PART TWO

COUNTRY FACTORS

Chapter TwoCountry Differences in Political Economy

Chapter ThreeDifferences in Culture

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CHAPTER TWO

NATIONAL

DIFFERENCES IN

POLITICAL

ECONOMY

Brazilian Privatization

In the middle years of the 20th century, many Latin American govern-ments took a large number of private companies into state ownership.This wave of nationalizations reflected a populist ideology that wasinterlaced with socialist, nationalist, and, on occasion, fascist rhetoric.Supported by strong trade unions, particularly in Argentina and tosome extent Brazil, many politicians advocated taking privateenterprises into public ownership so they could be run “for the benefitof the state and its citizens, rather than the enrichment of a small capi-talist elite.”

However, by the early 1990s, inefficient management, politicalmanipulation, and corruption had turned many state-ownedenterprises into national liabilities. An example was Brazil’s Embraer,the only manufacturer of jet aircraft in Latin America. Founded by amilitary regime in 1969, Embraer developed a reputation for solid engi-neering. Unfortunately, protected by public ownership from the needto account for its performance to private investors, no one at Embraerseemed to care about costs or customers. As a result, in 1994 Embraerlost $310 million on sales of only $253 million.

At the same time, the winds of change were also blowing throughmany other economies. Communism was collapsing in Eastern Europe,socialism was in retreat throughout much of the rest of the world, andfree market economics was clearly on the ascendancy. Against this

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background, during the early 1990s there was a sharp move among theLatin American political establishment toward free market economics.This shift in political and economic ideology expressed itself throughadoption of programs and plans to privatize many state-ownedenterprises.

In Brazil, the privatization program began slowly and quietly but hasrecently accelerated. Around 70 state-owned enterprises were sold toprivate investors between 1990 and 1996 for a total take of $14.9billion. In 1997, Brazil sold over $20 billion of state-owned assets,including Companhia Vale do Rio Doce (CVRD), the world’s largestiron ore producer. Plans called for sales of a further $30 billion worth ofstate assets in 1998, including the sale of Telebras, Brazil’s telecommu-nications company, which was to be broken up into four companies.

Early evidence suggests these privatizations are having the desiredeffects on the companies involved. Following its privatization inDecember 1994, Embraer reduced its payroll from 12,700 to 3,600 in1996 as the new management team struggled to turn the companyaround. Today new orders are flowing in; production, sales, and profitsare all projected to increase, and in 1997 the company added 1,100employees to handle increased sales. Another example concernsBrazil’s formerly state-owned steel industry, which between 1991 and1993 was sold as six separate companies for a total of $8.2 billion. In1990 the state-owned monopoly employed 115,000 people andproduced 22.6 million tons of steel, or 196 tons per employee. In 1996the six successor private companies produced 25.2 million tons of steelwith only 65,000 employees, or 388 tons per employee, a strikingincrease in employee productivity. Along similar lines, the new privateowners of CVRD think they can cut operating costs by at least 20 per-cent over the next few years.

The benefits of privatization are not limited to improved efficiencyof former state-owned enterprises, important as that is. The Braziliangovernment is also opening the sale of state-owned assets to foreigninvestors and allowing foreign companies to set up enterprises in indus-tries formerly controlled by state monopolies, such as steel, electricpower generation, and telecommunications. The result has been asurge in private investment, much from foreign sources and much of ittargeted toward basic infrastructure. Excluding telecommunications,infrastructure projects worth $190 billion were planned between 1997and 2000. This compares to total spending of only $10 billion between1993 and 1996. If this investment is made, it will have a significantimpact on the growth rate of Brazil’s economy.*

http://www.cvrd.com.br*”Let the Party Begin,” The Economist, April 26, 1997, pp. 57–58, and “A VeryBig Deal. A Survey of Business in Latin America,” The Economist, December6, 1997, pp. S9–S12.

CHAPTER OUTLINE

BRAZILIAN PRIVATIZATION

INTRODUCTION

POLITICAL SYSTEMSCollectivism and Individualism Democracy and Totalitarianism

ECONOMIC SYSTEMSMarket EconomyCommand EconomyMixed EconomyState-Directed Economy

LEGAL SYSTEMSProperty RightsThe Protection of Intellectual

PropertyProduct Safety and Product LiabilityContract Law

THE DETERMINANTS OF

ECONOMIC DEVELOPMENTDifferences in Economic

DevelopmentPolitical Economy and Economic

ProgressOther Determinants of Development:

Geography and Education

STATES IN TRANSITIONThe Spread of DemocracyUniversal Civilization or a Clash of

Civilizations?The Spread of Market-Based

SystemsThe Nature of Economic

TransformationImplications

IMPLICATIONS FOR BUSINESSAttractivenessEthical Issues

CHAPTER SUMMARY

DISCUSSION QUESTIONS

GENERAL ELECTRIC IN

HUNGARY

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34 Part II Country Factors

IntroductionAs noted in Chapter 1, international business is much more complicated than domes-tic business because countries differ in many ways. Countries have different politicalsystems, economic systems, and legal systems. Cultural practices can vary dramati-cally from country to country, as can the education and skill level of the population,and countries are at different stages of economic development. All of these differ-ences can and do have major implications for the practice of international business.They have a profound impact on the benefits, costs, and risks associated with doingbusiness in different countries; the way in which operations in different countriesshould be managed; and the strategy international firms should pursue in differentcountries. A main function of this chapter and the next is to develop an awareness ofand appreciation for the significance of country differences in political systems, eco-nomic systems, legal systems, and national culture. Another function of this chapterand the next is to describe how the political, economic, legal, and cultural systems ofmany of the world’s nation-states are evolving and to draw out the implications ofthese changes for the practice of international business.

The opening case illustrates the changes occurring in the political and economicsystems of one nation, Brazil. As in many other countries, over the last decade, polit-ical and economic ideology in Brazil has shifted toward a more free market orienta-tion. One consequence of this shift in ideology has been adoption of an aggressiveprivatization program that is transforming Brazil’s economy. Another has been theopening of the Brazilian economy to foreign investors. These changes are creatingenormous opportunities for foreign investors, who for the first time in recent historycan invest in many sectors of Brazil’s expanding economy. For example, in 1997 theU.S.-based telecommunications company BellSouth paid $2.45 billion to the Brazil-ian government for a license that will enable it to install and market a wirelessphone network in Brazil’s largest city, Sao Paulo. Since there are only 12 telephonelines per 100 people in Sao Paulo, BellSouth believes that a huge untapped marketexists here.1

This chapter focuses on how the political, economic, and legal systems of countriesdiffer. Collectively we refer to these systems as constituting the political economy of acountry. The political, economic, and legal systems of a country are not independentof each other. As we shall see, they interact and influence each other, and in doing sothey affect the level of economic well-being in a country. In addition to reviewingthese systems, we also explore how differences in political economy influence thebenefits, costs, and risks associated with doing business in different countries, and howthey impact on management practice and strategy. In the next chapter we will look athow differences in culture influence the practice of international business. Bear inmind, however, that the political economy and culture of a nation are not indepen-dent of each other. As will become apparent in Chapter 3, culture can exert animpact on political economy, and the converse can also hold true.

Political SystemsThe economic and legal systems of a country are often shaped by its politicalsystem.2 As such, it is important that we understand the nature of different politicalsystems before discussing the nature of economic and legal systems. By political sys-tem we mean the system of government in a nation. Political systems can be assessedaccording to two related dimensions. The first is the degree to which they emphasizecollectivism as opposed to individualism. The second dimension is the degree towhich they are democratic or totalitarian. These dimensions are interrelated; sys-tems that emphasize collectivism tend to be totalitarian, while systems that place ahigh value on individualism tend to be democratic. However, there is a gray area in

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Chapter Two National Differences in Political Economy 35

the middle. It is possible to have democratic societies that emphasize a mix of collec-tivism and individualism. Similarly, it is possible to have totalitarian societies thatare not collectivist.

The term collectivism refers to a system that stresses the primacy of collective goalsover individual goals.3 When collectivism is emphasized, the needs of society as awhole are generally viewed as being more important than individual freedoms. Insuch circumstances, an individual’s right to do something may be restricted on thegrounds that it runs counter to “the good of society” or to “the common good.” Advo-cacy of collectivism can be traced to the ancient Greek philosopher Plato (427–347BC), who in the Republic argued that individual rights should be sacrificed for the goodof the majority and that property should be owned in common. In modern times thecollectivist mantle has been picked up by socialists.

SocialismSocialists trace their intellectual roots back to Karl Marx (1818–1883). Marx arguedthat the few benefit at the expense of the many in a capitalist society where individualfreedoms are not restricted. While successful capitalists accumulate considerablewealth, Marx postulated that the wages earned by the majority of workers in a capital-ist society would be forced down to subsistence levels. Marx argued that capitalistsexpropriate for their own use the value created by workers, while paying workers onlysubsistence wages in return. Put another way, according to Marx, the pay of workersdoes not reflect the full value of their labor. To correct this perceived wrong, Marxadvocated state ownership of the basic means of production, distribution, andexchange (i.e., businesses). His logic being that if the state owned the means of pro-duction, the state could ensure that workers were fully compensated for their labor.Thus, the idea is to manage state-owned enterprise to benefit society as a whole,rather than individual capitalists.4

In the early 20th century, the socialist ideology split into two broad camps. Thecommunists believed that socialism could be achieved only through violent revolu-tion and totalitarian dictatorship, while the social democrats committed themselvesto achieving socialism by democratic means and turned their backs on violent revolu-tion and dictatorship. Both versions of socialism have waxed and waned during the20th century.

The communist version of socialism reached its high point in the late 1970s, whenthe majority of the world’s population lived in communist states. The countries underCommunist rule at that time included the former Soviet Union; its Eastern Europeanclient nations (e.g., Poland, Czechoslovakia, Hungary); China, the Southeast Asiannations of Cambodia, Laos, and Vietnam; various African nations (e.g., Angola,Mozambique); and the Latin American nations of Cuba and Nicaragua. By the mid-1990s, however, communism was in retreat worldwide. The Soviet Union had col-lapsed and had been replaced with a collection of 15 republics, most of which were atleast nominally structured as democracies. Communism was swept out of EasternEurope by the largely bloodless revolutions of 1989. Many believe it is now only amatter of time before communism collapses in China, the last major Communistpower left. Although China is still nominally a communist state with substantial lim-its to individual political freedom, in the economic sphere the country has recentlymoved away from strict adherence to communist ideology.5

Social democracy also seems to have passed its high-water mark, although the ide-ology may prove to be more enduring than communism. Social democracy has hadperhaps its greatest influence in a number of democratic Western nations includingAustralia, Britain, France, Germany, Norway, Spain, and Sweden, where social demo-cratic parties have from time to time held political power. Other countries wheresocial democracy has had an important influence include India and Brazil. Consistent

Collectivism andIndividualism

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36 Part II Country Factors

with their Marxists roots, many social democratic governments nationalized privatecompanies in certain industries, transforming them into state-owned enterprises to berun for the “public good rather than private profit.” In Britain, for example, by theend of the 1970s, state-owned companies had a monopoly in the telecommunica-tions, electricity, gas, coal, railway, and shipbuilding industries, as well as having sub-stantial interests in the oil, airline, auto, and steel industries.

However, experience has demonstrated that far from being in the public interest,state ownership of the means of production often runs counter to the public interest.In many countries, state-owned companies have performed poorly (see the openingcase on Brazil). Protected from significant competition by their monopoly positionand guaranteed government financial support, many state-owned companies becameincreasingly inefficient. In the end, individuals found themselves paying for the lux-ury of state ownership through higher prices and higher taxes. As a consequence, anumber of Western democracies voted many social democratic parties out of office inthe late 1970s and early 1980s. They were succeeded by political parties, such asBritain’s Conservative Party and Germany’s Christian Democratic Party, that weremore committed to free market economics. These parties devoted considerable effortto selling state-owned enterprises to private investors (a process referred to as privati-zation). Thus, in Britain the Conservative government sold the state’s interests intelecommunications, electricity, gas, shipbuilding, oil, airlines, autos, and steel to pri-vate investors. Moreover, even when social democratic parties have regained thelevers of power, as in Britain in 1997 when the left-leaning Labor party won control ofthe government, they now seem to be committed to greater private ownership.

IndividualismIndividualism is the opposite of collectivism. In a political sense, individualism refersto a philosophy that an individual should have freedom in his or her economic andpolitical pursuits. In contrast to collectivism, individualism stresses that the interestsof the individual should take precedence over the interests of the state. Like collec-tivism, however, individualism can be traced back to an ancient Greek philosopher,in this case Plato’s disciple Aristotle (384–322 BC). In contrast to Plato, Aristotleargued that individual diversity and private ownership are desirable. In a passage thatmight have been taken from a speech by Margaret Thatcher or Ronald Reagan, heargued that private property is more highly productive than communal property andwill thus stimulate progress. According to Aristotle, communal property receives lit-tle care, whereas property that is owned by an individual will receive the greatest careand therefore be most productive.

After sinking into oblivion for the best part of two millennia, individualism was re-born as an influential political philosophy in the Protestant trading nations of Eng-land and the Netherlands during the 16th century. The philosophy was refined in thework of a number of British philosophers including David Hume (1711–1776), AdamSmith (1723–1790), and John Stuart Mill (1806–1873). The philosophy of individu-alism exercised a profound influence on those in the American colonies who soughtindependence from Britain. Individualism underlies the ideas expressed in the Decla-ration of Independence. In more recent years, the philosophy has been championedby several Nobel prize-winning economists, including Milton Friedman, Friedrichvon Hayek, and James Buchanan.

Individualism is built on two central tenets. The first is an emphasis on the impor-tance of guaranteeing individual freedom and self-expression. As John Stuart Millput it,

The sole end for which mankind are warranted, individually or collectively, in interfering withthe liberty of action of any of their number is self-protection . . . The only purpose for whichpower can be rightfully exercised over any member of a civilized community, against his will, isto prevent harm to others. His own good, either physical or moral, is not a sufficient warrant. . . .

