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Master of Business Administration – MBA Semester 4

MB0037 – International Business Management


Assignment Set- 1

Note: Each question carries 10 Marks. Answer all the questions.


Q.1 a. How has liberalizing trade helped international business? (6 marks)
Sol.
The Benefits of Trade Liberalization
Policies that make an economy open to trade and investment with the rest of the
world are needed for sustained economic growth. The evidence on this is clear. No
country in recent decades has achieved economic success, in terms of substantial
increases in living standards for its people, without being open to the rest of the
world. In contrast, trade opening (along with opening to foreign direct investment)
has been an important element in the economic success of East Asia, where the
average import tariff has fallen from 30 percent to 10 percent over the past 20 years.
Opening up their economies to the global economy has been essential in enabling
many developing countries to develop competitive advantages in the manufacture of
certain products. In these countries, defined by the World Bank as the "new
globalizers," the number of people in absolute poverty declined by over 120 million
(14 percent) between 1993 and 1998.
There is considerable evidence that more outward-oriented countries tend
consistently to grow faster than ones that are inward-looking. Indeed, one finding is
that the benefits of trade liberalization can exceed the costs by more than a factor of
10. Countries that have opened their economies in recent years, including India,
Vietnam, and Uganda, have experienced faster growth and more poverty reduction.
On average, those developing countries that lowered tariffs sharply in the 1980s grew
more quickly in the 1990s than those that did not.
Freeing trade frequently benefits the poor especially. Developing countries can ill-
afford the large implicit subsidies, often channeled to narrow privileged interests that
trade protection provides. Moreover, the increased growth that results from free
trade itself tends to increase the incomes of the poor in roughly the same proportion
as those of the population as a whole. New jobs are created for unskilled workers,
raising them into the middle class. Overall, inequality among countries has been on
the decline since 1990, reflecting more rapid economic growth in developing
countries, in part the result of trade liberalization.
The potential gains from eliminating remaining trade barriers are considerable.
Estimate of the gains from eliminating all barriers to merchandise trade range from
US$250 billion to US$680 billion per year. About two-thirds of these gains would
accrue to industrial countries. But the amount accruing to developing countries would
still be more than twice the level of aid they currently receive. Moreover, developing
countries would gain more from global trade liberalization as a percentage of their
GDP than industrial countries, because their economies are more highly protected and
because they face higher barriers.
Although there are benefits from improved access to other countries’ markets,
countries benefit most from liberalizing their own markets. The main benefits for
industrial countries would come from the liberalization of their agricultural markets.
Developing countries would gain about equally from liberalization of manufacturing
and agriculture. The group of low-income countries, however, would gain most from
agricultural liberalization in industrial countries because of the greater relative
importance of agriculture in their economies.

b. What are the merits and demerits of international trade? (4 marks)


Sol.
Advantages and Disadvantages of International Trade
Advantages to consider:
• Enhance your domestic competitiveness
• Increase sales and profits
• Gain your global market share
• Reduce dependence on existing markets
• Exploit international trade technology
• Extend sales potential of existing products
• Stabilize seasonal market fluctuations
• Enhance potential for expansion of your business
• Sell excess production capacity
• Maintain cost competitiveness in your domestic market

Disadvantages to keep in mind:


• You may need to wait for long-term gains
• Hire staff to launch international trading
• Modify your product or packaging
• Develop new promotional material
• Incur added administrative costs
• Dedicate personnel for traveling
• Wait long for payments
• Apply for additional financing
• Deal with special licenses and regulations

Q. 2 Discuss the impact of culture on International Business. (10 marks)


Sol.
The following can be looked as the various aspects of the cultural dichotomies.
Table 2.1: Cultural Dichotomies
In this new millennium, few executives can afford to turn a blind eye to global
business opportunities. Japanese auto-executives monitor carefully what their
European and Korean competitors are up to in getting a bigger slice of the Chinese
auto-market. Executives of Hollywood movie studios need to weigh the appeal of an
expensive movie in Europe and Asia as much as in the US before a firm commitment.
The globalizing wind has broadened the mindsets of executives, extended the
geographical reach of firms, and nudged international business (IB) research into some
new trajectories. One such new trajectory is the concern with national culture.
Whereas traditional IB research has been concerned with economic/ legal issues and
organizational forms and structures, the importance of national culture – broadly
defined as values, beliefs, norms, and behavioural patterns of a national group – has
become increasingly important in the last two decades, largely as a result of the
classic work of Hofstede (1980). National culture has been shown to impact on major
business activities, from capital structure (Chui et al., 2002) to group performance
(Gibson, 1999). For reviews, see’ Boyacigiller and Adler’ (1991) and ‘Earley and
Gibson’ (2002).
The purpose of this Unit is to provide a state-of-the-art review of several recent
advances in culture and IB research, with an eye toward productive avenues for
future research. It is not our purpose to be comprehensive; our goal is to spotlight a
few highly promising areas for leapfrogging the field in an increasingly boundary-less
business world. We first review the issues surrounding cultural convergence and
divergence, and the processes underlying cultural changes. We then examine novel
constructs for characterizing cultures, and how to enhance the precision of cultural
models by pinpointing when the effects of culture are important. Finally, we examine
the usefulness of experimental methods, which are rarely employed in the field of
culture and IB. A schematic summary of our coverage is given in Table 2.1, which
suggests that the topics reviewed are loosely related, and that their juxtaposition in
the present paper represents our attempt to highlight their importance rather than
their coherence as elements of an integrative framework.

1 Cultural change, convergence and divergence in an era of partial globalization


An issue of considerable theoretical significance is concerned with cultural changes
and transformations taking place in different parts of the world. In fact, since the
landmark study of Haire et al. (1966) and the publication of Industrialism and
Industrial Man by Kerr et al. (1960), researchers have continued to search for
similarities in culture-specific beliefs and attitudes in various aspects of work related
attitudes and behaviours, consumption patterns, and the like. If cultures of the
various locales of the world are indeed converging (e.g., Heuer et al., 1999), IB-
related practices would indeed become increasingly similar. Standard, culture-free
business practices would eventually emerge, and inefficiencies and complexities
associated with divergent beliefs and practices in the past era would disappear. In the
following section, we review the evidence on the issue and conclude that such an
outlook pertaining to the convergence of various IB practices is overly optimistic.

2 Evolution of partial globalization


Globalization refers to a ‘growing economic interdependence among countries, as
reflected in the increased cross-border flow of three types of entities: goods and
services, capital, and know-how’ (Govindarajan and Gupta, 2001, 4). Few spoke of
‘world economy’ 25 years ago, and the prevalent term was ‘international trade’
(Drucker, 1995). However today, international trade has culminated in the emergence
of a global economy, consisting of flows of information, technology, money, and
people, and is conducted via government international organizations such as the
North American Free Trade Agreement (NAFTA) and the European Community; global
organizations such as the International Organization for Standardization (ISO);
multinational companies (MNCs); and cross – border alliances in the form of joint
ventures, international mergers, and acquisitions. These inter – relationships have
enhanced participation in the world economy, and have become a key to domestic
economic growth and prosperity (Drucker, 1995, 153).
Yet, globalization is not without its misgivings and discontents (Sassan, 1998). A vivid
image associated with the G8 summits is the fervent protests against globalization in
many parts of the world, as shown in television and reported in the popular media.
Strong opposition to globalization usually originates from developing countries that
have been hurt by the destabilizing effects of globalization, but in recent times we
have also seen heated debates in Western economies triggered by significant loss of
professional jobs as a result of off shoring to low – wage countries. Indeed, workers in
manufacturing and farming in advanced economies are becoming increasingly wary of
globalization, as their income continues to decline significantly. In parallel to the
angry protests against globalization, the flow of goods, services, and investments
across national borders has continued to fall after the rapid gains of the 1990s.
Furthermore, the creation of regional trade blocs, such as NAFTA, the European
Union, and the Association of Southeast Asian Nations, have stimulated discussions
about creating other trade zones involving countries in South Asia, Africa, and other
parts of the world. Although it is often assumed that countries belonging to the World
Trade Organization (WTO) have embraced globalization, the fact is that the world is
only partially globalized, at best (Schaeffer, 2003). Many parts of Central Asia and
Eastern Europe, including the former republics of the Soviet Union, parts of Latin
America, Africa, and parts of South Asia, have been sceptical of globalization
(Greider, 1997). In fact, less than 10% of the world’s population is fully globalized
(i.e., being active participants in the consumption of global products and services)
(Schaeffer, 2003). Therefore, it is imperative that we analyze the issues of cultural
convergence and divergence in this partially globalized world.
‘Universal culture’ often refers to the assumptions, values, and practices of people in
the West and some elites in non-Western cultures. Huntington (1996) suggested that it
originates from the intellectual elites from a selected group of countries who meet
annually in the World Economic Forum in Davos, Switzerland. These individuals are
highly educated, work with symbols and numbers, are fluent in English, are
extensively involved with international commitments, and travel frequently outside
their country. They share the cultural value of individualism, and believe strongly in
market economics and political democracy. Although those belonging to the Davos
group control virtually all of the world’s important international institutions, many of
the world’s governments, and a great majority of the world’s economic and military
capabilities, the cultural values of the Davos group are probably embraced by only a
small fraction of the six billion people of the world.
Popular culture, again mostly Western European and American in origin, also
contributes to a convergence of consumption patterns and leisure activities around
the world. However, the convergence may be superficial, and have only a small
influence on fundamental issues such as beliefs, norms, and ideas about how
individuals, groups, institutions, and other important social agencies ought to
function. In fact, Huntington (1996, 58) noted that ‘The essence of Western
civilization is the Magna Carta, not the Magna Mac. The fact that non-Westerners may
bite into the latter has no implications for their accepting the former’. This argument
is obvious if we reverse the typical situation and put Western Europeans and
Americans in the shoes of recipients of cultural influence. For instance, while Chinese
Kung Fu dominates fight scenes in Hollywood movies such as Matrix Reloaded, and
Chinese restaurants abound in the West, it seems implausible that Americans and
Europeans have espoused more Chinese values because of their fondness of Chinese
Kung Fu and food. A major argument against cultural convergence is that
traditionalism and modernity may be unrelated (Smith and Bond, 1998). Strong
traditional values, such as group solidarity, interpersonal harmony, paternalism, and
feminism, can co-exist with modern values of individual achievement and
competition. A case in point is the findings that Chinese in Singapore and China
indeed endorsed both traditional and modern values (Chang et al., 2003; Zhang et al.,
2003). It is also conceivable that, just as we talk about Westernization of cultural
values around the world, we may also talk about Easternization of values in response
to forces of modernity and consumption values imposed by globalization (Marsella and
Choi, 1993).
Although the argument that the world is becoming one culture seems untenable,
there are some areas that do show signs of convergence. We explore in the following
the roles of several factors that simultaneously cause cultures of the world to either
converge or diverge, in an attempt to identify several productive avenues for future
research.

