MAN Exam 2

Definition and sources of Country Risk

• Country Risk (also known as “political risk”)

  • exposure to potential loss or adverse effect on company operations and profitability caused by developments in a country’s political and/or legal environments

  • each country has unique political and legal systems that often pose challenges for company performance

• Dimensions of country risk

  • Harmful or unstable political system

  • Laws and regulations unfavorable to foreign firms

  • Inadequate or underdeveloped legal system

  • Bureaucracy and red tape

  • Corruption and other blunders

  • Government intervention, protectionism, and barriers to trade/investment

  • Mismanagement and failure of the
    economy

• Two types of Country Risk

  • Systematic- affects all industries, all firms in a country

  • Unsystematic- affects only a subset of firms

• Sources of country risk

  • political systems

    • Government

    • Political parties

    • Legislative bodies

    • Lobbying groups

    • Trade unions

    • Other political institutions

  • Legal systems

    • Laws, regulations, and rules that aim to:
      • ensure order in commercial activities
      • resolve disputes
      • protect intellectual property
      • tax economic output

Political Systems

functions of political systems

• Provide protection from external threats

• Ensure stability based on laws

• govern the allocation of valued resources among the members of a society

• Define how society’s members interact
  with each other.

political system: A set of formal institutions that constitute a government.
• It includes legislative bodies, political parties, lobbying groups, and trade unions.
• The system also defines how these groups interact with each other.
• Three major types of political systems:
§ Totalitarianism
§ Socialism
§ Democracy
• These categories are not mutually exclusive
Political Systems: Totalitarianism
• Government controls all economic and political matters.
• Either theocratic (religion-based) or secular
• Led by a dictator.
• Sustained via secret police, propaganda, regulation of free discussion and criticism.
• Some countries in the Middle East and Africa; Cuba, North Korea.
• Ex-totalitarian states tend to have much government intervention and bureaucracy.
▪ China (1949–1980s)
▪ Germany (1933–1945)
▪ Soviet Union (1918–1991)
▪ Spain (1939–1965)
Political Systems: Socialism
• Capital is vested in the state and used primarily as a means of production for use rather than for profit.
• Group welfare outweighs individual welfare.
• Government’s role is to control the basic means of production, distribution, and commercial activity.
• Socialism occurs often as social democracy (e.g., Western Europe, Brazil, India).
• Corporate income tax rates are higher. Land Ownership
Political Systems: Democracy
• Economic activity occurs freely, as per market forces.
• Limited government: The government performs only essential functions that serve all citizens, such as national defense, maintaining law & order, foreign relations, and providing basic infrastructure.
• Private property rights: The ability to own property and assets and to increase one’s asset base by accumulating private wealth. Property includes land, buildings, stocks, contracts, patents. Encourages initiative, ambition, innovation.
Countries & Political Systems
Fact #1: Relationship Between Economic and Political Freedom
Sources: James Gwartney, Robert Lawson, and Joshua Hall, Economic Freedom of the World: 2014
Fact #2:
Democracy and Openness
• Democracy is associated with “openness”, the lack of regulation and
barriers to the entry of firms in foreign markets.
• Openness is associated with:
§ Successful market entry.
§ Increased market demand.
§ Competition on quality, which improves overall product quality.
§ Increased competition, leading to efficiencies and lower prices.
Example
Since the 1980s, India steadily lowered entry barriers to its car market. Foreign carmakers entered the market, greatly increasing the number of models for sale. Greater competition increased the quality of available cars, and car prices fell.
Fact #3: Political and Economic Systems
• Totalitarianism is associated with command economies, wherein the state makes all decisions on what to produce, how much at what prices.
• Democracy is associated with market economies.
• Socialism is associated with mixed economies, which have features of both market and command economies (e.g., Sweden and Singapore).