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Chapter Two National Differences in Political Economy 37

The only part of the conduct of any one, for which he is amenable to society, is that which con-cerns others. In the part which merely concerns himself, his independence is, of right, absolute.Over himself, over his own body and mind, the individual is sovereign.6

The second tenet of individualism is that the welfare of society is best served byletting people pursue their own economic self-interest, as opposed to some collectivebody (such as government) dictating what is in society’s best interest. Or as AdamSmith put it in a famous passage from the Wealth of Nations, an individual whointends his own gain is

led by an invisible hand to promote an end which was no part of his intention. Nor is it alwaysworse for the society that it was no part of it. By pursuing his own interest he frequentlypromotes that of the society more effectually than when he really intends to promote it. I havenever known much good done by those who effect to trade for the public good.7

The central message of individualism, therefore, is that individual economic andpolitical freedoms are the ground rules on which a society should be based. This putsindividualism in direct conflict with collectivism. Collectivism asserts the primacy ofthe collective over the individual, while individualism asserts just the opposite. Thisunderlying ideological conflict has shaped much of the recent history of the world.The Cold War, for example, was essentially a war between collectivism, championedby the now-defunct Soviet Union, and individualism, championed by the UnitedStates.

In practical terms, individualism translates into an advocacy for democratic politi-cal systems and free market economics. Viewed this way, we can see that since the late1980s the waning of collectivism has been matched by the ascendancy of individual-ism. A wave of democratic ideals and free market economics is sweeping away social-ism and communism worldwide. The changes of the past few years go beyond therevolutions in Eastern Europe and the former Soviet Union to include a move towardgreater individualism in Latin America and in some of the social democratic states ofthe West (e.g., Britain and Sweden). This is not to claim that individualism hasfinally won a long battle with collectivism—it has not—but as a guiding political phi-losophy, individualism is on the ascendancy. This represents good news for interna-tional business, since in direct contrast to collectivism, the pro-business and pro-freetrade values of individualism create a favorable environment within which interna-tional business can thrive.

Democracy and totalitarianism are at different ends of a political dimension. Democ-racy refers to a political system in which government is by the people, exercisedeither directly or through elected representatives. Totalitarianism is a form of govern-ment in which one person or political party exercises absolute control over all spheresof human life and opposing political parties are prohibited. The democratic–totalitar-ian dimension is not independent of the collectivism–individualism dimension.Democracy and individualism go hand in hand, as do the communist version of col-lectivism and totalitarianism. However, gray areas exist; it is possible to have a demo-cratic state where collective values predominate, and it is possible to have atotalitarian state that is hostile to collectivism and in which some degree of individu-alism-particularly in the economic sphere-is encouraged. For example, Chile in the1980s was ruled by a totalitarian military dictatorship that encouraged economic free-dom but not political freedom.

DemocracyThe pure form of democracy, as originally practiced by several city-states in ancientGreece, is based on a belief that citizens should be directly involved in decision mak-ing. In complex, advanced societies with populations in the tens or hundreds of mil-lions this is impractical. Most modern democratic states practice what is commonly

Democracy andTotalitarianism

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38 Part II Country Factors

referred to as representative democracy. In a representative democracy, citizens peri-odically elect individuals to represent them. These elected representatives then forma government, whose function is to make decisions on behalf of the electorate. A rep-resentative democracy rests on the assumption that if elected representatives fail toperform this job adequately, they will be voted down at the next election.

To guarantee that elected representatives can be held accountable for their actionsby the electorate, an ideal representative democracy has a number of safeguards thatare typically enshrined in constitutional law. These include (1) an individual’s rightto freedom of expression, opinion, and organization; (2) a free media; (3) regular elec-tions in which all eligible citizens are allowed to vote; (4) universal adult suffrage; (5)limited terms for elected representatives; (6) a fair court system that is independentfrom the political system; (7) a nonpolitical state bureaucracy; (8) a nonpoliticalpolice force and armed service; and (9) relatively free access to state information.8

TotalitarianismIn a totalitarian country, all the constitutional guarantees on which representativedemocracies are built—such as an individual’s right to freedom of expression andorganization, a free media, and regular elections—are denied to the citizens. In mosttotalitarian states, political repression is widespread and those who question the rightof the rulers to rule find themselves imprisoned, or worse.

Four major forms of totalitarianism exist in the world today. Until recently themost widespread was communist totalitarianism. As discussed earlier, communism isa version of collectivism that advocates that socialism can be achieved only throughtotalitarian dictatorship. Communism, however, is in decline worldwide and many ofthe old Communist dictatorships have collapsed since 1989. The major exceptions tothis trend (so far) are China, Vietnam, Laos, North Korea, and Cuba, although all ofthese states exhibit clear signs that the Communist Party’s monopoly on politicalpower is under attack.

A second form of totalitarianism might be labeled theocratic totalitarianism.Theocratic totalitarianism is found in states where political power is monopolized bya party, group, or individual that governs according to religious principles. The mostcommon form of theocratic totalitarianism is based on Islam and is exemplified bystates such as Iran and Saudi Arabia. These states restrict not only freedom of politi-cal expression but also freedom of religious expression, while the laws of the state arebased on Islamic principles.

A third form of totalitarianism might be referred to as tribal totalitarianism. Tribaltotalitarianism is found principally in African countries such as Zimbabwe, Tanzania,Uganda, and Kenya. The borders of most African states reflect the administrativeboundaries drawn by the old European colonial powers, rather than tribal realities.Consequently, the typical African country contains a number of different tribes.Tribal totalitarianism occurs when a political party that represents the interests of aparticular tribe (and not always the majority tribe) monopolizes power. Such one-party states still exist in Africa.

A fourth major form of totalitarianism might be described as right-wing totali-tarianism. Right-wing totalitarianism generally permits individual economic free-dom but restricts individual political freedom on the grounds that it would lead tothe rise of communism. One common feature of most right-wing dictatorships is anovert hostility to socialist or communist ideas. Many right-wing totalitarian govern-ments are backed by the military, and in some cases the government may be madeup of military officers. Until the early 1980s, right-wing dictatorships, many ofwhich were military dictatorships, were common throughout Latin America. Theywere also found in several Asian countries, particularly South Korea, Taiwan, Sin-gapore, Indonesia, and the Philippines. Since the early 1980s, however, this form ofgovernment has been in retreat. The majority of Latin American countries are now

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Chapter Two National Differences in Political Economy 39

genuine multiparty democracies, while significant political freedoms have beengranted to the political opposition in countries such as South Korea, Taiwan, andthe Philippines.

Economic SystemsIt should be clear from the previous section that there is a connection between politi-cal ideology and economic systems. In countries where individual goals are given pri-macy over collective goals, we are more likely to find free market economic systems.In contrast, in countries where collective goals are given preeminence, the state mayhave taken control over many enterprises, while markets in such countries are likelyto be restricted rather than free. More specifically, we can identify four broad types ofeconomic system—a market economy, a command economy, a mixed economy, and astate-directed economy.

In a pure market economy all productive activities are privately owned, as opposed tobeing owned by the state. The goods and services that a country produces, and thequantity in which they are produced, are not planned by anyone. Rather, productionis determined by the interaction of supply and demand and signaled to producersthrough the price system. If demand for a product exceeds supply, prices will rise, sig-naling producers to produce more. If supply exceeds demand, prices will fall, signalingproducers to produce less. In this system consumers are sovereign. The purchasingpatterns of consumers, as signaled to producers through the mechanism of the pricesystem, determine what is produced and in what quantity.

For a market to work in this manner there must be no restrictions on supply. Arestriction on supply occurs when a market is monopolized by a single firm. In suchcircumstances, rather than increase output in response to increased demand, amonopolist might restrict output and let prices rise. This allows the monopolist totake a greater profit margin on each unit it sells. Although this is good for the monop-olist, it is bad for the consumer, who has to pay higher prices. Moreover, it is probablybad for the welfare of society. Since, by definition, a monopolist has no competitors, ithas no incentive to search for ways of lowering its production costs. Rather, it cansimply pass on cost increases to consumers in the form of higher prices. The net resultis that the monopolist is likely to become increasingly inefficient, producing high-priced, low-quality goods, while society suffers as a consequence.

Given the dangers inherent in monopoly, the role of government in a market econ-omy is to encourage vigorous competition between private producers. Governments dothis by outlawing monopolies and restrictive business practices designed to monopolizea market (antitrust laws serve this function in the United States). Private ownershipalso encourages vigorous competition and economic efficiency. Private ownershipensures that entrepreneurs have a right to the profits generated by their own efforts.This gives entrepreneurs an incentive to search for better ways of serving consumerneeds. That may be through introducing new products, by developing more efficientproduction processes, by better marketing and after-sale service, or simply throughmanaging their businesses more efficiently than their competitors. In turn, the con-stant improvement in product and process that results from such an incentive has beenargued to have a major positive impact on economic growth and development.9

In a pure command economy, the goods and services that a country produces, the quan-tity in which they are produced, and the prices at which they are sold are all planned bythe government. Consistent with the collectivist ideology, the objective of a commandeconomy is for government to allocate resources for “the good of society.” In addition, in

Market Economy

Command Economy

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40 Part II Country Factors

a pure command economy, all businesses are state owned, the rationale being that thegovernment can then direct them to make investments that are in the best interests ofthe nation as a whole, rather than in the interests of private individuals.

Historically, command economies were found in communist countries where col-lectivist goals were given priority over individual goals. Since the demise of commu-nism in the late 1980s, the number of command economies has fallen dramatically.Some elements of a command economy were also evident in a number of democraticnations led by socialist-inclined governments. France and India both experimentedwith extensive government planning and state ownership, although governmentplanning has fallen into disfavor in both countries.

While the objective of a command economy is to mobilize economic resources for thepublic good, just the opposite seems to have occurred. In a command economy, state-owned enterprises have little incentive to control costs and be efficient, because theycannot go out of business. Moreover, the abolition of private ownership means there isno incentive for individuals to look for better ways to serve consumer needs; hence,dynamism and innovation are absent from command economies. Instead of growing andbecoming more prosperous, such economies tend to be characterized by stagnation.

Between market economies and command economies can be found mixed economies.In a mixed economy, certain sectors of the economy are left to private ownership andfree market mechanisms, while other sectors have significant state ownership andgovernment planning. Mixed economies are relatively common in Western Europe;although they are becoming less so. France, Italy, and Sweden can all be classified asmixed economies. In these countries the governments intervene in those sectorswhere they believe that private ownership is not in the best interests of society. Forexample, Britain and Sweden both have extensive state-owned health systems thatprovide free universal health care to all citizens (it is paid for through higher taxes).In both countries it is felt that government has a moral obligation to provide for thehealth of its citizens. One consequence is that private ownership of health care opera-tions is very restricted in both countries.

In mixed economies, governments also tend to take into state ownership troubledfirms whose continued operation is thought to be vital to national interests. TheFrench automobile company Renault was state owned until recently. The govern-ment took over the company when it ran into serious financial problems. The Frenchgovernment reasoned that the social costs of the unemployment that might result ifRenault collapsed were unacceptable, so it nationalized the company to save it frombankruptcy. Renault’s competitors weren’t thrilled by this move, since they had tocompete with a company whose costs were subsidized by the state.

A state-directed economy is one in which the state plays a significant role in direct-ing the investment activities of private enterprise through “industrial policy” and inotherwise regulating business activity in accordance with national goals. Japan andSouth Korea are frequently cited as examples of state-directed economies. A state-directed economy differs from a mixed economy in so far as the state does not rou-tinely take private enterprises into public ownership. Instead, it nurtures privateenterprise but proactively directs investments made by private firms in accordancewith the goals of its industrial policy. For example, in the early 1970s, the JapaneseMinistry of International Trade and Industry (MITI) targeted the semiconductorindustry as one in which it would like to see Japanese firms have a major presence.10

Industrial policy often takes the form of state subsidies to private enterprises toencourage them to build significant sales in industries deemed to be of strategic valuefor the nation’s economic development. Thus, the Japanese government subsidizedresearch and development (R&D) investments made by Japanese semiconductorcompanies. It also used direct administrative pressure to persuade several companies

Mixed Economy

State-DirectedEconomy

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Chapter Two National Differences in Political Economy 41

to enter the industry. To help targeted industries develop, the state may also protectthem from foreign competition by erecting barriers to imports and foreign directinvestment. Accordingly, Japanese semiconductor companies were protected fromforeign competition by barriers to imports and restrictions on the ability of foreignersto establish operations in Japan.

The intellectual foundation for a state-directed economy is based on the so-calledinfant industry argument (which we shall review in greater depth in Chapter 5). Thisargument suggests that in some industries, economies of scale are so large and incum-bent firms from developed nations have such an advantage that it is difficult for newfirms from developing nations to establish themselves. Industrial policy is seen as ameans of overcoming this economic disadvantage. Moreover, it is argued that state-directed industrial policy may allow a country to establish a leading position in anemerging industry where scale economies will ultimately be of great importance (thisargument is at the core of the new trade theory, which we review in Chapter 4).

One criticism of state-directed economies is that government bureaucrats don’tnecessarily make better decisions about the allocation of investment capital than themarket mechanism would. For a long time, the economic success of countries such asJapan and South Korea allowed advocates of state involvement to dismiss such criti-cisms.11 However, a decade of stagnant growth in Japan coupled with the 1997 implo-sion of the South Korean economy have added legitimacy to these criticisms. TheSouth Korean collapse, in particular, has been widely attributed to uneconomicinvestments by Korean companies in industries that the government deemed to be ofnational importance, such as semiconductors.

Legal SystemThe legal system of a country refers to the rules, or laws, that regulate behavior alongwith the processes by which the laws are enforced and through which redress forgrievances is obtained. The legal system of a country is of immense importance tointernational business. A country’s laws regulate business practice, define the mannerin which business transactions are to be executed, and set down the rights and obliga-tions of those involved in business transactions. The legal environments of countriesdiffer in significant ways. As we shall see, differences in legal systems can affect theattractiveness of a country as an investment site and/or market.

Like the economic system of a country, the legal system is influenced by the pre-vailing political system. The government of a country defines the legal frameworkwithin which firms do business-and often the laws that regulate business reflect therulers’ dominant political ideology. For example, collectivist-inclined totalitarianstates tend to enact laws that severely restrict private enterprise, while the lawsenacted by governments in democratic states where individualism is the dominantpolitical philosophy tend to be pro-private enterprise and pro-consumer.

The variances in the structure of law among countries is a massive topic that war-rants its own textbook. We do not attempt to give a full description of the variations;rather, we will focus on three issues that illustrate how legal systems can vary-and howsuch variations can affect international business. First, we look at the laws governingproperty rights with particular reference to patents, copyrights, and trademarks. Sec-ond, we look at laws covering product safety and product liability. Third, we look atcountry differences in contract law.

In a legal sense the term property refers to a resource over which an individual or busi-ness holds a legal title; that is, a resource that they own. Property rights refer to thebundle of legal rights over the use to which a resource is put and over the use made ofany income that may be derived from that resource.12 Countries differ significantly inthe extent to which their legal system protects property rights. Although almost all

Property Rights

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42 Part II Country Factors

countries have laws on their books that protect property rights, the reality is that inmany countries these laws are not well enforced by the authorities and property rightsare routinely violated. Property rights can be violated in two ways-through privateaction and through public action.