3 Role of multiculturalism and cultural identity


The broad ideological framework of a country, corporation, or situation is the most
important determinant of the cultural identity that people develop in a given locale
(Triandis, 1994). The ‘melting pot’ ideology suggests that each cultural group loses
some of its dominant characteristics in order to become the mainstream: this is
assimilation, or what Triandis (1994) calls subtractive multiculturalism.
In contrast, when people from a cultural group add appropriate skills and
characteristics of other groups, it may be called integration, or additive
multiculturalism. Both of these processes are essential for cultural convergence to
proceed. However, if there is a significant history of conflict between the cultural
groups, it is hard to initiate these processes, as in the case of Israelis and
Palestinians. In general, although there has been some research on the typology of
animosity against other nations (e.g., Jung et al., 2002), we do not know much about
how emotional antagonism against other cultural groups affects trade patterns and
intercultural cooperation in a business context. The issues of cultural identity and
emotional reactions to other cultural groups in an IB context constitute a significant
gap in our research effort in this area.

4 Implications of convergence and divergence issues


One message is clear: while convergence in some domains of IB activity is easily
noticeable, especially in consumer values and lifestyles, significant divergence of
cultures persists. In fact, Hofstede (2001) asserts that mental programs of people
around the world do not change rapidly, but remain rather consistent over time. His
findings indicate that cultural shifts are relative as opposed to absolute. Although
clusters of some countries in given geographical locales (e.g., Argentina, Brazil, Chile)
might indicate significant culture shifts towards embracing Anglo values, the changes
do not diminish the absolute differences between such countries and those of the
Anglo countries (i.e., US, Canada, UK). Huntington, in his ‘The Clash of Civilizations’
(1996), presents the view that there is indeed a resurgence of non-Western cultures
around the world, which could result in the redistribution of national power in the
conduct of international affairs. The attempt by the Davos group to bring about
uniform practices in various aspects of IB and work culture, thereby sustaining the
forces of globalization, is certainly worthwhile. However, our analysis suggests that
there is no guarantee that such convergence will come about easily, or without long
periods of resistance.
IB scholars need to understand that although some countries might exhibit strong
tendencies toward cultural convergence, as is found in Western countries, there are
countries that will reject globalization, not only because of its adverse economic
impacts (Greider, 1997) but also because globalization tends to introduce distortions
(in their view) in profound cultural syndromes that characterize their national
character.
Furthermore, reactions to globalization may take other forms. Bhagat et al. (2003)
have recently argued that adaptation is another approach that could characterize the
tendencies of some cultures in the face of mounting pressures to globalize. Other
approaches are rejection, creative synthesis, and innovation (Bhagat et al., 2003).
These different approaches highlight once again the complex dynamics that underlie
cultural convergence and divergence in a partially globalized world. Also, in
discussing issues of convergence and divergence, it is necessary to recognize that the
shift in values is not always from Western society to others, but can result in the
change of Western cultural values as well. For example, the emphasis on quality and
teamwork in the West is partly a result of the popularity of Japanese management
two decades ago.
Scholars of IB should recognize that the issue of convergence and divergence in this
era of partial globalization will remain as a persistent and complex issue whose
direction might only be assessed on a region-by-region basis. It is also wise to adopt
an interdisciplinary perspective in understanding the forces that create both
convergence and divergence of cultures in different parts of the world. For instance,
in Understanding Globalization, Schaeffer (2003) has provided an insightful discussion
of the social consequences of political, economic and other changes, which have
significant implications for IB. The cause-effect relationships of globalization and its
various outcomes, especially the cultural outcomes, are not only characterized by bi-
directional arrows, but are embedded in a complex web of relationships. How these
complex relationships and processes play out on the stage of IB remains to be
uncovered by IB researchers.

5 Processes of cultural changes


In the previous section, we make the point that, through the process of globalization,
cultures influence each other and change, but whether or not these changes will bring
about cultural convergence is yet to be seen. In this section, we delineate a general
model that describes and explains the complex processes underlying cultural changes.
As explained before, IB is both an agent and a recipient of cultural change, and for
international business to flourish it is important to understand its complex, reciprocal
relationships with cultural change.
In line with the view of Hofstede (2001) that culture changes very slowly, culture has
been treated as a relatively stable characteristic, reflecting a shared knowledge
structure that attenuates variability in values, behavioral norms, and patterns of
behaviors (Erez and Earley, 1993). Cultural stability helps to reduce ambiguity, and
leads to more control over expected behavioral outcomes (Weick and Quinn, 1999;
Leana and Barry, 2000). For instance, most existing models of culture and work
behaviour assume cultural stability and emphasize the fit between a given culture and
certain managerial and motivational practices (Erez and Earley, 1993). High fit means
high adaptation of managerial practices to a given culture and, therefore, high
effectiveness. The assumption of cultural stability is valid as long as there are no
environmental changes that precipitate adaptation and cultural change. Yet, the end
of the 20th century and the beginning of the new millennium have been characterized
by turbulent political and economical changes, which instigate cultural changes. In
line with this argument, Lewin and Kim (2004), in their comprehensive chapter on
adaptation and selection in strategy and change, distinguished between theories
driven by the underlying assumption that adaptation is the mechanism to cope with
change, and theories driven by the underlying assumption of selection and the
survival of the fittest, suggesting that ineffective forms of organization disappear,
and new forms emerge. However, although organizational changes as a reaction to
environmental changes have been subjected to considerable conceptual analyses, the
issue of cultural change at the national level has rarely been addressed.
There are relatively few theories of culture that pertain to the dynamic aspect of
culture. One exception is the eco-cultural model by Berry et al. (2002), which views
culture as evolving adaptations to ecological and socio-political influences, and views
individual psychological characteristics in a population as adaptive to their cultural
context, as well as to the broader ecological and socio-political influences. Similarly,
Kitayama (2002) proposes a system view to understanding the dynamic nature of
culture, as opposed to the entity view that sees culture as a static entity. This system
view suggests that each person’s psychological processes are organized through the
active effort to coordinate one’s behaviors with the pertinent cultural systems of
practices and public meanings. Yet, concurrently, many aspects of the psychological
systems develop rather flexibly as they are attuned to the surrounding socio-cultural
environment, and are likely to be configured in different ways across different socio-
cultural groups.
These adaptive views of culture are supported by empirical evidence. For example,
Van de Vliert et al. (1999) identified curvilinear relationships between temperature,
masculinity and domestic political violence across 53 countries. Their findings showed
that masculinity and domestic violence are higher in moderately warm countries than
in countries with extreme temperatures. Inglehart and Baker (2000) examined cultural
change as reflected by changes in basic values in three waves of the World Values
Surveys, which included 65 societies and 75% of the world’s population. Their analysis
showed that economic development was associated with shifts away from traditional
norms and values toward values that are increasingly rational, tolerant, trusting, and
participatory. However, the data also showed that the broad cultural heritage of a
society, whether it is Protestant, Roman Catholic, Orthodox, Confucian, or
Communist, leaves an enduring imprint on traditional values despite the forces of
modernization.
The process of globalization described before has introduced the most significant
change in IB, with its effects filtering down to the national, organizational, group and
individual levels. Reciprocally, changes at micro-levels of culture, when shared by the
members of the society, culminate into macro level phenomena and change the
macro-levels of culture. In the absence of research models that can shed light on this
complex process of cultural change, Erez and Gati (2004) proposed that the general
model of multi-level analysis (Klein and Kozlowski, 2000) could be adopted for
understanding the dynamics of culture and cultural change.
6 The dynamics of culture as a multi-level, multi-layer construct
The proposed model consists of two building blocks. One is a multi-level approach,
viewing culture as a multi-level construct that consists of various levels nested within
each other from the most macro-level of a global culture, through national cultures,
organizational cultures, group cultures, and cultural values that are represented in
the self at the individual level, as portrayed in Figure 2.1. The second is based on
Schein’s (1992) model viewing culture as a multi – layer construct consisting of the
most external layer of observed artifacts and behaviors, the deeper level of values,
which is testable by social consensus, and the deepest level of basic assumption,
which is invisible and taken for granted. The present model proposes that culture as a
multi – layer construct exists at all levels – from the global to the individual – and that
at each level change first occurs at the most external layer of behavior, and then,
when shared by individuals who belong to the same cultural context, it becomes a
shared value that characterizes the aggregated unit (group, organizations, or
nations).
In the model, the most macro-level is that of a global culture being created by global
networks and global institutions that cross national and cultural borders. As
exemplified by the effort of the Davos group discussed earlier, global organizational
structures need to adopt common rules and procedures in order to have a common
‘language’ for communicating across cultural borders (Kostova, 1999; Kostova and
Roth, 2003; Gupta and Govindarajan, 2000).
Figure 2.1: The dynamic of top-down–bottom-up processes across
levels of culture.
Given the dominance of Western MNCs, the values that dominate the global context
are often based on a free market economy, democracy, acceptance and tolerance of
diversity, respect of freedom of choice, individual rights, and openness to change
(Gupta and Govindarajan, 2000).
Below the global level are nested organizations and networks at the national level
with their local cultures varying from one nation or network to another. Further down
are local organizations, and although all of them share some common values of their
national culture, they vary in their local organizational cultures, which are also
shaped by the type of industry that they represent, the type of ownership, the values
of the founders, etc. Within each organization are sub-units and groups that share the
common national and organizational culture, but that differ from each other in their
unit culture on the basis of the differences in their functions (e.g., R&D vs
manufacturing), their leaders’ values, and the professional and educational level of
their members. At the bottom of this structure are individuals who through the
process of socialization acquire the cultural values transmitted to them from higher
levels of culture. Individuals who belong to the same group share the same values that
differentiate them from other groups and create a group – level culture through a
bottom-up process of aggregation of shared values. For example, employees of an
R&D unit are selected into the unit because of their creative cognitive style and
professional expertise. Their leader also typically facilitates the display of these
personal characteristics because they are crucial for developing innovative products.
Thus, all members of this unit share similar core values, which differentiate them
from other organizational units. Groups that share similar values create the
organizational culture through a process of aggregation, and local organizations that
share similar values create the national culture that is different from other national
cultures.
Both top-down and bottom-up processes reflect the dynamic nature of culture, and
explain how culture at different levels is being shaped and reshaped by changes that
occur at other levels, either above it through top-down processes or below it through
bottom-up processes. Similarly, changes at each level affect lower levels through a
top-down process, and upper levels through a bottom-up process of aggregation. The
changes in national cultures observed by Inglehart and Baker (2000) could serve as an
example for top-down effects of economic growth, enhanced by globalization, on a
cultural shift from traditional values to modernization. However, in line with Schein
(1992), the deep basic assumptions still reflect the traditional values shaped by the
broad cultural heritage of a society.
Global organizations and networks are being formed by having local-level
organizations join the global arena. That means that there is a continuous reciprocal
process of shaping and reshaping organizations at both levels. For example,
multinational companies that operate in the global market develop common rules and
cultural values that enable them to create a synergy between the various regions, and
different parts of the multinational company. These global rules and values filter
down to the local organizations that constitute the global company, and, over time,
they shape the local organizations. Reciprocally, having local organizations join a
global company may introduce changes into the global company because of its need
to function effectively across different cultural boarders. A study by Erez-Rein et al.
(2004) demonstrated how a multinational company that acquired an Israeli company
that develops and produces medical instruments changed the organizational culture of
the acquired company. The study identified a cultural gap between the two
companies, with the Israeli company being higher on the cultural dimension of
innovation and lower on the cultural dimension of attention to detail and conformity
to rules and standards as compared with the acquiring company. The latter insisted
on sending the Israeli managers to intensive courses in Six – Sigma, which is an
advanced method of quality improvement, and a managerial philosophy that
encompasses all organizational functions. Upon returning to their company, these
managers introduced quality improvement work methods and procedures to the local
company, and caused behavioural changes, followed by the internalization of quality –
oriented values. Thus, a top-down process of training and education led to changes in
work behaviour and work values. Sharing common behaviours and values by all
employees of the local company then shaped the organizational culture through
bottom–up processes. The case of cultural change via international acquisitions
demonstrated the two building blocks of our dynamic model of culture: the multi-
level structure explains how a lower-level culture is being shaped by top-down
effects, and that the cultural layer that changes first is the most external layer of
behaviour. In the long run, bottom – up processes of shared behaviours and norms
shape the local organizational culture.

