Effect of Globalization on Business and Profit Making

Chapter 1

Throughout history, profit-making entities (among other) have constructed an ever-more-global economy. In the last 15 years or so, unprecedented changes in communications and computer technologies have given the process new momentum.

Multinational corporations manufacture products in many countries and sell to consumers around the world. Money, know-how and raw materials move ever more rapidly across national borders. Along with products and finances, ideas and cultures mingle more unreservedly.

As globally mobile capital reorganises business firms, it sweeps away regulation and undermines local and national politics. Globalisation creates new spins of old trading ideas (auctions are becoming increasingly prevalent in buying and selling); it starts new markets and it contributes to wealth, even as it causes extensive distress, chaos, and strife. It is both a source of tyranny and a medium for global movements of social integrity and liberation.

Undoubtedly, in the first quarter of the 21st century, the profit-making firm functions in an environment full of global opportunities and threats; and in the wake of recent corporate scandals, the firm, simultaneously, is heavily constrained by ethical self-restraining as well as innovative regulations enforced by domestic and global-governance institutions.

1 Globalisation

According to A.T. Kearney/Foreign Policy Globalization Index (2003), which is based on indicators such as economic integration, technological connectivity, personal contact, and political engagement (see Table 1 below), from about 1999 to 2003, global foreign direct investment and portfolio capital flows slowed down significantly thus contributing to the weakening of globalisation. Other global trends, especially international tourism, telephone traffic and worldwide access to the internet stayed strong helping to compensate for the weakening of international economic ties, thus deepening global links overall. What are the lessons that the profit-making firm may derive from the globalisation of economic activity?

It appears that global markets, as discussed in the remainder of the section, ‘offer’ to the firm less legal restrictions, induce reduction in excess capacity, cause higher market concentration and contribute to higher profits. Consider 1, which links together two 2-dimensional diagrams: one has its origin in the southwest with global concentration measured on the vertical axis and profits on the horizontal; the other has its origin in the northeast with excess capacity measured on the vertical axis and legal restrictions on the horizontal.

As it is discussed below, globalisation enables firms to move ‘northeast’ from point A to point B.

Table 1 A.T. Kearney/Foreign Policy Globalization Index (2003)

The 2003 results do not show causation, but they do point to significant correlations; they demonstrate that the most global countries are those where residents live the longest, healthiest lives; women enjoy the strongest social, educational, and economic progress; global integration leads to secularisation. For the third year in a row, in 2003, Ireland ranks as the most global, due to the country’s deep economic links and high levels of personal contact with the rest of the world. Western Europe claimed six out of the ten most globally integrated countries in this year’s survey. And the USA broke into the top ten, ranking first in the number of secure servers and internet hosts per capita. Countries from Central and Eastern Europe, Australasia, and Southeast Asia also made it into the upper tier (the five most global countries are reported above followed by the top five global firms in Europe and Asia).

Ranking indicators

· Economic integration: trade, foreign direct investment, portfolio capital flows, and investment income.

· Technological connectivity: internet users, internet hosts, and secured servers.

· Personal contact: international travel and tourism, international telephone traffic, and remittances and personal transfers (including worker remittances, compensation to employees, and other person-to-person and non-governmental transfers).

· Political engagement: memberships in international organisations, personnel and financial contributions to UN Security Council missions, international treaties ratified, and governmental transfers.

1.1 Legal restrictions

As globalisation expands, many firms find themselves (by choice or coincidence) operating in countries that impose less legal business regulations relative to their home countries. Global firms put pressure on local governments to establish more favourable business regulations or refrain from enforcing their regulatory laws (regardless of how minimal or fair they are) or, if such laws do not exist, to avoid applying them. As a result, less regulated or totally unregulated markets reduce barriers on the flow of goods and money across borders, creating a more integrated and profitable global economy.

Over regulation: Business firms in developing nations face much larger regulatory constraints than those in developed nations; as reported in Doing Business in 2005 [World Bank, (2004), p.3],

“(a) they face 3 times the administrative costs, and nearly twice as many bureaucratic procedures and delays associated with them. And they have fewer than half the protections of property rights of rich countries. (b) Heavy regulation and weak property rights exclude the poor from doing business. In poor countiers 40% of the economy is informal. Women, young and low-skilled workers are hurt the most.”