Legal Systems
The Rule of Law
• Existence of a legal system where rules are clear, publicly disclosed, fairly enforced, and widely respected by individuals, organizations, and the government.
• Common in the advanced economies.
• Economic activity suffers and uncertainty increases when the rule of law is weak.
Legal Systems: Common Law
• A legal system that originated in England and spread to Australia, Canada, USA, and other former members of the British Commonwealth (also known as case law).
• The basis of law is tradition, past practices, and legal precedents set by courts via interpretation of statutes, legislation, and past rulings.
• Judges have much power to interpret laws based on the circumstances of individual cases. Thus, common law is relatively flexible.
Legal Systems: Civil Law
• Found in France, Germany, Italy, Japan, Turkey, and much of Latin America.
• Based on an all-inclusive system of laws that have been “codified” – clearly written by legislative bodies.
• Laws are more “cast in stone” and not strongly subject to interpretation by courts.
• A key difference is that common law is mainly judicial in origin and based on court decisions, whereas civil law is mainly legislative and based on laws passed by national and state legislatures.
Common Law vs. Civil Law
Legal Systems: Religious Law
• Strongly influenced by religious beliefs, ethical codes, and moral values, viewed as mandated by a supreme being.
• Most important religious legal systems are based on Hindu, Jewish, and Islamic law.
• Islamic law spells out norms of behavior regarding politics, economics, banking, contracts, marriage, and many other social and business issues.
• Strongly influenced by religious beliefs, ethical codes, and moral values, viewed as mandated by a supreme being.
• Most important religious legal systems are based on Hindu, Jewish, and Islamic law.
• Islamic law spells out norms of behavior regarding politics, economics, banking, contracts, marriage, and many other social and business issues.
Legal Systems: Mixed Systems
• Two or more legal systems operating together.
• The contrast between civil and common law has become blurred as countries combine both systems.
• Totalitarianism is most associated with religious law and socialist law.
• Democracy is associated with common law, civil law, and mixed systems.
Example
Legal systems in Lebanon, Morocco, and Tunisia share elements of civil law and Islamic law. Dominant Legal Systems in Selected Countries.
Legal Systems: Mixed Systems
• Two or more legal systems operating together.
• The contrast between civil and common law has become blurred as countries combine both systems.
• Totalitarianism is most associated with religious law and socialist law.
• Democracy is associated with common law, civil law, and mixed systems.
Example
Legal systems in Lebanon, Morocco, and Tunisia share elements of civil law and Islamic law. Dominant Legal Systems in Selected Countries
Types of Country Risks
Actors in Political & Legal Systems
• The government, or the “public sector”, operating at national and local levels.
• International organizations such as the World Bank, World Trade Organization, and the United Nations.
• Regional economic blocs, such as the European Union, NAFTA, and many
others.
• Special interest groups such as labor unions and environmental advocates.
• Local competing firms, which oppose foreign firms
Types of Country Risks
Actors in Political & Legal Systems
• The government, or the “public sector”, operating at national and local levels.
• International organizations such as the World Bank, World Trade Organization, and the United Nations.
• Regional economic blocs, such as the European Union, NAFTA, and many others.
• Special interest groups such as labor unions and environmental advocates.
• Local competing firms, which oppose foreign firms.
Special Interest Groups
Government Takeover of
Corporate Assets
• Confiscation: Seizure of corporate assets without compensation.
• Expropriation: Asset seizure with compensation.
• Nationalization: Takeover of an entire industry, with or without compensation.
Creeping Expropriation
• The most common expropriation today.
• The government gradually modifies regulations and laws after foreign MNEs have made big local investments in property and plants.Examples
• Abrupt termination of contracts.
• Creation of laws that favor local firms.
• The governments in Bolivia, Russia, and Venezuela have modified tax regimes to extract revenues from coal, oil, and gas companies.

