Global Business homework

I need Global Business assignment done by Monday , December 3rd, 2012 by 8:00 pm New York time.

I am A student, I just have too much in my plate to catch up, so I need good paper not to drop my grade. No plagiarism please, I will check it for plagiarism.

Assignment details below

http://extmedia.kaplan.edu/business/AB220_MT220_1203C/Unit_1/index.html

– Assignment Scenario

http://extmedia.kaplan.edu/business/AB220_MT220_1203C/220_u4assignment – Assignment details

please see attached chapters to be used for assignment and assigment details on pdf.

Thanks,

Bakiliyam

L
E

A
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N
IN

B
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E

C
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IV
E

After you have read this chapter you should be able to:

1
Recognize current trends regarding foreign direct investment in

the world economy.

2
Explain the different theories of foreign direct

investment.

3
Understand how political ideology shapes a government’s

attitudes toward FDI.

4
Describe the benefits and costs of FDI to home and

host countries.

Explain the range of policy instruments that governments use

to influence FDI.

6
Identify the implications for management practice of the theory and

government policies associated with FDI.

part 3 Cross-Border Trade and Investment

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opening case

Japan has been a tough market for foreign firms to enter. The level of foreign direct invest-ment (FDI) in Japan is a fraction of that found in many other developed nations. In 2008, for example, the stock of foreign direct investment as a percentage of GDP was 4.1 percent in
Japan. In the United States, the comparable figure was 16 percent; in Germany, 19.2 percent; in
France, 34.7 percent; and in the United Kingdom, 36.9 percent.
Various reasons account for the lack of FDI into Japan. Until the 1990s, government regulations
made it difficult for companies to establish a direct presence in the nation. In the retail sector, for
example, the Large Scale Retail Store Law, which was designed to protect politically powerful
small retailers, made it all but impossible for foreign retailers to open large-volume stores in the
country (the law was repealed in 1994). Despite deregulation during the 1990s, FDI into Japan
remained at low levels. Some cite cultural factors in explaining this. Many Japanese companies
have resisted acquisitions by foreign enterprises (acquisitions are a major vehicle for FDI). They
did so because of fears that new owners would restructure too harshly, cutting jobs and break-
ing long-standing commitments with suppliers. Foreign investors also state that they find it
difficult to find managerial talent in Japan, since most managers tend to stay with a single
employer for their entire career, leaving very few managers in the labor market for foreign
firms to hire. Furthermore, a combination of slow economic growth, sluggish consumer
spending, and an aging population makes the Japanese economy less attractive than it
once was, particularly when compared to the dynamic and rapidly growing economies
of India and China, or even the United States and the United Kingdom.
The Japanese government, however, has come around to the view that the country
needs more foreign investment. Foreign firms can bring competition to Japan where
local ones may not, because they do not feel bound by existing business practices
or relationships. They can be a source of new management ideas, business poli-
cies, and technology, all of which boost productivity. Indeed, a study by the
Organization for Economic Cooperation and Development (OECD) sug-
gests that labor productivity at the Japanese affiliates of foreign firms is
as much as 60 percent higher than at domestic firms, and in services

Walmart in Japan

Foreign Direct Investment

7c h a p t e r

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242 Part Three Cross-Border Trade and Investment

firms it is as much as 80 percent higher. (The OECD is a Paris-based inter-
governmental organization of “wealthy” nations whose purpose is to provide
its 29 member states with a forum in which governments can compare their
experiences, discuss the problems they share, and seek solutions that can then
be applied within their own national contexts. The members include most Euro-
pean Union countries, the United States, Canada, Japan, and South Korea).
It was the opportunity to help restructure Japanʼs retail sector, boosting
productivity, gaining market share, and profiting in the process, that attracted
Walmart to Japan. The worldʼs largest retailer, Walmart entered Japan in 2002
by acquiring a stake in Seiyu, which was then the fifth-largest retailer in
Japan. Under the terms of the deal, Walmart increased its ownership stake
over the next five years, becoming a majority owner by 2006. Seiyu was con-
sidered an inefficient retailer. According to one top officer, “Seiyu is bogged
down in old customs that are wasteful. Walmart brings proven skills in man-
aging big supermarkets, which is what we would like to learn to do. ”
Walmartʼs goal was to transfer best practice from its U.S. stores and use
them to improve the performance of Seiyu. This meant implementing
Walmartʼs cutting-edge information systems, adopting tight inventory control,
leveraging its global supply chain to bring low-cost goods into Japan, intro-
ducing everyday low prices, retraining employees to improve customer ser-
vice, extending opening hours, renovating stores, and investing in new ones.
Itʼs proven to be more difficult than Walmart hoped. Walmartʼs entry
prompted local rivals to change their strategies. They began to make acquisi-
tions to grow and started to cut their prices to match Walmartʼs discounting
strategy. Walmart also found that it had to alter its merchandising approach,
offering more high-value items to match Japanese shopping habits, which
were proving to be difficult to change. Also, many Japanese suppliers were
reluctant to work closely with Walmart. Despite this, after years of losses, it
looked as if Seiyu would become profitable in 2010, indicating that Walmart
might ultimately reap a return on its investment. •
Sources: D. R. John, “Wal-Mart in Japan: Survival and Future of Its Japanese Business,” Icfai University Journal
of International Business 3 (2008), pp. 45–67; United Nations, World Investment Report, 2009 (New York and
Geneva: United Nations, 2009); “Challenges Persist in Japan,” MMR , December 14, 2009, p. 45; and J. Matusitz
and M. Forrester, “Successful Globalization Practices: The Case of Seiyu in Japan,” Journal of Transnational
Management 14, no. 2 (April 2009), pp. 155–76.

Introduction
Foreign direct investment (FDI) occurs when a firm invests directly in facilities to
produce or market a product in a foreign country. According to the U.S. Department
of Commerce, in the United States FDI occurs whenever a U.S. citizen, organization,
or affiliated group takes an interest of 10 percent or more in a foreign business entity.
Once a firm undertakes FDI, it becomes a multinational enterprise . An example of FDI

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Chapter Seven Foreign Direct Investment 243

is given in the opening case: Walmart’s investment in Japan. Walmart first became a
multinational in the early 1990s when it invested in Mexico.
FDI takes on two main forms. The first is a greenfield investment, which involves
the establishment of a new operation in a foreign country. The second involves acquiring
or merging with an existing firm in the foreign country (Walmart’s entry into Japan was
in the form of an acquisition). Acquisitions can be a minority (where the foreign firm
takes a 10 percent to 49 percent interest in the firm’s voting stock), majority (foreign in-
terest of 50 percent to 99 percent), or full outright stake (foreign interest of 100 percent). 1
We begin this chapter by looking at the importance of foreign direct investment in
the world economy. Next, we review the theories that have been used to explain foreign
direct investment. The chapter then moves on to look at government policy toward
foreign direct investment and closes with a section on implications for business.

Foreign Direct Investment

in the World Economy
When discussing foreign direct investment, it is important to distinguish between the
flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI
undertaken over a given time period (normally a year). The stock of FDI refers to the
total accumulated value of foreign-owned assets at a given time. We also talk of
outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, the
flow of FDI into a country.

TRENDS IN FDI The past 30 years have seen a marked increase in both the flow
and stock of FDI in the world economy. The average yearly outflow of FDI increased
from $25 billion in 1975 to a record $1.8 trillion in 2007 (see Figure 7.1). However, FDI
outflows did contract to $1.2 trillion in 2009 in the wake of the global financial crisis,
although they are forecasted to recover in 2011. 2 In general, however, over the past three
decades the flow of FDI has accelerated faster than the growth in world trade and world
output. For example, between 1992 and 2008, the total flow of FDI from all countries
increased more than eightfold while world trade by value grew by some 150 percent and
world output by around 45 percent. 3 As a result of the strong FDI flow, by 2009 the
global stock of FDI was about $15 trillion. At least 82,000 parent companies had 810,000
affiliates in foreign markets that collectively employed more than 77 million people
abroad and generated value accounting for about 11 percent of global GDP. The foreign
affiliates of multinationals had over $30 trillion in global sales, higher than the value of
global exports of goods and services, which stood at close to $19.9 trillion. 4
FDI has grown more rapidly than world trade and world output for several reasons.
First, despite the general decline in trade barriers over the past 30 years, business firms
still fear protectionist pressures. Executives see FDI as a way of circumventing future
trade barriers. Second, much of the increase in FDI has been driven by the political and
economic changes that have been occurring in many of the world’s developing nations.
The general shift toward democratic political institutions and free market economies
that we discussed in Chapter 2 has encouraged FDI. Across much of Asia, Eastern Eu-
rope, and Latin America, economic growth, economic deregulation, privatization pro-
grams that are open to foreign investors, and removal of many restrictions on FDI have
made these countries more attractive to foreign multinationals. According to the United
Nations, some 90 percent of the 2,600 changes made worldwide between 1992 and 2008
in the laws governing foreign direct investment created a more favorable environment
for FDI (see Figure 7.2). 5 However, since 2002, the number of regulations that are less
favorable toward FDI has increased, suggesting the pendulum may be starting to swing

Greenfield
Investment
Establishing a new
operation in a foreign
country.

LEARNING OBJECTIVE 1
Recognize current trends

regarding foreign direct
investment in the world

economy.

Flow of FDI
The amount of FDI
undertaken over a given
time period (normally a
year).

Stock of FDI
The total accumulated
value of foreign-owned
assets at a given time.

Outflows of FDI
The flow of FDI out
of a

country.

Inflows of FDI
The flow of FDI into
a country.

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244 Part Three Cross-Border Trade and Investment

the other way. Latin America, in particular, has seen an increase in regulations that are
less favorable to FDI; two-thirds of the reported changes in 2005 and 2008 made the
environment for direct investment less welcome there. Most of these unfavorable
changes were focused on extractive industries, such as oil and gas, where governments
seem focused on limiting FDI and capturing more of the economic value from FDI
through, for example, higher taxes and royalty rates applied to foreign enterprises.

20
08

20
06

20
05

20
04

20
03

20
02

20
01

20
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92

19
87

–9
1

19
82

–8
6

$
B

ill
io

2000

1000

200

400

600

800

800
600
400
200
0

figure 7.1

FDI Outflows, 1982–2009
($ billion)

Source: Constructed by the author

from data in United Nations, World

Investment Report, 2009 (New York

and Geneva: United Nations, 2009).

figure 7.2

National Regulatory
Changes Governing FDI,

1992–2008

Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).
19
92
19
93
19
94
19
95
19
96
19
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99
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01
20
02
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03
20
04
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05
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06
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08

20
07

100

150

200

250

More favorable to FDI Less favorable to

FDI

N
um

be
r

at
io

na
l r

eg
ul

at
or

y
ch

an
ge

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Chapter Seven Foreign Direct Investment 245

19
95
19
96
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19
99
20
00
20
01
20
02
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03
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04
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07

Developed nations Developing natio

$
B
ill
io
ns
0

1600

1200

1400

200
400
600
800
1000

Notwithstanding recent adverse developments in some nations, the general desire
of governments to facilitate FDI also has been reflected in a sharp increase in the
number of bilateral investment treaties designed to protect and promote investment
between two countries. As of 2009, 2,676 such treaties involved more than 180 coun-
tries, a 12-fold increase from the 181 treaties that existed in 1980. 6
The globalization of the world economy is also having a positive impact on the vol-
ume of FDI. Many firms (such as Walmart profiled in the opening case) now see the
whole world as their market, and they are undertaking FDI in an attempt to make sure
they have a significant presence in many regions. For reasons that we shall explore later
in this book, many firms now believe it is important to have production facilities based
close to their major customers. This, too, creates pressure for greater FDI.

THE DIRECTION OF FDI Historically, most FDI has been directed at the
developed nations of the world as firms based in advanced countries invested in the oth-
ers’ markets (see Figure 7.3). During the 1980s and 1990s, the United States was often
the favorite target for FDI inflows. The United States has been an attractive target for
FDI because of its large and wealthy domestic markets, its dynamic and stable economy,
a favorable political environment, and the openness of the country to FDI. Investors
include firms based in Great Britain, Japan, Germany, Holland, and France. Inward in-
vestment into the United States remained high during the 2000s, totaling $271 billion in
2007 and $316 billion in 2008. The developed nations of the European Union have also
been recipients of significant FDI inflows, principally from U.S. and Japanese enter-
prises and from other member states of the EU. In 2007, inward investment into the
EU reached a record $842 billion, although it fell to $503 billion in 2008. The United
Kingdom and France were the largest national recipients. Some $280 billion was in-
vested in the United Kingdom in 2007 and 2008 combined, and $275 billion in France. 7
Even though developed nations still account for the largest share of FDI inflows, FDI
into developing nations has increased (see Figure 7.3). From 1985 to 1990, the annual

7.3 figure

FDI Inflows by Region,
1995–2008 ($ billion)

Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).

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246 Part Three Cross-Border Trade and Investment

inflow of FDI into developing nations averaged $27.4 billion, or 17.4 percent of the total
global flow. In the mid- to late 1990s, the inflow into developing nations was generally
between 35 and 40 percent of the total, before falling back to account for about 25 per-
cent of the total in the 2000–2002 period and then rising to 31 to 40 percent between 2004
and 2008. Most recent inflows into developing nations have been targeted at the emerg-
ing economies of South, East, and Southeast Asia. Driving much of the increase has been
the growing importance of China as a recipient of FDI, which attracted around $60 bil-
lion of FDI in 2004 and rose steadily to hit $108 billion in 2008. 8 The reasons for the
strong flow of investment into China are discussed in the accompanying Country Focus.
Latin America emerged as the next most important region in the developing world
for FDI inflows. In 2008, total inward investments into this region reached about $144
billion. Mexico and Brazil have historically been the two top recipients of inward FDI
in Latin America, a trend that continued in 2008. At the other end of the scale, Africa
has long received the smallest amount of inward investment, although the continent
did receive a record $87 billion in 2008. In recent years, Chinese enterprises have
emerged as major investors in Africa, particularly in extraction industries where they
seem to be trying to assure future supplies of valuable raw materials. The inability of
Africa to attract greater investment is in part a reflection of the political unrest, armed
conflict, and frequent changes in economic policy in the region. 9
Another way of looking at the importance of FDI inflows is to express them as a per-
centage of gross fixed capital formation. Gross fixed capital formation summarizes the
total amount of capital invested in factories, stores, office buildings, and the like. Other
things being equal, the greater the capital investment in an economy, the more favorable
its future growth prospects are likely to be. Viewed this way, FDI can be seen as an im-
portant source of capital investment and a determinant of the future growth rate of an
economy. Figure 7.4 summarizes inward flows of FDI as a percentage of gross fixed

Gross Fixed
Capital Formation

Summarizes the total
amount of capital

invested in factories,
stores, office buildings,

and the like.

0
5

%
o

f g
ro

ss
fi

xe
d

ca
pi

ta
l

fo
rm

at
io
n
19
92

–9
7

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00
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01
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02
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03
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04
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05
20
06
20
07
20
08

Developed nations Developing nations

figure 7.4

Inward FDI as a
Percentage of Gross

Fixed Capital
Formation, 1992–2008

Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).

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Chapter Seven Foreign Direct Investment 247

Foreign Direct Investment in China

Beginning in late 1978, China’s leadership decided to move
the economy away from a centrally planned socialist sys-
tem to one that was more market driven. The result has
been close to three decades of sustained high economic
growth rates of about 10 percent annually compounded.
This rapid growth has attracted substantial foreign invest-
ment. Starting from a tiny base, foreign investment in-
creased to an annual average rate of $2.7 billion between
1985 and 1990 and then surged to $40 billion annually in the
late 1990s, making China the second-biggest recipient of
FDI inflows in the world after the United States. By the
late 2000s, China was attracting between $80 billion and
$100 billion of FDI annually, with another $60 billion a year
going into Hong Kong.
Over the past 20 years, this inflow has resulted in estab-
lishment of over 300,000 foreign-funded enterprises in
China. The total stock of FDI in mainland China grew from
effectively zero in 1978 to $378 billion in 2008 (another
$835 billion of FDI stock was in Hong Kong). FDI amounted
to about 8 percent of annualized gross fixed capital for-
mation in China between 1998 and 2008, suggesting that
FDI is an important source of economic growth in China.
The reasons for the investment are fairly obvious. With
a population of more than 1 billion people, China repre-
sents one of the world’s largest markets. Historically, im-
port tariffs made it difficult to serve this market via
exports, so FDI was required if a company wanted to tap
into the country’s huge potential. Although China joined
the World Trade Organization in 2001, which will ulti-
mately mean a reduction in import tariffs, this will occur
slowly, so this motive for investing in China will persist.
Also, many foreign firms believe that doing business in
China requires a substantial presence in the country to
build guanxi, the crucial relationship networks (see Chap-
ter 3 for details). Furthermore, a combination of cheap
labor and tax incentives, particularly for enterprises that
establish themselves in special economic zones, makes
China an attractive base from which to serve Asian or
world markets with exports.
Less obvious, at least to begin with, was how difficult it
would be for foreign firms to do business in China. Blinded
by the size and potential of China’s market, many firms
have paid less attention than perhaps they should have to
the complexities of operating a business in this country un-
til after the investment has been made. China may have a
huge population, but despite two decades of rapid growth,
it is still relatively poor. The lack of purchasing power

translates into relative weak markets for many Western
consumer goods. Another problem is the lack of a well-
developed transportation infrastructure or distribution sys-
tem outside of major urban areas. PepsiCo discovered this
problem at its subsidiary in Chongqing. Perched above the
Yangtze River in southwest Sichuan province, Chongqing
lies at the heart of China’s massive hinterland. The Chong-
qing municipality, which includes the city and its surround-
ing regions, contains more than 30 million people, but
according to Steve Chen, the manager of the PepsiCo sub-
sidiary, the lack of well-developed road and distribution
systems means he can reach only about half of this popu-
lation with his product.
Other problems include a highly regulated environment,
which can make it problematic to conduct business trans-
actions, and shifting tax and regulatory regimes. For ex-
ample, a few years ago, the Chinese government suddenly
scrapped a tax credit scheme that had made it attractive to
import capital equipment into China. This immediately
made it more expensive to set up operations in the country.
Then there are problems with local joint-venture partners
that are inexperienced, opportunistic, or simply operate
according to different goals. One U.S. manager explained
that when he laid off 200 people to reduce costs, his Chi-
nese partner hired them all back the next day. When he
inquired why they had been hired back, the executive of
the Chinese partner, which was government owned, ex-
plained that as an agency of the government, it had an “ob-
ligation” to reduce unemployment.
To continue to attract foreign investment, the Chinese
government has committed itself to invest more than
$800 billion in infrastructure projects over the next 10 years.
This should improve the nation’s poor highway system. By
giving preferential tax breaks to companies that invest in
special regions, such as that around Chongqing, the Chinese
have created incentives for foreign companies to invest in
China’s vast interior where markets are underserved. They
have been pursuing a macroeconomic policy that includes
an emphasis on maintaining steady economic growth, low
inflation, and a stable currency, all of which are attractive
to foreign investors. Given these developments, it seems
likely that the country will continue to be an important mag-
net for foreign investors well into the future.

Sources: Interviews by the author while in China; United Nations, World
Investment Report, 2009 (New York and Geneva: United Nations, 2009);
Linda Ng and C. Tuan, “Building a Favorable Investment Environment:
Evidence for the Facilitation of FDI in China,” The World Economy, 2002,
pp. 1095–114; and S. Chan and G. Qingyang, “Investment in China Migrates
Inland,” Far Eastern Economic Review , May 2006, pp. 52–57.

3 C o u n t r y F O C U S

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248 Part Three Cross-Border Trade and Investment

capital formation for developed and developing
economies for 1992–2008. During 1992–1997, FDI
flows accounted for about 4 percent of gross fixed
capital formation in developed nations and 8 percent
in developing nations. By 2006–2008, the figure was
14 percent worldwide, suggesting that FDI had
become an increasingly important source of invest-
ment in the world’s economies.

These gross figures hide important individual
country differences. For example, in 2008, inward
FDI accounted for some 47 percent of gross fixed
capital formation in Sweden and 21 percent in the
United Kingdom, but 2.3 percent in Venezuela and
2.2 percent in Japan—suggesting that FDI is an im-
portant source of investment capital, and thus eco-
nomic growth, in the first two countries but not the
latter two. These differences can be explained by
several factors, including the perceived ease and at-
tractiveness of investing in a nation. To the extent

that burdensome regulations limit the opportunities for foreign investment in countries
such as Japan and Venezuela, these nations may be hurting themselves by limiting their
access to needed capital investments (see the opening case for more details on Japan).

THE SOURCE OF FDI Since World War II, the United States has been the
largest source country for FDI, a position it retained during the late 1990s and
early 2000s. Other important source countries include the United Kingdom,
France, Germany, the Netherlands, and Japan. Collectively, these six countries ac-
counted for 56 percent of all FDI outflows for the 1998–2008 period and 61 per-
cent of the total global stock of FDI in 2008 (see Figure 7.5). As might be expected,
these countries also predominate in rankings of the world’s largest multinationals. 10
These nations dominate primarily because they were the most developed nations
with the largest economies during much of the postwar period and therefore home

2000

500

1500

1000
500

U
.S

. d
ol

la
rs

(b
ill

io
ns

)

U
ni

te
d

St
at

U
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te
d

Ki
ng

do
m

N
et

he
rla

nd
s

G
er

m
an

Ja
pa

Fr
an

figure 7.5

Cumulative FDI
Outflows, 1998–2008

($ billions)

Note: Share accounted for by the

United States would have been

larger were it not for significant

one-time investment inflows in 2005

due to changes in U.S. tax laws.

Source: Constructed by the author
from data in United Nations, World
Investment Report, 2009 (New York
and Geneva: United Nations, 2009).

A n o t h e r P e r s p e c t i v e
Diageo Makes “Spirited” Entry into China
London-based Diageo, the world’s largest seller of pre-
mium spirits, beer, and wine, operates in 180 markets
worldwide. Its family includes such well-known brands as
Baileys, Captain Morgan, Guinness, Johnny Walker, Jose
Cuervo, Smirnoff, and Tanqueray. The company tradition-
ally has generated about three-fourths of its revenues in
Europe and North America. However, when sales were
down in those regions, the company decided to introduce
its premium Johnny Walker brand in China shortly before
the Chinese New Year. The product, which retails for an
eye-popping $300 per bottle, sold out quickly. Diageo plans
to deepen its reach into China as well as the rest of Asia.
(“Diageo Makes Play for Asia,” Foreign Direct Invest-
ments, April 15, 2010, http://fdimagazine.com)

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Chapter Seven Foreign Direct Investment 249

to many of the largest and best-capitalized enter-
prises. Many of these countries also had a long his-
tory as trading nations and naturally looked to
foreign markets to fuel their economic expansion.
Thus, it is no surprise that enterprises based there
have been at the forefront of foreign investment
trends.

THE FORM OF FDI: ACQUISITIONS
VERSUS GREENFIELD INVESTMENTS
FDI can take the form of a greenfield investment in a
new facility or an acquisition of or a merger with an
existing local firm. The data suggest the majority of
cross-border investment is in the form of mergers
and acquisitions rather than greenfield investments.
UN estimates indicate that some 40 to 80 percent of
all FDI inflows per annum were in the form of merg-
ers and acquisitions between 1998 and 2008. In 2001,
for example, mergers and acquisitions accounted for
some 78 percent of all FDI inflows. In 2004, the fig-
ure was 59 percent, while in 2008 it was 40 percent. 11
However, FDI flows into developed nations differ markedly from those into develop-
ing nations. In the case of developing nations, only about one-third of FDI is in the
form of cross-border mergers and acquisitions. The lower percentage of mergers and
acquisitions may simply reflect the fact that there are fewer target firms to acquire in
developing nations.
When contemplating FDI, why do firms apparently prefer to acquire existing assets
rather than undertake greenfield investments? We shall consider it in greater depth in
Chapter 12; for now we will make only a few basic observations. First, mergers and
acquisitions are quicker to execute than greenfield investments. This is an important
consideration in the modern business world where markets evolve very rapidly. Many
firms apparently believe that if they do not acquire a desirable target firm, then their
global rivals will. Second, foreign firms are acquired because those firms have valuable
strategic assets, such as brand loyalty, customer relationships, trademarks or patents,
distribution systems, production systems, and the like. It is easier and perhaps less
risky for a firm to acquire those assets than to build them from the ground up through
a greenfield investment. Third, firms make acquisitions because they believe they can
increase the efficiency of the acquired unit by transferring capital, technology, or man-
agement skills. However, there is evidence that many mergers and acquisitions fail to
realize their anticipated gains. 12

Theories of Foreign Direct Investment
In this section, we review several theories of foreign direct investment. These theories
approach the various phenomena of foreign direct investment from three complemen-
tary perspectives. One set of theories seeks to explain why a firm will favor direct in-
vestment as a means of entering a foreign market when two other alternatives, exporting
and licensing, are open to it. Another set of theories seeks to explain why firms in the
same industry often undertake foreign direct investment at the same time, and why
they favor certain locations over others as targets for foreign direct investment. Put
differently, these theories attempt to explain the observed pattern of foreign direct

When you see a BP gas station as you are driving down the road, do you
realize that the company is British owned? BP = British Petroleum.

