lower priority in their national budget.
ii. Government officials may lack competence to maintain and analyze accurate
records because they are not well educated. Manual calculations may be used
instead of electronic data processing systems.
iii. Publication of false or misleading information to purposely mislead government

officials or companies and institutions abroad. They may use data selectively and
create false impressions.
iv. Academicians may conduct studies based on too few observations, non-
representative samples or poorly designed questionnaires.
v. Culture may also cause mistrust of how the data gathered will be used, leading
survey respondents to answer inaccurately.
vi. People may cover up their personal data, such as unreported income, to avoid
taxes. Published figures may thus be substantially distorted.
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b. Comparability Problems
i. Countries may publish data based on different time periods, so companies need to
extrapolate or make inferences from those different periods.
ii. There may also be differences in definitions. For example, accounting rules for
depreciation may differ, or the „“family income” category may include only parents
and children, while other countries may also include grandparents, uncles and
cousins.
iii. Countries differ in how they measure investment flows. They may be recorded as
the value of the total project, merely the value of foreign capital, or percentage of
the project owned by foreigners.
iv. National income and per capita income may also not reflect the actual activities
taking place outside the market economy. For example, the extent of people in one
country who may grow their own vegetables, sew clothes or bake bread for their
own consumption may distort comparisons with other countries where people
generally buy these products and services.
v. Fluctuations in exchange rates also make comparison difficult. Appreciation or

depreciation in currency values may reflect an increase or decrease in wealth in
relation to other currencies, but it does not affect domestic purchasing power or
living standards.
ACTIVITY 5.2
What are several reasons for inaccuracies and compatibility problems in conducting market
research? Discuss your answers with your classmates in our group page.
Deadline of submission:
Therefore, firms need_______________________ Date of discussion:
to be aware of these problems _____________________
when relying on available published
(secondary) information. In some countries, such as the former Soviet Union and countries of Eastern
Europe, market information may not be available and firms may be required to conduct a more
expensive primary research.
ACTIVITY 5.3
Your company is considering expanding its operations abroad. Which type of data would you
recommend to be obtained first and why?
Task Reminder
FOREIGN MARKET ENTRY STRATEGIES

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When a firm has decided to enter a foreign market, the firm has to further decide on the best
mode of entry. Firms can choose between six main modes of entry, namely exporting, turnkey
projects, licensing, franchising, establishing joint ventures or setting up a new wholly owned
subsidiary. These strategies are explained in the subtopics that follow.
A. Exporting
(a) Advantages of Exporting
Firstly, substantial costs of establishing a manufacturing operation in the foreign country can
be avoided. Secondly, by manufacturing the product from a centralized location and exporting it
to other countries, the firm may be able to achieve economies of scale from the large volume of
production and sales. Using this strategy, firms such as Sony and Matsushita was able to
dominate world markets with their televisions and video cassette recorders.
(b) Disadvantages of Exporting
Exporting from the home country may not be suitable if there is other lower- cost locations
abroad for manufacturing the firm’s products. Firms may not be able to take advantage of cheaper
resources or labor elsewhere. However, firms can identify and manufacture its products at the
best location abroad and export to the rest of the world from that location.
Secondly, high transportation costs can make exporting uneconomical, especially for bulk
products. One way to overcome this is by manufacturing at a regional location, thus enabling the
firm to realize some degree of economies of scale and simultaneously limit its transportation costs.
The third disadvantage is that tariff barriers can also make exporting uneconomical and risky.
For example, when Japanese car manufacturers/ exporters were threatened with the imposition
of import duties by the United States government, they set up manufacturing plants in the United
States to avoid the high duties.
Lastly, exporter firms need to rely on local agents (in the foreign country) for marketing. As the
foreign agents often carry the products of competitor firms, they may not be totally loyal and do
as good a job as expected. Firms can overcome this by setting up a wholly owned subsidiary in
the foreign country to handle marketing, while continuing to manufacture from a single location.
B. Turnkey Projects
Turnkey projects are most common in the chemical, pharmaceutical, petroleum refining and
construction industries. Contractor firms that specialize in the design, construction and start-up of
turnkey plants, handle every aspect of the project, including the training of operating personnel. Upon
completion of the project, it is handed over to the foreign client (usually governments) ready for full
operation.
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(a) Advantages of Turnkey Projects
Firms with the technological know-how, which is a valuable asset, can earn high
returns from turnkey projects. These firms can employ this strategy in countries where Foreign
Direct Investments (FDIs) are restricted by the country’s government regulations. It may also
be less risky in a country with unstable political and economic environment.
There are also benefits to the client. Clients need not identify individual contractors or
sub-contractors and deal with conflicting schedules in assigning responsibilities. Under the
turnkey package, there is only one entity (i.e., the contractor) to negotiate, supervise and hold
accountable. This arrangement also allows the client to acquire a complete system, together
with skills training provided to the client’s personnel to maintain and operate the system upon
its hand-over.
(b) Disadvantages of Turnkey Projects
There are three main disadvantages in turnkey projects. Firstly, the contractor firm will
not have any long term interest in the foreign country. Their business relationship would end
once the project is completed and this may be disadvantageous in countries which are
potential major markets for the output from the technological process exported. Firms can take
up a minority interest in the operation to ensure their presence over a longer term.
The second disadvantage is that the foreign client firm may eventually become a
competitor to the foreign contractor firm, such as the oil firms in Saudi Arabia, Kuwait and
other Arab countries competing with western firms who originally provided them with oil
refining technology.
Thirdly, the contractor firm may lose their competitive advantage to potential or actual
competitors if the technological know-how is their source of competitive advantage.
ACTIVITY 5.4
A firm that enters into a turnkey project usually may no longer have any long-term interest in
the foreign country. This can be a disadvantage if that country subsequently proves to be a major
market for the output of the process that has been exported. How might a firm get around this
problem?
C. Licensing
Licensing is an arrangement whereby a firm (the licensor) permits another firm (the licensee) the use of
its intellectual property for a specified period and receives royalty payments in return.
The property licensed includes patents, trademarks, copyrights, technology and technical
know-how and formulas. For example, the Walt Disney Company allows other firms to use its
trademarks (brand names, logos, cartoon characters) to be used in a variety of merchandise (e.g
Disney and Happy Skin Cosmetics).
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(a) Advantages of Licensing
The licensor does not have to bear the costs of market development or risks associated with
opening a new foreign market. The licensee puts up most of the capital necessary. This strategy is
also attractive when a firm lacks the capital to develop its operations abroad or is unwilling to commit
resources to an unfamiliar or politically unstable market. Licensing can also be used when a firm is
prohibited from entering a foreign market by barriers imposed. Lastly, a firm can use this strategy
when it possesses an intellectual property but it does not want to develop it. For example, AT&T had
invented the transistor circuit in the 1950s but did not want to produce the transistors, so it licensed
the technology to several other companies such as Texas Instruments.
(b) Disadvantages of Licensing
Firstly, licensing does not allow the firm to realize economies of scale because each licensee
would set up its own manufacturing operations, thus not allowing the licensor tight control over
manufacturing, marketing and strategy. Secondly, the licensor may not be able to coordinate
strategies across countries by using the profits earned in one country to support a different licensee
operating in another country (apart from the royalty payments).
Thirdly, the licensor may lose its competitive advantage, in the form of the property licensed
out, to the licensee. To reduce this risk, firms can enter into a cross-licensing agreement whereby
a firm licensing its property may request that the foreign partner license some of its know-how to the
firm, in addition to a royalty payment.
ACTIVITY 5.6
Let us suppose a firm is entering into a licensing agreement. Identify how it can reduce the
risks of losing control over its technology.
D. Franchising
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Franchising is similar to licensing. However, it is a longer term

commitment in which the franchisor firm not only sells intellectual
property to the franchisee, but also insists that the franchisee abide
by prescribed rules as to how it does business. McDonald’s is one of
the companies that have many franchisees around the world. Thus,
McDonald’s imposes strict rules as to how franchisees should operate
a restaurant, extending ongoing control over the menu, cooking
methods, staffing policies as well the design and location of its outlets.
McDonald’s also organizes its franchisees’ supplies and provide
management training and financial assistance. The franchisor and the
franchisee are interdependent and each party contributes its part of
the product or service that is ultimately offered to the customer.
The franchisor may also penetrate a foreign market by setting up a master franchisee which
holds the rights to open outlets on its own or develop sub- franchisees in the country or region. The
sub-franchisees would pay royalties to the master franchisee, which would remit a predetermined
percentage of it to the franchisor. This approach is favored when it is costly to directly oversee and
control the franchisees’ operations or they are not confident in the evaluation of franchisees.
(a) Advantages of Franchising
Similar to licensing, the franchisee assumes the cost and risks of opening a foreign market.
Using this strategy, firms can quickly expand their business internationally at relatively low cost and
risk. Franchising has a strong market potential and offer high financial gains, especially when the
franchisor has established a strong reputation for quality that can attract customers. From the
franchisee’s perspective, the franchise offers a lower risk as they are undertaking a proven successful
concept. There are also major benefits from a governmental perspective. The franchisor’s country
does not suffer a loss or replacement of jobs, as opposed to a situation when manufacturing firms
relocate to other countries to obtain lower costs of labor and resources. The franchisee’s countries
do not face a large outflow of foreign exchange because the bulk of the profits generated from
franchise outlets would remain within the country.
(b) Disadvantages of Franchising
Franchises often face the problem of quality control. While brand names such McDonald’s or
Hilton Hotel conveys a message of quality, foreign franchisees may not safeguard quality as they are
supposed to. As a result, the poor quality service may damage the firm’s reputation worldwide. In the
case of McDonald’s, the large number of outlets worldwide also makes quality control difficult. Master
franchisees, which is wholly owned or partially owned by the parent company, may help overcome
this problem. The firm can then place its own managers in the subsidiary to help monitor the
franchises.

What is the differences between licensing and franchising?
E. Joint Ventures
A joint venture can be defined as the participation of two or more independent firms in a
jointly owned enterprise with each party contributing assets and shares risks and a common business
objective. The 2008 Joint venture of NBC Universal Television Group (Comcast) and Disney ABC
Television Group (The Walt Disney Company). The objective of the joint venture was to create a video
streaming application or a website named “HULU”. This product provides streaming quality content
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which is on computers, laptops or mobile phones. The product became a huge success with the
offering lining up to $1 billion.
(a) Advantages of Joint Ventures
Firstly, a firm contributing technological know-how may benefit from the local partner’s
knowledge of the host country’s culture, language, competitive conditions, business practices and
political systems.
Secondly, partner firms may share the high costs and risks of opening a foreign market.
Thirdly, many governments regulate foreign equity participation in local operations or the
political situation may be unstable. Joint ventures may be the only feasible mode of entry besides
reducing the risk of take overs and government interference, as local partners may have some
influence over the host government’s policies.
(b) Disadvantages of Joint Ventures
Joint ventures have several disadvantages. First, a firm may risk losing control of its
technology to its joint venture partner. However, agreements can be drawn up to minimize this risk or
firms can opt to hold majority ownership in the joint venture company.
Secondly, a firm may not be able to exercise tight control needed in order to achieve
economies of scale, nor does it allow a firm to achieve the high levels of coordination in its operations
that is required in global competition.
The third disadvantage is that the shared ownership can lead to conflicts and struggle for
control between the partners in the event goals and objectives change or their strategic views differ.
Conflicts may also occur when the foreign partner’s knowledge about local markets increases and
they become less dependent on the local partner. This increases the foreign partner’s bargaining
power leading to conflicts over control of goals and strategies.
F. Wholly-owned Subsidiaries
A wholly-owned subsidiary is 100% owned by the international

firm. It can be established either by setting up a new operation in the
foreign country, often called a “greenfield” operation, or it can acquire
an established firm in the foreign country to promote its products or
services. For example, when Jollibee Foods Corporation penetrated
the US, they successfully acquired, in gradual, a burger chain store
called Smash Burger to gain global market presence.
(a) Advantages of Wholly-owned Subsidiaries
A firm whose competitive advantage lies in its technological expertise may not want to risk
losing their advantage. Thus, for many high-tech firms, a wholly-owned subsidiary is preferred.
Secondly, this mode of entry allows the firm to maintain tight control over its operations in
different countries enabling it to coordinate its global strategies, such as using profits from one country
to meet competition in another country.
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The third advantage is it enables the firm to realize economies of scale by specializing a
subsidiary in the manufacturing of certain products or components and exchanging the products or
components with other subsidiaries.
(b) Disadvantages of Wholly-owned Subsidiaries
Generally, establishing a wholly-owned subsidiary is the most expensive method of entering

foreign markets. Firms have to bear the full costs and risks of setting it up, and acquisitions may give
rise to problems of merging different corporate cultures.
ACTIVITY 5.7
Let us suppose a firm’s core competency is dependent on its technological expertise. The firm
is pursuing a global strategy although its transportation costs and trade barriers are very high. What is
the optimal mode of entry for this firm to enter a foreign market?
G. Strategic Alliances
Strategic alliances are cooperative business arrangements in which two or more firms
cooperate for their mutual benefit. These firms may be potential or actual competitors.
(a) Advantages of Strategic Alliances
Firstly, strategic alliances may facilitate entry into a foreign market. For example, Motorola
struck a deal with Toshiba to secure government approval to enter the Japanese market by building
microprocessors for Toshiba, who provided Motorola with marketing expertise.
Secondly, strategic alliances allow firms to share the costs and risks of developing new
products or processes.
Thirdly, complementary skills and assets that neither company can develop on their own can
be combined, such as the case between JVC and Thompson to manufacture videocassette recorders.
Fourthly, it can be used to help firms establish industry technological standards, such as the
case between Phillips and Matsushita in establishing the digital compact cassette system (DCC) as
the new technical standard against Sony’s mini compact disc technology then.
(b) Disadvantages of Strategic Alliances
The major concern is that alliances may allow competitors to gain a low-cost route to new
technology and markets. For example, many strategic alliances between US and Japanese firms were
seen as a Japanese strategy to obtain the project engineering and production process skills from
successful US companies. New inventions were channelled to Japan, while the resulting products
were distributed and sold in the US markets.
Task Reminder
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INTERNATIONAL BUSINESS ETHICS AND SOCIAL

