CHAPTER THREE

THE POLITICAL AND LEGAL ENVIRONMENTS

FACING BUSINESS

THE POLITICAL ENVIRONMENT

A political system is the complete set of institutions, political organizations, and
interest groups, the relationships among those institutions, and the political norms
and rules that govern their functions. Thus, it integrates the various parts of a society
into a viable, functioning entity. It also influences the extent to which government
intervenes in business and the way in which business is conducted both domestically
and internationally. The ultimate test of any political system is its ability to hold a
society together.
A. Individualism and Collectivism
It is useful to profile the similarities and differences among political systems
according to the general orientation within a society about the primacy of the
rights and role of the individual versus that of the larger community. Under an
individualistic paradigm (e.g., the United States), political officials and
agencies play a limited role in society. The relationship between government
and business tends to be adversarial; government may intervene in the economy
to deal with market defects, but generally it promotes marketplace competition.
Under a collectivist paradigm, whether democratic (Japanese) or authoritarian
(Chinese) in nature, the government defines economic needs and priorities, and
it partners with business in major ways. Government is highly connected to and
interdependent with business; the relationship is cooperative.
B. Political Ideology
A political ideology is the body of constructs, theories, and aims that constitute
a sociopolitical program (e.g., liberalism or conservatism). Pluralism indicates
the coexistence of a variety of ideologies within a particular society. Although
shared ideologies create bonds within and between countries, differing ideol-
ogies tend to split societies apart. The two extremes on the political spectrum
are democracy and totalitarianism. [See Fig. 3.2.]
1. Democracy.
A democracy represents a political system in which citizens participate in the
decision-making and governance process, either directly or through elected
representatives. Contemporary democracies share the following characteristics:
freedom of opinion, expression, and the press; freedom to organize; free
elections; an independent and fair court system; a nonpolitical bureaucracy and
defense infrastructure; and citizen access to the decision-making process. In
decentralized democracies, e.g., Canada and the United States, companies may
face different and sometimes even conflicting laws from one state or province to
another.) The defining characteristic of democracy is freedom. Measures of
political rights and civil liberties have been developed to assess levels of
freedom; a country may be rated as free, partly free, or not free. [See Map 3.2.]
2. Totalitarianism.
Totalitarianism represents a political system in which citizens seldom, if ever,
participate in the decision-making and governance process; power is
monopolized by a single agent and opposition is neither recognized nor
tolerated. In theocratic totalitarianism, religious leaders are also the political
leaders. In secular totalitarianism, the government imposes order through
military power. Variants of totalitarianism include authoritarianism and
fascism.
3. Trends in Political Systems.
Several factors have powered the democratization of the world. First, many
totalitarian regimes failed to improve the economic lives of their citizens, who
eventually challenged the right of the state to govern. Second, vastly improved
communications technology weakened the ability of regimes to control peoples
access to information. Third, many people who champion democracy truly
believe that greater political freedom leads to economic freedom and higher
standards of living. Although the world is experiencing general movements
towards democracy and more open economies, this does not necessarily indicate
an increasing homogenization of political systems. In fact, differentialism,
i.e., the clash of civilizations, refers to the argument that apparently innate and
largely irreconcilable differences among cultures can trigger a backlash against
Western ideas regarding political rights and civil liberties.

4. Political Risk.
Political risk reflects the expectation that the political climate in a country will
change in such a way that a firms operating position or investment value will
deteriorate. Leading sources of political risk are: expropriation or
nationalization, international war or civil strife, unilateral breaches of contract,
destructive governmental actions, harmful actions against people, restrictions on
the repatriation of profits, differing points of view, and discriminatory taxation
 policies. [See Table 3.2.] The following types of political risk range from the
least to the most destructive.
1. Systemic Political Risk. Systemic political risk creates risks that affect
all firms because of a change in public policy. However, such changes do
not necessarily reduce potential profits.
2. Procedural Political Risk. Procedural political risk reflects the costs
of getting things done because of such problems as government corruption,
labor disputes, and/or a partisan judicial system.
3. Distributive Political Risk. Distributive political risk reflects
revisions in such items as tax codes, regulatory structure, and monetary
policy imposed by governments in order to capture greater benefits from
the activities of foreign firms.
4. Catastrophic Political Risk. Catastrophic political risk includes
those random political developments that adversely affect the operations of
all firms in a country.