LEARNING OBJECTIVE 2
Explain the different

theories of foreign direct
investment.

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250 Part Three Cross-Border Trade and Investment

investment flows. A third theoretical perspective, known as the eclectic paradigm ,
attempts to combine the two other perspectives into a single holistic explanation of
foreign direct investment (this theoretical perspective is eclectic because the best aspects
of other theories are taken and combined into a single explanation).

WHY FOREIGN DIRECT INVESTMENT? Why do firms go to all of the
trouble of establishing operations abroad through foreign direct investment when
two alternatives, exporting and licensing, are available for exploiting the profit
opportunities in a foreign market? Exporting involves producing goods at home and
then shipping them to the receiving country for sale. Licensing involves granting a
foreign entity (the licensee) the right to produce and sell the firm’s product in return
for a royalty fee on every unit sold. The question is important, given that a cursory
examination of the topic suggests that foreign direct investment may be both expen-
sive and risky compared with exporting and licensing. FDI is expensive because a firm
must bear the costs of establishing production facilities in a foreign country or of
acquiring a foreign enterprise. FDI is risky because of the problems associated with
doing business in a different culture where the rules of the game may be very differ-
ent. Relative to indigenous firms, there is a greater probability that a foreign firm
undertaking FDI in a country for the first time will make costly mistakes due to its
ignorance. When a firm exports, it need not bear the costs associated with FDI, and
it can reduce the risks associated with selling abroad by using a native sales agent.
Similarly, when a firm allows another enterprise to produce its products under
license, the licensee bears the costs or risks. So why do so many firms apparently
prefer FDI over either exporting or licensing? The answer can be found by examining
the limitations of exporting and licensing as means for capitalizing on foreign market
opportunities.

Limitations of Exporting The viability of an exporting strategy is often con-
strained by transportation costs and trade barriers. When transportation costs are
added to production costs, it becomes unprofitable to ship some products over a large
distance. This is particularly true of products that have a low value-to-weight ratio and
that can be produced in almost any location. For such products, the attractiveness of
exporting decreases, relative to either FDI or licensing. This is the case, for example,
with cement. Thus, Cemex, the large Mexican cement maker, has expanded interna-
tionally by pursuing FDI, rather than exporting (see the Management Focus feature
on Cemex). For products with a high value-to-weight ratio, however, transportation
costs are normally a minor component of total landed cost (e.g., electronic compo-
nents, personal computers, medical equipment, computer software, etc.) and have little
impact on the relative attractiveness of exporting, licensing, and FDI.
Transportation costs aside, some firms undertake foreign direct investment as a
response to actual or threatened trade barriers such as import tariffs or quotas. By
placing tariffs on imported goods, governments can increase the cost of exporting
relative to foreign direct investment and licensing. Similarly, by limiting imports
through quotas, governments increase the attractiveness of FDI and licensing. For
example, the wave of FDI by Japanese auto companies in the United States during the
1980s and 1990s was partly driven by protectionist threats from Congress and by
quotas on the importation of Japanese cars. For Japanese auto companies, these factors
decreased the profitability of exporting and increased that of foreign direct investment.
In this context, it is important to understand that trade barriers do not have to be
physically in place for FDI to be favored over exporting. Often, the desire to reduce
the threat that trade barriers might be imposed is enough to justify foreign direct
investment as an alternative to exporting.

Licensing
Occurs when a firm (the

licensor) licenses the
right to produce its

product, its production
processes, or its brand

name or trademark to
another firm (the

licensee); in return for
giving the licensee these

rights, the licensor
collects a royalty fee

on every unit the
licensee sells.

Exporting
Sale of products

produced in one country
to residents of another

country.

Eclectic Paradigm
Argument that combining

location-specific assets
or resource endowments
and the firm’s own unique
assets often requires FDI;

it requires the firm to
establish production

facilities where those
foreign assets or

resource endowments
are located.

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Chapter Seven Foreign Direct Investment 251

M a n a g e m e n t F O C U S

Foreign Direct Investment by Cemex

In little more than a decade, Mexico’s largest cement man-
ufacturer, Cemex, has transformed itself from a primarily
Mexican operation into the third-largest cement company
in the world behind Holcim of Switzerland and Lafarge
Group of France. Cemex has long been a powerhouse in
Mexico and currently controls more than 60 percent of the
market for cement in that country. Cemex’s domestic suc-
cess has been based in large part on an obsession with
efficient manufacturing and a focus on customer service
that is tops in the industry.
Cemex is a leader in using information technology to
match production with consumer demand. The company
sells ready-mixed cement that can survive for only about
90 minutes before solidifying, so precise delivery is impor-
tant. But Cemex can never predict with total certainty what
demand will be on any given day, week, or month. To better
manage unpredictable demand patterns, Cemex developed
a system of seamless information technology, including
truck-mounted global positioning systems, radio transmit-
ters, satellites, and computer hardware, that allows it to
control the production and distribution of cement like no
other company can, responding quickly to unanticipated
changes in demand and reducing waste. The results are
lower costs and superior customer service, both differenti-
ating factors for Cemex.
The company also pays lavish attention to its distributors—
some 5,000 in Mexico alone—who can earn points toward
rewards for hitting sales targets. The distributors can then
convert those points into Cemex stock. High-volume
distributors can purchase trucks and other supplies
through Cemex at significant discounts. Cemex also is
known for its marketing drives that focus on end users, the
builders themselves. For example, Cemex trucks drive
around Mexican building sites, and if Cemex cement is
being used, the construction crews win soccer balls, caps,
and T-shirts.
Cemex’s international expansion strategy was driven by a
number of factors. First, the company wished to reduce its
reliance on the Mexican construction market, which was
characterized by very volatile demand. Second, the com-
pany realized there was tremendous demand for cement in
many developing countries, where significant construction
was being undertaken or needed. Third, the company be-
lieved that it understood the needs of construction busi-
nesses in developing nations better than the established
multinational cement companies, all of which were from
developed nations. Fourth, Cemex believed that it could
create significant value by acquiring inefficient cement
companies in other markets and transferring its skills in

customer service, marketing, information technology, and
production management to those units.
The company embarked in earnest on its international
expansion strategy in the early 1990s. Initially, Cemex tar-
geted other developing nations, acquiring established
cement makers in Venezuela, Colombia, Indonesia, the
Philippines, Egypt, and several other countries. It also pur-
chased two stagnant companies in Spain and turned them
around. Bolstered by the success of its Spanish ventures,
Cemex began to look for expansion opportunities in devel-
oped nations. In 2000, Cemex purchased Houston-based
Southland, one of the largest cement companies in the
United States, for $2.5 billion. Following the Southland ac-
quisition, Cemex had 56 cement plants in 30 countries,
most of which were gained through acquisitions. In all
cases, Cemex devoted great attention to transferring its
technological, management, and marketing know-how to
acquired units, thereby improving their performance.
In 2004, Cemex made another major foreign investment
move, purchasing RMC of Great Britain for $5.8 billion.
RMC was a huge multinational cement firm with sales of
$8.0 billion, only 22 percent of which were in the United
Kingdom, and operations in more than 20 other nations,
including many European nations where Cemex had no
presence. Finalized in March 2005, the RMC acquisition
has transformed Cemex into a global powerhouse in the
cement industry with more than $15 billion in annual
sales and operations in 50 countries. Only about 15 per-
cent of the company’s sales are now generated in Mex-
ico. Following the acquisition of RMC, Cemex found that
the RMC plant in Rugby was running at only 70 percent of
capacity, partly because repeated production problems
kept causing a kiln shutdown. Cemex brought in an inter-
national team of specialists to fix the problem and quickly
increased production to 90 percent of capacity. Going
forward, Cemex has made it clear that it will continue to
expand and is eyeing opportunities in the fast-growing
economies of China and India where currently it lacks
a presence, and where its global rivals are already
expanding.

Sources: C. Piggott, “Cemex’s Stratospheric Rise,” Latin Finance, March
2001, p. 76; J. F. Smith, “Making Cement a Household Word,” Los Angeles
Times, January 16, 2000, p. C1; D. Helft, “Cemex Attempts to Cement Its
Future,” The Industry Standard, November 6, 2000; Diane Lindquist, “From
Cement to Services,” Chief Executive, November 2002, pp. 48–50;
“Cementing Global Success,” Strategic Direct Investor, March 2003, p. 1;
M. T. Derham, “The Cemex Surprise,” Latin Finance, November 2004,
pp. 1–2; “Holcim Seeks to Acquire Aggregate,” The Wall Street Journal,
January 13, 2005, p. 1; J. Lyons, “Cemex Prowls for Deals in Both China and
India,” The Wall Street Journal , January 27, 2006, p. C4; and S. Donnan,
“Cemex Sells 25 Percent Stake in Semen Gresik,” FT.com , May 4, 2006, p. 1.

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252 Part Three Cross-Border Trade and Investment

Limitations of Licensing A branch of economic theory known as internalization
theory seeks to explain why firms often prefer foreign direct investment over licensing
as a strategy for entering foreign markets (this approach is also known as the market
imperfections approach). 13 According to internalization theory, licensing has three major
drawbacks as a strategy for exploiting foreign market opportunities. First, licensing may
result in a firm’s giving away valuable technological know-how to a potential foreign competitor .
For example, in the 1960s, RCA licensed its leading-edge color television technology to
a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw
licensing as a way to earn a good return from its technological know-how in the Japanese
market without the costs and risks associated with foreign direct investment. However,
Matsushita and Sony quickly assimilated RCA’s technology and used it to enter the U.S.
market to compete directly against RCA. As a result, RCA is now a minor player in its
home market, while Matsushita and Sony have a much bigger market share.
A second problem is that licensing does not give a firm the tight control over manufac-
turing, marketing, and strategy in a foreign country that may be required to maximize its
profitability. With licensing, control over manufacturing, marketing, and strategy is
granted to a licensee in return for a royalty fee. However, for both strategic and op-
erational reasons, a firm may want to retain control over these functions. The ratio-
nale for wanting control over the strategy of a foreign entity is that a firm might want
its foreign subsidiary to price and market very aggressively as a way of keeping a for-
eign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably
not accept such an imposition, because it would likely reduce the licensee’s profit, or it
might even cause the licensee to take a loss.
The rationale for wanting control over the operations of a foreign entity is that the
firm might wish to take advantage of differences in factor costs across countries, pro-
ducing only part of its final product in a given country, while importing other parts
from elsewhere where they can be produced at lower cost. Again, a licensee would be
unlikely to accept such an arrangement, since it would limit the licensee’s autonomy.
Thus, for these reasons, when tight control over a foreign entity is desirable, foreign
direct investment is preferable to licensing.
A third problem with licensing arises when the firm’s competitive advantage is
based not as much on its products as on the management, marketing, and manufactur-
ing capabilities that produce those products. The problem here is that such capabilities
are often not amenable to licensing . While a foreign licensee may be able to physically
reproduce the firm’s product under license, it often may not be able to do so as effi-
ciently as the firm could itself. As a result, the licensee may not be able to fully exploit
the profit potential inherent in a foreign market.
For example, consider Toyota, a company whose competitive advantage in the
global auto industry is acknowledged to come from its superior ability to manage the
overall process of designing, engineering, manufacturing, and selling automobiles;
that is, from its management and organizational capabilities. Indeed, Toyota is cred-
ited with pioneering the development of a new production process, known as lean
production , that enables it to produce higher-quality automobiles at a lower cost than
its global rivals. 14 Although Toyota could license certain products, its real competitive
advantage comes from its management and process capabilities. These kinds of skills
are difficult to articulate or codify; they certainly cannot be written down in a simple
licensing contract. They are organizationwide and have been developed over the
years. They are not embodied in any one individual but instead are widely dispersed
throughout the company. Put another way, Toyota’s skills are embedded in its organi-
zational culture, and culture is something that cannot be licensed. Thus, if Toyota
were to allow a foreign entity to produce its cars under license, the chances are that
the entity could not do so anywhere near as efficiently as could Toyota. In turn, this

Internalization
Theory

The argument that firms
prefer FDI over licensing

to retain control
over know-how,
manufacturing,

marketing, and strategy
or because some firm

capabilities are not
amenable to licensing;

also known as the market
imperfections approach.

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Chapter Seven Foreign Direct Investment 253

would limit the ability of the foreign entity to fully develop the market potential of
that product. Such reasoning underlies Toyota’s preference for direct investment in
foreign markets, as opposed to allowing foreign automobile companies to produce its
cars under license.
All of this suggests that when one or more of the following conditions holds, mar-
kets fail as a mechanism for selling know-how and FDI is more profitable than licens-
ing: (1) when the firm has valuable know-how that cannot be adequately protected by
a licensing contract; (2) when the firm needs tight control over a foreign entity to
maximize its market share and earnings in that country; and (3) when a firm’s skills and
know-how are not amenable to licensing.

Advantages of Foreign Direct Investment It follows that a firm will favor
foreign direct investment over exporting as an entry strategy when transportation costs
or trade barriers make exporting unattractive. Furthermore, the firm will favor foreign
direct investment over licensing (or franchising) when it wishes to maintain control
over its technological know-how, or over its operations and business strategy, or when
the firm’s capabilities are simply not amenable to licensing, as may often be the case.

THE PATTERN OF FOREIGN DIRECT INVESTMENT Observation
suggests that firms in the same industry often undertaken foreign direct investment
about the same time. There also is a clear tendency for firms to direct their investment
activities toward certain locations. The two theories we consider in this section at-
tempt to explain the patterns that we observe in FDI flows.

Strategic Behavior One theory is based on the idea that FDI flows are a reflec-
tion of strategic rivalry between firms in the global marketplace. An early variant of
this argument was expounded by F. T. Knickerbocker, who looked at the relationship
between FDI and rivalry in oligopolistic industries. 15 An oligopoly is an industry
composed of a limited number of large firms (e.g., an industry in which four firms
control 80 percent of a domestic market would be defined as an oligopoly). A critical
competitive feature of such industries is interdependence of the major players: What
one firm does can have an immediate impact on the major competitors, forcing a re-
sponse in kind. By cutting prices, one firm in an oligopoly can take market share away
from its competitors, forcing them to respond with similar price cuts to retain their
market share. Thus, the interdependence between firms in an oligopoly leads to imita-
tive behavior; rivals often quickly imitate what a firm does in an oligopoly.
Imitative behavior can take many forms in an oligopoly. One firm raises prices, the
others follow; one expands capacity, and the rivals imitate lest they be left at a disad-
vantage in the future. Knickerbocker argued that the same kind of imitative behavior
characterizes FDI. Consider an oligopoly in the United States in which three firms—
A, B, and C—dominate the market. Firm A establishes a subsidiary in France. Firms B
and C decide that if successful, this new subsidiary may knock out their export busi-
ness to France and give firm A a first-mover advantage. Furthermore, firm A might
discover some competitive asset in France that it could repatriate to the United States
to torment firms B and C on their native soil. Given these possibilities, firms B and C
decide to follow firm A and establish operations in France.
Studies that looked at FDI by U.S. firms during the 1950s and 60s show that firms
based in oligopolistic industries tended to imitate each other’s FDI. 16 The same phe-
nomenon has been observed with regard to FDI undertaken by Japanese firms during
the 1980s. 17 For example, Toyota and Nissan responded to investments by Honda in
the United States and Europe by undertaking their own FDI in the United States and
Europe. More recently, research has shown that models of strategic behavior in a
global oligopoly can explain the pattern of FDI in the global tire industry. 18

Oligopoly
An industry composed
of a limited number of
large firms.

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254 Part Three Cross-Border Trade and Investment

Knickerbocker’s theory can be extended to embrace the concept of multipoint com-
petition. Multipoint competition arises when two or more enterprises encounter
each other in different regional markets, national markets, or industries. 19 Economic
theory suggests that rather like chess players jockeying for advantage, firms will try to
match each other’s moves in different markets to try to hold each other in check. The
idea is to ensure that a rival does not gain a commanding position in one market and
then use the profits generated there to subsidize competitive attacks in other markets.
Kodak and Fuji Photo Film Co., for example, compete against each other around the
world. If Kodak enters a particular foreign market, Fuji will not be far behind. Fuji
feels compelled to follow Kodak to ensure that Kodak does not gain a dominant posi-
tion in the foreign market that it could then leverage to gain a competitive advantage
elsewhere. The converse also holds, with Kodak following Fuji when the Japanese firm
is the first to enter a foreign market.
Although Knickerbocker’s theory and its extensions can help to explain imitative
FDI behavior by firms in oligopolistic industries, it does not explain why the first firm
in an oligopoly decides to undertake FDI rather than to export or license. Internaliza-
tion theory addresses this phenomenon. The imitative theory also does not address the
issue of whether FDI is more efficient than exporting or licensing for expanding
abroad. Again, internalization theory addresses the efficiency issue. For these reasons,
many economists favor internalization theory as an explanation for FDI, although
most would agree that the imitative explanation tells an important part of the story.

The Product Life Cycle Raymond Vernon’s product life-cycle theory, described
in Chapter 5, also is used to explain FDI. Vernon argued that often the same firms that
pioneer a product in their home markets undertake FDI to produce a product for
consumption in foreign markets. Thus, Xerox introduced the photocopier in the
United States, and it was Xerox that set up production facilities in Japan (Fuji Xerox)
and Great Britain (Rank Xerox) to serve those markets. Vernon’s view is that firms
undertake FDI at particular stages in the life cycle of a product they have pioneered.
They invest in other advanced countries when local demand in those countries grows
large enough to support local production (as Xerox did). They subsequently shift pro-
duction to developing countries when product standardization and market saturation
give rise to price competition and cost pressures. Investment in developing countries,
where labor costs are lower, is seen as the best way to reduce costs.
Vernon’s theory has merit. Firms do invest in a foreign country when demand in that
country will support local production, and they do invest in low-cost locations (e.g., de-
veloping countries) when cost pressures become intense. 20 However, Vernon’s theory
fails to explain why it is profitable for a firm to undertake FDI at such times, rather than
continuing to export from its home base or licensing a foreign firm to produce its prod-
uct. Just because demand in a foreign country is large enough to support local produc-
tion, it does not necessarily follow that local production is the most profitable option. It
may still be more profitable to produce at home and export to that country (to realize
the economies of scale that arise from serving the global market from one location). Al-
ternatively, it may be more profitable for the firm to license a foreign company to pro-
duce its product for sale in that country. The product life-cycle theory ignores these
options and, instead, simply argues that once a foreign market is large enough to support
local production, FDI will occur. This limits its explanatory power and its usefulness to
business in that it fails to identify when it is profitable to invest abroad.

THE ECLECTIC PARADIGM The eclectic paradigm has been championed by
the British economist John Dunning. 21 Dunning argues that in addition to the various
factors discussed above, location-specific advantages are also of considerable importance

Multipoint
Competition

Arises when two or more
enterprises encounter
each other in different

regional markets,
national markets,

or industries.

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Chapter Seven Foreign Direct Investment 255

in explaining both the rationale for and the direction of foreign direct investment. By
location-specific advantages , Dunning means the advantages that arise from utilizing
resource endowments or assets that are tied to a particular foreign location and that a
firm finds valuable to combine with its own unique assets (such as the firm’s technologi-
cal, marketing, or management capabilities). Dunning accepts the argument of internal-
ization theory that it is difficult for a firm to license its own unique capabilities and
know-how. Therefore, he argues that combining location-specific assets or resource en-
dowments with the firm’s own unique capabilities often requires foreign direct invest-
ment. That is, it requires the firm to establish production facilities where those foreign
assets or resource endowments are located.
An obvious example of Dunning’s arguments are natural resources, such as oil and
other minerals, which are by their character specific to certain locations. Dunning sug-
gests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this
explains the FDI undertaken by many of the world’s oil companies, which have to in-
vest where oil is located to combine their technological and managerial capabilities
with this valuable location-specific resource. Another obvious example are valuable hu-
man resources, such as low-cost, highly skilled labor. The cost and skill of labor varies
from country to country. Since labor is not internationally mobile, according to Dunning
it makes sense for a firm to locate production facilities in those countries where the
cost and skills of local labor is most suited to its particular production processes.
However, Dunning’s theory has implications that go beyond basic resources such as
minerals and labor. Consider Silicon Valley, which is the world center for the computer
and semiconductor industry. Many of the world’s major computer and semiconductor
companies, such as Apple Computer, Hewlett-Packard, and Intel, are located close to
each other in the Silicon Valley region of California. As a result, much of the cutting-
edge research and product development in computers and semiconductors occurs
there. According to Dunning’s arguments, there is knowledge being generated in Sili-
con Valley with regard to the design and manufacture of computers and semiconduc-
tors that is available nowhere else in the world. To be
sure, as it is commercialized that knowledge diffuses
throughout the world, but the leading edge of knowl-
edge generation in the computer and semiconductor
industries is to be found in Silicon Valley. In Dun-
ning’s language, this means that Silicon Valley has a
location-specific advantage in the generation of knowl-
edge related to the computer and semiconductor in-
dustries. In part, this advantage comes from the sheer
concentration of intellectual talent in this area, and in
part it arises from a network of informal contacts that
allows firms to benefit from each others’ knowledge
generation. Economists refer to such knowledge
“spillovers” as externalities , and a well-established
theory suggests that firms can benefit from such ex-
ternalities by locating close to their source. 22
In so far as this is the case, it makes sense for
foreign computer and semiconductor firms to invest
in research and, perhaps, production facilities so
they too can learn about and utilize valuable new
knowledge before those based elsewhere, thereby
giving them a competitive advantage in the global
marketplace. 23 Evidence suggests that European,
Japanese, South Korean, and Taiwanese computer

Location-Specific
Advantages
Advantages that arise
from utilizing resource
endowments or assets
that are tied to a
particular foreign
location and that a firm
finds valuable to combine
with its own unique
assets (such as the firm’s
technological, marketing,
or management
capabilities).

Externalities
Knowledge spillovers.

Silicon Valley has long been known as the epicenter of the computer and
semiconductor industry.

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256 Part Three Cross-Border Trade and Investment

and semiconductor firms are investing in the Silicon Valley region, precisely because
they wish to benefit from the externalities that arise there. 24 Others have argued that
direct investment by foreign firms in the U.S. biotechnology industry has been mo-
tivated by desires to gain access to the unique location-specific technological knowl-
edge of U.S. biotechnology firms. 25 Dunning’s theory, therefore, seems to be a useful
addition to those outlined above, for it helps explain how location factors affect the
direction of FDI. 26

Political Ideology and Foreign

Direct Investment
Historically, political ideology toward FDI within a nation has ranged from a dog-
matic radical stance that is hostile to all inward FDI at one extreme to an adherence to
the noninterventionist principle of free market economics at the other. Between these
two extremes is an approach that might be called pragmatic nationalism .

THE RADICAL VIEW The radical view traces its roots to Marxist political and
economic theory. Radical writers argue that the multinational enterprise (MNE) is an
instrument of imperialist domination. They see the MNE as a tool for exploiting host
countries to the exclusive benefit of their capitalist-imperialist home countries. They
argue that MNEs extract profits from the host country and take them to their home
country, giving nothing of value to the host country in exchange. They note, for ex-
ample, that key technology is tightly controlled by the MNE, and that important jobs
in the foreign subsidiaries of MNEs go to home-country nationals rather than to citi-
zens of the host country. Because of this, according to the radical view, FDI by the
MNEs of advanced capitalist nations keeps the less developed countries of the world
relatively backward and dependent on advanced capitalist nations for investment, jobs,
and technology. Thus, according to the extreme version of this view, no country should
ever permit foreign corporations to undertake FDI, since they can never be instru-
ments of economic development, only of economic domination. Where MNEs al-
ready exist in a country, they should be immediately nationalized. 27
From 1945 until the 1980s, the radical view was very influential in the world econ-
omy. Until the collapse of communism between 1989 and 1991, the countries of East-
ern Europe were opposed to FDI. Similarly, communist countries elsewhere, such as
China, Cambodia, and Cuba, were all opposed in principle to FDI (although in prac-
tice the Chinese started to allow FDI in mainland China in the 1970s). Many socialist
countries, particularly in Africa where one of the first actions of many newly indepen-
dent states was to nationalize foreign-owned enterprises, also embraced the radical
position. Countries whose political ideology was more nationalistic than socialistic
further embraced the radical position. This was true in Iran and India, for example,
both of which adopted tough policies restricting FDI and nationalized many foreign-
owned enterprises. Iran is a particularly interesting case because its Islamic govern-
ment, while rejecting Marxist theory, has essentially embraced the radical view that
FDI by MNEs is an instrument of imperialism.
By the end of the 1980s, the radical position was in retreat almost everywhere. There
seem to be three reasons for this: (1) the collapse of communism in Eastern Europe;
(2) the generally abysmal economic performance of those countries that embraced the
radical position, and a growing belief by many of these countries that FDI can be an
important source of technology and jobs and can stimulate economic growth; and
(3) the strong economic performance of those developing countries that embraced
capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan).

LEARNING OBJECTIVE 3
Understand how political
ideology shapes a
government’s attitudes
toward FDI.