RESPONSIBILITY
The term ethics commonly refers to the rules and principles that determine what is right and
wrong conduct. Business ethics is the application of general ethical principles to business behavior.
Although many ethical principles such as “do not kill”, “do not steal“ or “not to break business
agreements without reason” are universally accepted, some are bound by culture. Under such
circumstances, international business firms are confronted with difficult ethical dilemmas.
Since culture and customs vary from country to country, some argue that business firms
should adopt the customs of the country in which they are currently operating, regardless of their own
ethical principles. This view is known as the “cultural relativism” approach to business ethics, or the
“when in Rome, do as the Romans do” approach. The cultural relativist approach can be shown to be
inappropriate. For example, does this mean that if slavery is practiced in a country, then it is
acceptable to practice slavery when doing business in that country?
Thus, the differences that exist between countries may cause some important ethical issues
to arise, such as violation of human rights, product safety, pollution of the environment and corruption
or bribery. This subtopic focuses on the issues that have been the subject of much debate with respect
to the activities of international business firms.
The notion of social responsibility holds that a firm’s responsibility is not only to make profits
(an economic view), but further include protecting and improving the welfare of society wherever they
operate (a socio-economic view). It is therefore the business firm’s obligation to pursue long-term
goals that are good for society, beyond what is required by law and economics. More international
firms have begun to implement various training programs to develop ethical awareness among
members of their organizations and to build an ethical corporate culture. In so doing, firms strive to
strike a balance between the achievement of their economic goals (profits) and the goals of the society
within which they operate (welfare of society) to realize the long-term benefits of being socially
responsible.
The United Nations Development Program’s Human Development Report 2000 points out that
“Global corporations can have enormous impact on human rights in their employment practices, in
their environmental impact, in their support for corrupt regimes or in their advocacy for policy
changes”.
ACTIVITY 5.8
Since culture and customs vary from country to country, some argue that business firms should
adopt the customs of the country in which they are currently operating, regardless of their own ethical
principles. Do you agree with this statement? If not, why?
Discuss with your classmates on our group page.
A. Human Rights
Firstly, we look at the ethical issue of international firms doing business in countries that abuse
or violate human rights.
The United Nations Universal Declaration of Human Rights, 1948 has laid down the basic
principles that should always be adhered to irrespective of the culture in which one is doing business.
It has been accepted by almost every country. The following image highlights Article 23 of the said
Declaration.
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Totalitarian countries like China have been reported to routinely violate the human rights of
their citizens by restricting their political freedom through repression of political dissidents. China has
also been known to allow the employment of child labor, forced labor or very poorly paid “sweat shop”
labor.
The above example would imply that the “rights” under Article 23 as mentioned above “just
and favorable working conditions”, “equal pay for equal work”, and remuneration that ensures
“existence worthy of human dignity” have been abused.
It would be unethical to employ child labor in sweat shop conditions and pay wages below
subsistence, even if it is an accepted practice in countries such as China and Bangladesh.
Several international firms which have manufacturing facilities or their suppliers in China, such
as Gap, Disney, Wal-Mart and Nike, have been criticized for using sweat shop labor. The ethical
dilemma facing these firms is to terminate the employment of children and let them live on the streets
begging for food or continue their employment and pay subsistence wages. By abandoning them, it
may do more harm than good if the interests of the children were to be protected. Finding a way to
improve their lives would be the ethical thing to do.
For example, when Levi Strauss discovered that its supplier employed child labor, it further
investigated the situation and found that many women workers in the factory brought their children to
work with them because there were no school facilities and the little amount that the children earned
helped keep the family income above subsistence level. Levi Strauss built a school for the children
under 14 years of age, and additionally paid the parents the money which the children would have
otherwise earned. It may be a small price for Levi Strauss to pay, but it meant a big difference for the
children’s lives.
B. Product Safety
Another ethical issue is whether an international firm should comply with the same standards
of product safety as that required in its home country when operating in foreign countries. The United
States and several European countries are guided by their respective product safety laws, while in
other countries they are less extensive. Under these laws, firms can be held responsible (concept of
product liability) when a product causes injury, death or damage. Complying with safety standards
and product liability insurance increases costs and firms may tend to follow the more relaxed local
standards in the foreign country.
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From the moral point of view, William H. Shaw, an ethics lecturer and author, states that the
responsibilities of businesses in the area of product safety include:
(a) Giving safety the priority as warranted by the product;
(b) Not having the misconception that accidents occur exclusively as a result of
product misuse and they are thereby absolved from all responsibility;
(c) Monitoring the manufacturing process from design, testing to production to ensure
specifications are complied;
(d) Reviewing marketing strategies and advertising for any potential safety problems;
(e) Providing written information about the product’s performance to consumers; and
(f) Investigating customer complaints about products and taking the necessary
response.
For example, when Levi Strauss discovered that its supplier employed child labor, it further
investigated the situation and found that many women workers in the factory brought their children to
work with them because there were no school facilities and the little amount that the children earned
helped keep the family income above subsistence level. Levi Strauss built a school for the children
under 14 years of age, and additionally paid the parents the money which the children would have
otherwise earned. It may be a small price for Levi Strauss to pay, but it meant a big difference for the
children’s lives.
C. Environmental Protection
As countries pursue economic development and industrialization proceeds at a rapid pace,

the Earth’s air, land and waters are being increasingly polluted. Depletion of the ozone layer and
global warming caused mainly by deforestation (cutting down of trees) and chlorofluorocarbons
(CFCs) are major concerns. These are said to be the result of industrial activities which are posing a
threat to the future of the planet. Thus, the business activities of large multinational corporations have
also been contributory. Environmental protection, such as installing anti-pollution devices and using
manufacturing processes that reduce pollution or waste may increase the costs of business.
In 1992, more than 100 countries met in Rio De Janeiro, Brazil for the first international United
Nations Earth Summit to address the problems of environmental protection. In 1997, another
convention was held in Kyoto, Japan to commit participating countries to reduce greenhouse gas
emissions. 55 countries who are responsible for 55% of the of world’s gas emissions must ratify the
treaty in order for it to take effect. The United States rejected the treaty because of the high costs it
would bring to its industry. The United States is responsible for 25% of the world’s carbon dioxide
emissions.
While environmental protection laws may be lacking in less developed countries, other
countries face the problem of enforcement. Some international firms locate their production facilities
in countries which have weak environmental laws to save costs. However, other firms have shown to
be environmentally responsible companies by redesigning their manufacturing processes and use
inputs more efficiently. In 2002, more than 700 companies attended the UN Summit on Sustainable
Development in Johannesburg, South Africa to cooperate in environmental agreements. These
agreements would put all companies on the same level, so that companies that practice
environmental protection would not be at a cost disadvantage.
D. Corrupt Practices
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The last issue is concerning the payment of bribes to corrupt government officials in order to
gain access to a foreign country or the giving of gifts to support business relationships. Member
countries of the Organization for Economic Cooperation and Development (OECD), comprising about
20 of the world’s most powerful economies, have worked towards making the bribery of foreign
government officials a criminal offence. The United States’ Foreign Corrupt Practices Act prohibits
American companies from paying bribes to foreign officials to obtain or retain business, although
many developed countries do not have such laws. In many other countries, payoffs to government
officials are deemed a common acceptable practice.
There are opposing economic views regarding investments which involve bribery. Some
economists argue that such investments bring substantial benefits to the local population in terms of
jobs created and income, and should not be ignored. It may help improve economic efficiency and
growth in these developing countries. However, other economists are of the view that corruption
reduces the returns on business investments, thus reducing the incentive to invest and may affect the
economic growth in such countries.
Gray areas also exist in cultures where the giving of gifts is practiced and expected in
developing relationships with foreign government officials. Although it may appear to be reasonable
in countries like China, this practice conflicts with western principles of fair play. For example, two
western firms are competing to secure a supply contract from a Chinese firm. The winning firm is not
the lowest bidder, but the firm that had employed the son of the Chinese firm’s CEO as a negotiation
consultant. The winning firm has simply been able to recognize the importance of relationships,
although principles of fair play seem to have been violated.
According to an ethicist, Thomas Donaldson, firms in international business should be guided

by three ethical principles:
(a) Respect for core human values (rights), which determine the absolute moral
threshold for all business activities;
(b) Respect for local tradition; and
(c) The belief that context matters when deciding on what is right and wrong.
Thus, ethical decisions must respect core human values while simultaneously observing local
cultural differences.
Task Reminder
SUMMARY
● The need for firms to carry out a global market research to gather information about foreign
markets is to help them make appropriate decisions as to which foreign market is feasible to
enter, what competitive strategy as well as the mode of entry to use.
● Many firms fail in their ventures abroad because they neglect to conduct such a research.
● There are several reasons given for this neglect, ranging from the managers’ lack of sensitivity
to differences in foreign culture and tastes, limited appreciation to different marketing
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environments, lack of familiarity with sources of data and how to use them, and relying on the
few experiences they had in foreign country dealings as a substitute.
● The general business strategies of cost leadership, differentiation, focus and six different
modes of entry into foreign markets (exporting, turnkey projects, licensing, franchising, joint
ventures and wholly-owned subsidiaries) were discussed at length together with each mode’s
advantages and disadvantages.
● The issues that often arise in international business ethics are the issues of human rights,
product safety, environmental protection and corruption involving countries, where
international firms operate or involving the firms’ own practices.
● The concept of social responsibility and how firms tend to benefit in the long- term if they
indulge in socially responsible activities were also briefly discussed.
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EXERCISES
EXERCISE 5.1
1. All the following issues may give rise to comparability problems in global market research,
EXCEPT:
A. Fluctuation in exchange rates.
B. Different methods of measuring investment flows.
C. Differences in time periods of data compiled.
D. Different countries using similar definitions.
2. Primary research refers to:
A. All researches conducted by a firm to fill specific information needs.
B. All types of research conducted by international firms.
C. The preliminary research conducted before commencing the actual research
D. Research that does not address issues that firms are particularly concerned about.
3. The ideal size of a focus group comprises:
A. 4 to 5 members
B. 5 to 7 members
C. 7 to 10 members
D. 9 to 12 members
4. Secondary data may be used for many purposes other than the original one it was intended
for.
A. True
B. False
5. Cultural factors may affect government officials’ ability to maintain and analyze records.
A. True
B. False
6. What are the factors that may cause inaccurate data or information to be gathered in global
market research?
7. Explain the four major reasons international managers’ belief that global market research is
relatively unimportant and fail to conduct one.
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EXERCISE 5.2
1. ____________ is a type of ownership sharing among international firms, in which two or

more firms own the company.
A. Turnkey operation
B. Joint venture
C. Franchise
D. Licensing
2. ____________ is a complete system whereby a every aspect of the project, including the
training of operating personnel is handed over to the client upon completion of the project
ready for full operation.
A. Licensing
B. Franchising
C. Joint venture
D. Turnkey operation
3. Exporting from the home-country would be more advantageous to the firm because:
A. Transportation costs are high.
B. Foreign governments impose tariff barriers.
C. It can achieve economies of scale.
D. Cheaper resources can be found in other countries.
4. The more the firms in a joint venture, the more likely the venture will be successful.
A. True
B. False
5. Cross-licensing is an agreement providing for the exchange of technology between the firms
involved.
A. True
B. False
6. Discuss the advantages and disadvantages of a strategic alliance.
7. Explain what is meant by licensing agreements.
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EXERCISE 5.3
1. The United States’ Foreign Corrupt Practices Act:

A. Prohibits American firms from paying bribes in their home- country, but allows it in
foreign countries.
B. Prohibits American firms from paying bribes wherever they operate.
C. Prohibits American firms from paying bribes in European countries, but allows it in Third-
World countries.
D. Prohibits foreign firms from paying bribes to American firms in the United States.
2. The Universal Declaration of Human Rights was proclaimed in 1948 by participating countries
of the:
A. Asia Pacific Economic Cooperation
B. Organization for Economic Cooperation and Development
C. United Nations
D. Organization of Petroleum Exporting Countries (OPEC)
3. A socially responsible company will balance the benefits to be gained against the costs of
achieving those benefits.
A. True
B. False
4. All economic views agree that corruption reduces the returns on business investments, thus
reducing the incentive to invest and may affect the economic growth in such countries.
A. True
B. False
5. Global warming is caused mainly by deforestation (cutting down of trees) and
chlorofluorocarbons (CFC) released into the atmosphere from industrial activities.
A. True
B. False
6. What are the steps that firms should take in order to follow ethical product safety practices?
Chapter 99
6
Operational and
Functional Considerations
in International Business
LEARNING OBJECTIVES LEARNING CONTENTS
After this chapter, the student must be able to: In this chapter, you will learn about:
LO1.Discuss several types of organizational LC1. Organizational Design and

structures; Control
LO2. Assess the different requirements in a LC2. International Marketing
foreign marketing environment with Management
regard to the firm’s products, pricing LC3. International Financial
decisions, promotional approaches, Management
and distribution channels; LC4. Human Resource Management
LO3. Explain the mode of financial
settlement in international transactions
and the sources of investment capital
available;
LO4. Examine the staffing policies in
international human resource
management; and
LO5. Describe the approach to managing
expatriate managers and foreign
country employee relations.
INTRODUCTION
This chapter focuses on the operational and functional aspects of international business firms.
We shall look at alternative organizational structures for use in international operations and control
systems to ensure that the firms’ strategies and goals can be monitored and achieved. Then, we shall
learn about the 4Ps of marketing from an international perspective, namely the issues of product
attributes, pricing, communication (promotion) and distribution (place) strategies. Next, we shall
discuss the financial management aspects of international business, such as payments and receipts,
working capital and sources of investment capital. Finally, we shall discuss the issues of equipping
international managers for foreign postings and managing the local employees of foreign subsidiaries
where the different approaches to staffing polices together with performance appraisal and
compensation systems shall be explained.
ORGANIZATIONAL DESIGN AND CONTROL

Organizational design (or organizational structure) is the pattern of structural components and
configurations used to manage the total organization. It is the vehicle through which strategies are
implemented and work is accomplished. The structure provides the firm with a route or channel for
communicating decisions and reports, and coordinating the overall activities of the organization. More
specifically, the organizational structure is used by the firm to:
a. Allocate resources;
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b. Assign tasks to its employees;
c. Inform employees about the firm’s rules, procedures and expectations about the employees’
job performance; and
d. Collect and transmit information necessary for problem solving and decision making.
As a domestic firm expands internationally, their products and services, markets and people
in the organization become more diverse. The firm’s organizational structure and control system must
change to accommodate their international activities. The design of an international firm’s structure
will depend on three factors:
a. Stage or degree of internationalization (involvement in international activities);
b. Most desirable way to group people (human resources) and physical resources to achieve
organizational goals; and
c. Type and degree of control to be exercised by headquarters.
There is no organizational structure which we can term as the best or perfect. A structure that
works for one company may not be appropriate for another. A new structure implemented may turn
out to be not working out as planned and needs to be fine-tuned. In more extreme cases, the structure
may be found to be totally ineffective and an entirely new organizational structure must be devised.