Private ActionPrivate action refers to theft, piracy, blackmail, and the like by private individuals orgroups. While theft occurs in all countries, in some countries a weak legal systemallows for a much higher level of criminal action than in others. An example much inthe news of late is Russia where the chaotic legal system of the post-Communist era,coupled with a weak police force and judicial system, offers both domestic and foreignbusinesses scant protection from blackmail by the “Russian mafia.” Often successfulbusiness owners in Russia must pay “protection money” to the Mafia or face violentretribution, including bombings and assassinations (there were around 500 contractkillings of businessmen in 1995 and again in 1996).13 In one example, Ivan Kivelidi, abanker and founder of the Russian Business Roundtable, was murdered by poisonapplied to the rim of his coffee cup. In another, Vladislav Listiev, the head of Channel1, Russia’s largest nationwide TV network, announced in 1996 that he was going toremove unsavory elements (i.e., Mafia) from the network. Soon afterward he wasgunned down by professional assassins outside of his apartment building.14 And inperhaps the most disturbing case, American businessman Paul Tatum was assassinatedin late 1996 after a Moscow hotel joint venture that he was involved in turned sour.15

Of course, Russia is not alone in having Mafia problems. The Mafia has a long his-tory in the United States. In Japan, the local version of the Mafia, known as theyakuza, runs protection rackets, particularly in the food and entertainment indus-tries.16 However, there is an enormous difference between the magnitude of such activ-ity in Russia and its limited impact in Japan and the United States. This differencearises because the legal enforcement apparatus, such as the police and court system, isso weak in Russia. Many other countries have problems similar to or even greater thanthose currently being experienced by Russia. In Somalia during 1993–1994, for exam-ple, the breakdown of law and order was so complete that even United Nations foodrelief convoys proceeding to famine areas under armed guard were held up by bandits.

Public ActionPublic action to violate property rights occurs when public officials, such as politi-cians and government bureaucrats, extort income or resources from property holders.This can be done through a number of mechanisms including levying excessive taxa-tion, requiring expensive licenses or permits from property holders, taking assets intostate ownership without compensating the owners (as occurred to the assets ofnumerous US firms in Iran after the 1979 Iranian revolution), or by demanding bribesfrom businesses in return for the rights to operate in a country, industry, or location.17

For example, the government of the late Ferdinand Marcos in the Philippines wasfamous for demanding bribes from foreign businesses wishing to set up operations inthat country.18

Another example of such activity surfaced in mid-February 1994 when the Britishpaper The Sunday Times ran an article that alleged a 1 billion sterling ($750 million)sale of defense equipment by British companies to Malaysia was secured only afterbribes had been paid to Malaysian government officials and after the British OverseasDevelopment Administration (ODA) had agreed to approve a 234 million sterlinggrant to the Malaysian government for a hydroelectric dam of (according to The Sun-day Times) dubious economic value. The clear implication was that UK officials, intheir enthusiasm to see British companies win a large defense contract, had yielded topressures from “corrupt” Malaysian officials for bribes-both personal and in the formof the development grant.19

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Chapter Two National Differences in Political Economy 43

Intellectual property refers to property, such as computer software, a screenplay, amusic score, or the chemical formula for a new drug, that is the product of intellectualactivity. It is possible to establish ownership rights over intellectual property throughpatents, copyrights, and trademarks. A patent grants the inventor of a new product orprocess exclusive rights to the manufacture, use, or sale of that invention. Copyrightsare the exclusive legal rights of authors, composers, playwrights, artists, and publishersto publish and disperse their work as they see fit. Trademarks are designs and names,often officially registered, by which merchants or manufacturers designate and differ-entiate their products (e.g., Christian Dior clothes).

The philosophy behind intellectual property laws is to reward the originator of anew invention, book, musical record, clothes design, restaurant chain, and the like,for his or her idea and effort. Such laws are a very important stimulus to innovationand creative work. They provide an incentive for people to search for novel ways ofdoing things and they reward creativity. For example, consider innovation in thepharmaceutical industry. A patent will grant the inventor of a new drug a 17-yearmonopoly in production of that drug. This gives pharmaceutical firms an incentive toundertake the expensive, difficult, and time-consuming basic research required togenerate new drugs (on average it costs $150 million in R&D and takes 12 years to geta new drug on the market). Without the guarantees provided by patents, it is unlikelythat companies would commit themselves to extensive basic research.20

The protection of intellectual property rights differs greatly from country to coun-try. While many countries have stringent intellectual property regulations on theirbooks, the enforcement of these regulations has often been lax. This has been the caseeven among some countries that have signed important international agreements toprotect intellectual property, such as the Paris Convention for the Protection ofIndustrial Property, which 96 countries are party to. Weak enforcement encouragesthe piracy of intellectual property. China and Thailand have recently been among theworst offenders in Asia. Local bookstores in China commonly maintain a section thatis off-limits to foreigners; it ostensibly is reserved for sensitive political literature, butit more often displays illegally copied textbooks. Pirated computer software is alsowidely available in China. Similarly, the streets of Bangkok, the capital of Thailand,are lined with stands selling pirated copies of Rolex watches, Levi blue jeans, video-tapes, and computer software.

The computer software industry suffers more than most from lax enforcement ofintellectual property rights. Estimates suggest that violations of intellectual propertyrights cost computer software companies revenues equal to $12.3 billion in 1994, $13.3billion in 1995, and $11.2 billion in 1996.21 According to the Business SoftwareAlliance, a software industry association, in 1996 43 percent of all software applica-tions used in the world were pirated. The worst region was Eastern Europe, where thepiracy rate was 80 percent. This was followed by piracy rates of 79 percent in the Mid-dle East, 68 percent in Latin America, 55 percent in Asia, 43 percent in WesternEurope, and 28 percent in North America. One of the worst countries was China,where the piracy rate in 1996 ran 96 percent and cost the industry $704 million in lostsales, up from $444 million in 1995.22

Music recordings represent another area where piracy is rampant. According toone estimate, nearly 200 million illegal compact disks are stamped each year, almost60 percent of them in China. The International Federation of the PhonographicIndustry claims that its members lose $2.2 billion annually to pirates.23

International businesses have a number of possible responses to such violations.Firms can lobby their respective governments to push for international agreements toensure that intellectual property rights are protected and that the law is enforced. Anexample of such lobbying is given in the next Management Focus, which looks at howMicrosoft prompted the US government to start insisting that other countries abideby stricter intellectual property laws.

The Protection of IntellectualProperty

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44 Part II Country Factors

Partly as a result of such actions, international laws are being strengthened. As weshall see in Chapter 5, the most recent world trade agreement, which was signed in1994 by 117 countries, for the first time extends the scope of the General Agreementon Tariffs and Trade (GATT) to cover intellectual property. Under the new agree-ment, as of 1995 a council of the newly created World Trade Organization (WTO) isoverseeing enforcement of much stricter intellectual property regulations. These reg-ulations oblige WTO members to grant and enforce patents lasting at least 20 yearsand copyrights lasting 50 years. Rich countries had to comply with the rules within ayear. Poor countries, in which such protection generally was much weaker, had 5years’ grace, and the very poorest have 10 years.24 (For further details, see Chapter 5.)

One problem with these new regulations, however, is that the world’s biggestviolator—China—is not yet a member of the WTO and is therefore not obliged toadhere to the agreement. However, following pressure from the US government,which included the threat of substantial trade sanctions, in 1996 the Chinese gov-ernment agreed to enforce its existing intellectual property rights regulations (inChina, as in many countries, the problem is not a lack of laws; the problem is thatexisting laws are not enforced). During 1996 Chinese officials closed 19 counterfeit

MANAGEMENT FOCUSMicrosoft Battles Software Piracy in China

Microsoft, the world’s biggest personal computer soft-ware company, developed MS-DOS and then Windows,respectively the operating system and graphical userinterface that now reside on over 90 percent of theworld’s personal computers. In addition, Microsoft has aslew of best-selling applications software, including itsword processing program (Microsoft Word),spreadsheet program (Excel), and presentation program(Power Point). An integral part of Microsoft’sinternational strategy has been expansion into mainlandChina, where 3.2 million personal computers were soldin 1997, a number that was expected to grow by at least1 million per year through the rest of the decade. With apopulation of 1.5 billion, China represents a potentiallyhuge market for Microsoft.

Microsoft’s initial goal is to build up Chinese salesfrom nothing in 1994 to $100 million by 2000.However, the company has to overcome a very seriousobstacle before it can achieve this goal-softwarepiracy. Over 96 percent of the software used in Chinain 1996 was pirated. Microsoft is a prime target of thisactivity. Most Microsoft products used in China are ille-gal copies. China’s government is believed to be one ofthe worst offenders. Microsoft’s lawyers complain thatBeijing doesn’t budget for software purchases, forcingits cash-strapped bureaucracy to find cheap software

solutions. Thus, Microsoft claims, much of the govern-ment ends up using pirated software.

To make matters worse, China is becoming a massexporter of counterfeit software. Microsoft executivesdon’t have to go far to see the problem. Just a fewblocks from the company’s Hong Kong office is a tinyshop that offers CD-ROMs, each crammed withdozens of computer programs that collectively areworth about $20,000. The asking price is about 500Hong Kong dollars, or $52! In further evidence of theproblem, Hong Kong customs seized a shipment of2,200 such disks en route from China to Belgium.

Microsoft officials are quick to point out theproblem arises because Chinese judicial authorities donot enforce their own laws. Microsoft found this outwhen it first tried to use China’s judicial system to suesoftware pirates. Microsoft pressed officials in China’ssouthern province of Guangdong to raid amanufacturer that was producing counterfeitholograms that Microsoft used to authenticate its soft-ware manuals. The Chinese authorities prosecuted themanufacturer, acknowledged that a copyright violationhad occurred, but awarded Microsoft only $2,600 andfined the pirate company $3,000! Microsoft is appeal-ing the verdict and is requesting $20 million indamages.

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Chapter Two National Differences in Political Economy 45

CD-ROM factories with a capacity of 30 to 50 million units a year. Still, accordingto the Business Software Alliance, a further 21 counterfeit CD-ROM factories wereoperating in China as of late 1996.25

In addition to lobbying their governments, firms may want to stay out of countrieswhere intellectual property laws are lax, rather than risk having their ideas stolen bylocal entrepreneurs (such reasoning partly underlay decisions by Coca-Cola and IBMto pull out of India in the early 1970s). Firms also need to be on the alert to ensure thatpirated copies of their products produced in countries where intellectual property lawsare lax do not turn up in their home market or in third countries. The US computersoftware giant Microsoft, for example, discovered that pirated Microsoft software, pro-duced illegally in Thailand, was being sold worldwide as the real thing (including inthe United States). In addition, Microsoft has encountered significant problems withpirated software in China, the details of which are discussed in the Management Focus.

Product safety laws set certain safety standards to which a product must adhere. Prod-uct liability involves holding a firm and its officers responsible when a product causesinjury, death, or damage. Product liability can be much greater if a product does not

whttp://www.mircosoft.com

Another Microsoft response to the problem hasbeen to reduce the price on its software in order tocompete with pirated versions. In October 1994Microsoft reduced the price on its Chinese software byas much as 200 percent. However, this action mayhave little impact, for the programs are still priced at$100 to $200, compared to $5 to $20 for an illegal copyof the same software.

Yet another tactic adopted by the company has beento lobby the US government to pressure Chinese author-ities to start enforcing their own laws. As part of its lob-bying effort, Microsoft has engaged in its own version of“guerrilla warfare,” digging through trash bins, payinglocals to spy, even posing as money-grubbing business-men to collect evidence of piracy, which they have thenpassed on to US trade officials. The tactic has workedbecause the US government currently has someleverage over China. China wishes to join the WorldTrade Organization and views US support as crucial. TheUnited States has said it will not support Chinese mem-bership unless China starts enforcing its intellectual prop-erty laws. This demand was backed up by a threat toimpose tariffs of $1.08 billion on Chinese exports unlessChina agreed to stricter enforcement. After a tenseperiod during which both countries were at loggerheads,the Chinese backed down and acquiesced to US

demands in February 1995. The Chinese governmentagreed to start enforcing its intellectual property rightslaws, to crack down on factories that the United Statesidentified as pirating US goods, to respect UStrademarks including Microsoft’s, and to instruct Chinesegovernment ministries to stop using pirated software.

Whether this agreement will make a differenceremains to be seen. Microsoft, however, is taking nochances. The company announced it would work withthe Chinese Ministry of Electronics to develop aChinese version of the Windows 95 operating system.Microsoft’s logic is that the best way to stop theChinese government from using pirated software is togo into business with it. Once the government has astake in maximizing sales of legitimate Microsoft prod-ucts, the company reckons it will also have a strongincentive to crack down on sales of counterfeitsoftware.*

Source: S. Bilello, “US Wages War on China’s Pirates,” Newsday,February 7, 1995, p. A41; (2) C. S. Smith, “Microsoft May GetHelp in China from its Uncle Sam,” Wall Street Journal, Novem-ber 21, 1994, p. B4; “Making War on China’s Pirates,” The Econ-omist, February 11, 1995, pp. 33–34; interviews with Microsoftofficials; M. O’Neill, “Microsoft Chairman Says China Has KeyFuture Role,” South China Morning Post, December 12, 1997, p.1; and “Intellectual Property: Bazaar Software,” The Economist,March 8, 1997, pp. 77–78.

Product Safety andProduct Liability

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46 Part II Country Factors

conform to required safety standards. There are both civil and criminal product liabil-ity laws. Civil laws call for payment and money damages. Criminal liability laws resultin fines or imprisonment. Both civil and criminal liability laws are probably moreextensive in the United States than in any other country, although many other West-ern nations also have comprehensive liability laws. Liability laws are typically leastextensive in less developed nations.

In the United States a boom in product liability suits and awards resulted in a dra-matic increase in the cost of liability insurance. In turn, many business executivesargue that the high costs of liability insurance are making American businesses lesscompetitive in the global marketplace. This view was supported by the Bush adminis-tration. Former Vice President Dan Quayle once argued that the United States hastoo many lawyers and that product liability awards are too large. According toQuayle, the result is that product liability insurance rates are typically much loweroverseas, thereby giving foreign firms a competitive advantage. In the United States,tort costs amount to about 2.4 percent of gross national product (GNP), three timesas much as in any other industrialized country. So the cost of lawsuits does seem to putAmerica at a competitive disadvantage.26

In addition to the competitiveness issue, country differences in product safety andliability laws raise an important ethical issue for firms doing business abroad. Whenproduct safety laws are tougher in a firm’s home country than in a foreign countryand/or when liability laws are more lax, should a firm doing business in that foreigncountry follow the more relaxed local standards or should it adhere to the standards ofits home country? While the ethical thing to do is undoubtedly to adhere to home-country standards, firms have been known to take advantage of lax safety and liabilitylaws to do business in a manner that would not be allowed back home.