Embargoes and Sanctions
• Governments may respond to offensive activities of foreign countries by imposing embargoes and sanctions.
• Sanctions are bans on international trade with extra tariffs, trade barriers, import duties, and import/export quotas.
• Embargoes makes trade activities with specific countries illegal. Example: The
U.S. has enforced embargoes against Cuba, Iran, and North Korea, labeled as state sponsors of terrorism.
• Balkans
• Belarus
• Burma (Myanmar)
• Cuba
• Iran
• Iraq
• Libya
• Lebanon
• North Korea
• Somalia
• Sudan
• Syria
• Zimbabwe Source:
U.S. Office of Foreign Assets Control
Current U.S. Sanction Programs Boycotts against Firms and Nations
• Voluntary refusal to engage in commercial dealings with a nation or a company.
Wars, Insurrection, and Violence
• War and insurrection – Indirect effects can be disastrous for company activities.
• Terrorism: The threat or actual use of force or violence to attain a political goal through fear and intimidation.
• Some terrorism is sponsored by national governments. Terrorism particularly affects certain
industries – tourism, hospitality, aviation, finance, retailing.
Host and Home Country Risks
Country Risk Produced by Host Country Legal Systems
• Foreign investment laws
• Controls on operating forms and practices
• Marketing and distribution laws
• Laws regarding income repatriation
• Environmental laws
• Contract laws
• Inadequate or underdeveloped legal systems
• Internet and e-commerce regulations
Country Risk Produced by Home Country Legal Systems
• The Foreign Corrupt Practices Act (FCPA)
• Antiboycott regulations
• Accounting and reporting laws
• Transparency in financial reporting
Host Country Risks
Country Risk Arising from the Host Country
• Foreign investment laws affect FDI- based entry.
Examples:
•Japan – The “large-scale retail store law” restricted foreigners from opening warehouse-style stores like Toys”R”Us, in favor of smaller Japanese retailers.
•Mexico – Foreign oil companies cannot obtain 100% ownership of Mexican oil firms.
•United States – Restricts inward investments seen to affect national security. e.g., The U.S. Congress blocked Dubai Ports World, a Middle Eastern firm, which sought a deal to manage U.S. ports.
Country Risk Arising from the Host Country (cont’d)
• Controls on operating forms and practices are laws and regulations on how firms can conduct production, marketing, and distribution activities.
Example:
In the telecommunications sector in China, the Chinese government requires foreign investors to seek joint ventures with local firms. This ensures local control of the telecom industry; and China gains access to foreign capital and technology.
Country Risk Arising from the Host Country (cont’d)
• Marketing and distribution laws regulate practices in advertising, promotion, and distribution.
Examples:
• Finland, France, Norway, and New Zealand prohibit cigarette advertising on television.
• Canada and other countries cap prices in the pharmaceutical and other industries.
Country Risk Arising from the Host Country (cont’d)
• Controls on operating forms and practices are laws and regulations on how firms can conduct production, marketing, and distribution activities.
Example:
In the telecommunications sector in China, the Chinese government requires foreign investors to seek joint ventures with local firms. This ensures local control of the telecom industry; and China gains access to foreign capital and technology.