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Chapter Seven Foreign Direct Investment 257

THE FREE MARKET VIEW The free market view traces its roots to classical
economics and the international trade theories of Adam Smith and David Ricardo (see
Chapter 5). The intellectual case for this view has been strengthened by the internaliza-
tion explanation of FDI. The free market view argues that international production
should be distributed among countries according to the theory of comparative advantage.
Countries should specialize in the production of those goods and services that they can
produce most efficiently. Within this framework, the MNE is an instrument for dispers-
ing the production of goods and services to the most efficient locations around the globe.
Viewed this way, FDI by the MNE increases the overall efficiency of the world economy.
Imagine that Dell decided to move assembly operations for many of its personal
computers from the United States to Mexico to take advantage of lower labor costs in
Mexico. According to the free market view, moves such as this can be seen as increas-
ing the overall efficiency of resource utilization in the world economy. Mexico, due to
its lower labor costs, has a comparative advantage in the assembly of PCs. By moving
the production of PCs from the United States to Mexico, Dell frees U.S. resources for
use in activities in which the United States has a comparative advantage (e.g., the de-
sign of computer software, the manufacture of high-value-added components such as
microprocessors, or basic R&D). Also, consumers benefit because the PCs cost less
than they would if they were produced domestically. In addition, Mexico gains from
the technology, skills, and capital that the PC company transfers with its FDI. Con-
trary to the radical view, the free market view stresses that such resource transfers
benefit the host country and stimulate its economic growth. Thus, the free market
view argues that FDI is a benefit to both the source country and the host country.
For reasons explored earlier in this book (see Chapter 2), the free market view has
been ascendant worldwide in recent years, spurring a global move toward the removal of
restrictions on inward and outward foreign direct investment. However, in practice no
country has adopted the free market view in its pure form (just as no country has adopted
the radical view in its pure form). Countries such as Great Britain and the United States
are among the most open to FDI, but the governments of these countries both have still
reserved the right to intervene. Britain does so by reserving the right to block foreign
takeovers of domestic firms if the takeovers are seen as “contrary to national security in-
terests” or if they have the potential for “reducing competition.” (In practice, the British
government has rarely exercised this right.) U.S. controls on FDI are more limited and
largely informal. For political reasons, the United States will occasionally restrict U.S.
firms from undertaking FDI in certain countries (e.g., Cuba and Iran). In addition, in-
ward FDI meets some limited restrictions. For example, foreigners are prohibited from
purchasing more than 25 percent of any U.S. airline or from acquiring a controlling in-
terest in a U.S. television broadcast network. Since 1988, the government has had the
right to review the acquisition of a U.S. enterprise by a foreign firm on the grounds of
national security. However, of the 1,500 bids reviewed by the Committee on Foreign In-
vestment in the United States under this law by 2008, only one has been nullified: the sale
of a Seattle-based aircraft parts manufacturer to a Chinese enterprise in the early 1990s. 28

PRAGMATIC NATIONALISM In practice, many countries have adopted nei-
ther a radical policy nor a free market policy toward FDI, but instead a policy that can
best be described as pragmatic nationalism. 29 The pragmatic nationalist view is that
FDI has both benefits and costs. FDI can benefit a host country by bringing capital,
skills, technology, and jobs, but those benefits come at a cost. When a foreign company
rather than a domestic company produces products, the profits from that investment go
abroad. Many countries are also concerned that a foreign-owned manufacturing plant
may import many components from its home country, which has negative implications
for the host country’s balance-of-payments position.

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258 Part Three Cross-Border Trade and Investment

Recognizing this, countries adopting a pragmatic stance pursue policies designed to
maximize the national benefits and minimize the national costs. According to this view,
FDI should be allowed so long as the benefits outweigh the costs. Japan offers an example
of pragmatic nationalism. Until the 1980s, Japan’s policy was probably one of the most
restrictive among countries adopting a pragmatic nationalist stance. This was due to
Japan’s perception that direct entry of foreign (especially U.S.) firms with ample manage-
rial resources into the Japanese markets could hamper the development and growth of
their own industry and technology. 30 This belief led Japan to block the majority of appli-
cations to invest in Japan. However, there were always exceptions to this policy. Firms
that had important technology were often permitted to undertake FDI if they insisted
that they would neither license their technology to a Japanese firm nor enter into a joint
venture with a Japanese enterprise. IBM and Texas Instruments were able to set up wholly
owned subsidiaries in Japan by adopting this negotiating position. From the perspective
of the Japanese government, the benefits of FDI in such cases—the stimulus that these
firms might impart to the Japanese economy—outweighed the perceived costs.
Another aspect of pragmatic nationalism is the tendency to aggressively court FDI
believed to be in the national interest by, for example, offering subsidies to foreign
MNEs in the form of tax breaks or grants. The countries of the European Union often
seem to be competing with each other to attract U.S. and Japanese FDI by offering
large tax breaks and subsidies. Britain has been the most successful at attracting Japa-
nese investment in the automobile industry. Nissan, Toyota, and Honda now have
major assembly plants in Britain and use the country as their base for serving the rest
of Europe—with obvious employment and balance-of-payments benefits for Britain.

SHIFTING IDEOLOGY Recent years have seen a marked decline in the number
of countries that adhere to a radical ideology. Although few countries have adopted a pure
free market policy stance, an increasing number of countries are gravitating toward the
free market end of the spectrum and have liberalized their foreign investment regime.
This includes many countries that less than two decades ago were firmly in the radical
camp (e.g., the former communist countries of Eastern Europe and many of the socialist
countries of Africa) and several countries that until recently could best be described as
pragmatic nationalists with regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most
Latin American countries). One result has been the surge in the volume of FDI world-
wide, which, as we noted earlier, has been growing twice as fast as the growth in world
trade. Another result has been an increase in the volume of FDI directed at countries that
have recently liberalized their FDI regimes, such as China, India, and Vietnam.
As a counterpoint, there is recent evidence of the beginnings of what might be-
come a shift to a more hostile approach to foreign direct investment. Venezuela and
Bolivia have become increasingly hostile to foreign direct investment. In 2005 and
2006, the governments of both nations unilaterally rewrote contracts for oil and gas
exploration, raising the royalty rate that foreign enterprises had to pay the govern-
ment for oil and gas extracted in their territories. Bolivian President Evo Morales in
2006 nationalized the nation’s gas fields and stated he would evict foreign firms un-
less they agreed to pay about 80 percent of their revenues to the state and relinquish
production oversight. In some developed nations, too, there is increasing evidence of
hostile reactions to inward FDI. In Europe in 2006, there was a hostile political reac-
tion to the attempted takeover of Europe’s largest steel company, Arcelor, by Mittal
Steel, a global company controlled by the Indian entrepreneur Lakshmi Mittal. In
mid-2005 China National Offshore Oil Company withdrew a takeover bid for
Unocal of the United States after highly negative reaction in Congress about the
proposed takeover of a “strategic asset” by a Chinese company. Similarly, as detailed
in the accompanying Management Focus, in 2006 a Dubai-owned company withdrew

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Chapter Seven Foreign Direct Investment 259

its planned takeover of some operations at six U.S. ports after negative political reac-
tions. So far, these countertrends are nothing more than isolated incidents, but if
they become more widespread, the 30-year movement toward lower barriers to
cross-border investment could be in jeopardy.

Benefits and Costs of FDI
To a greater or lesser degree, many governments can be considered pragmatic nation-
alists when it comes to FDI. Accordingly, their policy is shaped by a consideration of
the costs and benefits of FDI. Here we explore the benefits and costs of FDI, first
from the perspective of a host (receiving) country, and then from the perspective of
the home (source) country. In the next section, we look at the policy instruments gov-
ernments use to manage FDI.

HOST-COUNTRY BENEFITS The main benefits of inward FDI for a host
country arise from resource-transfer effects, employment effects, balance-of-payments
effects, and effects on competition and economic growth.

Resource-Transfer Effects Foreign direct investment can make a positive contri-
bution to a host economy by supplying capital, technology, and management resources
that would otherwise not be available and thus boost that country’s economic growth
rate (as the opening case makes clear, the Japanese government has recently come
around to this view and has adopted a more permissive attitude to inward investment). 31

M a n a g e m e n t F O C U S

DP World and the United States

In February 2006, DP World, a ports operator owned by the
government of Dubai, a member of the United Arab Emir-
ates and a staunch U.S. ally, paid $6.8 billion to acquire
P&O, a British firm that runs a global network of marine
terminals. With P&O came the management operations
of six U.S. ports: Miami, Philadelphia, Baltimore, New
Orleans, New Jersey, and New York. The acquisition had al-
ready been approved by U.S. regulators when it suddenly
became front-page news. Upon hearing about the deal,
several prominent U.S. senators raised concerns about
the acquisition. Their objections were twofold. First, they
raised questions about the security risks associated with
management operations in key U.S. ports being owned by
a foreign enterprise that was based in the Middle East.
The implication was that terrorists could somehow take
advantage of the ownership arrangement to infiltrate U.S.
ports. Second, they were concerned that DP World was a
state-owned enterprise and argued that foreign govern-
ments should not be in a position of owning key “U.S. stra-
tegic assets.”
The Bush administration was quick to defend the takeover,
stating that it posed no threat to national security. Others
noted that DP World was a respected global firm with an

American chief operating officer and an American-educated
chairman; the head of the global ports management opera-
tion would also be an American. DP World would not own the
U.S. ports in question, just manage them, while security is-
sues would remain in the hands of U.S. customs officials and
the U.S. Coast Guard. Dubai was also a member of America’s
Container Security Initiative, which allows U.S. customs offi-
cials to inspect cargo in foreign ports before it leaves for the
United States. Most of the DP World employees at American
ports would be U.S. citizens, and any UAE citizen transferred
to DP World would be subject to American visa approval.
These arguments fell on deaf ears. With several U.S.
senators threatening to pass legislation to prohibit foreign
ownership of U.S. port operations, DP World bowed to the
inevitable and announced it would sell the right to manage
the six U.S. ports for about $750 million. Looking forward,
however, DP World stated it would seek an initial public
offering in 2007, and that the then-private firm would in all
probability continue to look for ways to enter the United
States. In the words of the firm’s CEO, “This is the world’s
largest economy. How can you just ignore it?”
Sources: “Trouble at the Waterfront,” The Economist , February 25, 2006,
p. 48; “Paranoia about Dubai Ports Deals Is Needless,” Financial Times,
February 21, 2006, p. 16; and “DP World: We’ll Be Back,” Traffic World ,
May 29, 2006, p. 1.

LEARNING OBJECTIVE 4
Describe the benefits and
costs of FDI to home and

host countries.

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260 Part Three Cross-Border Trade and Investment

With regard to capital, many MNEs, by virtue of their large size and financial strength,
have access to financial resources not available to host-country firms. These funds may be
available from internal company sources, or, because of their reputation, large MNEs
may find it easier to borrow money from capital markets than host-country firms would.
As for technology, you will recall from Chapter 2 that technology can stimulate
economic development and industrialization. Technology can take two forms, both of
which are valuable. Technology can be incorporated in a production process (e.g., the
technology for discovering, extracting, and refining oil) or it can be incorporated in a
product (e.g., personal computers). However, many countries lack the research and
development resources and skills required to develop their own indigenous product
and process technology. This is particularly true in less developed nations. Such coun-
tries must rely on advanced industrialized nations for much of the technology required
to stimulate economic growth, and FDI can provide it.
Research supports the view that multinational firms often transfer significant tech-
nology when they invest in a foreign country. 32 For example, a study of FDI in Sweden
found that foreign firms increased both the labor and total factor productivity of
Swedish firms that they acquired, suggesting that significant technology transfers had
occurred (technology typically boosts productivity). 33 Also, a study of FDI by the Or-
ganization for Economic Cooperation and Development (OECD) found that foreign
investors invested significant amounts of capital in R&D in the countries in which
they had invested, suggesting that not only were they transferring technology to those
countries, but they may also have been upgrading existing technology or creating new
technology in those countries. 34
Foreign management skills acquired through FDI may also produce important
benefits for the host country. Foreign managers trained in the latest management
techniques can often help to improve the efficiency of operations in the host coun-
try, whether those operations are acquired or greenfield developments. Beneficial
spin-off effects may also arise when local personnel who are trained to occupy man-
agerial, financial, and technical posts in the subsidiary of a foreign MNE leave the
firm and help to establish indigenous firms. Similar benefits may arise if the superior
management skills of a foreign MNE stimulate local suppliers, distributors, and

competitors to improve their own management
skills.

Employment Effects Another beneficial em-
ployment effect claimed for FDI is that it brings
jobs to a host country that would otherwise not be
created there. The effects of FDI on employment
are both direct and indirect. Direct effects arise
when a foreign MNE employs a number of host-
country citizens. Indirect effects arise when jobs
are created in local suppliers as a result of the in-
vestment and when jobs are created because of in-
creased local spending by employees of the MNE.
The indirect employment effects are often as large
as, if not larger than, the direct effects. For exam-
ple, when Toyota decided to open a new auto plant
in France, estimates suggested the plant would
create 2,000 direct jobs and perhaps another 2,000
jobs in support industries. 35

Cynics argue that not all the “new jobs” created
by FDI represent net additions in employment.

A n o t h e r P e r s p e c t i v e
Uganda Reaches Out to Foreign Investors
Unlikely though it may seem, the East African nation of
Uganda is making strides in attracting foreign direct in-
vestment. Once the scene of bloody unrest and tribal war,
today this landlocked country (bordered by Congo, Kenya,
Rwanda, and Tanzania) works to maintain stable economic
policies and provide the kind of predictable environment
that makes foreign investment more appealing. Aided by its
Investment Authority, a government body established to
promote foreign investment, Uganda has attracted busi-
nesses in the agriculture, banking, energy, insurance, min-
ing, and telecommunications sectors. Foreign direct
investment has brought jobs, improved Uganda’s communi-
cations and financial services sectors, and generally en-
hanced its infrastructure. (Keith Kallyegira, “Uganda Tops
Region in FDIs,” New Vision Online, February 18, 2010,
www.newvision.co.ug)

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Chapter Seven Foreign Direct Investment 261

In the case of FDI by Japanese auto companies in the United States, some argue that
the jobs created by this investment have been more than offset by the jobs lost in U.S.-
owned auto companies, which have lost market share to their Japanese competitors. As
a consequence of such substitution effects, the net number of new jobs created by FDI
may not be as great as initially claimed by an MNE. The issue of the likely net gain in
employment may be a major negotiating point between an MNE wishing to under-
take FDI and the host government.
When FDI takes the form of an acquisition of an established enterprise in the host
economy as opposed to a greenfield investment, the immediate effect may be to re-
duce employment as the multinational tries to restructure the operations of the ac-
quired unit to improve its operating efficiency. However, even in such cases, research
suggests that once the initial period of restructuring is over, enterprises acquired by
foreign firms tend to grow their employment base at a faster rate than domestic rivals.
For example, an OECD study found that foreign firms created new jobs at a faster rate
than their domestic counterparts. 36 In America, the workforce of foreign firms grew by
1.4 percent per year, compared with 0.8 percent per year for domestic firms. In Britain
and France, the workforce of foreign firms grew at 1.7 percent per year, while employ-
ment at domestic firms fell by 2.7 percent. The same study found that foreign firms
tended to pay higher wage rates than domestic firms, suggesting that the quality of
employment was better. Another study looking at FDI in Eastern European transition
economies found that although employment fell following the acquisition of an enter-
prise by a foreign firm, often those enterprises were in competitive difficulties and
would not have survived if they had not been acquired. Also, after an initial period of
adjustment and retrenchment, employment downsizing was often followed by new
investments, and employment either remained stable or increased. 37

Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments ac-
counts is an important policy issue for most host governments. A country’s balance-of-
payments accounts track both its payments to and its receipts from other countries.
Governments normally are concerned when their country is running a deficit on the cur-
rent account of their balance of payments. The current account tracks the export and
import of goods and services. A current account deficit, or trade deficit as it is often called,
arises when a country is importing more goods and services than it is exporting. Govern-
ments typically prefer to see a current account surplus rather than a deficit. The only way
in which a current account deficit can be supported in the long run is by selling assets to
foreigners (for a detailed explanation of why this is the case, see the appendix to Chapter
5). For example, the persistent U.S. current account deficit since the 1980s has been fi-
nanced by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations)
to foreigners. Since national governments invariably dislike seeing the assets of their
country fall into foreign hands, they prefer their nation to run a current account surplus.
There are two ways in which FDI can help a country to achieve this goal.
First, if the FDI is a substitute for imports of goods or services, the effect can be to
improve the current account of the host country’s balance of payments. Much of the
FDI by Japanese automobile companies in the United States and Europe, for example,
can be seen as substituting for imports from Japan. Thus, the current account of the
U.S. balance of payments has improved somewhat because many Japanese companies
are now supplying the U.S. market from production facilities in the United States, as
opposed to facilities in Japan. Insofar as this has reduced the need to finance a current
account deficit by asset sales to foreigners, the United States has clearly benefited.
A second potential benefit arises when the MNE uses a foreign subsidiary to export
goods and services to other countries. According to a UN report, inward FDI by foreign
multinationals has been a major driver of export-led economic growth in a number of

Balance-of-
Payments Accounts
National accounts that
track both payments to
and receipts from other
countries.

Current Account
In the balance of
payments, records
transactions involving the
export and import of
goods and services.

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262 Part Three Cross-Border Trade and Investment

developing and developed nations over the last decade. 38 For example, in China exports
increased from $26 billion in 1985 to more than $250 billion by 2001 and to $969 billion
in 2006. Much of this dramatic export growth was due to the presence of foreign multi-
nationals that invested heavily in China during the 1990s. The subsidiaries of foreign
multinationals accounted for 50 percent of all exports from that country in 2001, up
from 17 percent in 1991. In mobile phones, for example, the Chinese subsidiaries of
foreign multinationals—primarily Nokia, Motorola, Ericsson, and Siemens—accounted
for 95 percent of China’s exports.

Effect on Competition and Economic Growth Economic theory tells us that
the efficient functioning of markets depends on an adequate level of competition between
producers. When FDI takes the form of a greenfield investment, the result is to establish a
new enterprise, increasing the number of players in a market and thus consumer choice. In
turn, this can increase the level of competition in a national market, thereby driving down
prices and increasing the economic welfare of consumers. Increased competition tends to
stimulate capital investments by firms in plant, equipment, and R&D as they struggle to
gain an edge over their rivals. The long-term results may include increased productivity
growth, product and process innovations, and greater economic growth. 39 Such beneficial
effects seem to have occurred in the South Korean retail sector following the liberalization
of FDI regulations in 1996. FDI by large Western discount stores, including Walmart,
Costco, Carrefour, and Tesco, seems to have encouraged indigenous discounters such as
E-Mart to improve the efficiency of their own operations. The results have included more
competition and lower prices, which benefit South Korean consumers.
FDI’s impact on competition in domestic markets may be particularly important in
the case of services, such as telecommunications, retailing, and many financial services,
where exporting is often not an option because the service has to be produced where it
is delivered. 40 For example, under a 1997 agreement sponsored by the World Trade
Organization, 68 countries accounting for more than 90 percent of world telecommu-
nications revenues pledged to start opening their markets to foreign investment and
competition and to abide by common rules for fair competition in telecommunications.
Before this agreement, most of the world’s telecommunications markets were closed to
foreign competitors, and in most countries the market was monopolized by a single
carrier, which was often a state-owned enterprise. The agreement has dramatically in-
creased the level of competition in many national telecommunications markets produc-
ing two major benefits. First, inward investment has increased competition and
stimulated investment in the modernization of telephone networks around the world,
leading to better service. Second, the increased competition has resulted in lower prices.

HOST-COUNTRY COSTS Three costs of FDI concern host countries. They
arise from possible adverse effects on competition within the host nation, adverse effects
on the balance of payments, and the perceived loss of national sovereignty and autonomy.

Adverse Effects on Competition Host governments sometimes worry that the
subsidiaries of foreign MNEs may have greater economic power than indigenous
competitors. If it is part of a larger international organization, the foreign MNE may
be able to draw on funds generated elsewhere to subsidize its costs in the host market,
which could drive indigenous companies out of business and allow the firm to mo-
nopolize the market. Once the market is monopolized, the foreign MNE could raise
prices above those that would prevail in competitive markets, with harmful effects on
the economic welfare of the host nation. This concern tends to be greater in countries
that have few large firms of their own (generally less developed countries). It tends to
be a relatively minor concern in most advanced industrialized nations.

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Chapter Seven Foreign Direct Investment 263

In general, while FDI in the form of greenfield investments should increase competi-
tion, it is less clear that this is the case when the FDI takes the form of acquisition of an
established enterprise in the host nation, as was the case when Cemex acquired RMC is
Britain (see the Management Focus, “Foreign Direct Investment by Cemex”). Because an
acquisition does not result in a net increase in the number of players in a market, the ef-
fect on competition may be neutral. When a foreign investor acquires two or more firms
in a host country, and subsequently merges them, the effect may be to reduce the level of
competition in that market, create monopoly power for the foreign firm, reduce con-
sumer choice, and raise prices. For example, in India, Hindustan Lever Ltd., the Indian
subsidiary of Unilever, acquired its main local rival, Tata Oil Mills, to assume a dominant
position in the bath soap (75 percent) and detergents (30 percent) markets. Hindustan
Lever also acquired several local companies in other markets, such as the ice cream mak-
ers Dollops, Kwality, and Milkfood. By combining these companies, Hindustan Lever’s
share of the Indian ice cream market went from zero in 1992 to 74 percent in 1997. 41
However, although such cases are of obvious concern, there is little evidence that such
developments are widespread. In many nations, domestic competition authorities have
the right to review and block any mergers or acquisitions that they view as having a det-
rimental impact on competition. If such institutions are operating effectively, this should
be sufficient to make sure that foreign entities do not monopolize a country’s markets.

Adverse Effects on the Balance of Payments The possible adverse effects
of FDI on a host country’s balance-of-payments position are twofold. First, set against
the initial capital inflow that comes with FDI must be the subsequent outflow of earn-
ings from the foreign subsidiary to its parent company. Such outflows show up as
capital outflow on balance of payments accounts. Some governments have responded
to such outflows by restricting the amount of earnings that can be repatriated to a
foreign subsidiary’s home country. A second concern arises when a foreign subsidiary
imports a substantial number of its inputs from abroad, which results in a debit on the
current account of the host country’s balance of payments. One criticism leveled
against Japanese-owned auto assembly operations in the United States, for example, is
that they tend to import many component parts from Japan. Because of this, the favor-
able impact of this FDI on the current account of the U.S. balance-of-payments posi-
tion may not be as great as initially supposed. The Japanese auto companies responded
to these criticisms by pledging to purchase 75 percent of their component parts from
U.S.-based manufacturers (but not necessarily U.S.-owned manufacturers). When the
Japanese auto company Nissan invested in the United Kingdom, Nissan responded to
concerns about local content by pledging to increase the proportion of local content
to 60 percent and subsequently raising it to more than 80 percent.

National Sovereignty and Autonomy Some host governments worry that FDI
is accompanied by some loss of economic independence. The concern is that key deci-
sions that can affect the host country’s economy will be made by a foreign parent that
has no real commitment to the host country, and over which the host country’s gov-
ernment has no real control. Most economists dismiss such concerns as groundless
and irrational. Political scientist Robert Reich has noted that such concerns are the
product of outmoded thinking because they fail to account for the growing interde-
pendence of the world economy. 42 In a world in which firms from all advanced nations
are increasingly investing in each other’s markets, it is not possible for one country to
hold another to “economic ransom” without hurting itself.

HOME-COUNTRY BENEFITS The benefits of FDI to the home (source)
country arise from three sources. First, the home country’s balance of payments benefits

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264 Part Three Cross-Border Trade and Investment

from the inward flow of foreign earnings. FDI can
also benefit the home country’s balance of payments
if the foreign subsidiary creates demands for home-
country exports of capital equipment, intermediate
goods, complementary products, and the like.

Second, benefits to the home country from out-
ward FDI arise from employment effects. As with the
balance of payments, positive employment effects
arise when the foreign subsidiary creates demand for
home-country exports. Thus, Toyota’s investment in
auto assembly operations in Europe has benefited
both the Japanese balance-of-payments position and
employment in Japan, because Toyota imports some
component parts for its European-based auto assem-
bly operations directly from Japan.

Third, benefits arise when the home-country
MNE learns valuable skills from its exposure to for-
eign markets that can subsequently be transferred
back to the home country. This amounts to a re-
verse resource-transfer effect. Through its exposure
to a foreign market, an MNE can learn about supe-
rior management techniques and superior product
and process technologies. These resources can then
be transferred back to the home country, contribut-
ing to the home country’s economic growth rate. 43

For example, one reason General Motors and Ford invested in Japanese automobile
companies (GM owned part of Isuzu, and Ford owns part of Mazda) was to learn about
their production processes. If GM and Ford are successful in transferring this know-
how back to their U.S. operations, the result may be a net gain for the U.S. economy.

HOME-COUNTRY COSTS Against these benefits must be set the apparent
costs of FDI for the home (source) country. The most important concerns center on the
balance-of-payments and employment effects of outward FDI. The home country’s bal-
ance of payments may suffer in three ways. First, the balance of payments suffers from
the initial capital outflow required to finance the FDI. This effect, however, is usually
more than offset by the subsequent inflow of foreign earnings. Second, the current ac-
count of the balance of payments suffers if the purpose of the foreign investment is to
serve the home market from a low-cost production location. Third, the current account
of the balance of payments suffers if the FDI is a substitute for direct exports. Thus, in-
sofar as Toyota’s assembly operations in the United States are intended to substitute for
direct exports from Japan, the current account position of Japan will deteriorate.