A contract is a document that specifies the conditions under which an exchange is to takeplace and details the rights and obligations of the parties involved. Many business transac-tions are regulated by some form of contract. Contract law is the body of law that governscontract enforcement. The parties to an agreement normally resort to contract law whenone party feels the other has violated either the letter or the spirit of an agreement.

Contract law can differ significantly across countries, and as such it affects the kind ofcontracts an international business will want to use to safeguard its position should a con-tract dispute arise. The main differences can be traced to differences in legal tradition. Twomain legal traditions are found in the world today—the common law system and the civillaw system. The common law system evolved in England over hundreds of years. It is nowfound in most of Britain’s former colonies, including the United States. Common law isbased on tradition, precedent, and custom. When law courts interpret common law, theydo so with regard to these characteristics. Civil law is based on a very detailed set of lawsorganized into codes. Among other things, these codes define the laws that govern businesstransactions. When law courts interpret civil law, they do so with regard to these codes.Over 80 countries, including Germany, France, Japan, and Russia, operate with a civil lawsystem. Since common law tends to be relatively ill-specified, contracts drafted under acommon law framework tend to be very detailed with all contingencies spelled out. In civillaw systems, however, contracts tend to be much shorter and less specific, because many ofthe issues typically covered in a common law contract are already covered in a civil code.

The Determinants of Economic DevelopmentThe political, economic, and legal systems of a country can have a profound impacton the level of economic development and hence on the attractiveness of a countryas a possible market and/or production location for a firm. Here we look first at howcountries differ in their level of development. Then we look at how political economyaffects economic progress.

Contract Law

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Chapter Two National Differences in Political Economy 47

Different countries have dramatically different levels of economic development. Onecommon measure of economic development is a country’s gross national product perhead of population. GNP is often regarded as a yardstick for the economic activity ofa country; it measures the total value of the goods and services produced annually.Map 2.1 summarizes the GNP per capita of the world’s nations in 1997. As can beseen, countries such as Japan, Sweden, Switzerland, and the United States are amongthe richest on this measure, while the large countries of China and India are amongthe poorest. Japan, for example, had a 1997 GNP per head of $37,850, whereas Chinaachieved only $860, and India $390. The world’s poorest country, Mozambique, had aGNP per head of only $90, while the world’s richest, Switzerland, came in at$44,320.27

However, GNP per head figures can be misleading because they don’t take intoaccount differences in the cost of living. For example, although the 1997 GNP perhead of Switzerland, at $44,320, exceeded that of the United States, which was$28,740, the higher cost of living in Switzerland meant that American citizens couldactually afford more goods and services than Swiss citizens. To account for differencesin the cost of living, one can adjust GNP per capita to account for differences in pur-chasing power. Referred to as a purchasing power parity (PPP) adjustment, thisadjustment allows for a more direct comparison of living standards in different coun-tries. The base for the adjustment is the cost of living in the United States. Table 2.1gives the GNP per capita measured at PPP in 1997 for a selection of countries, alongwith their GNP per capita and their growth rate in GNP over the 1990–1997 timeperiod. Map 2.2 summarizes the GNP per capita in 1997 for the nations of the world.

As can be seen, there are striking differences between the standard of living in dif-ferent countries. Table 2.1 suggests that the average Indian citizen can afford to con-sume only 5.7 percent of the goods and services consumed by the average US citizen.Given this, one might conclude that, despite having a population of close to one bil-lion, India is unlikely to be a very lucrative market for the consumer products pro-duced by many Western international businesses. However, this is not quite thecorrect conclusion to draw, for India has a fairly wealthy middle class, despite its largenumber of very poor people.

Table 2.1:

PPP Index and GNP Datafor Selected Countries

GNP per Capita, Annual Average

GNP per capita measured at PPP, Growth in GDP,

Country 1997 (US $) 1997 (US $) 1990–97 (%)

Mozambique 90 520 6.9%India 390 1650 5.9%China 860 3570 11.9%Indonesia 1110 3450 7.5%Romania 1420 4290 0.0%Russia 2740 4190 -9.0%Mexico 3680 8120 1.8%Brazil 4720 6240 3.1%S. Korea 10550 13500 7.2%United Kingdom 20710 20520 1.9%Australia 20540 20170 3.7%Canada 19290 21860 2.1%Singapore 32940 29000 8.5%United States 28740 28740 2.5%Japan 37850 23400 1.4%Switzerland 44320 26320 –0.1%

Source: World Bank. World Development Report 1998/99. Tables 1, 11. Oxford: Oxford University Press, 1999.

Differences inEconomicDevelopment

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50 Part II Country Factors

A problem with the GNP and PPP data discussed so far is that they give a staticpicture of development. They tell us, for example, that China is much poorer thanthe US, but they do not tell us if China is closing the gap. To assess this, we have tolook at the economic growth rates achieved by different countries. Table 2.1 gives therate of growth in GNP achieved by a number of countries between 1990 and 1997.Map 2.3 summarizes the growth rate in GNP over the 1990–97 time period. Althoughcountries such as China and India are currently very poor, their economies are grow-ing more rapidly than those of many advanced nations. Thus, in time they maybecome advanced nations themselves and huge markets for the products of interna-tional businesses. Given their future potential, it may well be good advice for interna-tional businesses to start getting a foothold in these markets now. Even though theircurrent contributions to an international firm’s revenues might be small, their futurecontributions could be much larger. One might also note, however, that Table 2.1tells us that the economy of Russia shrank substantially over the 1990–97 time period.

A number of other indicators can also be used to assess a country’s economic devel-opment and its likely future growth rate. These include literacy rates, the number ofpeople per doctor, infant mortality rates, life expectancy, calorie (food) consumptionper head, car ownership per 1,000 people, and education spending as a percentage ofGNP. In an attempt to estimate the impact of such factors upon the quality of life in acountry, the United Nations has developed a Human Development Index. Thisindex is based upon three measures: life expectancy, literacy rates, and whether aver-age incomes, based on PPP estimates, are sufficient to meet the basic needs of life in acountry (adequate food, shelter, and health care). The Human Development Index isscaled from 0 to 100. Countries scoring less than 50 are classified as having lowhuman development (the quality of life is poor), those scoring from 50–80 are classi-fied as having medium human development, while those countries that score above80 are classified as having high human development. Map 2.4 summarizes the HumanDevelopment Index scores for 1995, the most recent year for which data is available.

It is often argued that a country’s economic development is a function of its economicand political systems. What then is the nature of the relationship between politicaleconomy and economic progress? This question has been the subject of a vigorousdebate among academics and policymakers for some time. Despite the long debate,this remains a question for which it is not possible to give an unambiguous answer.However, it is possible to untangle the main threads of the academic arguments andmake a few broad generalizations as to the nature of the relationship between politicaleconomy and economic progress.

Innovation Is the Engine of GrowthThere is general agreement now that innovation is the engine of long-run economicgrowth.28 Those who make this argument define innovation broadly to include notjust new products, but also new process, new organizations, new management prac-tices, and new strategies. Thus, Toys “R” Us’s strategy of establishing large warehouse-style toy stores and then engaging in heavy advertising and price discounting to sellthe merchandise can be classified as an innovation because Toys “R” Us was the firstcompany to pursue this strategy. One can conclude that if a country’s economy is tosustain long-run economic growth, the business environment within that countrymust be conducive to the production of innovations.

Innovation Requires a Market EconomyThis leads logically to a further question—What is required for the business environ-ment of a country to be conducive to innovation? Those who have considered this issuehighlight the advantages of a market economy.29 It has been argued that the economicfreedom associated with a market economy creates greater incentives for innovation

Political Economyand EconomicProgress

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Chapter Two National Differences in Political Economy 53

than either a planned or a mixed economy. In a market economy, any individual whohas an innovative idea is free to try to make money out of that idea by starting a busi-ness (by engaging in entrepreneurial activity). Similarly, existing businesses are free toimprove their operations through innovation. To the extent that they are successful,both individual entrepreneurs and established businesses can reap rewards in the formof high profits. Thus, in market economies there are enormous incentives to developinnovations.

In contrast, in a planned economy the state owns all means of production. Conse-quently there is no opportunity for entrepreneurial individuals to develop valuablenew innovations, since it is the state, rather than the individual, that captures all thegains. The lack of economic freedom and incentives for innovation was probably amain factor in the economic stagnation of so many former communist states and ledultimately to their collapse at the end of the 1980s. A similar stagnation phenomenonoccurred in many mixed economies in those sectors where the state had a monopoly(such as health care and telecommunications in Britain). This stagnation providedthe impetus for the widespread privatization of state-owned enterprises that we wit-nessed in many mixed economies during the mid-1980s and is still going on today(privatization refers to the process of selling state-owned enterprises to privateinvestors).

A recent study of 102 countries over a 20-year period provided compelling evi-dence of a strong relationship between economic freedom (as provided by a marketeconomy) and economic growth.30 The study found that the more economic freedoma country had between 1975 and 1995, the more economic growth it achieved andthe richer its citizens became. The six countries that had persistently high ratings ofeconomic freedom during the 1975–1995 period (Hong Kong, Switzerland, Singa-pore, the United States, Canada, and Germany) were also all in the top 10 in terms ofeconomic growth rates. In contrast, no country with a persistently low ratingachieved a respectable growth rate. For the 16 countries for which the index of eco-nomic freedom declined the most during the 1975–95 period, average annual grossdomestic product fell at an annual rate of 0.6 percent.

Innovation Requires Strong Property RightsStrong legal protection of property rights is another requirement for a business envi-ronment to be conducive to innovation and economic growth.31 Both individuals andbusinesses must be given the opportunity to profit from innovative ideas. Withoutstrong property rights protection, businesses and individuals run the risk that the prof-its from their innovative efforts will be expropriated, either by criminal elements, orby the state itself. The state can expropriate the profits from innovation through legalmeans, such as excessive taxation, or through illegal means, such as demands fromstate bureaucrats for kickbacks in return for granting an individual or firm a license todo business in a certain area. According to the Nobel prize-winning economist Dou-glass North, throughout history many governments have displayed a tendency toengage in such behavior. Inadequately enforced property rights reduce the incentivesfor innovation and entrepreneurial activity—since the profits from such activity are“stolen”—and hence reduce the rate of economic growth.

The Required Political SystemThere is a great deal of debate as to the kind of political system that best achieves afunctioning market economy where there is strong protection for property rights.32

We in the West tend to associate a representative democracy with a market economicsystem, strong property rights protection, and economic progress. Building on this, wetend to argue that democracy is good for growth.33 However, some totalitarianregimes have fostered a market economy and strong property rights protection andhave experienced rapid economic growth. Four of the fastest-growing economies of

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54 Part II Country Factors

the last 30 years—South Korea, Taiwan, Singapore, and Hong Kong—all have grownfaster than the Western democracies. All these economies had one thing in commonat the start of their economic growth-undemocratic governments! At the same time,there are examples of countries with stable democratic governments, such as India,where economic growth remained sluggish for long periods.

In 1992, Lee Kuan Yew, Singapore’s leader for many years, told an audience, “I donot believe that democracy necessarily leads to development. I believe that a countryneeds to develop discipline more than democracy. The exuberance of democracyleads to undisciplined and disorderly conduct which is inimical to development.”34

Others have argued that many of the current problems in Eastern Europe and thestates of the former Soviet Union arose because democracy arrived before economicreform, making it more difficult for elected governments to introduce the policiesthat, while painful in the short run, were needed to promote rapid economic growth.It has become something of a cliché to argue that Russia got its political and eco-nomic reforms in the wrong order-unlike China, which maintains a totalitarian gov-ernment but has moved rapidly toward a market economy.

However, those who argue for the value of a totalitarian regime miss an importantpoint-if dictators made countries rich, then much of Africa, Asia, and Latin Americashould have been growing rapidly for the past 40 years, and this has not been the case.Only a certain kind of totalitarian regime is capable of promoting economic growth.It must be a dictatorship that is committed to a free market system and strong protec-tion of property rights. Moreover, there is no guarantee that a dictatorship will con-tinue to pursue such progressive policies. Dictators are rarely so benevolent. Many aretempted to use the apparatus of the state to further their own private ends, violatingproperty rights and stalling economic growth. Given this, it seems likely democraticregimes are far more conducive to long-term economic growth than are dictatorships,even benevolent ones. Only in a well-functioning, mature democracy are propertyrights truly secure.35

Economic Progress Begets DemocracyWhile it is possible to argue that democracy is not a necessary precondition for estab-lishment of a free market economy in which property rights are protected, subsequenteconomic growth often leads to establishment of a democratic regime. Several of thefastest-growing Asian economies have recently adopted more democratic govern-ments, including South Korea and Taiwan. Thus, while democracy may not always bethe cause of initial economic progress, it seems to be one consequence of thatprogress.

A strong belief that economic progress leads to adoption of a democratic regimeunderlies the fairly permissive attitude that many Western governments have adoptedtoward human rights violations in China. Although China has a totalitarian govern-ment in which human rights are abused, many Western countries have been hesitantto criticize the country too much for fear that this might hamper the country’s marchtoward a free market system. The belief is that once China has a free market system,democracy will follow. Whether this optimistic vision comes to pass remains to beseen. Nevertheless, such a vision was an important factor in the US government’s1996 decision to grant China most favored nation trading status (which makes it eas-ier for Chinese firms to sell products in the United States) despite reports of wide-spread human rights abuses in China.

While a country’s political and economic system is probably the big locomotive dri-ving its rate of economic development, other factors are also important. One that hasreceived attention recently is geography.36 But the belief that geography can influenceeconomic policy, and hence economic growth rates, goes back to Adam Smith. Theinfluential Harvard University economist Jeffrey Sachs argues that

Other Determinantsof Development:Geography andEducation

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Chapter Two National Differences in Political Economy 55

Throughout history, coastal states, with their long engagements in international trade, have beenmore supportive of market institutions than landlocked states, which have tended to organizethemselves as hierarchical (and often military) societies. Mountainous states, as a result of physicalisolation, have often neglected market-based trade. Temperate climes have generally supportedhigher densities of population and thus a more extensive division of labor than tropical regions.37

Sachs’s point is that by virtue of favorable geography, certain societies were morelikely to engage in trade than others and were thus more likely to be open to anddevelop market-based economic systems, which in turn would promote faster eco-nomic growth. He also argues that, irrespective of the economic and political institu-tions a country adopts, adverse geographical conditions, such as the high rate ofdisease, poor soils, and hostile climate that afflict many tropical countries, can have anegative impact on development.