III. THE LEGAL ENVIRONMENT

A legal system is the mechanism for creating, interpreting, and enforcing the laws in
a specified jurisdiction. It is the means and methods a country uses to regulate
business practices, define how companies conduct business transactions, specify the
rights and obligations of those engaged in business transactions, and spell out the
methods of legal redress for those who believe they have been wronged. Generally,
legal systems fall into one of the following categories: [See Map 3.3.]
Common law. Common law originated in the United Kingdom and is based
upon tradition, judge-made precedent, custom, and usage; therefore, courts play
an important role in interpreting the law. Common-law nations include
Australia, Britain, Canada, New Zealand, and the United States.
Civil law. Civil law, aka Roman law, originated with the Romans and is based
upon a detailed set of laws that comprise a code that includes rules for
conducting business; therefore, courts play an important role in applying the law.
Civil law nations include France, Germany, and Japan.
Theocratic law. Theocratic law is based upon religious precepts; ultimate
legal authority is conferred upon religious leaders who govern society. The best
example is Islamic law, or Sharia, which is based on the Koran, the Sunnah, the
writings of Islamic scholars, and the consensus of Muslim countries legal
communities. (The key for business success is to adhere to the constraints of
ancient Islamic laws while maintaining sufficient flexibility to operate in a
modern global economy.)
Customary law. Customary law anchors itself in the wisdom of daily
experience or great spiritual or philosophical traditions. Customary law may
play a significant role in matters of personal conduct in countries with mixed
legal systems.
Mixed Legal System. A mixed legal system emerges when two or more
legal systems are used within a single country. Although the majority of such
 countries are found in Africa and Asia, the United States legal system combines
both common and civil law.
A. Diffusion of Legal Systems
The evolution and diffusion of the civil and common law systems gives
managers a sense of the degree of current and likely convergence across
countries. The diffusion of the common law system is embedded in the
colonization of the British Commonwealth. Other European countries followed
the lead of the Romans in developing their own civil law traditions and then
influenced the legal systems of many neighboring, African, and North and South
American countries. More recently, successful efforts to standardize laws,
particularly with respect to the conduct of business, can be seen in the actions of
the European Union and in the development of worldwide standards in
accounting, disclosure, and bankruptcy. [See Fig. 3.4.]

IV. LEGAL ISSUES IN INTERNATIONAL BUSINESS

National laws may affect day-to-day operations and a firms long-term competitive-
ness both within and beyond a countrys borders and pertain to both domestic and
foreign firms. Areas addressed include health and safety standards, employment
practices, antitrust prohibitions, contractual relationships, environmental practices,
intellectual property, cross-border investment flows, tariffs, and non-tariff barriers, to
name but a few. In addition, international treaties among nations may also affect the
nature and extent of business operations.
A. Operational Concerns
Efforts to start a business, to enter and enforce contracts, to hire and fire
employees, and to close a business are all affected by national laws and
regulations. While there appears to be an inverse relationship between a
countrys per capita income and its tendency to regulate business, the legal
systems of the more highly developed countries tend to regulate the major
operational features of business activity more consistently than do the less
developed nations. Further, those countries that make it easy to start a business
also tend to impose fewer and simpler regulations to hire and fire workers and
impose less regulation in their courts and bankruptcy systems. [See Table 3.3.]
B. Strategic Concerns
Many legal issues affect the process of value creation. The following legal
contingencies often shape an international competitors strategic plans.
1. Product Safety and Liability. Often products must be customized in
order to comply with local standards, which may be higher than those found
in a firms home market. While product liability laws are very stringent in
markets such as the United States, they are spotty, absent, and at times even
arbitrary in many less developed countries.
2. Marketplace Behavior. National laws determine permissible practices in
pricing, distribution, advertising, and the promotion of products, and they
vary widely from one country to another.
3. Product Origin. Local content is important to all nations, and most
countries push foreign firms to add value locally. In addition, product
 origin determines applicable fees and may be subject to quantitative
restrictions as well.
4. Legal Jurisdiction. Every country specifies which law should apply and
where litigation should occur when agents are involvedwhether they are
legal residents of the same or different countries.
5. Arbitration. Most arbitration is governed by the New York Convention, a
protocol specified in 1958 that allows parties to choose their own mediators
and resolve disputes on neutral ground.