With regard to employment effects, the most serious concerns arise when FDI is
seen as a substitute for domestic production. This was the case with Toyota’s invest-
ments in the United States and Europe. One obvious result of such FDI is reduced
home-country employment. If the labor market in the home country is already
tight, with little unemployment, this concern may not be that great. However, if the
home country is suffering from unemployment, concern about the export of jobs
may arise. For example, one objection frequently raised by U.S. labor leaders to the
free trade pact between the United States, Mexico, and Canada (see the next chap-
ter) is that the United States will lose hundreds of thousands of jobs as U.S. firms
invest in Mexico to take advantage of cheaper labor and then export back to the
United States. 44

A n o t h e r P e r s p e c t i v e
FDI Effects: Look at the Whole Picture
Some critics of globalization suggest that FDI is an ad-
vanced form of colonialism that destroys local cultures in
developing countries. What these critics say may have
some limited validity, but it isn’t the whole picture. Take
Freeport McMoRan, a U.S.-based mining company with op-
erations in West Papua, the former Irian Jaya, Indonesia,
where the world’s largest gold, mineral, and copper re-
serves have been found. Freeport formed a joint venture
with the Indonesian government to mine a concession, an
isolated tract of land the size of Massachusetts on a remote
island, half of which is the country of Papua New Guinea.
Freeport has brought education, Internet connections,
world-class health care, and the modern world to the iso-
lated local tribes in West Papua, nomadic peoples who
wear loincloths and hunt in the forest. Their traditional,
subsistence way of life is threatened, while at the same
time, they gain from their share of the operation’s profits,
from their increased health care and education, and from
local employment opportunities with FCX. Is this colonial-
ism or a kind of ethical investing? See more on this issue at
www.FCX.com and www.corpwatch.org.

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Chapter Seven Foreign Direct Investment 265

INTERNATIONAL TRADE THEORY AND FDI When assessing the costs
and benefits of FDI to the home country, keep in mind the lessons of international
trade theory (see Chapter 5). International trade theory tells us that home-country
concerns about the negative economic effects of offshore production may be misplaced.
The term offshore production refers to FDI undertaken to serve the home market.
Far from reducing home-country employment, such FDI may actually stimulate eco-
nomic growth (and hence employment) in the home country by freeing home-country
resources to concentrate on activities where the home country has a comparative ad-
vantage. In addition, home-country consumers benefit if the price of the particular
product falls as a result of the FDI. Also, if a company were prohibited from making
such investments on the grounds of negative employment effects while its international
competitors reaped the benefits of low-cost production locations, it would undoubtedly
lose market share to its international competitors. Under such a scenario, the adverse
long-run economic effects for a country would probably outweigh the relatively minor
balance-of-payments and employment effects associated with offshore production.

Government Policy Instruments and FDI
We have now reviewed the costs and benefits of FDI from the perspective of both
home country and host country. We now turn our attention to the policy instruments
that home (source) countries and host countries can use to regulate FDI.

HOME-COUNTRY POLICIES Through their choice of policies, home coun-
tries can both encourage and restrict FDI by local firms. We look at policies designed
to encourage outward FDI first. These include foreign risk insurance, capital assis-
tance, tax incentives, and political pressure. Then we will look at policies designed to
restrict outward FDI.

Encouraging Outward FDI Many investor nations now have government-
backed insurance programs to cover major types of foreign investment risk. The types
of risks insurable through these programs include the risks of expropriation (national-
ization), war losses, and the inability to transfer profits back home. Such programs are
particularly useful in encouraging firms to undertake investments in politically unsta-
ble countries. 45 In addition, several advanced countries also have special funds or banks
that make government loans to firms wishing to invest in developing countries. As a
further incentive to encourage domestic firms to undertake FDI, many countries have
eliminated double taxation of foreign income (i.e., taxation of income in both the host
country and the home country). Last, and perhaps most significant, a number of inves-
tor countries (including the United States) have used their political influence to per-
suade host countries to relax their restrictions on inbound FDI. For example, in
response to direct U.S. pressure, Japan relaxed many of its formal restrictions on in-
ward FDI in the 1980s. Now, in response to further U.S. pressure, Japan moved to-
ward relaxing its informal barriers to inward FDI. One beneficiary of this trend has
been Toys “R” Us, which, after five years of intensive lobbying by company and U.S.
government officials, opened its first retail stores in Japan in December 1991. By 2009,
Toys “R” Us had more 170 stores in Japan, and its Japanese operation, in which Toys
“R” Us retained a controlling stake, had a listing on the Japanese stock market.

Restricting Outward FDI Virtually all investor countries, including the United
States, have exercised some control over outward FDI from time to time. One policy
has been to limit capital outflows out of concern for the country’s balance of payments.
From the early 1960s until 1979, for example, Britain had exchange-control regulations

Offshore
Production
FDI undertaken to serve
the home market.

LEARNING OBJECTIVE 5
Explain the range of

policy instruments
that governments

use to influence FDI.

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266 Part Three Cross-Border Trade and Investment

that limited the amount of capital a firm could take out of the country. Although the
main intent of such policies was to improve the British balance of payments, an impor-
tant secondary intent was to make it more difficult for British firms to undertake FDI.
In addition, countries have occasionally manipulated tax rules to try to encourage
their firms to invest at home. The objective behind such policies is to create jobs at
home rather than in other nations. At one time, Britain adopted such policies. The
British advance corporation tax system taxed British companies’ foreign earnings at a
higher rate than their domestic earnings. This tax code created an incentive for British
companies to invest at home.
Finally, countries sometimes prohibit national firms from investing in certain coun-
tries for political reasons. Such restrictions can be formal or informal. For example,
formal U.S. rules prohibited U.S. firms from investing in countries such as Cuba and
Iran, whose political ideology and actions are judged to be contrary to U.S. interests.
Similarly, during the 1980s, informal pressure was applied to dissuade U.S. firms from
investing in South Africa. In this case, the objective was to pressure South Africa to
change its apartheid laws, which happened during the early 1990s.

HOST-COUNTRY POLICIES Host countries adopt policies designed both to
restrict and to encourage inward FDI. As noted earlier in this chapter, political ideology
has determined the type and scope of these policies in the past. In the last decade of the
twentieth century, many countries moved quickly away from a situation where they ad-
hered to some version of the radical stance and prohibited much FDI and toward a situa-
tion where a combination of free market objectives and pragmatic nationalism took hold.

Encouraging Inward FDI It is common for governments to offer incentives to for-
eign firms to invest in their countries. Such incentives take many forms, but the most
common are tax concessions, low-interest loans, and grants or subsidies. Incentives are
motivated by a desire to gain from the resource-transfer and employment effects of FDI.
They are also motivated by a desire to capture FDI away from other potential host coun-
tries. For example, in the mid-1990s, the governments of Britain and France competed
with each other on the incentives they offered Toyota to invest in their respective coun-
tries. In the United States, state governments often compete with each other to attract
FDI. For example, Kentucky offered Toyota an incentive package worth $112 million to

persuade it to build its U.S. automobile assembly plants
there. The package included tax breaks, new state
spending on infrastructure, and low-interest loans. 46

Restricting Inward FDI Host governments
use a wide range of controls to restrict FDI in one
way or another. The two most common are owner-
ship restraints and performance requirements.
Ownership restraints can take several forms. In
some countries, foreign companies are excluded
from specific fields. They are excluded from to-
bacco and mining in Sweden and from the develop-
ment of certain natural resources in Brazil, Finland,
and Morocco. In other industries, foreign owner-
ship may be permitted although a significant pro-
portion of the equity of the subsidiary must be
owned by local investors. Foreign ownership is re-
stricted to 25 percent or less of an airline in the United
States. In India, foreign firms were prohibited from

Often governments provide incentives to attract foreign firms. For
example, Kentucky offered Toyota an incentive package worth $112
million to build its assembly plant there.

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Chapter Seven Foreign Direct Investment 267

owning media businesses until 2001, when the rules were relaxed, allowing foreign
firms to purchase up to 26 percent of a newspaper. 47
The rationale underlying ownership restraints seems to be twofold. First, foreign
firms are often excluded from certain sectors on the grounds of national security or
competition. Particularly in less developed countries, the feeling seems to be that local
firms might not be able to develop unless foreign competition is restricted by a com-
bination of import tariffs and controls on FDI. This is a variant of the infant industry
argument discussed in Chapter 6.
Second, ownership restraints seem to be based on a belief that local owners can
help to maximize the resource-transfer and employment benefits of FDI for the host
country. Until the early 1980s, the Japanese government prohibited most FDI but al-
lowed joint ventures between Japanese firms and foreign MNEs if the MNE had a
valuable technology. The Japanese government clearly believed such an arrangement
would speed up the subsequent diffusion of the MNE’s valuable technology through-
out the Japanese economy.
Performance requirements can also take several forms. Performance requirements
are controls over the behavior of the MNE’s local subsidiary. The most common per-
formance requirements are related to local content, exports, technology transfer, and
local participation in top management. As with certain ownership restrictions, the
logic underlying performance requirements is that such rules help to maximize the
benefits and minimize the costs of FDI for the host country. Many countries employ
some form of performance requirements when it suits their objectives. However, per-
formance requirements tend to be more common in less developed countries than in
advanced industrialized nations. 48

INTERNATIONAL INSTITUTIONS AND THE LIBERALIZATION OF
FDI Until the 1990s, there was no consistent involvement by multinational institu-
tions in the governing of FDI. This changed with the formation of the World Trade
Organization in 1995. The WTO embraces the promotion of international trade in
services. Since many services have to be produced where they are sold, exporting is not
an option (for example, one cannot export McDonald’s hamburgers or consumer
banking services). Given this, the WTO has become involved in regulations governing
FDI. As might be expected for an institution created to promote free trade, the thrust
of the WTO’s efforts has been to push for the liberalization of regulations governing
FDI, particularly in services. Under the auspices of the WTO, two extensive multina-
tional agreements were reached in 1997 to liberalize trade in telecommunications and
financial services. Both these agreements contained detailed clauses that require signa-
tories to liberalize their regulations governing inward FDI, essentially opening their
markets to foreign telecommunications and financial services companies.
The WTO has had less success trying to initiate talks aimed at establishing a univer-
sal set of rules designed to promote the liberalization of FDI. Led by Malaysia and India,
developing nations have so far rejected efforts by the WTO to start such discussions. In
an attempt to make some progress on this issue, the OECD in 1995 initiated talks
between its members. The aim of the talks was to draft a multilateral agreement on
investment (MAI) that would make it illegal for signatory states to discriminate against
foreign investors. This would liberalize rules governing FDI between OECD states.
These talks broke down in early 1998, primarily because the United States refused
to sign the agreement. According to the United States, the proposed agreement con-
tained too many exceptions that would weaken its powers. For example, the proposed
agreement would not have barred discriminatory taxation of foreign-owned companies,
and it would have allowed countries to restrict foreign television programs and music
in the name of preserving culture. Environmental and labor groups also campaigned

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268 Part Three Cross-Border Trade and Investment

against the MAI, criticizing the proposed agreement because it contained no binding
environmental or labor agreements. Despite such setbacks, negotiations on a revised
MAI treaty might restart in the future. As noted earlier, many individual nations have
continued to liberalize their policies governing FDI to encourage foreign firms to in-
vest in their economies. 49

Focus on Managerial Implications

Several implications for business are inherent in the material discussed in this chapter.
In this section, we deal first with the implications of the theory and then turn our at-
tention to the implications of government policy.

The Theory of FDI
The implications of the theories of FDI for business practice are straightforward.
First, it is worth noting that the location-specific advantages argument associated with
John Dunning does help explain the direction of FDI. However, the location-specific
advantages argument does not explain why firms prefer FDI to licensing or to export-
ing. In this regard, from both an explanatory and a business perspective perhaps the
most useful theories are those that focus on the limitations of exporting and licensing;
that is, internalization theories. These theories are useful because they identify with
some precision how the relative profitability of foreign direct investment, exporting,
and licensing vary with circumstances. The theories suggest that exporting is prefera-
ble to licensing and FDI so long as transportation costs are minor and trade barriers
are trivial. As transportation costs or trade barriers increase, exporting becomes un-
profitable, and the choice is between FDI and licensing. Since FDI is more costly and
more risky than licensing, other things being equal, the theories argue that licensing is
preferable to FDI. Other things are seldom equal, however. Although licensing may
work, it is not an attractive option when one or more of the following conditions exist:
( a ) the firm has valuable know-how that cannot be adequately protected by a licensing
contract, ( b ) the firm needs tight control over a foreign entity to maximize its market
share and earnings in that country, and ( c ) a firm’s skills and capabilities are not ame-
nable to licensing. Figure 7.6 presents these considerations as a decision tree.
Firms for which licensing is not a good option tend to be clustered in three types of
industries:

1. High-technology industries in which protecting firm-specific expertise is of
paramount importance and licensing is hazardous.

2. Global oligopolies, in which competitive interdependence requires that
multinational firms maintain tight control over foreign operations so that they
have the ability to launch coordinated attacks against their global competitors.

3. Industries in which intense cost pressures require that multinational firms
maintain tight control over foreign operations (so that they can disperse
manufacturing to locations around the globe where factor costs are most favorable
in order to minimize costs).

Although empirical evidence is limited, the majority of the evidence seems to support
these conjectures. 50 In addition, licensing is not a good option if the competitive ad-
vantage of a firm is based upon managerial or marketing knowledge that is embedded

LEARNING OBJECTIVE 6
Identify the implications for
management practice of the
theory and government
policies associated with FDI.

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Chapter Seven Foreign Direct Investment 269

in the routines of the firm or the skills of its managers, and that is difficult to codify in
a “book of blueprints.” This would seem to be the case for firms based in a fairly wide
range of industries.
Firms for which licensing is a good option tend to be in industries whose conditions
are opposite to those specified above. That is, licensing tends to be more common, and
more profitable, in fragmented, low-technology industries in which globally dispersed
manufacturing is not an option. A good example is the fast-food industry. McDonald’s
has expanded globally by using a franchising strategy. Franchising is essentially the ser-
vice-industry version of licensing, although it normally involves much longer-term com-
mitments than licensing. With franchising, the firm licenses its brand name to a foreign
firm in return for a percentage of the franchisee’s profits. The franchising contract spec-
ifies the conditions that the franchisee must fulfill if it is to use the franchisor’s brand
name. Thus McDonald’s allows foreign firms to use its brand name so long as they agree
to run their restaurants on exactly the same lines as McDonald’s restaurants elsewhere in
the world. This strategy makes sense for McDonald’s because ( a ) like many services, fast
food cannot be exported; ( b ) franchising economizes the costs and risks associated with
opening up foreign markets; ( c ) unlike technological know-how, brand names are rela-
tively easy to protect using a contract; ( d ) there is no compelling reason for McDonald’s

Export

FDI
FDI
FDI

Then license

Low

High

Yes

Yes
No
Yes
No

Is tight control over
foreign operation

required?

How high are
transportation

costs and tariffs?

Is know-how
amenable to

licensing?

Can know-how be
protected by

licensing contract?

7.6 figure

A Decision Framework

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270 Part Three Cross-Border Trade and Investment

to have tight control over franchisees; and ( e ) McDonald’s know-how, in terms of how to
run a fast-food restaurant, is amenable to being specified in a written contract (e.g., the
contract specifies the details of how to run a McDonald’s restaurant).
Finally, it should be noted that the product life-cycle theory and Knickerbocker’s the-
ory of FDI tend to be less useful from a business perspective. The problem with these two
theories is that they are descriptive rather than analytical. They do a good job of describ-
ing the historical evolution of FDI, but they do a relatively poor job of identifying the
factors that influence the relative profitability of FDI, licensing, and exporting. Indeed,
the issue of licensing as an alternative to FDI is ignored by both of these theories.

Government Policy
A host government’s attitude toward FDI should be an important variable in decisions
about where to locate foreign production facilities and where to make a foreign direct
investment. Other things being equal, investing in countries that have permissive pol-
icies toward FDI is clearly preferable to investing in countries that restrict FDI.
However, often the issue is not this straightforward. Despite the move toward a free
market stance in recent years, many countries still have a rather pragmatic stance to-
ward FDI. In such cases, a firm considering FDI must often negotiate the specific
terms of the investment with the country’s government. Such negotiations center on
two broad issues. If the host government is trying to attract FDI, the central issue is
likely to be the kind of incentives the host government is prepared to offer to the
MNE and what the firm will commit in exchange. If the host government is uncertain
about the benefits of FDI and might choose to restrict access, the central issue is likely
to be the concessions that the firm must make to be allowed to go forward with a pro-
posed investment.
To a large degree, the outcome of any negotiated agreement depends on the relative
bargaining power of both parties. Each side’s bargaining power depends on three factors:

• The value each side places on what the other has to offer.
• The number of comparable alternatives available to each side.
• Each party’s time horizon.

From the perspective of a firm negotiating the terms of an investment with a host
government, the firm’s bargaining power is high when the host government places a high
value on what the firm has to offer, the number of comparable alternatives open to the
firm is greater, and the firm has a long time in which to complete the negotiations. The
converse also holds. The firm’s bargaining power is low when the host government places
a low value on what the firm has to offer, the number of comparable alternatives open to
the firm is fewer, and the firm has a short time in which to complete the negotiations. 51

greenfield investment, p. 243
flow of FDI, p. 243
stock of FDI, p. 243
outflows of FDI, p. 243
inflows of FDI, p. 243
gross fixed capital formation, p. 246

eclectic paradigm, p. 250
exporting, p. 250
licensing, p. 250
internalization theory, p. 252
oligopoly, p. 253

multipoint competition, p. 254
location-specific advantages, p. 255
balance-of-payments accounts, p. 261
current account, p. 261
offshore production, p. 265

Key Terms

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Chapter Seven Foreign Direct Investment 271

Summary

The objectives of this chapter were to review theo-
ries that attempt to explain the pattern of FDI
between countries and to examine the influence of
governments on firms’ decisions to invest in foreign
countries. The following points were made:

1. Any theory seeking to explain FDI must
explain why firms go to the trouble of
acquiring or establishing operations abroad,
when the alternatives of exporting and
licensing are available to them.

2. High transportation costs or tariffs imposed on
imports help explain why many firms prefer
FDI or licensing over exporting.

3. Firms often prefer FDI to licensing when
( a) a firm has valuable know-how that cannot
be adequately protected by a licensing
contract, ( b) a firm needs tight control over a
foreign entity in order to maximize its market
share and earnings in that country, and (c ) a
firm’s skills and capabilities are not amenable
to licensing.

4. Knickerbocker’s theory suggests that much
FDI is explained by imitative behavior by rival
firms in an oligopolistic industry.

5. Vernon’s product life-cycle theory suggests
that firms undertake FDI at particular stages
in the life cycle of products they have
pioneered. However, Vernon’s theory does not
address the issue of whether FDI is more
efficient than exporting or licensing for
expanding abroad.

6. Dunning has argued that location-specific
advantages are of considerable importance in
explaining the nature and direction of FDI.
According the Dunning, firms undertake FDI
to exploit resource endowments or assets that
are location specific.

7. Political ideology is an important determinant
of government policy toward FDI. Ideology
ranges from a radical stance that is hostile to
FDI to a noninterventionist, free market
stance. Between the two extremes is an
approach best described as pragmatic
nationalism.

8. Benefits of FDI to a host country arise from
resource transfer effects, employment effects,
and balance-of-payments effects.

9. The costs of FDI to a host country include
adverse effects on competition and balance of
payments and a perceived loss of national
sovereignty.

10. The benefits of FDI to the home (source)
country include improvement in the balance of
payments as a result of the inward flow of
foreign earnings, positive employment effects
when the foreign subsidiary creates demand for
home-country exports, and benefits from a
reverse resource-transfer effect. A reverse
resource-transfer effect arises when the foreign
subsidiary learns valuable skills abroad that can
be transferred back to the home country.

11. The costs of FDI to the home country
include adverse balance-of-payments effects
that arise from the initial capital outflow and
from the export substitution effects of FDI.
Costs also arise when FDI exports jobs
abroad.

12. Home countries can adopt policies designed
to both encourage and restrict FDI. Host
countries try to attract FDI by offering
incentives and try to restrict FDI by dictating
ownership restraints and requiring that foreign
MNEs meet specific performance
requirements.

Critical Thinking and Discussion Questions

1. In 2004, inward FDI accounted for some 24
percent of gross fixed capital formation in
Ireland, but only 0.6 percent in Japan. What do
you think explains this difference in FDI inflows
into the two countries?

2. Compare and contrast these explanations of FDI:
internalization theory, Vernon’s product life-cycle
theory, and Knickerbocker’s theory of FDI. Which
theory do you think offers the best explanation of
the historical pattern of FDI? Why?

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272 Part Three Cross-Border Trade and Investment

3. Read the Management Focus on Cemex and
then answer the following questions:

a. Which theoretical explanation, or explanations,
of FDI best explains Cemex’s FDI?

b. What is the value that Cemex brings to the host
economy? Can you see any potential drawbacks
of inward investment by Cemex in an economy?

c. Cemex has a strong preference for acquisitions
over greenfield ventures as an entry mode.
Why?

d. Why is majority control so important to
Cemex?

4. You are the international manager of a U.S.
business that has just developed a revolutionary

new personal computer that can perform the
same functions as existing PCs but costs only
half as much to manufacture. Several patents
protect the unique design of this computer.
Your CEO has asked you to formulate a
recommendation for how to expand into
Western Europe. Your options are ( a ) to
export from the United States, ( b ) to license a
European firm to manufacture and market the
computer in Europe, or ( c ) to set up a wholly
owned subsidiary in Europe. Evaluate the pros
and cons of each alternative and suggest a
course of action to your CEO.

Use the globalEDGE Resource Desk (http://
globalEDGE.msu.edu/resourcedesk/) to complete
the following exercises:

1. You are working for a company that is
considering investing in a foreign country.
Management has requested a report regarding
the attractiveness of alternative countries based
on the potential return of FDI. Accordingly, the
ranking of the top 10 countries in terms of FDI
attractiveness is a crucial ingredient for your
report. A colleague mentioned a potentially
useful tool called the FDI Confidence Index, which
is updated periodically. Find this index and

provide additional information regarding how
the index is constructed.

2. Your company is considering opening a new
factory in Latin America, and management is
evaluating the specific country locations for this
direct investment. The pool of candidate
countries has been narrowed to Argentina,
Brazil, and Mexico. Prepare a short report
comparing the foreign direct investment climate
and regulations of these three countries, using
the Country Commercial Guides prepared by the
U.S. Department of Commerce.

Research Task http://globalEDGE.msu.edu

Spain’s Telefonica

Established in the 1920s, Spain’s Telefonica was a typical
state-owned national telecommunications monopoly until the
1990s. Then the Spanish government privatized the company
and deregulated the Spanish telecommunications market.
What followed was a sharp reduction in the workforce, rapid
adoption of new technology, and focus on driving up profits
and shareholder value.
In this new era, Telefonica was looking for growth. Its
search first took it to Latin America. There, too, a wave of de-
regulation and privatization was sweeping across the region.

For Telefonica, Latin America seemed to be the perfect fit.
Much of the region shared a common language and had deep
cultural and historical ties to Spain. After decades of slow
growth, Latin American markets were now growing rapidly,
increasing the adoption rate and usage not just of traditional
fixed-line telecommunications services, but also of mobile
phones and Internet connections.
Having already transformed itself from a state-owned en-
terprise into an efficient and effective competitor, Telefonica
now believed it could do the same for companies it acquired

closing case

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Chapter Seven Foreign Direct Investment 273

in Latin America, many of which were once part of state-
owned telecommunications monopolies. In the late 1990s,
Telefonica invested some $11 billion in Latin America, acquir-
ing companies throughout the region. Its largest investments
were reserved for Brazil, the biggest market in the region,
where it spent some $6 billion to purchase several compa-
nies, including the largest fixed-line operator in San Paulo,
the leading mobile phone operator in Rio de Janeiro, and the
principal carrier in the state of Rio Grande do Sul. In Argen-
tina, it acquired 51 percent of the southern region’s monopoly
provider, a franchise that included the lucrative financial dis-
trict of Buenos Aires. In Chile, it became the leading share-
holder in the former state-owned monopoly, and so on.
Indeed, by the early 2000s Telefonica was the No. 1 or 2
player in almost every Latin American country, had a conti-
nent-wide market share of around 40 percent, and was gen-
erating 18 percent of its revenues from the region.
Still, for all of its investment, Telefonica has not had it all
its own way in Latin America. Other companies could also
see the growth opportunities, and several foreign telecom-
munications enterprises entered Latin America’s newly
opened markets. In the fast-growing mobile segment, America
Movil, controlled by the Mexican billionaire Carlos Slim,
emerged as a strong challenger. By 2008, the Mexican company
had 182 million wireless subscribers across Latin America,
compared to Telefonica’s 123 million, and intense price competi-
tion between the two companies was emerging.
With the die already cast in Latin America by the mid-2000s,
Telefonica turned its attention to neighboring countries in
Europe. For years, there had been a tacit agreement between

national telecommunications companies that they would
not invade each other’s markets. In 2005 this started to break
down when France Telecom entered Spain, purchasing
Amena, the country’s second-largest mobile carrier behind
Telefonica. Telefonica moved quickly to make its own
European acquisition, acquiring Britain’s major mobile phone
operator, O2, for $31.4 billion. O2 already had significant
operations in Germany as well as the United Kingdom. The
acquisition transformed Telefonica into the second-largest
mobile phone operator in the world measured by customers,
behind only China Mobile.