Country Risk Arising from the Host Country (cont’d)
• Marketing and distribution laws regulate practices in advertising, promotion, and distribution.
Examples:
• Finland, France, Norway, and New Zealand prohibit cigarette advertising on television.
• Canada and other countries cap prices in the pharmaceutical and other industries.
• It is a quite serious issue particularly in selected few countries including China.
• Laws on income repatriation limit the amount of net income or dividends that firms can bring back to the home country.
• Environmental laws aim to preserve natural resources, combat pollution, and ensure safety.
• Contract laws affect the sale of goods and services; intermediary agreements; licensing and franchising; foreign direct investment; and joint ventures.
• It is a quite serious issue particularly in selected few countries including China.
Country Risk Arising from the Host Country (cont’d)
• Laws on income repatriation limit the amount of net income or dividends that firms can bring back to the home country.
• Environmental laws aim to preserve natural resources, combat pollution, and ensure safety.
• Contract laws affect the sale of goods and services; intermediary agreements; licensing and franchising; foreign direct investment; and joint ventures.
• Inadequate or underdeveloped legal systems, or poor enforcement of existing laws.
• Laws may be weak regarding intellectual property, pollution, consumer protection, and other areas.
• While the problem is common in developing economies, it can occur in advanced economies too.
Country Risk Arising from the Host Country (cont’d)
Examples:
•In China and Russia, foreign firms sometimes abandon business ventures due to erratic legal environments.
•The recent global financial crisis was triggered partly by poor regulation in the United States and Europe.
Home Country Risks
• Inadequate or underdeveloped legal systems, or poor enforcement of existing laws.
• Laws may be weak regarding intellectual property, pollution, consumer protection, and other areas.
• While the problem is common in developing economies, it can occur in advanced economies too.
Country Risk Arising from the Host Country (cont’d)
Examples:
•In China and Russia, foreign firms sometimes abandon business ventures due to erratic legal environments.
•The recent global financial crisis was triggered partly by poor regulation in the United States and Europe.
Home Country Risks
• Extraterritoriality: The application of home-country laws to other countries. For example, the European Union pursued Microsoft for monopolistic practices.
• The Foreign Corrupt Practices Act (1966; U.S.) made it illegal to offer bribes to foreign parties. But the act may harm U.S. firms because foreign competitors are usually not so constrained.
Country Risk Arising from the Home Country (cont’d)
• Accounting and reporting laws differ widely around the world. Two examples:
▪ Physical asset valuations: Canada and the U.S. use historical costs. Some Latin American countries use inflation-adjusted market value.
▪ R&D costs: Expensed as incurred in most of the world; capitalized in South Korea and Spain. Some countries use both.
• Transparency in financial reporting is the degree to which firms regularly reveal substantial financial and accounting information. This varies worldwide.
Managing Country Risks
• Proactive environmental scanning: Management should develop a comprehensive understanding of the political and legal environment in target countries.
• Local employees
• Embassy and trade association officials.
• Consulting firms
• Goal is to minimize exposure to country risks.
Managing Country Risk
• Strict adherence to ethical standards:
Firms that engage in questionable practices or operate outside the law invite
redress from the governments of the host countries where they do business.
• Alliances with qualified local partners:
For example, firms often enter China and Russia by partnering with local firms who assist in navigating the complex legal and political landscape.
Managing Country Risk
• Protection through legal contracts: Contract law varies widely. The firm must follow the law in each country. Three approaches for resolving contract disputes:
o Conciliation is a formal process of negotiation whose objective is to resolve differences in a friendly manner. It is the least adversarial method and common in China.
o In arbitration, a neutral third party hears both sides of a case and decides in favor of one party or the other, based on an objective assessment of the facts.
o Litigation occurs when one party files a lawsuit against another. The most adversarial approach, it is common in the United States.
Managing Country Risk
• Strict adherence to ethical standards:
Firms that engage in questionable practices or operate outside the law invite redress from the governments of the host countries where they do business.
• Alliances with qualified local partners:
For example, firms often enter China and Russia by partnering with local firms who assist in navigating the complex legal and political landscape.

Managing Country Risk
• Protection through legal contracts: Contract law varies

Chapter 7A

Government Intervention Overview of Gov’t Intervention
Government Intervention
• Governments intervene in trade and investment to achieve political, social, or
economic objectives.
• Governments impose trade and investment barriers that benefit interest groups, such as domestic firms, industries, and labor unions.
• Government intervention alters the competitive landscape, by hindering or helping the ability of firms to compete internationally.
• Government intervention is an important dimension of country risk.
Government Intervention
• Protectionism – National economic policies that restrict free trade. Usually intended to raise revenue or protect domestic industries from foreign competition.
• Customs – The checkpoint at national ports of entry where officials inspect imported goods and levy tariffs.
Government Intervention is a Component of Country Risk
Objectives of Gov’t Intervention
• To achieve political, social, or economic objectives
– Creating jobs
– Generating revenues
• Seeking benefit for specific interest groups such as domestic firms, industries, and labor unions
• Altering the competitive landscape
• Ensuring the safety, security, and welfare of citizens
Government Intervention:
Key Instruments
• Tariff – A tax on imports (e.g., Citrus, textiles).
• Nontariff trade barrier – Government policy, regulation, or procedure that impedes trade.
• Quota – Quantitative restriction on imports of a specific product (e.g., Imports of Japanese cars).
• Administrative barriers – Documentations and procedures
• Investment barriers – Rules or laws that hinder foreign direct investment (e.g., Mexico’s restrictions in its oil industry).