Together with colleagues at Harvard’s Institute for International Development,Sachs tested for the impact of geography on a country’s economic growth ratebetween 1965 and 1990. He found that landlocked countries grew more slowly thancoastal economies and that being entirely landlocked reduced a country’s annualgrowth rate by roughly 0.7 percent per year. He also found that tropical countriesgrew 1.3 percent more slowly each year than countries in the temperate zone.

Education emerges as another important determinant of economic development.The general assertion is that nations that invest more in education will have highergrowth rates because an educated population is a more productive population. Somerather striking anecdotal evidence suggests this is the case. In 1960 Pakistanis andSouth Koreans were on equal footing economically. However, just 30 percent of Pak-istani children were enrolled in primary schools, while 94 percent of South Koreanswere. By the mid-1980s, South Korea’s GNP per person was three times that of Pak-istan’s.38 More generally, a survey of 14 statistical studies that looked at the relation-ship between a country’s investment in education and its subsequent growth ratesconcluded investment in education did have a positive and statistically significantimpact on a country’s rate of economic growth.39 Similarly, the recent work by Sachsdiscussed above suggests that investments in education help explain why severalcountries in Southeast Asia, such as Indonesia, Malaysia, and Singapore, have beenable to overcome the disadvantages associated with their tropical geography and growfar more rapidly than tropical nations in Africa and Latin America.

States in TransitionSince the late 1980s there have been major changes in the political economy of manyof the world’s nation-states. Two trends have been evident. First, during the late1980s and early 1990s, a wave of democratic revolutions swept the world. Totalitariangovernments collapsed and were replaced by democratically elected governments thatwere typically more committed to free market capitalism than their predecessors hadbeen. The change was most dramatic in Eastern Europe, where the collapse of com-munism bought an end to the Cold War and led to the breakup of the Soviet Union,but similar changes were occurring throughout the world during the same period.Across much of Asia, Latin America, and Africa there was a marked shift towardgreater democracy. Second, there has been a strong move away from centrallyplanned and mixed economies and toward a more free market economic model. Weshall look first at the spread of democracy and then turn our attention to the spread offree market economics.

One notable development of the past 15 years has been the spread of democracy (andby extension, the decline of totalitarianism). Map 2.5 reports data on the extent oftotalitarianism in the world as determined by Freedom House.40 This map charts

The Spread of Democracy

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56 Part II Country Factors

political freedom in 1997, on a scale from 1 for the highest degree of political freedomto 7 for the lowest. Among the criteria that Freedom House uses to determine ratingsfor political freedom are the following:

• Free and fair elections of the head of state and legislative representatives.• Fair electoral laws, equal campaigning opportunities, and fair polling.• The right to organize into different political parties.• A parliament with effective power.• A significant opposition that has a realistic chance of gaining power.• Freedom from domination by the military, foreign powers, totalitarian parties,

religious hierarchies, or any other powerful group.• A reasonable amount of self-determination for cultural, ethnic, and religious

minorities.

Factors contributing to a low rating (i.e., to totalitarianism) include military or for-eign control, the denial of self-determination to major population groups, a lack ofdecentralized political power, and an absence of democratic elections.

The number of democracies in the world has increased from 69 nations in 1987 to118 today, the highest total in history. Almost 55 percent of the world’s populationnow lives under democratic rule. Many of these new democracies are to be found inEastern Europe and Latin America, although there have also been some notable gainsin Africa during this time period, such as in South Africa.

There are three main reasons for the spread of democracy.41 First, many totalitarianregimes failed to deliver economic progress to the vast bulk of their populations. Thecollapse of communism in Eastern Europe, for example, was precipitated by the grow-ing gulf between the vibrant and wealthy economies of the West and the stagnanteconomies of the Communist East. In looking for alternatives to the socialist model,the populations of these countries could not have failed to notice that most of theworld’s strongest economies were governed by representative democracies. Today, theeconomic success of many of the newer democracies, such as Poland and the CzechRepublic in the former Communist bloc, the Philippines and Taiwan in Asia, andChile in Latin America, has helped strengthen the case for democracy as a key com-ponent of successful economic advancement.

Second, new information and communications technologies, including shortwaveradio, satellite television, fax machines, desktop publishing, and now the Internet,have broken down the ability of the state to control access to uncensored informa-tion. These technologies have created new conduits for the spread of democraticideals and information from free societies. The 1989 collapse of East Germany’s Com-munist government was in part due to unrest among a population who for years hadbeen exposed via TV to the affluent lifestyles of West Germans. Today the Internet isallowing democratic ideals to penetrate closed societies as never before. In response,some governments have tried to restrict citizens’ access to the Internet; for example,China limits access to government employees and those affiliated with universities.42

Third, in many countries the economic advances of the last quarter century haveled to the emergence of increasingly prosperous middle and working classes who havepushed for democratic reforms. This was certainly a factor in the democratic transfor-mation of South Korea. Entrepreneurs and other business leaders, eager to protecttheir property rights and ensure the dispassionate enforcement of contracts, areanother force pressing for more accountable and open government.

Having said this, it would be naive to conclude that the global spread of democ-racy will continue unchallenged. There have been several reversals. In the formerSoviet republic of Belarus, for example, the president, Alexander Lukashenko, dis-solved a democratically elected parliament and harassed the press. In the Africannation of Niger, a military coup deposed a democratically elected government. In

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58 Part II Country Factors

Asia, Singapore’s Lee Kuan Yew and China’s Marxist–Leninist leaders continue toadvocate the virtues of authoritarian paths to democracy and to denounce Westerndemocracies as an unacceptable model.

Also, democracy is still rare in large parts of the world. In Africa, just 18 nations,one-third of those on the continent, are electoral democracies. Among the 12 coun-tries that are full or associated members of the Commonwealth of Independent States(i.e., the republics of the former Soviet Union minus the Baltic states) there are onlyfour electoral democracies. And there are no democracies in the Arab world.

The end of the Cold War and the “new world order” that followed the collapse of com-munism in Eastern Europe and the former Soviet Union, taken together with the col-lapse of many authoritarian regimes in Latin America, have given rise to intensespeculation about the future shape of global geopolitics. Authors such as FrancisFukuyama have argued that “we may be witnessing . . . the end of history as such: thatis, the end point of mankind’s ideological evolution and the universalization of West-ern liberal democracy as the final form of human government.”43 Fukuyama goes on toargue that the war of ideas may be at an end and that liberal democracy has triumphed.

Others have questioned Fukuyama’s vision of a more harmonious world dominatedby a universal civilization characterized by democratic regimes and free market capi-talism. In a controversial book, the influential political scientist Samuel Huntingtonargues that there is no “universal” civilization based on widespread acceptance ofWestern liberal democratic ideals.44 Huntington maintains that while many societiesmay be modernizing-they are adopting the material paraphernalia of the modernworld, from automobiles to Coca-Cola and MTV-they are not becoming more West-ern. On the contrary, Huntington theorizes that modernization in non-Western soci-eties can result in a retreat toward the traditional, such as the resurgence of Islam inmany traditionally Muslim societies:

The Islamic resurgence is both a product of and an effort to come to grips with modernization.Its underlying causes are those generally responsible for indigenization trends in non-Westernsocieties: urbanization, social mobilization, higher levels of literacy and education, intensifiedcommunication and media consumption, and expanded interaction with Western and other cul-tures. These developments undermine traditional village and clan ties and create alienation andan identity crisis. Islamist symbols, commitments, and beliefs meet these psychological needs,and Islamist welfare organizations, the social, cultural and economic needs of Muslims caught inthe process of modernization. Muslims feel a need to return to Islamic ideas, practices, and insti-tutions to provide the compass and the motor of modernization.45

Thus, the rise of Islamic fundamentalism is portrayed as a response to the alien-ation produced by modernization.

In contrast to Fukuyama, Huntington sees a world that is split into different civi-lizations, each of which has its own value systems and ideology. In addition to West-ern civilization, Huntington sees the emergence of strong Islamic and Sinic(Chinese) civilizations, as well as civilizations based on Japan, Africa, Latin America,Eastern Orthodox Christianity (Russian), and Hinduism (Indian). Moreover, Hunt-ington sees the civilizations as headed for conflict, particularly along the “fault lines”that separate them, such as Bosnia (where Muslims and Orthodox Christians haveclashed), Kashmir (where Muslims and Hindus clash), and the Sudan (where abloody war between Christians and Muslims has persisted for decades). Figure 2.1summarizes his views as to which civilizations are most likely to come into conflict inthe future. Huntington predicts conflict between the West and Islam, and betweenthe West and China. He bases his predictions on an analysis of the different value sys-tems and ideology of these civilizations, which in his view tend to bring them intoconflict with each other.

UniversalCivilization or a Clash ofCivilizations?

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Chapter Two National Differences in Political Economy 59

If Huntington’s views are even partly correct, they have important implications forinternational business. They suggest many countries may be increasingly difficultplaces in which to do business, either because they are shot through with violent con-flicts or because they are part of a civilization that is in conflict with an enterprise’shome country. Bear in mind, however, that Huntington’s views are speculative. It isby no means a sure thing that his predictions will come to pass. More likely is the evo-lution of a global political system that is positioned somewhere between Fukuyama’suniversal global civilization based on liberal democratic ideals and Huntington’svision of a fractured world. That would still be a world, however, in which geopoliti-cal forces periodically limit the ability of business enterprises to operate in certain for-eign countries.

Paralleling the spread of democracy since the 1980s has been the transformation fromcentrally planned command economies to market-based economies. More than 30countries that were in the former Soviet Union or the Eastern European Communistbloc are now engaged in changing their economic systems. A complete list of coun-tries would also include Asian states such as China and Vietnam, as well as Africancountries such as Angola, Ethiopia, and Mozambique.46 There has been a similar shiftaway from a mixed economy. Many states in Asia, Latin America, and WesternEurope have sold state-owned businesses to private investors (privatization) andderegulated their economies to promote greater competition. India’s experience isdetailed in the next Country Focus.

The underlying rationale for economic transformation has been the same theworld over. In general, command and mixed economies failed to deliver the kind ofsustained economic performance that was achieved by countries adopting market-based systems, such as the United States, Switzerland, Hong Kong, and Taiwan. As aconsequence, ever more states have gravitated toward the market-based model.

Map 2.6, based on data from the Heritage Foundation, a conservative United Statesresearch foundation, gives some idea of the degree to which the world has shiftedtoward market-based economic systems. The Heritage Foundation has constructed anindex of economic freedom that is based on 10 indicators such as the extent to whichthe government intervenes in the economy, trade policy, the degree to which property

Figure 2.1

The Global Politics of CivilizationsSource: Reprinted with permissionfrom Simon & Schuster, Inc. fromThe Clash of Civilizations and the NewWorld Order, by Samual P.Huntington (New York) p. 245.Copyright © 1996 by Samual P.Huntington.

Japan Othodox(Russia)

Islam

Sinic(China)

Hindu(India)

West

African

LatinAmerican

More Conflictual

Less Conflictual

The Spread ofMarket-BasedSystems

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60 Part II Country Factors

rights are protected, foreign investment regulations, and taxation rules. A country canscore between 1 (most free) and 5 (least free) on each of these indicators. The lower acountry’s average score across all 10 indicators, the more closely its economy representsthe pure market model. According to the 1998 index, which is summarized in Map 2.3,the world’s freest economies are (in rank order) Hong Kong, Singapore, Bahrain, NewZealand, Switzerland, the United States, Luxembourg, Taiwan, and the United King-dom. By way of comparison, Japan is ranked 12, France at 34, Indonesia at 65, Polandat 65, Brazil at 90, Russia at 106, India at 120, China at 124, while the commandeconomies of Cuba, Laos, and North Korea prop up the bottom of the rankings.47

Economic freedom does not necessarily equate with political freedom, as detailedin Map 2.5. For example, the top three countries in the Heritage Foundation index,Hong Kong, Singapore, and Bahrain, cannot be classified as politically free. HongKong was reabsorbed into Communist China in 1997, and the first thing Beijing didwas shut down Hong Kong’s freely elected legislature. Singapore is ranked as only“partly free” on Freedom House’s index of political freedom due to practices such aswidespread press censorship, while Bahrain is classified as “least free” due to themonopolization of political power by a hereditary monarchy (see Map 2.2).

COUNTRY FOCUSThe Changing Political Economy of India

After gaining independence from Britain in 1947, Indiaadopted a democratic system of government.However, the economic system that developed in Indiawas a mixed economy characterized by a heavy doseof state enterprise and planning. This system placedmajor constraints around the growth of the private sec-tor. Private companies could expand only with govern-ment permission. Under this system, derisivelydubbed the “License Raj,” private companies oftenhad to wait months for government approval of routinebusiness activities, such as expanding production orhiring a new director. It could take years to get permis-sion to diversify into a new product. Moreover, muchof heavy industry, such as auto, chemical, and steelproduction, was reserved for state-owned enterprises.The development of a healthy private sector was alsostunted by production quotas and high tariffs onimports. Access to foreign exchange was limited,investment by foreign firms was restricted, land usewas strictly controlled, and prices were routinely man-aged by the government, as opposed to beingdetermined by market forces.

By the early 1990s, it was clear that after 40 yearsof near stagnation, this system was incapable of deliv-ering the kind of economic progress that many South-eastern Asian nations had started to enjoy. By 1994India’s economy was still smaller than Belgium’s,

despite having a population of 950 million. Its GDP perhead was a paltry $310; less than half the populationcould read; only 6 million had access to telephones;only 14 percent had access to clean sanitation; theWorld Bank estimated that some 40 percent of theworld’s desperately poor lived in India; and only 2.3percent of the population had a household income inexcess of $2,484.