What are the benefits that a firm will gain from its organizational design?
A. Types of Organizational Structures
We shall now learn about the various basic structures usually implemented according to the
different stages of internationalization.
(a) Little or No Formal Organization Stage
In the very early stages of international

involvement, international activities are handled by
the domestic operations. Sales and profit are so
small that there is no change in the organizational
structure. As transactions increase and the firm’s
interest expands, an export sub-department within
the marketing division may be established with a
few experienced employees to take responsibility
for the international activities as shown in the
following figure on the left.
As international involvement grows, the firm may alternatively set up a separate export
division with equal ranking as the other functional divisions of finance, R&D or human
resources.
(b) International Division Stage
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Under this stage, the

firm has become much more
involved in foreign markets and
the export department structure
becomes obsolete. For
example, apart from exporting,
the firm may undertake joint
ventures which require
employees involved to have
functional experience. The firm
would usually establish an
international division,
centralizing all responsibility for
international activities, as shown in the structure on the right.
(c) The Global Organization Stage
As the firm becomes totally committed to international operations, communication and

coordination among parts of the organization which may be located in many and distant
locations becomes most important. Firms must also be able to react to competitors
simultaneously in many parts of the world, if competition is on a global basis.
The major consideration at this stage is how employees and related physical resources
of the company should be grouped, or arranged, in order to accomplish the tasks assigned to
them efficiently. Four basic approaches are available: the functional, product, geographic (or
area) and the matrix structure. Sometimes, firms may apply several approaches in various
parts of the organizational structure.
The four basic approaches are discussed in the following paragraphs.
(i) The Functional Division Structure
Using the functional structure, the firm

organizes personnel according to the
type of work to be done, such as
marketing, engineering, finance or
production.
For example, the production

division would be responsible for the
firm’s worldwide production
operations. From the administrative
point of view, the functional structure
is the simplest form because it emphasizes on the basic tasks of the firm. It works best
when both the products and customers are relatively few and similar in nature. An
example of a company which uses functional division structure is ExxonMobil whose
products and production methods are basically similar worldwide.
(ii) The Product Division Structure
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In this structure, workers

are organized according
to the different types of
product, as illustrated
(see figure on the right).
Each product
division is responsible for
all the manufacturing
and marketing of the
firm’s products
worldwide. Thus, cost
efficiency can be
improved through the
centralization of manufacturing facilities.
This structure is one of the most often used by consumer

product multinational corporations, mainly because of the diversity of
their products, such as Unilever.
(iii) The Geographic (Area) Division Structure
This approach follows closely the marketing concept because attention is

concentrated on individual areas or markets. Resources are organized on the basis of
where work is to be done. Each geographic division, as illustrated in Figure 6.6 is
responsible for the manufacturing and marketing in their respective geographic area
or region such as implemented by the Ford Motor Company.
(iv) The Matrix Division Structure

In this organizational structure, a subsidiary
reports to more than one group. The figure
on the left shows an example of this
structure. Here you can see that the United
Kingdom subsidiary reports to the product
division (textiles and agricultural products
division). As each division shares
responsibility over foreign operations, the
divisions will become more independent,
exchange information and resources with
each other. Eastman Kodak for example,
implements a matrix system.
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Due to the dynamic nature of business and growth, a firm’s structure often evolves along with
its business. Most firms have a mixed structure. For example, PepsiCo is organized by product lines
(soft drinks and snacks). However, each product line has its own international division, which
separates it from the firm’s domestic operations. Generally, as firms grow in size, their product lines
increase and they grow more dependent on foreign operations, new structures will evolve in order to
maintain control over the increasing complexity of their operations.
ACTIVITY 6.1
What are the advantages and disadvantages of the functional, product, geographic (or area) and the
matrix structures? Discuss with your classmates on our group page.
B. Deadline of submission:
Centralization versus _______________________
Decentralization Date of discussion: _____________________
In the design of its organization, the third major factor for the firm to consider is the
type and degree of control to be exercised by headquarters (HQ). The firm must determine
the level of autonomy, power and control that it wants to grant to its subsidiaries.
If the firm wants to maintain tight control and strategic decision making is concentrated at headquarters,
the system is described as centralization. On the other hand, if subsidiaries are allowed a high degree
of autonomy and most decisions are made at the local (subsidiary) level, it is known as
decentralization.
Both approaches possess advantages and disadvantages. For example, a firm may
choose to decentralize decision making by allowing individual subsidiaries a wide discretion
over strategy, finance, production and marketing decisions. Subsidiary managers may then
focus only on the subsidiary’s needs rather than on the firm’s overall needs. In order to avoid
this situation, the firm decentralizes its decision- making authority at corporate HQ so that
decisions can then take into account the firm’s overall needs. However, such a step would
restrict the managers from responding quickly and effectively to changes in market conditions,
they being closest to the markets.
To realize the benefits of both approaches, firms are typically neither totally centralized
nor decentralized. The overall corporate strategy is provided by the HQ, while subsidiaries are
allowed the freedom to implement the strategies within the limits approved by HQ – an
approach known as “coordinated decentralization”. For example, some functions of the firm,
such as finance and R&D, may be decided centrally, while others, such as promotional
decisions, are left to the subsidiaries. Using this approach, firms are able to address the need
to coordinate all their international activities without overlooking the role and contribution by
subsidiaries.
ACTIVITY 6.2
Decentralization may result in better decision making. Do you agree with this statement? Why? Discuss
with your classmates on our group page.
C. Deadline
Controlof submission: _______________________ Date of discussion: _____________________
Systems
While the organizational structure provides a framework within which the firm’s
objectives can be met, a control system is a process to verify and correct those actions that
differ from the firm’s established plans. Control serves as an integrating mechanism to ensure
that the actions of the sub-units (i.e. divisions or subsidiaries) of the firm are consistent and in
support of the overall strategic and financial objectives of the firm, despite the global
differences.
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In multinational corporations, four main types of control systems are used as shown in
the following:
Most firms use all four systems, although emphasis may vary with the firm’s strategy.
(a) Personal Control
Personal control is exercised by personal contact with subordinates, by which

subordinates’ actions are directly supervised. In large international firms, it is used between
managers at different levels of its organizational structure. For example, the CEO may use
personal control to influence the behavior of his immediate subordinates, such as the head of
divisions. Heads of divisions in turn may use personal control to influence their subordinates,
and so on down through the corporation.
(b) Bureaucratic Control
This is a system of rules and procedures that directs the actions of business sub-units.
The most important form of bureaucratic control within international firms are budgets and
capital spending procedures.
Budgets are a set of rules for allocating a firm’s financial resources, and specify
precisely how much the sub-unit may spend. For example, the R&D budget specifies how
much cash the unit can spend on product development. If they spend too much on one project,
they may have less to spend on other projects. They will take action to stay within the budget.
Most budgets are set through negotiations between HQ and the sub-units. Capital spending
rules sets limits on a sub-unit’s amount of capital expenditure (say, USD50,000), exceeding
which HQ approval must be obtained. It gives HQ additional control over how money is spent.
(c) Cultural Control
Cultural control requires an extensive socialization process whereby employees

absorb the norms and value systems of the firm, and share a corporate culture. When this
occurs, employees tend to control their own behavior, which reduces the need for direct
supervision. At Matsushita, for example, new managers spend their early months attending
cultural and spiritual training to build a common vision and values. They study the company
credo, the Seven Spirits of Matsushita, and the philosophy of its founder, Konosuke
Matsushita. They will learn to translate these lessons into their daily behavior and decision
making.
Firms seldom purely use one type of control mechanism, but opt for a combination.
However, they may place different levels of emphasis on different types of performance
measures.
(d) Output Control

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Output control involves setting performance goals for sub-units to achieve, such as
profitability, productivity, growth, market share and quality. Goals depend on the subsidiaries’̂
role in the firm. Product divisions or subsidiaries are usually given goals for profitability, sales
growth and market share. Functional divisions are given goals related to their particular
activity, and R&D will be given product development goals. Performance goals are also
established through negotiations between HQ and sub-units. Control is achieved by
comparing actual performance against the targets and intervening to take corrective action.
If goals are met or exceeded, sub-unit managers will be rewarded. If they are not met,
HQ or top management will intervene to find out why and take the appropriate corrective action
to look for ways to improve. Managers may also be replaced.
D. Managing Change
Change management is another important aspect in international firms. An

organization change refers to any significant alteration in a firm’s strategy, organizational
structure, technology, culture or employees. The international environment is never static, thus
managing change in ways that enhance a firm’s productivity and profitability is a continual
challenge faced by firms.
(a) Reasons for Change
Firms need to change for several reasons. The most significant is when there are
changes in the environment in which the firm operates. New markets may open, while other
markets shrink in size. For example, upon completion of the European Union’s (EU) internal
market, firms must develop appropriate strategies. Some firms rearranged production among
their existing factories to benefit from economies of scale, others restructured their product
lines, and yet others buy over their competitors to widen their presence within the EU. Firms
also have to improve their productivity and quality in meeting increased competition.
Technology requires firms to make changes in work roles and reporting systems. For
example, personal computers in the workplace reduced the need for mainframe computers
and altered the role of corporate management information systems staff. Advances in
telecommunications technology have also allowed computer firms to establish joint ventures
with foreign software suppliers, which software is then transmitted electronically via satellite.
Cultural values and norms can also drive firms to undertake organizational change.
Decrease in the consumption of tobacco products in the United States, for example, caused
firms like Phillip Morris to diversify into other products. Changing strategies, Phillip Morris
purchased General Foods and Kraft, and aggressively entered the European market.
(b) Instituting Change
How firms initiate or introduce change is important so that any resistance to change
can be overcome and ensure success in the international arena. Several issues and
approaches are mentioned as follows.
i. When change disrupts basic values, such as those that are against religion, the people
affected may resist it. It is much easier to adapt to things that do not challenge our
value systems than to things that do.
ii. Any adjustments made abroad must take into account the costs or benefits of the
change. Some adjustments can improve performance, such as productivity or sales.
Other changes may only improve performance marginally. Some adjustments are
costly, while others are inexpensive.
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iii. Resistance to change may be lower if the number of changes is not too many. Firms
should not demand too much adjustment at one time and introduce new policies more
slowly.
iv. Discuss changes with those affected and allow them to participate in the decision to
change. For example, employees may be more satisfied if management listened to
their views, even though management make decisions contrary to the employees’
suggestions.
v. Individuals or groups who must support change should receive some benefits from the
change. For example, firms may develop a bonus system to reward productivity and
quality based on the new approach.
vi. Firms should locate opinion leaders, who can play a strong role in influencing others,
to help speed up the acceptance of change. As examples, workers in Mexico may be
more willing to listen to their peers rather than supervisors, and in India and Korea,
opinion leaders are generally older people.
vii. Firms should implement change when resistance is likely to be low. For example,
labor-saving production methods may make employees fear that they will lose their
jobs. Such measures should therefore be introduced in times of labor shortage.
viii. Firms should not only bring their home-grown expertise abroad, but also learn from
whichever country they operate. These experiences should then be capitalized not
only in their own country but among all the countries in which it operates the
transnational practice.
ACTIVITY 6.3
Which type of organizational structure does Samsung use?
Discuss with your classmates on our group page.
Task Reminder
INTERNATIONAL MARKETING MANAGEMENT

In determining the product, pricing, promotion and distribution strategies to satisfy individual
and organizational objectives across different countries, a firm needs to first determine whether a
mass produced or standardized product is appropriate. When it is not appropriate, firms have to adapt
and adjust their marketing strategy accordingly. While the firm needs to consider the additional cost
of adapting, neglecting the differences in consumer taste and preferences among countries can lead
to failure.
In the following subtopics, we shall discuss several major problems as well as ways they can
be overcome in respect of the marketing mix of international firms.
A. Product Attributes
Products can sell well when their attributes match consumer needs. For example, the
attributes of a car includes its power, design, quality, performance, fuel consumption and
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comfort. Consumer needs, however, vary from country to country depending on their culture
and level of economic development. Product sales are also constrained by a country’s different
product standards.
(a) Cultural Differences
As we have learned, consumer tastes and preferences are influenced by cultural

elements, the most important of which is customs and tradition. It particularly impacts
consumers’ consumption habits. Thus, different types of food and drinks are consumed and
favored across different countries. Scent preferences also differ from one country to another.
Thus, a range of other cultural differences exist between countries, although some cultural
convergence has occurred.
(b) Economic Development
The level of economic development of a country can influence consumer behavior.

Consumers in highly developed countries prefer a lot of extra performance attributes in their
products, while consumers in less developed countries prefer more basic products and
product reliability may be more important. These differences can be attributed to their different
levels of income and purchasing power.
(c) Product and Technical Standards
Mass production and marketing of a standardized product is also not possible due to
different product standards imposed by the government of various countries. Firms also have
to incur additional cost when products have to be modified to meet the different standards and
specifications. Technical standards such as for video equipment and television frequency
signals also limit the firm’s ability to standardize their products.
B. Pricing Strategy
We shall study three aspects of international pricing strategies, i.e. price discrimination,
strategic pricing methods and government regulations that limit a firm’s ability to set prices
that it would prefer.
a. Price Discrimination
Price discrimination, by charging different prices for the same product in

different countries, can help a firm maximize its profits. If a firm has a monopoly,
it can charge as high a price as the market will bear, while prices have to be
lower in a competitive market.
However, two conditions must exist before price discrimination can work. First,
the firm must be able to keep its country markets separate. For example, a Ford
Escort may cost USD2,000 more in Germany than in Belgium. If Ford cannot
keep the two markets separate, car dealers can buy Escorts in Belgium and
sell them in Germany slightly lower than Ford was selling and make a profit.
The second condition is that there must be different price elasticity’s of demand
in different countries. In countries where demand is inelastic, i.e. when a large
change in price produces only a small change in demand, firms may charge a
higher price. Demand is said to be elastic when a small change in price results
in a large change in demand. The two most important factors that determine
elasticity are income levels and competitive conditions. When consumers’
incomes are limited, they tend to be very price conscious and when there are
many competitors, consumers may buy from the firm that charges the lowest
price.
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b. Strategic Pricing
Strategic pricing consists of three types as follows:
 Predatory pricing – Refers to using price as a competitive weapon to drive

weaker competitors out of the market. Once competitors have left the
market, the firm can raise prices and enjoy high profits.
 Multipoint pricing – Refers to a firm’s pricing strategy in one market which

impacts its competitors’ pricing strategies in another market. For example,
when Fuji cut the prices of film rolls in the US, Kodak responded by
aggressively cutting their prices in Japan. Fuji eventually withdrew its
aggressive stance in the US.
 Experience curve pricing – Refers to fixing low prices in an attempt to

build global sales as quickly as possible. The larger sales volume would
allow the firm to move down the experience curve and enjoy economies of
scale.
c. Government Regulations
Regulations, such as anti-dumping regulations and competitive policies, may

limit a firm’s ability to implement price discrimination or strategic pricing
strategies.
 Anti-dumping regulations – Dumping means selling a product for a price

that is less than the cost of producing it. Governments may impose anti-
dumping regulations by charge higher duties on imports of products found
to have violated anti-dumping regulations.
 Competitive policy – Most industrialized countries have laws to promote

fair competition and restrict monopoly practices, which can be used to limit
the prices a firm can charge in a particular country. For example, Hoffman-
La Roche (a Swiss pharmaceutical manufacturer) was found overcharging
their tranquilizers and was ordered to reduce its prices by 35 to 40 per cent
by the British government.
ACTIVITY 6.4
Let us suppose that your firm sells electric appliances in two different countries, which is Country “A”
and Country “B”. It is strategized that the appliances sold in one country cannot be used in the other
country because each of these countries uses a different voltage system. The average income level in
Country “B” is well above that found in Country “A”. Besides that, many other firms are selling the same
electric appliances in Country “A”. There are very few competitors in Country “B.”
What strategy should your firm pursue to increase its profits?
C. Communication Strategy
In communicating product attributes to prospective customers in another country,

several communication channels are available including direct selling, sales promotion, direct
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marketing and advertising. Some firms use several channels simultaneously to communicate
their message. However, the effectiveness of a firm’s international communication can be
jeopardized by cultural barriers, source effects and noise levels. We shall discuss these three
factors in the following:
(a) Cultural Barriers
Due to cultural barriers, a message that means one thing in one country may mean
something different in another country. For example, Benetton had won an award in France
for their advertisement which featured a black man and a white man handcuffed together. The
advertisement was attacked by US civil rights groups for promoting racial discrimination, and
Benetton had to withdraw it. Cultural differences restrict a firm from using the same marketing
message and selling approach all over the world.
Apart from developing cultural literacy, the firm should use a local advertising agency
to develop its marketing message, and employ a local sales force if the firm uses direct selling.
(b) Source and Country of Origin Effects
Source effects occur when the receiver of the message, for example the potential
consumer, evaluates the message based on the status or image of the sender. It can be
damaging for an international firm if the potential consumers have a bias against foreign firms.
One way to overcome source effects is to de-emphasize the products’̂ foreign origin.
Country of origin effects refers to the extent to which potential consumers evaluate
products based on the place of manufacture, especially when the consumer lacks adequate
knowledge of the product. When there is a negative country of origin effect, the firm may have
to use promotional messages that strongly stress the positive attributes of the product.
However, source and country of origin effects can also be positive. For example, Italian
clothes and German cars enjoy positive source effects universally. In such cases, the firm
should emphasize its foreign origins.
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(c) Noise Levels
Noise refers to the amount of other messages competing for potential consumers’
attention. It tends to reduce the effectiveness of communication. Noise levels also vary among
countries, tending to be high in developed countries and lower in developing countries.
D. Distribution Strategy
Distribution is the process of getting products and services from the firm into the hands of
customers. In this subtopic, we shall discuss selecting the means by which to offer its goods
for sale in the markets it wants to serve.
Channels of Distribution
A typical distribution system consists of a channel that includes a wholesale distributor

