American Society of Business and Behavioral Sciences Journal Covers Fair Value Reporting

American Society of Business and Behavioral
Sciences
eJournal
Volume 6, Number 1
Spring 2010
ISSN: 1557-5004
Editors
Pani N. Chakrapani, University of Redlands
Wali I. Mondal, National University
THE CHALLENGE OF FAIR VALUE REPORTING TO THE FINANCIAL COMMUNITY by
Ament, Joseph D. 1
THE SUPREME COURT GRANTS CERTIORARI TO REVIEW THE SECOND CIRCUIT’S

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THE LEBANESE GOVERNMENT TREASURY BILL by Ben Sita, Bernard 23
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BRITAIN by Bootheway, Giles B.P. and Sotak, Kristin L. 32
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Frank R. 41
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BEHAVIOR? AN EXPLORATORY STUDY by Ho, Raymond, Kehoe, William J. and Whitten,
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King, Darwin L. and Case, Carl J. 71
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CHALLENGE by Peebles, Dawn and Bacon, Frank. 100
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UNITED STATES by Pyatt, Edward J. 118
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ORDER VS. TRADE-OFF by Smiy, David and Bacon, Frank. 132
BEST PRACTICES: A USEFUL PROXY FOR DYNAMIC CAPABILITIES THROUGH THE

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ASBBS E Journal Vol.6, No.1, 2010
MANAGEMENT BY OBJECTIVES: AN EFFECTIVE TOOL FOR ORGANIZATIONAL
PERFORMANCE by Qureshi, M. Tahir , Khan, A. Shafkat, Sheikh, A. Rauf, Ramay, I.
Mohammad and Khan, B. Mohammad 146
ii
ASBBS E Journal Vol.6, No.1, 2010
THE CHALLENGE OF FAIR VALUE REPORTING
TO THE FINANCIAL COMMUNITY
Ament, Joseph D.
Professor-Accounting and Taxation
Walter E. Heller College of Business Administration
Roosevelt University
Chicago, Illinois
jament@roosevelt.edu
ABSTRACT
After the 2008 financial crisis experienced by the United States, accounting standards setters are
busy trying to find ways they can help to get the economy back to a stable position. Many
accounting professionals believe the source of the problem is fair value measurement and
recognization. It was not until the SEC received some criticism from Congress about the issues
that fair value accounting has created that the Commission finally began to look more closely at
the subject and worked towards creating a fair value study requirement in the financial bailout
bill.
In its March 2008 hearing, Congress told FASB Chairman Robert Herz to act quickly to issue
new guidance on the controversial rules on fair value measurement that is presented in FAS 157.
After this order, the Financial Accounting Standards Board put itself on an ultra-fast track to
issue more guidance on how to carry out fair value accounting for troubled financial assets and
to make more operational rules on the write-down of securities. At the FASB March 16, 2009
meeting a two-step approach was tentatively accepted to address the fair value accounting issues.
This paper will discuss the two-step approach and several of the major developments in 2009
necessitating attention and decisions to additional issues given by the FASB. This paper will also
discuss the effects that the change in fair value accounting will have on the Finance/Accounting
fields.
INTRODUCTION
With the current controversy surrounding fair value accounting, it is important to understand
actually what it is. Under Generally Accepted Accounting Principles (GAAP), fair value is
ASBBS E Journal, Vol. 6, No.1, 2010 1

Ament Fair Value Reporting to Financial Community
defined as the amount at which an asset can be bought or sold in a current transaction between
willing parties, or transferred to an equivalent party, other than in a liquidation sale. On the
opposite side of the balance sheet, the fair value of a liability is the amount at which the liability
can be incurred or settled in a current transaction between willing parties, other than in
liquidation. Fair value is sometimes referred to as the “exit value”.
In September of 2006, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (FAS) No. 157: Fair Value Measurements (FAS 157) to serve as
a guide for entities on how to determine fair value estimations for financial reporting purposes.
FAS 157 emphasizes the use of market inputs in valuing an asset or liability. Examples of such
market inputs are quoted prices, interest rates and credit data, among other things. When fair
value is not available due to the lack of an actual transaction, it is logical to use information from
an active market. An active market can be defined as a market in which securities as a whole are
trading at a high volume. However, sometimes, quoted prices might not represent the best
estimate of fair value, which some experts have come to determine in circumstances such as the
recent economic crisis.
The lack of a single consistent framework for applying fair value measurements and developing a
reliable estimate of a fair value in the absence of quoted prices has created inconsistencies and
incomparability, especially in today’s financial markets. For this reason, guidance is needed to
eliminate the inconsistencies and develop a solid framework that can be used in any fair value
measurement.
The basis of such a framework should be centered on the fair value hierarchy which indicates the
reliability of inputs used to estimate fair value. The hierarchy is broken down into three levels:
1. Level One is for liquid assets with quoted prices. In this level, the use of unadjusted
quoted prices from an active market for identical assets and liabilities is required. To use
this level, the entity must have immediate access to the market. If more than one market
is available, FAS 157 requires the use of the “most advantageous market”, moreover,
both the price and the costs to do the transaction must be considered in determining
which is the most advantageous market.
2. Level Two is the valuation based on market observables. In this level, fair value is
estimated using a valuation technique. The significant assumptions or inputs utilized in
the valuation technique require the use of inputs that are observable in the market.
Examples of these observable market inputs are quoted prices for similar assets,
prepayment speeds and interest rates, just to name a few. In addition, the assumptions
used in estimating fair value must be assumptions that an unrelated party would use in
estimating fair value.
3. Level Three is valuation based on non-observable assumptions. In this level, fair value is
estimated using a valuation technique just like in level two, however, the significant
assumptions and inputs used in this valuation technique are based upon inputs that are not

observable in the market. For this reason, it is necessary to utilize internal information.
In such a case, the entity may only rely on internal information, if the cost and effort to
obtain external information is too high. Additionally, financial instruments must have an
input that is observable over the entire term of the instrument. Even though internal
inputs are used in this level, the objective remains the same and that is to estimate fair
value by using the assumptions of a third party. This practice is also known as mark to
management.
The FASB has been charged with the task of creating a new guidance on fair value measurement.
At its March 16 meeting, FASB tentatively accepted a two-step approach model that would aid in
determining whether it is necessary to quote prices for identical or similar assets and liabilities in
an inactive market.
DISCUSSION
Prior to the establishment of FAS 157, there were different definitions of fair value and there was
limited guidance on how to apply fair value definitions in GAAP. The guidance was dispersed
among many accounting pronouncements that required fair value measurements. The differences
in the guidance to fair value measurement created some inconsistencies that make applying
GAAP more complex. When developing FAS 157, FASB considered the need for an increase in
consistency and comparability when it came to the subject of fair value measurements and also a
need for expanded disclosures about fair value measurements.
With the creation of FAS 157, FASB set out to improve financial reporting by creating a single
definition of fair value and creating a framework for measuring it. This, FASB believed, would
result in increased consistency and comparability in fair value measurements.
The board also felt that the expanded disclosures about the use of fair value to measure assets and
liabilities would provide the users of financial statements with better information on the extent to
which fair value could be used to measure recognized assets and liabilities, the inputs used to
develop the measurements, and the effect of certain measurements on earnings for a period.
With the passage of FAS 157, the board hoped to simplify and codify the accounting literature
and eliminate the differences that had added to the complexity of GAAP.
Under the statement, holders of financial assets recorded in fair-value must report how they came
up with the value. The holder should classify the measurements into three levels based on how
“observable” the information is. Observable inputs, as defined in FAS 157 are those inputs that
reflect the assumptions the holder would use in pricing an asset or a liability based on market data
obtained from sources independent of the holder. An unobservable input is one that reflects the
holder’s own assumptions on the value of the asset or liability based on the best information
available in the situation. In classifying the measurements, the fair value hierarchy is utilized.
The issue with the classification of the measurements arises from the many constituents
mistakenly use in an observable market transaction even when the transaction may be distressed
or the market for the transaction may not be active.

When companies undergo financial distress as a result of a variety of underlying causes, the result
is a distressed transaction. No matter what the cause, all companies with distressed transactions
face the same issues which are that they are unable to pay their debts as they become due, and the
going- concern value of their business is in danger of declining, if it doesn’t quickly address
liquidity and other financial and operating issues. There are a host of challenges that can
contribute to a company becoming distressed. Some of the challenges are:
Changes in the industry conditions

Stretched payables
Decline in operating performance and cash flow
Total debt exceeds enterprise value
Significant liquidity constraints
With qualified and experienced advice, a company’s “distress” can easily be managed to help to
prevent any hostile relationship between the company and its creditors. With the help of effective
company advisors experienced in distressed situations equity holders can and will often work
diligently with the company’s creditors to facilitate a consensual resolution that can maximize
recoveries.
FASB staff members believe that the emphasis on the use of the “last transaction price” as the
primary basis for fair value even when an adjustment may be required has resulted in the
misapplication of FAS 157 when estimating the fair value of certain financial assets. Another
issue that has been identified is the fact that corporate management and auditors have a
longstanding attachment to the use of the level two data in fair value hierarchy and tend to use it
even when the standards indicate that level three should predominate. However, FAS 157 does
state that when a transaction is considered distressed, the most recent trading prices do not need
to be used to value the asset. Instead, other valuation techniques can be used such as
management’s estimate of expected cash flows.
PROPOSAL
As lawmakers are trying to pull the U.S. from under its current economic hardships many
professionals and academics are trying to figure out what actually could have caused the economy
to take a turn for the worse, as far as the accounting field is concerned. Additionally, the current
economic crisis has created a continuing controversy over what role fair value accounting played
in the 2008 and 2009 financial crisis and whether it accelerated an already terrible situation.
Many accounting practitioners and professors are also wondering what affects the 2008/2009
financial crisis will have on some accounting policies such as the international convergence, the
independence of accounting standard setters, the attempts to move from a mixed-attribute
accounting model for financial instruments, and the application of existing impairment standards.
Many Finance/Accounting professionals feel that fair value accounting will be the most
significant issue in 2009 as the country works towards rebuilding its economy. It was not until
the SEC received some criticism from Congress about the issues that fair value accounting has

created that the Commission finally began to look more closely at the subject and work towards
creating a fair value study requirement in the financial bailout bill.
Since the beginning of this heated topic, there have been some opposing views on the subject, just
like every issue in the accounting field. The fair value controversy centers on its application to
financial instruments and how it may have contributed to the decline in mortgage-backed
securities and other collateralized debt obligations in the financial crisis of 2008/2009. Eugene
Imhoff, an accounting professor at the University of Michigan, stated that if the SEC and FDIC
auditors had placed a little more consideration on the fair value accounting of financial
institutions, many problems that are glaring everyone in the face now, would have and could have
been addressed in a more orderly manner.
One of the hot topics in the fair value accounting debate is the amount of disclosures needed in
fair value accounting. The current rule on fair value disclosures is that assets and liabilities not
stated on the balance sheet should only be disclosed once a year. However, many experts believe
that additional disclosures on financial instruments could be useful with respect to financial
institutions, but some point out that additional disclosures could actually result in a deterioration
of the overall disclosure “package” for non-financial institutions. Hence, there is a need for
standard setters to develop a disclosure framework.
This initial thought was presented by the SEC’s Advisory Committee on Improvements to
Financial Reporting in its committee reports in August 2008. The committee posed that the
disclosure framework should integrate existing SEC and FASB disclosure requirements into a
cohesive whole to ensure meaningful communication and logical presentation of disclosure based
on consistent objectives and principles. This, the committee felt, would eliminate duplication and
provide a single source of disclosure guidance.
In an April 2009 meeting FASB responded to the Advisory Committee’s suggestion and voted
that fair value disclosures should be reported on a quarterly basis in an effort to provide
qualitative and quantitative information about fair value estimates for all the financial instruments
not measured on the balance sheet at fair value. In commercial banking, the financial asset that
will be greatly affected by this change is loans, which will now have to be disclosed every
quarter.
In its March 2008 hearing, Congress put all the opposing issues with fair value accounting to rest
and told FASB Chairman Robert Herz to act quickly to issue new guidance on the controversial
rules on fair value measurement that is presented in FAS 157. After this order, the Financial
Accounting Standards Board put itself on an ultra-fast track to issue more guidance on how to
carry out fair value accounting for troubled financial assets and to make more operational rules on
the write-down of securities. At the FASB March 16, 2009 meeting a two-step approach was
tentatively accepted to address the fair value accounting issues.
In step one of the FASB’s proposed two-step approach, a firm must determine whether there is a
factor or are factors present that signal that the market for the asset is not active. FASB has listed

seven non-exclusive factors that should be considered when a firm is determining whether a
market is inactive. The seven factors are:
1. There are few recent transactions in the market.

2. Price quotes aren’t based on current information.
3. The quotations vary heavily, either over time or among brokers.
4. Indexes that in the past were highly linked to the asset’s fair values “are demonstrably
uncorrelated” with recent fair values.
5. Abnormally big liquidity risk premiums or yields on the assets.
6. Abnormally wide bid-ask spreads or big hikes in the spreads.
7. Little publicly released information.
If after studying these factors the evidence reveals that the market is inactive, the firm should
move on to step two of the model. In step two the firm evaluates the quoted price, which is the
price recently quoted by a transaction or a broker, to decide whether the quoted price is not
associated with a distressed transaction.
FASB’s goal was to move people away from calling a transaction distressed without providing
additional evidence supporting the judgment. The board felt the only way to prevent this from
happening was to get the right data, analyze it, and apply a sound judgment. The board believed
that additional guidance was needed on fair value because people didn’t seem to be able to
provide a sound judgment after obtaining data and analyzing it without the extra guidance in
troubled markets. The board seeks to guide companies more toward the study of cash flows and
the use of other relevant “inputs”, based on what is referred to as a “marketplace participant
view” in Statement 157.
In the FASB proposal, reporting entities with market quotes related to distressed transactions
should use another valuation technique other than the one that uses the quoted price without
significant adjustment. Additionally, for market quotes that are not related to distressed
transactions, the proposed guidance stated that the quoted price may be a relevant observable
input that should be considered in estimating the fair value. However, the proposal also said that
the reporting entity should consider whether other factors warrant making an adjustment to the
quoted price.
After the proposal was presented, FASB chairman, Robert Herz, commented that the FASB
needed to strike a balance between the efforts to improve standards to address the issues
identified by bankers, lawmakers, and the SEC staff. Another subject Mr. Herz felt needed
attention was the FASB’s mission of writing standards for reporting accurate, reliable financial
information that would be useful for investors and other readers of financial statements.
After observing the FASB’s proposal on fair value measurement, the International Accounting
Standards Board (IASB) decided to press ahead with the publication of its draft on fair value
measurement. The IASB formulated a fair value advisory board to review the U.S. proposal.
After reviewing FASB’s proposal, the members of the advisory board believed it to be not even
worthy of consideration.
After the FASB issued its final proposal on fair value on April 9, 2009, many individuals and
professional groups began to point out its issues. The American Bankers Association (ABA)
stated in a May 13, 2009 letter addressed to the House Committee on Financial Services that the
fair value definition as stated by FASB would be misleading to users of financial statements.
ABA also noted that the discussion by the FASB was a rushed one, after receiving pressure from
Congress. They felt significant work was needed to provide a basis for financial institutions to
focus on how to supply credit and help individuals and their businesses grow in their
communities without any distractions.
On May 26, 2009, the Committee on Capital Markets Regulation pointed out that FASB’s final
guidance, given on April 9, did not solve the problems associated with fair value measurement.
The committee urged FASB and IASB to review the standard in hopes of improving it. The
committee added that fair value should be supplemented by requiring preparers to disclose two
additional balance sheet presentations that would differentiate between credit value and market
value to help minimize investor confusion. This initiative, the committee felt, would substantially
increase transparency, particularly in financial institutions.
CONCLUSION
After observing the concerns with its proposed approach on fair value measurement, FASB
decided to perform trials of the newly proposed “beefed- up” disclosures on fair value which
would in turn push the draft version of the proposal back to mid- July 2009 and the issuance of
the final rules on the topic of fair value back to mid-November. In what the FASB calls “field
visits”, the board would conduct visits to firms to test the operation of the proposed footnote
reporting rules. The rules would be aimed at making a clear company judgment on valuation
methodologies and the underlying information that lead to specific valuation choices. After the
field visits, the FASB would utilize the information gained from them to determine if the
disclosure requirements would be practicable for a range of enterprises.
To prevent the shortcomings of the current disclosures, FASB agreed on a set of measures that
would aid in the process of improving disclosures requirements:
On disaggregation, or how deeply to drill down in disclosures, the panel decided that “the
level of disaggregation generally should be greater than the line items for assets and
liabilities in the statement of financial position.
On inputs, FASB decided to include a clarification that the required discussion of
valuation techniques used to gauge fair value under FAS 157 should include descriptive
disclosures about significant inputs for both Level 2 and Level 3 estimates.
On the “effect of reasonably possible alternative inputs,” in application of disclosure
requirements to Level 3 estimates only, “entities should disclose any significant effect of
reasonably possible alternative inputs and how the effect was calculated
On transfers between levels in the hierarchy, the board decided that entities should
disclose any significant transfers between Levels 1, 2, and 3 during the reporting period
and the reasons the transfers were made.

Another concern that was brought to FASB’s attention was that net asset value per share may
not represent the fair value of the investment in all circumstances. People argued that there
were certain features of an investment that would warrant making adjustments to net asset
value per share to estimate the fair value of investments. In response to this concern, the
revised FASB Staff Position (FSP), which is a draft document utilized to solicit comments on
proposed narrow and limited revisions to GAAP literature, proposes that in circumstances in
which net asset value per share of an investment is not determinative of fair value, a
reporting entity is allowed to estimate the fair value of an investment without further
adjustment. The FASB requested that feedback on this proposal be given to them by July 8,
2009.
FASB was set to resume rulemaking on the subject of “practical expedient” for investors
having to gauge the fair value of their interests in hedge funds, private equity funds and other
alternative investments in its August 5, 2009 meeting. In the meeting the board reviewed the
comment letters submitted by interested persons and parties on the subject to determine
whether to allow, in certain circumstances and under some strictures, the use of a “net asset
value per share” (NAV) -without adjustments- in estimating fair values of investments. The
final decision of the board was to issue, by August 31, 2009, the expedient that would allow
investors to use NAV when estimating the fair value of investments in certain situations.
Although there are some opposers of the FASB’s decision, who point out that NAV will not
always be the equivalent of fair value in some instances, the majority of accounting
professionals agree that the NAV will be close to the fair value of an investment in most
cases.
On July 8, 2009, FASB Chairman, Robert Herz, announced that the board would begin work
on the disclosure framework. Some specific areas that the project will evaluate and address
include whether the framework should:
Apply to all entities or perhaps exclude private or nonprofit entities
Apply to interim reporting
Focus only on high-level principles
Focus only on notes to financial statements or extend to better integrate information

provided in financial statements, MD&A, and other parts of a company’s public
reporting package.
The board plans to begin deliberations on the framework this quarter and expects to issue
a preliminary views document in the first half of 2010.
On the subject of fair value recognition and measurement, FASB board members agreed
to present a proposal, in August 2009, to improve financial reporting for financial
instruments. The board reached this decision in its July 15, 2009 meeting. FASB looks
to expand the use of fair values on corporate income statements and balance sheets “in
ways it never has before”. Even loans will be carried on the balance sheet at fair value.
With FASB’s tentative plan to require that all assets be recorded at fair value on the

balance sheet every quarter, this will end asset classifications, such as held for
investments, held to maturity and held for sale. This means that banks will have to
present their loans on the balance sheet at the cost, with a line item below showing the
accumulated change in fair value with the net fair-value figure below. For lenders, the
changes would mean faster recognition of loan losses which will result in lower earnings
and book values. Liabilities would also have to be reported at fair value as a result of the
changes but some exceptions will apply for things like the company’s own debt.
The effects of the fair value accounting proposals by FASB spans widely across the
accounting/finance field but will have a significant effect on the banking industry. The
changes will require more work on the side of the banker but will help them in the
process. For instance, if a bank’s loans are significantly higher than stated on its balance
sheet the current rule on fair value, which requires this to be disclosed once a year would
not reflect that the bank has been insolvent for months. However, with the new rule
requiring that such assets and liabilities be recorded on a quarterly basis, the additional
disclosures could serve as an early warning of trouble ahead. Nevertheless, bankers do
not want any expansion of fair value accounting as stated by Donna Fisher, the American
Bankers Association’s tax and accounting director. Many believe that if the bankers
don’t like the new rule, that it’s probably a good sign that the FASB is doing something
right.
In August 2009, the FASB decided which fair value measurements would be presented
in net income recognition and those that are recognized in the statement of other
comprehensive income. Changes in fair value recognized in net income would require
presentation of only the fair value on the balance sheet. The notes to financial statements
could disclose the instrument’s value at amortized cost and at a reconciliation to fair
value.
A recent issue that has come up with the fair value measurement and recognition subject
is whether there is a need for a sensitivity analysis when arriving at the fair value of
financial instruments. Sensitivity analysis, also known as “stress tests”, is intended to
yield information on how the value of an asset would be affected due to changes in
assumptions about economic conditions, such as rises in joblessness or drops in housing
prices. In its July 29, 2009 meeting, the Financial Accounting Standards Board signaled
that it did not intend to call for sensitivity analysis in the draft for guidance on improving
disclosures about how companies arrive at fair values. However, in the board’s August 5
meeting, the board voted (3-2) in favor of including the sensitivity analysis in the draft
guidance on disclosures for fair value. FASB Chairman Robert Herz believes that the
analysis is needed in order to properly state the fair value. Herz stated that every time
the board meets with who he referred to as “sophisticated users”, sensitivity analysis is
always discussed. The proposed accounting standard update, or ASU, had a 45-day
comment period. After which the board plans to have the update effective for financial
statements covering annual and interim periods ending after December 15, 2009 with the
exception of Level 3 sensitivity disclosures, if approved as final guidance.
The Valuation Research Cooperation Alert issued in September 2009 showed minimum
confidence in fair value accounting, particularly recent rivalry in bank valuations and
fund valuations. We will look forward to look at the changes that may arise after
reporting begins under the new fair value guidance.

The new FASB accounting guidance issued September 30, 2009, on how to estimate the
fair value will impact reporting entities that hold investments that are required or
permitted to be measured at fair value in such alternative investments as hedge funds,
real estate funds, venture capital funds, and private equity funds, for which there is not a
readily determinable fair value.
The valuation research groups of the FASB has expressed concern that the sensitivity
analysis requirement would be difficult to implement for certain companies, because of
discount rate, credit rate and other variables that would have to be considered.
Fair value will also continue to be a controversial topic between the FASB and the IASB.
David Tweedie, IASB chairman, in late October 2009, commented upon work in
progress regarding modifications to IAS 39 by stating that “under our model, whether
there is an increase or decrease of fair value for a particular institution will depend on the
institution’s business model and holdings. Let me state clearly: the IASB will not
require that the loan books of banks be held at fair value…” He then stated that he and
the IASB members “will seek to reach a common agreement on a forward-looking model
for loan loss provision and a simplified hedging methodology. I remain optimistic that
we can overcome our current differences.” In that regard, commencing November 2009
and thereafter into 2011, monthly meetings were contemplated by him with Robert Herz,
chairman of the FASB.
We conclude that as of the ending months of 2009, much controversy and differences of
opinion continue to exist regarding fair value accounting.
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disclosures for fair value. Daily Tax Report. (149), G-3 - G-4.
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value, financial asset impairment. Daily Tax Report, 51, G-4 - G-5.
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Accounting Standard Board Web site: http://www.fasb.org/ed_info.shtml&pf=true
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ACKNOWLEDGMENTS
The author expresses his thanks to graduate assistant, Ashley N. Williams for her help in
the preparation of this paper.

THE SUPREME COURT GRANTS CERTIORARI TO
REVIEW THE SECOND CIRCUIT’S RULING THAT
NEW YORK CITY HAS STANDING TO BRING A
CIVIL RICO CLAIM TO COLLECT CIGARETTE
TAXES ON INTERNET SALES
Aquilio, Mark
St. John’s University
aquiliom@stjohns.edu
ABSTRACT
In Hemi Group, LLC, et al. v. City of New York, 129 S. Ct. 2159 (2009) the Supreme Court
recently granted certiorari to review the Second Circuit Court of Appeals ruling consolidating
four cases in City of New York v. Nexicon, Inc., Hemi Group, LLC et al., 541 F.3d 425 (CA-2,
2008) that New York City has standing to bring a civil RICO claim to collect cigarette taxes on
internet sales made by out-of-state sellers who failed to file reports with New York State as
required by the Jenkins Act. The court held there was standing to bring a civil claim under RICO
§ 1964(c) by asserting a violation of RICO § 1962(c) via mail and wire fraud, which caused
damages to its “business or property,” even though they did not arise from a commercial
transaction. Also, the court opined that there were distinct RICO “persons” and “enterprises”
and the proximate cause necessary to bring a civil RICO claim.
The Supreme Court’s decision will resolve a split among the circuit courts of appeals on the
issue of whether or not state and local governments can sue under RICO § 1964(c) to collect
taxes and similar noncommercial losses incurred by a government acting in its sovereign
capacity as injuries to “business or property.”
INTRODUCTION
In recent years there has been a proliferation of civil claims brought under the Racketeer
Influenced and Corrupt Organizations Act (RICO). Addressing a growing concern that organized
crime was expanding beyond its traditional sources of revenue from illegal activities into what
appeared to be legitimate businesses in 1970 Congress enacted RICO as title IX of the Organized
Crime Control Act, Pub. L. 91-542, 84 Stat. 941, as amended, 18 U.S.C. §§ 1961-1968 (2000 ed.
and Supp. III) and included provision for civil claims. Reversing the expanding scope of RICO
civil claims in the area of unfair competition in Anza, et al, v. Ideal Steel Supply Corp., 547 U.S.
451, 126 S. Ct. 1991, 164 L. Ed. 2d 720 (2006) the Supreme Court severely limited civil RICO
claims by ruling that Ideal lacked standing to bring a civil claim under RICO § 1964(c) based on
RICO § 1962(c) seeking recovery of damages to its business caused by its competitor‟s alleged
racketeering activity of unlawfully selling products free of state and local sales tax and submitting
fraudulent sales tax returns in violation of mail and wire fraud statutes. The tax scheme allegedly
cost Ideal profits as it lost customers to its competitors who weren‟t charging the sales tax. The
Court ruled that Ideal could not maintain its RICO claim as proximate cause was lacking. The
Court reasoned that there was not a direct relation between the asserted injury and the alleged
injurious conduct. Since it ruled that the claim lacked proximate cause as Ideal was not the

Aquilio Collect Cigarette Taxes on Internet Sales
immediately direct victim of the alleged racketeering activity, the Court did not rule on whether
reliance on the fraudulent misrepresentations by Ideal was a necessary element to the civil RICO
claim or proximate cause.
Most recently, in Hemi Group, LLC, et al. v. City of New York, 129 S. Ct. 2159 (2009) the
Supreme Court granted certiorari to review the Second Circuit Court of Appeals‟ ruling in City of
New York v. Nexicon, Inc., Hemi Group, LLC., et al., 541 F.3d 425 (CA-2, 2008), which
consolidated four cases and reversed the decisions of the District Court of the Southern District of
New York. Hemi Group, LLC et al. were parties in the case brought against Nexicon, Inc., which
was formerly known as CYCO.net, Inc. The Second Circuit held in a 2-1 decision that New York
City (NYC) has standing to bring a civil RICO claim to collect cigarette taxes on internet sales
made by out-of-state sellers who failed to file reports with New York State as required by the
Jenkins Act. The court held there was standing to bring a civil claim under RICO § 1964(c) by
asserting a violation of RICO § 1962(c) via wire and mail fraud, which caused damages to its
“business or property,” even though they did not arise from a commercial transaction. Also, the
court opined that there were distinct RICO “persons” and “enterprises” and the proximate cause
necessary to bring a civil RICO claim.
In 2005 the District Court dismissed NYC‟s state law claims and it‟s RICO claims, with leave to
amend, for failure to plead "distinctness" in the enterprise allegations necessary for RICO in City
of New York v. CYCO.net, Inc. et al., 383 F. Supp. 2d (S.D.N.Y., 2005). The state law claims are
not discussed herein. In 2006, after the City amended its complaints, the District Court again
dismissed the complaints, this time with prejudice, for failure to plead the “distinctness” in the
enterprise element necessary in City of New York v. Nexicon, Inc. f/k/a CYCO.net, Inc. et al., No.
03 Civ. 383, 2006 U.S. Dist. LEXIS 10295 (S.D.N.Y. Mar. 15, 2006); City of New York v.
Smokes-Spirits.com, Inc. et al., No. 04 Civ. 6616, 2006 U.S. Dist. LEXIS 11954 (S.D.N.Y. Mar.
21, 2006); City of New York v. NCCigarettes, No. 03 Civ. 7715, 2006 U.S. Dist. LEXIS 11922
(S.D.N.Y. Mar. 22, 2006); and City of New York v. EZTobacco, No. 03 Civ. 10091, 2006 U.S.
Dist. LEXIS 11953 (S.D.N.Y. Mar. 22, 2006). As in 2005, the District Court dismissed the
Nexicon (f/k/a CYCO.net, Inc.) case first. It then dismissed the other three related cases on
collateral estoppel grounds.
The implications of the court‟s ruling are far-reaching and greatly expand the reach of the RICO
civil provision for treble damages. The Supreme Court‟s decision will resolve a split among the
circuit courts of appeals on the issue of whether or not state and local governments can sue under
RICO § 1964(c) to collect taxes and similar noncommercial losses incurred by a government
acting in its sovereign capacity as injuries to “business or property.” It will also provide further
clarity on the direct injury standard necessary for proximate cause and the elements necessary to
satisfy the distinct enterprise requirement in RICO. Before analyzing the holding in Nexicon a
brief overview of the relevant provisions of RICO is necessary.
OVERVIEW OF THE PROVISIONS OF RICO AND THE JENKINS ACT RELEVANT

TO THE HOLDING IN CITY OF NEW YORK V. NEXICON, INC.
The civil remedies provision of RICO provides in relevant part that "[a]ny person injured in his
business or property by reason of a violation of section 1962 of this chapter [Title 18] may sue
therefore in any appropriate United States district court and shall recover threefold the damages
he sustains and the cost of the suit, including a reasonable attorney's fee." 18 U.S.C. §§ 1964(c)
(1988 and 2000). (emphasis added).

Section 1962 provides, in relevant part:

(c) It shall be unlawful for any person employed by or associated with any enterprise engaged in,
or the activities of which affect, interstate or foreign commerce, to conduct or participate, directly
or indirectly, in the conduct of such enterprise's affairs through a pattern of racketeering activity...
(emphasis added).
Thus, to establish standing and state a claim for civil damages under RICO, a plaintiff must allege
that: (1) the defendant has violated a substantive provision of RICO § 1962; (2)an injury to the
plaintiff‟s business or property; (3) and that the injury was caused by reason of the defendant‟s
violation of RICO § 1962.
To plead a violation of the substantive RICO statute, a plaintiff must allege the existence of
seven constituent elements: "(1) that the defendant (2) through the commission of two or more
acts (3) constituting a 'pattern' (4) of 'racketeering activity' (5) directly or indirectly invests in, or
maintains an interest in, or participates in (6) an 'enterprise' (7) the activities of which affect
interstate or foreign commerce." Moss v. Morgan Stanley Inc., 719 F.2d 5 (CA-2, 1983), cert.
denied, 465 U.S. 1025 (1984).
Racketeering activity "consists of no more and no less than the commission of a predicate act."
Sedima, S.P.R.L. v. Imrex Co., 473 U.S. 479, 496 (1985). A "pattern of racketeering activity" is
defined as requiring the commission of at least two of the predicate acts enumerated in 18 U.S.C.
§ 1961(1) within a ten year period. 18 U.S.C. § 1961(5). RICO § 1961(1)(B) defines
"racketeering activity" as any act that is indictable under, inter alia, 18 U.S.C. §§ 1341
(prohibiting mail fraud), and 1343 (prohibiting wire fraud). 18 U.S.C. §§ 1341 and 1343 prohibit
the use of the mail or wire communication to further "any scheme or artifice to defraud, or for
obtaining money or property by means of false or fraudulent pretenses, representations, or
promises."
Regarding the “enterprise” requirement, the Supreme Court has reasoned that a plaintiff must
"allege and prove the existence of two distinct entities: (1) a 'person'; and (2) an 'enterprise' that is
not simply the same 'person' referred to by a different name." Cedric Kushner Promotions, Ltd. v.
King, 533 U.S. 158, 161-62, 121 S. Ct. 2087, 150 L. Ed. 2d 198 (2001). A "person" is defined as
"any individual or entity capable of holding a legal or beneficial interest in property." 18 U.S.C. §
1961(3). An "enterprise" is defined as "any individual, partnership, corporation, association, or
other legal entity, and any union or group of individuals associated in fact although not a legal
entity." 18 U.S.C. § 1961(4).
A RICO enterprise based on an association-in-fact theory is "a group of persons associated

together for a common purpose of engaging in a course of conduct," the existence of which is
"proved by evidence of an ongoing organization, formal or informal, and by evidence that the
various associates function as a continuing unit." United States v. Turkette, 452 U.S. 576, 583,
101 S. Ct. 2524, 69 L. Ed. 2d 246 (1981).
The dual requirements of distinctness and the evidence needed to establish an association-in-fact
serves to eliminate claims brought as RICO actions but which are not. The “distinctness doctrine”
requires a plaintiff to demonstrate that the RICO “person” is legally separate from the RICO
“enterprise.” The association-in-fact requirements prevent distinctness from being established by
simply tacking on entities to the “enterprise” which do not function as a "continuing unit" or
share a "common purpose." See, Turkette, 452 U.S. at 583.

In order to satisfy the requirement in RICO § 1964(c) that a plaintiff demonstrate its business or
property was injured by reason of the defendant‟s violation of RICO § 1962 the plaintiff must
show both “direct” and “proximate” causality. The plaintiff must establish that the RICO
violation was not only the “but for” cause of the damages but was also the legally cognizable or
“proximate cause” of the damages. Holmes v. Securities Investor Protection Corp., 503 U.S. 258,
112 S. Ct. 1311, 117 L. Ed. 2d 532 (1992), Anza v. Ideal Steel Supply Corp., supra and Sedima,
S.P.R.L., supra.
In Holmes, Securities Investor Protection Corporation (SIPC), a private corporation with a duty to
reimburse the customers of registered broker-dealers who became unable to meet their financial
obligations, alleged that Robert Holmes conspired with others to manipulate stock prices. The
fraud resulted in a precipitous drop in the stock price, causing two broker-dealers financial
difficulties resulting in their liquidation and inability to meet their obligations to their customers.
Hence, SIPC had to advance nearly $13 million to cover the claims of customers of those broker-
dealers. SIPC sued Holmes on the theory, among others, that he violated RICO §1962(c). SIPC
claimed that it was subrogated to the rights of those customers of the broker-dealers who did not
purchase manipulated securities. The Court ruled against SIPC reasoning that the nonpurchasing
customers' injury was not proximately caused by the defendant's conduct, because “the
conspirators have allegedly injured these customers only insofar as the stock manipulation first
injured the broker-dealers and left them without the wherewithal to pay customers' claims.”
Holmes, 503 U.S. at 271.
The Holmes Court rejected an interpretation of the “by reason of” language to require only that
the RICO violation was a “but for” cause of the plaintiff‟s injury. It noted the "unlikelihood that
Congress meant to allow all factually injured plaintiffs to recover." Id., at 266. Rather, applying
the common law principles of proximate cause, it required a direct relation between the injury
and the injurious conduct in a civil RICO action. Thus, it ruled that RICO § 1964(c) requires a
plaintiff to demonstrate proximate cause to show injury “by reason of” a RICO violation. The
Court explained that proximate cause is a flexible concept not lending itself to “a black-letter rule
that will dictate the result in every case.” It noted that the direct-relation requirement for
proximate cause eliminates the difficulties attended to determining the plaintiff‟s damages due to
the defendant‟s actions as opposed to other independent factors. It also prevents courts from
having "to adopt complicated rules of apportioning damages among plaintiffs removed at
different levels of injury from the violative acts, to obviate the risk of multiple recoveries," and
acknowledges that directly injured victims can generally be counted on to vindicate the law as
private attorneys general, without any of the problems attendant upon suits by plaintiffs injured
more remotely." Id., at 269-70. Ultimately, the Court found the connection between the alleged
stock manipulation and the broker-dealers‟ customers‟ losses as too remote since it was purely
contingent on the harm suffered by the broker-dealers. It held that SIPC‟s losses were not
directly related to the defendant‟s injurious activity, but were derivatively associated.
In 1949 Congress enacted the Jenkins Act (15 U.S.C. §§ 375-378) to offset the loss of state taxes
caused by interstate taxing discrepancies. It requires out-of-state cigarette sellers to file a report
with the tobacco tax administrator of each state into which the seller ships cigarettes to non-
distributors, identifying the name, address, and quantity of cigarettes purchased by the non-
distributor state residents. An amendment to the Jenkins Act in 1955 requires the seller of
cigarettes in interstate commerce to register with the tobacco tax officials of states where he
advertises or into which he ships cigarettes. See, 15 U.S.C. § 376(a). States use the information
provided by out-of-state cigarette sellers under the Jenkins Act to collect the payment of cigarette
taxes directly from the purchasers.

CITY OF NEW YORK v. NEXICON, INC., HEMI GROUP, LLC et al.