Sources: R. Tomlinson, “Dialing in on Latin America,” Fortune ,
October 25, 1999, pp. 259–62; T. Serafin, “Spanish Armada,” Forbes ,
January 9, 2006, p. 132; and G. Smith, “The Race for Numero Uno in
Latin Wireless,” BusinessWeek Online , November 27, 2006.

Case Discussion Questions
1. What changes in the political and economic environment

allowed Telefonica to start expanding globally?

2. Why did Telefonica initially focus on Latin America? Why
was it slower to expand in Europe, even though Spain is a
member of the European Union?

3. Telefonica has used acquisitions, rather than greenfield
ventures, as its entry strategy. Why do you think this has
been the case? What are the potential risks associated
with this entry strategy?

4. What is the value that Telefonica brings to the companies
it acquires?

5. In your judgment, does inward investment by Telefonica
benefit a host nation? Explain your reasoning?

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L
E

A
R

N
IN

B
J
E

C
T

IV
E

After you have read this chapter you should be able to:

1
Describe the different levels of regional

economic integration.

2
Understand the economic and political arguments for regional

economic integration.

3
Understand the economic and political arguments against regional

economic integration.

4
Explain the history, current scope, and future prospects of the world’s

most important regional economic agreements.

5
Understand the implications for business that are inherent in regional economic

integration agreements.

part 3 Cross-Border Trade and Investment

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8 c h a p t e r

Regional Economic

Integration

NAFTA and Mexican Trucking
opening case

W
hen the North American Free Trade Agreement (NAFTA) went into effect in 1994, the
treaty specified that by 2000 trucks from each nation would be allowed to cross each
other’s borders and deliver goods to their ultimate destination. The argument was that

such a policy would lead to great efficiencies. Before NAFTA, Mexican trucks stopped at the bor-
der, and goods had to be unloaded and reloaded onto American trucks, a process that took time
and cost money. It was also argued that greater competition from Mexican trucking firms would
lower the price of road transportation within NAFTA. Given that two-thirds of cross-border
trade within NAFTA goes by road, supporters argued that the savings could be significant.
This provision was vigorously opposed by the Teamsters Union in the United States, which
represents truck drivers. The union argued that Mexican truck drivers had poor safety re-
cords, and that Mexican trucks did not adhere to the strict safety and environmental stan-
dards of the United States. To quote James Hoffa, the president of the Teamsters: “Mexican
trucks are older, dirtier and more dangerous than American trucks. American truck drivers
are taken off the road if they commit a serious traffic violation in their personal vehicle.
That’s not so in Mexico. Limits on the hours a driver can spend behind the wheel are
ignored in Mexico.”
Although they did not state so explicitly, the Teamsters were also clearly motivated by
a desire to protect the pay and employment opportunities for American truck drivers.
Under pressure from the Teamsters, the United States dragged its feet on im-
plementation of the trucking agreement. Ultimately the Teamsters sued to stop
implementation. An American court rejected the union’s arguments and stated
the country must honor the treaty. So did a NAFTA dispute settlement
panel. This panel ruled in 2001 that the United States was violating the
NAFTA treaty and gave Mexico the right to impose retaliatory tariffs.

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276 Part Three Cross-Border Trade and Investment

Mexico decided not to do that, instead giving the United States a chance to
honor its commitment. The Bush administration tried to do just that, but was
thwarted by opposition in Congress, which approved a measure setting
22 new safety standards that Mexican trucks would have to meet before en-
tering the United States.
In an attempt to break the stalemate, in 2007 the U.S. government set up a
pilot program under which trucks from some 100 Mexican transportation
companies could enter the United States, provided they passed American
safety inspections. The Mexican trucks were tracked, and after 18 months,
that program showed that the Mexican carriers actually had a slightly better
safety record than their U.S. counterparts. The Teamsters immediately lob-
bied Congress to kill the pilot program. In March 2009 an amendment at-
tached to a large spending bill did just that.
This time the Mexican government did not let the United States off the
hook. As allowed to under the terms of the NAFTA agreement, Mexico im-
mediately placed tariffs on some $2.4 billion of goods shipped from the
United States to Mexico. California, an important exporter of agricultural
products to Mexico, was hit hard. Table grapes now faced a 45 percent tariff,
while wine, almonds, and juices will pay a 20 percent tariff. Pears, which
primarily come from Washington State, faced a 20 percent tariff (4 out of
10 pears that the United States exports go to Mexico). Other products hit
with the 20 percent tariff include exports of personal hygiene products and
jewelry from New York, tableware from Illinois, and oil seeds from North
Dakota. The U.S. Chamber of Commerce has estimated that the current situ-
ation costs some 25,600 U.S. jobs. The U.S. government said it would try to
come up with a new program that both addressed the “legitimate concerns”
of Congress and honored its commitment to the NAFTA treaty. What that
agreement will be, however, remains to be seen, and as of early 2010, there
was no agreement in sight. •
Sources: “Don’t Keep on Trucking,” The Economist , March 21, 2009, p. 39; “Mexico Retaliates,” The Wall Street
Journal , March 19, 2009, p. A14; J. P. Hoffa, “Keep Mexican Trucks Out,” USA Today , March 1, 2009, p. 10; “The
Mexican-American War of 2009,” Washington Times , March 24, 2009, p. A18; and J. Moreno, “In NAFTA Rift,
Profits Take a Hit,” HoustonChronical.com , November 12, 2009.

Introduction
In this chapter we will take a close look at the arguments for regional economic in-
tegration through the establishment of trading blocs such as the European Union
and the North American Free Trade Agreement. We will discuss the difficult process
of forming such blocks and using them as an institutional means for lowering the
barriers to cross-border trade and investment between member states. The opening
case illustrates some of the promise and problems associated with integrating the

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Chapter Eight Regional Economic Integration 277

economies of different nations into regional trading blocs. The NAFTA provision
to remove barriers to trucking across borders was meant to encourage greater effi-
ciencies, with the lower costs benefitting the citizens of all three signatory coun-
tries. However, as described in the case, political opposition has stymied any
attempt to implement this aspect of NAFTA. By 2009 Mexico was imposing retalia-
tory tariffs on imports of U.S. goods, as allowed for by the treaty, in an attempt to
get the Americans to honor their commitment. Doing so will not be easy, however,
given the strong opposition from the well-connected Teamsters Union in the
United States.
By regional economic integration we mean agreements among countries in a
geographic region to reduce, and ultimately remove, tariff and nontariff barriers to the
free flow of goods, services, and factors of production between each other. The past
two decades have witnessed an unprecedented proliferation of regional trade blocs
that promote regional economic integration. World Trade Organization members are
required to notify the WTO of any regional trade agreements in which they partici-
pate. By 2010, nearly all of the WTO’s members had notified the organization of
participation in one or more regional trade agreements. The total number of regional
trade agreements currently in force is around 400. 1
Consistent with the predictions of international trade theory and particularly the
theory of comparative advantage (see Chapter 5) agreements designed to promote freer
trade within regions are believed to produce gains from trade for all member countries.
As we saw in Chapter 6, the General Agreement on Tariffs and Trade and its successor,
the World Trade Organization, also seek to reduce trade barriers. With 153 member
states, the WTO has a worldwide perspective. By entering into regional agreements,
groups of countries aim to reduce trade barriers more rapidly than can be achieved
under the auspices of the WTO.
Nowhere has the movement toward regional economic integration been more
successful than in Europe. On January 1, 1993, the European Union (EU) formally
removed many barriers to doing business across borders within the EU in an at-
tempt to create a single market with 340 million consumers. However, the EU did
not stop there. The member states of the EU have launched a single currency, the
euro; they are moving toward a closer political union. On May 1, 2004, the EU ex-
panded from 15 to 25 countries and in 2007 two more countries joined, Bulgaria and
Romania, making the total 27. Today, the EU has a population of almost 500 million
and a gross domestic product of €11 trillion, making it larger than the United States
in economic terms.
Similar moves toward regional integration are being pursued elsewhere in the
world. Canada, Mexico, and the United States have implemented the North American
Free Trade Agreement (NAFTA). Ultimately, this promises to remove all barriers to
the free flow of goods and services between the three countries. While the implemen-
tation of NAFTA has resulted in job losses in some sectors of the American economy,
in aggregate and consistent with the predications of international trade theory, most
economists argue that the benefits of greater regional trade outweigh any costs.
South America, too, has moved toward regional integration. In 1991, Argentina, Brazil,
Paraguay, and Uruguay implemented an agreement known as Mercosur to start reduc-
ing barriers to trade between each other, and although progress within Mercosur has
been halting, the institution is still in place. There are also active attempts at regional
economic integration in Central America, the Andean region of South America,
Southeast Asia, and parts of Africa.
While the move toward regional economic integration is generally seen as a good
thing, some observers worry that it will lead to a world in which regional trade blocs
compete against each other. In this possible future scenario, free trade will exist

Regional Economic
Integration
Agreements among
countries in a geographic
region to reduce, and
ultimately remove, tariff
and nontariff barriers to
the free flow of goods,
services, and factors of
production between
each other.

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278 Part Three Cross-Border Trade and Investment

within each bloc, but each bloc will protect its
market from outside competition with high tariffs.
The specter of the EU and NAFTA turning into
economic fortresses that shut out foreign produc-
ers with high tariff barriers is worrisome to those
who believe in unrestricted free trade. If such a
situation were to materialize, the resulting decline
in trade between blocs could more than offset the
gains from free trade within blocs.

With these issues in mind, this chapter will ex-
plore the economic and political debate surround-
ing regional economic integration, paying particular
attention to the economic and political benefits and
costs of integration; review progress toward re-
gional economic integration around the world; and
map the important implications of regional eco-
nomic integration for the practice of international
business. Before tackling these objectives, we first
need to examine the levels of integration that are
theoretically possible.

Levels of Economic Integration
Several levels of economic integration are possible in theory (see Figure 8.1). From
least integrated to most integrated, they are a free trade area, a customs union, a com-
mon market, an economic union, and, finally, a full political union.
In a free trade area, all barriers to the trade of goods and services among member
countries are removed. In the theoretically ideal free trade area, no discriminatory

LEARNING OBJECTIVE 1
Describe the different
levels of regional economic
integration.

figure 8.1

Levels of Economic
Integration

Customs union

Common market

Economic union

Political union

NAFTA

Level of integration

Free trad

are

EU
2003

A n o t h e r P e r s p e c t i v e

Economic Integration in the Classical World
Traditionally, the success of the Roman Empire has been
explained by economic historians as an example of cen-
tralized, forced reallocation of goods. Recent scholarship,
though, suggests that there was not a single empire-wide,
centralized market for all goods, but that local markets
were connected and that most exchanges were voluntary,
based on reciprocity and exchange. Ancient Rome had an
economic system that was an enormous, integrated con-
glomeration of interdependent markets. Transportation and
communication took time, and the discipline of the market
was loose. But there were many voluntary economic con-
nections between even far-flung parts of the early Roman
Empire. (Karl Polanyi, The Livelihood of Man [New York:
Academic Press, 1977]; and Peter Temin, “Market Economy
in the Early Roman Empire,” University of Oxford, Discus-
sion Papers in Economic and Social History)

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Chapter Eight Regional Economic Integration 279

tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade
between members. Each country, however, is allowed to determine its own trade poli-
cies with regard to nonmembers. Thus, for example, the tariffs placed on the products
of nonmember countries may vary from member to member. Free trade agreements
are the most popular form of regional economic integration, accounting for almost
90 percent of regional agreements. 2
The most enduring free trade area in the world is the European Free Trade As-
sociation (EFTA). Established in January 1960, EFTA currently joins four countries—
Norway, Iceland, Liechtenstein, and Switzerland—down from seven in 1995 (three
EFTA members, Austria, Finland, and Sweden, joined the EU on January 1, 1996).
EFTA was founded by those Western European countries that initially decided not to
be part of the European Community (the forerunner of the EU). Its original mem-
bers included Austria, Great Britain, Denmark, Finland, and Sweden, all of which are
now members of the EU. The emphasis of EFTA has been on free trade in industrial
goods. Agriculture was left out of the arrangement, each member being allowed to
determine its own level of support. Members are also free to determine the level of
protection applied to goods coming from outside EFTA. Other free trade areas in-
clude the North American Free Trade Agreement, which we shall discuss in depth
later in the chapter.
The customs union is one step farther along the road to full economic and political
integration. A customs union eliminates trade barriers between member countries
and adopts a common external trade policy. Establishment of a common external trade
policy necessitates significant administrative machinery to oversee trade relations with
nonmembers. Most countries that enter into a customs union desire even greater eco-
nomic integration down the road. The EU began as a customs union, but has now
moved beyond this stage. Other customs unions around the world include the current
version of the Andean Community (formally known as the Andean Pact) between
Bolivia, Colombia, Ecuador, Peru, and Venezuela. The Andean Community established
free trade between member countries and imposes a common tariff, of 5 to 20 percent,
on products imported from outside. 3
The next level of economic integration, a common market has no barriers to trade
between member countries, includes a common external trade policy, and allows fac-
tors of production to move freely between members. Labor and capital are free to
move because there are no restrictions on immigration, emigration, or cross-border
flows of capital between member countries. Establishing a common market demands
a significant degree of harmony and cooperation on fiscal, monetary, and employment
policies. Achieving this degree of cooperation has proven very difficult. For years, the
European Union functioned as a common market, although it has now moved beyond
this stage. Mercosur, the South American grouping of Argentina, Brazil, Paraguay, and
Uruguay (Venezuela has also applied to join), hopes to eventually establish itself as a
common market.
An economic union entails even closer economic integration and cooperation than
a common market. Like the common market, an economic union involves the free
flow of products and factors of production between member countries and the adop-
tion of a common external trade policy, but it also requires a common currency, har-
monization of members’ tax rates, and a common monetary and fiscal policy. Such a
high degree of integration demands a coordinating bureaucracy and the sacrifice of
significant amounts of national sovereignty to that bureaucracy. The EU is an eco-
nomic union, although an imperfect one since not all members of the EU have ad-
opted the euro, the currency of the EU; differences in tax rates and regulations across
countries still remain; and some markets, such as the market for energy, are still not
fully deregulated.

Free Trade Area
A group of countries
committed to removing
all barriers to the free
flow of goods and
services between each
other, but pursuing
independent external
trade policies.

European Free
Trade Association
(EFTA)
A free trade association
including Norway,
Iceland, Liechtenstein,
and Switzerland.

Customs Union
A group of countries
committed to (1) removing
all barriers to the free
flow of goods and
services between each
other and (2) the pursuit
of a common external
trade policy.

Common Market
A group of countries
committed to (1) removing
all barriers to the free
flow of goods, services,
and factors of production
between each other and
(2) the pursuit of a
common external
trade policy.

Economic Union
A group of countries
committed to (1) removing
all barriers to the free
flow of goods, services,
and factors of production;
(2) the adoption of a
common currency;
(3) the harmonization of
tax rates; and (4) the
pursuit of a common
external trade policy.

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280 Part Three Cross-Border Trade and Investment

The move toward economic union raises the issue of how to make a coordinating
bureaucracy accountable to the citizens of member nations. The answer is through
political union in which a central political apparatus coordinates the economic, social,
and foreign policy of the member states. The EU is on the road toward at least partial
political union. The European Parliament, which is playing an ever more important
role in the EU, has been directly elected by citizens of the EU countries since the late
1970s. In addition, the Council of Ministers (the controlling, decision-making body of
the EU) is composed of government ministers from each EU member. The United
States provides an example of even closer political union; in the United States, inde-
pendent states are effectively combined into a single nation. Ultimately, the EU may
move toward a similar federal structure.

The Case for Regional Integration
The case for regional integration is both economic and political. The case for integra-
tion is typically not accepted by many groups within a country, which explains why
most attempts to achieve regional economic integration have been contentious and
halting. In this section, we examine the economic and political cases for integration
and two impediments to integration. In the next section, we look at the case against
integration.

THE ECONOMIC CASE FOR INTEGRATION The economic case for re-
gional integration is straightforward. We saw in Chapter 5 how economic theories of
international trade predict that unrestricted free trade will allow countries to special-
ize in the production of goods and services that they can produce most efficiently. The
result is greater world production than would be possible with trade restrictions. That
chapter also revealed how opening a country to free trade stimulates economic growth,
which creates dynamic gains from trade. Chapter 7 detailed how foreign direct invest-
ment (FDI) can transfer technological, marketing, and managerial know-how to host
nations. Given the central role of knowledge in stimulating economic growth, opening
a country to FDI also is likely to stimulate economic growth. In sum, economic theo-
ries suggest that free trade and investment is a positive-sum game, in which all par-
ticipating countries stand to gain.
Given this, the theoretical ideal is an absence of barriers to the free flow of goods,
services, and factors of production among nations. However, as we saw in Chapters 6
and 7, a case can be made for government intervention in international trade and FDI.
Because many governments have accepted part or all of the case for intervention, un-

restricted free trade and FDI have proved to be
only an ideal. Although international institutions
such as the WTO have been moving the world to-
ward a free trade regime, success has been less than
total. In a world of many nations and many political
ideologies, it is very difficult to get all countries to
agree to a common set of rules.

Against this background, regional economic in-
tegration can be seen as an attempt to achieve ad-
ditional gains from the free flow of trade and
investment between countries beyond those attain-
able under international agreements such as the
WTO. It is easier to establish a free trade and in-
vestment regime among a limited number of adja-
cent countries than among the world community.

Political Union
A central political

apparatus that
coordinates economic,

social, and foreign policy.

LEARNING OBJECTIVE 2
Understand the economic
and political arguments for
regional economic
integration.

A n o t h e r P e r s p e c t i v e

Economic Integration and the EU Worker
Being a citizen of a country that is regionally integrated,
such as the countries of the European Union, may have
benefits related to career development. From an employer’s
perspective, workers are more mobile. They can move
from Spain to Finland, Latvia to France, and never have to
think about work permits and, depending on the countries,
currencies. In addition, labor and commercial law is be-
coming integrated across the EU. The mobility and flexibil-
ity of such employees may be attractive to a U.S. MNE as
well, because it could use them in many markets.

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Chapter Eight Regional Economic Integration 281

Coordination and policy harmonization problems are largely a function of the number
of countries that seek agreement. The greater the number of countries involved, the
more perspectives that must be reconciled, and the harder it will be to reach agree-
ment. Thus, attempts at regional economic integration are motivated by a desire to
exploit the gains from free trade and investment.

THE POLITICAL CASE FOR INTEGRATION The political case for re-
gional economic integration also has loomed large in several attempts to establish free
trade areas, customs unions, and the like. Linking neighboring economies and making
them increasingly dependent on each other creates incentives for political cooperation
between the neighboring states and reduces the potential for violent conflict. In addi-
tion, by grouping their economies, the countries can enhance their political weight in
the world.
These considerations underlay the 1957 establishment of the European Commu-
nity (EC), the forerunner of the EU. Europe had suffered two devastating wars in the
first half of the 20th century, both arising out of the unbridled ambitions of nation-
states. Those who have sought a united Europe have always had a desire to make an-
other war in Europe unthinkable. Many Europeans also believed that after World War II,
the European nation-states were no longer large enough to hold their own in world
markets and politics. The need for a united Europe to deal with the United States and
the politically alien Soviet Union loomed large in the minds of many of the EC’s
founders. 4 A long-standing joke in Europe is that the European Commission should
erect a statue to Joseph Stalin, for without the aggressive policies of the former dicta-
tor of the old Soviet Union, the countries of Western Europe may have lacked the
incentive to cooperate and form the EC.

IMPEDIMENTS TO INTEGRATION Despite the strong economic and po-
litical arguments in support, integration has never been easy to achieve or sustain for
two main reasons. First, although economic integration aids the majority, it has its
costs. While a nation as a whole may benefit significantly from a regional free trade
agreement, certain groups may lose. Moving to a free trade regime involves painful
adjustments. For example, due to the 1994 establishment of NAFTA, some Canadian
and U.S. workers in such industries as textiles, which employ low-cost, low-skilled
labor, lost their jobs as Canadian and U.S. firms moved production to Mexico. The
promise of significant net benefits to the Canadian and U.S. economies as a whole
is little comfort to those who lose as a result of NAFTA. Such groups have been at
the forefront of opposition to NAFTA and will continue to oppose any widening of
the agreement. Thus, as we saw in the opening case, the Teamsters Union in the
United States has vigorously opposed the implementation of a trucking agreement
in the treaty.
A second impediment to integration arises from concerns over national sover-
eignty. For example, Mexico’s concerns about maintaining control of its oil interests
resulted in an agreement with Canada and the United States to exempt the Mexican
oil industry from any liberalization of foreign investment regulations achieved un-
der NAFTA. Concerns about national sovereignty arise because close economic in-
tegration demands that countries give up some degree of control over such key
issues as monetary policy, fiscal policy (e.g., tax policy), and trade policy. This has
been a major stumbling block in the EU. To achieve full economic union, the EU
introduced a common currency, the euro, controlled by a central EU bank. Although
most member states have signed on, Great Britain remains an important holdout. A
politically important segment of public opinion in that country opposes a common
currency on the grounds that it would require relinquishing control of the country’s

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282 Part Three Cross-Border Trade and Investment

monetary policy to the EU, which many British perceive as a bureaucracy run by
foreigners. In 1992, the British won the right to opt out of any single currency
agreement, and as of 2010, the British government had yet to reverse its decision,
nor did it seem likely to.

The Case Against Regional Integration
Although the tide has been running in favor of regional free trade agreements in recent
years, some economists have expressed concern that the benefits of regional integration
have been oversold, while the costs have often been ignored. 5 They point out that the
benefits of regional integration are determined by the extent of trade creation, as op-
posed to trade diversion. Trade creation occurs when high-cost domestic producers
are replaced by low-cost producers within the free trade area. It may also occur when
higher-cost external producers are replaced by lower-cost external producers within the
free trade area. Trade diversion occurs when lower-cost external suppliers are replaced
by higher-cost suppliers within the free trade area. A regional free trade agreement will
benefit the world only if the amount of trade it creates exceeds the amount it diverts.
Suppose the United States and Mexico imposed tariffs on imports from all coun-
tries, and then they set up a free trade area, scrapping all trade barriers between them-
selves but maintaining tariffs on imports from the rest of the world. If the United States
began to import textiles from Mexico, would this change be for the better? If the
United States previously produced all its own textiles at a higher cost than Mexico, then
the free trade agreement has shifted production to the cheaper source. According to the
theory of comparative advantage, trade has been created within the regional grouping,
and there would be no decrease in trade with the rest of the world. Clearly, the change
would be for the better. If, however, the United States previously imported textiles
from Costa Rica, which produced them more cheaply than either Mexico or the United
States, then trade has been diverted from a low-cost source—a change for the worse.
In theory, WTO rules should ensure that a free trade agreement does not result in
trade diversion. These rules allow free trade areas to be formed only if the members
set tariffs that are not higher or more restrictive to outsiders than the ones previously
in effect. However, as we saw in Chapter 6, GATT and the WTO do not cover some
nontariff barriers. As a result, regional trade blocs could emerge whose markets are
protected from outside competition by high nontariff barriers. In such cases, the trade
diversion effects might outweigh the trade creation effects. The only way to guard
against this possibility, according to those concerned about this potential, is to increase
the scope of the WTO so it covers nontariff barriers to trade. There is no sign that this
is going to occur anytime soon, however; so the risk remains that regional economic
integration will result in trade diversion.

Regional Economic Integration in Europe
Europe has two trade blocs—the European Union and the European Free Trade
Association. Of the two, the EU is by far the more significant, not just in terms of
membership (the EU currently has 27 members; the EFTA has 4), but also in terms of
economic and political influence in the world economy. Many now see the EU as an
emerging economic and political superpower of the same order as the United States.
Accordingly, we will concentrate our attention on the EU. 6

EVOLUTION OF THE EUROPEAN UNION The European Union (EU)
is the product of two political factors: (1) the devastation of Western Europe during
two world wars and the desire for a lasting peace, and (2) the European nations’ desire

LEARNING OBJECTIVE 3
Understand the economic
and political arguments
against regional economic
integration.

LEARNING OBJECTIVE 4
Explain the history, current

scope, and future prospects
of the world’s most
important regional

economic agreements.

Trade Creation
Trade created due to

regional economic
integration; occurs when

high-cost domestic
producers are replaced

by low-cost foreign
producers in a free

trade area.

Trade Diversion
Trade diverted due to

regional economic
integration; occurs when

low-cost foreign suppliers
outside a free trade area

are replaced by higher-
cost foreign suppliers in a

free trade area.

European Union
An economic group of

27 European nations;
established as a customs
union, it is moving toward
economic union; formerly
the European Community.