and a retailer. Distribution systems between countries may vary according to its retail
concentration, channel length or channel exclusivity, each of which we will study in the
following.
(a) Retail Concentration
A retail system may be concentrated, which means that there are a few retailers
which supply most of the market. While in a fragmented retail system, there are many
retailers but no one has a major share of the market.
In densely populated countries like Japan, which also has a large number of
urban centers, the retail system is more fragmented with many small stores that serve
local neighborhoods and to which people frequently walk to. The small retailers also
enjoy government legal protection. These small retailers can obstruct the setting up of
a large retail outlet by petitioning to their local government.
The retail systems in many developing countries are also very fragmented, but
for different reasons. In India, for example, Unilever has to sell to 600,000 rural villages
by means of bullock carts or bicycles since they do not have proper roads.
In other countries, like the United States and France, the retail system is more
concentrated. The increase in the number of car ownership, number of households
with refrigerators and freezers, and the number of two-income households have
contributed to the growth of large retail firms such as Wal-Mart and Carrefour.
(b) Channel Length
Channel length means the number of intermediaries between the manufacturer

and the consumer. When a manufacturer sells directly to the consumer, the channel is
very short. If the manufacturer has to sell through an import agent, a wholesaler and a
retailer, a long channel exists. Channel length is determined most importantly by the
degree to which the channel system is fragmented because it encourages more
wholesalers to emerge to serve retailers.
For the producer, the more fragmented the retail system, the more expensive
it is to sell directly to so many small retailers, each yielding only a small order. The
producer firm would also need a large sales force. Thus, it is more economical for the
producer to sell to wholesalers and the wholesalers to deal with the retailers. When
the retail system is concentrated, the firm would deal directly with retailers, cutting out
the need for wholesalers.
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(c) Channel Exclusivity
An exclusive distribution channel is one that is difficult for firms to gain access,
such as shelf space in supermarkets. Reputable and long-established producers enjoy
exclusivity because retailers prefer to carry their products rather than the products of
new or unknown firms. In Japan, for example, manufacturers, wholesalers and retailers
have long established relationships. Based on this relationship plus an attractive mark-
up offered by the manufacturer, distributors will not carry the products of competitors.
Thus, many US and European manufacturers find it difficult to gain access to the
Japanese market.
In choosing the optimal distribution strategy, firms have to consider the relative
costs and benefits of each alternative. The relative costs and benefits may vary from
country to country depending on the three factors – retail concentration, channel length
and channel exclusivity.
ACTIVITY 6.5
Can you suggest any product or product line that requires little or no modifications in marketing
strategies wherever in the world they are being sold? Discuss with your classmates in our group page.
Task Reminder
INTERNATIONAL FINANCIAL MANAGEMENT

Firms engaged in international business are confronted with the problem of having to trust
parties they may have never seen or met, who abide by a different legal system and who could be
very difficult to track down if they default on an obligation.
For example, a United States firm exporting to an importer in France might fear that if he ships
the products to France before he receives payment, she might take delivery of the products and not
pay him. On the other hand, the French importer might worry that if she pays for the products before
they are shipped, the US firm might keep the money and never ship the products, or might ship
defective products. Each has his or her own preferences to protect his or her interests. While the
United States exporter would prefer the French importer to pay for the products before they are
shipped, the French firm would prefer not to make payment for the goods until they arrive.
To overcome this problem, a third party, normally a reputable bank (which both parties can
trust) is used to act as an intermediary. The following subtopic explains the payment and collection
procedures in detail.
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A. Methods of International Payment
There are two methods of payment involving the bank. The first is known as the documentary
collection method whereby the bank acts merely as an agent to facilitate the collection of
funds. In the second method, called the letter of credit (L/C) collection method, the bank is
directly involved in the transaction by guaranteeing payment to the exporter on behalf of the
importer. We shall study these methods in detail.
(a) Documentary Collection Method
Step 1:
Buyer and seller agree on the terms of the contract, including the buyer’s obligation to make
payment upon delivery of the following normally required documents:
(i) An invoice (or packing list) which details the price and description of the merchandise.
(ii) A draft (also called a bill of exchange). The draft is an order written by an exporter (drawer)
instructing the importer (drawee) to pay a specified amount of money at a specified time. There
are two major types of draft. A sight draft requires payment to be made upon the transfer of
title (i.e. ownership) to the goods from the exporter to the importer. When the bank in the
importer’s country receives the sight draft from the exporter’s bank, it shall notify the importer
who then pays the draft. Upon payment, the bank shall give the bill of lading to the importer
who can then take delivery of the goods.
A time draft allows for payment to be delayed, normally or 30, 60, 90 or 120 days. Once
accepted by the importer by stamping a notice of acceptance on the draft, it becomes a
promise to pay by the importer.
(iii) A bill of lading is issued by the carrier company to the exporter. It serves three purposes.
First, as an acknowledgement of receipt to indicate that the carrier has received the
merchandise described in the document; secondly, as contract obligating the carrier to deliver
the goods to the designated destination; and thirdly, as a document of title to the merchandise
which shall be transferred to the importer upon final payment.
Step 2:
The seller ships the merchandise as consigned in the bill of lading to the collecting
bank in the foreign country (Hong Kong). The seller draws the draft, payable on sight of the
documents, and delivers it to the remitting bank (in the United States) together with all other
documents.
Step 3:
The United States bank sends the documents with instructions to the collecting bank.
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Step 4:
When the merchandise arrives in Hong Kong, the shipping company notifies the
collecting bank. The collecting bank advises the buyer that the cargo has arrived and that
payment is due. The buyer accepts the draft and makes payment. The collecting bank then
endorses the bill of lading to the buyer, which allows the buyer to take delivery of the
merchandise from the port. The funds collected are then forwarded to the seller through the
remitting bank.
Using the method mentioned, the seller is able to control the merchandise until
payment is made. However, there is some degree of risk for the seller. The buyer may not
accept the draft and make payment (a non-acceptance) leaving the buyer with only a few
options arrange to ship the merchandise back to the US, try to find another buyer, abandon
the merchandise at the port, or renegotiate the contract with the original buyer. Due to these
risks, the documentary collection method is usually used only between subsidiaries of the
same company or with a customer whom the seller has had a long and excellent relationship
with.
(b) Letter of Credit Collection Method
Figure 6.10 illustrates the letter of credit collection method. In this method, all the
documents are as in the documentary collection method with the exception of an additional
document, called the letter of credit. The letter of credit is an undertaking by a bank to
guarantee payment to the exporter (seller) upon fulfillment of the terms set forth in the letter,
usually the presentation of the required shipping and export documents. While the banks
merely act as intermediaries in the documentary collection, they are parties directly involved
under the letter of credit method.
The procedure can be simplified to seven different steps as follows:
 Step 1:
o The buyer and seller agree on the terms of the contract, which includes the buyer’s
obligation to furnish the seller with a confirmed, irrevocable (cannot be changed or
altered) letter of credit.
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 Step 2:
o The buyer applies to the bank in his area for a letter of credit. (The bank evaluates the
application in the same way as in a loan application.)
 Step 3:
o Assuming the bank approves the letter of credit application, it will issue the letter of
credit, guaranteeing payment to the seller if the terms of the letter are met. The letter
of credit is then forwarded to a bank in the seller’s area.
 Step 4:
o The appointed bank in the seller’s area (advising bank) advises the seller that he is the
beneficiary of the issuing bank’s letter of credit. The confirming bank (may also be the
advising bank) further adds its guarantee of payment to that of the issuing bank’s.
 Step 5:
o The seller ships the merchandise and presents the documents specified in the letter of
credit (usually the invoice, draft, bill of lading) to the confirming bank. When the
confirming bank accepts the documents, the seller will be paid.
 Step 6:
o The confirming bank forwards the documents to the issuing bank.
 Step 7:
o The issuing bank endorses the bill of lading over to the buyer allowing the buyer to
collect the merchandise.
In the event the buyer refuses to make payment under this procedure, this is a problem
of the issuing bank. The arrangement between the applicant (buyer) and the issuing bank is
of no concern to the seller. As long as the seller has provided the documents as specified in
the letter of credit, the transaction is completed and the seller is entitled to payment. Thus, the
interest of both the buyer and the seller can be protected.
B. Managing Working Capital and Cash Flow
The task of managing working capital and cash balances is more complicated for
international firms than for domestic firms. International firms’̂ dealings involve foreign
subsidiaries and foreign markets each using a different currency. The processes involve three
corporate financial goals, and they are to:
● Minimize working capital balances;

● Minimize currency conversion costs; and
● Minimize foreign exchange risks.
(a) Minimizing Working Capital Balances
Working capital is required to facilitate the firm’s day-to-day transactions and to cover
against unexpected demands for cash. As the rate of return on working capital is low, financial
managers prefer to invest surplus cash in some other form so as to earn higher rates of return.
At the same time, a firm needs to maintain sufficient cash balance to pay workers or suppliers.
Running out of cash may result in expensive emergency borrowings or a loss of reputation
that may cause suppliers and lenders to cut off their lines of credit. Thus, the firm has to
balance their need for cash against the cost of holding assets which yield low returns.
A centralized cash management system can be used, whereby a central cash manager
in the Treasury Division at HQ coordinates the firm’s worldwide cash flows. Each subsidiary
provides the central cash manager with a daily cash report and an analysis of its expected
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cash balances and needs over the short-term which will be used to decide how much cash
each subsidiary should hold. Cash in excess of their needs will be sent to a central corporate
bank account. The pooled funds can be channeled to subsidiaries with an unexpected or
emergency need for cash, and also investing in short-term opportunities available. Thus, the
firm is able to reduce the precautionary cash balances held as a whole and reduce their assets
from being tied up in low returns accounts.
(b) Minimizing Currency Conversion Costs
International firms’ subsidiaries continually buy and sell parts and finished goods
among themselves. Thus, there is a constant need to transfer funds among the subsidiaries’
bank accounts. The bank charges for transferring these funds and charges for converting
currencies involved can be substantial.
These costs can be reduced by the subsidiaries engaging in a process of bilateral

netting i.e. between two subsidiaries. For example, a firm’s Mexican subsidiary has to convert
US$1 million worth of pesos into sterling pounds and the British subsidiary has to convert
US$3 million worth of pounds into pesos. Instead of incurring so much transfer charges and
cost of conversion, the British subsidiary can simply pay the Mexican subsidiary the difference
of US$2 million in pesos. These costs can be reduced further by multilateral netting, a similar
process but involving three or more subsidiaries.
(c) Minimizing Foreign Exchange
Currency values may appreciate or depreciate in value. Firms therefore try to increase
their net holdings of currencies that are expected to rise and decrease net holdings of
currencies that are expected to fall in value. For example, if the Thai baht is expected to decline
in value, the firm’s financial officers would try to minimize the firm’s holding of baht-
denominated assets by demanding that transactions in baht be paid quicker (a process known
as leading) or by reducing their baht bank balances. Firms may also try to delay payments in
baht (known as lagging) or by increasing their short-term baht denominated borrowings. If the
currency is expected to rise in value, the same techniques can be employed in reverse.
C. Source of Investment Capital
Capital funds are required to finance a firm’s expansion in foreign markets. If capital is
provided by the owners of the firm, it is called equity capital. If it is obtained through borrowings
such as from banks, it is called debt capital. These funds can be obtained from the following
major sources:
(a) Euro Note Market
Large international firms are sometimes larger and more creditworthy than the banks
they are borrowing from. Therefore, instead of borrowing from the banks, these firms sell their
own debt notes directly to the market to obtain funds and bypass the costs of bank borrowings.
These notes are known as commercial paper. In international money markets, they are known
as Euro- commercial paper.
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(b) International Bond Market
A bond is a debt instrument carrying a promise by the firm to repay the principal along
with interest on a specified date. For example, Royal Dutch Shell sells global bonds
denominated in US dollar and Euros to raise USD1 billion and €500 million respectively. The
US dollar bond will carry a maturity period of 10 years, while the €500 million bonds will have
a seven-year maturity.
(c) International Equity Market
Foreign firms may issue new shares in foreign stock markets by listing their shares on
major stock exchanges, such as New York, Tokyo or London.
(d) Private Placements
A private placement is the sale of debt or equity to a large investor. The sale is normally
a one-time transaction in which the investor holds the bond until maturity (if debt) or until hold
the shares until it is repurchased by the firm (if equity).
Task Reminder
HUMAN RESOURCE MANAGEMENT

Differences in culture, levels of economic development and legal systems among the countries
where a firm operates require firms to customize its recruiting, terminating, training and compensation
policies between countries.
A. Types of Staffing Policy
Staffing policy refers to the selection of employees for particular jobs. It does not only
concern selecting individuals who possess the necessary skills, but it also whose behaviors,
beliefs and value systems are consistent with the firm’s corporate culture.
In international business, there are three types of staffing policies: the ethnocentric
approach, the polycentric approach and the geocentric approach.
(a) The Ethnocentric Approach
In an ethnocentric staffing policy, key management positions are held by the parent
country’s personnel. For example, all the important positions in the foreign subsidiaries of
Dutch firm Phillips would be held by Dutch nationals. Firms pursue this type of policy because
they believe that:
i. The host country lacks qualified individuals to fill these senior positions, especially in less
developed countries;
ii. This policy is the best way to maintain a unified corporate culture. Parent country managers
would have been fully socialized into the firm’s culture while employed in the home country;
and
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iii. This is the best way to transfer core competencies to a foreign operation, i.e. by transferring
parent country personnel who have the skills and knowledge of that competency to the foreign
subsidiary.
However, this practice is declining because it limits career advancement opportunities

for the host country personnel, which may lead to dissatisfaction, lower productivity and higher
turnover. An ethnocentric staffing policy can also cause firms to fail to understand the cultural
differences in host country marketing and management termed as “cultural myopia”.
(b) The Polycentric Approach
A polycentric policy requires that host country nationals be recruited to manage the
subsidiaries. Parent country nationals would occupy the key positions at corporate
headquarters. This policy has two advantages:
i. It reduces the likelihood of cultural myopia. Host country nationals are unlikely to commit
mistakes arising from cultural misunderstanding; and
ii. It is less expensive to maintain host country nationals compared to parent country nationals.
iii. The polycentric approach also has disadvantages, as follows:
(i) A gap may develop between host country managers and parent country
managers due to the cultural differences. This may lead to a lack of
integration and isolation between corporate headquarters and foreign
subsidiaries, making coordination and implementation of strategies difficult;
and
(ii) Host country nationals’ progress may be limited to the senior positions
within their own subsidiary with limited opportunities to gain experience
outside their own country.
(c) The Geocentric Approach
The geocentric staffing policy recruits the best people for key management positions
throughout the organization, regardless of nationality. As advantages, this policy enables the
firm to:
i. Make the best use of its human resources;

ii. Build a team of international executives who are comfortable working in a number of cultures
and suffers no cultural myopia; and
iii. Better capitalize on the multidirectional transfer of core competencies compared to the other
approaches.
However, the firm’s ability to pursue this policy may be limited by host country laws
that require foreign subsidiaries to employ their citizens. A geocentric policy can also be very
expensive because of the higher compensation structure enjoyed by geocentric managers
and may cause resentment within the firm.
Firms may also vary their staffing policies from subsidiary to subsidiary, managing
some on an ethnocentric basis and others on a polycentric or geocentric basis.
ACTIVITY 6.6
What would generally be the most appropriate staffing policy approach for a firm pursuing an
international, multidomestic and transnational business strategy? Why?
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B. Managing Expatriates
Expatriates are citizens of one country who are working in another country. For
example, a Filipino citizen working in Japan as an expatriate manager. One important issue
concerning these managers is expatriate failure, i.e. the premature return of an expatriate
manager to his home country, which incurs a high cost to the parent firm. The reasons for this
failure are as follows:
 Inability to cope with larger overseas responsibilities;