The facts in Nexicon are complex. As most states do, New York State (NYS) imposes a tax on all
cigarettes used or sold in NYS. It also authorizes NYC to impose its own tax on cigarettes, thus
NYC imposes a tax on all cigarettes possessed in NYC for sale or use. Generally, the combined
NYS and NYC cigarette taxes are either the highest or among the highest in the nation. In-state,
the cigarette taxes are collected through the sale of tax stamps to in-state vendors. However, out-
of-state cigarette sellers are not responsible for collecting or paying either NYS or NYC sales
taxes on cigarettes.
The Jenkins Act requires out-of-state cigarette sellers to report only to state taxing authorities.
However, NYS and NYC have entered into various agreements for the administration and
collection of cigarette taxes whereby NYC alleges it will be “fully and promptly” informed by the
NYS Department of Taxation and Finance of any information relevant to the collection of
cigarette taxes, including Jenkins Act reports.
In its complaint NYC alleged that the out-of-state defendants advertise their cigarettes over the
Internet to NYC residents. Orders are then shipped by common carrier or the United States Postal
Service into NYC; however, the defendants do not comply with the Jenkins Act registration or
reporting requirements. NYC contended that the savings due to purchasing the cigarettes over the
Internet are almost entirely generated by the failure to charge or pay the NYS and NYC taxes,
thus the failure to comply with the Jenkins Act is an essential part of the defendant‟s business
model. While the defendants are not liable to pay the tax themselves, allegedly, the defendants
failed to notify customers of their use tax obligations. Also, most made false representations to
customers, such as informing inquiring customers that they are prohibited from disseminating
customer information to taxing authorities, advertising their cigarettes as "tax-free" and assuring
customers that sales would not be reported to the NYS tax authorities. Further, NYC alleged that
Nexicon defendants attempted to prevent it from accessing their sales records so as to maintain
their customers' trust. Accordingly, NYC alleged that the defendants engaged in a "pattern of
racketeering" prohibited by RICO § 1962(c) by committing mail or wire fraud each time they
used, or cause to be used, the mails or wires to effect a sale of cigarettes to a NYC resident and
failed to comply with the Jenkins Act's reporting requirements to NYS, thus causing NYC injury
to “business or property” under RICO § 1964(c) in the amount of "tens[,] if not hundreds[,] of
millions of dollars a year in cigarette excise tax revenue."
The alleged RICO enterprises in the four consolidated cases before the Second Circuit took one
of two forms. In “Enterprise 1” form a defendant corporate entity allegedly was a passive
enterprise with its defendant officer(s) and/or director(s) acting as the "person[s]" under RICO §
1962(c) who conduct the illegal affairs of the enterprise. An “Enterprise 2” form is composed of
association-in-fact enterprises with the association consisting of a defendant entity and a third
party, and the RICO § 1962(c) "person[s]" consisting of the defendant entity and the officers
and/or directors of the entities comprising the enterprise.
As previously noted the Second Circuit reversed the District Court and ruled that NYC has
standing to bring a civil RICO claim. The Second Circuit summarized the holding of the District
Court as follows: “The District Court held that while the structure of the alleged primary
enterprises was legally viable, the alleged RICO persons (employees and/or officers of the
businesses) did not have individual duties to file Jenkins Act reports, and thus could not have
committed the alleged predicate racketeering acts. The court explained: „[T]he language of the
Jenkins Act prohibits „persons‟ from transferring cigarettes for profit in interstate commerce. The
statute defines „person‟ as including: „corporations, companies, associations, firms, partnerships,

societies, and joint stock companies, as well as individuals. 15 U.S.C. § 375(1). Employing basic
statutory construction analysis, it is clear that companies are the primary entities responsible for
filing Jenkins Act reports. The catch-all phrase „as well as individuals‟ suggests a separate class
of people who may be liable under the Jenkins Act, but does not by any means connote officers or
directors of the business entities listed before the phrase. Accordingly, as only the Defendant
companies are responsible for filing the reports, and only they can be accused of fraudulently
concealing such reports by not filing them, only the Defendant companies may be considered as
having committed predicate acts. Thus, only they may properly be considered „persons‟ under the
definition of the Jenkins Act and under RICO. Given the unique facts of the instant case, where a
company is statutorily required to perform a function that it fails to do, resulting in fraud . . . the
„persons‟ for purposes of RICO cannot be the officers of the companies, but must be the
companies themselves.‟ Nexicon, 2006 U.S. Dist. LEXIS 10295, at *25-26. Accordingly, with
respect to the alleged primary enterprises, the District Court found that the City failed to state a
claim. 2006 U.S. Dist. LEXIS 10295, at *26.
With respect to the alternatively pled association-in-fact enterprises, the District Court explained
that, under well settled law, an enterprise cannot consist solely of employees associating with
their corporate employer, and that the City apparently tried to circumvent this rule by „tacking
on‟ other companies with which each corporate defendant associated. The problem with this
approach, the court found, was that while the City had alleged technically legitimate enterprises,
(1) the City had failed to sufficiently allege that the tacked-on members of the enterprise shared a
„common purpose‟ with the defendant corporations, … (2) the City failed to allege a nexus
between the RICO predicate acts and the association-in-fact enterprises; and (3) the City failed to
„explain each participant's role in the alleged course of fraudulent conduct.‟ Nexicon, 2006 U.S.
Dist. LEXIS 10295, at *28-29. In sum, the District Court found that while the City alleged that
defendants have relationships with the third-party companies, the City „has not shown how the
various components of the enterprise engaged in a fraudulent course of conduct together.‟ 2006
U.S. Dist. LEXIS 10295, at *30.” Nexicon, Inc., 541 F.3d at 438-439.
In reversing the District Court on the ground that it did not adequately plead a RICO enterprise
the Second Circuit ruled that the City adequately (1) pleaded a violation of RICO § 1962 (c), (2)
demonstrated injury to its "business or property” and (3) the injury was “by reason of" the alleged
RICO violations as required by RICO § 1964(c), thus satisfying the causation requirement. The
court analyzed each of these issues in reverse order.
Regarding the issue of causation, the court applied the standards established in Anza, Holmes and
Sedima. The court held that the injury suffered by NYC, a specific dollar amount of taxes
imposed on each pack of cigarettes sold without filing the necessary Jenkins report, was a direct
result of the fraudulent scheme to deny NYC use taxes, which was the central theme of the
alleged predicate acts of mail and wire fraud. The court stated, “The City's claims are easily
distinguishable from the ones found to be insufficient in Holmes. … That New York State may
also have been injured by defendants' alleged schemes does not make the City's injury any less
direct; the City is owed a certain amount of taxes independent of any amount owed to or collected
by the State. … The fact that the failure to file Jenkins Act reports with the State leads directly to
the City's alleged harm, namely loss of tax revenues, also distinguishes this case from Anza,
where the injury was found to be too attenuated. … Moreover, Anza is distinguishable from this
case in two important, related, respects. First, Anza involved a RICO claim of a competitor
complaining of another merchant's ability to offer lower prices, and the Court's holding sought to
limit RICO standing in that type of case. ... As the Court explained, „claims brought by economic
competitors . . . if left unchecked, could blur the line between RICO and the antitrust laws.‟ …

Second, because competition claims may involve a host of market factors unrelated to the alleged
RICO violation, following the causal chain and measuring damages involve evidentiary
complexities beyond what a factfinder should be expected to reasonably or reliably parse through.
… Here, by contrast, the City's claim is not market based. While the City's case will not be free of
evidentiary wrinkles, any potential wrinkles are nowhere near the type or degree involved in
Anza. ” Nexicon, Inc., 541 F.3d at 441-442.
The court reasoned that the Holmes standard is satisfied as the direct damages could easily be
calculated by counting the packs of cigarettes sold by the defendants. Also, the court held that the
fact that the cigarette purchasers might be partially to blame for the injury doesn‟t defeat
proximate cause as the Second Circuit has held that defendants are still liable where their actions
were a substantial factor in causing the loss in Lerner v. Fleet Bank, N.A., 459 F.3d 273 (CA-2,
2006). The court stated, “A contrary rule would effectively require that a plaintiff's injury be
caused by only one source, and, as this is often not the case, it would operate to insulate from
liability defendants who scheme with others in violation of RICO. Here, defendants' actions are
clearly alleged to be a substantial factor in the City's loss.” Nexicon, Inc., 541 F.3d at 443.
The court reasoned that the concern in Holmes of apportioning damages among plaintiffs so that
there aren‟t multiple recoveries is not a problem as only NYC can claim loss of its use taxes and
NYS would have separate damages since it charges separate taxes. Also, it determined that
while NYS may also seek to sue to vindicate the law, NYC should not have to rely on NYS to sue
under RICO, where its injury of lost taxes is no less direct than the injury of NYS.
In dealing with the Second Circuit cases where causation was lacking which the defendants used
to support their claim the court stated, “… there are no speculative steps in this chain of
causation. When defendants fail to comply with the Jenkins Act, defendants deprive both the City
and the State of information needed to collect taxes from the in-State and in-City cigarette
purchasers. And the City has alleged that it „will be 'fully and promptly' informed by the New
York State Department of Taxation and Finance of any information relevant to the collection of
cigarette taxes, including Jenkins Act reports.‟ … Though the City and State are injured by the
same activity, the City's injury does not depend on the State being injured. … And it is clear that
the City is alleged to be the target of the scheme because a large part of, if not the driving force
behind, defendants' business plans was to sell cigarettes in such a way as to allow consumers to
evade New York City's taxes. …The fact that the State may also have been targeted by
defendants' schemes does not change the result. … „No precedent suggests that a racketeering
enterprise may have only one 'target,' or that only a primary target has standing‟; indeed, „there is
a broad class of plaintiffs under RICO.‟…”. Nexicon, Inc., 541 F.3d at 443-444.
Interestingly, the court opined that the predicate racketeering acts were the mail and wire fraud
violations and not the Jenkins Act violations. Thus, causation is determined by viewing the mail
and wire fraud and tying it directly to the lost taxes. The court stated, “In the City's allegations,
the Jenkins Act violations form the basis of defendants' scheme to defraud, an essential element
of the alleged predicate acts of mail and wire fraud, which targeted both the City and State in an
effort to deprive both of the information needed to collect use taxes. The fact that defendants have
no statutory duty to the City under the Jenkins Act does not make the City's alleged harm from
the mail and wire fraud violations derivative, unforeseeable, or any less direct. … [T]he mail and
wire fraud statutes extend to protect taxing authorities from fraud. … Moreover, we do not share
our dissenting colleague's concern that this case represents a „major expansion of mail fraud
doctrine.‟ … [T]he City has alleged an injury in the form of lost taxes that is independent from,
even if parallel to, any injury suffered by the State. … By recognizing the City's right to proceed

in this case, we are neither extending the scope of the mail and wire fraud statutes, nor the scope
of RICO, beyond their established reach.” Nexicon, Inc., 541 F.3d at 444.
Regarding the issue that NYC demonstrated injury to its "business or property,” the court ruled
that the injury was not required to be one incurred by NYC as a party to a commercial
transaction. Thus, lost taxes constitute injury to “business or property” under RICO. The court
ruled that its holding in Town of West Hartford v. Operation Rescue, 915 F.2d 92(CA-2, 1990),
where it suggested that a municipality must have sustained its injury as a party to a commercial
transaction to have standing under RICO, was dicta, citing Att'y Gen. of Can. v. R.J. Reynolds
Tobacco Holdings, Inc., 268 F.3d 103, 132 n.40 (CA-2, 2001), cert. denied, 537 U.S. 1000
(2002). The court reasoned that the Supreme Court has held RICO is to be read broadly, and that
there is no reason to add another standing requirement on municipalities for civil RICO claims. It
noted that the Second Circuit has ruled that tax losses due to unpaid taxes are “property” under
the mail and wire fraud statutes. In addition, the court viewed Anza as suggesting that the
Supreme Court implied a State would have a recoverable injury based on lost taxes due to fraud.
The Second Circuit‟s decision adds to the split among the circuit courts over whether the injury to
“business or property” requires that a governmental entity be acting in its sovereign capacity to
have standing. The Seventh Circuit in Illinois Dep't of Revenue v. Phillips, 771 F.2d 312 (CA-7,
1985) rejected the requirement that a State government unit must be alleging competitive or
commercial injuries under RICO. In reversing the district court the court stated, “Although we
have doubts about the application of RICO to the facts of this case we cannot say that it does not
come within the framework of the statute." Id., at 317.
Conversely, the Ninth Circuit in Canyon County v. Syngenta Seeds, Inc., 519 F.3d 969, 979 (CA-
9, 2008), cert. denied, 129 S.Ct. 458 (2008) held that a county government lacked RICO standing
to sue for injuries it alleged incurred "in its sovereign and/or quasi-sovereign capacities… ." It
relied on Hawaii v. Standard Oil Co., 405 U.S. 251, 264 (1972) where the Supreme Court held
that Hawaii lacked standing under the Clayton Act because the phrase "business or property"
refers "to commercial interests or enterprises," and does not include loss of tax revenues.
The Sixth Circuit also held that State government and its subdivisions lack standing under RICO
to sue for damages from noncommercial losses as “injury to business or property” when it
affirmed the district court‟s decision in Michigan Dep't of Treasury v. Fawaz, 653 F. Supp. 141
(E.D. Mich., 1986), aff'd, 848 F.2d 194 (CA-6, 1988) that Michigan could not use RICO to sue its
own citizens in a federal forum for state sales tax violations. The Sixth Circuit affirmed the
district court in a decision not recommended for full text publication. See also, Township of
Marlboro v. Scannapieco, 545 F. Supp. 2d 452 (D. N.J., 2008) (seeking damages due to bribes to
Township employees) and West Virginia v. Moore, 895 F. Supp. 864 (S.D. W.Va. 1995) (seeking
the recovery of lost tax revenue), where district courts in the Third and Fourth Circuits,
respectively, denied standing in RICO claims by governmental authorities.
Regarding its holding that NYC adequately pleaded a violation of RICO § 1962 (c), the court
stated that it is settled law in the Second Circuit that a Jenkins Act violation may form the basis of
a mail and wire fraud conviction. It held that the named RICO defendants directed the enterprises
not to file Jenkins Act reports while using the mails or wires to affect the sales to NYC residents,
which constitutes a scheme to defraud NYC of use taxes as the defendants deprived it of the
information needed to collect those taxes.

The court held that NYC generally adequately alleged the existence of two distinct entities,
namely a “person” and “enterprise” that is not the same “person.” The court applied the
distinctiveness standard to each of the enterprises in the case and found the standard generally
satisfied. The court ruled with regard to the primary enterprises, – i.e., NCCigarettes, and
Nexicon, “that the enterprise is an innocent corporation, with its own legal basis for existing, and
the persons are employees or officers of the organization unlawfully directing the enterprises‟
racketeering activities.” Nexicon, Inc., 541 F.3d at 448. The court reasoned that regarding
NCCigarettes there was distinctness as the sole proprietorship involved is not a one-man show.
Also, the court ruled that the District Court erroneously held that NYC failed to plead an
enterprise regarding the Nexicon association-in-fact enterprise, but upheld its rulings of failure to
adequately plead an enterprise regarding the Hemi Group and NCCigarettes association-in-fact
enterprise.
In a well-reasoned dissent, Judge Winter reasoned that the RICO violations were not the
proximate cause of NYC‟s injuries, thus it lacked standing under RICO. Winter reasoned that the
alleged fraud is based on violations of the Jenkins Act, thus the nature and consequences of the
fraud should be determined by the scope of it. Winter rejected the majority‟s opinion that the
predicate racketeering acts were not Jenkins Act violations, but were the mail and wire fraud
violations. He noted the majority‟s description of the allegations of mail and wire fraud, its direct
cause of the injury and calculation of damages was tied to the failure to comply with the Jenkins
Act. Hence, he reasoned, the only fraudulent acts that “sound of fraud” are violations of the
Jenkins Act. He also noted that there are no cases holding an illegal failure to report sales to a
state tax authority constitutes fraud on a municipal tax authority.
He stated, “Absent the Jenkins Act, appellees would have owed no duty to disclose their sales to
anyone, and their failure to disclose could not conceivably be deemed fraud of any kind.
Appellees owe no taxes to the City. The tax evasion is by the purchasers of the tobacco products.
Even with the Jenkins Act, which requires reporting only to state authorities, appellees have no
duty to disclose anything to the City. Indeed, conspicuously absent from the City's pleadings is
any claim brought pursuant to the Jenkins Act itself, rather than RICO, seeking enforcement of
the Jenkins Act, effectively an admission that the Act does not protect the City. Nexicon, Inc.,
541 F.3d at 460.
Winters disagreed with the majority‟s distinguishing of Anza. He stated, “First, they emphasize
that the plaintiff in Anza was a competitor of the defendant. If anything, however, the plaintiff in
Anza had a stronger case with respect to proximate causation than the plaintiff here. In Anza, the
defendant was the tax evader and had thereby lowered its costs and gained a competitive
advantage over the plaintiff. In the present case, the City lost tax revenue because appellees sold
cigarettes to purchasers, but did not report these sales to the State, as required by the Jenkins Act;
because of this failure to report, the State was unable to pass on reports of such sales to the City
even if it had been inclined to do so; without reports from the State, the City was unable to collect
sales taxes from purchasers; concurrently, the purchasers individually opted not to fulfill their tax
obligations to the City's taxing authorities. The City was at best an expectant gratuitous donee of
information from the State, and the suggestion that the City's harm is somehow less attenuated
than the plaintiff's in Anza seems to me unsustainable… .” Nexicon, Inc., 541 F.3d at 460.
Winters disagreed with the majority‟s reading of Holmes distinguishing Anza, stating, “… even if
the Holmes' rationale is not completely apt in a particular case, a successful plaintiff must still
show that it is a direct victim and, where a statutory violation is alleged to have caused the
plaintiff's injury, is a member of the class the particular „statute meant to protect‟ and the harm

was one „the statute sought to avoid.‟ … Moreover, the Holmes rationale applies to the present
case. My colleagues' view that information provided to the State under the Jenkins Act would in
fact be passed along and would, without any cost or friction whatsoever – „as simple as counting
the number of cigarette packs sold by defendants to New York City residents,‟ … translate into
precisely calculable tax revenue recovered from the various addressees is highly exaggerated. …
A concern of taxing authorities everywhere is balancing the costs of collection against the
recoverable revenue, a matter of great significance where the taxpayers are, as here, anything but
inclined toward voluntary compliance. Moreover, the state appears uninterested in enforcing the
Jenkins Act and may not collate or maintain accurate records of reports from out-of-state vendors
or reliably pass them along. City customers, large numbers of individuals owing relatively small
amounts in taxes, may be hard to trace, may assert various defenses in cases based solely on
Jenkins Act reports, and may easily use non-City addresses. Finally, as to Holmes … the City
hardly has greater incentive to enforce the Jenkins Act through RICO than Anza-like competitors
who lose sales because of their rivals' sales tax evasion.” Nexicon, Inc., 541 F.3d at 461.
CONCLUSION
The Second Circuit has ruled in a 2-1 decision that NYC has standing to bring a civil RICO claim
to collect cigarette taxes on internet sales made by out-of-state sellers who failed to file reports
with New York State as required by the Jenkins Act. The court held there was standing to bring a
civil claim under RICO § 1964(c) by asserting a violation of RICO § 1962(c) via mail and wire
fraud, which caused damages to its “business or property,” even though the damages did not arise
from a commercial transaction. The court opined that there were distinct RICO “persons” and
“enterprises.” Also, it held that the direct injury standard set forth by the Supreme Court in
Sedima, Holmes and Anza was satisfied, thus there was the proximate cause necessary to bring a
civil RICO claim.
The Supreme Court has granted certiorari to review the decision in Nexicon. With its ruling the
Supreme Court will resolve a split among the circuit courts and either greatly expand or severely
limit the potential for civil RICO claims by governments. The Court‟s ruling will also provide
further clarity in applying the direct injury standard. Since Judge Sotomayor was one of the two
judges who constituted the majority in Nexicon, it will be interesting to see her influence on the
Court in this case and the Court‟s handling of the well reasoned dissent.
Whichever way the Court rules, one side is sure to be fuming as they see their claim regarding
cigarette taxes go up in smoke.
REFERENCES
Anza, et al. v. Ideal Steel Supply Corp., 547 U.S. 451, 126 S. Ct. 1991, 164 L. Ed. 2d 720 (2006)
City of New York v. CYCO.net, Inc. et al., 383 F. Supp. 2d (S.D.N.Y., 2005)
City of New York v. Nexicon, Inc. f/k/a CYCO.net, Inc. et al., No. 03 Civ. 383, 2006 U.S. Dist.
LEXIS 10295 (S.D.N.Y., Mar. 15, 2006)
City of New York v. Nexicon, Inc., Hemi Group, LLC., et al., 541 F.3d 425 (CA-2, 2008)
Hemi Group, LLC, et al. v. City of New York, 129 S. Ct. 2159 (2009)
Holmes v. Securities Investor Protection Corp., 503 U.S. 258, 112 S. Ct. 1311, 117 L. Ed. 2d 532,
(1992)
Jenkins Act (15 U.S.C. §§ 375-378)Title IX of the Organized Crime Control Act, Pub. L. 91-542,
84 Stat. 941, as amended, 18 U.S.C. §§ 1961-1968- Racketeer Influenced and Corrupt
Organizations Act (RICO)

PUBLIC DEBT AND INTEREST RATES:
INVESTIGATING THE FORWARD PREMIUM OF
THE LEBANESE GOVERNMENT TREASURY BILL
Ben Sita, Bernard

Lebanese American University
bernard.bensita@lau.edu.lb
ABSTRACT
This paper investigates the relationship between the interest rate differential (IRD) and the exchange
rate differential (ERD). We define the IRD as the difference between the yield on the Lebanese
government 3-month Treasury bill (LB3TB) and the yield on a comparable U.S. government Treasury
bill (US3TB), and the ERD as the difference between the spot and the forward exchange rate of the
Lebanese Pound. Based on the uncovered interest parity hypothesis, the paper investigates also the
relationship between the IRD and the country risk given in terms of investment, liquidity, insolvency
and political risk. Within an error correction model, we find that the IRD and the ERD are co-
integrated, but a positive IRD is not exactly matched by an equal positive ERD in the short-run.
Furthermore, we find that the IRD is inversely related to the insolvency risk, while it increases with
the liquidity risk. Finally, we reach the conclusion that holders of the LB3TB played down the
exchange rate, investment and political risk as the LB3TB yielded more than any other alternative
investment in this burgeoning economy.
INTRODUCTION
In the absence of a functioning capital market pricing financial securities is arbitrary and hazardous.
In developing economies, where the conditions for risk-free arbitrage are either inexistent or watered
in different ways, arbitrage opportunities can be large in dealing with financial securities. The
purpose of this paper is to investigate the interest rate differential (the forward rate premium) of the
Lebanese government Treasury bill (LB3TB) and the exchange rate differential (ERD) of the
Lebanese Pound. Based on the uncovered interest parity (UIP) under risk aversion, the paper
investigates also the relationship between the interest rate differential (IRD) and the country risk
given in terms of investment, insolvency, political and liquidity risk, respectively.
Given that the Lebanese Pound (LBP) is since 1998 pegged to the U.S. dollar (USD), we use the U.S.
3-month Treasury bill as the benchmark to which the LB3TB must converge. In the course of our
analysis, we define the IRD as the spread between the yield on the LB3TB and the yield on a
comparable U.S. government T-bill (US3TB). For a Lebanese investor or any other investor the
opportunity cost of holding the LB3TB is the yield on the US3TB.
Empirical studies on the relationship between the IDR and the ERD are based on the UIP hypothesis.
The UIP hypothesis predicts that a positive IRD of a certain magnitude should be associated with an
ERD of the same magnitude and sign in order to prevent arbitrage opportunities. The UIP hypothesis
is commonly rejected (e.g. Engle (1996)). Against evidence, Chinn and Meredith (2005) shows that
the UIP hypothesis hold when long-horizon data are used instead of short-horizon data.
The contribution of this paper is in examining the dynamics of interest rates for a country with a
limited access to the international capital market and with a long history of political instability. After
Lebanon reached in 1989 a political agreement on how the political power should be shared among
political forces, an ambitious reconstruction plan was set forth. With billions of dollars needed to

Ben Sita, Bernard Lebanese Government Treasury Bill
finance its plan, the government has essentially to rely on the domestic market to borrow at rates that
were much higher than they were, for instance, in the U.S. in the 1990s. In examining the dynamic of
the yield on the LB3TB, we investigate whether the bill was intentionally underpriced for political
purposes. In doing so, our paper sheds some light on the relationship between the yield on the bill and
the growing public sector debt. The rest of the paper proceeds in the following ways. The following
section presents the data set and some preliminary results. The empirical results are given in the third
section. The last section concludes the paper.
DATA, VARIABLES AND PRELIMINARY RESULTS

In this section, we present the data set, and report some stylized facts of the data.
Data
Due to the availability of monthly data, we work with two data sets. Our longest data set goes from
1982/01 to 2009/09 and includes the US3TB from the Federal Reserve of St-Louis, quasi money
(QM) and monetary reserves (RS) from the International Financial Statistics (IFS), and the LB3TB,
the LBP/USD, and the special drawing rate to the Lebanese Pound (LBP/SDR) from the Lebanese
Central Bank (LCB). Our shortest data set is from 1993/01 to 2009/09 from the LBC and includes the
public sector debt (DT), total imports (IMP), construction permits in units (CPU), tons of cement
deliveries (TCD), stock market capitalization (SMC), arrivals to (ARR) and departures from (DEP)
the Beirut International Airport. Our data are used in the following ways. First, we use IMP as a
proxy for the gross domestic product (GDP), less reliable at yearly frequency and not available at
monthly frequency. A motivation is that IMP is an important component of the Lebanese GDP as the
country profiles itself as a financial centre, and a leisure destination. Furthermore, the production
capacity has several times been destroyed on occasions of different armed conflicts. Second, since the
LBP is pegged to the USD since 1998/10, we use LBP/SDR for LBP/USD. In fact, the correlation
between LBP/SDR and LBP/USD is 99.79%. Similarly, since the forward exchange rate on the
LBP/USD is not available, we use as proxy the 12-month moving average (MA) on the LBP/USD.
Third, we measure the investment risk in terms of the ratio of (a) CPU to IMP, (b) TCD to IMP and
(c) the variance of the SMC, the political risk in terms of the ratio of DEP to ARR, the liquidity risk
in terms of the ratio of QM to RS, and the insolvency risk in terms of the ratio of DT to IMP.
In analyzing the relationship between the IRD and the ERD, we use our longest data set, which we
refer to as Sample A. Specifically, we refer to Sample A1 including data from 1983/01 to 1992/12,
Sample A2 including data from 1993/01 and 1999/12, Sample A3 including data from 1999/01 to
2009/09, and Sample A4 including data from 1983/01 to 2009/09. Sample A2 is particular important
in examining the hypothesis that the government greased the palm of its patronisers. In analyzing the
relationship between the IRD and the country risks, we use our shortest sample, which we refer to as
Sample B. Specifically, Sample B1 includes data from 1993/01 to 2009/09, Sample B2 includes data
from 1993/01 to 1998/12, and Sample B3 includes data from 1999/01 to 2009/09. Using Sample B1,
Figures 1A and 1B exhibit the patterns of the ratio of the domestic debt-to-gdp, and the proportion of
the internal debt to total debt.

Given that IMP is a good proxy of monthly GDP, Figure (1A) shows that the internal component of
the public sector debt has never been below 100% of GDP since 1993. Similarly, Figure (1B) shows
that between 1993 and 2003 more than 60% of the public debt originated from the domestic market.
However, the external component rose above the domestic component of the debt since 2003,
suggesting either the government exhausted the internal capital market or Lebanese investors were
not longer satisfied to earn lower interest rates for higher country risk when they could earn elsewhere
about the same yield at lower country risk.
Figures 2A and 2B exhibit the patterns of the LB3TB and the US3TB, and the spot and the forward
exchange rate of the LBP/USD (FSDR). Whereas the deviation of the FSDR from the SDR is
discernable between 1991/06 and 1994/02, the deviation of the LB3TB from the US3TB is obvious.
Looking at the dotted line representing the LBP/USD, Figure 2B shows that the opportunity cost of
pegging the LBP to the USD is not negligible. Finally, Figure 2A shows that the LB3TB converged to
the US3TB in 2007/02 at fixed exchange rate of LBP1507.5. Figure 2B shows clearly that the LB3TB
was much higher than the US3TB. Two explanations can be given. First, the LBP/USD was at
forward discount whenever the IDR was positive. Illustratively, suppose the LBP/USD is 1,507.50 at
spot, and the LB3TB is 35% against 5% for the U.S. A dollar exchanged at spot yields at year-end
LBP 2,035.125. However, if the LBP depreciates with respect to the USD by 35%, the apparent profit
is wiped out leaving the investor with missing profit opportunities in terms of the US3TB. That is, for
depreciation lower than 30% or larger than 40%, arbitrage opportunities exist in terms the IRD or in
terms of the ERD.
Second, risk premium offsets positive IRD. Specifically, we expect the systematic risk coefficient
(beta) to be equal to the one predicted by a hypothetical pricing model. That is, the IRD is a (linear)
function of betas associated with risk premiums in terms of for example insolvency, liquidity or
investment risk. Therefore, arbitrage opportunities are present whenever the IRD plots off the
expected lines in terms of betas. Hence, the absence of arbitrage opportunities implies that the beta
associated with the ERD equals 1.
Variables, statistics and co-integration
Denoting the US3TB as Rtf and the LB3TB as Rth , we define the IRD as
t 1 Rth 1 Rt f 1 (1)
To prevent arbitrage opportunities, the economic theory suggests for Rth Rtf , the LBP/USD should be
s
at forward discount. Denoting the spot rate of LBP/USD as Xt and the forward rate of LBP/USD as
X tf , the ERD is given by
t X tf X ts X ts , (2)
where in the absence of FSDR, we use a proxy for X tf , which is the 12-month MA of X ts . On the
basis of the IRD and the ERD, we test whether the depreciation of the LBP/USD wipes out the
apparent positive IRD. Table (1) reports the descriptive statistics of the IRD and the ERD.

Table 1: Descriptive Statistics

SAMPLE A1 A2 A3 A4
Interest Rate Differential (IRD)
Mean 0.103 0.105 0.045 0.081
Maximum 0.304 0.190 0.095 0.304
Minimum -0.001 0.071 0.002 -0.001
Std Dev 0.049 0.032 0.029 0.048
Skewness 0.781 0.966 0.084 0.667
Kurtosis 6.977 2.862 1.957 5.086
UROOTS -1.920 -2.988 -1.633 -2.900
FOC 0.902 0.894 0.986 0.952
Exchange Rate Differential (ERD)
Mean 0.393 -0.023 0.008 0.147
Maximum 1.857 0.055 0.060 1.857
Minimum -0.150 -0.117 -0.042 -0.150
Std Dev 0.408 0.035 0.025 0.317
Skewness 1.221 -0.259 -0.074 2.537
Kurtosis 4.131 3.394 2.045 9.739
UROOTS -2.861 -1.963 -2.560 -2.886
FOC 0.910 0.862 0.908 0.946
NOBS 114.000 72.000 114.000 301.000
Note: UROOTS is the unit root statistic on the Augmented Dickey-Fuller test. NOBS are the number of observations and
FOC is the first-order serial correlation.
The average of the IRD ranges between 4.5% and 10.5% and its standard deviation ranges between
2.7% and 5.0%, whereas the average of the ERD ranges between (2.03%) and 39.3% and its standard
deviation between 2.5% and 40.8%. However, these moments are unreliable as the IRD and the ERD
are nonstationary. Examining the autocorrelation function (ACF) of the two series, the first-order
autocorrelation (FOC) is near unity. However, the ACF of the series drops abruptly after the first lag.
Testing for the presence of unit root with the Augmented Dickey-Fuller test, we cannot reject the null
hypothesis of unit root in both IRD and ERD. Since ERD and IRD are nonstationary, we test based on
Engle and Granger (1987) whether the two series converge to a common long-run mean.
Starting with t c t et , where et is the error term, we test whether the residual is stationary. In fact,
we will expect such a long-run relationship between the ERD and the IRD to exist, as the two series
might deviate in the short-run, but not in the long-run. Given that the IRD and the ERD are co-
integrated, we can express their relationship as t 0 1 t 2et 1 ut , where 1 is the impact
multiplier of the short-run effects and 1 is the feedback effect showing how the system adjusts to its
steady state in the long-run. Since t c t et , we interpret as the long-run response. Table (2)
reports the co-integration results over the four samples.
Table 2: Co-integration tests between IRD and ERD

SAMPLE A1 A2 A3 A4
c 0.816* 0.098* 0.912* 0.073*
0.537* -0.327* 9.364* 0.053*
UROOTS -3.475* -3.361* -1.953 -3.157*
ADJ R-square 0.131 0.135 0.113 -0.066
UROOTS is the unit root statistic tested against traditional critic values. One asterisk (*) means that the coefficient or the
statistic is significant at 10%.

Table (2) shows that the IRD and the ERD are co-integrated in Sample A1, A2 and A4. Looking at
Sample A4 including all the observations, with the LBP/USD depreciating by 1%, the IRD will in the
long-run increase by 5.3%, which is about 28% below the mean given by c=7.3%. In contrast, Sample
A2 indicates that with the LBP/USD appreciating by 1%, the IRD increases by 32.27%. Since Sample
A2 covers the most controversial period in the life of the LB3TB, there is indication of non-negligible
arbitrage opportunities, as investors not only earned on average 8% in excess of the US3TB, but also
got a magnification bonus in terms of a favourable exchange rate.
Although, looking at Sample A3, IRD and ERD are not co-integrated. In the absence of a linear
combination between IRD and ERD over 1999/01 to 2009/09, the coefficient associated with the
ERD is biased and lacks economic meaning, as it is from a spurious regression. Nonetheless, the
results of Sample A2 show that the yield on the bill was higher when the LBP/USD was appreciating.
Hence, there is indication that the LB3TB was then diverted.
RESULTS ON THE ECM

Our primary finding is that the IRD deviates from the ERD. While economic theories suggest that
arbitrage opportunities disappear as they appear in a well-functioning capital market, the results on
the long-run relationship between IRD and ERD show that possible arbitrage opportunities existed in
the life of the LB3TB. In this section, we further examine the dynamic of the IRD with respect to
information set at time t, t , including t and zt ln Zt .
The information set
We define z t in terms of the country risk. One way to estimate z t is in terms of insolvency risk given
by t dtt gdpt . Since a government “cannot” go bankrupt, investors will accept any level of debt that
does not lead to insolvency. Denoting the optimal level of debt as * *
t ; whenever t t the IRD
increases. Since investors require a premium for t
*
t , a positive relationship between t and t is
expected. Another way to estimate zt is in terms of the political risk. While we can define political
instability, it is not easy to measure it. Using dummy variables might lead to identification problems.
Another difficulty in measuring the political risk is that political events are discrete and rare in nature,
while the dynamic of the IRD is continuous. We define the political risk in terms of population
movements. Lebanon has been confronted to a number of armed conflicts leading to a huge
emigration of its population. It is estimated that there are more Lebanese outside than inside Lebanon.
Although, whenever the internal situation improves Lebanese have the tendency to return home.
Therefore, the ratio of DEP to ARR given by dt dept arrt may say something about the internal
political situation. A third way to define zt is in terms of the liquidity risk. Following Bouvatier
(2007), we measure the liquidity risk as lt qmt rst . As reserve shrinks or money increases, this might
cause inflation. Since inflation leads to higher rates, a positive relationship between lt and t is
expected. A fourth way to define z t is in terms of the investment risk. Due to the scarcity of stock
data (only available since 1997), when dealing with Samples B1, B2 and B3, we define the
investment risk in terms of variance as t smct smct 1 . In consistency with earlier findings, we will
expect a negative relationship between t and t , as bond is a close substitute of equity. We define
also the investment risk in terms of pt cput gdpt and ct tcdt gdpt , respectively. Since the making of new
roads, facilities and buildings is related to a booming economy, pt and ct capture the extent to which
public debt curbs private investments. Whereas a negative relationship will be expected in an
economy dominated by private investments, the relationship may turn positive in an economy where
the government is the main borrower.

Country risks and co-integration

Table (3) reports the average and unit root statistics on t and zt , where zt includes t , t , dt , ct ,
pt , t and lt .
Table 3: Unit root tests of the risk factors and the IRD
SAMPLE B1 B2 B3
AVERAGE UROOTS AVERAGE UROORTS AVERAGE UROOTS
t 0.067 -2.861 0.105 -2.882 0.045 -1.277
t -0.005 -3.270 -0.023 -2.611 0.005 -2.971
t 0.050 -3.132 0.013 -2.337 0.071 -5.150*
pt 0.677 -2.616 0.709 -2.468 0.659 -4.827*
ct 0.618 -1.274 0.634 -2.073 0.609 -1.853
dt 0.999 -3.043 1.000 -5.414* 0.999 -2.512
t 1.169 -1.739 1.144 -1.641 1.183 -3.288
lt -2.563 1.064 -2.516 1.059 -1.488 1.067
Table (3) shows that the IRD is highest in Sample B2 covering the period under which the LB3TB
was at its highest level ever. Looking at UROOTS, Table (3) shows that IRD and ERD are
nonstationary. Regarding the country risk factors, they are globally nonstationary. Note that the
UROOTS are tested against the null hypothesis of unit root. Table (4) reports the results of the Engle
and Granger (1987)’s co-integration test.
Table 4: Co-integration tests between the IRD and the country risk factors
UROOTS UROOTS
SAMPLE t c t et t c lt et
B1 -1.057* -3.323* 0.650* -3.558*
B2 -1.087* -3.300* 1.676* -2.786
B3 0.415* -0.970 1.551* -1.730
t c ct et t c pt et
B1 1.172* -3.920* 0.817* -3.804*
B2 0.759* -3.189* 0.487* -3.175*
B3 0.035 -1.045 0.305* -0.970
t c t et t c dt et
B1 -0.186* -5.077* 0.115 -3.519*
B2 -0.497* -3.402* 0.018 -3.328*
B3 -0.051* -1.487 0.111 -1.254
One asterisk (*) means that the coefficient or the statistic is significant at 10%, at least.
Looking at Sample B1 including all the observations, Table (4) shows that the IRD is co-integrated
with all the variables. Therefore, the coefficients associated with each of these variables can be
interpreted as long-run responses of the IRD to the country risks. Since the IRD exhibits long-run
relationships, the deviation of the IRD from the ERD may be explained by the existence of systematic
risks for which investors required compensation. In other words, the ERD is potentially correlated
with the country risk in terms of the solvency, liquidity and investment risk. Focusing on Sample B2,
the coefficient associated with the debt-to-gdp ratio is near unity, denoting a quasi one-by-one

relationship with the IRD. But the relationship between IRD and debt is reversal, which implies that
the gap between the LB3TB and the US3TB increased when the debt-to-gdp ratio decreased.
Similarly, the relationship between the IRD and the stock variance is negative in consistency with
much of earlier finding on the relationship between bonds and equities. Whereas Table (4) reports
interesting results, the coefficients associated with the country risks may be biased due to possible
historical patterns in residuals, as these models deal only with long-run effects. Therefore, we
estimate a more general error correction model (ECM).
Bivariate Error Correction Models
Referring the reader to Engle and Granger (1987), we state our general ECM model as
3 3
t 10 2i t i 3i zt i eˆ
4 t 1 t , (3)
i 1 i 0
where zt is change in any of the explanatory variables, 3i 0 2i 1 is the feedback adjustment of the
IRD to its own past realizations, 3i 0 3i 2 is the short-run response of the IRD to changes in any of
the country risks or the ERD, 4 is the adjustment effect toward the long-run equilibrium at the time
period, eˆt t 1 ˆ1 ˆ2 zt 1 , and t is a white noise error term. The main point of (3) is given by 4 . This
error coefficient shows how much adjustment is realized at each period. Since in models of Table (2)
and (4) the error terms may be biased, our ECM model (given under the understanding that the best fit
is obtained with lags fixed to 3) yields a robust long-run parameter, 2 1 . This parameter measures
the long-run impacts of zt on t . Table (5) reports the results of (3) using Sample B1.
Table 5: Estimates of bivariate error correction models

t t lt dt
10 -0.0004 -0.0004 -0.0004 -0.0005
1 0.3400* 0.2537* 0.2068* 0.2942*
2 0.0242 -0.2552* 0.9816* -0.0469
4 0.0287* 0.0333* 0.0153 0.0276*
2 1 -0.0711 1.0062 -4.7460 0.1594
2
R 0.2273 0.2009 0.3062 0.2196
Q24 13.3670 14.0600 25.3190 13.7450
pt ct t
10 -0.0004 -0.0004 -0.0004

1 0.3380* 0.3084* 0.2954*
2 -0.0299 -0.0231 0.0068
4 0.0495* 0.0439* 0.0356*
2 1 0.0885 0.0749 -0.0231
2
R 0.2130 0.2271 0.1839
Q24 14.8010 14.9680 12.3830
Note: R2
2 1 is the (robust) long-run parameter, is the adjusted r-square, and Q24 is the Ljung-Box statistic at lag 24.
One asterisk (*) means that the coefficient is significant at 5%.

In Table (5) we calculate the standard errors of 1 and 2 by taking the square root of the sum of the
covariance matrix associated with 2i and 3i , respectively. These standard errors are robust to serial
correlation, as the Ljung-Box statistic leads to the acceptance of the null hypothesis that all the
coefficients up to lag 24 are jointly uncorrelated.
Looking at 1 ranging between 0.20 and 0.34, changes in IRD are persistent. While the IRD is
positively related to its past values, its response through 2 to a change in ERD, dt , pt , ct and t is
not significant. In contrast, t and lt impact the IRD in the short-run to the extent that a percent
positive change in t and lt will lead to a decrease of the IRD of 0.26% and to an increase of the
IRD of 0.98%. Whereas the coefficient associated with the liquidity risk exhibits the expected sign,
the same thing cannot be said about the insolvency risk. The counterintuitive sign on t implies that
the gap between the LB3TB and the US3TB shrinks with more debt and widens with less debt. The
reversal sign of t can be explained only if investors perceived the LB3TB as a riskless security
paying more than any other risky asset in the economy. With such a huge investment opportunity,
investors ignore the risk associated with debt. But to consider the LB3TB as a riskless security is one
thing, to be overconfident about the government capacity to honour its obligation is another thing. As
debt leads to higher future taxes, investors must have thought that future taxes are hypothetical as
opposed to the profits reaped from an underpriced bill. Because the government is inefficient in
collecting taxes, investors may have considered that the cost of paying taxes in the future was much
lower than the benefit of bidding up the bill. Looking at the adjustment coefficient, 4 , the IRD
converges slowly to its long-run mean. It will take for example about 34 months for the IDR and the
EDR to converge to their steady state. Furthermore, lt does not exhibit a significant adjustment
mechanism because the responsiveness of the IDR to change in change liquidity is almost one-by-one
in the short-run. Looking at the long-run parameters t moves one-by-one with the IRD, whereas lt
increases almost four times faster than the IRD shrinking by 1%.
CONCLUSION
This paper investigates the relationship between the interest rate differential (IRD) and the exchange
rate differential (ERD). Based on the modified UIP hypothesis, the paper investigates also the
relationship between the IRD and the country risk given in terms of the insolvency, liquidity, political
and investment risk. Within the ECM, we find that the response of the IRD to changes in ERD is very
weak, only 0.02% for every 1% depreciation of the LBP/USD. The situation does not improve
looking at its long-run response about 0.07% for every 1% appreciation of the LBP/USD. One
explanation for the weak response of the IRD is that prior to 2003 most of debt was held by Lebanese
so that movement in the LBP/USD has less direct impact. Another reason is that the LBP is pegged to
the USD, suggesting that the government bears the exchange risk in terms of the USD for a Lebanese
investor holding the LB3TB.
While the positive gap between the LB3TB and the US3TB could not be explained in terms of the
IRD, we find that the insolvency and the liquidity risk impacts the IRD. However, we unexpectedly
found that the insolvency risk is negatively related to the IRD implying that the IRD increased as the
public sector indebtedness decreased. We conjecture that the LB3TB was perceived as a riskless
security paying more than any other alternative investment in the economy. Our conjecture is
supported by the finding that the insolvency risk moves one-by-one with the IRD in the long-run.
Overall, it is shown that the LB3TB exhibited price misalignments in the 1990s. While the question is
still debatable in Lebanon whether high interest rates in the 1990s were meant to grease the palm of
politicians, this study shows that these high rates represented to some extent risk-adjusted
compensation to investors for unseen risks.

REFERENCES
Bouvatier, Vincent (2007). “Are international rate differentials driven by the risk premium? The case
of Asian countries.” Economics Bulletin, Volume 5, Issue 6, 1-14.
Chinn, Menzie, D. and Meredith Guy (2005). “Testing uncovered interest parity at short and long
horizons during the post-Bretton Woods Era.” Working Paper, University of Wisconsin.
Engle, Charles (1996). “The forward discount anomaly and the risk premium: A survey of recent
evidence.” Journal of Empirical Finance, Volume 3, Issue 2, 123-192.
Engle, Robert F. and Granger Clive W.J. (1987). “Co-integration and error correction:
Representation, estimation, and Testing.” Econometrica, Volume 55, Issue 2, 251-276.

THE ORIGINS AND ECONOMICS OF BODY
SNATCHING IN EARLY 19th CENTURY BRITAIN
Bootheway, Giles B.P.

St. Bonaventure University
gboothew@sbu.edu
Sotak, Kristin L.
ksotak@sbu.edu
ABSTRACT
Economics studies how to allocate scarce resources. However, a resource cannot be properly
allocated if it is not recognized, or miss valued, in the first place. As early as the thirteenth
century, the States and City-States of continental Europe disposed of the bodies of executed felons
by donating them to anatomists, for the advancement of science. By contrast, in the British Isles,
the State, cognizant that although Christian, much of the populous sill clung to old pagan
superstitions, especially those surrounding death and passage into an afterlife, chose to add
desecration through gibbeting, to a death sentence, rather than divert the bodies of the executed
to research. The State’s preference for the double-deterrent to crime - physical death and eternal
damnation – over scientific progress, stunted medical advancement in the British Isles. The
resulting non-participation of such a significant part of the then known world inevitably hindered
overall medical progress. However, in the early eighteenth century, a market for disinterred
bodies emerged, and for nearly one hundred years operated in almost perfect conformity with the
collective assumptions of perfect competition. A victim of its own success, the market eventually
drifted into imperfect competition, and, when the unscrupulous started murdering for dissection
rather than digging for it – the State, through the 1832 Anatomy Act, obviated the market by
legislating a new source of corpses.
INTRODUCTION
In 1818, Mary Shelley published Frankenstein: or, The Modern Prometheus. The title character is
not the monster (as so many suppose) but the scientist, Viktor Frankenstein, who created it from
body parts stolen from charnel houses. The tale, amongst other things, is an allegory of the
dangers of subordinating life to science, yet this fiction was based in fact, since during that time
bodies were indeed disinterred and sold for profit to anatomists. Indeed, Mary‟s own mother,
Mary Wollstonecraft, was buried in the St. Pancras parish churchyard, a well-known haunt of
body snatchers or Resurrectionists as was their wry sobriquet.
Markets do not emerge spontaneously out of a void; instead they arise in response to a specific
need. The genesis of the market for corpses was that authorities in the British Isles, and
particularly in England, were aware that the populous, although Christian, still clung to certain
pagan superstitions and rituals, especially those surrounding death. Thus, the government could
not only deprive a felon of life through execution but could also deprive the felon of an after-life
by denying the body a Christian burial. Instead, the corpses were often gibbeted: enclosed in an
iron cage, tarred, and hung in a conspicuous place for all to view. The effectiveness of this
double deterrent will never be known, but unlike in mainland Europe, where the bodies of

Bootheway, Sotak Body Snatching in 19th Century Britain
executed criminals were made available to anatomist, gibbeting deprived their British
counterparts of the material to hone their skills and advance their science. As such, the progress
of medicine in the British Isles was severely hindered and it was only till the passage of the
Anatomy Act in 1832 that anatomists and medical schools were afforded an adequate supply of
bodies
The Anatomy Act was not, as one could so easily believe, Parliament‟s final realization that
medical progress required the dissection of bodies; it was instead a response to a homicidal
development in the shadowy market for corpses. The market had existed for centuries, and was
generally tolerated by government since legally, a corpse was not viewed as property, and as such
its theft could not be a crime. However, as progress in medicine began to accelerate in Europe,
the demand for clandestinely obtained corpses in Britain increased. The inevitable culmination
was, that rather than attempt to spirit away a corpses from a graveyard, the unscrupulous could
create their own supply by murder the living.
The paper will proceed as follows. Firstly, a historical perspective needs to be taken in order
isolate why body snatching was more prevalent in Britain than on the Continent.
Secondly, the structure of the market will be examined and compared to the textbook definition of
Perfect Competition. Thirdly, how the market drifted towards Imperfect Competition, with the
formation of cartels, the loss of product homogeneity, and barriers to entry.
THE HISTORICAL BACKGROUND

Bodysnatching, as opposed to grave robbing, the act of stealing items of value other than the body
from a grave, has existed in the British Isles for hundreds of years. William Shakespeare‟s own
epitaph bear witness to this fact.
Good friend, for Iesus sake forebeare

To digge the dust encloased heare.
blessed ye man [that] spares these stones,
And curste be he [that] moves my bones.
Although not unknown on the Continent, bodysnatching for profit on behalf of anatomists was
peculiarly an Anglo-Saxon phenomenon. In Catholic Europe, Detestande feritatis, the 1299 Bull
of Pope Boniface VIII, forbade the dissection of bodies for preservation or transportation, but not
for education. Thus, the bodies of executed criminals provided material for the medical schools of
major European universities, such as those of Paris and Padua, where Faculties of Medicine were
held in the same esteem as those of Law and Theology. In 1543 Andreas Vesalius, often referred
to as the founder of modern human anatomy, published De humani corporis fabrica. By contrast,
in England it had taken till 1540 for surgeons to receive a Royal Charter from Henry VIII but
only as the Company of Barbers and Surgeons. The Charter gave the annual right to the bodies of
a mere four hanged felons. Indeed it was only as late as 1800 did the surgeons finally managed to
rid themselves of the association with barbers by earning their own Charter. Although the current
standing of surgeons in Britain has substantially improved, their correct form of address remains
Mr. not Dr.
Even though Pope Boniface‟s Bull in 1299 gave carte blanche for Catholics to advance anatomy
through dissection, the Reformation did little to change matters. As the Protestant faith slowly
found its feet, its outright abhorrence at the worship of the remains of Saints precluded it from
anything more than a cursory respect for a corpse, since to do otherwise would represent a
potentially dangerous drift towards animism.

As further evidence the Catholic St. Augustine was revered by Protestant, especially Calvinists
and Lutherans. In Confessions Bk IX 10-11, Augustine quoted the dying words of his adored
mother Monica: “Lay this body anywhere, and take no trouble over it.” The fact that St.
Augustine recorded this speaks of his own insouciance as to the physical fate of a corpses – even
that of his own mothers.
Hence, for diametrically opposed reasons, the Protestant and Catholic churches had little quarrel
with the dissection of bodies; thus, with a steady supply of executed criminals, European
anatomists were able to the Renaissance to medicine. Their prestige only grew when in 1687
Louis XIV underwent a successful and much publicized surgery for an anal fistula. However,
handicapped by a paucity of bodies, their counterparts across the English Channel had to travel
abroad to develop their knowledge and skill. The most notable of these was William Harvey,
whose De moto cordis et sanguinis proving the circulation of blood, was published in 1628.
However, the bulk of Harvey‟s studies had taken place in Padua and on his return to the British
Isles he had the macabre good fortune of having both his father and sister die (of natural causes)
while in his care. Thus, under his own roof, he held the equivalent of 50% of the entire annual
stipend of dead bodies, allocated the Company of Barbers and Surgeons. His place in medical
history attests to the good use he made of them.
One may now legitimately ask why, when thinkers and artists of the Enlightenment in British
Isles were keeping pace with, and often exceeding the progress being made in Europe – was
anatomy and medicine allowed to languish by being starved of the corpses whose dissection had
led to such progress abroad? As will become clear, the hindrance flowed from the British
Government through its judiciary and it took the intervention of a free but shadowy market for the
impasse to be broken.
As Clark (1982) observed, when Christianity arrived in the British Isles, it took care to adopt
pagan feasts, such as All Souls and Christmas. As their own, thus easing the initial shock to the
indigenous and facilitating the inevitable conversion. Moreover, since the reformation, an
„official‟ and a „folk‟ theology existed side by side. The Victorian folklorist Gomme (1908)
concurs and writes of a principle of antagonism between pew and pulpit; the former‟s conformity
being only a matter of convenience. Thus, when death came it was more likely to be „old‟
traditions and rituals that would ease the newly dead into the thereafter, rather than those of the
Church. Since the death rituals were seemingly harmless, the Church tolerated them (Richardson,
1987). Thus, the rituals of drinking, waking, watching, washing, and all matter of folk belief were
perpetuated. As Addy (1895) recorded: "When you drink wine at a funeral, every drop that you
drink is a sin which the dead person committed. You thereby take away the dead persons sins and
bear them yourself.” Leather (1912) reports when invited to the funeral of a farmer‟s sister, he
was asked to drink but refused on the ground that he never took wine, whereupon the farmer said
“But you must drink, sir. It‟s like the Sacrament. It‟s to kill the sins of my sister.”
Jones (1974) writes “Every custom or ritual or formula designed to bring about results in the
outer…world…is based ultimately on the idea that the human mind possesses the
power to influence the course of nature in the outer world, a power which religion attributed to
deity, and achieves by the more indirect technique of prayer.”
With little guidance from the Church such eschatology promoted the belief that the corpse and the
body co-existed for some indeterminate time after death. Thus, the rites and traditions
surrounding the corpse were there to ease the departed‟s journey to their reward. However,
failure to do so would consign the departed some to eternal damnation.

Cognizant of the folklore surrounding death, authorities capitalized on the superstitions

and beliefs of the people by not only threatening potential felons with execution, but further to
have their remains desecrated in a manner that would preclude any resurrection to a Thereafter.
As was alluded to earlier, the most common fate was to be gibbeted. However, noting the abject
repugnance exhibited by those who attended the few sanctioned public dissections, a
Parliamentary Act was passed in 1752 “for better preventing the horrid crime of murder.” It gave
judges the discretion to further punish the condemned by having their bodies dissected rather than
gibbeted. Richardson (1987) reports that from her reading of the act (Act 25 Geo II c.37) that
“The intention of both punishments was to deprive the wrongdoer of a grave,” rather than to
accommodate the anatomists. Indeed, the wording in the Act describes dissection as a “further
Terror and peculiar Mark of Infamy,” it goes on to stress that “in no Case whatsoever the Body of
any Murderer shall be suffered to be buried,” and that any interference with the surgeon‟s
subsequent custody would earn the malefactor “transportation to His Majesty‟s Colonies for
Seven Years” and death upon any subsequent early return.
The last point above is especially telling. The inclusion in the Act of a penalty for those who
attempted to rescue the condemned body speaks to the awareness of the authorities of the deep
unpopularity of the aggravating sentence of dissection. It seems that while the public accepted
the sentence of death, it felt that dissection went too far. By contrast, and for deterrent effect, the
government designed the public execution and subsequent dissection with a pageantry that was to
be repeated forty years later surrounding the French Guillotine.
While it is true that after the 1752 Act the supply of bodies to anatomists increased well beyond
Henry VIII‟s stipend of four, a number later raised to eight by Charles II. The flow continued to
be inadequate, due to the public outrage that the Act itself had anticipated. Still disorganized,
individual anatomists would fight each other, as well as, the public mob for possession of a body
at the gallows. Limbaugh (1975) describes how at Tyburn, the location of public executions in
London, crowds of near 50,000 would assemble and riot as anatomists attempted to claim a body
– he writes “the added humiliation of the surgeon‟s scalpel to the hangman‟s noose rendered the
injustice of the law all the more loathsome.”
Prior to 1752, there is evidence to suggest that it was the anatomists themselves who were the
first bodysnatchers; Guttmacher (1936) writes that in 1721, apprentices at the Edinburgh College
of Surgeons had to assure the College in writing that they would not involve themselves in
exhumations. It is unclear when the first professional body snatchers appeared, but likely in the
early part of the eighteenth century as medical schools began to grow. Although well educated
and eager for greater knowledge, their profession itself was not held in as high esteem then as it is
now. It is therefore likely that anatomist were prepared to pay others to risk social ostracism
rather than be caught themselves in a graveyard at night- shovel in hand. With the emergence of
the professional bodysnatcher, corpses became a tradable commodity and thus the market was
formed.
THE ECONOMICS OF BODYSNATCHING – PERFECT COMPETITION

Loosely dated, the market for bodies lasted approximately one-hundred years and ended with the
1832 Anatomy Act. Due to the very nature of the commodity, the market was somewhat
shadowy, yet it is this very fact that gives it great appeal to economists; since for well over fifty
years it conformed almost perfectly to the economic assumptions of Perfect Competition. It is
interesting to note that the market price of bodies rose almost exponentially as the demand from
anatomist increased.

Bailey (1896) reports that in 1794, a south London gang operating out of Lambeth gang charged
two guineas and a crown per adult. By 1811, bodies changed hands for four guineas, and by 1820
prices were as high as twenty guineas. In 1811, after expenses were paid the average gang
member‟s share was about eleven guineas per week. By contrast, in 1811, the average wage of
farm laborer was around nine shillings per week and the wage of skilled urban workers was
around thirty shillings a week. I should however, be noted that bodysnatching was seasonal,
coinciding with the academic year of medical and anatomy school. Regardless, financially, the
lot of a bodysnatcher was not a bad one.
When introducing students to microeconomics, instructors are at pains to point out that perfect
competition is an abstraction, a model starting point. Certainly, some of the assumptions are
individually realistic, for example: milk is a homogeneous product and that the market for milk
has a large number of buyers and sellers who are all price takers. Collectively however, the
assumptions are unrealistic or are they? Consider the four assumptions of perfect competition.
(i) The market is made up of a large number of small buyers and sellers.
No participant is large enough to influence the price.
(ii) The product is homogeneous. Each producer‟s output is

indistinguishable from one another.
(iii) There are no barriers to entry or exit.
(iv) Each participant has full information.
The participants in the market for corpses were the bodysnatchers who operated as small gangs.
Similarly, the anatomists, who ran small schools, also competed with each other to attract fee
paying students‟ par. Similarly, the bodysnatchers themselves operated in small groups and were
in competition with other bodysnatchers. Bailey (1896) reports that on the night of August 7,
1812, one gang beat another to a grave in the south London Parish of St. John Horselydown.
Rather than move on, members of the latter gang informed the authorities on the activities of the
former.
The assumption of homogeneity was met since the commodity had contract specifications in the
sense that bodysnatchers knew that anatomists would not purchase bodies that were over five-
days old. As such they did not dig them up. Although there appears to have been little product
differentiation, a separate market existed for the bodies of children. Dopson (1949) writes of the
same Lambeth as Bailey, whereas adult bodies were sold for two guineas and a crown, the price
for children was six shillings for the first foot in length, and nine pence for each additional inch.
Since a dead body was not property, the consequences of being caught bodysnatching were
minimal. Linebaugh (1975) reports that in 1736, a gravedigger in the east London parish of
Stepney was severely whipped for selling bodies from the churchyard to private anatomists.
However, whereas the bodysnatcher had little to fear from the law, an outraged mob was a
different matter. Richardson (1987) reports how, in 1832 two medical students were apprehended
in the village of Inveresk, near Edinburgh. They were confined in a private house till morning,
when, at their own request, they were committed to gaol as “a place of greater security from the
threatened vengeance of the outraged citizens.” However, “outraged citizens” notwithstanding,
there were no barriers to enter or exit the business of bodysnatching.

The assumption of Full Information tends to vary from textbook to textbook, and indeed in some
texts such as Mankiw (2008) it is omitted altogether. However, the game theoretical definition of
Common Knowledge, serves the purpose. Each party knew what role they had played in the
transaction, and knew that the other party knew of that role.
A further point could be made that each party knew its own opportunity cost, although the
anatomists probably had a better idea of the opportunity cost of the bodysnatcher, than the
bodysnatcher had of that of the anatomist.
THE ECONOMICS OF BODYSNATCHING – IMPERFECT COMPETITION

In 1814, after nearly a century of perfect competition, imperfections emerged; at first slowly, but
gaining such a pace that the British government, although loath to given up the double deterrent
of execution and dissection, was forced to intervene with the 1832 Anatomy Act.
Social disgust at both the bodysnatchers and the anatomists, although not forcing the market
underground, very much ensured its clandestine nature. However, by the beginning of the
nineteenth century the existence of the market was common knowledge. Peachy (1924) writes
that in medical circles, names, prices, market terminology were bandied about freely with little or
no sense of embarrassment. An advertisement placed by an anatomy school in The Dissector (no.
9, 1.12.1827) illustrates the point: “Just arrived four handsome skeletons.”
As market transparency increased, participants were afforded a better view of the entire market,
and entrepreneurial opportunities presented themselves. As the price of corpses rose, so did the
search for substitutes. In 1742, Pope Benedict XIV concerned with the public‟s opinion on
dissection, commissioned the sculptor Ercole Lelli to create anatomically correct wax bodies.
Lelli produced no fewer than fifty, demonstrating musculature and the nervous system.
Bailey (1896) reports the introduction of product differentiation in 1811. Israel Chapman, a
Jewish bodysnatcher dealing exclusively with Jewish corpses, was able to command higher
prices, as “Jews bury early, their cemetery [yields] the best and freshest subjects.”
Again Bailey (1896) writes of a bodysnatcher named Ben Crouch who in 1814 attempted to
cartelize the suppliers of corpses to drive prices higher. If Crouch intercepted a rival gang with a
fresh body, he and his fellows “hacked and cut about so as to make it [the body] quite useless for
anatomical purposes.” Those recalcitrant gangs, who refused to join the cartel by withholding
their bodies from the market, were simply informed upon to the authorities. Although still not a
crime, minor charges, such as those violating public morals or public decency, could
inconvenience bodysnatchers.
Finally, the perfect competitive assumption that there be no barriers to entry was literally
violated. Entrepreneurs began to advertize and sell tamperproof coffins and mausoleums.
Richardson (1987) writes that a metal coffin was patented in 1781, by one Thomas Wright (Patent
No. 1307). In 1818, Edward Bridgeman patented his Patent Coffin “made of cast or wrought
iron, with concealed springs on the inner side of the lid to prevent levering.”
Moss (1898) writes that the poor, unable afford secure coffins, would mix the earth above the
coffins with sticks, stones, and hay to make digging more arduous. If large rocks were at hand,
these would be manhandled onto the grave. Poorer neighborhoods would organize themselves by
erecting watch-houses and lighting the graveyards with lamps hung beyond reach in trees.

THE 1832 ANATOMY ACT – THE ERA OF BODYSNATCHING ENDS

Having been granted their own Royal Charter in 1800, surgeons and anatomists began to impress
upon the British government, the importance of anatomy and the shortage of bodies for
dissection. In 1828, a Parliamentary Select Committee on anatomy was formed to investigate the
question. The committee recommended a bill that, in essence, allowed any unclaimed body from
a prison or a Poor House be made available to anatomists and surgeons. The bill failed in the
House of Lords when a paternalistic aristocracy, with the support of the Archbishop of
Canterbury, argued in favor of the poor‟s right to a decent funeral. Circumstances were soon to
change.
In 1827, an Irishman named William Burke moved into to a lodging-house in Edinburgh‟s West
Port district run by Margaret Hare and her husband William. Neither Burke nor Hare were
bodysnatchers, but when a lodging house tenant died of natural causes, owing Hare four-pounds
in rent, rather than bury the body they decided to sell it to the anatomist Dr. Robert Knox for
seven-pounds and ten shillings. Intoxicated by such easy money, Burke and Hare are alleged to
have murdered seventeen people in order to sell their bodies to Dr. Knox. The spree, which
lasted a year, ended when a fellow lodger discovered a dead body under a bed and contacted the
police.
The case against Burke and Hare was largely circumstantial and a conviction was by no means
assured. However, in an elegant application of game theories prisoner's dilemma, Hare was
induced to turn state‟s evidence in return for testimony against William Burke. Hare was released
and fled into anonymity, never to be heard from again. William Burke was hanged.
The Burke and Hare case was much publicized and the verb to Burke was coined to mean murder
for dissection. In 1831, burking came to London and horrified, public opinion began to turn. To
oppose dissection was one thing, but to have people being murdered for dissection was quite
another. In 1832 the Anatomy Act was re-presented to Parliament and passed both houses. Two
years later, the Hanging in Chains Act repealed gibbeting.
CONCLUSION
Folklorist in the nineteenth and twentieth century recorded that many in the British Isles, despite
being Christian, still clung to superstitions and rites dating back to pagans times, especially those
surrounding death. Although these superstitions varied according to geography, the belief was
that for some indeterminate time after death, the body and soul co-existed. As such, to assure
passage into some after-life, the physical corpse had to be cared for both prior to and after burial.
In taking advantage of these superstitions, the state was able to impose the double deterrent of
death followed by gibbeting. The effectiveness of the deterrent will never be known, but the
paucity of bodies for dissection effectively stunted medical progress in the British Isles till at least
1832, with the passage of the Anatomy Act. How much faster might medical progress have been
if the constituent states of the British Isles had, like their European cousins, given a free flow of
bodies to anatomists is a matter of conjecture.
As so often happens, un-satiated demand gives rise to a market, in this case the market for
corpses. Although not strictly illegal, bodysnatching was highly unpopular as such market
operations were clandestine with little transparency; this resulted in the market exhibiting for
nearly one-hundred years, all the qualities that economists require for perfect completion.
Eventually, as demand increased, the market was forced out of the shadows. With the mechanics
of the market exposed, opportunistic participants were able to break the status quo. Cartels were
formed, substitutes and product differentiation occurred, and finally physical barriers were
introduced to thwart the efforts of bodysnatchers.

Perhaps inevitably, with significant amounts of money changing hands, some chose the shortcut
of murdering rather than digging for dissection. Although still horrified by dissection, the general
public was even more horrified by the thought of people being murdered for dissection. The
ensuing Anatomy Act of 1832 resulted in unclaimed bodies from prisons and poor-houses be
allocated to anatomists. With an increase in the legitimate supply of corpses, the market ceased to
be.

REFERENCES
Addy, S.O. (1895). “Households Tales.” Pawson & Brailsford. Sheffield
Bailey, J.B. (1896). “The Diary of a Resurrectionists 1811-1812. To Which are Added an
Account of the Resurrection Men in London, and a Short History the Passing of the
Anatomy Act.” Swann Sonnenschein & Co. London.
Clark, D. (1982). “Between Pulpit and Pew.” Cambridge University Press.
Dopson, L. (1949). “ St. Thomas‟s Parish Vestry Records and a Body-snatching Incident.”
British Medical Journal.
Goome, G. L. (1904). “Folklore as an Historical Science.” Methuen & Co. London.
Guttmacher, A.F. (1936). “Bootlegging Bodies: A History of Bodysnatching.” 4 Bulletin of the

Society of Med. Hist. of Chicago.
Jones, Ernest. (1974). “Psycho-myth, psycho-history.” Hillstone. New York.
Leather, E.M. (1912). “The Folklore of Hertfordshire.” Sidgwick & Jackson.
Linebaugh, Peter, Hay, Doug, and Thompson, E.P. (eds.). “Albion's Fatal Tree: Crime
and Society in Eighteenth-Century England”. Pantheon Press, 1975.
Moss, F. (1898). “Folklore: Old Customs and Tales of my Neighbors.” Didsbury: The Author.
Peachey, G. (1924). “A Memoir of William & John Hunter.” W. Brendon. Plymouth.
Richardson, R. (1987). “Death, Dissection and the Destitute.” University of Chicago Press.
Chicago and London.

CREATING INTRINSIC MOTIVATION IN A
PRINCIPLES OF FINANCE CLASS
Flanegin, Frank R. MBA, Ph.D.

Professor of Finance
Robert Morris University
flanegin@rmu.edu
ABSTRACT
One of the most difficult aspects of teaching the “Principles of Finance” class is
motivation. The majority of students in the common finance class are not finance or accounting
students, but management and marketing students who approach this course as just one more
requirement for graduation. The recent economic turmoil has forced even the average American
to become much more aware of his/her individual financial future, of which Social Security is a
very integral component. This paper taps into the student’s increased narrow self-interested
awareness/motivation to better understand their financial future. By integrating Time Value of
Money concepts with an overview explanation of the Social Security System, we are not only
teaching TVM but preparing a more informed citizenry to handle future financial problems facing
our society.
INTRODUCTION
As business educators for decades we have attempted to redirect the focus of future
managers from quarterly bonuses to the longer term goal of shareholder wealth maximization.
While we have focused our attention on training the future business leaders of America we have
neglected our responsibility to train the future citizens of America. The recent economic turmoil
has forced even the average American to become concerned with both his/her individual financial
sustainability of which Social Security is a very integral component. It is the belief of the author
that we can utilize this new awareness to create an intrinsic motivation process that will not only
allow our students to become better business people, but also help them become more
knowledgeable citizens.
EXTRINSIC AND INTRINSIC MOTIVATION

Student motivation is often divided into two categories:
Extrinsic motivation: A student can be described as extrinsically motivated

when he or she engages in learning "purely for the sake of attaining a reward or
for avoiding some punishment" (Dev, 1997). School practices that seek to
motivate students extrinsically include publicly recognizing students for

Flanegin Principles of Finance Class
academic achievements; giving out stickers, candy, and other rewards; and taking
away privileges, such as recess, on the basis of students' academic performance
(Brooks et al., 1998).
Intrinsic motivation: A student can be described as intrinsically motivated when

he or she is motivated from within: Intrinsically motivated students actively
engage themselves in learning out of curiosity, interest, or enjoyment, or in order
to achieve their own intellectual and personal goals. According to Dev, 1997, "A
student who is intrinsically motivated . . . will not need any type of reward or
incentive to initiate or complete a task. This type of student is more likely to
complete the chosen task and be excited by the challenging nature of an activity"
(p. 13).
This paper will employ examples from two distinct long term financial objectives; 1. The
need to recognize and comprehend the current condition of the Social Security system, which
then leads to objective 2; to provide examples of how to
introduce time value of money techniques in a way that
utilizes “intrinsic motivation”, helping students realize it is in
their individual self interest to understand and obtain personal
and national financial sustainability. Why is this important?
We do not want students to be in the same position as the
investor to the right.
For this paper we will utilize the 2008 and 2009

Annual Reports of the Board of Trustees of the Federal Old-
Age and Survivors Insurance and Federal Disability
Insurance Trust Funds, better known as Social Security. We
as financial educators can teach both time value of money,
principles and financial sustainability through examples that
closely approximate the much more complex calculations of
the Social Security Trustee’s report. In the end we will be
preparing our students to become both more informed on a
personal level and a more informed citizenry on the national level.
WHAT IS SOCIAL SECURITY?

Understanding the problems and benefits of social security and making the correct
decisions for future generations will be one of the cornerstones of future financial sustainability.
Currently more than 50 million people are receiving benefits including more than 35 million
retired workers and dependents, more than 6 million survivors and more than 9 million disabled
workers and their dependents.
Social Security is actually two different programs the first OASI (Old Age Survivors
Insurance) Trust Fund and the Disability Insurance Trust Fund. Only the OASI will be reviewed
for this paper since it is more than five times as large as the Disability Insurance Trust Fund.
The trust fund ended the year with a positive balance of more than $2.2 trillion, so what
is the problem? In truth Social Security is faced with a multi trillion future deficit. When viewed
in the context of recent economic events and the amount of “Stimulus”, and “Bail Out” moneys
spent by the government the Social Security problem may not appear to be that imperative.
However, we must attempt in some manner to put this amount of money in perspective?

SO WE ASK THE QUESTION: (WHAT IS A TRILLION DOLLARS?)

Less than 40 years ago Senator Strom Thurmond of South Carolina, in a speech
concerning the federal budget stated “a million here and a million there pretty soon we will be
talking about real money”. So, in just 40 years we jumped to 100’s of millions then skipped right
through billions and finally we have raced to a trillion. We now talk about trillion here and a
trillion there, what is a trillion dollars? To help us understand what a $1 trillion is here are some
more understandable relationships. Laid end to end the length $1 trillion is 500,000,000 ,000 feet
or 94,876,600 miles or enough money laid end to end to make 397 trips to the moon. It takes 454
$1 dollar bills to make a pound how much does $1 trillion weight? 2,202,643,171 pounds or
1,101,321 tons. If we had to move $1 trillion how many tractor trailers carrying an average of
40,000 pounds would it take to haul $1 trillion? It would take 55,066 tractor trailers, so how
many miles would this convey stretch? If the average length of the tractor trailer is 55 feet this
convey be? 574.6 miles long. Lastly if you were placed in a booth with endless dollar bills
supplied and you could grab a dollar bill every second how long would it take to grab a trillion
dollars? 32,000 years.
Now that you may now better appreciate the magnitude of our fiscal and monetary
problems we must begin to pay closer attention as our elected officials with reckless abandon
throw around the term “1 Trillion Dollars”. If this realization is not bad enough we must come to
grips with the fact that the national debt now tops $11 Trillion Dollars or on a more personal level
every man, woman, and child in the United States is debt for $37,000 and that number grows
every second of every hour, of every day. So where does this leave us? Remember this is just
today’s debt.
A CLOSER LOOK AT THE SOCIAL SECURITY PROBLEM

The first step in correcting any problem is the understanding of the problem. Trust fund
receipts for 2008 amounted to more than $695.5 billion while disbursements amounted to only
$516.2 billion.
Financial adequacy or solvency reflects the ability to pay promised benefits in full and on
time. To measure the adequacy, or solvency the “trust fund ratio” is utilized. This is a ratio that
compares the promised benefits for the year with the combination of the total asset value and
current contributions. If the combination of total asset value and current contributions exceed the
promised benefits for that year, then the trust fund has a ratio of 100%. Currently the trust fund
has a ratio far in excess of 100% and growing reflecting the fact that we as Americans have in the
past and currently contribute more on annual basis than is paid out on an annual basis.
Under the most likely set of assumptions the OASDI will pay out more than it brings in
for the first time in 2015 or 2016 and by approximately 2037 all assets will be exhausted and the
continuation of benefits will require payments from the federal government. This negative
outflow is a result of the increasing percentage of the population that are of retirement age.
Currently there are 32 beneficiaries receiving payments for every 100 workers, by 2035 this
number is forecasted to swell to 48 beneficiaries per 100 workers. As we past 2035 and the
number of “Baby Boomers” declines and hence the number of beneficiaries per 100 workers is
also estimated to decline, it should reach the low 40’s by 2085.
With an average age of 19 in this class and the current retirement age of 67 the Social
Security system will be insolvent or bankrupt long before you can collect and since most of you
will not live to see 2085, so where does that leave you. This actually leaves you and millions of

young adults with the responsibility to save for your retirement while at the same time trying to
repair Social Security.
LEARNING THE MATH OF INVESTING

Present Value and Future Value of a Single Sum
Question 1; what amount of money/investments would you feel comfortable with at retirement
age?
$500,000
$750,000
$1,000,000
Before you can accurately answer this question you must understand one of the most
fundamental laws of finance, “A dollar today is worth more than a dollar tomorrow” or a million
dollars 48 years from now is not worth what a million dollars is today. So, how much in today’s
dollars is this $1,000,000 you want at retirement really worth. This involves finding the “present
value” of a future sum. The future sum is you $1,000,000 needed to retire. Using the assumptions
that the average age of a student in this class is 19 and will retire at 67 giving you 48 years to save
and the fact that the United States for the most part has been extremely lucky in that our average
rate of inflation has been low, over the last 25 years it has averaged below 3% we have the inputs
needed to answer the question. We should interject one caveat, many economists believe that
this rate will increase as a result of the current massive government spending program and
exploding national debt, any increase in the inflation/interest rate used for this calculation will
only make the outcome worse so we will just continue to assume the average inflation rate will
remain at 3%. This is more than likely a “best case” scenario.
Present Value
PV = FV/( 1+i)n
$1,000,000/(1+.03)48 = $241,998
Utilizing a financial calculator you would have the following inputs
N = 48
I =3
PV =? Solve for this
FV = 1000000
The above is an example of “Discounting”, bringing a future sum back to its present
equivalent value. This means that when you retire you will have the equivalent purchasing power
of $241,998 today. Could you live on that for 20 or more years? We will explore the answer to
this question later in the paper/class.
Question 2; If your long lost rich uncle died and left you $50,000, after taxes, and you invested it
today at 9% how much would you have in 48 years? This is an example of taking a sum today
and finding the “Future Value”, also known as compounding.

This could be one very easy and convenient way to fund your retirement, if you were so
lucky. We will utilize a rate of return or interest rate of 9%. Many investors would consider 9%
conservative since over the last 40 years a well diversified portfolio has returned in excess of
10%. This is a long run average sure we lost 30% in 2008 but we have already gained 12% in
2009.
Future Value
FV = PV( 1+i)n
$50,000(1+.09)48 = $3,129,261.85
Utilizing a financial calculator you would have the following

inputs
N = 48
I =9
PV = 50000
FV =? Solve for this
The above is an example of “Compounding”, taking a

present sum and growing it into the future equivalent value. This
means that when you retire you will have $3,129,261.85.
$3,000,000 would appear to be a much more realistic retirement
goal and one that would allow you to enjoy those golden years.
As can be seen from the two examples above the two important assumptions/inputs for
the calculations have been time and interest rates. Let us explore their individual impacts. With
an increase of 5 years in the retirement age the effects would be dramatic. As an example what
would be the increase in your retirement fund if it had just five additional years to grow.
N = 53
I =9
PV = 50000
Under this scenario you would retire with not
$3,129,261.85, but with $4,814,757. Retirement life is
looking better and better. As can be seen by this
example time is an extremely important variable, an
increase of 10% in the time period led to an increase of
54% in value.
Now that we have seen a dramatic change in

value from a relatively small change in time what
amount of change would be generated from an increase
of just 1% in the interest rates? Again the effects
would be dramatic. As an example what would be the
increase in your retirement fund if it the rate of return
increased from 9% to just 10%.
N = 53
I = 10
PV = 50000

Under this scenario you retirement account would not be $4,814,757, but would be
$7,812,361. Retirement life is again looking better and better. As can be seen by this example,
the rate of return is also an extremely important variable, an increase of just 1/9 or 11% in the rate
of return led to an increase of 62% in the value of your account at retirement age. Or as the
advertisement from Worth magazine above states “Every percent counts”.
The same changes that resulted in huge increases in a student’s personal wealth would
lead also help Social Security stay solvent for additional years; one is to increase the retirement
age. The effect of this change would be two-fold; each person will have to pay into the trust fund
for any additional years, and at the same time will receive benefits for fewer years before death.
The other major change that could help Social Security stay solvent for additional years is to
increase the average rate of return. This change would also produce a twofold improvement, each
dollar a person pays into the trust fund will grow, or “compound” at a higher rate and as
participants draw money out their account the increased rate of return would also allow their
account to stay positive for a longer point of time.
PRESENT VALUE AND FUTURE VALUE OF ANNUITIES

In reality we do not fund our retirement with single lump sum investment and Social
Security is not funded by one time lump sum investments, both are funded with payments over
time. When these payments over time are equal amounts they are referred to as an annuity. The
present value and future value of annuities equations listed below are much more cumbersome
than the equations for present value and future value of single sums above so it is very important
that students utilize a financial calculator.
Annuity Payments
FVA = PMT{[( 1+i)n /i] – 1/i}
PVA = PMT{[1/i –[1/(i (1+i)n ]}
As can be seen by the above equations even though they are more involved than single
sum equations the variables remain the same, except for the addition of PMT or the Payment.
N =
I =
PV =
FV =
PMT =
Let us return to Example # 1 “Discounting”. In this example we calculated the present
value of the $1,000,000 saved for retirement. Our job, utilizing the same variables is now to
calculate the payment or how much per year, in today’s dollars, you would receive if you had the
$241,998.00 in purchasing power when you retired. To complete this calculation we must make
one additional assumption. To correctly answer this question we have to assume how long
benefits will be paid after retirement. In reality the question is if we assume you are retiring at 67
how many years after retirement are you going to live? The Social Security Administration
utilizes data from the National Center for Health Statistics to create their “Period Life
Expectancy” Table V.A.1 page 83 of the annual report. According to this table if you are female
and born between 1985 and 1990 you life expectancy is 78.5 years, if you are male your life
expectancy is 71.6. However this does not actually answer our question since life expectancy at
birth is different than life expectancy at age 67. According to the same table if you are a woman

and reach age 67 you can expect to live 16.9 years longer and if you are a male and reach age 67
you can expect to live 14.8 additional years. For these calculations we will average them together
and assume that the average student in this class will live 15.85 years after retirement.
Inputting the data into your financial calculator we can we can solve for the payment.
N = 15.85
I =9
PV = 241998
FV = 0
PMT =? Solve for
In this example you would receive annual payments of $29,240 dollars per year for 15.85
years. The only problem arises that if you live past your allotted time you will be broke.
Being broke and 73 years old could present a problem so just to be careful you decide to plan on
living to 100 after retiring at 67 with a financial calculator all we must do is change N from 15.85
to 33.
N = 33
I =9
PV = 241998
FV = 0
PMT =? Solve for
In this example you would receive annual payments of $23,125 dollars per year for 33
years, however you will still be broke at the end of the time period, but at least you will have
made it to 100.
APPLYING TIME VALUE OF MONEY PRINCIPLES TO SOCIAL SECURITY

As we have shown in previous examples the two most important variables in the
compounding or discounting of single sums and annuities are time and rate of return. As
mentioned in the introduction Social Security is by law required to invest in only U.S. Treasury
securities which while being very safe continue to lag behind many other viable investment
options. As an indication of the experienced and expected low returns for the Trust Fund
investments the following excerpt is from the 2009 Social Security report page 101. “In
developing a reasonable range of assumed ultimate future real interest rates for the three
alternatives, historical experience was examined for the 40 years, 1968-2007, and for each of the
10-year sub periods, 1968-77, 1978-87, 1988-97, and 1998-2007.” The report goes on to analyze
the data and then states “For the next 10-year short-range projection period, nominal interest
rates are projected based on changes in the business cycle and in the CPI. Under the
intermediate assumptions, the nominal interest rate is projected to decline from an actual value
of 3.6 percent for 2008 to 3.0 percent for 2009, reflecting a weak economy along with a negative
rate of inflation. Thereafter, the nominal interest rate rises to the ultimate assumed level of
5.7 percent for 2018.
Appendix 1 consists of a spreadsheet constructed from data within the 2009 Social
Security report. The overall rate of return has also been calculated ranging from 4.74% in 2009
to 5.23 % in 2018. As can be seen by the upper half of the spreadsheet by 2015 benefits paid will
exceed contributions collected, however the Trust Fund will continue to grow for a number of
years as a result of the taxes collected and the investment returns. When these additional inflows
and the outflows for expenses are accounted for the Trust Fund outflows are projected to exceed
inflows within two years of the end of this table. While at this point the Trust fund continues to
have a positive balance this balance will continue to decline until 2037.

The second panel of Appendix 1 shows that while the contributions and benefits paid
over the time period does not change a change in the investment structure could have definite
effect on the sustainability of the Trust Fund. By investing 25% of the Trust fund into the Stock
Market projected returns increase substantially and allow the 2018 Trust Fund balance to grow
from $3,962 Billion to $4,400 Billion. In addition the increased yearly revenue from investments
pushes out more than a decade the time at which total outflows exceed total inflow and by almost
two decades the 2037 date at which the assets would hit Zero.
CONCLUSION
The goal of this paper was to help finance instructors to step beyond the Extrinsic
Motivation provided in grade school and high school and elevate learning process to the level of
Intrinsic Motivation. While trying to elevate the learning process to the intrinsic level we must
compete with 500 channel TV’s, Text Messaging, and e-mail in an effort to grab the student’s
attention. While this approach to teach a rather dry and mathematical concept may not be for
everyone it has proven to interest and engage the students in my classes. By beginning the subject
with an attention getting “What is a Trillion Dollars” we relate to the students who have become
used to lists for everything. The ten best dressed, the ten worse dressed, the ten best sports plays,
the ten best bloopers and so on. We continue this relationship building by providing moments of
entertainment tied directly to the material concepts with “Your best bet is “, “Time is Money” and
“Every Percent Counts” all the while utilizing these simple one line statements to re-enforce some
very important financial information.
This will help our students become better prepared to face an uncertain financial future
and become aware of the structural non-sustainable financial condition of Social Security, and as
they say the first step in finding a cure is knowing that you’re sick. Lastly while everyone in this
room will more than likely retrieve all of their contributions into Social Security, personally “I am
going to live forever or die trying”, the same cannot be said for our students.
REFERENCES
Becker, W. (1997). Teaching Economics to Undergraduates. Journal of Economic Literature.

35(3), 1347 – 1373.
Dev, P.C. (1997). Intrinsic motivation and academic achievement: What does their relationship
imply for the classroom teacher? Remedial and Special Education, 18(1), 12-19.
The 2008 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors
Insurance and Federal Disability Insurance Trust Funds.
The 2008 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors
Insurance and Federal Disability Insurance Trust Funds.

Financial Sustainability Worksheet

Data from Table IV.A1 Page 35
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Assets at Beg. Of Year 2202.9 2349.5 2502.3 2672.2 2860.8 3056.2 3251.1 3443 3627.2 3801.2
Contributions 579 599.4 628.9 667.4 702.8 737.2 772.8 806.6 841.9 878.2
Tax on Benefits 21.7 23.9 25.2 26.8 30.1 32.6 35.7 38.8 42.1 44.9
Return Earned 107.8 110.6 117.7 128.3 141.3 154.8 166.9 178.6 190.6 202.9
Total Increase 708.5 733.9 771.8 822.5 874.2 924.6 975.4 1024 1074.6 1126
Benefits Paid 554.7 573.8 594.5 626.3 671.2 721.8 775.3 831.5 891.8 956.3
Expenses 7.2 7.3 7.4 7.6 7.6 7.9 8.2 8.3 8.8 9.1
Total Outflow 561.9 581.1 601.9 633.9 678.8 729.7 783.5 839.8 900.6 965.4
Increase in Assets 146.6 152.8 169.9 188.6 195.4 194.9 191.9 184.2 174 160.6
Asset at End of Year 2349.5 2502.3 2672.2 2860.8 3056.2 3251.1 3443 3627.2 3801.2 3961.8
Rate of Return 4.74% 4.56% 4.55% 4.64% 4.78% 4.91% 4.99% 5.05% 5.13% 5.23%
Market Return 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
25% of the Assets Invested in the Market
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Assets at Beg. Of Year 2202.9 2375.0 2557.8 2761.2 2986.6 3222.3 3461.6 3702.6 3941.1 4174.7
Contributions 579 599.4 628.9 667.4 702.8 737.2 772.8 806.6 841.9 878.2
Tax on Benefits 21.7 23.9 25.2 26.8 30.1 32.6 35.7 38.8 42.1 44.9
Return Earned 133.3 140.6 151.2 165.1 181.6 199.2 216.0 232.9 250.2 268.0
Total Increase 734.0 763.9 805.3 859.3 914.5 969.0 1024.5 1078.3 1134.2 1191.1
Benefits Paid 554.7 573.8 594.5 626.3 671.2 721.8 775.3 831.5 891.8 956.3
Expenses 7.2 7.3 7.4 7.6 7.6 7.9 8.2 8.3 8.8 9.1
Total Outflow 561.9 581.1 601.9 633.9 678.8 729.7 783.5 839.8 900.6 965.4
Increase in Assets 172.1 182.8 203.4 225.4 235.7 239.3 241.0 238.5 233.6 225.7
Asset at End of Year 2375.0 2557.8 2761.2 2986.6 3222.3 3461.6 3702.6 3941.1 4174.7 4400.4

DOES CONSUMER CONFIDENCE AFFECT
DEMAND (OR JUST PROXY FOR THINGS THAT
DO)? TESTING THE MICHIGAN CONSUMER
SURVEY
Heim, John J.
Rensselaer Polytechnic Institute
heimj@rpi.edu
ABSTRACT
This paper examines whether changes in consumer confidence, independent of changes in
economic status, affects consumer demand. Consumer demand models, similar to Fair’s
econometric models are tested. Results are compared with VAR methods used by others.
Examined for the first time, is whether consumer confidence affects investment decisions. The
measures examined are the University of Michigan’s Indices of Consumer Sentiment (ICS) and
Expectations (ICE). Results suggest causation runs from consumer confidence to consumption
and investment, that the ICS and ICE are systematically related to consumer spending only on
nondurable goods, not on durables, services, or investment. Effects on 2009 GDP are estimated.
C20, C22, E20, E21, E22
If income or wealth decline, theory and empirics lead us to expect declining consumption. Not so
clear is whether consumer confidence itself affects consumer spending, controlling for changes in
an individual’s income, wealth, or other variables known to influence consumption. If consumer
confidence can independently influence spending, i.e. through “fear itself” as Roosevelt might
have said, public officials must be careful to avoid hyperbole when reporting economic news, so
as not to create a self fulfilling prophecy. Many believe confidence levels to be important. For
example, Carroll, Fuhrer and Wilcox, (1994) note the 1990 collapse of consumer confidence
“frequently was cited as an important – if not the leading – cause of the economic slowdown that
ensued”. Kelly (2009) cites declining consumer confidence after the stock market crash in 1929
as one of the 5 major causes of the great depression. The chair of the President’s Council of
Economic Advisors also recently remarked that
…Consumer spending depends on many things, including income, taxes,

confidence, and wealth… (Romer, 2009)
If economic policy pronouncements by public officials affect consumer confidence, these

pronouncements may indirectly be a determinant of economic activity, if confidence itself affects
spending. The tone and content of policy pronouncements could themselves be a type of
economic policy. Hence, the need to assess the impact of consumer confidence on consumer and
investment spending.
1.0. PREVIOUS STUDIES

Using methods similar to those used here, Heim (2009E) examined a different measure of
consumer confidence, the Conference Board’s Index of Consumer Confidence (ICC), and found
the ICC systematically related, after a one year lag, to spending on durable goods, nondurable
goods and services. Relationships to investment spending were also tested, and the average value

Heim Testing Michigan Consumer Survey
of the Conference Board’s index of consumer expectations over the current and past two years
was found significantly related to housing and inventory investment. Extensive controls on other
factors affecting consumption and investment were used.
Other studies have examined consumer confidence using different methods (VAR – based) than
are used in this study. Carroll, Fuhrer and Wilcox (1994) examined the impact of consumer
confidence on consumption using the University of Michigan’s ICS and found it related to overall
consumer spending, and spending for goods, but not services. Their method involved a VAR
methodology in which several lags of the ICS variable were added to a regression already
containing several lags of the dependent variable and income as a control variable, to see if ICS
significantly contributed to explained variance.
The best known study of the University of Michigan’s Indices of Consumer Sentiment (ICS) and
Consumer Expectations (ICE) to date is Bram and Ludvigson’s (1998) study. It also used a VAR
– like methodology derived from Carroll, Fuhrer and Wilcox, but added interest rates and stock
market values to the controls. They examined these Indices finding them related to only a few
categories of consumer spending: only goods consumption, exclusive of motor vehicles, was
found related to the ICS, and only motor vehicles consumption was found related to the ICE.
They also analyzed the Conference Board’s Indices, and found total consumption, motor vehicles
consumption and other durable goods consumption significantly related to the ICC, but services
consumption, and consumption of all goods (except motor vehicles) insignificant. Since goods
consumption is overwhelmingly nondurables, this implies the ICC was unrelated to spending on
nondurable goods. Using the ICE, they found total consumption, motor vehicles consumption
and services consumption significant. Hence, the findings were somewhat inconsistent between
the Conference Board’s two indices.
Their study tested a model for of the following type:
∆Ln(Ct) = α0 + Σ1n(βiSt-i ) + γZt-i + εt
Where the S are the consumer sentiment (ICS) and expectations (ICE) variables, and Z are the
control variables. The control variables were lagged values of a labor income variable and the
dependent variable, the 3 month treasury rate and a stock market measure (both in first
differences). Four lagged values of each variable were used in the model. The test is designed to
see if adding the ICS or ICE to regressions on the other predictor variables increased forecasting
ability (i.e., increased the model’s explained variance. This criterion can lead to misleading
results. If a variable in the model has been proxying for a variable not yet entered, entering the
new variable (such as the ICS) may show it to be statistically significant without changing the
total explained variance significantly. An example of this occurring when a consumer confidence
variable is added to the model is shown at Heim (2009E, p.11)
The problem is, models using dependent variable lags on the right side are biased and inconsistent
(Hill, Griffith, Judge 2001), therefore interpretation is problematic. In addition, parameters for
exogenous variables can be difficult to determine if there are multiple lags of the dependent
variable used. Therefore, it can be difficult to assess the economic, as opposed to statistical,
meaning of the results.
The models tested in this paper will be of a more explanatory type. All variables other recent
studies have found to be determinants of consumer behavior will be included as controls, using
only lagged values found significantly related to the dependent variable, and theoretically
justifiable. Past values of the dependent variable are not used on the right side. They are but

functions of past values of the exogenous variables, which this study attempts comprehensively to
include, where warranted.
Properly constructed, explanatory and predictive models need not be unrelated. One can move
back and forth from one to the other, depending on whether one is trying to explain what makes
the economy work, or predict where it will go in the future. For example, let consumption be
described by the following model, which (for simplicity), has only one “control” variable, income
(Y), in addition to the consumer confidence variable (ICS). It also includes a one period lagged
value of the dependent variable.
1) C0 = α + β1 Y-1 + β2 ICS-1 +γ C-1
Then it is easy to show that with two backward substitutions into the dependent variable on the
right hand side, in steady state equation two becomes
2) C0 = (1 + γ+ γ2) α + + (1+ γ+ γ2) β1 Y-1 + (1+ γ+ γ2) β2 ICS-1 γ3 C-3
Infinite series expansion tells us that with infinite additional backward substitutions, in steady
state this yields
3) C0 = (1/1-γ) α + (1/1-γ) β1 Y-1 + (1/1-γ) β2 ICS-1
Using this process, Professor Fair’s consumption equations (Fair 2004), which we would
characterize as predictive, can be easily converted to explanatory models.
2.0. METHODOLOGY
The models tested below are of the type shown in (3) above. Empirical tests are linear in their
variables and in their effects. Variables used as determinants of consumption, and the specific
lagged value used with each, will be taken from previous studies of which variables/lags seem to
explain the most variance in consumption. These will be used as control variables. Individual
lagged values of ICS or ICE will be added to these previously tested models, using the same data
set they used, to see if they are significantly related to consumption. t-statistics on the added ICS
or ICE variables are used to evaluate the results.
2.1. ESTIMATING CONSUMER DEMAND

Table 1 below shows how demand for consumer goods and services was divided between
durables, nondurables and services during the 1960 – 2000 period. Typically, durables demand
was only 10% of total consumer demand. Note that even in 1960, services were the largest
component of consumer demand, followed by demand for non durable goods.
This paper, econometrically tests the effect of consumer confidence on consumption spending,
and whether changes in consumer confidence are lagging, leading or concurrent indicators of
changes in consumer and/or investment demand., Recent work by Heim (2009A&B) estimated
the separate effects of a large group of variables commonly theorized to determine consumer and
investment demand using demand driven models similar to those used in large scale Cowles
Commission –type econometric models like those of Fair (2004). Annual data for1960-2000 was
used, taken from the 2002 Economic Report of the President, or other related data available from
the Commerce Department’s Bureau of Economic Analysis. The variables found statistically
significant determinants of consumption or investment are used as control variables in this study.
Using these controls, the same data set is retested adding Michigan’s ICS or ICE variable, to see

TABLE 1
COMPONENTS OF REAL U.S. CONSUMPTION 1960 – 2000
(Billions of Chained 1996 Dollars)
Year Total Durables Nondurables Services .

1960 $1510.8 $101.7 $ 612.8 $ 791.7
1970 2317.5 184.4 854.8 1275.7
1980 3193.0 279.6 1065.8 1858.5
1990 4474.5 487.1 1369.6 2616.2
2000 6257.8 895.4 1849.9 3527.6
Av.% 100% 10% 33% 57%
Source: Economic Report of the President 2002, Tables B2, B7.B16
if their t-statistics show them to be systematically related to consumption or investment.
The 2009A paper assumed that the demand for consumer goods was principally driven by factors
suggested by Keynes (1936): income, wealth, fiscal policy (taxes) and possibly the rate of
interest. Keynes also noted the need for saving might affect consumption spending.
Two other factors were added to this demand model. First, a “crowd out” variable is added,
similar to the one used in investment studies to control for periods of limited credit availability
which may occur in response to government deficits. Preliminary studies had indicated this
variable was as strong a force affecting consumer spending, as it is in investment spending (Heim
2007, 2008A). The same studies also showed that Keynesian formulations of current period
income explain far more variance in consumption than do Friedman/Modigliani average income
formulations (suggesting these averages mainly serve as imperfect proxies for current income).
Second, we also add an exchange rate variable based on preliminary tests indicating this variable
explains changes in consumer demand not otherwise explained by the other variables in the
demand model. A four year average value for this variable was most appropriate (Heim 2009C).
These studies used a stepwise regression model to determine which of the above-hypothesized
variables actually explained variance in consumer spending. The lagged value explaining the
most variance was defined as the one to add to the stepwise model. In the stepwise process, a
new (possible) determinant of consumption is added and tested. Each new variable is added and
tested, using its current year value and the preceding four years values, to determine which lag
level best explain current consumption.
Results on a consumer demand function of the following type explained 92% of the variance in
consumer spending during the 1960 - 2000 period:
C = β1 + β2 (Y-TG) + β3(TG - G) - β4 (PR). + β5 (DJ)-2+ β6 (XR)AV0123

where
(Y-TG) = Disposable income defined as the GDP minus the government receipts net of
those used to finance transfer payments
(TG – G) = The government deficit, interpreted as a restrictor of consumer as well as
investment credit. It was found highly significant in a preliminary study
(Heim 2008A), and is regressed as two separate variables because of earlier
findings of differential effects.

PR = The Prime interest rate for the current period. It is deflated to get the “real”
rate using the average of the past two year’s CPI inflation rate.
DJ-2 = A stock market wealth measure, the Dow Jones Composite Average, lagged
two years
XRAV0123 = The trade - weighted exchange rate (XR An average of the XR value for the
current and past three years is used to capture what preliminary studies
showed was slow, multiyear process of adjustment to exchange rate changes
(Heim, 2007)
Regression results for this model were calculated using
2SLS Regression to deal with simultaneity between C and Y

Newey –West heteroskedasticity corrections to standard errors
1st differences of the data to reduce multicollinearity, autocorrelation and nonstationarity
1960 – 2000 data from The Economic Report of the President, 2002
The actual regression results obtained were as follows:
ΔC0 =.66Δ(Y-TG)0 +.48ΔTG(0) + .06ΔG0 – 6.81 ΔPR0.+.69 ΔDJ-2 + 1.39 ΔXRAV0123 R2 = 92%
(t =) (27.9) (5.2) (0.5) (-3.2) (5.1 ) (2.3) D.W.= 2.0
We shall take this as a well developed, comprehensive model of consumption’s (other)

determinants when testing consumer confidence variables below. One modification is made for
consistency with other work that follows in this paper: the exchange rate used above, the G-10
rate, was dropped in favor of the Federal Reserve’s real Broad exchange rate, to better reflects
U.S. trading patterns. The change had virtually no effect on the estimated effects of other
variables. The “baseline” model of consumption modified to include the real Broad rate instead of
the G-10 rate was:
ΔC0 =.66Δ(Y-TG)0 +.49ΔTG(0) + .04ΔG0 – 6.92 ΔPR0.+.62 ΔDJ-2 + 2.83 ΔXRAV0123 R2 = 92%
(t =) (29.2) (5.7) (0.3) (-3.2) (4.9 ) (3.2) D.W.= 2.0
Throughout this paper, for the 1960 -2000 data set used, t-statistics of 2.0 and 2.7 are significant
at the 5% and 1% level respectively.
To test whether the (ICS), or later, the (ICE) explain any variation in consumption when the
effects of the “baseline” variables above have been controlled for, we then add the ICS or ICE
and retest. If the t-statistic on the regression coefficient for the ICC or ICE
variable is significant at the 5% level or above, we conclude it is systematically and
independently related to consumption.
2.2. ESTIMATING INVESTMENT DEMAND: METHODOLOGY

Total investment spending in the GDP accounts is divided into three separate parts: plant and
equipment (71%), inventories(3%) and residential housing investment (26%). The percentages
cited are for the year 2000, and are reasonably stable over time for the two largest parts.
The investment model used to test the ICS and ICE variables includes controls for a large
number of variables traditionally thought to be determinants of investment. See, for example,
Keynes (1936), Jorgenson (1971), Terragossa (1997), and Spenser & Yohe (1970).

ΔI = β1 ΔACC + β2 ΔDEP + β3 ΔCAP-1 + β4 ΔTG - β5 ΔG - β6 ΔPR-2*Y-4 + β7 ΔDJ-2 + β8 ΔPROF-2 + β9 ΔXRAV0123
The variables included in these equations are
ΔACC = An accelerator variable Δ(Yt - Yt-1)

ΔDEP = Depreciation
ΔCAP-1 = A measure of last year’s capacity utilization
ΔPROF-1 = A measure of business profitability two years ago
ΔDJ-1 = Last Year’s Dow Jones Composite Index – A Proxy For “Tobin’s q “
PR-2*Y-4 = The Real Prime Interest Rate Lagged two years Multiplied By The Size
of The GDP Two Years Before That (A Way Of Adjusting Interest Rate
Effects For Economy Size)
The other variables in the model (exchange rate, government deficit) have the same meanings as
in the consumption model previously discussed, with lags as noted. These actual regression
results (Heim 2009B) for this model were calculated using
2SLS Regression to deal with simultaneity between C and Y

Newey –West heteroskedasticity corrections to standard errors
1st differences of the data to reduce multicollinearity, autocorrelation and nonstationarity
1960 – 2000 data from The Economic Report of the President, 2002
This study had shown these variables would explain 90% of the variance in total investment
demand 1960-2000. Detailed econometric results are shown below. Variables are shown in
order of their contribution to explained variance using the previously mentioned stepwise
regression procedure:
ΔI =.43 ΔTG -.39ΔG +.29ΔACC + .86ΔDEP - 1.17ΔPR-2 *Y-4 +.50 ΔDJ-1 +.38 ΔPROF-1 + 3.77 ΔXRAV0123 +.17ΔCAP-1 R2=.90
(t =) (4.4) (-2.2) (8.5) (3.0) (-2.5) (3.2) (2.6) (2.2) (0.2) DW =2.3
Here again, t-statistics of 2.0 and 2.7 are significant at the 5% and 1% level respectively. To test
whether the Index of Consumer Sentiment (ICS), or its subcomponent, the Index of Consumer
Expectations (ICE) explains any variation in investment when the effects of the “baseline”
variables above have been controlled for, we will add the ICS or ICE variable being tested to the
above model, and retest. If the t-statistic on the regression coefficient for the ICS or ICE variable
is significant at the 5% level or above (t>= 2.0), we will conclude that it does explain variance
otherwise unexplained in a reasonably well specified investment function.
3.0. SENSITIVITY OF CONSUMER DEMAND TO THE (ICS)

The Index of Consumer Sentiment was added to the baseline consumption model from section
2.1, and the model reestimated for each of a number of different lags. The lags included
individual year lags from the current year value (ICS0), through (ICS-5 ). Various multiyear
averages of the index were also tested, from ICSAV0-1 through ICSAV0-1-2-3-4-5-6. Results are given
in Table 3 below.
The findings were uniformly supportive of the hypothesis that consumer confidence, as measured
by Michigan’s ICS, was unrelated to spending on total consumer spending.
Overall consumption spending is made up of three quite different subcomponents: demand for
durable goods, demand for non durable goods and demand for services. Though overall

consumer demand may not be systematically related to consumer sentiment, it may be that at least
one of its subcomponents is. The Heim 2009A study found the following the determinants of
each, using the stepwise regression technique previously mentioned:
Consumer Durables1:
ΔCD = ƒ [ β1 Δ(Y-TG)t, + β2 Δ TG + β3 ΔG + β4 Δ XRAV0123 + β5 ΔDJ-2, + β5 ΔPR + β6 ΔHOUSE + β7 ΔPOP]
|Δ(Y-TG) | Δ TG | ΔG |ΔXRAV0i23 |Δ DJ t-2 | ΔMORT | ΔPR |ΔHOUSE | ΔPOP

R2/Adj.(DW) | β1t(t) | β2T (t) | β2G(t) | β3(t)| | β4(t) | β67(t) | β5(t) | β8(t) | β6(t) .
| | | | | | | | |
94/92% (2.2) | .14 (5.7) | .12 (3.4) |-.05 (-0.7) | 1.89 (4.1) |.35 (5.3) | |-1.59(-2.0) | .20 (2.7) |-.004(-2.5)
| | | | | | | | | .
Consumer Non-Durables1:
ΔCND = ƒ [ β1 Δ(Y-TG)t, + β2T&2G Δ(Crowd Out)t, + β3 ΔDJ-3, + β4 ΔPR, + β5 ΔPOP]
|Δ(Y-TG) | Δ TG | ΔG | Δ DJ -3 | ΔPR | ΔPOP

R2/Adj.(DW) | β1(t) | β2T (t) | β2G(t) | β3(t)| | β4(t) | β5(t)
.
| | | | | |
86/84% (2.1) | .13(5.5) | .18 (5.9) |-.07(-1.1) | .28 (3.7) |-1.96(-2.4) | .003 (1.7)
| | | | | |
.
Consumer Services1:
ΔCs = ƒ [ β1 Δ(Y-TG)t, + β2T&2G Δ(Crowd Out )t, + β3 ΔPOP + β4ΔDJ-2, + β5 Δ(16-24)/65, + β6 Δ MORT ]
| Δ(Y-TG) | Δ TG | ΔG | ΔPOP | DJ -2 | Δ16-24/65 | ΔMORT

R2/Adj.(DW) | βt(t) | β2T (t) | β2G(t) | β3(t) | β4(t) | β5(t) | β6(t) .
| \ | | | | |
81/78% (1.6) | .18 (5.1) |.10 (2.4) | .13 (1.4) | .013 (5.1) |.39 (4.0) |-212.9(-1.8) |-4.66(-1.7)
| | | | | | | .
________________________________________
1
(Heim, 2009A, pp.8, 10 and 12)
All variables above are as previously defined except (MORT), the current year nominal interest
rate on mortgages, and (Δ16-24/65), the percent of young adults in the population relative to
older adults. The theory was that young adults, either because they are students, or just forming
households, have less money to spend on services.
These models of the determinants of durable and nondurable goods and services will be
considered baseline models. The ICS variable will be added, and the models retested. Regression
coefficients and t-statistics for the ICS variable are also shown below in Table 2 for these
subcomponent parts of total consumption.
Of consumption’s three component parts, only nondurable goods spending, after a year’s lag,
seems systematically related to the ICS. Spending on services and nondurable goods was not
found related. Table 2 findings also suggest the average value of the ICS for the past two years is
related to consumption. However, since the lag for two years ago was not found significant
alone, this seems only because it is averaged with the(-1) lag which was found significant, i.e.,
the average is serving as an imperfect proxy for the ICS-1 variable alone.
3.3 CONCLUSIONS REGARDING THE RELATIONSHIP OF ICS TO CONSUMPTION

Based on Table 2, we conclude consumer confidence, measured by ICS, is only significantly
related to one type of consumer demand: nondurable goods, and only after a one year lag. These
findings reflect extensive efforts to control variation in consumption caused by other variables.

Absent these controls, the ICS may be able function as a proxy for some of them (e.g., income),
appearing to explain additional variance better explained by an economic variable.
Table 2
Regression Coefficients (β) And t-Statistics (t) For Various Lagged ICS Variables
Using Different Components of Total Consumption As The Dependent Variable
Durables Nondurables Services Total Consumption1 Total Consumption2

Lag Used βD (t) βND (t) βS (t) βT (t) βT (t) .
0 .07 ( 0.4) - .02 (-0.1) - .15 (-0.5) - .25 (-0.8) - .29 (-0.6)
-1 - .02 (-0.1) .58 ( 2.7) - .09 (-0.3) .97 ( 4.1) .47 ( 0.8)
-2 .23 ( 1.3) .00 ( 0.0) .28 ( 1.0) .14 ( 0.5) .60 ( 1.2)
-3 - .10 (-0.7) - .05 (-0.2) - .13 (-0.6) - .57 (-2.4) - .43 (-0.9)
-4 - .26 (-1.6) - .19 (-1.2) .30 ( 1.0) - .03 (-0.2) - .67 (-1.2)
-5 .22 ( 1.6) .05 ( 0.3) - .06 (-0.3) - .26 (-0.9) .28 ( 0.5)
-6 .01 ( 0.0) - .03 (-0.2) - .13 (-0.9) .07 ( 0.3) .02 ( 0.0)
AV0-1 .05 ( 0.2) .55 ( 1.8) .26( 0.8) 1.94 ( 2.9) .20 ( 0.2)
AV-1-2 .26 ( 1.4) .54 ( 2.1) .24 ( 0.6) .96 ( 1.9) 1.16 ( 1.4)
AV0-1-2 .52 ( 1.7) .67 ( 1.5) .19 ( 0.4) 1.38 ( 1.5) 1.21 ( 0.9)
AV0-1-2-3 .34 ( 0.6) .89 ( 1.4) .02 ( 0.0) .14 ( 0.1) 1.27 ( 1.1)
AV0-1-2-3-4 - .33 (-0.6) .60 ( 0.9) 1.39 ( 1.8) - .02 (-0.0) .45 (.0.3)
AV0-1-2-3-4-5 .40 ( 0.8) .67 ( 0.8) 1.36 ( 1.2) - .61 (-1.5) -1.19 (-0.6)
AV0-1-2-3-4-5-6 .57 ( 0.6) 1.13 ( 1.2) .41 ( 0.3) - .13 (-0.1) - .70 (-0.4)
1
Total consumption is regressed on a model using as controls all variables found to be
determinants of any subcomponent of total consumption. This baseline model was then retested
with the ICS variable added. Results above show the regression coefficient and t-statistic for the
ICS variable.
2
From Heim 2008A, with controls for housing demand and population growth added.
The following demand equations for nondurables is a revision of the (Heim 2009A) model. They
are revised to include the one year lagged ICS variable. Demand determinants are those used in
Table 3 above for nondurable goods.
Consumer Non-Durables (Revised Model):

ΔCND = ƒ [ β1 Δ(Y-TG)t, + β2T&2G Δ(Crowd Out)t, + β3 ΔDJ-3, + β4 ΔPR, + β5 ΔPOP+ β6 ΔICC-1 ]
|Δ(Y-TG) | Δ TG | ΔG | Δ DJ -3 | ΔPR | ΔPOP | Δ ICS -1

R2/Adj.(DW) | β1(t) | β2T (t) | β2G(t) | β3(t)| | β4(t) | β5(t) | β6(t) .
| | | | | | |
89/87% (1.9) | .10(4.5) | .15 (4.6) |-.06(-1.4) | .36 (6.2) |-2.19(-2.7) | .004 (2.6) | .58 (2.7)
| | | | | | | .
Notice the earlier estimates of parameter values for the other variables are relatively robust to
changes in the model when the ICS variable is added.

3.3.1. ESTIMATED IMPACT ON GDP OF ICS DECLINE DURING 2008

The Index of Consumer Sentiment averaged 85.58 during 2007, and fell to and average of 63.75
for 2008, declining 21.83 points. The first six months of 2009, the index averaged 62.95, rising
in the last four of these months and suggesting the index “bottomed out” and was turning around.
The initial impact of the change in the Index during 2008 (- 21.83 points) is treated as an
exogenous change in consumer demand (specifically, demand for nondurables one year later).
The change is ($.58 billion )*(-21.83) = $-12.66 billion in 2009. However, this initial decline is
further augmented by both multiplier and accelerator effects, recently estimated at 2.22 for the
multiplier alone, but increasing to 5.88 when accelerator effects are added (Heim 2008B). Hence
our estimated total decline (during 2009) of the 2008 decline in the ICS is
(5.88)*($ -12.66 billion) = $ -74.44 billion total decline in 2009 GDP (in real 1996 dollars)
resulting from the 2008 decline in
ICS, (ceteris paribus).
The GDP price deflator has increased approximately 30% since 1996, so our $-74.44 estimate in
1996 dollars is approximately $96.8 billion in 2009 dollars, or about 7/10 of one percent of the
GDP. And this is for the largest annual decline ever in the ICS. By comparison, the BEA
reported declines in the GDP for the fourth quarter of 2008 of 6.3% (4th quarter results
annualized) ) and 5.5% (annualized) for the first quarter of 2009 (BEA News Release,
6/25/2009). Hence, we conclude that while the decline in consumer confidence may have caused
the GDP to decline, even the largest ever annual drop which occurred in 2008 will probably only
be responsible for a relatively small part of the overall decline in the GDP in 2009. (By
comparison with the 2008 drop of 21.83 points, the drop in 1979 was 13.4 points and the drop in
1974 was 12.4 points . These were followed by slumps the following year; but the slumps were
small: in both cases the decline in the real GDP the following year was only about 1/5 of 1%.)
The average annual change in the ICS 1961 - 2000 was 5.7 index points (in absolute terms) or
about 26% of the 2008 change. 80% of the changes 1961 – 2000 were less than 10 index points.
Hence, while a factor, changes in consumer confidence, as measured by the ICS, seem to
typically have a noticeable, though relatively small impact on the GDP.
4.0. CONSUMER DEMAND: TESTING THE INDEX OF CONSUMER

EXPECTATIONS (ICE)
All the tests applied to the ICS in Section 3 to determine ICS’s significance were again repeated
using Michigan’s ICE, and employing exactly the same controls. The basic results were
strikingly consistent with our ICS findings. No lagged variant of the ICE was found significantly
related (with the theoretically correct sign) to total consumption. Of consumption’s three
component parts, only nondurable goods spending, after a year’s lag, seems systematically related
to the ICE. Spending on services and nondurable goods were not found related to the ICE, as had
been the case earlier for the ICS. Table 3 findings also suggest the average value of the ICE for
the past two years is also related to consumption. However, since the lag for two years ago was
not found significant when tested by itself, this finding of significance for the average seems only
because the (-1) lag, which was found significant, is also in the average, i.e., the average is
significant only because it is serving as an imperfect proxy for ICS-1 alone.
4.1. CONCLUSIONS REGARDING THE RELATIONSHIP OF (ICE) TO

CONSUMPTION
Based on the Table 3 results, we conclude the ICE is not meaningfully related to either total
consumption, durables consumption or services consumption when other factors influencing

consumption are properly controlled for. However, it is related to spending on nondurable

consumer goods. However, absent adequate controls on other variables affecting consumption,
ICE can proxy for them, appearing to be significantly related to consumption when it really is not.
Table 3
Regression Coefficients (β) And t-Statistics (t) For Various Lagged ICE Variables
Using Different Components of Total Consumption As The Dependent Variable
Expectations Durables Nondurables Services Total Consumption1

Lag Used βD (t) βND (t) βS (t) βT .
0 - .09 (-0.6) - .09 (-0.6) - .23 (-1.0) - .66 (-2.3)
-1 .17 ( 1.2) .40 (2.2) .01 ( 0.1) .34 ( 0.9)
-2 .12 ( 1.1) .08 (0.4) .20 ( 0.8) .68 ( 1.3)
-3 - .21 (-1.3) - .14 (-0.9) - .10 (-0.5) - .57 ( 1.4)
-4 - .13 (-1.3) - .07 (-0.5) .22 ( 0.9) - .36 (-1.0)
-5 .15 ( 1.1) - .02 (-0.2) - .08(-0.5) .01 ( 0.0)
-6 .08 ( 0.5) - .03 (-0.2) - .14 (-1.0) .14 ( 0.5)
AV0-1 .07 ( 0.4) .32 (1.3) - .27 (-0.9) - .34 (-0.6)
AV-1-2 .29 ( 1.8) .45 (2.0) .23 ( 0.8) 1.07 ( 1.6)
AV0-1-2 .30 ( 1.2) .50 (1.3) - .01 (-0.0) .59 ( 0.6)
AV0-1-2-3 - .21 (-0.4) .51 (1.0) - .22 (-0.3) - .63 (-0.7)
AV0-1-2-3-4 - .79 (-1.1) .46 (0.7) .81 ( 1.3) -1.89 (-1.4)
AV0-1-2-3-4-5 - .08 (-0.2) .27 (0.4) .62 ( 0.6) -1.75 (-1.0)
AV0-1-2-3-4-5-6 .21 ( 0.3) .70 (1.0) - .50 (-0.6) -1.56 (-1.2)
.
1
Total consumption is regressed on a baseline model containing all variables
found to be determinants of any of the subcomponents of total consumption.
The baseline model was then retested with the ICE variable added. Results
above show the regression coefficient and t-statistic for the ICE variable.
5.0. SENSITIVITY OF INVESTMENT DEMAND TO THE (ICS)

The investment model in Section 2.2 includes most variables commonly thought to influence
investment. Econometric estimates of the model show the following results (variables are shown
in order of their contribution to explained variance using a stepwise regression procedure):
ΔI =.43 ΔTG -.39ΔG +.29ΔACC + .86ΔDEP - 1.17ΔPR-2 *Y-4 +.50 ΔDJ-1 +.38 ΔPROF-1 + 3.77 ΔXRAV0123 +.17ΔCAP-1 R2=.90
(t =) (4.4) (-2.2) (8.5) (3.0) (-2.5) (3.2) (2.6) (2.2) (0.2) DW =2.2
To this model, the University of Michigan’s Index of Consumer Sentiment (ICS) was added, and
the model retested. Doing so tests the hypotheses that businesses are sensitive to changes in
consumer confidence, which may affect future consumer spending, and tailor investment
accordingly. The model above was tested with a wide range of different individual and average
ICS lags. t-statistics for the ICS variable were used as the criteria for evaluation. In all cases the
ICS was found insignificant (or had the wrong sign).
These findings for total investment presume that controlling for variables found to be significant
determinants of total investment provides an adequate set of controls for other influences on total
investment. Heim (2009B&D) found that some factors not found significantly related to total
investment in the tests above, were found to be significant determinants of some specific part of
investment: either investment in plant and equipment, housing, or inventories. This may occur

because the variation in total investment was much larger than for the individual part, thereby
causing the variable found significantly related to the part to be “drowned out” when regressed
against total investment. For example, three variables found significant in explaining housing
investment (about a third of total investment), were not found to be statistically significant
determinants of total investment:
the mortgage interest rate,

the relative price of housing relative to income, and
the proportion of the population composed of younger people 16-24
These additional controls were added and the housing investment model retested. Plant and
equipment investment and, inventory investment, were also retested using only the combination
of controls found to be their statistically significant determinants. These models will be
considered the baseline models. To test the ICS variable, each variant was added to the baseline
models and retested. The results indicated no variant of the ICS variable found significantly
related to demand for either total investment or any of its three component parts individually.
6.0. INVESTMENT DEMAND AND THE INDEX OF CONSUMER EXPECTATIONS

Businesses plan for the future and they may gear their plans to consumer expectations for the
future, rather than their current confidence levels. To test this hypothesis, we repeat our
investment testing procedure from above, changing only the measure of consumer confidence
from the ICS to its subcomponent, Michigan’s Index of Consumer Expectations (ICE). Based on
the test results, we concluded the ICE is not systematically related to total investment or any of its
three component parts when we have controlled for other variables that can influence investment.
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HOW DOES A FINANCIAL CRISIS AFFECT 401(k)
PARTICIPANTS’ INVESTMENT BEHAVIOR?
AN EXPLORATORY STUDY
Ho, Raymond
Skyline College
raymond@ho-cpa.com
Kehoe, William J.
University of Virginia
wjk@virginia.edu
Whitten, Linda K.
Skyline College
lkwhitten@aol.com
ABSTRACT
This paper investigates the question whether 401(k) participants invest differently during a
period of slowing economic activity. Retirement accounts now comprise 35 percent of U.S.
household financial assets (Investment Company Institute 2008). In the present period of
slowing economic activity, with some economists positing that a U. S. recession began in the last
quarter of 2008, the stock market lost over 40 percent its value. The Commerce Department
reported GDP decreased 6.2 percent in the last quarter of 2008, the economy's worst showing
since 1946. Such contracting of the economy is posited to affect investors’ confidence and their
investing behaviors. This study examines the impact of a financial crisis on investment
behaviors. The study is a small preliminary study to a planned larger study. As such, the study
necessarily has low external validity. The study sampled data from employees of a small
computer manufacturing company. Findings were that conservative participants moved a
majority of their assets into money market funds while risk-taking participants poured more
money into equity funds. The participants re-balanced their portfolio infrequently, tended not to
adjust their monthly contribution amounts to re-balance their portfolios, and continued to
contribute to the 401 (k) plans despite poor returns of their plan assets.
INTRODUCTION
This paper investigates 401(k) participants’ investing behaviors during a period of depressed
economic activity. Workers in the United States are encouraged to save for their retirement. Tax
benefits are available to workers participating in their company’s retirement plans. For example,
a saver tax credit up to 50% of contribution towards a retirement plan is available to reward low-
income and moderate-income workers who save for retirement. The 2008 Individual Retirement
Account (IRA) contribution limit has increased to $5000 from approximately $4000. For those
taxpayers who are over the age of 50, the IRA contribution limit is $6000 and an additional
catch-up 401(k) contribution of $5000 is available for 401(k) participants if allowed by their
employers’ plans. According to Investment Company Institute (2008), U.S. retirement assets
totaled $15.9 trillion as of September 30, 2008, increasing from approximately $9 trillion in
1997. Retirement savings account for approximately 35 percent of all household financial assets
in the United States. Employers also encourage employees to save for retirement. In a Deloitte

Ho, Kehoe, Whitten Financial Crisis and 401(k) Participants’ Behavior
(2008) survey of 426 401(k) plans, 42% of companies offering these 401(k) plans to their
employees included an automatic enrollment feature to encourage employee retirement savings.
All of the 426 plans allowed employees to change their asset allocations via Internet access,
thereby affording flexibility for employees to self manage their accounts.
Some economists argue that the United States officially entered into recession during the last
quarter of 2008. By many measures, the year 2008 was especially harsh for investors. The
harshness includes the following examples. Home foreclosures in 2008 were up 81% from 2007
levels (Christie 2009). The Dow-Jones Industrial Average retreated 46.7% from its all time
closing high of 14,164 on October 9, 2007 to a closing low of 7,552 on November 20, 2008.
According to the Bureau of Labor Statistics (2009), the nation’s unemployment rate jumped
from 4.9% in January to 7.2% in December, 2008 and the number of Americans filing for first-
time unemployment benefits rose to a 26-year high for the weekending December 20, 2008. The
Federal Reserve Bank reduced federal funds rate to a record low near zero percent in December
2008. Designed to stimulate the economy, it arguably did not facilitate consumers’ confidence.
The Consumer Confidence Index fell to a record low of 38 in December 2008 from a high of
83.7 in January 2007 (Conference Board 2009). The Wall Street Journal reported that the stock
value evaporation rocked the confidence of millions of Americans who manage their own
retirement savings through 401(k) plans (Laise 2009). The Committee of Labor and Pensions of
the U. S. House of Representatives held a hearing to explore the impact of the financial crisis on
retirement accounts. Congressman Miller (2008) suggested that the Committee would examine
different measures that may be needed to ensure a safe and secure retirement for workers,
retirees and their families.
LITERATURE REVIEW
A Deloitte study (2008) found many employees are confused about how to allocate their 401(k)
investments; therefore, an interesting research question is how do 401(k) participants allocate
their contributions to different mutual funds in their 401(k) plans. Benartzi and Thaler (2001)
assert that participants most likely allocate their contributions equally among the funds offered
in a plan, which is described as a naïve 1/n diversification hypothesis. Huberman and Jiang
(2006) examine six hundred 401(k) plans and found that participants allocated their contribution
evenly over the selected mutual funds, which limited the availability in the plan to only two to
five funds out of numerous selections. Elton, Gruber, and Blake (2005) found equal installment
allocations in contribution do not necessarily lead to better portfolio performance. Liang and
Weisbenner (2002) conclude that many participants apply the “1/n” diversification rules while
investing in their company stocks, where n is the total number of investment options.
Agnew, Balduzzi, and Sundén (2003) found 401(k) participants have the following
characteristics: equity allocation is around zero and 100 percent, a strongly bimodal distribution;
participants re-balance their portfolios infrequently; and if given a choice, they would maintain
their default asset allocations. Agnew and Balduzzi (2006) found that 401(k) investors change
their equity and fixed income investment allocations largely based on one-day market news, and
rebalances are infrequent. The authors also found that both transfers and returns respond
strongly to news on changes in the Federal Funds rate, but returns to transfers of funds from one
to another are mostly insignificant. Finally, the authors found asset returns correlate significantly
with transfers.
In an international-focused study, Karlsson, Massa and Simonov (2007) concluded that

participants in the Swedish pension system do not treat retirement accounts as close substitute of
regular taxable equity holdings and availability of mutual fund selections induced investors to

participate in the stock market. Morrin et al. (2008) found that less financial competent 401(k)
investors may be subject to a menu effect of a plan and unknowingly take on more risks in asset
allocations, while there is no risk impact on the allocation strategies for those investors who are
more financial knowledgeable. Dolvin and Templeton (2006) assert that 401(k) investors
increase portfolio diversifications and improve risk management after attending financial
education seminars.
There is a large body of literature examining investors’ risk taking behaviors. Kahneman and
Tversky (1979) assert that investors are more sensitive to losses than gains in reference to a
given reference point. Investors are willing to take additional risks following losses to get back
to equilibrium, but become risk adverse following gains. Massa and Simonov (2003) report of
investors bias to risk taking when they have previous overall gains in the financial market, while
previous losses reduce their risk taking and forces investors to consider total gains/losses in their
overall wealth, including financial and real estate wealth. In addition, the authors found that
investors’ stock choices are mostly influenced by the availability of information. Odean (1998)
suggests that investors choose to sell their winners, but hold on to their losers when it comes to
stock dispositions likely hoping that eventually gains may be realized. Barberis and Huang
(2001) posit that investors use mental accounting to categorize investments into gains and losses,
but tend to react separately to gains and losses from different stocks. Gomes (2003) posits that
loss-averse investors refrain from having stocks in their portfolios unless the equity premium
expectation is quite high. Bernartzi and Thaler (1995) hypothesize that investors find risky
investments more attractive over a longer period of time. Built on that theory, Gneezy and
Potters (1997) report that the average level of investments in risky assets is lower if more
frequently returns on investments are evaluated. Benartzi and Thaler (1999) found that investors
allocate higher proportion of retirement savings to riskier equity investments with the
understanding that equity investments have historically higher return than bonds. Valenti (2007)
found women are less likely to contribute less from their current incomes to retirement plan.
Gysler, Kruse and Schubert (2002) found that gender differences in risk attitude reduce after an
increase in knowledge in a financial decision making.
METHODOLOGY OF THE EXPLORATORY STUDY

It should be noted in considering methodology for this preliminary study that most 401(k)
research is done on an aggregate plan level examining data of numerous participants in different
plans across various industries over a period of time. Brown, Liang, and Weisbenner (2007)
posit that plan level data illustrates how investment structure influences portfolio behavior while
worker level data can better explain investor’s individual behavior rather than plan level data.
Similarly, Elton, Gruber, and Blake (2005) assert that their plan level data can provide robust
information on aggregate participant behavior since the data are gathered from 43 plans with
various performances over 289 plan years. But, these data cannot explain the behavior of
individual participants. This exploratory study employed a case approach to focus on worker
data in one plan at one firm (a small computer manufacturing company) to gain insight to the
behavior of individual participants. The authors plan to move forward from this small
exploratory case-study sample to a larger study across larger firms in different industries
A small computer manufacturing company’s 401(k) plan 2008 annual data were used in this
study. The company has less than 200 full-time employees and 64 of them participated in the
plan. The plan assets were about $1.7 million at the end of 2008. The Plan is a defined
contribution plan covering all full-time employees of the company who have three months of
service with no age limit. However, it is subject to the provisions of the Employee Retirement
Income Security Act of 1974 (ERISA). The plan permits catch-up contributions effective

January 1, 2007. All Employees who are eligible to make elective deferrals under this plan and
those of age 50 are eligible to make Catch-up Contributions in accordance with, and subject to
the limitations of, Section 414(v) of the Treasury Code. The annual compensation of each
participant taken into account in determining allocations for the plan year 2008 shall not exceed
$230,000. Participants directly invested their contributions into various investment options
offered by the Plan. The Plan currently offers participants forty-two mutual fund investment
options. There is no company contribution requirement in the plan.
Participants may borrow from their fund accounts up to a maximum equal to the lesser of
$50,000 or 50% of their account balance. The loans are secured by the balance in the
participant’s account and bear interest, determined quarterly by the Plan Administrator, at 8.25%
for the year 2008. Principal and interest is paid through monthly payroll deductions. On
termination of service due to death, disability or retirement, a participant may elect to receive
either a lump-sum amount equal to the value of the participant’s vested interest in his or her
account or receive annual installments over a ten-year period. For termination of service due to
other reasons, a participant may receive the value of the vested interest in his or her account as a
lump-sum distribution.
ANALYSIS OF THE SUBJECT FIRM’S PLAN

There were 64 participants with an average age of 49 in the plan during the period of the study.
The average contribution rate per pay period was $449. The total plan value in the beginning of
2008 was $2,012,313 and the balance increased by contribution of $324,333 from 36 employees.
There were 30 employees who made contributions to the plan in 2007. The highest employee
annual contribution was $21,615 and the lowest was $675. The plan account value was reduced
by withdrawals amounted to $90,494 by six employees. Four of them rolled over their account
balances to retirement accounts in other financial institutions, one withdrawal was under
hardship provision of the plan and another withdrawal was under the minimum distribution
respectively. The plan’s account balance was further reduced by a reported investment loss of
$529,325 and plan fees of $635. The ending value of the plan was $1,716,821. The largest
account balance was $154,536, while the smallest account balance was $352. A total of 31
employees contributed $65,175 to the retirement plan in the last quarter of 2008, which was less
than the 35 employees who contributed $258,397 in the first three quarters of the year averaging
$86,132 per quarter. There was one employee who started contribution while five employees
ceased contributions in the last quarter of 2008. In further analysis of participant information,
two of the employees who ceased contributions in the last quarter of 2008 had reached their
contribution limit of $20,500.
The average 2008 investment loss percent in the plan was about 28% based on average balances
of 2007 and 2008, while there was a plan loss of 15% of its absolute asset value over 2007.
These figures can be quite misleading; the loss is actually more due to the fact the plan value
was increased by 2008 contributions, but reduced by withdrawals. The average percentage of
loss was much lower than the expected market loss of over 40%.
There were a total of only 10 participant transfers in the year. Seven of the transfers were from
equity and bonds funds to money market funds, which yielded a year-to-date 2.43% rate per
trustee document. It is interesting to note that only two workers rebalanced a substantial value
of their assets from riskier assets into conservative assets. The remaining five workers
transferred a smaller portion of the assets into money market funds. Two workers actually
rebalanced within equity risky assets: Mid Cap and Appreciation funds respectively. However,
in further review of the seven workers who rebalanced their plan assets, the result was

astonishing- six out of the seven workers had almost 100% of their plan assets in money market
funds after the re-allocation of assets.
All but one worker who rebalanced assets from riskier assets to money market funds already had
a substantial holding in conservative assets. Therefore, these risk-averse workers became even
more conservative due to the recession. All seven workers contributed consistently into the
401(k) retirement plan during the year and the new portfolio mix reduced the overall loss
percentage. On the other hand, the workers who had riskier assets at the beginning of the year,
but chose not to rebalance their portfolios to reduce risk exposures, did not react to the recession.
They had a higher risk tolerant level and were willing to stay put during the bad time. In fact, the
workers who experienced investment loss percentage exceeding 30% in 2008 did not even
rebalance their plan assets to reduce their risks. Only one participant rebalanced every quarter
and four participants transferred twice during the year.
A total of 33 participants made contributions to the plan in the last quarter of 2008 compared to
31 participants in the third quarter. Three workers stopped contributions in total amount of
$10,347; five had reduced their contributions in amount of $10,486; one new participant
contributed $7,953; and 26 participants actually increased their contributions by $8,708 during
the recessionary fourth quarter period. Therefore, total contributions in the fourth quarter 2008
were lower than the third quarter by $4,382. It is interesting to note that all 33 participants
changed their contribution amounts from the 3rd quarter.
Excluding one new contribution and three withdrawals in the 4th quarter, twelve participants
changed their 4th quarter contributions to another assets distribution from the 3rd quarter of
2008. As expected, nine participants re-allocated their 4th quarter contribution to money market
funds and bonds, but a similar number of participants also re-allocated their 4th quarter
contributions into more risky funds such as Growth and Mid-Cap funds. It is interesting to note
that one participant changed his contribution from a domestic growth fund in the third quarter to
a European growth fund. Only international growth funds experienced a net loss of contribution
from the third quarter.
DISCUSSION
Participants did not rush into shifting their plan assets to more conservative ones during a
contracting economy. However, the participants who had an existing high level of conservative
assets sold most of their riskier assets to become even more conservative, thereby their 2008
investment loss percentage was much lower than the risk-taking participants due to these
conservative holdings. On the other hand, the participants who invested in riskier equity assets
tended to invest more into equity assets which increased their percentage of investment loss
during the collapse of stock market. This might suggest that the participants still had confidence
in the historical higher return of the equity market and wanted to gain back the lost ground by
investing more in the equity market. Consistent with prior research, Kumar (2007) found
diversification choices of individual investors influence stock returns. Therefore, higher risk-
tolerant participants should carefully review their asset allocations and reduce their risk exposures
during the recession. On the same token, conservative participants missed the opportunity to
invest into lower priced equity funds during the fall in prices of the equity market to help
maintain a well-diversified portfolio.
This study found that the risk-taking participants tended not to react to economic reality, but
rather on their individual expectation. Consistent with Agnew and Balduzzi (2006), this study
found participants rebalanced infrequently. Such a buy-and-forget investment strategy might not

have a great impact on performance during a normal year, but is problematic during a financial
crisis. All participants should monitor their account activities often due to rapid changes in the
capital market and make adjustment accordingly. Lauricella and Lobb (2009) reported that
investors are frustrated with the downward spiral of stock values and have no idea what to do
with their portfolios. Their desperation has escalated to the point that some investors don’t want
to open their 401(k) statement envelopes so as not to find out how much they have lost. Arguably
such denial behavior is risky because it is the worst time for investors to put their heads in the
sand hoping everything will be better. Likely, such will not be the case. Rather, a recession is the
time for action by investors to reduce their risks exposure. For example, if a participant has a high
percentage of current contribution to equity funds and also has a high level of equity balance, the
participant should consider adjusting her/his current contribution allocation more to money
market/bond funds to reduce additional exposure in the equity market. On the other hand, a
financial crisis might be an opportune time for conservative investors to adjust their contribution
allocation more towards equity funds and take advantage of the record low equity prices to
diversify their portfolios. Of course, this is done according to their expected retirement age and
overall asset allocation.
Consistent with prior research, this study found that the participants practiced the naive 1/n
investment allocation method. Most participants had selections between one to five mutual funds
despite the availability of 42 mutual fund options. Low cost Index Funds not available to the
participants merit attention. Plan administrators should monitor plan structure to make low cost
Index Funds available to employees. Similar types of funds from various institutions do not
necessarily offer more choices. The 401(k) Fair Disclosure for Retirement Security Act of 2008
(H.R. 3185), requires all 401(k) plans to include at least one low cost index fund as an option for
participants. The effective date is one year from the date of enactment, April 16, 2008. It will be
interesting to see if this legislation helps participants to increase return while minimizing risk.
An interesting observation from the research was participants continued to contribute to their
future retirements during a contracting economy and, in fact, some participants increased their
fourth quarter contributions from the third quarter. This suggests that participants develop their
own expectations of the market and may not be affected by the adverse economic news. One
possible explanation is that the investors expect historically that high equity performance levels
will return and losses have not reached their reference points as suggested by Kahneman and
Tversky (1979). It will be interesting to see whether or not investors' habits change when a
financial crisis worsens and lasts over a significant length of time. During the period of this study,
only one participant withdrew the assets based on the hardship provision of the plan. That one
withdrawal was much lower than the 9% increase in hardship withdrawals during 2006 to 2007
reported by The Vanguard Group. It is comforting to know only one person out of the plan’s
sixty-four participants invoked the hardship provision of the plan.
RESEARCH PROPOSITIONS
Loss adverse investors are more sensitive to losses based on new information and tend to sell
winners to protect their gain (Kahneman and Tversky 1979; Odean 1998). That is, investors likely
rebalance their holdings from riskier equities to bonds/cash funds when the economy is nearing a
recession. Therefore, several propositions for future research are posited from this exploratory
study. These propositions will develop to form hypotheses for future larger sample studies:
P1 There will be more participant transfer-outs from riskier equity funds into bonds/cash
mutual funds in during a recessionary period (e.g., the 4th quarter of 2008).
P2 Individual contributions to retirement plans will be less in the 4th quarter of a
recessionary year (e.g., 2008) than the same quarter of the previous non-recessionary year