CHAPTER SIX
INTERNATIONAL TRADE
AND FACTOR MOBILITY THEORY
INTERVENTIONIST THEORIES
Interventionist trade theories prescribe government action with respect to the
international trade process.
A. Mercantilism
The concept of mercantilism (a zero-sum game) served as the foundation of
economic thought for nearly three hundred years (15001800). It purports that a
countrys wealth is measured by its holdings of treasure (usually gold). To
amass a surplus (a favorable balance of trade), a country must export more
than it imports and then collect gold and other forms of wealth from countries
that run a deficit (an unfavorable balance of trade).
B. Neomercantilism
Neomercantilism represents the more recent strategy of countries that use
protectionist trade policies in an attempt to run favorable balances of trade
and/or accomplish particular social or political objectives.

I. FREE TRADE THEORIES

The explanatory power of the theories of absolute and comparative advantage is
limited to the demonstration of how economic growth can occur via specialization
and trade. The concept of free trade (a positive-sum game) purports that nations
should neither artificially limit imports nor artificially promote exports. The
invisible hand of the market will determine which competitors survive, as customers
buy those products that best serve their needs. Free trade implies specialization
just as individuals and firms efficiently produce certain products that they then
exchange for things they cannot produce efficiently, nations as a whole specialize in
the production of certain products, some of which will be consumed domestically,
and some of which may be exported; export earnings can then in turn be used to pay
for imported goods and services.
A. Theory of Absolute Advantage
In 1776 Adam Smith asserted that the wealth of a nation consisted of the goods
and services available to its citizens. His theory of absolute advantage holds
that a country can maximize its own economic well being by specializing in the
production of those goods and services that it can produce more efficiently than
 any other nation and enhance global efficiency through its participation in
(unrestricted) free trade. Smith reasoned that: (i) workers become more skilled
by repeating the same tasks; (ii) workers do not lose time in switching from the
production of one kind of product to another; and (iii) long production runs
provide greater incentives for the development of more effective working
methods. Smith also asserted that country-specific advantages can either be
natural or acquired.
1. Natural Advantage. A country may have a natural advantage in the
production of particular products because of given climatic conditions,
access to particular resources, the availability of labor, etc. Variations in
natural advantages among countries help to explain where particular
products can be produced most efficiently.
2. Acquired Advantage. An acquired advantage represents a distinct
advantage in skills, technology, and/or capital assets that yields
differentiated product offerings and/or cost-competitive homogeneous
products. Technology, in particular, has created new products, displaced old
products, and altered trading-partner relationships.
3. Resource Efficiency Example. Real income depends on the output of
products as compared to the resources used to produce them. By defining
the cost of production in terms of the resources needed to produce a
product, the production possibilities curve shows that through the use of
specialization and trade, the output of two countries will be greater, thus
optimizing global efficiency. [See Fig. 6.2.]
B. Comparative Advantage
In 1817 David Ricardo reasoned that there would still be gains from trade if
a country specialized in the production of those things it can produce most
efficiently, even if other countries can produce those same things even more
efficiently. Put another way, Ricardos theory of comparative advantage holds
that a country can maximize its own economic well-being by specializing in the
production of those goods and services it can produce relatively efficiently and
enhance global efficiency through its participation in (unrestricted) free trade.
1. An Analogous Explanation. Would it make sense for the best
physician in town, who also happens to be the most talented medical
secretary, to handle all of the administrative duties of an office? No. The
physician can maximize both output and income by working as a physician
and employing a less skilled secretary. In the same manner, a country will
gain if it concentrates its resources on the production of the goods and
services it can produce most efficiently.
2. Production Possibility Example. A country can simultaneously
have a comparative advantage and an absolute advantage in the production
of a given product. Assume that the United States is more efficient than
Costa Rica in the production of both wheat and tea; however, the U.S. has a
comparative ad-vantage in wheat production. By concentrating on the