 Manager’s inability to adjust;
 Spouse’s inability to adjust;
 Personal or emotional problems;
 Lack of technical competence; and
 Other family problems.
The order of importance, however, may vary among parent companies. For example,
for Japanese firms the most common reason is the managers’ inability to cope with larger
overseas responsibilities, but for US firms the top reason is the inability of the managers’
spouses to adjust in the new foreign environment.
(a) Expatriate Selection and Training
Research conducted by Mendenhall and Oddou stated that expatriates’ tendency to equate
domestic performance with overseas performance potential as a major cause of expatriate
failure in many firms. A manager who performs well in the domestic environment may not be
able to adapt to managing in a different cultural environment. They further identified that
success in a foreign posting may depend on the following characteristics of the manager:
(i) Self-orientation – An expatriate with high self-esteem, self confidence and

mental strength is more likely to be able to adapt.
(ii) Others-orientation – Willingness to communicate using the host country’s

language and to develop relationships with host country nationals.
(iii) Perceptual ability – Ability to understand and appreciate why people of other
countries behave the way they do and not treat them as if they were home
country nationals.
(iv) Cultural-toughness – Refers to how well an expatriate adjusts to postings to

„tougher‰ countries whose culture is more unfamiliar and uncomfortable. For
example, some countries may have poor health care and housing standards,
inhospitable climates, lack of western entertainment (for western country
nationals) and difficulties in language.
The next step after selecting the manager with the four above mentioned attributes,
the manager has to be trained to undertake a specific job and equip themselves with the skills
required for success in a foreign posting. The types of training are:
(i) Cultural Training

It involves training not only the manager, but also the manager’s whole
family, in the host country’s culture, history, politics, economy, religion, and
social and business practices to foster appreciation.
(ii) Language Training
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Although it is possible to conduct business all over the world using only
English, a willingness to communicate using the local language can help
build rapport and with local employees and increase the manager’s
effectiveness. A foreign language training enables managers to relate more
easily to a foreign culture and foster a better image of the firm.
(iii) Practical Training
This may take the form of arranging a familiarization trip to the host country
before the formal posting so as to ease culture shock. Where there exists
an expatriate community, firms ensure that the new expatriate family is
quickly integrated into the group which serves as a support network of
friends and information.
Another important issue is that firms tend to overlook preparing expatriate

managers for re-entry into their home-country organization upon
completion of their foreign assignment. A research study revealed that
many expatriates did not know what their new position would be when they
returned home and were uncertain about their new roles and future career
development, while some were given lower level jobs. Thus, firms lose the
knowledge, skills and capabilities of these expatriates when they leave to
take up new jobs at other firms. Firms should carefully plan to re-integrate
them back into the home-country organization.
ACTIVITY 6.7
In general, most countries differ in its compensation practices and this raises a difficult question for an
international business. Should the firm pay executives in different countries according to the standards
in each country or standardize pay on a global basis? Why?
C. Performance Appraisal and Compensation
The issue of performance appraisal and compensation concerns how best to evaluate
the expatriate managers’̂ performance and how to adjust compensation according to different
country’s economic and compensation practices.
(a) Problems in Performance Appraisal
The expatriates’ performance appraisal by headquarters management are seen as

unfair and does not fully appreciate their skills and experience, due to reasons of unintentional
bias. Expatriate managers may be evaluated by two groups i.e. host-country management
and home-country management who are both subject to bias.
For example, an expatriate manager introduced participative decision making while

working in a subsidiary in India. Due to the social stratification in India, the host-country
management viewed this negatively, since expatriate managers are looked upon as experts
who should not ask subordinates for help in making decisions.
Home-country managers may rely solely on hard data, such as the subsidiary’s
productivity, profitability or market share when evaluating an expatriate manager’s
performance. Due to the distance and lack of working experience abroad, home-country
managers fail to take into account factors that are beyond the expatriate manager’s control,
such as adverse changes in exchange rates and economic downturns. The expatriate
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manager’s other less visible abilities (or “soft variables’), such as ability to develop cross-
cultural awareness and to work productively with local managers were neglected.
Several steps can be taken to reduce these biases. First, more weight should be given
to an on-site manager’s appraisal than to an off-site manager’s appraisal. The on-site manager
is more likely to evaluate the soft variables. The on-site manager should also be of the same
nationality as the expatriate manager to avoid cultural bias and should preferably be one who
has served in the same location. Lastly, the on-site manager should consult home- country
managers in termination evaluations to balance any cultural misunderstanding.
(b) Compensation Issues
International firms face the question of whether to pay executives in different countries
according to each country’s standards or to equalize pay on a global basis. In a polycentric
policy, pay can follow each country’s standards because of the manager’s lack of mobility
among different countries, while an ethnocentric firm can formulate a common pay scheme
for all expatriates. However, problems arise with geocentric policies because expatriate
managers include many different nationalities.
A firm’s compensation package must be effective in:
i. Providing an incentive to leave the home country on a foreign assignment;

ii. Maintaining a given standard of living;
iii. Taking into consideration career and family needs; and
iv. Facilitating re-entry into the home country.
The components of a typical expatriate compensation package consist of the following:
i. Base salary – Is normally similar in amount as for a similar position in the home-country.
ii. Foreign service premium – Is extra pay for working outside their country of origin, as an
incentive to accept foreign assignments.
iii. Allowances – May include hardship allowances (for ’tough’ locations), housing allowances,
cost of living allowances and education allowances for expatriate children.
iv. Taxation – May be higher than home country rates or expatriates may have to pay taxes both
in the host-country and home-country. Firms may pay whatever difference in the higher
amount of tax so that the expatriates’ take-home pay would not be reduced.
v. Benefits – Refer to medical and pension benefits.
D. International Labor Relations
The human resource management function of an international business firm is also to

foster harmony and minimize conflict between the firm and organized labor (i.e. trade unions).
Labor unions generally work to better the interests of the workers they represent, such
as better pay, greater job security and better working conditions through negotiations with
management. Their bargaining power is derived from threats to disrupt production, such as
through protests and strikes. Unions are most concerned about multinational firms because
their bargaining power can be reduced by the firm’s power to shift their operations to another
country. The other concern is that international firms employ only low-skilled tasks in foreign
operations, while keeping highly-skilled jobs in their home-country. This also makes it easy for
a firm to switch production from one location to another. Unions also fear that when firms
import employment practices from the firm’s home- country, their influence and power will be
reduced.
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Although labor unions have tried to increase their bargaining power by establishing
international labor organizations, by lobbying for governments to impose restrictions on
multinationals and by trying to achieve international regulations on multinationals through the
United Nations, these efforts have not been very successful.
International firms approach labor relations differently from each other. In a

decentralized approach, labor relations activities are left to their foreign subsidiaries to
manage because of varying labor laws, union power and the nature of collective bargaining.
Other firms use a centralized approach to labor relations in order to control labor costs, which
accounts for a large percentage of total costs. Centralized decisions are required if firms were
to move production to other countries which involve major new investments and plant closures.
Task Reminder
SUMMARY
● At the most advanced stage, the globalization stage, firms may be structured according to four
basic structure types, i.e. a product, functional, geographic/ area and matrix division structure.
● Since organizational structures are designed for the purpose of allocating resources and tasks
across its worldwide operations, firms more often use a combination of designs in their overall
organizational structure according to what fits their strategies and objectives best.
● Business activities further require an effective control system to ensure that objectives can be
met, and to take corrective measures if otherwise.
● Relevant aspects of international marketing according to the four components of product,

price, communication and distribution were also explained.
● Important issues arise mainly due to the different marketing environments abroad, especially
whether marketing strategies and programs should be standardized worldwide or customized
to suit each market’s unique needs.
● While customization incurs high costs, neglecting to take into account the different market
needs may lead to failure.
● We further discussed the issue of trust and the risk exporters and importers have to bear when
they are engaged in international transactions.
● We learned how a third party, the bank, can act as an intermediary to overcome this mistrust.
● Firms also strongly need a competent cash flow and working capital management system to
ensure they are able to maintain sufficient cash to meet daily expenditures while ensuring a
decent return on their short-term assets and to avoid the risk of a fall in the value of the
currencies that the firm holds.
● These tasks can be performed by centralized monitoring and control by headquarters.
● In the final section of the topic, we focused on the important issues in managing human
resources across many countries.
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● In staffing, there are three different approaches the ethnocentric, polycentric and geocentric
policies.
● Next, we discussed the issue of adequately preparing expatriate managers to ensure a

successful foreign posting, how their performance can be appropriately appraised and their
re-entry into the home-country organization.
● The nature of expatriate compensation systems, which should be adequate for their needs as
well as being able to provide an incentive were also discussed.
● Lastly, we studied the role of trade unions and how firms can manage their international labor
relations better, whether through centralizing or decentralizing labor relations decisions
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EXERCISES
EXERCISE 6.1
1. Which of the following organizational structure division is ideal when the firm’s products and
production methods are basically similar worldwide?
A. International
B. Functional
C. Product
D. Matrix
2. Interdependence among division and the exchange of information and resources are features of
a ____________ structure organization.
A. geographic
B. functional
C. matrix
D. product
3. When successfully implemented, which type of control system would require the least amount of
direct supervision?
A. Personal
B. Bureaucratic
C. Output
D. Cultural
4. In a matrix structure, a subsidiary has to report to more than one group.

A. True
B. False
5. As product lines become more diverse, a firm is likely to shift from a product to a functional
structure.
A. True
B. False
6. In determining the level of autonomy, power and control that firms wish to grant to its foreign
subsidiaries, what are the three different approaches available?
7. Explain what are the major factors that may require a firm to change its strategies, organizational
structure, technology or employees in today’s dynamic environment.
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EXERCISE 6.2
1. The most important factors a firm must consider in their product attributes to match them with the
needs of consumers are as follows, EXCEPT:
A. Cultural elements, especially customs and traditions.
B. The level of economic development of countries.
C. The degree of retail concentration of countries.
D. Product and technical standards of countries.
2. Which of the following is generally not true about “channel length”
in a more fragmented retail system?
A. It is more expensive to sell directly to the many small retailers.
B. A larger sales force is required to service the retailers.
C. It is more economical to deal with wholesalers.
D. Firms need not use the services of wholesalers.
3. Negative “source effects” in product communications/messages can develop when consumers:
A. Evaluate products based on the status or image of the sender.
B. Lack adequate knowledge of the product concerned.
C. Evaluate products based on the product’s place of manufacture.
D. Have a bias against foreign firms.
4. Price discrimination is the charging of different prices for similar products in different countries to
maximize profits.
A. True
B. False
5. The greatest potential cost savings are through the standardization of products.
A. True
B. False
6. Explain the three types of strategic pricing methods firms can use in their international marketing
programs.
What is meant by the term “channel exclusivity”?
Mode of submission: _______________________ Date of discussion: _____________________
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EXERCISE 6.3
1. A firm mainly uses “netting” for cash flow management for the purpose of:
A. Eliminating foreign currency risk.
B. Reducing the volume of foreign currencies to be managed.
C. Diversifying its financing across several currencies.
D. Borrowing in foreign currencies.
2. All of the following are the main financial objectives of working capital and cash flow management,
EXCEPT:
A. To minimize working capital balances.
B. To minimize currency conversion costs.
C. To minimize purchases of raw materials.
D. To minimize foreign exchange risks.
3. Which of the following can be a source for both debt as well as equity capital?
A. Equity market
B. Bond market
C. Private placement
D. Euro note market
4. An applicant for a letter of credit deals directly with the advising bank.
A. True
B. False
5. A commercial bill of exchange that requires payment to be made immediately is known as a sight
draft.
A. True
B. False
6. What are the three major purposes of the bill of lading?
7. Explain in proper sequence the various steps in a documentary collection method.
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EXERCISE 6.4
1. “Cultural toughness” as a criterion of a successful expatriate manager means:

A. The superior physical strength of the manager.
B. The ability to speak many foreign languages.
C. The ability to adjust to an unfamiliar and uncomfortable foreign culture.
D. The ability to uphold one’s own culture in a foreign environment.
2. Expatriates are ____________.

A. people who are naturalized citizens of a country.
B. people who are citizens of a third-country.
C. people working outside their home-country.
D. locals from the country of the foreign subsidiary.
3. All of the following were efforts made by labor unions to increase their bargaining power, EXCEPT:
A. Establishing international labor organizations.
B. Increasing the number of union membership.
C. Lobbying governments to impose restrictions on multinationals.
D. Trying to achieve international regulations on multinationals through the United Nations.
4. To reduce biases in the performance appraisals of expatriate managers, an off-site manager’s

evaluation should be given more weight than an on-site manager’s.
A. True
B. False
5. In a geocentric staffing policy, expatriates can be paid following country’s standards because of
the manager’s lack of mobility among different countries.
A. True
B. False
6. Distinguish between the ethnocentric, the polycentric and geocentric staffing policies.
7. Discuss the types of training that can be provided to managers to equip them with the skills
required for a successful foreign assignment.
Chapter 127
7 International Logistics and

Supply Chain Management
LEARNING OBJECTIVES

LEARNING CONTENTS
LO1.Explain the international logistics and the LC1. International Logistics

issues in “make or buy” decisions; LC2. Issues in International Logistics
LO2. Identify the issues of location decisions LC3. International Transportation
and inventory management in LC4. Supply Chain Management
international business;
LO3. Discuss the various modes of
international transportation and the
factors to consider in the selection of an
appropriate mode; and
LO4. Describe the concept of the supply
chain, use of information systems and
quality management.
INTRODUCTION
In this chapter, we will discuss international firms’ activities that involve the production and
distribution of products or services. As the distribution of products or services is frequently managed
as part of the marketing function in a firm, we shall be focusing more on the production aspects and
on physical products rather than services.
With activities dispersed around the globe, international firms are faced with the issue of
deciding where to locate their manufacturing facilities, whether they should be concentrated in a single
country or dispersed as well. They are further confronted with sourcing decisions, such as whether
they should make component parts for their final products themselves, or buy them from external
suppliers. In this respect, firms attempt to optimize their performance by striving for lower costs while
creating value in their activities to better serve customer needs. Then, we shall further discuss the
related topics pertaining to international modes of transport and inventory management, all of which
are part of the process of international logistics and can provide an important source of competitive
advantage to international firms. Finally, we shall study the concept of the supply chain and discuss
the issues of information systems and quality management of a global supply chain.
INTERNATIONAL LOGISTICS
Business logistics can be defined as the process of planning, implementing, and controlling the efficient,
cost-effective flow and storage of raw materials, in process inventory, finished goods, and related
information from point-of-origin to point-of-consumption for the purpose of conforming to customer
requirements. Sources: Council of Supply Chain Management Professionals
128
International logistics refer to the management of the flow of materials, parts, supplies and
other resources into, through and out of the international firm. This process consists of two major
stages:
(a) Materials Management
This stage of the process refers to the management of the flow of materials, parts, supplies
and other resources from suppliers to the firm and between subsidiaries within the firm itself. Materials
management, therefore, also includes sourcing, materials or parts inventory management,
transportation between suppliers and manufacturers.
ACTIVITY 7.1
How can the role of information and technology influence the materials management functions?
(b) Physical Distribution
The physical distribution stage involves the flow of finished products from the firm to the
customers. As in materials management, this stage also involves the selection of appropriate modes
of transportation, the carrying costs of inventory costs and speed of delivery to customers. Physical
distribution is often managed as part of a firm’s marketing function.
International logistics can be differed from domestic logistics based on two classifications of differences
which are basic differences and country differences.
Basic differences emerge because the firm deals with more than one country.
(i) Firstly, firms often have to ship goods over longer distances to reach their customers;
(ii) Secondly, it involves the use of different currencies;
(iii) Thirdly, countries differ in their border-crossing procedures such as documentations and
customs inspections. This may require the participation of additional intermediaries such
as freight forwarders, customs agents and banks; and
(iv) Lastly, the modes of transportation may also be different, such as trucks, railway and by
sea or air.
Country differences refer to the more specific attributes within each foreign country.
Transportation systems and intermediaries available may vary from country to country and freight
rates may be computed differently. The packaging and labelling requirements may also differ among
countries.
Logistics play an important role for firms in integrating their geographically dispersed
manufacturing and distribution networks where materials or components may be sourced from one
country, processed or assembled in a second country and sold in yet another country.
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Based on your reading, state two major stages involved in international logistics.
ACTIVITY 7.2
In your own words, what is the role of logistics in the management of international services?
Task Reminder
ISSUES IN INTERNATIONAL LOGISTICS