The lowering of over regulatory constraints is actively pursued because it brings benefits to firms (they spend less money and time on dealing with regulations) and to governments (they spend fewer resources regulating and more providing social services). Moreover, fewer regulations attract foreign firms with all benefits and, of course, costs associated with them. Hence, globalisation enables firms to benefit from the removal of unnecessary regulations and the establishing of trade-encouraging, incentive-loaded laws. At the same time though due to ‘global’ complexity, the emergence of new innovative technology-driven markets as well as inability of regulatory authorities to enforce the existing legal enactments (reformed or not), some firms, as described below under illicit trade, may avoid compliance with domestic or international laws.

Illicit trade: The fact that, globally, unlawful trade in products and services involving intellectual property, money laundering, third shift production and alien smuggling has been on the rise, implies that authorities in various countries experience hard time in dealing with the problem.

As Naim (2003) writes, intellectual property illegalities, a modern kind of piracy, involves business software, shampoos, motorbikes, medical drugs, industrial valves, supply of illegally copied copyrighted music, and among other, theft of brand names. In Naim’s words:

“Governments have attempted to protect intellectual property rights through various means, most notably the World Trade Organization’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS). Several other organizations such as the World Intellectual Property Organization, the World Customs Union, and Interpol are also involved. Yet the large and growing volume of this trade, or a simple stroll in the streets of Manhattan or Madrid, show that governments are far from winning this fight.”

Additionally, deregulations of financial markets have given rise to rogue global banking, tax havens, and money laundering. All these factors make possible cross-border money transfers, while simultaneously, improvements in electronic technologies make distance less of a barrier and turn money into e-money defined by Naim as “cards with microchips that can store large amounts of money and thus can be easily transported outside regular channels or simply exchanged among individuals.” Naim states that

“estimates of the volume of global money laundering range between 2 and 5 percent of the world’s annual gross national product, or between $800 billion and $2 trillion. … The sophistication of technology, the complex web of financial institutions that crisscross the globe, and the ease with which “dirty” funds can be electronically morphed into legitimate assets make the regulation of international flows of money a daunting task” magnified by the introduction of e-money.”

Moreover, according to the United Nations, alien smuggling is the fastest growing business of organised crime. According to Naim, this kind of modern enslavement has become a $7 billion a year enterprise and it involves mostly women and children; and contrary to the efforts made by governments to curtail the problem, especially in the UK, Southern Europe and in the USA, the problem is becoming more difficult and complicated over time. Again, Naim puts it graphically:

“A woman can be “bought” in Timisoara, Romania, for between $50 and $200 and “resold” in Western Europe for 10 times that price. The United Nations Children’s Fund estimates that cross-border smugglers in Central and Western Africa enslave 200,000 children a year. Traffickers initially tempt victims with job offers or, in the case of children, with offers of adoption in wealthier countries, and then keep the victims in subservience through physical violence, debt bondage, passport confiscation, and threats of arrest, deportation, or violence against their families back home.”

And of course, intellectual property, humans, and financial capital are not the only products and/or services traded illegally for big profits by global networks. There are also markets in human organs, endangered species, stolen fine art, and deadly industrial waste. The unlawful worldwide trades in all these merchandise and services share numerous essential characteristics such as high-tech innovations, societal and political transformations and open fresh markets. Fast spreading globalisation causes the regulatory environment to become more complex which serves as a cover for opportunistic profit through illicit trade, networks and markets. At the same time, governments are becoming increasingly ineffective in dealing with the problem.

Although the global community attempts to regulate global business activity through entities such as the World Trade Organization (WTO), the International Monetary Fund (IMF) the World Bank (WB), alliances such as the G-7, or the G-20, and treaties such as the Kyoto Protocol, the global business environment, by and large, is becoming gradually freer.