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Chapter Eight Regional Economic Integration 283

to hold their own on the world’s political and economic stage. In addition, many
Europeans were aware of the potential economic benefits of closer economic integra-
tion of the countries.
The forerunner of the EU, the European Coal and Steel Community was formed in
1951 by Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands. Its
objective was to remove barriers to intragroup shipments of coal, iron, steel, and scrap
metal. With the signing of the Treaty of Rome in 1957, the European Community
was established. The name changed again in 1994 when the European Community
became the European Union following the ratification of the Maastricht Treaty (dis-
cussed later).
The Treaty of Rome provided for the creation of a common market. Article 3 of the
treaty laid down the key objectives of the new community, calling for the elimination
of internal trade barriers and the creation of a common external tariff and requiring
member states to abolish obstacles to the free movement of factors of production
among the members. To facilitate the free movement of goods, services, and factors of
production, the treaty provided for any necessary harmonization of the member states’
laws. Furthermore, the treaty committed the EC to establish common policies in agri-
culture and transportation.
The community grew in 1973, when Great Britain, Ireland, and Denmark joined.
These three were followed in 1981 by Greece, in 1986 by Spain and Portugal, and
in 1996 by Austria, Finland, and Sweden, bringing the total membership to 15 (East
Germany became part of the EC after the reunification of Germany in 1990).
Another 10 countries joined the EU on May 1, 2004, 8 of them from Eastern
Europe plus the small Mediterranean nations of Malta and Cyprus. Bulgaria and
Romania joined in 2007, bringing the total number of member states to 27 (see
Map 8.1). With a population of almost 500 million and a GDP of €11 trillion, larger
than that of the United States, the EU through these enlargements has become a
global superpower. 7

POLITICAL STRUCTURE OF THE EUROPEAN UNION The
economic policies of the EU are formulated and implemented by a complex and
still-evolving political structure. The four main institutions in this structure are the
European Commission, the Council of the European
Union, the European Parliament, and the Court of
Justice. 8
The European Commission is responsible for
proposing EU legislation, implementing it, and
monitoring compliance with EU laws by member
states. Headquartered in Brussels, Belgium, the
commission has more than 24,000 employees. It is
run by a group of commissioners appointed by each
member country for five-year renewable terms.
There are 27 commissioners, one from each mem-
ber state. A president of the commission is chosen by
member states, and the president then chooses other
members in consultation with the states. The entire
commission has to be approved by the European
Parliament before it can begin work. The commis-
sion has a monopoly in proposing European Union
legislation. The commission makes a proposal,
which goes to the Council of the European Union
and then to the European Parliament. The council

Treaty of Rome
The 1957 treaty that
established the European
Community.

European
Commission
Body responsible for
proposing EU legislation,
implementing it, and
monitoring compliance.

L’Oreal Chief Executive Officer Lindsay Owen-Jones and L’Oreal Deputy
Chief Executive Officer Jean-Paul Agon attend a press conference to
announce that L’Oreal was buying Body Shop International, renowned
for its ethical hair and skin products. L’Oreal, the world’s leading cosmetics
company, bought Body Shop for £652 million pounds (€940 million;
$1.143 billion). The European Commission reviews acquisitions such
as this between competitors.

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284 Part Three Cross-Border Trade and Investment

cannot legislate without a commission proposal in front of it. The commission is also
responsible for implementing aspects of EU law, although in practice much of this
must be delegated to member states. Another responsibility of the commission is to
monitor member states to make sure they are complying with EU laws. In this polic-
ing role, the commission will normally ask a state to comply with any EU laws that
are being broken. If this persuasion is not sufficient, the commission can refer a case
to the Court of Justice.
The European Commission’s role in competition policy has become increasingly
important to business in recent years. Since 1990 when the office was formally as-
signed a role in competition policy, the EU’s competition commissioner has been
steadily gaining influence as the chief regulator of competition policy in the member
nations of the EU. As with antitrust authorities in the United States, which include the
Federal Trade Commission and the Department of Justice, the role of the competition
commissioner is to ensure that no one enterprise uses its market power to drive out

Portugal

España

Andorra

France

Luxembourg Č eská
republika

Monaco
Italia

Slovenija
Hrvatska

Österreich
Liechtenstein

Polska
Belarus’

Ukraïna

Moldova
Slovensko

Magyarország

Deutschland

Rossija

Sakartvelo

Haïastan

Latvija

Lietuva

Eest

Suomi
Finland

Norge

Sverige

Danmark

United Kingdo

Ireland
Éi

Ísland

Nederland

Belgie
Belgique

România

Bǎlgarija

Ellada

Malta

Türkiye

Srbija

P.J.R.M.
Città
del

Vaticano Shqipëria

Crna Gora

San Marino

Suisse
Schweiz
Svizzera

Bosna i
Hercegovina

Açores (P)

Madeira (P)

Canarias (E)

G
u

a
d

e
lo

u
p

e
(

F
)

M
a

r
ti

n
iq

u
e

(F
)

Réunion (F)Brasil

Guyane (F)
Suriname

Kypros
Kibris

map 8.1

Member States of the European Union in 2010

Source: The European Union; http://europa.eu/abc/european_countries/index_en.htm.

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Chapter Eight Regional Economic Integration 285

competitors and monopolize markets. The commissioner also reviews proposed merg-
ers and acquisitions to make sure they do not create a dominant enterprise with sub-
stantial market power. 9 For example, in 2000 a proposed merger between Time
Warner of the United States and EMI of the United Kingdom, both music recording
companies, was withdrawn after the commission expressed concerns that the merger
would reduce the number of major record companies from five to four and create a
dominant player in the $40 billion global music industry. Similarly, the commission
blocked a proposed merger between two U.S. telecommunication companies, World-
Com and Sprint, because their combined holdings of Internet infrastructure in Europe
would give the merged companies so much market power that the commission argued
the combined company would dominate that market. Another example of the commis-
sion’s influence over business combinations is given in the accompanying Manage-
ment Focus, which looks at the commission’s role in shaping mergers and joint
ventures in the media industry.
The European Council represents the interests of member states. It is clearly the
ultimate controlling authority within the EU since draft legislation from the com-
mission can become EU law only if the council agrees. The council is composed of
one representative from the government of each member state. The membership,

M a n a g e m e n t F O C U S

The European Commission
and Media Industry Mergers

In late 1999, U.S. Internet giant AOL announced it would
merge with the music and publishing conglomerate Time
Warner. Both the U.S. companies had substantial operations
in Europe. The European commissioner for competition,
Mario Monti, announced the commission would investigate
the impact of the merger on competition in Europe.
The investigation took on a new twist when Time Warner
subsequently announced it would form a joint venture with
British-based EMI. Time Warner and EMI are two of the top
five music publishing companies in the world. The proposed
joint venture would have been three times as large as its
nearest global competitor. The European Commission now
had two concerns. The first was that the joint venture be-
tween EMI and Time Warner would reduce the level of com-
petition in the music publishing industry. The second was that
a combined AOL–Time Warner would dominate the emerging
market for downloading music over the Internet, particularly
given the fact that AOL would be able to gain preferential ac-
cess to the music libraries of both Warner and EMI. This
would potentially put other online service providers at a dis-
advantage. The commission was also concerned that AOL
Europe was a joint venture between AOL and Bertelsmann, a
German media company that also had considerable music
publishing interests. Accordingly, the commission announced
it would undertake a separate investigation of the proposed
deal between Time Warner and EMI.

These investigations continued into late 2000 and were
resolved by a series of concessions extracted by the
European Commission. First, under pressure from the com-
mission, Time Warner and EMI agreed to drop their proposed
joint venture, thereby maintaining the level of competition
in the music publishing business. Second, AOL and Time
Warner agreed to allow rival Internet service providers
access to online music on the same terms as AOL would
receive from Warner Music Group for the next five years.
Third, AOL agreed to sever all ties with Bertelsmann, and the
German company agreed to withdraw from AOL Europe.
These developments alleviated the commission’s concern
that the AOL–Time Warner combination would dominate the
emerging market for the digital download of music. With
these concessions in hand, the commission approved the
AOL–Time Warner merger in early October 2000.
By late 2000 the AOL–Timer Warner merger had been com-
pleted. The shape of the media business, both in Europe and
worldwide, now looked very different, and the European
Commission had played a pivotal role in determining the out-
come. Its demand for concessions altered the strategy of
several companies, led to somewhat different combinations
from those originally planned, and, the commission believed,
preserved competition in the global media business.

Sources: W. Drozdiak, “EU Allows Vivendi Media Deal,” Washington Post,
October 14, 2000, p. E2; D. Hargreaves, “Business as Usual in the New
Economy,” Financial Times, October 6, 2000, p. 1; and D. Hargreaves,
“Brussels Clears AOL-Time Warner Deal,” Financial Times, October 12,
2000, p. 12.

European Council
The ultimate controlling
authority within the EU.

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286 Part Three Cross-Border Trade and Investment

however, varies depending on the topic being discussed. When agricultural issues are
being discussed, the agriculture ministers from each state attend council meetings;
when transportation is being discussed, transportation ministers attend, and so on.
Before 1993, all council issues had to be decided by unanimous agreement between
member states. This often led to marathon council sessions and a failure to make
progress or reach agreement on commission proposals. In an attempt to clear the
resulting logjams, the Single European Act formalized the use of majority voting
rules on issues “which have as their object the establishment and functioning of a
single market.” Most other issues, however, such as tax regulations and immigration
policy, still require unanimity among council members if they are to become law. The
votes that a country gets in the council are related to the size of the country. For ex-
ample, Britain, a large country, has 29 votes, whereas Denmark, a much smaller state,
has 7 votes.
The European Parliament, which now has 732 members, is directly elected by the
populations of the member states. The parliament, which meets in Strasbourg, France,
is primarily a consultative rather than legislative body. It debates legislation proposed
by the commission and forwarded to it by the council. It can propose amendments to
that legislation, which the commission and ultimately the council are not obliged to
take up but often will. The power of the parliament recently has been increasing, al-
though not by as much as parliamentarians would like. The European Parliament now
has the right to vote on the appointment of commissioners as well as veto some laws
(such as the EU budget and single-market legislation).
One major debate waged in Europe over the past few years is whether the council
or the parliament should ultimately be the most powerful body in the EU. Some in
Europe expressed concern over the democratic accountability of the EU bureau-
cracy. One side argued that the answer to this apparent democratic deficit lay in in-
creasing the power of the parliament, while others think that true democratic
legitimacy lies with elected governments, acting through the Council of the European
Union. 10 After significant debate, in December 2007 the member states signed a new
treaty, the Treaty of Lisbon , under which the power of the European Parliament is
increased. Ratified by all member states by the end of 2009, the treaty makes the
European Parliament the co-equal legislator for almost all European laws. 11 The
Treaty of Lisbon also creates a new position, a president of the European Council,
who will serve a 30-month term and represent the nation-states that make up the
European Union. Under the treaty, the European Commission will be reduced to
18 members, with a rotation system that ensures that every member state has regular
and equal membership.
The Court of Justice, which is comprised of one judge from each country, is the
supreme appeals court for EU law. Like commissioners, the judges are required to
act as independent officials, rather than as representatives of national interests. The
commission or a member country can bring other members to the court for failing
to meet treaty obligations. Similarly, member countries, companies, or institutions
can bring the commission or council to the court for failure to act according to an
EU treaty.

THE SINGLE EUROPEAN ACT Two revolutions occurred in Europe in
the late 1980s. The first was the collapse of communism in Eastern Europe. The
second revolution was much quieter, but its impact on Europe and the world may
have been just as profound as the first. It was the adoption of the Single European
Act by the member nations of the European Community (EC) in 1987. This act
committed member countries to work toward establishment of a single market by
December 31, 1992.

European
Parliament

Elected EU body that
consults on issues

proposed by the
European Commission.

The Treaty of
Lisbon

Treaty signed in 2007 that
made the European

Parliament the co-equal
legislator for almost all

European laws and also
created the position of

the president of the
European Council.

Court of Justice
Supreme appeals court

for EU law.

Single
European Act

A 1987 act, adopted by
members of the European

Community, that
committed member

countries to establishing
an economic union.

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Chapter Eight Regional Economic Integration 287

The Single European Act was born of a frustration among members that the com-
munity was not living up to its promise. By the early 1980s, it was clear that the EC
had fallen short of its objectives to remove barriers to the free flow of trade and invest-
ment between member countries and to harmonize the wide range of technical and
legal standards for doing business. Against this background, many of the EC’s promi-
nent businesspeople mounted an energetic campaign in the early 1980s to end the
EC’s economic divisions. The EC responded by creating the Delors Commission. Un-
der the chairmanship of Jacques Delors, the commission proposed that all impedi-
ments to the formation of a single market be eliminated by December 31, 1992. The
result was the Single European Act, which was independently ratified by the parlia-
ments of each member country and became EC law in 1987.

The Objectives of the Act The purpose of the Single European Act was to have
one market in place by December 31, 1992. The act proposed the following changes: 12

• Remove all frontier controls between EC countries, thereby abolishing delays and
reducing the resources required for complying with trade bureaucracy.

• Apply the principle of “mutual recognition” to product standards. A standard
developed in one EC country should be accepted in another, provided it meets
basic requirements in such matters as health and safety.

• Open public procurement to nonnational suppliers, reducing costs directly by
allowing lower-cost suppliers into national economies and indirectly by forcing
national suppliers to compete.

• Lift barriers to competition in the retail banking and insurance businesses, which
should drive down the costs of financial services, including borrowing, throughout
the EC.

• Remove all restrictions on foreign exchange transactions between member
countries by the end of 1992.

• Abolish restrictions on cabotage—the right of foreign truckers to pick up and
deliver goods within another member state’s borders—by the end of 1992.
Estimates suggested this would reduce the cost of haulage within the EC by
10 to 15 percent.

All those changes were predicted to lower the costs of doing business in the EC, but
the single-market program was also expected to have more complicated supply-side
effects. For example, the expanded market was pre-
dicted to give EC firms greater opportunities to ex-
ploit economies of scale. In addition, it was thought
that the increase in competitive intensity brought
about by removing internal barriers to trade and in-
vestment would force EC firms to become more ef-
ficient. To signify the importance of the Single
European Act, the European Community also de-
cided to change its name to the European Union
once the act took effect.

Impact The Single European Act has had a sig-
nificant impact on the EU economy. 13 The act pro-
vided the impetus for the restructuring of substantial
sections of European industry. Many firms have
shifted from national to pan-European production
and distribution systems in an attempt to realize scale
economies and better compete in a single market.

Creation of a single financial services market in the European Union has
taken longer than expected due to member states’ differing regulations
and the significant amount of inertia involved in getting people to accept
this change.

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288 Part Three Cross-Border Trade and Investment

The results have included faster economic growth than would otherwise have been
the case.
However, nearly two decades after the formation of a single market, the reality still
falls short of the ideal. For example, as described in the accompanying Country Focus, it
has been hard work to establish a fully functioning single market for financial services

Creating a Single Market in Financial
Services

The European Union in 1999 embarked upon an ambitious
action plan to create a single market in financial services
by January 1, 2005. Launched a few months after the euro,
the EU’s single currency, the goal was to dismantle barriers
to cross-border activity in financial services, creating a
continent-wide market for banking service, insurance ser-
vices, and investment products. In this vision of a single
Europe, a citizen of France might use a German firm for ba-
sic banking services, borrow a home mortgage from an
Italian institution, buy auto insurance from a Dutch enter-
prise, and keep her savings in mutual funds managed by a
British company. Similarly, an Italian firm might raise capi-
tal from investors across Europe, using a German firm as
its lead underwriter to issue stock for sale through stock
exchanges in London and Frankfurt.
One main benefit of a single market, according to its ad-
vocates, would be greater competition for financial ser-
vices, which would give consumers more choices, lower
prices, and require financial service firms in the EU to be-
come more efficient, thereby increasing their global com-
petitiveness. Another major benefit would be the creation
of a single European capital market. The increased liquidity
of a larger capital market would make it easier for firms to
borrow funds, lowering their cost of capital (the price of
money) and stimulating business investment in Europe,
which would create more jobs. A European Commission
study suggested that the creation of a single market in fi-
nancial services would increase the EU’s gross domestic
product by 1.1 percent a year, creating an additional
€130 billion in wealth over a decade. Total business invest-
ment would increase by 6 percent annually in the long run,
private consumption by 0.8 percent, and total employment
by 0.5 percent a year.
Creating a single market has been anything but easy. The
financial markets of different EU member states have his-
torically been segmented from each other, and each has its
own regulatory framework. In the past, EU financial ser-
vices firms rarely did business across national borders be-
cause of a host of different national regulations with regard
to taxation, oversight, accounting information, cross-border

takeovers, and the like, all of which had to be harmonized.
To complicate matters, long-standing cultural and linguistic
barriers complicated the move toward a single market.
While in theory an Italian might benefit by being able to pur-
chase homeowners’ insurance from a British company, in
practice he might be predisposed to purchase it from a lo-
cal enterprise, even if the price were higher.
By 2010 the EU had made significant progress. More than
40 measures designed to create a single market in finan-
cial services had become EU law and others were in the
pipeline. The new rules embraced issues as diverse as the
conduct of business by investment firms, stock exchanges,
and banks; disclosure standards for listing companies on
public exchanges; and the harmonization of accounting
standards across nations. However, there had also been
significant setbacks. Most notably, legislation designed to
make it easier for firms to make hostile cross-border acquisi-
tions was defeated, primarily due to opposition from German
members of the European Parliament, making it more difficult
for financial service firms to build pan-European opera-
tions. In addition, national governments have still reserved
the right to block even friendly cross-border mergers be-
tween financial service firms. For example, Italian banking
law still requires the governor of the Bank of Italy to give
permission to any foreign enterprise that wishes to pur-
chase more than 5 percent of an Italian bank—and no for-
eigners have yet to acquire a majority position in an Italian
bank, primarily, say critics, due to nationalistic concerns
on the part of the Italians.
The critical issue now is enforcement of the rules that
have been put in place. Some believe that it will be at least
another decade before the benefits of the new regulations
become apparent. In the meantime, the changes may im-
pose significant costs on financial institutions as they at-
tempt to deal with the new raft of regulations.

Sources: C. Randzio-Plath, “Europe Prepares for a Single Financial
Market,” Intereconomic, May–June 2004, pp. 142–46; T. Buck, D.
Hargreaves, and P. Norman, “Europe’s Single Financial Market,” Financial
Times, January 18, 2005, p. 17; “The Gate-keeper,” The Economist,
February 19, 2005, p. 79; P. Hofheinz, “A Capital Idea: The European Union
Has a Grand Plan to Make Its Financial Markets More Efficient,” The Wall
Street Journal, October 14, 2002, p. R4; and “Banking on McCreevy:
Europe’s Single Market,” The Economist , November 26, 2005, p. 91.

3 C o u n t r y F O C U S

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Chapter Eight Regional Economic Integration 289

in the EU. Thus, although the EU is undoubtedly moving toward a single marketplace,
established legal, cultural, and language differences between nations mean that imple-
mentation has been uneven.

THE ESTABLISHMENT OF THE EURO In December 1991, EC mem-
bers signed a treaty (the Maastricht Treaty ) that committed them to adopting a
common currency by January 1, 1999. 14 The euro is now used by 16 of the 27 member
states of the European Union; these 16 states are members of what is often referred
to as the euro zone. It encompasses 330 million EU citizens and includes the power-
ful economies of Germany and France. Many of the countries that joined the EU on
May 1, 2004, and the two that joined in 2007, will adopt the euro when they fulfill
certain economic criteria—a high degree of price stability, a sound fiscal situation,
stable exchange rates, and converged long-term interest rates. The current members
had to meet the same criteria.
Establishment of the euro has rightly been described as an amazing political feat
with few historical precedents. Establishing the euro required participating national
governments not only to give up their own currencies, but also to give up control over
monetary policy. Governments do not routinely sacrifice national sovereignty for the
greater good, indicating the importance that the Europeans attach to the euro. By
adopting the euro, the EU has created the second most widely traded currency in the
world after that of the U.S. dollar. Some believe that ultimately the euro could come
to rival the dollar as the most important currency in the world.
Three long-term EU members, Great Britain, Denmark, and Sweden, are still sit-
ting on the sidelines. The countries agreeing to the euro locked their exchange rates
against each other January 1, 1999. Euro notes and coins were not actually issued until
January 1, 2002. In the interim, national currencies circulated in each of the 12 coun-
tries. However, in each participating state, the national currency stood for a defined
amount of euros. After January 1, 2002, euro notes and coins were issued and the na-
tional currencies were taken out of circulation. By mid-2002, all prices and routine
economic transactions within the euro zone were in euros.

Benefits of the Euro Europeans decided to establish a single currency in the EU
for a number of reasons. First, they believe that businesses and individuals will realize
significant savings from having to handle one currency, rather than many. These sav-
ings come from lower foreign exchange and hedging costs. For example, people going
from Germany to France no longer have to pay a commission to a bank to change
German deutsche marks into French francs. Instead, they use euros. According to the
European Commission, such savings amount to 0.5 percent of the European Union’s
GDP, or about $55 billion a year.
Second, and perhaps more importantly, the adoption of a common currency makes
it easier to compare prices across Europe. This has been increasing competition be-
cause it has become easier for consumers to shop around. For example, if a German
finds that cars sell for less in France than Germany, he may be tempted to purchase
from a French car dealer rather than his local car dealer. Alternatively, traders may
engage in arbitrage to exploit such price differentials, buying cars in France and re-
selling them in Germany. The only way that German car dealers will be able to hold
on to business in the face of such competitive pressures will be to reduce the prices
they charge for cars. As a consequence of such pressures, the introduction of a com-
mon currency has led to lower prices, which translates into substantial gains for
European consumers.
Third, faced with lower prices, European producers have been forced to look for
ways to reduce their production costs to maintain their profit margins. The introduction

Maastricht Treaty
Treaty agreed to in 1991,
but not ratified until
January 1, 1994, that
committed the 12 member
states of the European
Community to adopt a
common currency.

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290 Part Three Cross-Border Trade and Investment

of a common currency, by increasing competition, has produced long-run gains in the
economic efficiency of European companies.
Fourth, the introduction of a common currency has given a boost to the development
of a highly liquid pan-European capital market. Over time, the development of such a
capital market should lower the cost of capital and lead to an increase in both the level of
investment and the efficiency with which investment funds are allocated. This could be
especially helpful to smaller companies that have historically had difficulty borrowing
money from domestic banks. For example, the capital market of Portugal is very small
and illiquid, which makes it extremely difficult for bright Portuguese entrepreneurs with
a good idea to borrow money at a reasonable price. However, in theory, such companies
can now tap a much more liquid pan-European capital market.
Finally, the development of a pan-European, euro-denominated capital market will
increase the range of investment options open to both individuals and institutions. For
example, it will now be much easier for individuals and institutions based in, let’s say,
Holland to invest in Italian or French companies. This will enable European investors
to better diversify their risk, which again lowers the cost of capital, and should also
increase the efficiency with which capital resources are allocated. 15

Costs of the Euro The drawback, for some, of a single currency is that national
authorities have lost control over monetary policy. Thus, it is crucial to ensure that the
EU’s monetary policy is well managed. The Maastricht Treaty called for establishment
of the independent European Central Bank (ECB), similar in some respects to the
U.S. Federal Reserve, with a clear mandate to manage monetary policy so as to ensure
price stability. The ECB, based in Frankfurt, is meant to be independent from political
pressure—although critics question this. Among other things, the ECB sets interest
rates and determines monetary policy across the euro zone.
The implied loss of national sovereignty to the ECB underlies the decision by
Great Britain, Denmark, and Sweden to stay out of the euro zone for now. Many in
these countries are suspicious of the ECB’s ability to remain free from political pres-
sure and to keep inflation under tight control.
In theory, the design of the ECB should ensure that it remains free of political pres-
sure. The ECB is modeled on the German Bundesbank, which historically has been
the most independent and successful central bank in Europe. The Maastricht Treaty
prohibits the ECB from taking orders from politicians. The executive board of the
bank, which consists of a president, vice president, and four other members, carries out
policy by issuing instructions to national central banks. The policy itself is determined
by the governing council, which consists of the executive board plus the central bank
governors from the 17 euro zone countries. The governing council votes on interest
rate changes. Members of the executive board are appointed for eight-year nonrenew-
able terms, insulating them from political pressures to get reappointed. Nevertheless,
the jury is still out on the issue of the ECB’s independence, and it will take some time
for the bank to establish its credentials.
According to critics, another drawback of the euro is that the EU is not what
economists would call an optimal currency area. In an optimal currency area, simi-
larities in the underlying structure of economic activity make it feasible to adopt a
single currency and use a single exchange rate as an instrument of macroeconomic
policy. Many of the European economies in the euro zone, however, are very dissimi-
lar. For example, Finland and Portugal have different wage rates, tax regimes, and
business cycles, and they may react very differently to external economic shocks. A
change in the euro exchange rate that helps Finland may hurt Portugal. Obviously,
such differences complicate macroeconomic policy. For example, when euro econo-
mies are not growing in unison, a common monetary policy may mean that interest

Optimal
Currency Area

One where similarities in
the underlying structure

of economic activity
make it feasible to adopt

a single currency.