In 1991 the lack of progress led the government ofPrime Minister P. V. Narasimha Rao to embark on anambitious economic reform program. Much of theindustrial licensing system was dismantled, andseveral areas once closed to the private sector wereopened up including electricity generation, parts of theoil industry, steelmaking, air transport, and some areasof the telecommunications industry. Foreigninvestment, formerly allowed in only grudgingly andsubject to arbitrary ceilings, was suddenly welcomed.Approval is now automatic for foreign equity stakes ofup to 51 percent in an Indian enterprise, and 100percent foreign ownership is now allowed undercertain circumstances. The government announcedplans to privatize many of India’s state-ownedbusinesses. Raw materials and many industrial goodscan now be freely imported, and the maximum tariffthat can be levied upon imports has been reducedfrom 400 percent to 65 percent. The top rate of

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The shift toward a market-based economic system typically entails a number of steps-deregulation, privatization, and creation of a legal system to safeguard property rights.We shall review each before looking at the track record of states engaged in economictransformation.

DeregulationDeregulation involves removing legal restrictions to the free play of markets, theestablishment of private enterprises, and the manner in which private enterprises oper-ate. For example, before the collapse of communism, the governments in most com-mand economies exercised tight control over prices and outputs, setting both throughdetailed state planning. They also prohibited private enterprises from operating inmost sectors of the economy. Deregulation in these cases involved removing price con-trols, thereby allowing prices to be set by the interplay between demand and supply,and abolishing laws regulating the establishment and operation of private enterprises.

In mixed economies, deregulation has involved abolishing laws that either prohib-ited private enterprises from competing in certain sectors of the economy or regulatedthe manner in which they operated. For example, as outlined in the Country Focus

www.ib-net.com

income tax has also been reduced, and corporate taxhas come down from 57.5 percent to 46 percent in1994 and then to 35 percent in 1997.

Judged by some measures, the response has beenimpressive. The economy has been expanding at anannual rate of almost 5 percent between 1992 and1996; exports have begun to grow at a respectablepace (they were up 20 percent between 1993 and1994); and corporate profits have jumped. Deliverytrucks loaded with once-banned foreign products, suchas Ruffles potato chips and Nestlé Crunch bars, rumbleover India’s potholed highways. Advertisements forAT&T’s communications solutions can be seen on NewDelhi streets, signs of an upcoming liberalization of thetelecommunications industry. Moreover, foreigninvestment, which is a good indicator of foreign com-panies’ perceptions about the health of the Indianeconomy, has surged from $150 million in 1991 to anestimated $3.5 billion in 1998.

However, India is still short of achieving the kind offree market economic system now found in manyWestern states. The reform process is being fought bymany bureaucrats and politicians. Several Westerncompanies now investing in India have painful memo-ries of the 1970s when India nationalized the assets offoreign companies on terms that were tantamount toconfiscation. Such memories are one reason

companies such as IBM, Coca-Cola, and Mobil havekept their investment modest. Other foreigncompanies have made major investmentcommitments to India only after securing special guar-antees. For example, AES Corporation, a power gener-ating company based in Virginia, concluded a deal tobuild power stations in India, but only after the Indiangovernment agreed to give guarantees that it wouldpay for power delivered to Indian electric utilities if theutilities defaulted.

Despite ambitious plans, India’s privatizationprogram has proceeded slowly. By 1997 thegovernment had sold equity stakes in about 40 compa-nies to private investors, including state-ownedtelecommunications, steel, and electronicsenterprises. However, India still has around 245 state-owned companies that are engaged in activities rang-ing from baking bread to making railway carriages.Many outside observers feel that the governmentneeds to accelerate its privatization program if it is tocontinue to attract foreign capital.*

Source: S. Moshavi, and P. Endarido. “India Shakes off Its Shack-les,” Business Week, January 30, 1995, pp. 48–49; “A Survey ofIndia: The Tiger Steps Out,” The Economist, January 21, 1995; J.F. Burns, “India Now Winning US Investment,” New York Times,February 3, 1995, pp. C1, C5; “Tarnished Silver,” The Economist,September 6, 1997, pp. 64–65; and P. Moore, “Three Steps For-ward,” Euromoney, September 1997, pp. 190–95.

The Nature ofEconomicTransformation

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feature on India, deregulation there has involved reforming the industrial licensing sys-tem that made it difficult to establish private enterprises, opening up areas that wereonce closed to the private sector such as electricity generation, parts of the oil industry,steelmaking, air transport, and some areas of the telecommunications industry; andremoving restrictions to foreign investment. In another case, the Japanese governmentis trying to abolish some of the 11,000 regulations and 10,000 administrative guidelinesthat regulate and restrict private enterprise in that economy. Some of these regulationsare very restrictive. For example, if a private enterprise wants to open a retail store withfloor space of more than 1,000 square meters, it must first gain the consent of a govern-ment advisory panel charged with limiting the influence on the local shops againstwhich the new retail store wants to compete! In addition, the average large retailer mustfile over 150 documents to gain permission to sell everyday items such as meat, tofu, andelectronic appliances. In an effort to unravel such restrictions, the Japanese governmentplans to deregulate a diverse range of industries including power generation, gasolineretailing, financial services, retail, telecommunications, and transportation.48 Howquickly this can be achieved, however, depends on the ability of a weak government toimpose its wishes on Japan’s traditionally powerful civil service bureaucracies, whichcan be expected to resist any attempt to diminish their influence on the economy.

PrivatizationHand in hand with deregulation has come a sharp increase in privatization activityduring the 1990s. Privatization transfers the ownership of state property into thehands of private individuals, frequently by the sale of state assets through an auc-tion.49 Privatization is seen as a way to unlock gains in economic efficiency by givingnew private owners a powerful incentive—the reward of greater profits—to search forincreases in productivity, to enter new markets, and to exit losing ones.

The privatization movement started in Britain in the early 1980s when then-PrimeMinister Margaret Thatcher started to sell state-owned assets, such as the British tele-phone company, British Telecom (BT). In a pattern that has been repeated aroundthe world, this sale was linked with the deregulation of the British telecommunica-tions industry. By allowing other firms to compete head-to-head with BT, deregula-tion ensured that privatization did not simply replace a state-owned monopoly with aprivate monopoly.

The opening case to this chapter details the extent of privatization activity in Brazil,and the Country Focus feature discusses privatization in India. As these two examplessuggest, privatization has become a worldwide movement. In Africa, for example,Mozambique and Zambia are leading the way with very ambitious privatization plans.Zambia has put over 145 state-owned companies up for sale, while Mozambique hasalready sold scores of enterprises, ranging from tea plantations to a chocolate factory.The most dramatic privatization programs, however, have occurred in the economies ofthe former Soviet Union and its Eastern European satellite states. In the Czech Repub-lic, three-quarters of all state-owned enterprises were privatized between 1989 and1996, helping to push the share of gross domestic product (GDP) accounted for by theprivate sector up from 11 percent in 1989 to 60 percent in 1995. In Russia, where theprivate sector had been almost completely repressed before 1989, 50 percent of GDPwas in private hands by 1995, again much as a result of privatization. And in Poland theprivate sector accounted for 59 percent of GDP in 1995, up from 20 percent in 1989.50

However, Poland also illustrates how far some of these countries still have to travel.Despite an aggressive privatization program, Poland still had 4,000 state-owned enter-prises that dominate the heavy industry, mining, and transportation sectors.

Legal SystemsAs noted earlier in this chapter, laws protecting private property rights and providingmechanisms for contract enforcement are required for a well-functioning marketeconomy. Without a legal system that protects property rights, and without the

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machinery to enforce that system, the incentive to engage in economic activity canbe reduced substantially by private and public entities—including organized crime—that expropriate the profits generated by the efforts of private-sector entrepreneurs.As noted earlier, this has become a problem in many former Communist states, suchas Russia, where organized crime has penetrated deeply into the fabric of many busi-ness enterprises. When communism collapsed, many of these countries lacked thelegal structure required to protect property rights, all property having been held bythe state. Although many states have made big strides toward instituting the requiredsystem, it will be many more years before the legal system is functioning as smoothlyas it does in the West. For example, in most East European nations, the title to urbanand agricultural property is often uncertain because of incomplete and inaccuraterecords, multiple pledges on the same property, and unsettled claims resulting fromdemands for restitution from owners in the pre-Communist era. Also, while mostcountries have improved their commercial codes, institutional weaknesses still under-mine contract enforcement. Court capacity is often inadequate, and procedures forresolving contract disputes out of court are often inadequate or poorly developed.51

The Rocky RoadIn practice, the road that must be traveled to reach a market-based economic systemhas often turned out to be rocky.52 This has been particularly true for the states ofEastern Europe in the post-Communist era. In this region, the move toward greaterpolitical and economic freedom has sometimes been accompanied by economic andpolitical chaos.53 Most East European states began to liberalize their economies in theheady days of the early 1990s. They dismantled decades of price controls, allowedwidespread private ownership of businesses, and permitted much greater competition.Most also planned to sell state-owned enterprises to private investors. However, giventhe vast number of such enterprises and how inefficient many were, making themunappealing to private investors, most privatization efforts moved forward slowly. Inthis new environment, many inefficient state-owned enterprises found that theycould not survive without a guaranteed market. The newly democratic governmentsoften continued to support these money-losing enterprises in an attempt to stave offmassive unemployment. The resulting subsidies to state-owned enterprises led to bal-looning budget deficits that were typically financed by printing money. Printingmoney, along with the lack of price controls, often led to hyperinflation. In 1993 theinflation rate was 21 percent in Hungary, 38 percent in Poland, 841 percent in Russia,and a staggering 10,000 percent in the Ukraine.54 Since then, however, many govern-ments have instituted tight monetary policies and brought down their inflation rates.

Another consequence of the shift toward a market economy was collapsing outputas inefficient state-owned enterprises failed to find buyers for their goods. Real grossdomestic product fell dramatically in many post-Communist states between 1990 and1994. However, the corner has been turned in several countries. Poland, the CzechRepublic, and Hungary now all boast growing economies and relatively low inflation.But some countries, such as Russia and the Ukraine, still find themselves grapplingwith major economic problems.

A study by the World Bank suggests that the post-Communist states that havebeen most successful at transforming their economies were those that followed aneconomic policy best described as “shock therapy.” In these countries—which includethe Czech Republic, Hungary, and Poland—prices and trade were liberated fast, infla-tion was held in check by tight monetary policy, and the privatization of state-ownedindustries was implemented quickly. Among the 26 economies of Eastern Europe andthe former Soviet Union, the World Bank found a strong positive correlationbetween the imposition of such shock therapy and subsequent economic growth.Speedy reformers suffered smaller falls in output and returned to growth more quicklythan those such as Russia and the Ukraine that moved more slowly.55

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The global changes in political and economic systems discussed above have severalimplications for international business. The ideological conflict between collectivismand individualism that so defined the 20th century is winding down. The free marketideology of the West has won the Cold War and has never been more widespreadthan it was at the beginning of the millennium. Although command economies stillremain and totalitarian dictatorships can still be found around the world, the tide isrunning in favor of free markets and democracy.

The implications for business are enormous. For the best part of 50 years, half ofthe world was off-limits to Western businesses. Now all that is changing. Many of thenational markets of Eastern Europe, Latin America, Africa, and Asia may still beundeveloped and impoverished, but they are potentially enormous. With a popula-tion of 1.2 billion, the Chinese market alone is potentially bigger than that of theUnited States, the European Union, and Japan combined! Similarly India, with its930 million people, is a potentially huge future market. Latin America has another400 million potential consumers. It is unlikely that China, Russia, Poland, or any ofthe other states now moving toward a free market system will attain the living stan-dards of the West anytime soon. Nevertheless, the upside potential is so large thatcompanies need to consider making inroads now.

However, just as the potential gains are large, so are the risks. There is no guaran-tee that democracy will thrive in the newly democratic states of Eastern Europe, par-ticularly if these states have to grapple with severe economic setbacks. Totalitariandictatorships could return, although they are unlikely to be of the communist variety.Moreover, although the bipolar world of the Cold War era has vanished, it may bereplaced by a multi-polar world dominated by a number of civilizations. In such aworld, much of the economic promise inherent in the global shift toward market-based economic systems may evaporate in the face of conflicts between civilizations.While the long-term potential for economic gain from investment in the world’s newmarket economies is large, the risks associated with any such investment are also sub-stantial. It would be foolish to ignore these.

IMPLICATIONS FOR BUSINESSThe implications for international business of the material discussed in this chap-ter fall into two broad categories. First, the political, economic, and legal environ-ment of a country clearly influences the attractiveness of that country as a marketand/or investment site. The benefits, costs, and risks associated with doing busi-ness in a country are a function of that country’s political, economic, and legal sys-tems. Second, the political, economic, and legal systems of a country can raiseimportant ethical issues that have implications for the practice of internationalbusiness. Here we consider each of these issues.

The overall attractiveness of a country as a market and/or investment sitedepends on balancing the likely long-term benefits of doing business in that coun-try against the likely costs and risks. Below we consider the determinants of ben-efits, costs, and risks.

Benefits

In the most general sense, the long-run monetary benefits of doing business in acountry are a function of the size of the market, the present wealth (purchasingpower) of consumers in that market, and the likely future wealth of consumers.While some markets are very large when measured by number of consumers(e.g., China and India), low living standards may imply limited purchasing power

Implications

Attractiveness

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and, therefore, a relatively small market when measured in economic terms.While international businesses need to be aware of this distinction, they alsoneed to keep in mind the likely future prospects of a country. In 1960, for exam-ple, South Korea was viewed as just another impoverished Third World nation. By1996 it was the world’s 11th largest economy, measured in terms of GDP. Interna-tional firms that recognized South Korea’s potential in 1960 and began to do busi-ness in that country may have reaped greater benefits than those that wrote offSouth Korea.

By identifying and investing early in a potential future economic star, interna-tional firms may build brand loyalty and gain experience in that country’s busi-ness practices. These will pay back substantial dividends if that country achievessustained high economic growth rates. In contrast, late entrants may find thatthey lack the brand loyalty and experience necessary to achieve a significantpresence in the market. In the language of business strategy, early entrants intopotential future economic stars may be able to reap substantial first-mover

advantages, while late entrants may fall victim to late-mover disadvantages.56

(First-mover advantages are the advantages that accrue to early entrants into amarket. Late-mover disadvantages are the handicap that late entrants might suf-fer from.)

A country’s economic system and property rights regime are reasonably goodpredictors of economic prospects. Countries with free market economies inwhich property rights are well protected tend to achieve greater economic growthrates than command economies and/or economies where property rights arepoorly protected. It follows that a country’s economic system and property rightsregime, when taken together with market size (in terms of population), probablyconstitute reasonably good indicators of the potential long-run benefits of doingbusiness in a country.57

Costs

A number of political, economic, and legal factors determine the costs of doingbusiness in a country. With regard to political factors, the costs of doing busi-ness in a country can be increased by a need to pay off the politically powerful inorder to be allowed by the government to do business. The need to pay whatare essentially bribes is greater in closed totalitarian states than in open democ-ratic societies where politicians are held accountable by the electorate (althoughthis is not a hard-and-fast distinction). Whether a company should actually paybribes in return for market access should be determined on the basis of thelegal and ethical implications of such action. We discuss this considerationbelow.