Example of Protectionism:
U.S. Steel Industry
• The U.S. government imposed tariffs on imports of foreign steel to protect U.S. steel manufacturers from foreign competition, aiming to give the U.S. steel industry time to restructure and revive itself.
• However it resulted in:
§ Higher steel costs.
§ Increased production costs for firms that use steel, such as Ford, Whirlpool, and General Electric.
§ Reduced prospects for selling products in world markets, making U.S. steel firms less competitive.
• The steel tariffs were removed within two years.
Example of Protectionism:
Auto Industry
• In the 1970s, the U.S. government imposed “voluntary” export restraints (quotas) on imports of cars from Japan, to insulate the U.S. auto industry from foreign competition.
§ Result 1: Detroit automakers had less of an incentive to improve quality, design, and overall product appeal.
§ Result 2: Detroit’s ability to compete in the global auto industry weakened.
Consequences of Protectionism
• Reduced supply of goods to buyers.
• Price inflation
• Reduced variety, fewer choices available to buyers.
• Reduced industrial competitiveness.
• Various adverse unintended consequences (e.g., While the home country dithers, other countries can race ahead).
Rationales and Effects of Gov’t Intervention
General Rationale for Government Intervention
• Tariffs can generate substantial government revenue. This is a key rationale for protectionism in undeveloped economies.
• Helps ensure the safety, security, and welfare of citizens. e.g., Most countries have basic regulations to protect the national food supply.
• Helps the government pursue broad economic, political, and social objectives for the nation.
• Can serve the interests of the nation’s firms and industries.
Two Types of Rationale for Protectionism
• Defensive barriers
– Safeguarding industries, workers, special interest groups
– Protecting infant industries
– Promoting national security (export controls)
• Offensive barriers
– Pursuing a strategic or public policy objective
• Increasing employment
• Generating taxes.
Defensive Rationale for Government Intervention
• Protection of the national economy – Weak or young economies sometimes need protection from foreign competitors. e.g., India imposed barriers to shield its huge agricultural sector, which employs millions.
• Protection of an infant industry – A young industry may need protection, to give it a chance to grow and succeed. e.g., Japan long protected its car industry.
• National security – The United States prohibits exports of plutonium and similar products to North Korea.
• National culture and identity – Canada restricts foreign investment in its movie and TV industries.
Offensive Rationale for Government Intervention
• National strategic priorities – Protection helps ensure the development of industries that bolster the nation’s economy. Countries create better jobs and higher tax revenues when they support high value-adding industries, such as IT, automotive, pharmaceuticals, or financial services.
• Increase employment – Protection helps preserve domestic jobs, at least in the short term. However, protected industries become less competitive over time, especially in global markets, leading to job loss in the long run.

Effects of Government Interventions
Tariff Barriers
Sampling of Import Tariffs
Decline in Average Tariff Rates.
Relationship between Tariffs,
World GDP, and the Volume of World Trade

Tariffs are Widespread
• Harmonized code – Standardized worldwide system that determines tariff amount.
• In developing economies, tariffs are common.
• In advanced economies, tariffs still provide significant revenue.
• For example, in a given year the U.S. collects more tariff revenue on shoes than on cars (e.g., $1.63 billion versus $1.60 billion).
• The European Union applies tariffs up to 215% on meat, 116% on cereals, and 17% on tennis shoes.
Import Tariffs Have Been Declining
• Governments have reduced tariffs over time, mainly via the General Agreement on Tariffs and
Trade (GATT), which became the World Trade Organization (WTO).
• Economic integration also leads to lower tariffs, but only within economic blocs. e.g., Under NAFTA, Mexico eliminated nearly all tariffs on imports from the U.S., but maintains tariffs with the rest of the world.
• China reduced its tariffs since joining the WTO in 2001.
• Firms bypass tariffs by entering countries via FDI. e.g., Toyota built factories in the U.S. partly to avoid tariffs.
Tariff Barriers
• Tariffs with some objectives
– Protective tariff
– Revenue tariff
– Punitive tariff
– Antidumping duties
– Countervailing duties-to fight against foreign gov’t subsidies
• Tariffs with different ways to be levied (e.g., Chapter 82)
– Ad valorem tariff- a fixed percentage of the value of the product.
• 10% of value
– Specific tariff- set amount charged per unit.
• $.25 per unit
– Compound tariff- a combination of the two tariffs.
• $.50 per unit + 7%
Non-Tariff Barriers
• Quotas
– are limits on the quantity of imports.
• Local content regulation
– Mandatory use of some locally sourced parts
• Subsidies
– directly paid to domestic competitors to offset their lack of competitiveness.
• Administrative barriers
– Testing, certification, or inspection requirements (for motor vehicles and electrical equipment)
– Health regulations for hygienic food preparation
– Labeling requirements identifying country of origin
– Excessive documentation