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Chapter Eight Regional Economic Integration 291

rates are too high for depressed regions and too low for booming regions. It will be
interesting to see how the European Union copes with the strains caused by such
divergent economic performance.
One way of dealing with such divergent effects within the euro zone might be for
the EU to engage in fiscal transfers, taking money from prosperous regions and pump-
ing it into depressed regions. Such a move, however, would open a political can of
worms. Would the citizens of Germany forgo their “fair share” of EU funds to create
jobs for underemployed Portuguese workers?
Some critics believe that the euro puts the economic cart before the political
horse. In their view, a single currency should follow, not precede, political union.
They argue that the euro will unleash enormous pressures for tax harmonization
and fiscal transfers from the center, both policies that cannot be pursued without the
appropriate political structure. The most apocalyptic vision that flows from these
negative views is that far from stimulating economic growth, as its advocates claim,
the euro will lead to lower economic growth and higher inflation within Europe. To
quote one critic:

Imposing a single exchange rate and an inflexible exchange rate on countries that
are characterized by different economic shocks, inflexible wages, low labor mobility,
and separate national fiscal systems without significant cross-border fiscal transfers
will raise the overall level of cyclical unemployment among EMU members. The
shift from national monetary policies dominated by the (German) Bundesbank
within the European Monetary System to a European Central Bank governed by
majority voting with a politically determined exchange rate policy will almost
certainly raise the average future rate of inflation. 16

The Experience to Date Since its establishment January 1, 1999, the euro has
had a volatile trading history against the world’s major currency, the U.S. dollar. After
starting life in 1999 at €1 5 $1.17, the euro steadily fell until it reached a low of €1 5
$0.83 in October 2000, leading critics to claim the euro was a failure. A major reason
for the fall in the euro’s value was that international investors were investing money in
booming U.S. stocks and bonds and taking money out of Europe to finance this
investment. In other words, they were selling euros to buy dollars so that they could
invest in dollar-denominated assets. This increased the demand for dollars and de-
creased the demand for the euro, driving the value
of the euro down.
The fortunes of the euro began improving in
late 2001 when the dollar weakened, and the cur-
rency stood at a robust all-time high of €1 5 $1.54
in early March 2008. One reason for the rise in
the value of the euro was that the flow of capital
into the United States had stalled as the U.S.
financial markets fell. 17 Many investors were now
taking money out of the United States, selling
dollar-denominated assets such as U.S. stocks and
bonds, and purchasing euro-denominated assets.
Falling demand for U.S. dollars and rising de-
mand for euros translated into a fall in the value of
the dollar against the euro. Furthermore, in a vote
of confidence in both the euro and the ability of
the ECB to manage monetary policy within the
euro zone, many foreign central banks added more

A n o t h e r P e r s p e c t i v e

What to Do about Greece?
Since its establishment in 1994, no member nation of the
European Union (EU) has skated as close to insolvency as
Greece, which in early 2010 announced its national deficit
had soared to nearly 13 percent of gross domestic product.
Under pressure from the EU, the Greek government crafted
a stringent austerity program that includes sales tax hikes
on alcohol, tobacco, and fuel; a tax on luxury goods; and
deep wage cuts for civil servants. These moves persuaded
the EU to announce it would support Greece with a bailout,
if needed. The bailout, should it occur, would be the first
in EU history. (Stephen Castle and Niki Kitsantonis, “E.U.
Endorses Greek Austerity Efforts,” The New York Times,
March 4, 2010, www.nytimes.com)

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292 Part Three Cross-Border Trade and Investment

euros to their supply of foreign currencies. In the first three years of its life, the euro
never reached the 13 percent of global reserves made up by the deutsche mark and
other former euro zone currencies. The euro didn’t jump that hurdle until early 2002,
but by 2004 it made up 20 percent of global reserves. Currency specialists expected the
growing U.S. current account deficit, which reached 7 percent of GDP in 2005, to
drive the dollar down further, and the euro still higher over the next two to four
years. 18 In 2007 this started to occur, with the euro appreciating steadily against the
dollar from 2005 until early 2008. Since the euro has weakened somewhat, reflecting
concerns over slow economic growth and growing budget deficits among several EU
member states, particularly Greece, Portugal and Spain (see the accompanying Coun-
try Focus for more details). Nevertheless, in early 2010 the exchange rate, which stood
at €1 5 $1.35, was still strong compared to the exchange rate in the early 2000s. While
the strong euro has been a source of pride for Europeans, it does make it harder for
euro zone exporters to sell their goods abroad.

ENLARGEMENT OF THE EUROPEAN UNION A major issue facing the
EU over the past few years has been that of enlargement. Enlargement of the EU into
Eastern Europe has been a possibility since the collapse of communism at the end of

Crisis in the Euro Zone

When the euro was established, some critics worried that
free-spending countries in the euro zone (such as Italy)
might borrow excessively, running up large public-sector
deficits that they could not finance. This would then rock
the value of the euro, requiring their more sober brethren,
such as Germany or France, to step in and bail out the prof-
ligate nation. In early 2010, this worry was fast becoming a
reality as a financial crisis in Greece rocked the value of
the euro.
The financial crisis had its roots in a decade of free
spending by the Greek government. The government ran
up a high level of debt to finance extensive spending in the
public sector. Much of the increase in spending could be
characterized as an attempt by the government to buy off
powerful interest groups in Greek society, from teachers
and farmers to public employees, rewarding them with
high pay and extensive benefits. To make matters worse,
the government misled the international community about
the level of its indebtedness. In October 2009 a new gov-
ernment took power and quickly announced that the 2009
deficit, which had been projected to be around 5 percent,
would actually be around 12.7 percent. The previous gov-
ernment had apparently been cooking the books.
This shattered any faith that international investors
might have had in the Greek economy. Interest rates on
Greek government debt soared to 7.1 percent, about 4 per-
centage points higher than the rate on German bonds.

Two of the three international rating agencies also cut
their ratings on Greek bonds and warned that further
downgrades were likely. The main concern now was that
the Greek government might not be able to refinance
some €20 billion of debt that matured in April or May 2010.
A further concern was that the Greek government might
lack the political willpower to make the large cuts in pub-
lic spending necessary to bring down the deficit and re-
store investor confidence. This raised the specter that
either the IMF, or the European Central Bank with the sup-
port of Germany and France, would have to step in and
bail out the Greek government, imposing fiscal discipline
on the country in return for loans that would keep the
country from defaulting on its debt.
Nor was Greece alone in having large public-sector defi-
cits. Three other euro zone countries—Spain, Portugal,
and Ireland—also all had large debt loads, and interest
rates on their bonds also surged as investors sold out. This
raised the specter of financial contagion, with large-scale
defaults among the weaker members of the euro zone. If
this did occur, the EU and IMF would most certainly have to
step in and rescue the troubled nations. With this possibil-
ity, once considered very remote, investors started to move
money out of euros, and the value of the euro started to fall
on the foreign exchange market.

Sources: “A very European Crisis,” The Economist , February 6, 2010,
pp. 75–77; and L. Thomas, “Is Debt Trashing the Euro?” The New York
Times , February 7, 2010, pp. 1, 7.

3 C o u n t r y F O C U S

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Chapter Eight Regional Economic Integration 293

the 1980s, and by the end of the 1990s, 13 countries had applied to become EU mem-
bers. To qualify for EU membership the applicants had to privatize state assets, de-
regulate markets, restructure industries, and tame inflation. They also had to enshrine
complex EU laws into their own systems, establish stable democratic governments,
and respect human rights. 19 In December 2002, the EU formally agreed to accept the
applications of 10 countries, and they joined May 1, 2004. The new members include
the Baltic countries, the Czech Republic, and the larger nations of Hungary and
Poland. The only new members not in Eastern Europe are the Mediterranean island
nations of Malta and Cyprus. Their inclusion in the EU expanded the union to 25 states,
stretching from the Atlantic to the borders of Russia; added 23 percent to the land-
mass of the EU; brought 75 million new citizens into the EU, building an EU with a
population of 450 million people; and created a single continental economy with a
GDP of close to €11 trillion. In 2007, Bulgaria and Romania joined, bringing total
member ship to 27 nations.
The new members were not able to adopt the euro until at least 2007 (and 2010 in
the case of the latest entrants), and free movement of labor between the new and exist-
ing members was not allowed until then. Consistent with theories of free trade, the
enlargement should create added benefits for all members. However, given the small
size of the Eastern European economies (together they amount to only 5 percent of
the GDP of current EU members) the initial impact will probably be small. The big-
gest notable change might be in the EU bureaucracy and decision-making processes,
where budget negotiations among 27 nations are bound to prove more problematic
than negotiations among 15 nations.
Left standing at the door is Turkey. Turkey, which has long lobbied to join the
union, presents the EU with some difficult issues. The country has had a customs
union with the EU since 1995, and about half of its international trade is already with
the EU. However, full membership has been denied because of concerns over human
rights issues (particularly Turkish policies toward its Kurdish minority). In addition,
some on the Turk side suspect the EU is not eager to let a primarily Muslim nation of
66 million people, which has one foot in Asia, join the EU. The European Union for-
mally indicated in December 2002 that it would allow the Turkish application to pro-
ceed with no further delay in December 2004 if the country improved its human rights
record to the satisfaction of the EU. In 2004 the EU agreed to allow Turkey to start
accession talks in October 2005, but those talks are not moving along rapidly, and the
nation will not join until 2013, if at all.

Regional Economic Integration

in the Americas
No other attempt at regional economic integration comes close to the EU in its
boldness or its potential implications for the world economy, but regional economic
integration is on the rise in the Americas. The most significant attempt is the North
American Free Trade Agreement. In addition to NAFTA, several other trade blocs
are in the offing in the Americas (see Map 8.2), the most significant of which appear
to be the Andean Community and Mercosur. Also, negotiations are under way to
establish a hemisphere-wide Free Trade Area of the Americas (FTAA), although cur-
rently they seem to be stalled.

THE NORTH AMERICAN FREE TRADE AGREEMENT The govern-
ments of the United States and Canada in 1988 agreed to enter into a free trade agree-
ment, which took effect January 1, 1989. The goal of the agreement was to eliminate

LEARNING OBJECTIVE 4
Explain the history, current
scope, and future prospects
of the world’s most
important regional
economic agreements.

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294 Part Three Cross-Border Trade and Investment

all tariffs on bilateral trade between Canada and the United States by 1998. This was
followed in 1991 by talks among the United States, Canada, and Mexico aimed at es-
tablishing a North American Free Trade Agreement for the three countries. The
talks concluded in August 1992 with an agreement in principle, and the following year
the agreement was ratified by the governments of all three countries. The agreement
became law January 1, 1994. 20

NAFTA’S Contents The contents of NAFTA include the following:

• Abolition by 2004 of tariffs on 99 percent of the goods traded between Mexico,
Canada, and the United States.

• Removal of most barriers on the cross-border flow of services, allowing financial
institutions, for example, unrestricted access to the Mexican market by 2000.

• Protection of intellectual property rights.

NAFTA
MERCOSUR
Andean community
Central America
Caribbean community

Continental Commerce

map 8.2

Economic Integration in
the Americas

Source: The Economist , April 21,

Economist Newspaper Ltd. All

rights reserved. Reprinted with

permission. Further reproduction

prohibited. www.economist.com

North American
Free Trade
Agreement

(NAFTA)
Free trade area between
Canada, Mexico, and the

United States.

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Chapter Eight Regional Economic Integration 295

• Removal of most restrictions on foreign direct investment between the three
member countries, although special treatment (protection) will be given to
Mexican energy and railway industries, American airline and radio
communications industries, and Canadian culture.

• Application of national environmental standards, provided such standards have a
scientific basis. Lowering of standards to lure investment is described as being
inappropriate.

• Establishment of two commissions with the power to impose fines and remove
trade privileges when environmental standards or legislation involving health and
safety, minimum wages, or child labor are ignored.

The Case for NAFTA Proponents of NAFTA have argued that the free trade
area should be viewed as an opportunity to create an enlarged and more efficient pro-
ductive base for the entire region. Advocates acknowledge that one effect of NAFTA
would be that some U.S. and Canadian firms would move production to Mexico to
take advantage of lower labor costs. (In 2004, the average hourly labor cost in Mexico
was still one-tenth of that in the United States and Canada.) Movement of production
to Mexico, they argued, was most likely to occur in low-skilled, labor-intensive manu-
facturing industries where Mexico might have a comparative advantage. Advocates of
NAFTA argued that many would benefit from such a trend. Mexico would benefit
from much-needed inward investment and employment. The United States and Canada
would benefit because the increased incomes of the Mexicans would allow them to
import more U.S. and Canadian goods, thereby increasing demand and making up for
the jobs lost in industries that moved production to Mexico. U.S. and Canadian con-
sumers would benefit from the lower prices of products made in Mexico. In addition,
the international competitiveness of U.S. and Canadian firms that move production to
Mexico to take advantage of lower labor costs would be enhanced, enabling them to
better compete with Asian and European rivals.

The Case against NAFTA Those who opposed NAFTA claimed that ratifica-
tion would be followed by a mass exodus of jobs from the United States and Canada
into Mexico as employers sought to profit from Mexico’s lower wages and less strict
environmental and labor laws. According to one extreme opponent, Ross Perot, up to
5.9 million U.S. jobs would be lost to Mexico after NAFTA in what he famously char-
acterized as a “giant sucking sound.” Most economists, however, dismissed these num-
bers as being absurd and alarmist. They argued that Mexico would have to run a
bilateral trade surplus with the United States of close to $300 billion for job loss on
such a scale to occur—and $300 billion was the size of Mexico’s GDP. In other words,
such a scenario seemed implausible.
More sober estimates of the impact of NAFTA ranged from a net creation of
170,000 jobs in the United States (due to increased Mexican demand for U.S. goods
and services) and an increase of $15 billion per year to the joint U.S. and Mexican
GDP, to a net loss of 490,000 U.S. jobs. To put these numbers in perspective, employ-
ment in the U.S. economy was predicted to grow by 18 million from 1993 to 2003. As
most economists repeatedly stressed, NAFTA would have a small impact on both
Canada and the United States. It could hardly be any other way, since the Mexican
economy was only 5 percent of the size of the U.S. economy. Signing NAFTA re-
quired the largest leap of economic faith from Mexico rather than Canada or the
United States. Falling trade barriers would expose Mexican firms to highly efficient
U.S. and Canadian competitors that, when compared to the average Mexican firm, had

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296 Part Three Cross-Border Trade and Investment

far greater capital resources, access to highly educated and skilled workforces, and
much greater technological sophistication. The short-run outcome was likely to be
painful economic restructuring and unemployment in Mexico. But advocates of
NAFTA claimed there would be long-run dynamic gains in the efficiency of Mexican
firms as they adjusted to the rigors of a more competitive marketplace. To the extent
that this occurred, they argued, Mexico’s economic growth rate would accelerate, and
Mexico might become a major market for Canadian and U.S. firms. 21
Environmentalists also voiced concerns about NAFTA. They pointed to the sludge
in the Rio Grande River and the smog in the air over Mexico City and warned that
Mexico could degrade clean air and toxic waste standards across the continent. They
pointed out that the lower Rio Grande was the most polluted river in the United
States, and that with NAFTA, chemical waste and sewage would increase along its
course from El Paso, Texas, to the Gulf of Mexico.
There was also opposition in Mexico to NAFTA from those who feared a loss of
national sovereignty. Mexican critics argued that their country would be dominated by
U.S. firms that would not really contribute to Mexico’s economic growth, but instead
would use Mexico as a low-cost assembly site, while keeping their high-paying, high-
skilled jobs north of the border.

NAFTA: The Results Studies of NAFTA’s impact to date suggest its initial effects
were at best muted, and both advocates and detractors may have been guilty of exag-
geration. 22 On average, studies indicate that NAFTA’s overall impact has been small
but positive. 23 From 1993 to 2005, trade between NAFTA’s partners grew by 250 per-
cent. 24 Canada and Mexico are now the number one and two trade partners of the
United States, suggesting the economies of the three NAFTA nations have become
more closely integrated. In 1990, U.S. trade with Canada and Mexico accounted for

Many workers in the United States initially believed that NAFTA would take away their jobs as employers looked for
cheaper labor in Mexico. However, a 1996 study by researchers at the University of California–Los Angeles concluded the
impact on jobs was a net gain of 3,000 for the United States in the first two years of the NAFTA regime.

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Chapter Eight Regional Economic Integration 297

about a quarter of total U.S. trade. By 2005, the figure was close to one-third. Canada’s
trade with its NAFTA partners increased from about 70 percent to more than 80 per-
cent of all Canadian foreign trade between 1993 and 2005, while Mexico’s trade with
NAFTA increased from 66 percent to 80 percent over the same period. All three
countries also experienced strong productivity growth over this period. In Mexico,
labor productivity has increased by 50 percent since 1993, and the passage of NAFTA
may have contributed to this. However, estimates suggest that employment effects of
NAFTA have been small. The most pessimistic estimates suggest the United States
lost 110,000 jobs per year due to NAFTA between 1994 and 2000—and many econo-
mists dispute this figure—which is tiny compared to the more than 2 million jobs a
year created in the United States during the same period. Perhaps the most significant
impact of NAFTA has not been economic, but political. Many observers credit
NAFTA with helping to create the background for increased political stability in
Mexico. Mexico is now viewed as a stable democratic nation with a steadily growing
economy, something that is beneficial to the United States, which shares a 2,000-mile
border with the country. 25

Enlargement One issue confronting NAFTA is that of enlargement. A number of
other Latin American countries have indicated their desire to eventually join NAFTA.
The governments of both Canada and the United States are adopting a wait-and-see
attitude with regard to most countries. Getting NAFTA approved was a bruising po-
litical experience, and neither government is eager to repeat the process soon. Never-
theless, the Canadian, Mexican, and U.S. governments began talks in 1995 regarding
Chile’s possible entry into NAFTA. As of 2008, however, these talks had yielded little
progress, partly because of political opposition in the U.S. Congress to expanding
NAFTA. In December 2002, however, the United States and Chile did sign a bilateral
free trade pact.

THE ANDEAN COMMUNITY Bolivia, Chile, Ecuador, Colombia, and Peru
signed an agreement in 1969 to create the Andean Pact. The Andean Pact was largely
based on the EU model, but was far less successful at achieving its stated goals. The
integration steps begun in 1969 included an internal tariff reduction program, a com-
mon external tariff, a transportation policy, a common industrial policy, and special
concessions for the smallest members, Bolivia and Ecuador.
By the mid-1980s, the Andean Pact had all but collapsed and had failed to
achieve any of its stated objectives. There was no tariff-free trade between member
countries, no common external tariff, and no harmonization of economic policies.
Political and economic problems seem to have hindered cooperation between
member countries. The countries of the Andean Pact have had to deal with low
economic growth, hyperinflation, high unemployment, political unrest, and crushing
debt burdens. In addition, the dominant political ideology in many of the Andean
countries during this period tended toward the radical/socialist end of the political
spectrum. Since such an ideology is hostile to the free market economic principles
on which the Andean Pact was based, progress toward closer integration could not
be expected.
The tide began to turn in the late 1980s when, after years of economic decline, the
governments of Latin America began to adopt free market economic policies. In 1990,
the heads of the five current members of the Andean Community—Bolivia, Ecuador,
Peru, Colombia, and Venezuela—met in the Galápagos Islands. The resulting Galápagos
Declaration effectively relaunched the Andean Pact, which was renamed the Andean
Community in 1997. The declaration’s objectives included the establishment of a free
trade area by 1992, a customs union by 1994, and a common market by 1995. This last

Andean Pact
A 1969 agreement
between Bolivia, Chile,
Ecuador, Colombia, and
Peru to establish a
customs union.

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298 Part Three Cross-Border Trade and Investment

milestone has not been reached. A customs union was implemented in 1995, although
until 2003 Peru opted out and Bolivia received preferential treatment. The Andean
Community now operates as a customs union. In December 2003, it signed an agree-
ment with Mercosur to restart stalled negotiations on the creation of a free trade area
between the two trading blocs. Those negotiations are currently proceeding at a slow
pace. In late 2006, Venezuela withdrew from the Andean Community as part of that
country’s attempts to join Mercosur.

MERCOSUR Mercosur originated in 1988 as a free trade pact between Brazil
and Argentina. The modest reductions in tariffs and quotas accompanying this pact
reportedly helped bring about an 80 percent increase in trade between the two
countries in the late 1980s. 26 This success encouraged the expansion of the pact in
March 1990 to include Paraguay and Uruguay. In 2006, Venezuela signed a member-
ship agreement, although this has yet to be ratified and it may take years for Venezuela
to become a full member.
The initial aim of Mercosur was to establish a full free trade area by the end of
1994 and a common market sometime thereafter. In December 1995, Mercosur’s
members agreed to a five-year program under which they hoped to perfect their free
trade area and move toward a full customs union—something that has yet to be
achieved. 27 For its first eight years or so, Mercosur seemed to be making a positive
contribution to the economic growth rates of its member states. Trade between
Mercosur’s four core members quadrupled between 1990 and 1998. The combined
GDP of the four member states grew at an annual average rate of 3.5 percent between
1990 and 1996, a performance that is significantly better than the four attained during
the 1980s. 28
However, Mercosur had its critics, including Alexander Yeats, a senior economist
at the World Bank, who wrote a stinging critique of the pact. 29 According to Yeats,
the trade diversion effects of Mercosur outweigh its trade creation effects. Yeats
pointed out that the fastest-growing items in intra-Mercosur trade were cars, buses,
agricultural equipment, and other capital-intensive goods that are produced rela-
tively inefficiently in the four member countries. In other words, Mercosur coun-
tries, insulated from outside competition by tariffs that run as high as 70 percent of
value on motor vehicles, are investing in factories that build products that are too
expensive to sell to anyone but themselves. The result, according to Yeats, is that
Mercosur countries might not be able to compete globally once the group’s exter-
nal trade barriers come down. In the meantime, capital is being drawn away from
more efficient enterprises. In the near term, countries with more efficient manufac-
turing enterprises lose because Mercosur’s external trade barriers keep them out of
the market.
Mercosur hit a significant roadblock in 1998, when its member states slipped into
recession and intrabloc trade slumped. Trade fell further in 1999 following a financial
crisis in Brazil that led to the devaluation of the Brazilian real, which immediately
made the goods of other Mercosur members 40 percent more expensive in Brazil,
their largest export market. At this point, progress toward establishing a full customs
union all but stopped. Things deteriorated further in 2001 when Argentina, beset by
economic stresses, suggested the customs union be temporarily suspended. Argentina
wanted to suspend Mercosur’s tariff so that it could abolish duties on imports of capi-
tal equipment, while raising those on consumer goods to 35 percent (Mercosur had
established a 14 percent import tariff on both sets of goods). Brazil agreed to this re-
quest, effectively halting Mercosur’s quest to become a fully functioning customs
union. 30 Hope for a revival arose in 2003 when new Brazilian President Lula da Silva
announced his support for a revitalized and expanded Mercosur modeled after the

Mercosur
Pact between Argentina,

Brazil, Paraguay, and
Uruguay to establish a

free trade area.

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Chapter Eight Regional Economic Integration 299

EU with a larger membership, a common currency, and a democratically elected par-
liament. 31 As of 2010, however, little progress had been made in moving Mercosur
down that road, and critics felt that the customs union was, if anything, becoming
more imperfect over time. 32

CENTRAL AMERICAN COMMON MARKET, CAFTA, AND CARICOM
Two other trade pacts in the Americas have not made much progress. In the early
1960s, Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua attempted to
set up a Central American Common Market. It collapsed in 1969 when war
broke out between Honduras and El Salvador after a riot at a soccer match between
teams from the two countries. Since then the six member countries have made
some progress toward reviving their agreement (the five founding members were
joined by the Dominican Republic). The proposed common market was given a
boost in 2003 when the United States signaled its intention to enter into bilateral
free trade negotiations with the group. These cumulated in a 2005 agreement to
establish a free trade agreement between the six countries and the United States.
Known as the Central America Free Trade Agreement, or CAFTA, the aim is to
lower trade barriers between the United States and the six countries for most goods
and services.
A customs union was to have been created in 1991 between the English-speaking
Caribbean countries under the auspices of the Caribbean Community. Referred to
as CARICOM, it was established in 1973. However, it repeatedly failed to progress
toward economic integration. A formal commitment to economic and monetary
union was adopted by CARICOM’s member states in 1984, but since then little
progress has been made. In October 1991, the CARICOM governments failed, for
the third consecutive time, to meet a deadline for establishing a common external
tariff. Despite this, CARICOM expanded to 15 members by 2005. In early 2006, six
CARICOM members established the Caribbean Single Market and Economy
(CSME). Modeled on the EU’s single market, the goal of CSME is to lower trade
barriers and harmonize macroeconomic and monetary policy between member
states. 33

FREE TRADE AREA OF THE AMERICAS At a hemisphere-wide Summit
of the Americas in December 1994, a Free Trade Area of the Americas (FTAA) was
proposed. It took more than three years for the talks to start, but in April 1998,
34 heads of state traveled to Santiago, Chile, for the second Summit of the Americas
where they formally inaugurated talks to establish an FTAA by January 1, 2005—
something that didn’t occur. The continuing talks have addressed a wide range of
economic, political, and environmental issues related to cross-border trade and in-
vestment. Although both the United States and Brazil were early advocates of the
FTAA, support from both countries seems to be mixed at this point. Because the
United States and Brazil have the largest economies in North and South America,
respectively, strong U.S. and Brazilian support is a precondition for establishment of
the free trade area.
The major stumbling blocks so far have been twofold. First, the United States
wants its southern neighbors to agree to tougher enforcement of intellectual property
rights and lower manufacturing tariffs, which they do not seem to be eager to em-
brace. Second, Brazil and Argentina want the United States to reduce its subsidies to
U.S. agricultural producers and scrap tariffs on agricultural imports, which the U.S.
government does not seem inclined to do. For progress to be made, most observers
agree that the United States and Brazil have to first reach an agreement on these cru-
cial issues. 34 If the FTAA is eventually established, it will have major implications for

Central American
Common Market
A trade pact between
Costa Rica, El Salvador,
Guatemala, Honduras,
and Nicaragua, which
began in the early 1960s
but collapsed in1969 due
to war.