We shall study the issues or aspects in the materials management which require the
international firm to make important strategic considerations.
A. “Make-or-Buy” Decisions
These are sourcing decisions whether the firm should manufacture the component
parts for their final products or to outsource them i.e. buying from independent outside
suppliers. The extent to which the firm makes or buys the component parts that they require
production is known as vertical integration.
For example, a car contains more than 10,000 components. Ford in Europe makes
only about 45 per cent of the car’s value in its own plants. The remaining 55 per cent comes
from independent suppliers. However, firms like Nike and Reebok practice very little vertical
integration by outsourcing most of its production to outside suppliers in low-wage countries
like China and Thailand.
(a) Advantages of “Make” Decision
Apart from lower costs, manufacturing component parts itself would allow the firm to
invest in highly specialized assets, protect proprietary product technology and facilitate the
scheduling of related processes.
(i) Efficient in Productions
The firm may be more efficient in the production of the component parts than
any other firm. Boeing, for example, outsources some component parts to their aircraft,
but produces the aircraft wings in- house because it is more efficient compared to any
other firm in the world. It therefore makes little sense for Boeing to outsource this
particular activity.
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(ii) Facilitate Specialized Investments
Investment in specialized assets refers to investments in equipment that can

be used for a specific purpose in the manufacturing of a uniquely designed component.
As an example, Ford has developed a high-performance, high-quality and uniquely
designed fuel-injection system, which increased fuel efficiency, and can help sell more
Ford cars. To manufacture the fuel-injection system requires investments in
specialized equipment that can only be used for this particular purpose (i.e.,
specialized assets).
If Ford decides to outsource its manufacturing, the appointed independent

supplier may become dependent on Ford for business, since Ford is the only possible
customer. Ford is perceived to be in a stronger bargaining position, and might use its
position to force the supplier to lower its prices. On the other hand, Ford also might
become too dependent on the supplier for a vital component of the car. Ford cannot
obtain it from alternative suppliers who do not have the necessary specialized
equipment. The supplier may be perceived by Ford to have a stronger bargaining
power and use it to demand higher prices. This mutual dependency may result in Ford
manufacturing its own fuel-injection systems.
(iii) Protect Proprietary Product Technology
This refers to technology that is unique to a firm and gives the firm a competitive
advantage. The firm would not want the technology to fall into the hands of competitors.
Thus, the firm may prefer to make such component parts in-house to maintain control
over its technology.
(iv) Improved Scheduling
Through vertical integration, the firm may be able to save costs because it
makes planning, coordination and scheduling of related processes easier. For
example, Ford’s vertical integration into steel foundries, iron ore shipping and mining
made it possible for the firm to achieve tight coordination and scheduling enabling it to
produce engine blocks within 24 hours. Ford substantially reduced its iron ore inventory
holding costs.
(b) Advantages of “Buy” Decision
Buying component parts from independent suppliers allows the firm greater flexibility and
lowers the firm’s costs and may help the firm to secure orders from international customers.
(i) Flexibility
The firm can maintain flexibility by being able to switch to other suppliers as
circumstances require. The attractiveness of sources of supply may change with changes in
exchange rates, trade barriers and political instability. The firm can avoid these risks by
switching their orders to other suppliers from other countries.
(ii) Lower Costs
Vertical integration into the manufacture of component parts may increase the firm’s
cost structure, thus making it more advantageous to outsource their supplies. Firstly, the
additional manufacturing sub- units and their activities may bring greater problems of
coordination and control. More information has to be processed and the increased activities
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may be difficult to control effectively. The resulting inefficiencies may more than offset any
advantages that can be derived from vertical integration. Secondly, the manufacturing sub-
units may lack an incentive to reduce costs because it has a secure customer within the firm
and need not compete with other suppliers. Thirdly, the pricing for goods transferred to sub-
units within the firm can become a complex process because of different tax systems in the
countries where they are located, fluctuation in exchange rates and headquarter’s lack of
knowledge about local conditions. These problems can be avoided by buying the component
parts from outside suppliers.
(iii) Securing Orders from International Customers
By outsourcing some manufacturing to independent suppliers based in other countries,

it may help the firm to secure more orders from that country. For example, the Indian
government may ask Boeing to award some sub-contracting work to Indian manufacturers
before Air India places a large order for commercial aircraft.
When faced with these make-or-buy decisions, the firm has to consider which brings
them the most benefits. Manufacturing in-house may be most beneficial when highly
specialized assets are involved, or proprietary technology need to be protected, or when the
firm is simply more efficient than any other external supplier. When no such benefits exist, it
may be better to outsource production to take advantage of greater flexibility and control, or
gain from the larger orders that it may be able to secure. The table below highlights the
advantages of “make-or-buy” decisions.
Advantages of “Make or Buy” Decisions

MAKE BUY
 Efficient Production  Flexibility
 Facilitate Specialized Investments  Lower Costs
 Protect Proprietary Product  Securing Orders from International
Technology Customers
 Improved Scheduling
ACTIVITY 7.3
Let us suppose a firm must decide whether to produce a component part in-house or to outsource
to an independent supplier. To manufacture the component part, a high amount of investment is required,
while the most efficient suppliers are located in countries with fluctuating exchange rates. What are the
pros and cons of:
(a) Manufacturing the component part in-house; and

(b) Outsourcing to an independent supplier.
Which option would you recommend? Why?
B. Location Decisions
An international firm that chooses to make their own component parts rather than buy
them faces the decisions of where to locate its production. The firm’s decision must take into
consideration several factors that are country-related or product- related issues, government
policies and organizational issues. The table below shows the factors that influence the firm’s
location decisions.
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Factors that Influence the Firm’s Location Decisions

 Cost and availability of resources
Country-related Issues  Infrastructure support
 Country of origin effects
 Value-to-Weight ratio
Product-related Issues  Production technology
 Quick customer feedback
 Political stability
 Trade Policies
Government Policies
 Economic development incentives
 Foreign Trade Zones (FTZ)
 Business Strategies
Organizational Issues  Organizational Structure
 Inventory Management
(a) Country-related Issues
The most important features of countries that can influence the location decisions are:
(i) Cost and Availability of Resources
Countries that have abundant supply of a factor of production at low cost will attract
firms that require the factor. Thus, China was able to attract toys, footwear and textile
manufacturers because of a large and low-cost labor force.
(ii) Infrastructure
Manufacturing facilities require infrastructural support, such as construction

contractors, materials and equipment. For the facility to be utilized effectively, it requires
electrical, water, transportation and telephone services. It also requires adequate medical,
education, housing and other related services for its managers and employees and their
families.
(iii) Country of Origin Effects
Certain countries have such a high reputation for manufacturing high- quality products,
such as Italy for stylish design and Germany for engineering as opposed to a country like
Pakistan, that it can affect consumer preference towards a firm’s product. For example, it
would be easier to sell watches made in Germany than the ones made in Pakistan, especially
in industrialized countries. Therefore, firms wishing to market its product as high quality may
choose to be located in Germany or Japan, while firms competing on the basis of low costs
and prices may choose to be based in Pakistan or Indonesia.
(b) Product-related Issues
These are issues related to the product’s value-to-weight ratio, the production
technology required and customer feedback.
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(i) Value-to-weight Ratio
Goods with low value-to-weight ratios, such as iron ore, cement and coal tend to be
produced in many locations in order to minimize transport costs. Other goods such as
microprocessors or diamonds, which have high value-to-weight ratios, can be produced in a
single or a few locations without losing cost-competitiveness.
(ii) Production Technology
The type of manufacturing technology in terms of its fixed costs, achievement of

economies of scale and flexibility may also influence location decisions. The fixed costs of
setting up a manufacturing plant can be so high that a firm has to manufacture from a single
or a few locations and serve their worldwide market. Conversely a relatively low fixed cost can
make it more economical to manufacture in many locations. This allows the firm better local
responsiveness and avoid the risks associated with becoming too dependent on one location,
such as an adverse change in exchange rates.
(iii) Quick Customer Feedback
Products for which firms require quick customer feedback are often produced in
locations closer to the customers. In the United States’ apparel industry, for example, the more
fashionable items such as sportswear are produced near or in the United States to enable the
manufacturer to respond quickly to changing market trends. Low- fashion items like socks and
briefs are more likely to be produced outside the United States, such as in Taiwan or Indonesia
to take advantage of lower costs.
(c) Government Policies
The more important aspects are political stability, trade policies, economic
development incentives and foreign trade zones.
(i) Political Stability
A government that alters their fiscal, monetary and other regulations without consulting
the business community would raise the risk and uncertainty of operating in that country. A
country that allows firms to make knowledgeable investment, production and staffing decisions
will be a more desirable location
.
(ii) Trade Policies
Trade barriers, such as high tariffs or export restrictions, may force a firm to locate a
facility within the country. For example, Toyota, Nissan and Mazda built factories in the United
States to avoid the export restriction imposed by the Japanese government to limit the export
of Japanese-made cars to the United States.
(iii) Economic Development Incentives
Governments may offer international firms cheap land, highway improvements, job-
training programs and discounted water and electricity rates to attract them so that jobs can
be created by new factories.
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(iv) Foreign Trade Zones (FTZ)
FTZ is a specially designated and controlled geographic area in which foreign goods
may be kept, processed and then re-exported without incurring any duty. The existence of
FTZs allows the international firm greater flexibility in importing or exporting and creates an
opportunity to lower their costs.
(d) Organizational Issues
This refers to the firm’s business strategies, organizational structure and inventory
management that are also important considerations in location decisions.
(i) Business Strategies
A firm that adopts a cost-leadership strategy must look for low-cost locations, where
as a firm that focuses on product quality must locate facilities with adequate skilled labor and
managerial talent.
(ii) Organizational Structure
A firm’s organizational structure also influences the location of its factories. A firm using
geographic area decentralizes authority to the respective area managers. These managers,
seeking to maintain control over their respective area are likely to locate factories within their
own areas. For example, Ford was once structured as three area groups – North America,
Europe and Asia Pacific. Rather than exporting automobiles from these regions, each area
focused on producing automobiles to meet the needs of customers in its respective areas. On
the other hand, a firm with a global product structure will locate factories anywhere in the world
to meet the firm’s cost and quality performance goals.
(iii) Inventory Management
The firm’s location decisions may affect inventory management policies. While firms
attempt to keep lower levels of inventory to reduce their holding costs, they must ensure that
they do not run out of materials and/or finished goods despite the distances and longer times
involved in shipping goods.
For firms implementing a “Just-In-Time” (JIT) inventory system, where the factory is
located is even more critical. It requires close coordination between the firm and its suppliers
because materials or component parts are delivered usually in frequent small shipments
directly to the firm’s factory, just as they are needed for production. As such, car parts makers
such as Toyota Machine Works and TRW Steering Systems for example, are located in Wales
or England to better serve their major customers like Jaguar and Range Rover.
ACTIVITY 7.4
In your opinion, what are the problems that a firm may encounter when making wrong decisions
regarding location?
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C. Inventory Management
In deciding the level of inventory to be maintained, the firm needs to take into
consideration three major factors, which are the order cycle time, the desired level of customer
service and the use of inventories as a strategic tool. These are discussed in the following
paragraphs.
(a) Order Cycle Time
The order cycle time refers to the time that passes between the placement of an order
and the receipt of the goods. In international business, the order cycle is often longer than in
domestic business. It involves the time taken to transmit orders, process the orders, prepare
and pack the goods for shipment and transporting them. Consistency in the order cycle time
is also difficult to maintain, as delivery times would depend on the choice of transportation
mode. Thus, larger inventories will have to be maintained to meet both the firm’s domestic and
international orders.
The order cycle time can be reduced and consistency increased without increasing
costs by altering the methods of transportation, changing the location where inventories are
kept or improving the way orders are transmitted and processed.
(b) Customer Service Levels
Customer service level is the measure of the firm’s ability to fill all orders within the set
time. A customer service level of 100 per cent denotes that the firm is able to fill all orders
according to the time specified by the customer. If this is also the firm’s inventory policy, which
is to achieve a 100 per cent customer service level, then the firm has to keep more inventory
on hand, thus raising inventory holding costs.
Due to this higher cost, the firm should not set a goal to achieve the highest possible
customer service level, but rather an acceptable level. The firm should realize that different
country customers have differing needs, requirements and expectations. For example, if a
foreign customer expects to receive the goods she ordered within 30 days, the firm should not
promise delivery within 10-15 days. Customers may not demand or expect such quick delivery.
(c) Inventories as a Strategic Tool
The international firm can use inventories as a strategic tool by increasing or

maintaining inventories according to different circumstances. When there is a strong likelihood
of currency devaluation, the firm may increase its inventories instead of holding cash to reduce
its exposure to devaluation losses. In the case of high inflation, keeping larger inventories can
provide the firm with an inflation hedge. However, in countries where a property tax is levied
on inventories, the firms have to balance between the cost of maintaining high levels of
inventories with the benefits accruing from hedging against inflation or devaluation.
The management of inventory therefore has to recognize the trade-offs between the
benefits and costs under the different circumstances to achieve optimum results in line with
the firm’s overall corporate strategy.
Task Reminder
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INTERNATIONAL TRANSPORTATION
Transportation determines how and when goods will be received and represents a significant
element of cost. Thus, a reduction in transportation costs can provide an opportunity for the firm to
increase their profits. International transportation can be divided into three parts, as follows:
(a) Transportation Infrastructure
An established transportation network consists of superhighways, bridges, tunnels, ports, and

air and rail facilities. Transportation infrastructures vary from country to country. Some countries, for
example, may have excellent port facilities but lack internal highways and roads. There are also
infrastructure related difficulties, such as costs and efficiency of loading and unloading, theft and
piracy, which hamper the efficient flow of goods. The frequency of transportation services also vary.
For example, a particular port may not be visited by a ship for several weeks or even months.
Sometimes, only small-sized vessels serve a given location.
The firm has to therefore consider these issues when planning its location and transportation
framework.
(b) Availability of Transportation Modes
International transportation
frequently requires ocean and airfreight
modes, although some goods are shipped
abroad by rail or truck. In addition, land or
sea bridges allow for the transfer of freight
among various modes of transportation,
resulting in intermodal movements. The
photos show some of the modes of
transportation available.
In ocean shipping, the most