With regard to economic factors, one of the most important variables is thesophistication of a country’s economy. It may be more costly to do business in rel-atively primitive or undeveloped economies because of the lack of infrastructureand supporting businesses. At the extreme, an international firm may have to pro-vide its own infrastructure and supporting business if it wishes to do business in acountry, which obviously raises costs. When McDonald’s decided to open its firstrestaurant in Moscow, it found that in order to serve food and drink indistinguish-able from that served in McDonald’s restaurants elsewhere, it had to verticallyintegrate backward to supply its own needs. The quality of Russian-grown pota-toes and meat was too poor. Thus, to protect the quality of its product, McDon-ald’s set up its own dairy farms, cattle ranches, vegetable plots, and foodprocessing plants within Russia. This raised the cost of doing business in Russia,relative to the cost in more sophisticated economies where high-quality inputscould be purchased on the open market.

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As for legal factors, it can be more costly to do business in a country where locallaws and regulations set strict standards with regard to product safety, safety inthe workplace, environmental pollution, and the like (since adhering to such regula-tions is costly). It can also be more costly to do business in a country like theUnited States, where the absence of a cap on damage awards has meant spiralingliability insurance rates. Moreover, it can be more costly to do business in a countrythat lacks well-established laws for regulating business practice (as is the case inmany of the former Communist nations). In the absence of a well-developed bodyof business contract law, international firms may find that there is no satisfactoryway to resolve contract disputes and, consequently, routinely face large lossesfrom contract violations. Similarly, when local laws fail to adequately protect intel-lectual property, this can lead to the “theft” of an international business’s intellec-tual property, and lost income (see the Management Focus on Microsoft).

Risks

As with costs, the risks of doing business in a country are determined by a numberof political, economic, and legal factors. On the political front, there is the issue ofpolitical risk. Political risk has been defined as the likelihood that political forceswill cause drastic changes in a country’s business environment that adverselyaffect the profit and other goals of a particular business enterprise.58 So defined,political risk tends to be greater in countries experiencing social unrest and disor-der or in countries where the underlying nature of a society increases the likelihoodof social unrest. Social unrest typically finds expression in strikes, demonstrations,terrorism, and violent conflict. Such unrest is more likely to be found in countriesthat contain more than one ethnic nationality, in countries where competing ideolo-gies are battling for political control, in countries where economic mismanagementhas created high inflation and falling living standards, or in countries that straddlethe “fault lines” between civilizations, such as Bosnia.

Social unrest can result in abrupt changes in government and government pol-icy or, in some cases, in protracted civil strife. Such strife tends to have negativeeconomic implications for the profit goals of business enterprises. For example, inthe aftermath of the 1979 Islamic revolution in Iran, the Iranian assets of numer-ous US companies were seized by the new Iranian government without compen-sation. Similarly, the violent disintegration of the Yugoslavian federation intowarring states, including Bosnia, Croatia, and Serbia, precipitated a collapse in thelocal economies and in the profitability of investments in those countries.

On the economic front, economic risks arise from economic mismanagementby the government of a country. Economic risks can be defined as the likelihoodthat economic mismanagement will cause drastic changes in a country’s businessenvironment that adversely affect the profit and other goals of a particular busi-ness enterprise. Economic risks are not independent of political risk. Economicmismanagement may give rise to significant social unrest and hence political risk.Nevertheless, economic risks are worth emphasizing as a separate categorybecause there is not always a one-to-one relationship between economic mis-management and social unrest. One visible indicator of economic mismanage-ment tends to be a country’s inflation rate. Another tends to be the level ofbusiness and government debt in the country.

In Asian states such as Indonesia, Thailand, and South Korea, businessesincreased their debt rapidly during the 1990s, often at the bequest of the govern-ment, which was encouraging them to invest in industries deemed to be of “strate-gic importance” to country. The result was overinvestment, with more industrial(factories) and commercial capacity (office space) being built than could be justifiedby demand conditions. Many of these investments turned out to be uneconomic.

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The borrowers failed to generate the profits required to meet their debt paymentobligations. In turn, the banks that had lent money to these businesses suddenlyfound that they had rapid increases in nonperforming loans on their books. Foreigninvestors, believing that many local companies and banks might go bankrupt, pulledtheir money out of these countries, selling local stocks, bonds, and currency. Thisaction precipitated the 1997–1998 financial crisis in Southeast Asia. The crisisincluded a precipitous decline in the value of Asian stocks markets, which in somecases exceeded 70 percent; a similar collapse in the value of many Asian currenciesagainst the US dollar; an implosion of local demand; and a severe economic reces-sion that will affect many Asian countries for years to come. In short, economicrisks were rising throughout Southeast Asia during the 1990s. Astute foreign busi-nesses and investors, seeing this situation, limited their exposure in this part of theworld. More naive businesses and investors lost their shirts!

On the legal front, risks arise when a country’s legal system fails to provideadequate safeguards in the case of contract violations or to protect propertyrights. When legal safeguards are weak, firms are more likely to break contractsand/or steal intellectual property if they perceive it as being in their interests to doso. Thus, legal risks might be defined as the likelihood that a trading partner willopportunistically break a contract or expropriate property rights. When legal risksin a country are high, an international business might hesitate entering into a long-term contract or joint-venture agreement with a firm in that country. For example,in the 1970s when the Indian government passed a law requiring all foreigninvestors to enter into joint ventures with Indian companies, US companies suchas IBM and Coca-Cola closed their investments in India. They believed that theIndian legal system did not provide for adequate protection of intellectual propertyrights, creating the very real danger that their Indian partners might expropriatethe intellectual property of the American companies—which for IBM and Coca-Cola amounted to the core of their competitive advantage.

Overall Attractiveness

The overall attractiveness of a country as a potential market and/or investmentsite for an international business depends on balancing the benefits, costs, andrisks associated with doing business in that country. Generally, the costs and risksassociated with doing business in a foreign country are typically lower in econom-ically advanced and politically stable democratic nations and greater in less devel-oped and politically unstable nations. The calculus is complicated, however, by thefact that the potential long-run benefits bear little relationship to a nation’s currentstage of economic development or political stability. Rather, the benefits dependon likely future economic growth rates. Economic growth appears to be a func-tion of a free market system and a country’s capacity for growth (which may begreater in less developed nations). This leads one to conclude that, other thingsbeing equal, the benefit, cost, risk trade-off is likely to be most favorable in thecase of politically stable developed and developing nations that have free marketsystems and no dramatic upsurge in either inflation rates or private-sector debt. Itis likely to be least favorable in the case of politically unstable developing nationsthat operate with a mixed or command economy or in developing nations wherespeculative financial bubbles have led to excess borrowing.

Country differences give rise to some important and contentious ethical issues.Three important issues that have been the focus of much debate in recent yearsare (1) the ethics of doing business in nations that violate human rights, (2) theethics of doing business in countries with very lax labor and environmental regula-tions, and (3) the ethics of corruption.

Ethical Issues

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Ethics and Human Rights

One major ethical dilemma facing firms from democratic nations is whether theyshould do business in totalitarian countries that routinely violate the human rightsof their citizens (such as China). There are two sides to this issue. Some arguethat investing in totalitarian countries provides comfort to dictators and can helpprop up repressive regimes that abuse basic human rights. For instance, HumanRights Watch, an organization that promotes the protection of basic human rightsaround the world, has argued that the progressive trade policies adopted by West-ern nations toward China has done little to deter human rights abuses.59 Accord-ing to Human Rights Watch, the Chinese government stepped up its repressionof political dissidents in 1996 after the Clinton administration removed humanrights as a factor in determining China’s trade status with the United States. With-out investment by Western firms and the support of Western governments, manyrepressive regimes would collapse and be replaced by more democraticallyinclined governments, critics such as Human Rights Watch argue. Firms that haveinvested in Chile, China, Iraq, and South Africa have all been the direct targets ofsuch criticisms. The 1994 dismantling of the apartheid system in South Africa hasbeen credited to economic sanctions by Western nations, including a lack ofinvestment by Western firms. This, say those who argue against investment intotalitarian countries, is proof that investment boycotts can work (althoughdecades of US-led investment boycotts against Cuba and Iran, among other coun-tries, have failed to have a similar impact).

In contrast, some argue that Western investment, by raising the level of eco-nomic development of a totalitarian country, can help change it from within. Theynote that economic well-being and political freedoms often go hand in hand. Thuswhen arguing against attempts to apply trade sanctions to China in the wake ofthe violent 1989 government crackdown on prodemocracy demonstrators, theBush administration claimed that US firms should continue to be allowed to investin mainland China because greater political freedoms would follow the resultingeconomic growth. The Clinton Administration used similar logic as the basis for its1996 decision decoupling human rights issues from trade policy considerations.

Since both positions have some merit, it is difficult to arrive at a general state-ment of what firms should do. Unless mandated by government (as in the case ofinvestment in South Africa) each firm must make its own judgments about theethical implications of investing in totalitarian states on a case-by-case basis. Themore repressive the regime, however, and the less amenable it seems to be tochange, the greater the case for not investing.

Ethics and Regulations

A second important ethical issue is whether an international firm should adhere tothe same standards of product safety, work safety, and environmental protectionthat are required in its home country. This is of particular concern to many firmsbased in Western nations, where product safety, worker safety, and environmen-tal protection laws are among the toughest in the world. Should Western firmsinvesting in less developed countries adhere to tough Western standards, eventhough local regulations don’t require them to do so? This issue has taken onadded importance in recent years following revelations that Western enterpriseshave been using child labor or very poorly paid “sweat-shop” labor in developingnations. Companies criticized for using sweatshop labor include the Gap, Disney,Wal-Mart, and Nike.60

Again there is no easy answer. While on the face of it the argument for adher-ing to Western standards might seem strong, on closer examination the issue

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becomes more complicated. What if adhering to Western standards would makethe foreign investment unprofitable, thereby denying the foreign country much-needed jobs? What is the ethical thing to do? To adhere to Western standards andnot invest, thereby denying people jobs, or to adhere to local standards andinvest, thereby providing jobs and income? As with many ethical dilemmas, thereis no easy answer. Each case needs to be assessed on its own merits.

Ethics and Corruption

A final ethical issue concerns bribes and corruption. Should an international busi-ness pay bribes to corrupt government officials to gain market access to a foreigncountry? To most Westerners, bribery seems to be a corrupt and morally repug-nant way of doing business, so the answer might initially be no. Some countrieshave laws on their books that prohibit their citizens from paying bribes to foreigngovernment officials in return for economic favors. In the United States, for exam-ple, the Foreign Corrupt Practices Act of 1977 prohibits US companies frommaking “corrupt” payments to foreign officials to obtain or retain business,although many other developed nations lack similar laws. Trade and finance minis-ters from the member states of the Organization for Economic Cooperation andDevelopment (the OECD), an association of the world’s 20 or so most powerfuleconomies, are working on a convention that would oblige member states tomake the bribery of foreign public officials a criminal offense.

However, in many parts of the world, payoffs to government officials are a partof life. One can argue that not investing ignores the fact that such investment canbring substantial benefits to the local populace in terms of income and jobs. Giventhis, from a pragmatic standpoint, perhaps the practice of giving bribes, althougha little evil, is the price that must be paid to do a greater good (assuming theinvestment creates jobs where none existed before and assuming the practice isnot illegal). This kind of reasoning has been advocated by several economists,who suggest that in the context of pervasive and cumbersome regulations indeveloping countries, corruption may actually improve efficiency and helpgrowth! These economists theorize that in a country where preexisting politicalstructures distort or limit the workings of the market mechanism, corruption inthe form of black marketeering, smuggling, and side payments to governmentbureaucrats to “speed up” approval for business investments may actuallyenhance welfare.61

However, other economists have argued that corruption can reduce the returnson business investment.62 In a country where corruption is common, the profitsfrom a business activity may be siphoned off by unproductive bureaucrats whodemand side payments for granting the enterprise permission to operate. Thisreduces the incentive that businesses have to invest and may hurt a country’seconomic growth rate. One economist’s study of the connection between corrup-tion and growth in 70 countries found that corruption had a significant negativeimpact on a country’s economic growth rate.63

Given the debate and the complexity of this issue, one again might concludethat generalization is difficult. Yes corruption is bad, and yes it may harm a coun-try’s economic development, but yes, there are also cases where side paymentsto government officials can remove the bureaucratic barriers to investments thatcreate jobs. What this pragmatic stance ignores, however, is that corruption tendsto “corrupt” both the bribe giver and the bribe taker. Corruption feeds on itself, andonce an individual has started to walk down the road of corruption, pulling backmay be difficult if not impossible. If this is so, it strengthens the moral case fornever engaging in corruption, no matter how compelling the benefits might seem.

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Summary of ChapterThis chapter has reviewed how the political, economic,and legal systems of different countries vary. The poten-tial benefits, costs, and risks of doing business in a coun-try are a function of its political, economic, and legalsystems. More specifically:

1. Political systems can be assessed according to twodimensions: the degree to which they emphasizecollectivism as opposed to individualism, and thedegree to which they are democratic or totalitar-ian.

2. Collectivism is an ideology that views the needsof society as being more important than the needsof the individual. Collectivism translates into anadvocacy for state intervention in economicactivity and, in the case of communism, atotalitarian dictatorship.

3. Individualism is an ideology that is built upon anemphasis of the primacy of individual’s freedomsin the political, economic, and cultural realms.Individualism translates into an advocacy fordemocratic ideals and free market economics.

4. Democracy and totalitarianism are at differentends of the political spectrum. In a representativedemocracy, citizens periodically elect individualsto represent them and political freedoms are guar-anteed by a constitution. In a totalitarian state,political power is monopolized by a party, group,or individual, and basic political freedoms aredenied to citizens of the state.

5. There are four broad types of economic system: amarket economy, a command economy, a mixedeconomy, and a state-directed economy. In a marketeconomy, prices are free of controls and privateownership is predominant. In a command economy,prices are set by central planners, productive assetsare owned by the state, and private ownership is for-bidden. A mixed economy has elements of both amarket economy and a command economy. A state-directed economy is one in which the state plays asignificant role in directing the investmentactivities of private enterprise through “industrialpolicy” and in otherwise regulating business activityin accordance with national goals.