production of the product in which it has the greater advantage (wheat) and
allowing Costa Rica to produce the product in which the United States is
 comparatively less efficient (coffee), global output can be increased, and
specialization and trade will benefit both countries. [See Fig. 6.2.]
C. Some Assumptions and Limitations of the Theories of Specialization
The theories of absolute and comparative advantage are based upon the
economic gains from specialization, i.e., concentration on the production of a
limited number of products. Each holds that specialization will maximize output
and that subsequent trade will maximize consumer welfare. However, both
theories make certain assumptions that may not always be valid.
1. Full Employment. Both theories assume that resources are fully
employed. When countries have many unemployed or underemployed
resources, they may seek to restrict imports in order to employ their own
available workers and other assets.
2. Economic Efficiency Objective. Individuals and countries often
pursue objectives other than economic efficiency. Individuals may prefer
activities and/or occupations that are economically less productive, and
nations may choose to avoid overspecialization because of the vulnerability
created by potential changes in technology and price fluctuations.
3. Division of Gains. Although specialization does maximize output, it is
unclear how those gains will be divided. If one country believes that a
trading partner is receiving too large a share of the benefits, it may choose
to forego its relatively smaller gains in order to prevent the partner country
from receiving larger gains.
4. Two Countries, Two Commodities. The world is comprised of
multiple countries and multiple commodities. Nonetheless, the theories are
still useful; economists have applied the same reasoning and demonstrated
the economic efficiency advantages in multi-product and multi-country
production and trade relationships.
5. Transport Costs. If it costs more to deliver products than can be saved
via specialization, then the gains from trade are negated.
6. Statics and Dynamics. Although the theories of absolute and
comparative advantage consider gains at a given time (a static view), the
relative conditions that surround a countrys particular advantage or
disadvantage are dynamic (constantly changing). Thus, one cannot assume
that future advantages will remain constant. (This idea will also be relevant
to the discussion of the dynamics of the location of production and export
sources.)
7. Services. Although the theories of absolute and comparative advantage
were developed from the perspective of trade in commodities, much of the
same reasoning can be applied to trade in services.
8. Mobility. Neither the assumption that resources can move domestically
from the production of one good to another and at no cost, nor the
assumption that resources cannot move internationally, is entirely valid.
Nonetheless, domestic mobility is greater than the international mobility of
resources. Clearly, the movement of resources such as capital and labor is a
very real alternative to trade.
 A. Product Life Cycle (PLC) Theory
Product life cycle theory states that the optimal location for the production of
certain types of goods and services shifts over time as they pass through the
stages of market introduction, growth, maturity, and decline. [See Table 6.3.]
1. Changes Through the Cycle. A great majority of the new
technology that results in new products and production methods originates
in industrial countries.
Introduction. Innovation, production, and sales occur in the domestic
(innovating) country. Because the product is not yet standardized, the
production process tends to be relatively labor-intensive, and
innovative customers tend to accept relatively high introductory prices.
Growth. As demand grows, competitors enter the market. Foreign
demand, competition, exports, and often direct investment activities
also begin to accelerate.
Maturity. Global demand begins to peak, production processes are
relatively standardized, and global price competition forces production
site relocation to lower-cost developing countries.
Decline. Market factors and cost pressures dictate that almost all
production occur in developing countries. The product is then imported
by the country where it was initially developedthe importing firm
may or may not be the innovating firm.
2. Verification and Limitations of PLC Theory. Exceptions to the
typical pattern of the product life cycle theory would include: products
that have very short life cycles, luxury goods and services, products
that require specialized labor, products that can be differentiated from
direct competitors, and product for which transportation costs are
relatively high.

CHAPTER SEVEN
GOVERNMENTAL INFLUENCE ON TRADE

III. ECONOMIC RATIONALES FOR GOVERNMENTAL INTERVENTION

Government intervention in the trade process may be either economic or
noneconomic in nature.