common types of vessels are the
conventional cargo vessel, the container
ships and the combination container and
roll- on, roll-off vessels. Conventional
cargo vessels are used for oversized and
unusual cargo which may be less efficient than container ships. Container ships carry standardized
steel containers which facilitate loading and unloading onto truck trailers, railroad cars or barges. As
a result, the time the ship has to spend in port is reduced. Expanding the capabilities of the container
ship is the combination vessel, which additionally features a roll- on, roll-off capability. This
combination vessel has a portion of the ship below deck for trucks, cars, buses, construction
equipment, which provides flexibility in ocean shipping. However, the use of ocean shipping is
constrained by the lack of ports and port services, especially in developing countries that lack the
funds to develop ports. Firms may use the neighboring countries’ ports and facilities and then
transport the goods over land to their final destination.
Air freight is available in most countries. However, the total volume of air freight compared to
the total volume of international shipments is small (less than 1 per cent). High value items are more
likely to be shipped by air. Various efforts have also been made to develop better and more efficient
airport services as well as the aircrafts. Jumbo cargo planes and passenger- cargo combination
aircrafts are now in use.
(c) Choice of Transportation Modes
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The appropriate choice of the available modes of transportation will be strongly influenced by
the needs of the firm and its customers. The performance of each mode must be considered on four
dimensions.
(i) Transit Time
Transit time is the period between the departure and arrival of the carrier. This varies
significantly between ocean freight and airfreight, which can have a major impact on the firm’s
overall logistical operations. For example, a 45-day ocean shipment can be reduced to 24
hours if the firm chooses air freight which may reduce the need for inventories if they
replenished frequently. In emergency situations such as production delays, a shipment
normally made by ocean freight can be made by air so as not to miss its delivery date.
Perishable products, which has a short life span, would require short transit times and be
transported by airfreight.
(ii) Predictability
Both ocean freight and air freight are subject to delays in arrival time, often due to
weather hazards. However, delays via air relative to ocean freight tend to be shorter and are
more predictable. Due to the higher predictability of air freight, firms can keep lower inventory
safety stock and can make more precise delivery promises to their customers. Goods shipped
by air are also likely to suffer less loss or damage from exposure to movement.
(iii) Cost
Cost is a major factor in considering the choice of international transportation modes.

While air freight is more predictable and faster, it is also more costly than ocean freight. Firms
have to consider both the costs and the benefits or value of their choice of mode. Firstly, the
physical density and the value of the cargo – bulky products may be too expensive to be
shipped by air, whereas very compact products may be more appropriate for air transport.
Thus, high-priced items such as diamonds or microprocessors can be easily justified to be
sent by air than coal or iron ore. Secondly, the firm must determine how important it is for the
goods to arrive on time. The need to reduce or increase inventory must be measured. Firms
using air freight as a tool for aggressive market expansion must consider the cost of the
transportation as it may also affect the price of the product and the need for the product’s
availability abroad. The firm, must therefore, consider the effects of its choice of transport on
its overall activities in relation to cost.
(iv) Government Involvement
Carrier companies may be owned or heavily subsidized by governments. Firms can

thus be pressured to use their national carriers, even if there are more economical alternatives.
Such preferential policies are often enforced when government cargo is being transported.
The United Nations Conference on Trade and Development (UNCTAD) has recommended,
for balance of payment reasons that 40 per cent of shipping between two countries be
allocated to vessels of the exporting country, 40 per cent to vessels of the importing country
and 20 per cent to third-country vessels (the 40/40/20 guideline). Firms have to adapt their
choice of modes within the international transportation environment they operate in.

International transportation can be divided to three parts. Explain each part.
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ACTIVITY 7.5
In your opinion, what is the importance of transportation in a firm’s decision
to conduct international business?
Task Reminder
SUPPLY CHAIN MANAGEMENT

A firm’s supply chain includes the coordination of materials, information and funds from the
initial raw materials supplier to the ultimate customer. While logistics focuses much more on
transportation and storage of materials, parts and final goods, supply chain management goes further
to include the management of the firm’s relations with suppliers and customers. We shall study the
supply chain network that coordinates suppliers, intermediaries, manufacturers and customers.
A. International Sourcing
Sourcing is the process of obtaining inputs, whether raw materials or component parts,
and supply it to the firm’s production process. It is the first step in the process of materials
management that we studied in the beginning of the topic.
For example, Ford assembles its cars in Mexico for sale in Mexico and the United
States. The cars are designed by Mazda in Japan. Ford purchases parts manufactured in
Japan, ships them to Mexico or the United States for final assembly and sells them in either
or both the countries. In Europe, Ford decided to manufacture the Escort model by sourcing
parts globally from plants in 15 different countries for final assembly in the United Kingdom
and Germany.
Although firms can obtain parts and materials in the home country and avoid problems
connected with language differences, long distances, exchange rate fluctuations, politics and
complex transportation channels, domestic sources may be unavailable for many firms or they
may be more expensive than foreign sources. The firm may also decide to purchase most
materials or parts from independent suppliers while producing the most expensive parts itself.
The reasons for firms to pursue global sourcing strategies can be summarized as follows:
1. Reduce costs through cheaper labor, land and facilities and/or less restrictive
work rules;
2. Improve quality;
3. Increase exposure to technology available worldwide;
4. Improve the process of supplies delivery;
5. Supplement domestic supplies with foreign sources;
6. Gain access to materials that are only available abroad, due to its technical or
product capabilities;
7. Establish a presence in a foreign market;
8. Secure more orders from the supplier country; and
9. React to competitors’ foreign sourcing practices.
Let us look at supplier relations and procurement strategy in international sourcing:

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(a) Supplier Relations
When a firm decides that it must outsource its supplies of raw materials or component
parts, it must then determine how to work and manage its relationship with suppliers. Apart
from the outsourcing approach that we have learned (also known as arm’s length relationship),
Japanese firms such as Toyota employs what is known as the keiretsu relationship with their
independent suppliers. Under this system, Toyota will first send a team of their manufacturing
experts to each of their key suppliers to observe how the supplier makes its parts. The team
may advise on how to cut costs and enhance quality. Toyota commonly identifies two suppliers
for each part and have the suppliers aggressively compete with each other. Both suppliers,
however, will have an ongoing relationship, with the supplier that performs best getting the
most business. While Japanese companies develop close relationships with their suppliers,
American firms tend to maintain an arm’s length relationship.
(b) Procurement (Purchasing) Strategy
When firms outsource from independent suppliers on a global basis, the purchasing
function becomes an important link. There are five major purchasing strategies that firms can
implement, namely:
(i) Assign a domestic buyer or buyers for international purchases;
(ii) Use foreign subsidiaries or business agents;
(iii) Establish international purchasing offices;
(iv) Assign the responsibility to a specific business unit or units; and
(v) Integrate and coordinate worldwide sourcing.
These strategies would illustrate the firm’s move from the simple to the more complex
process of purchasing as the firm’s degree of internationalization increases. The firm’s key
concern is to select the best supplier, establish a solid relationship and evaluate the supplier’s
performance continuously to ensure that they can secure the best price, quality and punctual
delivery of materials or component parts.
B. Information Systems
Another key part of a global supply chain management is information. Information

technology and systems can be used to link suppliers, manufacturers, intermediaries and
customers, such as Enterprise Resource Planning (ERP), Electronic Data Interchange (EDI)
and E-commerce systems.
(a) Enterprise Resource Planning (ERP)
Business organizations are complex systems in which various functions such as

purchasing, production, distribution, sales, human resources, finance and accounting must
work together to achieve the goals of the organization. However, in the functional structure
used by many business organizations, information flows freely within each function, but not so
between functions. Human interaction is essential to maintain global communication and
human skills are a vital factor to manage information flow of the supply chain. However, it is
not possible to practice global supply chain management without advanced technology.
Software solutions also abound for just about every supply chain function, from planning to
warehouse inventory management and shipping. The next generation of ERP products are
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aimed beyond the single enterprise and manufacturing sector to encompass the entire supply
chain and also service companies (see figure below).
ERP represents an expanded effort to integrate standardized record keeping that will
permit information sharing among different areas of an organization in order to manage the
system more effectively. ERP software provides a system to capture and make data available
in real time to decision makers and other users throughout an organization. It also provides a
set of tools for planning and monitoring various business processes to achieve the goals of
the organization. ERP systems are composed of a collection of integrated modules. There are
many modules to choose from, and different software vendors offer different but similar lists
of modules. Some are industry specific, and others are general in purpose. Among the most
widely used are modules for accounting and finance (e.g. general ledger, account payable,
account receivable, payroll), manufacturing (e.g. master scheduling, MRP, capacity
requirements planning), sales (e.g. order entry), supply chains (e.g. purchasing, inventory
control), human resources and maintenance.
(b) Electronic Data Interchange (EDI)
EDI allows for transmission of vast quantities of data at high speeds in a secure
fashion. With the advent of the Internet and Web, many companies are utilizing the Internet
as a transmission tool and for retaining EDI message sets. This combination of EDI/Internet
has been replaced by a new generation of Web-enabled ERP software systems and
applications that handle all supply chain functions, and provide electronic commerce
capabilities. This switchover promotes what experts call intelligent networking, which will allow
flexible intercommunication between global networks. In a world of rapidly changing
technology and consumer-driven global markets, the company needs a partner who embraces
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these realities while committing to the company’s goals of supply chain security and efficiency
(see figure below).
Types of EDI can be classified into:
(i) Proprietary system – It involves an EDI system that is managed and owned
by a single company that buys from multiple suppliers or directly receives
orders from customers without using a third party.
(ii) Value-added network (VAN) – It is known as the third-party network or many-

to-many system that is widely used in the EDI system. During the process of
VAN system, the EDI transmission will go through the third party company that
acts as the intermediary or central clearing house. When buying firms send
purchase order (PO) to various suppliers through VAN, the third-party company
will sort and transmit according to the supplier. If the trading partners have a
different system, VAN system can still transform or transmit the information
because it is a compatible system that can be used by all companies.
And many of these solutions are starting to be offered on the web through application
service providers (ASP). The most common message set for supply chain information has
been the electronic data interchange (EDI). The following are several advantages of EDI:
(i) Reduced paperwork;

(ii) Improved accuracy compared to previous system which is manually processed;
(iii) Increased transmission speed of order;

(iv) Reduced administrative work such as filing, data entry and etc;
(v) Reduced cost of order placement and related processing and handling; and
(vi) Improved information availability such as shipment advises.
(c) Material Requirements Planning (MRP)
MRP is a computer-based information system that translated the finished product

requirements of the master schedule into time-phased requirements for subassemblies,
component parts, and raw materials, working backward from the due date using lead times
and other information to determine when and how much to order. Hence, requirements for end
items generate requirements for lower-level components, which are broken down by planning
periods (e.g. week) so that ordering, fabrication and assembly can be scheduled for timely
completion of end items while inventory levels are kept reasonably low. MRP is as much a
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philosophy as it is a technique, and as much an approach to scheduling as it is to inventory

control.
MRP begins with a schedule for finished goods that is converted into a schedule of
requirements for the subassemblies, component parts, and raw materials needed to produce
the finished items in the specified time frame.
Thus, MRP is designed to answer three questions – “What is needed?”, “How Much is
needed?” and “When is it needed?”.
The primary inputs of MRP are a bill of materials, which tells the composition of a
finished product; a master schedule; which tells how much finished product is desired and
when; and an inventory records file, which tells how much inventory is on hand or on order.
The planner processes this information to determine the net requirements for each period of
the planning horizon.
Outputs from the process include planned-order schedules, order releases, changes,
performance-control reports, planning reports and exception reports. An MRP system has
three major sources of information:
(i) A master schedule – One of three primary inputs in MRP; states which end
items are to be produced, when they are needed, and in what quantities.
(ii) A bill-of-materials – One of the three primary inputs of MRP; a listing of all of
the raw materials, parts, subassemblies, and assemblies needed to produce
one unit of a product.
(iii) An inventory records file – One of the three primary inputs in MRP; includes
information on the status of each item by time period.
(d) Free-Trade Zones (FTZ)
A free-trade zone (FTZ) is a specific class of special economic zone. They are a
geographical area where goods may be landed, handled, manufactured or reconfigured, and
re-exported without the intervention of the customs authorities. Only when the goods are
moved to consumers within the country in which the zone is located do they become subject
to the prevailing customs duties. Free trade zones are organized around major seaports,
international airports, and national frontiers – areas with many geographical advantages for
trade. It is a region where a group of countries has agreed to reduce or eliminate trade barriers.
The areas include airport, seaport, or any other designated areas for duty- free import
of raw materials, components, sub-assemblies, semi-finished or finished goods. Such items
can be stored, displayed, assembled, or processed for re-export or entry into the general
market of the importing country (after paying the required duties). Read more at
http://www.businessdictionary. com/definition/free-trade-zone-TZ.html.
(e) Just-In-Time (JIT) and Lean Operations
The term Just-in-time (JIT) is used to refer to an operations system in which materials
are moved through the system and services are delivered with precise timing so that they are
delivered at each step of the process just as they are needed. Initially, the term JIT referred to
the movement of materials, parts and semi-finished goods within a production system. Over
time, the scope of JIT broadened and the term become associated with lean operations. Now
the two terms are often used interchangeably to refer to a highly coordinated, repetitive
manufacturing or service system designed to produce a high volume of output with fewer
143
resources than more traditional repetitive systems, but with the ability to accommodate more
variety than traditional systems.
In some respects, the just-in-time concept was operational over 60 years ago at Henry
Ford’s great industrial complex in River Rouge, Michigan. Toyota learned a great deal from
studying Ford’s operations and based its JIT approach on what it saw. However, Toyota was
able to accomplish something that Ford could not; a system that could handle variety. Many
of the methods that are common to JIT and lean operations were developed as part of
Japanese car maker Toyota’s approach to manufacturing. You can get a sense of terms such
as:
 Muda – Waste and inefficiency. Perhaps the driving philosophy. Waste and
inefficiency can be minimized by using certain tactics.
 Kanban – A manual system used for controlling the movement of parts and
materials that responds to signals of the need (i.e. demand) for delivery of parts or
materials.
 Pull system – Replacing material or parts based on demand; produce only what
is needed.
 Heijunka – Variations in production volume lead to waste. The workload must be

leveled; volume and variety must be averaged to achieve a steady flow of work.
 Kaizen – Continuous improvement of the system. There is always room for

improvement, so this effort must be ongoing.
 Jidoka – Quality of the source. Each worker is expected to perform ongoing quality
assurance. The objective is to avoid passing defective products to the following
work stations, and to make workers aware of quality.
 Poka-yoke – Safeguards built into a process to reduce the possibility of committing

any errors.
 Team concept – Use small teams of workers for process improvement.
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(f) Five S
Workers cannot be efficient if their workplaces are messy and disorganized. A great
deal of time can be wasted looking for the right tool or moving around piles of materials that
are scattered about. Within the lead production system, firms can use the “Five S” principle to
create a more organized work environment. The five S’s are derived from Japanese terms:
seiri (sort), seiton (straighten), seiso (shine), seiketsu (standardize) and shitsuke
(sustain).
Five S Term Definition