6. Differences in the structure of law betweencountries can have important implications for thepractice of international business. The degree towhich property rights are protected can varydramatically from country to country, as can

product safety and product liability legislation andthe nature of contract law.

7. The rate of economic progress in a country seemsto depend on the extent to which that countryhas a well-functioning market economy in whichproperty rights are protected.

8. Many country are now in a state of transition.There is a marked shift away from totalitariangovernments and command or mixed economicsystems and toward democratic politicalinstitutions and free market economic systems.

9. It is not clear, however, that we are witnessing theemergence of a universal global civilization basedon democratic institutions and free marketcapitalism. The bipolar world of the Cold War eramay ultimately be replaced by a multi-polar worldof ideologically divergent civilizations.

10. The attractiveness of a country as a market and/orinvestment site depends on balancing the likelylong-run benefits of doing business in that countryagainst the likely costs and risks.

11. The benefits of doing business in a country are afunction of the size of the market (population), itspresent wealth (purchasing power), and its futuregrowth prospects. By investing early in countriesthat are currently poor but are nevertheless grow-ing rapidly, firms can gain first-mover advantagesthat will pay back substantial dividends in thefuture.

12. The costs of doing business in a country tend to begreater where political payoffs are required to gainmarket access, where supporting infrastructure islacking or underdeveloped, and where adhering tolocal laws and regulations is costly.

13. The risks of doing business in a country tend to begreater in countries that are (1) politically unsta-ble, (2) subject to economic mismanagement, and(3) lacking a legal system to provide adequatesafeguards in the case of contract or propertyrights violations.

14. Country differences give rise to several ethicaldilemmas. These including (1) should a firm dobusiness in a repressive totalitarian state, (2)should a firm conform to its home product, work-place, and environmental standards when theyare not required by the host country, and (3)should a firm pay bribes to government officials togain market access?

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72 Part II Country Factors

CLOSING CASE General Electric in Hungary

In the heady days of late 1989 when Communistregimes were disintegrating across Eastern Europe, theGeneral Electric Company (GE) launched a majorexpansion in Hungary with the $150 million acquisi-tion of a 51 percent interest in Tungsram. A manufac-turer of lighting products, Tungsram waswidely regarded as one of Hungary’sindustrial gems. GE was attracted toTungsram by Hungary’s low wage ratesand by the possibility of using the com-pany to export lighting products toWestern Europe. Like many other West-ern companies, GE believed thatHungary’s shift from a totalitarian Com-munist country with a state-owned andplanned economic system to a politi-cally democratic country with a largelyfree market economic system would cre-ate enormous long-run business opportu-nities.

At the time, many observers believed that GeneralElectric would show other Western companies how toturn enterprises once run by Communist party hacksinto capitalist money makers. GE promptly transferredsome of its best management talent to Tungsram andwaited for the miracle to happen. The miracle was slowin coming. As losses mounted, General Electric facedthe reality of what happens when grand expectationscollide with the grim realities of an embedded culture ofwaste, inefficiency, and indifference about customersand quality.

The American managers complained that the Hun-garians were lackadaisical; the Hungarians thought theAmericans pushy. The company’s aggressive manage-ment system depended on communication betweenworkers and managers; the old Communist system had

forbidden this, and changing attitudes atTungsram proved difficult. The Ameri-cans wanted strong sales and marketingfunctions that would pamper customers;used to life in a centrally planned econ-omy, the Hungarians believed that thesethings took care of themselves. The Hun-garians expected GE to deliver Western-style wages, but GE came to Hungary totake advantage of the country’s low wagestructure.

In retrospect, GE managers admit theyunderestimated how long it would take toturn Tungsram around-and how much itwould cost. As Charles Pipper, Tungsram’s

American general manager, says, “Human engineeringwas much more difficult than product engineering.” GEnow believes it has turned the corner. However, getting tothis point has meant laying off half of Tungsram’s 20,000employees, including two out of every three managers. Ithas also meant an additional $440 million investment innew plant and equipment and in retraining the employeesand managers that remained. By 1997 the investmentfinally seemed to be paying off. Despite a 50 percent cut inthe work force, production volume is now double the 1989level. Although some large Eastern European customers

Critical Discussion Questions1. Free market economies stimulate greater

economic growth, whereas state-directedeconomies stifle growth! Discuss.

2. A democratic political system is an essential con-dition for sustained economic progress. Discuss.

3. During the late 1980s and early 1990s, Chinawas routinely cited by various international orga-nizations such as Amnesty International andFreedom Watch for major human rightsviolations, including torture, beatings, imprisonment, and executions of political dissi-dents. Despite this, in the mid-1990s Chinareceived record levels of foreign directinvestment, mainly from firms based in democra-

tic societies such as the United States, Japan,and Germany. Evaluate this trend from an ethi-cal perspective. If you were the CEO of a firmthat had the option of making a potentially veryprofitable investment in China, what would youdo?

4. You are the CEO of a company that has to choosebetween making a $100 million investment inRussia or the Czech Republic. Both investmentspromise the same long-run return, so your choiceis driven by risk considerations. Assess thevarious risks of doing business in each of thesenations. Which investment would you favor andwhy?

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Chapter Two National Differences in Political Economy 73

Notes1. M. Kreinin, “Brazil: the Land of Telecom Opportunity:

US Firms Profit from Privatization,” USA Today,December 1, 1997, p. B12.

2. Although as we shall see, there is not a strict one-to-one correspondence between political systems and eco-nomic systems. A. O. Hirschman, “The On-and-OffAgain Connection between Political and EconomicProgress,” American Economic Review 84, no. 2 (1994),pp. 343–348.

3. For a discussion of the roots of collectivism andindividualism see H. W. Spiegel, The Growth ofEconomic Thought (Durham, NC: Duke UniversityPress, 1991). An easily assessable discussion of collec-tivism and individualism can be found in M. Friedmanand R. Friedman, Free to Choose (London: PenguinBooks, 1980).

4. For a classic summary of the tenets of Marxism details,see A. Giddens, Capitalism and Modern Social Theory(Cambridge: Cambridge University Press, 1971).

5. For details see “A Survey of China,” The Economist,March 18, 1995.

6. J. S. Mill, On Liberty (London: Longman’s, 1865), p.6.7. A. Smith, The Wealth of Nations, Vol. 1 (London: Pen-

guin Books), p. 325.8. R. Wesson, Modern Government-Democracy and Author-

itarism, 2nd ed. (Englewood Cliffs, NJ: Prentice Hall,1990).

9. For a detailed but accessible elaboration of thisargument see M. Friedman and R. Friedman, Free toChoose (London: Penguin Books, 1980). Also see P. M.Romer, “The Origins of Endogenous Growth,” Journalof Economic Perspectives 8, no. 1 (1994), pp. 2–32.

10. M. Borrus, L. A. Tyson and J. Zysman, “CreatingAdvantage: How Government Policies Created Tradein the Semiconductor Industry,” in Strategic Trade Policy

and the New International Economics, ed. P. Krugman(Cambridge, MA: MIT Press, 1986).

11. See Lester Thurow, Head to Head (New York: WarnerBooks, 1993).

12. D. North, Institutions, Institutional Change, andEconomic Performance (Cambridge: Cambridge Univer-sity Press, 1991).

13. P. Klebnikov, “Russia’s Robber Barons,” Forbes,November 21, 1994, pp. 74–84; C. Mellow, “Russia:Making Cash from Chaos,” Fortune, April 17, 1995, pp.145–151; and “Mr Tatum Checks Out,” The Economist,November 9, 1996, p. 78.

14. “Godfather of the Kremlin?” Fortune, December 30,1996, pp. 90–96.

15. “Mr Tatum Checks Out.”16. K. van Wolferen, The Enigma of Japanese Power (New

York: Vintage Books, 1990), pp. 100–05.17. P. Bardhan, “Corruption and Development: A Review

of the Issues,” Journal of Economic Literature, September1997, pp. 1320–46.

18. K. M. Murphy, A. Shleifer, and R. Vishny, “Why IsRent Seeking So Costly to Growth,” AmericanEconomic Review 83, no. 2 (1993), pp. 409–14.

19. Keiran Cooke, “Honeypot of as Much as $4 Billion Downthe Drain,” Financial Times, February 26, 1994, p. 4.

20. Douglass North has argued that the correct specificationof intellectual property rights is one factor that lowersthe cost of doing business and, thereby, stimulates eco-nomic growth and development. See D. North, Institu-tions, Institutional Change, and Economic Performance(Cambridge: Cambridge University Press, 1991).

21. Business Software Alliance, Global Software PiracyReport: Facts and Figures, 1994–1996. Available fromhttp://www.bsa.org.

are no longer on Tungsram’s books, many of those werethemselves poorly run state-owned enterprises.*

J. Perlez, “GE Finds Tough Going in Hungary,” New York Times, July 25,1994, pp. C1, C3; C. R. Whitney, “East Europe’s Hard Path to New Day,”New York Times, September 30, 1994, pp. A1, A4; and T. Agassi, “Hun-gary for Capitalism,” The Jerusalem Post, June 18, 1997, p. 8.

http://www.ge.com

Case Discussion Questions1. What does GE’s experience in Hungary tell you

about the relationship among economic systems,political systems, and national culture?

2. Given the problems GE experienced withTungsram, in retrospect might it have chosen abetter strategy to attack the Western Europeanlighting products market?

3. How important to the economic developmentof Hungary are investments such as GE’s? What are the benefits that GE brings toHungary?

4. If Tungsram had continued under local ownership,what do you think would have been its fate?

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74 Part II Country Factors

22. Ibid.23. S. Greenberger and C. S. Smith, “CD Piracy Flourishes

in China and the West Supplies Equipment,” WallStreet Journal, April 27, 1997, pp. A1, A4.

24. “Trade tripwires,” The Economist, August 27, 1994, p. 61.25. Business Software Alliance, “Software Piracy in China,”

press release, November 18, 1996.26. “A Survey of the Legal Profession,” The Economist, July

18, 1992, pp. 1–18.27. The World Bank, World Development Report, 1998/99:

Knowledge For Development (Oxford: Oxford UniversityPress, 1999).

28. G. M. Grossman and E. Helpman, “Endogenous Inno-vation in the Theory of Growth,” Journal of EconomicPerspectives 8, no. 1 (1994), pp. 23–44, and P. M.Romer, “The Origins of Endogenous Growth,” Journalof Economic Perspectives, 8, no. 1 (1994), pp. 3–22.

29. F. A. Hayek, The Fatal Conceit: Errors of Socialism(Chicago: University of Chicago Press, 1989).

30. James Gwartney, Robert Lawson, and Walter Block,Economic Freedom of the World: 1975–1995 (London:Institute of Economic Affairs, 1996).

31. North, Institutions, Institutional Change and EconomicPerformance See also Murphy, Shleifer, and Vishny,“Why Is Rent Seeking so Costly to Growth?”

32. Hirschman, “The On-and-Off Again Connectionbetween Political and Economic Progress, A.Przeworski and F. Limongi, “Political Regimes and Eco-nomic Growth,” Journal of Economic Perspectives 7, no.3 (1993), pp. 51–59.

33. As an example, see “Why Voting Is Good for You,” TheEconomist, August 27, 1994, pp. 15–17.

34. Ibid.35. For details of this argument see M. Olson,

“Dictatorship, Democracy, and Development,” Ameri-can Political Science Review, September 1993.

36. For example see Jarad Diamond, Guns, Germs, andSteel (New York: W. W. Norton, 1997). Also see J.Sachs, “Nature, Nurture and growth,” The Economist,June 14, 1997, pp. 19–22.

37. Ibid.

38. “What Can the Rest of the World Learn from theClassrooms of Asia?” The Economist, September 21,1996, p. 24.

39. J. Fagerberg, “Technology and InternationalDifferences in Growth Rates,” Journal of Economic Liter-ature, 32 (September 1994), pp. 1147–75.

40. See “1997 Freedom Around the World,” FreedomReview, January–February 1997, pp. 5–29.

41. Ibid.42. L. Conners, “Freedom to Connect,” Wired, August

1997, pp. 105–06.43. F. Fukuyama, “The End of History,” The National Inter-

est 16 (Summer 1989), p. 18.44. S. P. Huntington, The Clash of Civilizations and the

Remaking of World Order (New York: Simon & Schus-ter, 1996).

45. Ibid., p. 116.46. S. Fisher, R. Sahay, and C. A. Vegh, “Stabilization and

the Growth in Transition Economies: the Early Experi-ence,” Journal of Economic Perspectives 10 (Spring1996), pp. 45–66.

47. B. T. Johnson, K. R. Holmes, and M. Kirpatrick, 1999Index of Economic Freedom (Heritage Foundation, 1998).

48. N. Weinberg, “First the Pain, Then the Gain,” Forbes,May 5, 1997, pp. 134–37.

49. J. C. Brada, “Privatization Is Transition-Is It?” Journal ofEconomic Perspectives, Spring 1996, pp. 67–86.

50. M. S. Borish and M. Noel, “Private SectorDevelopment in the Visegrad Countries,” World Bank,March 1997.

51. Ibid.52. Fischer, Sahay, and Vegh, “Stabilization and Growth in

Transition Economies.”53. M. Bleaney, “Economic Liberalization in Eastern

Europe: Problems and Prospects,” The World Economy17, no. 4 (1994), pp. 497–507.

54. M. Wolf and C. Freeland, “The Long Day’s Journey toMarket,” Financial Times, March 7, 1995, p. 15.

55. “Lessons of Transition,” The Economist, June 29, 1996,p. 81.

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Chapter Two National Differences in Political Economy 75

56. For a discussion of first-mover advantages, see M. Liber-man and D. Montgomery, “First-Mover Advantages,”Strategic Management Journal 9 (Summer Special Issue,1988), pp. 41–58.

57. “Of Liberty and Prosperity,” The Economist, January 13,1996, pp. 21–23.

58. S. H. Robock, “Political Risk: Identification andAssessment,” Columbia Journal of World Business,July/August 1971, pp. 6–20.

59. Steven L. Myers, “Report Says Business Interests Over-shadow Rights,” New York Times, December 5, 1996, p.A8.

60. Jo-Ann Mort, “Sweated Shopping,” The Guardian,September 8, 1997, p. 11.

61. Bardhan Pranab, “Corruption and Development,” Jour-nal of Economic Literature 36 (September 1997), pp.1320–46.

62. A. Shleifer and R. W. Vishny, “Corruption,” QuarterlyJournal of Economics, no. 108 (1993), pp. 599–617.

63. P. Mauro, “Corruption and Growth,” Quarterly Journalof Economics, no. 110 (1995), pp. 681–712.

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