A. Unemployment
Persistent unemployment pushes many groups to call for protectionism; one of
the most effective is organized labor. By limiting imports, local jobs are
retained as firms and consumers are forced to purchase domestically produced
goods and services. As we can see from the case against new U.S economic
policies included raising of prices in cuba for imported items made them to rely
 on domestic ones, they may result in a decline in export-related jobs because of
(i) price increases for components or (ii) lower incomes abroad.
Thus, governments must carefully balance the costs of higher prices with the
costs of unemployment and the displaced production that would result from
freer trade when enacting such measures.

Infant-Industry Argument
First presented by Alexander Hamilton in 1792, the infant-industry argument holds that
a government should temporarily shield emerging industries in which the country may
ultimately possess a comparative advantage from international competition until its firms
are able to effectively compete in world markets.
As we can see from the case that U.S has stopped trading with cuba because of Castros
incite revolution which made them gain Eventual competitiveness in the world market
Two basic problems associated with this argument are the assumptions that (i)
governments can in fact identify those industries that have a high probability of success
and (ii) firms within those industries should receive government assistance. Infant-
industry protection requires some segment of the economy (typically local consumers) to
incur the initial higher cost of inefficient local production. Ultimately, the validity of the
argument rests on the expectation that the future benefits of an internationally
competitive industry will exceed the costs of the associated protectionist measures.

Industrialization Argument
Many of todays emerging economies emulate historical practices and use protectionism
to spur local industrialization. The industrialization argument purports that the
development of national industrial output (and hence economic growth) should be
supported, even though domestic prices may not be competitive on the world market.
Reasons to support it are numerous.
1. Use of Surplus Workers. Surplus workers can more easily be used to
increase manufacturing output than agricultural output. However, this shift
may also lead to (i) increasing demand for social services because of the
rural to urban migration and (ii) decreasing agricultural output. In this
instance, improved agriculture practices may be a better means of achieving
economic success.
2. Promoting Investment Inflows. Import restrictions encourage foreign
direct investment by foreign firms that want to avoid the loss of a lucrative
or potential market. FDI inflows in turn lead to increased local
employment, an attractive outcome for policy makers.
3. Diversification. Price variations can wreak havoc on economies that rely
on just a few commodities for job creation and export earnings. Contrary to
expectations, however, unless a countrys industrial base is truly expanded,
a move into manufacturing may simply shift that dependence from a
reliance on the basic commodities to the downstream manufactured goods
produced from them.
4. Greater Growth for Manufactured Products. Terms of trade refers
to the quantity of imports that a given quantity of a countrys exports can
buy. Many emerging nations have experienced declining terms of trade
 because the demand for and prices of raw materials and agricultural
commodities have not risen as fast as the demand for and prices of finished
goods. In addition, changes in technology have reduced the need for many
raw materials. Cost savings realized from manufactured products go mainly
to higher profits and wages, thus fueling the industrialization process.
5. Import Substitution versus Export Promotion. Import
substitution represents an economic development strategy that relies on the
stimulation of domestic production for local consumption by erecting
barriers to imported goods. If the protected industries do not become
globally competitive, however, local customers will continually be
penalized by high prices. On the other hand, export-led development, i.e.,
export promotion, encourages economic development by harnessing a
country-specific advantage (e.g., low labor costs) and building a vibrant
manufacturing sector through the stimulation of exports. In reality, when
effectively crafted, import substitution policies eventually lead to the
possibility of export promotion as well.
6. Nation Building. The industrialization process helps countries build
infrastructure, advance rural development, enhance the quality of peoples
lives, and boost the skills of the workforce.

B. Economic Relationships with Other Countries

Countries track their own performance as compared to other nations to deter-
mine whether to impose trade restrictions as a means of improving their
competitive positions. Primary motivations are four.
1. Balance of Payments Adjustments. The trade account (the
current account) is a major part of the balance of payments for most
countries. If balance-of-payments difficulties persist, a government
may restrict imports and/or encourage exports in order to balance its
trade account. If it chooses to devalue its currency, the value of all
transactions will be affected. If, however, it wishes to target certain
products, then protectionist measures (both tariffs and nontariff
barriers) will be more effective.