Central America
Free Trade
Agreement
(CAFTA)
The agreement of the
member states of the
Central American
Common Market joined
by the Dominican
Republic to trade freely
with the United States.

CARICOM
An association of
English-speaking
Caribbean states that
are attempting to establish
a customs union.

Caribbean Single
Market and
Economy (CSME)
Unites six CARICOM
members in agreeing
to lower trade barriers
and harmonize
macroeconomic and
monetary policies.

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300 Part Three Cross-Border Trade and Investment

cross-border trade and investment flows within the hemisphere. The FTAA would
open a free trade umbrella over 850 million people who accounted for some $18 tril-
lion in GDP in 2008.
Currently, however, FTAA is very much a work in progress, and the progress has
been slow. The most recent attempt to get talks going again, in November 2005 at
a summit of 34 heads of state from North and South America, failed when oppo-
nents, led by Venezuela’s populist president, Hugo Chavez, blocked efforts by the
Bush administration to set an agenda for further talks on FTAA. In voicing his
opposition, Chavez condemned the U.S. free trade model as a “perversion” that
would unduly benefit the United States, to the detriment of poor people in Latin
America whom Chavez claims have not benefited from free trade details. 35 Such
views make it unlikely that there will be much progress on establishing a FTAA in
the near term.

Regional Economic Integration Elsewhere
Numerous attempts at regional economic integration have been tried throughout Asia
and Africa. However, few exist in anything other than name. Perhaps the most signifi-
cant is the Association of Southeast Asian Nations (ASEAN). In addition, the Asia-
Pacific Economic Cooperation (APEC) forum has recently emerged as the seed of a
potential free trade region.

ASSOCIATION OF SOUTHEAST ASIAN NATIONS Formed in 1967,
the Association of Southeast Asian Nations (ASEAN) includes Brunei, Cambodia,
Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam.
Laos, Myanmar, Vietnam, and Cambodia have all joined recently, creating a regional
grouping of 500 million people with a combined GDP of some $740 billion (see
Map 8.3). The basic objective of ASEAN is to foster freer trade between member
countries and to achieve cooperation in their industrial policies. Progress so far has
been limited, however.
Until recently only 5 percent of intra-ASEAN trade consisted of goods whose
tariffs had been reduced through an ASEAN preferential trade arrangement. This
may be changing. In 2003, an ASEAN Free Trade Area (AFTA) between the six
original members of ASEAN came into full effect. The AFTA has cut tariffs on
manufacturing and agricultural products to less than 5 percent. However, there are
some significant exceptions to this tariff reduction. Malaysia, for example, refused
to bring down tariffs on imported cars until 2005 and then agreed to only lower the
tariff to 20 percent, not the 5 percent called for under the AFTA. Malaysia wanted
to protect Proton, an inefficient local carmaker, from foreign competition. Simi-
larly, the Philippines has refused to lower tariff rates on petrochemicals, and rice,
the largest agricultural product in the region, will remain subject to higher tariff
rates until at least 2020. 36
Notwithstanding such issues, ASEAN and AFTA are at least progressing toward
establishing a free trade zone. Vietnam joined the AFTA in 2006, Laos and Myanmar
in 2008, and Cambodia in 2010. The goal was to reduce import tariffs among the six
original members to zero by 2010, and to do so by 2015 for the newer members (al-
though important exceptions to that goal, such as tariffs on rice, will persist).
ASEAN also recently signed a free trade agreement with China. This went into ef-
fect January 1, 2010. Trade between China and ASEAN members more than tripled
during the first decade of the 21st century, and this agreement should spur further
growth. The agreement between ASEAN and China removes tariffs on 90 percent of
traded goods. 37

LEARNING OBJECTIVE 4
Explain the history, current
scope, and future prospects
of the world’s most
important regional
economic agreements.

Association of
Southeast Asian

Nations (ASEAN)
An attempt to establish a
free trade area between

Brunei, Cambodia,
Indonesia, Laos,

Malaysia, Myanmar,
Philippines, Singapore,
Thailand, and Vietnam.

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Chapter Eight Regional Economic Integration 301

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302 Part Three Cross-Border Trade and Investment

ASIA-PACIFIC ECONOMIC COOPERATION Asia-Pacific Economic
Cooperation (APEC) was founded in 1990 at the suggestion of Australia. APEC cur-
rently has 21 member states including such economic powerhouses as the United States,
Japan, and China (see Map 8.4). Collectively, the member states account for about 55 per-
cent of the world’s GNP, 49 percent of world trade, and much of the growth in the world
economy. The stated aim of APEC is to increase multilateral cooperation in view of the
economic rise of the Pacific nations and the growing interdependence within the region.
U.S. support for APEC was also based on the belief that it might prove a viable strategy for
heading off any moves to create Asian groupings from which it would be excluded.
Interest in APEC was heightened considerably in November 1993 when the heads of
APEC member states met for the first time at a two-day conference in Seattle. Debate
before the meeting speculated on the likely future role of APEC. One view was that
APEC should commit itself to the ultimate formation of a free trade area. Such a move
would transform the Pacific Rim from a geographical expression into the world’s largest
free trade area. Another view was that APEC would produce no more than hot air and
lots of photo opportunities for the leaders involved. As it turned out, the APEC meeting
produced little more than some vague commitments from member states to work
together for greater economic integration and a general lowering of trade barriers.

Asia-Pacific
Economic

Cooperation
(APEC)

Made up of 21 member
states whose goal is to

increase multilateral
cooperation in view of

the economic rise of the
Pacific nations.

Russia

United States

Canada

Mexico

Peru

Chile

China

Thailand
Vietnam

Malaysia
Papua

New Guinea

Brunei

Singapore

Philippines

Chinese Taipei
Hong Kong, China

I n d o n e s i a

Japan
Korea

Australia

New Zealand

New Caledonia

Member

Nonmembers

APEC Members

map 8.4

APEC Members

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Chapter Eight Regional Economic Integration 303

However, significantly, member states did not rule out the possibility of closer economic
cooperation in the future. 38
The heads of state have met again on a number of occasions. At a 1997 meeting,
member states formally endorsed proposals designed to remove trade barriers in
15 sectors, ranging from fish to toys. However, the vague plan committed APEC to
doing no more than holding further talks, which is all that they have done to date.
Commenting on the vagueness of APEC pronouncements, the influential Brookings
Institution, a U.S.-based economic policy institution, noted that APEC “is in grave
danger of shrinking into irrelevance as a serious forum.” Despite the slow progress,
APEC is worth watching. If it eventually does transform itself into a free trade area, it
will probably be the world’s largest. 39

REGIONAL TRADE BLOCS IN AFRICA African countries have been ex-
perimenting with regional trade blocs for half a century. There are now nine trade
blocs on the African continent. Many countries are members of more than one group.
Although the number of trade groups is impressive, progress toward the establishment
of meaningful trade blocs has been slow.
Many of these groups have been dormant for years. Significant political turmoil in sev-
eral African nations has persistently impeded any meaningful progress. Also, deep suspi-
cion of free trade exists in several African countries. The argument most frequently heard
is that because these countries have less developed and less diversified economies, they
need to be “protected” by tariff barriers from unfair foreign competition. Given the preva-
lence of this argument, it has been hard to establish free trade areas or customs unions.
The most recent attempt to reenergize the free trade movement in Africa occurred
in early 2001, when Kenya, Uganda, and Tanzania, member states of the East African
Community (EAC), committed themselves to relaunching their bloc, 24 years after it
collapsed. The three countries, with 80 million inhabitants, intend to establish a cus-
toms union, regional court, legislative assembly, and, eventually, a political federation.
Their program includes cooperation on immigration, road and telecommunication
networks, investment, and capital markets. However, while local business leaders wel-
comed the relaunch as a positive step, they were critical of the EAC’s failure in practice
to make progress on free trade. At the EAC treaty signing in November 1999, mem-
bers gave themselves four years to negotiate a customs union, with a draft slated for
the end of 2001. But that fell far short of earlier plans for an immediate free trade
zone, shelved after Tanzania and Uganda, fearful of Kenyan competition, expressed
concerns that the zone could create imbalances similar to those that contributed to the
breakup of the first community. 40 Nevertheless, in 2005 the EAC did start to imple-
ment a customs union, although many tariffs remained in place until 2010. In 2007,
Burundi and Rwanda joined the EAC.

Focus on Managerial Implications

Currently the most significant developments in regional economic integration are
occurring in the European Union and NAFTA. Although some of the Latin American
trade blocs, ASEAN, and the proposed FTAA may have economic significance in the
future, the EU and NAFTA currently have more profound and immediate implications

LEARNING OBJECTIVE 5
Understand the implications

for business that are inherent
in regional economic

integration agreements.

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304 Part Three Cross-Border Trade and Investment

for business practice. Accordingly, in this section we will concentrate on the business
implications of those two groups. Similar conclusions, however, could be drawn with
regard to the creation of a single market anywhere in the world.

Opportunities
The creation of a single market through regional economic integration offers signifi-
cant opportunities because markets that were formerly protected from foreign compe-
tition are increasingly open. For example, in Europe before 1992 the large French and
Italian markets were among the most protected. These markets are now much more
open to foreign competition in the form of both exports and direct investment. None-
theless, to fully exploit such opportunities, it may pay non-EU firms to set up EU
subsidiaries. Many major U.S. firms have long had subsidiaries in Europe. Those that
do not would be advised to consider establishing them now, lest they run the risk of
being shut out of the EU by nontariff barriers.
Additional opportunities arise from the inherent lower costs of doing business in a
single market—as opposed to 27 national markets in the case of the EU or 3 national
markets in the case of NAFTA. Free movement of goods across borders, harmonized
product standards, and simplified tax regimes make it possible for firms based in the
EU and the NAFTA countries to realize potentially significant cost economies by
centralizing production in those EU and NAFTA locations where the mix of factor
costs and skills is optimal. Rather than producing a product in each of the 27 EU
countries or the 3 NAFTA countries, a firm may be able to serve the whole EU or
North American market from a single location. This location must be chosen care-
fully, of course, with an eye on local factor costs and skills.
For example, in response to the changes created by EU after 1992, the St. Paul,
Minnesota-based 3M Company consolidated its European manufacturing and distribu-
tion facilities to take advantage of economies of scale. Thus, a plant in Great Britain now
produces 3M’s printing products and a German factory its reflective traffic control mate-
rials for all of the EU. In each case, 3M chose a location for centralized production after
carefully considering the likely production costs in alternative locations within the EU.
The ultimate goal of 3M is to dispense with all national distinctions, directing R&D,
manufacturing, distribution, and marketing for each product group from an EU head-
quarters. 41 Similarly, Unilever, one of Europe’s largest companies, began rationalizing its
production in advance of 1992 to attain scale economies. Unilever concentrated its pro-
duction of dishwashing powder for the EU in one plant, bath soap in another, and so on. 42
Even after the removal of barriers to trade and investment, enduring differences
in culture and competitive practices often limit the ability of companies to realize
cost economies by centralizing production in key locations and producing a stan-
dardized product for a single multi-country market. Consider the case of Atag Hold-
ings NV, a Dutch maker of kitchen appliances. 43 Atag thought it was well placed to
benefit from the single market, but found it tough going. Atag’s plant is just one mile
from the German border and near the center of the EU’s population. The company
thought it could cater to both the “potato” and “spaghetti” belts—marketers’ terms
for consumers in Northern and Southern Europe—by producing two main product
lines and selling these standardized “euro-products” to “euro-consumers.” The main
benefit of doing so is the economy of scale derived from mass production of a stan-
dardized range of products. Atag quickly discovered that the “euro-consumer” was a
myth. Consumer preferences vary much more across nations than Atag had thought.
Consider ceramic cooktops; Atag planned to market just 2 varieties throughout the
EU but has found it needs 11. Belgians, who cook in huge pots, require extra-large
burners. Germans like oval pots and burners to fit. The French need small burners
and very low temperatures for simmering sauces and broths. Germans like oven

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Chapter Eight Regional Economic Integration 305

knobs on the top; the French want them on the front. Most Germans and French
prefer black and white ranges; the British demand a range of colors including peach,
pigeon blue, and mint green.

Threats
Just as the emergence of single markets creates opportunities for business, it also pres-
ents a number of threats. For one thing, the business environment within each group-
ing will become more competitive. The lowering of barriers to trade and investment
between countries is likely to lead to increased price competition throughout the EU
and NAFTA. For example, before 1992 a Volkswagen Golf cost 55 percent more in
Great Britain than in Denmark and 29 percent more in Ireland than in Greece. 44 Over
time, such price differentials will vanish in a single market. This is a direct threat to
any firm doing business in EU or NAFTA countries. To survive in the tougher single-
market environment, firms must take advantage of the opportunities offered by the
creation of a single market to rationalize their production and reduce their costs. Oth-
erwise, they will be at a severe disadvantage.
A further threat to firms outside these trading blocs arises from the likely long-term
improvement in the competitive position of many firms within the areas. This is particu-
larly relevant in the EU, where many firms have historically been limited by a high cost
structure in their ability to compete globally with North American and Asian firms. The
creation of a single market and the resulting increased competition in the EU is begin-
ning to produce serious attempts by many EU firms to reduce their cost structure by ra-
tionalizing production. This is transforming many EU companies into efficient global
competitors. The message for non-EU businesses is that they need to prepare for the
emergence of more capable European competitors by reducing their own cost structures.
Another threat to firms outside of trading areas is the threat of being shut out of the
single market by the creation of a “trade fortress.” The charge that regional economic
integration might lead to a fortress mentality is most often leveled at the EU. Although
the free trade philosophy underpinning the EU theoretically argues against the cre-
ation of any fortress in Europe, occasional signs indicate the EU may raise barriers to
imports and investment in certain “politically sensitive” areas, such as autos. Non-EU
firms might be well advised, therefore, to set up their own EU operations. This could
also occur in the NAFTA countries, but it seems less likely.
Finally, the emerging role of the European Commission in competition policy sug-
gests the EU is increasingly willing and able to intervene and impose conditions on com-
panies proposing mergers and acquisitions. This is a threat insofar as it limits the ability
of firms to pursue the corporate strategy of their choice. The commission may require
significant concessions from businesses as a precondition for allowing proposed mergers
and acquisitions to proceed. While this constrains the strategic options for firms, it should
be remembered that in taking such action, the commission is trying to maintain the level
of competition in Europe’s single market, which should benefit consumers.

regional economic integration, p. 277
free trade area, p. 278
European Free Trade Association
(EFTA), p. 279

customs union, p. 279
common market, p. 279
economic union, p. 279

political union, p. 280
trade creation, p. 282
trade diversion, p. 282

Key Terms

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306 Part Three Cross-Border Trade and Investment

European Union, p. 282
Treaty of Rome, p. 283
European Commission, p. 283
European Council, p. 285
European Parliament, p. 286
Treaty of Lisbon, p. 286
Court of Justice, p. 286
Single European Act, p. 286
Maastricht Treaty, p. 289

optimal currency area, p. 290
North American Free Trade
Agreement, p. 294
Andean Pact, p. 297
Mercosur, p. 298
Central American Common
Market, p. 299
Central America Free Trade
Agreement (CAFTA), p. 299

CARICOM, p. 299
Caribbean Single Market and
Economy (CSME), p. 299
Association of Southeast Asian
Nations (ASEAN), p. 300
Asia-Pacific Economic Cooperation
(APEC), p. 302

Summary

This chapter pursued three main objectives: to ex-
amine the economic and political debate surround-
ing regional economic integration; to review the
progress toward regional economic integration in
Europe, the Americas, and elsewhere; and to distin-
guish the important implications of regional eco-
nomic integration for the practice of international
business. The chapter made the following points:

1. A number of levels of economic integration are
possible in theory. In order of increasing
integration, they include a free trade area, a
customs union, a common market, an economic
union, and full political union.

2. In a free trade area, barriers to trade between
member countries are removed, but each
country determines its own external trade
policy. In a customs union, internal barriers to
trade are removed and a common external
trade policy is adopted. A common market is
similar to a customs union, except that a
common market also allows factors of
production to move freely between countries.
An economic union involves even closer
integration, including the establishment of a
common currency and the harmonization of
tax rates. A political union is the logical
culmination of attempts to achieve ever closer
economic integration.

3. Regional economic integration is an attempt to
achieve economic gains from the free flow of
trade and investment between neighboring
countries.

4. Integration is not easily achieved or sustained.
Although integration brings benefits to the

majority, it is never without costs for the
minority. Concerns over national sovereignty
often slow or stop integration attempts.

5. Regional integration will not increase
economic welfare if the trade creation effects in
the free trade area are outweighed by the trade
diversion effects.

6. The Single European Act sought to create a
true single market by abolishing administrative
barriers to the free flow of trade and
investment between EU countries.

7. Sixteen EU members now use a common
currency, the euro. The economic gains from a
common currency come from reduced
exchange costs, reduced risk associated with
currency fluctuations, and increased price
competition within the EU.

8. Increasingly, the European Commission is
taking an activist stance with regard to
competition policy, intervening to restrict
mergers and acquisitions that it believes will
reduce competition in the EU.

9. Although no other attempt at regional
economic integration comes close to the EU in
terms of potential economic and political
significance, various other attempts are being
made in the world. The most notable include
NAFTA in North America, the Andean Pact
and Mercosur in Latin America, ASEAN in
Southeast Asia, and perhaps APEC.

10. The creation of single markets in the EU and
North America means that many markets that
were formerly protected from foreign
competition are now more open. This creates

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Chapter Eight Regional Economic Integration 307

major investment and export opportunities for
firms within and outside these regions.

11. The free movement of goods across borders,
the harmonization of product standards, and
the simplification of tax regimes make it
possible for firms based in a free trade area to
realize potentially enormous cost economies by
centralizing production in those locations

within the area where the mix of factor costs
and skills is optimal.

12. The lowering of barriers to trade and
investment between countries within a trade
group will probably be followed by increased
price competition.

Critical Thinking and Discussion Questions

1. NAFTA has produced significant net benefits for
the Canadian, Mexican, and U.S. economies.
Discuss.

2. What are the economic and political arguments
for regional economic integration? Given these
arguments, why don’t we see more substantial
examples of integration in the world economy?

3. What effect is creation of a single market and a
single currency within the EU likely to have on
competition within the EU? Why?

4. Do you think it is correct for the European
Commission to restrict mergers between
American companies that do business in Europe?
(For example, the European Commission vetoed
the proposed merger between WorldCom and
Sprint, both U.S. companies, and it carefully
reviewed the merger between AOL and Time
Warner, again both U.S. companies.)

5. How should a U.S. firm that currently exports
only to ASEAN countries respond to the
creation of a single market in this regional
grouping?

6. How should a firm with self-sufficient
production facilities in several ASEAN countries
respond to the creation of a single market? What
are the constraints on its ability to respond in a
manner that minimizes production costs?

7. After a promising start, Mercosur, the major
Latin American trade agreement, has faltered
and made little progress since 2000. What
problems are hurting Mercosur? What can be
done to solve these problems?

8. Would establishment of a Free Trade Area of the
Americas (FTAA) be good for the two most
advanced economies in the hemisphere, the
United States and Canada? How might the
establishment of the FTAA impact the strategy
of North American firms?

9. Reread the Management Focus “The European
Commission and Media Industry Mergers,” then
answer the following questions:

a. Given that both AOL and Time Warner were
U.S.-based companies, do you think the
European Commission had a right to review
and regulate their planned merger?

b. Were the concessions extracted by the
European Commission from AOL and Time
Warner reasonable? Whose interests was the
commission trying to protect?

c. What precedent do the actions of the
European Commission in this case set? What
are the implications for managers of foreign
enterprises with substantial operations in
Europe?

Use the globalEDGE Resource Desk (http://global
EDGE.msu.edu/resourcedesk/) to complete the
following exercises:

1. The enlargement of the European Union into
Eastern Europe has brought together countries

with different levels of economic development.
Choose two long-term EU member countries
and two newer members. Compare and contrast
the macroeconomic situation in these countries
by analyzing each country’s primary economic

Research Task http://globalEDGE.msu.edu

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308 Part Three Cross-Border Trade and Investment

The European Energy Market

For several years now the European Union, the largest re-
gional trading bloc in the world, has been trying to liberalize
its energy market, replacing the markets of its 27 member
states with a single continent-wide market for electricity and
gas. The first phase of liberalization went into effect in June
2007. When fully implemented, the ability of energy producers
to sell electricity and gas across national borders will in-
crease competition. The road toward the creation of a single
EU energy market, however, has been anything but easy.
Many national markets are dominated by a single enterprise,
often a former state-owned utility. Electricitie de France, for
example, has an 87 percent share of that country’s electricity
market. Injecting competition into such concentrated markets
will prove difficult.
To complicate matters, most of these utilities are vertically
integrated, producing, transmitting, and selling power. These
vertically integrated producers have little interest in letting
other utilities use their transmission grids to sell power to end
users, or in buying power from other producers. For the full
benefits of competition to take hold, the EU recognizes that
utilities need to be split into generation, transmission, and
marketing companies so that the business of selling energy
can be separated from the businesses of producing it and
transmitting it. Only then, so the thinking goes, will indepen-
dent power marketing companies be able to buy energy from
the cheapest source, whether it is within national borders or
elsewhere in the EU, and resell it to consumers, thereby pro-
moting competition.
For now, efforts to mandate the de-integration of utilities
are some way off. Indeed, in February 2007 national energy
ministers from the different EU states rejected a call from the
European Commission, the top competition body in the EU, to
break apart utilities. Instead the energy ministers asked the
commission for more details about what such a move would

accomplish, thereby effectively delaying any attempt to de-
integrate national power companies. In mid-2008, they reached
a compromise that fell short of mandating the unbundling, or
de-integration, of national energy companies due to powerful
opposition from France and Germany among others (both
nations have large vertically integrated energy companies).
The response of established utilities to the creation of a
single continent-wide market for energy has been to try to
acquire utilities in other EU nations in an effort to build sys-
tems that serve more than one country. The underlying logic
is that larger utilities should be able to realize economies of
scale, and this would enable them to compete more effec-
tively in a liberalized market. However, some cross-border
takeover bids have run into fierce opposition from local politi-
cians who resent their “national energy companies” being
taken over by foreign entities. Most notably, when E.ON, the
largest German utility, made a bid to acquire Endesa, Spain’s
largest utility, in 2006, Spanish politicians sought to block the
acquisition and keep ownership of Endesa in Spanish hands,
imposing conditions on the deal that were designed to stop
the Germans from acquiring the Spanish company. In re-
sponse to this outburst of nationalism, the European Commis-
sion took the Spanish government to the European Union’s
highest court, arguing that Madrid had violated the commis-
sion’s exclusive powers within the EU to scrutinize and ap-
prove big cross-border mergers in Europe. Subsequently,
Enel, Italy’s biggest power company, stepped in and pur-
chased Endesa.

Sources: “Power Struggles: European Utilities,” The Economist ,
December 2, 2006, p. 74; “Anger Management in Brussels,”
Petroleum Economist , April 2006, pp. 1–3; R. Bream, ”Liberalization
of EU Market Accelerates Deal-making,” Financial Times , February
28, 2007, p. 4; “Twists and Turns: Energy Liberalization in Europe,”
The Economist , December 8, 2007, p. 76; and “Better than Nothing?”
The Economist , June 14, 2008, p. 80.

closing case

indicators available from the most recent version
of Eurostatistics Data for Short-Term Economic
Analysis, a statistical book published periodically
by Eurostat. Prepare a short report describing
the similarities and differences between the two
groups of countries.

2. The establishment of the Free Trade Area of the
Americas could be a threat as well as an

opportunity for your company. Identify the
countries participating in the negotiations for
the FTAA. Are there any countries in the
Americas not participating in the negotiations?
What are the main issues covered in the
negotiation process?

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Chapter Eight Regional Economic Integration 309

Case Discussion Questions
1. What do you think are the economic benefits of

liberalizing the EU energy market? Who stands to gain
the most from liberalization?

2. What are the implications of liberalization for energy
producers in the EU? How will the environment they
face change post-liberalization. What actions will they
have to take?

3. Why is the de-integration of large energy companies
seen as such an important part of any attempt to
liberalize the EU energy market?

4. Why do you think progress toward the liberalization of
the EU energy market has been fairly slow so far?

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