FDI and Gov’t Interventions
Why FDI?
• Includes start-ups of new operations and purchases of existing companies.
• Reasons for foreign direct investment
– Marketing factors- expansion, growth and service; derived demand by follow-on
suppliers.
– Barriers to trade require a local presence.
– Cost factors of nearness to raw materials and labor.
– Investment climates of some markets favor investments.
• Chevy in Korea

Impacts of FDI-Host Country Perspective
The Positive Impacts
• Capital formation
• Transfer of technology and management skills
• Regional and sectorial evelopment
• Internal competition and entrepreneurship
• Favorable effect on balance of
payments
• Increased employment
The Negative Impacts
• Industrial dominance
• Technological dependence
• Disturbance of economic
plans
• Cultural change
• Interference by home
government of MNC
• “Brain Drain”
The Positive Impacts
• Increase in GNP
• Stimulus to economic growth
The Negative Impacts
• Domestic job loss
• Giving away technology and competitive position

Impacts of FDI-Home Country Perspective
Types of FDI Incentives
• Fiscal Incentives
– Tax break
• Financial Incentives
– Land
– Building
– Loans
– Loan Guarantees
• Non-financial Incentives
– Government Purchases
– Protection from Competitors
– Infrastructure
History of Gov’t Intervention
Economic Freedom
• Economic freedom is the absence of government coercion so that people can work, produce, consume, and invest however they want to.
• The Index of Economic Freedom assesses the rule of law, trade barriers, regulations, and other criteria.
• Virtually all advanced economies are “free”.
• Emerging markets are either “free” or “mostly free”.
• Most developing economies are “mostly unfree” or “repressed”.
• Economic freedom flourishes with appropriate of intervention; too much regulation harms the economy.
Evolution of Gov’t Intervention
• Protectionism/isolationism and the Great Depression prevailed early 20th century world
trade.
• The Smoot-Hawley Act (1937) raised U.S. tariffs to more than 50% (compared to only 3% today).
• Progressive trade policies reduced tariffs after WWII.
• In 1947, 23 nations signed the General Agreement on Tariffs and Trade (GATT). The
GATT:
§ Reduced tariffs via continuous worldwide trade negotiations;
§ Created an agency to supervise world trade
§ Created a forum for resolving trade disputes; and
§ Most favored nation
The GATT (cont’d)
• The GATT’s concept of most favored nation (aka normal trade relations) requires each member nation extend the tariff reductions covered in a trade agreement with one country to all other countries
• In 1995 the GATT was superseded by the World Trade Organization (WTO), and grew to include 150 member nations.
• The GATT and WTO together contributed to the elimination of various trade barriers.
• In 2001, China joined the WTO.
• But, some countries like India still has a high tariff (i.e., average rate of 20%)

Responding to Gov’t Intervention
• Research to gather knowledge and intelligence. Understand trade and investment barriers abroad. Scan the business environment to identify the nature of government intervention.
• Choose the most appropriate entry strategies. Most firms choose exporting as their initial strategy, but if high tariffs are present, other strategies should be considered, such as licensing, or FDI and JVs that allow the firm to produce directly in the market.
Responding to Giv’t Intervention
• Take advantage of foreign trade zones. FTZs are areas where imports receive preferential tariff treatment, intended to stimulate local economic development. e.g., A successful experiment with FTZs has been the maquiladoras — export- assembly plants in northern Mexico.
• Seek favorable customs classifications for exported products. Reduce exposure to trade barriers by ensuring that products are classified properly.
Responding to Giv’t Intervention (cont’d)
• Take advantage of investment incentives and other government support programs.
• Lobby for freer trade and investment. Increasingly, nations are liberalizing markets in order to create jobs and increase tax revenues.
Examples:
• The government of Hong Kong put up much of the cash to build the Hong Kong Disney Park.
• Mercedes-Benz received several hundred million dollars in subsidies to build a plant in the U.S. state of

Chapter 7B

Economic Integration
Types of Economic Integrations
• Over 50 percent of world trade today occurs under some form of preferential trade agreements signed by groups of countries.
• Cooperating nations obtain:
§ increased product choices, productivity, living standards,
§ lower prices, and
§ more efficient resource use.