(e.g., 2007).
P3 More new contributions will be invested in bonds/cash mutual funds during the last
quarter of a recessionary year (e.g., 2008) than the same quarter of the previous non-
recessionary year (e.g., 2007).
CONCLUSION
In analyzing the data from a small computer manufacturing company, this study found that,
during an economic crisis, conservative participants moved more of their assets into money
market funds, while more aggressive participants continued to contribute into riskier equity funds.
This finding implies that a period of economic recession did not appear to affect participants’
confidence in their contributions to their 401(k) plans. Most participants did not diversify and
maintained their investment habits. Of course, this finding is limited by the sampling units in this
one-firm exploratory study and presents a caveat that the present study has low external validity.
The authors plan to expand the study to the employees of other firms in different industries
thereby increasing the sample size and concomitant external validity so as to enable greater
generalization of the results. One conclusion that we venture is that conservative participants
should consider diversification of their asset holdings.
The purpose of the study was to better understanding of 401(k) investors’ behaviors during a
period of economic contraction. Companies and retirement plan institutions should educate
participants about the importance of retirement fund diversification during a contracting market.
Further research is needed to track plan participants’ investing behavior and their reactions to
financial return volatility over a longer period of time during recession. Future studies will
examine the factors of salary, age, financial returns, culture, and tenure relationship on 401(k)
investment behavior in samples from other firms in different industries.
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Investment Decisions,” Journal of Deferred Compensation, Vol. 13 Issue 1, p50-73, 24p

THE EVOLVING MISSION STATEMENT:
AN ESSENTIAL COMMUNICATION TOOL
King, Darwin L.
dking@sbu.edu
Case, Carl J.
ccase@sbu.edu
ABSTRACT
The mission statement has existed for well over thirty years as one of the primary tools of
strategic planning. Peter Drucker argued in the early 1970’s that a clear definition of a firm’s
mission and purpose is essential for the organization to establish realistic business objectives. In
recent years, virtually all large corporations have included a mission or core values statement on
their websites. These critical communications provide interested stakeholders with information
on the firm’s priorities, strategies, and plans. This paper reviews the development and
modifications made to typical mission statements. In particular, the stakeholders, goals, and
objectives mentioned in current mission statements are analyzed.
INTRODUCTION
Peter Drucker recognized the importance of developing a mission statement in many of his early
publications. He felt that defining the mission of the company was the foundation for establishing
plans, priorities, and strategies (Drucker, 1974). Drucker believed that “structure follows
strategy” and “strategy determines the key activities of the firm” (Drucker, p.75). He also felt that
firms must know “what their business is and what it should be” in order to determine appropriate
business strategy. Finally, Drucker thought that answering the “what is our business” question
could be difficult, and the answer was rarely obvious (Drucker, p.77).
Many authors are in agreement that a mission statement should communicate two things about an
organization: “who it is and what it does” (Falsey, 1989; Bart, 2000; Collins & Porras, 1991;
David, 1989). This statement is critical to communicate an accurate impression to both internal
and external stakeholders concerning the reason for a firm’s existence. According the Morphew
& Hartley, it has been over 30 years since “a furor over mission statements swept over corporate
America” (Morphew & Hartley, 2006). During the mid-1970s, the mission statement made its
appearance on a widespread basis. Prior to this date, a limited number of firms recognized the
importance of developing such a communication.
Fred David argues that a mission statement is a declaration of an organization’s “reason for
being” (David, 2009). A clear mission statement is necessary for the firm to effectively establish
objectives and formulate long-term strategies. David also states that every organization has a
reason for being and any organization that fails to develop a comprehensive and inspiring mission
statement loses the opportunity to present itself favorably to existing and potential stakeholders.
According to David, a good mission statement reveals an organization’s customers, products or
services, markets, technology, concern for survival, growth, profitability, philosophy, self-

King, Case Mission Statement- A Communication Tool
concept, concern for public image, and concern for employees. These factors, he believes, serve
as a practical framework for evaluating and writing mission statements.
Vern McGinnis believes that a good mission statement must accomplish a number of important
objectives (McGinnis, 1981). First, the statement must define what the organization is and what it
expects to be in the future. Next, the mission must distinguish the organization from all others. In
addition, it must be limited enough to exclude some ventures but broad enough to allow for
creative growth. The mission statement must also serve as a framework for evaluating both
current and prospective activities. Finally, it must be stated in terms that are clear enough to be
understood throughout the entire organization. This certainly shows that much is expected from
one short communication that affects both internal and external stakeholders.
Abrahams agrees with McGinnis in that a mission statement should communicate a number of
important facts such as its nature and reason for being; how it plans to get there; what its
priorities, values and beliefs are; and how it is distinctive (Abrahams, 1995). Other authors
including Bartkus, Glassman, and McAfee believe that the mission statement should have a much
narrower focus (Bartkus, Glassman, & McAfee, 2000). They argue that the mission statement is
solely a communications tool. In addition, these authors argue that most firms would be better off
if they narrowed the purpose of the mission statement to that of “realistically communicating
product and market objectives to stakeholders” (Bartkus, Glassman, & McAfee, 29). Other
authors including Ireland & Hitt agree with Bartkus, et. al. as they also feel that overextending the
scope of the mission statement is a mistake for most organizations (Ireland & Hitt, 1992).
In recent years, mission statements can be found on many company websites. In a previous 2006
study by Jones, Little and Lovett, the authors found that only 327 or 65% of the Fortune 500
companies included a mission statement on their website (Jones, Little, and Lovett, 2006). The
mission statements were located on the website predominantly (60%) under the “About the
Company” caption. The remaining 40% of the firms listed the mission statement under other
corporate information, investor relations, or elsewhere on the site. In many cases the mission
statement was not readily accessible by an interested party without a significant amount of
searching. The following section of this paper provides early examples of mission statements.
EARLY MISSION STATEMENT EXAMPLES

Graham and Havlick published a book that they assert to be the first and largest compilation of
mission statements (Graham & Havlick, 1994). The text includes 622 mission statement examples
from the United States and Canada. The examples encompass a period of over 100 years. The
authors state that of the 622 statements no two “follow the same exact format, formula, or
pattern” (Graham & Havlick, 3). One of the first brief definitions of a mission statement was
written by John A. Pearce II (Pierce, 1982). He defined a mission statement as:
The company mission statement is a broadly defined but enduring statement of purpose
that distinguishes a business from other firms of its type but identifies the scope of its
operations in product and market terms. Not only does the company mission statement
embody strategic decision makers’ business philosophy, but it also reveals the image the
company seeks to project, reflects the firm’s self-concept, and indicates the principal
product or service areas and the primary customer needs the company will attempt to
satisfy. In short, the company mission statement describes the firm’s product, market, and
technology in a way that reflects the values and priorities of the strategic decision makers
(Pierce, 4).
This early definition provides an excellent summary of what an organization should include in
this especially important communication to stakeholders. Examples of early mission statements
are presented in the following paragraphs.

One of the earliest mission statements included in the Graham & Havlick text was written by the
executives of Northwestern Mutual Life Insurance Company in 1888 (Graham & Havlick, 379).
The ambition of the Northwestern has been less to be large than to be safe: its aid is to
rank first in benefits to policyholders rather than first in size. Valuing quality above
quantity, it has preferred to secure its business under certain salutary restrictions and
limitations rather than to write a much larger business at the possible sacrifice of those
valuable points which have made The Northwestern pre-eminently the policyholder’s
company.
This is an excellent example of an early mission statement that stresses the importance of
customer satisfaction. Northwestern realized that it was more important to provide customer
benefits than become a huge organization. The company did not want to become so large that
they could not provide “personalized” service to their customers. This indeed is an example of the
marketing concept that stresses that “customers should come first.”
Eaton Corporation, an auto parts and related equipment company, issued a very brief mission
statement in 1911 (Graham & Havlick, 202). J.O. Eaton, the owner, wrote the following:
Eaton’s mission is: “Producing the highest quality products at costs which make them
economically practical in the most competitively priced markets.”
Many current mission statements also emphasize the importance of producing a quality product
that can be priced to satisfy the mass markets. This short mission statement did not specifically
mention any primary stakeholders such as customers or employees.
Dime Savings Bank of New York issued a mission statement somewhat similar to Northwestern
Insurance in that customers were the primary emphasis (Graham & Havlick, 185). Dime Savings
Bank’s concise mission statement was:
The secret of our growth lies in the fact that we have not tried to please ourselves, but to
please our customers. There is no chilly formality here, but friendliness, courtesy, and an
obliging spirit.
Dime, like Northwestern, realized that long-term profits are the result of satisfying customers.
This requires an attitude that is friendly and courteous.
Rand, formerly The Rand Corporation, introduced a concise mission statement in 1948 that
stressed the importance of public service (Graham & Havlick, 412). Their one sentence mission
was:
To further and promote scientific, educational, and charitable purposes, all for the public
welfare and security of the United States of America.
Rand, a consulting company, realized that one important goal was to maintain the welfare and
security of the U.S. by providing a quality service. This goal is now especially relevant since the
terrorist attacks of 2001.
Leo Burnett, the advertising giant, issued a mission statement in 1955 that, like Eaton
Corporation above, stressed the importance of a quality product or service (Graham & Havlick,
310). Burnett’s mission read as follows:
The mission of Leo Burnett Company is to create superior advertising. In Leo’s words:
“Our primary function in life is to produce the best advertising in the world, bar none.
This is advertising so interrupting, so daring, so fresh, so engaging, so human, so
believable and so well-focused as to themes and ideas that, at one and the same time, it
builds a quality reputation for the long haul as it produces sales for the immediate
present.”
Leo Burnett realized that a quality product would produce profitable operations in both the short
and long run. The importance of being the best in the industry is apparent in this statement.

Armstrong World Industries, Inc., a large carpet, tile, and building supplies company, published
their mission statement in the form of core beliefs or core values. This is common in many
current mission statements in an effort for the firm to communicate all their identified goals and
objectives (Graham & Havlick, 72). Armstrong’s mission in the form of operating principles is:
Armstrong’s four Operating Principles go back to the company’s very beginnings in
1860. We believe that our adherence to these principles is a central reason for the success
we have attained. They have stood through successions of management and with tens of
thousands of employees working in numerous core businesses during periods of stability
as well as those of dramatic change. The principles are as meaningful to Armstrong
people today as when they were first set down in writing. Operating Principles include:
1. To respect the dignity and inherent rights of the individual human being in all dealings
with people.
2. To maintain high moral and ethical standards and to reflect honesty, integrity,
reliability, and forthrightness in all relationships.
3. To reflect the tenets of good taste and common courtesy in all attitudes, words and
deeds.
4. To serve fairly and in proper balance the interests of all groups associated with the
business, customers, stockholders, employees, suppliers, community neighbors,
government, and the general public.
These Operating Principles overlay the workday experiences of all Armstrong employees
as they strive to increase the value of the company and in this way to enhance the market
price of its stock.
These core values or operating principles are certainly as relevant today as in 1960 when this
statement was issued. The emphasis on human dignity and moral and ethical standards is
consistent with recent legislation such as the Sarbanes Oxley Act of 2002. The prominence of
good taste and common courtesy are also timeless qualities. Finally, Armstrong’s fourth operating
principle lists all primary stakeholders.
These historical mission statement examples show that it was common to identify both related
stakeholders and goals and objectives of the company. Although the various mission statements
are in no way standardized, it continues to be common today for businesses to include both
stakeholders and goals in this critically important management communication. A study
conducted in 2008 determined that mission statements did not dramatically change in the last 20
years in their content components and rhetorical strategies used to create an identity or image
(Williams, 2008). The authors of this paper feel that overall this may be true but there are
significant changes that can be identified when mission statements from 2001 and 2008 are
compared.
A previous study, by the lead author of this paper, in 2001 reviewed the top Fortune 100 mission
statements analyzing their content (King, 2001). These mission statements were analyzed to
determine the stakeholders mentioned in the statements as well as any identified goals and
objectives of the company. It is the authors’ intent in this paper to compare the 2001 mission
statement content with the 2008 versions. The appendix of this paper includes a listing of mission
statements from the top 50 companies found in the 2008 Fortune 100 list. The following
comparison of 2001 and 2008 mission statements highlights any significant changes over this
seven year period in both stakeholders and goals and objectives identified by the firm.
REVIEW OF 2001 AND 2008 MISSION STATEMENTS

This study utilized the CNN Money website (money.cnn.com) to obtain a list of the top 2008
Fortune 50 companies. The same website was used in 2001 to identify the top Fortune 100
companies in that year. The company website was then examined to determine if a mission
statement existed on the site. If the mission statement was not available from the website, the

authors emailed the company to locate the current version of the statement. A vast majority of the
firms in the Fortune listing provided a mission statement for the author’s analysis.
The appendix of this paper includes a listing of the top Fortune 50 company’s mission statements.
Only two firms (4%), Berkshire Hathaway and Lehman Brothers Holdings, did not provide a
mission or vision statement, a corporate credo, or a list of core values. The appendix includes the
other 48 company’s communication in the form of one of the previously mentioned
communications. In the previous 2001 study of the Fortune 100 firms, a total of 13 (13%)
companies did not have a mission statement available for public review (King, 2001). It appears
that most organizations in 2008 realized the importance of providing a thoughtfully developed
mission statement to all stakeholders. The following summarizes the mission statement content of
the 2008 Fortune top 50 firms.
Table 1
2008 Fortune Top 50 - Mission statements that included the following stakeholders or goals:
Customers 31 Quality 26
Employees 17 Global 17
Communities 15 Ethics 15
Stockholders 14 Environmental 8
Core Values 7 Leadership 7
Suppliers 5 Profits 6
Government/Laws 2 Technology 1
This summary shows that for the top 50 Fortune firms’ in 2008 customers and employees
continue to be the most mentioned stakeholders. Consistent with mission statements from many
years ago, business enterprises realize the importance of the “marketing concept.” The firms
emphasize that if the customers are not satisfied, the business can not possibly succeed.
Employees, communities, and stockholders are other significant stakeholders that are commonly
mentioned in current mission statements.
Considering the goals and objectives identified in 2008 mission statements, the importance of
producing and selling a quality product was most commonly included. This is consistent with the
historical statements from many years ago presented earlier in this paper (see Eaton Corporation
and Leo Burnett above).The next two most common goals included in the mission statements are
an emphasis on global operations and the importance of ethical behavior.
The following Table 2 summary, presented in percentage format, compares the 2001 and 2008
mission statements based on both stakeholders and goals included in the communication.
Table 2
Percentages of Mission Statements Containing the Following Stakeholders & Goals:
Stakeholder 2001 Statements 2008 Statements

Communities 6% 30%
Competitors 9% 0%
Customers 61% 62%
Employees 21% 34%
Government/Law 2% 4%
Stockholder 34% 28%
Suppliers 6% 10%

Goal/Objective
Core Values 25% 14%
Environmental 9% 16%
Ethics 3% 30%
Global 15% 34%
Leadership 17% 14%
Profits 6% 12%
Quality/Value 25% 52%
Technology 14% 2%
One of the significant trends from 2001 to 2008 appears to be the emphasis on the idea of
“communities” in the mission statements of the largest firms. In 2000, only 6% of mission
statements included the concept of communities. Only seven years later, 30% of the top
businesses have chosen to include this term. Examples of the “communities” concept found in the
2008 mission statements include:
Chevron: Our Company’s foundation is built on our Values, which distinguish us and guide
our actions. We conduct our business in a socially responsible and ethical manner. We
respect the law, support universal human rights, protect the environment, and benefit the
communities where we work.
Valero Energy: Commitment to our Communities - We are committed to taking a
leadership role in the communities in which we live and work by providing company
support and encouraging employee involvement.
Cardinal Health: We consider the highest standards of personal and professional ethics as
the cornerstone of trust among our customers and ourselves; We deliver on the
commitments we make; We recognize our obligation to the communities where we live and
work; We hold ourselves accountable not only for what we achieve but how we achieve it.
Another trend apparent in the comparison of the 2001 and 2008 mission statements is the increase
in the percentage of firms that emphasize ethical and honest behavior. This is logical given recent
legislation such as the Sarbanes-Oxley Act which emphasizes ethical behavior and the reduction
of fraudulent acts. The percentage of firms identifying ethical behavior increase ten-fold from 3%
in 2001 to 30% in 2008. The authors expect this trend to continue as ethical and honest business
behavior increases in importance.
Examples of the importance of ethical behavior in 2008 mission statements include:
Exxon Mobil: Is committed to being the world’s premier petroleum and petrochemical
company. To that end, we must continuously achieve superior financial and operating
results while adhering to the highest standards of business conduct.
Chevron: See above with communities.
AT&T: We operate with unyielding integrity, obeying all laws and adhering to a stringent
code of business conduct. We will not tolerate unethical business conduct by our team
members.
General Electric: Always With Unyielding Integrity.
This ethical theme is consistent with the mission of Armstrong World Industries, Inc.
presented earlier. Their mission statement from 1960 stressed the need “to maintain high
moral and ethical standards and to reflect honesty, integrity, reliability, and forthrightness
in all relationships.” The authors believe that all business firms must continue to improve
their “corporate climate” in an effort to maintain the highest level of ethical behavior.

Other observations in the comparison of 2001 and 2008 mission statements include the
fact that firms continue to emphasize product quality and value. In 2001, 25% of the
largest firms included this in their mission statements and by 2008 that percentage had
increased to 52%. Marketing campaigns emphasize that “quality counts” and our firm
maintains the highest quality standards. Emphasis on the development and maintenance
of global operations is also apparent as 34% of 2008 mission statements included this
concept compared to only 15% in the 2001 statements. Statements of concern for the
environment in the statements also increased during this seven year period.
Environmental statements increased from 9% in 2001 to 16% in 2008. This is consistent
with various media advertising stressing that firms are developing a greater interest in
protecting the global environment.
The largest percentage of either stakeholders or goals/objectives identified in modern

mission statements continues to be “marketing concept” related. Large corporations
realize that they must satisfy customer needs and wants both in the short and long run in
order to be truly successful. Customers were named in 61% of mission statements in
2001 and 62% in 2008. Except for the goal of providing a quality product at a good
value, which was included in 52% of 2008 statements, there were no other stakeholders
or goals that were mentioned in more that 34% of the statements. In summary, producing
a quality product or service, at a value price, to satisfy the firm’s customers was the most
common theme in 2008 mission statements.
SUMMARY
There is little doubt that the mission statement is critically important for any large company.
According to Pearce and David, the mission statement “may be the most visible and public part of
a strategic plan (Pearce & David, 1987). It is apparent that mission statements are constantly
evolving. In recent years, the emphasis on global operations, concern for customers, care of the
environment, and the attempt to produce a quality product or service at a value price had been
communicated in the large firm’s mission statements. It will be interesting in future years to
observe which stakeholders and goals/objectives increase and diminish in importance as reported
in this vitally important business communication. Mission statements will continue to evolve as
organizations and the environment in which they exist continue to undergo change.
Due to length restrictions, the Appendix containing the 2008 Fortune top fifty firm’s mission
statements is not included.

REFERENCES
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Americas Top Companies,” Berkeley, CA, Top Ten Press
Bart, C.K. (2000). “Lasting Inspiration.” CA Magazine, 133(4), 37-39.
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Mirrors?” Business Horizons, 43(6), 23-29.
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David, F.R. (2009). Strategic Management: Concepts and Cases (Twelfth Edition). Upper Saddle
River, NJ: Pearson Prentice Hall.
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corporate communicators and management,” Westport, CT: Greenwood.
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and Nonprofit Sectors,” New York, Garland Publishing, Inc.
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Jones, I.S., Little D.L. & Lovett, M.G. (2006). “Mission Statements on Fortune 500 Web Sites: A
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Communications Journal, Volume 5, Numbers 1 and 2, 75-100.
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31(6), 41.
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An Investigative Account on Study Abroad Models for
Business Students Concentrating in Hospitality and
Tourism Management
Richard J Mills Jr.

Robert Morris University
mills@rmu.edu
Abstract
International studies and a study abroad are options that are offered by most colleges and
universities in the academic arena. These programs allow students to consider courses at locations
around the world, by semester, summer programs, or mini semesters. International studies is one
of the most effective ways to develop universal perspectives and promote global understanding,
yet at many colleges and universities, too few students participate in these programs. Recognition
of the added value of the international studies experience is not always acknowledged by the
institution or perspective employers upon a participants return to their home campus. Robert
Morris University is conducting a pre- and post survey of its specific international studies
program for hospitality students in an attempt to evaluate its effectiveness in developing an
engaged learner with a heightened awareness of the current international landscape. By using a
study abroad model as a planning tool, participation in the Cultural Geography course constituted
a vehicle for connecting pedagogical research, redesigning curriculum development, and creating
new and different student engaged experiences.
Introduction
International programs provide an undeniably valuable curricular activity while at the same time
fostering a wider variety of extra-curricular activities. The curricular activities provide students
with the opportunity to further their college course work with diverse offerings. At Robert Morris
University students in the hospitality program can participate in a course (Cultural Geography)
which is aimed at making the most of their study abroad time. The overarching program at Robert
Morris University is intended to advance and expand students’ knowledge and understanding of
different cultures throughout the world. Robert Morris University offers international study
programs in Australia, Chile, England, France, Germany, Italy, Norway, Switzerland, Monaco,
India, Japan, Mexico, Chile, Honduras, Africa, and many other countries. The purpose of the
hospitality international studies program is to assist students in learning in five areas. The
program helps students gain a deeper understanding of hospitality in a global environment,
enables students to understand the interaction of different cultures in the workplace environment,
helps to expand their knowledge and thought processes by finding different ways to problem
solve while developing new attitudes about different cultures, helps with the integration of the
cultural experiences they obtain with their existing schema, and the ability to communicate in a
global environment. It provides the students with the opportunity to participate in international
internships, an impressive asset in today's mobile marketplace, provides students with the
opportunity to learn what it really means to be an “American”, students will become part of the
elite 4% of undergraduates were participated in international programs. All of these skill sets are
important to hospitality students because these experiences create a well-rounded person who is
able to apply their diverse experiences in the workplace when they have completed a degree
program.

Mills Study Abroad for Tourism and Hospitality Mgmt.
In a more general sense there are many non hospitality related advantages to overseas travel.
According to IES Abroad, students gain academically, culturally, and personally. Study abroad
impacts students academically in the following ways; there is an impact on future educational
endeavors, foreign language study and increased interest in more academic studies. Students were
impacted culturally because study abroad helped them understand cultural values, mores and
biases. It also helped them seek out a greater diversity of friends. Study abroad helped students
personally and with their careers by helping them to obtain a specific skill set, increasing their
maturity and self confidence while impacting their world view.
The hospitality and tourism's international program makes students well-rounded individuals
especially in the world of business. With more companies beginning to outsource, students need
to be more cultural diversified, and meet the companies’ needs, wants and desires. Studying
abroad will provide the student with first-hand experiences in foreign business settings and allow
them to incorporate these lessons for their fellow collegians at Robert Morris University. A study
abroad model was created to design and fulfill a new and innovative faculty led program. The
following model helped guide the students and instructor through the different segments of the
study abroad experience.
International Studies Program Engagement Model
Student Engaged
Learning Robert Morris
University
Student
Survey
Cultural
Hospitality
An International
Studies
Course
Educational CEPA Europe’s

Outcomes Role
Robert Morris University’s International Studies Program

Our program combines the best of worlds, an immersion experience at a host university with
extensive global, regional, local travel and intercultural experiences, and specific academics in a
traditional classroom. We know of no other international programs that combine traditional
classroom experiences, and contact hours, with the amount of international travel our program
contain. We scheduled the travel components of our program to enhance the academic and
personal experiences of the students without disrupting the traditional classroom work. For the
student who wants to get the most out of their summer experience, our program is ideal. The

director of the Hospitality and Tourism program at Robert Morris University (RMU) believes that
international studies provide an important component to the overall education of hospitality
students. Students from the Hospitality and Tourism program at RMU have gone on to work in
Nassau, Bahamas, St. Thomas, Virgin Islands, Costa Rica, Brazil, Russia, Germany, Japan and
Australia. Because of the importance of such a program Robert Morris University is currently
attempting to establish a scholarship fund for the hospitality students who wish to participate in
the international program. Once the fund is in place every hospitality student who participates in
the international program will receive a scholarship that covers $1,000.00 of the cost of the
program. In addition there are other sources for scholarships for study abroad programs such as
the IES study a broad’s $1.1 million in merit award scholarships.
Cultural Hospitality an International Studies Course
This course is an introductory survey of world travel destinations, including an exploration of the
cultures, customs, habits, festivals, languages, religions and historic sites of other countries as
they relate to the tourism industry. Included in this course is an in-depth examination of the social
psychology of leisure. This course will focus on the study of hospitality, food, language and
intercultural communications to examine how these educational components bring together all
human beings in one form or another. The consumption of food is both personal and communal.
The Language of hospitality and food consumption reflects and shapes all cultures in regards to
general meaning and cultural adaptation. We identify a culture through the words and meanings
of food and the dispersion of meals. Hospitality and food, moreover, have a good claim to be
considered one the world’s most important cultural subjects. Hospitality and food is what matters
most to most people for most of the time in every culture. This course will also emphasize
research in and application of the historical and cultural aspects of food. As such, the course will
provide a vehicle wherein the preparation and presentation of an authentic experience is
representative of a particular culture, region and time. By the end of the course, the student will
be able to provide a framework for viewing cross-cultural experiences. The course allowed for
the student to engage on various concepts and ideas in regard to intercultural communication
(theoretically & experientially). The course engaged each student in reflective learning in-order to
share personal experiences in dining in regards to cultural adaptation. The assignments provided
students an opportunity to discover how food and intercultural communication work together to
offer rhetorical engagement with community and the meal. Each student developed a definition of
the determinants of cuisine and the effect of cuisine upon history. Each student had critical
exposure in the preparation, service and evaluation of foods from various historical periods and
geographical areas. The course examined how the distribution of population changed from one
culture to the next and how tourism activities changed from one country to the next. A total
geographic overview of the world and each major geographic region provided insights about the
geographic character of specific regions to show how they establish settings for tourism. The
class learned to move effectively and appropriately through a wide range of trans-cultural
situations by combining ethics, cultural-specific knowledge with mindful listening and
communication skills. The internet and/or other technologies were used strength student
knowledge.
Student Engaged Learning
At the end of the course each student had some form of student engagement in the following
areas. Each student sharpened their interpersonal and technical skills needed to visit an
international commercially oriented food service operation. Students developed an understanding
to the components of the dining experience from an international perspective and increased
awareness and continued to develop a critical ability to evaluate the dining experience. Each
student explored cultural diversity and ethical requirements in menu and world tourism
development. Students outlined possibilities for identifying a customer base by using online
tracking systems and menu analysis. Each student formulated a public relations piece that uses

international recipes dining and international experiences to create a culturally diverse reflection
essay and power point presentation that can be presented to future students.
CEPA Europe’s Role
CEPA Europe customized educational programs abroad is a provider of quality study abroad
programs in Europe. This international travel consulting and educational program provider has
been a third party provider for the Robert Morris University Cultural Hospitality Course. Initially
when the course was developed the creation of site analysis and travel destination outcomes were
designed to meet the faculty led course objectives. CEPA read the course design and made to fit
destinations and events that met the overall course design. In sum the customization came to
development through the overall expected outcomes of the course. The trip itself lasted eleven
days and completed travel to three different countries, Germany Switzerland and France. Trip
itinerary is as follows.
Robert Morris University Geography and World Tourism Study Abroad Program in 2010 a
10 day study abroad program in Switzerland, France and Germany:
The study abroad package includes:
Day 1 >> Mon. May 10:
• Flight to Zurich, Switzerland (not included in the package price;
Optional: group flights can be arranged upon request)
Day 2 >> Tues. May 11: (Zurich - Freiburg - Strasbourg)
• Arrival at Zurich Airport
• Transfer by private bus from the airport to Strasbourg with a stop-over in Freiburg
• Guided walking tour of the university town of Freiburg to get a first impression of Europe
• Afterwards or before some free time for lunch at own expense (depends on flight)
• 2 nights in twin bedded rooms with shared bathrooms incl. breakfast
At the SIU Campus “Château de Pourtalès” in Strasbourg, France
• Dinner at the Château’s restaurant and Winstub “Le Jardin du Pourtalès”
Day 3 >> Wed. May 12: (Strasbourg)
• Breakfast at the Château
• Transfer by private bus during the day
• Guided walking tour of Strasbourg in the morning to get a first impression of the city
• Visit to the Kronenbourg brewery incl. beer tasting in the afternoon
• BBQ Dinner at the Château’s InteractionPark
Day 4 >> Thurs. May 13: (Strasbourg – Alsace - Engelberg)
Ascension - National holiday in France and Switzerland
• Breakfast at the Château
• Guided tour of the Haut-Koenigsbourg Castle in the morning
• Drive along the Alsatian Wine route with a stop-over at an Alsatian winery (incl. wine tasting)
• 5 nights in twin bedded rooms with shared bathrooms incl. breakfast
At Hotel Europe in Engelberg
• Dinner at Hotel Europe
Day 5 >> Fri. May 14: (Engelberg - Lucerne)
• Breakfast at Hotel Europe
• Lecture by RMU professor at a classroom at Hotel Europe (10:00 am – 1:00 pm)
• Train ticket to Lucerne and return
• Guided tour of the Casino in Lucerne in the afternoon
Day 6 >> Sat. May 15: (Engelberg)
• Visit to the cheese diary at Gerschnialp in the morning
• Lecture by RMU professor at a classroom at Hotel Europe (2:00 pm – 7:00 pm)
Day 7 >> Sun. May 16: (Engelberg - Lucerne)


• Train ticket to Lucerne and return
• Guided tour of the Convention Center Lucerne (KKL) in the morning
• Afterwards, free time to have dinner at own expense in Lucerne
• Late-evening return to Engelberg
Day 8 >> Mon. May 17: (Engelberg)
• Guest lecture on “Marketing of Engelberg and Switzerland as a Tourist Destination”
By a speaker of the Engelberg Tourist Office in the morning
• Lecture by RMU professor at a classroom at Hotel Europe (12:00 pm – 1:00 pm)
• Guided tour of the Engelberg Monastery in afternoon
• Älplermaggronen Dinner at the cabin Fluehmatt in Engelberg to bid-farewell to Engelberg
Day 9 >> Tues. May 18: (Zurich)
• Guided tour of the 5-star Hotel Widder in the morning
• Afterwards, free time for sight seeing and last-minute shopping in Zurich…
• Farewell Dinner at a restaurant in Zurich in the evening
• Late check-in: 1 night in twin bedded rooms with private bathrooms
incl. breakfast at a 2-star hotel in Zurich
Day 10 >> Wed. May 19: (Zurich)
• Breakfast at the hotel
• Transfer by private bus to the airport
• Departure from Zurich Airport to the USA
Faculty Instruction and Educational outcomes
This course is designed to guide University students through a reflective European travel
experience. The evaluation of study was done by preparing, presenting, and reflecting a highly
developed form of literature know as the “Journal.” The Journal provides the student with
substantial practice in writing. It teaches the student the art of careful observation. It provides the
student with accurate reporting and engages the student in real time cross-cultural analysis. All of
these academic skills are to taught, learned and credited. In addition a study abroad experience
should provide some insight or passage into an experience that individuals are introduced to
regarding new and sometimes uncomfortable situations. Some people find new meaning and
direction in their lives. A study abroad experience will in many cases provide a life stage
awareness that can serve as a goal oriented progression. In student journal responses they will be
recording their observations of your life in the host culture. The program is designed so each
student will be experiencing and recording different events that engage their academic study,
living situation, and travel time. The faculty led program has been designed in a way that each
student will meet people from many walks of life. Each student will begin to know the richness,
variety, contradictions and complexities of the country and culture that has been chosen for study
abroad credit. As each student seeks to understand a host culture, they will also be reflecting
upon issues in their own life. In each student journal they may progress in areas that deal with the
meaning of beliefs, values, morals, ethics, and life choice direction. While serving and studying
in a new culture, each student will not just be an observer or academic tourist. Through each
course meeting and interaction with the people from the host culture each student will have a
lasting effect on others. Every student journal response should convey some of the following
information. A factual description of any event and its various meanings to those involved. A
comparison between a current event and past event, a reflection upon a personal experience or an
idea, cultural practice, or situation, a conversation reflecting the ideas and personalities of two or
more persons, or between two sides of yourself, a letter, note, or advertised item. Be honest, be

specific, and be clear. But above all, enjoy the academic, enterprise of journal writing and
recording.
Robert Morris University Student profile Survey Results
In order to determine the program's effectiveness, we designed an evaluation instrument for
students to complete. From results obtained we have, implemented changes which students
requested or suggested. The result has been a stronger program and satisfied students. The
evaluation form is given to students on the same day of their final week in the states, and their
final week upon return from international travel. The survey is conducted online and the results
are tabulated by hospitality faculty. The multipage instrument includes questions on personal
background, the academic program, orientation and service at the host institution, and evaluation.
There is a comment section at the end of the Paris and post survey. The survey has three main
components, educational experience, social cultural experience, and individual development. Of
the 18 instruments distributed, 18 were returned, a response rate of 100%. All instruments
returned were usable for the study. Most of the participant are female, 21 years of age or older,
and between their junior and senior year in college. We did not attempt to identify student’s
social economic records, but there would seem to be a relationship with the level of Wolfowitz.
This is drawn out by our question on previous studies, travel and living abroad prior to entering
the program, 77% of the respondents have traveled outside the United States.
The purpose of the study was to determine whether or not the international studies program for
hospitality students was effective in enhancing students understanding of intercultural and global
issues. The study focused on the cultural geography course that took place in Germany,
Switzerland and France during the summer of 2009. The hospitality and tourism cultural
geography course had two distinct segments; segment one occurred during the spring semester of
2009. Students met with the instructor four times before their overseas experience to discuss
what would occur during their overseas class. The second segment consisted of the overseas
travel. Before the students traveled overseas they were given a pretest consisting of twenty
questions designed to evaluate the effectiveness of the pre-classes and students knowledge and
experiences in international travel. When the students returned to the United States they were
given a twenty question post test which evaluated their understanding of intercultural and global
issues. There were five questions that will be discussed in regards to the pretest. 100% of the
students stated that the study abroad program was not a deciding factor for attending the
university. This may indicate a lack of awareness by entering students about the international
program and that an introduction to the international studies program should be required by the
admissions office, counselors and the school of business. 100% of the students felt that the
international studies program would add to their global understanding. This concept was
reinforced during their classroom experience throughout the semester. 94% felt that the
experience would be beneficial for future job opportunities. This was also discussed in the pre-
class and there were suggestions given on how to incorporate their experiences overseas and in
the international studies program into their resume. 83% of students made arrangements for
communications with friends and family in the United States before they left the States.
Communications with friends and family was stressed during the pre-classes as a necessary
component of being successful in the program. 72% percent of students surveyed felt that they
were going to be going into a safe environment. The overall safety of the program and the
countries involved were discussed during the pre-class. There were six questions that will be
discussed in regards to the post test. 100% of the students felt the program for this particular
study abroad experience was marketed correctly. The hospitality program and international
student office produced brochures and had meetings discussing the proposed itinerary. 100% of
the students in the survey felt they had the freedom to explore in the host country. Students were
allowed to participate in unstructured tours on Saturday afternoons and Sundays. 100% of the
students indicated they were willing to try new things and were anxious to participate in social,
cultural, and culinary related activities. 100% of the students surveyed believed the study abroad

program enhanced their future employment opportunities. The four classes the students had prior
to their study abroad stressed the importance of including their international participation on their
resume and vitae. 100% of students would consider another trip abroad. A number of students
volunteered to speak next fall and spring to students who are interested in participating in the
international program in 2010.
Conclusion
The results of this study might provide some guidance to other institutions contemplating study
abroad programming. It can be observed that such programs are dynamic and require
considerable planning. With increased numbers of students we anticipate that observable
differences in our program can be observed and results presented in the current paper are based
on a small sample size. We hope, in the future, to be able to present common characteristics and
differences among student groups. We see our initial study as a starting point to determine long-
range ramifications for hospitality and tourism programs. Perhaps we are at the beginning of a
new phase of academic preparedness for students who will be residing and employed in an ever
increasing international environment. Up until now Robert Morris University has focused on
Europe as the key location for its international studies program. In the hospitality industry a focus
on Europe is excellent, however it is also important for student to gain experiences in countries
with emerging economies such as China and India. This is especially important for hospitality
students since these two countries represent over 33% of the world’s population and 30% of the
world’s production. Tourism in both countries is booming and here in the US we are seeing an
increase in tourism to the US from both of these countries, making it imperative that hospitality
programs prepare their students for potential careers that will include extensive contact with a
diverse group of clients and customers. The future goal for RMU’s hospitality program is to
incorporate China and India into the International Studies program and to provide students with
financial aid through the development of scholarship and grant programs.
References
IES Abroad. The Benefits of Studying Abroad. Retrieved May 13, 2009. From
https://www.iesabroad.org/IES/Students/alumniSurveyResultsStudents.htmlAnonymous. IES
Abroad announces $1,190,000 in scholarships and aid awarded for spring 2009. Retrieved May
13, 2009. From ProQuest Database.
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San Francisco, CA
Learning Theories Knowledgebase (2009, August). Humanist Theories at Learning-

Theories.com. Retrieved August 14th, 2009 from http://www.learning-
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McKinney, Kathleen (2007). The Student Voice: Sociology Majors Tell Us About Learning
Sociology. Teaching Sociology 35:112-134.
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Thousand Oaks, CA.

Shor, Ira and Paulo Freire (1987). A Pedagogy for Liberation: Dialogues on Transforming
Education. Gergin & Garvey Inc., Granby, MA.
Stewart, David W., Prem N. Shamdasani and Dennis W. Rook (2007). Focus Groups, Theory and
Practice, 2nd ed., Sage Publications, Thousand Oaks, CA.
Sweet, Stephen (1998). Practicing Radical Pedagogy: Balancing Ideals with Institutional
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Tuckman, Bruce W., & Jensen, Mary Ann C. (1977). “Stages of small group development
revisited', Group and Organizational Studies 2:419- 427.

A STUDY OF THE FACTORS INFLUENCING ONLINE
PURCHASE INTENTION OF CONSUMERS IN CHINA
Pan, Ying
Fujian Hwa Nan College
Fuzhou City, Fujian Province
The Peoples Republic of China
yingpan_hn@yahoo.com.cn
Chaipoopirutana, Sirion
Assumption University
Bangkok, Thailand
sirionc@gmail.com
Combs, Howard
San Jose State University
San Jose State University
San Jose, California
combs_h@cob.sjsu.edu
ABSTRACT
This study identifies the factors that affect online purchase intention of potential e-shoppers in China. The
data were collected by distributing self-administered questionnaires to respondents in Fujian Province of
the People’s Republic of China. Descriptive analysis, Pearson’s correlation and one-way ANNOVA were
applied for data analysis. The results revealed that online purchase intention was influenced by
individual perception, subjective norms, incentive programs and personal characteristics with the
exception of personal need for interaction. Moreover, there was a difference in online purchase intention
when segmented by education levels and income levels.
INTRODUCTION
Internet and global online shopping have undergone rapid growth over the past ten years and the number
of consumers who purchase online is increasing rapidly (Johnson, 2005; Cateora, Gilly, and Graham,
2009). Motivated by rapid growth in the global online population, marketers have been simultaneously
enlightened and pressured to set up businesses on the Internet, regardless of consumers’ online purchase
intention. Different from selling in physical stores, selling via the Internet requires marketers to develop
an insightful and critical understanding of online consumer behavior (Zhou, Dai and Zhang, 2007). So,
Wong and Scuill (2005) reported that understanding consumer behavior on the Web is based on a good
appreciation of the factors affecting the consumer’s online purchase intention. Such knowledge will help
online shopping businesses adapt their marketing strategies to better satisfy customer requirements. This
will convert potential customers into real customers and help to retain them. Furthermore, in view of
increasingly intensified competition in e-commerce, understanding antecedent factors of the consumer’s
online purchase intention aids online retailers to outshine their rivals and to obtain a competitive
advantage (Zhou et al., 2007). Hence, it is of top priority to identify the determinants of online purchase
intention, a common effective measure of response behavior as reported by Li, Dougherty and Biocca
(2002).
Schiffman and Kanuk (2007) stated that it is very important that marketers understand consumers’
individual perception and its related concepts to more readily determine what affects consumers’ intention

Pan, Chaipoopirutana, Combs On Line Purchase Consumers in China
to buy. Solomon (2007) also implied that perception has strategy implications for marketers because
consumers make decisions based on what they perceive and consumer perception accounts for consumer
behavior intention. Moreover, personal characteristics impact online purchase intention (Solomon, 2007).
Personal characteristics of consumers are incorporated in marketing and advertising messages to enhance
potential consumers’ intention to buy a certain product or service. Consumer purchase behavior occurs
when consumers are motivated by external factors and form purchase intention based on their personal
characteristics (Kotler and Keller, 2008).
Peter and Olson (2002) reported that incentive programs are a kind of sales promotion to stimulate
potential purchase intention. According to Fishbein and Ajzen (1975), Ajzen (2002) and Schiffman and
Kanuk (2007), subjective norms influence an individual’s behavioral intention. In addition, many studies
have found demographics to be important in analyzing consumers’ online shopping intention and web-
shop behavior (Ratchford, Talukdar and Lee, 2001; Burke, 2002; Kim & Kim, 2004). Therefore, the
current study investigated the effects of perception, personal characteristics, subjective norms, incentive
programs and demographics on potential e-shoppers’ online purchase intention.
Online shopping in the People’s Republic of China is growing very rapidly. Overall, the growth rate of
China’s online shopping was around 100 percent each year between 2002 and 2007
(http://www.ccwresearch.com.cn/store/article_content.asp?articleId=34018& Columnid=335&view=#,
visited on 23rd April, 2008). As reported by China Internet Research Center in January, 2008, transaction
volume over the Internet totaled 8 billion US dollars in China in 2007. This was up significantly from the
4.3 billion US dollars spent online just one year earlier
(http://www.chinapost.com.tw/china/_business/2008/03/17/ 147480/E-commerce- gaining.htm, visited on
April 23, 2008).
Much like the rest of the world, the development of China’s online shopping has encountered some
problems. In 2007, online shopping in China only had a 0.63 percent market share of the overall Chinese
retail market. Furthermore, A CNNIC survey in 2006 indicates that only 25 percent of online population
in China transact via the Internet (CNNIC, 2006). Such obstacles will need to be will need to be overcome
for online shopping to reach its potential in China.
Most online shopping studies have focused on western countries with China (now representing the largest
number of online consumers in the world) receiving little research attention. Hence, to continue fueling
the robust growth of online shopping in China, it is important to understand potential e-shoppers’ online
purchase intention in China. The current study was conducted in Fuzhou City, Fujian Province of China.
Online shopping development in Fujian Province is very similar to that in China as a whole and Fuzhou is
the capital city of Fujian province.
LITERATURE REVIEW
The theory of reasoned action (TRA), the theory of planned behavior (TPB) and the technology
acceptance model (TAM) are the most popular and frequently applied theories related to the study of
behavior intention towards Internet-based technologies. The theory of planned behavior (TPB) was
created by Ajzen (1985) as an extension of TRA (Fishbein & Ajzen, 1975) to ponder over the situations
where individuals do not have complete control over behavior. TPB indicates that attitude, subjective
norms and perceived behavior control influence intention to perform an action. Actual usage is a function
of behavior intention and perceived behavior control (PBC). TPB paves the way for analyzing consumer
behavior (Conner, 1993; Taylor and Todd, 1995; Scholderer and Grunet, 2001). In relation to Internet-
based shopping behavior, it has been adapted as a framework for Internet shopping (Shim, Easstlick, Lotz
and Warrington, 2001; Vijayasarathy, 2002). Ramus and Nielsen (2005) found that TPB provided a
comprehensive structure of psychological factors to account for consumer’s intention to use or refrain
from Internet purchasing. George (2002) also studied web-based shopping, following the guidance of
TPB.

The technology acceptance model (TAM) was constructed by Davis, Bagozzi and Warshaw (1989) to
predict adoption of new software and information technology. In accordance with TAM, attitudes towards
using the system can be determined by perceived usefulness and perceived ease of use. Actual usage is a
function of behavior intention, which, in turn, is predicted by attitude towards using the system. TAM has
been widely tested and regarded as a robust tool for measuring the acceptance of Internet-related new
information technologies such as use of e-commerce (van der Heijden, 2003; Yi & Hwang, 2003) and e-
banking ( Henderson & Divett, 2003; van Dolen & de Ruyter, 2002) in particular.
The research model as shown in Figure 1 was modified from TPB, while the research frameworks in
Figure 2 and 3 were designed on the basis of TAM.
Figure 1: a research model for understanding consumer online buying behavior
Perceived
consequences
Attitude towards
online shopping
Online purchase Internet shopping

intention
Personal
innovativeness
Perceived behavior
control
Subjective norms
Source: Limayem, Khalifa and Frini (2000), “What makes consumers buy from Internet”, IEEE:
Transactions on System, Man and Cybernetics Vol. 30, No. 4, p.423
As shown in Figure 1, Limayem, Khalifa and Frini (2000) attempted to find out key factors that determine
online purchase intention and actual behavior of buying online. This research model was developed from
TPB. The researchers explored new links (personal innovativeness and perceived consequences). It was
found that personal innovativeness, perceived consequences, subjective norms and perceived behavior
control are all important in determining a consumer’s intention to buy online.
Figure 2: Research framework for online purchase intentions

Source: Chiu, Lin and Tang (2005), “Gender differs: assessing a model of online purchase
intentions in e-tail services”, International Journal of Service Industry Management, Vol. 16,
No. 5, p. 417
Proposed by Chiu, Lin and Tang (2005), the framework shown in Figure 2 was devised to identify
antecedents of online purchase intentions and consumer attitudes towards purchasing via the Internet.
Two critical variables (personal awareness of security and personal innovativeness) were integrated into
the original TAM to enhance its explanation power. The new framework suggests that both online
purchase intention and attitude towards buying on the Internet are influenced by four independent
variables: perceived usefulness, perceived ease of use, personal awareness of security and personal
innovativeness.
Figure 3: a research model for behavior intention to use 3G mobile services in Taiwan
Perceived
usefulness
Perceived ease of Attitude towards Intention to use

use using 3G services 3G services
Perceived
enjoyment
Source: Liao, Tsou and Huang (2007), “Factors influencing the usage of 3G mobile services in
Taiwan”, Online Information Review, Vol. 31, No. 6, p.762
Liao, Tsou and Huang (2007) analyzed the factors affecting subscribers’ usage of 3G mobile services in
Taiwan (see Figure 3). The authors designed the research model on the basis of TAM but perceived
enjoyment was incorporated as an external variable in the research model.
Figure 4: Path diagram for prediction of online purchase intention
Transaction

Incentive programs
Online purchase Demographics
intention
Site design
Interactivity
Source: Kim and Kim (2004), “Predicting online purchase intentions for clothing products”,
European Journal of Marketing. Vol. 38, No.7, p. 891
Kim and Kim’s (2004) study discovered that only transaction, incentive programs and some demographic
variables (i.e. gender, income, education and number of children) can effectively indicate consumer’s
intention to purchase clothes, jewelry or accessories via the Internet (see Figure 4).
Figure 5: Research framework for adoption of e-government
Source: Gilbert, Balestrini and Littleboy (2004), “Barriers and benefits in the adoption of e-
government”, The International Journal of Public Sector Management, Vol.17, No. 4, p. 292
As shown in Figure 5, Gilbert, Balestrini and Littleboy (2004) identified the factors that indicate
willingness or intention to adopt e-government, the technology service delivery option by using the
Internet. These antecedent factors are classified into two categories: perceived relative benefits and
perceived barriers. Through the survey, the researchers drew a conclusion that willingness or intention to
adopt e-government technology service is strongly influenced by perceived barriers of reliability and
security as well as perceived time and cost benefit.

In addition, there are several empirical studies showing the linkage between purchase intention and
perception, personal characteristics, incentive programs and subjective norms. Lee, Fiore and Kim (2006)
found perceived usefulness, perceived ease of use, and perceived enjoyment all significantly predict
consumers’ intention to buy from a certain online retailer. As reported by Koufaris (2002), perceived
enjoyment affects intention to return to online shopping websites. Because the Internet is accessible 24
hours a day, this kind of time saving benefit leads to intention to shop online (Monsuwe, Dellaert and
Ruyter, 2004). Forrester (1998) discovered price sensitive individuals will be actively involved in e-
shopping so as to obtain lower prices. In addition, Gopi and Ramayah (2007) found perceived behavior
control to be an antecedent of behavior intention to use Internet stock trading.
Salisbury, Pearson, Pearson and Miller (2001) argued that personal awareness of security is crucial to
consumer purchase intention. The issue of online security of data such as credit card and back record
information has become an increasingly important factor in e-commerce worldwide.
Studies on consumer innovativeness (Citrin, Sprott, Silverman and Stem, 2000; Pedersen and Nysveen
2003) prove that there is a positive relationship between amount of Internet experience and online
purchase intention. Liang and Huang (1998) also found experienced Internet users tend to be engaged in
online shopping. Dabholkar and Bagozzi (2002) analyzed consumers with a high need for interaction
value human interaction, thus having low intention to use technology-based self-services. Walker, Craig-
Lees, Hecker and Francis (2002) discovered willingness or intention to accept technology-enabled service
is high when need for personal contact and interaction is low.
So et al. (2005) found that promotional offers are used as incentives to increase the intention of web-
shopping. Fusilier and Durlabhji (2005) verified subjective norms are significantly and positively related
to behavioral intention to use the Internet. Additionally, according to Monsuwe et al. (2004), the most
relevant demographic factors influencing online shopping are age, gender, education and income.
CONCEPTUAL FRAMWORK
Based on the five theoretical frameworks discussed above and supported empirical studies, the
researchers in this project developed the modified conceptual framework shown in Figure 6 to examine
the determinants of potential e-shoppers’ online purchase intention. The researchers were interested in
testing the differences in online purchase intention when segmented by the five demographic factors.
Figure 6: the modified conceptual framework for the research
Subjective norms
Individual Perception
Perceived usefulness
Perceived ease of use
Perceived enjoyment
Perceived time benefit
Perceived cost benefit
Incentive
Perceived behavior control
Online purchase intention programs
Personal characteristics
Demographics
Personal awareness of security
Personal innovativeness
Gender
Personal need for interaction
Age
Personal Internet experience
Education
ASBBS E Journal, Vol. 6, No.1, 2010 Occupation 93
Monthly income
Research Hypotheses
Seventeen hypotheses were developed based on the modified conceptual framework. All the null
hypotheses are stated as follows: (OPI=Online Purchase Intention)
H1o: There is no relationship between perceived usefulness and OPI.
H2o: There is no relationship between perceived ease of use and OPI.
H3o: There is no relationship between perceived enjoyment and OPI.
H4o: There is no relationship between perceived time benefit and OPI.
H5o: There is no relationship between perceived cost benefit and OPI.
H6o: There is no relationship between perceived behavior control and OPI.
H7o: There is no relationship between personal awareness of security and OPI.
H8o: There is no relationship between personal innovativeness and OPI
H9o: There is no relationship between personal need for interaction and OPI.
H10o: There is no relationship between internet experience and OPI.
H11o: There is no relationship between incentive programs and OPI.
H12o: There is no relationship between subjective norms and OPI.
H13o: There is no difference in online purchase intention when segmented by gender.
H14o: There is no difference in online purchase intention when determined by age.
H15o: There is no difference in online purchase intention when segmented by education.
H16o: There is no difference in online purchase intention when based on occupation difference.
H17o: There is no difference in online purchase intention when segmented by income.
RESEARCH METHODOLOGY
Descriptive research and survey research method were applied for the study. The target population of
concern in the research was Internet users in Fuzhou City, Fujian Province of the People’s Republic of
China (P.R.C.), who buy products or services in traditional physical stores and once browsed online
shopping websites but have never bought any product or service online. The sample size was 385
respondents.
The questionnaire of the study constituted seven parts. The first part eliminates the people ineligible for
data collection. It uses dichotomous style. The second part through the sixth part are measured by 5-point
Likert scale, ranging from strongly disagree (1) to strongly agree (5). The second part deals with
individual perception. The third part investigates personal characteristics. The fourth part is concerned
about expectation of online shopping incentive programs. The fifth part measures subjective norms. The
sixth part inquires into online purchase intention. Totally, 38 questions are included from Part 2 to Part 6.
The last part collects demographic information of the respondents. Several rounds of pre-test were
conducted among 50 respondents from the research population and the alpha value of each variable in the
final reliability test is greater than 0.75, thus ensuring the reliability of the questionnaire.
Table 1: Mean score rating and standard deviation of all the variables
Operational Dimensions Standard
N Mean Deviation
Perceived usefulness 385 3.7117 .66296
Perceived ease of use 385 3.4485 .75520
Perceived enjoyment 385 3.4329 .72701
Perceived time benefit 385 3.7108 .64734
Perceived cost benefit 385 3.5152 .68749
Incentive programs 385 3.9394 .72154
Perceived behavior control 385 3.5541 .66452

Personal awareness of 385 3.1056 .73624

security
Personal innovativeness 385 3.2216 .78169
Personal need for 385 3.6199 .69564
interaction
Personal Internet 385 3.4433 .80528
experience
Subjective norms 385 3.1576 .76678
Online Purchase intention 385 2.2900 .52305
Table 2: Summary of the hypotheses testing results

Statistical Significant Correlation
Hypotheses Treatment Level Coefficient Results
H1o: There is no relationship between Pearson’s
perceived usefulness and online correlation .000 .480** Reject H1o
purchase intention.
perceived ease of use and online correlation .000 .371** Reject H2o
purchase intention.
perceived enjoyment and online correlation .000 .455** Reject H3o
purchase intention.
perceived time benefit and online correlation .000 .339** Reject H4o
purchase intention.
perceived cost benefit and online correlation .000 .321** Reject H5o
purchase intention.
perceived behavior control and correlation .000 .400** Reject H6o
online purchase intention.
personal awareness of security and correlation .000 .448** Reject H7o
online purchase intention.
personal innovativeness and online correlation .000 .418** Reject H8o
purchase intention.
personal need for interaction and correlation .051 .099 Failed to reject
online purchase intention. H9o
Internet experience and online correlation .000 .413** Reject H10o
purchase intention.
incentive programs and online correlation .008 .134** Reject H11o
purchase intention.
subjective norms and online correlation .000 .562** Reject H12o
purchase intention.
H13o: There is no difference in online Independent
purchase intention when samples’ t-test .560 _ Failed to reject

segmented by gender. H13o

H14o: There is no difference in online One-way
purchase intention when ANNOVA .293 _ Failed to reject
determined by age levels. H14o
purchase intention when ANNOVA .014 _ Reject H15o
segmented by education levels.
purchase intention when based on ANNOVA .166 _ Failed to reject
occupation difference H16o
purchase intention when ANNOVA .002 _ Reject H17o
segmented by income levels.
DISCUSSION AND CONCLUSION

Based on the hypothesis testing results (see Table 2), it can be concluded that there is a positive
relationship between online purchase intention and each perception, subjective norms, incentive programs
and personal characteristics except personal need for interaction. Moreover, potential e-shoppers’ online
purchase intention differs only when segmented by education levels and income levels. The testing results
of the research are consistent with that of the studies conducted by Chiu et al. (2005), Heijden (2002),
Bayan (2000), Liao and Cheung (2001), Limayem et al.(2000), Crisp, Jarvenpaa and Todd (1997) and
Kim and Kim (2004).
According to the research findings, perceived usefulness was found to be the most important factor for
predicting potential consumers’ online purchase intention. It indicates that potential Chinese online
shoppers place great emphasis on usefulness when considering adoption of electronic shopping. However,
perceived ease of use does not generate as much effect on potential e-shoppers’ online shopping intention
as perceived usefulness. Moreover, among the perception factors, following perceived usefulness,
perceived enjoyment is the second strongest predictor of online purchase intention. Meanwhile, perceived
time benefit is only moderately associated with online purchase intention. This may be attributed to the
fact that life pace in Fuzhou is not as fast as that in major metropolitan cities such as Beijing, Shanghai
and Guangzhou. Therefore, potential online purchasers in Fuzhou do not sense much time pressure. Also,
compared with other perceptions, perceived cost benefit exhibits the weakest relationship with intention
of Internet-based shopping. It may be explained that for Chinese consumers, the rest of the perceptions
take precedence over perceived cost benefit in the context of online shopping.
Goldsmith, Freiden and Eastman (1995) proposed that consumer innovativeness is linked to early product
adoption. Consumer innovativeness in countries with a short history of online shopping such as China
may have more predicting power in anticipating online purchase intention than countries with a relatively
long history of e-shopping, such as the United states or western Europe. Although Chinese consumers
favor personal interaction with others, this factor does not forecast their online purchase intention. This
may be due to the fact that in China, online shopping mainly deals with financial transactions and
therefore, it may be regarded as more associated with the factor of transaction security. Furthermore, in
the Chinese context, the more Internet experience accumulated by potential e-shoppers, the more online
purchase intention they demonstrate.
RECOMMENDATIONS
Based on the findings of the study, several recommendations can be made to both e-marketers and e-
tailers wishing to do business online in China. First, maximize potential e-shoppers’ perception of
usefulness, ease of use and enjoyment. Software developers must communicate relevant and up-to-date
messages in shopping websites, post frequently asked questions (FAQs) on the home page and establish
virtual online communities. Moreover, e-tailers should develop a simple and easy-to-use system and

ensure concise and easy-to-comprehend website contents. Furthermore, it is advisable to create an

enjoyable and entertaining shopping environment.
It is desirable to simplify the procedures required to conclude a transaction. It is also suggested that online
shopping businesses appeal to time-oriented, busy people as these people are very likely to be converted
into web-shopping lovers. Additionally, by making a comparison between online shopping and traditional
shopping, the advantage of time benefit brought by online purchase will be introduced to potential e-
shoppers.
Online marketers in China should adopt measures to minimize security concern in order to build
consumer confidence in Internet-based shopping. E-tailers must ensure the privacy of buyer information
and promise never to disclose or sell customers’ sensitive personal information. Website designers should
display the implemented measures guarding against online shopping fraud. Security payment systems
need to be established. For instance, two well-known online shopping website, e-Bay from the United
States and Alibaba from China have adopted PayPal and AliPay respectively to assure customers of
online payment safety.
In order to nurture consumer innovativeness, promotion should be targeted at consumers already equipped
with rich Internet experience. Although it is difficult to identify innovative people, e-tailers can try to
nurture consumer innovativeness by creating online shopping websites that reward exploration to
influence the Internet users to become innovative. On the other hand, online shopping businesses are
strongly recommended to seek cooperation with China telecom, the major Internet access service provider
in China, to identify the households and companies with a relatively long online history and direct
marketing activities at these households and companies to experiment with online shopping.
Online marketers in China should utilize the mass media for shopping website promotion. E-marketers
should select a Chinese friendly celebrity to be the spokesperson of their websites. This spokesperson not
only provides guidance on how to complete a transaction online easily and quickly, but also functions as a
promoter that effectively recruits potential e-shoppers. Television commercials introducing online
shopping websites should be produced as TV is still the most pervasive media in China. Finally, when
planning for marketing activities, online marketers must take education levels and income levels into
consideration for market segmentation and identification of the appropriate target market.
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THE FAILURE OF INDYMAC: A TEST OF
MARKET EFFICIENCY AND THE BEHAVIORAL
CHALLENGE
Peebles, Dawn M.
Longwood University
peeblesdm@longwood.edu
Bacon, Frank
Longwood University
baconfw@longwood.edu
ABSRACT
This event study tested the effect of the IndyMac Bank failure announcement on the stock prices’
rate of return for a randomly selected sample of 30 banks; 15 savings and loan banks and 15
money center banks traded on either the NYSE or the NASDAQ. Using standard risk adjusted
event study methodology with the market model, the study analyzed 6,541 recent observations on
the thirty publicly traded firms and the corresponding S&P 500 market index. Results show the
IndyMac bank failure announcement had a significant negative impact on the firm’s share price
up to 30 days prior to announcement day 0. The risk adjusted return of the stock price is not
significantly affected by this type of information on the announcement date. Likewise, the risk
adjusted return of the stock price of the two samples of banks is significantly affected around the
announcement date as defined by the event period. This finding supports the significance of the
information around the event since the market’s reaction was observed. Finally, results show the
reaction of risk adjusted return of the stock price of the sample of money center banks to the
IndyMac bank failure announcement is not significantly different from the reaction of risk
adjusted return of the stock price of the sample of savings and loan banks around the
announcement date as defined by the event period. Overall, findings support efficient market
theory at the semi-strong form level as documented by Fama (1970). Similar to many other event
study findings in the finance literature (stock options, repurchase, dividend announcements etc.),
apparently trading activity on the basis of this information surfaced prior to it being made public.
Likewise, evidence of the behavioral challenge was observed by the significant overreaction of
the risk adjusted rate of return of the sample of financial firms to the IndyMac bank failure news.
INTRODUCTION
On July 11, 2008, the leading mortgage lender, IndyMac was seized by the Federal Deposit
Insurance Corporation (FDIC) and filed for Chapter 7 bankruptcy. According to the efficient
market hypothesis, if the market is semi-strong efficient, this event will not cause a significant
fluctuation in stock price returns of other financial institutions since the stock prices and returns
adjust so rapidly to new information that no investor can trade on this public information and earn
an above normal return.
Many event studies in the finance literature examine how public announcements affect stock
returns. Both anticipated and unanticipated events can and do affect the market. However, when
does the market react to the public announcement of the event? The timing of the market’s
reaction or how quickly the stock returns respond to the new information could depend on what

Peebles, Bacon Failure of IndyMac
information the investors were able to obtain prior to the public announcement and whether other
similar events within the same range of time enable the anticipation of the event under study.
Because of known financial distress among many banks, the IndyMac failure may have been
predicted. IndyMac’s financial distress preceding its demise was characterized with the closing
of offices and employee lay-offs presumably to offset huge losses from defaulted mortgage loans.
Sen. Charles E. Schumer sent a letter to the FDIC and other federal agencies suggesting that
IndyMac may be having serious problems with its loan holdings. According to the Los Angeles
Times, Schumer said, “I am concerned that IndyMac’s financial deterioration poses significant
risks to both taxpayers and borrowers. The bank could face a failure if prescriptive measures are
not taken quickly.” Following this public warning, depositors pulled $1.3 billion out of accounts
causing IndyMac’s liquidity crisis and ultimate failure.
How did the announcement of the failure of IndyMac on July 11, 2008 impact banks’ stock
returns? Did stock returns react before, on, or after the public announcement? How efficient is
the stock market with respect to this public information? Is the market’s reaction to the public
announcement of the IndyMac’s failure weak form or semi-strong form efficient? In particular,
does the market’s reaction differ between savings and loan and money center banks?
The purpose of this event study is to test the semi-strong form efficient market hypothesis by
analyzing the effects of the announcement of the IndyMac failure on the stock price returns of
other banks. If the stock market is efficient, this study should not observe a reaction on the
announcement date since the stock price returns immediately reflect all the past and public
information regarding the public announcement.
This study tests the public announcement of the IndyMac bank failure for semi-strong form
market efficiency by analyzing two randomly selected samples: 15 money center banks and of 15
savings and loan banks. The analysis should explain if the stock return reaction to the public
announcement varies by type of bank.
LITERATURE REVIEW
According to the efficient market hypothesis stock price returns “fully reflect” all available
information. Stock prices react so fast to public information that no investor can earn an above
normal return by acting on any public announcements such as the IndyMac bank failure.
Fama defined market efficiency in terms of how quick the stock market reacts to the information
and suggested three kinds of market efficiency: Weak form, semi-strong and strong form
efficiency. If market is weak for efficient, then stock price reacts so fast to all past information
that no investor can earn an above normal return (higher than the market or the return on the S&P
500 index). This study shows how investors will not earn a high return from acting on public
information (bank failure announcement), while investors having access to inside information
will make an abnormal return.
A second kind of market efficiency is semi-strong. It states that stock price reacts so fast to all
public information that no investor can earn an above normal return (higher than the market or the
return on the S&P 500 index) by acting on this type of information. (Fama 1970). Public
announcements of events usually result in immediate price reaction, but study done by Fama
(1970), Dodd, Patell and Wolfson, found that there is no evidence of abnormal return after the
release of public information. They concluded that the market assimilates and takes into
consideration public information very fast, within 5 to 15 minutes after the disclosure (Malkiel).
This supports the idea that an investor acting on public information will not earn an above normal
return. When this happens the market is said to be semi-strong form efficient.

If the market is strong form efficient, then stock price reacts so fast to all information (both public
and private), that no investor can earn an above normal return (higher than the market or the
return on the S&P 500 index) by acting on this kind of information. Studies made by Friend,
Brown concluded that profit can only be gained by having access to private or inside information,
which is illegal. Fama presents evidence supporting that efficiency is not met in the strong form
and that the semi-strong form is more accurate.
Accordingly to the study done by Brewer, announcement of bank failures could contribute to a
negative perception of the industry overall and have a spillover effect on other banks which
would be worse for the weaker banks. The announcement of a failed bank could raise concerns
about the long-term viability of surviving banks.
Is the concept of market efficiency merely academic and not practical in the real world of
investing? The three conditions that guide market efficiency are: rationality, independent
deviations from rationality, and arbitrage. In essence, the irrational pricing caused by amateurs is
cancelled out by the rational valuation of the professionals. Professional investors engage in
arbitrage by buying underpriced stocks while simultaneously selling overpriced securities or
correctly priced substitutes resulting in a balance of the mispricing caused by the amateur
investors and thus, keep the market efficient. If the effects of the two opposing groups, the
amateurs vs. the professionals, is about the same the market can remain efficient.
The behavioral challenge to the efficient market hypothesis argues that none of three conditions
(rationality, independent deviations from rationality, and arbitrage) remain true in reality. People
are not always rational which may cause them to over or under react to information causing a
bubble effect in the stock prices. The theory argues that arbitrage is too risky for the prices to
adjust to the correct levels. For example, suppose stocks A and B should have identical values
based rational valuation models. Upon observing in the market that stock A’s price is $30 per
share and B’s is $20 per share, the arbitrager immediately spots the market imperfection and sell
A short and buys B and waits for the market correction with A falling and B rising resulting in
profit on the spread. What if, after the arbitrager takes the position, good news comes out on A
and bad news is released on B causing the spread to increase. Clearly, market and stay out of
equilibrium longer than the arbitrager can stay liquid.
METHODOLOGY AND STUDY SAMPLES

This study examined two randomly selected samples consisting of 15 money center banks and 15
savings and loan banks in order to test the impact of the announcement of IndyMac’s failure on
stock price returns. The study event date was the IndyMac Bank failure on July 11, 2008. Bank
stock price and the corresponding S&P Index data was collected from 180 days prior to 30 days
after the event date.
Using standard event study methodology from the finance literature, this study analyzed the two
samples of money center and savings and loan banks against the corresponding S&P 500 Index
with 6,541 observations to test the semi-strong form efficient market hypothesis with respect to
the announcement of the IndyMac bank failure. The announcement date of the IndyMac failure is
day 0. Historical stock and corresponding S&P 500 prices used in this event study were obtained
from the Yahoo Finance website (http://finance.yahoo.com). The following steps were taken to
conduct the event study test. The historical stock prices for the samples of money center and
savings and loan banks as well as the S&P 500 index were obtained for the event period from -
180 days to +30 days from the event date. Days -30 through +30 are considered the event period
and day 0 is considered the announcement date of July 11, 2008. Next, the holding period returns
of the banks and the corresponding S&P index were calculated for each day in this study period

using the following formula: HPR = (Current day’s closing price – Previous day’s closing
price) / Previous day’s closing price. Then, a regression analysis was performed for the pre-event
period from day -180 through day -31 using the actual daily return percentage for each of the
banks as the dependent variable and the corresponding S&P 500 daily return percentage as the
independent variable. Table 2 shows the alphas and betas for each bank. Next, the risk-adjusted
method was used in order to calculate the normal expected returns as follows: E(R) = alpha + beta
Step 5: After that, the excess return was calculated as follows: ER = Actual Return (R) –
Expected Return E(R). The Average excess returns (AER) were calculated for each day during
the event period (from –30 through +30) as follows: AER = Sum of all excess returns for each
day / N where: N equals the number of banks which in this test is 15 money center banks and
15 savings and loan banks. Then, the Cumulative AER (CAER) was calculated for the event
period by added the AERs for each day for both the money center banks and the savings and loan
banks. After that, graphs of the AER and CAER were plotted for the event period and are
included in Chart 1 and Chart 2. Table 1 describes the two samples of money center and savings
and loan banks.
Table 1: Description of Study Sample
Money Center Banks

TICKER FIRM NAME TRADED
INDEX
BAC Bank Of America NYSE
BBT BB&T Corporation NYSE
C Citigroup Inc. NYSE
FCFL First Community Bank Corporation of NASDAQ
America
JPM JP Morgan Chase & Co. NYSE
KEY KeyCorp NYSE
OLCB Ohio Legacy Corporation NASDAQ
OFG Oriental Financial Group Inc. NYSE
PNC PNC Financial Services Group NYSE
STI Suntrust Banks, Inc. NYSE
BK The Bank of New York Mellon Co. NYSE
TCB TCF Financial Corporation NYSE
TD Toronto-Dominion Bank NYSE
UBOH United Bancshares Inc. NASDAQ
WFC Wells Fargo & Co. New NYSE
Savings & Loan Banks
ABBC Abington Bancorp Inc. NASDAQ
AF Astoria Financial Corporation NYSE
BKMU Bank Mutual Corporation NASDAQ
ESBF ESB Financial Corporation NASDAQ
FCJ Ford Motor Credit Co. LLC NYSE
HFFC HF Financial Corporation NASDAQ
KRNY Kearny Financial Corporation NASDAQ
CASH Meta Financial Group, Inc. NASDAQ
PBHC Pathfinder Bancorp, Inc. NASDAQ
PROV Provident Financial Holdings NASDAQ
PULB Pulaski Financial Corporation NASDAQ

QCCO QC Holdings, Inc. NASDAQ

SIFI SI Financial Group, Inc. NASDAQ
STSA Sterling Financial Corporation NASDAQ
WSB WSB Holdings, Inc. NASDAQ
Table 2 presents results from the regression analysis to include alphas and betas for each bank.
To calculate the alphas and beta, the actual daily return percentage from each bank’s stock is the
dependent variable and the actual daily return percentage from the S&P 500 index is the
independent variable in the regression analysis.
Table 2: ALPHAS AND BETAS OF STUDY SAMPLE
Money Center Banks

TICKER FIRM NAME ALPHA (α) BETA(β)
BAC Bank Of America 0.00022 0.424974
BBT BB&T Corporation -0.00037 0.337494
C Citigroup Inc. 0.00067 0.319791
FCFL First Community Bank -0.00054 0.06366
Corporation of America
JPM JP Morgan Chase & Co. -0.00053 0.331144
KEY KeyCorp -0.00003025 0.274613
OLCB Ohio Legacy Corporation -0.00045 0.015138
OFG Oriental Financial Group Inc. -0.00117 0.188821
PNC PNC Financial Services Group -0.00048 0.437094
STI Suntrust Banks, Inc. -6.17915 0.334196
BK The Bank of New York Mellon -0.00048 0.369346
Co.
TCB TCF Financial Corporation -9.852895 0.269
TD Toronto-Dominion Bank -0.00058 0.540524
UBOH United Bancshares Inc. -0.00046 0.034486
WFC Wells Fargo & Co. New -0.00025 0.342464
Savings & Loan Banks
ABBC Abington Bancorp Inc. -0.000777 0.45379
AF Astoria Financial Corporation -0.00046 0.310469
BKMU Bank Mutual Corporation -0.00077 0.4209
ESBF ESB Financial Corporation -0.00052 0.278909
FCJ Ford Motor Credit Co. LLC -0.00039 0.117404
HFFC HF Financial Corporation -0.00052 0.054079
KRNY Kearny Financial Corporation -0.00032 0.330277
CASH Meta Financial Group, Inc. -0.00037 0.039307
PBHC Pathfinder Bancorp, Inc. -0.00048 0.007145
PROV Provident Financial Holdings -0.00049 0.01038
PULB Pulaski Financial Corporation -0.00044 0.074733
QCCO QC Holdings, Inc. -0.00032 0.11896
SIFI SI Financial Group, Inc. -0.00042 0.085237
STSA Sterling Financial Corporation 0.000523 0.193276
WSB WSB Holdings, Inc. -0.00045 0.022428

To test for semi-strong market efficiency on the IndyMac Bank failure announcement, the
following null and alternative hypotheses are used for the two bank samples:
H10: The risk adjusted return of the stock price of the two samples of banks is not significantly
affected by this type of information on the announcement date.
H11: The risk adjusted return of the stock price of the two samples of banks is significantly
negatively affected by this type of information on the announcement date.
H20: The risk adjusted return of the stock price of the two samples of banks is not significantly
affected by this type of information around the announcement date as defined by the event period.
H21: The risk adjusted return of the stock price of the two samples of banks is significantly
positively or negatively affected around the announcement date as defined by the event period.
H30: The reaction of risk adjusted return of the stock price of the sample of money center banks
to the IndyMac bank failure announcement is not significantly different from the reaction of risk
announcement date as defined by the event period.
H31: The reaction of risk adjusted return of the stock price of the sample of money center banks
to the IndyMac bank failure announcement is significantly different from the reaction of risk
QUANTITATIVE TESTS AND RESULTS

Did the market react to the announcement of the IndyMac bank failure? Was the information
surrounding the event significant? A’priori, one would expect there to be a significant difference
in the Actual Average Daily Returns (Day -30 to Day +30) and the Expected Average Daily
Returns (Day -30 to Day +30) if the information surrounding the event impounds new, significant
information on the market price of the firms' stock. If a significant risk adjusted difference is
observed, then we support our hypothesis that this type of information did in fact significantly
either increase or decrease stock price. To statistically test for a difference in the Actual Daily
Average Returns and the Expected Daily Average Returns over the event period day -30 to day
+30, we conducted a paired sample t-test for the two samples and found a significant difference at
the 5% level between actual average daily returns and the risk adjusted expected average daily
returns. Average Excess Return (AER) graphs are shown below. Results here support the
alternate hypothesis H21: The risk adjusted return of the stock price of the two samples of banks
is significantly affected around the announcement date (IndyMac bank failure) as defined by the
event period. This finding supports the significance of the information around the event since the
market’s reaction was observed.
Is it possible to isolate and observe the samples’ daily response to the announcement from day -
30 to day +30? If so, at what level of efficiency did the market respond to the information and
what are the implications for market efficiency? Another purpose of this analysis was to test the
efficiency of the market in reacting to the IndyMac bank failure. Specifically, do we observe
weak, semi-strong, or strong form market efficiency as defined by Fama, 1970, in the efficient
market hypothesis? The key in the analysis is to determine if the AER and CAER are
significantly different from zero or that there is a visible graphical or statistical relationship
between time and either AER or CAER. T-tests of AER and CAER both tested different from
zero at the 5% level of significance. Likewise, observation of the following CAER Graph 3
(graph of CAER from day –30 to day +30 for combined bank samples) confirms the significant
and consistent negative reaction of the risk adjusted returns for the two samples of banks up to 30
prior to the announcement of the IndyMac failure. Graph 3 demonstrates that the IndyMac bank
failure announcement had a significant negative impact on the firm’s share price up to 30 days
prior to announcement day 0. The evidence supports the null hypothesis H1 0: The risk adjusted

return of the stock price of the two combined samples of banks is not significantly affected by
this type of information on the announcement date when made public. For the samples of firms
analyzed, an investor is unable to earn an above normal risk adjusted return by acting on the
public announcement of the bank failure. As of the announcement date, the firms’ stock prices
had already adjusted to the new information embedded in the bank failure news. In fact, after the
announcement, stock price exhibited and positive overreaction from days +3 to +12 (suggesting
an over-reaction by investors to the news) then returning to announcement day equilibrium
thereafter. This observed overreaction is consistent with the behavioral challenge to market
efficiency explained earlier. Overall, the results are consistent with the semi-strong form market
efficiency hypothesis which states that the stock price reflects all publicly available information.
Interestingly, the results for this sample suggest significant trading activity up to 30 days prior to
the announcement of IndyMac’s failure possibly suggesting that investors may have anticipated
the event.
In addition, the study analyzes whether or not market efficiency varies by type of bank or savings
and loan versus money center banks. Observation and comparison of Graph 1 (AER for Savings
and Loan bank sample) and Graph 2 (AER for Money Center bank sample) show similar reaction
to the IndyMac failure announcement. Specifically Graph 1 shows that the savings and loan
banks were more responsive during days -6, 1, and 4. Graph 2 shows that the money center
banks were more responsive during days -7, 0, 3, and 7. While there are minor observable
differences in the two samples’ reaction to the bank failure news, overall the results support H30.
The reaction of risk adjusted return of the stock price of the sample of money center banks to the
IndyMac bank failure announcement is not significantly different from the reaction of risk
Graph 1:
Savings & Loan Banks vs AER

0.05
0.04
0.03
0.02
0.01
AER
-0.01 -30 -27 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27 30
-0.02
-0.03
-0.04

Graph 2:
Money Center Banks vs AER

0.05
0.04
0.03
0.02
0.01
AER
0
-30 -27 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27 30
-0.01
-0.02
-0.03
-0.04
Graph 3:
Savings & Loan and Money Center Banks vs

CAER
0.05
0.04
0.03
0.02
CAER
0.01
0
-30 -27 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 27 30
-0.01
-0.02
-0.03
CONCLUSION
This event study tested the effect of the IndyMac failure announcement on the stock prices’ rate
of return for a randomly selected sample of 30 banks; 15 savings and loan banks and 15 money
center banks. These banks are all traded on either the NYSE or the NASDAQ. Using standard
risk adjusted event study methodology with the market model, the study analyzed 6,541 recent

observations on the thirty publicly traded firms and the corresponding S&P 500 market index.
The findings reveal an increase in market activity and a fluctuation of returns for both savings and
loan and money center banks around the announcement date. Results show the IndyMac bank
failure announcement had a significant negative impact on the firm’s share price up to 30 days
prior to announcement day 0. The risk adjusted return of the stock price of the two combined
samples of banks is not significantly affected by this type of information on the announcement
date when made public. For the samples of firms analyzed, an investor is unable to earn an above
normal risk adjusted return by acting on the public announcement of the bank failure. As of the
announcement date, the firms’ stock prices had already adjusted to the new information
embedded in the bank failure news.
Likewise, the risk adjusted return of the stock price of the two samples of banks is significantly
affected around the announcement date (IndyMac bank failure) as defined by the event period.
This finding supports the significance of the information around the event since the market’s
reaction was observed. Finally, results show the reaction of risk adjusted return of the stock price
of the sample of money center banks to the IndyMac bank failure announcement is not
significantly different from the reaction of risk adjusted return of the stock price of the sample of
savings and loan banks around the announcement date as defined by the event period.
Findings support efficient market theory at the semi-strong form level as documented by Fama
(1970). Similar to many other event study findings in the finance literature (stock options,
repurchase, dividend announcements etc.), apparently trading activity on the basis of this
information surfaced prior to it being made public. Likewise, evidence of the behavioral
challenge was observed by the significant overreaction of the risk adjusted rate of return of the
sample of financial firms to the IndyMac bank failure news.
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705

THE JOY OF KITSCH IN THE MIDDLE CLASSES
Purinton, Elizabeth F.
Marist College
elizabeth.purinton@marist.edu
ABSTRACT:
A casual visit to the Internet will demonstrate that the definition of kitsch no longer
applies. Kitsch is defined as something meant to emulate a higher class but winds up looking
lower class because of it. The original argument is steeped in Victorian snobbery and the basis
that high class is better than low class. This included social class as well as refinement or taste.
Kitsch is a derogatory term.
Now, it is used with endearment, entertainment, and nostalgia. In July of 2009, 711 eBay
sellers readily listed their items as kitsch. On Etsy, a website for handmade products, sellers
used the word kitsch for their product or store name 34,998 times.
Is this a paradigm shift in consumer judgment or an overdue redefinition of a word? The
answer to this will have implications for both marketing practice and theory.
This paper will explore the etymology of kitsch, tracking it to current use. Its historical
use, combined with changes in our society, will help to anchor the current usage with its original
definition. As the current place for kitsch is defined, the marketing and theoretical implications
will become clear. Recommendations will be given for both marketing researchers and
practitioners.
INTRODUCTION
A casual visit to the Internet will demonstrate that the definition of kitsch no longer
applies. In July of 2009, eBay listed 711 items as kitsch and Etsy (a website for handmade
products) 34,998. One hundred eighteen Etsy sellers willingly used the word kitsch in the name
of their shop. You can read books entitled Star-Spangled Kitsch and Kitschy Crafts, or visit
TackyLiving.com. Obviously, we do not feel the shame originally intended by the term.
Is this a paradigm shift in consumer judgment or simply an overdue redefinition of a

word? The answer to this will have implications for both marketing practice and theory.
This paper will explore the etymology of kitsch, tracking it to current use. Its historical
use, combined with changes in our society, will help to anchor the current usage with its original
definition. As the current societal place for kitsch is defined, the marketing and theoretical
implications will become clear. Recommendations will be given for both marketing researchers
and practitioners.
ETYMOLOGY
It is believed the word kitsch comes from an adaptation of the German verb verkitschen
“to churn out cheaply”. It came into use during the period 1860-1880 when German artists would
turn out formulaic paintings to sell to tourists.
The first publication regarding kitsch was a 1925 pamphlet, Der Kitsch by Fritz Karpen.
It exemplified the use of kitsch in art criticism and the contempt for nouveau riche at the time.
To best understand the origin of the word, one should recall the consumer environment of
the Industrial Revolution. For the first time, manufactured goods were widely available. This

Purinton The Joy of Kitsch
meant products of all levels of quality. It also meant the rise of the bourgeoisie, those made
newly rich by the new economy.
Manufactured items made it easier for consumers to emulate classes higher than their
own. Ironically, to the higher classes, many of these objects were inexpensive and inferior,
making them appear lower class. When the product is accepted by the owner as “higher class”
than the quality warrants, it is known as “kitsch”.
All agree that kitsch is derivative of higher class items, uses formulas as replacement for
creativity, and uses stock motifs (examples include gold embellishments, angels, fleur de lis,
rhinestones, and many, many more). It has been considered aesthetic corruption.
A kitsch item must have been taken seriously (being considered high class), at least at
one time, in order to be kitsch. Kitsch is inadvertent. The purchaser believes the object endows
him with an air of richness, elegance or sophistication (Brown 1975). It is rarely frivolous.
Most of what we think of as kitsch were originally decorative pieces of another era. The
leg lamp in the Christmas Story movie was a decorative item in the 1950s (perhaps of
questionable taste even then but that is beyond the scope of this paper). Today, it is a joke. It is
also glorified as being a joke and instructions to make or purchase one‟s own can be found on
numerous web sites.
The concept of kitsch is steeped in Victorian snobbery and the basis that high class is
better than low class. This included social class as well as refinement or taste. This judgment
coincided with the emergence of the middle class and nouveau riche. The middle class did not
know what to do in their new role in society while the upper class, in turn, did not know what to
do with the new middle class, a heretofore unknown entity. Many in the middle class dealt with
this uncertainty by emulating the upper class, a concept seconded by Veblen. But in actuality,
they purchased cheap imitations which reinforce the appearance of the (former) lower social
class. Authors have noted several time periods for this. Broch (1933) discusses the Industrial
Revolution, Binkley (2000), the 1920s, and Hines (1986) the late 1950s.
“If you‟re a snob, kitsch is the stuff the neighbors collect, not the lovely things
that add to the joy and richness of living in your gracious home.” (Brown 1975)
But, there is also the outsider view, the perception that kitsch is a way of poking fun at
those who take it seriously. While we use the word kitsch to include the use of objects in an
ironic, self-knowing way it cannot be (Linstead 2002). Kitsch must be taken at face value,
considered by some to be high class items, in order to be kitsch. What we are really describing is
irony and the more extreme camp. Camp “exaggerates the staging of kitsch and brings it into
larger-than-life focus (Linstead 2002. p. 661).
An example from the 1950s could be seen in a Magnavox ad, “Free! Masterpiece replica
statue with any purchase of a new Philco solid-state stereo” That statue might have been of
praying hands, a Madonna, the head of JFK, or an eagle. To some it was art. To others it was
kitsch. Today, any and all of these items would show up in a collector's book and command a
high price.
Social Climate
While ever present, there have been three major periods of kitsch in U.S. history resulting
in a glut of consumer goods. This occurred first during the Industrial Revolution. The second

was around the 1920s with products made to look like late 19th century statues, ceramics,
paintings and other trappings of the high class, Victorian interior. x
The third big wave came in the 1950s and 60s with the surge of consumerism and
availability of post war manufactured goods. In post World War II America, there were many
changes in the middle class. More and more people were more and more prosperous. More
people able to own their own homes and consumer goods were more available and affordable,
especially plastic. (Note that a plastic item is not necessarily kitsch. If the plastic is made to look
like wood, and fails, it is kitsch. If the plastic is made to look like plastic [as was much of the
style in the late 50s and early 60s] it is just plastic.)
Let us examine the concept of taste and judgment to see where kitsch fits. Then, the
current use of kitsch will be discussed.
THE JOY OF JUDGMENT

Opinions of the universality of taste vary. The Latin term, de gustibus non est
disputandum means there is no dispute about taste. Kant also believed that aesthetic judgments
have universal validity. But both of these quotes were made before the Industrial Revolution, the
rise of the bourgeoisie, and the common use of plastic.
David Hume, an18th century philosopher, said, “beauty is not equally inherent in things,
but exists in the eye of the beholder”. And who wasn‟t raised with the adage, “One man's meat is
another man's poison”?
In North American society, the superficial belief is that there is no class hierarchy.
However, there is also acceptance that high and low cultures have more in common than
originally thought (Binkley 2000). This would imply that there is no such thing as kitsch, but that
it is a distinctive style. (This argument seems circular and so, we will accept that kitsch exists but
may be defined differently than the original condescension.)
Kitsch is “profound narcissism” for “a designer to insert oneself into a historical or

otherwise significant moment” (Engle 2007). It is always counterfeiting something, always
inauthentic. The OED calls it “worthless pretentiousness”.
Art Criticism
The origin of the use of kitsch in art criticism comes as no surprise. The word was
coined in response to “bad art”. Art criticism has a long history of assuming its own mantle of
superiority. This began when the church dictated the content and distribution of the art itself.
But the criticism continues. Bordieu (1984 [translation]) and later, Dorfles (1984) are considered
the two seminal works on taste both with strong opinions about the worthlessness of kitsch. For
example, Dorfles says that Superman is “idiotic”. But, does not an icon have value, if only as a
cultural symbol?
Joe Queenan‟s (1997) book, Red Lobster, White Trash and Blue Lagoon, about common
culture was 188 pages of jubilant judgment. He had grown bored of his elite subculture and
desired to delve into another social class. This required him to “furlough that part of his brain
that have long revered rare, precious, and beautiful, and the instead zero in on the hopelessly
plebian”. Of his experience, he writes, “I gradually realized that mainstream American culture
was infinitely more idiotic than I ever expected.” (Queenan, 1997, p.9)

Upper class judgment

Before discussing social classes, it should be noted that the author uses seven classes.
Upper and lower upper class (old and new money, respectively); three middle classes (the lower
being “blue collar” working class) and two lower classes (the lower being homeless, destitute
and/or incarcerated) (Kotler 1988). This is important because this categorization delineates
professional and working class rather than aggregating them as “middle class”. It also does not
refer to working class as “lower class” in the manner of some other scholars.
In the grand tradition of marketing, a few concepts from sociology are borrowed. The
first is that when there is no legal barrier among classes, such as in democracy, the social
hierarchy must be maintained somehow (Lawler 2005). The second is that the upper classes have
the social power to define taste.
Victorian Society was quite fond of judging other classes and finding them lacking.
Judgment of others often results in an impression of firmer social barriers. Baudelaire once
remarked, “what is so intoxicating about bad taste is the aristocratic pleasure of giving offense.”
Kitsch provides an opportunity to feel superior that there are people out there who take it
seriously and without irony. From one of the premier purveyors of bad taste films, John Waters
comments, “In order to acquire bad taste, one must first have very, very good taste” (page 12).
Middle class judgment

There are three middle classes. The upper middle includes successful professional and
leaders. These are college graduates who have achieved the equivalent of middle management.
They value quality and “high culture”. Often, they have moved up from the middle middle class.
This, combined with the desire for quality will make social comparisons common and the desire
to “win” them strong.
The middle middle are average paying white and higher paying blue collar workers
interested in the “better life”. They will seek out houses on the “better side of town”, keep up
with trends and spend money on education. “Better” implies judgment, that something else has
been found lacking.
The lower middle is the working class. These are blue collar workers. The desire for
upward social mobility is prevalent in the upper and middle middle classes and less common
among the lower middle class. Social comparisons and judgment is much less common here.
KITSCH TODAY
While kitsch certainly exists today in its original definition, that is not the current
meaning of the word. Today, kitsch is nostalgic sentimental, reassuring and fun.
Consumers in the 1945 to 1965 era are predominantly elderly today. At the same time,
those people who were children in at the time are currently middle-aged. The combination of the
sleeper effect and the fact that kitsch is known for being nostalgic endear it to this population.
The sleeper effect states that over time, we lose the emotional impact and retain the memory.
Therefore with products from one's childhood, one remembers them but not necessarily that one
did not like them.
Binkley (2000) contends that kitsch is a style on its own celebrating repetition,
conventionality, banality and sentimentality. Why would one choose banality over creativity?
Modern society contains a copiousness of consumer choices, ethical outlooks, life plans, and sets

of morality. All of these choices undermine security. Where there is too much creative freedom
it is unsettling. Creative freedom brings risk and danger. Too many consumer choices brings risk
and exhaustion (Dholakia 1995). We are removed from what is comfortable, safe and secure.
Kitsch is reassuring. It simplifies and sentimentalizes. It is familiar. It repeats common

themes in society. Remember, its original purpose was to provide a level of comfort to a social
group in unfamiliar territory.
Kitsch reduces all the complexity, desperation and paradox of human experience
to simple sentiment. (Binkley 2000, p. 145)
Where the avant-garde seeks new ways of expressing the inexpressible, kitsch
has as its objective precisely the opposite – new ways of expressing that which
has already been expressed so many times that it is instantly recognizable.
(Linstead, 2002, p 658).
Kitsch attracts attention, an almost childlike fascination with its gaudy colors, unusual
shapes, lack of sophistication, and nostalgia. It repels as it clashes with the authority of good
taste. It feeds the appetite for the “sick, the sentimental, the sensational, and the supercolossal”
(Brown 1975).
Think of bad taste as a kind of warehouse for fashion, whose time has run out,
decor that has disappeared, novelties that make you wince, and celebrities past
their best-before date. When this merchandise has been lying round gathering
dust for long enough, it appears to acquire a new aura. The previously,
unmitigated hideousness starts to suddenly shine with a new appeal and is
recharged with new energy. What was previously just awfulness starts to look
like naughty fun and we all want some. (Ward, 1997,p. 7)
The essence of today‟s usage of kitch is cultural recycling, the idea of reinventing
cultural mores to fit the current environment and society. Kitsch allows us to recreate the world
as we would like it to be (Olalquiaga 1998). With kitsch, this could be “thumbing the nose at the
notion of good taste, social rules, and mores” (Brown 1975, p. 18).
Kitsch has become, instead of the upper-class making fun of the lower-class, the middle
classes making fun of themselves being made fun of. This is the notion that, “If we are going to
be judged and found lacking, we might as well flaunt our bad taste.” Gillian and Young (2000)
refer to this as inverted snobbery. As Brown (1975) put it “After all, if kitsch isn‟t a pleasure.
Why bother?”
How is the word currently used by typical consumers? In one popular website discussion
the question was asked, “what is kitsch?” Some visitors‟ answers were:
“so ugly it‟s beautiful”

“…abundant at the time of its [sic] popularity but fell out of style”
“kitsch will often take time to „mature‟”
“perverse charm”
“Things that are just awful today will become desirable for their awfulness in two or
three decades.”
“that delicious ironic reverse – where it is SO bad it‟s good.”

“unapologetically aimed at the common mindset of the culture” (flickr.com)
Many of these reinforce the idea of the playfulness and attraction of objects today that
were taken seriously at one time. Or, they speak of the attraction/ repellent role of kitsch. It is
ugly enough to be considered “cute”.
CONCLUSIONS
Theoretical Implications
While those who live in a democracy like to believe in a “classless society” or at least
one with unlimited mobility, they will construct their own social boundaries and limitations.
Here, the discussion has shown an example of a genre of products that were once judged to be
tasteless that now are given significance and validity and enjoyed for their tastelessness.
The machinations of the social classes requires greater understanding in order to delve
into this phenomenon further. Exactly how do these judgments take place in different social
classes? While these assessments have been hypothesized here, they need empirical testing.
Future research into consumer judgments and taste can uncover a wealth of marketing
knowledge. Just when does one use a marketing campaign of social one-upmanship and when
would that backfire?
Marketing Implications
While the theoretical implications are interesting, it is the marketing implications that are
of immediate importance. How kitsch is portrayed by the marketer and perceived by the target
market can be the difference between getting attention or alienating the customer.
As with any marketing, knowledge of the target market is crucial. With the use of kitsch,
in particular, and taste, in general, social class of the target market will play a greater role than
often considered. If the target market belongs to one of the middle classes, further delineation is
necessary.
If the target market belongs to the middle middle or upper middle, the use of kitsch is
appropriate, especially as nostalgia. It can be used to engender a feeling of “being in on the
joke”. This requires a use of irony that is not too subtle. Do not leave too much interpretation up
to the audience.
If the target market is exclusively middle middle class, use kitsch for nostalgia only.
The lower middle-class has experienced being made fun of all too often and will not
appreciate it even in fun. Furthermore, do not take the chance that they will not draw the right
conclusion.
For the upper classes and lower classes, do not use kitsch. For the upper class the visual
will probably turn away the audience before the copy can make the point. The multi-level
judgment of kitsch is not appropriate for lower class.
Conclusion
This paper has examined the etymology of kitsch, its history and its current usage.
Explanation has been made of why the current usage is so different from the original definition.
Some research questions that have been raised include:

How do consumers judge good taste?
When is bad taste considered acceptable?
How long does it take for a tasteless product to take on nostalgic charm?
Was the Edsel kitsch?
Kitsch, in this paper, is defined as an object that was once made in imitation of something
tasteful. Its attempt to emulate high class failed making the object low class and tasteless. When
enough time passes, especially when people to remember the objects from their childhoods, the
object passes from the reviled tasteless to the fond kitsch. And, in the words of one on-line
discussant, “of course, seashells covered in glitter or googly eyes never hurt either” (flickr.com).
REFERENCES
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Bordieu, Pierre (1984), Distinction: A Social Critique of the Judgment of Taste, translated by
Richard Nice, Cambridge: Harvard University Press.
Broch, Hermann "Kitsch" (1933) and "Notes on the Problem of Kitsch" (1950), In Kitsch: The
World of Bad Taste, edited by Gillo Dorfles, New York: Universe Books, 1968.
Brown, Curtis F. (1975), Star-Spangled Kitsch: An Astounding And Tastelessly Illustrated

Exploration of The Bawdy, Gaudy, Shoddy Mass-Art Culture In This Great Land of Ours,
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Brown, Robert (1999), "Imputing Vulgarity", Journal of Value Inquiry, 33, no. 2.
Dorfles, Gillo (1968) Kitsch: The World of Bad Taste, New York: Universe Books.
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http://www.flickr.com/groups/kitsch_itch/discuss/72157619357346420/
Gillian, Leslie and Dave Young (2000), Kitsch Deluxe, London: Mitchell Beasley Publishers.
Hine, Thomas (1986), Populuxe, New York : Knopf.
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Olalquiaga, Celeste (1998), The Artificial Kingdom : a Treasury of the Kitsch Experience, New
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Ward, Peter (1997), Fantastic Plastic: The Kitsch Collector’s Guide, Edison, NJ: Chartwell
Books.

CONSUMER PERCEPTION OF ONLINE
FINANCIAL TRANSACTIONS:BRAZIL VS THE
UNITED STATES
Pyatt, Edward J.
Hampton University
edward.pyatt@hamptonu.edu
ABSTRACT
The internet makes it possible for financial transactions to be completed online at a
fraction of the cost of paper transactions. Such transactions have particular appeal to
businesses. Firms can improve their bottom line by shifting more of their transactions
online. Such of shift would require that consumers embrace online transactions and use
them extensively. In order for this to occur, consumers must view online transactions as
a viable substitution for paper transactions and must feel comfortable making financial
transactions online. This study seeks to ascertain what consumers in Brazil and the
United States actually think about utilizing the internet for financial transactions. It also
seeks to determine if there is a significant difference between consumer perception in the
two countries. The study is focused on perception rather than the actual state of the art
that exists for making financial transactions online. Consumer perception is a critical
element. If individuals do not feel comfortable with the internet based transactions then
they are not likely to make extensive use of them. The results show that consumers in
both countries still have serious reservations about using the internet for financial
transactions. The results imply that the business community has work to do if it is to reap
the full cost savings potential inherent in the internet.
INTRODUCTION
Commercial establishments in the United States offer a variety of online financial services to
consumers. Commercial banks and other depository institutions offer an array of online services
that have as a goal, inducing consumers to shift more of their financial transactions to electronic
means. Brokerage firms, insurance companies, and mutual funds are also trying to push more
consumer activity online. Online transactions are less expensive for commercial establishments
than paper transactions. Studies by the consultants Booz, Allen and Hamilton and by Lehman
Brothers found that in banks transactions involving a teller cost $1.07, ATM transactions cost
27¢, and a web transaction costs little more than 1¢ [Willis 2004].
Brazil, South America’s largest country, has also been quick to embrace electronic payment
systems. Banks in Brazil started investing in electronic banking components back in the late
1970’s. One reason for Brazilian banks’ early embrace of electronic payments systems was the
country’s persistent currency crises. In a twenty year period inflation destroyed three Brazilian

Pyatt On Line Financial Transactions Brazil Vs USA
currencies – the cruzerio, the cruzada, and the new cruzada. The electronic payments, while not
providing complete protection, did allow entities to make payments quickly without having to
deal with hordes of paper money that had the potential to be replaced.
A serious impediment for commercial establishments in this push toward more online financial
transactions has been the reaction of consumers. In 1998, checks accounted for 75% of all non-
cash transactions in the U.S. and credit card payments for 19% [Humphrey and Pulley 1998].
Improvements have been made. In 2004, for the first time, the number of electronic transactions
exceeded those made by paper. Debit card transactions led the growth in electronic payments
[Saranow 2004]. Americans still write almost three times the number of checks per person than is
the practice in Canada, France, or the U.K., which have the highest check use outside the U.S.
[Humphrey, Kim and Vale 2001]. Europe and Japan primarily favor the “giro.” The long
established giro is a centralized payment system usually operated by the post office and it makes
both paper and electronic transfer payments. It is roughly equivalent to the automated
clearinghouse (ACH) in the U.S. About 60% of Europe’s non-cash payments are made by giro,
rising to almost 90% in Japan [Wright 2003].
THE PROMISE OF THE INTERNET

The internet offers an intriguing prospect for improving services and lowering cost. Nearly every
bank now offers some services online [Stefanadis 2002]. There are many variants in the form and
nature of the online services offered by banks [Moody’s 2001]. Some online banking services are
“bundled” with popular software, such as Quicken or Microsoft Money, or offered through
internet service providers such as America Online [Yakal 1999]. Insurance companies, utility
companies, credit card companies, and brokerage firms all offer online financial transactions
options to their customers. The emergence of NASDAQ as a major market and the merger of the
New York Stock Exchange with Archipelago were driven by the increased emphasis on
electronic transfers [The Week 2006]. Firms seek to induce customers to use the internet to
transfer funds, pay bills electronically, buy and sell stocks and other securities, buy insurance,
apply for and receive loans and other common financial functions [Jullien 2005]. There is the
hope of offering even more services on the net such as obtaining cash by downloading it through
a computer using a special “smart card” and card reader. The smart card would be equipped with
a small computer processing unit that could process, store and share information [Xie and Shugan
2001]. Commercial establishments and financial institutions in Brazil have also made strides
toward moving more transactions online. The range of online financial options currently offered
in Brazil is not as extensive as those offered in the U.S. Nevertheless, they are extensive.
One of the strongest forces driving firms to the internet is the prospect of utilizing the internet to
build the infrastructure and systems to run as extremely low cost and efficient operation
[Massimb and Phelps 1994]. Electronic payments are faster, easier, and cheaper for shoppers,
merchants, and financial institutions alike. Banks, for example, have to transport an estimated
101 million checks, weighing 163 tons, each day. Clearing an E-payment costs banks only about
2 cents [Clark 2004].
Also, in the U.S., a group of internet-only banks have come into existence and are attempting to
revolutionize the way consumers do their banking [Alsop 1999]. Consumers cannot deposit or
withdraw cash over the net. However, the virtual banks can endeavor to build a healthy business
now in preparation for a huge business once smart cards do take hold [McAndrews 1997].

CONSUMER PERCEPTION
Online transactions have the potential to provide lots of options, conveniences, and savings for
nearly all firms [Pascoe 2004]. But how do consumers really view online financial
transactions? How do they feel about making use of the online financial transactions options
currently available? The benefits of using the internet to make financial transactions will depend,
in part, on how extensively the online services are used. This is referred to in the economics
literature as the “network effects.” The value of the network rises as the number of participants
increases. If only a few participants are connected to a particular online financial services
network, potential new participants might not view the service as having much utility. If the
network is extensive and offers virtually unlimited services, consumers attach high utility to it
[Economides 1996]. This study seeks to ascertain how consumers in the U.S. and Brazil perceive
and use online financial transactions. Moreover, the study seeks to ascertain the differences
between consumers in the two countries with respect to their perception of online financial
transactions. A survey is used to query consumers in both Brazil and the U.S. about their
perceptions. The same survey is administered in both countries.
Respondents in both countries are segmented into two groups. Respondents between the ages 18
and 30 are grouped into a young adult group and respondents aged 31 and above are grouped into
a mature adult group. Differences in and between the two countries and between the two groups
within each country are noted. The study has important implications. It may provide clues as to
how firms can influence consumer perception and induce more people to conduct more financial
transactions online. The study may also reveal if Brazil or the U.S. has done a better job at
directing consumer transactions online. If so, there may be things that one country can learn from
the other.
SURVEY PROCEDURES
Respondents in the U.S. and Brazil were given a survey containing 16, questions, including an
optional open-ended question. The open-ended question allowed respondents to write a short
essay detailing their opinion of on-line financial transactions. The survey was administered to
100 persons in the U.S. and to 90 in Brazil. Fifty of the U.S. respondents were in the age range of
18 to 30 and sixty in Brazil were in this age range. Fifty of the U.S. respondents were age 31 and
above and thirty of the Brazil respondents were age 31 and above. The respondents were
residents of the east coast of the U.S.A. and the eastern area of Brazil. The Brazil respondents
included persons from the country’s three largest cities, Sao Paulo, Rio de Janeiro, and Salvador.
They included college professors, secretaries, delivery persons, nurses, graduate students,
undergraduate students, sales clerks, and others. A Kolmogorov-Smirnov test is used to analyze
the survey responses. Kolmogorov-Smirnov is a test if goodness of fit. It is concerned with the
degree of agreement between the distribution of a set of sample values (observed scores) and
some specified theoretical distribution. It determines whether the scores in the sample can
reasonably be thought to have come from a population having the theoretical distribution.
The test involves specifying the cumulative frequency distribution which would occur under the
theoretical distribution and comparing that with the observed cumulative frequency distribution.
The theoretical distribution represents what would be expected under Ho. The point at which the
theoretical and observed distributions show the greatest divergence is determined. Reference to
the sampling distribution indicates whether such a large divergence is likely on the basis of
chance [SPSS 1998]. Two null hypotheses were tested. In one instance it is
hypothesized that consumers are indifferent to using online financial services. This option is
included because reality can often be more complex than “yes” or “no”. Also examined is the

hypothesis that a majority of consumers exhibit a preference for using online financial
transactions. The survey results were also tabulated separately for respondents who were
between 18 and 30 years of age as compared to those who were age 31 and older. The former
group is designated as “Young Adult” and the latter group is designated as “Mature Adult”.
SURVEY RESULTS
The survey revealed a number of interesting findings. This paper analyzes the responses to a few
key questions on the survey. Responses from the survey questions were tabulated as:
fy = number of “yes” responses on an item
fn = number of “no” responses on an item
fm = number of “maybe” responses on an item
S (x) = cumulative distribution of observed responses
F (x) = theoretical cumulative distribution under Ho
D = maximum | F (x) - S (x) |
The sampling distribution of D under Ho is known. The Kolmogorov-Smirnov test
focuses on the largest of the deviations. The probability of occurrence of a D ≥ maximum
| F (x) – S (x) | can be compared with the probability of occurrence of D under the theoretical
distribution.
In the test where the hypothesis that a majority of consumers exhibit a preference for online
financial transactions is examined, the “no” and “maybe” responses are collapsed into a single
category labeled “Other”. Table 1 presents the results for U.S. consumers and Table 2 for
Brazilian consumers. The top part of the tables presents the results for the hypothesis that
consumers are indifferent to using online financial transactions. If they are indifferent it is
hypothesized that a fairly equal proportion of the responses would fall into the “yes,” “maybe,”
and “no” categories. For the U.S. group all of the queries produce results that are significantly
different from the hypothesized response. Those related to using the internet for credit card
purchases and for buying stocks and bonds online are highly significant. Overall, the U.S. results
do not provide evidence to strongly and consistently refute the hypothesis that consumers are
indifferent to utilizing online financial services. For the Brazil group, only two of the queries
produced responses near the hypothesized outcome. One of the queries produced results that
were significantly different from the hypothesized outcome. This related to using the internet for
credit card purchases. Overall, the results do not provide evidence to strongly and consistently
refute the hypothesis that Brazilian consumers are indifferent to using the internet for financial
transactions.
The bottom part of Tables 1 and 2 presents results for the hypothesis that a majority of consumers
feel comfortable with online financial transactions. It is hypothesized that if a majority have a
positive perception of online financial functions, then at least 51% of the responses would fall
into the “yes” category on each of the four questions. For the U.S. group the results from all four
questions indicate a consistent and significant difference from the hypothesized result. For the
Brazilians the results from all but one of the questions indicate a consistent and significant
difference from the hypothesized results. The survey results do not
provide support for the hypothesis that a majority of Brazilian and U.S. consumers have a
favorable perception of online financial transactions.
The results for young adults, those between 18 and 30 are presented in Tables 3 and 4. Curiously
enough, in both countries they prove to be a bit more pessimistic about online financial
transactions than did older adults. Three out of four responses on the indifference hypothesis
proved significant in both Brazil and the U.S. But all four of the responses showed a wide

divergence from the assumption that a majority of young adults had a favorable perception on
online financial transactions. What might account for this divergence between the perception of
young adults and older adults? Well, one possibility is that young adults tend to use computers
and the internet more than older adults. Hence, they may be more familiar with both the
internet’s potential and its dangers.
The survey responses also revealed a curious phenomena about the fraud and loss concerns of
Brazilians. If there was absolutely no possibility of fraud, then an overwhelming majority of
Brazilians would favor online transactions. Brazilians do not appear to have confidence in their
banks to protect them from loss in the event of fraud. The reason for this lack of confidence may
be historical. Many Brazilians suffered losses when the country changed currency and there have
been three currency changes in the past thirty years.
Respondents also had the option of writing a short passage to express their opinion about
online financial transactions. Most of the comments were in the vein: “it is still in the early
developmental phases and too much of a risk;” “a good idea but too many risks involved;”
“…comfortable with my present arrangement …don’t see overwhelming benefits to make me
change;” and “if security gets better either by private industry or government intervention, I will
be all for online payments.”

TABLE 1: EXPRESSED AND HYPOTHETICAL PREFERENCES OF U.S. CONSUMERS FOR
ON-LINE FINANCIAL TRANSACTIONS
Question Feel comfortable using the Think Internet has Think Internet has Wo
Internet to pay bills via sufficient security features sufficient features to use it ban
online transfer of funds? to use it for purchasing for security (stocks, bonds, off
items with credit cards? etc.) purchases?
sponse Yes Maybe No Yes Maybe No Yes Maybe No Yes Maybe N
f 196 240 417 134 299 420 127 35 691 158 401 29
S(x) .230 .511 1.000 .157 .507 1.000 .149 .190 1.000 .185 .655 1.0
F(x) .333 .667 1.000 .333 .667 1.000 .333 .667 1.000 .333 .667 1.0
D .103** .156** 0 .176** .160** 0 .184** .477** 0 .148** .012 0
Response Yes Other Yes Other Yes Other Y

F 196 657 134 719 127 726 1
S(x) .230 1.000 .157 1.000 .149 1.000 .1
F(x) .510 1.000 .510 1.000 .510 1.000 .

D .280** 0 .353** 0 .361** 0 .3
N = 853 * Significant at .05 level ** Significant at .01
level

TABLE 2: EXPRESSED AND HYPOTHETICAL PREFERENCES OF BRAZILIAN CONSUMERS FOR
ON-LINE FINANCIAL SERVICES
Feel comfortable using the Would you use the Internet Do you think the Internet
Query
Internet to pay bills via to purchase items online has sufficient features to
online transfer of funds? with your credit card? use it for securities
(stocks, bonds, etc.)
transactions?
esponse Yes Maybe No Yes Maybe No Yes Maybe No Yes Maybe No

f 31 13 16 18 12 30 11 23 26 12 17 31
S(x) .517 .734 1.000 .300 .500 1.000 .183 .567 1.000 .200 .483 1.00
F(x) .333 .667 1.000 .333 .667 1.000 .333 .667 1.000 .333 .667 1.00
D .184 .067 0 .033 .167 0 .150 .100 0 .133 .184* 0
Response Yes Other Yes Other Yes Other

f 31 29 18 42 11 49
S(x) .517 1.000 .300 1.000 .183 1.000
F(x) .510 1.000 .510 1.000 .510 1.000
D .007 0 .210** 0 .327** 0 .3
N = 60 * Significant at .05 level ** Significant at .01 level

TABLE 3: EXPRESSED AND HYPOTHETICAL PREFERENCES OF U.S. CONSUMER
ON-LINE FINANCIAL TRANSACTIONS - MATURE ADULTS
Question Feel comfortable using Think Internet has Think Internet has W
the Internet to pay bills sufficient security features sufficient security ba
via online transfer of to use it for purchasing features to use it for off
funds? items with credit cards? financial assets(stock,
bonds, etc.) purchases?
Response Yes Maybe No Yes Maybe No Yes Maybe No Y

F 142 102 174 86 141 191 123 31 264 1
S(x) .340 .584 1.00 .206 .543 1.00 .294 .368 1.000 .2
F(x) .333 .667 1.00 .333 .667 1.00 .333 .667 1.00 .3
D .007 .083** 0 .127** .124** 0 .039 .299** 0 .0
Response Yes Other Yes Other Yes Other Ye

F 142 276 86 332 123 38 11
S(x) .340 1.000 .206 1.000 .294 1.000 .28
F(x) .510 1.000 .510 1.000 .510 1.000 .51
D .170** 0 .304** 0 .216** 0 .225
N = 418 ** Significant at .01 level *Significant at .05
level

TABLE 4: EXPRESSED AND HYPOTHETICAL PREFERENCES OF BRAZILIAN CONSUM
ON-LINE FINANCIAL SERVICES - MATURE ADULTS
Question Feel comfortable using the Would you use the Would you use Internet D
Internet to pay bills via Internet to purchase to invest in stocks, bonds, In
online transfer of funds? items online with your and other securities? s
credit card?
f 16 5 9 10 6 14 5 12 13 4
S(x) .533 .700 1.000 .333 .533 1.000 .167 .567 1.000 .1
F(x) .333 .667 1.000 .333 .667 1.000 .333 .667 1.000 .3
D .200 .033 0 0 .134 0 .166 .100 0 .20
F 16 14 10 20 5 15
S(x) .533 1.000 .333 1.000 .167 1.000 .
F(x) .510 1.000 .510 1.000 .510 1.000 .
D .023 0 .177 0 .343** 0 .3
N = 30 Age = 31 or more * Significant at .20 level
**Significant at .01 level

TABLE 5: EXPRESSED AND HYPOTHETICAL PREFERENCES OF U.S. CONSUMER
ON-LINE FINANCIAL TRANSACTIONS - YOUNG ADULTS
Question Feel comfortable using the Think Internet has Think Internet has W
Internet to pay bills via sufficient security features sufficient security features on
online transfer of funds? to use it for purchasing to use it for security if
items with credit cards? purchases?
Response
Yes Maybe No Yes Maybe No Yes Maybe No Y
F 72 132 231 63 142 230 56 68 311 1
S(x) .166 .469 1.000 .145 .471 1.00 .129 .285 1.000 .2
F(x) .333 .667 1.00 .333 .667 1.000 .333 .667 1.000 .3
D .167** .198** 0 .188** .196** 0 .204** .382** 0 .0

F 72 363 63 372 56 379 1
S(x) .166 1.000 .166 1.000 .129 1.000 .2
F(x) .510 1.000 .510 1.000 .510 1.000 .5
D .344** 0 .344** 0 .381** 0 .23
N = 435 ** Significant at .01 level
TABLE 6: EXPRESSED AND HYPOTHETICAL PREFERENCES OF BRAZILIAN CONSUM

ON-LINE BANKING SERVICES - YOUNG ADULTS
Question Feel comfortable using Would you use the Internet Do you think the Internet D
the Internet to pay bills to purchase items with your has sufficient features to In
via online transfer of credit card? use it for securities (stocks, se
funds? bonds, etc.) transactions? ov

f 15 8 7 8 6 16 6 11 13
S(x) .500 .767 1.000 .267 .467 1.000 .200 .567 1.000 .
F(x) .333 .667 1.000 .333 .667 1.000 .333 .667 1.000 .
D .167 .100 0 .066 .200 0 .133 .100 0 .
Response Yes Other Yes Other Yes Other

F 15 15 8 22 6 24
S(x) 0500 1.000 .267 1.000 .200 1.000 .
F(x) .510 1.000 .510 1.000 .510 1.000 .
D .010 0 .243* 0 .310** 0 .2
N = 30 Age = l8 to 30 *Significant at .05 level
** Significant at .01 level

CONCLUSIONS
The results of the Kolmogorov-Smirnov analysis provide support for the notion that consumers in both
the U.S. and Brazil are, at best, indifferent to using online financial transactions and, at worst, wary of
using the internet for making financial transactions. The survey reveals an overwhelming concern among
consumers in both countries about the safety and privacy of online financial transactions. Consumers are
also concerned about identity theft, a crime that has increased in tandem with internet use.
Research conducted a the University of California’s Berkeley Center for Law and Technology [Hoofnagle
2008] identified which U.S. banks had the highest reported incidences of identity theft claims during a
three month period in 2006. Bank of America, JP Morgan – Chase, and Capital One led the list. HSBC
and Wachovia Bank had lower incidences. The study implied that banks should be required to disclose
their track records with identity theft. It suggested that banks should report such basic statistics as the
number of attempts at identity theft, the number of successful attempts, the form of theft attempted, and
the products compromised (e.g. checking accounts, credit cards).
These concerns suggest that firms, must do two things if they are to achieve significant market
penetration with their online financial transactions. First, they must work to assure consumers that online
transactions are indeed safe and secure. New legislation and perhaps some form of regulation may be
needed to assure this. Second, firms must commit to an intensive campaign of educating the public about
the safety features of their online systems. At present much of the information that the public has and/or
receives about online financial transactions is by word of mouth. Few firms are making the effort to
provide the public with the details that could potentially make a difference in the way consumers perceive
online financial transactions. This is a mistake because it is consumers’ perception of online financial
transactions that will determine the extent to which they use it. Americans and Brazilians are not alone in
their concerns about online financial transactions. A study in Britain, commissioned by the internet firm
Symantec, found that two-thirds of the British think that online transactions puts them at risk of falling
victim to fraud. The report lays the blame for this squarely at the door of online businesses, which are not
giving customers the “confidence boost” they need [www.Symantec.com and Web User 2007].
A study by Forrester Research discovered that nineteen percent of affluent small business owners in the
U.S. declined to apply for a credit product online because of concerns about security and data privacy.
The study also found that victims of identity theft are more concerned than others about online theft and
fraud, and they curb their behaviors more than others due to privacy concerns. Yet these identity theft
victims tend to have higher incomes and more online experience. Hence these behavioral changes are
more pronounced among the types of customers
that financial firms most want to target [Penn and Gillespie 2005]. In some cases consumers just desire a
personal touch. Anderson [2007] cites the example of consumers being willing to use an online bank
portal to obtain a car loan but not to finance a house. The percentage of households owning computers is
increasing [Jarunee 2007] and consumers may respond more favorably than expected to a technology that
makes executing financial transactions very easy and more convenient provided they are convinced the
system is safe.
Perhaps the best way to overcome the reluctance of consumers is to be patient and to give them
more time to become informed and grow confident. As ordinary customers see more and more
people use the internet for making financial transactions with no apparent problems and as firms
step up the pace of disseminating information about their online security procedures, consumer
confidence should grow. More customers may then be drawn into making online financial
transactions thereby assuring that its potentials are realized.

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THE DEBT AND DIVIDEND DECISIONS FOR NON-
STOCK COOPERATIVES:
PECKING ORDER VS. TRADE-OFF
Smiy, David P.
Longwood University
david.smiy@live.longwood.edu
Bacon, Frank W.
Longwood University
baconfw@longwood.edu
ABSTRACT
This study tests the trade-off and pecking order theories about the debt and dividend capital
decisions for non-stock electric cooperatives. Decisions to finance investments with debt or equity
are important because they determine the firm’s capital structure. With the trade-off theory there
is an optimal balance of debt and equity, and the firm uses debt until it is more expensive than
issuing equity thus reaching the firm’s optimal capital structure. Meanwhile, the pecking order
theorem contends the firm should use internal funds first, then debt, and equity as a last resort.
Both theories have the same fundamentals for the payout of dividends. More profitable firms with
less risk and debt should pay out more dividends. This study examines non-stock firms, whose
dividend is referred to as a capital credit. Capital credits or dividends are the accumulated
profits (or retained earnings) the not-for-profit cooperatives payout to their owners who are also
the firms customers. Considerable debate in Congress over health care reform centers on using
the “cooperative model” to extend health insurance to millions of Americans. This study
analyzes rural electric cooperatives (RECs), firms identical to the “cooperative model” being
considered by Congress in the health care debate. Financial data from 807 RECs is examined in
an OLS regression analysis by testing the effects of selected financial variables on the debt and
dividend decisions. For the debt decision, results support the pecking order theory but are mixed
for the trade-off hypothesis. Results on the dividend decision are mixed for both theorems.
INTRODUCTION
This research study examines the pecking order and trade-off theories about debt and dividend
decisions for non-stock cooperatives. Do more profitable firms with more investment
opportunities have more financial leverage or less? Also how do these factors affect the non-stock
companies’ dividend payouts referred to as capital credits? Capital credits are the equivalent to
dividends for non-stock companies. Unlike previous stock company studies, this study will test
these theories and compare results from a large sample of non-stock companies.
A firm’s decision concerning the level of debt used to finance investments is important since the
choice between debt and equity determines the firms’ capital structure and cost of money. The
capital credit payout decision for the non-stock companies involves the choice between paying
out these credits to its owners/users or reinvesting these funds back into the company. The
pecking order and trade-off perspectives are the two most popular theories claiming to explain a

Smiy, Bacon Debt and Dividend Decisions for Non-Stock Coops.
company’s debt decision strategy. Both theories make predictions about dividend payouts and
this study will test these predictions on non-stock firms, an extension not found in the literature.
Considerable debate in Congress over health care reform centers on using the “cooperative
model” to extend health insurance to millions of Americans. This study analyzes rural electric
cooperatives (RECs), firms identical to the “cooperative model” being considered by Congress in
the health care debate. Thus, this research on the cooperative business model offers significant
and timely implications for the health care debate.
LITERATURE REVIEW
In the pecking order theory a firm would rather use internal funds before going outside the
company for debt and equity funds. Managers prefer this approach since there would be no
external stakeholders to get approval from. First the company would use retained earnings until
there were inadequate funds to finance the investments. The firm would then go to low risk debt
before getting to high risk debt. Finally if needed the firm would turn to equity for financing and
issue new common stock.
The trade-off theory is based on the assumption that there is a balance of debt and equity
financing that will maximize stockholder wealth. Debt interest is tax-deductible which gives it an
advantage over issuing equity. Though debt has this advantage there are disadvantages to using
debt. If profitability decreases while you are using debt to finance investments there could be
problems paying back the debt obligations and potential bankruptcy risks. Eventually there comes
an optimal degree of leverage where the cost of taking on more debt is more expensive than
issuing new equity.
One theory to explain dividends is the Modigliani-Miller (MM) Dividend Irrelevancy Theorem
which claims that mathematically (without tax considerations) the investor is indifferent about
whether the firm pays out the dividend or reinvests it into the company (Bacon and Kania 2).
There are behavioral reasons why companies pay out dividends and they include imperfections of
the market (taxes and agency cost) and the fact that most investors are risk-averse and they like
the predictability of dividend payouts. Some of the disadvantages of paying out dividends are
potential tax costs, agency costs, opportunity costs of reinvestment, and legal constraints (Bacon
and Kania 2). Since the study uniquely examines non-stock firms, application and comparison of
results to capital credits should add to the body of stock company debt and dividend literature.
According to the pecking order theory, more profitable firms payout higher dividends. Also it has
been found that investments and dividend payouts are positively correlated. Firms with high
leverage and less profitable assets are less likely to pay out dividends (Fama and French 11). The
trade-off theory has similar predictions to the pecking order when it comes to dividends (Fama
and French 6). The theory suggests that number of investments and profitability correlate
positively to dividend payouts. To explain this positive correlation between dividend payout and
profitability in the trade-off model the theory cites agency problems caused by free cash flows,
and that profitable firms need the discipline of dividend payouts to control the issue (Fama and
French 13).
Both theorems have been supported in previous studies. One study found that larger firms and
firms with more fixed assets take on more debt. The same study supported the trade-off theory in
that financial leverage was negatively related to risk. In contrast to the trade-off theory, but in
support of the pecking order theory, the study found that profitability was negatively related to
financial leverage. The pecking order was also disputed in this study as growth was found to be
negatively related to leverage (Bacon and Bacon 8).

In another study, Fama and French (28) found that more profitable firms payout more dividends
and firms with more investments payout less dividends. These findings support both the trade-off
and pecking order theories. Also the same study found that larger firms payout more dividends
and take on more debt. This agrees with both theorems and the reason explained by the theorems
is that larger firms tend to be less volatile in their earnings making it easier to payoff debts and
payout dividends. In this study it was also found that more profitable companies take on less
financial leverage. This finding goes against the trade-off theory, but supports the pecking order
model. One problem found in this study is that there may be the collinearity problem with the
independent variables and how they relate to each other and leverage (Fama and French 29).
In a study about dividends it was shown that dividends payouts relate negatively to risk,
profitability, and growth. The risk and growth relations to dividends payouts match both the
models discussed. Surprisingly, this study found that profitability related negatively to dividend
payout (Bacon and Kania 9).
Both the pecking order and trade-off theory have been sustained in previous studies. More
evidence has surfaced to support the pecking order model in terms of the debt decision. As far as
dividends are concerned, firms with more investments and more leverage will be less likely to
payout dividends. Results have differed when deciding the relationship between dividend payouts
and profitability.
METHODOLGY
This study sample includes 807 non-stock companies in the electric utility industry. These non-
stock firms are known as rural electric cooperatives (RECs). They are all part of the National
Rural Electric Cooperative Association (NRECA). RECs serve more than 40 million people in
47 states (NRECA Overview). RECs mostly serve areas that are rural with low density or
consumers per mile of distribution line. The interesting thing about the cooperatives is that the
owners are the users. They are not-for-profit organizations so after the costs are paid off the
excess revenues are returned to the owners/users in the form of capital credits (dividends). The
ownership is based on how much they pay for electricity during the year. The financial data on
these firms was taken from the period of 2004-2006 and was provided by the industry’s major
banker, the Cooperative Finance Corporation.
The non-stock companies were analyzed using ordinary least squares multivariate regression
models to analyze the determinants of the debt and capital credit decision about the trade off and
pecking order theories. Hypotheses for the debt and capital credit studies are shown below. The
variables were selected from previous studies and include the following:
DEBT DECISION = f (profitability, capital credit payout, growth, size, power reliability)
The study proposes the following null and alternate hypotheses for the debt decision:
H0debt: There is no significant relationship between the debt ratio and the independent variables
listed.
H1debt: There is a significant positive relationship between the debt ratio and the independent
variables listed.
H2debt: There is a significant negative relationship between the debt ratio and the independent
variables listed.