1.2 Global concentration

As legal constraints become wobblier, the power of global firms, in terms of concentration, increases. Widespread merger and acquisition (M&A) activities between already big industrial and financial firms started during the 1990s. The new gigantic corporations, by and large, control a large global market share in their respective industries. The build up in global concentration has sweeping implications for the 21st century. As reported by Mohamed (2004)

“total global mergers activity grew from over $150 billion in 1992 to over $2000 billion in 1998, when eight of the world’s ten largest mergers took place. By 1999 it was over $330 billion.”

The enhanced mass and influence of these new giants has been central to the intuition that globalisation advances at a blazing speed. In general, most of these global activities, such as M&A, foreign direct investment and international trade, are between developed nations. Mohamed reports that “this concentration of economic power and activity is clearly illustrated by the fact that over 95% of the companies on the Fortune 500 (ranked by value of sales) and FT (Financial Times) 500 (ranked by market capitalization) lists are developed-country companies. In addition, only a handful of developing-country companies feature on the list of the top 300 companies ranked by expenditure on research and development (R&D). When one considers that developed countries have less than 20% of the world’s population then the magnitude of the disparities in the global economy cannot be more evident.”

Escalated global economic concentration was caused by a number of actions. There was a shift towards focusing on core activities that led to unbundling of formerly diversified conglomerates. There were vast investments in knowledge capital, primarily in hardware, software and information technology (IT) services. Much of the R&D outlays of multinational corporations has been on IT, which has helped develop coordination of all aspects of their dealings internationally. There has been globalisation of mass media (e.g., CNN and BBC), which has led to the creation of global franchises (e.g., McDonalds and Wal-Mart), global brands (e.g., Nike) and global marketing infrastructure. The global reach, multiplication and liberalisation of financial markets as well as rapid growth of international capital flows since the 1970s contributed to the growth of multinational corporations. Much of the funds for the new giants came from institutional investors, who prefer big companies that sell popular brands, control large market shares, invest significantly on R&D and focus on their nucleus activities. Additionally, as reported by Mohamed,

“the process of global concentration that started in the 1990s happens not only in leading companies but also upstream in their suppliers and downstream in companies distributing their products. The leading companies have pressured their suppliers and distributors to work more closely with them and to become global leaders in their own areas by also growing through M&As. This process has further concentrated the global economy.”

1.3 Excess capacity

The massiveness of the global market (the market size effect) along with adaptive, flexible and responsive marketing (the marketing effect) enables global firms to sell more. Additionally, they sell at reduced prices because of lower production costs due to outsourcing and insourcing as well as due to new inexpensive technologies such as the internet and the cell phone (the cost effect).

Obviously, market and marketing effects induce firms to reduce their excess capacity but cost effects enable firms to add excess capacity. Whether or not the reduction in excess capacity is in absolute value greater than the increase in excess capacity is an empirical question.

Undoubtedly, global manufacturing is on the rise enabling firms to become more adaptable, more flexible in production and distribution as well as more responsive to the needs of customers; and since the global economy is on the rebound after the depths it reached in 2008/2009, see Table 2, it is perhaps reasonable to believe that rising global demand will contribute to a reduction in excess capacity which, in absolute value, would exceed the increase in excess capacity leading to more profit and, hopefully, to improved global economic well-being.

Finally, as stated by Helpman (2006), in this global economy we have experienced rapid expansion of trade in services and trade in intermediate inputs. With respect to exports [Helpman, (2006), p.590],

“only a small fraction of firms export, they are larger and more productive than firms that serve only the domestic market, and more firms export to larger markets. A small fraction of firms engage in FDI, and these firms are larger and more productive than exporting firms.”

And although according to Helpman (2006, p.591), the theory of comparative advantage, as an explanation of intersectoral international trade, and the theory of imperfect competition, as an explanation of intra-industry trade, are still valid, globalisation brings

“to trade theory a new focus: the organizational choices of individual firms. By focusing on the characteristics of individual firms, the theory can address new questions: Which firms serve foreign markets? And how do they serve them, i.e., which choose to export and which choose to serve foreign markets via FDI? Under what circumstances do they outsource in a foreign country rather than at home? And if they choose integration, under what circumstances do they choose to integrate in a foreign country, via FDI, rather than to integrate at home?”