Regional Economic Integration

The growing economic interdependence that results when nations within a geographic region form an alliance aimed at reducing barriers to trade and investment.
Economic Bloc
A geographic area consisting of two or more countries that agree to pursue economic integration by reducing tariffs and other barriers to the cross-border flow of products, services, capital, and, in more advanced cases, labor.
• Examples: European Union, NAFTA, MERCOSUR, APEC, ASEAN, and many others.
• There are five possible levels of economic integration.
Types of Economic Blocs
- US Tariffs-Low
- MX Tariffs-High No Tariffs
- Types of Economic Blocs
- No Tariffs
- Common Tariffs
- Factor Mobility
- Common Currency

Five Potential Levels of Regional Integration
• Free trade area: Simplest, most common arrangement. Member countries agree to gradually eliminate formal trade barriers within the bloc, while each member maintains an independent international trade policy with countries outside the bloc. One example is
NAFTA.
• Customs union: Similar to a free trade area except the members harmonize their trade policies toward nonmember countries, by enacting common tariff and nontariff barriers on imports from nonmember countries. MERCOSUR is an example.
Levels of Regional Integration
• Common market: Like a customs union, except products, services, and factors of production such as capital, labor, and technology can move freely among the member countries. e.g., The EU countries put in place many common labor and economic policies.
• Economic union: Like a common market, but members also aim for common fiscal and monetary policies, and standardized commercial regulations. The EU is moving toward an economic union by forming a monetary union with a single currency, the euro.
Current Economic Integrations
The EU:
A Full-Fledged Economic Union
1. Market access. Tariffs and most nontariff barriers have been eliminated.
2. Common market. Barriers to cross-border movement of production factors—labor, capital, and technology.
3. Trade rules. Cross-national customs procedures and regulations have been eliminated, which has streamlined transportation and logistics within Europe.
4. Standards harmonization. Technical standards, regulations, and enforcements have been harmonized.
5. Common fiscal, monetary, taxation, and social welfare policies is the ultimate goal over time.
Development of the European Union
European Coal and Steel Community
Paris Treaty - 1951
Single European Act
Amended Treaty of Rome - 1986
European Economic Community Treaty
Rome - 1957
European Atomic Energy Community Treaty (Euratom)
Rome - 1957
The Maastricht Agreement
(Treaty on European Union) Maastricht - 1991
Trade Agreement Common Market
(Political and) Economic Union
The European Union Today
• 26 members: Founders members are Belgium, Italy France, Germany, Luxembourg, and the Netherlands.
• New members such as Poland, Hungary, Czech Republic – are low-cost manufacturing sites.
• Most new EU entrants are in Eastern Europe – one-time satellites of the Soviet Union, most are emerging markets with fast economic growth rates.
• Brexit now effective.

FDI’s into EU:
• Peugeot, Citroën (France) – Czech Republic
• Hyundai (South Korea) – Kia plant in Slovakia
• Suzuki (Japan) – factory in Hungary

EU Member States
• Austria
• Belgium
• Denmark
• Finland
• France
• Germany
• Greece
• Ireland
• Italy
• Luxembourg
• Netherlands
• Portugal
• Spain
• Sweden
• United Kingdom (BREXIT)**
• Ten more countries joined in
May 2004:
Cyprus (Greek part), the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia.
• Romania* (joined 2007)
• Bulgaria* (joined 2007)
* = Euro adopted
** UK exited as of Dec. 2020