2. Comparable Access or Fairness. The comparable access

argument promotes the idea that a countrys firms are entitled to the same
access to foreign markets as foreign firms have to its market. Economic
theory reasons that producers operating in industries where increased
production leads to economies of scale but which lack equal access to
foreign competitors markets will struggle to become cost-competitive.
However, restricting trade, even on the grounds of fairness, may lead to
higher prices for domestic customers.
3. Restrictions as a Bargaining Tool. Import restrictions may be levied as a
means to try to persuade other countries to lower their import barriers. The danger,
however, is that each country will, in turn, retaliate by escalating its own restrictions. To
successfully use restrictions as a bargaining tool requires that they be (i) believable and
(ii) important to the targeted parties.
4. Price-Control Objectives. Countries may withhold products from international
markets in an effort to raise world prices and thus improve export earnings and/or favor
domestic customers. (Organization of Petroleum Exporting Companies (OPEC) is a case
in point.) The practice of pricing exports below cost, or below their home-country prices,
i.e., below their fair market value, is known as dumping. Most countries prohibit
imports of dumped products, but enforcement usually occurs only if the product
disrupts domestic production. The optimum-tariff theory claims that a foreign producer
will lower its prices if the destination country places a tariff on its products. So long as
the foreign producer reduces its price by any amount, some shift in revenue goes to the
importing country, and the tariff is deemed an optimum one.
IV. NONECONOMIC RATIONALES FOR GOVERMENT INTERVENTION
Governments may choose to intervene in the trade process for noneconomic reasons
such as the maintenance of essential industries, the prevention of shipments to
unfriendly nations, the maintenance or extension of spheres of influences, and/or the
protection of national identity.
A. Maintenance of Essential Industries
The essential industry argument states that a government applies restrictions
to protect essential domestic industries (particularly defense) so that the country
is not dependent on foreign sources of supply. Protecting an inefficient industry,
however, will lead to higher costs and possibly political consequences as well.
B. Prevention of Shipments to Unfriendly Countries
Groups concerned about security use national defense arguments to prevent the
export, even to friendly countries, of strategic goods that might fall into the
hands of potential enemies. Trade controls on non-defense goods may also be
used as a foreign policy weapon to try to prevent another country from meetings
its political objectives. However, retaliation often renders such protectionist
measures ineffective.

C. Maintenance or Extension of Spheres of Influence

To maintain their spheres of influence, governments may give aid and credits to
and encourage imports from countries that join a political alliance or vote a
preferred way within international bodies. Further, trade restrictions may coerce
governments to take certain political actions or punish firms whose governments
do not comply.
D. Protecting Activities that Help Preserve the National Identity
Countries are partially held together though a unifying sense of cultural and
national distinctiveness. To sustain this collective identity, governments may
limit the presence of foreign products in certain sectors.

V. INSTRUMENTS OF TRADE CONTROL

Governments use many rationales and seek a range of outcomes when they try to
influence the international trade process. The choice of instrument(s) is crucial
because each type of control may incite different responses from both domestic and
foreign groups. While some instruments directly limit the amount that can be traded,
others indirectly affect the amount traded by directly influencing prices, i.e., while
tariff barriers directly affect prices and subsequently the quantity demanded,
nontariff barriers may directly affect price and/or quantity. [See Fig. 7.4.]
A. Tariffs
A tariff (also called a duty) is a tax levied on (internationally) traded products.
Exports tariffs are levied by the country of origin on exported products; a
transit tariff is levied by a country through which goods pass en route to their
final destination; import tariffs are levied by the country of destination on
imported products. A tariff increases the delivered price of a product, and, at the
higher price, the quantity demanded will be less.
A specific duty is a tariff that is assessed on a per unit basis; an ad valorem
tariff is assessed as a percentage of the value of an item. If both a specific duty
and an ad valorem tariff are assessed on the same product, it is known as a
compound duty. A tariff controversy concerns the treatment of manufactured
exports to industrialized nations. While raw materials frequently enter industrial
countries tariff-free, when an ad valorem tariff is applied to manufactured goods,
it is generally applied to the total value of the product. Critics argue that the
effective tariff on the manufactured portion, i.e., the value-added portion, is
higher than the published tariff. [Note: review the optimum tariff theory on p.
76 of this manual, p. 250 of the text, and/or slide 7-12.]