Table 2 Real projected gross domestic product (GDP) and growth rates of GDP for regions (in billions of 2005 dollars) 2000-2015 GDP

Year

2000

2005

2006

2007

2008

2009

2010

2015

W

39190.56

44828.46

46641.28

48405.39

49297.02

47992.14

49005.27

58114.16

D

29313.46

32197.09

33091.60

33890.60

34017.97

32749.26

33146.61

37232.39

D less US

18220.25

19763.70

20300.67

20825.75

20895.84

19955.19

20032.69

22162.27

DE

8416.01

10729.04

11507.29

12319.63

12977.47

13056.42

13653.30

18126.72

FCP

1461.09

1902.34

2042.39

2195.16

2301.59

2186.46

2205.35

2755.04

EM

5890.55

7647.06

8198.94

8812.17

9278.61

9278.48

9704.73

12953.24

Annual growth rates

Year

2001

2005

2006

2007

2008

2009

2010

2015

W

1.71

3.38

4.04

3.78

1.84

-2.65

2.11

3.45

D

1.27

2.31

2.78

2.41

0.38

-3.73

1.21

2.32

D less US

1.59

1.84

2.72

2.59

0.34

-4.50

0.39

2.07

DE

2.78

6.30

7.25

7.06

5.34

0.61

4.57

5.68

FCP

4.50

5.72

7.36

7.48

4.85

-5.00

0.86

4.57

EM

3.55

6.09

7.22

7.48

5.29

0.00

4.59

5.78

Notes: W = World; D = Developed nations; D less US = Developed nations less US;
DE = Developing nations; FCP = Former centrally planned nations EM = Emerging market nations.

Source: Data found in World Bank World Development Indicators, International Financial Statistics of the IMF, Global Insight, and Oxford Economic Forecasting, as well as estimated and projected values developed by the Economic Research Service all converted to a 2005 base year. Available at http://www.ers.usda.gov/Data/Macroeconomics/Data/ProjectedRealGDPValues.xls.

1.4 Insourcing and urbanisation in developing economies

Insourcing (incoming foreign direct investment) and outsourcing (outgoing foreign direct investment) have been contributing to net benefits of formal firms in both developed and developing nations and in turn to the well being of all.

Drezner (2004, p.22), in response to rhetoric against outsourcing in the USA, states that

“outsourcing of American jobs to other countries has become a problem of epic proportion. Fortunately, this alarmism is misguided. Outsourcing actually brings far more benefits than costs, both now and in the long run. If its critics succeed in provoking a new wave of American protectionism, the consequences will be disastrous — for the U.S. economy and for the American workers they claim to defend.”

In developing nations though, insourcing has been transforming local economies in new directions that cause global anxiety. Demographics in China, India and many more economies indicate that populations, in search of jobs and a better life, have been migrating towards urban, industrialised, centres, abandoning their agrarian lands, creating megacities and giving rise to urbanisation-type problems. (See self-explanatory projected population data for China and India in Tables 3 and 4).

Table 3 Urban, rural population trends in China

Population (000s)

1985

2005

2025

Total

1,070,175

1,321,569

1,480,430

Urban
[Proportion (%)]

241,766
[22.6]

507,725
[38.4]

773,155
[52.2]

Rural
[Proportion (%)]

828,409
[77.4]

813,845
[61.6]

707,275
[47.5]

Source: Available at http://ww2.unhabitat.org/habrdd/conditions/eastasia/china.htm.

Table 4 Megacity population trends in India

Population (000s)

1991

2011

Total

844,272

1,292,506

Delhi

8,723

24,867

Mumbai

12,572

21,780

Calcutta

10,916

16,509

Source: Available at http://www.ifpindia.org/ecrire/upload/press_ifp_website/ indiapolis_articlerelu.pdf.