TABLE 1: VARIABLES AND HYPOTHESIS FOR DEBT DECISION

FACTOR VARIABLES DEFINITIONS HYPOSTHESIZED
SIGN
FINANCIAL Debt as % of assets 1 – equity as % of DEPENDENT
LEVERAGE assets VARIABLE
PROFITABILITY Operating margin Operating income to PECKING ORDER (-)
per KWH sold. net sales on a per TRADE-OFF (+)
KWH sold basis
CAPITAL CREDIT Annual capital Portion of equity that PECKING ORDER (-)
PAYOUT credit retired per is being returned to TRADE-OFF (-)
total equity members as capital
credits
GROWTH Growth in KWH Current year KWH PECKING ORDER (+)
sold sales minus previous TRADE-OFF (+)
year KWH sales /
previous year KWH
sales
SIZE Total KWH sold Natural Log of Total PECKING ORDER (+)
KWH sold at Dec. 31 TRADE-OFF (+)
of reporting year
POWER System Average Natural Log of Total N/A
RELIABILITY Interruption service interruption
Duration Index for consumers in
(SAIDI) hours
CAPITIAL CREDIT DECISION = f (profitability, liquidity, growth, size, power reliability,

financial leverage)
The study proposes the following null and alternate hypotheses for the capital credit decision:
H0div: There is no significant relationship between the capital credit ratio and the independent
variables listed.
H1div: There is a significant positive relationship between the capital credit ratio and the
independent variables listed.
H2div: There is a significant negative relationship between the capital credit ratio and the
independent variables listed.
TABLE 2: VARIABLES AND HYPOTHESIS FOR CAPITAL CREDIT DECISION

FACTOR VARIABLES DEFINITIONS HYPOSTHESIZED
SIGN
CAPITAL CREDIT Annual capital Portion of equity that DEPENDENT
PAYOUT credit retired per is being returned to VARIABLE
total equity members as capital
credits
PROFITABILITY Operating margin Operating income to PECKING ORDER (+)
per KWH sold. net sales on a per TRADE-OFF (+)
KWH sold basis

LIQUIDITY Current Ratio Current assets / PECKING ORDER (-)

Current liabilities TRADE-OFF (-)
GROWTH Growth in KWH Current year KWH PECKING ORDER (-)
sold sales minus previous TRADE-OFF (-)
year KWH sales /
previous year KWH
sales
SIZE Total KWH sold Natural Log of Total PECKING ORDER (+)
KWH sold at Dec. 31 TRADE-OFF (+)
of reporting year
POWER System Average Natural Log of Total N/A
RELIABILITY Interruption service interruption
Duration Index for consumers in
(SAIDI) hours
FINANCIAL Debt as % of assets 1 – equity as % of PECKING ORDER (-)
LEVERAGE assets TRADE-OFF (-)
QUANTITATIVE RESULTS AND FINDINGS
TABLE 3: REGRESSION RESULTS FOR DEBT DECISION

FACTOR VARIABLES BETA HYPOSTHESIZED
COEFFICIENT SIGN
FINANCIAL Debt as % of assets N/A DEPENDENT
LEVERAGE VARIABLE
PROFITABILITY Operating margin -0.583015*** PECKING ORDER (-)
per KWH sold. TRADE-OFF (+)
CAPITAL CREDIT Annual capital 0.493329*** PECKING ORDER (-)
PAYOUT credit retired per TRADE-OFF (-)
total equity
GROWTH Growth in KWH 0.181302** PECKING ORDER (+)
sold TRADE-OFF (+)
SIZE Total KWH sold -0.386018 PECKING ORDER (+)
TRADE-OFF (+)
POWER System Average 0.494841 N/A
RELIABILITY Interruption
Duration Index
(SAIDI)
R square 0.172267
F statistic 27.74937
N 807
*** Significant at the 1% level

** Significant at the 5% level
* Significant at the 10% level
The regression analysis shows that the capital credit payout is positively related to the debt
decision and is significant at the 1% level. This was unexpected and is significant. There was an
unexpected negative relationship between size and the debt decision, but this was insignificant. A

positive relation between growth and the debt decision was expected and is significant at the 5%
level. Power reliability was positively related but was insignificant also. Profitability is negatively
related and is significant at the 1%. This is in line with the pecking order but not the trade-off
theory. Overall, growth and profitability support the pecking order theory and both variables were
significant. As hypothesized, growth related positively to financial leverage and was significant in
support of the trade-off theory. Three of variables (profitability, capital credit payout, and size)
produced unexpected relationships under trade-off theory, but only two were significant. Two of
the variables (capital credit payout and size) did not support pecking order hypothesis, but only
one was significant.
TABLE 4: REGRESSION RESULTS FOR CAPITAL CREDIT DECISION

FACTOR VARIABLES BETA HYPOSTHESIZED
COEFFICIENT SIGN
CAPITAL CREDIT Annual capital N/A DEPENDENT
PAYOUT credit retired per VARIABLE
total equity
PROFITABILITY Operating margin 0.245967*** PECKING ORDER (+)
per KWH sold. TRADE-OFF (+)
LIQUIDITY Current Ratio -0.075600 PECKING ORDER (-)
TRADE-OFF (-)
GROWTH Growth in KWH 0.021728 PECKING ORDER (-)
sold TRADE-OFF (-)
SIZE Total KWH sold -0.118331 PECKING ORDER (+)
TRADE-OFF (+)
POWER System Average -0.157890* N/A
RELIABILITY Interruption
Duration Index
(SAIDI)
FINANCIAL Debt as % of assets 0.018831*** PECKING ORDER (-)
LEVERAGE TRADE-OFF (-)
R square 0.073915
F statistic 10.64203
N 807
*** Significant at the 1% level

** Significant at the 5% level
* Significant at the 10% level
The regression analysis for the capital credit decision showed three variables that were positively
related to the capital credit decision: profitability, growth, and financial leverage. Two of these
were significant at the 1%: profitability and financial leverage. As hypothesized by both theories,
profitability related positively to capital credit payout and was significant. Financial leverage was
significantly positively related to capital credit payout, unanticipated by both the trade-off and
pecking order theories. Liquidity and size were both negatively correlated but insignificant.
Power reliability had no hypothesized relation but turned out to be negatively correlated at the
10%. Out of the six variables being tested three were found to be significant at the 10% or lower.
Three variables had unexpected results with one being significant at the 1%.

The correlation results for the beta coefficients are based on individual regressions done for each
independent variable and also correlations between all the independent variables. A common
problem with multiple regression analysis arises when the potential for collinearity among the
selected independent variables or multicollinearity exists. We follow the process of Canavos
(1984) for testing for the presence of multicollinearity which is to employ a large sample of firms
and test the independent variables with a correlation matrix. According to Mason and Lind (1996,
pg. 541), “A common rule of thumb is that correlations among independent variables from
negative .70 to positive .70 do not cause problems.” As shown in Table 5, none of the selected
independent variables for each of four regressions were shown to be highly correlated since all
were within the –0.70 to + 0.70 guidelines. Therefore, we control for the problem of
multicollinearity.
TABLE 5: CORRELATION RESULTS

Annual
Debt % of Cap Current Op. Marg. Growth KWH KWH
Assets Credits Ratio Per KWH Sold Sold SAIDI
Debt % of
Assets 1
Cap 0.07908793
Credits 6 1
- -
Current 0.38969813 0.02547
Ratio 1 0036 1
-
Op. Marg. 0.13089218 0.23326 0.13684
Per KWH 2 8608 7823 1
Annual -
Growth 0.05919 0.04910 0.0452622
KWH Sold 0.08153737 9818 0023 44 1
- - -
0.08080312 0.05092 0.26412 0.1129338
KWH Sold 8 6733 9691 96 0.069053315 1
- - - -
0.09197492 0.05219 0.15123 0.0251782 0.0287
SAIDI 2 6011 0331 82 0.008745464 88 1
CONCLUSION
This study analyzed financial data from 807 rural electric cooperatives to test the trade-off and
pecking order theories about the debt and capital credit decisions. Selected financial variables
from the finance literature were regressed on the respective debt and dividend/capital credit
payout decisions using OLS regression. The data was provided by the industry’s major banker,
the Cooperative Finance Corporation and covered the period 2004-2006.
The regression for the debt decision used the debt as a percentage of assets ratio as the dependent
variable, with the following independent variables: operating margin per KWH sold, annual
capital credit retired per equity, growth in KWH sold, total KWH sold, system average
interruption duration index (SAIDI). As anticipated by both the trade-off and pecking order
theories, growth was positively related to financial leverage. Capital credit payout was positively
correlated with financial leverage, while size was negatively correlated; both of these results were
unexpected based on research from previous studies of publicly traded stock firms. Perhaps

electric cooperatives rely on debt capital to sustain capital credit or dividend payout. Higher
financial leverage leads to lower equity to support higher capital credit payout.
Profitability related negatively to financial leverage in support of the pecking order theory and
contrary to the trade-off hypothesis. The pecking order is correct with the assumption that
profitability is negatively correlated to financial leverage, which means that a more profitable
firm would rather use retained earnings to finance investments rather than take on more debt. This
contradicts the trade-off theory that more profitable firms would be able to take on more debt than
equity when financing investments. The results for growth show that it is positively correlated to
financial leverage which agrees with both theories. The more a firm is growing the more debt it
can take on to finance their investments. The pecking order contends that since the firm is already
using retained earnings for investments, the growth will cause the firm to look for external funds
for future investments. One variable that contradicted both theories was the capital credit payout
variable, relating positively to financial leverage when both theories hypothesized that dividend
payouts would be negatively related or firms with higher debt payout less dividends. This study
found that firms with more debt paid out more capital credits to its members and was at a
significant level in the regression. A logical extension of this study to examine this contrary
finding would be to duplicate this study on publicly traded stock firms in the electric utility
industry and compare results.
The study of the capital credit decision used the annual capital credit retired per equity ratio for
the dependent variable, with the following the independent variables: operating margin per KWH
sold, current ratio, growth in KWH sold, total KWH sold, system average interruption duration
index (SAIDI), and debt as a percentage of assets. Each of the following variables agrees with
both theories: profitability and liquidity. A more profitable firm is more likely to payout capital
credits. A firm with higher liquidity ratios doesn’t payout as much capital credits. Growth, size,
and financial leverage all disagreed with both theories, and financial leverage was at a significant
level. Firms with more debt paid out more capital credits to its members. This idea is unexpected
based on past studies of both theories. Again it may be because these RECs are technically not-
for-profit organizations, and their decisions to payout capital credits may be driven by different
forces than a stock firm paying out a dividend. One final interesting result from the capital credit
study was that power reliability was negatively correlated to the capital credit payout and it was
significant at the 10% level. This would mean that firms with less reliable power service may
payout more capital credits possibly to make up for their poor service. Possibly funds needed to
upgrade the electric distribution system to improve reliability were diverted to capital credits to
send a positive signal to members.
A logical extension of this study to examine these contrary findings would be to duplicate this
study on publicly traded stock firms in the electric utility industry and compare results.
REFERENCES
Bacon, Frank W., Sally Bacon. “Determinants of the Debt Decision: Trade-off vs. Pecking
Order.” pg. 1-9
Bacon, Frank W., Sharon L. Kania. “What Factors Motivate the Corporate Dividend Decision?”
pg. 1-9
Canavos, George (1984). “Applied Probability and Statistical Methods.” Boston: Little, Brown
and Company, 485-486.

Fama, Eugene F., Kenneth R. French. “Testing Trade-off and Pecking Order Predictions about
Dividends and Debt.” The Review of Financial Studies 15.1 March 2002: pg. 1-32.
Green, Christopher J., Guanqun Tong (October 2005). “Pecking Order or Trade-off Hypothesis?
Evidence On the Capital Structure of Chinese Companies.” Applied Economics. Volume
37, Issue 19. pg 2179-2189.
Mason, R.D., & Lind, D.A. (1996). “Statistical Techniques in Business & Economics”, Chicago:
Irwin, 541.
Myers, Stewart C. (1984). “The Capital Structure Puzzle.” The Journal of Finance. Volume 39,
Issue 3. 575-592.
National Rural Electric Cooperative Association. “History of Electric Co-ops.” 1 April 2009.
http://www.nreca.org/AboutUs/Co-op101/CoopHistory.htm
National Rural Electric Cooperative Association. “NRECA Overview.” 1 April 2009.

<http://www.nreca.org/AboutUs/Overview.htm>
Shyam-Sunder, L., and S.C. Myers (1994). “Testing Static Tradeoff against Pecking Order
Models of Capital Structure.” Journal of Financial Economics. 21. pg 263-292.

BEST PRACTICES: A USEFUL PROXY FOR
DYNAMIC CAPABILITIES THROUGH THE LENS OF
ORGANIZATIONAL LEARNING
Street, Jeffrey N.
Idaho State University
strejeff@isu.edu
ABSTRACT
‘Best practices’ of leading and successful companies has been a topic of interest for businessmen and
scholars since the 1980s. However, in business, the use of a best practice by a firm as the foundation
for a sustainable competitive advantage may be problematic and misguided. Any advantage gained
by the firm from the development of a best practice may be short-lived due to competitors ‘jumping on
the bandwagon’.
Perhaps of similar significance to researchers, the use of ‘best practice’ as a construct in scholarly
research may also be problematic. Best practice has become a commonly used label for numerous
organizational routines that have been considered constructs for the dynamic capabilities view of
competitive advantage. However, a dynamic capability by its theoretical nature is ever changing and
evolutionary, yet a best practice by its nature is codified, systematic and prescriptive in application.
Hence, a best practice has been characterized as a misleading proxy for dynamic capabilities
research. This paper attempts to revisit best practices as a useful construct for dynamic capabilities
by viewing the construct value of best practice through the lens of organizational learning.
INTRODUCTION
„Best practices‟ of leading and successful companies has been a topic of interest for businessmen and
scholars since the 1980s. Best practices are defined as those managerial practices that are
demonstrated by a company that lead to superior performance (Camp, 1989). Further defined in a
study of best practices by the American Quality Foundation, a best practice is not necessarily optimal
among all possible approaches, but it is a practice that has perhaps helped a low performing company
improve to medium or higher performance, or a medium performing company improve to the highest
of performance (International Quality Study, 1993). Thus, in this view, a best practice is a capability
of a firm that is context specific and relative to the set of firms in comparison. Yet, regardless of
whether a best practice is a capability that is best among all or simply a lead to better performance, it
certainly should be considered a valuable resource of the firm.
However, in business, the use of a best practice by a firm as the foundation for a sustainable
competitive advantage may be problematic and misguided. Any advantage gained by the firm from
the development of a best practice may be short-lived due to competitors „jumping on the
bandwagon‟. Once recognition of a best practice by industry constituents, competitors, and/or
popular press occurs, attempts at imitation of the practice by competing firms commonly follows.
Once the best practice is imitated, the superior company no longer has the competitive advantage
once held based on this particular capability. Conversely, the imitating firm does not gain a
competitive advantage over the imitated firm since both now have the capability, i.e. parity.
Furthermore, and perhaps of similar significance, the use of „best practice‟ as a construct in scholarly
research may also be problematic. Best practice has been considered a construct for the dynamic
capabilities view of competitive advantage. The central premise of theory application here is that a

Street Useful Proxies for Dynamic Capabilities
dynamic capability of a firm evolves into a best practice when it is recognized by others to be best for
a particular desirable result in a particular context or operational area. However, a dynamic capability
by its theoretical nature is ever changing and evolutionary, yet a best practice by its nature is codified
and inherently replicable in business application. Hence, a best practice has been characterized as a
misleading proxy for the dynamic capabilities view in research.
This paper attempts to revisit best practices as a useful construct for dynamic capabilities research by
viewing the value of a best practice through the lens of organizational learning. What the organization
learns from the development of best practices may indeed equip the firm to continually reinvent itself
to respond to an ever-changing competitive environment.
THEORY DEVELOPMENT
Dynamic capabilities, currently a capability centered view emerging from the broader resource-based
view of the firm (Helfat & Peteraf, 2003; McGuinness & Morgan, 2000; Zott, 2003), contends that an
organization‟s strength is not only in the tangible and intangible assets that it holds, but also in how
the organization “integrates, builds, and reconfigures internal and external competencies to address
rapidly changing environments” (Teece et al., 1997). Dynamic capabilities are higher-order
organizational routines and practices that allow the organization to reconfigure its resources to take
advantage of a strategic opportunity (Adner & Helfat, 2003; Winter, 2000). Consequently, as a
higher-order resource of the organization, dynamic capabilities serve as an element of the broader
resource-based view (RBV) of the firm (Wernerfelt, 1984; Barney, 1991). The resource-based view
implies that firms obtain or develop idiosyncratic processes (Huber, 1991; Schroeder et al., 2002) and
unique tangible or intangible assets.
Such higher-order resources require the element of knowledge within the organization; knowledge of
technology, markets, products, human resources, and processes. Knowledge gained through the path-
dependent process of internal and external learning leading to the development of unique processes
and technology (Schroeder et al., 2002). Hence, capabilities such as dynamic capabilities are
complex bundles (Barney, 1991) of skills and collective learning (Hooley & Broderick, 1998) that are
demonstrated through the processes of the organization (Amit & Schoemaker, 1993). Processes that
are refined and executed well enough to ensure superior performance of functional activities.
Subsequently, learning and the tacit knowledge that accompanies it are critical to achieving a
sustainable competitive advantage.
The dynamic capabilities view is not focused on the resources themselves but instead on the processes
and methods utilized to develop and deploy the resources (Teece et al., 1997). Zollo and Winter
(2002) describe dynamic capabilities as structured and persistent activity dedicated to process
improvements by an organization. In times of market stability dynamic capabilities are routines that
are complex, relying on existing organizational knowledge and path-dependent execution, i.e.,
routines often labeled best practices (Eisenhardt & Martin, 2000; Zott, 2003), not simply trial-and-
error or management improvisation (Winter 2003).
However, in high-velocity markets dynamic capabilities change to more experiential processes that
quickly adapt in an iterative fashion to the evolving environment (Eisenhardt & Martin, 2000). Thus,
a true dynamic capability is more experiential in nature than a best practice and relies to some modest
degree on management improvisation (Miner, et al., 2001) to quickly create a response for the firm in
an adaptive and iterative fashion to a change in the market or scope of operations. Dynamic
capabilities lead to an adaptable work organization. They become instruments of internal learning
characterized as “routine-changing routines” (Schroeder, et al., 2002) that emerge from problem
solving activities or tactics used for the exploitation of an opportunity or defense against a threat to
the firm. Dynamic capabilities emulate organizational learning (Winter, 2000; Zollo & Winter, 2002)

and much of the knowledge gained from an organizational process evolving into a dynamic capability
is tacit. In this context, it is not easy to attach descriptive labels to processes that embody dynamic
capabilities. However, familiar examples may fall under the generic names of research and
development, technology collaboration, architectural innovation, alliance creation, and virtual
integration.
BEST PRACTICE AS CONSTRUCT FOR DYNAMIC CAPABILITY

Commonly, a best practice is a routine process that relies on the existing knowledge of the
organization to execute a complicated and detailed process by a methodical approach (Eisenhardt &
Martin, 2000; Morita & Flynn, 1997). Once recognition of a best practice by industry constituents,
competitors, and/or popular press occurs, attempts at imitation of the practice by competing firms
commonly follows. The recognition is prompted by significantly strong performance results of the
practicing firm and emerges when the practice is systematized and codified. Once the best practice is
imitated, the superior company no longer has the competitive advantage once held based on this
particular capability (assuming the imitating firm has successfully implemented the best practice in its
substantive form). Conversely, the imitating firm does not gain a competitive advantage over the
imitated firm since both now have the capability. By their systemic nature and codifiability, best
practices are somewhat homogenous across organizations, especially those competing in the same
product-market. The practice is efficient and systematic and clearly methodical. Such a practice
creates few absolute barriers to other organizations for imitation. Familiar examples of best practices
that have pervaded the popular press and consulting ranks for years are Just-In-Time (JIT), Total
Quality Management (TQM), Materials Requirements Planning (MRP), Employee Involvement and
Concurrent Engineering (CE). Best practices that are presently emerging are Six-Sigma, Supply
Chain Management, Customer Relationship Management (CRM) and the High Involvement Work
Place (HIWP).
Eisenhardt and Martin (2000) in their effort to clearly define a dynamic capability as a non-vague
abstraction of RBV labeled best practices as dynamic capabilities. Perhaps here, as an organization
learns from exercising a superior and distinct organizational process, i.e. higher-order capability
(Hooley & Broderick, 1998) or dynamic capability, a best practice may emerge as a residual. The
dynamic capability becomes „routinized‟ and evolves to a best practice as it is recognized by others to
be best for a particular desirable result in a particular context or operational area (see Figure 1).
Figure 1:
Firm learns how to The process As the practice is Once recognition

exercise a superior subsequently systematized and of a best practice
and distinct higher becomes codified, the dynamic occurs, attempts at
order organizational „routinized‟ as a capability becomes a imitation of the
process result of best practice as it is practice by
i.e. Dynamic organizational recognized by others. competing firms
Capability learning follows.
The dynamic capability emerges and is codified into a best practice
Zott (2003), in his attempt to link dynamic capabilities to firm performance, posited that routines
affecting the evolution of the firm‟s resources are manifested when a firm imitates one or several
salient traits of the best performing firm in the industry.

However, Helfat and Peteraf (2003) described the best practices of Toyota in manufacturing and Wal-
Mart in logistics as superior operational capabilities, but not necessarily higher-order dynamic
capabilities. According to Helfat and Peteraf, the dynamic capability is one that does not directly
affect the product or service output, but indirectly contributes by building, integrating or
reconfiguring the operational capability to better implementation. In an attempt to bring coherence to
the disparity among these views, this paper sets forth to further the understanding of the commonality
between a best practice and a dynamic capability of a firm. In this, dynamic capabilities are distinct
from a best practice in that the form and details of the higher-order capability differ across
organizations, however, similar in that important commonalities are present that lead to the efficacy
of the capability in its „routinized‟ form across a variety of firms in different industries and markets.
GENERAL PROPOSITION FOR DYNAMIC CAPABILITY RESEARCH

To now, a question in dynamic capability research has been to what are plausible lenses that can be
used in the study of dynamic capabilities to reduce the vagueness surrounding the theoretical frame.
Here, we are proposing that the lens of organizational learning is appropriate for teasing out the subtle
but distinctive characteristic of best practice as a construct of dynamic capability. Subsequently, the
operationalization of dynamic capabilities through the construct of best practices could be quite useful
to help advance research.
CONCLUSION
This paper revisited best practices as a useful construct for dynamic capabilities by proposing that it
may be appropriate to view the value of a best practice through the lens of organizational learning.
The proposition of this study contends that the deployment of a best practice is often an evolution of a
dynamic capability of the firm brought about as the firm develops routines stemming from
organizational learning. By focusing empirical work in these areas perhaps a non-vague abstraction
of the dynamic capability can be captured.
REFERENCES:
Adner, R., Helfat, C.E. (2003). “Corporate effects and dynamic managerial capabilities”. Strategic
Management Journal, 24: 1011-1025.
Amit, R., Schoemaker, P.J.H. (1993). “Strategic assets and organizational rent”. Strategic
Management Journal, 14: 33-46.
Barney, J. (1991). “Firm resources and sustained competitive advantage”. Journal of Management,
17: 99-120.
Camp, R.C. (1989). Benchmarking- The Search for Industry Best Practices that Lead to Superior
Performance, ASQC Quality Press, Milwaukee, WI.
Eisenhardt, K.M., Martin, J. (2000). “Dynamic capabilities: What are they?” Strategic Management
Journal, Special Issue 21(10-11): 1105-1121.
Helfat, C.E., Peteraf, M.A. (2003). “The dynamic resource-based view: Capability lifecycles”.
Strategic Management Journal, 24: 997-1010.
Huber, G.P. (1991). “Organizational learning: The contributing processes and the literatures”.
Organizational Science, 2(1): 88-115.

Hooley, G., Broderick, A. (1998). “Competitive positioning and the resource-based view of the
firm”. Journal of Strategic Marketing, 6: 97-115.
International Quality Study (1993). Best Practices Report-An Analysis of Management Practices that
Impact Performance, American Quality Foundation and Ernst & Young, New York, NY.
McGuinness, T., Morgan, R.E. (2000). “Strategy, dynamic capabilities and complex science:
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MANAGEMENT BY OBJECTIVES:
AN EFFECTIVE TOOL FOR ORGANIZATIONAL
PERFORMANCE
Qureshi, M. Tahir
University of Central Punjab, Lahore Paksitan
Khan, A. Shafkat
Sheikh, A. Rauf
Ramay, I. Mohammad
Khan, B. Mohammad
International Islamic University, Islamabad Pakistan
ABSTRACT
This paper is analyzing the new revolutionary aspect of „Management by Objectives‟ (MBO) in
different Pakistani companies. In principle, implementation of MBO Practices improves
employee skills, motivation, and behavior and in turn, creates comparative advantage for the
organizations. This research study effectively contributes to the growing literature on the
influence of MBO practices on organizational and employee performance. The aim of this
research is to identify relationship between effective MBO practices, organizational and
employee performance. As a sample, 36 organizations were approached. The MBO practices,
Coaching & Mentoring, Performance Based Reward, Employee Participation and Job Description
were selected for analysis. Study concluded that all these practices are positively contributing
towards organizational and employee performance but employee participation ( = 0.43) and
Coaching & Mentoring ( = 0.40) are major contributors.
KEY WORDS
MBO, Motivation, Comparative advantage, Organizational performance, Employee
performance, Performance based reward, Employee participation, Job description, Coaching
and mentoring, Group processes, Group effectiveness, Job satisfaction, Competencies.
INTRODUCTION
In the early stages of industrialization Management by Objective (MBO) was used primarily at
finder (strategic) level of management but now it is being used at minder (tactical), grinder (front
line management) and at reminder (non managerial staff) level. This implies that goals should be
designed at group and at individual levels, furthermore minimum base should be settled down to
measure the performance. Growth of international competition has lead to an increase in
customer‟s expectations regarding quality. Success in today‟s competitive world depends less on
tangible assets and more on intangible assets (Qureshi M. Tahir et al., 2007). To be competitive
through high quality an organization is required to implement a continuous and effective MBO
system as a goal -setting technique for management. MBO is also a mechanism for appraising
performance. In fact, it is often used for assessing managers and professional employee. With
applying different MBO practices such as coaching and mentoring, performance based rewards,
employee participation, and job description, employees can be evaluated based on how they
accomplish specific goals set up by the manager. Majority of MBO based organizations are
performing dramatically in the form of better employee as well as organizational performance.
MBO set nomenclature for performance base planning with clear goals setting that reduces
ambiguity.

Qureshi, Khan, Sheikh, Ramay, Khan Management by Objectives
Antoni, C. (2005) said that MBO is an effective tool for leading self-regulating teams for high
performance. MBO offers a practical support at each management level and individuals job
satisfaction get improved through commitment towards goals achievement and by employee
participation in decision making. Proper coaching and mentoring promotes better organizational
productivity. MBO serves well as a means to attain control, especially if a systematic and proper
coaching program for teams is adopted. In practice, however, use of this type of control in
organization also requires support by a separate operation within the organization. Managers
should select best performing and most energetic employees who can utilize charisma with the
hope of attaining high performance based rewards.
A more positive view of MBO practices supported by the mutual research method would be more
reasonable when looking for scrutinize practical problems in organization. Studying practices in
industry is a better approach instead of theory or literature driven research. Conducting mutually
exclusive research is thus a means for communicating on a more equal balance with practicing
managers. Hopefully, this research approach will be further developed in the future. There is
more to MBO than objectives only. (Dahlsten F et al. (2005). Overlooking the use of MBO in
developed societies for better performance we planned this research study for finding impact on
performance of human resources and business joints in Pakistan. Different studies indicated an
extensive progress in employee and organizational performance by utilization of MBO rather than
tradition management practices. From efficiency point of view organizations giving power along
with defined goals to employees gets high return.
LITERATURE REVIEW
Antoni, C. (2005) said that MBO is very useful approach at individual, teams and organizational
levels. His study focused on group member‟s commitment, job productivity, employee
satisfaction and off course organizational performance ultimately. Study concluded that MBO is
an effective tool for leading self-regulating teams. For efficiency and effectiveness of teams goal
should be clear and attainable. This influence is just achieved by team characteristics, team
competencies and decision making opportunity/employee empowerment. Team competencies
have to be developed in such a way so that they meet the assigned tasks and goal requirements.
Coaching and mentoring for team plays a crucial role, so accordingly coaches should be trained in
this aspect. Otherwise team members might not be able to understand the goals plan. This
highlights management and leadership tasks of team leaders, supervisors and necessity to discuss
these factors with teams in the goal-setting process. If these aspects are handled carefully,
employees‟ and organizational performance will increase manifold. Drucker (1954) said that
MBO has come up to induce managers so that they incorporate their efforts in setting goals and
objectives for the group of employees within organization. Goals should be split at each
management level for ensuring that attaining goals at each level will help to reach the objectives
gradually at the next-higher level and finally appear as company goals (Carroll et al., 1973).
Recent research proposed that the settlement of higher specific group goals eventually caused
better group outcomes (O‟Leary-Kelly et al., 1994). Group‟s commitment towards their goals at
individual and group level is necessary. Setting the goal that a person or group supposes for
themselves cannot have subsequent action if they are not really trying for attaining these goals
(Locke et al., 1990). Goal commitment as the degree by which an individual or a group deems the
goal to be significance and achievability is determined to reach it by growing effort over time
(Klein et al., 1999). Determination and effects of goal commitment is such a crucial variable for
individual and group goal setting that these are still confusing (Tubbs, 1993). Extensive research

concludes only direct and no reasonable effects of goal commitment (Donovan and Radosevich,
1998; Erez and Zidon, 1984; Hollenbeck and Klein, 1987).
Task is defined as the degree to which group members must actually work together to perform the
task and influence each other‟s performance (Campion et al., 1993). Moreover task
interdependence, Weldon and Weingart (1993) supposes that task complexity is another variable
moderating the effects of group goals on group processes by influencing effectiveness of special
action strategies. Group planning is not important for simple tasks which are easy to evaluate, but
many choices exist for complex tasks, which are difficult to compare. Arbitrate processes are
assumed to explain how goal setting leads to higher performance. At the individual level, it has
been shown that goals influence the direction and determination of individual behavior (Locke et
al., 1990). On the other hand higher group goals lead to superior group efforts, commitment
towards goals, influence planning, co-operation and communication in the group (Weldon et al.,
1993). Antoni C. (2005) used goal-setting theory to develop a model of MBO at team level. The
model views group goals and goal commitment as influencing group effectiveness in terms of
organizational productivity, employee performance and employee satisfaction through the group
processes of joint planning and group effort. The key findings includes that MBO systems can
improve group effectiveness with respect to organizational performance, employee performance,
employee job satisfaction and can be an effective tool for coaching and mentoring employees in
self-regulating teams. However its usage depends on contextual factors with an addition of teams
influence in the way of goal achievement. This is completely dependent on team characteristics
such as team competencies and decision freedom. Secondly Prediction of group productivity is
the key of group goals whereas determining the commitment towards goal is another valuable key
towards explaining better employee performance as well as job satisfaction. The secret of
organizational and employee performance is hidden in commitment of group members towards
their goals. The points above denote the usage of MBO type of management results high
organizational as well as employee performance.
RESEARCH METHODOLOGY
Identification of captivating performance generating aspects is a difficult undertaking, many
global tycoons like Americans are strong believers of MBO and in developed world this
approach is very much famous with the slogan that “MBO is high performance generating
tool. Till now numerous organizations from the underdeveloped corporate world are still
highlighting MBO as stress creating buzz. This blurring is required to be unambiguous
therefore a research is required to be conducted to test the myth and reality. This Research
Study addresses this assumption directly and its focus is spinning around whether MBO
practices make a difference in organizational and employee Performance or not. If yes which
practices are appear to be burning? Based on this theoretical model we developed our two
research objectives, the first one is to examine and realize the scope of the association
between management by objectives practices and organizational performance, last but not the
least is to scrutinize and recognize the degree of association between management by
objectives practices and employees performance.
SAMPLING TECHNIQUE
In this research study, “Convenience Sampling technique has been used. This technique is
used to formulate research process faster by obtaining a large number of completed
questionnaires speedily and economically. Only listed companies having minimum five years
of corporate life were selected for the study. Management science research studies have used
surveys as methods of data collection many times in history. We followed the same approach
because secondary data in this field is not available in Pakistan. Due to the scarcity of time

and limited budget, we used one-to-one interviewing survey for data collection.
Organizations operating in the twin city (Rawalpindi and Islamabad) were personally visited
and the questionnaires were distributed to the Executives of the organizations. 36
organizations replied back out of 40, with response rate of 90 %.
RESPONSE RATE
Table (1) is showing industries‟ response rate of 36 organizations. Collected questionnaires
were coded and entered in Excel 2003 and for analysis Regression and Correlation are used.
Table No 1 (Industry Response Rate)
No. Industry Sample No. Industry Sample
01 Banking Sector 05 02 Oil & Gas 05

03 Software Engineering 05 04 Pharmaceutical Sector 05
05 Manufacturing 05 06 Telecommunication 05
07 Automobile 05 08 Others 01
N = ( 20 + 16 ) = 36
DESCRIPTION OF THE INSTRUMENT

Survey questionnaire was consisted on likert scaling 5 for Strongly agree 4 for Agree, 3 for
Indifferent, 2 for Disagree and 1 for Strongly disagree. Questionnaire included, age of
organization and number of employees as a control variables and MBO practices as
independent variables. Organizational and employee performance are selected as dependent
variables. Total 8 variables are considered for analysis, out of which, 4 are independent, 2 are
control and 2 are dependent variables.
RESEARCH MODEL
To test the impact of MBO practices Coaching & mentoring, performance based reward,
employee participation and job description are analyzed by using following regression equations.
Equation no. 01 Y1 = + 1 (x1) + 2 (x2) + 3 (x3) + 4 (x4) +
OP = + 1 (C&M) + 2(PBR) + 3 (EP) + 4(JD) +
Equation no. 02 „With addition of control variables‟
Y1 = + 1 (x1) + 2 (x2) + 3 (x3) + 4 (x4) + 5 (x5) + 6 (x6) +
OP = + 1 (C&M) + 2(PBR) + 3 (EP) + 4(JD) + 5 (NE) + 6 (LO) +
Equation no. 03 Y2 = + 1 (x1) + 2 (x2) + 3 (x3) + 4 (x4) +
EP = + 1 (C&M) + 2(PBR) + 3 (EP) + 4(JD) +
Equation no. 04 „With addition of control variables‟
Y2 = + 1 (x1) + 2 (x2) + 3 (x3) + 4 (x4) + 5 (x5) + 6 (x6) +
EP = + 1 (C&M) + 2(PBR)+ 3 (EP)+ 4(JD)+ 5 (NE)+ 6 (LO)+
Where as:
1. X1 = C&M =Coaching and Mentoring
2. X2 = PBR= Performance Based reward
3. X3 = EP = Employees Participation
4. X4 = JD = Job Description
5. X5 = NE = Number of Employees (Log is taken)
6. X6 = LO = Life of Organization in years (Log is taken)
7. Y1 = OP = Organizational Performance (equation 1,2)
8. Y2 = EP = Employees Performance (equation 3,4)

HYPOTHESIS
On the basis of an extensive literature review, one main and four supplementary hypotheses
are developed for this research study.
H1: There is a positive/significant relationship between the effective MBO
practices and Organizational and Employees Performance.
H1-a: Coaching and mentoring positively affects organizational and Employees
performance.
H1-b: Performance based reward positively affects organizational and Employees
performance.
H1-c: Employees Participation positively affects organizational and Employees
performance.
H1-d: Job Description positively affects organizational and Employees
performance.
Figure- 1 (Research Model)

Org.
Coaching & Mentoring Performance
+
Perf. base reward +
Effects
Org.
Success
Employee Participation +
+
Job Description
Employee
Performance
TMQ-MBO Model
RESEARCH FINDINGS:
While Table 2 is showing correlations for all variables, Table 3 is indicating the descriptive
statistics indicating mean, standard deviation, variance mode, range, minimum, maximum
values and count. There is a positive correlation amongst the dependent variables.
Organizational productivity and employee performance, correlation is (0.46). Mean of the
Organizational productivity is highest (3.83), and standard deviation is lowest (0.65). Where
as Mean of the employee performance is (3.67), and standard deviation is (0.89) it indicates
moderately strong relationship of dependent variables. There is also high correlation amongst
dependent variables and independent variables. Coaching and mentoring has correlation of
(0.48) with Organizational Productivity and (0.24) with employee performan ce. Performance
based rewards have (0.40) and (0.33) correlation with Organizational productivity and
employee performance respectively. These correlations indicate that whenever proper
coaching and mentoring is provided to employees both organizational performance and
employee performance will automatically be increased. Correlation between independent
variables is showing high relationship with each other, in particular with employee
participation and coaching & mentoring e.g. (0.55), this correlation is indicating that a
mentoring system caused better employee participation. (0.60) correlation between Job
description and coaching & mentoring system is showing mentoring effect. Between
performance based reward and job description, correlation is highest (0.59) indicating that

whenever a highly scientific and rigorous performance based reward is delivered to

employees, they act on job description in a proper manner therefore their performance
increased significantly. (0.59) correlation between Employee Participation and Job
description indicates that employee‟s increased participation in MBO Practices automatically
describes his/her Job area and goal.
In a nutshell, coefficient of correlation between organizational and employees performance is

(0.46) results shows that usage of regular coaching and mentoring, performance based
reward, employee participation and job description lead to higher organizational and
employee performance.
Table (2) Correlations of Variables
# of
Org.
O.P EP C&M P.B.R E.P J.D Em
Life
p.
Organizational Performance 1
Employee Performance (EP) 0.46 1
Coaching and Mentoring 0.48 0.24 1
Performance Based Reward 0.40 0.33 0.47 1
Employees Participation 0.04 0.06 0.55 0.47 1
Job Description 0.37 0.26 0.60 0.57 0.59 1
Organization's Life in Years -0.10 -0.06 -0.31 -0.24 -0.19 0.08 1
No of employees -0.01 0.04 -0.15 0.24 -0.11 0.12 0.54 1
The significant association between Job description, organizational productivity and the
employee‟s performance of organization (0.46) reflects that performance of employees is
measured on the basis of quantifiable results. The Coaching and mentoring system in these
organizations can be growth and development-oriented if the employees of the organizations
are provided performance based feedback. Counseling employees will increase their faith on
job description and employee participation will have a strong influence on individual as well
as team behavior.
The mean of employee participation/empowerment is (3.59) and standard deviation is (0.76)

which is comparatively higher than the job description. The impact of Coaching and
mentoring on the employee‟s performance of the organizations is showing a positive
relationship up to (0.24). It is indicating that Pakistani industrialists are moving steadily
towards coaching & mentoring approach, further it indicates that among individual MBO
practices, coaching & mentoring in routine decision-making as well as in strategic decision-
making, is also a very important factor which is likely to increase the organizations‟ market
share. It also indicates that the employees in the organizations are allowed to make decisions
related to cost and quality matters. They are asked by their supervisors to participate in
operations related decisions and suggest improvements in the way things are being done.
Table 3 Descriptive statistics mean standard deviation

Vari/DS Mean SD Variance Range Minimum Maximum Count
OP 3.83 0.65 0.43 2.33 2.33 4.67 36
EP 3.67 0.89 0.80 4.00 1.00 5.00 36
C&M 3.73 0.81 0.65 3.00 1.80 4.80 36
PBR 3.75 0.85 0.72 3.33 1.67 5.00 36
EP 3.59 0.76 0.57 2.40 2.20 4.60 36
JD 3.57 0.83 0.69 3.00 2.00 5.00 36
LIFE 11 14 193 54 3 57 36
Highest mean of performance based rewards (3.75) indicates that majority of managers in the
corporate sector are thinking that performance based reward is the most important factor in
organizational performance but job description is showing the lowest mean (3.57).
Table 4 gives the regression outcomes for Pakistani organizations from model A to D. These
regression models are noteworthy and significant. Not even a single control variable is
statistically significant. Four different varieties of models are used for analysis. Models A
and C includes all the MBO practices into the equation along with the control variables,
while models B and D contain MBO practices exclusive of the control variables. The output
in the case of model A is 29% variability and is explained through the organizational
performance. „Employee participation‟ and „coaching and mentoring‟ are high impact
creators in organizational performance. In model B, variability in dependent variable is
increase to 33% since „employee participation‟ and „coaching and mentoring‟ are having a
significant impact on organizational performance here. Similarly, in case of the „employee
performance‟, under model C, variability has extended to only 9%. This is because
„employee participation‟ is the only significant factor having impact on employee
Performance. In model D, variability in dependent variable is increased to 14% and is
impacted by „employee participation‟.
Regression Model for Organizational & Employees

Table 4
Performance because of MBO Practices
Organizational
Employees Performance
Coefficients Productivity
Model A Model B Model C Model D
Coaching & Mentoring **0.40 **0.40 0.19 0.22
Performance Based Reward 0.27 0.21 **0.40 **0.33
Employees Participation **0.43 **0.41 **0.56 **0.53
Job Description 0.14 vv0.16 0.25 0.25
Organization's Life in Years 0.00 -- 0.00 --
No of Employees 0.00 -- 0.00 --
R Square 0.41 0.40 0.25 0.24
Adjusted R Square 0.29 0.33 0.09 0.14
F 3.42 5.23 1.59 02.4
N = 36, *** P< 0.10, ** P<0.05, *P<0.01.

The MBO Practices selected for the research study are coaching & mentoring, performance
based reward, employee participation and job description. Research study highlighted that
organizations involved in coaching & mentoring system and allow employee participation get
increased organizational and suitable employee performance. Confidence level; which refers
to the probability about estimations correctness, for coaching & mentoring and employee
participation p value is less than 0.05. Whenever managers assign tasks to the employee,
implement proper supervision on the employee while the employee is determined himself to
achieve their goals with competency, organizational productivity and employee performance
get increased.
The data in Table 2 is giving confirmation of association sandwiched between effective MBO
practices and organizational Productivity. The results have shown a positive correlation
amongst several MBO practices (coaching & mentoring, performance based reward,
employee participation, job description and employee performance.
CONCLUSION
Analysis is indicating positive relationship amongst effective MBO practices, organizational
and employee performance. Independent variables namely coaching & mentoring, employee
participation, performance based rewards and job descriptions are having positive effect on
organizational and employee performance. Job description system has a positive and
significant impact and is one of the main indicators of high organizational performance.
Employee participation/empowerment is another effective MBO practice that has a
significant impact on employee performance and proving that an employee participation in
decision-making leads organization to perform much better than its competitors in the
industry, performance base pay is also important indicator of high employee and
organizational performance. Finally organizations investing in coaching & mentoring tend to
have a high employee productivity level that ultimately contributes towards high
organizational performance.
Pakistani scenario varies to an extent from the western corporate world because of
investment, exposure, and technological differences. MBO globally known approach has
increased the popularity in Pakistani corporate sector as employees and mangers wants to get
rid of old stereotype ways of management. Currently they want to change with a new
revolutionary aspect of management. This study identified that MBO practices are positively
affecting Pakistani corporate sector, and is acting like a mechanism towards growth and high
performance.
Further area of research could be exploration of Management by Values, Management by

Care and Management by Inspiration with their impact on organizational and employee
performance.
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