7 Factors that facilitate cultural change


Culture itself influences the level of resistance or acceptance of change. Harzing and
Hofstede (1996) proposed that certain cultural values facilitate change, whereas
others hinder it. The values of low power distance, low uncertainty avoidance, and
individualism facilitate change. Change threatens stability, and introduces
uncertainty, and resistance to change will therefore be higher in cultures of high
rather than low uncertainty avoidance (Steensma et al., 2000). Change also threatens
the power structure, and therefore will be avoided in high power distance cultures.
Finally, change breaks the existing harmony, which is highly valued in collectivistic
cultures, and therefore will not be easily accepted by collectivists (Levine and
Norenzayan, 1999).
A recent study by Erez and Gati (2004) examined the effects of three factors on the
change process and its outcomes:
· the cultural value of individualism – collectivism;
· the reward structure and its congruence with the underlying cultural values; and
· the degree of ambiguity in the reward structure.
The change process examined was a shift from choosing to work alone to a
behavioural choice of working as part of a team, and vice versa. Working alone is
more prevalent in individualistic cultures, whereas working in teams dominates the
collectivistic ones.

8 Understanding when culture matters: increasing the precision of cultural models


Beyond exploring new cultural constructs and the dynamic nature of culture, we also
argue for the importance of examining contingency factors that enhance or mitigate
the effect of national culture. Consider the following scenario. A senior human
resource manager in a multinational firm is charged with implementing an integrative
training program in several of the firm’s subsidiaries around the globe. Over the term
of her career, the manager has been educated about differences in national culture
and is sensitive to intercultural opportunities and challenges. At the same time, she
understands the strategic need to create a unified global program that serves to
further integrate the firm’s basic processes, creating efficiencies and synergies across
the remote sites. She approaches the implementation with trepidation. A key
challenge is to determine whether the program should be implemented in the same
manner in each subsidiary or modified according to the local culture at each site. Put
another way, in this complex circumstance, does culture matter?

Q.3. a. Explain the brief structure of WTO. (5 marks)


Sol.
Structure of World Trade Organization (WTO)
The WTO’s overriding objective is to help trade flow smoothly, freely, fairly and
predictably.
It does this by:
· Administering trade agreements
· Acting as a forum for trade negotiations
· Settling trade disputes
· Reviewing national trade policies
· Assisting developing countries in trade policy issues, through technical assistance
and training programs
· Cooperating with other international organizations

Structure
The WTO has nearly 150 members, accounting for over 97% of world trade. Around 30
others are negotiating membership.
Decisions are made by the entire membership. This is typically by consensus. A
majority vote is also possible but it has never been used in the WTO, and was
extremely rare under the WTO’s predecessor, GATT. The WTO’s agreements have
been ratified in all members’ parliaments.
The WTO’s top level decision-making body is the Ministerial Conference which meets
at least once every two years.
Below this is the General Council (normally ambassadors and heads of delegation in
Geneva, but sometimes officials sent from members’ capitals) which meets several
times a year in the Geneva headquarters. The General Council also meets as the
Trade Policy Review Body and the Dispute Settlement Body.
At the next level, the Goods Council, Services Council and Intellectual Property
(TRIPS) Council report to the General Council.
Numerous specialized committees, working groups and working parties deal with
the individual agreements and other areas such as the environment, development,
membership applications and regional trade agreements.
Secretariat
The WTO Secretariat, based in Geneva, has around 600 staff and is headed by a
director-general. Its annual budget is roughly 160 million Swiss francs. It does not
have branch offices outside Geneva. Since decisions are taken by the members
themselves, the Secretariat does not have the decision-making role that other
international bureaucracies are given with. The Secretariat’s main duties are to
supply technical support for the various councils and committees and the ministerial
conferences, to provide technical assistance for developing countries, to analyze
world trade, and to explain WTO affairs to the public and media.
The Secretariat also provides some forms of legal assistance in the dispute settlement
process and advises governments wishing to become members of the WTO.

Figure 5.1: Structure of WTO


The WTO is ‘member-driven’, with decisions taken by consensus among all member
governments.
The WTO is run by its member governments. All major decisions are made by the
membership as a whole, either by ministers (who meet at least once every two years)
or by their ambassadors or delegates (who meet regularly in Geneva). Decisions are
normally taken by consensus.
In this respect, the WTO is different from some other international organizations such
as the World Bank and International Monetary Fund. In the WTO, power is not
delegated to a board of directors or the organization’s head.
When WTO rules impose disciplines on countries’ policies, that is the outcome of
negotiations among WTO members, the rules are enforced by the members
themselves under agreed procedures that they negotiated, including the possibility of
trade sanctions. But those sanctions are imposed by member countries, and
authorized by the membership as a whole. This is quite different from other agencies
whose bureaucracies can, for example, influence a country’s policy by threatening to
withhold credit.
Reaching decisions by consensus among some 150 members can be difficult. Its main
advantage is that decisions made this way are more acceptable to all members. And
despite the difficulty, some remarkable agreements have been reached. Nevertheless,
proposals for the creation of a smaller executive body – perhaps like a board of
directors each representing different groups of countries – are heard periodically. But
for now, the WTO is a member-driven, consensus-based organization.
Highest authority: the Ministerial Conference
So, the WTO belongs to its members. The countries make their decisions through
various councils and committees, whose membership consists of all WTO members.
Topmost is the ministerial conference which has to meet at least once every two
years. The Ministerial Conference can take decisions on all matters under any of the
multilateral trade agreements.
Second level: General Council in three guises
Day-to-day work in between the ministerial conferences is handled by three bodies:
· The General Council
· The Dispute Settlement Body
· The Trade Policy Review Body
All three are in fact the same – the Agreement Establishing the WTO states they are
all the General Council, although they meet under different terms of reference.
Again, all three consist of all WTO members. They report to the Ministerial
Conference.
The General Council acts on behalf of the Ministerial Conference on all WTO affairs. It
meets as the Dispute Settlement Body and the Trade Policy Review Body to oversee
procedures for settling disputes between members and to analyze members’ trade
policies.
Third level: councils for each broad area of trade, and more back to top
Three more councils, each handling a different broad area of trade, report to the
General Council:
· The Council for Trade in Goods (Goods Council)
· The Council for Trade in Services (Services Council)
· The Council for Trade – Related Aspects of Intellectual Property Rights (TRIPS
Council)
As their names indicate, the three are responsible for the workings of the WTO
agreements dealing with their respective areas of trade. Again they consist of all WTO
members. These three also have the subsidiary bodies.
Six other bodies report to the General Council. The scope of their coverage is smaller,
so they are “committees”. But they still consist of all WTO members. They cover
issues such as trade and development, the environment, regional trading
arrangements, and administrative issues. The Singapore Ministerial Conference in
December 1996 decided to create new working groups to look at investment and
competition policy, transparency in government procurement, and trade facilitation.
Two more subsidiary bodies dealing with the plural-lateral agreements (which are not
signed by all WTO members) keep the General Council informed of their activities
regularly.
Fourth level: down to the nitty-gritty
Each of the higher level councils has subsidiary bodies. The Goods Council has 11
committees dealing with specific subjects (such as agriculture, market access,
subsidies, anti-dumping measures and so on). Again, these consist of all member
countries. Also reporting to the Goods Council is the Textiles Monitoring Body, which
consists of a chairman and 10 members acting in their personal capacities, and groups
dealing with notifications (governments informing the WTO about current and new
policies or measures) and state trading enterprises.
The Services Council’s subsidiary bodies deal with financial services, domestic
regulations, GATS rules and specific commitments.
At the General Council level, the Dispute Settlement Body also has two subsidiaries:
the dispute settlement “panels” of experts appointed to adjudicate on unresolved
disputes, and the Appellate Body that deals with appeals.
Heads of Delegations and other boards: the need for informality
Important breakthroughs are rarely made in formal meetings of these bodies, least of
all in the higher level councils. Since decisions are made by consensus, without
voting, informal consultations within the WTO play a vital role in bringing a vastly
diverse membership round to an agreement.
One step away from the formal meetings is informal meetings that still include the
full membership, such as those of the Heads of Delegations (HOD). More difficult
issues have to be thrashed out in smaller groups. A common recent practice is for the
chairperson of a negotiating group to attempt to forge a compromise by holding
consultations with delegations individually, in twos or threes, or in groups of 20 – 30
of the most interested delegations.
These smaller meetings have to be handled sensitively. The key is to ensure that
everyone is kept informed about what is going on (the process must be “transparent”)
even if they are not in a particular consultation or meeting, and that they have an
opportunity to participate or provide input (it must be “inclusive”).
One term has become controversial, but more among some outside observers than
among delegations. The “Green Room” is a phrase taken from the informal name of
the director-general’s conference room. It is used to refer to meetings of 20 – 40
delegations, usually at the level of heads of delegations. These meetings can take
place elsewhere, such as at Ministerial Conferences, and can be called by the minister
chairing the conference as well as the director-general. Similar smaller group
consultations can be organized by the chairs of committees negotiating individual
subjects, although the term Green Room is not usually used for these.
In the past delegations have sometimes felt that Green Room meetings could lead to
compromises being struck behind their backs. So, extra efforts are made to ensure
that the process is handled correctly, with regular reports back to the full
membership.
The way countries now negotiate has helped somewhat. In order to increase their
bargaining power, countries have formed coalitions. In some subjects such as
agriculture virtually all countries are members of at least one coalition – and in many
cases, several coalitions. This means that all countries can be represented in the
process if the coordinators and other key players are present. The coordinators also
take responsibility for both “transparency” and “inclusiveness” by keeping their
coalitions informed and by taking the positions negotiated within their alliances.
In the end, decisions have to be taken by all members and by consensus. The
membership as a whole would resist attempts to impose the will of a small group. No
one has been able to find an alternative way of achieving consensus on difficult
issues, because it is virtually impossible for members to change their positions
voluntarily in meetings of the full membership.
Market access negotiations also involve small groups, but for a completely different
reason. The final outcome is a multilateral package of individual countries’
commitments, but those commitments are the result of numerous bilateral, informal
bargaining sessions, which depend on individual countries’ interests. (Examples
include the traditional tariff negotiations, and market access talks in services.)
So, informal consultations in various forms play a vital role in allowing consensus to
be reached, but they do not appear in organization charts, precisely because they are
informal.
They are not separate from the formal meetings, however. They are necessary for
making formal decisions in the councils and committees. Nor are the formal meetings
unimportant. They are the forums for exchanging views, putting countries’ positions
on the record, and ultimately for confirming decisions. The art of achieving
agreement among all WTO members is to strike an appropriate balance, so that a
breakthrough achieved among only a few countries can be acceptable to the rest of
the membership.