Megacity build-up and abandonment of agrarian lands have been occurring throughout the developing world1. In all these countries, historical data seems to support two stages of development:

In Stage I, prior to insourcing, most of the population lives in the agrarian sector on subsistence agriculture and/or on meagre wages from selling their labour. Overpopulation forces people to exist under perpetually poor conditions causing the supply of labour to be perfectly elastic since there is around abundant low-skilled perfectly substitutable agrarian labour. In general, in this stage of development, the agrarian sector may be described by 2, where A = agrarian, e = equilibrium, WA = wage rate, LA = labour, DA = demand of labour, and LA = supply of labour2. Point V corresponds to the amount of available labour in the sector, point T to the amount of labour employed by the informal economy at equilibrium (point e) and (V-T) to the surplus of labour in the agrarian sector.

Insourcing gives rise to Stage II. Incoming foreign direct investment takes root in urban centres (in most cases near the coast, e.g., China) and offers higher wages to attract labour from agrarian regions. In this stage, the industrial sector may be described by 3, where I = industrial. It is assumed that at We supply of labour in the industrial sector is equal to zero (workers would have no incentive to migrate if they cannot receive higher wages). Equilibrium initially occurs at eI, where DI is equal to SI, and labourers get paid WeI > We. At this market wage rate, the industrial sector absorbs portion TU of the total surplus labour available in the countryside. In turn, because there is still unused surplus labour in the agrarian sector (portion UV), more insourcing triggers higher demand for labour in the industrial sector (DI¢) and migration of the remaining surplus labour; additional migration to urban areas causes the labour supply to become more elastic (the supply function flattens and rotates out to SI¢). At the new and final equilibrium of eI¢, WeI¢ < WeI and the left-over portion of surplus labour, UV, is employed.

The above analysis implies many benefits: employment and income improve; know-how spreads through technology transfer; saving, investment, and tax revenue increase greatly contributing to growth; in addition to the above, people may prefer the city because it is more likely to endeavour entrepreneurial opportunities, find formal education for their children, have access to healthcare, enjoy entertainment, live cosmopolitan lives, and take advantage of proximity to major transposition hubs (for travelling to other countries and inside their own).

However, the analysis implies costs as well, especially as they relate to urbanisation, such as: pollution (air, water and land); crime (especially in inner city areas); traffic jams; crowded housing; loss of arable land; food shortages (since people abandon their agrarian fields in the country and/or because they turn agrarian fields near the city into suburbs); creation and stagnation of an informal economy; lack of socialising due to isolation from, and alienation of, neighbours; deterioration in education (due to capacity limitations) as well as healthcare, transportation and governmental services (especially in utilities, fire and police protection); and finally, dependency on food importation, foreign direct investment and foreign capital markets.

1.4.1 Development views: ‘romantic’, ‘parasite’ and ‘dual economy’

In addition to the above, urbanisation in developing nations spawns informal business firms, which, in general, do not pay taxes or abide by laws and regulations. According to some economists, such firms do not contribute to the overall growth of the economy. Development economists agree though that registered, law abiding, efficiently run entities known as formal business firms have to be encouraged to exist through incentives and governmental policy for they are the only capable of boosting economic growth and development.

According to the United Nations (2008, p.1), “four billion people around the world are robbed of the chance to better their lives and climb out of poverty, because they are excluded from the rule of law.” Informal business firms account for up to about half of economic activity in developing nations but researchers disagree about their role. As explained by La Porta and Shleifer (2008, pp.275-276), “there are three broad views of this role, (referred) to as the romantic view, the parasite view, and the dual economy – ‘dual’ for short – view (otherwise known as the) ‘Wal-Mart’ theory of development.”

In the ‘romantic’ view, associated with de Soto (2000), informal firms, which are similar to formal (for example, they attract equally talented employees), are held back by barriers to official recognition: lack of secure property titles, deeds, securities and contracts that describe the economically significant aspects of assets. The lowering of such barriers would improve the ability of firms to borrow against registered and secured property-based collateral; additionally, it would enable them to more easily acquire, and/or merge with, other firms.

In contrast, the ‘parasite’ view holds that informal firms, led by less-able, mostly uneducated, entrepreneurs, choose to stay small; as such, they lack the needed scale to operate efficiently and, conveniently, they enjoy cost advantages since they do not pay taxes, offer fringe benefits to employees, follow safety requirements in the workplace or abide by other regulations and the rule of law. These firms impair the economy’s
growth: they reduce overall productivity and they take away market share from more productive formal firms because of their cost advantage over them. Hence, governmental initiatives to uproot these ‘parasites’ (such as enhancing audit capabilities to reduce tax evasion and enforce regulations) would contribute to efficiency, employment, growth and development.