Fortress Europe
• The concerns of countries outside the EU that integration of the EU may result in increased restrictions and barriers to trade and investment by outsiders.
NAFTA → USMCA
(Canada, Mexico, the United States)
Passage of NAFTA in 1994 was facilitated by the maquiladora program, through which U.S. firms located factories just south of the U.S. border to access low-cost labor without significant tariffs.
NAFTA:
• Eliminated tariffs and most nontariff barriers for products and services.
• Established trade and investment rules, uniform customs procedures, and intellectual property rights.
• Provided procedures for settling trade disputes.
• Recent Updates (FYI only)
• As of July 1, 2020, it became USMCA.
• In early 2025, a 25% tariff on all goods from Canada and Mexico has been proposed by President Trump. Nothing finalized yet! However, if introduced, it most likely means the end of NAFTA/USMCA.
Free Trade Area of the Americas (FTAA)
• A general agreement to form a regional trading zone stretching from Point Barrow, Alaska to
Tierra Del Fuego at the tip of Argentina by 2005.
• GOAL: to provide free market access for goods and services to the entire continent by 2005.
• Debates on FTAA
Central American Free Trade Agreement (CAFTA)
• Signed into law on August 2, 2005,
• Provide immediate and retroactive duty relief for textile and apparel merchandise shipped to/from the following member
• Countries involved:
– United States
– Costa Rica
– Dominican Republic
– El Salvador
– Guatemala
– Honduras
– Nicaragua
• Effective as of January 1, 2006.
Other Trading Blocs
El Mercado Comun del Sur (MERCOSUR)
• The leading economic bloc in South America, accounting for nearly all of the region’s GDP.
• Launched in 1991, the four initial members were Argentina, Brazil, Paraguay, and Uruguay.
• Established free movement of products and services, common external tariff and trade policy, and coordinated monetary and fiscal policies.
• May be integrated with NAFTA and DR-CAFTA as part of a future Free Trade Area of the Americas.
Other Economic Blocs
• El Mercado Comun del Sur (MERCOSUR)
• Caribbean Community and Common Market (CARICOM).
• Comunidad Andina de Naciones (CAN) among Bolivia, Colombia, Ecuador, Peru, and Venezuela.
• Association of Southeast Asian Nations (ASEAN).
• Asia Pacific Economic Cooperation (APEC).
• Australia and New Zealand Closer Economic Relations Agreement (CER).
Current Economic Bloc Talks
• The Trans-Pacific Partnership (TPP): a trade agreement discussed among Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, Vietnam, and the US. (Update: the US recently dropped out of the talk.)
• Regional Comprehensive Economic Partnership (RCEP): a proposed free trade agreement between the ten member states of the Association of Southeast Asian Nations (ASEAN) and the six ASEAN states. (Update: It is signed on Nov. 2020)
International Cartels
An association of producers of a particular good (e.g., OPEC) who agree to fix prices, allocate sales territories, and restrict production.
Economic Integrations?
Why Do Nations Pursue Economic Integration?
• Expand market size
§ Increases size of the marketplace for firms inside the economic bloc. Belgium has a population of just 10 million; the EU has a population of nearly 500m.
§ Buyers can access larger selection of goods.
• Achieve economies of scale and productivity
§ Bigger market facilitates economies of scale.
§ Internationalization inside the bloc helps firms learn to compete outside the bloc.
§ Competition and efficient resource usage inside the bloc leads to lower prices. No Tariffs
Why Nations Pursue Economic Integration (cont’d)
• Attract direct investment from outside the bloc
§ Compared to investing in stand-alone countries, foreign firms prefer to invest in countries belonging to an economic bloc. General Mills, Samsung, and Tata have invested heavily in EU-member countries.
• Acquire stronger defensive and political posture
§ Belonging to a bloc provides member countries with a stronger defensive posture relative to other nations and world regions. This was a key motive for formation of the European Union. Implications of Regional Integration for the Firm
• Internationalization by firms inside the economic bloc. Regional integration facilitates company internationalization. Expansion into neighboring countries provides valuable experience, prompting internationalization to other markets worldwide.
• Internationalization by firms from outside the bloc . Because external trade barriers mainly affect exporting, many foreign firms prefer to enter a bloc through FDI. In this way, after formation of the EU, Britain became the largest recipient of FDI from the United States.
Implications for the Firm (cont’d)
• Regional products and marketing strategy. Firms cut costs by standardizing products and services. Case Inc. reduced its Magnum line of tractors from 17 to only a few versions in Europe, following integration of the EU.
• Rationalization of operations. By restructuring and consolidating company operations, managers can develop strategies and value-chain activities suited to the region as a whole, not just individual countries. Goal is to cut costs and redundancy, and increase efficiencies via scale economies.
Are FTAs or Economic Integrations always a good idea?
View on CAFTA
Why Some Firms Favor FTA
While Others Don’t?
• Strong firms in the industry will favor
FTA.
• Weak firms will oppose it.
• Basically, their strengths in the international market will determine a firm’s position on whether favoring an FTA or not.