b. Highlight the drawbacks of GATT. (5 marks)


Sol.
Given its provisional nature and limited field of action, the success of GATT in
promoting and securing the liberalization of much of world trade over 47 years is
incontestable. Continual reductions in tariffs alone helped spur very high rates of
world trade growth – around 8 per cent a year on average during the 1950s and 1960s.
And the momentum of trade liberalization helped ensure that trade growth
consistently out-paced production growth throughout the GATT era. The rush of new
members during the Uruguay Round demonstrated that the multilateral trading
system, as then represented by GATT, was recognized as an anchor for development
and an instrument of economic and trade reform.
The limited achievement of the Tokyo Round, outside the tariff reduction results, was
a sign of difficult times to come. GATT’s success in reducing tariffs to such a low
level, combined with a series of economic recessions in the 1970s and early 1980s,
drove governments to devise other forms of protection for sectors facing increased
overseas competition. High rates of unemployment and constant factory closures led
governments in Europe and North America to seek bilateral market-sharing
arrangements with competitors and to embark on a subsidies race to maintain their
holds on agricultural trade. Both these changes undermined the credibility and
effectiveness of GATT.
Apart from the deterioration in the trade policy environment, it also became
apparent by the early 1980s that the General Agreement was no longer as relevant to
the realities of world trade as it had been in the 1940s. For a start, world trade had
become far more complex and important than 40 years before: the globalization of
the world economy was underway, international investment was exploding and trade
in services – not covered by the rules of GATT – was of major interest to more and
more countries and, at the same time, closely tied to further increases in world
merchandise trade. In other respects, the GATT had been found wanting: for
instance, with respect to agriculture where loopholes in the multilateral system were
heavily exploited – and efforts at liberalizing agricultural trade met with little success
– and in the textiles and clothing sector where an exception to the normal disciplines
of GATT was negotiated in the form of the Multi-fibre Arrangement. Even the
institutional structure of GATT and its dispute settlement system were giving cause
for concern.
Together, these and other factors convinced GATT members that a new effort to
reinforce and extend the multilateral system should be attempted. That effort
resulted in the Uruguay Round.

Q.4. a. Give a short note on the regional economic integration. (5 marks)


Sol.
Regional Economic Integration
Regional integration can take many forms, and nowhere is this more evident than in
the vastly different integration processes taking place in the regions of Europe and
East Asia. The subject of this paper is regional integration as it has developed in East
Asia with a focus on the drivers of that integration. While the paper is not intended as
a direct comparison of integration in East Asia and Europe, it will include some
comparisons between the two regions.
Integration in East Asia has progressed very slowly and is still in an early stage despite
that the process has continued for decades. In fact, it could be said that the process
began centuries ago – even as far back as the 15th century. By comparison, European
integration has progressed steadily and has gradually deepened over the last 50 years
to reach an advanced stage today with a common currency and well-developed
regional institutions. Thus, the speed of progression and the level of integration
attained in the two regions are quite dissimilar.
In addition to these differences, the drivers behind the integration process in each
region are different. In Europe, the origins of integration have been institutional in
nature, and the development of institutions has been prominent throughout the
process. Thus, regional institutions have been the driving force behind integration in
Europe. In East Asia, the development of regional institutions has also occurred;
however, progress in this area has been slow and the few existing institutions are
fairly weak and ineffective. Nevertheless, regional integration is taking place in East
Asia, but the driving force is the market rather than policy or institutions.
Corporations and the production networks they have established are driving
integration in East Asia.

b. Mention the benefits of WTO. (5 marks)


Sol.
Ten Benefits of WTO
1. The system helps to keep the peace
2. The system allows disputes to be handled constructively
3. A system based on rules rather than power makes life easier for all
4. Freer trade cuts the cost of living
5. It gives consumers more choice and a broader range of qualities to choose from
6. Trade raises incomes
7. Trade stimulates economic growth and that can be good news for employment
8. The basic principles make the system economically more efficient, and they cut
costs
9. The system shields governments from narrow interests
10. The system encourages good government

Q. 5 a. Explain five-element product wave model. (7 marks)


Sol.
The Five-Element Product Wave
As illustrated in Figure 4.5, the wave model employs design engineering, process
engineering, product marketing, production, and end-of-life activities as elements.
The first wave is associated with the "A" version of a product or service, and survives
through the traditional PLC introduction and growth phases. A second wave begins
with the "B" version, the markedly improved second model. It starts just before the
traditional life cycle maturity stage and lives until sales decline to a point at which an
EOL decision must be made.
Note that design engineering has a peak of activity level at each upgrade. Process
engineering activity shadows that of design engineering, as system changes will be
contemplated and made to facilitate the changes made in the product or service.
Product marketing also has activity level spikes that closely match engineering design
activity, lagged somewhat for product introduction. Production has one activity peak
that results from demand management and production planning through master
production scheduling.
Finally, the EOL curve peaks at each redesign. The last wave begins shortly before
original production ceases and ends when the product is no longer manufactured or
supported by the EOL Company or division. The EOL element requires that a decision
be made about the preceding version at each major redesign: continue production,
make a short-term run of spares, keep blueprints active so that parts can be made as
ordered, enter into a manufacturing and support agreement with another entity, or
discontinue production.
For the sake of parsimony, Figure 4.5 shows only a two-product model ("A" and "B"
versions). In reality, there may be hundreds of significant redesigns. The wave effect
comes from the fact that the process repeats for the successful firm, forming swells in
design engineering, process engineering, product marketing, and manufacturing
curves before the final crest at EOL activity.
The five-element product wave, or FPW, uses trigger points, rather than time, as the
horizon over which the element curves vary. Changes in magnitude, represented by
the vertical axis, result from differing activity levels within the five elements. Simple
changes in levels of dollar or unit product sales, in and of themselves, do not
necessarily determine the trigger points. Rather, the varying activity levels are a
direct result of product introductions and redesigns that, from the outset, must take
into account company strategy, core capabilities, and the state of the competitive
environment. For example, a product with strong sales may be redesigned in a
preemptive strike against competitors, further distancing that product from the
competition, such as with Caterpillar’s innovative high-drive bulldozers.
That the five-element wave is grounded in reality becomes apparent when considering
the recent research that suggests product introduction cycles are being compressed.
Bayus (1994) claims that knowledge is being applied faster, resulting in increasing
levels of new product introductions. Yet since product removals are not keeping pace
with introductions, there are an increasing number of product variations on the
market. Slater (1993) observes that product life cycles are growing shorter and
shorter. Vesey (1992) reports that the strategy for the 1990s is speed to market and
discusses the pressures the market is exerting to shorten product introduction lead
times.
Regardless of whether life cycles are actually being compressed or knowledge is
simply being applied faster, it is apparent that firms are increasing the speed with
which they bring their products to market. The effect of this is a compression of the
design engineering, process engineering, production, and product marketing elements
of the wave model. (The EOL curve may remain unchanged because accelerated
introductions do not necessarily affect EOL efforts.) The five-element wave clearly
shows the inefficiency of traditional "over-the-wall" systems as speed to market
increases. As the elements compress, more and more information is thrown over the
wall. Recipients find themselves with less and less time to take action. Taken to the
extreme, in-baskets, phone lines, conference rooms, desks, and floors are soon
gridlocked and littered with unanswered correspondence and things to do. Forget
quality; production itself grinds to a halt.
The solution is to maximize the advantage of the relationships within the five-
element wave and work in concurrent teams, as illustrated in Figure 6. That way,
responsibility is shared throughout the system. Members from each discipline optimize
the system. The method tears down barriers between departments and speeds the
introduction process, thus decreasing costs. The focal point becomes the customer,
rather than the task. The system is totally interactive and bound together. Each
element is connected to all of the others and is focused on the customer. (Note that
the authors have taken a great deal of artistic license here! No meaning should be
attached to the actual measure of overlap area in Figure 4.6.)
What is the recent experience with teams? There is evidence that using concurrent
design teams speeds the product to market and provides substantial savings. Boeing
expects that concurrent design will save some $4 billion in the development of its 777
airliner. Westinghouse recently suggested that concurrent engineering would
eliminate 200 duplicate processes in a project that consisted of 600 using traditional
over-the-wall approaches. Ford’s Team Taurus was able to cut a full year out of
model turnaround. In addition, design changes required after initial production began
were reduced by some 76 percent.
The strength of the five-element product wave is the fact that it illuminates critical
decision points in the life of a product or service. The interrelationships of the
elements clearly illustrate the benefit of working product introductions, design
changes, and end-of-life decisions in teams. This is particularly true in today’s rapidly
compressing environment of speeding products to market. Furthermore, the model is
flexible and may be expanded or contracted to include those functional areas
relevant to the production team. Thus, whether a given firm’s product is a service or
a manufactured good, the five-element wave is a powerful tool that can be deployed
to accelerate effective decision making in markets demanding ever-increasing levels
of speed and agility.

b. What do you mean by globalization? (3 marks)


Sol.
Economic "globalization" is a historical process, the result of human innovation and
technological progress. It refers to the increasing integration of economies around the
world, particularly through trade and financial flows. The term sometimes also refers
to the movement of people (labor) and knowledge (technology) across international
borders. There are also broader cultural, political and environmental dimensions of
globalization that are not covered here.
At its most basic, there is nothing mysterious about globalization. The term has come
into common usage since the 1980s, reflecting technological advances that have made
it easier and quicker to complete international transactions – both trade and financial
flows. It refers to an extension beyond national borders of the same market forces
that have operated for centuries at all levels of human economic activity – village
markets, urban industries, or financial centers.
Markets promote efficiency through competition and the division of labor – the
specialization that allows people and economies to focus on what they do best. Global
markets offer greater opportunity for people to tap into more and larger markets
around the world. It means that they can have access to more capital flows,
technology, cheaper imports, and larger export markets. But markets do not
necessarily ensure that the benefits of increased efficiency are shared by all.
Countries must be prepared to embrace the policies needed, and in the case of the
poorest countries may need the support of the international community as they do so.

Q. 6. Give some examples of companies doing international business and discuss


how they have they have managed their business in the international markets. (10
marks) Fall 2010
Sol.
A PERSPECTIVE OF THE NORTHEN ISLAND SOFTWARE COMPANIES, RAPD M–UP
Within six months of announcing it would invest $4.5 million to establish its new
software development center in Northern Ireland, IMR was up and running with more
than one-third its target staff.
"The fast start-up of the Belfast facility reaffirms our confidence to locate in Northern
Ireland," said Sanan. "The success to date in building a quality work force has
surpassed our expectations and opens up new ambitions for our interests in Northern
Ireland."
According to Arthur "Bro" McFerran, president of IMR (NI) Ltd., the company is hiring
12 to 18 programmers a month in Northern Ireland and is well on its way to meeting
its staffing goal of 300 by 1999. McFerran credited Northern Ireland’s Training &
Employment Agency (T&EA) with helping place the company’s staffing on the fast
track.
"The T&EA not only has helped us to identify and recruit qualified software graduates
from Northern Ireland’s universities, it is also assisting us with a unique initiative to
bring additional sources of high quality talent to the company," McFerran said.
Innovation In Training
Impressed by the number and quality of information technology graduates from the
region’s universities, IMR recognized an untapped resource in the well-educated,
versatile graduates of other fields in Northern Ireland. Working with the T&EA, IMR
developed "IMR Academy," an intensive
20-week training program at the Belfast Institute of Further and Higher Education, to
expand the skills of qualified applicants who are not computer software graduates,
but who are equally well-educated in other
Disciplines and who have demonstrated aptitude for learning computer software
programming.
Tom Scott of the T&EA said IMR applicants are assessed throughout the program and
those who successfully complete the course are awarded a National Computing
Certificate and full-time employment with IMR. Approximately 40 trainees have
already participated in the program.
"IMR is extremely pleased with the T&EAs ability to design and deliver a training
program customized to our needs, and one that is delivering us an impressive pool of
incremental programming talent," McFerran said.
Smart And Available
"The recent software investments by IMR and other companies provide a new
opportunity for Northern Ireland’s computer graduates," McFerrin said. Recruitment
research by IMR indicates that traditionally, nearly half of the region’s computer
graduates have been forced to seek jobs outside Northern Ireland due to the lack of
available information technology positions.
Now IT graduates have the chance to find good jobs in Northern Ireland, and
graduates from other fields can take advantage of the IMR Academy training program
to get a head start on a career in the growing software sector.
McFerrin said. Recruitment research by IMR indicates that traditionally, nearly half of
the region’s computer graduates have been forced to seek jobs outside Northern
Ireland due to the lack of available information technology positions.

Competitive Advantage
Northern Ireland recently has attracted information technology – based investments
from other multinational companies such as BT, Fujitsu, Liberty Mutual Group,
Seagate Technology, STB Systems and UniComp. These companies cite Northern
Ireland’s work force and favorable cost base in their decisions to locate in the region.
"The availability of high-quality graduates combined with the region’s competitive
operating costs and attractive incentives made Northern Ireland the best possible
location for STB," said Richard W. Cooke, STB’s director of engineering operations.
With salaries and fringe costs for well trained software engineers in Northern Ireland
approximately 50 percent lower than costs for US engineers, and low employee
turnover and favorable rates for office space, the overall annual per capita
operational costs to develop high quality software can be significantly less compared
with these same costs in the United States.
Typical starting salaries for IT graduates in Northern Ireland are $22,000 to $25,000
annually. At less than three percent annually, Northern Ireland’s employee turnover
rate is a fraction of the rates typically experienced in other parts of Europe and the
United States. Annual costs per square foot for office space, exclusive of property
taxes and service charges, range from as low as $5 per square foot in some
development areas, to approximately $14 in Belfast. These costs can be as much as 50
percent lower than office space costs in other European cities.
Master Of Business Administration-MBA Semester 4
MB0037 – International Business Management
Assignment Set-2

Note: Each question carries 10 Marks. Answer all the questions.


Q.1 Evaluate the monetary system and currency markets in international business
management. (10 marks)
Sol.
The IMF is an international organization of 185 member countries. It was established
to promote international monetary cooperation, exchange stability, and orderly
exchange arrangements; to foster economic growth and high levels of employment;
and to provide temporary financial assistance to countries to help ease balance of
payments adjustment.
The International Monetary Fund (IMF) is the intergovernmental organization that
oversees the global financial system by following the macroeconomic policies of its
member countries, in particular those with an impact on exchange rate and the
balance of payments. It is an organization formed with a stated objective of
stabilizing international exchange rates and facilitating development through the
enforcement of liberalising economic policies[1][2] on other countries as a condition for
loans, restructuring or aid.[3] It also offers highly leveraged loans, mainly to poorer
countries. Its headquarters is in Washington, D.C., United States.

Organization and purpose


IMF "Headquarters 1" in Washington, D.C.
The International Monetary Fund was created in July 1945, originally with 45
members,[4] with a goal to stabilize exchange rates and assist the reconstruction of
the world's international payment system. Countries contributed to a pool which could
be borrowed from, on a temporary basis, by countries with payment imbalances
(Condon, 2007). The IMF was important when it was first created because it helped
the world stabilize the economic system. The IMF works to improve the economies of
its member countries.[5]
The IMF describes itself as "an organization of 187 countries (as of July 2010),[6][7]
working to foster global monetary cooperation, secure financial stability, facilitate
international trade, promote high employment and sustainable economic growth, and
reduce poverty". With the exception of Cuba (left in 1964),[8] Taiwan (expelled in
1980),[9] North Korea, Andorra, Monaco, Liechtenstein, Tuvalu and Nauru, all UN
member states participate directly in the IMF. Member states are represented on a
24-member Executive Board (five Executive Directors are appointed by the five
members with the largest quotas, nineteen Executive Directors are elected by the
remaining members), and all members appoint a Governor to the IMF's Board of
Governors.[1

Data dissemination systems


In 1995, the International Monetary Fund began work on data dissemination standards
with the view of guiding IMF member countries to disseminate their economic and
financial data to the public. The International Monetary and Financial Committee
(IMFC) endorsed the guidelines for the dissemination standards and they were split
into two tiers: The GDDS and the SDDS.
The International Monetary Fund executive board approved the SDDS and GDDS in
1996 and 1997 respectively and subsequent amendments were published in a revised
"Guide to the General Data Dissemination System". The system is aimed primarily at
statisticians and aims to improve many aspects of statistical systems in a country. It is
also part of the World Bank Millennium Development Goals and Poverty Reduction
Strategic Papers.
The IMF established a system and standard to guide members in the dissemination to
the public of their economic and financial data. Currently there are two such systems:
General Data Dissemination System (GDDS) and its superset Special Data
Dissemination System (SDDS), for those member countries having or seeking access to
international capital markets.
The primary objective of the GDDS is to encourage IMF member countries to build a
framework to improve data quality and increase statistical capacity building. This will
involve the preparation of meta data describing current statistical collection practices
and setting improvement plans. Upon building a framework, a country can evaluate
statistical needs, set priorities in improving the timeliness, transparency, reliability
and accessibility of financial and economic data.

Q.2 a. Mention the different entry strategies to enter international markets. (4


marks)
Sol.
Entry Strategies
Methods of entry
With rare exceptions, products just don’t emerge in foreign markets overnight – a firm
has to build up a market over time. Several strategies, which differ in aggressiveness,
risk, and the amount of control that the firm is able to maintain, are available:
· Exporting is a relatively low risk strategy in which few investments are made in the
new country. A drawback is that, because the firm makes few if any marketing
investments in the new country, market share may be below potential. Further, the
firm, by not operating in the country, learns less about the market (What do
consumers really want? Which kinds of advertising campaigns are most successful?
What are the most effective methods of distribution?) If an importer is willing to do a
good job of marketing, this arrangement may represent a "win-win" situation, but it
may be more difficult for the firm to enter on its own later if it decides that larger
profits can be made within the country.
· Licensing and franchising are also low exposure methods of entry – you allow
someone else to use your trademarks and accumulated expertise. Your partner puts
up the money and assumes the risk. Problems here involve the fact that you are
training a potential competitor and that you have little control over how the business
is operated. For example, American fast food restaurants have found that foreign
franchisees often fail to maintain American standards of cleanliness. Similarly, a
foreign manufacturer may use lower quality ingredients in manufacturing a brand
based on premium contents in the home country.
· Contract manufacturing involves having someone else manufacture products while
you take on some of the marketing efforts yourself. This saves investment, but again
you may be training a competitor.
· Direct entry strategies, where the firm either acquires a firm or builds operations
"from scratch" involve the highest exposure, but also the greatest opportunities for
profits. The firm gains more knowledge about the local market and maintains greater
control, but now has a huge investment. In some countries, the government may
expropriate assets without compensation, so direct investment entails an additional
risk. A variation involves a joint venture, where a local firm puts up some of the
money and knowledge about the local market.

b. How has E-commerce helped in international marketing? (6 marks)


Sol.
Electronic Commerce
1 Prospects for electronic commerce
Electronic commerce – usually in the form of sales, promotion, or support through the
Internet – is a hot topic at the moment, evidenced by the high market capitalization
of firms involved in this kind of business. Growth rates have been considerable over
the last two years and are expected to persist, at least to some extent, for at least
the next several years. Yet, it should be recognized that so far, sales over the
Internet account for only a small portion of sales – especially outside the U.S.
2 Obstacles to diffusion
Obstacles to the diffusion of Internet trade come both from enduring sources and
temporary roadblocks which may be overcome as consumer attitudes change and
technology is improved. Currently, Internet connections are slower than desired so
that downloading pictures and other information may take longer than consumers are
willing to wait. "Glitches" in online ordering systems may also frustrate consumers,
who are unable to place their orders at a given time or have difficulty navigating
through a malfunctioning site. The lack of non-English language sites in some areas
may also be off-putting to consumers, and registering domain names in some
countries is difficult. Further, shipping small packages across countries may be
inefficient due to high local postage rates and inefficiencies in customs processing.
Most of these obstacles may be overcome within next few years.
Other obstacles may, however, have considerably greater staying power. First, there
are legal problems, as several different countries may seek to impose their
jurisdiction on advertising and laws of product assortment and business practices.
Further, the maintenance of databases, which are essential to delivering on the
promises of e-commerce, may conflict with the privacy rules of some countries – this
is currently a hot issue of contention between the United States and the European
Union. Finally, there are issues of taxation and collection. While the Clinton
Administration has sought to get the WTO to go along with a three year tax
"moratorium" on Internet purchases much like the one observed in the U.S., strong
opposition is expected. A great attraction of e-commerce in Europe is that people
may order from other countries and thus evade local sales taxes, which can be
prohibitive (e.g., 25% in Denmark and 16% in Germany). Some firms will ship to
customers in neighbouring countries without collecting sales taxes or duties, with the
responsibility of paying falling on the consumer. Although most consumers who order
and do not arrange to pay for these taxes get away with it, fines for those caught
through random checks can be severe.
3 Locus of the site
Some firms have chosen to maintain a global site, with reference only to local sales or
support offices; others, in contrast, have unique sites for each country. In some cases,
global sites will hyperlink surfers to a country or region relevant to the site. Note that
some confusion exists since many sites outside the U.S. maintain the ".com"
designation rather than their countries’ respective suffix (e.g., ".de" for Germany,
".se" for Sweden, and ".au" for Australia). Some firms have experienced problems
getting their banks to accept credit card charges in more than one currency, and thus
it may be difficult to indicate precise prices in more than one denomination (one site
based in Britain offered its American customers to be as accurate as possible, based
on current exchange rates, although the charge could be off "by a few pennies.")
4 Lifecycle stages across the World
It has been suggested that Europe runs some five years behind the U.S. in electronic
commerce, but some sources dispute this, suggesting that lack of success among
American retailers may have other origins, such as inadequate adaptation (for
example, some British users are put off by American English). There are, however,
some factors which cause most countries run behind. Even in Europe, Internet access
penetration rates are lower than they are in the U.S., and the slower speed
associated with downloading Asian characters is discouraging. In some countries,
credit card penetration is lower, and even in European countries with high
penetration rates, consumers are reluctant to use them. Further, the fact that
consumers in most countries have to pay a per minute phone charge discourages the
essential casual and relaxed browsing common in the U.S. so long as unlimited cable
or hardwired access is not offered.

Q.3 a. Explain Bill of Lading and Letters of credit. (8 marks)


Sol.
A bill of lading (sometimes referred to as a BOL,or B/L) is a document issued by a
carrier to a shipper, acknowledging that specified goods have been received on board
as cargo for conveyance to a named place for delivery to the consignee who is usually
identified. A thorough bill of lading involves the use of at least two different modes
of transport from road, rail, air, and sea. The term derives from the verb "to lade"
which means to load a cargo onto a ship or other form of transportation.
A bill of lading can be used as a traded object. The standard short form bill of lading
is evidence of the contract of carriage of goods and it serves a number of purposes:
• It is evidence that a valid contract of carriage, or a chartering contract, exists,
and it may incorporate the full terms of the contract between the consignor
and the carrier by reference (i.e. the short form simply refers to the main
contract as an existing document, whereas the long form of a bill of lading
(connaissement intégral) issued by the carrier sets out all the terms of the
contract of carriage);
• It is a receipt signed by the carrier confirming whether goods matching the
contract description have been received in good condition (a bill will be
described as clean if the goods have been received on board in apparent good
condition and stowed ready for transport); and
• It is also a document of transfer, being freely transferable but not a negotiable
instrument in the legal sense, i.e. it governs all the legal aspects of physical
carriage, and, like a cheque or other negotiable instrument, it may be
endorsed affecting ownership of the goods actually being carried. This matches
everyday experience in that the contract a person might make with a
commercial carrier like FedEx for mostly airway parcels, is separate from any
contract for the sale of the goods to be carried; however, it binds the carrier
to its terms, irrespectively of who the actual holder of the B/L, and owner of
the goods, may be at a specific moment.
• A standard, commercial letter of credit is a document issued mostly by a
financial institution, used primarily in trade finance, which usually provides an
irrevocable payment undertaking.
• The letter of credit can also be source of payment for a transaction, meaning
that redeeming the letter of credit will pay an exporter. Letters of credit are
used primarily in international trade transactions of significant value, for deals
between a supplier in one country and a customer in another. They are also
used in the land development process to ensure that approved public facilities
(streets, sidewalks, storm water ponds, etc.) will be built. The parties to a
letter of credit are usually a beneficiary who is to receive the money, the
issuing bank of whom the applicant is a client, and the advising bank of whom
the beneficiary is a client. Almost all letters of credit are irrevocable, i.e.,
cannot be amended or canceled without prior agreement of the beneficiary,
the issuing bank and the confirming bank, if any. In executing a transaction,
letters of credit incorporate functions common to giros and Traveler's cheques.
Typically, the documents a beneficiary has to present in order to receive
payment include a commercial invoice, bill of lading, and documents proving
the shipment was insured against loss or damage in transit. However, the list
and form of documents is open to imagination and negotiation and might
contain requirements to present documents issued by a neutral third party
evidencing the quality of the goods shipped, or their place of origin.

b. What is UNCITRAL and what it does? (2 marks)


Sol.
The United Nations Commission on International Trade Law (UNCITRAL) was
established by the United Nations General Assembly by its Resolution 2205 (XXI) of 17
December 1966 "to promote the progressive harmonization and unification of
international trade law.
When world trade began to expand dramatically in the 1960s, national governments
began to realize the need for a global set of standards and rules to harmonize
national and regional regulations, which until then governed

Q.4. Explain the importance of STP in international markets. (10 marks)


Sol.
The importance of STP
Segmentation is the cornerstone of marketing – almost all marketing efforts in some
way relate to decisions on who to serve or how to implement positioning through the
different parts of the marketing mix. For example, one’s distribution strategy should
consider where one’s target market is most likely to buy the product, and a
promotional strategy should consider the target’s media habits and which kinds of
messages will be most persuasive. Although it is often tempting, when observing large
markets, to try to be "all things to all people," this is a dangerous strategy because
the firm may lose its distinctive appeal to its chosen segments.
In terms of the "big picture," members of a segment should generally be as similar as
possible to each other on a relevant dimension (e.g., preference for quality vs. low
price) and as different as possible from members of other segments. That is, members
should respond in similar ways to various treatments (such as discounts or high
service) so that common campaigns can be aimed at segment members, but in order
to justify a different treatment of other segments, their members should have their
own unique response behaviour.
Q. 5 a. Write a short note on branding and trademarks. (6 marks)
Sol.
Branding and trademarks
As mentioned in chapter four, it is difficult to protect a trademark or brand, unless all
countries are members of a convention. Brand "piracy" is widespread in many
developing countries.
Other aspects of branding include the promotional aspects. A family brand of products
under the Zeneca (ex ICI) label or Sterling Health are likely to be recognised
worldwide, and hence enhance the "subjective" product characteristics.
Warranty
Many large value agricultural products like machinery require warranties.
Unfortunately not everyone upholds them. It is common practice in Africa that if the
original equipment has not been bought through an authorized dealer in the country,
that dealer refuses to honour the warranty. This is unfortunate, because not only may
the equipment have been legitimately bought overseas; it also actually builds up
consumer resistance to the dealer. When the consumer is eventually offered with a
choice, the reticent dealer will suffer, for example, with the new dealers coming up.
Cotton Production/Marketing Interface
Spinners
Machines are highly flexible, that is they can usually switch to a variety of yarn
requirements. The machines are geared to high production, are automated and are of
a precision for constant quality provision. There are strict process controls and built –
in quality control. Poor raw material, especially when contaminated with metal
particles, damages opening mills, grid knives, fans and card clothing. Previous devices
employed to remove these (magnets) are becoming less effective. The consequences
are damage in the blow room and carding and danger of fire. Quality is therefore
defined as properties of the end use (clothing etc.), efficiency of weaving and knitting
and the efficient running of the spinning plant. Spinners require raw cotton which is
free of trash; dust, sugar and honey dew contamination, seed coats, bark and foreign
fibres and, will not nep the cloth. Further requirements are a certain length (could be
short, medium or long), uniformity of length, strength, fineness, maturity and a
certain elongation and colour.
Suppliers
In order to meet these high quality demands, the growers have to ensure that the
production, picking and ginning is of a very high standard.
Cotton grading
The Liverpool Cotton exchange, for one, relied on the skills of its experts to manually
classify raw fibre purchases for its clients. It still holds the "standards" for length,
colour and trash content. As well as the demands of modem machinery, the lack of
standardised measuring and cotton classification procedures has resulted in
commercial conflict and legal disputes about the true nature of traded cotton. Now,
computer based high volume instrument listing systems of raw cotton (HVI systems)
are available. The system can handle large numbers of bales, reduce variation in
classification and the need for highly trained bate classifiers.
For cotton exporters the system offers the following advantages:
· enhanced objectivity in classification
· improve communication if similar systems are used by sellers or buyers
· reduced conflict and need for arbitration
· enhanced competitiveness against synthetic fibres
· improved integration with modern spinning machines
· reduced costs on training of experts and in measuring time.
The system can process 2000 bales per day and give a printout on the seven
parameters of grading. These include length and length uniformity, strength and
elongation, micronaire or fineness, leaf and colour. Manufacturers include SPINLAR
INC. of Knoxville, USA.
Service
In agricultural machinery, processing equipment and other items which are of
substantial value and technology, service is a prerequisite. In selling to many
developing countries, manufacturers have found their negotiations at stake due to the
poor back-up service. Often, this is no fault of the agent, distributor or dealer in the
foreign country, but due to exchange regulations, which make obtaining spare parts
difficult. Many organisations attempt to get around this by insisting that a Third World
buyer purchases a percentage of parts on order with the original items. Allied to this
problem is the poor quality of service due to insufficient training. Good original
equipment manufacturers will insist on training and updating as part of the agency
agreement. In order to illustrate the above points, cotton can be used as an example.
Cotton is a major foreign exchange earner for Zimbabwe. In 1990/91, 52,000 tons
were sold overseas at a value of Zim $ 238 million. As the spinners, particularly those
in the export market are in a highly competitive industry, it is essential that the raw
material is as clean as possible. Also today’s spinning equipment is highly technical
and the spinner wishes to avoid costly breakdowns by all means.
Product strategies
There are five major product strategies in international marketing.
Product communications extension
This strategy is very low cost and merely takes the same product and communication
strategy into other markets. However it can be risky if misjudgements are made. For
example, CPC International believed the US consumer would take to dry soups, which
dominate the European market. It did not work.
Extended product – communications adaptation
If the product basically fits the different needs or segments of a market it may need
an adjustment in marketing communications only. Again this is a low cost strategy,
but different product functions have to be identified and a suitable communications
mix developed.
Product adaptation – communications extension
The product is adapted to fit usage conditions but the communication stays the same.
The assumption is that the product will serve the same function in foreign markets
under different usage conditions.
Product adaptation – communications adaptation
Both product and communication strategies need attention to fit the peculiar need of
the market.
Product invention
This needs a totally new idea to fit the exclusive conditions of the market. This is
very much a strategy which could be ideal in a Third World situation. The
development costs may be high, but the advantages are also very high.
Table 9.2 summarizes the strategic alternatives with examples.
The choice of strategy will depend on the most appropriate product/market analysis
and is a function of the product itself defined in terms of the function or need it
serves, the market defined in terms of the conditions under which the product is
used, the preferences of the potential customers and the ability to buy the product in
question, and the costs of adaptation and manufacture to the company considering
these product – communications approaches.
Table 9.2 International strategic alternatives
Product Communications Product/ Conditions Examples
strategy strategy functions of product
Met use
1. Extension Extension Same Same Pepsi
2. Extension Adaptation Different Same Soups
3. Extension Same Different Agriculture
Adaptation chemicals
4. Adaptation Different Different Farm
Adaptation implements
5. Invention New Same – Tyson
turbine
water pump
Thailand
tuna

b. What are the features of exchange and currency markets? (4 marks)


Sol.
The exchange rate regimes adopted by countries in today’s international monetary
and financial system, and the system itself, are profoundly different from those
envisaged at the 1944 meeting at Bretton Woods establishing the IMF and the World
Bank. In the Bretton Woods system:
· exchange rates were fixed but adjustable. This system aimed both to avoid the
undue volatility thought to characterize floating exchange rates and to prevent
competitive depreciations, while permitting enough flexibility to adjust to
fundamental disequilibrium under international supervision;
· private capital flows were expected to play only a limited role in financing payments
imbalances, and widespread use of controls would prevent instability in such flows;
· temporary official financing of payments imbalances, mainly through the IMF, would
smooth the adjustment process and avoid unduly sharp correction of current account
imbalances, with their repercussions on trade flows, output, and employment.
In the current system, exchange rates among the major currencies (principally the
U.S. dollar, the euro, and Japanese yen) fluctuate in response to market forces, with
short-run volatility and occasional large medium-run swings (Figure 1). Some medium-
sized industrial countries also have market – determined floating rate regimes, while
others have adopted harder pegs, including some European countries outside the euro
area. Developing and transition economies have a wide variety of exchange rate
arrangements, with a tendency for many but by no means all countries to move
toward increased exchange rate flexibility (Figure 2).
This variety of exchange rate regimes exists in an environment with the following
characteristics:
· partly for efficiency reasons, and also because of the limited effectiveness of capital
controls, industrial countries have generally abandoned such controls and emerging
market economies have gradually moved away from them. The growth of
international capital flows and globalization of financial markets has also been
spurred by the revolution in telecommunications and information technology, which
has dramatically lowered transaction costs in financial markets and further promoted
the liberalization and deregulation of international financial transactions;
· international private capital flows finance substantial current account imbalances,
but the changes in these flows appear also sometimes to be a cause of
macroeconomic disturbances or an important channel through which they are
transmitted to the international system;
· developing and transition countries have been increasingly drawn into the
integrating world economy, in terms of both their trade in goods and services and of
financial transactions.
Lessons from the recent crises in emerging markets are that for such countries with
important linkages to global capital markets, the requirements for sustaining pegged
exchange rate regimes have become more demanding as a result of the increased
mobility of capital. Therefore, regimes that allow substantial exchange rate flexibility
are probably desirable unless the exchange rate is firmly fixed through a currency
board, unification with another currency, or the adoption of another currency as the
domestic currency (dollarization).
Flexible exchange rates among the major industrial country currencies seem likely to
remain a key feature of the system. The launch of the euro in January 1999 marked a
new phase in the evolution of the system, but the European Central Bank has a clear
mandate to focus monetary policy on the domestic objective of price stability rather
than on the exchange rate. Many medium-sized industrial countries, and developing
and transition economies, in an environment of increasing capital market integration,
may also continue to maintain market-determined floating rates, although more
countries could may adopt harder pegs over the longer term. Thus, prospects are
that:
· exchange rates among the euro, the yen, and the dollar are likely to continue to
exhibit volatility, and schemes to reduce volatility are neither likely to be adopted,
nor to be desirable as they prevent monetary policy from being devoted consistently
to domestic stabilization objectives;
· several of the transition countries of central and eastern Europe, especially those
preparing for membership in the European Union, are likely to seek to establish over
time the policy disciplines and institutional structures required to make possible the
eventual adoption of the euro.
The approach taken by the IMF continues to be to advise member countries on the
implications of adopting different exchange rate regimes, to consider the choice of
regime to be a matter for each country to decide and to provide policy advice that is
consistent with the maintenance of the chosen regime (Box 3).

Q. 6 Discuss the various International product and pricing decisions. (10 marks)
Sol.
Production decisions
In decisions on producing or providing products and services in the international
market it is essential that the production of the product or service is well planned and
coordinated, both within and with other functional area of the firm, particularly
marketing. For example, in horticulture, it is essential that any supplier or any of his
"out grower" (sub-contractor) can supply what he says he can. This is especially vital
when contracts for supply are finalized, as failure to supply could incur large
penalties. The main elements to consider are the production process itself,
specifications, culture, the physical product, packaging, labelling, branding, warranty
and service.
International Pricing In New Open-Economy Models
Recent developments in open-economy macroeconomics have progressed under the
paradigm of nominal price rigidities, where monetary disturbances are the main
source of fluctuations. Following developments in closed-economy models, new open-
economy models have combined price rigidities and market imperfections in a fully
micro founded inter-temporal general equilibrium setup. This framework has been
used extensively to study the properties of the international transmission of shocks,
as well as the welfare implications of alternative monetary and exchange rate
policies.
Imperfect competition is a key feature of the new open-economy framework. Because
agents have some degree of monopoly power instead of being price takers, this
framework allows the explicit analysis of pricing decisions. The two polar cases for
pricing decisions are producer-currency pricing and local-currency pricing. The first
case is the traditional approach, which assumes that prices are preset in the currency
of the seller. In this case, prices of imported goods change proportionally with
unexpected changes in the nominal exchange rate, and the law of one price always
holds.’ In contrast, under the assumption of local-currency pricing, prices are preset
in the buyer’s currency. Here, unexpected movements in the nominal exchange rate
do not affect the price of imported goods and lead to short-run deviations from the
law of one price.
Empirical evidence using disaggregated data suggests that international markets for
tradable goods remain highly segmented and that deviations in the law of one price
are large, persistent, and highly correlated with movements in the nominal exchange
rate, even for highly tradable goods. Moreover, there is strong evidence that the large
and persistent movements that characterize the behaviour of real exchange rates at
the aggregate level are largely accounted for by deviations in the law of one price for
tradable goods.
In this article I make use of a simplified version of a two-country model where the
two markets are segmented, allowing firms to price discriminate across countries, and
where prices are preset in the consumer’s currency. This model generates movements
in the real exchange rate in response to unexpected monetary shocks, which are a
result of the failure of the law of one price for tradable goods. I then compare this
model to a version in which prices are preset in the producer’s currency and examine
the implications of these two alternative price-setting regimes for several key issues.
The price-setting regime determines the currency of denomination of imported goods
and the extent to which changes in exchange rates affect the relative price of
imported to domestic goods and the international allocation of goods in the short run.
That is, different pricing regimes imply different roles for the exchange rate in the
international transmission of monetary disturbances. As we shall see, this assumption
has very striking implications for several important questions, namely real exchange
rate variability, the linkage between macroeconomic volatility and international
trade, and the welfare effects of alternative exchange rate regimes, among others.
While generating deviations from the law of one price that are absent from models
assuming producer-currency pricing, the assumption of local-currency pricing still
leaves important features of the data unexplained. The key role of this assumption in
the properties of open-economy models suggests that it is necessary to keep exploring
the implications of alternative pricing structures in open-economy models.
In Section 1, I review the empirical evidence on the behaviour of real exchange rates
and on international market segmentation and pricing. In Section 2, I present the
model with local-currency pricing and explore the main implications of this pricing
assumption. The final section concludes.
1 Some Evidence on Real Exchange Rates
I first review some empirical evidence on the behaviour of real exchange rates using
aggregate data. I then turn to a review of the evidence on the sources of movements
in real exchange rates.
The real exchange rate between two countries represents the relative cost of a
common reference basket of goods. For two countries, say the United States and
Japan, the real exchange rate is given by
where P^sub US^ and P^sub JP^ represent the American and Japanese price levels
(measured in terms of dollars and yen, respectively) and where e denotes the nominal
exchange rate (defined as the dollar price of one yen).
The theory of purchasing power parity (PPP) predicts that real exchange rates should
equal one, or at least show a strong tendency to quickly return to one when they
differ from this value. The fundamental building block of PPP is the law of one price:
due to arbitrage in goods markets, and absent barriers to trade, similar products
should sell in different countries for the same price (when converted in the same
currency). Large international price differentials would be only temporary, as profit-
maximizing traders would quickly drive international goods prices back in line.
Therefore, if arbitrage in goods markets ensures that the law of one price holds for a
sufficiently broad range of individual goods, then aggregate price levels (when
expressed in a common currency) should be highly correlated across countries.
Because aggregate prices are reported as indices rather than levels, most empirical
work has tested the weaker hypothesis of relative PPP, which requires only that the
real exchange rate be stable over time. Figure 1 show the log changes in the CPI-
based dollar-yen real and nominal exchange rates and the relative price level. In this
figure, which is typical for countries with floating exchange rates and moderate
inflation, it clearly stands out that short-run deviations from PPP are large and
volatile.(Delete) In the short run, movements in the real exchange rate mimic those
in the nominal exchange rate, with no offsetting movements in the relative price
level. Not surprisingly, early empirical work based on simple tests of short-run PPP
produced strong rejections of this hypothesis for moderate inflation countries.
However; these studies did not allow for any dynamics of adjustment to PPP and
therefore did not address the validity of PPP as a medium- or long-run proposition.
The conventional explanation for the failure of short-run PPP is the presence of
nominal price rigidities. If the short-term volatility of nominal exchange rates were
due mostly to monetary and financial disturbances, then nominal price stickiness
would translate these disturbances into short-run fluctuations in the real exchange
rate. If this were true, however, we should observe a substantial convergence to PPP
in one to two years, as the adjustment of prices and wages takes place. Purchasing
power parity, therefore, would be re-established in the medium to long run.
An extensive body of empirical literature has tested the hypothesis of long run PPP by
looking at the mean-reverting properties of real exchange rates. As is well known, it
has proved rather difficult to find evidence supporting convergence of real exchange
rates to PPP even in the long run.
Earlier empirical studies, which used only post-Bretton Woods data, found it difficult
to reject the hypothesis that bilateral real exchange rates for industrialized countries
follow a random walk under floating exchange rates. But if PPP deviations are very
persistent, then it may be difficult to distinguish empirically between a random walk
model and a slow mean-reversion model for the real exchange rate, especially when
this variable is highly volatile. As shown in Frankel (1986), the post-Bretton Woods
period may simply be too short to reliably reject the random walk hypothesis. To
overcome this problem of low power in tests of the random walk hypothesis, Frankel
used an extended data set (annual data for the dollar-pound exchange rates from
1869 to 1984) and rejected the random walk model in favour of a mean-reverting
model for the real exchange rate. His point estimate for the rate of decay of real
exchange rate deviations was 14 percent per year, which implies a half-life of PPP
deviations of 4.6 years. Other studies that test convergence to PPP using long-horizon
data sets tend to find values for the half-life of PPP deviations between three to five
years.
An alternative way to increase the power of unit root tests is to expand the number of
countries in the sample and to perform panel tests of convergence to PPP. Frankel
and Rose (1996), for example, use a panel set of annual data from 1948 to 1992 for
150 countries. They estimate half-lives for PPP deviations of about four years. Other
studies using panel data sets report similar estimates. Interestingly, these estimates
are also similar to those obtained using long-time series data sets.
In brief, studies using aggregate data provide strong evidence that deviations from
PPP are highly volatile and persistent. Consensus estimates suggest that the speed of
convergence to PPP is roughly 15 percent per year, implying a half-life of PPP
deviations of about four years. As we shall see next, a look at disaggregated data will
provide us with a much richer analysis of the sources of PPP deviations.
The Law of One Price: Market Segmentation and International Pricing
As I pointed out earlier, the idea underlying PPP is that the law of one price holds for
a wide range of individual goods. It has long been recognized, however, that even for
highly tradable goods and at different levels of aggregation, deviations in the law of
one price are large, persistent, and highly correlated with movements in the nominal
exchange rate.
One possible explanation for the failure of the law of one price is that international
markets are segmented by physical distance, like different markets within a country.
Engel and Rogers (1996), however, show that both the distance and the physical
border between countries are significant in explaining the variation in prices of
similar goods across different U.S. and Canadian cities. They find that price dispersion
is much higher for two cities located in different countries than for two equidistant
cities in the same country. In fact, the effect of the border is estimated to be
equivalent to a distance of 1780 miles between cities within one country. Engel and
Rogers also show that nominal price stickiness accounts for a large portion of the
border effect, suggesting that prices are sticky in the local currency and that changes
in the exchange rate lead to deviations in the law of one price.
Not only are failures of the law of one priced significant but, as recent evidence
suggests, they also play a dominant role in explaining the behaviour of real exchange
rates. Engel (1999) measures the proportion of U.S. real exchange rate movements
that can be accounted for by movements in the relative prices of non-traded goods.
Engel decomposes the CPI real exchange rate into two components: a weighted
difference of the relative price of non-traded to traded-goods prices in each country,
and the relative price of traded goods between the countries. If tradable, as a
category, closely followed the law of one price, then all variability in the real
exchange rate would be explained by movements in the first component. However,
Engel finds that movements in the relative price of non-traded goods appear to
account for almost none of the movement in U.S. real exchange rates, even at long
time horizons. Instead, nearly all the variability can be attributed to movements in
the relative price of tradable. This finding strongly suggests that consumer markets
for tradable goods are highly segmented internationally and that movements in the
international relative price of consumer tradable are very persistent. Moreover, given
the high volatility of nominal exchange rates, these findings indicate that consumer
prices of most goods (either imported or domestically produced) seem to be sticky in
domestic currency terms.
An alternative approach to studying the relationship between exchange rates and
goods prices is examining how firms in an industry (or country) pass through changes
in exchange rates to export prices. Knetter (1989, 1993) measures the degree of price
discrimination across export destinations that is associated with exchange rate
changes for U.S., U.K., German, and Japanese industry-level data. He finds that the
amount of exchange rate pass-through differs considerably depending on the country
and industry. Goldberg and Knetter (1997) provide an extensive survey of the
literature and find that local currency prices of foreign products do not respond fully
to exchange rate changes. While the response varies by industry, on average exchange
rate pass-through to U.S. import prices is only about 50 percent after one year,
mainly reflecting changes in destination-specific markups on exports.
In brief, there is strong evidence that international markets for tradable goods remain
highly segmented and that deviations from PPP are largely accounted for by
movements in the relative price of tradable goods across countries. At the consumer
level, exchange rate pass-through to import prices is virtually zero (suggesting that
consumer prices are sticky in domestic currency). At the producer level, however,
exchange rate pass-through is generally positive, but substantially below one.
Transaction Costs and the Adjustment of PPP and Law of One Price Deviations
Some recent empirical tests of long-run PPP and the law of one price have abandoned
the conventional framework, which assumes a linear autoregressive process for the
price differential. Instead, these studies have started to look into nonlinear models of
price adjustment, where the speed at which price differentials die out depends on
the size of the deviation itself.
This alternative framework for the empirical analysis of price differentials is
motivated by the observation that commodity trade is not costless. Persistent
deviations from the law of one price are implied as an equilibrium feature of models
with transaction costs, for deviations will be left uncorrected as long as they are
sufficiently small relative to the shipping cost.
The simplest econometric model that implements the notion of a nonlinear
adjustment for price differentials assumes that the process is well described by a
random walk for small deviations (that is, when deviations are within a "band of
inaction") and an autoregressive process for large deviations (that is, when deviations
are outside the band). Taylor (2001) shows that the improper use of linear models
when the true model is nonlinear may produce a large bias towards finding a low
speed of convergence. Intuitively, a linear model will fail to support convergence to
PPP if the true model is nonlinear and the process spends most of the time in the
random-walk band. Using both monthly data from the 1920s and annual data spanning
two centuries, Michael, Nobay, and Peel (1997) reject the linear adjustment model in
favour of a nonlinear model and provide strong evidence of mean-reverting behaviour
for PPP deviations for every exchange rate considered.

2 International Pricing in New Open-Economy Macroeconomic Models


The common starting point for most of the recent research in open-economy models
with price rigidities is the model developed in Obstfeld and Rogoff (1995). This model
explores the international monetary transmission mechanism in a general equilibrium
setup characterized by nominal price rigidities, imperfect competition, and
incomplete asset markets.
Obstfeld and Rogoff’s model does not generate deviations from the CPI– based
purchasing power parity. This feature reflects the fact that preferences are identical
across countries and that all goods are freely tradable, with prices set in the seller’s
currency. In this model, there is complete pass-through of exchange rate changes to
import prices, implying that the law of one price always holds for all goods and that
the real exchange rate is constant.
Motivated by the empirical evidence on the sources of real exchange rate
fluctuations, several recent papers have extended Obstfeld and Rogoff’s framework in
order to allow for pricing-to-market and deviations from the law of one price. This
class of models assumes that home and foreign markets are segmented, which allows
imperfectly competitive firms to price discriminate between home and foreign
consumers. Consumers’ inability to arbitrage price differentials between countries is
exogenous, possibly reflecting arbitrarily high transportation costs at the consumer
level. In addition to market segmentation, this class of models also assumes that
prices are sticky in each country’s local currency. That is, firms set prices in advance
in the buyer’s currency, as opposed to the standard assumption that prices are set in
the seller’s currency.
I, next outline a basic model in which firms set prices in advance in the local currency
of the buyer (or pricing-to-market). The model is then used to explore the main
implications of pricing-to-market.

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