Finally, according to the ‘dual’ view, informal and formal firms may coexist as long as government tax and regulatory policies support the development of formal firms without encouraging or discouraging informal firms. Unlike the romantic view, this view holds that formal firms are different than informal: formal firms attract more skilful employees, their owners are better entrepreneurs, they are officially recognised, they can raise capital and they abide by regulations. Unlike the parasite view, the dual view maintains that informal firms are not a threat to formal firms because, for the same products, they charge higher prices (due to inefficient production and thus high costs) and because they mostly operate in different markets selling to different clients.

La Porta and Shleifer (2008, p.278) report that empirical evidence supports the ‘Wal-Mart’ theory of economic development and they stress that “the dual view sees the (informal) firms as providers of a livelihood to millions, perhaps billions, of extremely poor people, and it cautions against any policies that would raise the costs of these firms. This view sees the hope of economic development in policies, such as human capital, tax, and regulatory policies, that promote the creation of (formal) firms, letting the (informal) ones die as the economy develops.”

2 The increasing relevance of auctions

Firms may participate in auctions as buyers (bidders) or sellers (auctioneers). As buyers, they want to maximise buyer surplus (the difference between what they would be willing to bid at and the bid they actually pay). As sellers, they want to maximise profit (the difference between the bid they would be willing to sell at and the cost of the auction’s object). Although any entity may rely on auctions for selling and buying, a few ‘liaison’ firms have become very famous over their valuable and pioneering business concepts. Such firms are Christies, Sotheby’s, and eBay.com.

Retail, franchise or land acquisition, government procurement, and various services, among many more, rely on auction-type selling and buying. For example, retail stores (such as Filene’s Basement in Boston) report a price on an item’s tag but the actual price paid by the client is lower the more time the item is up for sale on the floor;
in turn, unsold items are donated to charitable organisations. Similarly, sellers in fresh produce markets lower prices towards the end of the day prior to disposing off the
items. Governments purchase military assets and/or services of engineers for public infrastructure by relying on bids submitted by the sellers of those services and franchise owners bid for the privilege to own a franchise licence. Home developers, often, buy land in multiple lots through auctions and, of course, eBay has turned every single person on the planet into a potential auctioneer and/or a bidder.

Auction results depend on many factors such as type of auctions or design, information of bidders’ valuations (which may be identical or different) and their attitudes towards risk, whether or not bidders bid on many or on a bundle of units and, of course, on whether or not bidders and auctioneers act ethically. For more details and a guide to literature see Klemperer (1999).

2.1 Bidders (or buyers)

Table 5 describes five well-known auction types. Bidders in an English auction would have the incentive to bid higher than other bidders but lower than their true valuation. An advantage to English auctions is that, during the auction, bidders may swiftly revise bids upwards (up to but not higher than whatever they are willing to pay) based on information about the valuations of other bidders in the auction.

Bidders in Dutch and First-Price Sealed-Bid auctions would have the incentive
to bid strategically so that they never lose to someone with a lower valuation of the item under auction. A strategy for the bidder in these auctions would be to shade down the bid to the unknown second highest bid. As explained by Pepall et al. (2005, pp.640-641), each bidder may estimate the second highest bid as follows: assuming that each
bidder in the auction believes that her valuation is the highest, if bidders draw from a uniform distribution [0, υ] with all N bidders equally spaced on this interval (where
υ = highest bid), then the average of the highest value in samples of size N drawn from [0, υ], or the second highest bid, would be [(N – 1) / N]υ. (For example, if there are N = 5 bidders and a bidder’s highest valuation is $100, then the second highest valuation is
[(5 – 1) / 5] $100 = $80; hence, the optimal bid for this bidder would be $80). But, if the bidder is wrong on her belief that she is the highest bidder she may lose the auction. Thus, bid shading implies a possible benefit an