International Business Economics

A European Perspective

by Judith Piggott and Mark Cook

Answers to end of chapter questions

CHAPTER 1 THE CHANGING NATURE OF INTERNATIONAL BUSINESS

1) If the CR5 concentration ratio in the UK supermarket sector is the same in 2005 as it was in 1995, does this mean that there has been no change in market power?

Answer

The CR5 ratio measures the proportion of a market controlled by the top five organisations. It does not tell us how the proportion of the market held by each of the top five firms has changed or whether there is a new entrant into the market. For example suppose in 1995 the following supermarkets possess these particular proportions of the UK market:

Tesco – 20% 
Sainsbury – 18% 
ASDA – 18% 
Morrisons – 10% 
Waitrose – 6%

These are the top five firms and the CR5 ratio is 72%

In 2005 the same supermarkets are still the market leader but their percentage of the market is as follows:

Tesco – 28% 
Sainsbury – 18% 
ASDA – 16% 
Morrisons – 8% 
Waitrose – 2%

Once again the CR5 ratio is 72% but in 2005 the increased market dominance of Tesco's is hidden within the ratio as is the declining share of Waitrose. Other methods of market concentration therefore need to be considered alongside of the CR5 ratio.

It is also important to note that the supermarkets have moved into a variety of markets such as household goods, finance, gardening etc and it is becoming more difficult to discern the proportions that they hold of these markets within any C5 ratio. Because of the competition rules supermarkets are seeking to expand more into these non-food areas and into markets outside of the UK.

2) Why do companies such as the Halifax Bank prefer to grow by merger rather than by internal growth?

Answer

The banking sector like other sectors of the UK economy is subject to UK and European competition rules. As such, it may be difficult to grow the banking business in the UK and if the Halifax bank wishes to become a major player in international banking it may be forced to grow outside of the UK and perhaps outside of Europe. It is possible for the Halifax Bank to set up branches in other countries but brand recognition may be a problem. Furthermore, it is often the case that people in other countries like to deal with their own country's banks. Therefore the better option for Halifax may be to merger and takeover other banks in other countries whilst retaining these other countries bank names.

One other factor to note in the banking system in the UK is that banks may have difficulty in growing banking customer numbers. Most people have bank accounts and what banks may see is the churning of customers from one bank to another. What Halifax may need to do is grow the area of banking services that it offers. This might include insurance, mortgages and the like. Instead of growing these businesses internally a simpler way may be to purchase existing organisations in these areas and get control of a sector of the market through an established player in that market.

3) Internet groups AOL and MSN have been in talks regarding cooperation in their search and advertising network business (Financial Times, 2005). Why is this popular route to organisational growth?

Answer

The reasons why MSN and AOL were in talks to improve their levels of cooperation may be manifold. Two large organisations may perceive that the costs of gaining market share from their rival are too large to justify the expenditure. Yet both know the value in being larger organisations. MSN may realise that any action it takes to grow at the expense of MSN will be responded to by MSN, therefore some form of mutual cooperation would benefit both organisations. Such cooperative arrangements, however, can also break down in the future. Cooperation may also occur because of the high cost of developing further growth in the search and advertising business, thereby reducing costs to both organisations. It is also possible that the two companies are in slightly different areas of the market and cooperation could result in synergistic outcomes for both of the organisations. A further factor may be the size of any rival in the market. Two firms may seek to cooperate when there is a larger rival in the market place. Cooperation may occur also because of a downturn in demand for advertising business over the internet. Here it may be better to cooperate and survive rather than to try and go alone and then go into decline. Finally, cooperation may be forced on some organisations if there are rapid changes in technology which result in them having outmoded ways of doing things.

4) Why did some companies, such as IBM, seek to reduce their size during the 1990s? What are the problems with this strategy?

Answer

First we need to consider what is meant by size. Is this measured in terms of turnover, profits or employment? Companies like IBM are extremely large in a variety of computing markets. What they are likely to have recognised is that the growth of some of their computer markets was beginning to decline. Moreover, the level of competition in these markets has been growing not only from western PC manufacturers but from highly price competitive manufactures within South East Asia and China. It may also be possible that the cache of owning an IBM machine (as depicted as the "Rolls-Royce" of PCs) has been lost. Therefore IBM sold its PC business in the early part of this decade and concentrated on areas where its core competencies lay and where its can add the most value to the IBM business. Hence it concentrates more on computer solutions to problems and main frame business.

5) Using the case studies in this chapter, consider the ways in which organisations have strategically reduced in size.

Answer

The chapter has referred to a wide variety of organisations and their reasons for changes in size. The use of divestment to raise extra revenue for expansion elsewhere in the organisation can be seen through British Aerospace's sale of the Rover group to BMW and the sale of Falconbridge by Trellborg. Falling profitability was the reason for Siemens and Vattenfall selling their interests in a Chinese power station, whilst BAT divested itself of a number of businesses to avoid being the subject of an acquisition.

Sometimes organisations are forced to sell parts of their business by the competition authorities after they acquire another firm or firms (see Terra Firma). The chapter also reveals that changing the size of the organisation can come about through the need to restructure the company, seeking to refocus the organisation on its core competencies, a desire to improve capital flow because of a inappropriate previous company expansion, to satisfy the demand from shareholders for greater profit, and through the sale of a family business particularly where there is no member of the family willing to take on the whole of the business.

6) List the sectors where Europe has a large presence in the world market. Consider why Europe appears to have an advantage in these sectors compared with the United States and Japan.

Answer

Sectors where Europe is stronger than US/Japan together are banking and insurance. It is stronger than US and Japan separately in chemicals, food and utilities (but this is a small sample and the advantage is not as big as in finance). Reason for strength in finance area: history (UK and Switzerland), government policy, clustering (e.g. London – The City and Zurich), openness to trade

7) Similarly look at where Japan and the United States dominate, and consider why they appear to have an advantage in these sectors.

Answer

US dominates in telecommunications, pharmaceuticals, general merchandize – the latter would certainly be due to high domestic demand allowing economies of scale. This would also play a part in the other two areas but so would government policy. Japan – the main sector is motor vehicles and this would be due to government policy, technological advancement (linked to policy), innovation in products and processes and reputation.

8) Bearing in mind your answers to (1) and (2) above, consider the sectors where the NICs are likely to make the biggest impact on the world market and why.

Answer

NICS

- Government policy – see its role in S.Korea and shipbuilding – plus the car industry in Malaysia
- History – see in Hong Kong as financial sector flourishes
- Strong home demand – China obviously will have this as incomes grow.
- Technology – openness to FDI and technology brought with it is seen in many NICS (e.g. car industry) and in China.

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CHAPTER 2 INTERNATIONAL TRADE

1) In the past, companies within differing countries have been seen to have an absolute advantage ‘in everything’. In the early 19 th century this applied to the United Kingdom, then it shifted to the United States, Japan in the 1960s/1970s and now China. What gives them the advantage, and what problems does it bring with it? Use the example of China now, to illustrate your answer.

Answer

CA comes from cost differences – which come from such things as wage rates, productivity, technology etc.

2) If the production capacity of the Netherlands and Belgium in two goods, cheese and chocolates, is as follows, per unit of labour per day:
 

Chocolates

Cheese

Boxes

Rounds

Netherlands

20

50

Belgium

100

80

Belgium is 5x (100/20) better at producing chocolates and 1.6x (80/50) better at producing cheese – therefore has greater advantage (comparative advantage) in chocolates and should produce them and trade for cheese.

Netherlands should produce cheese as it has the least disadvantage in this (therefore a CA) and trade for chocolates.

2a). Which country has a comparative advantage in which product? Explain your conclusion.

Answer

Belgium would want the exchange rate as near to the Netherlands opportunity cost as possible – as near to 1B = 2.5 R as possible

2c). What rate of exchange would Belgium prefer and why?

Answer

Netherlands would like to be as near to Belgium’s opportunity cost as possible – 1B = 0.8R
2d). What rate of exchange would the Netherlands prefer and why?

Answer

It will finish somewhere between the two and depends on relative power

2e). Prove both will gain if they follow the principle of comparative advantage. Use the example of Belgium selling 30 boxes of chocolates and a rate of exchange (or terms of trade) of 1 box of chocolates = 1.5 cheeses.

Answer

If 1B = 1.5R.

Belgium sells 30 boxes of chocolates and gets 45 cheeses (30 x 1.5).

If it had sold 30 chocolates at home it would have got 24 cheeses (1B = 0.8R) – so has gained 21 cheeses through trade.

Netherlands paid 45 cheeses for 30 chocolates

For 45 cheeses at home it would only have got 18 boxes of chocolates – therefore has gained 12.

Both have gained. How much they gain, depends a lot on the exchange rate.

3) The Netherlands exports Heineken beer and imports Löwenbräu. What sort of trade is this an example of?

Answer

It is an example of intra industry trade – the same sort of product but slightly differentiated (e.g. with brand name).

In the chapter we showed that one of the major influences on world trade is and has been, the growth of regional trade agreements (see also Chapter 4). Imagine you are the manager of an EU electronics company attempting to sell your product to a customer in the NAFTA trading block, what problems do you think you might encounter.

Problems an EU electronics company could experience selling to NAFTA

a) tariffs/quotas

b) differing technical requirements

c) differing health and safety requirements

d) bureaucracy

e) if try to assemble product in the NAFTA area, could meet rules of origin requirements

4) In the chapter, the example given of Vernon’s product lifecycle is the market in colour televisions. Can you think of another product where you could trace the trading lifecycle in this way?

Answer

Most products have a lifecycle but it just has differing timelines. Take an example like MP3 players – short introductory phase, steep growth phase (which we are just coming to the end of) and we don’t know the length of the maturity phase, but could be short and steep drop if there is a change in technology. Could compare it to the lifecycle of the portable CD player.

5) In the chapter we looked at fair trade and the case study examined the case of coffee. However there have been other examples like this in the press in recent years, sugar and cotton being just two. (i) How could fair trade help the LDC producers and DC consumers in these two areas? (ii) Can you think of any other areas where fair trade is ‘long overdue’?

Answer

(i) Things that affect the growth of trade (many factors – here are a few):

Transport costs – e.g. massive increase in price of oil could raise costs and take away CA
Recession in the world or major areas of the world economy – eg US, EU, Asia. This reduces demand for trade
Trade protection e.g. if the WTO loses credibility and countries start building protectionist measures against each other e.g. 1930s
Financial crisis in major economies (e.g. US 1930s) – reduces confidence and demand and increases protectionist measures
Sugar (see chapter 3 for case study) and cotton (see chapter 3 website case study) – shows how highly subsidized this area is and how this affects the world trade. Also both products are dominated by large MNCs companies and agricultural business. To remove protection would reduce world price and DCs consumers would gain. LDC producers would have a chance at competing in a more fair market

Other products where fair trade is overdue – most agricultural products. Christian Aid does a video outlining the case for nuts – see their website.

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CHAPTER 3: THE PROTECTION OF TRADE

1 and 2 are dealt with in the website case study on Chinese Textiles.

3) Explain using examples, how restrictions on public procurement effectively block trade. Which companies gain and which lose? How could companies avoid such restrictions?

Answer

Restrictions on public procurement and effect on trade. Public procurement is government buying policies. Therefore any policy, which favours domestic producers, will, by its very nature, adversely affect foreign producers. The Cecchini report for example found that most EU government’s favoured domestic producers e.g. approx 98% of UK contracts went to UK producers and in Italy the figure was 100%. This lead to the EU imposing rules on how governments advertise such contracts. Those who gain are, obviously, local domestic producers who do not have to face such strong competition and those who lose are the more efficient foreign or non-local producers. Companies can get round this by moving or setting up branches in the locality eg across the EU (or franchising/licensing in the area).

4) The case study on beef hormones dispute between the United States and the European Union shows how health and safety legislation could possibly be used as a means of trade protectionism. Can you identify similar examples where legislation is apparently being used to protect consumers but could also be seen as really protecting producers from trade?

Answer

Health and safety – other examples – there are many but here are a few: Foreign skis banned from Japan as Japanese snow viewed as “different” from US and EU, therefore such skis were dangerous; US ban on cherry tomatoes from EU as could get stuck in the throat (why US throats and not EU is unclear); recent bans of UK meat due to foot and mouth outbreak (even though no evidence to say the disease is carried in meat).

5) In the Doha Development Agenda negotiations, one of the areas of dispute was cotton, or more specifically the way the United States protects its cotton producers. Show diagrammatically how the United States protects its producers and the effect of this on LDCs. (Also see companion website for case study).

Answer

Cotton – And extended case study on how US cotton subsidies affected LDCs can be found in Kevin Watkins speech on “Cultivating poverty: US cotton subsidies and Africa” to the WTO Public Symposium “Challenges ahead on the road to Cancun” 16-18 June 2003 which can be accessed via: http://www.oxfam.org/en/files/doc030619_cotton_WTOsympo

The details of the recent U turn by the US on such subsidies can be found on BBC news website http://news.bbc.co.uk/1/hi/world/americas/4672786.stm

– 2nd February 2006 – “US Congress scraps cotton subsidy”

The figure to show the effect of such subsidies for the US producers is shown in figure 3.3 page 69. The effect on other producers – the US subsidies make the US producers competitive when they otherwise would not be, so distorting competition in the US and the world markets and reducing demand for more efficient (lower cost) competitors. It also increases world supply (shifting out the world supply curve) and reducing price for all producers worldwide.

6) What is now happening about the Doha Development Round? Go to the WTO website –www.WTO.org - and see what progress (or not) has been made and what has been the impact on DC and LDC companies

At present, very little is happening with the Doha Round. Many are blaming the EU for the stalling of the negotiations due to their refusal to change agricultural policy without something in return.

7) A statement on the WTO website (accessed 1 May 2006) says

“Director-General Pascal Lamy told journalists on 24 April 2006 that “we may have missed the deadline but we are not in deadlock”. Earlier, in a statement at an informal meeting of heads of delegations, he said that “genuine and important progress has been made, but not fast enough to allow us to reach agreement on modalities by the end of the month”. He said that “from now on, the process to reach modalities will be continuous, Geneva-based, and focused on texts — and we should aim at finishing this work in a matter of weeks rather than months”.

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CHAPTER 4: ECONOMIC INTEGRATION

1) Assume that Austria, Hungary and Turkey all produce refrigerators and the domestic price per refrigerator in Austria is £600, in Hungary £500, and in Turkey £360.

a) Suppose Austria imposes a 100% tariff on refrigerators. What are the trading options open for Austria?

b) If Austria then formed a CU with Hungary with a common external tariff of 100% how would Austria's options change?

c) How would you describe the situation in (b)?

d) If the tariff rate in Austria in (a) were 50 per cent instead of 100 per cent how different would your answers to (a), (b), and(c) be?

Turkey is in a CU arrangement with Germany but not with Iran. Why would such a CU be better economically for Turkey?

3) Using the example in Table 5.2 explain the likely impact of trade creation and trade diversion on the French, German and Japanese businesses.


4) Which business sectors of which economies would have lost out most by UK’s membership of the EC in 1973?

Answer

It was always felt that Commonwealth countries were most likely to lose out by the UK joining the EC. In particular it was suggested that Australia and New Zealand – who had a substantial part their trade with the UK – would suffer. The agricultural sector in particular was seen as being the worst hit as these had a substantial part of their exports going to the UK.

5) How would you account for the relatively poor economic performance in Western Europe in the 1970s and 1980s? In what ways might the revival of European integration help this performance?

Answer

There are lots of reasons for the growth – too many to go into here. But relevant to this particular chapter would be the concept of Eurosclerosis – is the name given to the weak growth of the EU in the 1970s/80s. Much of the blame for this was placed on the European Social Model which protected labour markets and reduced flexibility especially when compared to the US more market based model (and the faster growth in the US in the period). It has been suggested that the greater integration – single currency and enlargement – has counter the Eurosclerosis by opening up markets and increasing the labour market but others are less optimistic (see The Economist (2003) “A Franco German Beauty Contest”, 16th October)

6) Do you think US businesses would view NAFTA as a success? Would Canadian and Mexican businesses think likewise? Why or why not?

Answer

Generally NAFTA has made it much easier to do business by removing tariffs from internal trade.

US business view – US firms have gained through lower labour costs and greater funds for new technology. It has also released US labour to train for higher skilled jobs. One of the fears was a loss of jobs from the US to Mexico but Hufbauer and Schott have pointed out that between 1994 and 2000 the US gained more than 2m jobs a year. Manufacturing jobs did fall but other areas more than made up for the fall. Also they suggest that most of the new jobs have been at higher than average wages (in The Economist 2004a).

There were also fears from the environmentalists that if production moved to Mexico with its lower environmental standards and enforcement, then US firms could do more damage to environment. There has been no conclusive evidence of this, although it is often said that if you go over the border just breathing the area proves it! (The Economist 2004a). However on positive side, what there has been is increased cooperation in this area and the environmental laws have been improved.

Canadian View – Canadian businesses have seen trade within the region expand dramatically; in 1990 US exports to Mexico and Canada represented approximately 25 percent of its trade, now it is more like 33 per cent.

Furthermore Canadian unemployment fell over the period but its main fear was that its social welfare model (with generous minimum wage for example) would be threatened. However despite some reductions in public spending, this has not happened (The Economist 2004a).

Mexican View - It is difficult to disentangle the effect of NAFTA from the effect of the Tequila crisis of 1994-5. The effect was a collapse of the financial system and the government was forced to bail out the weakened banks at huge cost. The system has still not recovered and the lower level of credit and financial services have affected the domestic economy considerably. On the positive side, Mexico has recovered from the crises more quickly than the previous crisis in 1982 and 1986. Also Mexico was less affected by the recent Brazilian and Argentinean crises that it probably would have been pre-NAFTA.

As to Mexican trade, this has increased, especially with the US with which it has had a trade surplus throughout its NAFTA membership. Data - US exports to Mexico doubled between 1993-2001 to $91bn but also imports from Mexico have tripled to $131bn. Given that US trade outside NAFTA has also grown strongly, it suggests most of this switch has been in the form of trade creation rather than diversion (Husted and Melvin 2004)

FDI has also increased and jobs in the export businesses have tended to pay more than in the rest of the (The Economist 2004a)

Mexico also still has problems with poor education, bureaucracy, poor infrastructure, lack of credit, corruption and weak tax base, which have perhaps stopped Mexico from gaining as much as it could have from NAFTA (The Economist 2004a)

7) If Asian businesses were asked which has had the most effect on your business, ASEAN or APEC, which do you think they would choose and why?

ASEAN is smaller but is a closer-knit economic community. It is also closer to a free trade area than APEC. It members are mainly Asian and geographically close therefore the scope for trading is greater.

But APEC is obviously much larger and gives greater scope for trade and investment opportunities. It is also a very useful pressure group and has potential for future growth.

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CHAPTER 5 : FOREIGN EXCHANGE MARKETS

1) The following exchange rates were quoted for 2 August 204

£1 = US$1.8184 
£1 = SF2.3264 
US$1 = SK13.9546 
(SF: Swiss franc; SK Swedish krona)


Calculate: (i) the sterling/krona exchange rate 
(ii) the US dollar/Swiss franc exchange rate 
(iii) the Swiss franc/krona exchange rate.


Answer

£1 = $1.8184 and £1 = SF 2.3265 NOTE CORRECTION - $1 = SK7.6739

So:-

i) Sterling to SK £1 = 1.8184 x 7.6739 = SK13.954

ii) S = SF £1 = SF 2.3264 = $1.8184 1.8184 = 2.3264 $1 = SF1.2794

iii) SF = SK £1 = 2.3264 = 13.954 (answer from i) 2.3264 = 13.954

SF1 = 5.998

2) What might be the effect on the exchange rate, within a flexible exchange rate system of:

income and spending within a country rising faster than that in the rest of the world?
- A government choosing to tighten monetary policy by raising interest rates?
- A government choosing to relax fiscal policy by permitting a growth in government spending financed by sales of government bonds?
- A country experiencing a sharp and sustained increase in the growth rate of productivity compared with the rest of the world?

Answers

If income and spending in any economy were rising faster than the rest of the world, it would suggest that this will draw in imports – so there will be increased demand for foreign currency which will be bought with domestic currency. So the supply curve for domestic currency will shift to the right and the exchange rate will weaken (eg £1 = $2 will fall to £1 = $1.5)

Rising the interest rate will tend to bring in capital flows and so increase demand for the domestic currency – this will increase the rate of exchange for the domestic currency (eg £1 = $2 will rise to £1 = $2.5) – this is the case as shown in figure 5.3 in the book.

Sales of government bonds – The price of bonds and interest rates are inversely related – so increasing the supply of bonds is likely to reduce their price and increase the interest rate – as seen in ii) and increased interest rate will increase the rate of exchange. Furthermore some of these extra bonds will be bought by foreign buyers, so increase demand for the domestic currency and further increasing the rate.

iv) This depends on who gains the benefit from the higher rate of growth of productivity compared to the rest of the world. It could go in higher wages in which case this should increase income and so have the effect of i). Furthermore it is likely this greater productivity will need further imports as raw materials, components etc and again boost imports – so the currency would weaken. However it could mean that businesses see the greater productivity as a way of cutting prices and so boosting export sales. This would bring more demand for the currency and so the exchange rate would strengthen.

Q3 – sections i-iii – these should not be there – they are not part of this question! (cut and paste that got into the wrong place – apologies!)

The question should only be

3) What might be the consequences of such changes for a country which was part of a fixed exchange rate system?

In i) and iv ) where the productivity gain goes in higher wages - we see pressure for the exchange rate to change downwards. If it is fixed then the exchange rate cannot fall and the government will have to work in the market to meet the greater demand for foreign exchange by buying sterling and selling foreign exchange. If the changes in i) and iv) turn out to the long term, then it will start to run out of foreign exchange reserves and may be forced to borrow (from the European Central Bank or the IMF – but both will have conditions). Ultimately the government will have to take steps to either change the situation in i) or iv) or devalue the exchange rate.

ii ) and iii ) and iv ) where the gain goes in lower prices – here the pressure is upwards. Again if the exchange rate is fixed it cannot rise. The government will be working the in the market to sell domestic currency and buy foreign exchange. If this is long term, then the government will be seeing an increasing the domestic money supply in the process and so risking inflationary pressure. Ultimately the government will have to take steps to either change ii) or iii) or revalue the exchange rate.

4) In recent years the United States has argued strongly that China should revalue its currency upwards. One piece of evidence that has been put forward for this is that the purchasing power of the Yuan appears to be higher than that of the dollar – in other words the Yuan appears to be undervalued relative to its PPP. In the light of the discussion of PPP, in this chapter how convincing do you find this argument to be?

Answer

In the light of the discussion in the chapter the argument is not very convincing. China seems potentially to be an example of the Balassa-Samuelson effect. To the extent that the exchange rate for the Yuan is governed by flows of traded goods, where Chinese productivity is relatively low, the value for the Yuan will be correspondingly low. However, because non-traded goods are relatively cheap in China, since wages are low but productivity in the non-traded sector is high, the Yuan has a large purchasing power and will seem to be undervalued.

However, we cannot simply say that China is a pure example of the Balassa-Samuelson effect because it is also the case that China has a (largely) fixed exchange rate and it may be the case that the Chinese authorities are keeping the value of the currency lower than the value which would arise if the currency were allowed to float freely (especially given the large Chinese trade surplus with the USA). So although the Balassa-Samuelson effect tells us that for developing countries we cannot simply assume that because currencies have a high purchasing power domestically they are undervalued, we cannot assume that their exchange rates are necessarily at the `right’ level either.

5) Dornbusch bases his overshooting model on the view that goods market prices adjust more slowly than asset market prices. Why do you think that he believed this? Do you think this is a realistic assumption?

Answer

There are two main reasons for supposing that asset market prices adjust more quickly than goods market prices:

Goods markets tend to be governed by medium or long term contractual arrangements while in asset markets contracts are often made for very short time periods and `rolled over’ if necessary
The costs of advertising and informing customers about price changes in good markets (so-called `menu costs’) are much greater than for asset markets (where electronic price dissemination systems are more prevalent). This is a disincentive to changing goods market prices unless changes in the economic environment can be known to be long-lasting. The immediate reaction to such changes will be to build up or run down stocks of goods rather than to change prices.

The assumption does seem quite a realistic one but in order for the model to be convincing it is still necessary to test whether markets really do operate in this way. `New classical’ macroeconomists have often argued that insufficient theoretical reasons have been put forward for assuming price `stickiness’ in goods markets. They claim that if price variability will increase economic welfare then new contractual arrangements and ways of organising markets are likely to emerge in order to allow such variability to obtain. Empirically, however, the volatility of asset prices does seem to be larger than that of goods prices.

6) How convincing do you think the explanations put forward in the text are for the failure of UIP to hold in practice? Can you think of any alternative explanations?

Answer

There is no strict `right or wrong’ answer to this question but the following considerations are ones which might be taken into account.

The explanation based on risk may well be becoming less convincing as opportunities for hedging against risk by using derivatives contracts become more prevalent. To the extent that such hedging can insure against the risk of holding particular currencies investors and traders are likely only to be concerned with returns.

The explanation based on expectations has some plausibility but for sophisticated foreign exchange traders it does seem reasonable to argue that expectations will on average be correct. Surely someone would not last very long in the competitive environment of international finance if they were systematically to under-predict or over-predict exchange rate values?

The explanation based on noise trading is one that has been used in stock markets to explain the divergence of prices from `fundamental’ values. It again has an intuitive plausibility but it does depend on a convincing explanation of why such speculative traders are not driven out of the market over time as they make losses on their rash trades.

Other explanations such as tax differences, exchange controls which hinder capital movements and so on do not seem any more convincing given the amount of financial deregulation we have seen over the last two decades. However, it may be the case that part of the reason for the failure of UIP to hold is the extent to which governments and central banks have deliberately influenced the value of national currencies to suit their own policy objectives. This may have lessened the impact of interest rate differentials in influencing currency sales and purchases.

7) You are the financial manager of a company which operates internationally, receiving funds and making payments in a variety of currencies. Your deputy has just completed an MBA and she tells you that the Meese-Rogoff results mean the company should simply abandon the attempt to explain exchange rate behaviour and adopt the random walk view that the best estimate of the exchange rate tomorrow is simply that it will stay the same as it is today. What would be the implications for such a company of adopting this view? Do you think it would be sensible for you as a financial manager to follow your deputy’s advice?

Answer

The implications for the company of adopting this view are that they would no longer try to predict exchange rates actively, while still, presumably, using derivatives (futures, forwards, options) to hedge against the risk that rates might fall or rise. Whether this is a sensible course of action to adopt or not depends very much on one’s view of the impact of the Meese-Rogoff results for attempts to predict rates. We cannot simply rely on hedging to eliminate exchange rate risk since we need some kind of prediction of future rate changes to determine the terms of the hedge. By adopting the random walk hypothesis we are not ceasing to make any prediction – we are simply saying that a rate rise is as likely as a rate fall. If the means to predict rate changes more precisely than this do exist then we could use them to improve the terms of our hedge and gain a financial reward. However, we would have to set the potential gains from that kind of active exchange rate prediction against any potential costs involved in employing forecasters and other staff. It might well be that, even if in theory using a specific model of the exchange rate would improve our ability to predict costs and revenues, in practice the costs involved in doing this would outweigh the benefits.

8) What current developments in the European Union might encourage or discourage movement towards the euro-zone countries becoming an optimal currency area? Do you think such a development is likely in the short or medium term?

Answer

According to the theory of OCAs four main kinds of development might increase the likelihood of the euro-zone becoming such an area:

Labour and capital mobility within the euro-zone might increase. The evidence in the chapter indicates that capital mobility within the zone is increasing but labour mobility also depends on cultural, social and linguistic factors and so is harder to predict.
Countries participating in the zone may adopt more open and diversified trade structures. Trade is already very open within the zone, but the question of diversification is more complex. The impact of the euro might go in one of two opposite directions. On the one hand it might encourage foreign investment within the zone leading to a greater amount of intra-industry trade and more diversified industrial structures within each participating country. This would make an OCA more likely. On the other hand it might lead to greater concentration of industry in particular favourable regional centres. This might well make industrial structures in each country less diversified and make an OCA less likely.
More similar policy preferences among participating countries . The hope of those promoting EMU was that the experience of having a common currency would bring policy preferences across Europe together and make an OCA more likely. This may well happen. On the other hand it could also be argued that the similarity of preferences evident in the 1990s was the result of a temporary unity around the specific project of implementing the Maastricht Treaty and that, now this has been done, old policy differences may re-emerge. Conflicts over the stability and growth pact among euro-zone members do give some credibility to this view.
Increased fiscal transfers between countries . Fiscal transfers within the euro-zone are small and actually seem to be getting less insofar as more of the EU budget is going to the `accession countries’ who joined in 2004 and are not (so far) euro-zone members. So to this extent the euro-zone may be moving away from becoming an OCA

9) What are the arguments for and against the euro becoming an international currency which could rival the dollar from the point of view of (a) the euro-zone countries and (b) the international financial system as a whole? Would such a development be one that European businesses should welcome?

Answer

From the point of view of the euro-zone countries the main arguments are (i) lower transactions costs in international dealings and (ii) seigniorage. However, neither of these seem convincing. The costs involved in holding dollars are surely not a major problem for European businesses operating globally – especially as many are now producing in North America as well as Europe. Seigniorage revenues are also not that high. So the main advantages probably relate to political power and prestige and the general position of Europe in world affairs.

The dangers of instability in world money arrangements if firms and businesses hold large amounts of currency in both dollars and euros (currency substitution) are potentially quite significant and might be a reason why the international financial system as a whole might be concerned about the rise of the euro. However, set against this, the availability of a second international currency would reduce risk to the system from possible irresponsible behaviour from the USA. For example, given the current size of the US trade deficit, the possible impact of a sharp devaluation of the dollar, to correct balance of payments imbalances, could be rather severe. The availability of the euro as an alternative might mitigate some of these problems.

Ultimately the issue of the relative weighting of the costs and benefits of the emergence of the euro as a potential competitor to the dollar is closely linked to the question of whether a `unipolar’ world order, centred on the USA, or a `multipolar’ world order is the most attractive way of organising international economic and political arrangements.

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CHAPTER 6: MULTINATIONAL CORPORATIONS OR MNCS

1) What do you understand the Transnationality Index to mean? What can we learn about the process of globalisation from the TNI evidence in Table 6.2?

Answer

The Transnationality index seeks to measure the extent to which MNCs are actually ‘global’ or truly international in their behaviour. As a proxy for measuring ‘globalness’ the TNI ranks companies according to the foreign share of their assets and employment.

Table 6.2 suggests or shows that the most transnational companies (as measured by the TNI) tend to be based in countries other than the world’s largest economies of USA, Japan and Germany. Only 3 Us companies figure in table 6.2 of the highest TNI ranking 37 MNCs, with 3 from Japan and 3 from Germany. Tables 6.1 and 6.2 give us rather different messages. The biggest companies are not high ranking on the TNI, and the high-ranking companies seem to start in relatively small economies. So perhaps the motivation for becoming transnational (or behaving truly as if in a borderless worlds, as in the Ohmae view) is simply one of necessity. To grow Swiss and Canadian companies, for example have to look outside their home economies.

Note that on the TNI rankings two companies taken by many to be absolutely symbolic of globalisation, McDonald`s and Coca Cola, only rank 24th and 26th respectively.

2) Ohmae says that we now live in a ‘borderless world’. What does he mean? Do you think he is right? What impact does this have on business?

Answer

Ohmae`s argument, in a nutshell, is that a modern international company is not essentially ‘home based’ in reality or in outlook. The typical MNC, says Ohmae, sees itself as a ‘citizen of the world’ seeking maximum growth and profits by taking advantage of production and marketing opportunities around the world. This, he says, is already the case for most big international companies, and this is a good thing.

The ‘borderless world’ approach to doing international business has clear beneficial impacts on business, Ohmae argues, especially as it makes use of best practice in free markets everywhere, thus imposing efficiency and effectiveness on companies and giving customers and other stakeholders around the world similar benefits.

3) Explain what ‘transfer pricing’ means in the context of globalised business activity. Why do businesses do this and what effect does it have on governments?

Answer

Transfer pricing, as explained in chapter 6, is a standard and necessary procedure in multi-plant or divisional firms in which plants and or divisions supply and are supplied by one another. It is a requirement of sensible management attempting to monitor and manage costs and efficiency. International firms may, however, use transfer pricing as a means of avoiding taxes by clever internal accounting. By managing internal supply prices firms can locate profits in divisions or subsidiaries based in low tax countries. This is clearly very helpful for firms, which by so doing reduce their tax liabilities and increase their profits. The practice of transfer pricing is very common indeed. For governments the costs are clear - lost potential tax revenues.

4) Some people argue that globalisation has failed to rid the world of poverty and is therefore not desirable. If poverty still exists, others might reply, it is because there has not been enough globalisation yet. When MNCs are truly free to operate where and how they want to, then the benefits of free markets will be able to raise everybody’s living standards. Explain these two viewpoints. Which do you think is the sounder argument?

Answer

Judgement as to which is the sounder of these two points of views ultimately up to the student or reader. One approach to the question could be to consider the different positions as ‘agents of control’ as against ‘agents of change’. The control idea claims that global firms seek to exploit whatever opportunities they can find, or indeed create, for business gain using their economic and political power to their own advantage. By implication these firms are assumed to do little or nothing to alleviate poverty around the world. The agents of change approach would see MNCs spreading new ideas, new techniques and new products around the world - so called ’technology transfer’, as well as creating employment opportunities. Furthermore, simple free market economics and the idea of the invisible hand suggest that firms in competitive markets must seek to serve their customers if they are to prosper. By so doing firms operate to the benefit of all consumers - including the poor.

Is ‘ridding the world of poverty’ a reasonable objective of global firms? Can society properly expect such business motivation? If not, and if most would argue that it is not, then this question could be seen as being deliberately provocative and attempting to stimulate debate.

5) It is sometimes said that MNCs limit the sovereignty of governments and nation states. Others argue that only governments can raise taxes or an army, and so governments are clearly more powerful than companies. Who is right?

Answer

Both points of view may be correct. There is considerable evidence of firms wielding influence over governments. A classic example from the 1970s was the Ford Motor Company insisting that the UK government intervene in industrial action being undertaken in some (then) very large Ford factories. The threat from the company was that if solutions could not be found to the conflicts then the factories could be closed down and production moved to other countries. This example illustrates that the concept of MNC power and its potential misuse, is not seen as applying only to weak poor or developing economies.

On the other hand it is of course true that firms do not have the ability to directly levy taxes, or to raise armies. But they may indeed negotiate the taxes they pay with the governments of host countries, seeking tax holidays or long-term tax relief in return for inward investment.

6) Look at the official EU ‘portal’ or gateway website (http://europa.eu.int ). What can you learn from this website about the EU approach to and attitude towards MNCs?

Answer

An open question, seeking student’s comments. The www sites may be found to give unclear information on what exactly is the stance of the EU towards the behaviour of existing non-EU MNCs within Europe, and on the question of conditional investment. (See q 5 above too).

7) Look at the quotation from the Communist Manifesto of 1848 in this chapter. Given what is said there, and using any other relevant information you have, how surprised do you think Marx and Engels would be if they could see the levels of globalisation now, in the 21 st century?

Answer

Probably neither Marx nor Keynes would be very surprised to see the levels of international trade and globalisation that exist now. But their interpretations would, presumably differ somewhat. Marx might see the current situation as evidence of international capitalism exploiting workers and markets around the world as part of the class struggle which has gone on since Greek and Roman times, whereas Keynes might see the modern business world simply of evidence of free markets flourishing. What would surely surprise them both would be the speed and scope of modern business communication systems, and of international travel.

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CHAPTER 7: FDI

1) Using information in Table 7.3, calculate the growth rate of FDI inflows for LDC’s between 1992 – 2003 and discuss the technological impact of this on the local firms.

Answer

(172 033 – 118 596) / 118 596 = 45 %

This a considerable increase in FDI inflows into LDCs between 1992 and 2003 which should have a discernible impact on the economies of LDCs. MNCs are more likely to bring their technologies with them when they set up their production facilities in LDCs since they are very unlikely to acquire them locally. There are two kinds of technological effect: direct and indirect. The direct effect occurs through the transfer of technologies to a local affiliate, which would adopt the same production techniques as the parent company. The indirect effect occurs through technology spillovers.

Technologies may spread to new users through both formal and informal means. Local firms may learn about the technology of a MNC in a formal way by being directly associated with it, for example in a joint venture or under a license, or informally by being connected with the MNC through a 'linkage'. Linkages may either be backward, which arise from the local MNC's relationship with local suppliers, or forward that stem from contact with local customers. Moreover, technological know-how may spread through employees switching firms from MNCs to local firms. However, the impact of technology transfer would ultimately depend upon whether the local firms are strong enough to compete with the new technology by gradually adapting to it or too weak to withstand the technological impact and go under.

2) Explain what the ‘O’ stands for in ‘OLI paradigm’? Give examples of firms which have used this specific advantage in determining their direct investment.

Answer

‘O’ in OLI paradigm stands for ‘ownership-specific advantages’ which refer to certain types of knowledge and privileges that a firm possesses but which are not available to its competitors. These advantages arise because of the imperfections in commodity and factor markets. Ownership-specific advantages include technical advantages such as patents, unavailable technology and management‑organizational techniques; the advantages arising from operating in an oligopolistic market such as those associated with joint R&D and economies of scale; financial and monetary advantages due to preferential access to capital markets so as to obtain cheaper capital; and privileged access to raw materials or minerals that becomes an ownership‑specific advantage.

Examples are Microsoft holding a patent on a particular software product, Shell having privileged access to Nigerian oil reserves, and pharmaceutical companies such as GSK operating in oligopolistic markets due to the huge R&D expenditure they undertake.

3) To what extent are radical explanations of FDI valid?

Answer

Radical explanations of FDI are still relevant today at least to some extent due to the following factors. Firstly, the bulk of the activities of the MNCs take place among the developed countries and only a small proportion relates to the LDCs. Secondly, despite the recent increase in the share of LDCs in world FDI flows, they are heavily concentrated on a handful of countries. Thirdly, the attitude of rich countries towards LDCs and FDI is less than desirable. The IMF, the WB and the EU advocate that LDCs liberalise and deregulate their policies regarding foreign investment but the rules of the game seem to favour the interests of the rich countries to the detriment of the developmental efforts of LDCs.

4) Table 7.2 indicates that FDI grew by almost 1000 per cent during the period 1982-2003 while exports grew by only 400 per cent in the same period. What is the implication of this difference in the two growth rates for business firms? (Hint: refer also to chapter 3.)

Answer

In conjunction with the fact that recent years have witnessed increased globalisation of the world economy helped by technological development as well as the liberalisation and privatisation policies followed by many governments in the 1980s, it means that M&A activity has grown at unprecedented rates in recent rates. This in turn implies that MNCs have assumed an increasingly important role in the global economy. In fact they account for some 80 per cent of world trade and an equal proportion of the private R&D expenditure. This has been achieved via vertical and horizontal integration of firms on an international scale. It also implies increased concentration of business activities (see chapter 1).

5) Tables 7.3 and 7.6 indicate that recently intra-EU FDI has increased in relation to extra-EU FDI. Can you give explanations for this?

Answer

ne explanation is the dramatic increase in cross-border M&As with in the EU. The number of cross-border intra-EU M&As increased from less than 100 in 1986 to well over 800 in 1991, and there was a similar rise in the number of extra-EU M&As targeting EU companies (see Chapter 7). However, the number of extra-EU bids, i.e. EU companies bidding for firms outside EU, fell in the late 1980s. The main cause for these developments was the planned completion of the Single European Market (SEM) in late 1992.

The introduction of the Euro Zone and the accession of another 15 (mainly East-European) countries into the EU are the additional factors contributing to the increase of intra-EU FDI.

6) Automotive, pharmaceuticals and software sectors are among the ones attracting most FDI in recent times in the EU. Can you explain this?

Answer

For automotive and software sectors one reason could be demand-oriented factors, that is, FDI driven by the size of the EU market (market-seeking FDI). Another reason would be LSA due to the fact that the EU market contains well educated and skilled but relatively cheap labour particularly in the case of Britain and the CEECs (resource-seeking FDI).

For pharmaceuticals and automotive sectors the main reason would be economies of scale again related to the size of the EU market (efficiency-seeking FDI)

7) Should LDCs try to attract FDI? What are the implications of FDI inflows for the labour and capital markets of LDCs?

Answer

One of the main and common characteristics of LDCs is that they need large amounts of capital to finance their developmental efforts and yet they lack capital. Therefore, they try to attract as much FDI as possible to fill this gap. However, FDI inflows are mixed blessing for a developing country since their economic impact could be negative as well as positive.

Positive effects of FDI on the labour market can be direct, that is new jobs are created; or they can be indirect, through new posts created along the value chain. Furthermore, MNCs may create spill-overs and increase the overall knowledge of local workers in an indirect fashion and thus raise labour productivity. However, the incoming MNC will fail to increase employment in the recipient country if they simply displace domestic production thus making workers redundant in the domestic firms. Additionally, in sectors where there is shortage of labour, the MNC will be in a position to offer better pay to workers and thus ‘crowd out’ the local firms. Moreover, it is possible that foreign-owned firms can influence the distribution of incomes because they demand different types of labour and pay higher wages to skilled workers. As foreign firms engage in business on international scale, they require more skilled workers in terms of managerial skills to run their day-to-day operations as efficiently as possible. Furthermore, as MNCs possess technologies and R&D facilities of the highest standards, they require skilled workers who can operate such technologies and are fast learners. All these factors compel MNCs to pay higher wages to more skilled workers as they are left with little choice due to the relative lack of skilled labour in most developing countries and thereby possibly increasing wage inequality between skilled and unskilled workers.

As for the capital market, developing countries hope that MNCs will bring in enough capital which will be available for local firms to borrow and realize their investment projects and that this will lead to strong and sustained growth.

If, however, MNCs entering developing countries choose to finance their investment from local financial markets and therefore compete with domestic firms for the capital available, they could end up driving the local firms out of business. It is a fact that MNCs are more profitable and possess more assets than domestic firms in developing countries and they may therefore be regarded as a more secure borrower compared with domestic firms and thereby absorb the available capital. This is the so-called 'crowding out' effect. It is further argued that the crowding out impact of inward FDI on domestic capital accumulation is sector specific. In particular, foreign investment in the high-wage manufacturing sector may have a far greater impact on capital available to domestic firms than in the primary sector. There is also the controversy regarding the role of FDI in creating growth. Some studies indicate that although growth often attracts FDI, there does not seem to be enough evidence to suggest that FDI contributes to growth.

Some argue that the effect of FDI on the capital market is not clear-cut, and that it depends on the characteristics of the investment, the recipient country, and the timing of the investment. Even if the firms facing credit constraints had savings put aside for investment purposes, they may not be able to channel these funds into productive investments because of the poorly developed financial markets, which exacerbate the credit deficiency in the market. Therefore, the foreign capital channelled through FDI, serves as provider of new capital and also it bypasses the undeveloped domestic institutions in channelling the funds into productive investment. In this it partially replaces domestic banks or venture capitalists in the process of financial intermediation.

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CHAPTER 8: INTERNATIONAL AND EUROPEAN CAPITAL MARKETS

1) What do you think are the main advantages and disadvantages involved in organising the financial system around either markets or institutions? Can you think of any reasons that the United Kingdom has tended to use markets more than continental Europe? Why do you think Gerschenkron argued that markets would become more important than institutions over time?

Answer

With regard to the advantages and disadvantages of the systems, market-based systems have generally been thought to be advantageous in terms of mobilising large amounts of funds from dispersed savers and in terms of spreading risk and allowing for diversification. They are often regarded as being more flexible and adaptable than institution-based systems. The advantage of institution-based systems is in their ability to build close relationships between borrowers and lenders which can avoid some of the potential `short-termism’ of the market. However, this can also be a disadvantage if the links get too close and lenders cease to ensure that borrowers are spending money wisely. As well as short-termism another potential disadvantage of market-based systems is instability – if markets become vulnerable to speculative bubbles then there can be rapid rises and falls in asset prices which can destabilise the system.

There are two main reasons that have been put forward for the UK using markets more than Continental Europe. Firstly, it may result from a general preference towards markets in Britain as a way of organising economic activity and a scepticism about state involvement and large companies (in a number of the European countries – notably France – there has been heavy government involvement in the institution based financial system). The second possibility, which is basically Gerschenkron’s argument, is that since the UK industrialised earlier than Continental Europe it was not faced with the same need to acquire centralised funds for very rapid investment projects in order to `catch up’ in its industrialisation process. The European countries, which did need to do this, relied on financial institutions to help them in this task.

Gerschenkron essentially argued that the role of institutions was closely related to this catching up process and that once industrialisation had taken place and countries could compete on a level playing field with one another the role of institutions would become less. It is also the case that both savers and borrowers may well move away from institutions as they become richer and more sophisticated. Neither wants to be tied to a particular intermediary and both may be attracted by the wider range of financial possibilities offered by markets.

2) Which of the three eras in the international financial system, as identified by Eichengreen and Fishlow, namely the eras of bond finance, bank finance and equity finance, was most desirable from the point of view of (a) the availability of funds for individual countries and firms, and (b) the stability of the overall system?

Answer

There is no definite right or wrong answer to this question but looking back to the advantages and disadvantages of market and institutional systems, as discussed in the answer to the previous question, we can suggest that bond and equity finance were able to offer access to a wider pool of funds than bank finance and that perhaps the popularity of bank finance in the 1970s resulted from the temporary weakness of financial markets rather than from the attractiveness of this form of finance in itself.

With regard to stability many would argue that equity finance is more stable than debt finance (either provided by banks or bonds). This is because if times get hard returns to equity holders are more inherently flexible than returns to debt holders (which have to be paid each year as interest) and so there is less possibility of defaults or bankruptcies spreading through the system. This may be one reason why there has not yet been an international financial crisis in the era of equity finance to rival those of the 1930s or the 1980s. However, one disadvantage of equity finance, to set against its benefits in terms of stability or flexibility, is the way that control over assets passes to overseas investors.

3) Why do you think the Eurocurrency market grew so fast? Which kinds of businesses do you think particularly benefited from the growth of this market? Were any problems associated with this growth?

Answer

The main reasons for the fast growth of the Eurocurrency market were (a) the ready availability of funds as a result of the rise in oil prices and (b) the lack of regulation which allowed banks both to cut costs generally and to offer competitive deals which might have been excluded for regulatory reasons elsewhere.

Apart from sovereign borrowers the main beneficiaries of the market were multinational companies who needed to step up their foreign currency borrowing in order to fund their international activities.

Two main problems have been raised with the growth of the market. Firstly, it was argued that it led to uncontrolled credit growth which might fuel global inflation. There has been considerable controversy amongst monetary economists about whether this is actually a real threat and it has been somewhat superseded anyway by the general fall in international inflation rates. Secondly, the growth in unregulated lending raises the possibility of financial turmoil which might threaten the stability of the international system. This could in theory have happened either through corporate or sovereign lending – in fact it was sovereign (government) borrowers who defaulted from 1982 onwards.

4) Many people have argued that asymmetric information and systemic risk justify government regulation of financial institutions and markets. Can you think of any ways in which such institutions and markets have been able to limit these problems on their own account, without having to rely on outside regulators? Are such alternative approaches to dealing with these problems preferable to regulation from the point of view of the businesses who are customers of these institutions and who deal in these markets?

Answer

There are two main ways in which it has been argued that the financial system could regulate itself without relying on government involvement. The first is to move much more radically towards a market-based system, with banks competing not just in terms of banking services but also in terms of issuing different kinds of money. The argument is that the money which is most reliable (because it is backed up by the most reliable bank) will win out in the competitive process and there will be no need for governments to intervene. So-called `free banking’ in the UK before the Bank Charter Act of 1844 and in the USA before the Civil War is an inspiration for this school of thought.

The second approach is to rely much more heavily on informal methods of ensuring stability, focusing on long-term links between lenders and borrowers, which lessen the problem of asymmetric information. The Japanese financial system (and to some extent the German system) has been seen as a possible way forward here.

Neither of these alternatives seems very satisfactory. The main problem with relying on informal networks, as in Japan, is the possibility of relationships between borrowers and lenders becoming too close, as appears to have happened in the 1980s, with a consequent build-up of bad debt. Such networks can also lead to unaccountable concentrations of economic power. In many ways the current international economic system, with no international central bank and with a multiplicity of currencies, provides something of a test of what a free banking system might be like nationally. It does not seem to have avoided financial instability over the last decade – rather the reverse (consider the crises in Mexico in 1994, Asia in 1997, Russia in 1998, Turkey and Argentina in 2001).

At present there seems no real alternative to a system of financial regulation. However, this does present the challenge of ensuring that such a system does not lead to moral hazard – with users and providers of funds simply scaling down their efforts to monitor the correct use of money in the light of a belief that the authorities will bale them out if times get hard.

5) The proposals for an international lender of last resort and an international bankruptcy court, which are outlined in the chapter, have been criticised because it is thought they might lead to moral hazard. Can you think of any ways in which these proposals might be modified in order to avoid this happening?

Answer

One way of approaching this is to look at the ways these institutions have been set up on a national basis in order to avoid problems of moral hazard. With regard to lenders of last resort the main way of ensuring that such lending does not lead to irresponsible behaviour is to charge a very high interest rate (often referred to as a `penal’ rate). Another approach is to make such lending conditional on changes in the management of institutions.

The situation with regard to bankruptcy is slightly more difficult, particularly as any bankruptcy procedure for sovereign borrowers would have to involve refinancing them in order to allow them to continue as independent countries. The most obvious way of avoiding moral hazard would be to make any declaration of bankruptcy involve some kind of transfer of ownership of national assets to those who had previously provided funds. However, this might be seen as resulting in too great a sacrifice of national independence to be acceptable.

6) What are the main problems involved in relying on capital adequacy ratios as a means of regulating the financial systems? Can you think of any ways in which the use of these ratios might be altered in order to avoid such problems? What changes do you think the introduction of such ratios might make to the strategies adopted by banks to obtain competitive advantage?

Answer

The main problems involved in capital adequacy ratios are those mentioned in the text: firstly that they can be destabilising and secondly that they are undiscriminating in their assessment of risk. In order to avoid the first problem one approach might be to have some kind of temporary allowance whereby in the event of adverse economic circumstances banks might be allowed to exceed the `normal’ ratio for a specified time period rather than calling in loans (this is in some ways analogous to some of the proposals for reform of the stability and growth pact associated with European monetary union). Alternatively there might be some kind of government owned or financed lender who would provide emergency finance to corporate or household borrowers in such circumstances.

Most of the proposals for reform of capital adequacy ratios have concentrated on the second problem and have tried to use a variety of credit scoring techniques in order to assess the risk of various loans more appropriately. Another approach here might be to weight the riskiness of loans more heavily if they are concentrated heavily in a particular sector.

The main change which the introduction of capital adequacy ratios is believed to have made to the competitive strategies of banks is to encourage merger and takeover activity in the sector as institutions try to boost their capital by taking over other well-capitalised banks. This can cause problems in terms of maintaining effective competition in the sector.

7) What are the main arguments for and against having a single European financial regulator? Do you think it would be a good idea to introduce such a regulator?

Answer

The main arguments for having a single regulator are ensuring consistency of treatment across Europe, resolving potential conflicts or ambiguous situations where it is not clear whether home or host countries have responsibilities for a particular institution (or where they each have responsibility for some of the actions of the institution), and avoiding a situation where the level of regulation is bid down by competitive pressures to too low a level.

The problems with having such a regulator are partly those resulting from the fact that we do not really yet know the optimum structure of financial regulation and in such circumstances it might be better to have a variety of different regulators trying different approaches in order to see which one works best. Having a single regulator also raises questions about who that regulator should be accountable to and about how personnel should be selected.

8) What are the main advantages and disadvantages of the approach to financial regulation proposed by the Lamfalussy Commission? Do you think that companies in the financial and non-financial sectors might differ regarding the desirability of this approach, and if so, why?

Answer

The main advantages have been regarded as being flexibility and speed in adapting to changing circumstances in the fast moving financial markets. The main problems with this approach concern a possible lack of democratic accountability and the difficulties involved in determining which of the four levels a particular issue should fall under.

With regard to different kinds of companies there may be a potential disagreement between financial and non-financial companies in that financial companies will generally want as light a regulatory structure as possible whereas non-financial companies will be more interested in the security provided by regulation (though they will not want regulations to be so extensive that they raise the cost of capital). Also, non-financial companies may well also value their links to national governments and the possibility of lobbying which this gives rise to, so they may not be so keen on taking financial regulation up to the pan European level and removing it from political influence, particularly if this means that national governments are less able to provide cheap funds to favoured companies.

9) What do you think are the main obstacles remaining to the creation of a single European financial market? Would such a single market provide significant benefits for European businesses?

Answer

There is no single right or wrong answer to this question. There is however a vigorous debate going on amongst academic observers of European finance which basically has led to two main positions. The first argues that the main obstacles to a single market lie in political or business obstruction to financial integration (for example the reluctance of banking regulators to facilitate cross-border mergers, the unwillingness of banks to adopt a structure based on branches rather than subsidiaries) and that the key issue for the future is breaking down this obstruction through appropriate legislative changes. The second argues that there are inherent characteristics of the financial markets which make integration difficult (for example the need for liquidity which has led to national specialisation in the issuance of government bonds and the way in which asymmetric information problems lead to the prevalence of relationship banking). In this case legislative changes on their own will not lead to integration, and something else is required. This might be some kind of innovation in terms of products or market structure. There seems to be some truth in both positions and the relative merits of each is a matter for continuing debate.

A further obstacle to creating a single financial market is likely to be the question of integrating into that market the countries of Central and Eastern Europe as they eventually adopt the euro.

While the proposed benefits of a single market put forward in the Cecchini report were probably over-optimistic the general consensus amongst growth theorists in recent years has been that large integrated financial markets do significantly aid business and economic development.

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CHAPTER 9: LABOUR MARKETS

Currently more women and more part-time workers are employed in European labour markets but the level of unionization has fallen. Alongside these facts, the European Union has introduced policies on maternity and paternity leave. Do all these features suggest that labour markets are becoming more flexible in Europe?

Answer

Flexibility in labour markets means many different things:

Wage or earning flexibility;
Increased labour mobility;
Functional flexibility, and;
Flexibility in the pattern and organisation of work.

The growth in female and part-time employment in Europe may be an indication of greater functional flexibility whilst the growth in maternity and paternity leave may an indication of greater flexibility in the pattern and organisation of work. Part of the changes in the labour market have been brought about through social pressures, particularly in the case of maternity and paternity leave. They will have an impact on labour market flexibility encouraging women to have longer periods of time off after the birth of a child. Nonetheless, such schemes are often not linked with full pay and their overall impact on flexibility may be small. The growth of women and part-time workers in the labour market may be strongly correlated in that for some women to return to work the availability of part-time work is important. Part-time work is also important for older workers who wish to stay in the labour market. These two groups can be used by employers to fulfil changing demands for their products and services. However, in terms of wage or earnings flexibility the impact is less clear, though having an increased pool of labour on which to draw may keep a lid on wage levels. Both changes have little impact on increased labour mobility unless part -time work and increased women's participation are seen as ways for people to improve their labour skills and therefore increase their ability to find other work.

2) The managing directors of the Rover Group earned high rewards whilst the company incurred high levels of debt before going into receivership in 2005. Do you consider that Rover executives’ pay should have been more of a reflection of the company performance?

Answer

This is a perennial debate that occurs within the press and at shareholder meetings. That is, executives are being rewarded for what appears to be mismanagement of the business. It raises issues of corporate governance. Some organisations argue that high salaries are required to gain the best people otherwise they will go elsewhere; others argue that the business may have performed even worse without these people at the helm. There is also the question that no matter who might have been appointed the business or sector was in decline and the executives could do little about this. External circumstances or unforeseen circumstances may also have affected the business.

The answer to this question should also explore the packages that an executive is offered. How much is actual salary, how much is in shares, when can these be "cashed in", and what are the payments to pension funds? Individual investors have begun to pressurise insurance companies and the like which hold the bulk of an organisations shares to be more questioning about executive pay.

3) Ignomenti, a dynamic Italian clothing firm, has always employed young designers and a young workforce while selling its products throughout Europe mainly to the 18-25 age group. What might be the implications for Ignomenti as the European population ages?

Answer

There may be two problems for Ignomenti - its workforce has been drawn from the younger age group and its customers are also from the same group. If Ignomenti has been selling its products in Europe, then the projections are that there will be a decline in numbers in younger age groups over the next 20 years at least and a rise in the numbers aged over 55. Ignomenti could look to sell its products in other areas of the world where the demographic profile of the population is still very young. It could look to migrant labour to keep its fairly young employee profile. Alternatively it could consider employing older people and change its designs for an older customer base.

4) In the United Kingdom the introduction of a minimum wage in 1997 and its subsequent upward revisions have been associated with a period of growing male and female employment. Reconcile this with the theoretical view that the introduction of minimum wages should lead to a fall in employment.

Answer

The diagram on page 269 of the text shows the theoretical impact on the labour market after the introduction of a minimum wage in a competitive market, where the minimum wage is set above the current equilibrium wage. In this case of the imposition of a minimum wage leads to a fall in the demand for labour and an increase in the supply of labour. The overall impact is for an increase in unemployment. However, in the case of the UK, the introduction of minimum wage legislation in 1997 did not appear to increase the level of unemployment but in fact the opposite occurred. There have been a number of reasons put forward to explain this phenomenon. Firstly, for those who know more about labour economics, it is possible for a minimum wage to lead to higher levels of employment when labour markets are not competitive. Secondly, the minimum wage was introduced when the UK economy was going through an upward part of its growth cycle so there was increased demand for jobs. Thirdly, the level of minimum wage was set at a level which was only just above the current equilibrium wage so that the impact on the labour market was negligible. Fourthly the sectors and hence the people affected by minimum wage legislation were relatively small since most people earned wages above the minimum wage. Fifthly, the percentage of the minimum wage paid to those under 21 meant that some employers could substitute younger workers for older workers (unemployment for older workers might rise but this is compensated by a fall in unemployment for younger workers). Finally, the decline in the power of trade unions has meant that any labour market unrest by those people who wanted to keep their wage differentials the same compared with those whose wages were raised through the introduction of a minimum wage was relatively small.

5) In Europe there are skill shortages in many of its craft industries of workers such as electricians, plumbers and builders. What could be the impact on the European Union if it does not deal with the skill deficiencies in these areas?

Answer

Where there are skill shortages in craft areas in the EU, then the wages for these groups of people will be above the EU average. This raises the costs to the building industry in particular. These higher building costs may result in higher prices for both commercial and industrial buildings and for domestic homes and this could dampen demand. Where there are skill shortages in craft areas, free market economists might argue that individuals perceiving the higher salaries in these areas would be attracted from other areas of the job market. Employers too may respond by setting up more apprenticeships or seeking these types of employees from outside of the EU, thereby creating a shortage worldwide (see the case of nurses in the UK and the impact on Africa). The EU and national governments could attempt to address some of these issues of skill shortages by setting up more training schools for craft workers. If nothing is done there will be less commercial and industrial building taking place and this will impact on prices. The knock-on effect might now be on foreign direct investment (FDI) where foreign companies see rental and build costs as too high in the EU and decide to develop their organizations in other countries outside of the EU where building costs are lower.

6) What is the importance of labour productivity to an economy? Using Table 9.5, explain why the United Kingdom has begun to catch up other European countries.

Answer

Labour productivity measures the output per person or output per hour worked. Therefore, economies that have higher levels of productivity can have higher levels of economic growth with the same level of resources. Since the same products can be produced with fewer man-hours in some countries they will also be price competitive. Labour productivity is also seen as an indication of the effectiveness to which resources are being used and is related to management expertise, trade union power, the level of skills and education of the workforce and the level of capital investment and R&D within an economy.

Table 9.5 indicates that the UK’s productivity, measured in terms of GDP per worker has been catching up that of France and Germany since 1998. Firstly, it is important to note that this is only a 5-year trend and that a longer period of data is called for if we wish to consider the UK’s longer-term productivity trend. There are many factors that could explain the productivity catch-up by the UK. Firstly, the catch-up is due to a range of supply-side policies introduced in the 1990s that are now feeding through the system. Could the UK have closed down some of its least efficient sectors? The figures are not sector specific so in some sectors the UK could still be falling behind. A further explanation could be that productivity catch-up occurred due to the range of skills and education policies introduced by the UK government during the 1990s. The growth of foreign direct investment (FDI) will also have enhanced UK productivity, since foreign owned firms tend to higher levels of productivity than UK owned firms. Levels of FDI relative to France and Germany may have increased in the UK during the 1990s. It is also possible that France and Germany were quicker to introduce new technology than the UK therefore in the period before 1998 their productivity levels rose dramatically and what we are seeing is the catch-up that results from the UK slowness of introducing this technology. Finally, perhaps there were circumstances in France and Germany that caused their productivity levels to slow down rather than for the UK to catch up. One of these may be the problem Germany has experienced through re-unification.

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CHAPTER 10 INDUSTRY POLICY AND COMPETITION POLICY

1) The Lisbon Agenda, or the Lisbon strategy, aims to establish the European Union as the most competitive economy in the world by 2010. What are the chances of this becoming reality? How do you think that either EU IP or CP could help in achieving these goals for the European Union?

Answer

Students should refer to relevant EU websites for up to date statements about the Lisbon Agenda and developments with it. Also press releases from the EU Competition Office will be helpful.

Cynicism should be avoided in answering a question like this, but it may be difficult not to be sceptical with reference to the hopes and ideals of the Lisbon Agenda. The EU still lags behind the USA and other countries, like Korea for example, in terms of international competitiveness. However there may be agreement, in principle at least, that IP and CP could and should contribute to improving European competitiveness. After all increasing competitiveness is the rationale of CP! So IP and CP could help. The problem as to whether IP and CP will help is complicated by political differences between member states. The European Union may be seen by some as a union more in name than in practice when we see the reluctance of many member states to give up their policies of support for domestic companies through state aid and public procurement procedures.

2) Both Lynch and Ferguson have approaches to classifying IP. Describe both UK and EU IP using both of their models.

Answer

Both Lynch and Ferguson and Ferguson do, indeed, have suggestions as to how IP may be classified or categorised. Lynch`s approach is the simpler, or some might say more limited, with its two extremes of Laissez-Faire and Dirigisme. (See ch 10 p. 284). In Lynch’s terms IP in both the UK and EU would be seen as predominantly Laissez-Faire, with some exceptions. Lynch points out that most countries have a mixture of both approaches.

According to the Ferguson and Ferguson taxonomy EU and UK IP would both be called supportive and broadly neutral, rather than Laissez-Faire, as there are certainly some interventionist elements in both (see page 285, and also the statements under heading ‘IP in the European Union’ p 286).

3) Argue the case that state aid is an unwarranted distortion of free markets and therefore should be totally outlawed in the European Union. How likely do you think it is that state aid will, one day, be totally banned in the European Union? Explain carefully.

Answer

There could be agreement that, strictly speaking, state aid is ‘a distortion of free markets’. This is almost a truism - true by definition. The purpose of state aid is to give firms some sort of assistance, or advantage, compared to rival firms either at home or abroad. Whether state aid is ‘unwarranted’ distortion is another matter. If there are arguments about its desirability so there may be arguments as to whether it should be banned. Points made in favour of state aid have a good deal in common with the defence of protectionism, especially the infant industry ideas. The political desires of many member states and regional authorities, to continue to use state aid, are important factors to consider when viewing the future of state aid. The wish to promote and sustain local or national firms, and employment providers, whether ‘champions’ or not, is strong. It seems very unlikely that sate aid will be totally banned in the EU. Even if there were to be a ban on state aid as such there would surely be other means by which some firms would continue to receive support, simply be renaming the support or providing for it with money from the cohesion and regional budgets.

4) Public procurement accounts for about 15-20 per cent of EU GDP. It is currently not conducted in very open and competitive markets. First, outline some arguments why public procurement should be more open and competitive, and show how businesses might gain. Then second, discuss what the main issues are in trying to make it more transparent.

Answer

Public procurement, of itself, is neither contentious nor controversial. It is simply the process whereby governments, both local and national, award contracts for the supply of goods and services to businesses. Where the controversy arises is when such contracts are awarded on a discriminatory basis, either by giving favourable terms to domestic firms or by restricting the access to such contracts, or both. Such behaviour can easily be declared to be a distortion of free markets and against the principles of the single market.

If public procurement were to be conducted in a more open way than it is at present then firms in ‘other countries’ would benefit from the extra opportunities to do business. Furthermore home based firms could also gain, in the long run if not the short run, from the exposure to more vigorous competition, on which efficient and effective business depends. The main difficulties in making public procurement more transparent in its operation are primarily political. As long as both governments and firms within a country or region are keen to cooperate in the ‘rigging’ of public contracts then it will remain difficult if not impossible to eliminate the practice.

5) It is sometimes said that business people know their own business best, and therefore there should be no interference at all by such bodies as the CP authorities. Defend and support this position.

Answer

To ‘defend and support’ the point of view expressed in the question a number of points could be made. It could be argued that CP practitioners around the world are almost always, and by necessity, public officials. They are typically civil servants, lawyers or seconded academics, and just occasionally from the world of commerce. Thus they are, to a greater or lesser extent, largely ignorant of how business works and how it works best. On this basis it might be argued that civil servants and lawyers are just about the last people who should be dictating to private enterprise how they should run their businesses. The discipline of the market place, and the force of public opinion should be relied upon to promote efficient and effective firms, and CP is either unnecessary and or a dysfunctional waste of time and effort.

Students could try to rebut this argument as outlined.

6) Given the evidence that suggests most, or nearly all, mergers have a negative effect on business performance, do you think that all mergers should be banned? Why or why not? Explain carefully and give some recent examples of where a merger has been banned and where it has not, and why.

Answer

The ‘given’ in the question could be challenged. Yes, there is much evidence that shareholder wealth (in terms of share values and dividends) is often negatively influenced, at least in the short run, following mergers. But such negative results, if they occur, may have many explanations. One important consideration is whether the merger is ‘friendly’ or ‘hostile’; by mutual agreement or unwanted takeover.

In the UK in the 1960s it was active government policy to encourage certain mergers, in some cases providing funds to facilitate reorganisation and restructuring of merged firms. The classic case for such mergers, then and now, is on the basis of rationalisation and the elimination of duplication of activities (especially in research And development), as well as general ideas of economies of scale. Further arguments that ‘synergy’ may provide gains may also be put forward.

It is, therefore, probably difficult to make a clear case for the outright prohibition of mergers. Indeed the current position in the UK and EU seems in practice to be rather the opposite: the general presumption being that mergers should be allowed to proceed unless there are clear public interest reasons to prevent them.

Students should refer to recent examples in UK and EU of mergers that have been both allowed and prohibited and should argue the merits of these cases.

7) What are the theoretical grounds for expecting monopolistic market structures to lean to poor economic performance? How does this relate to reality?

Answer

The basic theoretical grounds for the condemnation of monopoly are illustrated in figure 10.1. This theory may be challenged on various grounds, not least the ideas relating to dynamic technical progress associated in particular with Schumpeter and Galbraith. Even if the deadweight loss can be ‘proved’ this is ‘comparative static’s’ analysis (that is comparing two theoretical positions at different points in time), it can be argued. Reality is not about comparative statics. Much more important they, and many others, argue is how business performs over time. And over time big business is typically much more innovative and creative than small firms.

A counter argument would suggest that ‘in reality’ many big firms actively inhibit competition and progress, for example by buying up new ideas and patents, to prevent them being used by rivals, or similarly by buying scarce resources to prevent them being used by competitors. An example of the latter could be current allegations levelled at, and vigorously rebutted by, Tesco that they buy land suitable for retail development to prevent it falling into the hands of competitors as much as for their wish to build on it themselves. Similarly there are suspicions that Shaun Wright-Phillips, an excellent footballer, was bought by Chelsea Football Club to prevent other clubs having him. A player of international quality, he rarely gets a game for Chelsea!

8) It is sometimes argued that in modern economies, in which multinational corporations and globalisation are now the norm, the attempts to control big business behaviour by CP authorities are doomed to fail. Discuss this point of view.

Answer

It is often difficult, but not impossible, for national CP authorities to challenge or dictate terms to powerful global firms. However it can be done. Recent rulings by the EU CP authorities with respect to Microsoft are a case in point. Or, alternatively, the occasional high profile case where the authorities challenge a large global firm may be seen as the exceptions to prove the general rule that CP is typically virtually powerless against global firms. Here the Cowling and Sugden argument, relating to denial of market access, may be relevant. (See ch 8 p 181).

Within countries, and especially within a large grouping of economies like the EU, CP authorities clearly can and do have the force of the law and their governments behind them. The extent to which governments wish to support the CP practitioners is a matter of political will. CP activities are ‘doomed to fail’ is surely too strong and too negative a position to sustain.

9) Following on from question 8, consider the argument that CP is no more than pretence, or an attempt to persuade the public that they are protected from the power of monopolies and cartels. Is this a sound argument? State your case carefully.

Answer

As suggested in the answer to Q1 above, cynicism should be avoided even if a sceptical or critical view is taken. The present author has some personal knowledge and experience relating to the proposition that ‘CP is a pretence’, having once worked as a CP analyst. Of course it is the case that the balance of power between the CP authorities and some big firms is tilted in favour of the firms. When IBM were engaged in a long running case with the US anti-trust authorities in the 1970s and 1980s they employed hundreds of top lawyers and economists to argue their case. The anti-trust authorities were both out-numbered and out-resourced. In the end some compromise outcomes were agreed.

However to suggest that the whole panoply of CP rules and regulations in the UK, the EU and elsewhere is some sort of sham is not a point of view to accept.

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CHAPTER 11: EU REGIONAL, TRANSPORT AND ENVIRONMENTAL POLICY

1) Choose a large organisation in a European country. To what extent can regional policy at the national and European level be seen to have influenced its location?

Answer

Having selected an appropriate organisation, the following points might be of interest:

What types of regional policy are operated by the government in the chosen country?

What is the mix between national and EU regional policy?

Are there any restrictions on the type of policy or region in which it can be used?

The broad issue about regional policy both nationally and at a European level is whether it does attract organisations. In other words would these organisations have come to a particular area without the incentive of regional policy? In the case of a domestic firm that receives regional incentives, has it simply moved from one area of the country where there were not incentives to another area of the country where incentives are available? In this case the net gain in jobs might be zero. Were the incentives capital incentives or labour incentives? What is the value of the jobs created in term of the total incentives given? In fact the objectives of regional policy at a national and regional level need to be discussed in detail.

2) To what extent is the United States’ stance toward environmental policy influenced by its energy-producing companies?

Answer

The role of lobbying by businesses on both sides of the Atlantic has become increasingly important. In fact in the United States some large businesses and organisations pay money into the election coffers for candidates standing for office and in particular running for the presidency. If we look at the list of the biggest firm (shown in Chapter 1) it is noticeable that a number of energy firms are fairly high up the list. Many of these provide support for elected representatives in the US. They may be influencing, both directly and indirectly, therefore, the government’s position on energy use and the environment. Environmental legislation may raise these companies’ costs and reduce their profits; hence they may lobby heavily for governments not to change their environmental legislation. In fact they may argue that such an action may be good for the country since they now become more cost competitive and their sales may rise leading the higher levels of employment.

Companies may also seek to influence the government by threatening to move their production abroad if too stringent environmental legislation is introduced in their country. Therefore the role of “big business” might have quite an important impact on a government’s perspective on the environment.

3) In the road haulage sector, how has EU transport policy increased the costs of road haulage firms? What have been the benefits experienced by hauliers from EU transport policy?

Answer

The EU has introduced a number of policies within the road haulage sector over the past twenty years. By limiting the numbers of hours that a driver can be at the wheel has resulted in changes in the work patterns for some drivers. The result may be more local journeys and the need to set up new distribution points. Alternatively, two people may be required to drive the lorries over longer distance routes. Other pieces of EU transport policy such as seeking to harmonise weekend bans and the introduction of a drivers certificate together with the development of vocational training for drivers may increase costs to the transport companies. The introduction of the tachograph will also have reduced the ability of the driver to exceed more that the regulatory hours for driving. This may have increased the costs to the hauliers. Increasing the ability of foreign hauliers to operate in a country’s domestic market will also have increased the competitive pressures faced by transport companies. Of course one of the main costs is outside EU control and that is the cost of fuel. Transport organisations have argued that the differential tax rates on fuel have put some countries’ transport organisations at a distinct cost disadvantage.

EU transport policy has also led to some benefits for hauliers. The introduction of cabotage means that lorries can now have full loads on their return journey. By permitting the use of large lorries on some roads means that one lorry can now replace two – this saves on driver costs, and transport companies suggests reduces road wear and tear and environmental pollution. Attempting to align road transport policy with rail transport policy may also have benefited transport companies.

4) Consider Table 11.1. What factors suggest that regional policy should take a much hi8gher profile in EU policy making since the admission of the new accession countries in May 2004?

Answer

Table 11.1 indicates what many people have argued, that is, the new member states are relatively poorer both at a national and regional level than many of the original EU15 (see GDP per head figures). Unemployment records also tend to be higher, though the growth performances, albeit from a lower base, are generally higher. EU regional policy has a number of aims and one is to reduce the discrepancy between the regions within a country and between countries. For the EU15 there have been a few notable success stories such as that of Ireland and Spain and in the period up to 2004 there was some evidence of regional catch-up. However, as Table 10.1 indicates the entry of the ten new member countries is notable in the fact that on many of the measures or poor regions they stand out when compared with the EU15. In fact the difference between the new 10 countries and the old EU15 is larger than the difference that once existed between Greece, Spain and Ireland and the rest. Therefore the argument goes that there is an even greater need for regional policy funding now than there was before.

5) Spain was a major beneficiary of regional funding throughout the 1990s. How might the development of those regions in receipt of funding influence transport and the environment issues there?

Answer

As noted in four above, two of the success stories of EU regional policy have been Spain and Ireland. Often regional policy has been developed to attract or encourage new industries to deprived areas. Although this has created jobs, one of the issues that has often needed to be addressed is the poor level of infrastructure in some of these regions. Therefore part of the regional funding has gone to develop new roads and improve the rail network. The net result of this has been to create jobs but at the expense of increasing the level of pollution in the region. In addition there can now be congestion. New roads also attract other levels of regional development that comes without regional funding so exacerbating the problems. As incomes rise and more people move into the area than this may have an impact on the indigenous way of life and have implications for schools and housing. Increases in income can also lead to a rise in demand for private transport and access to airports. Therefore on the measurement of job creation and local economic growth regional policy can be judged a success but the downside of this is increased road usage and environmental degradation.

6) The United States has so far refused to sign up to the Kyoto Agreement, while the European Union has done so. What impact will this have on the competitiveness of US and EU car makers?

Answer

The impact may be unclear. On one level EU car makers might be considered to be placed at a cost disadvantage compared with their US contemporaries, however, consumers may be willing to pay the extra for the EU’s car because they admire the green credentials of the EU makers. The question also is one of whether any increased in costs by EU car manufacturers will be passed onto consumers. Many US car producers are multinational companies producing both within the US and the EU. If US car manufacturers face higher costs in Europe, since they now must abide by the European signing up to the Kyoto Agreement, then they may use some form of transfer pricing to offset the higher price in Europe by charging slightly more for their cars in the US. An alternative scenario is that US car manufacturers look to produce in countries outside of the EU (where environmental costs are lower) and then import their cars into the EU. However, they will need to compare the lower costs of production against the increased costs of transportation. It is also possible that where companies face higher costs because of any environmental charges that they need to make that they hold the price of the finished car constant and alter the quality of the material that are used to make the car.

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CHAPTER 12: SMALL BUSINESS AND EU POLICY

1) Using information from this chapter and other supporting material, consider why the SME sector is important for economic growth, job creation and export growth of the European Union.

Answer

During the 1970 - 1990 period it was realised that the SME sector was particularly important for many economies as a provider of employment. Whilst large firms were seen to be downsizing their workforces it was the SME sector that were creating jobs. The SME sector is also seen as important for innovation and is an underlying force in the growth performance of an economy. Tomorrow's large firms are today's SMEs. A large and growing SME sector is also seen as important for the export performances of economies. It may not be that SMEs are major exporters but an economy that embraces entrepreneurial activity is one that is likely to be competitive at all company size levels. As the chapter notes SMEs are often important behind knowledge creation, they increase the level of competition and thereby promote economic efficiency and they provide a greater diversity of firms and output. 

2) SMEs often argue that they are constrained by labour market shortages and lack of finance. To what extent has the European Union successfully addressed these problems?

Answers

In the list of constraining factors facing SMEs the inability to raise finance and the lack of suitable skilled labour are two of the most frequently mentioned factors by both start-up and growth SMEs and those SMEs who are seeking to internationalise or have internationalised. Different nation states within the EU have attempted to address these problems in varying ways dependent upon whether their economies are more market focused or state controlled. The Joint Employment Report (2002) considered ways to improve entrepreneurship and attempted to address the issue of self-employment. Because of the growing status of SMEs within the EU, a range of other policy objectives in the area of social or environmental policy have had specific focus on the SME sector. For example, in the area of Environmental Policy, SMEs have been the main beneficiary of the Financial Instrument for the Environment (LIFE) programme. Energy policy that has attempted to introduce competition into the energy sector will also have lowered energy costs for SMEs. State aid provisions were altered so that SMEs can get more favourable treatment and EU Structural Funding has been re-focussed on SMEs.

In terms of direct policy measures the information provided on p364 of the text addresses some of the main points. It should also be noted that some national governments have attempted to help the financial constraints of their SME sectors by actually providing grants and loan guarantee schemes. Other governments have taken a more stand-off approach attempting to provide the correct conditions for private equity funds to prosper and these can on-lend money or guarantee finance to SMEs.

3) Outline the main arguments for and against the stages approach to internationalisation.

Answer

The stages approach to SME internationalisation suggests that to become active in overseas markets requires a company to progress through a number of stages. These are:

No regular export activity (sporadic exporting)
Exports via independent representatives
The establishment of own sales subsidiaries abroad
The setting up of production facilities abroad

The supporters of stage theory point to the work on psychic distance, learning curve effects and innovation-adoption cycle models.

Critics of the stage theory point to the fact that some stage models have a different number of stages, that SMEs may progress through some stages and stop or even miss out some stages altogether. Other SMEs might progress part of the way through the stages and then return to an earlier stage of internationalisation. Further critics have argued that the weakness of the stages approach is that there is a lack of theoretical under-pinning and a lack of clear boundaries between stages. Furthermore stage theory has some difficulty in dealing with “born global” SMEs.

4) For large organisations entry into international markets often occurs through merger and acquisition, exporting and joint ventures. Which of the above, if any, are the approaches more likely to be taken by SMEs entering international markets?

Answer

When large firms choose to enter a market they often possess large amounts of financial resources. They can therefore begin by exporting or can move directly to setting up a subsidiary on a Greenfield site or gain entry through the merger and acquisition of an existing foreign firm in their chosen external market. For some small firms capital constraints may reduce the ability of the SME to enter a market through the route of merger and acquisition. Exporting is a favoured entry route especially connected to work of sales representatives in overseas markets. Joint ventures are also a possibility. SMEs may be part of a supply chain of larger organisations and the internationalisation of the larger firm may lead to the SME pulled abroad as the larger firm wishes to keep its current suppliers.

5) To what extent do firm factors, such as the size of the organisation and the level of competition in markets, rather than personal factors such as the willingness to take risks or the entrepreneur’s experience of export markets, determine SME internationalisation?

Answer

There are a number of theoretical models that have been developed to explain small firm internationalisation. Some have argued that the size of the firm and the sector in which the firm operates are important determinants of internationalisation behaviour. In fact some of the arguments lie as to whether push or pull factor dominate the move into internationalisation by SMEs. For example the high level of competition in domestic markets or the high level of regulation and taxation may encourage SMEs to internationalise. A domestic market may be too small for an SME to achieve economies of scale; therefore, additional external markets are sought. Others argue that internationalisation can be better linked to the characteristics of the entrepreneur rather than the SME. Therefore, factors such as foreign language knowledge, export or internationalisation experience of the entrepreneur, whether the entrepreneur had previously worked in an organisation that had sold products in external markets or whether the entrepreneur had been educated or lived abroad are considered as more relevant to the internationalisation move. Other personal characteristics of the entrepreneur have also been suggested as playing their part in the internationalisation move, such as, the risk attitude of the entrepreneur and whether they are introverted or extroverted .

6) The Polish Linen Company employs 25 people and has traditionally undertaken the majority of its sales in Eastern European markets. Its manager is aware of the potential that EU enlargement might bring to the organisation. Produce a report for the Polish Linen Company outlining the opportunities and threats to the organisation following from EU enlargement.

Answer

The report for the Polish Linen Company should include the potential of market expansion into the EU15 as trade barriers are reduced. The cost competitiveness of the Polish Linen Company vis-à-vis similar companies within the EU15 may give the Polish company a price advantage. Set against this could be the possibility of increased competition in the Polish market from other EU companies that might have greater levels of productivity. Polish consumers when faced with now being able to buy Polish linen or other EU linen (which may have faced entry barriers into Poland) may choose the latter since they consider it a superior product. Some EU15 firms may consider that the Polish Linen Company might make a useful addition to their product range and may seek to merge or takeover the company. The entry of Poland to the EU has also seen a flux of Polish workers leaving Poland to work in other EU countries. This flow of workers might have implications of the Polish Linen Company in their attempt to retain and attract new employees. The impact then could be on increased wages that need to be paid to Polish Linen Company workers, thus reducing the companies cost competitiveness. The Polish Linen Company may have received state support and this may not be allowed under EU rules, moreover, financial markets in Poland may not be as well developed as in other countries leading to financial constraints for the Polish Linen Company. Finally, the Polish Linen Company may not be able to compete once trade barriers are removed since it cannot achieve the same economies of scale that other EU15 manufacturers have been able to build up.

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