SORT Separate needed from unneeded items and discard the unneeded.
STRAIGHTEN Neatly arrange what is left, with a place for everything and everything in its place.
Organize the work area so that it is easy to find what is needed.
SHINE Clean and wash the work area and make it shine.
STANDARDIZE Establish schedules and methods for performing the cleaning and sorting.
SUSTAIN Create the discipline to perform the first four S practices, so that everyone
understands, obeys and practices the rules when in the plants.
(g) E-business
The commercial blossoming of the Internet has led to an explosion of Internet-related

activities, many of which have a direct impact on organizations’ supply chains, even if those
organization’s themselves are not users of the Internet. E-business refers to the use of
electronic technology to facilitate business transactions. E-business or e-commerce, involves
the interaction of different business organizations as well as the interaction of individuals with
business organizations. Applications include Internet buying and selling, e-mail, order and
shipment tracking, and electronic data interchange. In addition, companies use e-business to
promote their products or services, and to provide information about them. Delivery firms have
seen the demand for their services increase dramatically due to e-business.
Among them are giants UPS and FedEx. The following lists some of the numerous advantages
of e-business:
(h) E-commerce (EC)
The emergence of the Internet has rapidly transformed the management of globally
dispersed supply chains. It is less expensive and easier to install and manage, allowing even
small firms to use. This web-based system not only helps to automate and speed up the
internal processes of a firm (intranet) but also links the business systems of the firm’s suppliers
and customers efficiently.
As an example, Dell Computer Corporation has manufacturing facilities in the United

States, Brazil, Ireland, Malaysia and China. More than half of the firm’s 200 suppliers are
145
located in Asia. Dell’s business was originally based on direct selling to customers (mailings
and telephone contact), cutting off wholesalers and retailers, enabling it to offer lower prices
to consumers. Since the mid-1990s, the firm’s sales have been made over the Internet and by
the year 2000, 80 per cent of all its sales were made through this medium. Through the
Internet, Dell’s customers are able to customize their orders, mixing and matching computer
hardware components, to get the system that suits their requirements. Components suppliers
are constantly provided with these information so that they have up-to-the-minute information
about demand trends for the components that they supply together with volume expectations
for the next 4 to 12 weeks. These information are used by the suppliers to schedule their
production to produce components just enough for Dell’s needs. Dell is thus able to manage
its global supply chain to minimize its inventory while assembling the personal computers
according to customer orders and delivering on time. E-commerce has made Dell very
attractive to customers and provided it with a significant cost advantage over competitors.
ACTIVITY 7.6
In your opinion, how has the Internet enhanced the supply chain management system?
C. Quality Management
Quality is another important aspect in all levels of the supply chain. Quality of a product
or service is defined as conforming to specifications, value, fitness for use, support by the firm
and the image it carries. A quality product or service is one that meets or exceeds the
expectations of the customer. Firms that can offer better quality products or services have an
advantage over other firms in attracting customers.
(a) Quality Management
Total Quality Management (TQM) which was first practiced by Japanese firms, means
not tolerating any kind of defects (zero defects approach). The goal is to eliminate all defects
and focus on benchmarking their products or services against the best companies in the world
whether in design, processes or purchasing. The process of TQM is based on three important
principles, namely:
(i) Customer satisfaction;
(ii) Employee involvement in the process; and
(iii) Continuous improvements in quality.

Although achieving a higher level of customer satisfaction may increase
production costs in TQM, these costs would also decline in the long-run as defects
decline. TQM is a continuous improvement process (also known as kaizen) at every
level of the organization and involves employees to help identify and eliminate all
problems encountered. Thus, striving for continuous improvement is a part of every
employee’s daily work. TQM is even more challenging in an international setting due
to differences in culture and the environment.
Another new quality management tool known as Six Sigma was introduced by Motorola
and is now being used by many international firms, such as General Electric, GlaxoSmithKline
and Lockheed Martin. This approach focuses on the firm’s entire production system by
eliminating defects, cut down product cycle times and costs.
146
Both the above methods provide firms with the means to improve the quality of
organizations.
(b) Quality Standards and Certifications
(i) The Background
The ISO story began in 1946 when delegates from 25 countries met at the Institute of
Civil Engineers in London and decided to create a new international organization “to facilitate
the international coordination and unification of industrial standards”. On 23 February 1947
the new organization, ISO, officially began operations. Since then, this international
organization has published over 21000 International Standards covering almost all aspects of
technology and manufacturing. Today the committee has members from 163 countries and
3,368 technical bodies to take care of standards development. More than 135 people work full
time for ISOÊs Central Secretariat in Geneva, Switzerland.
Quality standards can be measured according to three different levels. At the general-
level, firms may be presented with awards for quality excellence, such as the Deming Award
or Malcolm Baldridge National Quality Award. There may also be quality standards at the
industry- level for suppliers to comply, and company-level standards set by individual
companies for their suppliers to follow.
Certification of quality such as by the International Standards Organization (ISO)

has become even more important. The ISO 9000, which has now been revised as the
ISO9001:2015, is an important part of business operations in Europe and has been adopted
in 161 countries throughout the world. It is intended to promote the idea of quality at every
level of an organization. Rather than evaluating the quality of a particular product, the ISO
9001:2015 evaluates and analyses the management systems and procedures including the
purchasing, design and training in organizations. A firm that wants to be ISO certified must
document the performance of each function in its organization that affects quality and follow
through the documented routine. A report will then be filed and certified by a team of
independent auditors. Although this process can be expensive and time consuming, and does
not provide the solution to all issues pertaining to quality, ISO certification will help firms to
obtain more business, especially in European countries.
(ii) What is a Standard?
A standard is a document that provides requirements, specifications, guidelines or

characteristics that can be used consistently to ensure that materials, products, processes
and services are fit for their purpose. Over 21,000 International Standards have been
published.
(iii) What are the Benefits of ISO International Standards?
ISO International Standards ensure that products and services are safe, reliable and
of good quality. For business, they are strategic tools that reduce costs by minimizing waste
and errors, and increasing productivity. They help companies to access new markets, level
the playing field for developing countries and facilitate free and fair global trade.
The most popular standards are:
● ISO 9000 Quality management;

● ISO 14000 Environmental management;
● ISO 3166 Country codes;
● ISO 26000 Social responsibility;
147
● ISO 50001 Energy management;

● ISO 31000 Risk management;
● ISO 22000 Food safety management;
● ISO 27001 Information security management;
● ISO 45001 Occupational health and safety;
● ISO 37001 Anti-bribery management systems; and
● ISO 13485 Medical devices.
(iv) Benefits of International Standards
International Standards are the backbone of our society, ensuring the safety and
quality of products and services, facilitating international trade and improving the environment
in which we live in. Conformity to International Standards helps reassure consumers that
products, systems and organizations are safe, reliable and good for the environment.
(v) Economic Benefits of Standards
Numerous studies have shown that standards boost business and economies. In the
UK, for example, standards account for an US$8.2 billion annual growth in GDP, while in
Canada, the use of standards has injected over US$91 billion into the economy since 1981.
For Business
International Standards are strategic tools and guidelines to help companies tackle some of
the most demanding challenges of modern business. They ensure that business operations are as
efficient as possible, increase productivity and help companies access new markets.
ISO standards help businesses to:

● Cut costs, through improved systems and processes;
● Increase customer satisfaction, through improved safety, quality and processes;
● Access new markets, through ensuring the compatibility of products and services; and
● Reduce their impact on the environment.
For Consumers
ISO has over 21000 standards touching almost all aspects of daily life. When products and
services conform to International Standards consumers can have confidence that they are safe,
reliable and of good quality. For example, ISO's standards on road safety, toy safety and secure
medical packaging are just a selection of those that help make the world a safer place. To make sure
that the benefits of ISO International Standards are as broad as possible, ISO supports the
involvement of consumers in standard development work with its Committee on consumer policy
(COPOLCO). International Standards on air, water and soil quality, on emissions of gases and
radiation and environmental aspects of products contribute to efforts to preserve the environment and
the health of citizens.
148
For Government
ISO standards draw on international expertise and experience and are therefore a vital
resource for governments when developing public policy. National governments can use ISO
standards to support public policy, which has a number of benefits, including the following:
● Getting expert opinion – By integrating an ISO standard into national regulation,

governments can benefit from the opinion of experts without having to call on their services
directly.
● Opening up world trade – ISO international standards are adopted by many governments,
so integrating them into national regulation ensures that requirements for imports and exports
are the same the world over, therefore facilitating the movement of goods, services and
technologies from country to country.
ACTIVITY 7.2
Name some Philippine firms which have received the ISO 9001:2015 certification.
Task Reminder
SUMMARY
 We have learned that international logistics refer to the management of the flow of materials,
parts, supplies and other resources into, through and out of the international firm.
 In this respect, firms have to decide whether to manufacture component parts that they need
in their final products themselves (“make”) or to outsource them from independent suppliers
(“buy”). We also learned that there are several advantages to each choice.
 In the event the firm decides to “make”, it is faced with the issue of where to locate their
manufacturing facilities that would meet their needs best.
 The firm must take into consideration several issues that are either country- related or product-
related, and government policies as well as organizational issues.
 In the management of inventory, firms have to decide the level of inventory needed against
the cost of holding inventory.
 In international transportation, the firm must first have knowledge on the available modes of
transport that it can use, which may vary from country to country according to their
infrastructures
 When choosing the most appropriate mode of transport, the firm must consider four important
factors. These are transit time factor which the period between the departure and arrival of the
carrier, predictability of the mode of transport, cost and whether there are any foreign or home-
country government policies that may restrict their choices.
149
 In the management of the firm’s global supply chain, the reasons that drive firms to source for
the materials or component parts from abroad were discussed.
 We also learned how the firm can manage their relationship with suppliers and the importance
of the purchasing function as the link between the firm and its suppliers.
 We further studied how information systems, such as EDI, ERP and E-Commerce can be used
in a firm’s global supply chain.
 Finally, we discussed quality management as another important aspect of the supply chain
through implementing quality management systems and quality standards.
150
EXERCISES
EXERCISE 7.1
1. Materials management involves all the following activities, EXCEPT:
A. Sourcing of raw materials and/or component parts.
B. Inventory management.
C. Transportation between suppliers and manufacturers.
D. Distribution of goods to wholesalers and retailers.
2. Physical distribution involves the flow of finished products from the firm to the customers.
A. True
B. False
3. Explain differences in international logistics that differentiate it from domestic logistics.
151
EXERCISE 7.2
1. Among the country-related issues to be considered in location decisions is:

A. Production technology
B. Cost and availability of resources.
C. Organizational structure.
D. Inventory management.
2. The order cycle times in inventory management can be reduced and consistency increased
without increasing costs by the following methods, EXCEPT:
A. Altering the methods of transportation.
B. Changing the location where inventories are kept.
C. Improving the way orders are transmitted and processed.
D. Changing customer service levels.
3. Which of the following products can be considered to have the highest value-to-weight ratio?
A. Iron ore
B. Trucks
C. Microprocessors
D. Cotton
4. Governments may offer incentives to international firms to set up factories so that jobs can be
created by the new factories.
A. True
B. False
5. Foreign Trade Zones (FTZ) is a specially designated and controlled geographical area where a
firm may keep goods, process and re- export the goods without incurring any duty.
A. True
B. False
6. Describe how firms can use inventory as a strategic tool.
7. In the “make-or-buy” sourcing decisions, explain the advantages of “make” to the firm.
Mode of submission: _______________________ Date of discussion: _____________________
152
EXERCISE 7.3
1. What is the greatest constraint in global ocean shipping?

A. Perishability of products
B. Lack of port facilities
C. Transit time
D. Weather conditions
2. In determining the cost of transportation, the firm must consider the following EXCEPT:
A. Justify the need against the cost of airfreight.
B. Analyze the importance of time in relation to cost.
C. Consider the total cost of each alternative mode of transport.
D. Look for carrier that can offer the lowest price.
3. Transit time is the time that passes between the placement of an order and the receipt of the
goods.
A. True
B. False
4. Intermodal movements in international transportation refers to the transfer of freight from one
mode of transportation to another.
A. True
B. False
5. Most international shipments in international business use air freight.
A. True
B. False
6. Explain what is meant by the 40/40/20 guideline recommended by UNCTAD in international
shipping.
153
EXERCISE 7.4
1. ISO 9000 was established by the ____________.

A. United Nations
B. European Union
C. North American Free Trade Agreement
D. International Monetary Fund
2. Determining the best processes used by the best companies in the world is called ____________.
A. Benchmarking
B. Improvising
C. Just-in-time
D. Enterprise resource planning
3. Walmart uses the ____________ system to connect its 14,000 suppliers throughout the world to
its inventory ordering system.
A. Enterprise Resource Planning (ERP)
B. ISO 9001:2015
C. Electronic Data Interchange (EDI)
D. Total Quality Management (TQM)
4. Kaizen is a continuous improvement process at every level of the organization and involves
employees to help identify and eliminate all problems encountered.
A. True
B. False
5. The purchasing function serves as a link between the firm and its suppliers.
A. True
B. False
6. Give five reasons why firms pursue a global sourcing strategy.

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Module

Chriselda Saniata G. Niala

INTRODUCTION TO INTERNATIONAL BUSINESS 1

CULTURAL, POLITICAL, LEGAL, AND ECONOMIC

INTERNATIONAL TRADE THEORIES AND INSITUTIONS 42

THE FINANCIAL ENVIRONMENT OF INTERNATIONAL

MARKET RESEARCH, MODE OF ENTRY, AND ETHICAL

INTERNATIONAL LOGISTICS AND SUPPLY CHAIN

REFERENCES AND OTHER RESOURCES

LO1. Define the term globalization; LC1. The Importance of International

THE IMPORTANCE OF INTERNATIONAL BUSINESS

A. The Growth of International Business

Self-Assessment Question 1.1

(a) Expansion of Technology

Developments in communications and transportation technology have enabled people in

(b) Government Deregulation

(c) Supporting Services

The development of banking, insurance and postal services by governments and

(d) Increase in Global Competition

(a) Trade and investment barriers;

Two important facets of globalization are:

(a) Globalization of Markets

Examples of Global Brands

(b) Globalization of Production

Self-Assessment Question 1.2

C. The Globalization Debate

Self-Assessment Question 1.3

a. Loss of Jobs and Income

b. Labor Policies and the Environment

However, supporters of globalization believe that free trade enables developing

c. Loss of National Sovereignty

Critics of globalization are also concerned that the increasing interdependence

d. Widening Gap between the Rich and Poor Nations

INTERNATIONAL BUSINESS ACTIVITIES

A. Exports and Imports

A portfolio investment is a non-controlling interest in a company. Firms may purchase foreign

Examples of portfolio investment

C. Other Forms of International Activities and Companies

A multidomestic company or sometimes called a locally responsive company allows each of

CONCEPTS AND CHALLENGES IN INTERNATIONAL

A. The External Influences on International Business

B. The Competitive Environment

a. Differences in Consumer Tastes and Preferences

Although modern communication and transportation have created some convergence

b. Differences in Infrastructure and Traditional Practices

Differences in electrical systems (110-volt/240-volt) infrastructure and traditional

c. Differences in Distribution Channels

An international firm’s marketing strategies may have to be varied according to different

d. Host Government Demands

MOTIVATIONS AND RESTRICTIONS IN

A. Why do Companies Engage in International Business?

The three major objectives are to:

Firms search international markets to increase sales. However, sales depend on

a. Maintain Essential Industries

b. Protect Infant Industries

Governments may implement import restrictions or export subsidies to protect young

d. Promote Local Industrialisation

e. Maintain National Security

f. Maintain Spheres of Influence

7. How is a global company different from a transnational company?

2 Cultural, Legal, Political,

After this chapter, the student must be able to:

LO1.Explain the diversity of culture and how

In this chapter, you will learn about: