Business and Its Environment, 6E David P. Baron Solution Manual.pdf

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Solution Manual

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Business and Its Environment

Edition: Author(s):

6th Edition David P. Baron

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Contents Introduction Sample Course Outline Part I Strategy and the Nonmarket Environment Chapter 1 Market and Nonmarket Environments Chapter 2 Integrated Strategy Chapter 3 The News Media and Nonmarket Issues Chapter 4 Private Politics Chapter 5 Crisis Management

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34 35 50 71 88 124 Part I Integrative Case: Wal-Mart: Nonmarket Pressure and Reputation Risk (A) 138 Part II Nonmarket Strategies and Government Institutions 142 Chapter 6 Nonmarket Analysis for Business 143 Chapter 7 Formulating Nonmarket Strategies for Government Arenas 158 Chapter 8 Implementing Nonmarket Strategies in Government Arenas 168 Part II Integrative Case: Fuel Economy Standards 2007 193 Part III Government and Markets 198 Chapter 9 Antitrust: Economics, Law, and Politics 199 Chapter 10 Regulation: Law, Economics, and Politics 209 Chapter 11 Environmental Protection: Economics, Politics, and Management 229 Chapter 12 Law and Markets 240 Chapter 13 Information Industries and Nonmarket Issues 255 Part III Integrative Case: Credit Card Regulation 278 Part IV Global Nonmarket Strategy 281 Chapter 14 The Political Economy of Japan 282 Chapter 15 The Political Economy of the European Union 293 Chapter 16 China: History, Culture, and Political Economy 315 Chapter 17 Emerging Markets Chapter 18 The Political Economy of International Trade Policy Part IV Integrative Case: Toys `R’ Us and Globalization 328 Part V Ethics and Responsibility 338 Chapter 19 Corporate Social Responsibility 357 Chapter 20 Ethics Systems: Utilitarianism 373 Chapter 21 Ethics Systems: Rights and Justice 374 Chapter 22 Implementing Ethics Systems 384 Chapter 23 Ethics Issues in International Business 396 Part V Integrative Case: GlaxoSmithKline and AIDS Drug Policy 408 438 446

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Instructor's Manual for Business and Its Environment, 6th Edition Introduction This instructor's manual includes a brief discussion of the objectives of each chapter, teaching notes for each case, and updates on the developments of each case. Several follow-up “(B)” cases are included, which can be distributed in advance or during class to extend the discussion. These cases are printed on separate pages to allow reproduction and can also be used as a basis for examination questions. The manual also contains a sample course outline.

PowerPoints, including lectures for each chapter and analyses of selected cases, and a Test Item File, containing examination questions for each chapter, are available for download at www.pearsonhighered.com/irc. Registration is simple and gives instructors immediate access to new titles and new editions. Visit http://247.pearsoned.com/ for answers to frequently asked questions and toll-free user support phone numbers.

Objectives of the Book Business and its Environment is intended for managerially-oriented courses focusing on business issues that arise primarily in the nonmarket environment of firms. The focus is on those issues that are not resolved solely in markets, and hence the term “nonmarket environment of business” is used. That environment is characterized by the issues, interests, institutions, and information that impact the performance of firms. The book does not take a public policy perspective but instead adopts the perspective of managers responsible for the performance of their firms. The approach focuses on strategies for effectively addressing nonmarket issues and emphasizes analysis and reasoning as the foundation for strategy formulation. The book presents methods and conceptual frameworks that form that foundation. The frameworks include the ethics systems of utilitarianism, moral rights, and justice.

Many of the issues that arise in the environment of business are sufficiently complex that simple prescriptions are poor substitutes for careful analysis. In addition, when normative and ethics issues are involved, people may differ in their judgments about appropriate courses of action. What serves managers best in the long-run is being able to reason thoroughly and thoughtfully about issues and to develop strategies for addressing them that are responsible and improve performance.

Because of the complexity of the issues and the diversity of perspectives held by individuals, discovery through discussion can be an important component of the learning process. To provide vehicles for that discovery, each chapter includes several cases that are integrated with the text.

The cases provide an opportunity to explore issues in more depth in complex settings.

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Many of the cases include considerable background and texture; others are short. The short cases are intended to engage the reader quickly, and provide only that descriptive detail necessary to apply the chapter material. The cases are not necessarily intended to provide exemplary lessons or descriptions of best practice but instead focus on challenges for managers that require analysis, formulation of a strategy, and a course of action. The cases typically are set at the point at which the firm must make a decision, develop a policy, or formulate a strategy. The book also contains integrative cases at the end of each of the five parts.

Features of Business and Its Environment, 6th Edition The book focuses on concepts, methods of analysis, and approaches to strategy formulation and its implementation, as well as on contextual and institutional detail. The chapters provide sufficient institutional detail to support the conceptual material, and examples are used to illustrate the concepts. The chapters are intended to help students learn to analyze and reason about issues in complex managerial settings. The cases then provide opportunities to practice analysis and develop strategies for addressing nonmarket issues. The text contains a number of illustrative examples.

Some of the distinguishing features of the book are the following. First, it provides a conception of the field of business and its environment and carries that conception throughout. The conception is that firms must operate effectively in both their market and nonmarket environments and that market and nonmarket strategies must be integrated. The approach is managerial and focuses on how firms and their managers can address nonmarket issues effectively in conjunction with the associated market implications.

Second, the book provides a comprehensive and integrated approach to the field of business and its environment. It covers strategy formulation, business and politics, the news media, activist and interest groups, crisis management, regulation, antitrust, environmental protection, intellectual property, common law, products liability, information industries, international trade policy and politics, country analysis and the nonmarket environment of business in China, Japan, the European Union, and emerging markets, corporate social responsibility, ethics and ethical reasoning, the application of ethics to managerial issues, and ethical issues in international business. The coverage emphasizes how these subjects are related and interrelated. For example, the news media and activists are considered because they play an important role in shaping the development of many nonmarket issues, some of which develop into crises. Ethics is included because nonmarket issues often have moral dimensions that require the application of moral principles.

The book is integrated by adopting a consistent perspective that guides the frameworks presented.

The frameworks include based positive and normative methods for analyzing issues and formulating strategies for addressing them. The perspective is that issues in the nonmarket environment of business are contested, and the forces that shape their outcomes require the attention of management. Companies must participate effectively and responsibly in the public and private processes addressing those issues, and to do so they must understand the issues and how they can be favorably resolved.

Third, the book adopts a managerial perspective and focuses on the formulation of nonmarket strategies. The managerial focus is used both in the chapters and in the cases, which are vehicles

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for considering how a firm should address nonmarket issues. Most of the cases are not descriptions of what a company did but instead characterize a challenge or issue facing a company and ask how the company should deal with it.

Fourth, the guiding approach to nonmarket issues involving government is that of political economy. This approach focuses on understanding how government institutions function and what forces determine outcomes. Interest group analysis, for example, is one foundation for this approach. Combining interest group analysis with knowledge of government institutions provides the basis for formulating effective nonmarket strategies.

Fifth, normative issues focusing on the responsibilities of business are considered as are issues with distinctly moral dimensions. The approach to these issues involves the application of ethics reasoning based on moral principles. Many of the issues considered are those on which reasonable people of goodwill may differ and hence on which ethics reasoning can contribute to clarity of understanding if not consensus. Applications to issues involving corporate social responsibility, interacting with stakeholders, and international business are provided.

Sixth, the book is current. It addresses a number of topics with which managers continue to struggle. For example, the cases address entrepreneurship, social and environmental entrepreneurship, Internet regulation, pricing of AIDS drugs in the developing world, activist challenges, globalization, pharmaceuticals safety, fuel economy standards, censorship in China, compulsory licensing, privatization, privacy, operating in developing countries, obesity, fair trade, environmental management, and social responsibility. Many of these issues will remain current for many years.

Seventh, the book is international. Many of the frameworks and perspectives are applicable to both domestic and international settings and issues. In addition, six chapters are devoted to international topics, including chapters on emerging markets, China, Japan, the European Union, international trade, and ethics issues in international business.

Principal Changes in the 6th Edition The sixth edition of Business and Its Environment represents continuity and change. It retains the structure, much of the subject matter, and the conceptual frameworks of the fifth edition. It also retains the strategy orientation and the guidance of the normative subjects of ethics and social responsibility. The sixth edition includes chapter cases for class discussion of managerial issues and applications of the conceptual frameworks and institutional material. At the end of each of the five parts of the book are integrative cases on an nonmarket challenges facing Wal-Mart, fuel economy standards, credit card regulation, global strategy, and the pricing of AIDS drugs for low-income countries. The sixth edition continues the focus on strategies for improving performance by addressing the challenges in the nonmarket environment and their effects on the market environment.

The approach draws on the disciplines of economics, political science, law, and ethics to provide a foundation for strategy formulation and a deeper understanding of the environment of business and nonmarket issues. An integrated perspective strengthens the managerial orientation of the book and also enhances the usefulness of the conceptual materials for other parts of the business curriculum.

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The principal changes in the sixth edition are a thorough updating of all the chapters, and further development of strategy concepts. The book contains two new chapters on crisis management and emerging markets. The crisis management chapter includes a framework for dealing with crises as well as lessons from crises such as the Tylenol poisoning and the Exxon Valdez oil spill. Major changes in two of the chapters on the environment and the responsibilities of business have been made. The chapter on the environment emphasizes management and the experience with tradable permits systems, and the responsibilities chapter includes a framework for understanding corporate social performance. The sixth edition contains 74 cases, including 24 new cases on Google, Mattel, Wal-Mart, Molecular Insight, the taxation of carried interest, Merck and its cervical cancer vaccine, fuel economy standards, price-fixing, diesel engine regulation, Samsung and nanotechnology, patent strategy for Plavix, credit card regulation, Google in China, Tesco PLC, Banco Compartamos, Kiva, MTN Group Limited, Siemens and bribery, De Beers and conflict diamonds, abuse of government setasides, tax shelters, GlaxoSmithKline and restless legs, and Gilead Sciences access proram for HIV Drugs. The new cases address issues in antitrust and regulation, pharmaceuticals policy, information technology, environmental protection, international business, the activist environment, and business ethics and responsibility. Twenty-seven of the cases concern global and international nonmarket issues, and 20 deal with environmental and health issues. Each case poses a managerial problem that requires analysis and strategy formulation.

Brief Introduction to the Chapters Part I: Strategy and the Nonmarket Environment Chapter 1: Market and Nonmarket Environments The objectives of this chapter are to introduce the concept of the nonmarket environment, provide frameworks for characterizing that environment, and present a framework for the development of nonmarket issues. The nonmarket environment is characterized by the four I's: issues, interests, institutions, and information. This characterization is illustrated in some detail for the automobile industry. The emphasis of the approach maintained throughout the book is on nonmarket strategy; i.e., actions by managers to improve the performance of their firms in both their market and nonmarket environments. The chapter presents the nonmarket issue life cycle and explores the origins of nonmarket issues. The chapter also includes a new case The Nonmarket Environment of Google, which illustrates the broad range of nonmarket issues with which the company must deal.

Chapter 2: Integrated Strategy The principal objectives of this chapter are to introduce the concept of an integrated market and nonmarket strategy, introduce the concept of positioning, and provide a framework for the analysis of nonmarket issues and for the formulation of nonmarket strategies. The chapter also reinforces the point made in Chapter 1 that managers are responsible for the formulation and implementation of nonmarket strategies. The chapter extends that perspective by focusing on the integration of those strategies with market strategies, as illustrated in Figure 2-1. One natural focal point for this integration is the relationship between market opportunities and the importance of nonmarket

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strategies, as illustrated in Figure 2-2 and 2-3. The chapter contains a section on the positioning aspect of nonmarket strategy and illustrates it with a detailed example of eBay’s positioning in legal space. The chapter includes a new entrepreneurship case on Molecular Insight Pharmaceuticals, a development-stage imaging company.

Chapter 3: The News Media and Nonmarket Issues This chapter considers the role of the news media in the life cycle of a nonmarket issue. It is intended to sensitize students to the types of issues the news media brings to the attention of activists, politicians, and the public and to provide a framework for understanding when the media will cover an issue and how the issue will be treated in that coverage. The media does not create nonmarket issues, but it can accelerate their development and broaden the set of actors who take an interest in them. Media coverage can also make it more difficult for management to address the issue if the firm’s actions are under close and continuing scrutiny. Because of the importance of the news media in the nonmarket environment, managers need to understand the objectives of the news media and journalists and how to interact with them in an effective manner. From time to time, a dispute between a firm and the news media develops, and managers need to understand the possible avenues of recourse.

Chapter 4: Private Politics This chapter further characterizes the nonmarket environment of business by considering activists and their activities, particularly those activities that take place outside of public institutions; i.e., private politics. The chapter also addresses approaches for dealing with activists and their actions.

Activists are important for a variety of reasons, especially because they play a central role in identifying and shaping the development of nonmarket issues. The chapter includes a framework for understanding the strategies of activist groups. The framework ties to the theory of the media presented in Chapter 3. The chapter case, Anatomy of a Corporate Campaign: Rainforest Action Network and Citigroup, considers the perspective, strategy, and organization of an activist group.

Chapter 5: Crisis Management This is a new chapter on crisis management. Crises happen. They can be caused by a natural disaster, such as Hurricane Katrina, a crime such as the poisoning of Tylenol capsules, or the reaction of activists and the public to activities of the firm. Avoiding crises is always the best strategy but a firm should have a crisis management policy in the event that a crisis occurs. The Exxon Valdez crisis was exacerbated by both the inability of the company to implement its policy and the failure to communicate effectively to the victims and the public. The chapter presents a framework based on the nonmarket issue life cycle for addressing a crisis. The chapter emphasizes dealing with the root cause of the crisis and with communication.

Part I Integrative Case: Wal-Mart: Nonmarket Pressure and Reputation Risk (A) This case identifies a set of nonmarket issues with which the firm must deal. Some of these issues arise from changes in the nonmarket environment; e.g., the public expectation that firms are to deal

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with global warming, and others from the advesaries of Wal-Mart, primarily labor unions and their allies. Labor unions financed organizations to criticize publicly the company, and some of the criticisms drew support from the public. Wal-Mart had to decide how to counter the critics and develop a new strategy for dealing with the issues. The Chapter 19 case Wal-Mart: Nonmarket Pressure and Reputation Risk (B): A New Nonmarket Strategy provides information on Wal-Mart’s strategy to address the challenges it faced.

Part II: Public Politics and Nonmarket Strategy Chapter 6: Nonmarket Analysis for Business This chapter develops a parsimonious approach to the analysis of political behavior. The approach combines the institutional information from the Appendix with an analysis of interest groups and provides the foundations for the formulation and implementation of political strategies as considered in Chapters 7 and 8, respectively. This chapter and the other chapters of Part II focus on legislative institutions and in particular Congress. Institutional information on regulatory and executive branch agencies is provided in Part III. Institutional information on Japan is presented in Chapter 14, the European Union in Chapter 15, and China in Chapter 16. The underlying theory is that of distributive politics in which political action is motivated by the benefits it can yield. The moral motivations of collective action are also briefly considered and are developed in more detail in Part V. Distributive consequences and moral motivations are one side – the demand side — of the political action calculus. The supply side focuses on the cost of individual and collective action.

The notion of the supply and demand of political action is more than a metaphor and can be used to predict the amount of action generated. The frameworks are illustrated in the Boeing and Foreign Leasing example. The Appendix provides information about the federal legislative institutions in the United States.

Chapter 7: Nonmarket Strategies for Government Arenas This chapter focuses on the formulation of strategies for participating effectively and responsibly in the politics of nonmarket issues. The focus is on legislative issues, but the framework and approach are applicable more generally. The discussion of strategy formulation is general and builds on the treatments of institutional characteristics and political analysis from the two previous chapters. The perspective taken is that strategy formulation is the responsibility of management and not of political consultants or advisors, although the latter can provide important inputs to the process and can assist in implementation. This chapter contains material on nonmarket strategy and introduces generic majority building and informational strategies for addressing nonmarket issues in the context of government institutions. The two principal majority building strategies are representation, which is based on the constituency connection, and vote recruitment, which is based on the provision of support for officeholders. Informational and agenda-setting strategies are also introduced and evaluated. The strategies are then related to the Lowi-Wilson matrix introduced I n Chapter 6.

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Chapter 8: Implementing Nonmarket Strategies in Government Arenas This chapter addresses the implementation of nonmarket strategies in legislative arenas, focusing on the types of activities firms engage in. Lobbying is the most important activity in informational strategies, and the text addresses its nature, what makes it effective, what enables it, and the regulation of lobbying. Lobbying must be responsible, and the chapter case Responsible Lobbying? considers a strategy of Merck to advance the adoption of Gardasil, a vaccine against cervical cancer. Whereas lobbying in an informational or representation strategy is typically done behind the scenes, grassroots campaigns are highly visible and orchestrated efforts to provide information but more importantly to apply constituent pressure on government officials. Coalition building is an important part of many representational strategies and is intended to leverage the political action of a firm. Testimony is often a component of a political strategy directed toward a legislature or a regulatory agency. The section on electoral strategies focuses on the myths and realities of campaign contributions. Communications and public advocacy strategies can be useful in representational strategies, but the most important communication in informational strategies is through lobbying. Advisory committees are important sources of information particularly in countries such as Japan as discussed in more detail in Chapter 14. Judicial strategies can be both costly and time consuming and the outcome uncertain, but in some industries such as pharmaceuticals and telecommunications they play an important role.

Part II Integrative Case: Fuel Economy Standards 2007 This case focuses on 2007 legislation to increase fuel economy standards for automobiles and trucks in the United States. The case addresses both private and public politics and focuses on a change in the U.S. automakers’ strategy given the broad public support for energy conservation and dealing with global warming.

Part III: Government and Markets Chapter 9: Antitrust: Economics, Law, and Politics This chapter addresses elements of antitrust law, its enforcement, and the underlying economics concepts. Antitrust is a broad and deep subject to which entire courses are devoted. Instead of trying to condense this subject, the chapter focuses on four aspects of it. The first is the law and its enforcement. The second is schools of thought about the role of antitrust and its application. The third is elements of the economics of antitrust, and the fourth is the politics of antitrust. The three schools of thought are the traditional or structural school, the Chicago school, and the new industrial organization (IO) approach. The chapter presents and contrasts the three schools of thought using the antitrust issues of vertical restraints, price-fixing and collusion, predatory pricing, and mergers.

Chapter 10: Regulation: Law, Economics, and Politics This chapter introduces the general framework of government regulation including its legal foundations, its economic rationale, and its politics. Chapter 11 is devoted to environmental

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protection and regulation. Regulatory commissions and agencies have one of the two different structures as described in the text, but both are subject to a set of political and legal influences illustrated in Figure 10-2. The explanations for regulation and the forms it takes are of two types.

One is political and focuses on the demand for and the opposition to regulation. The second explanation is found in market imperfections that, in the absence of regulation, can result in economic inefficiency. The chapter considers the major forms of market imperfections. The chapter also presents material on the law and administration of regulation as well as the theory of market imperfections and politics of regulation. The chapter updates developments in telecommunications, electric power deregulation, and auctions.

Chapter 11: Environmental Protection: Economics, Politics, and Management This chapter is largely new with additions of material on public and private measures to mitigate environmental externalities with a focus on global warming. The Coase theorem is presented to identify alternative means of achieving economic efficiency, and the theorem is used to provide a foundation for cap-and-trade systems. The economics of cap-and-trade systems are presented in a simple manner, and the principal systems in operation are reviewed. Those systems are the sulfur dioxide emissions trading system in the United States and the European Trading System. To date, the former has been a major success and the latter has achieved little. Environmental protection has very high costs, but those costs are largely borne by private parties rather than by government budgets. Environmental regulation thus is less affected by budget concerns and more by interest groups. The principal interest groups are firms and environmental groups. Recognition of the high costs of environmental protection has brought increased attention to achieving regulatory objectives in a socially-efficient manner.

Chapter 12: Law and Markets This chapter introduces a set of concepts from the law pertaining to markets. The topics include the common law, property with an emphasis on intellectual property, contracts, and torts with a focus on products liability. The law is only introduced in the chapter, and business law texts and law and economics books can be used as a supplement. The business law texts also include a set of court cases that can be used as a basis for a discussion. The Coase theorem introduced in Chapter 11 provides one framework for understanding contracts and remedies for breach. The Calabresi and Melamed principles are presented for choosing between the institutions of regulation and the law for dealing with market problems. The chapter provides an introduction to the law and economics of products liability. The objective is to examine the two principal institutions for addressing safety issues – the law of torts and regulation – and to consider nonmarket decision-making on safety issues.

Chapter 13: Information Industries and Nonmarket Issues This chapter presents several selected topics pertaining to information industries and in particular to the Internet and electronic commerce. Although the dotcom bubble burst, the opportunities in the information industries remain substantial and considerable growth can be expected in the future.

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The topics include the economics of winner-take-most markets, Internet privacy, tax policy, and online communities. Cases are available for each. The DoubleClick and Internet Privacy case focuses on an uproar concerning the merging of anonymous click-stream data and personallyidentifiable information gleaned from offline transactions. The eBay: Private Ordering for an Online Community case focuses on eBay’s approach to supporting its online community of remote and anonymous traders. The eBay and Database Protection case concerns the protection of intellectual property. The Chapter 8 case Internet Taxation case focuses on the politics of requiring the collection of state sales taxes on online transactions.

Part III Integrative Case: Credit Card Regulation Public concern over alleged abuses by credit card issuers and the difficulty people had making payments led regulators and Congress to restrain card issuers. The Federal Reserve was the principal regulatory body and issued a draft of stricter regulations. The comment period began. In part, this was to forestall legislation by Congress. The principal bill before Congress would impose stricter regulation than proposed by the Fed, and in an election year Congress had incentives to enact regulations that would be popular with voters.

Part IV: International Political Economy Chapter 14: The Political Economy of Japan This chapter presents a characterization of the political economy of Japan as a foundation for the development of nonmarket strategies. During the 1970s and particularly the 1980s Japan’s economy grew rapidly, but Japan’s bubble economy burst at the beginning of the 1990s as did its reputation for economic invincibility. Throughout the 1990s and into the 21st century Japan’s economy struggled as brief recoveries were followed by recessions. The Japanese government had lost a considerable measure of respect as a result of scandals, a degree of political instability, and an economy that has been mired in a mild recession for a dozen years. Political reform included a revised electoral system and a reorganization of the bureaucracy. In Japan government has traditionally been more important than in the United States, in part because of a long period of oneparty control by the LDP and extensive regulation by its powerful bureaucracy. The nonmarket environment, however, can be characterized in terms of issues, interests, institutions, and information. The other important factor is culture, as indicated in Figure 14-1, which plays a role in structuring relationships and channeling behavior. The frameworks used for the analysis are based on those presented in the first 3 parts of the book.

Chapter 15: The Political Economy of the European Union This chapter considers the political economy of the European Union (EU). The EU now has 27 member states that differ significantly, yet the mutual advantages for more open markets provide the incentive to transfer some degree of sovereignty to a central government. The EU government has substantial authority but the national governments continue to hold the power in the EU. The

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chapter characterizes the 4 I’s with an emphasis on EU institutions. Although considerable progress on the single market has been made, a number of politically sensitive issues remain.

Competition (antitrust) policy is considered and the Microsoft antitrust cases are updated. The experience with the European Trading System for greenhouse gasses permit trading is reviewed.

The increased authority given to the EU government has caused firms to shift some of their attention from national governments to the EU government. Nonmarket issues and strategies in the EU institutional structure are emphasized.

Chapter 16: China: History, Culture and Political Economy This chapter on the People’s Republic of China focuses on the political economy in the post-war (Communist) era. The chapter begins with a brief history of China including the pre-Republican period, the Republican era of the first half of the 20th century and the beginning of the communist movement, and the ascendance to power of Mao. The principal stages of the communist era are discussed with an emphasis on Deng’s open door policy and the subsequent growth in foreign direct investment and economic activity. The four I’s are considered with an emphasis on government institutions. Confucianism is considered along with the understandings it provides for Chinese culture, business activity, and government relations. Policies pertaining to foreign direct investment, trade, and joint ventures are considered. Current issues considered include human rights, corruption, workers’ rights, and piracy of intellectual property. The chapter includes three cases that provide opportunities to consider nonmarket strategy in the Chinese context. The Google in China case pertains to Google’s struggle to operate in China while abiding by the government’s Internet censorship policy.

Chapter 17: Emerging Markets This is a new chapter that provides an introduction to the opportunities and risks associated with doing business in emerging markets countries. The chapter illustrates an approach to country assessment, and identifies data sources to aid in that assessment. The chapter presents a set of opportunities, but those opportunities are largely specific to the markets in individual countries.

Fair trade systems and microfinance are considered. The risks are more generic, and the types of risks are identified and illustrated. Two chapter cases focus on microfinance, with one involving a for-profit microfinance bank and the other a nonprofit, Internet-based microfinance organization.

Another chapter case focuses on whether Tesco PLC should enter the retail market in India and if so, how it should do so. The fourth chapter case focuses on the MTN Group, a South African wireless company that operates in Africa and the Middle East.

Chapter 18: The Political Economy of International Trade Policy This chapter provides an introduction to the political economy of international trade, the principal international trade agreements, and U.S. trade policy and law. The WTO and the international agreements under its auspices are reviewed, and the dispute resolution mechanism is considered along with several ongoing trade disputes. The Doha Round is considered and its prospects

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assessed. U.S. trade law is considered as a foundation for the chapter cases. As indicated in Figure 18-1, whereas international trade policy is established by bilateral and multilateral negotiations among countries, the incentives for those negotiations come from the domestic economies of the countries. Interests in the countries work to influence trade policies. For example, NGOs have worked for a larger role in the next round of multilateral negotiations. Business organizations also play an important role in influencing negotiations. As illustrated in Figure 18-4 the politics of international trade policy are fundamentally majoritarian but pockets of concentrated costs and benefits provide incentives for interest groups to be active. Those incentives arise on both the export and the import-competing sides and lead toward interest group politics.

Part IV Integrative Case: Toys ‘R’ Us and Globalization Toys ‘R’ Us embarked on a globalization strategy of taking worldwide its market strategy of large stores, low prices, advertising, and direct supply. In doing so, it faced a set of nonmarket issues that differed across countries, but more fundamentally the interests and their organization and the institutions differed. The company’s entry into Germany, Japan, and Sweden are considered.

Part V: Ethics and Responsibility Chapter 19: Corporate Social Responsibility This chapter begins the explicitly normative part of the book. The purpose of the chapter is to raise the issue of the appropriate objectives of a firm and its responsibilities to its various constituencies.

The chapter has been substantially revised to provide better focus and to introduce a new framework. Two principal perspectives on corporate social responsibility (CSR) are considered.

The first is that of Milton Friedman, who argues that the responsibility of firms is to maximize profits. This is contrasted with the stakeholder perspective that holds that firms have responsibilities to their stakeholders and to society more generally. The chapter also presents a framework for understanding CSR and provides empirical evidence supporting that framework.

The framework considers the strategic use of CSR as well as CSR measures adopted in response to social pressure. The chapter concludes with a section on governance and the responsibilities of boards of directors. The chapter concludes that the content of social responsibility is found in ethics, which is the subject of the next two chapters. Two new cases are included. Chapter 22 presents a number of policies implemented by companies in accord with their conception of corporate social responsibility. Chapter 23 focuses on issues of ethics and corporate social responsibility in international business.

Chapter 20: Ethics Systems: Utilitarianism The perspective taken in this and the following chapter is that not all ethics systems yield the same evaluations of alternatives and indeed may yield conflicting evaluations. Moreover, people may not agree on which ethics system is appropriate. For these reasons, it is important to consider issues from the perspectives of several ethics systems. This chapter focuses on the nature of ethics, its methodology, and its managerial implementation. The chapter also introduces the moral

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philosophy of utilitarianism, its methodology, and its application, including several examples. It also addresses the issue of altruism in the context of utilitarianism. The chapter also distinguishes between act and rule utilitarianism using both the classical and the Harsanyi formulations of rule utilitarianism. The application of utilitarianism to management issues is considered and a methodology for its application is presented and critiqued. A series of applications is used to illustrate the application. The chapter includes a new case on abusive tax shelters.

Chapter 21: Ethics Systems: Rights and Justice This chapter distinguishes between consequentialist systems such as utilitarianism and deontological systems that are based on considerations independent of or in addition to consequences. This chapter presents ethics systems based on conceptions of rights and justice.

The chapter introduces Kant’s system and the relationship between rights and Kant’s maxims. The emphasis is on applied rights analysis and how to proceed when rights are in conflict. The consideration of justice focuses on distributive justice, and Rawls’ theory of justice and its application are the focus. Rawls’ difference principal is contrasted with utilitarianism and egalitarianism. The chapter also considers the issue of duty in rights-based and justice frameworks.

The chapter includes material on the law of equal employment opportunity in the employment relationship. The chapter also has a section on affirmative action that includes recent court decisions. A number of examples are used to illustrate the application of rights and justice frameworks to management problems. A new case considers GlaxoSmithKline’s promotional activities to identify a new malady that can be treated by an existing drug.

Chapter 22: Implementing Ethics Systems The step from ethics principles to practice is often a long one, and this chapter attempts to address the implementation of ethics principles systems by examining a set of corporate policies intended to guide managers in addressing issues involving responsibility and ethics. The examples were selected to provide a range from those such as Our Credo that express a general perspective to those such as Cummins’ that provide specific guides (see also Chapter 23). The chapter begins with a return to the framework introduced in Chapter 2. The analysis stage of the framework calls for the prediction of nonmarket activity, including that which is morally motivated, that is likely to arise in the context of a nonmarket issue. Ethics systems can be useful in understanding and predicting this activity by increasing the sensitivity of managers to ethics issues and more importantly by predicting the amount of nonmarket action. The chapter concludes with a discussion of factors that can lead to unethical behavior. The chapter includes a new case on Gilead Sciences’ efforts to make its HIV drug available in developing countries.

Chapter 23: Ethics Issues in International Business This chapter addresses a set of ethics issues encountered in international business. Those issues include (1) international law and conflicts with domestic laws, (2) whether to abide by universal principles, host country custom and practice, or the custom and practice of one’s home country, (3) questionable foreign payments, and (4) operating in developing countries. Ethics principles are intended to be universal and not country specific, yet it is clear that there are differences in what are

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acceptable practices across countries. Ethics issues are thus often more difficult when they have international dimensions. The chapter provides a set of frameworks for addressing these issues.

The chapter provides an extended discussion of cultural relativism and how to reason about issues set in other cultures. The chapter also includes a framework for reasoning about issues in developing countries, including the issue of sweatshops. The chapter presents a framework for analyzing situations in which a bribe may be solicited and where a competitor may be offering a bribe. The chapter includes two new cases, one of which is on Siemens’ bribery activities. The other concerns De Beers and conflict diamonds.

Part V Integrative Case: GlaxoSmithKline and AIDS Drug Policy The concrete application of corporate social responsibility derives from the application of ethics principles to managerial issues. Managers must adopt and implement policies that, in the best instances, are embodiments of moral principles. In this case students are asked to apply the ethics principles developed in Part V. The case focuses on the AIDS pandemic and GlaxoSmithKline (GSK), which was the world’s largest producer of AIDS drugs.

Teaching with the Book Course Design The text has been written to be used in conjunction with a variety of course designs. It is organized into five parts and each part concludes with an integrative case that brings together a number of the subjects covered in that part. This modular organization allows the instructor flexibility in electing materials for courses ranging from ones emphasizing interactions with governments to ones emphasizing interactions with the public as well as for courses that take a political economy perspective or ones that adopt the perspective of corporate social responsibility.

Class Sessions The book is designed to support a variety of types of class sessions. One is a lecture or discussion format that explains and expands on the topics covered in the chapter. Powerpoints are presented for this purpose. A second is a lecture or discussion that goes beyond the text. The subject could be recent events, a discussion of an issue related to the chapter material, or an alternative approach to a topic. The third is a case discussion.

The Cases The cases are integrated with the text and serve as vehicles for applying the chapter materials. The cases allow students to learn from each other by exploring concepts through discussions. They also allow students to develop their on-line analytical and communication skills. The cases are generally written from the perspective of a firm that must determine how to address a particular issue. The cases take the perspective of management that must assess the issue and develop an

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effective strategy to deal with it. Many of the cases contain information on the market environment as well as on the nonmarket environment. The short cases generally focus on relatively welldefined nonmarket issues. The integrative cases at the end of each part are generally longer and more complex than the chapter cases.

At the end of each case are several preparation questions intended to guide students’ preparation for a class discussion. The case discussion does not necessarily consist of simply answering the questions. That is, the questions the instructor uses to lead the discussion can differ from these in order and content. Discussion questions are given in this manual for all the cases.

Most of the cases are written so that students can take the role of the management of the firm in question. This enables them to identify more with the incentives, pressures, and constraints facing a manager who has to serve organizational objectives.

Teaching Cases Beginning the discussion: Case discussions are typically begun with an opening question. It can be a general question about the setting of the case and the issues in it, a specific question about an issue or problem, or an invitation to present a nonmarket strategy for the firm. The choice of an opening question depends on the instructor’s strategy for teaching the case. If the instructor wants to take a building block approach to the case, the questions should be specific and cumulative in the sense that they cover the scope of the issues and the components of the analysis of those issues. If a central dimension of the case is the students’ identifying the issues for themselves, a general question such as “What are the problems firm A faces?” can be used. Some instructors ask first for the “solution” to the case, and then have the class do the analysis of the case, and then reexamine the solution based on that analysis. If the instructor wants a rather complete “solution” to the case all at once, including identification and analysis of the issues involved, an evaluation of alternatives, and the presentation of a strategy, a general question such as “What are the dimensions of the environmental and Congressional action facing Ford and what strategy should it adopt to address legislation that would increase fuel economy standards 35 miles per gallon?” can be used.

If the objective is to focus on a particular aspect of the case, a more specific question can be asked.

The objective is frequently to explore that component by drawing out differences of opinion about the right course of action. This can be done by asking for participation by someone who disagrees with the first answer. Part of the learning experience using this approach is the process of exchange and debate.

Cold and warm calls: A cold call involves asking a student by name to answer an opening question or to begin the discussion of a case. (A cold call can also be used at other times during the discussion.) The advantage of cold calls is that they induce students to be better prepared for the discussion. The discussion is then typically more thoughtful and less “off the top of the head.” In the field of business and its environment, many of the issues and case situations are ones about which students have “opinions.” A danger is then that the discussion will become an exchange of opinions, which may in the aggregate amount to little more than an opinion poll. This is not necessarily bad, but the cases should be vehicles for analysis and strategy formulation and not for

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eliciting opinions. Cold calling with an opening question asking for analysis or for a strategy and the supporting analysis contributes to this objective.

Some instructors believe that cold calling creates tension in the classroom environment. If a cold call would be dysfunctional, a variant of a cold call – referred to as a warm call – can be used. On a warm call, the instructor asks a question and identifies a student, but rather than having the student begin immediately, the instructor discusses an issue or recent event for a few minutes giving the student an opportunity to collect his or her thoughts.

A variant of a warm call is a hot call. The instructor tells a student in advance of the class that she will be asked to begin the discussion of the case in the next session. This increases the chances that the student will make a well-prepared response to an opening question. The disadvantage of a hot call is that if it becomes a practice, other students will have a weaker incentive to prepare well.

Effective participation in case discussions: The quality of a student’s participation is at least as important as the quantity, and the following points characterize effective participation.

1. Do comments draw on the text and materials from this and other courses? Do they show evidence of analysis? Are the facts in the case utilized and combined with the concepts?

2. Does the student distinguish between positive and normative analysis? Does the student distinguish between opinion and well-supported analysis? Does the student distinguish between comments based on his or her own tastes and those reflecting principles?

3. Are the points made substantive? Are they linked to the comments of others? Do they advance the analysis of the case? Do they deepen the analysis?

4. Do comments clarify and highlight the important aspects of earlier comments and lead to a clearer statement of the concepts being considered? Is there an attempt to synthesize the discussion?

5. Is the student creative in analysis and in offering ideas that go beyond the commonplace?

What to write on the board: An instructor’s preparation for a case discussion may include a board plan that anticipates students’ comments and identifies where on the board those comments will be written. One temptation is simply to identify categories of comments and place student comments under those categories. This may be useful for the purpose of rewarding students (by writing their comments on the board), but it can result in lists. Instead, the emphasis should be on analysis and strategy formulation, causal relations, and the prediction of behavior and consequences. The objective then is to show how an observation or an analysis in a student's comment has implications for what the firm in the case should do. To the extent that categories of comments can be anticipated, the instructor has a basis for organizing the board according to those categories and their causal relationships.

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Writing students' comments on the board serves another purpose. Writing good comments on the board rewards their authors, and not writing a comment on the board distinguishes a bad comment from a good comment.

Obtaining closure: The objective is to have a discussion that has identified the issues in the case, provided an analysis of those issues, and developed a consensus around an effective strategy for addressing the issues in a case. Sometimes, however, consensus will not be reached and closure will not be obtained, and the instructor will face the task of moving the class toward closure. This is an art and can take a variety of forms, one of which is asking a student to summarize the discussion and identify what has yet to be resolved. A surer strategy, however, is for the instructor to identify the remaining issues and then push the class to resolve them. Sometimes a discussion is slowed by a remote possibility or an uncertainty that students believe should be resolved before proceeding to closure. In that case the instructor may intervene to explain why that possibility should not be given serious consideration or to explain how it can be resolved. This could also be done by asking students to accept it as an hypothesis to allow the discussion to continue. If a discussion seems far from closure, the instructor may have to present an appropriate course of action and ask the students to evaluate it.

From the perspective of a purist, a case discussion should end with all the important points on the board, leaving it up to the students to integrate the discussion and content. Most instructors, however, prefer to summarize or integrate the discussion. A summary can include an evaluation of the discussion pointing to particularly good or bad analysis or insights. The summary can also be used to reward students by mentioning their comments. Some instructors may use the summary to explore the extent to which the analysis or conclusions generalize, show how the analysis builds on material in the text, identify the key factors that make the strategy appropriate in this case but not in others, and relate the discussion to other issues in the course. Some instructors also include in the summary a discussion of what actually happened in the case and why.

Combining a lecture with a case discussion: When both a lecture and a case discussion are planned for a class session, the natural approach is to lecture first so that the material can be applied in the following case discussion. This, however, is often not successful, since students have difficulty applying the lecture material immediately. It is often more successful to lecture after the case discussion and to refer back to the case discussion to illustrate the lecture material.

Observations on case discussions: One challenge in leading a case discussion is deciding when to advance the discussion by moving to the next issue or question. In some instances this will be obvious, such as when the answers become repetitious or variations on the same themes. In other instances, the time remaining in the session and the issues remaining to be covered will dictate moving on. In between, the instructor should look for transition opportunities. For example, a student may raise the next issue to be discussed, and it is often useful to make the transition at that point rather than to complete the discussion of the current point. At times, the discussion will have to move on even though there are students who wish to make additional points on the current topic.

An important issue is how much the instructor should participate in the discussion. The purist approach is for the instructor to conduct but not participate in the discussion. If the students fail to raise and discuss all the central issues or do not arrive at a good “answer” to the case, so be it.

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Other instructors choose to participate actively in the discussion. This participation, however, runs the risk of causing students to rely on the instructor for too much of the work. Many instructors prefer to direct the discussion in a relatively structured manner, offer comments to flesh out issues, emphasize points, or provide a short lecture.

In some case discussions, a herd instinct may develop with students all taking the same side of an issue or all focusing on one particular course of action. When there are other sides to the issue or other reasonable courses of action, the instructor may have to represent the other side or act as the devil's advocate. The hope is that some students will then pick up on it, allowing the instructor to turn the discussion back to the class.

Role-playing can be used in case discussions by organizing groups of students to take and advocate a particular position with another group of students assigned to advocate an opposing position. One member of each group can then be selected (on a cold call, for example) to make an opening statement for her side. Controversy can be stressed by having the opposing groups sit across from each other in the classroom. Teamwork and cooperation can be stressed by asking others from the same group to build on what has been said in the opening presentation.

Although most case teachers probably do not do so, some like to take a vote at the end of a discussion on what should be done in the case. As a reality check, some instructors then ask the students to vote as they believe their classmates would really act. One can go further and ask the students what they think business executives would actually do.

Short Paper Assignments: Each chapter has more cases than could possibly be discussed in class.

Those that are not discussed in class could be used as examples or illustrations in a lecture or as the basis for a written assignment or examination question.

One effective type of written assignment is a short paper on a case. The following are instructions for such an assignment, intended to make sure that students back their recommendations with analysis and recognize that the company they are representing may not have control over the situation or the outcome. The instructions follow.

The short paper is intended to be read by busy executives who are generally familiar with the situation but are relying on you to frame the issues, identify alternatives, provide analysis, and make recommendations for a strategy. They, in conjunction with you, will make the ultimate decision regarding the adoption of your recommendations. They do not want to formulate the strategy or conduct the analysis themselves, but instead are relying on you for that. They, however, will not accept your recommendations just because you make them but instead must be convinced by your analysis.

There is no universal formula for writing such a paper, but the following suggestions may be helpful. Since the executives are generally familiar with the situation, you need only present a very brief statement of the issues. In some cases you may wish to delineate and prioritize the issues the company faces. Next you should provide a statement of the objectives you hope to achieve with your recommendations. These should be specific and conditional. That is, the objectives should not

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be stated as, “We should win this battle.” They should be stated as, “We will attempt to achieve outcome X, and if it appears that we are unable to achieve X, we should attempt to achieve Y, etc.”

The next step is to present a strategy for achieving the objectives. The strategy should be specific, and implementation details should be given. The details are important, because only they can give the executive confidence about the likely success of your proposed strategy. Your persuasiveness alone is unlikely to carry the day. Furthermore, you will have to live with and be accountable for your recommendations. You thus should be confident that your recommended strategy will accomplish the objectives you specified. Your recommended strategy should reflect the degree to which your firm has control of the situation and can influence the outcome.

The statement of objectives and the presentation of the strategy should either be preceded by an analysis of the issues and their context or should be followed by such an analysis. That analysis should focus on the underlying causal factors that will determine the outcome. The objective is to provide sufficient analysis to give the executives confidence that your strategy is likely to accomplish the objectives you specified. The analysis is a central feature of a strong paper because it provides the connection between the realities of the situation and your strategy. It should be evident to the reader that your recommendations follow from your analysis.

Term project assignment: Instead of short paper assignments, a more substantial term project can be used. The following course outline contains assignment instructions for such a project.

Sample Course Outline This course outline is for a 14-week course meeting twice a week for 90 minutes. The outline parallels the organization of the book.

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S CHOOLBOF USINESS GRADUATE STANFORDUNIVERSITY Professor David P. Baron

P230 STRATEGY AND THE BUSINESS ENVIRONMENT This course addresses managerial issues in the social, political, and legal environments of business.

The cases and readings emphasize strategies to improve the performance of companies in light of their multiple constituencies. Cases are set both internationally and within the United States and illustrate how managers are called upon to interact with the public and governments in local, national, and international settings. Topics include legislation affecting business, regulation and antitrust, intellectual property, international trade policy, emerging markets, activists and the media, and ethics and corporate responsibility.

Most core courses focus on firms’ interactions with customers, suppliers, and alliance partners in the form of mutually beneficial exchanges transacted in markets. This course considers the strategic interactions of firms with their various constituents outside of markets; i.e., in their market environments. Just as managers have the responsibility for formulating strategies for their company's activities in markets, they are also responsible for strategies in the broader public environment in which they operate. Markets and the business environment are interrelated, since issues such as legislation, regulation, judicial decisions, trade policy, and corporate social responsibility directly affect firms’ market performance. Conversely, the market activities of firms often give rise to issues that involve governments and the public. For example, the market strategies of firms have spawned public and government actions on issues ranging from intellectual property to privacy to responsibilities for working conditions in suppliers’ factories.

An important component of a company's interactions with its environment is how its managers deal with ethical issues. Managerial decision-making almost always has ethical implications. Those ethical implications, however, are often viewed as implicit byproducts, rather than explicit determinants, of business decisions. Ethics is made explicit by taking the perspective of managers who must formulate policies to address issues with ethical dimensions. The three principal objectives of this part of the course are (1) to expose students to a diverse and important set of ethics systems, (2) to increase the precision with which students think about, discuss, and practice ethics, and (3) to provide opportunities to apply ethics principles to specific business problems. The course does not attempt to present an exhaustive set of ethics systems nor to develop fully the philosophical structure of the systems considered. Instead, it focuses on systems that provide foundations for basic ethical intuitions pertaining to well-being, rights, and justice.

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The course is structured in five parts: 1. Business and the Public: focusing on the strategy of firms vis-à-vis the public, activists, the news media, and crises.

2. Strategy in the Political Economy: focusing on the strategy of firms in governmental arenas 3. Strategy and the Regulatory and the Legal Environment: focusing on strategy in regulatory arenas and in the courts 4. Strategy and Global Business: focusing on nonmarket issues in international settings 5. Corporate Responsibility and Ethics: focusing on normative considerations in the management of nonmarket issues.

COURSE MATERIALS Course materials include: 1. Business and its Environment (BIE), (6th edition, Prentice-Hall, 2009) by David P. Baron.

2. To supplement the book, additional reading materials are on reserve in Jackson Library.

COURSE REQUIREMENTS AND GRADING The course requirements are mastery of the content of the readings, constructive contributions to class discussions, and the final examination. Grades will be assigned as a weighted average of two components—class participation (40%) and the final examination (60%). The final examination will be open book and notes. Further information on the final exam will be given near the end of the course.

CLASS SESSIONS The course will be conducted on a case discussion basis. A class session will typically begin with an introduction to the conceptual material or the setting and issues in the case. Most of a typical class session will be devoted to the discussion of a case that serves as a vehicle for the application of the readings. The cases allow students to explore issues and approaches and develop their analytical and communication skills. A typical class session will conclude with a lecture that either addresses a conceptual approach or issue, provides additional information for the topic being addressed, or integrates the class discussion and the subject matter.

RESPONSIBILITIES At the GSB, students, along with the faculty and School more broadly, are jointly responsible for learning. In P230 students have a responsibility to contribute to the education of their classmates.

These contributions can take a number of forms, the most common of which is class participation.

Each student has a dual responsibility to contribute to and learn from class discussions. Class sessions should be viewed as business school analogs of professional business meetings. As such, you are expected to attend and be well prepared for every class session. and it is inappropriate to arrive late or to leave early. If you must miss a class due to an emergency, please send me a note of explanation as a courtesy. Absences are otherwise regarded as unexcused and will be reflected

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negatively in your class participation grade. You may not make up for absences by attending another professor's section (you may however attend another professor’s section withprior his consent if you wish to be exposed to the material).

CHARACTERISTICS OF EFFECTIVE CLASSROOM PARTICIPATION A student’s engagement in the course and in the class discussions is essential for individual and collective learning. The quality of participation in class discussions is more important than the quantity. Key characteristics of valuable participation include the following.

• • • • •

Comments are clearly related to the case and to the comments of others and apply the frameworks presented in the readings.

Comments clarify and highlight the important aspects of earlier comments.

Comments sharpen attention to key points and synthesize main components of the discussion.

Comments support the collective learning process of the class.

Comments go beyond the commonplace and provide fresh analytic perspectives.

STUDY GROUPS In the Spring Quarter study groups are not assigned by the GSB administration. Since it is usually advantageous to meet as a group and discuss cases prior to class, I strongly urge you to form your own study groups. The main purposes of group preparation are to review and clarify readings and to share and challenge individual analyses of the case. Reaching a consensus is a subordinate purpose of study group meetings.

PEER EVALUATION The GSB has introduced a system of peer evaluation for classroom participation, and P230 will utilize this system. At approximately the one-third and two-thirds marks in the quarter, each student will evaluate ten classmates in a simple Web-administered questionnaire. The evaluations of a student will subsequently be made available to him or her, but the evaluators’ identities will be concealed. That is, each student will be able to access the evaluations by peers of himself or herself, but no student will know who his or her evaluators were. To encourage candid and serious feedback and, if necessary, to provide corrective feedback, I reserve the right to monitor this process. I will not use the feedback you receive to assess your performance, but I will take the thoughtfulness of the feedback you give into account in the class participation component of your grade.

G300 FIRST-YEAR P ROJECT On an experimental basis the GSB is offering a 2-unit first-year project course G300. If you are interested in a project that is related to P230, I would be happy to discuss it with you. The deadline for having an agreement for a project is Friday, April 11. Please form a group of from four to six members. The expected output from the project will be a written paper and, since students in the past have been eager to learn what other groups have been doing, a presentation of the project to

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me and the other groups. This presentation session is tentatively scheduled for Wednesday, June 4 from 6:30-9:00 pm (dinner will be provided).

A project associated with P230 is intended to provide a deeper understanding of a specific organization, industry, or issue of your choice. The project should focus on the social, political, legal, or ethical environment of a company, nonprofit organization, or industry and on its strategy for addressing the issue or problem. You are encouraged to work with a company or organization, and since the quarter is short, you should make contact with the company or organization as soon as possible to confirm its participation.

Projects are more likely to be successful the more specific is the topic. Broad topics of interest can usually be recast at the company or organizational level. For instance, "trade barriers" by itself is much too broad a topic for the project, but a study of a company’s strategy for entering the retail market in India given the restrictions on foreign direct investment is a good topic.

By Friday, April 11 a prospectus must be agreed upon that provides at least four things: 1. A concise overview of the topic from the company or industry's perspective.

2. A list of the main frameworks you plan to use or extend in your analysis of the issue.

3. The strategic alternatives to be considered.

4. A work plan for completing the project. This may include any special issues or concerns that you anticipate could pose problems for your analysis and strategy formulation.

The final project paper is due on Wednesday, June 4 at the presentation session. The paper should be written in a style suitable for thoughtful executives who are generally familiar with the situation but who are relying on your analysis. Papers are to be no longer than 25 pages, including exhibits.

The entire group may take G300 on either a pass/fail basis or for a letter grade.

ADMINISTRATIVEDETAILS Class sessions will begin on time and run for approximately 90 minutes without a break. Section 1 will meet from 8:15 a.m. to 9:45 a.m. Section 3 will meet from 10:00 a.m. to 11:30 a.m. Office hours will be Monday and Thursday from noon to 1:30 pm or by appointment.

THE HONOR CODE Stanford has a tradition of respect for students’ integrity in academic work. The Honor Code outlines mutual obligations for students and faculty in making this system work. Students are encouraged to work in groups in preparing for class, but it is a violation of the Honor Code to secure and use another person’s notes or papers or handouts from an earlier section to prepare for class. Sorting out the issues for yourself is an important value-adding learning experience.

Constructive collaboration in the sense of sharing your ideas and synthesis with others after doing the basic work is also an important component of the learning experience, and you are strongly encouraged to collaborate. Your written work should be original and any material from other sources should be documented and referenced. Plagiarism is a violation of the Honor Code.

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Although not explicitly covered by the Honor Code, the availability of information services makes it easy to find information on the cases to be discussed in class. Students are encouraged to seek additional information on the case and on the conceptual materials assigned for a session. During the class discussion, however, you are to use only information that was available at the time at which the case is set.

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P230

COURSEOUTLINE I. Business and the Public SESSION 1: STRATEGY AND THE BUSINESS ENVIRONMENT This session introduces the nonmarket environment and provides an opportunity to characterize that environment in terms of issues, interests, institution, and information. The case concerns as set of issues facing Google and its strategies for addressing those issues. The nonmarket issue life cycle can be used to assess the current status of issues and how those issues might develop.

Case: The Nonmarket Environment of Google Reading: BIE Chapter 1

SESSION 2: INTEGRATED STRATEGY Nonmarket strategies are to be integrated with a company’s market strategy. This session focuses on integrated strategy and the positioning of a firm in its market and nonmarket environments. The case concerns a development stage pharmaceutical company. The nonmarket issues pertain to regulation and the protection of intellectual property.

Case: Molecular Insight Pharmaceuticals: Integrated Strategy for a Development Stage Molecular Medicine Company Reading: BIE Chapter 2

SESSION 3: BUSINESS AND THE MEDIA Companies frequently face issues brought to the attention of the public by the news media. In some cases the news media plays an active role in the events and story. This case involves an auto company and a media organization in an important episode. The case raises issues about whether General Motors should take any actions about the Dateline segment, and if so what it should do.

The role of the news media in the development of nonmarket issues will also be considered in Session 4.

Case: General Motors Like a Rock (A)?

Reading: BIE Chapter 3

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SESSION 4: PRIVATE P OLITICS AND THE BUSINESS ENVIRONMENT This session considers an episode in which activists, collective action, and media pressures arose to challenge a company's strategy. Just as companies choose strategies, activists also choose strategies to further their interests and objectives. Issues thus can involve strategic “competition” between companies and activists.

The case is written from the perspective of the management of Shell, but it is often useful to consider the position of a company’s potential competitors in the nonmarket environment; i.e., to conduct a competitor analysis. From the perspective of Greenpeace: 1) How do you view the issue in the case? 2) What are your objectives? 3) What are your capabilities? 4) What strategy would be most effective in stopping the deep-sea disposal of Brent Spar? 5) How would you implement that strategy?

Evaluate Shell UK’s decision process in choosing a BPEO. Compare this process with the process in Figure 2-5, BIE. Case: Shell, Greenpeace, and Brent Spar Reading: BIE Chapter 4

SESSION 5: STRATEGY UNDER PRESSURE This session brings together a number of the concepts introduced in part I of the book. The case focuses on an activist challenge to Citigroup centering on its financing of projects in developing countries. The Rainforest Action Network (RAN) views those policies as environmentally destructive and has launched a private politics campaign against Citigroup. The case considers the campaign from the perspective of RAN as well as that of Citigroup. The challenge for Citigroup is to develop a strategy for dealing with the activist challenge to a profitable line of business.

Case: Anatomy of a Campaign: Rainforest Action Network and Citigroup (A) (B)

SESSION 6: CRISIS MANAGEMENT Crises can result from acts of nature or from the actions of a company or those in its business environment. This session considers a crisis faced by Mattel, the largest U.S. toy company, when it learned that some of its toys imported from China contained lead in the paint. You are asked to make a series of decisions about how to deal with the crisis and prevent future crises. The case is intended to be discussed sequentially as the events unfolded, so in your preparation use only the information available to that point in the case.

Case: Mattel, Inc.: Crisis Management or Management Crisis Reading: BIE, Chapter 5

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II. Strategy in the Political Economy SESSION 7:INTERESTS AND THEIR ORGANIZATION This session focuses on the analysis of strategic situations in which interests are affected by legislative alternatives. Subsequent sessions focus on the features of government institutions and the objectives of their officeholders, and this session focuses on interests, whether they will organize to participate in the politics of the issue, and what their likely impact is. The reading introduces a framework for the analysis of actions by interests and the subsequent nature of the politics of their actions. The case concerns a bill in Congress that would result in a major increase in the taxes on carried interest prevalent in venture capital and hedge funds. The case focuses on formulating a strategy for venture capital firms in a setting where a number of interests are affected.

Case: Carried Interest Taxation Reading: BIE Chapter 6

SESSION 8: ANALYSIS AND STRATEGY IN LEGISLATIVE INSTITUTIONS The objective of the session is to bring together the analysis of interests and their likely impact with features of the institution and the preferences of their officeholders. The session is intended to begin the process of unlocking the “black box” of government by taking into account the workings of a legislature. The analysis of issues, their impact on interests, and the nature and features of institutions provide the foundations for formulating effective strategies for dealing with issues in government arenas. The Appendix of Chapter 7 provides a basic overview of Congress and of the principal political activities intended to influence congressional action. The Internet taxation issue continues to receive attention in Congress.

Case: Internet Taxation Reading: BIE Chapter 7

SESSION 9: STRATEGY IMPLEMENTATION IN GOVERNMENT AREANS Nonmarket Strategies must adapt to the likely outcomes of issues and must be implemented effectively. This session considers an issue on which the initial strategy of the auto industry became counter productive, requiring a change in both strategy and institutional focus. That strategy had to be implemented carefully and responsibly.

Case: Fuel Economy Standards 2007

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Reading: BIE Chapter 8

III. STRATEGY AND THE REGULATORY AND THE LEGAL ENVIRONMEN SESSION 10: ANTITRUST In the past decade antitrust enforcement authorities in the United States, the European Union, and other countries have become more active. In addition, they addressed issues in information industries. This session considers an important case affecting the computer, software, Internet, and related industries. In addition to its implications for those industries, the case provides some important lessons for dealing with government. The session will include a discussion of the implications of the economics of winner-take-most markets and the antitrust hazards in those markets. You are to contrast Cisco’s and Microsoft’s approaches to their antitrust environment.

Case: The Microsoft Antitrust Case Readings: BIE Chapter 9 “Microsoft’s Behavior is Helping Cisco Learn How to Avoid Trouble,” Wall Street Journal, June 1, 2000. (in case packet) SESSION 11: REGULATION Americans have borrowed large amounts on their credit cards, and credit car issuers have expanded their card offerings. Consumers have complained about high interest rates and unanticipated charges. The economic slow down beginning in 2007 added to the complaints and allegations of abuse by card issuers. The case considers regulatory action by the Federal Reserve and a legislative initiative in Congress to eliminate abuse and increase the transparency of credit card terms. The case focuses on the strategy of card issuers in a difficult situation.

Case: Credit Card Regulation Readings: BIE Chapter 10

SESSION 12: ENVIRONMENTAL PROTECTION Environmental issues are ubiquitous, and most pose managerial challenges. Governments are increasingly utilizing incentive approaches to environmental protection, including the trading of permits. The case deals with a permit system in Los Angeles that came under criticism from community groups based on justice claims. The case raises the issues in the context of an oil company that faces a moral and a legal challenge to its participation in an important government program.

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Case: Environment Justice and Pollution Credits Trading System Reading: BIE Chapter 11

SESSION 13: THE COMMON LAW AND TORTS Companies receive guidance on issues such as safety, health, and the environment from a number of public sources. One is regulation that imposes standards on performance and design. The setting of such standards is complex and difficult particularly when technology is changing. An alternative guide for companies comes from the common law, which is a system of law that relies on decisions by judges guided by precedents from earlier cases. This session considers the nature of the common law as applied in the case of a products safety issue—in this case, unvented kerosene space heaters. The reading on products liability characterizes this body of law with the objective of identifying the underlying principles. Case: California Space Heaters Reading: BIE Chapter 12

SESSION 14: INTELLECTUAL PROPERTY AND ITS PROTECTION In information industries intellectual property is the principal asset of many companies. For these companies protecting their information assets is crucial to creating and sustaining a competitive advantage and capturing value. The protection of digital intellectual property is a particular challenge as many companies have learned. This case concerns an e-commerce company that faces a database protection challenge and must formulate a strategy to deal it. The case is set in the United States, but intellectual property issues are pervasive, and the protection provided varies across countries.

Case: eBay and Database Protection Readings: BIE Chapter 13

SESSION 15: INTERNET PRIVACY AND PUBLIC AND PRIVATE POLICY The Internet is based on the free exchange of information, yet the access to and transferability of information can impose costs on things we value. The growth and ultimate potential of the Internet and ecommerce depend on the confidence people have in how information they provide is and could be used. This session deals with an important episode and an ongoing debate about Internet privacy rights and their enforcement. The purpose of the session is to consider the privacy issue, how it affects the strategy of a company, and how companies address the pressure from government and the public. The broader issue is whether self-regulation is workable and sufficient to ensure the degree of privacy the public demands. These public demands vary among countries, and part of the

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session will focus on whether the United States and the European Union can agree to what constitutes “adequate protection.”

Cases: DoubleClick and Internet Privacy The European Union Data Privacy Directive Reading: BIE Chapter 13

IV.G LOBAL N S ONMARKET TRATEGY SESSION 16: STRATEGY AND THE EUROPEAN UNION This session provides an opportunity to apply the course frameworks to develop an integrated strategy in the context of the European Union. The case centers on a Spanish duty-free operator, Aldeasa, that must deal with plans by the European Commission to abolish duty-free zones for intra-EU air travel. The session highlights the nature of the EU institutions and the generality of the course frameworks.

Case: Aldeasa and EU Duty Free Abolition (A) Reading: BIE Chapter 15

SESSION 17:NONMARKETSTRATEGY IN HINA C China represents tremendous opportunities for companies, yet its political system gives rise to a host of difficult issues. Internet companies operating in China face censorship by the Chinese government, and in some cases were required to provide information about their users. The censorship raises a host of moral issues, but companies that want to operate in China must abide by the laws and regulations or risk interruptions in their services or more severe measures. The case considers Google’s entry into China and the measures it has taken to deal with censorship and protect its users. Not only does Google face challenges in China, but human rights activists have exerted social pressure to leave China.

Case: Google in China Readings: BIE Chapter 16

SESSION 18:S TRATEGY IN EMERGING MARKETS

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Emerging markets represent both opportunities and risks. This session considers a South African mobile telecommunications company with operations in Africa and the Middle East. The case focuses on its expansion into new markets in Africa and the associated risk assessment. The company is also considering entry into India with a local partner.

Case: MTN Group Limited Reading: Chapter 17

SESSION 19:E NTRY STRATEGY IN MERGING E MARKETS Despite the reduction trade barriers in accord with WTO agreements, India maintains substantial restrictions on foreign direct investment in retailing. The case considers the entry decision of Tesco PLC, the largest retailer in the United Kingdom. The decision must be made at the same time that other foreign companies such as Wal-Mart and Carrefour are also making their entry decisions.

Since entrants are likely to take Indian partners, there is a need to find an attractive partner.

Case: Tesco in India?

Reading: Chapter 18

SESSION 20: STRATEGY ANDINTERNATIONALTRADE POLICY The Uruguay Round TRIPS agreement represented a major victory for the pharmaceutical industry in protecting patents from violations. As a result of the HIV/AIDS pandemic the prevalence of malaria, and other diseases, developing and middle-income countries began to protest the restrictions in TRIPS. During the Doha Round of negotiations those countries were able to obtain concessions allowing for compulsory licensing in national emergencies. Brazil had threatened compulsory licensing, resulting in price reductions on AIDS drugs by three companies. Thailand became the first country to issue compulsory licenses, and the case considers the compulsory licensing issue and the strategy of Abbott Laboratories in dealing with the compulsory licensing of one of its AIDS drugs.

Case: Compulsory Lobbying, Thailand, and Abbott Laboratories Readings: BIE Chapter 18

V. CORPORATE RESPONSIBILITY AND ETHICS SESSION 21:SOCIAL RESPONSIBILITY

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This session raises the issue of what a company is responsible for in the face of criticism and social pressure. The case follows up on the Part I integrative case Wal-Mart: Nonmarket Pressure and Reputation Risk (A). The case describes a number of the steps taken by Wal-Mart in response to pressure and to improve its public image and reputation. The case provides an opportunity to consider the various motivations of companies that undertake social activities and adapt policies under the label of corporate social responsibilities.

Case: Wal-Mart: Nonmarket Pressure and Reputation Risk (B): A New Nonmarket Strategy Reading: BIE Chapter 19

SESSION 22: IMPLEMENTING A SOCIAL RESPONSIBILITY POLICY Gilead Sciences, the leader in HIV drugs, has committed to making its principal HIV drug accessible to those who need it in the poorest countries. Gilead has failed in ite efforts to get its drug to patients in Africa with only 35,000 patients receiving it after nearly two years of trying to get the drug into the countries. The case provides an opportunity to consider the challenges in implementing a social responsibility policy and asks for a new approach to making its drug accessible.

Case: Gilead Sciences (A): The Gilead Access Program for HIV Drugs.

Reading: BIE Chapter 19

SESSION 23: UTILITARIANISM AND MANAGERIAL DECISION-MAKING The previous two sessions addressed issues centering on responsible conduct. This session introduces an important moral framework for reasoning about responsibilities stemming from moral concerns. Specifically, this session introduces a consequentialist framework— utilitarianism—for reasoning about ethical issues. In addition to applying utilitarian concepts to the case, you are to identify limitations of utilitarian analysis as well as omitted moral considerations, if any, that should be taken into account. The case focuses on the pricing of a pharmaceutical that provides benefits relative to other products.

Case: Pricing the Norplant System Reading: Chapter 20

SESSION 24: RIGHTS ANDDUTIES This session introduces a deontological ethics system based on rights considerations and their associated duties. These considerations differ from those in consequentialist systems, but the

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objective of this session is not to attempt to reconcile the differences. Instead, the objective is to encourage you to analyze a situation involving moral concerns from the perspective of rights in addition to a consequentialist perspective. This can provide a sounder basis for analysis and decision-making than reliance on a single system. You are to identify the rights involved in the case and formulate a policy governing the use of genetic testing for a company with operations that can result in injuries and health impairments for employees who are genetically susceptible.

Case: Genetic Testing in the Workplace Readings: BIE Chapter 21

SESSION 25: CORRUPTION This session focuses on corruption. The case involves a company in which widespread bribery occurred in at least one of its divisions. The case raises issues about why the bribery occurred, how to detect it, what should be done about those who provided the bribes, and who knew that the bribery was taking place. The session also allows a discussion of the harm caused by bribery.

Case: Anatomy of Bribery: Siemens Reading : BIE Chapter 23 SESSION 26:S OCIAL ENTREPRENEURSHIP This session focuses on alternative organizational forms for presiding microfinance. One case is on a non-profit Kiva that raises funds on the Internet and makes loans to entrepreneurs in developing countries. The other case is on a for-profit firm, Banco Compartamos, that raises funds in the capital market and has been able to expand quickly the number of borrowers. Kiva charges low interest rates whereas Banco Compartamos charges high interest rates. For loan dispersals and collections Kiva relies on non-profit organizations in the countries in which it lends, whereas Banco Compartamos has its own field offices and personnel to make collections and monitor the loans. The principal question asked is whether the organizations are acting responsibly and whether the organizational forms are “good.”

Cases: Social Entrepreneurship: Kiva Social Entrepreneurship: Banco Compartamos Reading: BIE Chapter 23 SESSION 27: C APSTONE

The application of corporate social responsibility derives from the application of ethics principles to managerial issues. Managers must adopt and implement policies that, in the best instances, are

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embodiments of moral principles. In this session you are to apply the ethics principles developed in the previous class sessions. The case focuses on the AIDS pandemic and GlaxoSmithKline (GSK), which is the world’s largest producer of AIDS drugs. The objective of this session is to formulate a specific strategy to address the moral concerns raised and the responsibilities of the company. You are to formulate an integrated strategy for GSK and a detailed implementation program, including a pricing policy for its AIDS drugs.

Case: GlaxoSmithKline and AIDS Drugs Policy Readings: BIE Chapter 23

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PART I STRATEGY AND THE NONMARKET ENVIRONMENT

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Chapter 1 Market and Nonmarket Environments The objectives of this chapter are to introduce the concept of the nonmarket environment, provide frameworks for characterizing that environment, and present a framework for understanding the development of nonmarket issues. The nonmarket environment is characterized by the four Is: issues, interests, institutions, and information. This characterization is illustrated in some detail for the automobile industry. The emphasis of the approach maintained throughout the book is on nonmarket strategy; i.e., actions by managers to improve the performance of their firms in both their market and nonmarket environments.

The field of business and its environment focuses on the nonmarket environment of business and its interrelationships with the market environment. To illustrate the perspective presented in Figure 11, an example involving Pizza Hut is presented below. The basic unit of analysis is a nonmarket issue, and in the Pizza Hut example the issue is how to open the institutional (hospitals, schools, etc.) market to fresh pizza. The auto industry example in the chapter illustrates the types and range of issues facing an industry.

This chapter also presents a characterization of the pattern of development of a nonmarket issue and discusses the causes of change in the nonmarket environment and how issues are placed on the nonmarket issue agenda. The nonmarket issue life cycle in Figure 1-2 is a useful framework for thinking about where an issue presently is and how it could develop. It is important to emphasize, however, that the focus of the book is how firms and their managers can participate effectively and responsibly in influencing the development of those issues.

A lecture based on Chapter 1 might begin with Figure 1-1 and illustrate the interactions between the market and nonmarket environments using the auto industry as an example. In an introductory lecture it is important to discuss those factors that distinguish the nonmarket environment from the market environment. Issues such as fuel economy standards have clear implications for the design and marketing of autos and for the likely success of U.S. and foreign manufacturers. (Fuel economy standards are considered in more detail in the Part II integrative case Fuel Economy Standards 2007. Environmental issues, such as global warming and emissions of pollutants, can also be used to illustrate these interrelationships. The safety issue can be used to point to the presence of interest and activist groups and their role in the nonmarket environment. (Activists and NGOs are considered in more detail in Chapter 4.) The Pizza Hut example presented below can also be used to illustrate the interrelationships.

In discussing nonmarket issues and the nonmarket environment, it is important to emphasize the role of managers both in addressing the issues and in formulating strategies. That is, management is in the center of Figure 1-1. Specialists, such as lawyers and consultants, can be important resources, but managers ultimately must make the decisions. In part because managers are at the center of decision-making, the appropriate level of analysis is organizational; i.e., from the point of

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view of a firm dealing with an issue in its environment. The unit of analysis is thus the conjunction of a nonmarket issue and the firm. The roles of institutions and interest groups should also be pointed out, although they are not considered in detail until subsequent chapters.

It would be useful to emphasize that institutions are not only formal and public, such as Congress and NHTSA, but are also private, such as arbitration mechanisms, or collections of private organizations as in the case of the news media (considered in Chapter 3). The Pizza Hut example can be used to illustrate the role of institutions and how an issue can move from one institutional arena to another. The chapter first characterizes the nonmarket environment in terms of the 4 Is. The Nonmarket Environment of McDonald’s case provides an opportunity to consider this characterization. Another possibility is to discuss the origins of nonmarket issues such as those for the auto industry or those on McDonald’s agenda. Some of those issues are the result of scientific discovery and technological change and some are the result of new understandings. For example, the concerns about the fat and salt content of fast foods are a result of both recent medical studies and the heightened concern of many people about their health. The chapter case The Nonmarket Environment of Google presents a set of issues that pose challenges for Google including operating in China, a controversial acquisition, and intellectual property protection. Many nonmarket issues arise because of moral concerns, and those moral concerns are the subject of Part V of the book. The Graduation Cards example illustrates the connection between moral concerns and the development and progress of nonmarket issues. Additional information on the example is presented below. The nonmarket issue life cycle depicted in Figure 1-2 reflects a progression for many issues. It begins with the origins of the issue and its identification by what are referred to here as interest groups. The auto safety example is a good illustration of the simple origins of an issue and how it may progress over an extended period of time. In the discussion of the cases, it is often useful to assess where an issue is in its issue life cycle. It is also useful to illustrate in which institutional arenas an issue is considered at the various stages in its development. An important point to make in discussing nonmarket issues is that the firm rarely has control over events or the resolution of a nonmarket issue. Instead, a firm has control over its nonmarket strategy, and that strategy may influence the resolution of the issue. Nonmarket issues are generally contested, and their resolution is often determined by a competition of strategies of the interests participating in the contest.

Beginning the course: In addition to the cases in Chapter 1, the Chapter 2 cases provide good vehicles for focusing on nonmarket strategy.

An Example of the Interactions of Market and Nonmarket Strategies: Pizza Hut This example illustrates the use of nonmarket strategies to shape market opportunities (Figure 1-1).

(Figure 2-2 illustrates the control of market opportunities by government.)

School cafeterias served nearly $500 million of pizza a year. Only frozen pizza was used, however, because freshly prepared pizza was effectively excluded by a U.S. Department of Agriculture

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(USDA) regulation that required inspection of any pizza with meat toppings that was sold at wholesale for resale. The same was true for other institutions such as hospitals and prisons. The broader issue was the closure of the institutional market to freshly-prepared foods such as pizza and other fast foods.

Pizza Hut’s overall business strategy was to become a “pizza distribution” company, and the institutional market was crucial to that strategy. According to Roger Rydell of Pizza Hut, schools were “‘a potentially enormous business for us. … We’d like to have every one of our [4,000] delivery-capable units nationwide serving at least one school.”’1 Since Pizza Hut was excluded from the institutional market by the USDA regulation, the task before Pizza Hut was to develop a nonmarket strategy to modify this regulation to allow school cafeterias and ultimately other institutions to order fresh pizza.

There were two basic institutional arenas in which Pizza Hut could address this nonmarket foreclosure of a market. One was the regulatory apparatus of the USDA. From the perspective of a bureaucracy such as the USDA, an exemption from its meat inspection responsibilities would be required. It seems unlikely that the USDA would want to weaken its own inspection program.

Indeed, the opponents of an exemption for fresh pizza, as led by the National Frozen Pizza Institute, sought to have the contentious issue resolved by the USDA. A resolution in that institutional arena would necessitate an extensive administrative process requiring public hearings, publication of proposed regulations in the Federal Register, a comment period, possible adoption of an exemption, and possible legal challenge in the federal courts by the losing side. This process would likely be quite lengthy. (See Chapter 10 for a discussion of this process.) Pizza Hut first attempted to obtain a USDA exemption without an administrative process but failed in its attempt.

The second institutional arena was Congress, which could enact legislation to overturn regulations.

Pizza Hut worked through Congress to include a provision in a 1991 agriculture bill that would allow fresh pizza to be purchased by school cafeterias without USDA inspection. The amendment directed the USDA to issue regulations by August 1992 allowing fresh pizza with meat toppings to be sold to private and public institutions.2 Pizza Hut had headquarters in Wichita, Kansas, and Representative Dan Glickman, whose district includes Wichita, commented that the USDA regulation was “a Byzantine, outdated and, quite honestly, an anti-competitive regulatory structure.”3 One question was whether this issue was resolved by interest group politics or by some public policy process based on a careful study of the costs and benefits. The opposition, for example, argued that an exemption posed a health hazard, whereas Pizza Hut argued that precooked toppings such as pepperoni had already undergone two inspections—one at the processing plant and one earlier at the slaughterhouse. These arguments likely had little effect on the decision other than to convince members of Congress that there was no health hazard in fresh pizza sold to institutions.

This issue was ultimately resolved through interest group politics, with Pizza Hut and other fastfood chains backing the exemption and frozen pizza interests opposing it.

1

Wall Street Journal, November 29, 1991.

Wall Street Journal, November 29, 1991.

3 San Francisco Chronicle, November 28, 1991.

2

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The actual process through which the amendment was adopted began in the House Committee on Agriculture. The committee was in a public mark-up session on H.R. 3029, sponsored by Representative De La Garza (D-TX), entitled the Food, Agriculture, Conservation, and Trade Act Amendments of 1991 and the Recreational Hunting Safety and Preservation Act of 1991.

Representative Glickman introduced an amendment that would change the standard for fresh pizza with meat toppings furnished in school lunch programs. After discussion, Glickman withdrew the amendment and offered another that would exempt fresh pizza with meat toppings from a final inspection by the USDA and directing the USDA to adopt new rules to allow this. That amendment was approved on a voice vote.

The final bill incorporated the needed provisions in Section 1016 of Title X -- Miscellaneous Technical Corrections. The provisions made changes in Section 23 of the Federal Meat Inspection Act (21 U.S.C. 623) and Section 15 of the Poultry Products Inspection Act (21 U.S.C. 464). As an example of the language enacted, the changes for meat stated, “the Secretary [of Agriculture] shall exempt pizzas containing a meat food product from the inspection requirements of this Act if -- (A) the meat food product components of the pizzas have been prepared, inspected, and passed in a cured or cooked form as ready-to-eat in compliance with the requirements of this Act; and inspected, and passed in a cured or cooked form as ready-to-eat in compliance with the requirements of this Act; and (B) the pizzas are to be served in public or private nonprofit institutions.”

The amendment providing the exemption was referred to as the Pizza Hut amendment.

Update on the Graduation Cards Example Hallmark’s marketing of the graduation cards featuring alcoholic beverages was quickly met with protests by the Orange County, California, chapter of MADD. According to Newsweek, “Since then MADD activists across the country have lobbied store owners to pull offending cards that had been shipped already off their shelves. ... Hallmark spokeswoman Diane Wall says the cards were aimed at adults finishing college. But MADD’s Janet Cater says they were bought just as often for younger high-school and college graduates. ‘The reality is more people graduate under 21 than any other age group,’ Cater says.”

Hallmark quickly agreed to stop producing the cards and not to ship any cards that had already been produced. “Hallmark has made a corporate decision to no longer manufacture graduation cards with reference to alcohol. Graduation cards of this type represented only 1 percent of the graduation card line this year.” (Letter from Diane Wall, Hallmark Cards, August 22, 1988.)

Although this issue was resolved, one consequence of Hallmark’s actions was that interest groups may now begin to monitor its cards for objectionable material. That is, Hallmark’s nonmarket environment could be changed by this episode.

To continue the discussion of this example, the following question might be asked: As the Hallmark manager responsible for New Year’s cards, would you make any changes in your design and marketing programs in light of these events?

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New Year’s cards do not involve the specific issue of underage drinking, but they do raise the issues of excessive drinking and drunk driving. Protests are less likely on New Year’s cards, however, in part because parents are not likely to be purchasing cards for their children.

Development NIMBY protests by local residents in India caused Tata Motors to suspend its construction of the plant to build the Nano.

Cases The Nonmarket Environment of the Pharmaceutical Industry This case is designed for the application of the conceptual frameworks presented in Chapter 1. The four principal frameworks to be applied are the interrelations among the nonmarket and market environments, the four Is, the nonmarket issue life cycle, and the origins of change.

This case illustrates the perspective presented in Figure 1-1. The success of the pharmaceutical industry in its market environment, as evidenced by the rapid increase in expenditures for drugs, led to pressures in its nonmarket environment for change. Much of this was interest group based, as payers, including both those in the private and public sectors, sought to control the impact on their respective bottom lines and budgets. In the nonmarket environment the industry’s efforts to revise FDA regulations on advertising to consumers provided an opportunity for firms to promote their products through direct-to-consumer advertising. This proved to be highly successful, and the success in the market environment created a nonmarket issue of restricting DTC advertising. Other interrelationships can also be identified in the discussion.

The four I's are straightforward to identify.

Issues: pharmaceutical expenditures, marketing expenditures, price increases (for the elderly), collective buying power (Maine, Florida), drug discounts for the elderly, formulary inclusion, sponsorship of research and asymmetric release of information, OTC switching, drug approval and regulation (U.S. and EU), price reporting and backdoor discounts, managed care, patent protection, deceptive advertising, post-marketing surveillance, prices for AIDS drugs, parallel trade.

Interests: pharmaceutical companies—generic and brand name companies, consumers/patients, PhRMA, Families USA, the elderly, Public Citizen, insurers (National Institute for Health Care Management), doctors and the AMA, Prescription Access Litigation Project, pharmacy benefits managers, drug stores, pharmacists (NCPA), managed care providers, trial lawyers.

Institutions: state legislatures, Congress, news media, public sentiment, federal courts, NIH, FDA, HHS, Medicare and Medicaid, FTC, Bush administration, Commission of the EU and cognizant agencies, German Medicines Control Agency, South African government, Brazilian government, WTO-TRIPS, Indian patent law.

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Information: about the causes of increased expenditures--drug price increases and prescriptions per person, regarding the effect of DTC advertising on patient health and quality of life, about research and clinical test results, about appropriate patent protection and incentives to develop new drugs, about the impact of parallel trade, and more generally about the organization of the health care industry.

Change in the nonmarket environment of the pharmaceutical industry originates from interest groups, such as those identified above, from changing market strategies (e.g., direct-to-consumer advertising), globalization, and from moral concerns. Institutional change is illustrated by the revisions in FDA regulations regarding marketing to consumers, which resulted in the boom in DTC advertising. Technological change in the pharmaceutical industry in recent years has focused on biotechnology, and there has been little opposition to the use of that technology for developing pharmaceuticals. The opponents of biotechnology focus on foods and cloning. Moral concerns originate from the AIDS tragedy and its growth in Africa and elsewhere. In the United States moral concerns, as well as interest group activity, generated pressure for discount drugs for the elderly.

The life cycle can be illustrated using a number of the issues. For example, the current DTC advertising issue began with revised FDA regulations (sought by the pharmaceutical companies).

Interest group activity began as critics became concerned about the impact on spending and possible undue influence on doctors to prescribe advertised drugs. The pharmaceutical industry strongly backed DTC advertising, since it increased the number of prescriptions written. In the case the issue is currently in the legislative stage as proposals are being made to regulate DTC advertising.

Patent protection issues are now in the enforcement stage, where enforcement is primarily through the courts and also through the discretion granted to the FDA (see the Chapter 12 case Patent Games: Plavix). The issue of OTC switching is in the administrative stage awaiting an FDA decision. Drug discounts for the elderly is in the legislative stage with both Congress and the Bush administration developing plans.

Teaching the case: This case focuses on analysis rather than strategy formulation, and the most straightforward way to discuss it is to apply the frameworks with the objective of characterizing the nonmarket environment in detail. To continue to the formulation of nonmarket and integrated strategies, this case could be followed by the Chapter 8 case Pharmaceutical Switching.

Additional cases on the pharmaceutical industry: The book includes several other cases on the pharmaceutical industry, some of which provide more information on issues in this case.

Molecular Insight Pharmaceuticals: Integrated Strategy for Development Stage Molecular Medicine Company (Chapter 2) Merck and Vioxx (Chapter 5) Pharmaceutical Switching (Chapter 8) Patent Games: Plavix (Chapter 12)

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Compulsory Licensing, Thailand, and Abbott Laboratories (Chapter 18) Pfizer and Celebrex (Chapter 19) Pricing the Norplant System (Chapter 20) Consumer Awareness or Disease Mongering?: GlaxoSmithKline and the Restless Legs Syndrome (Chapter 21) Gilead Sciences (A): The Gilead Access Program for HIV Drugs (Chapter 22) GlaxoSmithKline and AIDS Drug Policy (Part V Integrative Case)

The Nonmarket Environment of McDonald’s This case provides a vehicle for discussing the 4 I’s and for giving priority to the issues. It also identifies the need for a nonmarket strategy to address the issues on the company’s agenda. One thing is clear from the case and from subsequent events—McDonald’s is very concerned about its public image and hence is an inviting target for critics and activists. Also, McDonald’s has revealed that it is willing to make changes in its market strategy to lessen the criticism. Many of the issues facing McDonald’s are initiated by activists, and hence the frameworks of private politics (Chapter 4) are relevant.

The Issues are identified by the headings in the case and will not be listed here. One discussion point is the “level” at which issues should be addressed. For example, a number of broad issues are relevant for McDonald’s, but it is specific rather than broad issues that have to be addressed by the company. Three such broad issues are: the health consequences of fast food and food in general, who has responsibility for what one eats, and vegetarianism. McDonald’s may want to address the first, but the latter two are better addressed elsewhere. For example, McDonald’s basic competence is efficiency in delivering food and convenience that people want. If vegetarianism were to become widespread, McDonald’s would efficiently provide vegetarian fare. The responsibility for what one eats is a matter ultimately for the institutions of public sentiment, the courts, and Congress.

McDonald’s should vigorously defend itself in the courts and support the cheeseburger act, but it should do the latter behind the scenes. The first broad issue involves a set of specific concerns, and such concerns will continue to arise as science increases our understanding of the relation between food and health. Obesity has become a public concern, and McDonald’s has taken some measures to address the issue, as considered in the Chapter 12 case Obesity and McLawsuits. Health is of wide concern to the public and hence to the news media and new issues will arise. For example, after the writing of this case fast food chains came under government and activist pressure to eliminate trans fats from menu items.

The interests are varied and can be categorized as in the chapter.

Organized: NCBA, trial lawyers, Morgan Spurlock, National Restaurant Association, American Meat Association, United Egg Producers, franchisees in Brazil Unorganized: consumers, vegetarians, obese people

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NGOs: Physicians Committee for Responsible Medicine, CSPI, Competitive Enterprise Institute, Environmental Defense, PETA, Compassion Over Killing, ALF, ELF McDonald’s must address issues in a multitude of institutional arenas. The following list is not intended to be exhaustive.

Legislative: Congress, state legislatures (cheeseburger bills), Americans with Disabilities Act (ADA) Administrative and regulatory institutions: FDA, DOA, Centers for Disease Control and Prevention, Surgeon General Judicial: Federal courts (e.g., interpretation of ADA), state courts (obesity lawsuits) Private regulation: Code of Conduct for Suppliers, antibiotics policy, environmental policy, treatment of food animals International: courts in Chile and Brazil, green lights programs Nongovernmental: public sentiment (e.g., pertaining to treatment of food animals), news media (e.g., coverage of the obesity and fast food issue) Information: Information pertains to scientific evidence about health effects of fast food, obesity, acrylamide, etc., the extent of the public’s and customers’ concerns about the issues.

One distinction that is often difficult for students is to distinguish between interests and institutions.

In the framework presented in Chapter 1 an institution is an arena or forum in which nonmarket strategies are executed. Congress is an institution, and its officeholders should be viewed as part of the institution and not as an interest. The members of Congress may have their self-interest at heart, but they also are attentive to constituents both because of a duty to represent them and because they have reelection interests. They also have institutional roles as members of committees, for example.

A useful teaching exercise is to identify for selected issues, the interests that are active or inactive and the institutional arenas in which the issue will be addressed. For example, for the issue of obesity and fast foods interests include trial lawyers and their clients, food companies, restaurants, and activist NGOs. The institutions are Congress, state governments, federal and state courts, the FDA, public sentiment, and the news media. The life cycle concept can be used to discuss where the issues are in the life cycle, how they might progress, which interests will work to advance or reverse their progress, and the extent to which institutions will determine the progress of the issues.

This then naturally leads to a discussion of nonmarket strategy. As developed in Chapter 2, nonmarket strategy should not be considered in isolation from market strategy; i.e., a firm should integrate its market and nonmarket strategies. Strategies also have to be implemented, which is the subject of later chapters.

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In this regard, it is interesting to note that many of the issues McDonald’s faces and the pressures it encounters are in the realm of private politics as considered in Chapter 4. Self-regulation plays an important role in private politics.

In teaching the case students may be eager to move to strategy formulation. To make the transition from the 4 I’s to strategy and action, it is important to point out that the rest of the book is about frameworks for how to formulate effective strategies.

A reality check may be needed if the class seems to be moving toward the conclusion that McDonald’s should be doing all of what the activists and NGOs demand. McDonald’s customers may not see things the same way the activists do. McDonald’s has tried on several occasions to respond to health claims by activists. In 1984 it tried “Lite Mac,” in 1991 it introduced the “McLean Burger,” and in 2000 it introduced “McSalad Shakers.” All were failures.4 (Offering salads is different because a demand exists for them.) Moving away from its traditional core menu items could also provide opportunities for competitors to cater to its core customers. CEO Jim Skinner stated, “We’re certainly selling more chicken, and we’re selling more fish, and we’re selling more items all across the menu. But hamburgers and French fries … have been at the core of our menu, and I think will continue to be there for the long term.”5 The Chapter 12 case Obesity and McLawsuits considers the issue of the responsibility, if any, of McDonald’s for the obesity problem.

Teaching the case: The class discussion may be organized using the following questions.

1. Identify the 4 I’s?

2. For selected issues, identify the relevant interests and institutions.

3. What is McDonald’s nonmarket issue agenda? Which issues should have the highest priority?

4. Choosing one or two issues, the focus can then be on where those issues are in their life cycles, what forces are propelling them, and how far they are likely to progress.

5. The next step is to discuss some of the specific issues and then consider strategy formulation.

Developments and additional information: McDonald’s settled for $10 million two lawsuits filed by Hindus and other groups over its labeling of French fries and hash browns as vegetarian when the vegetable oil in which they were cooked contained “essence of beef” for flavoring. Most of the settlement funds went to organizations that deal with concerns raised by consumers.

During floor debate on the cheeseburger bill representatives cited a Gallup poll indicating that 89 percent of those surveyed “oppose the idea of holding fast food companies legally responsible for the diet-related health problems of fast food junkies.”

4 5

Fortune, August 9, 2004.

Wall Street Journal, February 23, 2005.

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Ben Cohen of the Center for Science in the Public Interest argued, “If Congress really believed in personal responsibility, it would help them make responsible choices by passing legislation that would require fast food chains to post signs showing the calorie count for each item on their menu.”6 Ken Barun, president of Ronald McDonald House charities, who had seen clips of the movie “Super-size Me,” commented, “We are talking about someone who has obviously gone to excess and exploited a brand that people will relate to in order to make his movie and capitalize on something that is unrealistic. It should be put in the category of the rest of the shock TV that you see. It’s a distortion of reality.”7 The movie was, however, fairly successful.

In January 2003 an epidemiological study by Loreli Mucci of the Harvard School of Public Health and Sweden’s Karolinska Institute and other researchers “found that eating foods with high levels of the chemical acrylamide appears not to increase risk for colorectal, bladder, and kidney cancers.”8 The acrylamide issue continued to progress, and some chains changed their cooking methods to reduce the generation of acrylamide.

To deal with the issue of the sustainability of fish supply, McDonald’s joined with the Center for Environmental Leadership in Business, a division of Conservation International, to integrate “conservation and sustainable agriculture into our global food supply chain and to work on issues related to sustainability in the fishing industry.”9 McDonald’s consulted with The Natural Step on the “impacts of all major business activities on the environment and the community.”

Bill Zucker of Burson-Marsteller explained, “The NCBA has been working on this issue for years to get the message out that U.S. beef is the safest in the world. The safeguards are there in the industry and from the USDA and FDA. By getting the facts out to avoid a panic, the Cattlemen were able to help people understand that and avoid misinformation and panic.”10 Walt Riker, a McDonald’s spokesperson said, “There is just a tremendous depth of experience and learning and best practices, so when something like this happens we don’t have to reinvent the wheel or go into what some people might think is a crisis mode.”11 Meat safety has continued to be an issue, but McDonald’s has not been specifically targeted.

The company also announced that it was asking suppliers to reduce the use of antibiotics. “It’s a public health concern, so we’re putting the word out that we want to buy less antibiotics in our meat.”

6

The Daily Buzz, www.foodservice.com, March 11, 2004.

The Daily Buzz, www.foodservice.com, February 26, 2004.

8 The study was published in the British Journal of Cancer, January 28, 2004.

9 McDonald’s Social Responsibility Report, May 2, 2003.

10 O’Dwyer’s PR Services Report, February 2004. Mad cow disease had been found in Canada 8 months earlier, and the NCBA had begun their informational campaign at that time. Barson-Marsteller’s tracking survey in January 2004 revealed that 90% of those surveyed viewed U.S. beef as safe, up from 87% prior to the discovery of BSE. 11 New York Times, January 1, 2004.

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The Nonmarket Environment of Google This is a broad case that provides for an assessment of the nonmarket environment of Google.

Some of these issues are addressed elsewhere in the book. In particular, the spectrum auction is discussed in Chapter 2, and the human rights in China issue is the subject of the Chapter 16 case Google in China.

The following table identifies the issues and the corresponding institutions and interests as well as the location of the issues in their life cycles. The fourth I, information, is not listed because it is more difficult to summarize in a few words. For example, on the Internet privacy issue there are a number of privacy activists that push privacy issues, but the information that remains unknown is how concerned the general population of Internet users is about this issue. Information is also uncertain about what the consequences would be if privacy legislation were enacted or regulation were promulgated by the FTC. Several issues are in the realm of private discretion and are labeled in the table as corporate social responsibility. These issues are included here because CSR is an important component of management in the market and nonmarket environments.

Issues

Institutions

Interests

Privacy

Congress; FTC; public sentiment

Activists, rights advocates, private politics Privacy activists, competitors Privacy advocates; citizens

DoubleClick EU privacy regulations Spectrum auction Google books Google news

FTC, courts EU Commission, data protection offices (regulators) FCC Courts Courts (Europe);

Competitors Publishers; competitors Content providers

FTC Courts Trademarks Courts Data protection

Google health Google telephone

Public sentiment Markets

Businesses (Websites) U.S. government; opponents of child pornography Privacy advocates Competitors 45

Location in Life Cycle On hold, prelegislative stage Administrative Enforcement

Legislative stage Interest group formation Enforcement (Europe); legislative (FTC) Enforcement administration

Issue identification [market issue]

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YouTube (IP) Tolls Courts FCC; Discrimination Congress Courts Environmental Public sentiment practices (market) Public sentiment Philanthropy Public sentiment Indigenous peoples China China: human government; rights U.S. Congress; public sentiment Regulators Regulators Courts; DOJ Congress; courts China: Online video China: Music downloads Microsoft and Vista Microsoft and Yahoo

Content providers ISPs Plaintiff [[market participants]]

Administration Interest group formation Enforcement Corporate social responsibility Corporate social responsibility Corporate social responsibility Administration

Human rights organizations; private politics Competitors Administration Competitors Enforcement (or lack there of) Microsoft Microsoft and other Enforcement Interest group competitors formation

On some of the issues Google was a nonmarket innovator. Google, for example, was exploring the limits of intellectual property law—from both sides of the law.

The criticisms of G-mail seem to have had no impact. The following are from the Google Web site www.gmail.google.com at the time it was introduced.

What is Gmail?

As part of Google's mission to organize the world's information and make it universally accessible and useful, we're testing an email service called Gmail.

Gmail is a free, search-based webmail service that includes more than 2,000 megabytes (two gigabytes) of storage. The backbone of Gmail is a powerful Google search engine that quickly finds any message an account owner has ever sent or received. That means there's no need to file messages in order to find them again.

When Gmail displays an email, it automatically shows all the replies to that email as well, so users can view a message in the context of a conversation. There are no pop-ups or untargeted banner ads in Gmail, which places relevant text ads and links to related web pages adjacent to email messages.

Gmail and privacy

1. Is Google reading my email?

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No. Google scans the text of Gmail messages in order to filter spam and detect viruses, just as all major webmail services do. Google also uses this scanning technology to deliver targeted text ads and other related information. This is completely automated and involves no humans.

2. Will my Gmail messages appear in Google search results?

No, the contents of your email will never be included as Google search results.

3. What does Google do with my personal data?

Google uses this information to provide you a reliable service. Google does not share or reveal email content or personal information with third parties, other than in certain exceptions dictated by the law and common sense. For full details, please refer to the 'When we may disclose your personal information' section of our privacy policy. These exceptions are standard across the industry and are necessary for email providers to assist their users and to meet legal requirements.

4. What does Google do to protect my privacy?

Google takes several steps to guard the confidentiality of users' information by offering a number of industry-leading protections. For full details, please visit the Protecting your privacy section below.

5. Are there ads in Gmail?

Yes, but they are small and unobtrusive. They don't fill half your screen and we don't make you read them just to get to your inbox. Ads are never inserted into the body text of either incoming or outgoing Gmail messages and you won't see any pop-ups or untargeted banner ads in Gmail.

Gmail users only see relevant text ads, similar to those on Google search results pages.

The matching of ads to content is a completely automated process performed by computers. No humans read your email to target the ads, and no email content or other personally identifiable information is ever provided to advertisers.

Ads are matched using the same technology that powers the Google AdSense program, which already places targeted ads on thousands of sites across the web by quickly analyzing the content of pages and determining which ads are most relevant to them.

Here's a sneak peek of how ads look in Gmail.

Quotes on privacy Google Mail: Virtue Lies in the In-Box - David Pogue New York Times - May 13, 2004 http://www.nytimes.com/2004/05/13/technology/circuits/13stat.html (registration required) "If Gmail creeps you out, just don't sign up. ... That would be a shame, though, because you'd be missing a wonderful thing. Even in its current, early state, available only to a few thousand testers, Gmail appears destined to become one of the most useful Internet services 47

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since Google itself. ... The ads are so subtle, so easily ignored, that it's hard to imagine anyone preferring the big, blinking, slow-loading graphic ads that appear every time you check for messages at the Hotmail and Yahoo Mail sites. Even more refreshing, Gmail doesn't turn you into an unpaid billboard for Yahoo or Microsoft (Hotmail's owner) by stamping ads on at the bottom of every outgoing message, no matter how sensitive the topic. ...

The only population likely not to be delighted by Gmail are those still uncomfortable with those computer-generated ads. Those people are free to ignore or even bad-mouth Gmail, but they shouldn't try to stop Google from offering Gmail to the rest of us. We know a good thing when we see it."

Discussion questions: 1. For each of the issues Google faces identify the corresponding institutions and interests.

For a selected few issues identify the information and uncertainties associated with the issues.

2. Where in their life cycles are the issues?

3. What are the origins of these issues? For example, Tolls and Google Books.

4. Let’s select a couple of issues and discuss what might be the outcome. (Two issues might be Tolls and Google Books.)

5. To what extent should Eric Schmidt, Sergey Brin, and Larry Page be involved in the management of these issues? For example, Google’s operating policies in China.

Updates To improve the efficiency of searches, the company used both cookies and user logs of search requests as well as other online information. This raised concerns among privacy advocates.

Information provided by Yahoo in accord with Chinese law led to the arrest of Wang Xiaoning who had posted pro-democracy literature on the Internet. Wang was sentenced to 10 years in prison.

Wang, his wife, and a human rights group filed a lawsuit against Yahoo seeking damages and an injunction against Yahoo to prevent it from providing such information to the Chinese government.

Yahoo eventually apologized for its actions. In November 2007 Yahoo settled for an undisclosed sum a lawsuit brought by two Chinese journalists who were jailed after Yahoo turned over to the Chinese government emails containing pro-democracy literature. Yahoo said it was complying with Chinese law.12 13 Google had been sharply criticized for following Chinese policies regarding policing of the Internet and had take steps to avoid placing its users in jeopardy.14 Within a month of offering Google.cn,

12

cnnmoney.com, November 13, 2007.

Google had been criticized when its social networking website Orkut gave a person’s IP address to Indian police who were investigating the person for a posting on the website. The person was convicted and jailed. (Daily Mail, December 1, 2007.)

14 See the Chapter 16 case Google in China for more information about the criticism and Google’s policies.

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Google came under criticism from two government-run newspapers in China. The Beijing News criticized the company for not doing enough to block “harmful information.” Referring to Google’s practice of informing users when search results had been censored, the China Business Times wrote in an editorial, “Is it necessary for an enterprise that is operating within the borders of China to constantly tell your customers you are following domestic law?” Both publications claimed that Google was operating as an Internet content provider without a proper license.15 In 2006 Google sold its stake in Baidu.

In 2008 the California Supreme Court agreed to hear the Google’s appeal of the Court of Appeals decision to allow Brian Reid’s age discrimination case to go to trial.

In 2008 Google India Private Ltd. was sued by a small business for defamation because of a posting on an anonymous blog made available by Google. The question was whether Indian law held a website responsible for postings on its service unless it could demonstrate that it had exercised due diligence. This appears to be in contrast to U.S. law as discussed in Chapter 2 and in Chapter 13.

Prosecutors in Italy filed charges against four Google executives of the Italian-language website for the posting of a video showing a disabled girl being taunted by her peers. The charges were defamation and violation of privacy. This case may involve a conflict between EU law and Italian law. According to Google EU law appeared to be similar to that in the United States, as discussed in Chapter 2, in that a website was not responsible for what others post on it.

Google pressed on with its plans to put health data on the Internet, beginning with a pilot project with the Cleveland Clinic. The project would not allow any sharing of information without prior consent.

Google lost its appeal of the Belgian court’s decision.

Google settled for $125 million two lawsuits brought by publishers over its plans to digitize and provide short excerpts on the Internet. The funds will be used to establish a registry system to allow copyright holders to obtain payments.

15

Washington Post, February 22, 2006. Google shared a license with a Chinese company Ganji.com. This practice was common among foreign Internet firms.

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Chapter 2 Integrated Strategy The principal objectives of this chapter are to introduce the concept of an integrated market and nonmarket strategy, introduce the concept of positioning, and provide a framework for the analysis of nonmarket issues and the formulation of nonmarket strategies. The chapter also reinforces the point made in Chapter 1 that managers are responsible for the formulation and implementation of nonmarket strategies. This chapter extends that perspective by focusing on the integration of those strategies with market strategies, as illustrated in Figure 2-1. One natural focal point for this integration is the relationship between market opportunities and the importance of nonmarket strategies, as illustrated in Figure 2-2. The influence of private politics illustrated in Figure 2-3 is considered in more depth in Chapter 4.

The principal factor restricting the pursuit of market opportunities is government policies. Two other factors are public sentiment and ethics. A lecture might begin with Figure 2-2 and then relate that to the concept of an integrated strategy. The Pizza Hut example in Chapter 1 of this manual can be used to illustrate Figure 2-2 and the nature of a nonmarket strategy to unlock a market opportunity. The Envirotest Systems Corporation (A) and Molecular Insight Pharmaceuticals: Integrated Strategy for a Development Stage Molecular Medicine Company cases provide opportunities to explore the formation of an integrated strategy in more detail.

The section on positioning provides a foundation for nonmarket strategy, but as importantly it affects the set of issues that the firm faces. Some of those issues are identified by government as considered in Part II of the book and others by the news media as considered in Chapter 3, and some are initiated by activists as considered in Chapter 4. eBay is the subject of two cases in Chapters 12 and 13. The chapter case Exclusive Resorts: Entrepreneurial Positioning and Nonmarket Strategy centers on positioning in the market and nonmarket environments.

The framework presented in Figure 2-4 provides a framework for addressing nonmarket issues.

This framework will be elaborated on in the following chapters, so at this point in the development it is primarily used to identify the stages in the framework. The stages are intended both to correspond to managerial decision-making processes and to distinguish between analysis, or thinking ahead, and deciding. The latter involves choosing a strategy to deal with an issue or a developing policy to guide managers in dealing with issues. Another way of thinking about the stages is that the analysis stage is positive in the sense of prediction and explanation, whereas the choice stage is normative in two senses. The first is that of choosing the alternative that is best in terms of the firm’s objectives. The second is normative in the sense of ethics principles. For example, the evaluation of claimed rights requires the application of applying ethics principles.

The Citibank and Credit Cards for Undergraduates example illustrates the application of the framework.

It is important that students understand that the perspective taken to the issues addressed in the book is not that of public policy chosen by a benevolent government. Also, the perspective is not that of doing good, or what might be called private social welfare. Instead, the perspective is that

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of a firm and its managers attempting to further the interests of the firm. No attempt is made to define the firm’s interest, but in the first several parts of the book those interests are assumed primarily to be profits. This is tempered by normative considerations based on ethics principles.

Part V of the book addresses issues of corporate social responsibility and the incorporation of ethics into this perspective. See, for example, the Levi Strauss example in Chapter 22.

The final part of a lecture could be on how to approach issues in the nonmarket environment. The framework presented in Figure 2-4 provides an approach to analysis and decision making in which positive analysis precedes the application of normative principles. The distinction between positive and normative approaches can be made at this point. Some students may be concerned that a normative focus — either in the sense of doing good or of applying ethical principles -- should be the centerpiece of any managerial process. As will be clear in Part V of the book, there is considerable support for doing good and also about who has which rights, but there is often considerable disagreement when the focus is specific issues or implementation details. The framework in Figure 2-4 is intended not only to provide an outline for the development of strategies but also to focus on analysis that a manager can use regardless of his or her normative beliefs. That is, even those who might disagree about what is right or good can analyze an issue and attempt to predict behavior and consequences. At this point in the book the objective is for students to be sensitive to issues with normative dimensions and to the actions those dimensions can motivate in the nonmarket environment.

The chapter includes a discussion of a Google’s integrated strategy directed at opening opportunities for its products. In 2008 Google petitioned the FCC to prevent Verizon Wireless from excluding a G-phone and other devices.

Google has also pressed forward on its campaign to obtain access to the white spaces.

Cases Exclusive Resorts: Entrepreneurial Positioning and Nonmarket Defense The purposes of this case are (1) to evaluate the positioning of Exclusive Resorts in its market and nonmarket environments, (2) to assess the nonmarket challenges that the firm may face, and (3) formulate a nonmarket strategy to address the challenges the company faces.

In its market environment Exclusive Resorts positioned itself at the high end of the potential market. This made sense since the number of wealthy people in the United States had increased rapidly in the past 10 to 20 years. Still, there was considerable uncertainty about demand. The challenge if the demand turned out to be strong would be able to purchase enough residences to satisfy demand in a particular location. Controlling the rate of entry of members with a waitlist was crucial. Demand proved to be so strong that the firm had to develop some residences itself.

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With regard to market positioning, a class session could work through the criteria with the objective of developing a better understanding of the basic business model of the firm. For example, making 80% of the membership fee refundable lowers the cost to members, since they likely would be able to withdraw most of their funds if an event occurred that changed their demand for vacations.

Brad Handler developed a model of demand for residences that indicated that 6 members per residence was optimal, which meant that if 20% of the membership fee went for administrative costs, $1,800,000 would be available for each residence. The remainder of the purchase price was then financed by mortgages. The business model thus provides the bulk of the funding for the residences.

The annual fees then can be set to cover the operating costs of the residences; e.g., concierge, housekeeping, taxes, maintenance, and management costs. Since membership provided vacation stays ranging from 30 to 60 days, the annual fees probably covered the operating costs of the residences. The nonrefundable portion ($75,000) of the membership fee was available to cover administrative expenses. Profits would then come from appreciation of the real estate holdings and from any excess of annual fees and nonrefundable membership fees over costs.

Exclusive Resorts positioned itself in the nonmarket environment so that it would not automatically come under the state laws governing timeshares. This meant that ER did not have to register in the states where it had properties and where it sold memberships. If it were registered to register, it would be subject to the laws and regulations in that state. To the extent that its nonmarket positioning was successful, it occupied an open space. That space could be of interest to state attorneys general and Departments of Real Estate. The positioning thus left open the issue of whether state laws and regulations would be re-interpreted or extended to cover ER. ER also positioned itself so that its membership contract would not be viewed as a security by the SEC. This meant that interest could not be provided on the refundable portion of the membership fee and that the refund could be no greater than the fee.

What were the nonmarket threats? The developers of vacation clubs were the principal market participants that could be hurt by the entry of Exclusive Resorts and other private vacation residence clubs. There were many of these companies, and they were members of ARDA. Their basic strategy was to have existing state regulations interpreted so that they covered Exclusive Resorts and other private residence vacation clubs.

The 3 million consumers who owned timeshares were not a nonmarket threat to Exclusive Resorts, because they had already purchased their share and the developer had moved on. Moreover, the resale market in timeshares is very thin and should be little affected by Exclusive Resorts. The 500,000 vacation club members were also not directly threatened unless for some reason the club might fail because of a difficulty getting enough members. People who might buy timeshares in the future could constitute a potential threat, but if there is a demand for timeshares dealers would supply them. The principal nonmarket opposition to Exclusive Resorts thus would come from the resort developers.

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An important threat to ER is that unscrupulous or undercapitalized players may enter the residence club market resulting in fraud or failures in which members incur losses. A number of residence clubs opened in 2004 and entry was apparently easy. The irony is that the more successful ER is the more copycats will try to enter the market on its coattails. The bad news is that with copycats there is greater risk of failure. The good news is that as the numbers increased forming a trade association becomes more attractive. Exclusive Resorts, however, would have to take the lead and carry much of the burden of a trade association.

The specific regulatory risk is that clubs may fail and leave their members holding the bag. In that case regulators may conclude that consumer protection is required, just as it was required for timeshares. Regulation is not just a risk in the locations in which the firm owns property, but the regulation could also be in states in which the firm seeks members. A major concern is that if one state applies timeshare law to private vacation residence, regulators in other states may also feel compelled to act. Therefore, it is important to prevent regulation in every state.

The regulatory risk from the SEC seems much less serious than that from state regulators. The FTC could become involved if there were deceptive or unfair acts by the clubs, but this is an area of state discretion, so the FTC was unlikely to act unless the states for some reason were unable to stop such practices, if they developed. Since most states had regulatory systems for time-shares in place, the FTC would likely defer to the states.

ER had two components to its nonmarket strategy: (1) voluntary self-regulation and (2) blocking the competitors’ nonmarket actions.

State regulators were primarily concerned about protecting consumer “investments” in a private vacation residence club that might be at risk, particularly from unscrupulous firms or from undercapitalized firms that would collapse; e.g., because they were unable to attract enough members to cover their promises. Exclusive Resorts had to assure regulators that its members were (1) not at risk and (2) if they were, the members could protect themselves. One approach taken by Exclusive Resorts when questioned by state regulators was to argue that regulatory resources could be better utilized elsewhere. That is, Exclusive Resorts members were able to write a personal check for $375,000, and they were quite capable of protecting themselves. This approach proved successful. Brad Handler and local lobbyists and consultants conveyed this message to regulators.

Possible failures by other private residence vacation clubs represented a bigger threat. As part of the first component of its nonmarket strategy, Exclusive Resorts prepared voluntary self-regulation guidelines that included features like requiring assets to exceed liabilities, accounts audited by a big-four accounting firm, and financial statements made available to members.

The private luxury residence club industry has enough companies to form a trade association to contribute to the nonmarket defense of the industry. One purpose of an association would be to stop false advertising that could injure the industry. Exclusive Resorts proposed the establishment of a trade association for vacation clubs and talked with other companies about forming it. The other companies responded that they would be willing to join but did not want to share in the cost. (Brad discussed this with a number of his competitors, and their typical response is that they would be happy to join if they did not have to pay anything. Their focus was building market share.) The

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other firms in the industry chose to free-ride on Exclusive Resorts. The burden of countering the developers thus fell on Exclusive Resorts.

The strategy of ARDA was to argue to state regulators that clubs such as Exclusive Resorts were really timeshares and hence should be covered by existing state law. ARDA’s “model club” exercise was the instrument of this strategy, and ARDA took its message to the state regulators.

This posed a major threat to Exclusive Resorts.

A major problem with state regulation is that it varies from state to state and hence would impose high costs on companies. (This is one reason that ARDA had prepared a model state timeshare act and worked for its adoption across the states.) Exclusive Resorts would welcome federal legislation that would pre-empt state regulation.

Teaching the case: 1. How well positioned is Exclusive Resorts in its market environment?

2. Will entry into the private vacation residence club market be easy or hard?

3. If others will enter, is there a risk that they will fail? Does that pose a risk to Exclusive Resorts?

4. How well positioned are Exclusive Resorts in its nonmarket environment? Is the line between a timeshare and a private vacation residence club a fine or a broad one?

5. If Exclusive Resorts is successful in its market environment, what are its competitors likely to attempt in its nonmarket environment?

6. What are the nonmarket risks the firm may face? What nonmarket competencies does Exclusive Resorts need to deal with the nonmarket challenges it is likely to face?

7. What nonmarket strategy should Exclusive Resorts deploy?

Developments: Entry into the vacation residence club segment of the market was easy, and by March 2005 over 30 companies were in the industry, all of which were offering lower cost packages and lower-value residences.

In its market environment Exclusive Resorts found that many people interested in membership we unable to spend 30-60 days on vacation, but were interested in shorter periods. Exclusive Resorts responded by offering an affiliate membership providing 15 days of vacation residence for a fee of $185,000.

By the spring of 2005 Exclusive Resorts was opening new residences on a regular basis building up to 200 residences, and beyond. The firm had a substantial waitlist, and those on the waitlist would be granted membership as the residences became available. The value of the 200 residences was $500 million.

Management and leadership of Exclusive Resorts passed from the Handlers to Steve Case, the founder of AOL. Case initially bought half the company and later assumed the role of chairman.

The CEO hired by the firm was formerly with AOL.

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Private Escapes revised its dividend promise within a few days of its initial posting. It replaced the word “dividend” with the word “payback” and dropped the sentence containing “tax free.” The “Get paid to play” page on its Web site then stated, “Given year-over-year appreciation of the real estate portfolio at 8-12%, you would receive approximately $3,000-$5,000 in credits annually to offset any travel or activity costs arranged through the Platinum Club.”16 Brad Handler attempted to form an industry association, but the other firms decided to free ride on Exclusive Resorts’ nonmarket strategy. The burden of countering the developers thus fell on Exclusive Resorts.

Could an ARDA member law firm file a complaint with a state regulator? There is no evidence that ARDA planned to take any direct legal action against Exclusive Resorts.

Some states wrote to ER stating that it may be required to register with the state. ER’s response was that it does not have recurring use, fixed use, or periodic use. The state regulators mostly agreed that ER was not required to register and was not subject to state regulation. ER hired local attorneys and lobbyists to oppose state regulation, and Brad Handler participated in those efforts.

No new legislation had been adopted in any state as of spring 2005. The threat remained, however.

Exclusive Resorts also experienced a number of local nonmarket challenges, many of which were common in the real estate business. In Hawaii Exclusive Resorts bought property in a private development, and one of the existing owners attempted to have the CC&R’s changed to prevent it from building new residences. He also pledged to file a lawsuit in state court to block development.

Exclusive Resorts’ nonmarket strategy must be defensive. In terms of Figures 2-1 and 2-2 its opportunities are not controlled by either government or private politics. There are no NGOs or activists likely to be concerned about the company, and no grassroots opposition can be expected.

The opportunities in the marketplace are open to the company, provided that it can avoid being classified as a timeshare and subjected to regulation. The threats come from organized interests (ARDA) and state regulators who may view private vacation residence clubs as covered by existing state laws. The best strategy to address these threats is to work proactively in the states with priority given to those with the most aggressive regulation. This would require lobbying of state regulators and committees in state legislatures with real estate regulation in their jurisdictions. The lobbying should be informational (Chapters 7 and 8) with the message that members are not at risk and are able to protect themselves. Moreover, the company itself is well-financed, well-managed, and honest and principled. The company should also continue to work to form an association that would self-regulate the industry, and this effort should be described to those it lobbies. Since Exclusive Resorts is a small company, it will have to hire lobbyists to supplement its own staff.

The other component of its nonmarket strategy should be to continue its dialogue with ARDA.

16

www.private-escapes.com/platinum/dividends.html August 20, 2004.

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Envirotest Systems Corporation (A) PowerPoints are available for this case.

This case focuses on market and nonmarket strategies and how they are integrated into a business strategy. It also illustrates how a change in the nonmarket environment can create a market opportunity that can be seized through an integrated strategy. The case, however, also illustrates how a good market strategy can be damaged by nonmarket actions. The discussion of the (A) case should conclude with an analysis of what could go wrong in Envirotest’s nonmarket environment and how it should deal with those potential problems. The Envirotest Systems Corporation (B) case presented later in the manual identifies the nonmarket problems Envirotest encountered and focuses on how the company should deal with the challenges it faces.

This case has three purposes. The first is to bring together much of the chapter material on strategy and competencies. The second is to provide an opportunity to tie nonmarket analysis and strategy formulation to market strategy as taught in a course on competitive analysis or strategic management. The third purpose is to demonstrate the importance of nonmarket considerations and forces and their potential impact on the market strategy and success of a firm. This last purpose is developed further in the Envirotest Systems Corporation (B) case, which discusses the nonmarket problems the company faced as it attempted to implement its integrated strategies. The discussion of the (B) case in this manual provides additional information on those problems.

With respect to Figure 2-1 this is a case in which managers are at the heart of the analysis, strategy formulation, and strategy implementation stages. That is, this is a relatively small company, and its principals are involved in all aspects of the firm’s strategy. They also explicitly bring together the market and nonmarket components of a business strategy.

With respect to Figure 2-2 it is clear that government controls opportunities at several levels: 1) the air quality standards in the Clean Air Act of 1990, 2) the EPA’s stated preference for centralized testing, and 3) state government implementation plans. Note that these are associated with three different institutions: 1) Congress, 2) a federal regulatory agency, and 3) a state environmental or transportation agency. (The regulatory agencies are themselves subject to a variety of forces and Figure 10-1 in Chapter 10 can be used to illustrate the forces influencing an agency.) In this case government has created opportunity, but what government has created it can also take away. The most difficult, if not impossible, to take away is the air quality standards mandated in the Clean Air Act. The EPA’s stated preference for centralized testing can be changed relatively easily, as can its selection of the enhanced I/M240 standard.

As discussed in the context of Figure 2-2, another force—public sentiment—affecting opportunities is present in this case. Envirotest is in a sensitive market because as a sole-source supplier of centralized testing in a state, customers have no alternative supplier to whom to turn if they are dissatisfied with the service. Their only alternative is to complain, and they will turn to the government and to the news media, which will be interested in this issue because it matters to many people (has high intrinsic audience interest in the terminology of Chapter 3) and hence matters to public officeholders. Because of the constituency connection discussed in Part II of the book, those

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officeholders will be sensitive and responsive to the complaints of the public. For this reason, Envirotest is very sensitive to the public’s reception of its testing service.

The demand for centralized testing is the result of a number of problems with decentralized testing, and the discussion might initially focus on those problems for the purpose of identifying the advantages, and disadvantages, of centralized testing. Those problems are: 1) The conflict of interest; i.e., repair shops (service stations) have an incentive to fail autos so they can do the repairs, and once they have worked on a vehicle they have an incentive to pass it even if they have been unable to fix the problem. (There is also the possibility of bribery.) 2) The testing in a decentralized system is not as sophisticated in a number of ways: a) it tests only at idle whereas a treadmill test can be done at highway speeds, b) the test itself is not as accurate because centralized testing uses more sophisticated equipment, and c) centralized testing can test for nitrogen oxides.

(See the (B) case.) 3) Another problem mentioned in the case is tampering with the emissions control equipment. Centralized testing seems no better able to deal with this than is decentralized testing. Remote testing, however, is potentially better able to deal with this problem because it can detect vehicles with excess emissions and at least force owners to bring the vehicle in for inspection and testing. This reduces the benefit from tampering and hence should reduce its incidence.

The following presents Porter’s concepts of market forces and generic strategies. Porter (1980)(1985) identified fundamental aspects of competitive strategies in markets. One conceptual framework he presents is the "five forces" that a strategy must contend with. The five market forces are: 1) rivalry among existing firms, 2) threat of new entry, 3) threat of substitute products or services, 4) bargaining power of buyers, and 5) bargaining power of suppliers.17 From Porter’s perspective the key to an effective strategy is defending against the five forces, “An effective competitive strategy takes offensive or defensive action in order to create a defendable position against the five competitive forces.”18 Porter also argued that, “Given the pivotal role of strategic advantage in superior performance, the centerpiece of a firm’s strategic plan should be its generic strategy. A generic strategy specifies the fundamental approach to competitive advantage a firm is pursuing, and provides the context for the actions to be taken in each functional area.”19 The three generic market strategies are: 1) overall cost leadership, 2) differentiation (of product), and 3) focus (on a customer group, product line, geographic market, etc.).

Envirotest employed a focus market strategy with limited product extensions in terms of safety testing and dispute resolution. This strategy may be coupled with cost leadership, although there is no clear evidence of a cost advantage. Certainly, Envirotest has a scale and experience competitive advantage, and it may have a competitive advantage in its managerial capabilities. It has also developed a financial capability. It has a technological advantage in having two centralized testing technologies. There is no evidence that it has a competitive advantage in remote testing. Its principal competitive advantages, however, are its experience and reputation.

17

This discussion is taken from Baron (1995) Copyright © by the Regents of the University of California. Reprinted form the California Management Review, Vol. 37, No. 2. By permission of The Regents.

18 Porter, 1980, op. cit., p. 29.

19 Porter, 1985, op. cit., p. 25.

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Envirotest faces few real market threats and is well equipped to deal with the five forces Porter identifies. As indicated in the case, it faces rivalry from several companies, but they are considerably smaller and less experienced. Another possible rival, however, is a state government, which could choose to provide the centralized testing.

Entry into the market is possible but with states letting seven-year contracts and rushing to meet the EPA deadline, any entry must be soon. Envirotest does face a potential substitute from remote testing, and entry is easier with that technology. For example, Hughes has been marketing a remote testing system referred to as the “smog dog.” Envirotest faces little threat from suppliers, since for many of them it is a large customer. It does face a threat from its customers—government, and its constituents, the public. It is here where Envirotest must focus its attention. Its nonmarket strategy is the principal instrument for dealing with this force.

Envirotest’s nonmarket challenges can be organized into pre-bid, bid, and post-bid activities.

Nonmarket activities are important at both the pre-bid and post-bid stages. Activities at the pre-bid stage are intended to win a contract, and activities at the post-bid stage are intended to secure a contract.

Envirotest’s nonmarket strategy focuses on government and the public and has a number of components. With respect to governments, Envirotest maintains relationships with the EPA and Davenport has personal relationships with a number of officials in the federal government.

The developments in the nonmarket environment that could cause Envirotest’s business strategy to fail range from minor customer complaints to repeal of sections of the Clean Air Act of 1990 dealing with air quality standards. The principal risks faced by Envirotest come from the nonmarket environment and operate through distributive politics, as considered in Chapter 4 One source of distributive politics is the repair shop operators who fear losing business and jobs as a result of centralized testing. As indicated in the Envirotest example in Chapter 4, repair shop operators are well organized and have complete coverage of state legislative districts. (See Chapter 6 for a discussion of the concept of coverage.) They will exercise their political leverage in an attempt to get the state to negotiate an arrangement with the EPA that will preserve their position.

The other principal source of distributive politics is the burden, both in terms of dollars and in terms of time and frustration of motorists. Particularly in states that do not have auto emissions testing, the additional burden may generate protests. The outlets for the complaints of motorists are government and public sentiment. The news media, as considered in Chapter 3, will certainly cover the inauguration of the centralized testing program as well as any problems in the implementation of the program. The news media will air the complaints of motorists.

States and municipalities may be classified into three categories: 1) those that already have a centralized testing program, 2) those that have a decentralized testing program, and 3) those with no program. In the first category, opposition is likely to be minor. In the second category, opposition can come from the repair shops and from the time and costs borne by motorists. In this category, the cost of the test itself is not likely to be a major concern, but the possibility of having to pay up to $450 for repairs is a lightning rod. The possibility of having to make three stops is also

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a real concern. In the third category it is only the time and costs that are likely to be a source of protests. One point for analysis is whether opposition to centralized testing is stronger in states that have a decentralized testing program or one in which there is no program. The reaction of motorists to centralized testing might be greater in a state with no decentralized program, but in such a state there will be less opposition from repair shops. Which will be the stronger is difficult to determine, but Envirotest should be prepared to deal with both. One source of opposition to the EPA’s mandated centralized emissions testing program stems from the current opposition to federal mandates. One dimension of this is the opposition to command and control regulation under which a regulatory agency mandates how (e.g., centralized auto emissions testing) a regulatory objective (clean air) is to be achieved. More generally, the current mood in Congress is to delegate activities to the states so that they can use their local knowledge to design programs that best meets their own needs. One focus of the discussion should be Envirotest’s Pre-Bid Marketing. The discussion might address which kinds of activities are appropriate at this stage and how aggressive the company should be. These activities involve extensive lobbying and other personal contacts with state officials. In Connecticut, Envirotest’s activities caused a political storm as Governor Weicker overruled the decision of “his motor vehicle commissioner, gave the contract to Envirotest and then fired the commissioner.”20 Envirotest lobbyists in Connecticut included Vernon Jordan. The Connecticut legislature responded by passing new rules on lobbyists’ activities. The nonmarket threats to Envirotest are at several levels. At the level of the motorist, complaints can arise from the cost and inconvenience. At the level of the state threats come from a preference for decentralized or remote testing alternatives or from balking at achieving the air quality goals established in the Clean Air Act. At the federal level the threats are several fold. First, the EPA may allow tests other than the I/M240 test that Envirotest helped develop. Second, the EPA may back away from its mandate of centralized testing. Third, Congress may back away from the clean air standards. This last threat might involve legislation giving states more time and flexibility to meet air quality standards. The fact that centralized testing programs have been in operation in a number of states indicates that motorists can become accustomed to them. Another long-term issue is whether the states will in fact enforce the Clean Air Act standards. If they will, then automobile emissions testing should be an important part of any air quality program. That is, compared to alternatives such as mandatory car-pooling and restrictions on driving, centralized testing is surely preferred by motorists. Other alternatives such as scrapping old cars are possible, as are reductions on industrial emissions, but the latter can affect growth and jobs. As Envirotest well understands, the design and implementation of a centralized auto emissions testing program is a complicated management problem. Consider the crucial issue of avoiding long delays at testing facilities.

Testing involves balance and peak load considerations. Testing facilities must be located so that some are not overcrowded and others underutilized. Location and

20

Wall Street Journal, March 4, 1994.

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the number of testing lanes are thus crucial. Peak load problems are also a concern, since if motorists prefer to bring their vehicles to be tested at the same time, long delays could occur.

Moreover, motorists go to a testing facility only every two or so years, so they will not learn when the peak periods are. Envirotest thus has a marketing challenge to induce motorists to come in at off-peak times.

One dimension not mentioned in the case is that Envirotest is a minority-owned and managed firm.

Both Mr. Davenport and Ms. Edwards are African-Americans, as are a majority of its board of directors. Mr. Davenport was the first African-American to graduate from the University of Georgia School of Law. Davenport remained the principal of Georgetown Partners. He was featured in an article entitled, “How One Man Used Corporate Affirmative Action in Ameritech Deal,” The New York Times, April 12, 1999.

The following summarizes Envirotest’s market strategy.

1. Focus strategy: a single line of business—vehicle testing • testing and not repairs nor selling equipment; i.e., use the absence of a conflict of interest as a plus in contract awards • design, own, and operate testing facilities • complete systems; e.g., including public education 2. Be the most experienced (important because this will be the first time with centralized testing for many states?)

3. Lessen competition through acquisition • this also adds experience and capacity • adds technology 4. Develop an organizational capability to handle multiple contracts • acquire trained and experienced personnel • develop personnel internally 5. Acquire sufficient financial resources to assure states and to have the capability to handle many contracts at once: public offering, credit facilities; Union Bank, Internationale Nederlanden 6. Be a technology leader and invest in new technology • multiple technologies • acquired the remaining half of a remote-sensing technology from Systems Control 7. Customer convenience and user-friendliness 8. Organizational culture 9. Product (service) extension • pre-emissions safety inspection • referee service • quality assurance service 10. Hire local firms and employees to build a local rent chain (Chapter 7).

Competencies: Market: 1) state-of-the-art technology and systems testing; 2) multiple technologies; 3) complete systems supplier; 4) experience; 5) relatively far down the experience curve; 6) ability to 60

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transfer technology across state programs; 7) organizational capability of handling multiple contracts Nonmarket: 1) sophistication in dealing with government: knowledge, skills, access; 2) government in its dual roles as regulator and customer; 3) sophistication and experience in dealing with interests: a) organized—repair shops, competitors; b) unorganized—motorists, public; 4) skills in lessening pressure on state regulators; 5) minority-operated enterprise Competitive advantage: 1) centralized testing; 2) no conflict of interest; 3) size and experience; 4) unparalleled and proprietary technology; 5) large number of experienced personnel; 6) ability to handle multiple contracts; 7) financial capacity Envirotest’s nonmarket strategy has the following elements: 1. Understand government and issues and know the officeholders • understand it as a customer (states) • understand it as a creator of demand (EPA) • understand it as a regulator; e.g., as a chooser of technology 2. Encourage states to choose centralized testing 3. Help develop expertise and a specialized market; work with the EPA in developing an I/M 240 testing procedure 4. Proactive relations with constituents/interest groups as in Colorado.

5. Defusing the opposition; e.g., repair shops 6. Develop in-state partnerships 7. Minority-owned business--states under pressure to fulfill program promises • employees: 32% minorities and 35% women • M/WBE program 8. Contracting process: 1) pre-bid activities; 2) bidding; 3) post-bid activities 9. Exemptions; e.g., for fleet, dealer, government vehicles to reduce opposition from these interests Teaching the case:

The discussion can be guided with the following questions.

1. What are the problems with decentralized testing? What are the advantages of centralized testing? Are there any disadvantages of centralized testing?

2. What is Envirotest’s market strategy? How effective is it?

3. What are its distinctive market competencies?

4. What kinds of activities are involved in the “pre-bid marketing” phase of the bid process? Can Envirotest run into any troubles in this type of activity?

5. What is Envirotest’s nonmarket strategy? How effective is it?

6. What are its nonmarket competencies?

7. How well integrated are its market and nonmarket strategies?

8. What threats does Envirotest face?

9. How should it deal with those threats?

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Envirotest Systems Corporation (B) Envirotest’s most serious threats came from its nonmarket environment. At the federal level the National Automobile Dealers Association had filed a lawsuit challenging the procedures that the Environmental Protection Agency (EPA) used in making its ruling that, in effect, required centralized testing and took from the states the ability to design their own programs.21 Also, at the federal level the General Accounting Office questioned the efficacy of the EPA’s I/M 240 test, and in response the EPA indicated that it would assess alternative tests. Some states objected because the EPA regulations took a command-and-control approach rather than employing performance standards under which states would have flexibility in choosing the program they believed most effectively met their air quality objectives.

Some states had no prior emissions testing program, and others had had such a program—in most cases a decentralized one. In states with no prior emissions testing program, the principal threat came from motorist objections to emissions testing and centralized testing in particular. The EPA estimated that the average cost of a centralized test was $17 and ranged from $35 to $70 in a decentralized system, but for a state with no previous testing program, the cost could be a source of complaints.

In addition to the cost of the tests, the failure rate was often set high, and the cost of repairs could be substantial, particularly for older cars. The Colorado Request for Proposals (RFP) specified an initial-test failure rate of 30 percent and a retest failure rate of 25 percent, and Pennsylvania also estimated that the failure rate would be 30 percent. In addition, the EPA’s enhanced testing requirements included for the first time testing for nitrogen oxide, causing some vehicles that would have passed under the previous decentralized program to fail. Repairs costing as much as $450 could be required, which could force some motorists to scrap their older cars.22 Although the centralized test took only 12 minutes, there could at times be significant waits at the testing facility. Motorists would also have longer drives to the facility, since there would be far fewer testing sites under a centralized system. Furthermore, vehicles that failed a test would have to return to be reinspected. Complaints could also arise from testing inaccuracies and errors, although the technology was far more accurate than that used in decentralized systems. Centralized testing facilities would also affect traffic volume near the site, which could result in objections by local residents.

Complaints could also come from unexpected sources. Maine was first to implement an enhanced centralized testing program (provided by Systems Control and not Envirotest) under the EPA mandate, but within months public opposition forced the state to suspend testing for six months.

Maine had chosen to expand, beyond that required by the EPA, the region in which testing was required, yet citizens complained of unequal treatment since testing was required in some regions and not in others. Motorists also complained about the $24 cost of a test and the possibility of having to spend up to $450 for repairs. Automobile owners also complained because buses and large trucks did not have to be tested. Some implementation mistakes were made as well. Motorists were required to pay in cash, which drew widespread complaints. Also, some of the staff were

21 22

The Court of Appeals subsequently rejected the suit and held for the EPA. Most centralized testing programs provide a waiver if the cost of repairs exceeded a figure such as $450.

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poorly trained and ineffective in dealing with motorists. The most incendiary event, however, was the governor’s decision to allocate pollution credits, earned as a result of the emissions testing program, for the expansion of a plant that had been cited for pollution violations. Some state legislators were furious as were voters, who began a petition drive to repeal the testing program.

In Pennsylvania, which had a decentralized testing program, opposition arose from a variety of sources, including owners of classic cars produced before emissions controls were required. They held a rally on the steps of the state capitol to oppose centralized testing. The centralized testing program became a political football as both gubernatorial candidates accused each other of having imposed the program on the voters. Both pledged to renegotiate with the EPA.23 Some legislators seized the opportunity to complain that the contract was too lucrative. Calls for rescinding the contract mounted. The state legislature passed a bill to delay implementation of the program, but the retiring governor vetoed it. A special session was scheduled for after the November election to vote on overriding the veto. Envirotest threatened to sue the state, seeking damages of $355 million if the state breached its contract. After the election the state legislature easily overrode the veto, and the governor-elect reiterated his campaign pledge to negotiate with the EPA for a program like the one California had negotiated earlier in the year.

In states with decentralized testing programs, a powerful interest group opposing centralized testing was the repair shops that performed testing and repairs. In California there were 9,300 licensed Smog Check shops and 22,000 licensed Smog Check mechanics. The association of repair shops estimated that 1,300 establishments would have to close and 3,000 jobs would be lost as a result of centralized testing. The proponents of centralized testing countered that the higher failure rate with centralized testing would mean more repairs. Furthermore, the centralized testing facilities would create jobs—but not necessarily for the same people who feared that their jobs would be lost.24 Carol Browner, administrator of the EPA, argued that not only would centralized testing add jobs, but it would also save Californians money. She said: “Californians today pay much more than other Americans for their inspections, about $32 per test. In Maryland, I pay $9 per test every two years.

The average cost in test-only states is a bit lower; only $8.50.”25 Despite her threat that the state would lose $600 to $800 million of highway funds, the pressure from the repair shops and others satisfied with the state’s current Smog Check program and skeptical of centralized testing caused the state to balk. Reminding Washington of the 54 electoral votes in California and that the presidential election was only a little over two years away, both the governor and the state legislature in effect dared the federal government to impose penalties on the state. Willie Brown, the Democrat speaker of the state assembly, said that imposing the EPA’s program would be “a fatal step for Bill Clinton’s candidacy in 1996.” The EPA quickly entered into negotiations with the state and reached a compromise in which the state would retain its current decentralized testing program but would centrally test 15 percent of the vehicles in 1995, increasing to 30 percent in 1996 if the overall program was not sufficiently effective. The state would also experiment with a

23

One candidate had been lieutenant governor when the enabling legislation was passed, and the other had voted for the Clean Air Act when in Congress.

24 Booz-Allen Hamilton estimated that the net effect would be the addition of 700 jobs. An SRI study estimated an increase of 975 jobs.

25 Los Angeles Times, September 9, 1993.

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remote testing program. The two sides would then evaluate the experience with the program and its success.

Observing the experience in California, other states began to balk. Virginia refused to establish a centralized testing program, and the EPA backed away from imposing penalties. Maine suspended its program, and Pennsylvania moved to renegotiate its program. Centralized emissions testing was in jeopardy.

Preparation Questions: 1. What went wrong in the EPA’s attempt to implement an enhanced emissions testing program?

What types of politics were involved in the emissions testing issue?

2. Is the EPA likely to withhold funds from Pennsylvania?

3. Does Envirotest have any allies in its efforts to have states implement centralized testing programs?

4. What integrated—market and nonmarket—strategy should Envirotest adopt to address the issues in Pennsylvania and California?

Copyright © 1994 by the Board of Trustees of Leland Stanford Junior University. All rights reserved. Reprinted with permission.

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Comments on the (B) case and subsequent developments: The problems Envirotest is encountering stem from both its own activities and a broader opposition to more burdensome environmental measures. The latter centers on specific costs of environmental regulation that have directly impacted citizens. Some of these regulations are the requirement of reformulated diesel fuel which has infuriated truckers because of its higher price and the difficulty in starting engines in cold weather. Oxygenated gasoline required in metropolitan areas as diverse as Los Angeles and Fairbanks costs more than regular gasoline and motorists objected to the higher price. (MTBE has been banned, and opposition to ethanol has developed because it yields worse mileage and has a higher price.) Motorists claimed that the reformulated gasoline made them ill.

As indicated in the (B) case, motorists in a number of states objected to centralized testing programs, and other states objected to testing itself. Nissan argued that the problem it was having with engine fires in its vehicles was due in part to the oxygenated fuels.

These protests occurred at the same time as the electoral victory of the Republicans, many of whom were opposed to government regulation and wanted to roll back environmental regulation such as the endangered species act and wetlands regulations. Envirotest was caught in this wave of protest, as political entrepreneurs sought to be responsive to constituents’ complaints. The events in Pennsylvania illustrate this.

The specific problems Envirotest faces in the case are the result of distributive politics and entrepreneurial politics on the part of states. The distributive politics result from automobile dealers who now have to have their used cars inspected. (In Pennsylvania one-quarter of the automobiles inspected were from automobile dealers.) The pressure from repair shops and auto dealers and from the opponents of command-and-control regulation led the GAO to investigate the efficacy of the IM/240 test.

The distributive politics stem from two sources. One is motorists who objected to the cost of the test, the time the test takes including the waiting time, the inconvenience from the possibility of having to make three stops (the test, the trip to the repair shop, and the retest), the relatively high intended failure rates, inconsistencies arising from testing inaccuracies, any difficulties in making repairs to correct failures, botched implementation as in Maine, and perceived unfairness when not all vehicles are tested as in Maine.

The other is the repair shops and remote testing companies that opposed mandatory and universal centralized testing. The repair shops have extensive coverage of state legislative districts and have considerable influence. In addition to their concerns about the loss of income and jobs, they also face the difficulty of making repairs to meet what are now more stringent standards; i.e., the enhanced IM/240 standard. Moreover, the repair shops no longer have the option of certifying to the motorist that the problem has been corrected, since the centralized facility does the retesting.

The remote testing companies have the opportunity to argue that their technology is as accurate and is less obtrusive than centralized testing. The advantage of remote testing is that it can distinguish between the polluters and the nonpolluters. The disadvantage is that it could be less accurate. The remote testing technology surely has appeal and has advocates in Congress and at the state level.

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Entrepreneurial politics were the result of opportunities seized by political candidates, as in Pennsylvania, and by opponents of command and control regulation. States were also under considerable pressure from repair shops as in the case of California.

The EPA has threatened to withhold highway funds from states that do not implement centralized testing. This seems unlikely given the political climate surrounding environmental issues.

Envirotest’s managerial challenge is to address the threats at both the federal and state level and with the public. At the federal level Envirotest should work, to the extent it can (recognizing that it is a small company but one that has considerable political expertise), support the EPA, calm the concerns in Congress, and calm (to the extent it can) the Republicans opposed to command and control approaches. The repeal of the Clean Air Act of 1990 is not in the cards, although the Republicans will seek to reverse certain actions such as the endangered species. (President Clinton would veto any attempt to repeal the Clean Air Act.) At the state level Envirotest must work to manage its contracts as efficaciously as possible so that the public does not have complaints. Envirotest must be even more proactive than it has been by trying to anticipate problems.

Envirotest should, in its lobbying, highlight the failings of other testing methods. The primary objective is to preserve centralized testing in states that have already chosen that technology and to keep the opportunity for centralized testing alive in those states that have not yet made a decision.

Discussion questions for the (B) case: 1. What factors contributed to the uprisings against centralized emissions testing?

2. Are other states likely to go the route of California?

3. Why do the repair shops have so much political leverage?

4. How should Envirotest address the threat from remote testing?

5. What strategy should Envirotest adopt to address the revolt in Pennsylvania? How aggressive should it be?

6. Should Envirotest change its basic strategy?

Developments: In Pennsylvania the governor indefinitely suspended the program in February 1995. He was, however, studying how to comply with the Clean Air Act requirements. Envirotest and the state entered into negotiations on compensation for the canceled contract. Envirotest reported that it had spent $200 million building 86 testing facilities in the state. Envirotest received $125 million in compensation.

In Colorado problems resulted from peak loads. The bulk of the motorists brought their vehicles in for testing between 10:00 a.m. and 3:00 p.m., resulting in long delays. (This was complicated by delays in finding a testing site in Denver, which was short on testing stations.) This not only resulted in complaints to motorists but also in fines of $55,000 for Envirotest. One alternative would be for motorists who had to wait more than a specified number of minutes to have the fee for

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the test waived. The free test could be in lieu of a fine. The problem with this alternative is that it would induce some motorists to come at peak times in the hope of not having to pay for the test.

Automobile dealers accounted for one out of every four cars tested in Colorado, and Envirotest could attempt to induce them to bring their autos in at non-peak times. In Colorado motorists also complained about having to make three stops rather than one under a decentralized program. Also, Envirotest made some mistakes. For example, it failed Land Cruisers because it had classified them as automobiles.

To deal with the peak-load problem, Envirotest offered a 30% discount on the testing price if the motorists brought their vehicles in at an off-peak time. It also has opened its testing facilities an hour earlier. The discount shifted demand considerably. The average wait decreased from 14.4 minutes in March to 9.9 minutes in April.

In Colorado Envirotest was opposed aggressively by the repair shops. One problem facing repair shops is that they may have difficulty finding the cause of the failure and hence may not be able to make repairs that will cause the vehicle to pass the retest.

In 1995 several bills were introduced in the Colorado legislature ranging from canceling the contract to restructuring it. Envirotest mounted an intense lobbying campaign that included hiring two Colorado lobbying firms and a prominent law firm. All the bills were defeated.

Another risk is that states will not volunteer regions to be included in an enhanced testing program.

The governor of Pennsylvania withdrew the western region including Pittsburgh from the program.

As a result of the protests and problems encountered, Envirotest’s share price fell nearly 80 percent in a few months in late 1994 and early 1995. Envirotest has survived buts its aspirations were more modest.

While all of this was happening, Envirotest was awarded a $470 million, seven-year contract for New York City and Long Island. It also was awarded a contract in Wisconsin. In April 1995 it was awarded a 10-year $93 million contract to run an enhanced emissions testing program in the Cleveland area. The company was testing 1.3 million automobiles annually in Ohio under contracts worth $250 million over 10 years.

At the federal level, in March 1995 a House hearing was held on the EPA’s emissions testing program. Pressure for the hearing came from the Service Station Dealers of America which represented 50,000 independent gasoline dealers. The EPA’s formal rule on emissions testing was scheduled to be issued in August or September 1995. Envirotest hired American Continental Group to lobby on environmental legislation.

The EPA was to make a final rule determination in August or September 1995, and one possibility in the new political reality was that it would choose a performance standard and given the states considerable time to achieve it. That would in effect allow states to do much as they choose.

As a consequence of the backlash described in the Envirotest Systems Corporation (B) case, the company continued to struggle. It was subsequently sold to Stone Rivet, Inc. for $266 million.

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Molecular Insight Pharmaceuticals: Integrated Strategy for a Development Stage Molecular Medicine Company This case provides an opportunity to discuss an integrated strategy for a small pharmaceutical company engaged in molecular imaging and targeted radiotherapeutics. This company is unusual because its first two pharmaceuticals are based on molecules that are used in drugs available in Europe and Japan. Zemiva is based on a compound BMIPP, which is used in Japan but has never been used in the United States. What Molecular Insight has contributed is twofold: first, it has stripped BMIPP of nonessential components to produce a purer compound that should produce fewer side effects, and second, its Ultratrace technology allows the drug to be targeted much more effectively. Azedra is based on a compound MIBG that is used as a first-line therapy in Europe, but it is available only on a compassionate use basis in the United States. MIP has a patent on Ultratrace MIBG, but the compound itself is not patented in the United States. Its Ultratrace technology allows better delivery of the drug to tumors, and MIP has also developed a purer version of MIBG. The challenge for MIP is to bring its products successfully to market. This requires an integrated strategy with market and nonmarket components.

Nonmarket strategy: A nonmarket strategy for MIP has three principal components: intellectual property protection, FDA approval, and reimbursement.

The patents on its two lead compounds had expired, so no patent protection was available. This meant that other companies could develop drugs using the same compounds. The greater the success of its drugs, the more likely this was to happen. MIP sought to deal with this in two stages.

In the first, in lieu of patent protection MIP could pursue exclusivity that would prevent others from marketing drugs using the same compound. This protection was not as strong as a patent, but it can be effective. The second stage was to develop new versions of the drugs that could be patented, providing some protection for the original version as well as protection for improved versions.

Obtaining exclusivity for Azedra involved obtaining orphan drug status, which involved a fairly routine FDA process. For Zemiva obtaining exclusivity would be much more difficult because the provisions of Hatch-Waxman had not previously been used. This required considerable nonmarket effort to lead the FDA to conclude that exclusivity should be granted. This effort should commence once the critical Phase IIB trials for Zemiva have been completed.

A second crucial component of its nonmarket strategy targets the FDA approval process. This involves the design of clinical trials and the approval process. As discussed later, MIP should attempt to lay the groundwork to allow the FDA to move expeditiously. This basically means to make sure that the FDA is fully informed about the progress on the drugs and that there are no misunderstandings. MIP attempted to provide information that would allow the FDA to approve the drugs, assuming that the clinical trials would be successful, in less than 18 months. At the point at which the case is set, this is far away. Nevertheless, MIP should continue to meet with the FDA whenever it has new information important to the approval process.

It should be emphasized that much of the success of MIP’s strategy rested with the government, particularly the FDA. Just as clinical trials determined the fate of products, so did the FDA review for approval. The FDA process was beyond MIP’s control, and influencing the process or the

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review was difficult. The most MIP could hope for is that its nonmarket strategy cleared certain uncertainties from the process and guided the clinical trials to address the likely concerns of the FDA. This involved educating the FDA staff and officials about the drug.

The component of the strategy directed at reimbursement is also crucial but lies a couple of years in the future. Reimbursement approval by the government would be crucial for Zemiva to generate a substantial return on its investments. Since approval was not imminent, there was little that MIP could do immediately.

Market strategy: Products : One aspect of MIP’s market strategy is to find new indications for its drugs. Several research studies were underway on the application of its drugs to new diseases. Another aspect is to use its Ultratrace and other targeting technologies with other compounds. MIP had underway a research program called Trofex for the detection and monitoring of prostate cancer. This program focused on compounds discovered in house.

Developing new compounds is a very lengthy and very costly process, so MIP tried to short-cut this process by in-licensing compounds from other pharmaceutical companies. MIP in-licensed Solazed, for the detection and treatment of metastatic melanomas, from Bayer Schering Pharma and Onelta, for the treatment of pancreatic cancer, from Novartis Pharma AG. Both of these drugs had undergone some clinical trials.

Finance: Because the funds were viewed as two costly, MIP had intentionally stayed away from venture capital to finance its initial operations. Instead, it raised funds from private investors and from the hedge fund Cerebus. MIP completed its IPO in 2006 raising $53 million at a share price of $14. In November 2007 it successfully issued $150 million of convertible bonds.

Manufacturing: In 2007 MIP purchased a radiotherapeutics manufacturing facility for $3 million.

The purpose of the purchase was to reduce its dependence on a single supplier, MDS Nordion, for the radio isotopes it uses. The manufacturing facility was mothballed until FDA approval of its drugs was obtained.

Sales and Marketing: MIP planned to develop its own sales force for Zemiva and Azedra. In the case of Zemiva a sales force of approximately 100 would be needed to cover the hospital emergency rooms that were the principal locus of demand. The alternative for MIP was to enter into an arrangement with a major pharmaceutical company to market its drugs.

The Nature of Integration: A key to success for MIP was to get to market with its drugs as soon as possible, and this required conducting the clinical trials required by the FDA and then obtaining approval for the drugs. MIP attempted to speed the process by meeting with FDA officials to explain its products and the preliminary results it had obtained. MIP also worked with the FDA to identify the requirements for Phase II and III trials. MIP also worked with patient groups to argue for rapid approval for Azedra. These components of its nonmarket strategy basically enabled the company’s market strategy.

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How effective all this was in the case of Zemiva is hard to assess. The FDA had been under fire from critics on a number of dimensions and this may have slowed the process. (Zemiva was unlikely to be approved by 2009, as MIP had hoped.) Azedra received orphan drug status and was granted fast-track approval. It was likely that Azedra would be approved for marketing by the FDA before Zemiva was approved, provided that the clinical trial hurdles were met. Orphan drugs are priced high, so although there are relatively few people who would be treated with the drug, revenue could be substantial.

Since the basic compounds on which its two lead products were based were not under patent, other companies could develop competing drugs. Obtaining protection that would allow MIP to capture the rents on its products was essential to its success. Designating Azedra as an orphan drug provided 7 years of exclusivity, which was substantial protection. Zemiva required a grant of exclusivity under Hatch-Waxman, and at the time of this writing no decision had been made, presumably because the drug was still in Phase IIB clinical trials. In any event, MIP planned to obtain patents on versions of Zeniva, that would provide protection for a second-generation drug.

Another aspect of integration was with the clinical trial process and the subsequent marketing of the drugs, once approved. Clinical trial sites were identified with an eye to future marketing of the drugs, and it was helpful to have multiple sites in several different states.

Discussion questions:

1. Why are investors willing to provide the funds for a company without patents on its two key compounds?

2. What does MIP have to accomplish with its market strategy?

3. What does it have to accomplish with its nonmarket strategy?

4. How should those strategies be integrated?

5. What specifically should MIP do?

Developments: Governance and leadership: In September 2008 MIP added four new board members, all with extensive experience in the pharmaceutical industry. Four days later the board replaced Barlow as CEO and began a search for a new CEO. At the time of this writing critical trials were underway on Zemiva. These trials focused on possible side effects from the use of Zemiva.

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Chapter 3 The News Media and Nonmarket Issues This chapter considers the role of the news media in the life cycle of a nonmarket issue. It is intended to sensitize students to the types of issues the news media brings to the attention of activists, politicians, and the public and to provide a framework for understanding when the media will cover an issue and how the issue will be treated. The media does not create nonmarket issues, but it can accelerate their development and broaden the set of actors who take an interest in them.

Media coverage can also make it more difficult for management to address the issue if the firm’s actions are under close and continuing scrutiny. Furthermore, as the Alar example illustrates, the news media can intentionally or inadvertently play a role in the nonmarket strategy of an interest group. Because of the importance of the news media in the nonmarket environment, managers need to understand the objectives of the news media and journalists and how to interact with them in an effective manner. From time to time, a dispute between a firm and the news media develops, and managers need to understand the possible avenues of recourse.

An interesting insight into the making of a news program is provided by the videotape originally made available by the Illinois Power Company. This videotape is discussed below in the context of that case. If a copy can be obtained, it can be used to identify how the media constructs a story, makes it attractive to an audience, and shapes the story. It can also be used to discuss whether the segment was fair and balanced.

From the perspective of nonmarket issues and their development, the objective is to be able to predict which issues involving a firm are likely to be covered by the news media, and for those that are likely to be covered, how they will be treated. As the Alar example illustrates, the media can substantially expand an issue, particularly if it is acting in its role as a “protector of the right of the public to know.” On some issues, the media can also act as an advocate for a particular group or for a particular resolution of an issue.

The news media has a difficult job obtaining information often under considerable time pressure.

A lecture could address the difficulty of this task. A lecture can also emphasize the broad set of roles of the news media in society and its important role in a democracy.

Predicting coverage and treatment requires a theory, and the chapter presents a theory based on two explanatory variables—intrinsic audience interest and societal significance. The theory can be illustrated through examples from the previous chapters. On many issues, reporters seek interviews for balance, controversy, or to have both sides of an issue telling their story. In such cases, the story may already be "in the can," as indicated in the following episode. John E. Swearingen, chairman of Amoco, Inc. (now part of British Petroleum), described his interview with a major television network on the issue of natural gas price regulation: “That interview lasted for about an hour and forty minutes. … she was working from a prepared script, hoping to goad me into giving her a few outrageous answers that would fit into that script. The show, in other words, was already in the can…. What is required for television is the quick, easy answer, the scene that stirs people

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up, the emotional hook which will cause the ratings to jump. And, I suppose, from the point of view of the television producer, there could be nothing more deadly in the vicious ratings game than a long discussion of the facts and figures of an extremely complicated economic program.”26 This statement illustrates that television seeks short, easy to understand, and visual messages and that complexity and detail are difficult for it to handle. It also suggests that a substantial component of the business community is suspicious of the news media and views it as hostile. See also General Motors Like a Rock? (B).

One issue for discussion is whether the news media is biased or just sufficiently inaccurate that its stories (particularly in the case of television) appear biased to those who are knowledgeable about the subject. The incidents of fabrication, at least those that are detected, are sufficiently common to call into question the review processes of the news media. The incidents also indicate the strong desire among some journalists to have their work published or broadcast. The incidents also indicate that journalism ethics and the law are not sufficient to prevent serious violations of standards.

The General Motors Like a Rock? (A) chapter case and the General Motors Like A Rock? (B) case in this manual deal with a faked media story and a courageous, and ultimately successful, strategy of GM for managing its aftermath. The revelations of faked stories have become sufficiently common that suspicions about news coverage linger. Shortly before the November 2004 election CBS News aired on 60 Minutes a segment on President Bush’s National Guard record. The segment was quickly shown to be based on faked documents, and Dan Rather was forced to admit that the documents were false. An independent investigation commissioned by CBS lead to the firing of Mary Mapes, the producer of the segment, and three others. Dan Rather had earlier announced his retirement from CBS News and was spared disciplinary action. His role in the segment was widely derided, however. He was subsequently terminated by CBS. Some inaccurate or biased news stories can have more serious consequences. In May 2005 Newsweek reported that U.S. soldiers at Guantanamo Bay, Cuba, had desecrated a copy of the Koran. Riots and anti-American demonstrations broke out in Afghanistan, Iraq, Pakistan, and elsewhere and cost the lives of several demonstrators. Newsweek shortly thereafter acknowledged that there were “inaccuracies” in the story, and under continued pressure admitted that the inaccuracies were sufficiently serious that it decided to retract the story. Newsweek admitted that its sole source had backed away from the information he had provided. Newsweek editor Mark Whitaker, who the day after the retraction was scheduled to speak at Stanford University on the changing environment of the news media, cancelled his trip.

As an example of the courts reducing a libel damages award, a jury had awarded $222.7 million in damages to MMAR Group Inc. as a result of an article in The Wall Street Journal. The amount exceeded Dow Jones’ annual profit. The judge lowered the damages to $22.7 million. (In 1999 the judge ordered the case retried because of the possibility that the plaintiff had misclassified evidence that the defendant could have used in its defense.)

26

Swearingen, John E. "Responsibility in Journalism: A Business Perspective."The In Responsibilities of Journalism.

See Schumuhl (1984), pp. 100-1.

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Comments of the Procter & Gamble and Neighbor to Neighbor Example: This example examines the interactions between a firm and a media organization in the context of an interest group attempting to use the media as part of its political strategy. The central issue is whether an advertiser should attempt to discipline a broadcaster. This following discussion looks at the issue from the perspective of Proctor & Gamble and assesses its strategy alternatives.

Although the claim that purchases of Salvadoran coffee contributed to deaths in El Salvador may have some degree of truth, the link, if it existed, was likely to be quite indirect. Whatever the link, Neighbor to Neighbor had a political agenda, and its advertisements were one component of its political strategy.

The basic alternatives available to Procter & Gamble were to fight Neighbor to Neighbor or to make concessions. Concessions might be made either because Neighbor to Neighbor’s allegation was true or because the pressure was harmful. Procter & Gamble could fight because of principle; i.e., Neighbor to Neighbor was wrong, and/or because it wished to establish a reputation for not making concessions to pressure groups. The advertisements probably had little impact on Folgers’ sales, so concessions might not be required. Furthermore, Procter & Gamble could in all likelihood use its advertising power to reduce the probability that other stations or newspapers would publish the advertisement. The broadcast by WHDH-TV may also have been idiosyncratic to its management, since all the other (except one) stations rejected the advertising. This suggests that Procter & Gamble could uphold a principle without bearing a significant cost. Procter & Gamble could, and should at a minimum complain directly to the management of WHDH-TV. If Procter & Gamble chose to fight, a defamation suit was probably not a realistic alternative.

Winning was not likely, and a lawsuit would be costly. It would also add publicity to the issue if and when it went to trial. Withdrawing advertising involved some cost, since some sales would be lost, but a withdrawal would establish a reputation for not tolerating irresponsible actions by media organizations. (The withdrawn advertising dollars could always be shifted to some other Boston television station, so the loss in sales may not be significant.) Withdrawing its advertisements would result in some news coverage in the Boston area and in some national newspapers, but coverage would not likely last very long because of low audience interest. The other potential cost was that activists could be motivated by the withdrawal and might step up their attacks.

Whether a withdrawal of advertising would amount to an attempt to manage the content of the media depends on one’s point of view. It is useful, however, to note that a withdrawal would not be because of news coverage or an editorial but rather would be due to a paid advertisement by an interest group. A withdrawal would be an explicit use of economic power, but that is surely within the rights of Procter & Gamble.

On the anniversary of the murder of the six Jesuit priests in El Salvador, Neighbor to Neighbor launched another attack and called for additional support of its boycott of Folgers coffee. WHDHTV broadcast a news story on the issue featuring Mayor Flynn of Boston pledging that his city was joining the boycott. A sound bite from an interview with a boycott leader was also included in the story along with a P&G statement, read by the correspondent, to the effect that everyone was entitled to his own opinion.

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The issue resurfaced in April 1991, when 10 Boston clerics, including priests, nuns, a Protestant minister, and a rabbi, conducted a vigil to force WHDH-TV to release the final version of the Armstrong report. Father Jack Seery stated, “‘ years have passed and 75,000 murders have occurred since they killed Romero, largely because the American people are kept in the dark.’”27 Armstrong’s report was said to conclude that the coffee industry was behind many of the death squad killings. “Don Tassone, a spokesman for Proctor & Gamble, yesterday said that the draft of the report was filled with ‘false and misleading information’ about Folgers, which he said buys less than 2 percent of its coffee from El Salvador and does not have ‘operations on the ground’ in that country. ‘I know of no evidence from any reliable source linking our coffee purchases to violence in El Salvador,’ he said.”28 WHDH-TV stated that the final report was a matter between P&G and itself.

Some restaurant and food-service customers expressed concern over the boycott and asked P&G if it could supply its Maryland brand coffee in a flaked grind which yields more cups per pound than does regular grind. Folgers is available in flaked grind but contains Salvadoran coffee, whereas some Maryland blends do not use Salvadoran beans but do not come in flaked grind. In response to customer inquiries, a P&G sales manager, Richard L. Francis, wrote customers that P&G was developing a Folgers blend without Salvadoran beans.29 The boycott had led Pizzeria Uno to drop Folgers coffee, and other chains were under pressure. Francis wrote PepsiCo, whose fast food restaurants used Folgers, and PepsiCo planned to test the new blend. According to Tom Pirko of BevMark Inc., a consulting firm, “‘P&G wants to pacify a small segment, but the company doesn’t want the public mainstream to get the impression that it’s being bought by left-of-center consumer groups.’”30 On the same day The Wall Street Journal carried a story about P&G’s plan to develop the new coffee blend, the Farabundo Marti National Liberation Front announced that in light of the progress being made in peace talks it would cease fighting in El Salvador. The U.S. Department of State had urged P&G to continue buying Salvadoran beans while United Nations peace talks to end the war in El Salvador were continuing.

The day after The Wall Street Journal reported that P&G would develop a Folgers blend without Salvadoran beans, P&G Chairman Edwin L. Artzt stated "our company will continue to use Salvadoran coffee beans in all our coffees whenever appropriate for blend-quality reasons…

Simply put, we are not going to produce ‘boycott coffee’ for anybody.”31 Mr. Artzt had been a consistent opponent of the boycott.32 As a result of a peace accord between the government and rebels in El Salvador, in March 1992, the boycott was called off. According to a report in The Wall Street Journal, “Neighbor to Neighbor said it now gives credit to P&G for efforts to ‘aid in the reconstruction’ of El Salvador.”33 27

New York Times, April 16,1991.

Boston Globe, April 16, 1991.

29 Wall Street Journal, November 18, 1991.

30 Wall Street Journal, November 15, 1991.

31 Wall Street Journal, November 18, 1991.

32 Mr. Artzt’s management style is described in an article Business in Week, February 3, 1992.

33 Wall Street Journal, March 23, 1992, p. B3A. 28

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Cases

General Motors Like a Rock (A) PowerPoints are available for this case.

This case presents a specific nonmarket issue that can be analyzed using the frameworks presented in the chapter. It illustrates the interaction between the market and nonmarket environments, indicates that managers are at the center of such issues, and serves as a focus for managerial decision-making.

General Motors provided a videotape of the Harry Pearce press conference with retractions by NBC and acceptances by GM. Also available from GM were two videotapes of Michelle Gillen’s interviews with a GM engineer and an attorney representing GM in the Moseley case. The contact was: Mr. Ed Lechtzin, Director of Legal and Safety Issues, GM Communications Staff, New Center One Building--7305, 3031 West Grand Boulevard, Detroit MI, 48202. A segment on the GM pickup trucks was broadcast on the McNeil-Lehrer Report, November 30, 1993.

The issue has three components: 1) the dispute over the safety of the pickup trucks, 2) the Dateline program, and 3) the public’s perspective on this affair. The issue that underlies all of these is safety.

With respect to the Dateline segment, it is clear (from the information presented in the case and subsequent disclosures) that NBC had fabricated the explosion and fire. GM concluded that this was the case, and management was incensed by NBC’s false presentation. One alternative was to do nothing, and that was what some media advisors frequently advocate; i.e., get the issue out of the public’s eye. In this case, however, GM should address the issue directly. In addition to the recent court judgment against GM, politicians and regulators might become more active on this issue. It is unlikely to go away, and activists would work to make sure that it does not. Indeed, the Center for Auto Safety planned a news conference in a few days.

A major decision for GM was whether to take this issue to the public or to deal with it behind the scenes. At some risk, GM decided that the right thing to do was to present its information to the public.

Another alternative was for GM to file a defamation suit against NBC News, which GM did. In this case, GM had quite a good opportunity to win, since it is clear that NBC fabricated the fire, falsely reported the events, and knew it was doing so.

The case discussion can be strengthened by drawing on the section on liability in Chapter 12. In the case of the GM pickups, NHTSA accident data indicated that for a year of driving the odds of dying in an accident in a GM pickup with exterior mounted gasoline tanks are one in 6,605, whereas the odds of dying in a Ford heavy pickup are 1 in 6,916 and for a Dodge the odds are 1 in

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8,606. For a Nissan light pickup the odds are 1 in 4,521. Heavy pickup trucks were considerably “safer” than passenger cars.34 One concern with the NHTSA accident records was that they do not control for how the vehicles were used, which could affect the frequency with which they were involved in accidents. A more informative approach would be to examine how safely the vehicle protects the passengers in an accident. Data from a study of fatal and major injury accidents indicated that per 1000 collisions GM C/K pickups had a lower rate of fatal and major injuries than did either the Ford F-Series pickup or the Dodge D/W Series Pickup. The frequencies are: GM 33.82, Ford 34.30, Dodge 35.21. For side impact collisions the frequencies of fatal or major injury were: GM 23.03, Ford 23.59, and Dodge 25.53. No statistical test, however, was likely to show that GM pickups were less safe than Ford or Dodge pickups. Newsweek titled the article cited in the previous footnote, “Just as Safe at Any Speed.”

Regardless of these data, safety activists argued that the GM pickups should be recalled. Their viewpoint was that if a hazard can be eliminated then it should be eliminated. NHTSA asked GM to voluntarily recall the C/K pickups, and it refused to do so. Secretary of Transportation Pena then announced a mandatory recall of the GM C/K pickups, and GM filed a lawsuit challenging the basis for that action. The Secretary quickly backed down, and GM and the Department of Transportation reached an accord settling the issue without a recall and with terms judged by observers to be quite favorable to GM. The discussion of this case may be structured by asking the following series of questions in addition to the Preparation Questions at the end of the case.

Discussion Questions: 1. What is the specific issue underlying the broadcast?

2. What were its origins?

3. Where is the issue in its life cycle?

4. Which interests are active on this issue? Which forces are moving this issue through its life cycle?

5. Which institutions will address this issue? Is this issue likely to be of renewed interest to members of Congress and federal regulators in NHTSA and the Department of Transportation?

6. What role does information play in the development of this issue?

7. What are the ethics dimensions of this issue?

8. Who in GM is responsible for deciding what to do about the Dateline story? (Answer: top management.) How should management interact with staff specialists; e.g., the general counsel?

9. Should GM pursue the Dateline story with NBC directly, in the courts, or in the court of public opinion, etc.? How should it implement its decision?

10. Suppose NHTSA asks GM to voluntarily recall the pickups. Should it do so?

11. Suppose NHTSA issues a formal recall order. Should GM contest it in the courts if it believes its pickups are at least as safe as those of other automakers?

34

Newsweek, May 10, 1993.

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The following is an assignment for a group presentation on the case. In the absence of a group assignment, the questions can be used to focus on the NBC Dateline story.

Group Assignment Assume that you work directly for the Vice President who heads GM’s light truck division. Form a nonmarket strategy for GM that is sensitive to media and collective action concerns. Address the following specific questions: * Should GM file a defamation lawsuit? If so, why, and what else should it do? If not, why not, and what should it do instead? * Should GM withdraw its advertising from NBC? If so, which portions? News only? * What direct contact with NBC, if any, does your strategy entail? Identify the range of NBC’s responses and specify contingency plans. * What sorts of communication with its employees should GM undertake? * What policy should GM adopt if NHTSA responds to the CAS petition for a recall? Should GM cooperate or fight? * Should GM try to meet with Ditlow of the CAS prior to his news conference?

The following (B) case provides an update.

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General Motors Like a Rock? (B) Challenges to the safety of GM’s trucks prompted the company to form a self-described "swat team" to address the emerging issue in a way that eliminated the rigid bureaucratic boundaries that often form in large businesses. The team included two public relations specialists, three attorneys, and two engineers.35 NBC asked GM for an interview two weeks prior to, and with no advance notification about, the “unscientific tests” to be conducted in rural Indiana. GM had a tradition of not going on camera if the interview might be edited, but William J. O’Neill Jr., GM’s public affairs director for North American operations and a member of the swat team, convinced GM management that its policy was outdated. O’Neill’s main argument was that the program would be far more destructive were GM to decline participation.

In advance of the first NBC contact, articles had begun to appear in various publications about alleged safety problems. Many of these were traceable to the Center for Auto Safety, which had asked the National Highway Traffic Safety Administration (NHTSA) to investigate. Although GM consented to go on camera for NBC, GM insisted first on replying to a NHTSA request for information on its trucks. To GM, the issue should be the overall comparative safety of its trucks and this, in turn, had a governmental regulatory component as well as public relations and media components. GM seems to have anticipated questions from NBC on regulatory compliance, so it wanted to make sure its answers were truthful and non-damaging.

GM proposed three conditions for the interview with NBC. First, the interview had to be with an engineer and lawyer together. Second, Mr. Read (the Dateline producer) and Ms. Gillen (the reporter) had to spend several hours with GM officials before the interview to run through the material so they understood GM’s views. Third, GM was to be allowed to tape NBC taping GM. According to Edward S. Lechtzin, director of legal and safety issues for the GM communications staff, the third condition “almost scrubbed the project.”36 O’Neill and Lechtzin met with Read and Gillen for two hours on November 12, 1992, to go over the ground rules for the interview. Read and Gillen reiterated NBC’s opposition to interviewing a lawyer and engineer together, but GM stood firm given its expectation that some questions would be of a legal nature and pertain to upcoming product-liability litigation. Eventually, the parties consented to proceed as GM wished.

The interview session was described by Lechtzin as follows: It was no interview session. It was a medieval inquisition with modern torture devices: hot lights and the unblinking TV eye. Of the four hours under the hot lights, about three 35

One of the public relations specialists was Edward S. Lechtzin, author of “One Year After the Infamous Dateline NBC Test-Crash Show, GM Executive Tells How Automaker ‘swatted’ back,” TJFR Business News Reporter, December 1993. Lechtzin’s article was helpful in the preparation of this case, but as such raises the possibility that the case itself is in part an outcome of GM’s strategy. The case should be read accordingly, though it attempts to be neutral and objective.

36 TJFR Business News Reporter, December 1993, pp. 4-5.

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hours were taped. We could have been out of there in less than five minutes if we had just answered two repeatedly asked questions the way they wanted. The questions were “How many people have you knowingly killed?” and “You knew that you put a defective product into the marketplace. Why haven’t you changed it?” That’s all we had to do, answer those two questions they wanted so they would have a good sound bite and we would have been out of there. We had two magnificent people on camera and would put them up against any interviewer.37 Near the end of four hours, in spite of the incessant repetition of the key questions in varying disguises, Mr. Read didn’t have the sound bites he wanted and was literally screaming questions for Ms. Gillen to ask. That’s when we decided we’d had enough and said, “No more!” Print journalists who have viewed the entire interview tape have asked why we didn’t walk sooner. They know they wouldn’t have been given that amount of time with that approach.38 The GM team watched the Dateline show together when it aired in November. Of the three hours of interview tape one minute was used on Dateline. Concluding that the coverage was unfair, a GM lawyer, Mr. William Kemp Jr., proposed immediately that a letter be sent to Mr. Read of NBC. Many of the ensuing communications are described in the case, General Motors Like a Rock? (A).

Approximately two months elapsed before knowledge of the more incendiary details of NBC’s journalism reached the very top level of GM management. GM’s president, John F. Smith Jr., first heard of the rockets at President Clinton’s inaugural ball in January when O’Neill pulled him aside.

Smith’s first reaction was “You’re kidding me.” His second reaction was, “Don’t overplay it, but do what’s right.” It remained the task of the small, flexibly organized swat team to form and implement a specific strategy consistent with Smith’s general advice.

As GM’s investigations progressed, the team repeatedly asked two questions: “Do we have enough information?” and “Are we doing the right thing?” By early February the practical answers to these questions were “yes.” Timing played a crucial role in the implementation of GM’s nonmarket strategy. The rock and the hard place between which GM was caught were the announcement of the Moseley verdict at the end of the first week of February 1993 and the anticipated collective action the following week by the Center for Auto Safety (CAS). The Moseley verdict and the media attention it generated formed an ideal news hook on which the CAS could hang its less-thandelicately dubbed crusade, “Campaign GM Firebombs.” GM’s timing objective was to preempt media-facilitated collective action in the regulatory arena by going on the offensive against NBC. The kickoff event was a GM press conference at 1:00 p.m. on Monday February 8. By holding a conference in which the bulk of GM’s findings would be made public, the swat team realized that it ran a high risk of media organizations “circling their wagons” to protect their own. The bold prediction, however, was that GM could show that NBC had been so clearly irresponsible in its coverage that other media would be reluctant to come to NBC’s defense. To the extent that any self-criticism within media would arise, GM stood to benefit at the margin from more balanced coverage after GM exposed the unknown facts about NBC’s coverage. More balanced coverage, in turn, would be helpful if and when interest groups such as the CAS persisted in their efforts to propel the pickup recall issue into public view.

37 38

Both were GM executives. Their names are not given.

TJFR Business News Reporter, December 1993, p.5.

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GM’s spokesperson at the press conference was Harry Pearce, executive vice president and general counsel. (Years earlier Pearce successfully litigated a GM-NHTSA dispute regarding the proposed recall of GM’s X-cars with allegedly defective breaks.) For two hours and seven minutes, he addressed 150 print media journalists and 25 camera crews. The conference was broadcast over closed circuit TV to GM dealers and major suppliers across the nation. Also watching were NBC executives in Rockefeller Center in New York. Pearce presented a well-orchestrated sequence of exhibits, video footage, and photographs, making frequent references to the recovered trucks that were on display for reporters’ inspection. Part of the conference gave an account of GM’s communications with NBC, part of it described GM’s persistent efforts to recover evidence about the NBC tests, and a great deal of it focused on the issue of overall comparative truck safety, as opposed to safety only in side-impact crashes in which a fire occurred. On the whole the audience seemed attentive and receptive.39 GM spent about $90 million in advertising on all NBC programs through the first three quarters of 1992, so withdrawing all of its advertising from NBC would be significant. Instead, the strategy adopted was to temporarily shift advertising from NBC news programs to NBC entertainment and sports programming. The explanation offered by GM for this decision provides clues about the depth of principles underlying the advertising strategy. O’Neill said that GM did not pull its advertising from NBC’s entertainment or sports programs because this advertising was a good value.40 Another component of GM’s strategy was to file a defamation suit against NBC, the first ever by GM. This was announced early in Pearce’s conference but downplayed thereafter. Considerable action occurred behind the scenes, however. In the aftermath of the press conference, which was covered extensively by major newspapers, GM set its sights on prime time television on Tuesday evening, February 8. Negotiations began between Pearce and NBC executives regarding a Dateline retraction. GM considered itself in a strong position after the press conference and its coverage by other media, but as Dateline began its broadcast on Tuesday, no agreement had been reached.

Within the hour, however, the eye of the media blinked: NBC agreed to broadcast a retraction. The final agreement on wording was reached only five minutes before hosts Jane Pauley and Stone Philips began reading it. The retraction itself lasted 3.5 minutes, which commentators later called an eternity by TV standards.41 Following NBC’s retraction, Harry Pearce also made an announcement: “In view of NBC’s announcement, and because it is our business to design and manufacture great cars and trucks and not to be preoccupied with litigation, we are tomorrow dismissing the defamation suit that we brought Monday. NBC will reimburse General Motors for its actual costs of this investigation.”42

39

Lechtzin described the journalists at the conference as “mesmerized.” Although this may be an overstatement, GM’s satisfaction with Pearce’s performance is reflected by the willingness with which the company provides a free copy of the videotape to those who request it.

40 New York Times, February 11, 1993.

41 GM also appended a video copy of the retraction to its press conference tape.

42 General Motors press release, February 9, 1993. Elsewhere it was reported that GM incurred approximately $2,000,000 in expenses. NBC’s crash tests, in contrast, were estimated to have cost $4,200

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The ripple effects of the GM-NBC confrontation on collective action and regulation are difficult to measure, but at least some evidence suggests that the consequences were favorable to GM. First, although the Center for Auto Safety held its press conference on February 9 as planned, the conference received significantly less coverage than NBC’s extraordinary retraction. Second, although the issue of recalling pickups did not go away entirely, subsequent media treatment of recall efforts usually summarized the main “overall safety” arguments GM had made to counter NBC’s imagery.43 44 Finally, communications from GM management to GM employees were extensive during the crisis period. The consensus within the company was that GM’s strategy and its implementation provided a significant boost in company morale.

Postscript: NBC Morale at NBC was a different story. It dropped precipitously. “Many people at the network felt that [the Dateline incident] was a result of NBC’s ratings-at-whatever-cost atmosphere. Matters weren’t helped when Mr. Wright, NBC’s president, told employees [in March] that the problem . . . wasn’t so much that it happened, but that NBC got caught.”45 A more critical assessment originated with NBC’s hiring of an outside firm to investigate the Dateline news division. The firm issued a report that highlighted several major “lapses” within the division overall.46 Meanwhile, the ruminations and fates of individual NBC employees were mixed.

• Robert Read (producer of “Waiting to Explode?”) stated at one point that he was “happy that NBC’s report vindicates the fundamental honesty of the GM segment. There was absolutely no intention to deceive.”47 This was not a consensus opinion. Read was fired.

• David Rummel (Dateline senior producer) and Jeff Diamond (Dateline executive producer) resigned from NBC. They went to work for ABC’s news magazine 20/20.

• Michael Gartner (NBC News president) also resigned but claimed that he had wanted to go back to Iowa with his family anyway. He ran the Ames Daily Tribune.

• Michele Gillen (NBC reporter) mounted a behind the scenes campaign within NBC to acquit herself, claiming to have objected to the segment. She was reassigned to NBC’s Miami affiliate as an anchor.

• Three other NBC employees were criticized in the commissioned report but not reprimanded.

43

In November 1994 GM announced a voluntary recall on pickups for fire hazards, albeit on its newer pickups that no longer use sidesaddle tanks ( New York Times, November 22, 1994). Also in November, the MacNeil/Lehrer Newshour ran a segment on attempts to recall the older trucks. Relative to Dateline a year earlier, the segment was balanced. For example, considerable airtime was given to a professor of the Yale Law School who specializes in regulatory issues and who described and quantified the often-overlooked costs as well as benefits associated with recalls. But the segment had a more conventional news-magazine controversy-seeking component as well. Clarence Ditlow of the CAS was interviewed as were safety advocates who had picketed various GM dealerships. When asked whether dealers had been responsive to their concerns, one protester told an interviewer that, yes, dealers were responsive in a way: they responded by piping music through their loudspeakers on the car lot. The music played was “Light my fire.”

44 The article in Newsweek, May 10, 1994, is representative.

45 Wall Street Journal, March 2, 1993.

46 GM provides a copy of NBC’s commissioned study in its information packet.

47 New York Times, March 23, 1993.

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• Jane Pauley (Dateline co-anchor) tried to boost morale at NBC at a major staff meeting after the retraction. Members at the meeting said “Ms. Pauley had delivered a pep talk in which she said she took a ‘perverse sense of pride’ in acknowledging the mistake. She also emphasized that both she and her husband, the cartoonist Garry Trudeau, found Tuesday night’s edition of the program, which included investigative reports on the insurance fraud and tainted meat, one of the best segments the program has ever done.”48 In its retraction on Dateline Jane Pauley and Stone Phillips acknowledged that NBC knew that incendiary devices had been put under the trucks and that the fire occurred because in the crash gasoline was forced out of the filler tube because the fuel cap did not fit the tube. NBC did not dispute GM’s conclusion that there was no puncture in the gas tanks and that the impacts were at speeds significantly higher than stated in the broadcast. NBC concluded by announcing a new policy. “We have also concluded that unscientific demonstrations should have no place in hard news stories at NBC. That’s our new policy.”

GM had settled a class action lawsuit by 650,000 Texas owners of the pickup trucks by agreeing to provide $1,000 discounts to owners on the purchase of a new GM pickup truck. A Texas appeals court, however, threw out the settlement on the grounds that the value of the coupons was low, since most people would not choose to purchase a new GM pickup truck.

In April 1995, the federal Court of Appeals rejected the settlement of a lawsuit in federal court that provided $1,000 coupons to all owners of GM pickup trucks with sidesaddle gas tanks. The appeal had been made by the Center for Auto Safety. The Court of Appeals ruled that the coupons had little real value and were a “sophisticated marketing program.”

This case was prepared by Professor Keith Krehbiel for class use. Copyright ©1994 by the Board of Trustees of the Leland Stanford Jr. University. All rights reserved. Reprinted with permission.

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, February 11, 1993.

New York Times

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Illinois Power Company (A) A revealing videotape had been made available from the company to accompany this case. The videotape was entitled "Illinois Power: Our Story" and had been available from Barbara Barnett, Illinois Power Co., 500 South 27th Street, Decatur, Illinois 62525. The videotape, however, is no longer available as a result of the acquisition of Illinois Power by Dynergy.

This case provides the opportunity to study a media story and a firm’s response to it. This is best accomplished using the videotape prepared by Illinois Power if it is available. That videotape intersperses the company’s response into the 60 Minutes segment. This provides considerable insight into how a program such as 60 Minutes is constructed and its accuracy and fairness. In one sense, Illinois Power’s response is a devastating critique of the accuracy of the segment and of its fairness. (This is not to say that Illinois Power did not strategically present its own version of the truth.) The bottom line of the 60 Minutes segment — that Illinois Power was experiencing a substantial cost overrun on the construction of its Clinton nuclear power plant and that the job was much more complex than the company or its contractor had understood — was correct.

The videotape shows how 60 Minutes constructed its story, how it used and emphasized visual effects, how it built conflict and controversy into the segment, and how it stretched the facts to make the segment more “entertaining.” The videotape also shows how poorly Illinois Power handled Harry Reasoner and the producer during their visit to Illinois Power’s facility. Illinois Power made mistakes of two types. The first was that it failed to present effectively its side of the issue. For example, Mr. Gerstner read a table of data on cost overruns of other nuclear power plants under construction to show that the Clinton plant was not out of line with those plants. The piece was not included in the 60 Minutes segment because it was long and dull. Had Mr. Gerstner had graphics (e.g., a bar chart) to show Mr. Reasoner, that information might have been included.

As another example, the interview with Mr. Gerstner was in his office and the setting was cold and made him seem unsympathetic. He sat behind a desk with closed Venetian blinds behind him. In contrast, the conversation with Illinois Power’s “sharpest critic” was set in his living room before a window through which trees could be seen swaying gently in the breeze. In addition, Mr. Reasoner asked (possibly rehearsed) questions intended to portray the critic in a sympathetic manner.

Another concern about the 60 Minutes segment is that it provides no real comparison between the Clinton plant and other nuclear power plants under construction. (To the extent that this story was about the nuclear power industry and Illinois Power was only a representative illustration, perhaps this is understandable, but the story was also about Illinois Power and its management.) The producer had asked a prominent economist, an expert on the nuclear power industry, for an interview. The economist agreed to the interview but said he would not be filmed. 60 Minutes was not interested. (The economist had refused to be filmed because he knew that at most the producer would extract 15 seconds from an hour interview and that the extract was likely to be a one-liner that could never capture the complex reality of nuclear power plant construction costs.) Indeed, the 60 Minutes segment contained no interviews with experts or government officials. It also provided no data. Because of this, the segment provided no new information to regulators or to politicians.

It, however, worsened the political climate for nuclear power and provided encouragement to the activists opposing nuclear power on the grounds of safety. The segment provided an opportunity to attack nuclear power on cost as well as safety grounds.

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The messages contained in the 60 Minutes segment were many. For example, the interviews with fired and disgruntled employees conveyed the impression that Illinois Power was unfair to its employees.

One of the principal steps Illinois Power should take is to communicate with its stakeholders in an attempt to assure them that management was on top of the situation.

Teaching the case: Depending on the length of the class session, between 15 and 20 minutes of the videotape might be shown. It is useful to begin by reminding the class that the company is a medium-sized power company that largely serves rural areas in Illinois. Its territory does not include Chicago or its suburbs. It is headquartered in a small town.

The discussion can be guided with the following questions: 1. What messages did the viewers receive from the 60 Minutes segment?

2. Why was the story newsworthy? That is, what was its societal significance? (The story is actually about the nuclear power industry, and 60 Minutes used Illinois Power as an illustration.)

Why was there audience interest?

3. What were CBS’s objectives in presenting this segment?

4. How did 60 Minutes treat the issues and present the story? Was the presentation fair, accurate, and balanced?

5. What problems does the 60 Minutes story create for Illinois Power?

6. Should Illinois Power have met with 60 Minutes in the first place? Would refusing to do so have caused 60 Minutes to abandon the story or to have featured some other company?

7. Did Mr. Gerstner effectively handle the interviews with Harry Reasoner and the producer? What might he have done that would have been more effective?

8. What actions should Illinois Power take in response to the broadcast? Should it file a lawsuit?

The following (B) case can be used to continue the discussion.

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Illinois Power Company (B) Illinois Power Company executives, meeting on Monday, November 26, 1979, decided to produce a videotape rebuttal to the 60 Minutes segment which had appeared the night before criticizing Illinois Power for mismanagement of its Clinton Nuclear Plant construction.

The rebuttal videotape, which was produced by interspersing the 60 Minutes film with company commentary and excerpts from the company’s tapes of the complete interviews conducted by 60 Minutes, was ready by the following Sunday, December 1.

The company immediately began showing the videotape to all its own employees and, at its public offices, to customers and other interested individuals.

Illinois Power also decided to send a letter to its stockholders explaining the controversy and pointing out the errors in the 60 Minutes program.

The Company decided not to sue CBS for damages. While legal counsel advised them they “probably” would win, such a suit might take 6 to 8 years, considerable management time, and might, in the end, secure damages no more than the legal fees. Similarly, seeking “equal time” through the Federal Communications Commission was evaluated as a long, expensive process with some chance of success but little payoff. Company officials feared the “equal time” might turn out to be early Sunday morning.

Illinois Power did send a copy of its tape to the National News Council, which was willing to consider the case but requested a standard waiver from Illinois Power that the company give up its right to later pursue the issue through the courts or before the FCC. Uncertain of its own plans, the company withdrew its case before the National News Council.

Illinois Power also sent a copy of the videotape rebuttal to CBS and received a reply from the news division in late January. In part, the reply indicated some errors would be corrected on the January 27, 1980, 60 Minutes program. However, the reply defended most of the statements and charges to which Illinois Power had objected.

The corporate community in Illinois and nationally seemed impressed by the aggressiveness with which Illinois Power responded to 60 Minutes. Many other companies, apparently feeling they, too, often had been “victims” of television reporting, requested copies of the videotape rebuttal.

Within a year, 2300 copies of the videotape were circulating amongst other companies in the United States and abroad. Some were being used in schools.

SOURCE: This case was prepared by Kirk O. Hanson, Senior Lecturer in Business Administration, from publicly available sources as a basis for class discussion rather than to illustrate the effective or ineffective handling of an administrative situation. Copyright © 1981 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reprinted by permission.

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Illinois Power Company (B): The outcome: The Illinois Power videotape was not made for broadcast because television stations generally will not broadcast such statements. The videotape was shown in Illinois Power’s local offices and to employees in an attempt to counter the impressions left by the segment. Its purpose was to show that it had not been unfair to its employees, its management was responsible, and costs were under control. The last of these three clearly turned out to be wrong.

On December 5, 1980, one year after the original CBS report on the Clinton facility, Illinois Power announced a new construction schedule and cost estimate for its Clinton Nuclear Power plant. The new schedule estimated the date for fuel loading as January 1983, nine months later than the previous estimate. The new cost estimate was $1.7 billion, $345 million more than the previous estimate. The company stated that new design requirements in the wake of the Three Mile Island accident made the delays necessary. The company further stated that 26% of the cost increase was due to materials cost increases during the delay, 29% due to financing costs for the entire facility made necessary by the delay, 19% for new equipment necessary to comply with new regulations, and 26% due to design changes and underestimating by the company.

On Sunday, December 14, 1980, 60 Minutes aired an update on the Clinton story of one year earlier. The update featured the delays in completion of the plant and the increases in costs.

After Illinois Power produced and distributed its videotape reply, the Edison Electric Institute awarded Illinois Power its highest honor for “distinguished service to the electric utility industry.”

The award was given, “For foresight in anticipating and preparing for a potentially misleading television broadcast and for innovation in communicating with the public; for leadership and courage in demonstrating the gross inaccuracies and distortions of fact by the electronic media can be effectively countered; and for presenting a valuable case study to the electric utility industry, the media, and the nation at large of the vital importance to the public interest of responsible journalism.”

By December 1991, the estimated cost had increased to $1.8 billion, and by 1982 the estimate was $2.17 billion. In 1982 the NRC fined Illinois Power $90,000 for inadequate quality assurance programs. (Many utilities were similarly fined.) Two electric cooperatives were partners of Illinois Power in the Clinton plant, and under pressure in March 1984 Illinois Power agreed to limit their share of the cost to $450 million. The final cost of the plant was $3.8 billion. The Illinois Commerce Commission made a variety of rulings during this period regarding the amount of the Clinton costs that could be added to the rate base. The result was that in 1989 Illinois Power had to write off $346 million in its Clinton plant and suspend its dividends on common and preferred stock. After four new members joined the Commission in 1990 and changed its strong proconsumer orientation, Illinois Power received a rate increase and resumed paying dividends.

In August 1992, the Illinois Commerce Commission reversed an earlier decision and ruled that Illinois Power was not entitled to recover $202 million of post-construction costs. In late 1991 the company had resumed paying a dividend, and it was expected to have to discontinue its dividend law since its retained earnings would be negative. Illinois law prohibits the company paying a

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dividend on either common or preferred stock in that event. Its share price fell nearly 25% when the decision was announced. The experience with the Clinton plant confirmed the bottom line of the 60 Minutes program, but the evidence 60 Minutes provided in its segment was highly questionable, as the videotape makes clear. While the sloppiness and possible bias in the 60 Minutes segment is inexcusable, it is evident that the nuclear power industry as a whole, and Illinois Power in particular, experienced dramatic increases in construction costs on nuclear power plants. Some of those costs were due to exogenous factors, but some was also due to inadequate management of projects that were considerably more complex than had been anticipated.

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Chapter 4

Private Politics This chapter introduces the concept of private politics and distinguishes it from public politics, which is the focus of Part II of the book. The private and public politics terminology is maintained throughout the book. Private politics is typically initiated by NGOs and activist organizations, but as the National Audubon Society example below indicates, it can also be used by business interests.

The participants in private politics are viewed as strategic, in the same sense that a firm chooses market and nonmarket strategies to improve its performance. Private politics is also viewed as competition, and that competition often centers around a campaign. The two Rainforest Action Network cases reflect this perspective.

In addition to characterizing the NGO/activist component of the nonmarket environment and highlighting actions that take place outside of public institutions, the chapter also addresses approaches for dealing with activists and their campaigns. Activists are important for the variety of reasons indicated in the chapter and especially because they play a central role in identifying and shaping the development of nonmarket issues. Some activist groups, such as environmental interest groups, are members of informal networks of organizations that at times coordinate their actions.

Activist/NGO challenges to firms are intended to obtain changes in the practices of individual firms and their industries. In response to these challenges, some firms take proactive measures by changing their practices to avoid being targeted. This may be referred to as self-regulation.

Proactive self-regulation and corporate social responsibility do not mean that a firm will not be targeted, however, as Starbucks has learned. Firms that are targeted can fight a campaign or bargain with the activist to end it. When the firm changes its practices as a result of a campaign it is also exercising self-regulation, albeit forced self-regulation. In some cases, such as the Nike campaign considered in the chapter case Nike in Southeast Asia and in Chapter 23, an industry and the activists may engage in private regulation in which an organization, or private institution, is established to govern industry practices and compliance. The Fair Labor Association governs the conduct of participating footwear and apparel companies.

In Part II, an interest group is defined as a collection of individuals or organizations that benefit from the nonmarket actions of the group. That is, the interest group acts on behalf of its members, typically through public politics. Activists may also be acting in their own self-interest and in the interests of their members, but they generally claim that they are acting on behalf of others as well.

Some prefer to refer to themselves as advocates.

The susceptibility of a company to a challenge by activists depends on a variety of factors including the seriousness of the issue and on characteristics of the company itself and its policies. Figure 4-1 can be used to assess a company’s susceptibility and can be applied in both the Shell, Greenpeace, and Brent Spar and the Nike in Southeast Asia cases. A generic strategy used by activists is presented in Figure 4-2 and can be used to analyze the activist strategies in these two cases. The

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figure can also be used to summarize on the board the strategy being deployed against the company and its practices.

The chapter case The Anatomy of an Activist Campaign: Rainforest Action Network and Citigroup (A)(B) deals with a campaign and provides an opportunity to consider strategic responses by the target Citigroup. As indicated in the text, a companion case Strategic Activism: The Rainforest Action Network provides insight into an activist organization and its strategy.

The success of the strategies of activists depends importantly on their ability to attract the attention of the public and government officeholders to their cause. They may attempt to attract the media through the use of advocacy science and through networks. In addition, activists monitor firms and may call to the attention of the public actions of a firm to which they object. Activists may organize a boycott of a company. Activists also use their standing before public institutions to leverage their other actions, either when other aspects of their strategies fail or when an additional front can be opened to advance a cause.

Although some activists are successful, particularly when they are able to attract additional support, others have relatively weak organizations and are unable to sustain campaigns. In some cases, the cause of the activist may be wrong or misplaced, and the responsible action may be to oppose the demands. Some of the cases provide an opportunity to assess the demands of activists, their strength, and their cause.

The following is an example of private politics that could be used in a lecture. The National Audubon Society produced a television special “Ancient Forests: Rage Over Trees,” which was to be broadcast on the Turner Broadcasting System’s cable channel WTBS as part of its regular airing of the “World of Audubon” series. The special dealt with the logging of old growth forests in the Northwest, which has been the source of a long-standing conflict between environmentalists and loggers. The timber industry in the Northwest has been economically depressed for a number of years, and the long-term prospects have not been good, particularly since timber companies had concluded that the cost of harvesting timber in the South is lower than in the Northwest. Old growth stands of timber thus represented an important source of employment for loggers in the Northwest.

Although Peter A.A. Berle, president of the National Audubon Society, said that the program was “balanced,” he stated that “the script does have a pro-environment attitude.” To oppose the special, the loggers organized a boycott of the sponsors of the program, and their pressure caused the Stroh Brewing Company, the Exxon Corporation, the Michelin Group, Ford Motor Company, and Sears, Roebuck to withdraw their advertisements. The program was aired with only public service announcements. William N. Grannell, executive director of the Western States Public Land Coalition of Pueblo, Colorado, claimed some credit, “Our people got the word out and told Stroh’s beer that if they sponsored such a program, well, our members would not be so inclined to drink Stroh’s beer any longer. I’m just glad these companies became sensitive to our side of the issue.”49 Stroh’s had contributed $100,000 to the Audubon Society for its specials.

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CASES

Shell, Greenpeace, and Brent Spar PowerPoints are available for this case.

The Brent Spar episode had a dramatic impact on companies such as Shell and British Petroleum.

The episode indicated how easily and quickly a nonmarket issue within the jurisdiction of one country can spill over to other countries in which the company operates. The lesson particularly for global companies is that nonmarket issues, and particularly those that are being pursued by activists, can through modern telecommunications spread widely around the world. For more information on Brent Spar and the disposal of deep-sea platforms, consult Brent Spar’s web site www.shellexpro.brentspar.com and Greenpeace’s web site www.greenpeace.org.

From Greenpeace’s Perspective The case describes the events and the outcome, so the discussion here focuses on the teaching of the case. It is useful to begin the discussion from the perspective of Greenpeace, since this is a confrontation, or competition, between Greenpeace and Shell both in governmental institutional arenas and in the arena of public sentiment. That is, it is helpful to view the issue from the perspective of one’s adversary.

The first question is, “How does Greenpeace view the issue?” Greenpeace understands that the North Sea is a maturing oil province and that many of the deep-water platforms will be scheduled for disposal in the near future. Amoco has already prepared its BPEO for the NW Hutton platform, and Conoco was preparing its BPEO for the Heather field. Greenpeace understands that if it wins the first battle (Brent Spar) it will have won the war. Greenpeace is thus playing a repeated game against a series of platforms and the oil industry and has strong incentives to win this battle.

Indeed, Greenpeace organizes around “campaigns.” In contrast, Shell is focusing on the disposal of one platform—Brent Spar. Moreover, Shell views the Brent Spar as a unique facility because it is a storage buoy rather than an oil production platform.

The next question can be about Greenpeace’s objective. One obvious answer is that its objective is to protect the oceans. It commissioned a study that concluded that at sea disposal was a bad alternative. Another answer that students give is that it wants a high profile campaign that will give it publicity and help it raise contributions and obtain new members. Another answer is that it is seeking a bully pulpit from which it can espouse its views. A final possibility is that it seeks to be the leader in the international environmental movement.

The next question is “Who are these people?” The answer is that they are experienced professionals who do this type of campaigning on a full-time basis. For example, the head of communications for Greenpeace was a former BBC journalist.

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Next, “What are its capabilities?” Greenpeace has ships, a helicopter, and sophisticated telecommunications equipment. It is experienced at battles at sea and fully capable of placing its people on a storage buoy even when it was under tow to the disposal site.

Greenpeace’s strategy is to take its concerns about deep-sea disposal to the public and to governments and to do so it must attract media coverage. The theory of the media in Chapter 3 can be used to assess the likelihood that its Brent Spar actions will be covered and how they will be treated. Environmental issues attract an instant audience particularly in Northern Europe, so the audience interest is present. The issue of the deep-sea disposal of oil platforms is complex, so the news media may treat the issue fairly objectively. However, Greenpeace members will be given the opportunity to express their concerns about damage to the environment and to present their conclusions, so the treatment of the issue will serve Greenpeace’s objectives.

To fully characterize Greenpeace’s strategy, it is useful to draw Figure 4-2 listing the steps Greenpeace took to get its messages to the public and to government officials in Europe and worldwide. Attracting the media was central to its strategy, and to do so it positioned itself not only as a low-cost source of information but it also staged events to make the story more newsworthy and attractive to audiences. To reduce the cost to the media, Greenpeace not only broadcast from its ships and from the Brent Spar, but it also brought along journalists to film and view the events.

The events were attractive to television viewers and newsworthy. Greenpeace demonstrated courage and resolve, and small rubber dinghy’s bouncing on the high seas under chase from Shell’s boats made great footage for the television cameras The messages that Greenpeace conveyed were simple. It had studied the issue of the disposal of oil platforms and concluded that deep-sea disposal would harm the environment. Moreover, it was able to portray Shell as indifferent to the harm that its littering of the ocean bottom would cause.

Casting Shell’s plans as something that ordinary citizens were not allowed to do was quite effective. In contrast to some of Greenpeace’s other campaigns, the messages were simple and easy for substantial segments of the public to accept.

Shell was unable to convey effectively its side of the story. It had two natural disadvantages. First, its side of the story was complex and technical and not easily presented on television (although it was presented in newspapers). Moreover, a long discourse on the reasons for Shell’s choice would have been boring to most viewers. Second, deep-sea disposal was considerably less costly than were the alternatives, and skeptical journalists and audiences would naturally wonder if Shell had made its BPEO decision based on cost rather than environmental considerations.

Shell’s culture also limited its ability to respond to Greenpeace’s messages. Shell had traditionally been a quiet company and did not communicate directly with the public. In the Brent Spar episode a BBC executive told me that they had to “beg Shell to tell its side of the story.” She added, “When they told it, they told it clumsily.”

Shell’s response of shooting water cannons at Greenpeace’s helicopter not only created vivid visual images for television viewers, but it also created a story within the story. That is, it cast Shell as big business beating up on the little guys in their small helicopter and rubber boats. This also

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extended the story. Greenpeace’s call for a boycott of Shell products also extended the story and gave it a life of its own.

At this point it is useful to ask why the reaction in Germany was much stronger than in the United Kingdom and to present the answers in terms of Figure 3-2 and the audience interest and societal significance dimensions. One explanation is that the public is more environmentally sympathetic in Germany that in the UK, as evidence by the recycling required in Germany and its recent generous subsidies for solar and wind power. Moreover, Germany has a Green Party, which in 1998 joined in the government with the Social Democrats. Germans also are major contributors to Greenpeace’s budget. Importantly, Germany has no North Sea oil production, whereas the UK has substantial production. In Figure 3-2 Germany would be toward the upper right corner, whereas the UK would be located down and to the left. A follow-up question could be where Norway would be on these dimensions. The answer is that it likely would be further down and to the left, due to the importance of North Sea oil to its economy.

Greenpeace had been beset by an internal disagreement between the “rubber suits” and the technocrats. The rubber suit contingent wanted to dramatize what they viewed as egregious actions harmful to the environment. The technocrats preferred to participate in public processes to find creative solutions to environmental problems. In this case, the rubber suits prevailed.

Another question is whether Shell was particularly vulnerable to the type of actions taken by Greenpeace and whether it was vulnerable to a boycott, as indicated by the list in Figure 4-1. The answer is that it is highly vulnerable—less so in the United Kingdom and more so in Northern Europe. Shell is a company with a brand name, and consumers can easily switch to other brands.

Shell also has a reputation that can be damaged just as Exxon’s was as a result of the Exxon Valdez oil spill in Alaska. It also operates in an interest group-rich environment in Europe. As considered in more detail below, it was also a highly decentralized company, so an issue that could spill over to other parts of the company could go unrecognized until it is too late.

One issue that is taken as given in the case is that Shell was the first company to attempt to dispose of a large deep-sea platform in the North Sea. But, why was Shell first. An Amoco manager told me that Amoco was ready to dispose of the Northwest Hutton platform but feared going first because of the possible protests. Amoco chose to continue to operate the platform at a loss rather than go first. Amoco continued to operate the platform and recently sold it to a company that may attempt to dispose of it.

What went wrong?

This question can be addressed to the decision regarding the disposal of the Brent Spar and to Shell’s response once Greenpeace had launched it campaign. The disposal decision involved both Shell and the UK government, and the processes in both were relatively closed. In preparing the BPEO, Shell generated the disposal alternatives internally and evaluated the alternatives itself with the assistance of consulting companies. Shell viewed the Brent Spar as a unique facility and focused on its disposal. There is no evidence that Shell was thinking of the broader issue of the disposal of a series of North Sea oil platforms. Instead, it viewed decisions as made on a case-bycase basis. Shell also focused on the UK, since the UK had sole jurisdiction over the disposal. The

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PowerPoints characterize Shell’s decision-making process and what was missing from that process in the context of Figure 2-4.

In particular, Shell UK did not consult with other Shell operating companies about the disposal of the Brent Spar. Shell is a highly decentralized company with operating companies responsible for their own function and/or region. Shell UK worked with Shell Expro but not with other operating companies. This decentralized organization structure stood in the way of detecting a potential reaction outside the UK. Information within Shell tended to flow up to the holding companies and then down to the operating companies, rather than directly between the operating companies.

The government approval process was also closed. First, note that due to UK law the Department of Energy was responsible for approval of the BPEO and not the Department of the Environment.

The latter department was held in low regard in Prime Minister John Major’s government. Second, the process was closed with consultations held only with officially designated parties such as Scottish Heritage and the Nature Conservancy. These also included legitimate users of the seas such as the fishing industry and British Telecom (undersea cables). Public hearings were not held nor was there apparently any opportunity for public commentary. Instead, the approval process focused on technical feasibility and hazards to the environment and to workers. The notification of other governments about the Department of Energy’s approval of deep-sea disposal as the BPEO was made at the ministerial level (i.e., bureaucrats rather than politicians). Since the UK government had sole jurisdiction, the ministries in other countries did not object. Note that the reaction of politicians, particularly when the public protests began, was markedly different.

What is most remarkable about this episode is that after the protests on the continent and in the UK and after other European heads of state had asked the UK government to halt the disposal at sea, Shell began to tow the Brent Spar to its disposal site exactly when it had planned to do so. It is important to recall that towing Brent Spar to its disposal site would take four weeks, giving Greenpeace many opportunities to reboard.

The protests escalated rapidly as Greenpeace successfully landed two of its people on the Brent Spar. It is also perplexing that after the first set of protests the head of Shell Germany did not attempt to intervene with Shell UK. Instead, the issue had to be resolved at the top of the Company.

Once Greenpeace had launched its campaign, the issue had advanced to the point in Figure 2-3 at which Shell was in crisis management mode. Shell was certainly experienced with crisis management and had well-established procedures for dealing with an oil spill or refinery explosion, for example. For whatever reason, there is little evidence that it had a crisis management plan for its nonmarket environment. One possible explanation is that Prime Minister John Major had publicly backed Shell’s decision, and if Shell had postponed or reversed its decision when protests erupted, it would have left the Prime Minister hanging out on a limb all alone. Once Shell did back down, it publicly and privately apologized to the Prime Minister.

In evaluating the BPEO process Shell completed, it is useful to ask four questions. “Is this an energy issue or an environmental issue?” “Is this a Shell UK issue or a Royal Dutch Petroleum/Shell Transport issue?” “Is this a Royal Dutch Petroleum/Shell Transport issue or an oil

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industry issue?” Is this a UK issue or is it a European or world issue?” The answers suggest how this type of issue should be handled.

A different approach to the issue of what went wrong is to ask whether Shell should have anticipated this. The answer is probably yes, but it more instructive to ask a related question, “Why was Shell first?” One answer is that it did not recognize the possibility of a reaction, but the better answer may be that Shell was first because no other oil company was willing to be first. Amoco had completed its BPEO before Shell completed its BPEO, but Amoco recognized the possibility of a reaction and chose not to be first. Not only did no oil company want to go first, but after Brent Spar no oil company wanted to go second. Amoco operated the NW Hutton platform for the next five years at a substantial loss because it did not want to be second. The same was true for all oil companies that had an oil platform that should be disposed of. A change resulted in 2001. Amoco sold NW Hutton to Oryx Petroleum, which planned to dispose of the platform by dismantling it in Norway and re to dispose of another platform.

Scycclinrge thee tnop ionf thge rig.Choice Oryx appaA

The following questions can be used to conclude the discussion: 1. Should Shell have backed down or gone through with its plan to sink the Brent Spar in the North Atlantic?

2. Once it had backed down, what should it do to develop a new BPEO? 3. How should issues in which there is a risk of spillover to other nonmarket environments be handled in the future within Shell?

Developments: The process used by Shell to develop a new BPEO is summarized in the PowerPoints as is the final disposal of the Brent Spar. As indicated, the new Labour government of Tony Blair gave the Department of the Environment a role in the approval of BPEOs. The UK Department of the Environment announced that all future disposals would be on land.

Lessons are included in the PowerPoints as is an example of a confrontation between Greenpeace and BP.

X (no iteration) Nike in Southeast Asia PowerPoints are available for this case.

Nike is known worldwide for its distinctive “Swoosh” symbol and its extensive advertising and promotional activities. Nike has also earned a reputation as an aggressive and combative company whose objective is to beat its rivals. Nike’s “edge” is reflected in Phil Knight’s comments such as “blasts from the media about our practices abroad,” his comment that workers in suppliers’ factories were earning more than they used to, his argument that Nike was good for the countries from which it obtains its shoes and apparel, and his offer to let the Congress members tour the

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factories. Nike was also the dominant company in the footwear industry and had grown rapidly.

Nike was an obvious target for activists and organized labor.

Nike was also a big target. It had 350 overseas suppliers employing 500,000 workers with 180 suppliers in Asia employing 350,000 workers. This also meant that it was a formidable task to ensure that at each facility the working conditions met appropriate standards at all time. More importantly, what should those standards be?

Nike had never produced its own shoes, relying on a set of contractors with whom it maintained long-term relationships. Its principal contractors were Korean and Taiwanese companies, and its shoes had been produced in those countries. As those countries developed, labor costs increased and its contractors moved production to low-wage counties, primarily China, Indonesia, and Vietnam. Many of its suppliers’ factories produced only for Nike. The footwear and apparel industries are competitive, and there is considerable pressure to keep costs down. To accomplish this, productivity must be high and wages low. Nike’s suppliers’ factories were efficient.

Moreover, most of the factories were modern. The criticism of Nike’s practices centered on the wage level, the employment of children, and abusive practices.

Employment of children is customary in many low-income countries. Levi Strauss & Co. sources much of its apparel in East Asia and has been a leader in developing and implementing policies to ensure acceptable standards at its suppliers’ facilities, yet its guidelines allow employment of children as young as 14 if the law allows it. The development of Levi Strauss & Co.’s policies is considered in Chapter 22.

Concerns about the conditions in the factories of overseas suppliers began to mount at the beginning of the 1990s particularly as the recession in the United States highlighted the movement of manufacturing jobs to countries in East Asia. The principal activists were human rights groups such as Global Exchange and labor unions. The human rights groups were concerned with the abuse of labor rights of workers. Labor unions were also concerned about labor rights but were perhaps more concerned about protecting jobs for their members in the United States. The movement of production from the United States to East Asia resulted in the loss of union jobs, and the unions sought to stem the flow. One way to do so was to raise the costs of overseas production.

The labor unions thus focused on wages and health and safety conditions. Women’s activist groups were also involved because most of the employees were women. The human rights organizations, women’s groups, and organized labor were aligned on this and other issues. Members of Congress also supported the critics.

Three issues were central to the criticisms. The first was the abusive treatment of workers, such as the well-publicized incidents described in the case. The second was health and safety standards in the factories. The activists and labor unions argued that the same standards applied in the United States should be maintained in factories that produced for export to the United States. The third was wages with activists and labor unions arguing for a “living wage” rather than the market wage or the minimum wage set by the government.

The media was attracted to the issues. The level of audience interest was moderate, but the issue of abuse of rights and unfair treatment of workers earning a few dollars a day to produce shoes that

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sold for $140 in the United States was viewed as high on the societal significance dimension. The news media treated these issues in its roles of protector of the people and exposer of injustice.

Incidents of abuse and protests as at the Indonesian and Vietnamese factories increased the drama and criticism. The label given to the factories by critics and the media was “sweatshops,” and the revelation of sweatshops employing legal and illegal immigrants in the United States added to the audience interest in the issues.

Throughout this period Nike had taken some modest steps to address the issues, but the arena of public sentiment and media coverage was largely left to its critics. Nike left a vacuum that its critics filled by framing the issues and using the worst conditions and events as examples. Nike contended their allegations, and the facts remained in doubt. Nike’s response was generally reactive and confrontational, rejecting the claims and arguing that its sourcing of shoes and apparel in Southeast Asia was good for the countries and the workers.

Explanations for Nike’s approach to these issues centered on its aggressive corporate culture and on its past experience in dealing with activists and media criticism. Nike had come under attack from the Reverend Jesse Jackson and Operation PUSH for not employing enough African-Americans and purchasing enough from African-American companies. Nike rejected the allegations and fought Jackson, as described in the case Nike and Operation PUSH in the second edition of this book. Nike had also come under attack for promoting its shoes in the inner city, and activists alleged that children were spending large sums to have the latest styles of shoes. A journalist wrote a sensational story of an inner city youth who killed another youth for a pair of basketball shoes. It was subsequently revealed that the journalist had fabricated the story.

Nike also adopted a series of measures to address the substance of the issues. It developed a code of conduct for its suppliers. It hired Ernst & Young to audit the working conditions in its suppliers’ factories, but results of the audits were not made pubic as activists had developed. As a result of the audits Nike took a number of steps, including canceling contracts with four factories in Indonesia. Factory supervisors responsible for the abuse of workers were promptly fired. Nike also established a Labor Practices Department to monitor and improve conditions. (Nike personnel are generally assigned to suppliers’ factories to monitor the quality of goods produced, so it was not ignorant of the conditions under which its shoes were produced.) However, revelations of incidents such as at the Vietnam factory, the withholding of wage increases in Indonesia, and the leaking of an Ernst & Young report about hazardous levels of chemicals at a factory overshadowed the steps Nike was taking. Nike’s hiring of Andrew Young to inspect suppliers’ factories and make recommendations for improvements, and Nike’s pledge to follow through on those recommendations, seemed to fuel rather than quench the flames of criticism.

Teaching the case: The basic approach to teaching the case is to utilize the frameworks in Chapter 4 and the earlier chapters. Figure 4-1 can be used to assess how good a target Nike is and how effective a boycott is likely to be. The framework in Figure 4-2 can be used to characterize and analyze the strategy of the activists in their efforts to advance these issues. The theory of the new media can be used to assess how extensively these issues will be covered and the treatment they are likely to receive.

The nonmarket life cycle can be used to assess the development of these issues and to assess where

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Nike was in dealing with the issues. The final part of the discussion can focus on what Nike should do to resolve these issues and whether it should change its market strategy. For example, should it negotiate with the activists and labor unions? Should it make substantial changes in its practices, and if so, what should it do?

Discussion questions: 1. Are the allegations against Nike serious? On moral grounds? On other grounds?

2. What are the motivations of Nike’s critics?

3. What role has the news media played in the development of these issues and their progress through their nonmarket life cycle? How much coverage are these issues and events likely to receive and why? What kind of treatment will the news media give them?

4. Are these issues largely in the realm of public relations as Knight suggests at the end of the case?

5. Are these issues likely to affect Nike’s sales? Is Nike susceptible to a boycott? Is a boycott likely to be effective?

6. Has Nike dealt effectively with these issues?

7. What should Nike have done? At what stages of their life cycles should Nike have addressed these issues?

8. Should Nike negotiate with its critics?

9. Should it make public the results of the Ernst & Young audits?

10. Should Nike open its suppliers’ factories to independent inspections by non-governmental organizations?

11. Should Nike own the factories that produce its products, so as to have better control over the working conditions? Should it change its market strategy?

12. How should Nike resolve these issues?

13. Suppose President Clinton asked Nike to join with other companies, activists, labor unions, and others to develop a voluntary set of standards for the working conditions in suppliers’ facilities.

Should Nike participate knowing that the activists and labor unions would push hard for a living wage and for U.S. health and safety standards?

14. If it accepts President Clinton’s invitation, what approach should it take in the group’s deliberations?

Developments: Nike accepted President Clinton’s invitation, and the group, known as the Apparel Industry Partnership (AIP), worked and battled for two years before finally reaching an agreement in 1998 on a code of conduct for the working conditions in suppliers’ facilities. This is discussed in Chapter 23 and will not be discussed in detail here other than to note that the code did not include a provision requiring a living wage. The Union of Needletrades, Industrial and Textile workers resigned from the AIP in protest over not including a living wage requirement in the code. The AFL-CIO and the Retail, Wholesale and Department Store Union, which were not part of the AIP, also rejected the agreement. The AIP agreement called only for the Department of Labor to conduct a study on the issue of a living wage. Nike pledged to follow the code.

Participants in the AIP established the Fair Labor Association (FLA) to provide independent monitoring and reporting of working conditions in suppliers’ factories. In response to protests by

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college students over the working conditions in factories producing their school’s licensed merchandise, the FLA allowed colleges and universities to affiliate with it and added one seat to its board to be selected by the affiliated schools. The FLA also established a College/University Advisory Council. The FLA has evolved since its founding, and information on the FLA can be found at www.fairlabor.org and in Chapter 23. The PowerPoints provide additional information.

In 1998 Nike changed its approach to the issues. It voluntarily announced a policy at the National Press Club that its suppliers would not hire anyone under the age of 18 in its footwear plants and 16 in its apparel plants. (In contrast, Levi Strauss & Co. allows its contractors to employ children as young as 14 if that is permitted by the law.) Knight also announced that it would require all shoe factories to monitor air quality for chemicals and to meet U.S. standards. (This issue had been identified by Ernst & Young in its audits.) Knight said that he wanted to eliminate “the cloud that has been over Nike’s head.” “The Nike product has become synonymous with slave wages, forced overtime and arbitrary abuse. I truly believe the American consumer doesn’t want to buy products made under abusive conditions.”50 Nike was also affected by the worldwide campaign of environmental activists to eliminate the use of polyvinyl chloride (PVC). In August 1998 it announced it would end the use of PVCs in the production of its shoes, although it would take some time to find a replacement. Greenpeace heralded Nike’s decision.

Nike has taken a variety of other measures as indicated in the PowerPoints. By the early 2000s Nike was considered the leader in working to implement high standards in its suppliers’ factories.

See Chapter 23.

In the quarter ending May 31, 1998, Nike reported its first quarterly loss in 13 years. The loss was due to a $130 million restructuring charge and to a sharp decline in sales in Asia and particularly Japan as a result of the Asian economic crisis. How much the boycott hurt Nike is not known.

In an important case with potential widespread implications in 2002, the Supreme Court of California ruled in a 4-3 decision that Nike could be tried for allegations of fraud because its speech discussing its working practices in overseas factories was commercial speech and hence not given the full protection of the First Amendment. An individual had filed a lawsuit alleging that Nike’s statements about its practices were fraudulent. Nike argued that its speech was protected by the First Amendment and appealed through the California courts. The majority wrote, “Because the messages in question were directed by a commercial speaker to a commercial audience, and because they made representations of fact about the speaker’s own business operations for the purpose of promoting sales of its products, we conclude that these messages are commercial speech for the purposes of applying state laws barring false and misleading commercial messages.”51 The court did not rule on the merits of the case but instead was only concerned with whether the case could go to trial. The decision of the majority went so far as to write that a statement could be viewed as commercial speech even when mixed with statements about noncommercial subjects. In a dissenting opinion Justice Ming Chin wrote, “While Nike’s critics have taken full advantage of their right to ‘uninhibited, robust, and wide open’ debate, the same cannot be said of Nike.” If this

50 51

New York Times , May 13, 1998. , May 3, 2002.

New York Times

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ruling were to stand, it could have a profound effect on companies’ communication with the public on nonmarket issues. As an indication of the potential importance of the case, Nike’s side was supported in a brief by the American Civil Liberties Union as well as the Chamber of Commerce, whereas the plaintiff’s side was supported by briefs from the California attorney general, the Sierra Club, and the state AFL-CIO. This case is discussed in Chapter 22. In short, the case was settled out of court.

The Anatomy of an Activist Campaign: Rainforest Action Network and Citigroup PowerPoints are available for this case The purpose of this case is to consider an activist challenge to a firm and the firm’s nonmarket strategies for dealing with the challenge. A companion case, Strategic Activism: The Rainforest Action Network, is available from the Stanford Business School and from the Harvard Business School case services. This case describes the organization and strategy of RAN. The (A) and (B) cases can be used for a group negotiation exercise. One group can assume the role of Citigroup and the other RAN. The assignment would be open-ended of the form: Citigroup calls RAN just before the annual meeting, asks for a truce, and expresses a willingness to negotiate. Or the assignment could be given more structure by giving the group instructions to address specific issues such as those identified in the (A) (B) and (C) cases. The (A) and (B) cases could also be used for an in-class role-playing exercise.

The (A) and (B) cases can be discussed together or sequentially. The following questions can be used in leading a discussion of the (A) case.

The following are three exhibits that may be distributed with the (A) case. (Copyright © 2004 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reprinted with permission. ) Following the three exhibits for the (A) case are two exhibits for the (B) case.

(Copyright (C) 2004 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reprinted with permission.)

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Exhibit 1 RAN’s Introductory Letter to Citigroup April 10, 2000 Dear

:

As one of the world’s largest and most dynamic financial institutions, the influence of Citigroup on the global environment and communities is tremendous. Because the private financial industry has such a pervasive global reach, Citigroup has an unprecedented ability to influence all the sectors of the economy. Our civilization is at an urgent juncture and Citigroup may choose to drive the world further down the path of environmental devastation and social breakdown or set a new course toward a healthy and equitable world for our children. Research into a multitude of environmentally and socially destructive projects and financial activities around the globe has repeatedly revealed Citigroup’s involvement. Fierce addiction to fossil fuels continues to pollute our atmosphere and alter the climate of the Earth alarmingly. Our primary forests dwindle as mining, oil exploration, and the archaic use of ancient trees for construction materials decimate a global treasure. Hydropower technology that we no longer accept in our own country is enthusiastically exported to developing nations. The impacts of this behavior are well known: extinction of species; entire ecosystems damaged; poverty and starvation around the world. To demonstrate true integrity in leadership, the individuals of Citigroup must immediately embody the values of a democratic society. Citigroup people must achieve environmental and social progress throughout all aspects of their business.

For example: Citigroup will have to extract itself from unsustainable investments in fossil fuels to move its capital support into renewable energy; they will have to cease funding destruction of primary forests for timber or mining or oil exploration and transition that support to alternative building supplies and paper materials; every financial decision must exhibit a larger commitment to basic human rights and modern environmental values. The recent outcry against financial and trade institutions demonstrates the level of public dissatisfaction with current standards of commitment to environmental and social concerns. Even the so-called best practices standards (e.g., the World Bank’s) are blatantly ineffectual. The onus lies with you as the industry leader of the largest economy in the world to pioneer a new model for commerce. A new economic ethic has emerged and it is clear that the public will no longer tolerate the status quo. Sincerely,

Kelly Quirke Executive Director

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Exhibit 2 Graphic from Ad Printed in Wired Magazine, May 2000

The graphic was also passed out as a postcard at Citigroup’s shareholder meeting, with the following text on the back:

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Exhibit 2 (continued) Ad Printed in Mother Jones, December 2000

Source: www.ran.org

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Teaching the case: RAN chose Citigroup as the first target in its global finance campaign not only because it was the industry leader and the worst offender but also because it had large consumer banking and credit card businesses that could be harmed by a campaign.

What leverage does RAN have over Citigroup?

If they respond “yes,” ask if they have leverage against all the project finance banks.

If Citigroup refuses to participate in the financing of a project, will it be easy to find replacement financing? Will that replacement financing be more costly?

As Citigroup can these standards impair your relations with host country governments where you hope to operate? That is, a government wants a project financed, but Citigroup either refuses to participate in financing it or requires costly changes in the project if it is to provide funding.

RAN wants to bargain/negotiate with Citigroup. How does it tell the difference between bargaining and discussions?

The case mentions “democracy in the marketplace.” Is that what is going on? That is, is RAN bringing democracy to the marketplace?

After Citigroup received the letter from RAN, can it begin to work with a less aggressive environmental group and have RAN back off? To answer this, first ask if the other environmental group is likely to be willing to work with Citigroup knowing it has been targeted by RAN. The answer may be “perhaps not.” Even if a group were willing to collaborate with Citigroup on this issue, that is unlikely to deter RAN because it sets very aggressive or extreme objectives which may not be shared by the other environmental group. (For example, in its campaign against Ford RAN set the objective of getting Ford to achieve 50 mpg by 2010, whereas more moderate groups like the Sierra Club, which had also targeted Ford, had set a goal of 40 mpg. RAN deliberately chose 50 mpg because it was maximum of what activists believed might be achievable with currently available technology.) Given the RAN was unlikely to back off and other environmental groups understood that, finding another group with which to work would not solve Citigroup’s problem. As indicated in the (C) case below, Citigroup joined with three other banks to address the environmental issues associated with project finance. This did not deter RAN. RAN engages in civil disobedience. This frequently involves violating laws and usually those laws are just and legitimate. Is it acceptable to break laws, such as trespass, in conducting their campaign?

With regard to legal actions, are its claims in its letter to Citigroup and its advertisements truthful, distorted, irresponsible, etc.?

Is RAN correct in its assertions? Does it matter?

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Discussion questions: 1. It is the spring of 2000 and you (Citigroup) receive a vague letter from RAN and Ran speaks at your annual meeting. What is it that RAN really wants?

2. Why didn’t RAN target the project companies; i.e., the construction companies, the oil companies, the mining companies?

3. Why did RAN think Citigroup was a good target? Isn’t Citigroup the largest, most-profitable, and perhaps the most powerful bank in the world?

4. If Citigroup stopped financing these projects, would not some other bank step in and provide the financing?

5. What harm can this campaign do to Citigroup?

6. Will the campaign attract much media coverage?

7. How will RAN try to get leverage on Citigroup? Will it work?

8. Should Citigroup wait them out? Stall?

9. Should Citigroup negotiate with them?

10. If Citigroup did what RAN has demanded, will it be rewarded in the marketplace? Why didn’t RAN offer a carrot rather than a stick?

11. If Citigroup were to negotiate an agreement with RAN, would it want its competitors to also reach the same agreement with RAN? 12. Is this introducing democracy into the marketplace?

13. Is this non-violent civil disobedience or is it coercion and intimidation?

RAN and Citigroup (B) Citigroup has been weakened by scandals and lost more that a quarter of its market value in two days. This and Weill’s desire to leave a legacy may have provided RAN with the opportunity for success.

RAN’s objective of stopping destructive projects may be worthy, but are the tactics employed in its campaigns acceptable? Is it acceptable for RAN to break laws such as trespass?

Taking the role of RAN, you are about to mount a protest at the Citigroup 2003 annual meeting and you receive a call from Citigroup proposing a truce. Do you agree? Under what conditions?

Do you say no unless something tangible is done to show good faith; e.g., promise to negotiate?

Announce publicly that you will stop financing a pipeline project in South America?

In the negotiations will you seek to write an enforceable contract with Citigroup? As Citigroup would you agree to an enforceable contract? How close to enforceability are you willing to go? A policy approved by the Board of Directors?

What kind of agreement would you as RAN accept?

What dimensions/items would you like covered?

What standards would be acceptable?

What monitoring and enforcement arrangements would you accept? Suppose Citigroup pledged to report on the projects it financed in its Social Responsibility report. Would that be sufficient?

How can RAN enforce an agreement with Citigroup?

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Can RAN rely on reports from local groups in the project countries?

What is it that RAN wants the public to do in its campaign?

In the Shell, Greenpeace, and Brent Spar case switching costs were very low—just drive to a service station of another oil company. In the case of Citigroup the switching costs of changing an account from Citibank to another bank are fairly high in terms of a person’s time. In the case of a person setting up an account for the first time, the switching costs are low since banks are fairly close substitutes. The switching costs associated with a credit card are quite low. For someone with multiple cards all that is needed is scissors. For someone with only one card, if there is such a person, the costs are somewhat higher because it would be necessary to apply for another card.

Wrap-up questions: 1. Would the banks have adopted these policies in the absence of pressure?

2. Would public politics have resulted in such an outcome? If so, how long would it have taken?

3. Would moral suasion have resulted in this outcome? How would they have gotten Citigroup’s attention?

4. If neither of these is likely to lead to change, will activists increasingly turn to private politics?

5. Will the public support these groups? Financially? With participation?

RAN and Citigroup (C): As a result of the Enron and WorldCom scandals, Citigroup’s reputation was damaged. The new CEO Chuck Prince pledged to repair the damage and prevent further damage. As indicated below, this was only partly successful. Alan Murray, writing in the Wall Street Journal, explained the responsiveness of the large banks to RAN's global finance campaign: “the real secret of RAN's success is that the big banks have neither the courage nor the credibility to stand up to the group.

That is the price paid for three years of scandal.”52 Bargaining with activists can be hampered by language and hostility barriers, since a firm may have difficulty understanding the activist and its demands. To help it understand RAN and facilitate its discussions, Citigroup hired a former Greenpeace member who had subsequently earned an MBA. (Similarly, Weyerhaeuser hired a facilitator to help in its discussions with RAN.) Once Citigroup and Ran have reached an agreement, should Citigroup expect any further demands from RAN? Is so, what are those demands likely to be? RAN said that it has additional demands, and Citigroup knows that they would follow. The first is for Citigroup to stop financing companies that engage in illegal logging, particularly in Southeast Asia. There is a question of what qualifies as “illegal” logging. One obvious candidate is logging that does not have the explicit approval of the property owner, if there is one, or the government. Governments can easily be corrupted, however, so a logging operation that has a government permit could still be deemed illegal in RAN’s view. The companies doing the illegal logging in Southeast Asia are primarily Asian companies, and RAN has difficulty getting any traction against them. Cutting off funding is one possible way to put some pressure on them.

52

Wall Street Journal, April 13, 2005. RAN had begun its campaign two years before the scandals became public.

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Can RAN really be successful if some other bank steps in and provides the financing of the projects? RAN has targeted the principal U.S. banks and may be able to get them to agree to principles similar to Citigroup’s. It will be much more difficult, however, to target Asian banks.

At a minimum RAN’s success with the U.S. banks will raise slightly the cost of financing for the projects. This means that for success RAN wants to get all project finance banks to impose environmental standards in their project finance.

Developments: In the Citigroup campaign RAN consulted with, but did not join, other groups, including the World Wildlife Forum, Friends of the Earth, Trillian Asset Management, and CERES, that were concerned about project finance. RAN differed from these groups in that its demands were more aggressive and in that it told Citigroup what its policy should be. In the end RAN did not achieve everything it had demanded.

Brune and Hogue negotiated for 8 months with Citigroup. RAN was unable to get its full set of demands and had to compromise somewhat on the matter of sustainable energy policy. It did achieve its demands on forest protection. RAN told Prince that Citigroup was far from supporting only sustainable activities. In the negotiations Randy Hayes was involved and Brune sent the first draft of Citigroup’s policy and the final agreement to the entire board, but the intermediate drafts were sent to only three or four board members for their thoughts. The Citigroup board did not approve the policy, and Brune did not know whether it had been discussed at the board level.

In April 2004 RAN met with CEO Chuck Prince to discuss implementation of their new policy.

They agreed to meet quarterly to discuss progress and to report formally annually. In addition to the implementation RAN and Citigroup reached a “no surprises” agreement. Citigroup agreed to notify RAN if they planned to violate its policy, and RAN agreed to give Citigroup warning if it was planning to criticize Citigroup. Brune said that Citigroup, along with Kinko’s, Home Depot, and Lowe’s were the best in terms of their commitments.

Prince had earlier offered to call Chase and BOA to urge them to follow its lead on an environmental policy. He made the calls. He certainly had an incentive to call, since Citigroup may have been at a disadvantage competitively in project finance.

Citigroup understood that RAN might make future demands. The next demand could be that Citigroup stop financing Asian companies that are doing illegal logging in Southeast Asia.

RAN gave “the liquidators” a deadline of April 22, 2004 for a draft policy. I visited RAN that day, and Brune stated that the Fed Ex packages were pouring in. Every bank sent a draft policy. In addition, Brune had an email from Chase asking for comments on its draft. Brune commented that the ones he had looked at were not very good.

The Equator Principles are a major accomplishment. The Equator Principles are discussed in Chapter 23.

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The Next Steps in the Global Finance Campaign After concluding the campaign targeting Citigroup RAN turned its attention to Bank of America and JP Morgan Chase. The letter to Bank of America is included below as an exhibit in the Anatomy of a Corporate Campaign: Rainforest Action Network and Citigroup (C). Bank of America quickly told RAN that it would go further than Citigroup had, and within a month or so it issued its new environmental policy. RAN was pleased and hailed it as another victory.

JP Morgan Chase did not act, however, and RAN launched a campaign similar to the Citigroup campaign, including a Day of Action on April 11, 2005. Shortly thereafter JP Morgan Chase issued a new environmental policy that went beyond Citigroup and Bank of America. RAN praised JP Morgan Chase and hailed it as another victory.

After the JP Morgan Chase victory, RAN wrote on its Web site, “Meanwhile investments of mass destruction are still being produced by other global financial institutions.” RAN listed the logos of the remaining Liquidators: Credit Suisse/First Boston, Goldman Sachs, Merrill Lynch, Morgan Stanley, Wachovia, and Wells Fargo.

The following are two figures from the (B) case.

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Exhibit 1 Ad Printed in The New York Times , November 2002

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Exhibit 2 Picture of the “Wanted” Poster of Sandy Weill

Source: www.ran.org

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ANATOMY OF A CORPORATE CAMPAIGN: (C) RAINFOREST A CTION NETWORK AND CITIGROUP Ilyse Hogue, campaign manager for the Global Finance Campaign, said that RAN started gaining traction with Citigroup when the stars aligned in the summer of 2002—Citibank was vulnerable from the criticism resulting from the Enron and Grubman scandals, and RAN had reached its height of effectiveness (the activist base was educated and aware). RAN took advantage of the situation and increased the pressure in the Global Finance Campaign. By the spring of 2003, action at universities had increased, particularly at Columbia, and the campaign became personal as activists canvassed Citigroup CEO Sandy Weill’s hometown. Adding to Citigroup’s vulnerability, Weill was on the verge of retiring from the CEO position. RAN believed that the attention generated by its campaign could jeopardize Weill’s legacy and reputation.

NEGOTIATIONS RAN planned protests at Citigroup’s April 15, 2003 annual meeting, marking the three-year anniversary of its initial challenge to Citigroup. Citigroup knew that RAN was planning protests.53 Hours before the annual meeting, Citigroup asked RAN for a cease-fire—during which RAN would stop campaign activities and Citigroup would start negotiating. RAN agreed to a three-month cease-fire. During the cease-fire, negotiations started with a joint review by Citigroup and RAN of various policies and best practices to protect against ecosystem destruction. Input from Citigroup’s clients and investors was also taken into consideration.

Citigroup’s vice president of community relations had become very knowledgeable about environmental issues and become more involved in the day- to-day negotiations with RAN. By July RAN reported that progress had been made regarding forest protection, global warming, and the rights of indigenous people. RAN extended the cease- fire for another 45 days, giving Citigroup more time to develop a policy.54

THE EQUATOR PRINCIPLES —AS F B TO TEP ORWARD OR A LOW

RAN?

In June in the midst of the Citigroup-RAN cease-fire, 10 banks, including Citigroup, voluntarily adopted the Equator Principles (EPs). The EPs were developed by the World Bank’s International Finance Corporation (IFC) and established environmental and social impact standards applicable to project finance. (The IFC had had safeguard policies in place for many years but had only recently worked with private banks to develop the EPs.) The banks participating in the EPs provided $9.1 billion in funds for infrastructure projects in 2002.55

53

In addition to outside protests, two shareholder resolutions were on the ballot. One asked Citigroup to set industry best practices in the area of environmental and social responsibility, and the other asked Citigroup to audit its investments in all greenhouse gas producing industries and commit to reduce that exposure over time.

54 “Rainforest Action Network Statement on Citi Negotiations,” RAN press release, July 15, 2003.

55 Michael M. Phillips and Mitchell Pacelle, “Banks Accept ‘Equator Principles’—Citigroup, Barclays, Others To Shun Projects Hurting Environment, Livelihoods,” The Wall Street Journal, June 4, 2003.

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Non-governmental organizations (NGOs), including RAN, praised the participating banks for taking steps to address the environmental and social problems, but they also said the EPs were inadequate. Hogue said, “We’re glad to see banks responding to pressure that’s been brought on them. But I think that you’ll find broad consensus around the NGO community that the Equator Principles don’t go far enough. The loopholes are wide enough for bulldozers to move through.”56 Some of the specific criticisms by the NGOs included:57 •

The NGOs concluded that the EPs, although pointing in the right direction, fell short. For instance, the EPs did not impose any “no-go” zones (or “red lights”) for endangered ecosystems deemed critical.

• The EPs would be monitored by the IFC, but the NGOs believed that the IFC, with only 30 environmental staff, had a poor track record of implementing its policies. For instance, the Oleoducto Crudos Pesados project in Ecuador had been funded although it did not meet IFC standards.

• The EPs had loopholes—projects under $50 million were not subject to the EPs and projects had to be generally consistent, but not strictly comply, with the EPs. • The EPs did not include disclosure rules, so there was no way to ensure that banks were actually abiding by the EPs—and if they were not, there was no way to enforce the EPs (especially since compliance with the EPs was voluntary).

• NGOs worried that the EPs, while a step in the right direction, would be seen as sufficient and would actually hinder the adoption of best practices. ’ NEW ENVIRONMENTAL INITIATIVES CITIGROUPS RAN continued to press Citigroup to go beyond the Equator Principles. Negotiations continued and shortly after the EPs were announced, both RAN and Citigroup drew up initial drafts of a new set of policies. Hogue said, “RAN and Citigroup did not speak the same language, so we often misunderstood each other.” To help the negotiation process, Citigroup hired Matt Arnold, who had worked at Greenpeace and earned an MBA at Harvard. Although Arnold was originally hired as a contractor to deal with the negotiations, he later helped Citigroup with implementation of the new policies. On January 22, 2004, following further negotiations (and shortly after Chuck Prince became Citigroup CEO), RAN and Citigroup announced that Citigroup had adopted new environmental initiatives (Appendix I). These initiatives went further than the EPs—for instance, Citigroup’s policy included certain rules to protect “high caution zones”—areas of significant ecological value. These rules, among other things, ensured that projects that would significantly degrade critical natural habitats were not funded (e.g., Citigroup would deny funding for commercial logging in tropical rainforests). In addition to defining and protecting the high caution zones, Citigroup’s initiatives covered illegal logging, investing in ecologically sustainable development (e.g., renewable energy), and climate change. The new initiatives went beyond project finance funding to include general corporate loans where proceeds were directed toward destructive activities or projects.

56 57

Ibid.

“Collective NGO Analysis of the Equator Principles,” http://www.ran.org/news/equator_ngo.html, March 8, 2004.

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RAN had a policy of publicly thanking its targets when an agreement was reached. Exhibit 1 presents a congratulatory advertisement placed by RAN in The New York Times. Other than the threat of restarting its campaign, however, RAN had no hold over Citigroup. As part of the agreement with RAN, Citigroup pledged to report on the progress on its initiatives in an annual Corporate Citizenship Report, and to report confidential data quarterly to RAN. Citigroup would also report on the greenhouse gas emissions from power projects in its project finance portfolio. In 2002 Citigroup first reported energy usage in the over 10,000 buildings it leased or owned globally.

THE LIQUIDATORS Although the Global Finance Campaign initially targeted only Citigroup, the goal was to move the entire financial sector. In the spring of 2004, Mike Brune, executive director at RAN, said, “We have a toehold, but the campaign is far from over. We need most of the major world banks to deny funding for a whole class of projects—whether to protect mangrove forests or prevent against over- fishing or irresponsible energy production.”

On January 23, 2004, RAN wrote to 10 other U.S. banks, which RAN dubbed “The Liquidators,” for term“liquidating the Earth's most valuable natural assets to post short-term profits at a longcost to the world.”58 The Liquidators were JPMorgan Chase, Bank One, Bank of America, Fleet Boston Financial, Wells Fargo, Goldman Sachs, John Hancock, Wachovia, U.S. Bancorp, and SunTrust. RAN challenged The Liquidators to “meet or beat” Citigroup’s policies. Not all of The Liquidators had Citigroup’s consumer presence, so it was unclear if RAN would find success using the same tactics it had used against Citigroup. Pursuing The Liquidators would also consume a SOURCE: Research Associate Erin Yurday, Cornell MBA 1998, prepared this case under the portion of RAN’s limited resources. supervision of David P. Baron. This case would not have been possible without the help of Mike The initial focus was on two banks, Bank of America and JPMorgan Chase, both of which Brune and Ilyse Hogue of Rainforest Action Network. Copyright © 2004 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reprinted with permission. had P QUESTIONS REPARATION pending mergers.

The first sentence of the letters from RAN to them read, “Congratulations on your pending merger...”

Exhibit forpolicy? the letter to Bank 1. Should Citigroup have(See adopted its 2new How shouldofitAmerica.) implement that policy?

2. How should RAN enforce and monitor Citigroup’s compliance? Is Citigroup’s reporting pledge adequate?

3. Should Citigroup be prepared to expect RAN to make further demands?

58

“RAN Dubs Destructive Lenders: ‘The Liquidators’,” RAN press release, January 23, 2004.

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4. Should RAN attempt to establish a regular forum for meeting with Citigroup to monitor compliance? If RAN makes such a request, should Citigroup agree to it?

5. What strategy should RAN use to obtain agreements with The Liquidators?

6. How should The Liquidators respond, if at all, to RAN’s challenge? How should Bank of America and JPMorgan Chase respond to RAN’s letters?

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Appendix I Citigroup’s New Environmental Initiatives 59 Introduction Protecting natural systems while lifting two billion people out of poverty and advancing economic development are the world’s greatest challenges. These three foundations of sustainable development are central to the UN Millennium Goals, to national governments, to companies and to civil society. Citigroup has a broad array of policies and programs addressing environment, poverty and the economy. In 2004 we announced a new set of policies and programs focused on sustainable development.

New Initiatives 1. High Caution Zones Consistent with its responsibilities under and the requirements of the Equator Principles and led by its project finance business, Citigroup will carefully evaluate requests for project finance loans where the borrower’s proposed use of proceeds would directly fund activities that Citigroup determines could adversely impact a critical natural habitat.60 Citigroup will ensure that the appropriate Citigroup bankers throughout the world are aware of and alert to this new Equator-based approach. Citigroup will periodically engage with various stakeholders and evaluate its experience with these policies in a year with stakeholders and report annually in our Corporate Citizenship Report. Citigroup will not finance any project or provide general corporate loans to any project (where the use of proceeds is known) if the project or use of proceeds is located within critical natural habitats, unless the sponsor or borrower, as appropriate, has demonstrated to Citigroup’s satisfaction:

The project sponsors have considered economic and technically feasible alternatives to avoid such areas and have addressed these issues in the publicly available EA; The project will not significantly degrade61 or convert62 the critical natural habitat; 59

www.ran.org.

Critical natural habitats are: (i) existing protected areas and areas officially proposed by governments as protected areas (e.g., reserves that meet the criteria of the World Conservation Union [IUCN] classifications), areas initially recognized as protected by traditional local communities (e.g., sacred groves), and sites that maintain conditions vital for the viability of these protected areas (as determined by the environmental assessment process); or (ii) sites identified on supplementary lists prepared by the World Bank or an authoritative source determined by IFC’s Environment and Social Development Department. Such sites may include areas recognized by traditional local communities (e.g., sacred groves); areas with known high suitability for biodiversity conservation; and sites that are critical for rare, vulnerable, migratory, or endangered species. Listings are based on systematic evaluations of such factors as species richness; the degree of endemism, rarity, and vulnerability of component species; representativeness; and integrity of ecosystem processes.

61 Degradation is modification of a critical or other natural habitat that substantially reduces the habitat's ability to 60

maintain viable populations of its native species.

62 Significant conversion is the elimination or severe diminution of the integrity of a critical or other natural habitat caused by a major, long-term change in land or water use. Significant conversion may include, for example, land clearing; replacement of natural vegetation (e.g., by crops or tree plantations); permanent flooding (e.g., by a reservoir); drainage, dredging, filling, or channelization of wetlands; or surface mining. In both terrestrial and aquatic ecosystems,

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Appendix I (continued) Citigroup’s New Environmental Initiatives Project management has adequate capacity and willingness to ensure biodiversity protection and respect for the rights of indigenous communities whose livelihoods or cultural integrity could be adversely impacted; Indigenous peoples63 impacted by the project, whether directly or by induced impact, have the opportunity and if needed, culturally appropriate representation, and have access to the information to engage in informed participation; The governmental authorities at the local, regional or national level have provided mechanisms for the affected communities to be represented or consulted, and international and local laws have beenAn upheld64; and Environmental Impact Assessment has been prepared that takes into account such consultations and is publicly available.

Categorical Exclusions In accordance with the Equator Principles, Citigroup will follow International Finance Corporation Safeguards in effect at the time Citigroup becomes engaged in a project, including the following:

Citigroup will not finance commercial logging operations or the purchase of logging equipment for use in primary65 tropical moist forest66.

Citigroup will finance only preservation and light, nonextractive use of forest resources in forest areas of high ecological value.

Citigroup will finance plantations only on nonforested areas (including previously planted areas) or on heavily degraded forestland.

Citigroup will not finance projects that contravene any relevant international environmental agreement which has been enacted into the law of, or otherwise has the force of law in, the country in which the project is located. conversion of natural habitats can occur as the result of severe pollution. Conversion can result directly from the action of a project or through an indirect mechanism (e.g., through induced settlement along a road).

63 In financing projects, consistent with the Equator Principles, Citigroup will respect the IFC Indigenous Peoples Safeguard Policy that states: “The Bank’s policy is that the strategy for addressing the issues pertaining to indigenous people must be based on the informed participation of the indigenous people themselves. For an investment project that affects indigenous peoples, the borrower should prepare an indigenous peoples development plan that is consistent with the Bank’s policy. Any project that affects indigenous peoples is expected to include components or provisions that incorporate such a plan.”

64 Including those laws related to the ratification and implementation of “Convention 169 Concerning Indigenous & Tribal Peoples in Independent Countries” of the ILO. 65 Primary forest is defined as relatively intact forest that has been essentially unmodified by human activity for the previous 60 to 80 years.

66 Tropical moist forest is generally defined as forest in areas that receive not less than 100 mm of rain in any month for two out of three years and have an annual mean temperature of 24o C or higher. Also included in this category, however, are some forests (especially in Africa) where dry periods are longer, but high cloud cover causes reduced evapotranspiration.

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Appendix I (continued) Citigroup’s New Environmental Initiatives 2. Illegal Logging Citigroup recognizes that illegal logging is increasingly a threat to forests worldwide. We appreciate that forests provide humanity with precious natural resources. As expressed in numerous international forums including the G8, The UN Forum on Forests and the World Summit on Sustainable Development, illegal logging is a significant contributor to the degradation and loss of critical forest ecosystems in many regions around the world. Citigroup recognizes the menace to valued ecosystems and forest community livelihoods posed by illegal logging. We recognize that violations of logging laws around the world can have irreparable damage in fragile forest ecological networks where such illegal activity occurs. Illegal logging causes a number of adverse environmental, economic, and political or social impacts such as depriving national and local governments of related tax revenue, as well as forest owners and local communities of significant revenues and benefits, and acts as a disincentive to sustainable logging. In some countries the corruption associated with illegal logging undermines the rule of law. As evidenced by recently enacted United Nations Security Council sanctions, illegal logging has been associated with civil wars and, is considered a conflict commodity in various battle zones, funding and sustaining violent upheavals. In this context Citigroup understands illegal logging to take place where timber is harvested in violation of local and national laws intended to stop illegal logging.67 Illegal logging includes: a) using corrupt means to gain access to forests, b) extraction without permission or from a legally unauthorized area, c) the cutting of protected species or the extraction of timber in excess of legal limits or in violation of legally approved forest management plans. Consistent with Citigroup’s Code of Conduct, all employees of the company and its subsidiaries are expected to act in accordance with the highest standards of personal and professional integrity in all aspects of their employment, and to comply with all applicable laws, regulations and company policies. As such, we will not make loans to companies whom we know to be in violation of local or national laws regarding illegal logging.

Citigroup is committed to contributing to the fight against illegal logging and preventing the flow of funds to illegal logging actors. This battle presents new challenges. Successful participation in this fight requires global cooperation by governments, the private sector and civil society. Citigroup will pursue four policies and programs regarding illegal logging:

Request Citigroup customers seeking loans related to the extraction or processing of forest resources to make appropriate representations regarding compliance with applicable law. This means that a customer will represent to Citigroup that it will comply with all applicable laws including national and local laws regarding illegal logging. Representation in this context is a binding and documented assurance which, if false, could constitute an event of default.

67

Illegal logging has not yet been written into international law, although issues relating to illegal logging have been addressed in some fashion by international treaties such as the Convention on Biological Diversity.

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Documentation includes all of the documents required to secure a loan including government authorization as necessary.

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Appendix I (continued) Citigroup’s New Environmental Initiatives Take the following steps to combat illegal logging as appropriate 1) engage government and industry forums on trade and governance, 2) participate in on-going forums on illegal logging, and 3) support civil society organizations to advocate for forest law enforcement and policy reform.

Ensure that our businesses and risk management throughout the world are aware of and alert to the issue of illegal logging.68 Deepen our collaboration with knowledgeable stakeholders to strengthen our collective efforts to help prevent illegal logging. Better information on the extent of the problem is a prerequisite to developing practical and effective countermeasures.

3. Investing in Ecologically Sustainable Development Citigroup has developed a program to invest in sustainable forestry and renewable energy.

Citigroup has identified experienced resources to screen and evaluate potential investments in the sustainable forestry and renewable energy industries to ensure that investment opportunities in these two sectors get exposure and an evaluation consistent with all other investments on an ongoing basis.

We see immediate opportunities in three areas: A. Investments in independently certified sustainable logging – Citigroup is evaluating specific investment funds dedicated to FSC certified forest products located in emerging markets. Portfolio companies in these funds are committed to low impact logging, maintaining ecosystem function in the forest lands, and marketing branded sustainable product. Their financial success will protect more forests and employ more local people in sustainable commerce. Citigroup will have the capacity to evaluate these investments on an ongoing basis.

B. Investments in renewable energy – Citigroup will identify experts to evaluate investment funds dedicated to renewable energy technologies such as wind, solar, hydrogen, biomass etc. Investments in these companies reduce the environmental footprint of the energy sector.

C. Residential Clean Energy Financing - Citigroup will explore existing programs to offer consumer financing for solar panels, residential wind turbines and fuel cells, and other forms of clean energy or energy efficiency fit for residential consumers.

Citigroup will offer and market a Fannie Mae energy efficient mortgage product by the first quarter of 2004.

68

A best practice is starting to develop to curtail illegal logging based on the chain of custody verification

offered by the Forest Stewardship Council.

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Appendix I (continued) Citigroup’s New Environmental Initiatives 4. Climate Change The Intergovernmental Panel on Climate Change (IPCC)-a United Nations panel of 2,000 of the world's top climate scientists-agree that human activities are changing the climate. As a global company, Citigroup is taking a proactive stance on this important issue.

Citigroup will play a role in the financial sector to reduce greenhouse gas emissions from its own operations, and assist customers to develop financial solutions that help reduce emissions in the value chain and invest in renewable energy. Citigroup published its first ever report on energy used in 2002 in the over 10,000 buildings it leases or owns globally. This process has engaged 150 employees, and is building Citigroup’s understanding and capacity in greenhouse gas emissions reporting and energy use reduction. Beyond its own direct emissions, Citigroup will report the greenhouse gas emissions from the power sector projects in its project finance portfolio beginning the latter half of 2003 and going forward. This report will occur annually in the Corporate Citizenship report. This is the first time that a private bank will offer such data, which will be produced with methodologies peer reviewed with experts and NGOs. As reporting methodologies become standardized for other sectors, Citigroup may expand the report. Finally, the above-mentioned program to identify investments in renewable energy and energy efficiency will help reduce emissions in Citigroup’s chain of activities, by adding customers and business partners with an explicit focus on greenhouse gases and energy efficiency.

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Exhibit 1 Ad Printed in The New York Times , January 2004

Source: www.ran.org

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Exhibit 2 RAN’s Letter to Bank of America January 22, 2004 Mr. Kenneth D. Lewis Chairman and Chief Executive Officer Bank of America Corporation 100 North Tryon Street Charlotte, NC 28255 Dear Mr. Lewis, Congratulations on your pending merger with Fleet Boston Financial.

I am writing to invite you to join Rainforest Action Network in the global effort to preserve the world’s last remaining old growth forests and their traditional inhabitants and to confront global warming as one of the most pressing ecological issues of our time. Today, Citigroup, the world’s largest financial institution, raised the bar as the world’s first major bank to commit to a global policy addressing the crisis in the world’s forest and climate. This landmark announcement clearly signals a sea change in how the financial sector commits itself to these challenges. Prohibitions on destructive investments in endangered ecosystems will shift the way the worldviews business as usual. However, our global society cannot fully enact the necessary protections until your company takes decisive action.

According to the World Resources Institute, more than three-quarters of the world’s old growth forests have been destroyed or degraded, much within recent decades. The New York Times reported in a January 9 article that leading scientists recently concluded global warming will become the number one cause of species extinction in the next 50 years, affecting up to 37% of species around the world. Private financial institutions over the last decade increased 700% to dwarf public finance as the determinant factor in mega development projects in the developing world. This offers leading banks a unique opportunity to offer solutions that will help to assure the long-term stability of Earth’s environment. Bank of America has long been the bank of choice among the top companies in the logging industry, including such notorious players as Sierra Pacific Industries, Asia Pulp and Paper, and International Paper. Bank of America’s leading role in the domestic oil and gas industry also indicates a lack of forward thinking driving your business practices.

These issues are all too familiar to an increasingly concerned public. The general public—in overwhelming proportions—is impatient for strong leadership from your industry. According to a 2001 poll in the Los Angeles Times, 9 in 10 Americans favor protection of remaining wilderness areas. This powerful concern for endangered forest protection is manifest in the marketplace, where more than four hundred companies, including many of your clients, are now working to help endangered forests, rather than harm them. According to an April 2003 Gallup Poll, 7 in 10 Americans believe that the effects of global warming have already begun to occur or will occur in their lifetimes.

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Exhibit 2 (continued) RAN’s Letter to Bank of America While Bank of America once prided itself on being the environmental leader, we are dismayed by the lack of action your company’s has displayed to stay ahead of these critical issues. How many species must be threatened with extinction before your company ends its participation in the destruction of our last endangered forests? How many indigenous communities and forest-dependent people will be marginalized and adversely affected? How many deaths from unpredictable weather are required before we start to reverse the climate crisis? With the world’s largest financial institution taking action, how long will Bank of America wait to assume full responsibility for your investments?

We ask that your company take the following steps immediately: 1. phase out all funding and investment for extractive industries (oil, gas, mining, logging) in endangered ecosystems; 2. commit to support the right of indigenous and local populations to have free and prior informed consent to projects on their land; 3. cease funding for all logging projects unless chain of custody certification can prove legality; 4. provide funding for sustainable alternatives, such as Forest Stewardship Council certified logging projects and clean energy sources such as solar and wind power; 5. provide competitive market incentives for consumers to utilize existing opportunities in renewable energy through energy efficient and energy improvement mortgages; 6. document the carbon emissions that are associated with your company’s facilities and investments, and commit to reduce those emissions across the company’s portfolio over time, in accordance with the prevailing international scientific recommendations of the reductions that are necessary to curb global climate change.

Acting now to address the crises in our forests and our climate will help us build an ecologically sustainable economy in our lifetime. With the pending FleetBoston merger, Bank of America is in a perfect position to seize this opportunity to create a more ecological business model that meets the environmental expectations of your customers. Without prompt attention to incorporate environmental and social policies into your core business, your company will increasingly come under scrutiny and pressure from a global marketplace that demands social and environmental ethics from corporations. If scientific and moral arguments do not persuade your company to act, perhaps economic and public pressure will.

Please, work with us to face this historic challenge now. We are available to meet within the next couple of weeks to discuss these issues in more detail. Please call me directly or have one of your staff contact our Global Finance Campaign Director, Ilyse Hogue, at the number below to confirm a date and time.

Sincerely, Michael Brune Executive Director

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Chapter 5

Crisis Management Dealing with a crisis is an altogether too common challenge for firms and their management. This chapter considers the origins and nature of crises, with a focus on those that become public knowledge either because the company makes it public or because an outside party makes it public.

The development of crises and the factors that resolve it are the focus. The chapter provides a framework, based on the nonmarket issue life cycle, that both reminds a reader about the origins and development of crises and provides an approach to managing in an environment in which crises can occur. The framework has five components: avoidance, preparedness, response, root cause analysis, and resolution. Avoidance is the most important, but when not all possible crises can be avoided, preparedness becomes paramount. Having a crisis management team and a crisis management plan can be crucial in dealing with a crisis in a responsible manner and in mitigating adverse consequences. If a crisis occurs, the plan should be implemented, but since the details of the crisis matter, there can be a myriad of things that are not covered by the plan. A response thus depends on the nature and details of the crisis. Effective communication can be crucial at this stage. Once a crisis has developed and an effective response has been implemented, attention should turn to root cause analysis. That analysis both helps identify problems that need to be corrected before the crisis can be resolved and lays a foundation for measures to avoid future crises.

The chapter cases are intended to develop sensitivity to possible crises of management’s creation and to provide opportunities to make decisions as a crisis unfolds. The Buffalo Savings Bank case focuses on readjusting home mortgage interest rates upward during difficult economic times. Its objective is to assess how likely the readjustment is to create a crisis. The Mattel case provides an opportunity to make managerial decisions as a crisis involving lead paint on toys unfolds. The case is presented in segments, or episodes, that require a sequence of decisions. The Merck and Vioxx case is organized similarly and focuses on whether the company should take Vioxx off the market as new evidence is developed on its side effects.

Cases

Buffalo Savings Bank (A) This case provides an opportunity to assess whether the market action of calling the loans is likely to become a nonmarket issue that develops into a crisis. In addition, the case also provides an opportunity to apply the framework presented in Figure 2-4. This case is also discussed in Chapter 21 and can be used as an example of the role of the media in Chapter 3. In the context of Figure 51 the case centers on avoidance and response. Prior to the discussion, students should be told that at the time of the case no other banks were calling home mortgages and refinancing them at sharply higher interest rates.

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Mr. Kenzie was profiled in articles in The Wall Street Journal, April 23, 1982 and in Fortune, February 21, 1983. Mr. Kenzie had been executive vice-president at Merrill, Lynch, but resigned upon being passed over for a promotion when Donald Regan left to join the Reagan administration.

He had a reputation as a hard-nosed manager who took the Buffalo Savings job to make his mark by saving and growing the struggling bank. He planned to make a series of acquisitions to create a large and successful bank. (By 1983, he had tripled its assets, and Buffalo Savings had become the second-largest savings bank in the nation.) Calling the loans and refinancing them at a higher rate would provide funds needed for the acquisitions. If the loans were refinanced at 14%, the additional income to the bank would be approximately $1.3 million per year (($355 $230)x12x900).

The case takes place at a time of rapidly rising interest rates. The bank made mortgage funds available when other lenders were out of the market. (At the time of the case, lenders were starting to make fixed-rate loans with balloon payments due in three years, for example, as a means of forcing refinancing at the market rate at that time. That is, mortgage loans were made at a fixed interest rate with the principal due at the end of three years. The lender would then refinance the loan at market rates.) At the time of the case, other banks were thus not yet forcing refinancing.

Buffalo Savings Bank was out front and alone on this issue. The first issue is whether the bank should call the loans.

Many students are likely to argue that the bank should call the mortgages because fiduciary responsibilities require that it do so. Furthermore, it has a granted (contractual) right to do so.

Some students will also argue that it is possible to explain the bank’s decision to the mortgagees and to the public. Others will be concerned about the public’s reaction and/or the burden on the mortgagees. This provides the potential for a lively discussion.

Data that might be useful in the discussion follow. Real income in the United States increased by only 3.5% over the previous five years as inflation soared. The CPI increased from 170.5 in 1976 when the loans were taken out to 272.4 in 1981. In real terms, a mortgage payment of $230/month in 1976 was equivalent to $367/month in 1981. (Of course, the mortgagees had anticipated a decrease in the real cost of the payments.) An interest rate of 14% thus does not represent a large increase in the real cost relative to 1976. As indicated below, this is largely irrelevant.

Teaching the case: The discussion is best channeled by asking those who want to call the mortgages how they would actually implement the call. This would involve asking questions such as the following. At what interest rate would you refinance the mortgage? How would you notify the mortgagees? Would you call a meeting of all of them? What would you tell them when you notify them? Do you treat them all the same or do you, for example, apply a means test? Do you negotiate the monthly payments or decide them unilaterally? Will you make the new loan callable? What will you do if a mortgagee is unable to meet the higher payments? What relief, if any, would you give the mortgagees?

Some students may argue that rather than raising the monthly payments, the term of the loan should be extended. This would ease the monthly payment burden on the mortgagee but the gain to the

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bank would be negligible, since dollars received twenty or twenty-five years in the future have a negligible present value when interest rates are nearly 20%. For example, stretching the payments of $230 per month from year 25 to infinity when discounted at 18% has a present value of $170. In comparison, refinancing a loan with a $230 monthly payment at 18% has a present value gain of $14,500, whereas at 14% the gain is $7,900. Students may also propose a variety of sharing arrangements, but none of them provides much income to the bank.

The next step in the discussion might be to ask how the mortgagees are likely to react to the call.

Some may not recall that they had known of the call provision, whereas others may have known but simply hoped that the mortgage would never be called. In all likelihood, the bank had notified them of the call provision, and the mortgagees were likely to have been represented by a lawyer, since a lawyer was required for home purchases in New York. Furthermore, even if there were some mortgagees who had not fully understood the terms of the loan, they would likely have accepted the mortgage terms even if they had understood, since the mortgage was offered at below market rates and other lenders were out of the market.

Regardless of what they had understood, the mortgagees will be angry when notified of the call and the refinancing offer. They are likely to act, for example, by taking their plight to someone who might be able to help them. They might turn to a politician, a union leader, or the news media.

Whatever they do, the media is likely to be attracted to the issue, as considered in Chapter 3.

Role playing is one means of drawing out the differences in the perspectives of the bank and the mortgagees. One student can be asked to play the role of a lending officer of the bank and another a mortgagee who has come in to discuss the terms of the refinancing. Having the mortgagee be an unemployed steelworker will illustrate the difference in perspective.

Another role playing opportunity is to ask one student to assume the role of Mr. Kenzie and another to assume the role of a correspondent of a local TV station who will interview Mr. Kenzie for the evening news. Role playing is particularly effective if the person playing the role of the journalist asks hard questions such as “Why are you doing this when you are making a profit?” (Mr. Kenzie then has the task of trying to explain to a TV camera the difference between the operating profit and the reported profit.) “Some of the mortgagees say they had never been informed of the call provision. Is that true?” “Do you realize that some of the mortgagees may be driven from their homes?” “Why can’t the bank spread out this cost among all its depositors?” The correspondent then can interview the mortgagee standing with his or her family outside the home they may lose.

Sentiment will clearly be with the mortgagees. At the end of the role playing, the person playing the bank official might be asked how effective his or her efforts were. Then, the class might be asked the same question.

If the media role playing goes well, the message should be that even though the bank has a reasonable story to tell, the mortgagees also have a reasonable story. Furthermore, the mortgagees have the more sympathetic side of the story, and viewers are likely to side with them. The analogy to the Citibank example in Chapter 2 should be apparent.

The focus of the discussion then should turn to what the mortgagees can do about the call. This is basically a collective action problem of the type discussed in more detail in Part II of the book.

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The principal lessons from this case are 1) that a firm may lose control over a straightforward market issue (calling loans) if that issue moves into the nonmarket arena and 2) that it is essential that managers attempt to predict what actions those in its environment are likely to take in response to a firm’s actions. The failure to predict in this case caused the bank to make a mistake. The importance of the analysis stage in Figure 2-4 should be emphasized.

The following (B) case can be distributed in class to continue the discussion.

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Buffalo Savings Bank (B) After much soul-searching the bank decided to call the 900 mortgages and offered to refinance them at 14 %. As a bank official explained, “It is not prudent to allow an unprofitable loan to exist when you can call it in.”

The reaction was immediate. Not only did the issue attract the attention of the national media over the weekend, but locally the mortgagees formulated plans to picket the bank’s branches and to urge the bank’s depositors to withdraw their deposits.

Bank officials recognized that the mortgage was a binding legal contract and that the borrowers had been informed of the call provision at the time, so a successful legal challenge was unlikely. Joseph Leto, however, had stated to the local press, “I saw the clause and questioned it.” They said, “Don’t worry, we’ve never called one in before, it’s just a formality. I have talked with other people who say they weren’t even told. How could 900 lawyers all misunderstand that clause?”

Faced with these threats, President Ross Kenzie had to decide what to do next. One alternative was to explain to the press and the residents of Buffalo that when the mortgages were extended it had been made clear to the borrowers that the loans were callable after five years and that the present operating losses of the bank were serious and had to be dealt with. Bank officials also reasoned that the bank could show the public the amount of the benefit that the borrowers had received during the five years that the mortgages had been outstanding. The other principal option, as the bank officials saw it, was to rescind the call of the mortgages and to allow them to remain outstanding at the 8.5 percent interest rate for the full term on which the monthly payment had originally been calculated.

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The outcome: The pressure on the bank caused it to rescind its call and leave the mortgages outstanding at the original interest rates. The inability to explain its position to the public through the media and the media advantage of the mortgagees had convinced the bank officials that it was better to concede than fight. It should be pointed out that if there were many banks calling mortgages at the time, the bank would likely have had far less difficulty in calling the loans.

As was the case with many savings institutions, Buffalo Savings Bank, which had changed its name to Goldome, failed and ceased to exist in May 1991. The bank was split between First Empire Corporation of Buffalo and Keycorp of Albany. At the time of its bankruptcy it was New York state’s largest savings institution and the 13th largest in the United States.

Mattel: Crisis Management or Management Crisis This case is designed to be taught in a sequence organized as events—information about product safety problems—unfold. To some extent this information is endogenous; i.e., it results from heightened investigations by Mattel management, but it is also to an important extent due to the normal pace of meeting delivery schedules. As written the case has three stages: the first dealing with the initial discovery of lead in the paint on toys, the second dealing with the discovery of lead in the paint on “Sarge” toy cars, and the third dealing with the revelation about lead in the plastic in some components of Mattel’s toy medical kit. The case also raises issues of social responsibility with respect to possible harm to customers or their children. The case includes reputational concerns and private and public politics pressure on the company and the toy industry.

The “climate” during which these events occurred involved what seemed like weekly revelations of tainted and sometimes unsafe products from China. It was clear that a significant number of Chinese companies were cutting corners, or worse doctoring their products, to improve their profits. Melamine, for example, was apparently used because it is not easy to detect.

Mattel management could also have become overconfident about the ability of the company’s policies and procedures to avoid product problems. In part, inspections of suppliers’ factories may not be as effective as one might expect, as discussed in Chapter 23. Moreover, suppliers are often under pressure to meet tight deadlines and may cut corners to meet those deadlines. (As discussed in Chapter 23 Nike sought through better scheduling for deliveries to relieve pressure on its suppliers as a means of reducing the amount of mandatory overtime imposed by factory managers.)

Because of the findings of unsafe products the Chinese government came under considerable pressure to address the problems. Initially the government refused and blamed others, but at some point it decided that the problems had to be dealt with in a manner that would restore confidence in

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products made in China. The U.S. and EU governments were also under pressure to act to protect consumers.

Phase I Mattel discovered the problem in-house, which means that it was not yet under the scrutiny of the media. It, however, could not delay because if it were to issue a recall, it needed to do it soon before more product reached retailers’ shelves. In terms of Figure 5-1 Mattel’s objective should be to get to a resolution quickly with as little impact on the company as possible. Then its emphasis should be on avoidance of future problems.

The ostensible root cause of the crisis is a failure to follow procedures, but those procedures themselves may be part of the cause. Mattel maintained long-term relationships with its direct suppliers but relied on those suppliers to ensure that subcontractors and suppliers were providing goods that met standards. This delegation could be at the root of the problem. More fundamentally, suppliers have incentives to cut corners and shirk on meeting standards, and some suppliers will succumb to those incentives. Mattel could also lessen those incentives or make the penalties for violating standards more severe.

To get the issue behind it and resolve the impending crisis, the product has to be recalled. The recall should be sufficiently broad, so that it does not find itself in a position in which it has to make a series of recalls. The dilemma for Mattel is that it needs to act quickly on the identified products and may not yet know whether other products will need to be recalled. One thing that Mattel can do is identify the product lots on which the lead paint was used and at the least recall all those product lots. (As the case reveals Mattel issued several more recalls through September.) As Mattel identifies the root causes on the problem, it must deal with the causes.

The following decisions need to be made, and these can be used to guide the discussion.

1. Should Mattel recall the products? What are the risks if it does not do so? (It should be clear that Mattel has a moral obligation to recall the product or at least let the CPSC make the decision. If it does not, it risks not only harming children but also having the lead paint detected by some outside party. Regardless of whether it recalls the product, it will face products liability lawsuits. If it does not recall the product, however, it could be found to be negligent, as considered in Chapter 12.)

2. Should Mattel issue a voluntary recall or should it let the CPSC make the decision of whether to recall the product?

3. How broad should the recall be?

4. In whatever public announcement is made, should Mattel name the suppliers and explain what had gone wrong? (RC2 had not named the suppliers when it made its product recall.)

5. Should Mattel fire the supplier?

6. Should Mattel strengthen its quality control standards and procedures? If so, what particularly should it strengthen?

7. What should Mattel say to consumers and how should it say it? Should a rebate or refund be offered to people who had bought the product?

8. What should Mattel do with respect to retailers who have bought the products?

9. Should Mattel own more of the factories that supply its toys?

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Crisis Phase II: The decisions here are the same as for Phase I with the addition of new information pertinent to whether to reveal the names of the suppliers. Also, this recall means that the root cause is something fundamental and not a one-time occurrence.

After discussing the decision and aftermath, the following questions could be asked:

1. Should Mattel have apologized in China?

2. Should Mattel investigate the “brutal conditions and illegal practices” allegations by China Labor Watch?

3. Should Mattel attempt to influence the decision in the EU regarding mandatory testing?

(Note that Mattel prefers mandatory testing.) Or should it attempt to persuade the Toy Industries of Europe Association to change its position?

4. Should Mattel actively lobby in the United States to support mandatory testing? Should it oppose the Senate bill?

5. What should be done with the recalled products? Should they be sold in other countries that tolerate lower standards?

Phase III Management Crisis The article in Consumer Reports raises another dimension of the toy safety issue. Hard plastic is used in hundreds of products, and embedded in the plastic could be toxic or hazardous chemicals.

Whether this is a significant health concern is not clear, and it is not even clear that it is a concern at all. What is clear is that safety and health activists are working to make it a concern and to require the elimination of the possible or imagined risks. (The issue here is similar to the precautionary principle used in the EU where a product or substance could be banned if it might pose a health risk. That is, the burden of proof is on the manufacturer to demonstrate that the product or substance is safe.) This issue surfaced in North America when Canada considered banning plastic bottles made with bisphenol, a chemical used to make the plastic shatterproof.

Activists in the United States called for a ban, and people who are nervous about their health turned away from the bottles. In October 2008 Canada banned the chemical bisphenol used in hardening plastic. According to the FDA the risk was negligible.

The potential hazard from lead in the plastic in the toy cuff is quite different from that of lead paint.

Since young children put objects in the mouths and like to suck on those objects, there is a risk that lead from paint could find its way into the body. Sucking on hard plastic, however, does not pose the same risk.

With respect to the public politics associated with the hard plastic issue, there will be many companies that use the plastic that would oppose any regulation or ban. It seems unlikely that the Congress will act on this issue in the absence of a crisis. Nevertheless, Mattel should be attentive to those legislators who signed the letter. It should meet with them to discuss the issue and provide whatever information it can.

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Discussion questions: 1. Should Mattel make a broader recall?

2. Is it risking products liability lawsuits? (See Chapter 12.)

3. What should it do in response to the letter from the member of Congress?

4. Formulate a comprehensive crisis management policy for Mattel for dealing with possible health and safety risks associated with its products? Should it seek more aggressive regulation by the CPSC? Developments: As a result of the problems encountered by Mattel and other toy manufacturers, in 2008 the United States enacted legislation requiring testing of toys by third-party laboratories. Mattel supported the legislation because it would protect children and protect the collective reputation of the industry against free-riders than skimp on safety precautions.

Mattel reported a 15 percent increase in its fourth quarter profit. CEO Eckert said in a conference call with analysts, “we have a lot of litigation around the world on things related to product recalls, and we’ve got a significant case coming to trial this year.”

Draft legislation was published in the EU in January to improve toy safety. The chair of the European Parliament’s consumer protection committee Arlene McCarthy commented, “This new law must take into account new toy risks and the fact that 90% of our toys are imported from China and other non-EU countries. It must stand the test of time and meet our demands that toy imports meet the highest standards.”

Sidney To, an executive with the toymaker Playmates Holdings Ltd. of Hong Kong, said his company had developed long-term relationships. He explained the company’s approach to its suppliers, “It’s always better to work with the devil you know than the devil you don’t. You would like to work with them to solve any issues that come up rather than just cut and run.”69 The CSPC had opposed a larger budget and stronger enforcement powers—due to the Bush administration’s opposition to broader regulation. Legislation enacted in 2008 increased the budget for the CPSC. In February 2008 the federal government indicted two Chinese companies and the U.S. importer that had intentionally falsified export licenses that allowed the wheat gluten tainted with melamine to be imported. The U.S. dog food manufacturers that included Menu Foods and Proctor & Gamble were not indicted because they were unaware that the wheat gluten had been contaminated.70 Safety problems with products made in China continued through 2008. In October several babies died in China and tens of thousands of others were sickened because melamine had been added to milk in China. That milk was also used in a variety of products, including candy and other foods.

This forced the recall of many products by producers such as Cadbury and Unilever.

69 70

Wall Street Journal, August 17, 2007.

New York Times , February 7, 2008.

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Merck and Vioxx This case focuses on an evolving crisis that threatens one of Merck’s most profitable drugs. The principal decision to be made is whether the drug should be withdrawn from the market. Much is still unknown about who knew what and when, so the discussion must proceed cautiously.

The case is written in segments giving a history of some of the decision points. A discussion could proceed segment by segment, as new information became available to Merck, the FDA, and the public. The case identifies a tension between self-interest and societal well-being, although any conclusions have to be made with qualifications. Moreover, any examination of the episode involves hindsight, and hindsight was not available at the time the decisions were made.

The following discussion tracks the progression of the episodes.

Initial Marketing The pain reliever market is huge, and patients with chronic pain would use an effective pain reliever on a regular basis. If the potential market were restricted to patients with gastrointestinal problems, sales would be low, and the corresponding profits would be moderate. Using DTC advertising would result in much larger sales and high profits. The margin on a patented pharmaceutical typically is 80-90 percent, so profits on Vioxx sales of $2.5 billion would be $2 billion or more. Self-interest would be served by marketing the drug broadly with heavy DTC advertising. This strong an incentive was probably difficult to pass by, particularly because Merck had a strong incentive to catch up quickly to Pfizer which had shortly before received approval to market its Cox-2 inhibitor Celebrex.71 Moreover, there are always risks associated with any new drug.

Having said that, some commentators believed that DTC advertising was a culprit in increasing demand beyond the point warranted by cost-benefit analysis. That is, when patients demand a drug by brand name, doctors are under pressure to prescribe it. Some will succumb to that pressure, when the drug is not needed. This means that the drug is used more broadly than warranted by its therapeutic value.

Not blocking the Cox-1 enzyme loses a cardiovascular benefit as with aspirin. This meant that there could be greater risk of cardiovascular events with Vioxx than with aspirin. The test against a placebo, however, had shown no statistically significant effect on cardiovascular risk.

The incentives to limit initial use of the drug and to conduct a clinical test on cardiovascular risk comes from the liability system, which as considered in Chapter 12 is a institution of society intended to align private and societal interests. If Merck evaluated the liability risks and concluded that the profits from sales outweighed the liability cost, a study would not be justified. The utilitarian calculus, however, is improved by enabling people to make informed decisions about their health care, so conducting a test and providing information would seemingly be justified.

Utilitarianism seems to call for conducting a test. Note that this may establish a right of patients to

71

An article on the initial marketing of Vioxx appeared The in New York Times , February 1, 2005.

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have the information on risks. That right would be instrumental. (A more detailed analysis of rights is provided in this Manual in the context of the Chapter 21 case Reporting of Clinical Trial Results.)

Prudence may also suggest that clinical tests be run to determine if there is a risk of cardiovascular events. Merck decided to conduct a clinical study, although not one to assess cardiovascular effects.

Success Vioxx was a huge success, and much of that success was due to DTC advertising. The VIGOR study was intended to establish the effectiveness of Vioxx for patients with gastrointestinal problems. The data indicated twice as high a rate of cardiovascular events with Vioxx compared to the control of naproxen. Since naproxen was believed to have beneficial cardiovascular effects and the initial Vioxx tests against a placebo found no difference, a plausible conclusion was that the difference was do to the benefits of naproxen. Still, the other hypothesis could not be rejected that Vioxx use caused a higher incidence of adverse cardiovascular events. The Merck press release entitled, “Merck Confirms Favorable Cardiovascular Safety profile for Vioxx” clearly seems unjustified. That Merck would issue such a press release suggests that it is basing its decisions on self-interest.

A reasonable approach for Merck would be to work with the FDA to determine not only what information should be incorporated on the label but also whether doctors and patients should be notified of the results. Reducing its DTC advertising would sacrifice self-interest for a possible reduction in as yet an unknown risk. If DTC advertising were to continue, the risk of cardiovascular events should receive greater mention.

Conducting a clinical trial to study cardiovascular risks certainly is more warranted given the results of the VIGOR trials.

APPROVe Study Criticism of Vioxx began in August 2001 and continued in conferences and in The Lancet. The FDA sharply criticized the Merck press release. Merck did not take this criticism as a reason to alert patients and doctors of the results of the APPROVe study.

Merck decided not to conduct clinical trials on cardiovascular risk, and this may be a reasonable decision if those risks could be identified using data from the APPROVe study that was already underway. It is interesting, however, to note that Merck had decided to conduct trials for a new indication for Vioxx and not to conduct a trial for the possible risk identified in the VIGOR study.

This again suggests that decisions were being made based on self-interest rather than utilitarianism.

If the liability system provides sufficient incentives for care, acting on self-interest is justified in the utilitarian framework.

When during the APPROVe study Merck should have gone to the FDA and warned patients and doctors is not clear. The role of its outside safety review board is also not clear. It is interesting to

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note, however, that it was the board that continued to point to the higher rate of cardiovascular results.

Certainly by September 2004 Merck had to act. Whether withdrawing the product form the market was required is not clear. At a minimum DTC advertising and push by Merck’s detail (sales) force had to be stopped. Moreover, doctors and patients had to be notified.

The Lancet Article Meta analysis is quite controversial because it collects studies of apples and oranges and treats them the same. In this case, Merck’s criticism of the article seems warranted. The meta-analysis showed nothing not contained in the earlier studies. Merck should provide a critique of the article, and let it go at that.

The article, however, is symptomatic of the feeding frenzy that occurred around the recall. Merck needs to be prepared to deal with the additional scrutiny and to recognize that it will now be conducting its affairs in the eye of the media.

Congressional Hearings Congressional hearings are to be taken seriously if for no other reason that they provide an opportunity for critics to air their criticisms before the committee and the news media. The study

by Dr. Graham was based on epidemiological data and used statistical analysis to estimate the effects. The FDA traditionally does not give much weight to such studies. Instead, it puts its confidence in controlled trials. It is not surprising that Graham’s study was referred to as junk science and said to be irresponsible. For example, suppose that Kaiser represented 1 percent of patients and that 2.7 million took Vioxx. Graham’s estimates then indicate a death rate of 1 percent of Vioxx users. Such a rate seems far too high, given the result of the controlled trials. Moreover, 27,785 deaths had been caused by Vioxx, someone would surely have noticed and notified the FDA or the news media.

Nevertheless, Merck has to take the hearings and Graham’s study seriously, since at a minimum they attract media attention. It should conduct informational lobbying with Congress members and provide a careful critique of Dr. Graham’s study.

Conclusions The bottom line is that utilitarianism does not require that Vioxx be withdrawn from the market, since it provides important pain relief for many patients and the additional risk of cardiovascular events is low. What utilitarianism commands is that the risk be fully disclosed, so that patients and doctors can make their own decisions about benefits and costs based on the available information.

Since DTC advertising results in use beyond that warranted by the therapeutic benefits of Vioxx, that advertising should be withdrawn or restricted. Indeed, DTC advertising about the possible risks associated with Vioxx might be warranted because of the overuse of the drug.

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Developments The hundreds of lawsuits filed against Merck for deaths and injuries were consolidated into a class action to be tried in federal court in New Orleans. The many shareholder lawsuits filed against the company were consolidated in a federal court in Trenton, New Jersey. Merck set aside $765 million for legal costs.

Vioxx provided an easy target for fraudulent lawsuits against Merck. The company sought dismissal of a lawsuit filed by a woman who claimed that her husband died of a heart attack caused

by Vioxx. Merck upon investigation found that the prescription for Vioxx had never been filled and that the free samples she claimed her husband had taken had not been manufactured until six months after his death. The judge refused to grant a dismissal.

In February 2005 documents were revealed indicating that Merck had organized and was prepared to launch a major cardiovascular study in 2002 but had abruptly cancelled it because it would have involved “high-risk patients.” The study was scheduled to be completed by March 2004. If that study had been conducted, the increased risk might have been identified earlier.

In October 2004 a study was halted that was testing whether Celebrex and naproxen reduced the risk of Alzheimer’s disease revealed that patients taking naproxen had a 50 percent higher incidence of cardiovascular events compared to a placebo. This seems to contradict the belief of Merck in the VIGOR study.

Also in February 2005 Wellpoint, a large health care insurer reported that a study of its patient data showed a 20 percent higher risk of heart attacks and strokes with Celebrex and Vioxx and 50 percent with Bextra. The study had compared people over 40 who had taken one of the drugs for over 18 months with people over 40 who did not take any of the three drugs.

In May 2005 Merck CEO Raymond V. Gilmartin resigned on the day congressional investigators disclosed documents indicating that the company had told its sales force not to mention the results of the VIGOR study but to emphasize the previous message that Vioxx protected the heart. Merck had argued that the study results were due to the beneficial effects of naproxen.

In additional to congressional investigations Merck was under investigation by the Department of Justice and the Securities and Exchange Commission.

The congressional investigations also focused on the FDA and its procedures for reviewing postmarketing data. An FDA official acknowledged that there were “lapses” in its reviews. The Bush administration had added $5 million to the FDA’s budget to increase its scrutiny of post-marketing data. The FDA established an advisory committee to review the safety of already approved drugs.

In February 2005 an FDA panel voted 17 to 15 that Vioxx could be sold to some patients but with strong warnings.

Merck decided to withdraw Vioxx from the market.

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Merck fought the lawsuits and won 11 of the 18 Vioxx lawsuits that went to trial, and in the most celebrated decision in Texas for the plaintiff the judge reduced the award from $253.4 million to $27.2 million. The court decisions strengthened the bargaining power of Merck. A total of 47,000 lawsuits alleging heart attacks or stokes from Vioxx had been filed, and under the auspices of a federal district judge Merck and 6 attorneys from around the country negotiated a settlement for $4.85 billion. The terms of the agreement required that 85 percent of the plaintiffs sign up for the settlement. A total of 44,000 signed up, allowing the settlement to take effect. The average settlement was expected to be $100,000.

Merck has not reintroduced Vioxx. Pfizer has never withdrawn Celebrex from the market.

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Part I Integrative Case Wal-Mart: Nonmarket Pressure and Reputation Risk (A) The two principal questions in this case are (1) what Wal-Mart should do regarding the social pressure it faces and (2) whether it should adopt a different approach to its nonmarket environment.

The first question pertains to the short-run, and the second question is longer-run, although a change could be implemented quickly.

A prior question that could be asked is how Wal-Mart came to be in the position it is in. Wal-Mart experienced spectacular growth through the 1990s, following a strategy of providing value through low prices. It was able to provide low prices and obtain high profits because of its efficiency and its buying power. Wal-Mart had focused its growth in small towns and suburbs. Wal-Mart also provided opportunity for advancement within the company, and opportunities were plentiful as it continued to open more stores. The company hired young and old, many of whom were saving for college or supplementing their household or retirement income. Wal-Mart became the second largest employer after the federal government and provided value to many millions of consumers.

Those benefits came at some cost, however. Wal-Mart caused many small stores to go out of business, and along with shopping malls harmed the traditional downtown areas in some towns.

Some critics claimed that it was affecting the culture in small towns. Wal-Mart was also criticized for low wages, for not providing benefits to its employees, and for its aggressive opposition to the unionization of its employees. Many of the criticisms were strategic in the sense that they reflected the self-interested advocacy intended to harm Wal-Mart before the public. For example, Wal-Mart paid low wages, but those wages were not lower, and may have been higher, than those paid by other mass retailers. Moreover, its benefits packages were probably comparable or better.

Wages and benefits were probably higher than those paid by small retailers, including those that went out of business because of Wal-Mart. Many of its young employees received benefits through their families, and many of its older employees received benefits under Medicare. Some of its employees were receiving Medicaid, which was also the case with a number of other employers in low wage industries.

This raises another question: Why was Wal-Mart the target and not Home Depot or Target or another big box retailer. One answer is simply that Wal-Mart is the biggest and hence the natural target. Another is that it has had the greatest impact along the lines raised by its critics. A third, as indicated in the case, is that it threatened union jobs in the supermarket industry. Home Depot and Target did not provide a threat to unions. It also unleashed NIMBY movements as it modified its store opening strategy and began to target large cities. Other big box stores also generated NIMBY opposition.

Most of the social pressure on Wal-Mart comes from private politics. In the case of the national campaigns against the company, the private politics is well-organized and well-financed. The motivation for the private politics campaigns is primarily the threat to unionized supermarket employees resulting from Wal-Mart’s importance in the grocery market. The unions have also had no success in recruiting Wal-Mart employees. The SEIU and UFCW set up and staffed Wal-Mart

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Watch and WakeUpWalMart.com. This is also an opportune time, since Kerry had lost the election leaving a number of Democrat operatives with nothing to do. The SEIU also financed the Center for Community and Corporate Ethics that focused on Wal-Mart. The unions also financed the media campaign against the company. With this leadership others that had complaints about Wal- Mart saw this as an opportunity to advance their agenda. The teachers’ unions jumped on Wal- Mart to oppose the support of school voucher programs. Other interest groups including MoveOn.org and ACORN also joined the fray. The opening of stores in large cities faces opposition of two types. The first is from unions that often are stronger in large cities than in the small towns and suburbs were Wal-Mart had concentrated its store openings in the past. The second is from NIMBY movements. This was not particularly a strong force in Chicago, but it was in Inglewood, California and in New York City. The Chapter 7 case WalMart and Its Urban Expansion Strategy addresses the issues surrounding Wal-Mart’s attempt to open two stores in Chicago. The private politics campaign poses two kinds of problems for WalMart. First, it may cause some of its current customers to stop shopping at its stores. How big this effect would be is not clear, since many of its customers will still want value. Second, it may harm Wal-Mart’s market strategy of seeking customers with bigger wallets who would buy higher margin items such as consumer electronics. These consumers have more discretionary income and could easily not go to Wal-Mart for an HD television, for example, even though they would have to pay more elsewhere. The public politics threats are also important. The WalMart bills are of concern in states in which unions are strong and Democrats are in control of the legislature and governor’s office. The Republican governor in California vetoed the bill. The other institution to control these bills is the courts. The courts overturned the bill in Maryland, as I recall, on the grounds that it did not provide equal protection to the companies subject to the provisions of the bill. Wal-Mart’s nonmarket strategy had two components. One was to counter the information, or misinformation in its view, provided by its opponents. The second was to develop a nonmarket strategy to address a set of fundamental issues, such as the environment and sustainability, that might establish a stronger reputation for social responsibility. This could appeal to current customers and particularly to potential customers with bigger wallets and greater discretion regarding their purchases. Some steps to address social issues such as the environment and the topical issue of health care benefits could appeal to the new customers it sought to attract. Some responses were out of the question. Wal-Mart had no reason to raise the wages it paid or provide more generous benefits, nor change its working conditions, although it should make sure that it is not violating the employment laws. The large number of applicants for jobs at Wal-Mart speaks volumes to the critics. Moreover, Wal-Mart employees are generally happy with their jobs. Wal-Mart certainly did not want to make it any easier for unions to sign-up its employees. The public does not particularly like unions, and many union members shop at Wal-Mart despite its opposition to unionization. Wal-Mart also does not want to assume the kinds of responsibilities that General Motors assumed after WWII. As CEO Scott said, retailing cannot play such a role. His reasoning was probably that retailing is very competitive and margins are thin, which makes it difficult to pay wages and provide benefits higher than required by the labor market.

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Another important characteristic of its operations was revealed in the leaked memo. After a year on the job store employees do not become more productive. This means that Wal-Mart can operate by attracting short-term employees rather than those who envision a career with the company accompanied by rising real income. (The exception is those employees who enter management.)

This also means that Wal-Mart can position itself in the labor market as providing a second income to a household. This may be a lower-cost alternative than some of the measures, such as higher wages and more generous benefits, its critics call for.

Little information about Wal-Mart’s market strategy is provided in the case, although many students will be familiar with its strategy. The two aspects that might be the focus of a discussion are its urban expansion strategy and its goal of attracting shoppers with larger wallets. The latter group could be influenced to some extent by Wal-Mart’s reputation and public image. The opposition to opening stores in urban areas can be lessened by taking some steps, but another way to lessen opposition is to essentially buy off the opposition. Wal-Mart attempted to do this, for example, by providing local businesses with opportunities to locate near its stores and to provide free advertising on Wal-Mart’s in-store communication system. More would likely be required to eliminate the opposition by local merchants.

An integrated strategy involves a nonmarket strategy to reduce the pressure and improve its reputation, and the potential reward is both from its current customers and from enabling a market strategy designed to attract customers with bigger wallets.

The following questions can be used to lead the discussion.

Discussion questions:

1. Why has Wal-Mart become the target of this nonmarket pressure and why did it happen when it did?

2. What should Wal-Mart do about the private politics campaigns? Should it fight back, bargain with the groups supporting the campaigns, or concede to their demands?

3. What should Wal-Mart do about the public politics campaigns?

4. Should Wal-Mart drop its opposition to unionization?

5. Formulate an integrated strategy for Wal-Mart.

Developments: The details of Wal-Mart’s new strategy are presented in the Chapter 19 case Wal-Mart: Nonmarket Pressure and Reputation Risk (B): A New Beginning. As that case indicates Wal-Mart adopted a very aggressive social responsibility policy, particularly with respect to the environment. This policy had some effect, although it is difficult to assess its full impact. It led the organizers of one of the campaigns to call off their campaign. To illustrate the effect, in September 2007 I chatted with a first-year MBA student at Stanford University who was interested in the environment and corporate social responsibility. She said that she and other students with similar interests had been discussing whether they could make a greater impact working for an NGO or working for Wal- Mart.

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With the economic slowdown in the summer of 2008 many retailers experience a decrease in sales.

Wal-Mart’s sales, however, increased, as cautious customers turned to Wal-Mart value. In October 2008 after the Dow Jones Index was just above 8,000 the only company in the Index whose value had increased during the past year was Wal-Mart.

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PART II

PUBLIC POLITICS AND NONMARKET STRATEGY

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Chapter 6 Nonmarket Analysis for Business This chapter develops a parsimonious approach to the analysis of political behavior. The approach combines the institutional knowledge provided in the Appendix with the analysis of interests and provides the foundations for the formulation and implementation of political strategies as considered in Chapters 7 and 8, respectively. Nonmarket action can take the form of private politics as considered in Chapter 4 or can be directed to government institutions. This chapter and the other chapters of Part II focus primarily on public politics and on legislative institutions and in particular Congress. Institutional information on regulatory and executive branch agencies is provided in Part III. Institutional information on Japan is presented in Chapter 14, the European Union in Chapter 15, and China in Chapter 16.

The underlying theory is that of distributive politics in which nonmarket action is motivated by the benefits it can yield. The moral motivations of collective action are also briefly considered and are developed in more detail in Part V of the book. Distributive consequences and moral motivations are one side—the demand side—of the nonmarket action calculus. The supply side focuses on the cost of individual and collective action. The notion of the supply and demand of nonmarket action is more than a metaphor and, in principle, can be used to predict the amount of action generated.

At a minimum, the approach is used to provide an assessment of the amount of the nonmarket action likely to be generated on an issue. This assessment can be summarized in the distributive politics spreadsheet presented in Figure 6-3.

The perspective taken in the chapter is that most nonmarket issues addressed in the arenas of government institutions are contested and that the competition over those issues, along with characteristics of the institutions and the preferences of institutional officeholders, are the principal determinants of the outcome. The nature of this competition is characterized in a highly simplified manner in Figure 6-2. This characterization is used in a number of the subsequent chapters and in several cases.

The underlying framework is based on the concept of structured pluralism, which is a general perspective for assessing the political economy of nations. This perspective is applied in Chapter 14 to the political economy of Japan. The perspective is that private interests are the principal force affecting political outcomes on nonmarket issues. Public policy analysis, in contrast, provides technical information about alternatives, whereas interests provide politically-relevant information.

This perspective also recognizes the pluralistic nature of interests, so interests may compete on issues. This is particularly the case on issues characterized by distributive politics.

The building blocks of the framework are an interest’s demand for nonmarket action on an issue and the cost of taking that action. The demand depends on the aggregate and per capita consequences likely to result from an alternative and any substitutes that allow the interest to offset some of those costs. The concept of substitutes is developed in the chapter and is applied in the Tobacco Politics case. The costs of nonmarket action include the direct costs of activities and other

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costs such as the cost of organizing for political action. The assessment of the costs of political action includes the assessment of the likely effectiveness of that action, which depends on the numbers participating in the political action and their coverage of legislative districts. The results of the assessment of the demand and cost of nonmarket action by the affected interests can be summarized in a distributive politics spreadsheet.

Two points worth emphasizing about the distributive politics spreadsheet are that it pertains to a specific alternative and that it pertains to interest groups and not institutions. The spreadsheet and the analysis that underlies it are specific to the particular nonmarket alternative in question. In the Boeing example the alternative is seeking an exemption for job-creating exports. The alternative that is considered determines which interest groups are on which side of the issue. In the Boeing example, that alternative puts the tax-exempts making sale-and-leaseback deals on the other side of the issue from Boeing. The second point is that the spreadsheet pertains to the action of interests and interest groups and not of institutional officeholders. The institutional officeholders are typically the target of the nonmarket action, as in the case in which the nonmarket action takes the form of lobbying. The institutional officeholders also act, but mostly that is within the structure and procedures of the institution. The principal exception is political entrepreneurship in which a legislator seeks to initiate action to appeal to or represent some organized or unorganized set of interests or voters. Institutional officeholders are important to the outcome of many nonmarket issues, but most legislators are interested in the consequences of alternatives for their constituents.

The interests of those constituents are what is summarized in the distributive politics spreadsheet.

The Boeing and Foreign Leasing example provides a comprehensive example of political analysis and strategy formulation. This example is sufficiently complex that a lecture could focus on the example reviewing how the approach is applied. This example is also useful in making the point that even an important, well-managed (at the time), and economically-powerful company like Boeing may not be able to muster enough political influence to obtain a favorable outcome. In this example, interests and institutional officeholders weigh against Boeing’s interests.

Pickle represented Lyndon Johnson’s former district. He was one of 5 Southern Democrats who voted for the Civil Rights Act of 1964. An article on Pickle was in Asset Financial International, May 2, 2003. http://global.factiva.com/en/arch/display.asp The Tax Reform Act of 1986 repealed the investment tax credit.

The appendix to this chapter presents institutional information about the structure and organization of Congress, the legislative process, and the behavior of legislators. The executive branch is also briefly considered. A number of executive branch agencies, such as the Environmental Protection Agency, antitrust enforcers, and independent regulatory commissions are considered in Part III of the book.

To illustrate the use of many of these concepts, the chapter presents a detailed analysis of the congressional extension of daylight saving time. This example includes an assessment of interests and their incentives for political action, the role of congressional committees and procedures, and political behavior. The outcome is interpreted through the median voter theorem. Supporters of a longer period of daylight saving time continued to work for extensions. For example, Senator

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Michael B. Enzi (R-WY) introduced the Halloween Safety Act of 1999 to extend daylight saving time to the end of the first Sunday of November. An extension of daylight saving time was included

by Congress in the energy bill, but as of May 2005 that bill had not been passed. An extension was subsequently enacted.

The median voter theorem, and much of the analysis of behavior in public institutions, is based on the preferences of institutional officeholders. As indicated in the chapter, those preferences can be thought of as derived from the preferences of the member’s constituents and from his or her personal policy preferences. These preferences are reflected in the voting of members, and that voting is evaluated by interest groups. These evaluations are not precise predictors of future voting and are better thought of as indicating preference tendencies.

The film, An Act of Congress, is an excellent introduction to the congressional process, the nature of political competition, interest group activity, and lobbying. The film has been available from Learning Corporation of America, Simon & Schuster, 420 Academy Drive, Northbrook, IL 60062.

The film follows a bill—the 1977 Clean Air Act Amendments—with a focus on auto emissions standards. The issues in 1977 were virtually the same as in the 1990 Clean Air Act amendments addressed in Chapter 11, and remain current in the 21st century. This film is nearly an hour in length, so I have shown it in a special (optional) session during the lunch hour. Representative Rogers and the environmental interest groups view the issue as providing benefits to everyone, whereas Representative Dingell and the auto industry view it as imposing heavy costs on identifiable groups. One aspect of this film is that it shows that firms and organized labor can be on the same side of an issue. This is an instance of entrepreneurial politics where Rogers is the entrepreneur. At the time the film was made, Rogers was moving the bill through Congress and was in a bargaining mode as he worked to obtain votes. The film does not show much of the activity of the environmental interest groups, but they were quite active on the issue.

(Rogers at one point refers to “environmental experts.”) The Sierra Club was quite active on the issue, but the battle was led by the National Clean Air Coalition. To lobby on the issue, the Coalition flew in constituents from twelve states whose representatives were largely uncommitted In preparation for watching the film, students might be asked to pay attention to the relationships between Congress members and interest groups, the various hurdles that a bill must surmount to be enacted, how the representatives attempt to frame the issue, and how Rogers and Dingell attempt to obtain votes. Students might also be asked how important political parties are on this issue and what role the president had on it. (Neither was very important.)

An Example of Nonmarket Analysis The following is an example of nonmarket and institutional analysis. This example can be used as a basis for a lecture to illustrate the incentives that distributive consequences provide for political action and the difficulty of sustaining collective action. The example also illustrates the difficulty Congress often has in resolving distributive issues.

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AARP and Catastrophic Health Insurance In the mid-1980s, the American Association of Retired Persons (AARP) initiated a broadscale campaign to obtain long-term care for the elderly. In 1987, the Reagan administration, under the leadership of Health and Human Services Secretary Otis Bowen, introduced legislation to provide limited coverage for the elderly against catastrophic illness. Because of the president’s commitment not to raise taxes, the coverage was to be financed by a small increase in the monthly premiums paid by those who elected Medicare’s Part B physician and outpatient cost coverage program.

AARP is representative of a number of interest groups, except for its size. To attract its 32 million members, it offers a variety of services. In 1988, AARP generated revenues of $262 million, of which membership dues accounted for $90 million. AARP received $34 million from its publications, $30 million from the sale of prescription drugs, interest income of $31 million, and $74 million from other activities.

In conjunction with the Villers Foundation, AARP organized a coalition, Long Term Care 88, to support catastrophic care legislation. The coalition also worked to influence the positions of candidates in the 1988 presidential elections. At the same time, Democrats in the Congress saw the Reagan administration’s initiative as an opportunity to expand Medicare, which had incurred budget cuts during the previous six years.

Surveys of AARP membership had consistently indicated that a long-term care program was their highest priority, and AARP sought to expand the Reagan administration initiative. The problem for AARP was that the federal deficit and the president’s commitment not to raise taxes meant that the expanded program, estimated to cost more than $20 billion annually and eventually perhaps as much as $50 billion, could not be funded within the realities of the federal budget.1 Increasing the monthly premiums to cover the cost of the catastrophic care program was judged to be infeasible because the premiums would be so high that many Medicare participants would drop Part B coverage. The congressional supporters of the expansion decided to finance the catastrophic care program by taxing those who would be able to pay, while exempting from the tax those who were likely to drop Part B coverage. Their strategy was to impose a surtax, referred to as a “supplemental premium,” on the 33 million beneficiaries of the program.2 Under this strategy, the 97 percent of the beneficiaries who elect Part B coverage would have $4 per month withheld from their social security checks. The 40 percent of the beneficiaries who pay $150 or more in federal income tax would in addition pay the surtax, which would rise with income to a maximum of $800 per person or $1,600 per couple. The surtax was to increase by more than 30 percent by 1993. To meet Gramm-Rudman-Hollings budget restrictions, the Ways and Means Committee specified that the additional premiums and surtax be front-loaded with the benefits to be phased-in after the tax had begun to be collected.

1

The catastrophic illness program was actively opposed by the Pharmaceutical Manufacturers Association which feared that the program could result in price controls for drugs and in provisions mandating the substitution of generic for brand name drugs.

2 Medicare is financed by payroll taxes, general tax revenues, and premiums paid by beneficiaries.

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AARP was successful in pressuring Congress to enact the catastrophic insurance program. Once enacted, however, a grassroots uprising against the surtax began among the elderly. Although the catastrophic insurance program was undoubtedly supported by a majority of the elderly, it was impossible for AARP to commit all its members to support the program. AARP members picketed the Florida AARP headquarters protesting their leader’s support for the program.

During the August congressional recess, many members of Congress were sharply criticized, and even harassed, upon return to their districts. In a highly publicized event, constituents blocked the automobile of Representative Dan Rostenkowski (D-IL), chairman of the Ways and Means Committee, calling him “Rottenkowski.” Such strong protests soon led Congress to take the rare action of repealing a law it had enacted only a year earlier.3 The supporters of the expansion of the Reagan administration proposal had attempted to redistribute income from one group of elderly to another. This generated protests from those elderly who would have to pay for the program. The most vociferous protests were from those who would pay the surtax but would not receive benefits. Nearly 3.3 million of the elderly had longterm care insurance policies paid by their former employers. Furthermore, many of the elderly had purchased “medigap” insurance from private insurers and did not need the coverage provided by the program. A 1989 Congressional Budget Office (CBO) study estimated that 7 million elderly already had coverage in part or in full from their previous employers and thus would receive little or no benefit from the program. Some 6.9 million elderly had no coverage beyond Medicare and would benefit from it as would 11.7 million with private insurance who would have their premiums on the private insurance reduced because double coverage was prohibited by the law.

One of the most active supporters of repeal of the catastrophic insurance program was the National Committee to Preserve Social Security and Medicare, which used scare tactics to induce the elderly to pressure the Congress.4 It referred to the financing of the program as a “seniors-only surtax” and implied that everyone participating in Part B of Medicare would have to pay the full $800.

New grassroots organizations were also formed to oppose the financing of the program. United Seniors of America was formed and conducted a campaign “to help spread the word to get this unfair law changed.” The Conservative Caucus conducted a campaign against the “Catastrophic Coverage Tax” urging seniors to contribute to the campaign because their contributions “could help save millions of Americans (including you) from paying an extra $800 per year (and more) in taxes 3– year after year after year.”5 The result was over 5 million letters to Congress members on the The repeal did not cover certain benefits provided under Medicaid, the program jointly-funded by states and the catastrophic illness program. The attack on the financing of the program had spread to the federal government.

4

The National Committee has a membership of 5 million, a budget of $48 million, and was headed by James

program Roosevelt, son of Franklin Delano Roosevelt.

5 Congressional Weekly Report, Octoberrepeal 14, 1989. itself, and for Quarterly many members of Congress was the easiest way out of the predicament.

The repeal occurred after repeated attempts in both the House and the Senate to preserve the 147introduced a proposal to reduce the surtax to no program in some modified form. Rostenkowski more 5 percent of an individual’s tax liability, but the surtax could still go as high as $800. In addition, increase the Rostenkowski proposal would double the deductible for Part B coverage and

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premiums by over 10 percent in the first year and by over 20 percent by the fourth year. The bill did not garner substantial support. Senator John McCain (R-AZ) introduced a compromise that would repeal both the surtax and two costly benefits, stop-loss coverage of doctor bills and coverage of prescription drug costs, but would preserve unlimited hospital stay coverage plus some other benefits. Senator McCain successfully steered the bill through the Senate, but the House voted 360 to 66 for repeal, and the Senate went along.6 The program had been repealed before it had even taken effect.

After the repeal, as Representative Willis Gradison (R-OH), a co-author of the 1988 bill, stated, “Even if you get 65% of the membership behind you, what we’ve learned is that the remaining 35% may have an effective political veto.”7 Gradison also remarked, referring to AARP, “All of us are entitled to be skeptical when any group purporting to represent the elderly says, ‘Our members are willing to pay for this if you give us that.”’8 The inability of AARP leadership both to discern the preferences of its members and to control their independent political activity was the cause of a major embarrassment to those who had supported the catastrophic insurance program. It also was a signal that AARP was not as powerful as had been believed.9

Cases

Tobacco Politics This case provides an opportunity to apply the framework assessing the motivations for nonmarket action, the demand for and supply of nonmarket action, and the nature of the politics.

First, consider the politics of the Tobacco Resolution. The resolution was the result of three-sided bargaining among state attorneys general, tobacco companies, and class action (trial) lawyers. The trial lawyers were parties to the bargaining because they represented class-action plaintiffs who claimed injury due to cigarette smoking. The politics of the bargaining were largely entrepreneurial with the trial lawyers and the state attorneys general representing interests, plaintiffs and taxpayers, respectively, acting as entrepreneurs with the tobacco companies bearing 6

The program had initially been approved by a 328 to 72 vote in the House and an 86 to 11 vote in the Senate.

The New York Times, December 27, 1989.

8 Congressional Quarterly Weekly Report, October 14, 1989.

9 One explanation for the willingness of a number of the members of Congress to repeal the program was that a catastrophic illness program for the elderly, many of whom already have insurance coverage, was not as important as providing care for those who had no health care insurance. After its defeat, AARP apparently concluded that a better strategy was to work for health care coverage for all. Some members of the Congress also voted for repeal because they believed that with the slate clean they could develop a new plan. Representative Gradison, however, commented, “I think the slate is going to remain clean for some time to come.” Congressional Quarterly Weekly Report, October 7, 1989, p. 2635. AARP was an active supporter of the Clinton administration’s attempt to restructure the U.S. health care system and provide universal coverage. As a result of its political activity, Senate Republicans held hearings on whether AARP’s tax-free status should be withdrawn 7

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the cost of the resolution. (The resolution was also beneficial to the tobacco companies relative to going through a series of trials and subsequent appeals.) The motivations of the bargainers basically resulted from distributive considerations, although one could argue that there were some moral motivations associated with reducing smoking. The state attorneys general, for example, sought funds to cover healthcare costs borne by taxpayers through the state budget.

They were also interested in claiming credit for the resolution and for some officeholders positioning themselves to run for higher office. Next, consider the bill S.1415, which would turn the Tobacco Resolution into law. The bill would increase regulation of tobacco including giving the FDA authority to regulate tobacco as a drug. The bill would also impose a hefty excise tax to pay for health care costs and would put tobacco company documents in the public domain.

Liability of tobacco companies would be capped at $6.5 billion a year. Advertising and promotion would be restricted, although cigarette-only stores would be exempt from the restrictions on promotions. Retail stores would be required to obtain a license to sell tobacco, and as mentioned above farmers would receive transition payments. The bill represents the negotiated resolution. A variety of interests that were not party to the bargaining over the resolution would be affected. Some of those, such as tobacco farmers, were provided for in the bill, but most were not. The distributive consequences of the bill fall on identifiable interests most of which are already organized for nonmarket action. Their objective is to reduce the costs they would bear if the bill were enacted. Those interests thus were positioning themselves as clients to be served by Congress, and they sought exemptions, transition payments, and other special provisions to reduce their burden. Any congressional responses to the clients would reduce the benefits to the dispersed taxpayer and plaintiff interests. Consequently, S.1415 was considered in the context of client politics. The clients were likely to use behind the scenes strategies such as lobbying rather than more public strategies such as grassroots demonstrations.

On the two sides of dispersed interests are two interest groups: trial lawyers who seek to preserve their fee arrangement and the tobacco companies (representing tobacco farmers, for example).

Whether these interests would be better or worse off if the bill failed and new negotiations resulted is not clear. Since they agreed to the resolution they may be better off with the resolution than with renewed bargaining or going to trial. The interests of the tobacco companies and the trial lawyers are diametrically opposed on some dimensions of S.1415, such as the cap on liability. Both the tobacco companies and the trial lawyers have a high demand for nonmarket action, are well- organized, and have considerable resources. Their numbers and coverage are limited, however. There are not many trial lawyers involved in the class action cases, but they may be able to call upon support from the Association of Trial Lawyers of America (ATLA), which is one of the more active and effective interest groups at the federal level. The ATLA is closely linked with the Democratic Party and is often the largest contributor of campaign contributions to Democrats. The tobacco companies can to some extent call on their rent chains (suppliers, distributors, farmers, etc.—see Chapter 7) for support, numbers, and greater coverage. Both interest groups will continue to be active in tobacco politics. State attorneys general also have an interest in the passage of S.1415, and their influence is through their links to members of Congress. They, however, are few in numbers, and those they represent have dispersed interests and high costs of organizing for and taking nonmarket action. Hence, they

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are not likely to be involved, and the state attorneys general are unlikely to be able to generate any substantial effective nonmarket action.

The principal clients in this case are the interests that were not represented in the bargaining over the Tobacco Resolution. Any exemptions and special provisions for them would likely be at the expense of the dispersed interests rather than the trial lawyers and the tobacco companies, which is characteristic of client politics.

Antismoking groups have few effective substitutes for S.1415, and their moral motivation makes their demand high. They are already well-organized and have chapters that give them extensive coverage, although the number of active participants in their activities is limited. They thus have a moderately high demand for nonmarket action, low costs of organizing for nonmarket action, modest resources, and small numbers. They will support stronger restrictions on smoking and large transfers to taxpayers and plaintiffs. Their effectiveness, however, will be limited by the relatively small number of active participants and limited resources. (Note that these groups have been working on restrictions on smoking for decades with only limited success. It was the class action lawsuits that led to the Tobacco Resolution.)

Wholesalers, convenience stores, grocery chains, and other retailers have high aggregate and per capita demand for exemptions and for less stringent restrictions. They have few substitutes for the decrease in demand that the excise tax and the restrictions on advertising and promotion would cause. Their demands are not identical but their interests are aligned. In addition to decreased cigarette volume, wholesalers will incur higher insurance and theft costs, and grocery stores will lose some slotting fees. All three of these interests have large numbers, substantial resources, extensive coverage, and low costs of organizing for nonmarket action. They will be active and effective in the client politics, but they will not oppose the bill.

Cigarette-only stores are relatively few in number compared to convenience stores, however, and the “adult bookstore” part of the business of many of them will limit their influence on officeholders. Their demand for nonmarket action has already been met to some extent by exempting them from restrictions on point-of-purchase promotions. They will work to preserve that exemption and otherwise are likely not to be active. (Presumably, anyone who enters a cigarette-only store is there to buy tobacco products, so promotions represent interbrand competition and are likely not to affect aggregate demand for tobacco products.)

Advertising agencies receive a significant portion of the estimated $5 billion in advertising and promotional expenditures on cigarettes, and S.1415 could significantly reduce that spending. The agencies have no substitutes for this source of revenue, and hence those with tobacco clients (high per capita benefits) have a substantial demand for nonmarket action. Their number is limited, however, and their coverage is likely to be moderate at best. Their cost of organizing for nonmarket action is probably moderate. They will be able to supply only limited nonmarket action unless they are able to enlist the AAAA. If they can do so, they gain numbers, coverage, and resources.

Concert promoters and organizers of golf and tennis tournaments would lose sponsors because of restrictions on promotional activities, but they have close substitutes in the form of other

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advertisers interested in sponsoring events. The demand for nonmarket action thus is small.

Moreover, they are few in number and have very limited coverage. They are not likely to be very active or effective.

Tobacco farmers are provided for in S.1415, although farmers have a demand for greater support.

They have as substitutes other crops that they could grow, although tobacco can be grown on marginal land, so substitutes may not be very close. There are many tobacco farmers in a moderate number of states, and farmers are well-organized for nonmarket action. They have modest resources. They can be expected to be active in seeking higher transition payments. If they can enlist the support of larger farmer organizations, such as the Farm Bureau, they would be able to generate substantial and effective nonmarket action.

Universities are unlikely to be active. They have the alternative of selling tobacco stocks as a substitute for their moral concerns.

The overall prediction from this analysis, which can be summarized in a distributive politics spreadsheet, is that there will be substantial nonmarket action on S.1415 with the clients seeking to whittle down the bill to their benefit or to load the bill with special provisions and exemptions. The bill stands a good chance of stalling in Congress.

Teaching the case: The organization of the discussion can center on filling in a distributive politics spreadsheet. The discussion can be led with the following questions: 1. Which interests are affected by S.1415? Which of them participated in the bargaining over the

Tobacco Resolution?

2. What is the nature of the politics of S.1415?

3. Assess the amount of effective nonmarket action each interest is likely to mount.

4. What strategies will the interests choose?

5. What is the likely outcome of S.1415 and why?

Outcome: S.1415 was referred to the Commerce Committee, which made changes in the liability provisions. This caused the tobacco companies to withdraw their support for the bill, and they launched a $40 million advertising campaign against the bill. Interest groups then became more active, and the lobbying by those favoring and opposing the bill intensified. Some Republican senators led a filibuster against the bill and three cloture votes failed along party-line voting.

On a fourth cloture vote, thirteen senators switched their votes, but that was not sufficient to invoke cloture. The bill died. The politics of S.1415 were sufficiently complex and intense that the resolution had unraveled. A new agreement was negotiated in 1999, but no new legislation was enacted. An analysis of S.1415 is provided in Alan Wiseman, “Votes for Smokes: VoteBuyer Theories and Tobacco Politics,” Working paper, Stanford University, 1999.

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Despite the collapse of the federal effort on tobacco settlements and regulation, the three dominant tobacco companies reached a settlement with the states in 1998. The tobacco companies agreed to change some of their practices and pay the states for a portion of their health care costs. In 2004 those payments were $6.1 billion. This agreement was titled the Master Settlement Agreement.

The Department of Justice later filed a lawsuit against the tobacco companies alleging a 50-year campaign of deceit and fraud in the marketing of cigarettes. This lawsuit may have been filed under RICO. The case was in trial in May 2005.

The Tobacco Settlement with the States: Update A little-noticed clause in the Master Settlement Agreement of 1998 provided the three tobacco companies with an opportunity to reduce their payments to the states. The clause provided relief on the payments because the companies had lost 6 points of market share (to a 91.9 percent share) to tobacco companies that were not part of the settlement. The loss of market share was due to the higher prices charged by those three companies to cover the costs of the settlement. The companies reported that the average cost per pack was $0.425. “You’ve had a boatload of consumers say ‘I don’t want to pay $1.70 for a pack of Camels or Marlboros, I’d rather pay $1.10 for a lower-end cigarette,’” Tommy J. Payne, an executive vice-president for Reynolds, said in an interview last fall.10 The three companies asked the states to return some of the $6.2 billion paid last year and planned to reduce payments in the current year. The states vowed to fight back. Some states indicated that they would go after the small tobacco companies.

Scrubbers and Environmental Politics The issue of scrubbers and environmental policy has been a recurring one and in Chapter 11 is considered in the context of the 1990 Clean Air Act. The issue addressed in this case is whether to require scrubbers for new power plants; i.e., the NSPS pertains to new power plants and not to old ones. The issue in 1990 was whether to mandate scrubbers for old (existing) power plants, and the motivation was the reduction of acid rain. In 1977 the politics of the issue overwhelmed considerations of economic efficiency, and the most efficient means of controlling emissions were not mandated. In 1990 efficiency considerations ultimately prevailed, as concerns mounted about the high cost of scrubbers and the effect on the price of electricity and the possible loss of jobs.

Scrubbers add about 15 percent to the cost of electricity.

The objective of this case is to assess the distributive consequences of a legislative alternative and the possibility of coalition formation to achieve an outcome preferred by groups with quite different interests. One point made by the case is that efficiency—or good public policy in this case—does not dictate the outcome of a political competition.

10

Business Week, May 23, 2005.

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In the context of the nonmarket issue life cycle, this issue is in the administrative stage of the Clean Air Act Amendments. The scrubber issue itself is at the interest group stage.

Teaching the case One way to begin the discussion of this case is to ask what is the most efficient means of achieving the NSPS. (Whether the NSPS represents the “right” amount of pollution to allow is quite another issue.) The answer is that utilities should be allowed to meet the standard in the manner they deem best. That is, to achieve the environmental objectives at the lowest cost, which ultimately means the lowest cost to customers. That is, the utilities would choose the most efficient means of meeting the NSPS whether that is using low sulfur western coal or scrubbers. (There are a number of other alternatives such as coal washing that removes sulfur prior to burning.) For many utilities low sulfur coal is the more efficient alternative. (This is considered in Chapter 11.) The next most efficient alternative is to mandate scrubbers in the east but not in the west, since in the west the power plants will use low sulfur coal anyway.

The next question might be “What is Congress likely to do?” The worst alternative is to require scrubbers everywhere, which is what the Congress did. The students should not be told this but should arrive at this conclusion.

The next question might be to ask about the politics of the situation. This is a case of distributive politics—note that environmentalists’ concerns are based on their preferences and hence are distributive although they may be motivated by altruism. Environmental interest groups claim to represent people more generally whose interests would not otherwise be represented, and in that sense, they act as political entrepreneurs. That claim may not be very persuasive in this case because the benefit would only occur in the west and would involve a reduction substantially below the NSPS. Moreover, electricity customers would be hurt. A more credible claim of representing the unrepresented can be made by the power companies in the east which will be forced to install scrubbers at a substantial cost to consumers. Much of those costs could be avoided by purchasing western coal. Doing so could also improve air quality relative depending on how reliable their scrubbers are.

The interests affected by the political alternative of mandating scrubbers are 1) eastern coal interests — both mining companies and the UMW, 2) western coal interests — primarily new mines that would open and new employees who would be hired, 3) electricity customers in both the east and the west, and 4) breathers — primarily in the west who would have somewhat better air quality if scrubbers are mandated. In terms of the Wilson-Lowi matrix, this issue involves interest group politics.

Note that the western coal interests are largely future interests, since new mines would be opened (or existing mines expanded) in response to an increase in demand by new eastern power plants.

These mines have as yet no sunk costs so their future rents equal their future profits. Future interests are costly to organize and hence cannot be expected to be very active in the political competition. In contrast, eastern coal interests are already in place. Eastern mines have high sunk costs and thus rents that are considerably in excess of their profits. UAW miners also earn

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substantial rents as a result of their high wages and generous benefits. There are thus substantial rents being earned in the east on mining jobs and on mining assets and hence a high demand for taking political action. The eastern coal interests are already well-organized, so they have low costs of supplying nonmarket action. Thus, eastern coal interests can be expected to generate considerable political pressure, and western coal interests can be expected not to generate much political pressure. Even though eastern coal interests are likely to be much stronger than western coal interests, those interests do not have coverage of enough legislative districts to pass a measure mandating scrubbers. Environmental interest groups are also well-organized and have a substantial demand for nonmarket political action in support of mandating scrubbers.

Environmentalists have little concern about whether eastern or western coal is burned in eastern power plants. Furthermore, they seem to have little concern for the dirtier air that could result from scrubbers that do not work effectively. That is, scrubbers and eastern coal can result in higher emissions than western coal and no scrubbing. Environmentalists are primarily interested in preventing the degradation of air quality in the west, but they are unlikely to have enough strength to pass a measure mandating scrubbers only in the west. This analysis identifies an opportunity for a coalition of eastern coal interests and environmentalists to support mandating scrubbers nationwide. This coalition was never official but was implicit as both groups backed the mandating of scrubbers. The opposition to this coalition was primarily the power companies. Because of average cost pricing imposed by regulation, the costs of scrubbers would be passed on to customers. Consumers have high costs of organization and for many the per capita additional cost of electricity is not high, so they cannot be expected to be politically active. Business customers might oppose mandatory scrubbers, but at this point in time the costs of scrubbers were not well-known. The higher price of electricity would result in the loss of jobs, but those potentially affected would be hard to identify and even harder to organize. One body that could represent customers was the state regulatory commissions which are responsible for passing on the cost of scrubbers to consumers. They were either not active or ineffective on this issue, however, because of the associated environmental politics. The distributive politics spreadsheet is useful for this case and helps explain the coalition between eastern coal interests and the western environmentalists. A spreadsheet is provided in the PowerPoints. Outcome Congress mandated scrubbers for new coal-fired power plants. The politics and economics of this issue are analyzed in Dirty Air/Clean Coal, by Bruce A. Ackerman and William T. Hassler, Yale University Press, New Haven, CT, 1981. They conclude that the scrubber coalition produced higher electricity costs, dirtier air in the east, and somewhat cleaner air in the west.

Scrubber technology

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and maintenance improved substantially over time, and they are now quite effective but remain quite costly. (See Chapter 11.)

In congressional language, a scrubber is now referred to as a Phase I technology defined as “a technological system of continuous emissions reduction that achieves a 90 percent reduction in emissions of a pollutant.”11 The sludge created by a spreadsheet is still a problem, although a limited market has for sludge has developed. The Tennessee Valley Authority (TVA) invested in more expensive scrubber systems that produce a powder rather than gooey sludge. The TVA sells the powder to companies that turn it into gypsum used in the production of wallboard.

Repeal of the Luxury Tax In the context of Figure 1-1, an action in the nonmarket environment—the imposition of a luxury tax—had a substantial impact on the market for the taxed goods. The impact on the market resulted in losses to producers and consumers, and those losses provided the incentives to seek repeal of the luxury tax.

This case is an instance of distributive politics with an emphasis on the demand for and supply of nonmarket action. One aspect of the distributive issue is obvious—people buying the luxury goods pay a tax which reduces their consumer surplus, whereas taxpayers and the public benefit from the taxes collected. The broader distributive issue, however, centers on the impact of the tax on the rents of those who produce the luxury goods. The tax shifts downward the demand for the luxury goods. The firms producing the goods lose profits and lose rents on their fixed factors of production, employees lose jobs or receive lower wages (e.g., through layoffs or decreased hours worked), suppliers lose sales and hence rents, and communities lose tax revenues and may experience an increase in the demand for public services. The greater the fixed factors of production of firms and the lower the alternative wages for employees who lose their jobs the higher is their demand for repeal.

The consumer surplus of the rich is also reduced, but the rich have other uses for their money, so many of them will simply not buy the taxed goods. That is, the demand for the taxed goods is probably elastic, and certainly that is consistent with the observed effect on the sales of yachts. If demand is very elastic, the amount of tax revenue generated is small because of the contraction in the number of units sold. Indeed, if sales decrease substantially, states lose sales tax revenue, and the federal government loses excise tax revenue.

An elastic demand also means that only the rich who buy the taxed goods lose much. The rich are widely dispersed, not well-organized, and have high costs of organization. Furthermore, they do not represent a substantial constituency of members of Congress. The demand for the repeal of the tax

11

Congressional Quarterly WeeklyReport, November 24, 1990, p. 3947.

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thus comes not from the rich but from the companies and employees that lose business and jobs because the tax reduces sales. The rich are essentially irrelevant to the politics in this case.

With respect to specific interest groups, the discussion might focus on the automobile industry.

The U.S. auto producers have relatively few models subject to the luxury tax, so they may benefit from the tax to the extent that it reduces the demand for foreign luxury automobiles. The U.S. automakers thus should oppose repeal of the tax on automobiles—as long as the tax does not hit their own models (or even if it hurts their models less than their gain from the sales gain due to the decrease in the demand for imported luxury cars). One way to accomplish this would be to index the tax threshold for inflation, so that the threshold stays above the price of U.S. cars.

To the extent that the demand for the luxury goods is elastic, the loss of rents by the producers is substantial and results in a high demand for repeal. The producers will be able to generate substantial pressure on their own representatives, but their coverage is somewhat limited. There are only a few aircraft producers (in Dole’s state), but there are more boat manufacturers, although they tend to be located on the coasts (e.g., in Maine). The fur and jewelry industries probably have greater coverage. Luxury auto dealers have considerable coverage. The principal advantage these interests have is that there will be little interest group opposition. Those opposing the repeal will be members of Congress who like to tax the rich.

Another dimension of the luxury tax was the IRS rules implementing it. The IRS was concerned about evasion, and some of its rules brought howls of protest. (The IRS received 586 complaints from jewelers alone.) Jewelers complained that the law required that the value of jewelry supplied by the customer must be counted toward the $10,000. Thus a customer that brought in a piece of jewelry worth $9,999 to have the stones reset would be subject to a tax on the total value of the item.

Clearly, the proponents of the repeal of the luxury tax want to maintain a low profile and keep their activities out of the eye of the media. Informational lobbying is the principal strategy. They may also use testimony. The key messages are that jobs are being lost and that not much tax revenue is being obtained; i.e., the tax that was intended to hit the rich is actually hitting the worker and small manufacturers the hardest.

The analysis of the effect of the luxury tax should be conducted using industry demand and supply functions to identify the loss of rents and consumer surplus. The taxes collected and the deadweight loss can also be identified.

The repeal of the luxury tax is a clear example of client politics. The benefits from repeal are concentrated among producers and their employees, whereas the benefits, if there are any, from opposing the repeal are widely distributed among taxpayers.

The frameworks presented in the chapter there can be applied. That is, the demand and supply of nonmarket action for and against repeal can be assessed. The politics of the repeal of the luxury tax are basically a competition among interest with those opposed to a repeal (taxpayers) having very little incentive to oppose repeal.

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Discussion questions: 1. Which interests have an incentive to support repeal of the luxury tax? What about the automobile industry?

2. Which interests oppose repeal?

3. How can the distributive consequences of the tax be identified using demand and supply analysis?

4. What is the ability of the interests to generate political action?

5. What outcome do you predict? .

Outcome Even before the luxury tax took effect on January 1, 1991 efforts were under way to repeal it. The Bush administration opposed repeal, but after a year of mounting pressure it announced it would agree to an elimination of the tax on boats and aircraft. Congress then voted to repeal the tax on boats, aircraft, furs, and jewelry, but President Bush vetoed the bill. Six months later Congress again passed the same bill, and Bush vetoed it again.

The Clinton administration’s 1993 budget reconciliation bill repealed the 10% luxury tax on yachts, aircraft, jewelry, and furs. The luxury tax was retained on automobiles that cost more than $30,000. The price threshold increased with inflation in $2,000 increments.

After the luxury tax on yachts was eliminated in 1993, the yacht industry began to pick up. Viking Yacht’s orders picked up, and it expected its workforce to increase from 65 in 1992 to 600 by January 1994. In 1990, however, it had employed 1,500. “Maybe it’s not like the old days, but I think there is an upward movement,” says Alvin Wagner, owner of Jefferson Beach Marina in St. Clair Shores, Michigan.12 Rhode Island, which has a large boat building industry, repealed its 7% sales tax on boats.

If the luxury tax was so easily repealed soon after it was enacted, why was it enacted in the first place? The answer is that the provision was added in conference committee largely in secret as a result of a deal between President Bush and the Democrat majority in Congress. Interests had little if any opportunity to oppose it at that time.

In 1997 legislation was enacted to phase out the luxury tax on automobiles over a five-year period.

Dick Armey, chairman of the FreedomWorks Foundation and former majority leader in the Senate, wrote, “I remember watching Senator George Mitchell sing the praises of a new luxury tax that would ‘tax the rich.’ But as any Economics 101 student might have predicted, the immediate effect of this luxury tax was a share decline in the sales of “luxuries,” particularly new boats, and a dramatic loss of boat-related manufacturing and service jobs. It was less than a year before Senator Mitchell was working to lift the tax so his constituents in boatyards in Maine could go back to work.” (Wall Street Journal, November 2, 2007.)

12

Business Week, August 30, 1993.

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Chapter 7 Nonmarket Strategies for Government Arenas This chapter focuses on the formulation of strategies for participating effectively and responsibly in the politics of nonmarket issues. The focus is on legislative issues, but the framework and approach are applicable more generally.

At about this point in the book, students may begin to wonder whether political action by firms is a “good” thing. Three basic responses can be given. The first is that firms and their managers do it, so it is worth studying how they do it. Second, nonmarket action by firms is legal and constitutionally protected. Third, the appropriate limits within the realm of legal activities is in the domain of ethics. The second section of Chapter 7 raises these issues and provides a partial response. That response is largely based on the law, and ethics concerns are discussed in Chapter 20. A lecture on responsible nonmarket action that expands on the material in the text would be good. The Chapter 8 case Responsible Lobbying? raises these issues.

The chapter is primarily concerned with formulating nonmarket strategies and illustrating nonmarket strategy formulation through examples. The discussion of strategy formulation is general and builds on the treatments of institutional characteristics and nonmarket analysis from the two previous chapters.

The perspective taken is that strategy formulation is the responsibility of managers and not of consultants or advisors, although they can provide important inputs to the process and can assist in implementation. A lecture could emphasize this point and focus on the components of strategy formulation as illustrated by the examples presented in the chapter. The links to nonmarket analysis and institutional knowledge should be emphasized to make it clear that the material in Part II is an integrated whole rather than a collection of independent components. One aspect of the nonmarket strategy formulation process that might be emphasized is the importance of developing nonmarket assets such as the rent chain.

A lecture can focus on the process of strategy formulation as illustrated in Figure 7-1. This figure emphasizes that strategy formulation is based on the framework for analysis presented in Chapter 6 and the institutional information presented in the appendix to that chapter.

The concept of a rent chain is important as a foundation for nonmarket strategies and should be emphasized in a lecture. The rent chain can be important in the implementation of the three basic types of political strategies: representational, majority building, and informational. The basic strategies can be used alone or can be combined.

Majority building strategies involve vote recruitment and agenda setting. The concept of pivotal voters is important and is well-illustrated by the Federal Express (A) case.

Vote recruitment occurs not only in government institutions but also in nongovernmental settings.

In 2003 Hewlett-Packard CEO Carly Fiorina faced a possible rejection by shareholders of the

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controversial acquisition of Compaq Computer. Deutsche Bank reportedly had decided to vote as many as 25 million shares against the acquisition, and Northern Trust was also believed to be against the acquisition. Fiorina left a voice mail message for the HP CEO stating, “So, if you would take Deutsche Bank, I’ll take Northern Trust, get on the phone and see what we can get, but we may have to do something extraordinary for those two to bring ’em over the line here.” The acquisition was narrowly approved.

Informational strategies are implemented by lobbying and public advocacy as considered in Chapter 8. These strategies are illustrated by the China and Most Favored Nation Status example.

Informational strategies are often a component of a broader strategy encompassing representation and majority building for issues considered in legislatures. For issues considered in regulatory and administrative institutions, informational strategies are often the centerpiece, although as indicated in Chapter 10 representational and majority-building strategies are frequently used to pressure regulatory agencies through the legislature.

Cases Federal Express and Labor Organization This case provides an opportunity to apply the analytics of a majority-building strategy through vote recruitment. Federal Express found itself in difficulty when the bill to eliminate the Interstate Commerce Commission may have inadvertently changed the law under which its employees could be organized (whether this was the case would have to be determined by the courts.) Federal Express’s objective was to have a provision inserted in a bill that would clearly designate it as an express company, which was the origin of the company, and hence put it clearly under RLA jurisdiction. To accomplish this, its allies inserted the provision in a conference committee report, but when the bill encountered a filibuster in the Senate, it faced a more serious problem. It had to recruit 60 votes to have cloture invoked, after which the bill would proceed to a vote and certain passage. That is, to be successful it had to deploy a supermajority-building strategy and recruit sufficient votes. Although organized labor opposed the alternative sought by Federal Express, it had already executed its strategy, and the final move in the Senate belonged to Federal Express.

This stage of the labor organization issue is thus characteristic of client politics with only Federal Express active.

The basic principles of vote recruitment are to recruit only enough votes needed to win and to recruit those votes that are least-costly. The least-costly votes are those of Senators who are only mildly opposed to RLA jurisdiction. The instrument of Federal Express’s strategy was politicallyvaluable resources such as favors and vote trades on other legislation.13

13

This is not a description of Federal Express’s analysis, but instead is an analytical characterization of the principles of vote recruitment strategies.

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The following are answers to the preparation questions: 1. Senators 46 through 100 prefer b to q, since b is closer to their ideal point than is q. Since they will vote for b anyway, they do not require vote trades or support. (This group includes Federal Express’s allies as well as others.) Senators 1 through 40 prefer q to b, and their vote is not needed to invoke cloture, so they will receive nothing.

2. This is the complement of question 1. The votes of senators 41 through 45 are needed to invoke cloture. point. Senator 45 is indifferent between q and b, since they are equidistant from her ideal She needs only a tiny favor or a low-value vote trade to vote for b. Senators 41 through 44 will require a more valuable vote trade or favor for their votes.

3. Of those senators whose vote must be obtained with a vote trade or a favor, more must be given to 41 than to the others because 41 prefers q to b more strongly than do 42, 43, 44, and 45.

4. Several principles are reflected in these answers: a) Those who will support you in any event do The outcome: not need special favors on the issue (other than maintaining relationships, etc.). b) Do not waste your time, resources, and attention on was those who are strongly opposed. c) Target Federal Express’s nonmarket strategy successful, and the vote on cloture waspivotal 66 to 31.14 One legislators (41-45). In this case, those pivotal voters are the ones who are mildly opposed to your interpretation thisvalue situation is that or Federal figuratively recruited alternative. d)ofThe of favors vote Express trades required is greater thesome moreadditional opposed votes the as insurance; i.e., to provide for the possibility that it might have misestimated the preferences of pivotal legislators.

The bill itself then passed the Senate 92-2. Eventually the House passed the bill, too, voter is. e) Agenda setting and the president signed it.explains where b is located.

Implementation of the strategy: The strategy deployed by Federal Express was to focus on pivotal legislators, who in this case were Democrats who typically would vote with organized labor on such an issue. Those senators included Ernest Hollings, Max Baucus, Bennett Johnston, and Tom Daschle. The following table presents their ratings (on a scale of 0 to 100) by two interest groups—COPE (the AFL-CIO) and COC (Chamber of Commerce). (These ratings are explained in Chapter 6.) A high rating by COPE means that the senator votes in line with organized labor on issues of importance to unions. A high rating by COC means that the senator votes with business on issues important to business. The issues used in the ratings by the two groups are not the same, so a senator such as Bennett Johnston can have favorable rating by both business and labor.

14

Federal Express had to win two votes. The first was to overrule the Senate parliamentarian who had ruled that insertion of the provision in conference committee exceeded the authority of the conferees. The vote to overrule was 56-39.

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1994 COPE Baucus (Montana) 100 Daschle (South Dakota) 63 Hollings (South Carolina) 71 Johnston (Louisiana) 75

COC 32 37 46 53

Federal Express’s strategy was to build on the relationships it had developed over time, to lobby for the provision, and to enlist the aid of its allies. Federal Express had a continuing set of issues involving Congress, so it was experienced both in addressing nonmarket issues and in deploying a broad set of nonmarket strategies to obtain its objectives. As Doyle Cloud, vice-president of regulatory and government affairs explained, “We have issues constantly in Washington that affect our ability to deliver the services our customers demand as efficiently as possible.”15 For all the issues on its agenda, during the first six months of 1996, Federal Express spent $1,149,150 on lobbying, including $367,000 on outside law firms. Using outside firms is common, particularly for their contacts and established relationships with government officials. Federal Express also had on its board of directors Howard H. Baker, Jr., former Republican leader in the Senate, and George J. Mitchell, former Democratic leader in the Senate. Federal Express also was the fifth largest campaign contributor in the 1995-1996 election cycle, contributing $600,500 through August 30, 1996. Also, on a regular basis Federal Express made its four corporate jets available to members of Congress. Although the members were required to reimburse the company at the equivalent of first-class air fare, the corporate jets provided privacy and convenience to their passengers. In most cases, the flights took members of Congress to fundraising events. “Mr. Cloud said that during political seasons, Federal Express might fly a group of lawmakers about once a week.”16 Federal Express also benefited from the efforts of its allies in the Senate, many of whom were from the South. In addition, former Senator James R. Sasser of Tennessee, the ambassador to China in 1996, was said to have chatted with Senator J. Bennett Johnston about the Federal Express provision.17 Senator Russell D. Feingold, Democrat of Wisconsin who voted against Federal Express, assessed its overall strategy: “I was stunned by the breadth and depth of their clout up here. ...The sense I got was that this company had made a real strong effort to be friendly and helpful to Congress. ... In these informal conversations [with senators], people mentioned that they had flown in a Fedex plane or gotten other favors.”18

15

New York Times, October 12, 1996.

New York Times, October 12, 1996.

17 Ambassador Sasser had been retained as a consultant by Federal Express prior to his confirmation as ambassador.

(New York Times, October 12, 1996.)

18 New York Times, October 12, 1996.

16

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The extent of Federal Express’s nonmarket efforts are surely greater than those of most firms, and in part that is explained by its operations in a semi-regulated business. Although its activities may be pushing the envelope of responsible nonmarket action, the principles of building a majority, developing access, lobbying, and providing politically-valuable resources as a means of recruiting votes are important components of the nonmarket strategies of firms, labor unions, environmentalists, and other interests.

Discussion questions 1. What must Federal Express accomplish to return to clear RLA jurisdiction?

2. Who will set the agenda for Federal Express?

3. Which votes should Federal Express recruit? Which are more or less costly in terms of vote trades by allies or support from Federal Express?

4. Is there any reason to recruit more than 60 votes?

5. In terms of implementing a vote recruitment strategy to build the needed supermajority, which actual senators should be targeted? What are their characteristics?

6. What if any should be the limits on Federal Express’s provision of support or politicallyvaluable resources?

Developments The battle between organized labor and Fed Ex took another turn in December 2000. Federal law allows an individual to ask the Department of Labor for an opinion letter on a workplace situation.

A Washington lawyer with ties to UPS and likely the Teamsters as well was believed to have asked for the opinion.19 (The Teamsters had organized approximately 200,000 UPS workers.) The situation described in the request closely resembled the situation of pick-up and delivery drivers for Caliber Systems, Inc., a business Fed Ex acquired in 1997. The letter basically indicated that the drivers in the hypothetical situation were employees, whereas Fed Ex claimed they were independent contractors. The Teamsters argued that the letter gave them a legal instrument to use in their next organization attempt. Fed Ex dismissed the Teamsters assertion. Apparently, the letter would only be of use if an actual dispute arose between the Teamsters and Fed Ex.

Carried Interest Taxation The issue in this case is straightforward—possible higher taxes on carried interest. The higher taxes would not be the result of higher tax rates, instead carried interest would be reclassified as ordinary income rather than a capital gain.

19

Wall Street Journal, December 22, 2000.

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There are three motivations for this reclassification. The first is that carried interest does not involve, in most cases, a capital investment but rather represents a stake in a venture that provides compensation for supervision and in some cases management of a start-up, an investment fund, or similar private equity activity. The second motivation is the extremely high income that results from carried interest being taxed as a capital gain. The third is to generate additional tax revenue to reduce the government deficit and allow lower taxes on other income or gains, permit a tax reduction as in the case of the corporate income tax, or to fund higher spending.

The principal interests affected are those involved in venture capital, private equity, hedge funds, fund management, certain real estate ventures, as well as some other ventures. These are almost always high dollar activities that are generally accessible only to those who can arrange large amounts of capital. The beneficiaries of higher taxes are taxpayers and citizens in general. This is a case of entrepreneurial politics in that the benefits of higher taxes on carried interest are widely distributed among taxpayers and citizens in general, whereas the costs are concentrated on those earning carried interest. The entrepreneur in 2007 was Representative Rangel, and in 2009 it could be President Obama. In entrepreneurial politics, other things equal the advantage is with those who have concentrated costs.

Congress is the relevant institution, and the President is involved to the extent that he can veto a bill. In an Obama administration the Department of Treasury could play a role in drafting a bill, particularly a comprehensive tax reform bill.

Tax bills are complex and can have wide ranging effects, so they are hard to pass and hence uncommon. In this case, however, Congress has to deal annually with the issue of the AMT, which has increasing bite as more taxpayers have higher incomes. Moreover, the 35 percent corporate tax rate is argued by business to be too high compared to the tax rates of other developed countries, placing them at a competitive disadvantage. The U.S. corporate tax rate is indeed high compared to those of other countries, but many corporations pay at much lower rates because of deductions, credits, loss carry forwards, and so on. That Rangel, a liberal Democrat, sponsored a bill to reduce the corporate tax rate, however, signals that the business has convinced many in Congress that a lower rate is needed.

Whether the pay-as-you-go rule will be retained in the next Congress is not clear, but even in its absence carried interest taxation is likely to resurface. The opponents of higher taxes on carried interest would like a separate bill that would deal only with that issue, but Congressional Democrats will surely bundle that issue with other changes in the tax bill, as Rangel has done.

Information is uncertain because the economic consequences of treating carried interest as ordinary income are difficult to quantity. The higher taxes would raise the cost of ventures that earn carried interest, and that higher cost would diminish their activities at the margin. This may have little effect on money management ventures and speculative hedge funds, although it could raise the cost of financing for venture capital. What matters politically is whether the creation of new businesses and new jobs would be affected significantly by higher taxes on carried interest. Many members of Congress do not want to risk any significant adverse effect on business and job creation. If the tax on carried interest were raised at the same time that the corporate tax rate were decreased, the two effects would be offsetting, but which would be larger is unclear.

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The following discussion is from the perspective of venture capital firms. Their strategy should not await a new bill in Congress. One principal strategy decision is what objective to pursue. One objective is to defeat any bill that would increase taxes on carried interest. Another objective is to seek an exemption from the higher taxes for ventures that create new businesses and new jobs. A third objective, if it appears that one of the other two cannot be achieved, is to seek a tax rate less than 35 percent. This might be done by taxing only a fraction of the carried interest. The first component of a strategy thus is to choose an objective, and that choice depends on how likely it is that each of the alternatives can be achieved.

Pursuing the first objective would allow venture capital firms to join a broad coalition formed by all those whose taxes would be increased. Pursuing the second objective would involve the venture capital industry going it alone and seeking to differentiate its activities from those of the others ventures earning carried interest. The dimension on which it wants to differentiate itself is on whether new businesses and new jobs would be created. Pursuing the third objective would allow participation in a comprehensive coalition. The lobbying messages would correspond to the objective chosen.

The best objective depends on the particular environment at the time Congress begins to take up this issue again. (The year 2008 is not a representative year because of the subprime mortgage crisis and the election.) If there is only moderate momentum behind a comprehensive tax bill, the objective should be to defeat any increase. If there is considerable momentum behind a tax increase; e.g., a Democratic Congress and president and a desire to implement Obama’s campaign tax proposal, the second objective should be pursued by the venture capital firms.

The principal implementation strategy for any objective is lobbying with the messages focusing on the creation of new businesses and new jobs. This could be accompanied by an advocacy campaign directed at member of Congress. The third component of an implementation strategy is coalition building. This should be led by the industry associations identified in the case.

Discussion questions: 1. What is the motivation for treating carried interest as ordinary income?

2. Identify the four Is. 3. What primary objective should the venture capital industry pursue? If it seems unlikely that that objective can be achieved, what objective should be pursued?

4. Formulate a nonmarket strategy to achieve the objective.

5. How should that strategy be implemented?

Developments: The economic rescue plan enacted in October 2008 permanently exempted 20 million additional taxpayers from the AMT. This will lessen the need to raise the income level of the AMT every year.

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Wal-Mart and Its Urban Expansion Strategy The principal source of the nonmarket problems Wal-Mart faces is its need to continue growing.

Its strategy until recent years was primarily to expand in small towns and the suburbs. In these locations interests were not well-organized, and Wall-Mart faced little opposition. Moreover, WalMart was often welcomed in those communities because of its prices, convenience, and range of merchandise. Its primary constituencies were customers and its employees. In those communities Wal-Mart wages probably were not viewed as unusually low. When it decided to enter urban markets, however, it faced organized interest groups. The principal interest groups were unions and NIMBY groups that did not want a large store in their neighborhoods.

At the same time it began entering urban markets it also introduced super-stores and expanded its merchandise to include groceries. This made it a threat to unions. The other large box retailers such as Target, K-Mart, Home Depot, Lowe’s, etc. are not unionized, but supermarket employees are. The big supermarkets are efficient, but the wages of union workers are higher than of WalMart employees, so Wal-Mart posed a threat to the UFCW. The threat was that supermarkets would lose market share to Wal-Mart, which happened as Wal-Mart’s expansion into groceries was quite successful. This put strong pressure on the supermarkets to reduce their labor costs. This was evident in a long strike in Southern California in 2004. Moreover, it was unlikely that Wal-Mart employees could be organized by the UFCW, since Wal-Mart had a long history of successfully opposing unionization.

Wal-Mart pays low wages, which is viewed as a threat by organized labor and its allies, although most of the retailers that compete with Wal-Mart also have low wages. Small mom and pop retailers probably also pay low wages. Nevertheless, the unions certainly are not happy with the wage scale provided by Wal-Mart. Moreover, unions have not been successful in organizing WalMart employees. There are thus a variety of reasons for unions to oppose Wal-Mart. Consumers, in contrast, like Wal-Mart. Moreover, Wal-Mart employees are generally happy with the company.

Wal-Mart thus faced organized interests in the form of local NIMBY groups and unions, particularly the UFCW. Its strategy in Chicago was to locate in areas of abandoned factories, where neighborhood NIMBY groups were either not present, as they would be in a suburban area, or would support its entry. Indeed, Wal-Mart was able to enlist the local neighborhoods to support its entry (PIMBY (Please in My Backyard)). The local neighborhoods, represented by their aldermen, wanted the jobs and lower prices that Wal-Mart would bring. The primary opposition thus was organized labor and the interest and activist groups traditionally aligned with it.

Expanding into urban areas appears to be a good competitive strategy for Wal-Mart despite the nonmarket problems it creates. One component of its overall business strategy is to provide opportunities for advancement to employees, and to continue to do so, it needs to grow.

Consumers like Wal-Mart, so there is a ready market. The stories in the press about opposition to Wal-Mart come from NIMBY groups and organized labor and its allies and not from the person in the street.

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Wal-Mart, the challenges it faces, and its initial steps at reputation management are considered in Chapters 2 and the Part I integrative chapter and the case in Chapter 19.

Discussion Questions 1. Why is there nonmarket opposition to Wal-Mart’s entry into Chicago when there was no opposition to the entry of Home Depot and Target and no opposition to Wal-Mart entry into the Chicago suburbs?

2. Should it agree to the demands of the Chicago Federation of Labor?

3. Should Wal-Mart abandon its plan for entering Chicago?

4. How should Wal-Mart build a majority in the city council?

5. What strategy should it use to succeed in Chicago?

Discussion The source of the nonmarket opposition Wal-Mart faces is identified above. Neither Home Depot nor Target sells groceries nor do they sell items that compete with union-organized firms. It may be that Wal-Mart has lower wages than the home improvement stores or K-Mart and Target, but there appears to be little hard data on this. Wal-Mart has also become a symbol of the failure of organized labor, whereas the other companies have not although they have no unions.

Agreeing to the demands of the Chicago Federation of Labor is unwise for two reasons. First, doing so would set a bad precedent for Wal-Mart for future stores in urban areas. Second, WalMart has a reasonable chance for success in entering Chicago. The local neighborhoods support entry as do the local aldermen. Moreover, the institutional norm in the Chicago City Council is to defer to the local alderman in local affairs such as store approval. Also, the mayor supports entry.

Wal-Mart should continue in its efforts to win approval for the stores. Of course, Wal-Mart will have to be a “good employer” once it enters so as to build a reputation to ease entry into other neighborhoods and other cities. Wal-Mart certainly believes that it is a good employer.

To achieve a majority on the council Wal-Mart should use a representational strategy, a votebuying strategy, and an informational strategy. The representation strategy is based on the neighborhood groups that support entry. They are already mobilized for action. The vote-buying strategy is to use its economic power to reduce the opposition from constituents of other aldermen on the council. The first paragraph in the next section identifies one of the steps taken. The votebuying focused on community initiatives and hiring of union labor by contractors that would build the stores. Another component of vote buying is to attract other businesses, such as restaurants and up-scale retailers, to locate proximate to the new stores. This would provide jobs and help revitalize the areas. The informational component of its strategy focused on continuing to provide information on the benefits flowing from Wal-Mart stores.

Developments in Chicago “On the eve of a City Council vote pivotal to advancing its urban strategy, Wal-Mart promised Tuesday to identify minority subcontractors to help build its first two Chicago stores and to do its best to fill ‛75 to 80 percent’ of the 500 jobs in those stores with local residents. In a ‘Dear

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alderman’ letter distributed to the City Council’s 50 members, Wal-Mart pledged that its construction management team and general contractor would ‘follow Chicago practices’ by hiring contractors and subcontractors that are ‘by and large union’ workers. The nation’s largest retailer also vowed to work with local aldermen Howard Brookins (21st) and Emma Mitts (37th) to identify ‘community initiatives’ to support with its charitable dollars.”20 Wal-Mart did not agree to the demands of the Chicago Federation of Labor.

Approval was given to the store in Ms. Pitts’ ward on a 32-15 vote, where there were few local retailers who would be affected by the Wal-Mart store. The other store application faced greater resistance, and the city council voted 25-21 in favor of the store, which was 1 vote short of the twenty-six votes required. A revote was planned. “Bisio said Wal-Mart would return to the zoning committee to work on approval for the second store. But he didn’t think it would get any easier.

‘As you become the biggest company in the world, you also become the biggest target,’ he said.”21 Opposition against Wal-Mart continued and perhaps intensified, leading the council to reject the store on the Ryerson site. Rejection means that the city council refused to grant the zoning change that would have allowed Wal-Mart to build its store. The Ryerson development plan had included plans for two large store sites, one of which would have been Wal-Mart. In 2005 the city council granted a zoning change for the other of the two stores sites, allowing a Lowe’s home improvement store to be built. Lowe’s first store in Chicago was under construction at the time of the announcement.

20 21

Chicago Sun-Times, May 26, 2004.

USA Today , May 27, 2004.

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Chapter 8 Implementing Nonmarket Strategies in Governmental Arenas This chapter addresses the implementation of nonmarket strategies, focusing on the types of activities firms use. Lobbying is the most important activity in informational strategies, and the text addresses its nature, what makes it effective, what enables it, and the regulation of lobbying.

Whereas lobbying in an informational or representational strategy is typically done behind the scenes, grassroots campaigns are highly visible and orchestrated efforts to provide information but more importantly to apply pressure on government officials. How effective these campaigns are is unclear, but what is clear is that firms have increased their use of grassroots campaigns in recent years. Grassroots strategies are most effective when they are tied to the constituency connection.

Coalition building is an important part of many representational strategies and is intended to leverage the political action of a firm. Coalition formation is a component of the chapter case Internet Taxation.

The Internet taxation issue is complex, and the politics are distributive and can be analyzed using the conceptual material in Part II of the book. From a public policy perspective taxes should be levied on electronic commerce and on mail order sales—provided the costs of administering them are not too large. The companies that would be taxed obviously emphasize those very real costs, and the proponents of taxing e-commerce must find a means to reduce those costs. The states are working on this, but the task is complex. The politics of Internet taxation are likely to continue for some time.

The treatment of electoral strategies highlights aspects of the debate on the importance of campaign contributions, not from the perspective of candidates in elections but from the perspective of the contributor. This is a topic that may be of more interest to students than to firms, so information is provided about the “market for contributions” and the laws governing those contributions. The text attempts to dispel some popular myths about campaign contributions.

Communications and public advocacy strategies can be useful in representational strategies, but the most important communication in informational strategies probably takes place in the context of lobbying. Advisory committees are important sources of information particularly in countries such as Japan as discussed in more detail in Chapter 14. From time to time a firm may have to resort to the courts to deal with an issue, but judicial strategies can be both costly and time consuming and the outcome uncertain. A lecture might develop further the issue of organizing for political effectiveness. An example presented here, “Soft Cookie Politics,” can be used as an illustration for a lecture.

The framing of an issue may be important to the extent that the issue can be strategically characterized. For example, in response to the abuse by tax-exempt entities of the leasing provisions of the Economic Recovery Tax Act of 1981 discussed in Chapter 6, Representative J.J. Pickle (D-TX) and his staff coined the slogan, “Those who don’t pay taxes shouldn’t get tax breaks.” With the coining of this slogan, the tax benefits to U.S. exporters that used leasing for their exports were imperiled.

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Pharmaceutical Industry Politics: As an addendum to the Pharmaceutical Politics example, the PMA did not quit the battle even after the bill had been signed by President Reagan. The industry sought a strengthening of patent protection for manufacturing processes against violations by foreign firms. Under existing law, the patent holder could challenge infringement only under U.S. trade laws which require a finding of substantial injury by the International Trade Commission.

(See Chapter 18.) The legislation sought by the PMA would make it easier for patent holders to sue domestic firms for patent infringement by their foreign suppliers. The GPIA asserted that this would allow U.S. drug companies to sue the European drug companies that supply the chemicals that generic drug companies use to produce their drugs. “‘What Congress has done is give us something with one hand and take it away with another,’ said William Haddad, director of the Generic Pharmaceutical Industry Association.”22 Example: Soft Cookie Politics An example of the use of a judicial strategy is provided by the “soft cookie war.” Proctor & Gamble (P&G) received a patent on a process for making cookies that are crisp on the outside and soft on the inside, and the cookie was very successful in its test market. Shortly after its introduction nationwide, Keebler, Nabisco, and Frito-Lay also introduced soft cookies. P&G’s market share plummeted.

In June 1984, P&G sued its three rivals, charging them with infringing its patent. P&G also sued them for unfair competition. P&G alleged that in March 1984, a Frito-Lay employee posed as a customer and attended a confidential sales meeting and that Keebler had taken pictures from an airplane of a P&G plant under construction.23 In August, Frito-Lay filed counterclaims alleging that P&G was attempting to eliminate competition in the soft cookie market. Keebler and Nabisco also filed counterclaims.

Frito-Lay denied P&G’s allegations that one of its employees had improperly attended a P&G sales meeting and that it had obtained information improperly on P&G’s patented production process.

According to Frito-Lay, one of its employees and his son were outside a baking facility where P&G’s Duncan Hines cookies were being made. Someone at Frito-Lay had authorized the employee to take photos outside.

“Without the company’s authorization or knowledge, the son twice walked into the plant during working hours,” the company said. “The son asked for and was given two unbaked cookie samples, which were believed to be Duncan Hines.”

When the samples and photos were taken to Frito-Lay headquarters in Dallas, a vice president “immediately had them destroyed,” Frito-Lay said.

22 23

Wall Street Journal, October 2, 1984.

Wall Street Journal, September 11, 1989.

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With respect to the sales meeting, Frito-Lay stated, “While a Frito-Lay employee was engaged in a sales call to a customer, a P&G sales representative joined them and made an unsolicited sales presentation to the customer in the Frito-Lay employee’s presence.”24 After pretrial activities extending over 872 days, involving over 200 expert witnesses, and producing over 100,000 pages of pretrial testimony, in September 1989, three weeks before trial was set to begin, the litigants entered into a consent decree in which P&G received over $125 million from the three defendants.25 Frito-Lay stated that it would pay less than $20 million and that insurance would cover the payment.

Cases Responsible Lobbying?

This case describes Merck’s activities to promote its HPV vaccine Gardasil and asks if its activities were responsible, as discussed in Chapter 7. The stakes for Merck were very high for four reasons.

First, the margins on patented drugs are very high. Second, the market is huge—every girl. Third, Gardasil will soon face competition from GSK’s Cervarix, and the first drug to be used may have a continuing advantage. Fourth, it faced potentially large liability judgments in lawsuits on Vioxx.

Is Gardasil different from other vaccines? The answer is no from a public health perspective in that the vaccine can help prevent a serious disease and can reduce the likelihood of transmission to others. Cervical cancer, however, is not common and conventional screening and treatments have been relatively effective. The answer is yes in the sense that it is addressing a disease that is spread by voluntary behavior rather than by contagion. This raises a moral issue about mandatory testing, although allowing an opt out relieves some of the concern. Another issue mentioned in the case is whether vaccination encourages sexual activity among very young girls.

Merck launched a broad scale strategy to develop the market for Gardasil, which would also provide it an advantage over Cervarix. Merck’s objective was to have states mandate vaccination for entry to middle school in line with the recommendation of the CDC advisory committee. This mandate could come from a state Department of Health, but most departments probably could only make the vaccine available and not mandate it. Working through the legislature was thus required in most states. If Gardasil could be specified as the vaccine, that would be ideal.

Merck’s implementation strategy is described in the case and involved advertising, financing educational campaigns conducted by NGOs, lobbying, and supporting and financing Women in Government. (GSK may also have worked to get the NGOs and Women in Government to give priority to HPV and cervical cancer.) The educational and advertising campaigns, e.g., “one less,”

24 25

Wall Street Journal, August 27, 1984.

New York Times , September 13, 1989.

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were likely directed more to building support for mandatory vaccination as influencing decisions by parents to seek Gardasil for their daughters.26 Merck also directly lobbied state governments and may have exploited personal relationships, as alleged in Texas.27 In addition to criticisms about the implementation of its strategy, critics complained about the Merck’s objective of mandating vaccination before entry into middle school.

The pharmaceutical industry has been widely criticized for its market and nonmarket activities, and restrictions continue to be imposed on its practices. These include requirements by medical journals that authors disclose funding provided by pharmaceutical companies for research, consulting, and advisory activities. These practices are widespread. As another example, pharmaceutical companies have provided funds to medical schools for stipends to doctors who return to the schools for courses. The companies often provided funding restricted to courses that pertained to their drugs. Some medical schools adopted policies prohibiting contributions restricted to particular courses.

In addition to the criticisms, lawsuits against pharmaceutical companies regarding the disclosure of clinical trial data continue to be filed. The Chapter 5 case Merck and Vioxx and the Chapter 20 case Pfizer and Celebrex concern the actions and events leading to thousands of lawsuits.

Evaluation

Merck appears to have done nothing in violation of the law, unless some of its activities in Texas, for example, violated restrictions on lobbying. Many pharmaceutical companies work with patient advocacy groups to build support for approval of their drugs by the FDA and build demand among potential patients. The case of Gardasil is a bit different because it does not involve patient advocacy groups but instead groups concerned about women’s health, but this difference seems minor. While these activities are not uncommon, because of criticism pharmaceutical companies have stopped or limited some practices such as paying for doctors’ attendance at conventions. A useful distinction here might be whether Merck’s contributions to groups are restricted to their activities related to cervical cancer or whether they are made without restrictions. The former seems to be more of concern than the latter. This distinction parallels that now used by some medical schools mentioned earlier to stop accepting contributions to support attendance at courses that pertain to the drugs of contributors.

Merck’s work with Women in Government to spearhead state legislative activity has been very effective and, provided there are no illegal payments, seems to be acceptable. The organization is free to choose the issues to support, and a women’s health issue seems natural. Seeking mandatory middle school vaccination is an aggressive objective that may be warranted from a public health perspective, but parents’ objections have to be taken into account. At a minimum Merck should not oppose opt-out provisions in any vaccination program. The recommendation by the CDC advisory committee for mandatory vaccinations provides the justification for Merck’s objective but perhaps not for such an aggressive campaign.

26

Direct-to-consumers advertising by pharmaceutical companies is intended to lead individuals to ask their doctors for the drugs by brand name.

27 GSK and Digene also engaged in some of these activities.

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Merck’s activities in Texas may have involved cronyism. In any event its efforts in Texas led to a backlash against the governor’s executive order, and it could face backlashes in other states as well.

From a purely self-interested perspective backing off its aggressive campaign seem warranted.

One concern is whether Gardasil has been adequately tested on very young girls. The concern is that there may be harmful side effects.

Another concern is with the effectiveness of Gardasil, as discussed in the last paragraph of the case.

On the one hand, concerns about its effectiveness for those already exposed to HPV can limit its application to older girls and women. On the other hand, those concerns strengthen the rationale for vaccination of very young girls. Whether Ceravix will generate the same concerns remains to be seen.

Discussion questions:

1. Merck has not achieved widespread mandatory vaccinations across the states. What should it do next to achieve that objective? Should it resume its aggressive campaign for mandatory vaccinations?

2. Let’s examine the specific measures Merck used. Which if any are objectionable and why?

3. Should it conduct additional clinical trials to determine whether there are side effects for young girls?

4. Should Merck seek approval for Gardasil for women over 26?

5. Should Merck launch a campaign for vaccination of boys?

6. GSK’s Cervarix could be a more effective drug than Gardasil. Should Merck try to slow its adoption by states once it is approved for marketing by the FDA? Developments: A 2008 survey of 13-17 teens with verification by their doctors showed that approximately 25 of the young girls were vaccinated with Gardasil in the first year after approval. Earlier in the year Merck had released a survey showing “that only about 1 percent of Hispanic teenagers are receiving the vaccine, and ‘they are the population that needs it the most’ because the frequency of infection is relatively high.”28 Gardasil was approved by the FDA in 2006, and in September 2008 the FDA approved Gardasil for the prevention of cancers of the vagina and vulva. Merck also sought approval for use for women between 27 and 45 years of age, but the FDA had not given approval.

The UK government selected Cervarix, produced by the UK’s GlaxoSmithKline, for a vaccination program scheduled to begin the fall of 2008 through the National Health Service. The French Haut Conseil de la Santé Publique gave a favorable recommendation to Gardasil, produced by Sanofi Pasteur MSD of France.

Virginia was the only state to have enacted a mandatory vaccination law.

28

Chicago Tribune, October 10, 2008.

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Studies published in the New England Journal of Medicine in 2008 argued that Gardasil and Ceravix were not cost-effective for females in their 20s.

Internet Taxation PowerPoints are available for this case.

This case focuses on the distributive politics of the issue of the Internet taxation of business-toconsumer sales. (B2B is taxed under a different system, and companies pay use taxes on their transactions.) I have used this case as a transition from the analysis of interests to the role of institutional factors. From a strategy perspective students can be assigned the role of a company such as Amazon.com and asked to develop a strategy and an implementation plan for addressing the Internet taxation issue. The PowerPoints cover the interests, institutions, and information for this issue, and present a strategy for Amazon.com. A distributive politics spreadsheet is provided in the PowerPoints.

This case also has an international and global dimension, since e-commerce is worldwide. The European Union, which generally has much higher taxes and government spending than does the United States is very important here, since it has a strong incentive to avoid revenue depletion through electronic commerce. The EU is ahead of the United States on this issue and has enacted a tax on downloadable products, as considered below.

The following plan can be used to teach this case: 1. Issues identification—loss of tax revenue, nexus definition, EU tax, global tax policy, California bill 2. Institutions—Congress, advisory commission, president, state and local governments, Supreme Court; the news media and public sentiment are not likely to be important here 3. The role of information—how much tax loss is there; how will the customer base respond to a tax; the administrative burden on e-retailers; the effect on the growth of the Internet; the effects on brick and mortar retailers 4. Interests—these are identified in the spreadsheets.

5. The role of mail order and catalog companies; the opponents of Internet taxation will argue that these retailers have to be taxed as well. The reason for this argument is that the opponents want mail order and catalog companies to oppose actively any Internet tax 6. To examine latent interests in more detail, students can be asked what the states will do if Internet sales are not taxed and considerable revenue is lost. This identifies taxpayers and recipients of state spending and beneficiaries of taxation of Internet sales. An important group that is not discussed in the case is the public employees whose jobs are funded by taxes, including teachers, road crews, etc., and other recipients such as those receiving welfare payments.

7. Nature of the politics—a majoritarian issue that has interest group politics at its core 8. Distributive politics spreadsheet 9. What is required to pass a moratorium? What do the opponents of a moratorium extension have to accomplish? (a filibuster in the Senate) Why is McCain stalled?

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10. What are the concerns of members of Congress? (Friendly to high tech and e-commerce; want to avoid being labeled “Web killers;” avoid pressure from main street; avoid pressure from home state and district governments) 11. Why did the House overwhelmingly pass a moratorium extension and the Senate stall?

Electoral explanation—one explanation is that all House seats are up for election, whereas only a third of the Senate seats are up.

12. If the moratorium is not extended, will the states enact a tax? No, they are worried about disadvantaging their states with regard to attractiveness to information industries.

13. What should Amazon.com do?

--primary objective—ban a tax --secondary objective—moratorium extension --tertiary objective—if taxes will be imposed, seek a lower tax rate for e-commerce than for main street sales --identify the potential impact on Amazon.com—no taxes may be a substantial advantage for a company that has been struggling to make a profit --work behind the scenes or in public?

--identify Amazon.com’s rent chain --should it attempt to mobilize its customers?

--yes—grassroots pressure can make a difference; could induce others to go along (Yahoo!, eBay); how effective would e-mail messages be? (order of importance of messages to members of Congress: fly-ins, bus-ins, handwritten letters, postcards, e-mail with an original message, e-mail with a conned message) --no—could it irritate customers; would free-riding prevent any collective mobilization; would Amazon.com be alone and hence standout—probably (mobilizing customers in not a good idea) --coalition possibilities --what should be its institutional focus—Senate Commerce Committee and McCain --lobbying messages—can provide information on the number of customers in each congressional district --messages—which would be politically effective --infant industry/infrastructure (The infrastructure argument is like the universal service policy in telecommunications.)

--states should simplify and harmonize their taxes first --fix mail order as well --states have surpluses, so no urgency --e-tailers do not use state resources --cost of administration --how active should it be on the California bill --strategy—see PowerPoints 14. strategy of opponents of an extension of the moratorium --grassroots/lobbying --move forward on tax simplification—to get around the Supreme Court decision --mobilize latent groups by focusing on tax revenue loss and like reductions in spending --credit card companies can handle remittance and collection --there is no need to act this year 15. implications of EU policies --will have to tax e-commerce

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--will this force the United States to act --is there any possibility of working out a global Internet taxation policy—unlikely --should Amazon.com participate in working parties advising the U.S. government Analysis and developments Other interests that became active on the Internet taxation issue included the recipients of expenditures funded by state taxes and those who might be forced to pay additional taxes if states were to lose sales tax revenue because of a shift to Internet sales. (In political science these are referred to as latent groups.) The former group included teachers, unions that represent state and local government employees, and other recipients such as contractors to the state. For example, the president of Rice University and 174 other economists lobbied Congress with the argument that education would be harmed by the failure to tax Internet sales. See the article “A Lobbying Machine Springs Up to Revive Issue of Internet Taxes,” Wall Street Journal, June 29, 2000.

The latter group included those who pay real estate taxes, and who feared that real estate taxes would be increased if states were forced to raise taxes. Texas, for example, has no state income tax, leaving real estate as a principal source of additional tax revenue. Real estate investment companies, for example, might be impacted by additional taxes. Stanford Alexander, the CEO of Weingarten Realty Investors, whose group owned 132 shopping centers in Texas, feared that taxes on commercial property would be increased if sales tax revenue were lost. State politicians would be reluctant to raise taxes on homeowners, which left commercial property as the likely source of additional tax revenue.

Local retailers also were active, reminding their congressional delegation of their role in local communities. Robert Benham, owner of a women’s fashion store in Oklahoma City, said, “We’re the ones who sponsor the Little league teams, who buy tables at charity events, who hold fashion shows. … When was the last time a dot-com did a charity fashion show in your district?”29 An important institutional characteristic is that only one-third of senators are up for election in 2000, and they are thus not as concerned about raising campaign contributions as are members of the House. Many members of Congress were nervous about being labeled a “Web killer.”

Note that there is no need for Congress to act this year, since the present moratorium extends through next year. The interests should continue to work, however, to prepare for the competition in 2001.

Some conservatives in Congress opposed Internet taxation because it meant additional taxes.

Others opposed it because of separation of powers concerns arguing that sales tax matters were for the states and not the federal government to decide. Some argued for a permanent ban on Internet taxes so as to “decriminalize the consumer.”

The presidential candidates were very concerned about raising campaign funds for the November election. The Center for Responsive Politics reported that since 1999 51% of the $8.9 million contributions by the computer, software and Internet-related companies were given to Democrats.

29

Wall Street Journal, June 29, 2000.

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One of the informal groups that had sprung up in support for the California bill was composed of bookstore owners, who wanted borders.com and barnesandnoble.com to collect taxes on their online sales to California residents. Karen Pennington of Kepler’s bookstore in Menlo Park, California said, “We have a physical store, we have a Web site, and when it went up, there was no question in our mind that we should pay sales tax. We find it unconscionable that Barnes & Noble and Borders are not.”30 California residents, of course, could switch to Amazon.com and avoid taxes.

It is interesting to note that although the Internet and e-Commerce companies are supposed to be location-less, the nexus principle makes them subject to location decisions. For example, if Amazon.com were to build a warehouse in a state, it would have to have collect sales tax from the residents of that state. This also means that e-Commerce companies would have incentives to locate distribution facilities in states with no sales tax. This also means that Amazon.com may have a significant advantage over Borders.com and Barnesandnoble.com, since the latter two companies have retail outlets in many/most states.

The cost of tax collection for online merchants would be (much?) higher than for brick and mortar merchants if the tax were levied on the residence of the buyer, since it is necessary to apply rates for each state rather than just one state.

A major issue in the implementation of Internet sales taxes is deciding whether a tax should be charged based on the location of the seller, the billing address of the customer, or the destination to which the good was shipped. The first seems infeasible, since companies would simply locate in states without sales taxes. Billing address seems to correspond most closely to how offline sales taxes are applied. That is, when a resident buys a gift and mails it to Aunt Millie in another state, the applicable tax is not that of Aunt Millie’s state. Another is to where the merchandise is sent. In 2000 an agreement was reached regarding taxation of cellular telephone use. If such an agreement can be reached, an Internet taxation system can be developed. Tax simplification and harmonization across the states would be a good idea even without a tax on Internet sales.

An important strategy of offline retailers such as Wal-Mart is to develop a technology to identify the relevant state and local sales tax. The development of such a technology would eliminate one of the principal arguments of online retailers against Internet taxes.

Governor Davis vetoed the bill on September 29, 2000. He wrote, “Imposing sales taxes on Internet transactions at this point in its young life would send the wrong signal about California’s international role as the incubator of the dot.com community.” In part the veto may be due to ambiguities in the bill. The American Electronics Association switched from supporting to opposing the bill because it did not address issues such as whether it would apply to borders.com, which has a return policy but does not sell or supply Internet sales from its stores.

In November 2001 Congress passed legislation extending the moratorium for two years. Senators supporting the extension referred to the “crazy quilt” tax system that would “chew up a vast amount of time for compliance.” The opponents of an extension introduced an amendment in the Senate

30

, June 7, 2000.

Los Angeles Times

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allowing for Internet taxation when 20 states agreed to collect taxes for each other. The amendment was rejected on a 57-43 vote on a procedural motion. Tax simplification efforts have been ongoing, and some progress on an agreement has been made.

In November 2004 President Bush signed a bill extending the moratorium on new Internet taxes to 2007. The bill was retroactive to November 2003, when the then existing moratorium expired.

The European Union The European Union enacted a directive requiring all business-to-consumer Internet companies to collect a tax on goods digitally downloadable in the EU. EU-based companies had already been subject to the tax, but this measure is said to level the playing field—somewhat. Under the EU policy non-European companies must register in one of the 15-EU member states and collect the tax from customers based on where the customers reside. The country in which it registered would then distribute the proceeds to the countries in which the purchasers reside. The EU registration policy should lead many non-EU companies to register in the lowest VAT states; i.e., Luxembourg.

EU-based companies would collect the tax based on the seller’s location. The United States claimed that this system violated the WTO requirement of equal taxation.

The most important aspect of this decision may be how the EU implements the tax. This could provide a precedent for a system of taxing e-commerce in the United States.

For several years the United States, the European Union, and other nations have been negotiating a worldwide Internet tax policy under the auspices of the OECD. Distributive politics spreadsheet A distributive politics spreadsheet for this issue is provided in the PowerPoints.

Pharmaceutical Switching PowerPoints are available for this case.

This is a case about strategic competition—not against market rivals (Allegra and Zyrtec) but against nonmarket rivals (WellPoint and others). The players are WellPoint and payers and Schering-Plough and pharmaceutical companies more generally. Forced switches are potentially very important to the pharmaceutical industry not only because of their effects on profits but also because they would disrupt the market strategies of the drug companies. The points addressed are: 1. Why a company (Schering-Plough (SP)) should participate in this public decision. 2. The nonmarket issue life cycle and its relation to strategies (see Chapter 2).

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3. The market success of Claritin and the stakes for SP and WellPoint.

4. SP’s market strategy for its antihistamines including Clarinex.

5. The pressures on the FDA and the institutions and interests that affect it (see Chapter 10).

6. The political responsiveness of the institutions involved (see Chapter 7).

7. The interest group alignment on the forced switch issue and their strengths.

8. Strategy principles and the strategy approach.

9. Formulation of an integrated strategy for SP and its implementation.

10. Formulation of an integrated strategy for WellPoint and its implementation.

11. Wrap-up and developments in the case.

The preparation questions I have used for an integrated strategy session in executive education are: Preparation questions: 1. Assess the significance of a forced switch for Schering-Plough, Aventis, and UCB/Pfizer.

2. How would a possible switch affect Schering-Plough’s market strategy and planning process?

3. What is WellPoint’s overall strategy regarding the prescription and OTC markets?

4. Formulate an integrated market and nonmarket strategy for Schering-Plough.

5. Formulate an integrated market and nonmarket strategy for WellPoint?

6. What are the implications of a forced switch for the pharmaceutical and health insurance industries?

In leading the discussion I have used the following questions: 1. Should Schering-Plough participate in this government decision-making process? (One purpose of this question is to engage in a discussion of whether a firm has a right to participate and a right to pursue its own self-interest. Another purpose is to ask why it should participate? The answer is because it may be able to affect the outcome. The next question is why it can have influence. One answer is because it may have information that others do not have. Another answer is that it may be able to represent the interests of groups that may not be able to represent themselves. To tie this to public policy, the perspective of pluralism is that the “public interest” is discovered through the participation, and competition, between the interests in society.)

2. Where is this issue in its life cycle? Is this petition the tip of an iceberg?

3. Why is Claritin so successful? What is the role of DTC advertising?

4. What are the stakes? (Assess the prescription and OTC markets.)

5. What has been SP’s strategy for Claritin? How is that strategy threatened by the petition?

6. Which institutions are involved in this decision? (courts, FDA, Congress) 7. Do they make decisions on the same bases? (See the PowerPoints.)

8. Which interests are aligned here? On which side are doctors? (Some doctors are opposed to DTC advertising because DTC ads put pressure on them to prescribe drugs when they think it is inappropriate to do so. Most probably trust the FDA panel (of doctors) that it would be safe to sell Claritin on the OTC market. ) 9. What are the concerns of Congress and the Bush administration?

10. What should SP’s objectives be?

11. Does SP want to deploy a nonmarket strategy behind the scenes or in public view?

12. How should its strategy be adapted to the institutions?

13. What messages/themes should SP use?

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14. What nonmarket strategy should WellPoint use? Which interests are on its side?

15. In the absence of nonmarket strategies, what decision would the FDA like to make? What process does it have to follow in making its decision?

16. What is likely to happen?

Comments on the analysis of the case follow.

The Four Is Issues

Immediate term: 1. the switch decision, 2) FDA policy with regard to Rx-OTC switches Long-term: 1. additional shifts, 2. pharmaceutical prices, 3. insurance coverage for pharmaceuticals.

An important question is whether there are many other drugs that might be switched from Rx to OTC status. WellPoint asserts that there are no others, although Clarinex might be a candidate in the future. WellPoint claims that Clarinex is not a breakthrough drug. The pharmaceutical companies assert that this is just the tip of an iceberg. Surely there must be others, but how many is the question. Lynn Simpson, a pharmacology professor at the University of Houston, commented that this was the first switch forced by and insurance company and that this would now become the strategy of managed care.31 An important issue is whether the forced switch issue could spill over to the DTC advertising issue and to the pricing issue. The pharmaceutical industry apparently spent $2.5 billion on DTC ads in 2000 compared to $26 billion on R&D. Interests and their stakes Pharmaceutical companies can be grouped into those directly affected by the switch and those only indirectly affected. Within each of these two categories are pioneer and generic drug companies.

(The generics may prefer the term brand name companies rather than pioneer.) The three companies with the second-generation antihistamines have big stakes and aligned interests, even though they are market rivals. Their market planning could be disrupted. All companies could be affected. SP’s stake can be readily estimated. IF SP’s margin is 80 percent and U.S. sales are $2.5 billion, Claritin’s contribution to profit is $2.0 billion. On the OTC market its profits would be a small fraction of that amount, so SP’s stake is probably over $1.5 billion. How big the stake is for the pharmaceutical industry depends on how many other drugs could be switched. If the amount of DTC advertising is any indication of the stake, the stake is very high.

The generic companies that will produce versions of the second-generation antihistamines also have large stakes, since this is a $5 billion market. WellPoint believes that in December 2002 there will be both generic Rx and generic OTC versions of Claritin marketed.

There are 140 generic drug companies operating in the United States, and they are represented by the Generic Pharmaceutical Association (GPHA). The GPHA states that about 10% of the $138 billion pharmaceuticals spending is accounted for by generics. The generic drug companies are

31

, March 9, 2002.

The Houston Chronicle

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quite concerned about DTC advertising. Bruce Downey, CEO and chairman of Barr Laboratories, stated on behalf of the GPHA, “Delays in the introduction of generic competition, combined with the nearly $3 billion spent annually on direct-to-consumer marketing for new products that often displace generic sales, have resulted in a stagnation of the growth of generic substitution. Nearly two decades after Hatch-Waxman, generic substitution rates hover in the low 40% area, rather than the 50-65% that was predicted by many experts just a few years ago.”32 WellPoint asserts that SP spent $180 million on DTC for Claritin and only $80 million on physician advertising. Rx Health Value argues that DTC ads should contain a “fair balance” of the disclosure of risks and side effects. The organization wants the FDA to establish a broadly-representative task force to make recommendations for the informational content of DTC ads.

Managed care companies/insurance companies have big stakes and aligned interests, even though they are market rivals. In addition, state government units that provide care and insurance (Medicaid) have similar interests and stakes. The stake of these companies is that high prices and expenditures increase the cost of insurance. This means that fewer consumers will purchase insurance for pharmaceuticals and employers will begin to limit benefits. This will hurt WellPoint’s sales and bottom line.

The switch issue thus pits one huge industry against another huge industry. Both industries are well-connected and sophisticated in their nonmarket strategies. Big pharma is certainly more powerful on these dimensions, however. The insurance companies are not loved, and their strength comes from the government’s aligned interest in controlling the rapid growth in health care costs.

Note that the drug companies want private insurers to provide coverage for prescription drugs.

They also want the buying power of insurers and the government in particular to be limited.

Otherwise, the buyer will use monopsony power to drive prices down.

Doctors may be viewed as concerned about the health of their patients and their own income, and both would be affected by the switch. What is better for patients is unclear, but if doctors are interested in making drugs widely available to those who want them, doctors should prefer the switch. The counterargument is that people will choose to self-medicate and not go to doctors when they have problems. The cynical view is that the physicians are interested in office visits, and a forced switch would certainly hurt their income.

Consumers with health care/prescription drug coverage would be hurt in the short-run if the price of the three drugs on the OTC market is above the co-payment. In the intermediate-run, they would benefit if the average price of the drugs falls and insurance coverage is maintained for prescription drugs. In the long-run consumers might or might not be harmed if there is a chilling effect on research and development. Since reductions in R&D would be at the margin, the effect might not be great if only a few drugs were switched. If more were switched, the effect could be substantial.

Patients are affected, and the AAN/MA represents some of them. The National Alliance for Hispanic Health also opposes a forced switch on the grounds that people will not visit their physicians if they have access to Claritin and hence for some other illnesses will not be diagnosed.

32

Testimony, House Energy and Commerce Committee, June 13, 2001.

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Consumers without health care/prescription drug coverage benefit unambiguously in the short-run and the intermediate-run. In the long-run they have the same considerations as those with coverage.

Payers: Most people with health care coverage and pharmaceutical benefits receive them through their employers as non-taxed fringe benefits. Employers thus ultimately bear the cost of health benefits and have interests similar to a combination of those of insurance companies and consumers. Payers have formed an association Rx Health Value that conducts analyses of pharmaceutical costs and usage. Members include consumer groups such as AARP, employers such as the auto companies, US West, and the Managed Health Care Association, Blue Cross Association, and providers including the American Hospital Association, and unions such as the UAW and the AFL-CIO. Rx Health Value was formed in 1999.

Government as an employer and insurer has same considerations as above. This insurance role will expand when prescription drugs are included in Medicare.

Medicaid covers some but not most OTC drugs. Medicaid beneficiaries thus could pay more than they currently pay.

One argument for keeping the prescription requirement is that consumers are more likely to make mistakes in selecting among the antihistamines. A counter-argument is that physician decisions regarding which drug to prescribe are influenced by advertising including direct promotion to doctors.

Institutions The principal institutions are the FDA, Congress, and the Bush administration. The FDA is a regulatory agency that follows its mandate and administrative rules. Although it is constrained by both, it has a degree of discretion that can be exercised when it is supported by professional judgment. It is, however, subject to political pressure from both Congress and the White House.

The White House will appoint a new commissioner and thus will have a degree of influence on the commissioner. Congress provides the FDA’s budget, and members of Congress frequently make inquiries to the FDA about various dockets and rules. Congress also exercises oversight and can through legislation direct the FDA to take particular actions. It frequently does so. A natural opportunity to exercise influence on the FDA is the Senate confirmation hearing on the Bush administration appointee. Bush’s principal advisor on the FDA is a former pharmaceutical company executive.

What does this issue look like from the point of view of the FDA? A forced switch is an unprecedented issue, but the FDA has dealt with quite a few drug company-initiated switches. The difference is that if the FDA orders the switch it will be in opposition to a primary constituency— the pharmaceutical industry.

The FDA maintains that it has the authority to mandate a switch due to a citizen’s petition. Nearly 40 ingredients have been switched since 1972. The switches can be of two kinds:

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1. A complete switch whereby all of the indications and dosage forms are switched from prescription to OTC status.

2. A partial switch whereby some of the prescription indications and dose regiments are switched to OTC status and the others remain prescription.33 With respect to procedures “FDA may use a wide range of public procedures (e.g., conferences, meetings, correspondence, hearings) during the process of evaluating the petition. When the FDA issues a final decision, however, it may be appealed through the court system.”34 In making its decisions the FDA does not take into account the economics of the issue. For example, it does not consider the impact on the incentives for research and development not does it consider the price of insurance. Those are matters for Congress.

The courts are also relevant, since the probability is high that one side or the other will appeal the FDA decision. The courts will decide based on three factors: 1) the FDA statutes, 2) the process the FDA followed and the docket record, and 3) precedents.

Information Important information is whether Claritin would be safe if sold on the OTC market. The advisory committee has clearly answered that question. The broader issue is whether selling Claritin over the counter would cause some patients not to visit a doctor and hence not to be diagnosed as having asthma or some other condition that would require treatment with a different drug. This is clearly the focus of the pharmaceutical companies, the doctors’ associations, and the AAN/MA. Other relevant information is what would happen to the price on the OTC market. This is important to the stakes of the companies and the impact on consumers. Both the pharmaceutical companies and the insurance companies have considerable experience with that market, and the FDA also is knowledgeable, although it does not take prices into account in its decision-making.

Most people believe that the price would fall substantially.

Timing The principal institutional arena is the FDA and attention should be given there immediately. The pharmaceutical companies should also focus immediately on Congress and the White House. Once the FDA makes its decision, the loser has the option of filing a lawsuit. Whoever is the loser should file a lawsuit. At this point the loser could also mount a focused political strategy seeking to reverse the decision. The FDA will probably be sued by both sides.

Distributive Politics Which side is the stronger? It is close in principle, but in reality it is likely to be the pharmaceutical industry.

For Schering-Plough the stakes are huge both in the short- and long-term. For Aventis and Merck the stakes are also large, but neither of the companies is as dependent on second-generation antihistamines as is SP. As large as these stakes are, the longer-term stakes for the pharmaceutical

33 34

Dr. Janet Woodcock, CDER, FDA, Testimony, House Energy and Commerce Committee, June 13, 2001. Dr. Janet Woodcock, CDER, FDA, Testimony, House Energy and Commerce Committee, June 13, 2001.

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industry are huge. There surely are other prescription drugs that could be moved to OTC status, and insurance companies would surely petition the FDA for a switch. At best an FDA-imposed switch would increase the uncertainty in the pharmaceutical companies’ planning process. At worst the entire strategy and planning process would be disrupted. This would affect not only the second-generation antihistamines but potentially many other drugs could be switched to OTC status. Having the drugs available over the counter would have two benefits for consumers. First, the price would be lower, so those patients without prescription drug coverage would pay less. For those with coverage, however, the OTC price was likely to be higher than the co-payment on the insurance plan. Ultimately, the lower price should be reflected in lower insurance premiums. Second, consumers who chose to self-diagnose would avoid the cost of a physician visit. The important factor is whether doctors will be active on the switch issue. Most will not, but those doctors whose patient-type may not be diagnosed may be active, particularly if they anticipate a loss of income from a decrease in patient visits. The two groups mentioned in the case may well be active. Patients will generally not be active because the effect on most is very small. Some, however, are represented by associations such as AAA/NA that wants the three antihistamines to remain Rx. They can be expected to be active, and one of their tactics may be to bring children to the hearing to testify about how important it is to see a doctor for diagnosis. The health care industry has far fewer resources than do the pharmaceutical companies, so if WellPoint is to mount a political strategy it will have to mobilize others. The potential here is considerable. The potential comes from the payers who ultimately bear the cost of the pharmaceuticals. Some payers are represented by Rx Health Value, and it can be expected to be active on pharmaceutical issues such as this. There are vastly more payers, but mobilizing them will be a challenge for a single company. House hearings on pharmaceutical issues were held on this issue, but the Senate did not considered it. Jane L. Delgado, President and CEO of the National Alliance for Hispanic Health, a national association of health and human service providers for Hispanics, supported DTC advertising, “DTC pharmaceutical advertising is more in the model of public health patient education rather than the Madison Avenue tradition of advertising…. Responsible DTC advertising is another tool that empowers consumers with information that includes both benefits and risks so that the consumer can make an informed choice.”35 The increase in spending on drugs is apparently more accounted for by increased utilization of prescription drugs, more prescriptions per person, than by higher prices.

35

Testimony, House Energy and Commerce Committee, June 13, 2001.

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Regarding the high prices for pharmaceuticals in the United States, one pharmaceutical industry executive drew an analogy between defense and pharmaceutical pricing. The United States provides a defense shield for much of the world, and the U.S. pharmaceutical market provides revenue to finance worldwide research and development by companies around the globe.

Integrated Strategy—Schering-Plough Schering-Plough has a well-integrated strategy with both market and nonmarket components. The petition threatens that strategy. The market strategy is 1) to bring in a new drug Clarinex to replace Claritin when it goes off patent, 2) to advertise heavily to switch consumers and doctors to Clarinex, and 3) to move Claritin to the OTC market and apply to the FDA for a period of market exclusivity. (With a voluntary switch and a period of exclusivity Claritin would be the only second-generation antihistamine on the OTC market during the period of exclusivity.) The nonmarket component of this strategy focuses on FDA approval for Clarinex, and an attempt to get a period of exclusivity for Claritin in the OTC market. The nonmarket component involves building a record for the two approvals. Typically there is little opposition in these processes, so this primarily involves compliance with FDA procedures. Schering-Plough now must redirect its nonmarket strategy to stop a forced switch.

One feature of the strategic situation is that it may be possible to get a two-year period of exclusivity in moving Claritin to the OTC market. As I understand it, if the switch is filed under a New Drug Application (NDA), a two-year period of exclusivity can be granted. When Rogaine was switched from Rx to OTC, the FDA made a “controversial” decision in refusing to grant any exclusivity. The basis for the decision was that no further studies were required.

The best strategy for Schering-Plough is probably to mount a nonmarket strategy aimed a delaying the FDA decision. This would give it a chance to deploy its original market strategy. Delay can be achieved through the threat of litigation, by encouraging patients and doctors to contact/lobby the FDA, attempting to induce members of Congress to intervene with the FDA, and similarly to induce the White House to intervene. The latter two primarily involve lobbying.

Market strategy Schering-Plough’s market strategy must, of course, begin with getting its production problems resolved. The corrections were under way.

Once the production problems are resolved, Clarinex should be approved expeditiously. There is no reason for Schering-Plough to delay introducing Clarinex. Since FDA approval of the switch is not a foregone conclusion, Schering-Plough should go ahead with its strategy of switching customers and doctors to Clarinex. SP’s strategy is to argue that further post-marketing studies on Claritin are needed before there is a switch. At some point Schering-Plough could submit a supplemental NDA with post-marketing data that supports Claritin’s safe use in the OTC market.

This is a delicate issue, however, because the company does not want to lose credibility with the FDA. If the forced switch were defeated, Claritin could be switched to the OTC market in December 2002 making it and the generics the only second-generation antihistamines available on the OTC

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market. Claritin would be the only one with brand recognition, giving it an excellent opportunity to establish a high price (for the OTC market).

Counteracting a forced switch Suppose that the FDA ruled that the three antihistamines could be sold over the counter but their manufacturers chose to restrict their availability. What would likely happen? One answer is that public pressure to make the drugs available on the OTC market would be considerable. This would likely cause one of the manufacturers to decide to move its drug to the OTC market. There could be a first-mover advantage in doing so. Which company might do it?

Schering-Plough has the most to lose, since Claritin is the best-selling of the three. This suggests that the manufacturer of Allegra or Zyrtec is the most-likely first-mover. But, Aventis does not have a replacement prescription antihistamine as Schering-Plough has with Clarinex and neither does Pfizer/UCB. (Levocetirizine apparently is not a third-generation antihistamine. UCB just renamed cetirizine in some foreign markets.) Clarinex is not yet approved, however. Another factor in the analysis is that Claritin will come off patent at the end of 2002, so the other companies can work backwards on when it will move to the OTC market (is there a three-year extension?)

This suggests that one of the other companies might move quickly to switch to the OTC market.

Uwe Reinhardt predicted, “One of them will put it out there and the others will cave.”36 In one scenario a forced switch would not be so bad for Schering-Plough. A switch would eliminate the prescription antihistamines leaving a relatively open field (at least initially) for Clarinex. The only other competitor would be Sepracor’s Soltara which was awaiting FDA approval. If Schering-Plough could shift doctors and patients from Claritin to Clarinex, it would have a decided advantage over Soltara. Two problems would remain, however. The first would be to get doctors to prescribe Clarinex rather than tell patients to use one of the OTC non-sedating antihistamines. Patients with insurance would benefit from the switch even if Clarinex were only marginally better than Claritin. One strategy for Schering-Plough would presumably be to advertise Clarinex heavily to prompt consumers to go to their doctor and ask for the new drug.

Doctors’ financial interests would be aligned with those of Schering-Plough because of the physician visits the advertising would generate. A better strategy would be to seek approval for Clarinex for indoor allergies, for which Claritin is not approved.

The second problem was that the insurance industry could petition the FDA to more Clarinex to the over-the-counter market, but that would likely not happen for years because post-marketing studies would be required (e.g., there would be no available data such s the Canadian experience). How likely this was would depend on how safe Clarinex is. The optimal position for a drug company might be to design the safety of the product so that it was safe enough to be prescribed by a doctor but not sufficiently safe to warrant OTC status.

Nonmarket strategy

The principal nonmarket strategy should be to link allergies with asthma. This would encourage and build on the strategies of the AAN/MA and the doctors that focus on asthma and diseases correlated with allergies. The objectives of this focus would at a minimum be to stretch the FDA’s decision-making process. This would give SP an opportunity to deploy its market strategy of migrating patients from Claritin to Clarinex.

36

, May 10, 2001.

The Washington Post

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The strategy of the generic drug companies is of interest. A forced switch would put them into the OTC market as well. This would certainly result in lower prices but would likely result in lower profits. They might well oppose a switch but may be silent on this issue because their drugs have not yet been approved. SP will surely argue that only the manufacturer can adequately monitor the post-marketing experience with a prescription drug and hence it should decide when to switch it to OTC status. If political strategies are to be directed at Congress or the White House, one issue is whether they should be conducted through an industry association or by individual companies. The companies have different interests (e.g., due to remaining patent lives), so they might act individually. The companies are market rivals, but they can be nonmarket allies. In this case the best strategy is for each company to conduct individual nonmarket strategies with the understanding that the other companies will be doing the same. A legislative strategy has an immediate component and a conditional component. The objective of the immediate component is to influence the switch decision. The conditional component is to reverse a switch decision if it occurs. This would require new legislation. This would probably involve inserting a directive to the FDA into an appropriations bill or a related piece of legislation. One strategy that might be used is to argue that label comprehension studies are needed. These would have to be done by the pharmaceutical companies and would delay any forced switch. One nonmarket strategy alternative would be to file a late patent followed by a patent infringement lawsuit. This would delay entry of the generics. Could the drug companies or the insurance companies mount grassroots pressure among their stakeholders for their side of the issue? Possibly, but much of the public does not have favorable impressions of either insurance companies or drug companies. The best possibility is already- organized patient groups. Both the pharmaceutical and the insurance industries have aggressive nonmarket strategies. According to the Center for Responsive Politics, the pharmaceutical industry was 12th in political contributions in the 2000 election cycle, contributing $26.3 million. Sixty percent was in soft money. The insurance industry was sixth with contributions of $40.4 million, with 40% in soft money. Blue Cross-Blue Shield was the largest insurance contributor with $2.0 million, but it is a national association and not just Blue Cross of California. WellPoint was not one of the top 20 insurance contributors, contributing only $10,550. Schering-Plough was 6th among the pharmaceutical companies with $1.2 million in contributions, most of which went to Republicans. Pfizer was 2nd with $2.3 million, and Aventis was 10th with $0.8 million. The Center for Responsive Politics reported that Schering-Plough spent $9.2 million on lobbying in 1999, of which $2.3 was for 17 lobbying firms. Pfizer spent $3.8 million, and Aventis spent $760,000 on hired lobbying.

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Lawsuits Threatening a lawsuit is a good idea, since it will make the FDA move cautiously in its decisionmaking. If the FDA rules that the drugs are to be sold over the counter, the companies will file lawsuits. The grounds for lawsuits could range from the statutory authority of the FDA to the process used for the approval. The companies could, for example, argue that the FDA has not followed precedents established in other manufacturer-requested Rx-OTC switches.

If the FDA rejects the Petition, WellPoint could file a lawsuit, but the grounds for a lawsuit are not clear.

The pharmaceutical companies may have better prospects in the courts if the decision goes against them than does WellPoint.

Richard F. Kingham, a lawyer who has represented pharmaceutical companies but who was testifying on his own behalf in opposition to a forced switch, said that beginning in the 1980s the FDA’s switch review procedure essentially always included an NDA or an NDA supplement.

Kingham also discussed the bases for a lawsuit challenging a forced switch. He referred to FDA precedents, the due process provision of the Constitution, the administrative procedures requirements, and property rights. He stated, “The company has proprietary rights in its NDA data, which cold not be used without consent, regardless of the regulatory procedures followed.”37 To illustrate the complexity of the patent-generic drug mix, in May 2001 seventeen consumer groups filed a lawsuit against AstraZeneca, a prescription drug company, and the generic drug company Barr Laboratories. The lawsuit argues that AstraZeneca and Barr entered into an agreement under which Barr agreed not to introduce their generic version of Nolvadex in exchange for a lump-sum payment of $21 million and the right to sell the prescription drug. The FTC was concerned with such agreements and negotiated a settlement with Aventis in the case of a delay in the introduction of a generic version of one of its prescription drugs. PhRMA argues that such settlements are efficient because they eliminate litigation expenses.

In April 2001 the FTC under the Clinton administration voted unanimously to file civil charges challenging an agreement among Schering-Plough and two generic drug companies that delayed the introduction of the generic drugs.

WellPoint WellPoint came up with the idea of a citizen’s petition as part of its review of options for dealing with the rapid increases in pharmaceutical spending. Antihistamines was a therapeutic class with one of the largest increases. In their review they kept coming up with the same theme—the second generation antihistamines are safer than the OTC antihistamines. They found this option in a review of the code for the FDA, in Section 21 of the Code of Federal Regulations, Paragraph 31.0 WellPoint’s strategy is to press on with the petition. It has the advantage as a result of the advisory committee votes, and it wants to press the FDA to follow the committee’s recommendation. The

37

Testimony, House Energy and Commerce Committee, June 13, 2001.

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tactics with the FDA focus on the use of extant studies from other countries, such as the study from Canada. The objective is to have the FDA accept these studies and not require any post-marketing studies in the United States.

Why does WellPoint have a long-term interest in this issue if when Claritin is moved to the OTC market patients are switched to Clarinex? The answer according to WellPoint is that Clarinex is not a significant improvement over Claritin, so WellPoint will not cover Clarinex because there is an OTC drug Claritin that is “as effective.”

S-P’s strategy is to advertise Clarinex to induce consumers to ask their physicians for it. This will put pressure on the physicians, since many patients will want the new drug. The patients will then be mad at either their physician for telling the patient to go to the OTC market or their insurer. In particular, Clarinex has an advantage over all other drugs in that it is both nonsedating and approved for both indoor and outdoor allergies. WellPoint indicated that it would not include Clarinex in its formulary, but it is likely to come under pressure from subscribers to do so.

If Clarinex is not a breakthrough drug or major improvement over the second-generation antihistamines, would it be a candidate for a forced switch? Perhaps in the long-run but probably not in the short-run, since post-marketing data will need to be collected. Note that there are no overseas studies of Clarinex at this point, since it has not yet been sold anywhere.

One issue pertaining to WellPoint’s petition is whether it filed it too late. Hindsight suggests that the answer is yes, but note that the FDA delayed nearly three years before the advisory committee was convened. If the FDA had acted expeditiously, a decision could have been reached well before the patent on Claritin expired. Perhaps, however, WellPoint should have anticipated this and filed the petition two years earlier. This seems an unfair criticism, since WellPoint was a nonmarket entrepreneur in this case and came up with the novel idea for a petition when it did. An appropriate criticism may be that WellPoint should have worked harder to speed the FDA in setting up the review process.

Prices What might happen to the prices of prescription drugs if they are sold over the counter? Would advertising increase or decrease? Would distribution costs decrease? The prescription drugs are already available at WalMart. Would price competition drive prices down? William O’Donnell of Schering-Plough said, “Were they to go over-the-counter, they would probably be priced as a premium product and costs to consumers would be higher than their co-payments.”38 This could be true, but the price should fall considerably from the current level.

In the June 13 House hearings WellPoint presented a comparison of the prices of Claritin, Benadryl, and Clor-Trimetron in chain drug stores in Canada and the UK, showing that they were all priced at the same level. WellPoint argued that Claritin would be priced at the level of those drugs in the U.S. if it were on the OTC market. That price would be about $15 a month. WellPoint argued that the average co-pay for a prescription drug in the U.S. is $17. In addition, the average co-pay for a doctor’s visit is $17.

38

The Sacramento Bee, May 11, 2001.

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Larger issue—pharmaceutical expenditures The longer-term considerations pertain to the solution to the pharmaceutical expenditure problem and to which drugs the solution should first be applied. The objective of the insurance industry is to reduce its expenditures by either reducing the price of pharmaceuticals or moving pharmaceuticals off its budget. Blue Cross of California chose antihistamines, which in some other countries are available over-the-counter. The long-term objective is to obtain lower prices for pharmaceuticals and then to offer insurance options providing for a variety of types of coverage for pharmaceuticals.

A potentially powerful group here is the payers. WellPoint has joined with other payers to form Rx Health Value (www.rxhealthvalue.com) to address the issue of rapidly increasing health care expenditures. The organization began with a study of drug expenditures increases that reported that prescription drug expenditures had increased nearly 25%. How active politically Rx Health Partners will be remains to be seen.

Another strategy issue is the type of relief to be sought. One possibility was to seek regulation of pharmaceutical prices. The grassroots opposition to the Clinton administration’s health care reform initiative caused it to go down in flames in 1993. Although various types of price regulation had been discussed from time to time, the prospects during the Bush administration were remote at best.

Price regulation would have to clear Congress, since there was no authority for such regulation of pharmaceuticals. The second basic alternative was to use competition to drive down expenditures.

The only ways to do this were to rely on generics or to move pharmaceuticals from the prescription to the over-the-counter market. When generics could be brought to market was fixed by law and would require action by Congress to change. Although restrictions on generic drugs had been relaxed in the past, it was a result of very heated politics and intense Congressional action.

Changes also took many years to achieve. Such a change seemed highly unlikely. The third basic alternative is to rely on monopsony power of the government, e.g., through Medicare, or through joint purchasing program among insurance plans.

Maine passed a law empowering the state to negotiate and purchase prescription drugs for its citizens. The state also can “prior authorize” drugs for Medicare. PhRMA filed a lawsuit against the state, and a federal court issued a preliminary injunction against the state preventing it from implementing the law. The U.S. Court of Appeals lifted the injunction in May 2001.

Related issue: DTC marketing A 1997 revision to the FDA rules change removed the “brief summary” of risks requirement which allowed the current DTC advertising. DTC marketing has become a major issue in the industry. It is a source of considerable profits for the industry, and the industry’s argument that the advertising involves consumers more actively in their health care decisions is important. However, the advertising increases the use of drugs with the average number of prescriptions per patient increasing in recent years. Even if prices have remained constant, the increase in prescriptions increases pharmaceutical expenditures. Critics complain that the DTC marketing not only results in higher expenditures, but it forces doctors to prescribe expensive drugs when they are not needed.

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Many doctors do not like DTC advertising because it puts them under pressure. That is, when consumers ask their doctor for a drug by its brand name, doctors have difficulty saying “no” or telling the consumer to use an OTC drug. One reason doctors feel they have to be responsive to consumer requests is that HMOs and other health care providers have decided they need happy clients. They have introduced feedback systems on office visits with doctors, and some now pay bonuses for patient satisfaction and other indicators of quality. These include WellPoint as well as Blue Cross of California and Harvard Pilgrim Health Care of Massachusetts.

Despite the concerns of doctors regarding DTC marketing, the American Medical Association (AMA) has not taken a position on the issue, although the AMA was studying the issue.

Developments At the end of 2001 Clarinex received FDA approval for one indication, and in February 2002 it received approval for the treatment of seasonal outdoor allergies. Initially, Clarinex was priced 18% below the price of Claritin. Approval had been delayed by negotiations between the company and the FDA over fines to be imposed as a result of its manufacturing problems.

When the FDA approved Clarinex, SP began an aggressive DTC advertising campaign. This approval was for seasonal, outdoor allergies, and in February 2002 Clarinex was approved for yearround indoor allergies. This was also important because Claritin had not been approved for indoor allergies, so SP could advertised that Clarinex was superior to Claritin. Moreover, this gave Clarinex an advantage over Allegra which was not approved for indoor allergies. Zyrtec was approved for both indoor and outdoor allergies, but it was not approved as non-sedating as were Allegra, Claritin, and Clarinex. (Recall that Allegra and Claritin were approved for use by pilots but Zyrtec was not). Early indications were that Clarinex was selling only moderately well.

When Clarinex was approved by the FDA, WellPoint announced that it would not include the drug in its formulary, so its policyholders would not be reimbursed for Clarinex. Robert Seidman said, “There’s no room for prescription drugs that provide no value over OTC versions.”39 In March 2002 Schering-Plough announced that it was filing a petition with the FDA to switch Claritin to the OTC market. Commentators believed that the reason was that American Home Products and Johnson & Johnson had announced that they would introduce generic versions of loratadine once Schering-Plough’s patent expired in December 2002. SP was silent about its pricing strategy for the OTC market. Consumers with insurance were expected to have to pay somewhat more for Claritin on the OTC market compared to their current co-payment, but the cost of their managed care insurance would be lower. SP lost about 5% of its market value upon the announcement.

SP had been unsuccessful in extending the patent for Claritin, so the patent would expire in December 2002. The FDA panel was not scheduled to meet until November 2002, FDA approval would occur at about the time the patent expired. SP had several reasons for this move. First, the voluntary switch would leave WellPoint’s petition moot. Second, American Home Products and

39

, March 8, 2002.

The Wall Street Journal

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Johnson & Johnson had announced that they would market OTC generic versions of Claritin forcing SP’s hand. Third, by switching Claritin to the OTC market, generic versions of Claritin could not be marketed on the Rx market. To accomplish this, SP had to obtain one additional approval, as indicated in the next paragraph.

In April 2002 an FDA panel endorsed OTC Claritin for the treatment of hives. If the FDA agrees with this conclusion, it would be a major victory for Claritin, since OTC Claritin would thus have the identical label as the Rx Claritin label. FDA regulations do not allow the identical drug to be sold simultaneously on the Rx and OTC markets. This means that if the switch to the OTC market is approved as expected (the panel meets in November 2002) there can be no generic versions of Claritin sold on the Rx market. The generic versions of Claritin would thus have to be marketed on the OTC market. This would also reduce the competition for Clarinex on the Rx market.

The voluntary shift has some advantages. The switch would preclude generic versions of Claritin from being sold on the prescription market, since FDA precluded the sale of the same drug on both the prescription and the OTC markets.

This left Allegra and Zyrtec in difficult positions because they would have to compete against Clarinex on the prescription market with sales drained by the availability of Claritin on the OTC market. They were also still subject to the WellPoint petition. WellPoint also raised the copayment on Allegra and Zyrtex from $30 to $40.

One important issue is whether this petition is the tip of an iceberg as Bert Spilker states in the case.

The answer seems to be yes in the sense that there are a number of other drugs that may be candidates for a switch. The two Cox-II inhibitors, Celebrex and Vioxx, are believed to be candidates, as may be Viagra. In addition, non-steroidal anti-inflammatory drugs may be candidates. These drugs, along with the second-generation antihistamines, account for much of the DTC advertising. This suggests that as one commentator put it, DTC = OTC. That is, if a drug is safe and effective and heavily advertised, it should be sold OTC. Conversely, if a drug is not safe for sale OTC, then it should not be advertised directly to consumers.

A related nonmarket issue in this is thus whether DTC advertising, which may be $4 billion a year, should be restricted. This is a controversial issue that will be on the nonmarket agendas of pharmaceutical companies in the immediate term.

To the best of my knowledge, the FDA had not acted on the WellPoint petition. One reason reportedly was that the FDA staff preferred to wait until an FDA commissioner was in office.

Because of continuing disagreements between the pharmaceutical industry and other health care interest groups had been unable to agree on a commissioner. The Bush administration took a long time before nominating a commissioner; in fact, this may have been the last major appointment made by the president. After he had been in office for nearly a year, newspapers speculated that the commissioner was preparing to make a decision on the petition. The Bush administration, however, asked the commissioner to head the agency responsible for Medicare. Another delay resulted in naming a replacement, and as of June 2005 the nominee had not been confirmed by the Senate.

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Other developments: In May 2002 the FDA and SP reached a consent decree under which SP agreed to pay a fine of $500 million for production quality problems at its facilities in New Jersey and particularly Puerto Rico. SP had spent $60 million to improve its quality control and hired 500 additional employees, but the consent decree required it to do more. SP agreed to discontinue production of 70 minor products, and to make a number of specific improvements. The consent decree was to last for five years. Two days before the consent decree was announced, SP disclosed that the FDA had begun a criminal investigation of its Puerto Rico plants. This may have been instigated by Public Citizen, which had written to the FDA alleging that deaths had occurred because SP had failed to include albuterol in its asthma inhalers. Separately, the FDA did not approve Sepracor’s Zoltara allergy drug. The FDA stated that the company had not shown that the drug did not cause heart problems. Sepracor lost half its market value on the day of the announcement. Sepracor reported that it found no evidence of heart problems in its clinical trials. Zoltara is a derivative of Hismanal, which was withdrawn from the market in 1999 because of concerns about side effects, including heart irregularities. Sepracor had developed derivatives of allergy drugs for Aventis and Schering-Plough, and those drugs became Allegra and Clarinex, respectively. In 2001 the Prescription Access Litigation Project filed a lawsuit against SP alleging that DTC advertisements for Claritin were deceptive. The state of ScheringPlough at the end of 2001 is assessed in “At Schering, Optimism and Problems,” The New York Times, November 15, 2001. Also see “Schering Plough Faces a Future with Coffers Unfortified by Claritin,” The Wall Street Journal, March 22, 2002. In 2004 Wellpoint and Anthem announced their intention to merge.

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Part II Integrative Case Fuel Economy Standards 2007 This case can be used in a session for Part II of the book, and it could also be used in conjunction with Chapter 11 on regulation, since the rulemaking for implementing higher standards has been delegated to the Department of Transportation (DOT) and its agency the National Highway Traffic Safety Administration (NHTSA).

This case is the sequel to two earlier cases in the previous editions of the book. In those cases the auto industry, particularly the U.S. big three, conducted an aggressive nonmarket campaign opposing higher standards. The campaigns involved lobbying, grassroots activities, public advocacy, testimony, and threats of legal action. The industry raised concerns about safety of down-sized cars, the cost required to meet higher standards, and the possibility, or certainty according to the industry, of reduced choice for consumers as large SUVs and pick-up trucks were driven from the market. The price of gasoline was low at the time, and many consumers were unconvinced that sharply higher standards were needed. The situation in 2007 was different.

Gasoline prices were higher and concerns about global climate change were more widespread.

Moreover, other countries had been adopting measures to address global climate change, although their accomplishments were limited in some cases, as discussed in Chapter 11.

A distributive politics spreadsheet for the McCain-Kerry bill in the case CAFE Standards 2002 from the fifth edition of this book is included here to indentify the basic interests relevant to a major increase in fuel economy standards.40 In 2002 the interests that would be harmed by the bill had concentrated consequences, whereas the beneficiaries had in most part widely-distributed consequences. This meant that the politics were entrepreneurial, and McCain and Kerry were the entrepreneurs. The interests prevailed as expected. As indicated on the second page of the case a number of changes occurred between 2002 and 2007, and those changes were sufficient to overcome the interests opposed to higher fuel economy standards.

Distributive Politics Spreadsheet Issue Combined CAFE of 35 mpg

Alternative

McCain-Kerry Bill

Predicted consequences of bill: 1) high redesign costs for auto companies, 2) downsizing of vehicles, 3) greater outsourcing of large cars or produce small cars in United States, 4) lower employment, 5) higher injury and fatality rates, 6) less choice for consumers, 7) lower fuel consumption, 8) reduced CO2 emissions. .......................Demand Side.............. ............................Supply Side............

Supporting

Substitutes

Environment few if any -alists (carbon tax)

40

Magnitude

Per Capita

Numbers

Coverage

High

low

high

extensive

Resources Modest

The McCain-Kerry bill would have increased fuel economy standards to 35 mpg.

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Cost of Org.

Exp. Impact

low for group high for indiv

substanti al

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public (global warming)

"

moderate

very low

huge

complete

Huge

very high

little if any

UAW (if outsourcing is restricted)

Resources

Cost of Org.

Exp. Impact

Opposing

Substitutes

Magnitude

Per Capita

Numbers

Coverage

U.S. auto mfg, suppliers, dealers

shift to small cars

very high

high (per company)

large

extensive (suppliers, dealers)

very high

low

very high

Japanese auto mfgrs, dealers, suppliers UAW

shift to very small cars

very high

high (per company)

moderate

moderate (suppliers, dealers)

high

low

moderate

none

very high

moderate

large

moderate

moderate

low

substanti al

car buyers

less choice

very high

low

huge

complete

high

high

Small

oil companies*

shift resources

High

moderate

moderate

extensive

very high

low

small*

N.B.: * very risky for oil companies to take a high profile position on this issue.

In 2007 the auto industry, through the AAM, began to implement a campaign similar to those it had used in 2002 and 1991. With the Democrats having a majority in both chambers of Congress and with broader public support for measures to address global climate change and energy security, it soon became clear that the campaign would fail. Moreover, it could alienate members of Congress and segments of the public. The industry then turned to a different strategy based on the institutional structure illustrated in Figure 7-1. In that figure the Institutional Arena corresponds to the Congress, which is expected to enact sharply higher fuel economy standards.

Congress could specify the details of the implementation, but those details are contentious and the ensuing politics would be intense and certainly would delay enacting the higher standards. The alternative is to delegate to regulatory agencies the implementation details, as illustrated on the right side of the figure. This would relieve pressure on Congress and would allow the regulatory agencies to exercise their expertise. The auto industry and individual companies thus turned their attention to DOT and NHTSA.

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Passage of the higher fuel economy standards: Congress specified some details sought by the industry, requiring attribute-based standards, fleetwide use of credits, tradable credits, and flex-fuel credits. The industry was unable to get separate standards for autos and trucks. The detailed rule-making was delegated to NHTSA, which had had responsibility for fuel economy standards in the past.

Some of the specific implementation decisions to be made by DOT are the following: 1. How the industry fuel economy standard of 35 mpg is to be allocated to manufacturers, model types, and performance characteristics (e.g., large trucks). For example, all manufacturers could be required to meet the 35 mpg standard, or standards could differ between manufacturers based on the vehicles they produce or the current fuel economy of their fleets. The percentage approach could be used with the latter.

2. Interim standards to be met before 2020.

3. Flex-fuel credits.

4. Feasibility considerations for standards for medium and light trucks.

5. A low-volume rule.

6. A one fleet or two-fleet system. The latter is strongly opposed by the UAW. 7. Design of a credits trading system 8. Design of a credits transfer system within a fleet.

9. It is also possible that DOT could attempt to block states from setting standards higher than federal standards, as California has attempted to do.

Nonmarket strategy and implementation NHTSA is required to follow a set of administrative procedures and satisfy substantive standards as discussed in Chapter 10. The principal implementation strategy for influencing a regulatory agency is informational lobbying. The objective is to provide information to allow NHTSA to take into account in its rulemaking the impacts of alternatives on the auto companies and their customers.

The big three have similar interests, and on some dimensions those interests are in opposition to those of high mileage manufacturers such as Toyota, Honda, and the Korean manufacturers. For example, the big three favor the percentage approach, since it would result in higher standards for the currently high mileage manufacturers and lower standards for the low mileage manufacturers, which includes the big three. This seems important enough to risk driving Toyota from the AAM. The alternative is to have the AAM be silent on this issue and have the individual companies do their own lobbying. The latter seems to be the best strategy.

On one thing the auto companies can agree—the more flexibility in the system the better. All companies should want a flexible credits system with credits transferable within a manufacturer’s fleet and credits that can be bought and sold between companies. A transferable credits system would be designed in a manner similar to that discussed in Chapter 11 for trading sulfur dioxide permits and carbon permits. The objective should be to have as few restrictions as possible, and if any credits are to be allocated initially, the auto companies want them distributed without charge.

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The big three also want interim standards to be easily achievable, and their best argument is that time is needed to develop and implement new technologies, including retooling factories.

Environmentalists and others have criticized the auto industry because flex fuel credits are given but the vehicles rarely using alternative fuels. The best strategy for the big three is to align with the ethanol lobby, which is a potential beneficiary of the credits. The approach is not to focus on the past but on the future.

The big three want a one-fleet rule so that their imports and their domestic production can be treated together rather than have to meet standards on both their imported fleet and their domestic fleet. This is vehemently opposed by the UAW, since it would allow the big three to move some of their small car production to Asia. The one-fleet rule seems likely because the legislation specified an industry standard that pertains to vehicles used in the United States.

Setting standards for medium and large trucks will be a complex task because of the variety of types and uses of those trucks. The best approach on this issue is to align with customers who know the effects of specific rules on their uses of the trucks.

The industry should work hard for a rule prohibiting states from setting standards higher than the federal standards.

The following questions can be used to guide the discussion.

Discussion questions:

1. Could the auto industry defeat sharply higher fuel economy standards as it had done in the past?

2. What are the advantages and disadvantages of the features of the Senate bill for the auto industry?

3. What objectives should the U.S. big three pursue in the rulemaking by NHTSA? 4. Should the big three lobby for the percentage method of setting overall fleet standards?

What would be the implications for Ford and Toyota? Is there a risk that this would drive Toyota out of the AAM? 5. What should the big three seek with respect to the standards for medium and large trucks?

6. What should be done about states seeking to set standards higher than the federal standards?

7. Should the big three seek to handicap diesels, since they have a technological disadvantage in diesel automobiles?

8. Should the big three oppose the small volume exemption—or seek to increase the qualification hurdle?

9. Formulate a strategy for addressing the rule-making by NHTSA. Developments: In the economic recovery act (or bailout bill) passed in October 2008, the auto industry was granted $25 billion in loan guarantees for use in retooling factories. As soon as it became clear that the economy had slowed and there was a subprime mortgage problem and would require government assistance, the auto industry began a campaign for a loan guarantee. It was easy for Congress to

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accommodate the industry when it was providing funds to shore up the banks and financial markets. In April DOT issued proposed standards of 31.6 mpg by 2015, which was viewed as aggressive, and the comment period began. The proposed standards would differ across manufacturers with a standard of 27.4 for Ford and 29.6 for Honda. The proposed rules would also prohibit states from setting higher standards. The big three sought a lower interim standard. As of the writing of this manual, NHTSA had not issued final rules.

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PART III GOVERNMENT AND MARKETS

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Chapter 9 Antitrust: Economics, Law, and Politics This chapter addresses elements of antitrust law, its enforcement, and some underlying economics concepts. Antitrust is broad and deep subject to which entire courses are devoted. Instead of trying to condense this subject, the chapter focuses on four aspects of it. The first is the law and its enforcement. The second is schools of thought about the role of antitrust and its application. The third is elements of the economics of antitrust, and the fourth is the politics of antitrust. The three schools of thought are the traditional or structural school, the Chicago school, and the new industrial organization (IO) approach.

A lecture that goes beyond the chapter materials can be based on any number of the sources listed in the references. The case law provides a rich set of material for a discussion of antitrust law, its enforcement, and the underlying economics.

One point that might be emphasized is that the vast majority of antitrust cases are private (do not involve the government as a plaintiff). These cases are typically filed by a firm against one of its competitors or by a distributor or supplier against a firm. These suits are encouraged by the opportunity to collect treble damages. Some legal scholars believe that treble damages generate lawsuits that have the effect of discouraging competition.

A lecture also might emphasize the distinction between per se violations and the rule of reason as illustrated by the reasoning in the Northern Pacific and Continental TV cases.

As an example of a vertical practices case, the attorneys general of 44 states filed an antitrust lawsuit against Toys ‘R’ Us alleging that it conspired with Mattel and Little Tikes to limit the quantities of popular toys distributed to warehouse and price clubs. Toys ‘R’ Us agreed to donate $27 million toys and $13.5 million in cash to be used for toys and educational materials for children in all 50 states.

A lecture on the schools of thought can be based on Figure 9-3. The figure is arranged so that one can proceed item by item down the figure contrasting the structural, Chicago school, and new IO approaches.

Another topic for a lecture is the revised merger guidelines that the Federal Trade Commission and the Department of Justice issued in mid-1992. The revisions allow merging firms to show that the merger would not hurt competition. This provision was expected to be applicable only in extraordinary cases. The revisions also reduce the likelihood of a challenge to a merger if entry is likely into the industry.

The chapter case The Staples-Office Depot Merger? deals with an important horizontal merger case in which the government effectively used price data and internal company records to define the

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relevant market and identify the likely effect of a merger on prices. The availability of bar code data is likely in the future to play a role in horizontal mergers of retailers.

The chapter case The Microsoft Antitrust Case is an important case for the software, Internet, and ecommerce industries. The case identifies the reasoning of the court about the conduct of a dominant company in an industry in which there are network externalities. This case has finally been resolved as the last complaints by the states have been resolved. The case includes the decision up to the balking by the states.

Antitrust in the European Union is considered in Chapter 15, including cases against Microsoft.

The section on the politics of antitrust indicates that antitrust law and enforcement are not just legal and economic issues but are also political issues. Antitrust politics is largely distributive, so the framework developed in Part II can be applied to it. The case The Malt Beverage Interbrand Competition Act in the second edition of the book is concerned with a bill that would grant a special antitrust exemption to the beer distribution industry, similar to that for the soft-drink industry.

Antitrust law continues to evolve through court decisions even when no new legislation is enacted.

The following describes a Supreme Court decision pertaining to the right to sue under the antitrust laws and to the illegality of certain price fixing practices. In 1982, ARCO adopted a new pricing policy in which it eliminated its credit cards and lowered the prices it charges its retailers for gasoline. USA Petroleum, which competed with ARCO in California, Nevada, and Washington, claimed that ARCO’s new policy caused it to lose $800,000 a month. USA Petroleum filed an antitrust suit alleging that ARCO conspired with its dealers to fix prices at a low level. The courts have ruled that price fixing is a per se violation of Section 1 of the Sherman Act, and USA Petroleum sought to sue under Section 4 of the Clayton Act which allows private suits in the case of violations of the antitrust laws. The chapter case Price Fixing in the Airways considers price fixing on fuel surcharges for freight transport.

A federal district court in California rejected USA Petroleum’s right to sue under the Clayton Act, holding that a suit could be brought only if the prices were predatory. A federal Court of Appeals panel overturned that decision and held that USA Petroleum could sue since “price-fixing of any kind distorts in a basic way the competitive process the antitrust laws were meant to protect.” The Supreme Court, however, in May 1990 overturned the Court of Appeals in ruling that USA Petroleum did not have standing to sue on the basis that a price-fixing conspiracy was a per se violation of the Sherman Act. Writing for the 7-2 majority, Justice Brennan said, ‘“The antitrust injury requirement cannot be met by broad allegations of harm to the ‘market’ as an abstract entity…. Low prices benefit consumers regardless of how those prices are set, and so long as they are above predatory levels, they do not threaten competition. Hence, they cannot give rise to antitrust injury.’”1 2

1

ARCO v. USA Petroleum, No. 88-1668.

It is important to note that none of these rulings addressed the merits of the case itself. They only pertained to the right to bring a private antitrust suit.

2

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Cases Price Fixing in the Airways This episode may have begun with an innocent telephone conversation lamenting the rising cost of airline fuel, but such conversations can lead to illegal acts, as presaged by the quotation from Adam Smith at the beginning of the chapter. As recognized by Smith price fixing is harmful and is viewed as per se illegal by all three schools of thought. The Chicago school might be skeptical about the ability of the colluding parties to sustain their collusion, but convictions for collusion and price fixing are sufficiently common that such skepticism should be viewed as a reminder rather than a belief that collusive activities always fail. That is, it is important from a public policy perspective to recognize that cheating on cartel arrangements can occur, but there are enough convictions to demonstrate that it occurs. The ease with which firms can fix prices varies across industries, as does the incentive to do so. The incentive may be strongest for homogeneous products, and the ease may be greatest when there are few competitors. Freight and passenger air service seems to meet both conditions. What is not observable is how many cartels have not yet been discovered, and how many have disintegrated without having ever been identified.

The economic costs of price fixing are straightforward to identify. Price fixing restricts competition resulting in higher prices and hence lower consumer plus producer surplus. That is, consumers lose more than producers gain because some economic activity is foregone because of the higher price of air freight. The quotation from the producer in Australia illustrates this.

Collusion could also occur on non-price dimensions, although this seems less common than collusion on prices.

What is not known in this case is who in the airlines knew of the price fixing. The airlines claimed that the price fixing was done by lower level managers and that the top executives were ignorant of the price fixing.

The leniency programs of OFT and the DOJ are helpful for exactly the type of situation described in the case. The programs provide an incentive for executives who learn that their companies have been price fixing to inform the authorities—before an executive in another of the colluding companies does so. The companies are basically in a prisoners’ dilemma, since they have an incentive to inform the authorities if they have some doubt that another party may do so. This situation is actually somewhat more complicated than a standard prisoners’ dilemma because the colluding managers may not have an incentive to go to the authorities (since they are likely to be fired and face civil or criminal charges), but other managers who learn about the price fixing do have such an incentive.

When a company informs the antitrust authorities under a leniency program, the leniency pertains only to government actions. The price-fixing companies are subject to civil lawsuits for damages, as indicated in the case.

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Individual managers involved in price fixing are subject to criminal charges, and if found guilty can be sentenced to prison. This was the result in the lysine price fixing discussed in the chapter.

Companies can also be charged with a criminal offense.

In this case British Airways appears to have been the initiator of the fixing of fuel surcharges for the Atlantic routes. What is not known (to me) is whether BA was also the initiator of the price fixing on the Pacific routes.

The motivation and rationale for those managers who carried out the price fixing is not clear. One possibility was to just avoid a competition in fuel charges. Another possibility is that the managers may have feared that adding different surcharges might set off a new round of price competition of freight shipments. This would be of particular concern if the allegations made by the Ryanair CEO were true.

It is also useful to explore the incentives for a manager to engage in price fixing from an ex ante perspective. That is, identify the gain from successful collusion, and compare that to the expected loss if the collusion is detected. The expected loss is the probability that the collusion will be detected multiplied by the fines, civil and criminal judgments, and reputation damage from being caught.

Discussion questions: 1. Why did this price fixing occur?

2. What is the harm caused by price fixing? Did this price fixing of fuel charges actually harm competition if the airlines were competing on freight prices?

3. What are the personal and company risks associated with price fixing?

4. As an executive with British Airways suppose you learn that managers have been “coordinating” fuel surcharges with other airlines. What would you do? Do you notify OFT immediately? What do you do about the managers who have been involved with fixing the fuel surcharges? Suppose their supervisor had learned of the “coordination” and ordered it stopped but had not notified you. What should you do with respect to the supervisor?

5. What management processes would you institute to make sure that price fixing does not occur in the future?

6. Should you investigate to determine if the allegation by Ryanair is true or false?

The Staples-Office Depot Merger?

Most mergers challenged by the Department of Justice or the Federal Trade Commission are quickly abandoned by the firms involved or are “fixed” through negotiations aimed at alleviating the anticompetitive effects of concern to the government. In the Staples-Office Depot case the FTC opposed the merger, and the firms and the FTC staff negotiated a proposed consent decree to fix the problems. The commissioners, however, rejected the proposed consent decree, and the companies

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decided to go to court to contest the FTC’s preliminary injunction prohibiting the companies from taking any implementation actions to consummate the merger. The subsequent trial revealed the court’s review of the evidence and reasoning about the effects of the merger on competition. The data reviewed by the courts are proprietary, so no actual data are available. What is available in the record are comments about the data contained in both conclusions of the court and the testimony of witnesses. This case is important because of the way the court drew conclusions from the data.

The office products market is massive and superstores have only a small share, yet there are only three superstore chains, and the largest two are involved in the merger. As a starting point for analyzing this case, economic theory would predict the following effects from the merger: (1) The merger would allow some cost efficiencies in terms of more efficient distribution systems and information systems, for example. (2) The merged company would have more bargaining power relative to suppliers and manufacturers and hence could achieve savings by bargaining for lower prices. Some of the cost saving from (1) and (2) would be passed on to customers. (3) Competition would be reduced in the 42 markets in which Staples and Office Depot currently compete. Reduced competition would result in higher prices for customers, unless other sellers of office products were close substitutes for the office superstores. The CEO of Office Max suggested that price competition would be lessened. He said. “It’s better to have two players instead of three.” (4) The threat of entry would be lessened, and the diminished threat would result in higher prices.

The question for the court was to assess how large these effects were likely to be. In rejecting the merger the FTC voiced skepticism about any claimed cost efficiencies that could not “be verified by reasonable means.” The court was likely to share this skepticism.

The strategy of the merging companies was to argue that (a) the market should be broadly defined and that Staples and Office Depot had only a small share of that market; (b) the cost efficiencies were large; and (c) the major proportion of the cost efficiencies would be passed on to customers.

The FTC sought to show that the market in which the companies competed was the office superstore market, which was largely independent of the broader market, and that the merger would lessen competition and raise prices sufficiently more than any reasonable portion of the cost savings that would likely be passed on to customers.

The key conclusion of the court was that the relevant market for application of the antitrust laws was the sale of office supplies “through office superstores.” There was no disagreement between the companies and the FTC that the relevant geographic market was the 42 markets in which the companies competed against each other. The court reached its conclusion based on price data and on internal documents from the companies pertaining to how they viewed the relevant market. The price data showed two things. First, the cross-elasticity between prices (demand) at the superstores and prices in non-superstores was low, suggesting that the superstores served a relatively distinct market. Second and more importantly, price data showed that prices were on average 13% higher in markets in which there was only one office superstore than where there were three and well over 5% higher than in markets where two compete. These price differences prevailed despite the presence of other discount stores, supporting the conclusion that the cross-elasticity between superstores and non-superstores was low. In addition, to the price data, internal company records indicated the companies viewed their competition as other office superstores and not discount

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stores. The companies attempted to explain the price differences but were unable to offer any explanations supported by data.

With the market defined as office supplies sold through office superstores, the HHI was extremely high and would increase far more than the level specified in the merger guidelines for triggering an antitrust review by the enforcement agencies. The merger guidelines are not laws, however, and in its decision the court followed the antitrust laws and the precedents established in past cases.

The court also assessed the likelihood that a new office superstore would be formed to compete with the merged company and Office Max. Based on the data about the past failed entry by major retailers, the court concluded that the entry of a new office superstore was unlikely.

The next issue was the claimed cost efficiencies and the portion that might be expected to be passed on to customers. The companies estimated that the sum of the cost saving from (1) and (2) above would be between $4.9 and $6.5 billion over five years. (The companies, however, did not estimate how much would be saved through bargaining in the absence of the merger.) The companies argued that two-thirds of the cost savings would be passed on to consumers in the form of higher prices. The FTC viewed these claims with skepticism and not verifiable “by reasonable means.” The data did show that historically only 15% to 17% of cost efficiencies were passed on to customers.

The court concluded that the FTC was likely to prevail if the case went to trial, and hence the court allowed the preliminary injunction against the merger. In light of the court’s reasoning and the evidence, the companies abandoned their merger.

The key factors leading to the court’s decision were its definition of the relevant market for antitrust purposes and the price differences in one-firm, two-firm, and three-firm markets. The conclusion about the relevant market was clearly consistent with the price data, and any other definition of the relevant market would have to explain the price differences. The companies were unable to do so.

This raises the question of why the companies were unable to predict the court’s decision and hence went forward with their merger plans at considerable cost. The answer is not known, but it seems likely that the companies believed that the relevant market would be defined as office products regardless of where they were sold. As noted, this does not explain why they did not view the price data as compelling. There is little indication in the court records or in the comments by the officers of the two companies outside the courtroom that the companies had analyzed the data in the manner in which the FTC analyzed it. If they had done so, they might have avoided a costly embarrassment.

Teaching the case: The court’s reasoning and the discussion above identify the issues to be discussed.

1. Why do these two companies want to merge?

2. What does economic theory predict about the likely effects of the merger of the two companies?

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3. How should the relevant market be defined? What do the data indicate about how the market should be defined?

4. What is the import of the data on price differences in one-firm, two-firm, and three-firm markets?

5. Could it reasonably be expected that two-thirds of the cost efficiencies would be passed on to customers?

6. Did the court make the right decision?

7. Why did the companies not anticipate that decision?

Developments: As the court anticipated, within a few days after the injunction was granted, the merger agreement was terminated by mutual consent of the parties. The failure of the merger after ten months impacted the two companies, particularly Office Depot. 3 On June 30, 1997, the day the court decision was announced, Office Depot’s Chairman and CEO, David Fuente, said: “Even if the merger should not happen, the last 10 months have still been beneficial for Office Depot. The combined Integration Task Forces spent months analyzing our business and developing ‘Best Practices’ recommendations that Office Depot is already implementing ... Furthermore, because Office Depot’s information systems were going to be the base platform for the combined company, we invested heavily in building a stronger, more reliable MIS structure ... While the company has lost some personnel over the last few months, our core management team remains in place and Office Depot will immediately embark on an aggressive recruiting effort to re-staff any open positions ... Office Depot remains number one in the office products industry in terms of total sales and average sales per store, and we’re fully prepared to continue growing and thriving as a stand-alone company, just as we have for the last 11 years.”

The Microsoft Antitrust Case PowerPoints are available for this case.

The antitrust case is obviously very complex with major implications for the development of several of the most innovative industries. The decision will be made in the institutional arena of the courts. The trial has two components. The first centers on the facts relevant to the government’s allegations. The second commences if the judge renders a guilty verdict and deals with the remedy to be imposed. Then, there is the possibility or likelihood of an appeal. Judge Jackson had been scolded by the Court of Appeals in his decision ordering the separation of Internet Explorer from the Windows operating system. He was not cautioned, however, and continued to speak outside the courtroom. The Court of Appeals criticized him and removed him from the case.

3

For example, Office Depot’s financial statements for the nine-month period ending September 1997 include a charge of $16,094,000 for merger related costs.

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The trial produced testimony that the DOJ argued showed abuse of power and which Microsoft argued established neither monopoly nor conduct that was not customary in the industry. In teaching the case, it would be useful to discuss the ways in which Microsoft’s conduct could be anticompetitive. The discussion in the case about thwarting a competitor with a complementary product and the use of exclusionary practices and tying could serve as the focal point. The discussion could also focus on how Microsoft could target Netscape. For example, Microsoft could license its operating system only to those PC manufacturers that agreed to use Internet Explorer or not to use Netscape Navigator. A less drastic practice would be to offer Windows at a discount to PC manufacturers that agreed to use Internet Explorer rather than Navigator.

In the rebuttal testimony an IBM executive testified that Microsoft had said that IBM would have to pay a higher price for Windows if it continued to promote Lotus’s Smartsuite office software.

(Lotus is a division of IBM.) The IBM executive testified, “I was told that as long as you compete against Microsoft you will suffer in terms of pricing and support.” As an example, the executive said that negotiations with Microsoft regarding licensing Windows 95 dragged on until the day of Microsoft’s rollout of the new operating system. IBM thus did not have time to put Windows 95 on its PCs, when consumers rushed to purchase computers with Windows 95. He stated that this “impacted measurably on our business.”

The economic rationale for an antitrust case against Microsoft is that it has protected its monopoly in operating systems through exclusionary practices, tying, and offering its own versions of complementary products to extend its monopoly and to stifle competition (e.g., Netscape). This conduct has implications for the current marketplace, but more importantly it can have implications for the rate of innovation in the industry. That is, if Microsoft is allowed to use these practices to drive competitors out of business, rivals will be hesitant to innovate for fear that they will be overwhelmed by Microsoft’s conduct directed at their products. The loss in dynamic efficiency and innovation could be much larger than any damage to the current market place. The DOJ did not raise the issue of the impact of Microsoft’s conduct on innovation until the end of the trial, and it was apparently not considered by the courts. The economics of the software industry is considered in Chapter 13.

Microsoft argued that the AOL-Netscape merger rendered the government’s case moot. That is, the merger and the alliance with Sun Microsystems showed that Netscape was not harmed and that Microsoft indeed had a formidable competitor capable of using an Internet access site as a platform for a variety of software applications. In addition to the argument that AOL-Netscape-Sun represented a formidable competitor, Microsoft argued that the merger and alliance showed how dynamic the industry was and how it was impossible to have a true monopoly. William Neukom of Microsoft said, “The $10 billion merger of AOL and Netscape completely undercuts the government’s case. Competition and innovation are stronger than ever in the software industry …

Consumers are seeing extraordinary benefits from Microsoft and the industry as a whole.”4 Microsoft thus argued that it did not have a monopoly and its practices were customary in the industry. There is little to suggest that Judge Jackson gave this argument any weight.

Both Judge Jackson and the Court of Appeals concluded that Microsoft had a monopoly in operating systems.

4

, May 17, 1999.

San Jose Mercury News

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In the trial the government was successful in presenting evidence of abusive practices by Microsoft and in discrediting some of the testimony of Microsoft executives. The government was less successful in showing that consumers had been injured by those practices. This led some commentators to argue that the government’s case was more about protecting Microsoft’s competitors than about protecting consumers.

In a further embarrassment to Microsoft, during the rebuttal testimony Microsoft entered into evidence data supporting the claim that Netscape’s browser was healthy and thriving. The DOJ produced a recent e-mail from one Microsoft executive to others asking, “What data can we find right away, showing that the Netscape browser is still healthy? The Government is introducing a bunch of data showing Netscape headed down big time and Microsoft way up.” Internet Explorer had approximately 85 percent of the browser market in 2001.

Teaching the case:

The following questions can be used to guide the discussion.

1. Microsoft has innovated and developed software products that have provided enormous benefits to consumers and helped launch industries. It has also created approximately 5,000 millionaires among its employees. What is the government’s concern in this case?

2. Is the government trying to protect competitors or consumers?

3. How might the alleged conduct harm consumers? What role do network effects play?

4. What specifically are the alleged violations of the antitrust laws and is there evidence to support those allegations? (The case is necessarily brief and cannot present all the evidence or Microsoft’s critique of that evidence.)

5. What were the impediments to settling this case?

6. Should Microsoft have been found guilty?

7. What are the pros and cons of the remedies discussed in the case? Did Judge Jackson make the right decision regarding remedies?

8. Was the settlement between the DOJ and Microsoft appropriate?

9. Were the 9 states right in rejecting the settlement?

10. After the appeal what remedies should the new court impose?

Discussion: The PowerPoints provide considerable details on the trial in Judge Jackson’s court.

The structural remedy of auctioning the source code for Windows to three or so bidders would allow the marketplace rather than the government to determine the development of the industry.

Also, Microsoft would not be limited in whatever it wanted to do. It could, for example, integrate all of its software and its related services businesses without excluding competitors who would have the source codes. Some commentators, however, argue that this would not have the desired effect because the purchasers would not be able to hire enough programmers and software writers in a short enough time to actually compete with Microsoft. (Recall that competing with Microsoft would require extremely rapid development engineering, since Microsoft has in the works a stream

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of new software applications and upgrades to its operating system.) Whether the government had the authority to order the auctioning of Microsoft’s intellectual property is not clear. Since the time at which the antitrust suit was rumored and then filed, Microsoft has relented on a number of its contract requirements with PC manufacturers giving them more flexibility in their use of software. Microsoft was also believed to have moderated its extensions into handheld machines and Internet access software. This gave rivals a window in which to innovate and compete. In 2002 both Netscape (AOL) and Sun Microsystems filed private antitrust lawsuits against Microsoft. In May 2002 Microsoft announced that it would offer a “service pack” that would allow computer makers and consumers to install non-Microsoft software such as browsers, e-mail services, and streaming software. This would also allow them to conceal Microsoft’s desktop icons. Microsoft was complying with the parts of the district court ruling upheld by the Court of Appeals. Microsoft has now resolved most if not all the antitrust lawsuits against it. It settled with Novell ($536 million), AOL ($750 million), and Sun Microsystems ($1.6 billion). It also settled with the 12 states and the District of Columbia reportedly for $1 billion, including Massachusetts $34 million, North Dakota $9 million, Arizona $104.6 million, and Tennessee $64 million. The status of the European Union’s antitrust case against Microsoft is discussed in Chapter 15.

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Chapter 10 Regulation: Law, Economics, and Politics This chapter introduces the general framework of government regulation including its legal foundations, its economic rationales, and its politics. Chapter 11 is devoted to environmental protection and regulation.

A lecture on regulation could expand the discussion of periods of regulation to provide more detail on the origins of regulation through public franchise and its introduction in the United States.

This might be combined with a discussion of the early court decisions on the constitutionality of regulatory statutes. The New Deal period has a rich regulatory history much of which involved extensions of industry regulation and the beginning of social regulation as in the case of the Food, Drug, and Cosmetics Act. The period beginning in the late 1960s has been characterized by two seemingly contradictory movements. One was deregulation in a number of industries, and the other was the explosion of social regulation focusing on safety, health, and the environment. These two movements are not really contradictory and stem from new thinking and changing political forces. Deregulation resulted from concerns about industry efficiency and reflected an inability of industries to mount sufficient political power to block the deregulation. (It should be emphasized that the firms and labor unions in the regulated industries opposed deregulation primarily because of the threat increased competition posed to their rents.) The courts also played an important role in certain industries such as telecommunications as the regulators had blocked entry and the courts ruled that entry could not be blocked under the statutes. The social regulation movement resulted from new concerns about the environment and the role of government in protecting the health and safety of individuals, from the evolving preferences of the public, and from activists’ strategies.

Administrative law is perhaps less interesting but is also quite important. This could be combined with a discussion of due process requirements and their influence on the way regulations are promulgated, particularly the effect of due process requirements on the speed with which regulatory agencies make decisions. Perhaps the principal explanation for the difference in regulation in the United States and Europe is that European countries do not have due process requirements, and hence many regulatory decisions are made in the administrative agencies (ministries) and largely out of the sight of the public.

Two important regulatory issues are likely to be addressed at the beginning of the century. The first is whether Congress will restrict regulation by passing legislation to limit regulatory taking without compensation. Similarly, the Supreme Court could conclude that the Constitution requires compensation for the loss of value due to regulation. It has taken some moderate steps in this direction. Voters in Oregon approved a ballot initiative that requires compensation for regulatory takings. The second is whether the courts will limit the delegation to agencies without specific policy guides by Congress. The Court of Appeals decision mentioned in the chapter has raised this issue. By 2008 little had happened on this issue other than at the state level, where some states adopted measures similar in spirit to but weaker than that adopted in Oregon.

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Regulatory commissions and agencies have one of the two different structures as described in the text, but both are subject to a set of political and legal influences illustrated in Figure 10-2. It is useful to point out that independent commissions are considerably more independent of the presidency than are the single administrator agencies. The Congress has a substantial influence on all regulatory agencies. Echelon and the Home Automation Standard (A) case and the discussion in the manual illustrate the nature of the environment of a regulatory agency. The explanations for regulation and the forms it takes are of two types. The political economy perspective focuses on the demand for and the opposition to regulation. The politics of regulation are largely distributive and can be analyzed and understood through the framework developed in Part II of the book. The second explanation is found in market imperfections that, in the absence of regulation, can result in economic inefficiency. It should be stressed that although regulation, in principle, can improve economic efficiency, government is itself characterized by imperfections. Coupled with political pressures that can distort policy away from efficiency, regulation can make performance worse than it would have been in the absence of regulation. This is one explanation for the deregulation movement. The literature on market imperfections and the appropriate response to them is extensive and provides material for a lecture that goes into more detail than could be provided in the text. Externalities provide the economic efficiency rationale for market-like regulatory mechanisms for environmental protection as considered in Chapter 11. Deregulation is continuing in a number of industries such as telecommunications, electric power, and natural gas, and current developments can serve as the basis for a lecture. The success of the FCC auctions of the radio spectrum indicates that regulators are turning to decentralized, efficiency-generating mechanisms. The problems in the California energy market could be used to discuss the design of markets. Additional incentive measures of generating efficiency are considered in Chapter 11 in the context of environmental regulation. An issue such as product safety can be addressed either by regulation or through the courts based on the tort system, which is considered in Chapter 12. Product safety regulation is intended to reduce injuries and respond to market imperfections. The Consumer Product Safety Commission has broad authority but limited resources, limited expertise, and a complex regulatory environment.

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Cases The FCC and Broadband Regulation PowerPoints are available for this case This case deals with extremely complex issues that are also very important both for firms and industries and for the nation. The broadband issue is intertwined with the policy for voice communications, since both are affected by the UNEs required. Currently, the UNEs for voice service are more important for the ILECs and CLECs than they are for broadband. In terms of new investment, however, broadband may be more important.

In addition to the FCC decisions the government could take specific measures regarding broadband infrastructure. One possibility was for government to subsidize the construction of broadband networks. Subsidization when private investment can be made seems unlikely. Another possibility was to rely on the private sector, but both the telecoms and the cable companies had moved more slowly than high tech companies preferred. Moreover, the slump in the economy and the meltdown of the telecoms made it more difficult for the CLECs in particular and the ILECs as well to raise capital. Private investment was discouraged by requiring UNEs, but UNEs were a fact of life and could not be eliminated. The FCC decision will be the principal government policy on broadband.

The Republican majority on the FCC is clearly in control, but the preferences of the three commissioners are not identical. In addition to their own preferences, the commissioners must keep in mind the possibility of remand by the courts, since the opponents will surely file a lawsuit.

The following section provides an analytical characterization of the preferences of the commissioners and a prediction of the outcome.

Analytics A variety of theories could be used to predict the FCC’s decision. One is simply that the chairman gets his way, since the chairman has the most power at the FCC. Another is that the majority gets its way. A third is that the pivotal voter will determine the outcome. The median voter theorem is the natural predictive tool, but the FCC’s decision is multidimensional, so an extension is required.

A fourth is that the strongest interests will prevail. The fifth is that the FCC will make the decision that Congress prefers.

The FCC is a regulatory agency that is only partly politically responsive, as identified in Figure 7-4.

In this framework, the FCC resembles to some extent a court. The FCC is also a voting institution.

Interests are important in this case, but their only strategy for the FCC is informational. The FCC is well informed on this issue, so the interests will have only a limited effect on the outcome.

The best theory for predicting the FCC decision is an extension of the median voter theorem. The PowerPoints provide a spatial model for predicting the outcome of the FCC deliberations. The FCC’s decision has two principal dimensions. One is the number of UNEs to require the ILECs to provide. The other is the extent of continuing regulation over UNEs and their prices. The first

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dimension can be arrayed as Few UNEs to Many UNEs, and the second from Deregulation to State PUC regulatory role. The figure locates each of the five commissioners, and the preferences of the interests are indicated on the following slide. Using the framework of the median voter theorem Martin is the “median in both dimensions.” Intuition suggests that the outcome will be that which Martin prefers. Indeed, that was more-or-less the outcome. The logic of the median in both dimensions perspective is that no change from the policy Martin prefers is supported by a majority of the commissioners.

Teaching the case The following questions can be used to guide the discussion.

1. How did DSL get into this regulatory quagmire?

2. How good a job has the FCC done so far in meeting the mandate of the Telecommunications Act? What have the courts said about the FCC’s rulemaking?

3. How important is nonmarket strategy to the interests involved? (Use Figures 2-2 and 2-3.)

4. How does DSL work and what are the UNEs? 5. How do the CLECs operate?

6. What would eliminating line sharing do?

7. What are the incentives to invest in broadband capacity? ILECs? CLECs? What is meant by false competition?

8. If the rules were changed substantially would the ILECs or CLECs invest more?

9. What are the issues in the Triennial Review? For example, TELRIC prices, discounts, the role of the state PUCs, new rules for new investment, discrimination, cable broadband, etc. (Use the spatial diagram to simplify the issue dimensions.)

10. What interests are involved? What does each want in the FCC decision?

11. Which institutions are involved? Is Congress likely to act?

12. How does the FCC make its decisions?

13. Looking inside the FCC, what are the preferences of the commissioners? Who is aligned with whom?

14. What should be Cisco’s strategy? (See the PowerPoints.)

15. Can we predict the decision the FCC will make?

16. What will the losers likely do?

The FCC Decision In a 3-2 decision the FCC made a complicated decision summarized here and in the PowerPoints.

UNE-P –switching is no longer a UNE for business DS-1 service –no unbundling of packet switching –copper loops remain unbundled –line sharing was eliminated as a UNE with a 3 year transition period.

–continued UNEs: shared transport, switches connecting COs, network interface devices, certain fiber loops, signaling (old rules) –specific criteria issued for determining impairment by state PUCs –a state PUCs can issue an order to transition off UNE-P with a transition period of 3 years

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Retaining switching as a UNE may allow CLECs to resell the entire ILEC network; i.e., they can essentially form UNE-Ps. TELRIC includes a risk-adjusted cost of capital.

Broadband received “unbundling relief” –no unbundling of fiber-to-the-home or fiber-to-the-curb loops –line sharing is no longer a UNE (reportedly 4 commissioners opposed this but it was bundled) –no unbundling for upgraded loops The ruling largely reflected Martin’s preferences. The PowerPoints also describe why Chairman Powell did not get his way.

The following summarizes the winners and losers among the interests: No one won because overall regulatory risk increased. State PUCs were given a major regulatory role in UNE impairment decisions. No uniform national policy was adopted. Much of that risk may be systematic and hard to diversify away.

Covad provides only broadband and uses line sharing—gone. It also lost because some new broadband facilities are not UNEs. ILECs lost because they must continue to provide UNEs on old equipment and on new voice equipment. Also, PUCs will keep UNE discounts. ILECs gained because TELRIC rates will take risk into account in capital costs. Also, some new broadband capacity is not a UNE and line sharing is gone.

Long-distance CLECs were flat because they will benefit from continued UNEs and PUC discounts, but TELRIC rates will be higher.

Local CLECs lost due to regulatory risk and the loss of line sharing. They gained on continued UNEs and price discounts.

Equipment makers lost due to regulatory risk and weak incentives In August 2003 the FCC issued its final order. The 576-page order provided rules and procedures for implementing the earlier decision. The interests generally reacted as anticipated. The final order contained some provisions not indicated in the initial FCC press releases. Importantly, the final order grandfathered Covad Communications. The ILECs are required to provide UNEs at discounted prices to Covad for its existing customers.

Commissioner Copps predictably praised the part of the order that gave control over discounts to the state commissions and criticized the broadband rules. He stated, “The bad news is that this decision plays fast and loose with the country’s broadband future. Make no mistake about it,

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today’s decision chokes off competition in broadband. Consumers, innovation, entrepreneurs and the Internet itself are going to suffer.”5 Chairman Powell stated, “There are some important achievements in this Order that have long been objectives of mine—namely, substantial broadband relief. Yet, regrettably, there are some fateful decisions as well that I believe represent poor policy and which flout the law. While I am pleased that the Majority had made a number of changes to their UNE-P decision that respond to my concerns, significant legal failings remain. Accordingly, I must respectfully dissent.”6 Commissioner Abernathy expressed similar views.

Within a week of the FCC final order SBC, BellSouth, Qwest, and the United States Telecom Association filed a lawsuit appealing the order. Verizon indicated that it also planned to file an appeal. AT&T vice-president Lawrence Lafaro commented that the arguments of the appellants’ petition “repeats the arguments that were made and properly rejected by the F.C.C.”7 Court Action In a 3-1 vote the FCC had ruled that cable modem (broadband) service was an information service rather than a telecommunications service. Because of this ruling cable was not required to share its lines with others, as was required of telecommunications DSL broadband.

Several lawsuits were filed contesting this FCC decision. The FCC decision was appealed by the Media Access Project, an activist public interest law firm, seeking “nondiscriminatory open access” to cable broadband. The decision was also appealed by Verizon seeking equal treatment with cable modems. Both the FCC and the National Cable & Telecommunications Association appealed to the Ninth Circuit Court of Appeals a lower court had ruled that cable broadband was in part a telecommunications service. The Ninth Circuit Court of Appeals vacated the FCC's ruling under AT&T v. City of Portland, 216 F.3d 871 (9th Cir. 2000), which held that cable modem service contained both telecommunication and information service elements.

A small company in California had filed a lawsuit challenging the FCC ruling that cable modem service was an information service rather than a telecommunications service. “The 9th Circuit in Brand X Internet Services v. F.C.C., 345 F.3d 1120 (9th Cir., 2003) affirmed the FCC's finding that cable modem service is not a cable service, but reversed the FCC with respect to its finding that cable modem service is not a telecommunications service. In the 9th Circuit's view, cable modem service is a telecommunications service. The Supreme Court granted a petition for certiorari filed by the cable industry and by the FCC and the United States to address whether cable modem service is a telecommunications service or an information service. F.C.C. v. Brand X Internet

5

“FCC Commissioner Michael J. Copps reacts to Release of Long-Awaited Triennial Review Decision,” FCC News, Washington, DC, August 21, 2003.

6 “Separate Statement of Chairman Michael K. Powell Approving in Part and Dissenting in Part,” Federal Communications Commission, August 21, 2003.

7 The New York Times, August 29, 2003.

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Services, 2004 WL 2153536 (December 3, 2004).”8 The Supreme Court decision was due in 2005.9 In April 2004 a panel of the 9th Circuit Court of Appeals refused to overturn a decision by a federal judge that ruled that Internet broadband service was a telecommunications service and hence was required to provide access to other broadband suppliers. The original lawsuit was filed by the Media Access Project.

Additional information In June 2003 Verizon, SBC, and BellSouth agreed to work together to establish technical standards to govern the installation of fiber optic cable to the curbside. Fiber to the curb would allow DSL speeds to be substantially increased. The companies were expected to make major financial commitments to rolling out fiber.

Broadband was viewed as crucial not only for the telecommunications and cable industries but also for equipment suppliers and content providers. Economists Robert Crandall and Charles Jackson estimated that universal access to broadband would provide benefits of as much as $500 billion.10 Broadband to the home was the key to new service offerings on the Internet, which would spur demand for servers and other equipment down the chain to personal computers and high-speed microprocessors. Content providers were hesitant to develop new Internet content, however, because of the slowing growth in broadband subscriptions, and broadband providers were hesitant to expand because the next generation of content services was not yet available. This broadband dilemma would eventually be resolved by market forces, since broadband subscriptions continued to grow, but the high tech industry called on the FCC and Congress to kick-start the broadband market.

The FCC had defined broadband as 200 kbs, but most industry members viewed broadband as requiring substantially higher speeds. Craig Barrett, president and CEO of Intel, argued, “Three hundred or 400 kilobits is not real broadband. When you get to five or 10 meg, that’s real broadband, going to 100. The capabilities you can provide the user…[get] to be phenomenal.”

Charles Hoffman, CEO of Covad Communications, however, said, “The FCC’s definition of broadband, anything over 200K bit/sec is very realistic. 100M bit/sec to the home will never happen.”11 Rick Roscitt, CEO of ADC Telecommunications, said, “100M bit/sec is really true broadband and maybe in 20 years that will seem slow. But the real issue is we have only scratched the surface of what broadband really is.”12 Some signs of the next generation of applications were present. The number of broadband subscribers was beginning to reach the point at which it made sense to provide content such as Disney’s Toontown. Also, with the continuing growth of broadband some business models based

8

Miller & Van Eaton, 2005. www.millervaneaton.com.

National Cable & Telecommunications Association v. Brand X Internet Services; Federal Communications Commission v. Brand X Internet Services, Nos. 04-277 and 04-281, oral arguments held (U.S. Mar. 29, 2005).

10 Robert W. Crandall and Charles L. Jackson, “The $500 Billion Opportunity: The Potential Economic Benefit of Widespread Diffusion of Broadband Internet Access,” Criterion Economics, Inc. 11 Network World, November 18, 2002.

12 Network World, November 18, 2002.

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on broadband were now becoming feasible. For example, John Doerr of Kleiner Perkins Caufield & Byers commented, “There’s no question that broadband enables paid-for-content business models.”13 Verizon supported legislation to deny competitors access to new broadband facilities it installed and to eliminate the requirement to provide access to last mile connections in areas where cable companies provided service.

To present its position, SBC conducted an advertising campaign telling TV viewers that unlike other providers of telecommunications services it was a full-service company that owned and maintained the facilities that others used.

SBC senior vice president-federal relations Timothy McKone explained the company’s objectives for 2003, “Our legislative priority will be to help Congress and the Administration find an avenue to bring this sector of the economy back to where it was. The leading sector of the economy that’s losing is telecommunications. The regulatory structure today under which we operate is flawed and is hindering our ability to make investments and create jobs.”14 In April 2002, 54 CLEC CEOs wrote to President George W. Bush urging him not to allow the FCC to adopt “one-sided policies to squelch competition among local broadband providers and recreate a monopoly for broadband services.”15 In particular, ATLS and CompTel sought to retain as UNEs line sharing, switching, and interoffice transport (transmission between ILEC central offices).

Len Cali, chief lobbyist for AT&T, said, “Broadband isn’t what they’re after. They’re after deregulating everything, most significantly their voice services.”16 CompTel countered SBC’s advertising campaign with a media campaign using a cartoon format in a fictitious magazine Monopoly Weekly patterned after Thomas Nast’s cartoons. The cartoons referred to the ILECs as colluding monopolists with the FCC undermining the state PUCs. One cartoon pointed to the 9 million consumers being served by the CLECs and the ILECs’ alleged attempts to thwart competition. The cartoons are included in the PowerPoints.

The consumer groups not only criticized the FCC but also directed their anger at Chairman Powell.

Mark Cooper, research director of the CFA, said, “He favors the big corporations at the expense of small competitors and consumers on every one of these issues.” Gene Kimmelman, senior director of public policy and advocacy for Consumers Union, said, “His ideological perspective is that government intervention does more harm than good. He’s so blinded by that sentiment that he refuses to see the day-to-day harms consumers face in unregulated markets.”17

13

The Wall Street Journal, January 8, 2003.

Washington Internet Daily, December 27, 2002.

15 Letter to President George W. Bush, April 24, 2002.

16 San Diego Union-Tribune, November 25, 2002.

17 San Jose Mercury News, February 10, 2003.

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A particular concern to the cable companies was that the FCC might order open access to their systems for multiple ISPs. The cable companies preferred negotiated arrangements with a single ISP, as in the case of Comcast and AOL. The National Cable Television Association (NCTA) made it clear that it would challenge in court any FCC order requiring open access.

The Coalition of Broadband Users and Innovators, whose members included Disney, Amazon.com, Yahoo!, and the Consumer Electronics Association, asked the FCC to prevent discrimination by the cable companies. Some companies sought regulation of the cable industry to prevent discrimination.

In January 2002 several of the high-tech CEOs participating in the Computer Systems Policy Project called on Vice President Dick Cheney, Homeland Security Director Tom Ridge, and House Speaker Dennis Hastert. Michael Dell said, “It’s an issue we think is important to all Americans.

Broadband is becoming integral to the way all Americans live and function.” Craig Barrett added that the group was not talking about 200 kbs service. “We’re talking real, full-blown broadband.”

Chris Galvin of Motorola said, “We were attempting to declare a broad national policy.”18 In July 2002 the CFA in conjunction with the Texas Office of Public Utility Counsel, the ISP Associations, the Texas ISP Association, the California ISP Association and EarthLink issued a report charging that the FCC’s intention to deregulate the Internet access market “will allow dominant cable and telephone companies to deny access to advanced telecommunications networks and will do considerable harm to the interests of consumers.” “If the FCC goes through with its plans and deregulates the high-speed Internet access market, cable companies and the Bells will quickly establish a monopoly on broadband service over their own networks,” said David Baker, Vice President, EarthLink. “Consumers accustomed to hundreds of competing ISPs to choose from for dial-up service will be left with just a handful of options for broadband service.”19 The CFA, CDD, and the Media Access Project implemented a new aspect of their strategy and wrote to the High Tech Broadband Coalition suggesting that Internet companies shared “the goal of ensuring that network owners do not discriminate against unaffiliated content and applications providers.” Matthew J. Taniellan, vice president of the Information Technology Industry Council (ITIC), replied, “We’re interested in talking… What that will lead to at this point, I am not sure. I believe that the high-tech industry and consumers have a lot in common on broadband issues.”20 “Paul Misener, vice president of global public policy for Amazon.com, who also worked at the FCC, said it is “an operating assumption” in his industry that there will be fewer Internet access providers in the future. Misener said the direction the FCC is headed creates the likelihood that while consumers will have a choice between high-speed Internet technologies—via cable or souped-up telephone service known as DSL—there will be only one or two Internet providers within each technology.”21

18

InfoWorld, January 24, 2002.

Consumer Federation of America, Press Release, July 1, 2002.

20 Multichannel News, September 9, 2002.

21 The Washington Post, January 3, 2003.

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The telecommunications industry had crashed in 2001, leaving bankruptcies and skeptical investors. Telecommunications companies continued to experience declining revenues and profits as a result of price pressures and the weak economy. The number of telephone lines in service in the United States had decreased in each of the past two years. AT&T’s revenue decreased 8.6% in the fourth quarter 2002, and BellSouth’s revenue dropped by 8.4%.22 TechNet TechNet was a political facilitation organization, whose membership was 200 CEOs and senior executives from leading high tech companies. TechNet facilitated the development of relationships between its members and members of Congress. TechNet also facilitated campaign contributions from its members to candidates. Tech Net members formed the CEO Broadband Task Force to advance broadband policy. Eric Benhamou, Chairman of 3Com, stated, “The importance of an explicit broadband policy for our nation cannot be overstated. TechNet’s recommendations are based upon a thorough analysis of the current deployment environment, and emphasize a careful balance of enhanced competitive and innovation, as well as lighter and effective regulation.” Craig Barrett argued, “It’s critically important for the United States to adopt a national broadband policy that encourages investment in new broadband infrastructure, application and services—particularly new last mile broadband facilities.

Regulatory policies should encourage all companies to deploy these expensive and risky facilities.” TechNet urged investments of hundreds of billion dollars in infrastructure including increased broadband capacity in the last mile, using fiber optics, to the home and business.

Fiber optic cable itself was not costly, but installation and access to rights of way could be very costly, particularly if local governments attempted to hold up the installing company. TechNet also called for legislation to require access to “public rights of way without discrimination, excessive regulation and exorbitant fees.”23 Legislation Eighteen broadband bills had been introduced in Congress in 2001-2002, but only one progressed out of committee. The TauzinDingell bill passed the House in 2002, but opposition from Senator Hollings (D-SC), Commerce Committee chair, caused the bill to die. The bill had been backed by the ILECs. SBC, for example, argued the bill would level the playing field with cable. The bill would not affect existing interconnection agreements, and competitors would be able to resell data services at discount prices for 3 years. After the phase-out period the bill would eliminate access to UNE at discount prices by requiring that rates be “just and reasonable.” Competitors would have access to ILEC rights of way, and line-sharing on copper would be preserved for competitors. The bill also allowed local telephone companies to carry data traffic across LATA and state boundaries.

CompTel complained, “Tauzin-Dingell would allow the Bells to leverage their current monopoly

22

BellSouth’s results were hurt by a net loss of customers at Cingular Wireless, which was 60% owned by SBC and 40% by BellSouth.

23 TechNet, “TechNet Broadband Principles: A National Imperative: Universal Availability of Broadband by 2010.” www.technet.org.

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over local phone service to create an Internet monopoly.” It predicted that 77,000 telecommunications jobs would be lost if the bill passed.24 The Breaux-Nickles bill introduced in the Senate would provide for equal or no regulation of broadband services, prohibit increased regulation by the FCC, require ILECs but not cable operators to provide ISPs with the telecommunications they need to provide their services, and assign to the FCC, and not state regulators, jurisdiction over broadband. The bill was backed by the HTBC, TIA, EIA, and the telecommunications unions.

Senator Jay Rockefeller (D-WV) and Representative Phil English (R-PA) had introduced bills to subsidize broadband through tax credits, but the bill had not been reported by the cognizant committee even though the two bills had 65 and 215 cosponsors, respectively. The substantial broadband penetration of DSL in South Korea was explained by subsidies, where the monthly charge was approximately $25.

Senator John McCain’s “Consumer Broadband Deregulation Act” provided for deregulation of residential broadband services but would retain FCC and state regulatory control over business broadband services. The bill also provided that nothing in the act would overturn any provisions in federal cable legislation. A cable-industry lawyer commented, “From a cable standpoint, that is one of the things that commends the bill.”25 The bill would also prevent local communities that control the public right-of-way from using that control to squeeze revenue from cable companies.

Because of the new Republican majority in the Senate, McCain became chair of the Senate Commerce Committee, replacing Hollings, who had been an outspoken critic of telecommunications deregulation. McCain’s web site stated that the ILECs “have tried every trick in the book to stop competition … and extend their local monopoly into broadband.”26 In the wake of the November congressional elections, William M. Daley, president of SBC Communications and former secretary of commerce, commented, “Senator Hollings has historically been very clear about his opinion of the Bells. McCain may be a little more open to some of the positions that we as an industry articulate.”27 The Senate Commerce Committee invited the FCC commissioners to a hearing on the state of competition in telecommunications.

24

CompTel, “Please Oppose H.R. 1452 (“Tauzin-Dingell”) The Bell “Internet Monopolization” Bill,” ND. Multichannel News, August 12, 2002.

26 Investor’s Business Daily, November 7, 2002.

27 The New York Times, November 11, 2002.

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Enron Power Marketing and the California Market The establishment of a market for electricity has been a major accomplishment, but the design of the market is a challenge because electricity is a nonstorable good. This means that electricity must have a time of supply (i.e., when electricity will be delivered into the grid) and a time of demand (i.e., when a user of electricity will take delivery). The ISO played the role of coordinating demand and supply and sending electricity through the power grid. The ISO was charged with meeting all demand, so it needed to maintain readily available reserve generating capacity or other supply to meet unexpected demand; e.g., because of hot weather. Market efficiency was enhanced by being able to move electricity from areas of excess supply to areas of excess demand.

The market for electricity and the California experience are discussed in the chapter. The design flaws are identified there. One major problem was that consumer demand was unaffected when shortages developed, since prices were fixed.

Several structural problems also complicated the market in California. First, no new generating capacity had been built in the state for a decade. This was due to opposition by environmentalists and NIMBY groups and because low-cost electricity could be imported from other states. Second, economic growth had increased the demand for electricity. Third, a bottleneck in the distribution grid made it difficult to move electricity between the north and south of the state. These factors as well as flaws in the design of the market provided opportunity for traders to manipulate the market.

Enron had a large share of the California electricity trading, but its share was probably less than half. Its share was large enough, however, to manipulate the market. Its “inc-ing” strategy was clear manipulation. Its Get Shorty strategy required providing false information to the ISO. Death Star and load shift also manipulated the market. Playing on the price cap took advantage of the California market rules about electricity produced in the state and electricity imported from other states. This strategy may or may not have been illegal, but it is clear that Enron was gaming the market. That the law firms told EPM to stop using these strategies also indicates that they were at least violating the rules established for the California market.

The market rules required that the telephone calls of all traders be recorded, so there is a record of the use of these strategies. Some of these recordings were used in the documentary movie Enron: The Smartest Guys in the Room released in 2005.

From the perspective of utilitarianism a market is intended to serve the goal of economic efficiency, which in turn increases aggregate well-being. The manipulation of the market made it operate less efficiently, so the manipulation was a moral wrong even if it were legal.

The manipulation also had distributive consequences. It resulted in a transfer of wealth from California customers to the traders. The customers that paid the high prices were generally businesses, since the price to residential consumers was fixed. This could be a wash in the utilitarian calculus as discussed in the text. The other losers were the shareholders of the electric utilities in California, which went bankrupt. These bankruptcies, however, were due to the regulated prices and the shortage which drove up wholesale prices. Those bankruptcies were likely little affected by the market manipulation. The other major distributive effect was on California

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taxpayers and customers who were required to pay for the electricity contracted for by the California governor. The trading manipulation probably had little effect on this contracting.

Teaching the case The following questions can be used to lead the discussion.

1. What was wrong with the design of the California market?

2. Should a company take advantage of flaws in the design of a market?

3. Should a company manipulate a market if it has the ability to do so?

4. Is this type of market manipulation commonplace in trading markets; e.g., on Wall Street as illustrated in the quotation from the CEO of Kiodex at the end of the case?

5. What was wrong with the inc-ing and Get Shorty strategies?

6. What was wrong with ricochet trades?

7. How should Enron Power Marketing have conducted its trading business?

8. Should the power trading companies be responsible for the contract signed by the California governor?

Developments Enron, as everyone knows, went bankrupt as indicated in the Chapter 19 case The Collapse of Enron: Responsibility and Governance. EPM was sold as indicated in this case.

Criminal charges apparently have not been brought against EPM or its traders.

On June 17, 2004 FERC Chairman Pat Wood, III said, “As our 2002-2003 staff investigation showed, the corporate culture at Enron ‘fostered a disregard for the American energy customer.’

These taped conversations indicate that this corrosive attitude seeped down from the corporate offices to the employees at the front line.”

California politicians sought to cancel the supply contracts signed by Governor Gray Davis. In June 2003 FERC rejected California’s request to invalidate those $12 billion contracts. FERC concluded that the prices were high but not invalidate by the trading strategies. FERC stated, “The contracts were entered into voluntarily in a market-based environment, the Commission pointed out. The Commission found no evidence of unfairness, bad faith, or duress in the original contract negotiations. It said there was no credible evidence that the contracts placed the complainants in financial distress or that ratepayers will bear an excessive burden.”28 In a separate proceeding California sought reimbursement of $9 billion on overcharges on electricity already purchased and consumed. FERC concluded that California should receive a $1.8 billion refund from power suppliers. Many other FERC actions have been taken against individual companies. Details are available at www.ferc.gov.

California officials also filed lawsuits in state courts to reclaim funds from suppliers. For example, the attorney general filed a lawsuit in May, 2005 seeking $1 billion from PowerEx and PNM. The

28

FERC News Release, June 25, 2003.

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lawsuit alleged that the companies engaged in ricochet trading by buying electricity in California, sending it out of state, and selling it back to the ISO at a high price.

The bottleneck between the north and south was finally relieved in December 2004, when a third transmission line was added to Path 15 in Fresno and Merced counties. The ceremonial switch was thrown by Governor Arnold Schwarzenegger, who was elected after voters recalled Governor Gray Davis. Davis had signed to electricity supply contracts with high prices.

The California electricity market has been redesigned and is back in operation.

The FCC Media Ownership Rules This case deals with one of the most politically-charged actions by the FCC. A large number of activists and NGOs opposed any change in the media ownership rule. The FCC, however, viewed itself as under a court mandate to justify its rules and retain only those that served the public interest. The conservative majority on the FCC viewed this as an opportunity to reexamine the ownership rules in light of the rise of the Internet as a source of information as well as the growth of cable channels. The majority clearly preferred less regulation. The action in this case focuses almost entirely on the National Television Ownership Rule, which was the most controversial.

The purpose of the case is to examine the workings of a regulatory commission and the pressures on it as identified in Figure 10-2. The Telecommunications Act of 1996 required an FCC review of the media ownership rules, and court decisions had remanded media ownership decisions to the FCC. The court had stated that the burden of proof was on the FCC to retain a rule, but the history of the media ownership rules was that they were seldom changed. Interest groups were active on both sides of the issues, and both Congress and the Bush administration were poised to act.

Moreover, technological change had increased the outlets for programming. The Internet and cable and satellite systems had expanded the number of outlets greatly and had the potential for further increasing that number.

The FCC was faced with a complex problem and a complex environment. The FCC also had no formal criteria for “reasonably determin[ing] that the rule is ‘necessary and in the public interest.’”

Its decisions thus fall in the realm of judgment. For example, is a National Television Ownership Rule with a 35 percent cap more in the public interest than a 25 percent cap or a 45 percent cap?

Indeed, a fundamental question is whether such determinations should be made by a regulatory commission or by Congress. That is, this is a political issue.

Analysis of interests This is straightforward. Supporting relaxation in the National Television Ownership Rule were the networks, and opposing it were local affiliates, independent programmers, activists, and organized interest groups. The later two groups reflected fairly broad concerns. Supporting relaxation of the Local Television Multiple Ownership Rule were the networks, other media companies, and local

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affiliates, and opposing it were activist groups like the Media Action Project. Note that the networks and their affiliates have aligned interests on the second rule and opposing interests on the first rule. The rules are independent of each other, so there is no dilemma created for these alignments of interests.

Institutional officeholders—the commissioners The case illustrates well the differences in viewpoints of the Democrats and Republicans on the issues. The Republicans prefer deregulation, which means relaxing the ownership rules.

Moreover, they have an opportunity to do so because of a legislative mandate and a remand from the court that the burden of proof is on the Commission to retain the rules. The Democrats fear larger media companies for a variety of reasons ranging from concerns about big corporations controlling what gets broadcast to the potential threat to the diversity of viewpoints. Recent developments with the emergence of groups like MoveOn.org and the growth and influence of the blogs suggests that viewpoints easily find expression. The Democrats’ concerns are that not everyone accesses such outlets, and the bulk of the people rely on broadcast television for their news.

The preferences of the three Republican commissioners appear to be quite similar, although Powell and Martin disagree on the diversity index. The preferences of the two Democrat commissioners also appear to be quite similar. The outcome within the FCC thus would be expected to be close to that preferred by the majority, recognizing that the opponents of relaxing the rules have the opportunity to take their case to other institutional arenas.

Analytics Each rule can be considered independently, and each can be more or less represented on a line; e.g., the percent of TV viewers reached. The preferences of the commissioners are likely to be singlepeaked, so the median voter theorem can be used to predict the outcome. In this case the Republicans seem to have pretty much the same preferences (in contrast to the broadband case), and they largely ignored the preferences of the two Democrats.

The Republicans did bargain over various sub-issues in their drafting of new rules. According to a May 11, 2003 New York Times article, “To win Mr. Martin’s support, for instance, Mr. Powell agreed to allow a company to own both a broadcaster and a newspaper in more concentrated and smaller markets than Mr. Powell had proposed. Mr. Powell also agreed to make less use of a socalled diversity index, a tool his staff had developed to measure whether a city has a diverseenough range of media outlets to permit further ownership concentration. … For his part, Mr. Martin has tentatively agreed to a modest increase in the maximum size of the national audience they reach. While Mr. Powell had considered a virtual elimination of the limit, the compromise is to raise it to about 45 percent, from the current 35 percent.” Both Viacom and News Corp. already had 39 percent due to their challenges in court of the FCC’s 35 percent cap.

Since the FCC makes decisions by majority rule, it is natural to apply the same frameworks to its decision-making as used in the study of congressional legislation. There are some important differences between a regulatory commission and Congress, however,

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Application of frameworks such as the median voter theorem to the FCC is both easier and harder than applying it to Congress. It is easier obviously because there are only 5 voters, which should make it easier to identify the pivotal voters. It is harder because it can be more difficult to identify the preferences of the commissioners. The preferences of members of Congress are fairly easy to identify from their past voting records and from the characteristics of their constituents. For example, more than a dozen groups provide voting scores for each member of Congress that is useful in identifying preferences. In addition, scholars have used statistical methods to estimate the preferences of members, including making the estimates consistent over time. Scholars have also estimated the characteristics of the constituents of members of Congress.

The preferences of the commissioners are harder to identify because they have no constituents, do not vote as often as do members of Congress, and serve for relatively brief periods. The preferences of commissioners can be identified from the speeches they make as well as from their opinions that accompany FCC decisions. Commissioners probably have little incentive to misrepresent their preferences, since they face no elections and have short horizons on the Commission.

With a small number of voters it might be possible for commissioners to trade votes on issues credibly by developing reputations for fulfilling promises. In the case of the FCC, however, commissioners do not serve for long periods, so it may be difficult to solidify reputations. It seems more likely that the commissioners vote individually without trading votes.

Changing institutional arenas This case also illustrates that issues can move from one arena to another. If the media ownership rules are relaxed, the opponents will surely take their concerns to Congress, where there is considerable opposition to greater media power. The proponents of relaxation will turn to the Bush administration. Moreover, at least one of the two sets of interest groups will likely take the issues to the courts.

Nonmarket strategy The nonmarket strategy of a major network follows from the principles developed in Part II of the book and the characteristics of regulatory institutions as developed in this chapter. The basic strategy of the networks is informational. The network must first provide encouragement for the Republican majority on the FCC, so that they will go ahead with relaxation of the rules from which the network will benefit. The networks implemented this part of their strategy though lobbying in ex parte meetings with the commissioners and the FCC staff.

The networks know that Congress will be concerned by a relaxation of the ownership rules and that the Bush administration will support Chairman Powell. Behind-the-scenes lobbying is the instrument.

The message to convey in lobbying is that the number of news and entertainment sources has expanded dramatically and the number of outlets for citizens has also expanded substantially. Old

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restrictions and rules thus may no longer be justified. It would also be useful to stress the arbitrariness of the 35 percent rule. The FCC decision will also be arbitrary, but the commission will have gone through a formal process in reaching its decision.

Discussion questions 1. Why is the FCC reexamining the media ownership rules?

2. What are the likely effects of relaxing the two rules?

3. What are the preferences of the Republican and Democrat commissioners?

4. What nonmarket strategy should a major network adopt? How should it be implemented?

5. What nonmarket strategy should an affiliate member of the National Association of Broadcasts adopt? How should it be implemented?

6. What is the FCC likely to do?

7. Will Congress act?

8. What will be the ultimate outcome?

The FCC rule-making The FCC voted 3-2 along party lines to adopt Powell’s draft with some minor concessions to Martin on the diversity index. The FCC also dropped a rule that prohibited cable companies from owning local television stations. Congressional Action The Senate quickly took up the media ownership rule, which many senators sought to return to the previous 35 percent limit. The National Association of Broadcasters (NAB), which represented local television stations, strongly supported the Hollings-Stevens bill. The bill, however, was quickly expanded to serve the interests of others potentially hurt by the FCC action. The bill was amended to restore the previous restriction on a single company owning both a television station and a newspaper in the same local market. The Senate Commerce Committee passed the bill with strong bipartisan support. Concerned about the amendment, the NAB reconsidered its support for the reported bill. It preferred the FCC action to the amended bill and sheepishly informed members of Congress that it opposed the bill. Observers believed that this change effectively killed the bill as written. The House also took up the media ownership rules, and in the face of heavy lobbying by the networks overwhelmingly approved Representative Obey’s provision reversing the changes in the National Broadcast Ownership Rule. Congressional Democrats had considered using a “Resolution of Disapproval” to overturn the expected FCC decision. This procedure was established by the Congressional Review Act of 1996, which allowed a simple majority in each house to veto a decision by a government agency. The procedure had been used only once, when in 2001 Congress overturned an ergonomics rule promulgated by the Department of Labor. In July 2003 the House voted 400-21 to reinstate the local television ownership rule to 35 percent. The 400 to 21 vote reflected the broad interest group—and perhaps public—opposition to the increase. Intense lobbying by the major networks could not overcome the opposition. The vote was largely motivated by the fear that media companies were becoming too large. The provision

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did not address the other changes by the FCC in the media ownership rules. An amendment was also introduced to overturn the rule prohibiting a company from owning a newspaper and a TV station in the same market and the rule to restrict the number of TV stations a company could own in a local market. This amendment was defeated on a 254-174 vote. Some members opposed it on substantive grounds and others opposed it because they thought the amendment would make the measure not veto-proof. The outcome was consistent with the preferences of the NAB. The White House had pledged to veto any legislation to reverse the FCC action, but in the face of such strong opposition to the change in the media ownership rule and the bundling of the provision in an appropriations bill, it would be costly for the president to veto it. Rumors began to circulate that Michael Powell would leave the FCC and be replaced by Kevin Martin. In 2005 Powell resigned and Martin was appointed chairman of the FCC. The defeat in the House of the amendment to overturn the new rules on ownership of a newspaper and a television station was perhaps not surprising. Every House member wants an endorsement from the local newspapers in their district, and the new rule would benefit most newspapers. The exceptions were those that feared a hostile takeover by a company owning a local television station and those that might suffer a competitive disadvantage if a rival newspaper were to be strengthened through a merger with a local television station. In contrast, the networks do not endorse candidates.

The Bush administration continued to threaten to veto any bill that would rollback the FCC decision. The congressional bargaining over the media ownership rules continued throughout 2003, and the resolution was incorporated in a 2004 budget bill that provided $328 billion covering most federal agencies. The compromise set the national audience coverage level at 39 percent for local television station ownership. This conveniently allowed Fox and CBS to retain the stations they currently owned. The other media ownership changes were not blocked. The legislation also required the FCC to reexamine the UHF discount.

Stanford economics professor Roger Noll noted that the markets for news from newspapers and news from television were largely separate and any benefits from the merger of a newspaper and a local television station would come in the gathering of news.29 The Networks’ Counterattack In September 2003 the networks began their counterattack grounded in a survey. “Frank Luntz, the pollster who was commissioned to prepare data, will be publicizing a survey suggesting that, for example, 87% of those polled think they have an adequate number of choices for receiving news.

The survey also shows that only 11% believe network ownership of their local station is a bad thing and 68% think the market should decide whether that should happen or not. One argument the networks are pushing: Loosened regulations would help preserve free TV for the 15% to 20% of households who rely on it by bolstering the networks’ financial health.”30 The networks planned a campaign under the banner “America Says: Don’t Get Between Me and My TV.”

29 30

Roger G. Noll, “The FCC’s New Television Ownership Rules,” SIEPR Policy Brief, June 2003.

The Wall Street Journal, September 3, 2003.

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The locally-owner stations opposed the networks’ efforts. The networks reportedly quit the NAB as a result of its position.

The FCC and Localism In August 2003 Chairman Powell announced the appointment of a task force to study localism in broadcasting. In announcing the study Powell noted, “During the proceeding and in the months that followed, however, we heard the voice of public concern about the media loud and clear.

Localism is the core of these concerns, and we are going to tackle it head on.”31 Earlier Powell had stated that he does not “necessarily think you have to have an owner live down the street to be responsive to localism.”32 Powell’s announcement was broadly criticized. Commissioner Michael Copps stated, “This proposal is a day late and a dollar short. It highlights the recent decision and boggles the mind. …

We should have vetted these issues before we voted. Instead, we voted; now we are going to vet.

This is a policy of ‘ready, fire, aim!”33 Mark Cooper of the Consumers Union said, “Talking about new rules to protect media localism, particularly when those rules creep into the area of content regulation, is merely an effort to divert attention from badly reasoned and badly written ownership rules that won’t stand up in court.”34 Senator Byron Dorgan (D-ND), who had led the Senate activity to overturn the FCC decision, commented, “It is a very curious strategy for the chairman to change the rules in a way that will dramatically damage localism and then, nearly three months later, propose a process to examine how those rules might affect localism.”35 The FCC went ahead with the implementation of its revised rules. The Media Access Project filed a request with the FCC for a stay of the order.

Court Action The Court of Appeals for the 3rd District in Philadelphia issued a stay on two of the FCC’s new media ownership rules, as discussed in the next paragraph. The petition for a stay was filed by the Prometheus Radio Project, an advocacy group for community radio, and backed by groups including the Media Access Project. The decision came as a surprise to the petitioners. They had sought to keep the case away from the Court of Appeals for the District of Columbia, which was the court that had overturned the FCC’s previous UNE decision. The stay gave Congress the opportunity to act.

At the end of 2004 2 rules, the newspaper-TV cross-ownership rule and the local TV ownership rule, were under remand to the FCC from the Court of Appeals in Philadelphia. The Bush administration decided not to appeal the decision to the Supreme Court. See the NYT, January 28, 2005. Broadcast and newspaper interests, however, appealed the decision, and in June 2004 the Supreme Court refused to consider the appeal.

31

FCC News, August 20, 2003.

The Wall Street Journal, August 21, 2003.

33 FCC News, August 20, 2003.

34 San Jose Mercury News, August 21, 2003.

35 The New York Times, August 21, 2003.

32

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The Fox decision called into question the FCC’s National Ownership Rule that limited media companies to 35 percent of the national market.

The Outcome Criticism of the FCC’s decision mounted. The public and activists continued their complaints, and members of Congress from both sides of the aisle expressed opposition to the decision. The opponents of the revisions of the media ownership rules turned to Congress in an attempt to overturn the rules. The focus was the National Television Ownership Rule. The politics were complicated when the National Association of Broadcasters (NAB) reversed its position and announced its opposition to legislation that would overturn the rule. The NAB had sought narrow legislation to reverse the National Television Ownership Rule, but the Senate bill would also reverse the rule on the ownership of a television station and a newspaper in the same local market.

NAB members wanted the opportunity to operate newspapers.

With a threat by President Bush to veto any bill that would rollback the FCC decision looming, the congressional bargaining over the media ownership rules continued throughout 2003. The final resolution was incorporated in a 2004 budget bill that provided $328 billion covering most federal agencies. The compromise set the national audience coverage level at 39 percent for the National Television Ownership Rule. This conveniently allowed Fox and CBS to retain the stations they currently owned. The other media ownership changes were not blocked. The legislation also required the FCC to reexamine the UHF discount.

In 2005 two rules, the newspaper-television cross-ownership rule and the National Television Ownership Rule, were under remand to the FCC from the Court of Appeals in Philadelphia. The Bush administration decided not to appeal the decision to the Supreme Court.36

36

, January 28, 2005.

The New York Times

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Chapter 11 Environmental Protection: Economics, Politics, and Management Environmental issues are very important, and environmental protection has broad public support reflecting the substantial widely distributed benefits resulting from that protection. Environmental protection, however, has very high costs, and those costs provide restraints on government regulation. Those costs are largely borne by private parties rather than by government budgets, so the politics of environmental protection involve powerful interests on both sides of the issues.

Citizen opposition to certain forms of environmental regulation has developed in some situations.

The Envirotest Systems Corporation (A) case in Chapter 2 illustrates an environmental revolt.

Recognition of the high costs of environmental protection has brought increasing attention to achieving regulatory objectives in a socially-efficient manner. The Coase theorem applies to environmental issues, which means that there are a variety of incentive mechanisms for achieving efficiency. Environmental taxes have now been used for CFCs and some other pollutants. Tradable permits systems are being used more extensively as discussed in the case. The chapter case Environmental Justice and Pollution Credits Trading Systems addresses a challenge to these systems. This case also includes a simple discussion of how such a system works.

As another example of the point in the text that an externality is reciprocal, Fina, Inc. built a refinery in Port Arthur, Texas in 1937. When it was built there were no homes near the refinery, but subsequently a subdivision grew up next to the refinery. When the subdivision was built, an externality resulted. Fina dealt with emissions, such as those that ate the paint on cars, by making small cash payments, as with a liability rule, to the residents of the Fairlea subdivision. The residents, however, decided to undertake a political campaign to force Fina to buy their entire subdivision. The political strategy involved lobbying, use of children to dramatize the claimed hazards, and even a media strategy orchestrated for the local TV stations. Fina eventually agreed to buy the 211 homes for a cost up to as much as $10 million, an amount that was more than its quarterly earnings.37 Fina responded to the externality caused jointly by the subdivision and its refinery by removing one side of the externality.

The Coase theorem applies to efficiency and not to distribution, and one feature of environmental regulation is that there remains uncompensated damages. This provides incentives for additional regulation.

The Environmental Protection Agency has the principal regulatory authority for the administration of a wide set of environmental laws. Its broad authority, however, is limited by the procedural requirements discussed in Chapter 10. In addition, many of the significant regulatory actions by the EPA have been challenged in court by one or more of the sides of an issue. Regulation is subject to government failure as discussed in Chapter 10, and the Superfund is a good example of a widely-criticized program due to litigation costs and the high cost of cleanup for what some people 37

, December 10, 1991.

The Wall Street Journal

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argue yields only small benefits. The performance of the Superfund would be a good subject for a lecture on the difficulty of administering a cleanup program. In August 2008 a federal Court of Appeals overturned an EPA rule that prevented states from establishing stricter monitoring of emissions than called for by federal law. The politics of environmental protection are complex and take place at all levels of government as well as through private politics, as in the case of NIMBY activities. The politics are complicated by scientific uncertainty about environmental damage. This provides an opportunity for advocacy science. The media clearly finds environmental protection issues to have both audience appeal and social significance. (The Alar example in Chapter 3 illustrates this point.) The private politics strategies taken by environmental groups are often quite sophisticated. A good example is their use of the Toxics Release Inventory to stimulate both national and local political action against polluters. During the Clinton administration the EPA under the leadership of Carol Browner initiated a number of new programs and adopted a set of new policies and rules in the absence of new legislation.

As indicated in the text, these initiatives created controversy, but with the Republican majorities in both houses of Congress there was little else the administration could do to pursue its ambitious environmental objectives. These initiatives were justified on the basis of interpretations of laws with vague language regarding protecting health and the environment.

Firms are increasingly giving higher status to internal environmental management units and are experimenting with approaches to environmental control. Environmental cooperation with NGOs appears to be a more productive approach to resolving certain environmental issues, and the McDonald’s and the other examples illustrate the approach. General Motors and the Environmental Defense Fund signed a working accord in mid-1992. Dow Chemical Company has formed a Corporate Environmental Advisory Committee which reviews its plans for production and product planning four times a year. Chaired by David T. Buzzelli, a vicepresident for environment, health, and safety, the Committee includes a former administrator of the EPA, a dean of environmental programs at a major university, and the head of an environmental research organization. Dow has also had its plant managers form local environmental advisory committees. Dow’s actions were not entirely applauded by the environmental interest groups. “Daniel J. Weiss, a legislative affairs director of the Sierra Club, said Dow is a leading member of the Chemical Manufacturers Association, which he said routinely lobbies against laws aimed at reducing emissions. ‘The company’s engineers have realized they can save money by reducing pollution, but unfortunately that does not extend to their policymakers,’ Mr. Weiss said. ‘They still use political money and their contacts to block legislation.’”38 Through its Responsible Care program the chemical industry has attempted to improve its environmental performance. In 2002 BP announced that it had already met its voluntary 2010 goal of reducing greenhouse gas emissions to 10 percent below 1990 levels. Peter Miller of NRDC said, “It’s refreshing. [Browne’s] shown it can be done. Predictions that it can’t be done, and that it would be too expensive, are clearly not true.”39

38 39

The New York Times , September 20, 1992.

San Jose Mercury News , March 12, 2002.

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Environmental cases in the book in addition to those in this chapter include Envirotest Systems Corporation (A) (Chapter 2), Shell, Greenpeace, and Brent Spar (Chapter 4), Anatomy of a Corporate Campaign: Rainforest Action Network and Citigroup (Chapter 4), Scrubbers and Environmental Politics (Chapter 6), Fuel Economy Standards 2007 (Part II Integrative Case), and The European Union Carbon Tax (Chapter 15).

The following provides additional information on the plan McDonald’s and EDF developed.

McDonald’s Environmental Actions The plan developed by McDonald’s and EDF would affect customers, suppliers, and employees.

“By December, for example, all McDonald’s suppliers must use corrugated boxes that contain at least 35% recyclable content. Suppliers will be asked to make regular reports to McDonald’s that measure their progress in reaching their new waste-reduction goals. This Spring, for example, the company will begin testing a starch-based material in consumer cutlery to replace plastic forks, knives and spoons. Ten restaurants have begun composting trials for egg shells, coffee grounds and food scraps. By December, McDonald’s will implement a nationwide program for recycling corrugated boxes. And later this year, the company will test reusable salad lids and shipping pallets, pump-style bulk dispensers for condiments and refillable coffee mugs.”40 “The initiatives include the use of brown bags made of recycled paper, smaller paper napkins, recycling of behind-the-counter cardboard boxes and the elimination of plastic cutlery wrappers where allowed by local health codes. And the company is trying out reusable coffee mugs, reusable coffee filters, and pump-style bulk condiment dispensers. The world’s largest food-service organization said it is looking into replacing the plastic forks, spoons and knives with starch-based cutlery that could be composted.”41 The task force that developed the plan was composed of four members from McDonald’s and three from the EDF. The EDF members were given access to McDonald’s data and allowed access to suppliers. McDonald’s estimated that the waste-reduction plan would cost $100 million a year.

Robert C. Williams, CEO of James River Corporation which had developed the quilted sandwich wrap that will replace McDonald’s clam-shell package, saw opportunities for certain suppliers.

“This project shows that partnerships can really work. Others can benefit from this, and I’m sure they will.”42

40

The Wall StreetJournal, April 17, 1991.

Boston Globe, April 17, 1991.

42 The Wall Street Journal , April 17, 1991.

41

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Cases Regulation as Opportunity: Cummins, Inc. The objective of this case is to show that some regulation can provide opportunity.43 The opportunity is created by sharply more stringent regulation on the emissions by diesel powered onroad vehicles and the requirement of ultra low sulfur diesel fuel which makes low emissions diesel vehicles feasible. Cummins is well positioned to enter a segment of the market by developing a high-performance light-duty diesel engine intended for the SUV-light truck segment of the market.

The standard takes full effect for on-road vehicles in 2010, which is the target year for Cummins.

Diesel engines have a bad reputation among consumers in the United States because of the experience of the 1970s in the aftermath of the Arab oil boycotts when diesel powered automobiles were beset with problems. Because of the bad reputation and the stringent emissions regulations in five states, diesel automobiles had had little penetration of the U.S. market. Diesel engines dominated in the heavy truck and nonroad segments of the market. Diesel engines were also used in the medium truck segment of the market and less frequently in the large end of the light truck market. The SUV/light truck market was the principal market segment for Cummins.44 Diesel engines were more costly than gasoline powered engines, and the new standards for large truck had had a large effect on the demand for trucks—and diesel engines—as indicated in the case.

The problem was meeting the tightened emissions standard.

Cummins sought to enter the SUV/light truck segment with a high-performance light-duty diesel engine that would have 50 percent better fuel economy that a 1997 gasoline-powered light truck that would meet 2010 standards. Cummins had two instruments for meeting the emissions standards. One was engine technology and the other was emissions control technology. These components of a market strategy were coupled with a nonmarket strategy that involved partnering with the Department of Energy (DOE). How important the DOE partnering was is unclear.

Cummins is a company with substantial sales but only modest profits. The quotation in the case characterized the recent history of the company.

Did Cummins’ commitment to corporate social responsibility make a difference? The answer is “perhaps yes” with regard to partnering with DOE, but it seems unlikely to have had any significant effect on the purchase decisions of light tuck and SUV customers. The government does not buy diesel engines, although agencies do purchase SUVs and light trucks. Whether Cummins is advantaged in this is unclear.

With regard to market entry Cummins may have an advantage in mid-size engines relative to diesel automobile companies such as Honda that planned to introduce a Diesel Accord by 2010 that would achieve 62.8 mpg on the highway. Cummins may also have an advantage relative to European companies that focus on small engines. Also, Cummins may have an advantage relative

43 44

See also the Chapter 2 case Envirotest Systems Corporation.

This segment of the market was devastated by the soaring gasoline prices in 2008.

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to engine manufacturers that focused solely on engines for large vehicles. Those manufacturers that currently supply the diesel medium truck market segment are the most likely competition.

Can Cummins get to market first with a superior product? Other companies recognize the same opportunity as does Cummins, and they have the resources to pursue the opportunity. The market segment is sufficiently large that it is worth pursuing even if other producers will also pursue it.

Whether there is a first-to-market advantage is unclear, but it seems unlikely that the advantage could not be dissipated by a superior engine. Working with Dodge Truck may be a wise component of its strategy.

The market component of Cummins’s integrated strategy should focus on technology development to achieve better fuel economy and on emissions technology. Its nonmarket strategy is directed at regulatory compliance and perhaps shaping the implementation of the standards. The most important aspect of its nonmarket strategy is probably assessing how much meeting or exceeding the new standards responsive will affect the demand for diesel-powered light trucks and SUVs. This involves not just assessing consumer tastes but also how big a price increase will be required because of the additions to engine technology and the cost of the emissions control system.

Cummins should continue to cultivate good relations with the regulatory agencies.

Discussion questions: 1. What regulatory changes provide the opportunity for Cummins?

2. How should Cummins interact with regulators?

3. What are the advantages of partnering with the DOE? 4. Are consumers likely to reward Cummins for its commitment to corporate social responsibility?

5. Formulate an integrated strategy for Cummins.

Emerging Regulation: Samsung, Nanotechnology, and Silver Ions The SilverCare washing machine is an innovation that has been quite successful in Japan. The washer involves tradeoffs. It reduces microbial contamination, allows cleaning without bleach, and uses less hot water. It also poses potential risks to the environment and perhaps to human health.

The benefits are relatively easy to identify and observe, whereas the risks are difficult to demonstrate and measure and some effects, if they are there, lie far in the future; e.g., affecting people’s natural immunity. The risks involve both those associated with the release of silver ions and with nanotechnology more generally. The principal direct risk for Samsung is that its washer will be subject to regulation that will limit its penetration of the market.

The principal market imperfection in this case is an externality if the silver ions are harmful to the environment. A possible second market imperfection is asymmetric information. This is present only if Samsung has information about possible externalities that other parties do not have. It

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seems more likely that information is simple incomplete but not asymmetric. That is, no one really knows whether or the extent to which the silver ions pose a threat to the environment or human health. The same may be the case for nanotechnology more generally.

The United States regulatory system has not been driven by the precautionary principle, which is used in some countries in Europe to protect against possible, as opposed to demonstrated, hazards.

That is, manufacturers in the United States do not have to demonstrate that their products are not harmful, although some harm is controlled by environmental regulation, such as that pertaining to disposal of products. In Europe the burden of proof is often put on the manufacturer to demonstrate that the product is free of risks. This principle has had a dramatic effect in Europe, for example, with regard to genetically modified organisms. In contrast in the United States the risk are regulated after they are demonstrated. However, the United States has an aggressive liability system that can subject manufacturers and others to financial penalties if an unregulated product proves to be harmful.

The decisions for Samsung are whether to introduce the washer in the United States as planned, and if so, how to position the washer in a regulatory minefield. The decision to introduce the washer can at relatively low cost be reversed by withdrawing the washer from the market, so both entry and exit costs are relatively low. How successful the washer will be depends on consumer evaluations and on measures Samsung takes in anticipation of or response to regulation. The washer has a high price between $1,100 and $1,400, so the margin on sales is high. It may sell to a niche market.

The principal source of pressure on Samsung comes from public politics, since the existing laws provide considerable opportunity to regulate the SilverCare washing machine. Activists and NGOs have the right to petition regulatory agencies under a number of statutes at the state and federal levels, and they can be expected to do so. This means that the action is likely to take place in government arenas and less so in the arena of public sentiment. It is possible that Congress could initiate a legislative process to regulate nanotechnology itself, but the applications of nanotechnology are so varied it will be difficult to do so.

The principal interests here are citizens in general and Samsung. Other manufacturers of washers are likely to have little benefit from stopping Samsung, and they want to avoid regulation that may affect themselves. In addition, they may want to use nanotechnology in their washers in the future.

The washer appears to be manufactured in Asia, so there is no U.S. rent chain that would have its rents affected. Citizens could be concerned with the possible risks to the environment and to human health, and their interests are represented by NGOs (NRDC) and some government associations (NACWA). Citizens who are potential consumers can represent themselves in the marketplace.

The regulatory risks come in a variety of forms, and part of the discussion can focus on enumerating the possibilities and assessing their likely impact. These laws typically do not allow tradeoffs between, for example, environmental protection and energy savings.

1. FIFRA The EPA will evaluate the washer because of microbial claims made by Samsung.

In the specific case of SilverCare this evaluation includes the effect on aquatic organisms.

More generally, a product is subject to regulation because of claims, for example, to kill

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bacteria or a pest but does not require prior approval or even screening of a product. This evaluation does not pertain to nanotechnology itself.

2. TSCA The law creates two kinds of risks. First, if a product poses an “unreasonable risk,” it can be banned. Second, a product with nanomaterials could be viewed as a new chemical and as such would require registration with the government. This would allow the government to require the manufacturer to provide information that could be used in a risk assessment. This could impose considerable costs on Samsung.

3. FDA The FDA was preparing regulations for cosmetics and medical products using nanomaterials, and claims about microbial properties could come to the attention of the FDA. 4. States Environmental and health regulations at the state level could be applied to the SilverCare washer or to nanotechnology more generally. Water agencies in California have already initiated this process. State regulation can impose large costs of companies because of the variation across states. Moreover, federal law often permits states to set more stringent regulations than required by federal law.

5. Cities Cities can also regulate products, although action by Berkeley does not mean that very many more would act on these issues. Cities generally do not have the expertise to make regulatory judgments in as informed a manner as do state and federal regulatory agencies.

Integrated Strategy Samsung’s market strategy should be to introduce the SilverCare washer in the United States, since the product can always be withdrawn if the regulatory burden becomes too severe. The due process requirements on regulatory processes mean that there will be time to exit before regulatory decisions are finalized. Samsung should work with the regulatory agencies, and particularly the EPA, do arrive at sensible regulations if any. For example, Samsung might work for simply a label attached to the machine identifying the possible environmental concerns. That is, Samsung should welcome informational regulation and oppose more stringent requirements.

On the nonmarket side the marketing claims made about the washer should be reviewed by experts knowledgeable about environmental and health regulation as well as lawyers regarding any possible exposure to liability.

Nanotechnology is a broad science with many applications and many materials in use. It will be difficult for Congress to act to regulate it unless there is a crisis associated with a product or substance. It is possible that with an Obama administration and a heavily Democratic Congress regulatory laws embracing the precautionary principle could be enacted. There is little that Samsung could do about this, so such a possibility should be left to industry associations.

Teaching the case: The following questions can be used to lead the discussion.

1. Identify the regulatory risks faced by Samsung in entering the U.S. market with its SilverCare washing machine.

2. Are the regulators likely to make tradeoffs, for example, of lower energy use versus a greater threat to aquatic organisms?

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3. Does Samsung face greater pressure from private politics or public politics?

4. Should Samsung introduce its SilverCare washer in the United States? Are their any precautions it should take?

5. How costly would it be to exit the United States market if the regulatory burden became too costly?

6. Does the fact that the SilverCare washer is popular and apparently not adversely regulated in Japan mean that it is unlikely to be regulated in the United States?

Nanotechnology Industry Strategy The NanoBusiness Alliance (NBA) represents companies that make or use nanomaterials and serves as “a collective voice for the emerging small tech industry and develop a range of initiatives to support and strengthen the nanotechnology community. …” This association appears to be primarily composed of small companies, so one of its primary objectives must be to broaden its membership to include larger companies that apply nanotechnology on a broader scale. The applications of nanotechnology are so broad that recruitment may be difficult. Also, to the extent that nanotechnology is applied broadly in existing industries means that the associations in those industries may put the issues on their agendas. The association’s Website www.nanobusiness.org provides information on the group’s agenda.

A nonmarket strategy for the industry includes efforts to avoid or contain regulation applied to nanomateials and particularly to avoid the jurisdiction of TSCA. The industry should also identify the harmful effects of the precautionary principle to the development of new businesses.

The association should demonstrate that the United States is and can remain the technological leader if the industry remains unregulated and has the proper incentives. One thing that new technologies often seek is subsidies, often in the form of tax credits, for research and development.

Subsidies appear not to be needed to stimulate research and applications.

The principal implementation strategies should include lobbying, advocacy, and testimony.

Environmental Justice and Pollution Credits Trading Systems PowerPoints are available for this case environmentaljustice.ppt.

This case is based on public information and “Westco” is a composite of a group of oil companies that were the targets of the environmental justice lawsuits and activist strategies in the Los Angeles area.

The environmental justice campaign involves private politics as led by activists outside of and within government. Activist groups have sought new ways of advancing their objectives of increasing protection of the environment and redistributing wealth and opportunity, and in this case pollution, in favor of the disadvantaged. (The strategies of activists and their private nonmarket 236

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action are considered in Chapter 4.) Within government the Clinton-Gore administration has sought to advance its corresponding goals without seeking new legislation from Congress, which beginning in 1995 had Republican majorities in both houses. In the environmental area EPA administrator Browner has started a number of innovative and controversial programs, as discussed in Chapter 12 of the book. The EPA’s environmental justice campaign and Clinton executive order are two examples of these initiatives.

The environmental justice issue arose in association with the location of hazardous waste facilities and dumps. These facilities were naturally located where land was cheapest. People with low incomes also locate where land prices and housing are cheap. This means that these facilities would tend to be located disproportionately in low-income areas. To the extent that minorities and women are disproportionately represented among low-income people, there is a disparate effect on them. To the extent that there are health hazards or other risks associated with these facilities, lowincome people could be disproportionately exposed to harm. Clinton’s executive order and Browner’s campaign addressed these concerns. This is thus an issue of distributive justice.

The lawsuits and activist actions in the Los Angeles area address quite a different issue—the distribution of pollution reduction. The pollution credits trading system in Los Angeles is used in conjunction with a pollution reduction program and is intended to achieve environmental objectives in a socially efficient manner. This type of trading system implements a utilitarian objective of aggregate welfare maximization by allowing low cost abaters to abate more and high cost abaters to abate less than the average required by the environmental objective. The way this is accomplished is by issuing permits for the emission of pollutants equal to the emissions allowed by the environmental objective and then allowing those who have low abatement costs to sell their excess permits to those with high abatement costs. This results in lower total costs of achieving the environmental objective. Because the aggregate cost of abatement is lower, the environmental objective can be more aggressive that it would have been had the aggregate cost of abatement been higher. These trading systems are discussed in Chapter 11 and an example is presented in the case.

Numerical examples such as that presented in the case can be tricky because a holder of permits can enter on either side of the market for permits; i.e., it can buy or sell credits. The example is set up so that the incremental cost of abatement is 15 for both buying and selling and hence there is a unique price of 15 for a credit. That is, if the price of a credit were less that 15, b would buy credits rather than abate 100 pounds. If the price were above 15, b would increase its abatement from 100 pound to 200 pounds and sell its allocation of 100 permits. For example, suppose that the price p of a credit were p = 16. Then, b has an incentive to increase its abatement from 100 to 200 pounds because doing so costs 15 a pound and it can sell the permits it no longer has to use for 16. Thus, even though in equilibrium a sells credits to c, it is b’s costs that establish the equilibrium price for a credit.

The facts pertaining to the lawsuits and the allegations of the activists are unclear, but if the AQMD is to be believed, the trading systems are not associated with an increase in pollution but instead with a decrease in pollution. The AQMD states that the standards of the CAA are met and that the program is in full compliance with the law. Moreover, the AQMD has a separate rule to deal with hot spots. In addition, there is no indication that pollution emissions at the refineries and the marine terminals are higher than they were before. Under the trading system, however, they may

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not have had to reduce their emissions, since they could have purchased credits as did source c in the example. This is the likely situation.

The activists’ claims are probably strategic and intended to attract news media coverage of their campaign and obtain sympathetic treatment of it. The activist’s objectives are probably for lower aggregate emissions in favor of the disadvantage and obtain compensation from the oil companies.

They may be willing to trade higher aggregate pollution levels for redistribution; i.e., to move from a utilitarian outcome such as point C in Figure 20-7 to the Rawlsian point B. The redistribution in favor of the residents near the oil refineries and the marine terminals thus comes at the expense of the other residents of the Los Angeles basin.

The activists’ strategy is not only to argue that the trading system results in violations of federal environmental standards but that it discriminates against minorities and women. The claimed legal basis for this argument is Title VI of the Civil Rights Act of 1964. Whether the courts will agree with this argument is problematic. Also, whether there is a greater incidence of certain diseases caused by hydrocarbon emissions around the facilities is unclear and requires a careful statistical study. The activists’ parading of ill people before the TV cameras is a standard strategy.

Without judging the merits of the lawsuits, the claim about the distribution of pollution reduction is a legitimate moral issue. As indicated above, a utilitarian system could yield a different conclusion than the Rawlsian system. Furthermore, if people have a moral right not to have their health harmed and if the facts are that there is harm, then a rights perspective could rule out some alternatives, including a trading system, as illustrated in Figure 20-3. Presumably, the AQMD’s separate rule for hot spots is intended to deal with such a health risk.

This issue could also be addressed from the perspective of the Coase theorem as discussed in Chapters 11 and 12. The rights in this case have been allocated to the refineries and marine terminals to emit pollutants in accord with established standards. The activists and the residents thus could pay the oil companies to reduce their emissions. Part of the activists’ strategy is to use the Civil Rights Act to change the assignment of rights. With the rights assigned to residents, the oil companies would be forced to pay the residents.

The business community reacted strongly against the environmental justice campaign, and Congress acted to slow its progress. Harry Alford has taken the point on this issue and argues that not only are the activists exploiting the civil rights laws but the campaign is likely to have adverse distributive consequences for people in the inner city and for poor people in other areas. He cites the adverse effect on the brownfields developments to provide jobs in cities, and the U.S. Conference of Mayors apparently agrees with him. Alford also points to the loss of jobs in lowincome areas, as in the case of the Louisiana petrochemicals plant. The environmental justice campaign seems to require that a company whose facilities emit pollutants allowed under the law should locate in an area where there were no low income people and where minorities and women are not disproportionately located.

PowerPoints are provided for use in teaching the case.

Teaching the case:

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The following questions can be used to lead the discussion.

1. What is the moral justification for a pollution credits trading system?

2. How does such a system work to achieve social efficiency?

3. How does a trading system affect the distribution of pollution compared to a command-andcontrol system in which each pollution source is required to meet the same emissions standard?

4. What are the moral claims of the activists? Are they morally justified? Under which ethical system? Are the rights implicitly claimed instrumental or intrinsic?

5. What strategy are the activists using to pursue their objectives? What are their objectives?

6. Evaluate Alford’s arguments. Are they compelling?

7. If their claims were morally valid, what measures could be used to address the moral concerns?

Should a trading system be abandoned? Modified?

8. What should Bentley do?

Discussion The moral issues in this case seem to be matters of justice rather than rights. That is, the hot spots policy is intended to deal with immediate health risks, and it is not the case that people have a wellestablished right to have their health protected from possible hazards of the type present in the case.

If there is an imminent health risk, the AQMD should so determine and take action.

The principal issue is then social efficiency versus responding to the interests of low income people. More specifically, should a trading system that can yield major cost savings to society be sacrificed in favor of the disadvantaged? The answer seems to be “no.” There are likely to be better means of responding to the interests of the disadvantaged, if that is morally justified. One means is to provide them with cash. A second would be to move them from the areas around the refineries. A third would be to provide services including medical care for those who are ill.

The Bush administration reined in the EPA’s environmental justice program, and the courts did not overturn trading systems. Activists continue to complain about environmental justice, but they have had little effect.

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Chapter 12

Law and Markets This chapter introduces a set of concepts from the law pertaining to markets. The topics include the common law, property with an emphasis on intellectual property, contracts, and torts with a focus on products liability. The law is only introduced in the chapter, and a lecture could go into considerably more detail. There are many business law texts and law and economics books that can be used as a basis for a lecture. The business law texts also include a set of court cases that can be used as a basis for a discussion. The Coase theorem introduced in Chapter 11 provides one framework for understanding contracts and remedies for breach, as developed by Polinsky (2003).

Property is a central underpinning of markets, and intellectual property is perhaps the most challenging aspect of the law of property. Intellectual property law has both efficiency and distributive effects. The latter motivates much of the politics of intellectual property, and the Chapter 1 case The Nonmarket Environment of the Pharmaceutical Industry identifies the incentives inherent in the pharmaceutical industry, and the chapter case Patent Games: Plavix considers one episode. Intellectual property is also the central focus of the Chapter 13 case eBay and Database Protection case.

Torts are civil wrongs, and hence they raise both economics and ethics issues. The social efficiency perspective discussed in the chapter is consistent with utilitarianism as considered in Chapter 20. Justice considerations may also be relevant as considered in Chapter 21.

A video which then can be used with this chapter is a CBS News Special “Eye on the Media: Business and the Press,” which centers on how the media would cover the issue of the sale of 2K rather than 1K kerosene for the space heaters of the type discussed in the California Space Heaters, Inc. (A) case. (The film is available from Carousel Films, Inc., 241 East 34th Street, New York, NY 10016.) This is a useful film for this chapter, and it is also useful in conjunction with Chapter 3 on the news media.

The product safety problem is an important one for most firms. It centers on pure accidents, market imperfections that lead to injuries, and distorted incentives that lead to inefficient levels of care. As indicated in Figure 12-4, a producer must take into account in its ex ante decisions the ex post consequences of the use of its products. Product safety is costly, and the two costs are those associated with taking care and those resulting from the injuries and property damage.

The Coase theorem provides a perspective on the socially efficient means of addressing the safety issue. It is important that students understand that, in the absence of transactions costs, efficiency can result from any of the assignments of entitlements and their protection discussed in Chapter 11, but the distributive consequences and the transactions costs of the various assignments can differ substantially.

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The Calabresi and Melamed principles are important for reasoning about how in the presence of transactions costs entitlements should be assigned for social efficiency objectives. These principles are also used in the context of utilitarianism in Chapter 20.

A lecture could center on other court cases, examples of which can be found in most business law texts. An expansion of the treatment of the imperfections in the liability system is also a good topic for a lecture. The politics of products liability are also interesting, but complex, with major federal legislation continually before Congress.

One point that might be discussed in a lecture is that the liability system deals with the free-rider problem. Absent the liability system, a firm that produces a hazardous problem could have an incentive to free-ride on the quality image for the product class. For example, if the industry had voluntary product safety standards, a firm might be able to produce a product that does not meet the standards, sell it at a lower price, and benefit. The liability system, however, forces that firm to bear the costs of the hazards associated with its product.

The case of a woman who spilled coffee from McDonald’s while she was driving and successfully sued for damages has been followed by additional coffee lawsuits in the United States. In April 2002 a judge in the United Kingdom dismissed 36 cases of individuals suing over alleged burns from fast food restaurant coffee. The British judge wrote, “I am quite satisfied that McDonald’s was entitled to assume the consumer would know that the drink was hot, and there are numerous commonplace ways of speeding up cooling, such as stirring and blowing.” A British newspaper applauded the decision, “It’s wise judges like him that might, just might, stop this country sliding into the absurd compensation culture that has gripped America for years.” The original McDonald’s case arose when a 79-year old woman driving a car with an open cup of coffee between her legs was burned and required skin grafts. The jury awarded $2.7 million, and a judge later reduced it to $480,000. The two sides then settled out of court. The ridicule heaped on this case has haunted the trial lawyers, who provide a justification for the decision at www.atlanet.org/CJFacts/other/mcdonald.ht#anchor887148.45

Cases California Space Heaters, Inc. (A) PowerPoints are available for this case.

This case addresses the managerial problem of how safe to make a product whose use inherently involves hazards of a variety of types but also provides considerable benefits. The information in the case on product safety was incomplete as in most product design decisions regarding new

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San Jose Mercury News

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products. (One source of additional information is the article “Are kerosene heaters safe?”

Consumer Reports, October 1982, pp. 499-507.)

A kerosene space heater is a highly beneficial product that can save consumers considerable amounts on their heating bills. The product is safe when used properly, but there are potential hazards that require the company and consumers to take care. From the perspective of management, the company needs guidance about how to determine the appropriate level of care.

The liability system provides information to this effect, although it has a number of shortcomings.

Students should understand that many millions of these heaters have been sold. They should also understand that there are deaths, injuries, and property damage associated with their use. I have no information on the damage done by kerosene space heaters, but the Consumer Products Safety Commission Fact Sheet No. 98, entitled “Electric Space Heaters,” states that “in 1982 electric space heaters were associated with 3300 fires resulting in 130 deaths, 370 injuries and 35.2 million dollars in property loss.”

The basic problem faced by the company is that although the heaters are safe in proper use there are a variety of hazards from improper use that can result in death, injury, and property damage. Some hazards, such as the risk of fire, may be relatively clear, but others surely are not. In particular, the indoor pollution problems and the risk of asphyxiation are not obvious. There is thus an informational asymmetry.

Safety regulation is one means of addressing the asymmetric information problem. The CPSC could mandate warnings, require information provision, and/or require safety features intended to reduce the risks. The liability system also provides incentives to the firm to take such measures.

Under products liability law the company can be found liable if its heaters are deceptive in the sense that the ordinary consumer might not use the heater properly. Furthermore, deceptive hazards could open the firm to negligence charges. The company has the duty to warn of hazards through instructions, explicit warnings, and instructions to dealers. Under strict liability, it also has a duty to anticipate misuse. The failure to do so can result in judgments against the company. A principal means of responding to anticipated misuse is through the incorporation of safety features.

The company can also take steps to induce consumers to take care. It can do so by incorporating safety features that reduce the cost of taking care (e.g., by incorporating a removable fuel tank or including a bottle of the clean burn additive), by encouraging self-selection so that consumers with respiratory problems, for example, are discouraged from purchasing a heater, and by anticipating misuse (e.g., by using siphon filling, electric ignition, etc.). Similarly, safety features such as an automatic cutoff could be incorporated to reduce the risk of fires due to accidental tip-over. In most cases such as this, the company’s information on the likelihood of injuries and deaths will be very limited and thus only rough estimates can be made. Nevertheless, managers have to make decisions about safety.

This leaves the issue of how decisions on specific safety features might be made. Using the information in the case, adding electric spark ignition to the least expensive heater would reduce the probability of death from 5 in 100,000 to 2.5. (These numbers are hypothetical and are

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intended to incorporate injuries as well as deaths.) The cost of electric spark ignition is $19.50 and the expected reduction in deaths is 2.5 x 10-5. Dividing yields a cost per death avoided of $800,000. An electric wick adjustment costs $32 and the reduction in deaths is 1.25 x 10-6.

Dividing yields a cost of $25.6 million per death avoided. Although the appropriate standard for the acceptable cost per death avoided is unknown, the electric wick adjustment seems unwarrantedly high and the electric spark ignition seems within the likely range of a warranted cost.

Perhaps the most difficult decisions pertain to pollutants. The standards set by the Navy and NASA are for people in good health, and the standard set by the EPA is for people with angina. There is a considerable range in between. One means of addressing this hazard is to stress information provision about leaving a window open for ventilation. One issue to raise is whether warnings must be made intelligible to the average consumer or to the lowest common denominator.

The use of warnings and information provision still leaves considerable room for consumer misuse, and the company may decide to incorporate safety features to reduce the likelihood of this type of misuse. One means of doing so is to incorporate sensors that can detect hazardous levels of certain gasses.

The pricing decision should be based on the full incremental cost of a heater. That cost is the sum of the product manufacturing cost and the liability cost. For example, if the safety features added are an automatic cutoff ($8), a siphon filling system ($12), electric ignition ($19.50), and a wick stop ($6.50), the product manufacturing cost would be $90. If the remaining risk were such that the liability cost per unit were $25 and marketing costs were $5, the cost would be $120. This is the cost on which the price should be based. With a markup of 100% the retail price would be $240. If this price generated sales of one million units, the total contribution to fixed costs would be compared to the fixed costs of production to determine if the product should be produced.

Whether the company should go beyond this kind of analysis (i.e., analysis that minimizes the sum of liability costs and the costs of safety features) is unclear. The firm might wish to do so if adverse publicity from injuries would damage the company. Reduced sales from adverse publicity should be taken into account in the same manner as liability costs. Another consideration is activist pressure motivated by a desire to reduce injuries rather than to minimize social costs.

Teaching the case:

The discussion can be led using the following questions. 1. Is this heater a beneficial product?

Should it be produced at all? (These questions are intended to allow those students who abhor hazards to come to the conclusion that there are many beneficial products that are accompanied by hazards and that managers have to make decisions about safety.) 2. Under what legal standards will consumer injuries be dealt with? 3. What framework should the company use to make decisions about product safety features? 4. To what extent can warnings and information be used to induce consumers to take care? 5. Should the company offer a line of products with various safety feature/price combinations from which customers can choose? 6. How should the product be priced?

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7. Is this the right framework for management to use to make decisions about product safety? For example, can the benefits from reductions in heating costs be compared with the expected costs from injuries associated with the product? (This question is intended to allow students to discuss whether a costs-benefits analysis is the appropriate basis for safety decisions.)

8. Should consumers have an entitlement to safety protected by a property rule?

Outcome: This case is a composite of information on the company that launched this product plus subsequent information from public sources. Millions of these heaters have been sold, and the models vary substantially in the number of safety features they incorporated. The 1982 Consumer Reports article mentioned above provides information on safety features and prices for 18 models. The prices range from $170 to $290. Referring to the set of models evaluated, Consumer Reports concluded that “All were judged inherently hazardous; they should be used with extreme care.” A 1985 consumer information notice No. 97 issued by the CPSC reported that 15 to 16 million were in use at that time.

Under Chair Nancy Harvey Steorts, the CPSC withdrew its standard for unvented gas heaters in favor of a voluntary standard. The CPSC obtained a change in that voluntary standard to require a nitrogen dioxide sensor.

The following two stories were told by students in an executive program. One who had been on Antarctic expeditions said that more people die on expeditions from asphyxiation from the use of kerosene heaters than from the natural hazards of the expedition. Another student said that the Philadelphia city government offered free maintenance and new wicks for kerosene space heaters to reduce the likelihood of fires in apartment houses and other multiple unit buildings. A principal concern of the city was the use of the space heaters in apartments in which the electricity had been cut off.

Effective at the beginning of 1994 the government required that diesel fuel be sold in three colors, red, blue, and clear, to distinguish the grade. Users then are to use the grade designated for their use. Buses, for example, are to use red, pleasure boats clear, commercial boats blue, and private automobiles clear.

Kerosene could also be color coded.

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California Space Heaters, Inc. (B) The company recognizes that in a year or so after it introduces the heaters, low-cost, low-quality kerosene space heaters are likely to be produced in Taiwan and the Philippines and exported to the United States. Management wonders what if anything can be done about the imports.

Preparation questions: 1. What risks to the company would such imports pose?

2. How should the company deal with the threat from imports using market and nonmarket strategies?

3. Is it responsible to take such actions?

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California Space Heaters, Inc. (C) California Space Heaters has been asked by a company owned by the government of Turkey to license it to produce its kerosene heaters in that country. The license request is for an inexpensive model with only minimal safety features such as an automatic shut-off for tip-over and a manual shut-off. The government believes that this model is best for a low-income country facing high energy costs. Sales are anticipated to be primarily in the mountainous central and eastern parts of the country where homes typically do not have central heating and rely on wood stoves or oldtechnology kerosene heaters. The president of California Space Heaters visited Turkey to discuss the license with the government-owned company and learned that kerosene is used in Turkey for a variety of purposes and many people are quite familiar with its use. He also learned that 2K (high sulfur) kerosene is more commonly available than 1K (low sulfur) and that many of the homes of the people who would likely use the heaters are poorly ventilated. He also learned that under the Turkish legal system it would be highly unlikely that California Space Heaters would be sued in either the United States or Turkey as a consequence of any accident associated with the heater.

Preparation questions: 1. Should California Space Heaters license the heater to Turkey? If so, should any precautions be taken? If not, why?

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Comments on the (B) Case: This is a fictitious case. There are two stages to the decision in the (B) case. The first is determining whether protection should be sought. The second is where it is most likely to be obtained.

Protection can be obtained in three ways. First, Congress can pass legislation to provide it. This small industry, however, is unlikely to be able to muster sufficient political support to induce Congress to act. Second, the industry can seek protection under existing trade laws. This is the subject of Chapter 18. To obtain protection, the industry must establish that it has been substantially harmed as a result of an unfair trade practice, which is not the case. Third, the industry can attempt to use the regulatory process to exclude the imports. This could be done by agreeing to mandatory product standards, or enforceable voluntary standards, approved by the CPSC. This would lessen the cost advantage of the imports. Obtaining voluntary standards is the quickest way to address the import issue, although there is some chance that the CPSC would not approve such standards. Mandatory standards would be more effective against imports, but they require a formal rule- making procedure which can be lengthy.

Whether the company should seek protection is unclear. Of course, the company has the private substitute of producing its products in Asia to reduce its costs.

Comments on the (C) Case: This is a fictitious case. From a profit perspective, there seems to be little risk from licensing the product. The likelihood that the company would face liability suits is very small, and U.S. courts would likely not grant standing. The likelihood that injuries in Turkey would significantly affect the market in the United States also seems quite small. How significant is the risk of injury is not clear, but people in many low-income countries regularly use kerosene for a variety of purposes including cooling and heating and are quite knowledgeable about its use. The risks thus may not be very significant, particularly when compared to their alternative sources of heating.

Taking the broader perspective of ethics, a utilitarian analysis is helpful in this case. This type of analysis is illustrated in Part V and particularly in Chapter 22 for an issue such as this, so only a brief commentary will be given here. The Calabresi and Melamed principles suggest that the Turkish company is best placed to assess the benefits and costs of the heaters, but California Space Heaters is best placed to induce the Turkish company to act to avoid social costs by taking appropriate care. Another way of saying this is that from a utilitarian perspective, the company has a moral duty to act to improve the excess of benefits over costs. It is best placed to warn about hazards, provide information on proper use, and provide information about the benefits of safety features. The company may go beyond this duty by assisting the Turkish company in making decisions about safety features and providing information to consumers. The decision, however, ultimately is the responsibility of the Turkish company.

The next issue is whether California Space Heaters should insist on the incorporation of safety features. When the Turkish company fully understands the hazards and the prevention measures, insisting on safety features would amount to paternalism, which is discussed in the book. One

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intermediate step would be to advise the Turkish company on product inspections and monitoring of accident and injury reports.

Patent Games: Plavix This case illustrates the measures pharmaceutical companies will take to protect a lucrative patent—measures that are of questionable legality. In this case Bristol-Myers Squibb (BMS) and Sanofi-Aventis (SA) may have crossed the line. BMS was experienced in trying to delay generic competition. It was already on notice and operating under a consent order resulting from measures it took to prevent generic competition for BuSpar and Taxol. This order required approval by the FTC and state attorneys general of any agreement that could be anticompetitive. BMS was also operating under a deferred-prosecution agreement with the Department of Justice stemming from securities fraud allegations.

This episode resulted from the aggressive strategy of Richard Sherman, CEO of Apotex, who searched for opportunities to introduce generic versions of patented drugs. Sherman contended that the patent on Plavix was invalid because an earlier patent that had expired. SA disagreed and filed a patent infringement lawsuit, which the courts eventually upheld. But in the interim Sherman was able to deploy his strategy. He obtained FDA approval for a generic version of Plavix that permitted Apotex to market its drug at risk. Sherman plowed ahead by constructing manufacturing facilities and building an inventory of the drug. Sherman must have known that BMS and SA would want to bargain to keep the generic version off the market until at least the patent had expired. Apotex had developed a strong bargaining position because it had received FDA marketing approval and had built an inventory.

The negotiated agreement gave Apotex the right to market its drug 8 months before patent expiration on Plavix. This was valuable to Apotex because it would make it less likely that other generic drug companies would enter the market with their own generic drug. Giving Apotex this advantage was relatively costless to BMS and SA because some generic drug company was certain to produce a generic version of Plavix, and the companies cared little about which one it was.

Moreover, if the period of exclusivity dissuaded other generic companies from entering, postpatent-expiration competition would be limited to only two drugs. Allowing entry of a generic drug 8 months before patent expiration, however, is costly because there would be competition during that period.

Not surprisingly, according to Sherman, the agreement was rejected under the consent decree, and BM quickly sent Bodnar to negotiate with Apotex to produce a modified agreement that would receive approval by the FTC and the state attorneys general. Apotex also obtained approval and rejection fees and a provision that prevented BMS and SA from filing for an injunction for five days after the generic drug was marketed. The modified agreement also had a provision limiting damages assessed on Apotex for marketing the drug to 50 percent of sales. Sherman claimed that Bodnar made oral promises that reinstated the provisions that had caused rejection of the first

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agreement. BMS and Bodnar denied the allegation. Apotex went ahead and demanded the $60 million rejection fee from the first agreement, and Bodnar replied with an angry email.

Apotex’s strategic position was strengthened when the FTC asked the Department of Justice to raid BMS offices to obtain information on the modified agreement. The FBI raided CEO Dolan’s office.

The FTC rejected the modified agreement, which provided the opportunity for Apotex to launch.

With BMS in a delicate position and with the two provisions of the modified agreement remaining in effect, Apotex decided to market its generic drug. Apotex had already lined up the large purchasers, and they were ready to buy when it launched. Since every party understood that BMS would file for a temporary injunction as soon as Apotex launched, the purchasers were prepared to buy large quantities immediately. When Apotex launched, they bought. BMS filed for a preliminary injunction, and after a hearing it was granted.

Sherman and Apotex seem to have outwitted BMS and SA throughout this affair. Sherman expected the agreements to be rejected, and the inventory he had built allowed him to cash in. The logic behind BMS’s actions is unclear, other than that it had a strong profit incentive to delay the introduction of a generic version of Plavix.

The first agreement seems anticompetitive, and the FTC and the state attorneys general reached that conclusion. The modified agreement absent any oral promises also seems anticompetitive, but the 6-month exclusivity period has been used by other drug companies in what is referred to as an authorized generic; i.e., authorized by the patent holder before patent expiration. In the case of BuSpar BMS had made a payment to a generic drug company to keep its drug off the market for 6 months. The inclusion of both a rejection and an approval fee in the first agreement amounted to a certain payment of either $40 million or $60 million to keep the drug off the market. These provisions may have killed the first agreement.

Discussion questions:

1. How strong are the incentives for BMS and SA to keep Apotex’s generic drug off the market?

2. Was the first agreement anticompetitive? On what grounds?

3. What was Sherman’s strategy? Was it shrewd?

4. Was his strategy ethical? Was it simply a game between two strategic players?

5. Why would BMS take such risky actions while under a deferred-prosecution agreement?

6. What penalties should BMS face for its efforts to produce an agreement to stop Apotex from introducing its drug?

Developments In June 2007 Bristol-Myers Squibb pleaded guilty to federal criminal charges that it made false statements to the FTC. The company was fined $1 million. BMS stated after the judge had ruled that it had pleaded guilty to take responsibility for the actions of Dr. Bodnar. BMS stated that there

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was no “‘side agreement’ of any kind with Apotex not to launch an authorized generic version of Plavix.”46 This seems to be a very carefully worded statement.

Dr. Andrew G. Bodnar, former executive vice president of Bristol-Myers Squibb, was indicted in April 2008 for having concealed from the FTC the agreement with Apotex. (New York Times, April 24, 2008) On June 19, 2007 a federal court judge upheld the validity of the patent on Plavix. Sales of Apotex’s drug during the brief time it was on the market was $1 billion according to Mr. Sherman.

Obesity and McLawsuits This case involves an ongoing issue that will likely be active for many years. Although as indicated below the CDC estimates that ignited the fire were grossly wrong, obesity remains an important health problem. Obesity is the focus of ongoing research, but the heat of the issue will not await the outcome of the research. The interest groups such as the trial lawyers will remain active and will attempt to win a case and then attempt to qualify a class action lawsuit. The court of appeals in New York overturned the judge’s decision in the lawsuit mentioned in the case, allowing the case to go to trial. The grounds were that New York law allowed lawsuits on a failure to adequately warn.

The trial lawyers will be relentless on this issue. Commenting on the likelihood of winning on obesity lawsuits, John Banzhaf said, “Is it a shoo-in? No. But if we pick our plaintiffs carefully, the guy who eats there every day, we can make our cases stick.”47 This case is intended to raise liability issues pertaining to the hazard of obesity, but it can also be used to discuss an emerging issue and how McDonald’s should deal with it. This relates to the Chapter 1 case The Nonmarket Environment of McDonald’s. The interests relevant to fast food and obesity include trial lawyers and their clients, food companies, restaurants, and activist NGOs. The institutions are Congress, state governments, federal and state courts, FDA, public sentiment, and the news media. The life cycle concept can be used to discuss where the issues are in the life cycle, how they might progress, which interests will work to advance or reverse their progress, and the extent to which institutions will determine the progress of the issues.

The logic of this case is: 1. What are the facts about the prevalence and health effects of obesity?

2. What has caused the increase in obesity in the United States?

3. What is the role of fast foods in obesity?

4. Who is responsible for what one eats?

5. How does the liability view responsibility for the prevalence and health effects of obesity?

6. What should McDonald’s do?

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New York Times , June 12, 2007.

San Jose Mercury News , August 29, 2004.

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These questions can also be used to lead the discussion.

The effect of obesity on health The CDC attracted a huge amount of attention along with considerable criticism. Because of mathematical errors the CDC researchers revised its estimates of deaths downward from 400,000 by 9 percent. Other researchers began to criticize the methodology of the study, identifying dubious assumptions on which the study was based. For example, the estimates of death were based on the assumption that a person became obese at an early age, whereas many people only become obese later in life. Dr. Stanton A. Glantz of the University of California, San Francisco, Medical School put the number closer to 100,000. He argued that obesity had little effect on life span for people over 65, and most people die after that age.48 A study by Flegal, Graubard, Williamson, and Gail (2005) estimated the number of deaths from obesity relative to normal weight (BMI 18.5-25) at 111, 909 and the number of deaths from underweight relative to normal weight at 33,746.49 Being overweight but not obese was associated with a greater longevity. The net effect of overweight and obesity was 25,814 excess deaths.

Another study showed that compared to the 1960-1962 period obese people currently had fewer adverse health characteristics. In particular, cardiovascular disease risk factors have “declined considerably.” This study used more recent CDC data than the original study. The lead author on the study was with the CDC. Referring to the JAMA study Executive Director Richard Berman of the Center for Consumer Freedom wrote to CDC Director Dr. Julie Gerberding stating, “It’s a scandal that the CDC’s 400,000 deaths estimate didn’t use this information, which was readily available on the agency’s computers. The American public deserves to know where the CDC stands on this greatly reduced number and whether obesity is truly worse than the Black Death, as you have stated.”50 As a result of the study published in JAMA, the media called on the CDC to explain its initial study.

Editorials referred to the CDC’s chicken little study.

Additional research was underway on the health effects of obesity, so the verdict remains out. The original CDC study, however, appears to be seriously flawed.

Causes of the increase in obesity There seems to be a consensus that obesity has indeed increased in the United States. The studies by economists cited in the case provide an explanation for the increase. The trial lawyers will not focus on these explanations but rather will focus on issues such as addiction, ignorance about the content of fast food, and advertising.

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The New York Times, November 24, 2004.

Flegal, Katherine M., Graubard, Barry I., Williamson, David F., and Gail, Mitchell H. 2005. “Excess Deaths Associated with Underweight, Overweight, and Obesity.” Journal of the American Medical Association. Vol. 293: 1861-1867.

50 Center for Consumer Freedom, April 19, 2005.

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The link between fast food and obesity This link is difficult to assess and estimate. People who become obese probably become obese eating at home, particularly eating between meals, eating at work, and eating at restaurants. The courts will look for evidence on where the plaintiff ate and will allow testimony on personal responsibility as well as on the effect of advertising.

The lawsuit mentioned in the case The lawsuit mentioned in the case, which had been dismissed twice, was revived by a decision by the U.S. Court of Appeals that held that “New York’s general business law requires a plaintiff to show only that deceptive advertising was misleading and that the plaintiff was injured as a result. …In a statement, Oak Brook, Ill.-based McDonald’s Corp. said ‘common sense tells you this particular case makes no sense,’ adding that the ruling ‘simply delays the inevitable conclusion that this case is without merit.”51 Who is responsible for what one eats?

This question can be addressed from both the perspective of philosophy and law. A prevalent view is that individuals are responsible for what they eat as well as how much they exercise. Individuals have a huge variety of food alternatives and opportunities for exercise, and from this perspective the individuals can choose whatever they prefer. Moreover, if individuals are concerned about the health consequences of food served in restaurants, they can eat at home.

The counterarguments center on the possibility of addiction, deceptive advertising, and societal pressures. The last is part of a broader issue of “the victim society” which views people’s problems as a result of the society in which we live. The addiction issue will be difficult to establish in court, since there is little research on food addiction. The issue of deceptive advertising is more difficult because people differ in their conception of what is deceptive. At one level McDonald’s does not make health claims about its foods, but at a different level its recently adopted Healthy Lifestyles initiative may suggest that some menu items are better for health than are others.

The logic of the law of liability The first issue is whether strict liability is applicable to obesity cases. The answer could vary across the states. Another relevant issue is what defenses, such as contributory negligence, are allowable. Although a tort case seems likely on obesity, a judge could dismiss a lawsuit if the defense cannot provide evidence on the link between fast food and obesity. This may be the reason that Banzhaf above mentions that they would like to find a plaintiff who ate at McDonald’s every day. It would be interesting to see what such a person ate at home.

The Restatement (Second) of Torts appears to provide some protection to McDonald’s under the strict liability standard. The Third Restatement provides more protection. The plaintiff’s attorney will allege that the menu items were unreasonably dangerous and that warnings were inadequate.

Certainly, consumers were not fully aware of the details, such as cholesterol and fat content, of

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menu items, so it is not inconceivable that warnings were not adequate. However, if the warnings were found to be inadequate, eating fast food would have to be linked to obesity and health impairment. (Lawyers could also file a lawsuit on behalf of a client who feared impaired health because of eating fast food.) Moreover, a judge or jury could compare fast food with fresh or processed food served at home.

Lawsuits could also be filed on other grounds, such as deceptive advertising. One unknown factor in such cases is whether compensation would be due for actual losses or as well for pain and suffering and whether punitive damages could be awarded. Punitive damages seem unlikely, since negligence would have to be proven.

This is new legal territory, so it is difficult to predict what will happen in court.

What should McDonald’s do?

Certainly, McDonald’s should contest the current lawsuit and any others that are filed. How far McDonald’s will choose to go is unclear, but a reasonable approach would be to establish a reputation for being tough on obesity lawsuits. This means taking them to trial and increasing the cost to the trial lawyers who will finance the lawsuits. As Banzhaf indicates, the trial lawyers will plaintiff shop.

An important issue is what the general public thinks about the responsibility for obesity. Perhaps a useful analogy is to the lawsuit filed by the woman burned when holding an open cup of McDonald’s coffee between her legs when riding in an automobile. A jury held for the woman, but the public largely ridiculed the decision.52 Another issue is whether the trial lawyers will be able to qualify for a class action lawsuit on obesity. McDonald’s will benefit from the 2004 legislation requiring most class action lawsuits to be tried in federal rather than state courts. This will prevent the trial lawyers from venue shopping.

Indeed, McDonald’s may support class action status for this reason.

McDonald’s should quietly support the cheeseburger bills. This should be low profile and behind the scenes. Of the 25 states in which it was introduced, 13 states had passed the cheeseburger bill.

State legislative progress can be obtained form the National Conference of State Legislatures.

Search on “Food Vendor Lawsuit Immunity.” A few states enacting the cheeseburger bill would not significantly deter lawsuits in other states. The chances of the cheeseburger bill passing in the U.S. Senate were slim.

McDonald’s liability insurance costs will surely increase as a result of the threat of obesity lawsuits.

In a much-publicized case in the 1990s a jury awarded $1.5 million to a woman who had been scalded after she put an open cup of McDonald’s coffee between her legs as she rode in a car. The award was overturned on appeal, and the case was settled out of court for an undisclosed amount.

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Developments Morgan Spurlock’s film was a major success at the box office.

McDonald’s is very serious about its healthy lifestyles menu. McDonald’s is now the largest seller of salads in the United States. The company continues to offer its regular menu items, and its approach is to offer the consumer a choice, such as a side of french fries or apples. McDonald’s has eliminated its super size menu offerings.

The healthy lifestyles strategy may have provided its competitors with an opportunity to go after the company’s traditional customer base. Hardee’s introduced a giant omelet, and its breakfast sales were reported to have increased 22 percent. Other competitors began to advertise huge hamburgers.

McDonald’s now provides on the back of tray liners additional information on the content of its menu items.

A study published in the New England Journal of Medicine in 2005 suggested that the current generation of children may have a shorter life expectancy than the previous generation.

No major class action lawsuit has been decided.

It remains unclear whether the social costs of obesity are borne primarily by the obese person rather than by others.

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Chapter 13

Information Industries and Nonmarket Issues This chapter presents selected topics pertaining to information industries and in particular to the Internet and electronic commerce. Although the dotcom bubble burst, the opportunities in the information industries remain substantial and considerable growth can be expected in the future.

The topics include the economics of winner-take-most markets, Internet privacy, tax policy, and online communities. Cases are available for each. The economics of winner-take-most is intended to be used in conjunction with The Microsoft Antitrust Case in Chapter 9 and with the eBay cases in this chapter. The Chapter 18 case Sophis Networks and Encryption Exports also involves an information industry. The Google cases in Chapters 1 and 16 involve nonmarket issues associated with Internet services.

The PowerPoints for the Microsoft Antitrust Case provide a summary of the economics. The online auction market also has the characteristics of winner-take-most markets, as discussed in this chapter, and eBay has been the winner. Additional information on the economics of information industries is available in Shapiro and Varian (1999).

Internet privacy is an issue that can be discussed from the perspective of a company, DoubleClick, attempting to deal with the issue in a charged environment. The DoubleClick and Internet Privacy case can also be discussed from a normative perspective, and the PowerPoints include an analysis of privacy rights. The Internet privacy issue is also the focus of the Chapter 15 case The European Union Data Protection Directive.

A number of companies have worked to develop an online community and none as successfully as eBay. This manual elaborates on the concept of a private ordering and identifies the incentive problems associated with the remote and anonymous trading. Additional information is provided about the historical context for the eBay: Private Ordering for an Online Community case.

Cases DoubleClick and Internet Privacy PowerPoints are available for this case.

By acquiring Abacus Direct, DoubleClick sought to gain a competitive advantage by merging its Internet browsing data with the personal information on individuals obtained by Abacus Direct.

The uproar over the planned merger of the data bases and DoubleClick’s subsequent reversal left

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the two data bases separate. Hence, the synergy DoubleClick had hoped to benefit from had disappeared. Whatever premium it had paid for that synergy had been wasted.53 Moreover, the DoubleClick name would be associated with Internet privacy for a long time. Fortunately for DoubleClick it is a B2B company and not a B2C company.

If the focus of the discussion is on strategy and dealing with a public uproar, the following plan could be used.

1. Analyze how information was collected by DC and Abacus Direct before the merger.

2. Consider how the information would be combined and how doing so would add value for advertisers. A 2x2 matrix could be used here with one dimension on what the data are about (transactions or browsing) and the other on identification (anonymous or PII (personally identifiable information)). Companies such as PayPal and BillPoint allow anonymous transactions.

Abacus Direct is in the PII-transactions cell, DC is in the anonymous-browsing cell), and Abacus Online would be in the PII-browsing cell bring together the other two cells. See the PowerPoints.

3. Is this a good market strategy?

4. What is objectionable about what DC, Abacus Direct, and Abacus Online do? Why was there no uproar about Abacus Direct prior to the merger? The answer is that Abacus Direct may have escaped attack but there were many laws enacted to protect privacy indicating the sensitivity of the privacy issue.

5. What are the protections DC planned for Abacus Online? What are the claimed benefits of Abacus Online?

6. What were the activists’ strategies?

7. Is this an attractive issue for the news media?

8. Should O’Connor and DC have anticipated this?

9. What do the activists want?

10. Why not just do what they want? The answer is that opt in would kill both Abacus Online and DC, since few people would make the effort to opt in.

11. What should DC do about the FTC investigation? Does DC have anything to help the FTC do its job (as it sees it)? Yes, it places ads on many Web sites and could refuse to place them if the sites did not have an adequate privacy policy. Moreover, NAI was formed to make this an industry issue, and it is the proper vehicle for negotiating a policy with the FTC. 12. What should DC do to restore confidence in the company and its line of business?

13. Is providing online privacy easy or hard? Why is not technology the solution to any problem?

14. Can Internet users protect their privacy—just as they provide security in their homes?

15. Can self-regulation work in the United States? What should be its components?

16. What organizational steps if any should companies take regarding Internet privacy? For example, should companies have a chief privacy officer?

17. Under what conditions would you relaunch Abacus Online?

I have used the following preparation questions in an assignment for a session focusing on strategy: 1. What is DoubleClick’s market strategy in acquiring Abacus Direct? Is it a good market strategy?

2. What are the nonmarket issues DoubleClick faces once Abacus Online is revealed by USA Today?

3. How serious are the objections of the activists to DoubleClick’s Abacus Online?

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The bursting of the dotcom bubble occurred considerably after the acquisition.

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4. What should DoubleClick do to restore public confidence in itself and the services it provides?

5. What should e-Commerce companies do with regard to the FTC’s request for new regulatory powers?

6. Is self-regulation workable and sufficient to provide an acceptable level of privacy on the Internet?

7. Should the broad privacy rights established in the European Union be adopted in the United States? Worldwide?

If the focus of the case is on privacy, the following questions might be asked.

1. Is Kevin Ryan right at the end of the case that users will become accustomed to data tracking as they did to using credit cards?

2. Or, what is the problem here? Abacus Direct has been collecting this sort of information for decades.

3. Is the problem DoubleClick or is it Abacus? Why hasn’t there been an uproar about Abacus?

Answer: Abacus Direct obtained data only on purchases. DoubleClick collects information on browsing—and that could be much more invasive. (Note that browsing involves a single party, whereas a catalog purchase involves two parties, where is a question about who has rights to the data on the transaction. Note that the user has no relationship with either Abacus Direct or DoubleClick, whereas the user chooses to have a relationship with a seller.) To merge the data on a person, the person would have to self-identify so that a name could be associated with the data obtained from the cookie.

4. What are the objections to Abacus Online from the perspective of ethics systems emphasizing rights and justice? (See Chapter 21.)

5. Is this an issue unique to DoubleClick and the particular business it is in? Answer: It has happened to AOL, Intel, Real Networks, Lexis-Nexis, and surely many other companies as well.

Moreover, many laws pertaining to privacy in other industries have been enacted, indicating the importance of privacy.

6. Privacy on the Internet. Is this just an issue of assuring users’ confidence in the Internet so as to increase traffic, which benefits everyone? That is, confidence in the privacy of transactions and browsing is a public good. Or does this involve a serious moral concern? From the latter perspective this can be viewed as a case of ethics as self-regulation.

7. What are the dimensions of privacy? One pertains to personal identification of users. Another pertains to the surveillance of users’ surfing activities. Another pertains to profiling, which consists of a statistical or artificial-intelligence derived description of a person’s characteristics, habits, preferences, and behavior.

8. What should be DoubleClick’s objective at this point? (a) Quell the uproar. (b) Obtain a policy or an industry practice that allows DoubleClick to realize at least some of the benefits of its two databases.

9. Why isn’t an opt-out policy sufficient?

10. Should consumers have access? To their personal information or to their profiles as well?

TRUSTe requires access to personal information.

11. Discuss the NAI’s negotiations with the FTC. Would you enter into negotiations with the FTC? What if the FTC and the Clinton administration asked you not to place ads on sites that did not maintain adequate privacy policies? (Would this be putting you in the role of a police officer?)

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What if the FTC demanded that there be a central gateway to allow users to opt out of all online profiling by NAI members? 12. Should the United States simply adopt the EU directive as its national standard? The Nonmarket Environment B2B is a much larger market than B2C, but which is more likely to drive Internet policy? (Or will Internet policy be differentiated between the two markets?) One line of argument is that B2C will drive policy. First, B2C is closer to the voter. Second, it is more costly for consumers to deal with privacy issues than it is for businesses.

That is, collective action costs are higher for voters, consumers, and Internet users than they are for business. Therefore, businesses should be able to use bargaining to resolve issues. Third, activists and advocates are involved more with B2C issues. Activists lower transactions costs. A major issue for Internet companies is to avoid the enactment of a myriad of Internet regulations by individual states. Moreover, some states want opt in rather than opt out requirements. The National Coalition on E-Commerce and Privacy has been opposing state legislation. The Coalition includes GE, Fidelity Investments, Visa USA, State Street Corp., in addition to those listed in the case. Schwab was reported to be organizing online brokers to oppose state legislation. The Financial Services Coordinating Council, which included the major banks, insurance companies, and securities firms, also opposed state initiatives. The financial services companies were required to notify their customers of their privacy policies and give them an opportunity to opt out and are prohibited from sharing their personal data with marketers.

(These requirements were contained in the 1999 legislation.) One objection to DoubleClick’s system was that consumers were never told what would be done with the data. Some consumers also did not know that their browsing was being tracked. Moreover, the identifier of consumers is persistent, and the user had not entered into a relationship with the company, as it does when making a purchase on the Internet. Moreover, the average consumer does not know of DoubleClick’s existence. Collecting click-stream data has been labeled surveillance, eavesdropping, and wire tapping. The comment that this was like putting a “bar code” on a consumer’s back captures the sentiment. Whether any actual harm would have come from Abacus Direct is unclear, but the alarmists had an easy time making claims about possible abuse. By 2005 the Internet privacy issue was drawing little attention, and privacy activists had turned to other issues such as security, RFID, and Google’s Gmail.

Policy Alternatives for Internet Privacy

1. Individuals protect themselves. Users can protect themselves through a growing variety of means. If there is a demand for such means of protection, the market will supply them. The usual criticism of this alternative is that unsophisticated users will not avail themselves of these alternatives and that lower-income individuals will not be willing to pay for the means of protecting themselves. Many of the suppliers of privacy software have failed.

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2. Voluntary consent; i.e., giving users the entitlement and requiring opt in. Individuals can in a limited manner sign away certain rights to privacy in exchange for compensation.

3. Self-regulation by ISPs. ISPs can establish policies and build credibility for following those policies. This has proven to be successful.

4. Government regulation. This would likely involve FTC rulemaking plus new legislation. State attorneys general could also get involved.

5. Courts. Using individual and class action lawsuits would discipline those considering violating privacy principles. This could require a statute to clarify rights and the basis for lawsuits.

The Market A number of other companies also collected offline information. 24/7Media, a rival to DoubleClick, has a database of 24 million consumers. Experian Direct Tech has buying information on 58 million households collected from 500 catalogers. Polk Co. has demographic and lifestyle data on 111 million households. Cogit.com offers anonymous profiling based on offline data from Polk and data collected from cookies it deposits on users’ hard disks. Many other companies profiled users based on click-stream data. Engage has a database of 42 million anonymous profiles obtained through AudienceNet, a collection of Web sites.

Virgin Entertainment, part of Richard Branson’s Virgin Group, offered Web surfing machines estimated to cost $300 to $500 to consumers if they agreed to provide personal information and to receive targeted ads. CEO Glen Ward said, “Getting hold of a customer’s name can be costly.

This is a more cost-effective way of doing it.”54 A new niche industry referred to as “permission-based marketing” centers on providing personalized information services in exchange for extensive personal information, with the understanding that targeted advertising would be received. LifeMinders.com has 11 million subscribers who provide information on income, savings, children, pets, cars, recreation interests, etc. In exchange users receive reminders, notices, and tailored advertising; e.g., dog food ads to dog owners. Other companies in this niche include WinWin.com and MoneyforMail.com.

The question then is, “If people are willing to sell their entitlement for so little, can the privacy issue really be that important?” The answer is that the “price” varies considerably among individuals. For many, the price seems to be low.

The Platform for Privacy Preferences (P3P) developed by the World Wide Web Consortium appears not to have gone as far as had initially been anticipated. P3P was unveiled at the White House, which installed it on its Web site. On the day of the unveiling, EPIC released a report criticizing P3P. When P3P was unveiled, Youpowered introduced software called Orby Privacy Plus that allows Internet users to choose four P3P settings: private, cautious, trusting, and open.

A potentially important market development is web sites that are blocking cookies. For example, IBM prohibits advertisers from collecting data on its advertising campaigns on other web sites.

P&G blocks its ad agency MatchLogic from collecting information on its site. GM designed a “super cookie” that is deposited on a user’s computer along with a cookie from a GM banner ad.

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The super cookie keeps the browsing data away from the online advertising service, reserving it for GM’s use.55 DoubleClick planned to enter the China market in 2000 with a Chinese partner (necessary to obtain a license). Seventeen percent of its revenue was from Asia in the first quarter of 2000.

Legislation and private initiatives The NAI entered into negotiations with the FTC to develop a set of principles for online information collection and profiling. Since the network advertisers had contracts with more commercial sites on the Internet, the FTC sought to use them to form improved practices on sites.

One proposal being negotiated was for network advertising firms to pledge to do business only with firms that abide by their privacy practices. This might have some leverage, since those sites would lose advertising revenue. Another aspect of the negotiations pertained to enhanced notice to users.

Negotiators were also discussing having a central “gateway” page that would allow users to opt out of all profiling by NAI companies.

The NAI and the FTC reached an agreement in which the NAI pledged to help the FTC deal with privacy concerns. The conditions agreed to are presented in the PowerPoints.

Federal legislation addressing the Internet privacy legislation was possible but none has been enacted. Many bills have been introduced in Congress, and in 2000 the leading candidate for passage was the McCain-Kerry bill. After the new Congress and administration took office in 2001 the concerns about Internet privacy waned somewhat, and the authors chose to assess the likelihood of passage before reintroducing the bill. After September 11 the focus in Congress shifted to stopping terrorism, and the potential conflict between protecting privacy and obtaining information on terrorist plots caused Internet privacy initiatives to be put on the back burner. Meanwhile, many Internet sites had strengthened their privacy policies. By May 2002 some members of Congress began to reexamine the Internet privacy issue. Information on the McCain-Kerry bill is included in the PowerPoints for this case and discussed in the chapter.

Building Public Confidence Public confidence is often needed because of unknown attributes of a product or service. For example, under what workplace conditions were a pair of Nike shoes produced? Is one’s bidding on online auction Web sites private (eBay)? What is the quality of this product (does it include genetically-engineered food)? Some of these matters are purely market issues, but others involve nonmarket considerations.

Mechanisms for establishing public confidence: 1. Reputation. a) Individual buyers and sellers on eBay can establish reputations. These reputations are established through feedback by trading partners. b) Companies can make public pledges that allow others to hold them to their promise.

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(1) An example is DuPont’s public pledge to cease production of CFCs if scientific evidence showed that they caused ozone depletion.

(2) Another example is the “pledge” by the CEO of DoubleClick not to include personal information in its databases that could identify an individual!

(3) Some supermarkets sell only rGBH-free milk products and rely on suppliers to certify that they do not use the hormone. (This is a rather weak way to build a reputation.) c) Companies can establish records of honoring promises.

2. Auditing a) Hiring an external party such as PricewaterhouseCoopers that has its own reputation to maintain. The last part is important because the auditor is being paid by the company it is auditing.

3. Establish a position with assigned responsibility. a) DoubleClick created the position of Chief Privacy Officer. b) Establish a committee of the Board of Directors to oversee a policy or practice. c) Formulate policies and train employees to follow and honor them.

4. Establish an independent organization to oversee/monitor company policy. a) Footwear and apparel manufacturers along with activist and nonprofit organizations established the Fair Labor Association to address sweatshop issues. The manufacturers have positions on the FLA Board. b) Predictive Networks established an Independent Privacy Board. c) DoubleClick established an independent privacy board.

5. Accept monitoring/auditing by an organization created by opponents. a) College students (backed by labor unions) established the Workers Rights Consortium to monitor footwear and apparel manufacturers. Quite a few colleges and universities have joined the consortium.

6. Economic incentives. a) Companies respect rules because violations are subject to penalty; e.g., lawsuits.

7. Resignation of those responsible. This is common in Japan in the aftermath of a major scandal or failure. This increases the cost to management of making a mistake or violating a policy. (In Japan the resignations appear to be only from the offices held with the individuals remaining with the company.)

DoubleClick’s Attempt to Recover In an op ed article in The Wall Street Journal, Kevin O’Connor argued, “The future of a free Internet must involve both the protection of individual online privacy and the ability of online advertisers to compete and deliver effective ads.” His public statement in the italicized heading of the case is carefully stated to allow DoubleClick to revise its new policy when “government and industry privacy standards” are in place.

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In early March DoubleClick took steps to fulfill its privacy initiative and address the skepticism among activists and some consumers about the use of its databases. It announced a five-point privacy program that included an Internet Privacy Education Campaign to inform consumers of their privacy rights and about how they could avoid having their Internet activity tracked. It announced that it would take out 50 million ads to urge Internet users to go to www.privacychoices.org to learn about the company’s data collection practices and their privacy options, including a new and simpler procedure to opt out of online profiling. Information on the program is included in the PowerPoints.

President Kevin Ryan said, “DoubleClick has led the online advertising industry in providing Internet users with notice and the choice not to receive targeted ads. Today, we are taking even more steps to educate consumers about their privacy rights, give them the choice to opt out and make the Internet a more secure environment for everyone. We are asking every Internet user to go to privacychoices.org, learn about privacy, and then make an informed choice about whether you want to receive the benefits of personalized ads.”56 Marc Rotenberg, of the Electronic Privacy Information Center, responded, “They’re launching a major ad campaign because they’re trying desperately to avoid legislation.”57 Jason Catlett, Junkbusters Corporation, criticized DoubleClick for “treating privacy as a public-relations problem.”58 In addition to adopting a privacy policy, the company created the position of Chief Privacy Officer and named Jules Polonetsky, New York City’s Consumer Affairs Commissioner, to the post.

DoubleClick also created a Privacy Advisory Board and named Robert Abrams, who had served as attorney general of the State of New York for fifteen years, as chair. DoubleClick also hired PricewaterhouseCoopers, LLP to “conduct an independent audit so that consumers may be confident that DoubleClick is living up to its privacy policies.”

In early April 2000, 26 companies, including DoubleClick, Broadvision, American Airlines, KPMG Consulting, PricewaterhouseCoopers, formed the Personalization Consortium to focus on privacy concerns. “Privacy is important; if the wrong set of dominoes falls, it could hurt the companies involved,” said an executive with one of the members. A partner in PricewaterhouseCoopers said, “We don’t want to force a given policy on every company.”59 The Consortium planned to give a seal of approval if companies notify consumers about what personal information is being collected, to make opt out easier, and to require Web sites to conduct an annual audit of their privacy practices.

DoubleClick also participated in the Privacy Leadership Initiative along with IBM and the Direct Marketing Association. On June 14, 2000 the Initiative announced that it would launch a consumer education campaign and would formulate privacy principles.

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The New York Times 58 , February 17, 2000.

The Wall Street Journal 59 , April 10, 2000.

Information Week 57

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In the wake of the DoubleClick episode Business Week, March 16, 2000, called for government privacy legislation based on four principles: clarity, choice, disclosure, and enforcement.

Jules Polonetsky, DC’s chief privacy officer, said, “Companies are learning from the missteps of the past year, and are obligated to bake privacy into the infrastructure of their new products lest they face the wrath of the critics.”60 Miscellaneous comments O’Conner said, “There are some people on the Internet who want to go back to the old days when there was no advertising and it was government controlled. We believe that [the Internet] is a tremendous thing and that it should be free. That means it is going to be funded by advertising.”61 DoubleClick’s opt out policy was available on its own Web site and required a user to read a 730work legal notice and a 294-word description of cookies before opting out.

DoubleClick explained in its opt out policy statement why a user should not opt out:

DoubleClick believes all users should have a positive Web experience. Because of this belief, we allow advertisers to control the frequency (the number of times) a Web user sees an ad banner. We also deliver advertising based on a user’s interests if that user has chosen to receive targeted advertising. We believe that frequency control, and relevant content makes advertising on the Web less intrusive by insuring that users are not bombarded with repeat and irrelevant ad messages. Opting-out removes our ability both to control frequency of exposure to individual users and to increase the level of relevant content.62 To illustrate the sensitivity of the privacy issue, the complaint filed with the FTC by the Center for Democracy and Technology mentioned Kozmo.com, and immediately upon the filing Kosmo announced that it would not release data to DoubleClick unless a user has given express permission. Marc Rotenberg commented, “The flipside of targeted marketing is a form of digital redlining—in other words, some people do not become aware of commercial offers because the information that marketers have about them indicates they are not interested in these products.”63 One could distinguish between the external policy—a stated policy/pledge to consumers accompanied by certification—and the internal policy; i.e., how employees are trained and company activities guided and where responsibilities are located (e.g., a CPO).

Stress that what you say in public can be taken by others as a pledge. So, be careful what you say, and only say what you will be willing to live up to. Make the point that external groups can hold

60

The New York Times, September 4, 2001.

The Guardian, February 25, 2000.

62 privacychoices.org 63 Financial Times, March 3, 2000.

61

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you to your word. Even if O’Conner had not made the pledge, however, the activists would have aggressively attacked Abacus Online.

[Internet speak uses the term “space” to refer to the type of activity in which a company is engaged.

DoubleClick is the leader in its space, and eBay is the leader in its space.] DoubleClick’s space may be labeled “network advertising services.”

DoubleClick apparently had difficulty enlisting companies in Abacus Online.

DoubleClick faced 16 class action lawsuits. O’Conner said, “Every Internet company right now that is financially healthy has class actions against them. We think they are baseless and we’re going to fight them.”64 The Toysmart case mentioned in the chapter raises the issue of how credible is a company’s privacy policy. Is the privacy policy to not share personal information unless the company (1) goes bankrupt, (2) merges with another company, or (3) changes its mind? The Yahoo! example below is in category (3).

Developments DoubleClick has a different privacy policy for each European country. For example, in Germany it does not use cookies.

NetCoalition, which plays a role in the eBay and Data Protection case in Chapter 12, took a position opposing the FTC’s call for legislation, calling it “premature.” NetCoalition argued that the industry was making progress on the privacy issue.

In October 2001 the FTC announced that it would not seek legislation giving it new powers to regulate online privacy. The Chairman announced that the commission would increase its enforcement efforts by 50 percent. He also announced that the FTC would create a national “do not call list.”

In January 2001 the FTC dropped its investigation of DC concluding that there had been no violation of its privacy policy because data from the two sources had never been merged. Marc Rotenberg of EPIC criticized the FTC because EPIC’s complaint was broader than the Abacus Online matter.

The Gramm-Leach-Bliley Act took effect in 2001 and limits the sale and use of financial data. This Act has been an instrument in the U.S. negotiations with the European Union over data privacy.

See the Chapter 15 case The European Union and Data Privacy.

A Federal judge dismissed one class action lawsuit against the company. In March 2002 DoubleClick settled the remaining class action lawsuits filed by consumers. DC agreed to pay up to $1.8 million in lawyer’s and other fees. It also agreed to give consumers “conspicuous notice” and to use opt-in if it planned to sell personally-identifiable information. It also pledged that any

64

, June 26, 2000.

The Wall Street Journal

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new cookies would have a life of no longer than 5 years. The case filed by the California woman was still in process.

In March 2002 DoubleClick’s privacy policies were certified by TRUSTe, and its site displayed the TRUSTe seal. DC and TRUSTe also announced that they were joining together to promote privacy certification for Web sites. DC planned to recruit advertisers, marketers, and Web publishers for TRUSTe certification.

Internet users may not be as concerned about privacy as the activists claim. One poll of Internet users found that 41 percent were willing to provide their personal data in exchange for a $100 gift certificate. A DoubleClick executive commented that consumers were not willing to spend the $20 or so to buy software that would mask their identity. He claimed that the companies offering such software were going out of business because of a lack of demand.

Many companies recognize that information on their customers can help them improve and target their marketing campaigns. Companies have been reluctant to share such information with companies such as DoubleClick and have blocked the tracking of visits to their sites. Instead, the companies track the visits and keep the data within the company. Related to this, one explanation for Microsoft’s scrapping its plans for .Net My Services was that the holders of information did not want someone else controlling access to their customers.

Reflecting the value of this information, Yahoo! announced in 2002 that it was changing its privacy policy so as to better target its and its partners’ marketing to AOL subscribers. Yahoo! reset the default settings on users’ preferences for receiving marketing messages, requiring them to “opt out” if they did not want to receive various marketing messages. Privacy advocates howled. (Yahoo! does not sell lists.)

Personal Web pages created using services such as AOL and Yahoo! frequently contain “web bugs,” also referred to as “clear gifs” and “Web beacons,” that transmit information to clients on who visits a Web site. In a 2001 survey web bugs were found on 18 percent of personal Web pages.

DoubleClick explains clear gifs on its Web site.

Spyware and Adware are a current focus of privacy concerns as indicated in the chapter.

DoubleClick and Online Tracking

DoubleClick pledged to Wall Street analysts that it would earn a profit in 2002, and it attempted to do whatever was needed to honor the pledge. For example, in November 2001 it sold its European media unit to a German company. The explanation for the sale was that the unit was losing money and impeding achievement of DC’s pledge to Wall Street. Despite a sharp drop (27 percent) in revenue due to the precipitous decline in online advertising, the company almost earned a profit in the first quarter of 2002 through reductions in its costs. One cost cutting measure was the suspension of its click-stream tracking and profiling service Intelligent Targeting. This enabled the company to reduce its staff. A DC executive explained that even though the company could demonstrate that its ad targeting service was x times better than

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with no tracking, if the client believes that the conversion (to sales) rate with online advertising is epsilon, then x times epsilon is still too small for the client. The company believed that it could have the click-stream tracking and profiling service up and running within six months whenever the market was ready for it.

DoubleClick transformed itself into a technology company and subsequently became profitable. By 2004 when Internet advertising grew substantially, DoubleClick was not the leader in advertising placement. In 2005 DoubleClick sold itself to Hellman and Friedman LLC for $1.1 billion.

DoubleClick Updates Kevin Ryan became the CEO. Articles on DoubleClick’s performance and prospects include: “DoubleClick Keeps Two Steps Ahead of Rivals,” The Wall Street Journal, April 26, 2001 and “DoubleClick Isn’t Deterred by Ad Slump,” The Wall Street Journal, November 5, 2002. One reason DoubleClick survived the Internet advertising collapse is that it has over $600 million in cash. Also, its competitors are failing. Producers of complementary goods are struggling, and DoubleClick has purchased a number of them.

DoubleClick survived the dot.com bust, and transformed itself into a technology company serving Internet advertising. Google acquired the company for $3.4 billion.

eBay and Database Protection PowerPoints are available for this case.

This case raises issues about intellectual property protection using a particular problem eBay faced with an auction aggregator. In the end Bidders Edge was stopped not by intellectual property law but by trespass law, but the broad issue of database protection is addressed nicely by the two bills before the House. The case also has a managerial focus through the choice of strategy by eBay. The chapter case eBay: Private Ordering for an Online Community provides additional information on eBay’s operations. The database protection case can also be used to illustrate the economics of information industries, as considered below and in the chapter. A useful article on eBay is “Meg Whitman and eBay, Net Survivor,” New York Times, May 5, 2002.

It is important to note that eBay has not copyrighted its database although it could do so at any moment.

Auction aggregators are not necessarily bad for eBay, since they may direct incremental customers to eBay. Indeed, eBay pays a small amount to auction aggregators that have reached an accord with it. Similarly, the auction aggregators pay eBay a small amount for access to its Web site.

These aggregators operate much like an eBay user operates. When a customer makes an inquiry to the aggregator, the aggregator then visits eBay’s site, searches for the item, extracts eBay’s response, and provides it to the customer. As the case makes clear Bidders Edge operates quite

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differently and refused to agree to the terms agreed to by the other auction aggregators. Moreover, its robotic copying occupied a substantial amount of eBay’s server capacity.

H.R. 354 was intended to be a limited measure restoring some of the protection that had been eliminated in the Fiest decision. H.R. 1858 was essentially the status quo, although eBay viewed it as worse than the status quo. It was introduced solely for the purpose of blocking H.R. 354, and it was crafted to put it in the jurisdiction of the Commerce Committee.

I have taught this case using the following outline: 1. Intellectual property and the economics tradeoffs; intellectual property law (Chapter 12 and the PowerPoints) 2. eBay’s business model (person-to-person auctions, serves as a venue (avoids the costs of physically handling goods), connects many-to-many, builds a self-regulating community of users, generates information it can use to develop new categories and services, exploits economies of scale and scope, leverages to other countries) 3. How does it monetize its site? listing fees + commissions, promoting affiliated businesses (half.com), advertising revenue 4. Why is its business model successful? gains from trade, development of trust within its online community, network externalities (Chapter 13 and the other eBay case), high switching costs, economies of scale and scope, first-mover advantage, tipping 5. The notion of a private ordering (see below) 6. Special costs; e.g., stopping fraud, possible liability (see Chapter 2 regarding eBay’s positioning in legal space), stopping aggregators.

7. What are the concerns about auction aggregators? creates competition from other sites; benefits other auction sites because they get “equal billing” even though they have far fewer listings; weakens its community; aggregators serve as portals—eBay wants to be the portal; information is stale in the case of Bidders edge; occupies time on eBay’s servers, particularly Bidders Edge 8. How might auction aggregators benefit eBay? (see above) 9. eBay’s strategy for dealing with the current problem

--should it go after Bidders Edge?

--seek a preliminary injunction because likely to prevail on the merits and harm is irreparable --negotiate with Bidders Edge; this is hopeless—eBay has tried --use technology to thwart Bidders Edge; this might work in the short-run but there are always means of getting around a technological fix --use firewalls; no, this would make the site less friendly and convenient to the members of its online community --use other statutes; possible, but eBay believes that a case based on these laws (Digital Millennium Copyright Act, Anti-Hacking statutes, computer fraud laws, state misappropriation laws) is unlikely to be successful; trespass is more likely but eBay must convince the judge that there is irreparable harm; possible hope from the Jurisline case, but that case involved a contract --use federal shields (Communications Decency Act, Telecommunications Act of 1996, court rulings)—this is a long shot --add creativity and originality and then copyright the database; this might run the risk of making eBay an Internet Content Provider rather than an Internet Service Provider (see Chapter 2) 10. Support H.R. 354 and oppose H.R. 1858

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--eCommerce Coalition --coalition with other database producers --should eBay mobilize its online community to support H.R. 354? (this is risky, its community is its most valuable asset) --use political strategies as in Part II --both sides have considerable political strength, so bargaining may be required to resolve the matter; H.R. 1858 is the status quo, so bargaining will be difficult at best.

--focus the argument on “piracy,” the incentives to create new collections of information 11. Debate on H.R. 354 and H.R. 1858 (assign student groups to the roles of eBay and Yahoo! to advocate their respective positions) In the context of the economics of intellectual property protection, H.R. 1858 favors the use of databases and H.R. 354 favors the incentives to create databases.

12. What should eBay do about the position taken by NetCoalition.com?

The arguments in favor of 1858 are: --allows use of data --provides protection for databases --prevents piracy by prohibiting duplication when the duplicate database is sold or distributed in commerce (this seems like a smokescreen since it would be simple to duplicate a portion of a database or release into commerce a slight modification or rearrangement of the database.

--354 would restrict real time stock quotes (this is what the financial services companies want to retain access to) --354 would result in the control of information that would stifle competition --354 threatens the Internet because information could not be readily collected and transmitted --limits access to search engines --James Carney, “This would rip the guts out of the Internet.”

--FTC enforcement would be sufficient (this may limit the ability of the creators of databases to file lawsuits) The arguments in favor of H.R. 354 are: --preserves incentives to collect databases; incentives have to be strong because there are high sunk costs to creating databases --encourages competition among collectors of databases and among collections (the winner may obtain a large prize) --technology erodes value, and hence incentives, through copying --piracy is wrong; the public opposes piracy --piracy threatens economic incentives --if there is a valuable additional use of a database, the collector will have an incentive to license use of the database for that purpose. This is Coase theorem reasoning.

--H.R. 354 allows private enforcement of intellectual property rights; this is consistent with the existing forms of enforcement of patents and copyrights --H.R. 354 provides the strong penalties needed to dissuade pirates; treble damages, loss of profits earned from piracy, and imprisonment --the EU has strong protection and there have not been problems such as those alleged by H.R. 1858’s supporters; business has not been hurt --H.R. 1858 would widen the gap between the U.S. and the EU

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One aspect of the database protection issue is what constitutes a database. It seems clear that eBay’s listings constitute a database, but what else is included. Maurer and Scotchmer state, “Scholars have been troubled by the fact that the core concept of a ‘database’ is essentially limitless. (J.R. Reichman and P. Samuelson, Vanderbilt Law Review. 50, 51 (1997)) H.R. 354 tries to remedy this defect by limiting protection to information ‘collected …for the purpose of bringing discrete items of information together in one place …so that users may access them.” However, this standard still literally includes such unlikely ‘databases’ as nonfiction books and movies, both of which ‘bring discrete items of information together in one place.’ Congress has relied on judges’ common sense to resolve similar ambiguities in the past.”65 They conclude, “Nevertheless, H.R. 354 could lead to sweeping changes throughout intellectual property law.” Their conclusion is quite different from that of the supporters of H.R. 354, who view it as a common sense and modest measure.

The Economics of winner-take-most markets—eBay The economic concepts presented in the chapter for understanding certain information industries can be illustrated by the case of eBay. eBay was in effect the first-mover in online auctions, and the network externalities were powerful. Demand-side economies of scale were present on both the buyers’ and the sellers’ sides of auctions. Those economies were stimulated very effectively through the development and support of trust. Trust allowed the community to grow, and collective lock-in helped retain that community. This allowed positive feedback to develop, and the market tipped in its favor. This effectively shut out competitors, although it is possible that Amazon.com or Yahoo! Auctions might eventually be able to successfully compete in the online auction marketplace. eBay expanded its scope through broadening the set of auctions it hosted and by allowing sellers to personalize their offerings. This strategy was successful in generating steady growth in revenue and profits. What eBay had not done was to take advantage of compatibility economies such as attracting complementary products. The chapter discusses its strategy to attract complementary products and programmers.

To elaborate on the positive feedback, the first-mover in this market attracted some buyers and sellers. As importantly, it had more buyers and sellers than did other sites. The larger number of buyers attracted sellers, and the larger number of sellers attracted buyers. This allowed for positive feedback to develop, and the community grew. eBay also benefited from collective lock-in, since it was very difficult to coordinate a collective move to another auction site by the traders in a particular item. Moreover, any individual seller risked losing access to the large number of customers. The sellers were thus in a prisoners’ dilemma. The same is true of the buyers, although they have more flexibility to visit other auction sites, since they only bear search costs of doing so.

Once positive feedback and collective lock-in occur, it is very difficult for competitors and new entrants to succeed.

65

Stephen M. Maurer and Suzanne Scotchmer. “Database Protection: Is It Broken and Should We Fix It?” , Science www.sciencemag.org.

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First-mover advantage As an example of the power of the first-mover advantage in developing an online community, Yahoo! auctions was the first to enter Japan through a joint venture with a Japanese partner.

Yahoo! Auctions Japan became the market leader with a high share, similar to eBay’s share in the United States. eBay entered the Japanese market and was unable to make substantial headway against Yahoo! In 2002 eBay gave up and announced that it was leaving the Japanese market. In March 2002 eBay bought EachNet, an online auction service in China. eBay hoped to become the dominant online marketplace in China. In the spring of 2002 Yahoo! announced that it was withdrawing from the European market because of its low market share. Yahoo! said that it would promote eBay’s auctions.

Database Protection in the European Union In 1996 the EU enacted a strong data protection directive (96/9/EC, O.J. (L77) 20 (1996)) that prohibits unauthorized copying of databases. This is a limited (15 year) sui generis property right.

According to eBay, this has not diminished the building of databases in the EU. In response to the claims of the opponents of the database protection, eBay argued that the EU experience is evidence that H.R. 354 would not chill the development of databases in the United States.66 One important aspect of the database protection issue is what constitutes a database. From eBay’s perspective it would be happy with a narrow definition of a database sufficient to protect its listings and compilations.

Court cases related to eBay’s data protection issue Jurisline.com and Reed Elsevier (Lexis) and Matthew Bender & Co. settled their lawsuit on June 20, 2000. “Jurisline has agreed to replace all materials obtained from Reed Elsevier and Matthew Bender with materials from other public sources.” Jurisline apparently lost this case and lost it largely because it had entered into a contract with Lexis when it obtained the CDs. In Ticketmaster v. Tickets.com the U.S. District Court, Central District of California, decided on August 10, 2000 not to issue a preliminary injunction against Tickets.com. Tickets.com used “deep hyperlinking” to extract ticket data from Ticketmaster’s database at the event level. The judge concluded that Ticketmaster did not meet the circumstances cited by the judge in the eBay case.

Despite not issuing a preliminary injunction the judge stated that “the copyright and trespass theories” “may well prove decisive at trial although the court does not now consider them sufficient for a preliminary injunction.” I am not aware that the case ever went to trial. Tickets.com subsequently filed an antitrust case against Ticketmaster.

Developments Instead of addressing the copyright issue, the trial judge ruled that Bidders Edge’s robotic search had trespassed on eBay’s website and reduced its server capacity. eBay had posted notices that it prohibited robotic searches, and it also policed its site to stop such searches. (Bidders Edge not only refused to respect the notice, but it used a variety of remote servers to disguise its searches.)

66 Maurer and Scotchmer provide an early analysis of H.R. 354 ( Science , www.sciencemag.org).

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The judge also concluded that this trespass injured eBay by occupying a substantial amount of its server capacity. The judge issued a temporary restraining order prohibiting Bidders Edge from using its search techniques. Bidders Edge responded to the order by placing an eBay button on its site. Clicking the site took the user to eBay’s site, just as if the user had entered eBay’ site when s/he logged on. Bidders Edge thus had lost whatever niche it might have had. The company began to wither away and disappeared.

Both H.R. 354 and H.R. 1858 were sponsored by Republicans and reported by committees on which Republicans were the majority. The Republican House leadership wanted to avoid a floor fight on the two bills because it could be harmful for the party. Neither bill was introduced in the 107th Congress so as to give the chairs of the two committees (Bliley had retired) time to negotiate an agreement on compromise legislation. September 11 caused the committees to turn to other issues, and the issue has remained unresolved.

eBay: Private Ordering for an Online Community This case has two purposes. One is to consider the concept of a private ordering. The other is to consider the development of a community of economic agents, the incentive problems inherent in remote and anonymous trading, the role of reputation and feedback in supporting trust, and the measures a company can take to supplement a reputation system. Additional information about eBay’s positioning in legal space is given in Chapter 2. The chapter case eBay and Database Protection and the discussion in this Manual provide additional information. A useful article on eBay is “Meg Whitman and eBay, Net Survivor,” New York Times, May 5, 2002. Ebay’s success has continued.

A private ordering is a pattern of behavior that allows individuals to rely on others in social and economic interactions. A useful perspective is to note that most economic transactions are not governed by explicit contracts or regulated by the government. In most cases people rely on others—both their words and their deeds. The law is used only where there is a serious dispute, and most lawsuits are settled outside of the courts without going to trial. This reliance is supported by the basic honesty of most people and by the incentives provided by repeated dealings with other economic agents or within a community of economic agents. This reliance, of course, takes place in the shadow of the law, since people have the option of turning to the courts. The eBay community of traders has a private ordering that has been supplemented by mechanisms (e.g., dispute resolution) and policies (e.g., insurance). Understanding how this ordering and its supporting institutions address the incentive problems inherent in remote and anonymous trading provides an important framework for managerial analysis. An analysis of this ordering is provided in David P. Baron, “Private Ordering on the Internet: the eBay Community of Traders.” Business and Politics. 4:245-274.

The management of a private ordering in support of a community is important to many businesses and other organizations. Online communities are maintained by Yahoo!, AOL, Amazon.com,

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Google, Microsoft (through MNS), and many others such as specialized online markets. eBay faced a variety of problems and has responded with clever mechanisms to deal with them.

The case can be taught in a variety of ways. One is to begin by asking general questions such as what allows this community of remote and anonymous individuals to rely on each other. To explore this more deeply, the discussion should identify the incentive problems and the opportunities to take advantage of others that are inherent in an online market. The next topic could be how a reputation and feedback mechanism deals with those problems. This discussion should identify a set of remaining incentive problems, and the next topic could focus on how eBay dealt with them. The four problems at the end of the case could then be addressed. The discussion could conclude by considering eBay’s overall business strategy and the role of its community in that strategy. eBay views its community as its principal asset. That asset also is what creates opportunities for partnering and for its business extensions.

Four additional decision problems are posed at the end of the case, and eBay’s responses are presented next.

What eBay did to address the four problems Communications To limit the potential for people to get email 67 addresses for inappropriate uses, and thus protect both the company and community, eBay’s first change was to make email addresses available only to those involved in transactions. For sixty to ninety days after a transaction was completed, sellers could access contact information on those who bid on their item and bidders could access the seller’s contact information. Nobody else could access contact information.

A further change was to create an email forwarding tool. When this was implemented, users no longer received the actual email address of the other party. They sent a message to the user ID of the person. eBay took the message and forwarded it to the email address of the recipient. They also included a note at the bottom of the message so that the recipient could notify eBay if the message was inappropriate. Once this step was implemented, users could no longer access email addresses of other users.68 Offline Transactions The limitations on email address availability helped this problem, but it still exists. As recently as June 27, 2001, Meg Whitman was lobbying Congress to include anti-harvesting measures in pending legislation. She noted that software robots were still able to harvest email addresses despite technical efforts to stop the practice.

67

This section was written by David Hoyt. Copyright © 2001 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reproduced with permission.

68 When registering, users chose a user ID. In some cases, a user chose his/her email address, although eBay discouraged this practice. In these cases, others would be able to obtain the email address, but it was the decision of the registrant when choosing the user ID.

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Effective May 31, 2001, eBay revised its listing policy to limit the hyperlinks that sellers put into their listings. The seller could have a link that gave more information about the item, or pictures of the item, but could not link to pages that offered other items for sale.69 Controversial Items In early 2000, eBay revised its policy, and prohibited Nazi-related items that were less than fifty years old. The rationale was that items that were at least fifty years old were of historical value.

However, the listings were not allowed to include hate speech or propaganda.

Then, effective May 17, 2001, eBay revised the policy further, prohibiting the sale of Nazi, Ku Klux Klan and other hate group material, as well as items related to “notorious individuals” who had committed crimes in the last one hundred years.70 The hundred-year limitation on crimes was intended to protect victims and their families, from being exposed to the sale of material that might be traumatic. It was felt that the sale of items related to crimes that took place more than one hundred years earlier would only be of historical interest (such as items related to the assassination of President Lincoln).

Recalled Products When it realized there was a potential problem, eBay removed the listings, and contacted the Consumer Products Safety Commission. Working with the CPSC, they identified categories that might be susceptible to the inadvertent sale of recalled products. When a seller lists an item in one of these categories, there is a pop-up warning that advised him/her about the potential problem, with a link to the CPSC website. This also occurs when a buyer places a bid on an item in these categories.

This program was a tremendous success for all concerned. The CPSC got much more traffic on its site, and problem products were being identified and taken out of circulation. Members wrote to eBay thanking the company for making them aware of dangerous items that they were planning to sell. eBay has established similar programs with other regulatory agencies. They have worked with the U.S. Customs Service to educate people about the import/export regulations that apply when trading with people overseas. They created links to other government sites including: • Department of Fish and Wildlife for information on animal parts, such as tortoise shells, that are illegal to sell.

• U.S. Food and Drug Administration for information about buying medical devices and prescription drugs online, and with information on the sale of used medical devices.

• Environmental Protection Agency, for information about freon.

• U.S. Postal Service for information about hazardous materials and perishables that may be illegal to transport.

69

Nick Wingfield, “eBay cracks down on users who conclude sales outside its purview,” Dow Jones Business News, May 11, 2001.

70 “eBay bans items connected to hate groups,” The Wall Street Journal, May 4, 2001

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In 2008 an animal welfare group reported that thousands of animal products from endangered species were listed on eBay. eBay then banned the sale of ivory products, including antique ivory. eBay worked with the U.S. Fish and Wildlife Service in enforcing endangered species laws.

Fraud remained a problem for eBay. Reportedly, 43 percent of the fraud complaints gathered by the FBI were associated with online auctions. Although eBay said that its fraud rate was very low, it signed an agreement with VeriSign to run background checks on sellers on eBay. The following exhibit is for use with the case or as background information.

Exhibit 1 Legal Issues Related to Operation as a Venue eBay operated as a venue for buyers and sellers to meet and conduct business. Its operation was in most respects similar to a newspaper classified advertising service, although its fee structure incorporated elements of a traditional auction house. In the Internet world its activities were more akin to a service provider than a content provider. These distinctions were important to the potential legal liabilities of the company.

In comparing classified ads and traditional auction houses, a newspaper was not liable for the content of the advertisements and exercised only minimal control over the ads. It could not verify the authenticity of the item being advertised, nor its condition. At most, it could screen those items that were obviously illegal and restrict offensive language or profanity in the advertisements. An auction house, however, had very different obligations and liabilities. For instance, it was responsible for ensuring the accuracy of claims made about the items being auctioned. In many states, auction houses were regulated by state law.

On the Internet this distinction had additional importance, although the laws were complicated and, in some cases, contradictory. The laws impacted eBay’s ability to monitor activity in its marketplace. The law was particularly contradictory when looking at the questions of protecting copyright owners from the sale of pirated materials and protecting the community from fraud.

The operation of eBay as a venue was important with respect to the Communications Decency Act (CDA) of 1996. The CDA stated that an Internet service provider (ISP) was not liable for speech published on its site, whether or not it monitored the site’s contents. This law overruled an earlier court decision that found that if people made damaging, untrue comments, the ISP may be liable.71 Thus, based on the CDA, if eBay was a venue (service provider), and not a content provider, it was not liable for what was listed by its members. The CDA, however, applied only to speech, not to intellectual property.

71

The case dealt with chat board comments about a company that were untrue and may have hurt the company’s stock price.

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Protecting Intellectual Property eBay sought to provide as safe a venue as possible for its community of buyers and sellers. A small percentage of sellers’ listings had the potential for harming that community. In some cases these listings were for items prohibited by eBay’s rules. In some cases, they were for items that were offered fraudulently, or in other cases they were illegal items such as bootleg CDs. Monitoring the site for potential violations was thus desirable. However, due to the enormous volume of sales, it was impractical for eBay to examine every single listing and research questionable ones.

The common sense solution was to monitor where practical, even if it was impossible to ensure that all of problems were discovered. This, however, led to serious legal issues, particularly in the area intellectual property.

A 1996 ruling by the 9th U.S. Circuit Court of Appeals in San Francisco, in the case of Fonovisa, Inc. a v. Cherry Auction, Inc. (“Cherry Auction”) posed potential problems. Cherry Auction was swap meet owner, that leased space to vendors. Fonovisa was an independent Latino recording label. A vendor at Cherry Auction’s swap meets sold pirated copies of Fonovisa recordings.

Fonovisa sued Cherry Auction and the vendor, and the court held that both Cherry Auction and the vendor were liable. The language most relevant to eBay was that “one may be vicariously liable if he has the right and ability to supervise the infringing activity and also has a direct financial interest in such activities.”72 Given the Cherry Auction decision, if eBay had the ability to monitor listings, it might be held liable for copyright infringements on its site. If it took any action to monitor, this may be evidence that it had the ability to monitor, creating a potential liability under Cherry Auction.

In October 1998, the Digital Millenium Copyright Act (DMCA) became law and clarified the issues raised in Cherry Auction.73 Part of this law dealt with issues that had been raised by Internet service providers (ISPs) and telephone companies. They noted that it was impossible for them to monitor all the traffic that crossed their sites and they should not be held liable for what people did on their sites. This was analogous to the argument that you didn’t hold the telephone company liable the for people planning a robbery over the telephone even though the plans were passing over company’s lines.

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ForDMCA the text ofstated the ruling, http://www.law.cornell.edu/copyright/cases/76_F3d_259.htm The thatsee: companies were not liable for copyright violations that took place on 73 The DMCA was the United States implementation of the World Intellectual Property Organization (WIPO) Copyright Treaty of 1996.

their sites if they did not monitor, as long as they removed copyright violating items when notified by 275 from a copyright holder of violations but did the copyright holders. If the ISP received notice not take action, it could be held liable. If an ISP actively monitored for violations, however, it may lose the protections provided by the DMCA. This created a penalty for monitoring, which conflicted with the legislative history of the law, which stated that there should be no penalty for monitoring.

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When this bill was being negotiated in Congress, eBay already had a program in place in which it worked with copyright holders to identify and remove violating materials. Rights owners searched the eBay listings, and notified eBay when they found copyright violations. Once it was notified, eBay removed the item. This program, now called “VeRO” (Verified Rights Owners), was reactive, as it depended on notification from the owners. Thus, as a result of the DMCA eBay did no monitoring and avoided the potential liabilities it could face had it monitored. eBay’s attorneys lobbied the content owners and legislators to provide safe harbor for responsible monitoring. They wanted to be able to look for problems on the site and take action if they found them. If they missed something, they wanted the content owners to notify them, at which point they would remove the violating listing. eBay believes this would be better for the content owners, and for the community, than just responding to notices filed by the content owners. The content community, however, felt that if eBay were able to monitor, it should be held liable for anything it missed. The result was that the enforcement of copyright law on eBay had to be reactive.

In the late 1990s, the Business Software Alliance (BSA), a software industry association, developed a model code of behavior for on-line marketplaces, based heavily on eBay’s VeRO program.

However, the BSA model code added the requirement that all items be prescreened before being listed for sale. eBay declined to agree to the code, as long as it included the prescreening requirement, which eBay believed was impractical. Instead, eBay encouraged BSA members to join its VeRO program.

In 1999 a lawsuit was filed against eBay, (Randall Stoner v. eBay Inc.) based on a California law that allowed people to sue companies for alleged violations of California laws. The suit alleged that illegal, bootleg recordings had been sold on the eBay site. On November 1, 2000 the suit was dismissed, with the judge stating that the CDA provided eBay with immunity with regard to the sale of bootleg recordings sold by third parties on its site in violation of California law, because the listing was regarded as content (generated by a third party), and eBay was a service provider, not a content provider. Since the finding was based on the CDA, it applied regardless of whether eBay monitored.74 In response to this ruling, and a similar ruling in January 2001 in a case involving sports memorabilia,75 eBay initiated a program that took a more proactive role in policing against listings that violated copyrights. Under the “Four Corners” policy, if an eBay support representative could determine, by looking within the “four corners” of a listing (i.e., solely by the material presented in the listing), that it infringed a valid copyright, eBay could remove the item without notice from the content owner. This policy change was based on the immunity granted to service providers under the CDA, which had been the basis for the two rulings. These were trial court decisions, with no bearing outside the specific cases. In relying on these court rulings, eBay believed that other courts would come to the same conclusion.

An interesting wrinkle is the issue of monitoring for fraud, which is described in the case. It could be argued that since eBay monitored for fraud, it could also monitor for copyright violations. This

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The text of the opinion, which was not officially published, can be found at: http://www.2001law.com/article_429.htm.

75 Gentry v. eBay, Inc. The ruling can be found at: http://legal.web.aol.com/decisions/dldecen/gentry.html.

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argument is somewhat strained, however, since looking for suspicious activity based on profiles is very different from ensuring that all items listed on the site are legal copies. In addition to reviewing all listings, eBay would have to maintain a data base of publications, and dates of release, since recordings are released in different countries at different times, and thus the legality of a sale could not be determined solely based on its title. However, before the Stoner and Gentry rulings, it could have been argued that monitoring for fraud created exposure to copyright liability (and could in the future if Stoner and Gentry were overruled, or if other courts ruled differently regarding the CDA protections for service providers).

SOURCE: Copyright © 2001 by the Board of Trustees of the Leland Stanford Junior University.

All rights reserved. Reproduced with permission.

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Part III Integrative Case Credit Card Regulation Most credit cardholders use their cards for convenience, but perhaps a third use them for periodic or regular unsecured borrowing. The latter group has been subject to a variety of fees, practices, and penalty interest rates that have invoked anger. Some practices such as universal default and payments applied to the lowest interest rate balances draw particularly strong criticism.

Cardholders also complained that they had not been informed or in most cases had not understood the terms and conditions accompanying their cards. Even if they had understood, they can still be angry when the face penalties. The fees and higher interest rates provide large amounts of revenue for the card issuers.

Information disclosure is regulated by the Federal Reserve as delegated under TILA, and the regulatory authority also allows the Fed to ban some practices. Congress can also pass new legislation, as it threatens to do. At the time the case is set the Fed has issued preliminary rules, and the comment period was underway. Bills had been introduced in both houses of Congress to restrict the practices of card issuers.

The credit card industry is highly competitive with thousands of firms issuing cards and six major issuers. They differentiate their offers, but it is simple to copy the offerings of other firms, so the differentiation advantages should be competed away. The possible market imperfection is that information may be incomplete or costly to obtain. That is, some cardholders are unable to understand the set of fees and conditions to which they are agreeing, and others do not invest the time to learn the fees and conditions under which interest rates will be adjusted. Greater disclosure and more complete explanations will be subject to a moral hazard problem because cardholders will have more to read and understand and may decide not to read it.

The market imperfection can be addressed by more and better information disclosure presented in a manner understandable to those with a limited education. In principle, informed decision-making should be sufficient, but some practices seem simply to be deceptive, unreasonable, or unfair. One such practice is applying a payment to the balance with the lowest interest rate. It is possible that better disclosure and the ensuing competition would drive such practices out of the market, but that is not certain. Banning certain practices could be efficient if disclosure about those practices would be subject to a moral hazard problem. In any event, this is a politically attractive issue for members of Congress, and many of them will focus on fairness to cardholders.

The predicted effect of restrictive regulations is higher interest rates, higher fees, and reduced credit availability. This will work against those cardholders who use their cards for unsecured borrowing.

Some of those will be unable to get a credit card, and others will pay more. Risk-based pricing will continue to pervade the industry, so the effects will not be felt on the convenience users. Many card issuers are likely to exit the industry if greater restrictions are placed on them.

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With risk-based pricing the cardholders that regularly use their cards for unsecured borrowing will bear the costs of the higher interest rates, higher fees, and restricted credit. Is this just? It probably is, since these cardholders are the ones who supposedly will benefit from the new regulations. The cardholders who use their cards for convenience will likely avoid much of the effects of higher rates.

This is a case with concentrated costs on the card issuers and widely distributed benefits to those cardholders who have been harmed by the current set of practices. Those with widely distributed benefits are very costly to organize, so an effective interest group is unlikely to form. The politics thus are entrepreneurial, and the entrepreneurs in Congress will claim credit for helping that subset of cardholders. The card issuers will lose rents and some will exit the industry. The Fed is not directly subject to these politics but has been directed by the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act to implement new disclosure regulations. The Fed decided that it should take the opportunity to go further and achieve a “new baseline for fairness.”

The following provide brief answers to the preparation questions.

The complaints by cardholders seem to reflect serious irritation. The fact that most people do not use their credit cards for borrowing is unimportant to the outcome of these issues, since there are enough people who are irritated by the practices of the card issuers. With respect to whether regulation or legislation is better, regulation is usually viewed as better because of the expertise of the regulatory agency. Legislation is viewed as best in responding to pressure from interests. In this case it is too late for self-regulation, since good practices by the large issuers will not lead to good practices by other issuers. Moreover, at this point regulation is likely to be too blunt an instrument to distinguish between card issuers with good and bad practices.

With respect to the strategy of a large issuer such as Chase or Capital One, self-regulation in the form of eliminating some practices that draw strong criticism has clearly failed to stop new regulation and legislation. The best that the companies can hope for is to obtain somewhat less restrictive regulations. Many of the restrictions are already incorporated in the current practices of the leading companies. The principal implementation strategy is informational lobbying and testimony when there is an opportunity. The principal messages to be conveyed are that (the severe) restrictions will increase interest rates, increase fees, and reduce the availability of credit cards. These effects will be concentrated on those people with weak credit ratings, whose opportunity to borrow unsecured will be narrowed. The issuers should focus the efforts on information about those proposed restrictions that have relatively few unfairness criticisms and among those the ones that have the greatest profit potential. The issuers should also argue that with the Fed’s likely rulemaking legislation is not needed. This, however, would mean that members of Congress would have foregone the opportunity to claim credit for helping their constituents.

Discussion questions

1. Is there a market failure in this case? What is its nature and how serious is it?

2. Are the complaints due to a failure of cardholders to read all the disclosures provided by the issuers?

3. What is more likely to provide the motivation for the Fed and Congress to act—market imperfections or fairness?

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4. Are the proposed restrictions by the Fed and Congress appropriate responses to the market imperfections and the fairness concerns?

5. What are the likely consequences of the proposed regulations on the credit card market?

6. Identify the relevant interests and the nature of the politics.

7. What should a “good practices” company such as Capital One or Chase do with regard to the proposed restrictions? Should they seek exemptions based on their self-regulation?

How much effect is the company likely to have?

8. What is likely to happen with the Fed’s proposed rules and the Mahoney bill?

Developments As of the time of this writing the Fed had not issued a final rule. The House passed the MaloneyFrank bill on a vote of 312-112, but the Senate was not expected to act during this Congress. The crisis stemming from the subprime mortgage debacle was occupying the efforts of Congress and the Fed. This legislation will surely come up again in the next Congress, and the major card issuers will employ the same strategy with only minor success.

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PART IV GLOBAL NONMARKET STRATEGY

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Chapter 14 The Political Economy of Japan This chapter and Chapters 15 and 16 provide an approach to country analysis using the nonmarket environment for Japan, the European Union, and China, respectively. Chapter 17 considers emerging markets. This material also provides an underpinning for material in Chapter 18 pertaining to international trade policy.

During the 1970s and particularly the 1980s Japan’s economy grew rapidly, and a number of its companies became leaders in their industries. The success of the Japanese companies often came at the expense of U.S. companies, and entire U.S. industries such as consumer electronics were decimated. The Japanese economy grew rapidly as did per capita income in Japan. Countries from around the world studied Japan seeking wisdom and lessons that could be applied at home. A number of Japanese business innovations, such as just-in-time production, have been widely applied by companies around the world, but the political economy of Japan has not been emulated.

Japan’s bubble economy burst at the beginning of the 1990s as did its reputation for economic invincibility. The experience of the 1990s and 2000s has shown that there was considerably less in its market environment to emulate than had been believed.

Throughout the 1990s and into the 21st century Japan’s economy struggled as brief recoveries were followed by recessions. Japan began to experience deflation as Japanese companies sought to decrease their prices to maintain sales. Japanese companies finally began to source their products in China to reduce their costs. Uniqlo was one of the first to take advantage of low cost production in China, and its market success achieved through low prices suggested that Japanese consumers were price responsive. The textile industry began to move production to China, and the electronics industry also began to do the same. Japan began to experience the same phenomenon that the United States experienced in the 1970s when production moved to Japan and then Korea and Taiwan. By 2007 the economy was growing successfully again.

The Japanese government lost a considerable measure of respect as a result of scandals, a degree of political instability, and an economy that has been mired in a mild recession for most of the decade.

A lecture could focus on the changes in Japan and its economic performance over the past two decades.

In Japan government has traditionally been more important than in the United States, in part because of a long period of one-party control by the LDP and extensive regulation by its powerful bureaucracy. Japanese business structure and management are also different as discussed in the chapter. The political economy of Japan is similar to that in the United States in a number of dimensions, but it is also different on a number of other dimensions. Interests underlie the political economy of both countries and distributive consequences motivate much of the political action that affects business. A good part of the activity in the nonmarket environment in Japan, however, is difficult to observe because it takes place behind the scenes. Moreover, the government system and the nature and importance of relationships with government bodies are different in the two

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countries. The nonmarket environment, however, can be characterized in terms of issues, interests, institutions, and information.

The other important factors are culture and history, as indicated in Figure 14-1. Culture and history play a role in structuring relationships and channeling behavior. The culture in Japan is changing, but there is considerable stability in the nature of relationships, even as elements of western social and business culture have intruded. In some cases, change occurs out of necessity. For example, a number of Japanese companies have adopted merit systems for compensation rather than basing pay on seniority which has been the widespread practice, and young Japanese workers now change jobs more frequently than in the past.

Much has been written on the Japanese government and business system, and these writings provide a rich set of material for supplemental lectures. A lecture could focus on a comparison between the structure of the governments of Japan and the United States with an emphasis on the nature of parliamentary systems, the greater role ministries play, and the correspondingly lesser role played by the legislature, in such systems. The control of government by the LDP for nearly 50 years also has important implications for the nature of interactions between business and government.

The political instability that developed during the 1990s continued into the 21st century. Prime Minister Koizumi was very popular and had promised reforms of the economy. Some reforms were made as described in the chapter, and the privatization of Japan Post is considered in a chapter case. In 2001 he allowed some companies to go bankrupt, but in 2002 he arranged a traditional bailout for a large debt-ridden retailer Daiei. Daiei with 286 stores, 25,000 full-time and 70,000 part-time employees was just too important to allow to fail. Daiei had $14 billion in debt. In the traditional manner Daiei’s lead banks arranged a $3.2 billion debt-for-equity swap. Daiei was to sell 69 of its 169 companies, but it planned to reduce employment without layoffs.

The turnover in the Japanese government continued as the Prime Minister abruptly resigned.

One particular feature of the political economy of Japan is the importance of the bureaucracy in government and for business activity. A lecture could focus on the role of the bureaucracy and the changing attitudes toward it. One reason the bureaucracy is powerful in Japan is its role in writing legislation based on its expertise in policy matters. Figure 14-2 indicates that both the Diet and the LDP have adopted organization structures that mirror the organization of the bureaucracy. Figure 14-3 identifies the role of the bureaucracy in the legislative process. The principal factor in its importance to business, however, is its extensive role in regulation. The recent reforms have reduced the relative power of the bureaucracy.

The bureaucracy also participates in political exchange with business as illustrated in Figure 14-4.

The close relationships that develop among business, political parties, and the bureaucracy can lead to improper and illegal activities as favors are exchanged. The PowerPoints japanbureaucracy.ppt summarizes the changing attitudes toward the bureaucracy and the amakudari system, which serves the interests of both bureaucrats and the companies that hire them.

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The media and the judiciary are less important components of the nonmarket environment in Japan than they are in the United States. Similarly, unions are somewhat less important. The Anti-Monopoly Law (AML), and more particularly its enforcement, has been a continuing source of contention between the United States and Japan. The United States contends that it serves to keep segments of the economy closed to foreign firms. The organization of business in Japan is different from that in the United States, and those differences can serve as the basis for a lecture. As in Europe, banks play a much larger role in the financing and control of firms, and although a number of European countries have holding companies, the keiretsu system is distinctly Japanese. Business practices are also considerably different with a greater emphasis on long-term performance and apparently less attention paid to profits. Much has been written about Japanese- style management, and an assessment of that style would be a topic for a lecture. The importance of implicit rather than explicit arrangements, hierarchical relationships, and mutual adjustment are important features of Japanese management. The unemployment rate in Japan, although it is low compared to unemployment rates in other countries, has increased in recent years. The relationships between business and government in Japan are multifaceted, and many of those facets are difficult to observe. Some of these relationships are personal, and many are behind the scenes. Political strategies are also less public in Japan with grassroots, public advocacy, and judicial strategies playing less of a role. As in the United States, access is important but is perhaps more varied in Japan. Information is crucial to successful business-government interactions in Japan, and firms invest in information acquisition activities. The basic approach to strategy formulation in Japan is the same as that developed in Chapter 7. The method involves the following principal steps:

1. Issue identification 2. Assessment of the nature of the politics 3. Identification of interests 4. Analysis of the supply and demand for political action 5. Identification of the relevant institutional arenas 6. Identification of important institutional procedures 7. Identification of key individuals and their interests 8. Prediction of the consequences from various strategy alternatives 9. Strategy formulation 10. Strategy implementation

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Cases The Proposed Break-up of Nippon Telephone and Telegraph PowerPoints are available for this case ntt.ppt.

This case focuses on the government process and the competition among interests affected by the proposed breakup. It also provides an opportunity to examine the nonmarket strategy of NTT and compare it to the types of strategies that would be employed in the United States. For example, a rent chain is available and could be easily mobilized. Pluralistic interests are present and active and they compete in institutional arenas. There is an agenda setter—the MPT—and a veto player—the government or more realistically the LDP. The institutional process is complex, and coalitions are important. One institutional difference is based on the cultural preference for the development of consensus. In the first round the MPT was unable to develop consensus, and it may be unable to do so this time as well. The vote in the Telecommunications Council was 19-3 indicating that some members had serious concerns with a break-up.

The basic public policy issue was how to achieve modern and efficient telecommunications services. NTT was widely viewed as hindering the implementation of the types of services needed by business in particular and setting high prices that discouraged the demand for services. The initial impetus for a break-up stemmed from the break up of AT&T and the developing competition in the United States. As the 1990s progressed the view changed somewhat as some involved in the issues began to believe that deregulation rather than a break-up was better. Others argued that a large company was needed to carry Japan’s flag in the emerging global competition in telecommunications. Moreover, negotiations taking place within the GATT-WTO framework were directed at opening domestic telecommunications markets to companies from other countries. To take advantage of these opportunities, a large company was said to be needed.

NTT differs significantly from the pre-break-up AT&T. First, it provides domestic service only.

Second, it has no manufacturing arm. These two differences give it somewhat of a nonmarket disadvantage. It can enlist the aid of the NTT family of suppliers, but it lacks revenue from international service. Moreover, the Japanese international carriers are potential domestic entrants if allowed to do so by a break-up or major deregulation. Like AT&T it faces some competitors in long-distance service, and it is said to be inhibiting competitors through high access prices and through lengthy negotiations regarding access.

Note that in this case MPT is the agenda setter, but before it can bring legislation to the Diet it must complete the process illustrated in Figure 14-2. That requires the approval of the cabinet, which is composed of member of the LDP and the SDP. NTT’s principal source of access to the SDP is through Zen Dentsu, since the minister of Posts and Telecommunications is from the SDP, which is supported by unions.

To break up NTT, the Diet will have to enact a law as it did for its privatization. The process is that illustrated in Figure 14-2 and has both a bureaucratic component and a party component, so both the bureaucracy and the government coalition will be involved. The cabinet will probably be the

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arbitrator. Also active will be the telecommunications Yosei-zoku that deals with telecommunications issues.

MITI has generally been opposed to a break-up believing that a large company was needed to compete effectively in global telecommunications markets. MOF is concerned with the implications of a break-up for NTT’s share price. The possible break-up of NTT, however, is not really within the jurisdiction of MITI and MOF, so they will remain officially neutral.

To be successful, NTT must block the process illustrated in Figure 14-2 from producing a bill.

Since the MPT will work for a break up, NTT must stop the MPT through the political part of the process represented at the bottom of the figure. This requires obtaining a blocking coalition within the government parties or within the factions of the LDP. Both the LDP and the SDP are relatively weak in the sense that they have lost electoral support and are racked with internal disagreements.

The selection of Prime Minister Hashimoto, who had a positive image with the public but relatively little power within the LDP, provides some hope to the LDP that it can return to power as a majority party. If the parties send a bill forward to the Diet, NTT’s only real hope of defeating the bill would be through the Yosei-zoku.

Zen Dentsu will work through the SDP and can be expected to claim that the public will be forced to pay higher prices for local service, whereas big business will benefit from lower long-distance rates. It may also join with NTT management to provide a unified front when going public on the issue.

To access the LDP, NTT can deal directly through its remaining personal relationships and its generalized support relationships. NTT can also work through the Yosei-zoku. NTT will seek to enlist allies.

NTT has an integrated strategy quite similar to that which would be employed in the United States.

Its market component focuses on pledges of efficiency and allowing competition to take place. It has spun off its software units, opened some markets, and pledged to lower access charges and cut employment. Its nonmarket component includes using its rent chain with Zen Dentsu working on the SDP and Minister Hiro. The NTT family of suppliers can take action directly with the LDP and the Yosei-zoku, and it can block the Keidanren from taking a position in favor of a break-up. NTT also has a set of affiliated companies that it may be able to mobilize. NTT itself uses its longestablished relationships with the LDP and the Yosei-zoku to lobby for leaving the company alone.

NTT also used informational strategies to counter the recommendation of the Telecommunications Council to create two local service companies. It provided estimates that the local service company with the western region would incur large losses. It also provided information about the importance of size in global competition.

To weaken the support of those, such as competitors, favoring a break-up, NTT offered a substitute in the form of its pledges to reduce access charges and open markets for competitors.

The PowerPoints summarize NTT’s strategy and identify several lessons from this case.

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Teaching the case: The following questions can be used to guide the discussion.

1. Where is this issue in its life cycle?

2. Why does the MPT want to break up NTT? 3. Will other ministries become involved in this issue? What positions will they take on the issue?

4. Which interest groups will be active on this issue?

5. As MPT, how would you advance this issue through the political process?

6. As NTT what nonmarket strategy would you adopt to oppose the break-up? What does NTT have to accomplish to avoid a break-up? Where should it focus its efforts? Does NTT have a rent chain that it can use?

7. Will the Keidanren become involved in this issue?

8. What decision process will the Japanese government have to go through to break up NTT? 9. What is likely to happen?

Developments Developments between 1990 and 1995: This section describes the events that transpired between 1990 and 1996. To advance the issue of a break up, the MPT appointed a Communications Council to prepare a recommendation about whether a break-up was desirable and if so, the form it should take. Mr. Eiji Toyota, Chairman of Toyota Motors, headed the Council. In March 1990, the Council recommended that NTT be broken up into a long-distance company, a local service company, and a cellular company.

The government, however, postponed the decision on a break-up until 1995 when the present analog telecommunications network was to be converted to a digital network. I suspect that the LDP viewed this issue as too controversial given the complicated and politically dangerous trade negotiations taking place with the United States at this time. The LDP may also have been wary of activity by the opposition parties on the issue of local service rates.

In November 1990, MOF announced that it would sell between 500,000 to 800,000 shares of NTT to the public in each of the next seven years beginning in 1991.1 The total to be sold was 5 million shares, and the government would hold 5.2 million shares, or one-third of the total shares, as required by law. (The shares are held in the Industrial Investment Special Account.)

NTT’s share price dropped to 720,000 yen on October 1, 1990, and NTT and the MOF called on MPT to allow NTT shares to be held by foreigners. According to The Wall Street Journal, “The Telecommunications ministry has kept tight control of NTT and is widely known to be the directing hand behind its businesses. There is speculation that [MPT] isn’t willing to sacrifice this control, by opening up NTT to foreign shareholders who may wish to take an active role in its administration.”2 When neither dividends nor capital gains are available, however, usually docile shareholders can become concerned. At NTT’s annual meeting in 1989, 4,500 shareholders, in an unusual scene in

1 2

, November 21, 1990.

The Wall Street Journal , November 30, 1990.

The Wall Street Journal

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Japan, grilled NTT management about its performance. NTT’s share price had fallen 62 percent from its peak in 1987 shortly after it was privatized, and profits before taxes were down 14.3 percent from the year earlier.

In August 1992, the MOF canceled plans to sell one million shares of NTT because the price had fallen 81 percent from its post-privatization peak. In part, the decline in the share price was due to decreased profits resulting from increased competition in long-distance service. NTT was forced to reduce its prices to compete with its rivals, but it had been unable to increase its rates for local service because the MPT had rejected its rate increase requests. To reduce its costs, NTT had trimmed its payroll by 66,000 employees since it was privatized in 1985.

As of 1995 the MOF still held 65 percent of NTT’s shares and prospects for further sales were viewed as bleak given the weakness in the Japanese stock market. NTT’s share price was 745,000 yen in February 1995. Mr. Yamamoto urged the government to find a way to fully privatize the company.

Developments after 1996: As might be expected from the failure of its first attempt to break up NTT, the MPT was unable to develop the support needed for a break up. The PowerPoints provide a summary of the immediate outcome, which was basically to postpone the decisions regarding NTT. Disagreement within the governing coalition resulted in a postponement of the decision.

The government subsequently allowed NTT to enter international service and to restructure its domestic operations. For example, in 1998 NTT spun off its mobile telephone business in an IPO that raised $18 billion. The company known as NTT DoCoMo has 57% of the cellular telephone market.

In 1999 NTT was reorganized into NTT East and NTT West that operate fixed wire facilities. Both remain under the control of the NTT holding company. NTT also has a subsidiary NTT Communications that provides international and long-distance subsidiary. NTT owned 64 percent of DoCoMo. In November 2001 NTT planned to write off $4.5 billion on its investment in Verio. The previous week NTT DoCoMo wrote off $2.19 billion in its investment in KPN Mobile NV of the Netherlands. The Ministry of Posts and Telecommunications pressed NTT to reduce its stakes in DoCoMo and NTT Communications.

The United States continued to press for reductions in NTT access charges. The European Union threatened to file a complaint with the WTO unless Japan leveled the playing field in telecommunications. The EU sought greater reductions in access charges than the 22.5 percent reduction scheduled to be implemented over the next five years.

At the end of 2000 the government owned 45.96 percent of NTT. In 2004 NTT purchased 800,000 shares held by the government, bringing the MOF holdings to 40.8 percent. In 2005 the government announced that it would sell 1.12 million shares, which would bring its holdings down to the minimum required to be held. The sale was expected to generate $4.3 billion for the MOF.

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The Privatization of Japan Post The objective of this case is to consider the nature of government decision-making in Japan and the role of interests. Japan Post is a huge organization, and it distorts markets by intervening in the capital markets backed by government guarantees and favorable tax status. Prime Minister Koizumi sought to privatize Japan Post to improve efficiency in the economy and stimulate private capital formation. Privatization, however, was opposed by interest groups and some LDP politicians aligned with those groups. The principal interest groups were the postmasters, who traditionally were an important source of strength of the LDP, management of Japan Post, and the labor unions. It is the postmasters rather than management that is the more powerful, since they have complete coverage of the legislative districts. In addition, the opposition parties had an incentive to at least embarrass the prime minister. The opposition parties may well have favored privatization or at least substantial reform of Japan Post.

The proponents of privatization are the Japanese public, who will benefit from greater efficiency in the economy. They will not be active, but their interests are represented by the prime minister, who is a political entrepreneur. The other proponents are the companies that will be able to compete for the business now claimed by Japan Post. The principal beneficiaries are the banks and insurance companies. The Japanese companies will work behind the scenes through the LDP and the MOF. The MOF will probably not be very active, since the decision is in the jurisdiction of another ministry. The foreign companies will be active and work both through the Japanese government and their home country governments.

The nature of decision making is as depicted in Figure 14-2. The prime minister has successfully navigated the bottom part of the process within the government parties, although some members of the LDP remain opposed. The top part of the figure involves grudging acquiescence by the bureaucracy. The former MPT has been incorporated into a larger ministry which probably reduced the opposition within the bureaucracy. Moreover, the prime minister probably put pressure on the bureaucracy. As indicated below the prime minister fired two top bureaucrats who did not support privatization. The remaining question was whether Prime Minister Koizumi would have to compromise with the opposition to obtain passage of privatization legislation. The principal strategy aspects of the case rest with the prime minister and Minister Takenaka.

Teaching the case The following questions can be used to lead the discussion.

1. Which interests will be active on the privatization issue?

2. What strategy will they use?

3. What points of access will they use to influence the government?

4. What process will be required to enact the legislation needed to privatize Japan Post?

5. What will Prime Minister Koizumi do to increase the probability of succeeding?

6. What should an American insurance company do?

7. What is the likely outcome?

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Analysis The postmasters will access the opposing members of the LDP, many of whom will be in the yoseizoku. The unions will access government through the political parties aligned with the unions.

Remember that unions are not powerful forces in Japan.

The American companies will have little influence other than through their home countries. In this case to have influence those countries would have to be effective in reducing the opposition among the opposing LDP members. That seems unlikely. The best the foreign companies can do is to make public pronouncements and work to avoid any legislative provisions that would advantage Japan Post during the transition period.

A dominant strategy for Japan Post is to broaden its lines of business even if that means risking restraints by the ministry.

Developments Prime Minister Koizumi was said by commentators to be hanging his political future on the privatization. He planned to push privatization legislation through the Diet during the 2005 session. His point person was Minister Takenaka. As an indication of the intensity of the politics of privatization, the prime minister replaced “two top bureaucrats of the Internal Affairs and Communications Ministry who were reluctant to back the postal privatization plan.”3 Koizumi was opposed by the postmasters, the unions representing Japan Post workers, and by some LDP members who saw Japan Post as important to the strength of the LDP. Chiefs of post offices protested the privatization legislation in May. An opposed LDP legislator stated, “Deciding the path of the post offices, which have played major roles [in local communities], simply from a viewpoint of business efficiency and profitability is absolutely unacceptable.”4 The Japan Economic Newswire noted that many of the postmaster posts were hereditary. Moreover, the postmasters were important in recruiting votes in rural Japan. The yusei-zoku had been organized by former Prime Minister Tanaka, one of the most powerful politicians in Japan at the time.

Both the Japan Postal Workers’ Union and the All Japan Postal Labor Union opposed the plan.

The two unions stated, “We cannot tolerate the plan as it would make the postal system, which serves as a social safety net and contributes to vitalizing the economy, collapse.”5 Frank Keating of the American Council of Life Insurers (ACLI) said, “No government guarantees should apply to any insurance policies issued by the new insurance entity. …Taxes paid by the new entity should be the same as those which apply to the private sector. A safety-net system should be mandated to which contributions will be made by the new insurance entity on a par with the requirement faced by the private sector.”6 He added, “Clear benchmarks should be established for determining this status [of equal footing], and a transparent process created in which Japanese and

3

Japan Economic Newswire, May 22, 2005.

Japan Economic Newswire, May 22, 2005.

5 Kyodo News International, April 27, 2005.

6 Best Wire, April 6, 2005.

4

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U.S. private sector insurance companies have a meaningful opportunity to participate.”7 In December 2004 the ACLI, the American Insurance Association, the Canadian Life and Health Insurance Association, the Coalition of Service Industries, the Comite European des Assurances, the Council of the European Business Community in Japan, the U.S. Chamber of Commerce, and the U.S. Japan Business Council lobbied for a level playing field.8 In April 2005 the government introduced legislation to privatize Japan Post along the lines described in the case with the government retaining one-third ownership after 2017. The bills were spearheaded by Minister Takenaka and endorsed by the General Council of the LDP. The Diet established a special committee to consider the legislation. The Democratic Party and the Social Democratic Party boycotted the legislative deliberations. This was apparently directed at the LDP as much as at the idea of privatization. The two parties supported reform of Japan Post.

After the prime minister introduced the government’s privatization legislation in April, 2005, the anti-privatization LDP members submitted a rival bill that would leave Japan Post intact. The bill was immediately rejected by the Diet because it had not been endorsed by the LDP. Former MPT minister Seiko Noda opposed privatization. Approximately 40 LDP members were said to be opposed to the privatization.

In 2005 Japan Post’s profits were down 46 percent, but they still exceeded those of Toyota.

Japan Post continued with its strategy to leverage its monopoly to strengthen its position in the event of privatization. Japan Post continued selling investment trusts. It also arranged with the Daily Yamazaki Co. and am/pm Japan Co. to handle Japan Post’s parcels.

Japan Post had 120 leisure accommodation facilities (hotels and guest houses) for its life insurance customers and 23 for its postal savings customers. The privatization bills called for closing or selling them by April 2007. In 2005 Japan Post announced that it would close 28 of the facilities.

As of this writing it was not clear whether Prime Minister Koizumi would succeed in enacting the legislation without amendment or whether compromises would have to be forged with the opposing members of the LDP.

Uniqlo: Success Breeds Nonmarket Challenges Uniqlo was a great success and an innovator in the retail industry in Japan. As it had intended it began opening stores in the United Kingdom in late 2001, and whether its success can be achieved outside Japan remains to be seen.

Uniqlo’s strategy of sourcing its clothing in China reflects the very high labor costs in Japan.

Labor costs in China were approximately 5 percent of the labor costs in Japan. Moreover, the 7 8

Best Wire, April 6, 2005.

Best Wire, April 6, 2005.

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distribution system in Japan is inefficient, and Uniqlo achieves efficiency by by-passing that system. By-passing the distribution system is also an important component of the strategy of McDonald’s in Japan and of Toys ‘R’ Us (see the Part IV integrative case Toys ‘R’ Us and Globalization).

The trade action by the textile industry reflects the economic pressure created by Uniqlo and other companies that have gained a cost advantage. Their action is little different than firms seeking protection in the United States. The particular trade action under the “safeguards” procedure sought by the textile firms is unusual and may not have been invoked in the years since the establishment of the WTO. The action in 2002 by the Bush administration to protect the U.S. steel industry invoked the safeguards procedure. In the context of trade law the safeguards procedure is intended to give the domestic industry time to adjust to low-cost imports. More realistically, the action protects the domestic industry for political purposes.

One observation is that the protection being sought by the towel industry is exactly what Japan had opposed for decades when the United States sought to slow the surge in imports from Japan.

The larger issue is that the Japanese economy may be transitioning from a producer economy to an investor economy. That transition will be difficult.

The process for applying Japanese trade law is such a case is not evident. The decision is sufficiently important that the government and particularly the LDP will take political considerations into account. The political considerations are the benefits from protecting a domestic industry and the cost of forcing up prices for consumers. The LDP has traditionally not catered to consumer interests, but that may be changing. To bolster its political support, the Koizumi government may support consumer interests. The towel industry is divided on this issue, which might have some impact on the government’s decision. The reason the industry is divided, however, is that jobs are moving from Japan to China.

In this context what should Uniqlo’s strategy be? Does the company have to act politically?

Certainly, if it does act, it will do so behind the scenes in the traditional manner. Uniqlo, however, may decide to simply defend its case in the bureaucratic channels under the expectation that the government will not choose protectionism. Uniqlo and other companies sourcing abroad could form a coalition and operate in the traditional Japanese style on this issue.

Uniqlo sells in the low-price segment of the apparel market, but it is also in the fashion business.

In 2001 Uniqlo’s bubble began to burst. Sales in April 2002 were off over 40 percent from the year earlier month. To restore growth to the company Yanai replaced himself as president with the 39year old managing director of the company, who had been responsible for the rollout of Uniqlo’s entry into the United Kingdom. Yanai remained as chairman. Fast Retailing’s stock price had fallen by 80 percent from the May 2000 level. Uniqlo had more serious problems than the possibility of a trade action.

The outcome of this case is not known.

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Chapter 15 The Political Economy of the European Union The structure of this chapter parallels the chapter on Japan using the framework for country analysis, as applied to the European Union (EU). The EU member states differ significantly, yet the mutual advantages for more open markets provide the incentive to transfer some degree of sovereignty to a central government. The EU government has substantial authority but the national governments continue to hold the power in the EU. Some scholars believe that political union has already gone as far as it need ultimately go.

The experience with the enlargement of the Union and the possible changes in the institutions would be a good topic for a lecture. The Constitutional Treaty was unanimously supported by the governments of the member states, and the treaty was quickly approved by eight member states.

Some member states decided to ratify the Treaty through a public referendum. Fifty-five percent of French voters voted against the treaty, and the following week 62 percent of the voters in the Netherlands rejected it. Both of these countries were among the original members of the European Union, and both had supported deeper political integration. The United Kingdom quickly called off its scheduled referendum, and the EU put the treaty on hold. Whether it will reappear is unclear.

The votes in France and the Netherlands evidenced a substantial gulf between political leaders and the public. To some extent voters may have cast their votes to penalize their governments for their lagging economies. More importantly, many voters could find something to dislike in the constitution or the conduct of the EU government. As discussed in the chapter, the attempt to enact the constitution as a treaty also failed.

Although considerable progress on the single market has been made, a number of politically sensitive issues remain. One is state aids, or subsidization. Another difficult problem is the harmonization of fiscal measures. Fiscal harmonization is the source of the nonmarket issue in the chapter case Aldeasa and the EU Duty Free Abolition (A).

The European central bank and the European Union currency, the euro, came into existence in 1999 and national currencies were replaced in 2002. Some commentators had expressed concerns that the EU central bank would concede to political pressure and respond to political objectives such as inflating so as to reduce unemployment levels. This has not happened.

The most important institutions of the EU are the European Commission, the Council of Ministers, and the Parliament. It is important to make clear that the Council is composed of the cognizant ministers for the issue under consideration. This is illustrated in the chapter case The European Union Carbon Tax. Over time, the European Parliament has been given more authority, and if the EU moves toward political union, it can be expected to be given additional powers. In 1999 the European Parliament fired the entire Commission as mentioned in the text. Whether this is a forerunner of a more aggressive Parliament is not clear.

The EU legislative process is a complex one that involves consultations among the institutions, although the Council of Ministers is the only body that can enact legislation. The co-decision

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process is described in Figure 15-3. Figure 15-5 identifies the constituencies and the points of access for the principal EU institutions.

Interests in the European Union are varied as they are in the United States, but the nature of their organization and their participation with government differ. For example, most socialist parties are closely aligned with unions, and union representation is high in most countries, compared to only 8% of the work force in the United States. Interests are also organized differently, since most work through peak organizations representing an industry or business more broadly. This corporatist system in Europe means there is less individual nonmarket action in the EU and more activity by associations and pan-EU associations. The chapter case The European Union Carbon Tax involves the activities of the European chemical industry among others.

The EU products liability system and competition policy can be contrasted with those of the United States as considered in Chapters 9 and 11, respectively.

The strategies for participating in nonmarket issues in the context of governmental institutions are evolving. The increased authority given to the EU government has caused firms to shift attention from national governments to the EU government. Lobbying has grown substantially in recent years, and firms have established offices in Brussels to support their lobbying and other interactions with the EU institutions. The slide eustyle.ppt summarizes some of the characteristics of nonmarket strategy and the style with which they are implemented in the European Union.

The United States and the European Union have been involved in a series of international trade disputes, as well as a set of disagreements such as those discussed in the example on data privacy in the book. Some of these disputes are particularly interesting because the stem less from interest group activity and more from the direct preferences of citizens; e.g., for privacy and for avoiding bioengineered foods. These and other disputes are discussed in Chapter 18.

The introduction of the euro has highlighted a number of nonmarket issues in the EU. One is that with a common currency the difference in prices of goods across the member states has been highlighted. This is the case despite the elimination of all trade barriers among the member states.

For example, the price of the identical automobile initially differed considerably across the member states. The explanation for the price differences was that the automobile industry had an antitrust exemption for certain practices such as exclusive territories and pricing practices. This allowed automakers to exercise control over the market. For example, the automakers could stop one dealer from selling cars in the territory of another dealer and across a border. Moreover, companies such as Volkswagen had prevented dealers in one country from selling to people from other countries who visited their showrooms. Germans had begun going to Italy to purchase Volkswagens, since Germany had the highest prices for automobiles. In early 2002 the EU commission drafted a directive that would eliminate the exemption in a country in which an automobile company had more than 10 percent to 15 percent of the market. The automobile companies were expected to oppose the directive vigorously. The commission supported eliminating the protection but the member states opposed any elimination. The parliament adopted a resolution to postpone any elimination until after 2005. Consumer groups complained.

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The Chapter 4 case Shell, Greenpeace, and Brent Spar addresses an issue initiated by activists in Europe.

Cases The European Union Carbon Tax PowerPoints are available for this case eucarbontax.ppt.

Throughout the 1990s Europeans expressed more concern about global warming than did Americans. The consideration of a carbon tax is one manifestation of this concern. This case is important not only because it is instructive about nonmarket strategies in the European Union but also because it indicates some of the complexities in using environmental taxes and tradable permits systems to deal with an encompassing externality such as global warming. Also, during the 1990s the economies of many European countries were sluggish with unemployment levels averaging 10 percent. At the time of this case in 1992 the EU was more optimistic about the economy than reality subsequently revealed. Nevertheless, European companies and the EU leaders remained concerned about the loss of competitiveness compared to Japan and the United States. It should be noted in the discussion of the case that energy prices in the European Union were already much higher than in the United States, and that Europeans had adopted much more extensive energy conservation measures than had the United States. The climate policy of the EU is addressed by Jon Birger Skjaerseth, “The Climate Policy of the EC: Too Hot to Handle?,” Journal of Common Market Studies. 32 (March 1994): 25-45.

In addition to its use in the discussion of environmental regulation, this case can be used to review the legislative process in the EU, as considered in Chapter 15. In this case the Council of Environment and Energy ministers set a goal of a 10 percent reduction in CO2 emissions, which required that a 5 percent reduction be achieved through intervention in markets. The Commission then prepared a draft proposal calling for a carbon tax and an energy tax to achieve the reduction.

The Council endorsed the draft proposal and then the formal legislative process began. It is important to note that by the time the Commission made its proposal considerable political lobbying had already taken place. Environmentalists wary of nuclear power did not favor the sole reliance on a carbon tax because that would provide incentives to turn to nuclear power. Countries that relied on carbon-intensive energy sources also supported an energy tax to raise costs in countries with less reliance on a carbon-based energy supply. This would protect jobs in the former set of countries.

To enact the tax it is necessary to obtain unanimity in the Council, so every member state is pivotal.

Since countries such as Greece, Portugal, Spain, and Italy would be substantially harmed by the tax, each has an incentive to block the tax. The EU, however, has structural funds that can be used to recruit the votes of countries, as considered in Chapter 7. Providing sufficient structural funds to recruit these votes requires a qualified majority in the Council. Germany and other northern European countries are clearly willing to provide the structural funds, but others may not be.

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Consider the United Kingdom. It would not only incur higher costs for its carbon-intensive energy supply, but it would have an increased tax burden to support the possibly large structural payments needed to recruit the needed votes for the tax. (It is not clear that the amount of structural funds presently available was sufficient to recruit the votes, so an increase in the funds might be needed.)

The theories of (super) majority building and vote recruitment considered in Chapter 7 can be used to structure the discussion.

In addition to strategies directed at the Council, interests will target the Commission. The commission has prepared a draft proposal which has been endorsed by the Council, but it now must prepare a final proposal which will include implementation details. The Commission attempts to work through consensus, and one strategy can be to attempt to foster disagreement within the Commission. At this point DG XVII (Energy) and DG XI (Environment) strongly support the carbon/energy tax, but DG III (Internal Market and Industrial Affairs) and DG IV (Competition Policy) will be concerned about the effects on the European economies and on individual industries and their rent chains, including the unions. These DGs should be targeted with the hope that an impasse will develop in the Commission and any action will be postponed.

The greatest impact on the economies of the member states would be in the poorer Southern countries, Greece, Portugal, Spain, and Italy. The carbon/energy tax would also have substantial effects on energy-intensive industries including electric power, coal and iron, and chemicals. These industries are generally well-organized for nonmarket action. Their organization is typically in the form of industry associations in each country which are generally part of or participate in a peak business organization. This is particularly the case in countries with corporatist systems. The national associations are linked in pan-European associations such as CEFIC for the chemical industry. These pan-European organizations then are affiliated with encompassing business organizations the most prominent of which is UNICE. (Three of the four largest chemical companies in the world are located in Germany.)

One use of this case is to review the effects of a carbon tax on social efficiency and on the rents of companies and their rent chains. The social efficiency perspective can be discussed using the framework and figures in Chapter 11. The tax would increase the costs of energy and ultimately of most other products. At the company level the tax would provide incentives to reduce energy consumption through conservation measures and through the substitution of less energy-intensive technologies. (Note that for some chemical companies that rely on petroleum feedstocks, there could be little substitution possible.) The tax would increase the costs of production for companies, and hence at the industry level the tax would shift the supply curve upwards. This would increase the price for the goods produced and reduce the quantity purchased and produced in the EU. In addition, the price increase would be mitigated by increased production from companies in other countries not subject to such a tax. This would shift the demand curve for the EU firms to the left resulting in an additional reduction in output. The EU companies could lose substantial sales to their foreign competitors, and jobs would be lost.

The politics of the tax are at one level majoritarian, since the tax will affect everyone both in terms of the benefits from reductions in global warming and in terms of the prices paid for all goods. At the level of nonmarket strategies, however, the politics are clientistic/entrepreneurial in the sense that the consequences fall heavily on certain industries and their rent chains. The politics are

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entrepreneurial in the sense that the EU government is representing people broadly in its attempt to respond to global warming, whereas the costs are borne disproportionately by certain industries such as chemicals. The politics are entrepreneurial when the alternative considered in enactment of a tax, but at the level of nonmarket strategies the alternative is better viewed as stopping the tax or obtaining exemptions such as rebates. When viewed from this perspective, the politics are clientistic with the benefits from defeating the task being concentrated on industries and the costs from not mitigating global warming being widely distributed.

The strategy of companies seeking to stop the tax should have the following components.

1. Develop politically-relevant information about the effects on global competitiveness and employment.

2. Use that information in lobbying the Commission, COREPER, and member state governments.

3. Exploit the uncertainty and complexity of the global warming issue.

4. Organize for political effectiveness. Industry associations are already in place, but it may be possible to form intra-industry coalitions as in the case of the 14 French companies that formed Business for the Environment.

5. Know the institutional process and focus on pivotal components both in the council and in the Commission. For example, the United Kingdom with a conservative government is wary of new taxes and seems only weakly supportive of the tax. If the UK and Italy, for example, were to oppose the use of structural funds to recruit votes, a blocking majority would require only one of the Southern countries.

6. Propose substitutes; i.e., announce voluntary measures to reduce energy use and remind the EU government of the strides industries such as chemicals have already made.

7. Mobilize components of rent chains, including unions and suppliers concerned about the likely loss of jobs. Note that even if the tax were implemented in a fiscally neutral manner by reducing other taxes, the incidence on energy-intensive industries would still be important. (If it were not, the tax would not have its desired effect of reducing energy usage.)

8. Foster disagreement within the Commission.

9. Argue that an exemption or a rebate is necessary to preserve competitiveness and jobs but also express real concerns that any such exemption or rebate could easily be withdrawn in the future.

10. Argue that a necessary condition for the enactment of any tax should be conditionality; i.e., the tax would go into effect only if Japan and the United States adopted equivalent measures. (The proposal by President Clinton and the bill submitted by Representative Stark are mild compared to the level of the tax being considered by the EU.) 11. Seize the opportunity in the UK, which has recently imposed a 7.5% VAT on domestic fuels with the tax due to increase to 17% in the future. In the UK the carbon/energy tax was labeled another VAT in environmental clothes.

The most powerful message of the chemical industry is that the carbon/energy tax would substantially damage the international competitiveness of the EU industry. With unemployment near 10 percent this message has impact with politicians and the governments of the member states.

One position the industry can take is to argue that while it might still have some concerns, it could support a tax conditional on a similar tax being enacted in the countries, primarily Japan and the United States, in which its principal competitors are located. (A related perspective is that action by the EU would provide a public good to everyone in the world, and a country like the United States would be free riding on the EU’s provision.)

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Reflecting these concerns the countries that had already enacted a carbon tax often gave rebates to companies adversely affected by the tax. This, of course, weakened the response of those companies to the tax. As a secondary or conditional objective the chemical industry can seek to have provisions incorporated in the law to allow member states to provide rebates of the tax to companies.

The PowerPoints identify the organization of interests, the distributive consequences and their incidence, which interests will be active and the nature of the politics, components of strategy and its implementation, how strategies are tailored to the relevant institution, how strategies are built on the organization of interests, and the strategy of the chemical industry.

Teaching the case: The following questions can be used to guide the discussion.

1. What is the nature of the externality the carbon/energy tax is intended to address?

2. Is the tax as specified in the Commission’s draft proposal a socially-efficient response to the

global warming problem?

3. To whom would the benefits from the tax accrue? 4. What are the likely distributive consequences of the tax? 5. What is the institutional process for deciding on the tax? 6. What is the nature of the politics of this issue? Which interests will be active? 7. What nonmarket strategy should a chemical company adopt regarding the tax? What objectives should it have?

8. How should that strategy be implemented? Outcome A variety of business interests opposed the tax, and their most effective message was that the global competitiveness of EU companies would be substantially harmed resulting in a major loss of jobs. The companies and other interests argued that a tax should be imposed only if other countries adopted an equivalent tax.

This conditionality approach was compelling, since if the EU acted unilaterally, not only would it provide benefits to others without any reciprocity but it would also shoot itself in its economic knee by disadvantaging its companies. This position carried the day both in the Commission and with the member states. In addition, the United Kingdom balked at the imposition of another tax. No final proposal was issued and the tax was put on the back burner. With the signing of the Kyoto Protocol the EU committed to reduce its emissions of greenhouse gasses substantially. A carbon tax may eventually be one of the measures it takes.

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The European Union Data Protection Directive PowerPoints are available for the case.

Differences in cultures and their associated concerns can give rise to nonmarket issues. Many Europeans are more concerned with privacy issues than are Americans, and these concerns have led to strong EU measures to protect information about people. These concerns range from information on credit card use to the planting of cookies to track Internet browsing to the collection of information.

Some countries ban telephone marketing and unsolicited sales attempts by e-mail or fax. Germany and the Netherlands, for example, have strong national laws and enforcement agencies governing information. These laws have a potentially important impact on electronic commerce and the Internert. For example, in allowing Citibank to provide a credit card in Germany in 1994, the German government obtained the right to supervise the data Citibank (now Citigroup) stores on cardholders. Inspectors from the Datenschutz regularly visit Citibank’s Sioux Falls, S.D. data center “to make sure that the data are being handled according to [German] law.”9 American Express reached a similar agreement with several countries. An official with the Data Protection Agency of the Netherlands commented, “We are at the beginning of a new information society, and no one really knows the outcome. But privacy and trust are important parts of this society.”10 At the EU level the Directive on Data Protection took effect in 1998 and required that a person grant explicit permission to a company to obtain personal information. Individuals also have the right to inspect any files maintained and to correct any errors. Furthermore, an individual must be notified in advance if any personal information is to be sold. According to a spokesperson for Oracle, “Your business is essentially tubed until you get this resolved. It can be a life-or-death situation for some businesses.”11 To address the differences in the standards for data privacy between the European Union and the United States, the U.S. Department of Commerce entered into negotiations with the EU seeking a safe harbor arrangement under which companies that agreed to follow specific data protection policies would be held harmless by the EU. The EU said it had no plans to stop data flows or to police the Internet and would decide specific issues on a case-by-case basis. The European activist group Privacy International, however, said it was investigating the practices of 25 companies, including Microsoft and United Airlines, and planned to file lawsuits if it identified any violations of the EU directive. A spokesperson for Time Warner in Brussels observed, “In Europe, people don’t trust companies, they trust government. In the U.S. it’s the opposite way around: Citizens must be protected from actions of the government.”12 The financial services industry continues to oppose the safe harbor principles because of the costs involved in satisfying them. The industry position is represented by the National Business

9

Business Week, November 2, 1998. , October 26, 1998.

The New York Times 11 San Jose Mercury News, October 26, 1998.

12 Business Week, November 2, 1998.

10

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Coalition on e-Commerce and Privacy (www.practicalprivacy.org). Also see the Financial Services Roundtable (www.fsround.org). The Bush administration supports the industry position.

Teaching the case I have taught this case in conjunction with the Chapter 13 case DoubleClick and Internet Privacy.

The focus of the discussion is on the difference between the self-regulation practices in the United States and the government regulation approach in the European Union. (The discussion of the DoubleClick case identifies the practices that constitute self-regulation in the United States.)

I then focus on the issue of whether U.S. practices provide adequate protection to allow the EU to permit PII to be transferred to the United States. I treat this as a negotiation between the U.S. Department of Commerce and the cognizant Directorate Generale in the European Union. Prior to the negotiation it is useful to assess which side has the bargaining power. One answer is that the EU has it because it has already staked out a position and backed it by legislation. Another answer is that the United States has the power because the EU is nervous about being left behind in the information age. If the bargaining power rests with the EU, then it could take the position that “adequate” means “equivalent.” I believe that the bargaining power rested with the United States.

The result of the bargaining between the two governments is summarized in the PowerPoints. The Safe Harbor Principles that can be found on the Department of Commerce Web site given later.

The United States appears to have won the negotiations and preserved self regulation. To be certified as meeting the adequate protection requirement, a company or Web site has only to meet TRUSTe standards for protecting privacy.

Developments After nearly two years of negotiations between the U.S. Department of Commerce and the EU Commission, the EU and the United States reached an agreement at the end of March 2000 on policies to meet the adequacy standard for transfer of data for processing. The so-called “safeharbor” agreement preserved a degree of self-regulation but under the supervision of the FTC. The FTC is to accumulate a list of companies that meet standards specified in the “International Safe Harbor Privacy Principles.” Those companies publicly pledging to satisfy the principles will be free of data blockages by the EU but will be subject to legal sanctions by the FTC if they are found to have violated stated policies. The agreement had to be approved by the Commission and a qualified majority of the member states after consultation with the committee of national data protection commissioners. Approval was given. The Commission’s approval is available at www.export.gov/safeharbor/DecisionSECGEN-EN.htm. In July 2000 the European Parliament on a 279-259 vote adopted a resolution criticizing the agreement. This put the Commission on notice that the Parliament would continue to monitor this issue.

The safe harbor principles are: 1) notice—“An organization must inform individuals about the purposes for which it collects and uses information about them, …”; 2) choice—“An organization must offer individuals the opportunity to choose (opt out) whether and how personal information they provide is used or disclosed to third parties …” when the information will be used for a purpose other than that for which the data were originally collected; 3) onward transfer—“An

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organization may only disclose personal information to third parties consistent with the principles of notice and choice.”; 4) security—“Organizations creating, maintaining, using or disseminating personal information must take reasonable precautions to protect it from loss, misuse and unauthorized access, disclosure, alteration and destruction.”; 5) data integrity—“Consistent with the principles, an organization may not process personal information in a way that is incompatible with the purposes for which it has been collected or subsequently authorized by the individual. To the extent necessary for those purposes, an organization should take reasonable steps to ensure that data is reliable for its intended use, accurate, complete, and current.; 6) access—“Individuals must have access to personal information about them that an organization holds and be able to correct, amend, or delete that information where it is inaccurate, except where the burden or expense …” is too high.; 7) enforcement—“Effective privacy protection must include mechanisms for assuring compliance with the principles, recourse for individuals … and consequences for the organization. … Sanctions must be sufficiently rigorous to ensure compliance by organizations.” The principles can be found on the Department of Commerce Web site www.export.gov/safeharbor/.

Companies could satisfy the principles in either of two ways.13 First, a company could participate in a self-regulatory privacy organization, such as TRUSTe. Second, a company could develop its own privacy policy consistent with the principles. Sarah Andrews of EPIC, which supported extending EU-style privacy rights to the United States, said, “It’s the fox guarding the hens. We think that there won’t be proper enforcement of it.”14 Government enforcement of the safe harbor principles is based on the FTC’s authority to prohibit “deceptive acts.” (See Chapter 9.) In its “Safe Harbor Overview” the DOC stated that “failure to abide by the commitments to implement the safe harbor principles might be considered deceptive and actionable by the Federal Trade Commission.”15 No case has been prosecuted on violations of the safe harbor principles, so it is not known whether the courts will interpret violation as a deceptive act.

The safe harbor principles drew fire from all directions. Activists in the European Union also objected to what they viewed as a weakening of privacy rights. “We want anyone who is doing business with the EU to respect the rights that we have built up here,” said James Murray, director of the European Consumers’ Organization, based in Brussels, Belgium. “If someone knows about your personal habits that would be viewed as excessive.”16 In addition to the criticisms of the privacy activists, some criticized it because the principles could constitute a trade barrier. “What we need is a reasonable balance between consumer rights to the privacy and security of data and the legitimate interests of businesses to use that data in order to meet our customers’ goals,” said John Schall of the National Business Coalition on E-Commerce and Privacy.17 Some Coalition members criticized the safe harbor principles as too vague. The Coalition wrote to the DOC stating, “The coalition questions the appropriateness of this importation of EU privacy standards into the U.S., especially at a time when Congress and state legislatures are

13

This agreement did not pertain to data collected in the United States.

San Jose Mercury News, June 5, 2000.

15 Department of Commerce, “Safe Harbor Overview,” www.export.gov/safeharbor.

16 San Jose Mercury News, June 5, 2000.

17 The New York Times, June 5, 2000.

14

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addressing what kind of privacy policy should apply on that country.”18 The Coalition members, most of whom are in financial services, had privacy rules established in the Financial Services Modernization Act of 1999. Senate Banking Committee chairman Phil Gramm (R-TX) criticized the EU directive for ignoring U.S. law. The Coalition wrote, “The EU’s failure to accept these U.S. laws as ‘adequate’ implies that U.S. financial-services organizations and other businesses, broadly defined, must accept EU standards in toto or face the serious consequences of possible denial of data flows, even if these organizations are in complete compliance with U.S. law.”19 Application of the Safe Harbor Principles to the financial services industry has been problematic.

The industry estimated that full compliance with the EU data protection directive would cost $17 billion a year and strongly opposed the safe harbor principles. The industry argued that the 1970 Fair Credit Reporting Act and the 1999 Gramm-Leach-Bliley Act, the Financial Services Modernization Act, provided adequate protection. To deal with companies that did not agree to the safe harbor principles, the EU developed an alternative compliance mechanism. It sent “take-it-orleave-it contracts to companies, and the contracts included, for example, an opt-in policy. The EU stated: “The standard contractual clauses contain a legally enforceable declaration (“warrant”) whereby both the “Data Exporter” and the “Data Importer” undertake to process the data in accordance with basic data protection rules and agree that individuals may enforce their rights under the contract.” This means that individuals who believed that their personal data had been inappropriately exported could file lawsuits for damages. The Bush administration firmly rejected the contracts, stating that the EU should accept U.S. law as giving adequate protection. A stalemate between the United States and the EU developed.

Many issues remained about the application of the EU Data Protection Directive. For example, what constitutes personally identifiable information? Does the permanent part of a computer’s IP address constitute personal information even though the identity of the user is not known? The EU apparently is prepared to treat it as such. This could prohibit anything other than session cookies— cookies that last only for the user’s current session on the computer.

The EU was also concerned about devices that tracked browsing. First, the devices were “invisible” to the user. Second, the principles of the Directive required that users know how information on their behavior would be used. The EU policy developed in 1999 thus required that browser software and hardware “should not, by default, allow for collecting, storing or sending of client persistent information.” This means that browsers by default should process only the minimal information needed for the purpose and “cookies should, by default, not be sent or stored.”20 One argument is that cookies do not violate the EU’s data directive because they contain only anonymous information and no personal information. This is a U.S. perspective.

Indeed, the EU may view the data privacy direction as pertaining to more than personally identifiable information (PII). The EU directive refers to “personal” data. For example, an EU Web site presents a report “Privacy on the Internet,” which states on page 67, “DoubleClick

18

The Wall Street Journal, April 6, 2000.

The Wall Street Journal, April 6, 2000.

20 The Working Party, February 23, 1999. The Working Party was established by the Directive and consisted of national privacy commissioners.

19

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collects and processes personal data …” “The personal data … are: the permanent part of the IP address, i.e., the Net address, domain, country, …, identification number (assigned by DoubleClick), referencing of browsing activities (collection and analysis of the sites visited by the user).” When DoubleClick operated in Europe it had a separate policy for each country so as to conform to host country laws. For example, in Germany it did not use cookies.

A survey of 75 large and medium-sized firm by Andersen Consulting released in August 2001 found that none satisfied all of the Safe Harbor Principles. Only 2 companies satisfied all but one principle, and 8 satisfied only one. “`Disruption to the conduct of business is a real risk,’” said Andersen principal Kerry Shackleford.21 The EU Commission Staff Working Paper, February 13, 2002 reviewed progress with the Safe Harbor Privacy Principles. The Paper indicated that few individuals had lodged complaints “and to the Commission’s knowledge, no complaint so far remains unresolved.” The Paper complained that as of December 1, 2001 only 129 U.S. companies had subscribed to the principles. Moreover, the Paper stated that “A substantial number of organizations that have self-certified adherence to the Safe Harbour do not seem to be observing the expected degree of transparency …” By mid2005 many hundreds of U.S. companies had satisfied the safe harbor principles.

Aldeasa and the EU Duty Free Abolition (A) PowerPoints are available for this case aldeasa.ppt.

The objectives of this case are threefold. First, the case provides an opportunity to examine the institutional structure of the European Union. Second, it provides an opportunity to formulate a nonmarket strategy for an EU company. Third, it raises the question of whether the strategy Aldeasa and the other duty-free operators used is likely to become more common as the EU enlarges and its institutions are granted additional power. The PowerPoints provide information on the first two objectives.

Teaching the case The following discussion questions can be used: • How much progress has the EU made in tax harmonization? The answer is very little. • Why is there any hope for reversing the elimination?

That is, why would the EU even consider changing the directive? There are two possibilities.

The first is that since very little progress has been made in harmonizing fiscal policy, why should harmonization of duty-free be required? The second is that the industry could mount a successful nonmarket strategy.

• What is Aldeasa’s current market situation? What is at risk?

21

Yahoo! News, August 16, 2001.

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• What are its competencies? This is a company selling luxury goods to captive customers in a monopoly environment in a single country. It is not at all clear that it has any distinctive competencies outside its current setting.

• How has its diversification been progressing? The airport division still accounts for nearly 90 percent of its revenue.

• Should it diversify more? Why? In which directions? Can it do it profitably?

• Taxes are high in the EU. Does this mean that prices are low in duty-free stores? Why not?

• What do you want to do about your contract with AENA? (Fee is a percent of sales; contract ends in 3 years.)

• What pricing strategy should it adopt if duty-free is eliminated?

• What is the Commission’s rationale for eliminating duty-free on intra-EU travel? At one level the answer is that it is being eliminated because it distorts markets. At a higher level it is being eliminated because the EU is supposed to be harmonizing its tax policies.

• How was the June 30, 1999 date arrived at? Why did the United Kingdom want a 15-year transition? The answer probably was to protect scotch whiskey.

• Which EU institutions will be involved in any consideration of repeal or postponement?

• Where does authority rest?

• What is the political responsiveness of the EU institutions?

• Is there a mismatch between authority and political responsiveness? The answer is yes and it works to the disadvantage of Aldeasa because the most politically responsive institutions are not the ones with the authority.

• What do you have to achieve to be successful? The answer is unanimity in the council.

• Nonmarket strategy formulation What is the issue? In its lobbying and advocacy the issue is travel and tourism.

What is your objective? primary: repeal, secondary: postpone Does Aldeasa have nonmarket assets relative to the EU institutions? no What is the nature of the politics? client Is the Parliament likely to respond? Where do you turn to influence the council? ECOFIN Which interests are on your side?

What provides an opportunity for repeal or postponement? The answer is several fold: 1) Unemployment in the EU is about 10 percent, and eliminating duty-free may increase that.

2) Some member states have elections coming up. For example, Gerhard Schroeder supported postponement.

What specifically do you do? coalitions, grassroots activity, advocacy What types of influence strategies do you use? representation and informational Which messages do you use in your informational strategy?

Where do you go in the EU government and what do you seek there?

Discussion Note that Aldeasa does not have a brand, has no products, has limited name recognition, and has little in the way of a regular clientele. Moreover, its principal asset is the exclusive concessions contract with AENA. It can try to build diversify, but there is little reason to believe that diversification will be successful.

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Aldeasa should attempt to renegotiate its contract with AENA as soon as possible. It should seek to extend exclusivity. It should seek better risk sharing by basing the fee on gross profits rather than sales, and it should of course seek a lower fee. On the contract Aldeasa wants negotiation rather than the required open bidding. The right argument to use to support negotiation is that these are exceptional circumstances. Does Aldeasa have a favorable bargaining situation? Yes. First, it will be negotiating with its (partial) owner. Second, the MOF (80 percent owner) wants Aldeasa to be financially healthy for its privatization sale. Third, the company has connections in government.

This last factor is nonmarket. (Unfortunately, its connections and nonmarket assets are all specific to Spain. The objective then is to get the Spanish government to represent its interests in the EU, but unanimity is required in the council.)

The nonmarket objective of obtaining a postponement can be argued to be a reasonable one until the time VAT and excise taxes are harmonization. The EU postponed it once, and maybe it will do it a second time. Although a postponement seems unlikely, the supporters of a postponement almost succeeded.

The interests opposing a postponement include taxpayers, who are difficult to organize and have low per capita stakes in the issue. Retailers are located everywhere, but their per capita stakes are low. The retailers, however, are well organized, making collective action low cost. Their collective incentive is strong, so they can be expected to be politically active. The beneficiaries of government expenditures would oppose a postponement, but they are widely distributed and the per capita benefits are low. It is important to remember that most Europeans view government expenditures and the taxes that fund them as a good rather than a bad. Their interests are represented by governments and ministries that view them as clients. Other possible opponents are domestic airlines, but there are few of these. Note that there are in effect little in the way of opposing, organized interests, so this is client politics.

As a basis for a nonmarket strategy, the issue here is the effect of repeal on travel and tourism. The interests that would benefit from a postponement include, of course, the duty-free operators, and it is useful to note that these companies do not compete head-to-head in individual markets because of exclusive contracts. (They do compete when there contracts are put up for bid.) Other interests include suppliers of gifts, perfumes, alcohol, and the other items sold in the shops. (A particular concern of the duty-free operators is that some suppliers may withdraw their products from dutyfree shops if duty-free is eliminated. Apparently, some high-end alcohols were withdrawn.)

Carriers and other companies that own parts of duty-free operators also have stakes, as do airports that receive fees from the operators. Fees would, of course, continue, but presumably they would be lower. These interests are significant and are the ones that will be politically active, but they are unlikely to be enough to be successful. The most important are those who can be represented by these interests. They are travelers, destinations, and the travel and tourism industries. Travelers, however, have low stakes and may be difficult to communicate with. The tourism industry and tourist destinations would also be affected, and they are already organized. The impact on travel and tourism is not known, so it is important to develop information to be used in lobbying and advocacy programs.

The basic components of a strategy have now been identified: 1) there is little interest group opposition, so focus on government and not those who would bear the cost of a postponement. 2)

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Build a coalition among the aligned interests benefiting from a postponement. 3) Represent the dispersed interests of travelers. 4) Attempt to mobilize travelers to support a postponement. 5) Develop information on the harmful consequences of failing to postpone the elimination.

The coalition is easy to organize, and much of the organizational work has already been done. The existing organizations are IDFC, AFCHOT, TFWA, and most importantly ETRF representing travel interests. Travelers can be represented by the coalition in their lobbying and advocacy campaign, but the better approach would be to mobilize them for letter writing and other forms of communication with their home governments. To mobilize travelers, the coalition must communicate with them. The most straightforward way to accomplish them is to communicate when the duty-free issue is most prominent in their minds. That is, communicate with them in airports and other facilities where duty-free shops are located. Remember that travelers are “captive,” so they have time to listen. This suggests advertising in airports, distributing materials and petitions, advertising in in-flight magazines, etc. General advertising could also be helpful.

The obvious theme is “save duty free.” This means that the campaign will have to be high profile.

Note that this is unusual in Europe, where the nature of parliamentary systems means that the most political and nonmarket strategies are implemented behind the scenes.

The key to the coalition is ETRF, which was formed for this purpose. Its specific assignment is to develop information on the adverse consequences of eliminating duty-free and to mount a campaign against elimination. The focus is on travel. The components of the campaign should be tailored to the institutions.

The three institutions of the EU are the council, the commission, and the parliament. The commission is the least politically responsive and the parliament the most responsive. The parliament has no formal role in this issue, however, so there is a degree of mismatch between responsiveness and authority.

The principal institution is the council, which is accessed through the governments of the member states. The duty-free operators and the travel and tourism industries should participate directly in this. Producers of luxury goods, such as scotch and cognac, will also participate. The relevant council is ECOFIN, and those ministries should be the focus. The coalition should also lobby the governments of the member states, since they will have to decide ultimately on how to vote.

(Interestingly, the vote took place in a Council of Europe, the heads of state, meeting.) Lobbying should also be directed at COREPER and can be done by the coalition but better yet by the interests in each member state.

The challenge is that every member state must support a postponement. Some states such as Greece own their duty-free operator, and they might be expected to be active supporters. Other countries that do not own their duty-free operators and do not rely as heavily on tourism may be the difficulty. Note that if these countries are high-income countries, structural funds cannot be used to buy their votes. Indeed, since unanimity is the decision rule, there are many possible member states that could cast a veto.

The other two relevant institutions are the commission and the parliament. The parliament has no role in this but its members, or more realistically the parties represented, can put pressure on the

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member state governments. The commission is important because it develops information and sets the agenda on the implementation of the single market. DG XXI is the lead on this issue and supports elimination. The best approach is to try to get the commission to be neutral on this issue by developing opposition within the other DGs for transport and industry. (Note that the EU apparently has decided to refer no longer to the DGs by their numbers and to use instead their names.)

The campaign carried out by the coalition centered on mobilizing travelers and the travel industry, and public advocacy was the principal instrument. The theme was “Save Duty Free” and it was communicated in magazines, airports (billboards), airlines, and on the Internet. The objective was both to influence government officeholders and to mobilize citizens. The coalition worked to generate letters and email from travelers to EU and member state governments.

A component of the nonmarket strategy of the duty-free industry was information provision.

ERTA conducted studies to identify the adverse economic consequences of the abolition of dutyfree. The information provided based on these studies is identified in the PowerPoints. This information was the basis for informational lobbying. For example, ERTA estimated that jobs would be lost due to an abolition.

The opposing retailers association countered the duty-free industry’s information lobbying with the data of its own showing that jobs would be created by an abolition of duty-free. A lobbyist for the retailers association said that it was easy to counterlobby.

The developments in the case are presented in the following (B) and (C) cases. The PowerPoints summarize the strategy of the coalition and the outcome.

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DUTY FREE ALDEASA AND EU THE ABOLITION (B) 22 “Seldom in the history of the European Union has so much money and time been spent by such a wide coalition of interests on trying to reverse a Council decision. I can understand that lobbying budgets increase exponentially with the difficulty of the objective sought, and that duty-free lobbying budgets are enormous…” Mario Monti, EU Commissioner for the Internal Market, September 1997.

In June 1997 SEPPa (Sociedad Española de Participaciones Patrimoniales), a government agency which owned 80% of Aldeasa, announced the structure of the privatization process. Tabacalera, a company in which SEPPa also owned a 52% stake, acquired AENA’s 20% stake and then fully subscribed a capital increase, raising its stake to 30%. Tabacalera held a monopoly on the distribution of cigarettes in Spain. The two companies would develop innovative market initiatives to further enhance Aldeasa’s airport retailing business, both duty free and duty paid.

Tabacalera also had important logistical operations that could benefit Aldeasa. The remaining 70% of Aldeasa’s capital were sold to domestic and foreign institutional investors through an IPO in September of 1997. Aldeasa made its debut on the stock market on September 29, at €19.89. As expected, the impact of the abolition on the company’s operations was a major issue raised by investors. To address the issue, Aldeasa developed and implemented an integrated market and nonmarket strategy.

Aldeasa Goes to Brussels In the EU arena Aldeasa pursued a coordinated non-market strategy with the rest of the duty free retailers. The small number of players, the absence of head-to-head competition (as retailers operated in under exclusive concessions in different airports) and the pre-existing relationships through some related organizations such as the Tax Free World Association favored the formation of a broad coalition. In 1995, the two main industry associations came together to jointly fight the abolition of intra-EU duty free sales: the French AFCOHT (Association Française du Commerce Hors Taxes - luxury articles) and the AngloSaxon IDFC (International Duty Free Confederation - spirits and cigarettes). Together with duty free operators they sponsored the creation of the European Travel Research Foundation (ETRF), to gather data on the impact of abolition. ETRF’s membership included retailers, airport authorities, carriers, suppliers and trade associations. Its first objective was to create an accurate database for the EU market, establishing its value and identifying the proportion of duty free sales made to intra-EU travelers. Between January and July 1997 the ETRF ordered 35 in-depth research studies from “independent” consultants, in order to assess the impact of the abolition of intra-EU duty free in such sectors as air and sea transport, tourism, producer industries, employment and public finances. A summary of the studies is shown in Exhibit 1, and served as a basis for the coalition’s informational strategy. The coalition hired an impressive group of top EU lobbyists in Brussels (including two ex-Director- Generals of ‘DGVII – Transports’ and ‘DGXXI – Taxes’). These high ranking ex-EU officials had in-depth 22 SOURCE: This caseinstitutions was preparedand for class use by Gonçalo Cadete, Antonio Varas and Wacziarg. knowledge of EU procedures, and were able to carry out a Romain nonmarket Copyright © 1999 by the Leland Stanford Jr. University. All rights reserved. Reprinted with permission.

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strategy targeted at three different arenas: the Council of Ministers, the Commission and the European Parliament. As a result of these efforts, in the spring of 1996 a series of questions started being raised in the European Parliament about the abolition. These questions, directed at the European Commission, focused mainly on the possible harmful effects of the abolition on employment and travel. After a long hibernation since early 1992, duty free interests were set into motion to obtain a further postponement or even a reversal of the Council decision.

On September 24th 1997, the coalition’s lobbying efforts came into the public eye, as it organized a highly publicized conference in Brussels under the theme “Duty Free in Europe”. Concurrently, another set of questions was raised at the EP. A campaign to save duty free sales was launched in widely read magazines, newspapers, airports, airlines and ferries, as well as on a web-site. The campaign (“Save Duty Free”) also included a massive PR and grassroots effort. Passengers, readers and online users were urged to support duty free by e-mail or to send letters to the EU Commission and national authorities. At the country level the industry started to exert pressure on national governments. Employment being an important public policy priority in most countries of the EU, it also became the main issue of the campaign: according to a report commissioned by the ETRF, between 112,000 and 147,000 jobs would be lost as a result of the abolition.

The European Commissioner Mario Monti (responsible for tax issues), who was invited to the conference, was clear about the Commission’s position: “You were given seven and a half years to prepare for the end of duty free sales to travelers within the Single Market in June 1999. It’s high time you used this time constructively, instead of trying to turn the clock back.23” In response to the conference and to the campaign, the Commission further issued a press release and a memo with the suggestive titles of “Duty free sales: Commissioner Monti appeals to reason” and “Duty free sales – the facts”. The latter summarized the Commission’s arguments to support the end of intraEU duty free sales.

Until March 1998 the lobby tried to gather support at the Transports Council and the Tourism Council, deemed more receptive to its arguments. However, both Councils referred a possible postponement decision to the ECOFIN Council. On March 9th, the finance ministers of the EU confirmed the 1991 and 1992 decisions. On April 4th 1998, the EP adopted a resolution requesting from the Commission a study concerning the regional and socio-economic impact of duty free abolition as well as its impact on employment. The Commission refused to conduct such a study on the grounds that the decision had already been made and that no further study was therefore required. In July the EP adopted another resolution on the issue. The EP took no stance on abolition but urged the ECOFIN Council to discuss the matter again and suggested an extension of the deadline. On September 17 the Regions Committee presented a Resolution favorable to the lobby. Although this Resolution had no immediate practical effects, it was a politically important step for the duty free industry, as it signaled that the EP might support its efforts to extend the postponement or reverse the abolition decision.

On December 1st, 1998, at the ECOFIN Council, France (with the support of Germany, Greece and Ireland) defended a postponement of the abolition date. Later on that month (December 11 and 12), the European Council in Vienna decided to ask “the Commission and the ECOFIN Council to

23

European Commission press release IP/97/808 - Brussels, 24 September 1997 - 'Mr. Monti commenting on the occasion of a Brussels conference on "Duty Free in Europe"'

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analyze, until March 1999, possible problems related with unemployment and study, based on proposals by the Commission, eventual measures to solve these problems, including a limited prorogation of the transitional dispositions”. In response to this request, the Commission presented a communication to the Council under the title “Consequences for employment of abolishing tax free and duty free sales to intra-EU travelers”. The Commission concluded that the abolition would only have local and temporary effects on employment. For this reason, it also considered that a uniform solution such as the extension of the transitional period was not adequate. The most efficient way of addressing such specific problems would be through other instruments, such as using European Structural Funds to ease the transition.

Aldeasa in Spain Aldeasa was extremely active in the national sphere as well. In March 1997, four months before its privatization, it successfully renegotiated its exclusive concession contract with AENA. The original concession signed in October 1992 was due to expire in July 1999, and the new contract was extended until the end of 2006. According to the Spanish regulations all concession contracts to operate airport facilities and related businesses should be awarded through a public open bidding process, but the new concession was negotiated privately between Aldeasa and AENA24.

Moreover, the new contract included several provisions to protect Aldeasa from the negative impacts of abolition in 1999. First, Aldeasa’s current duty free stores would be automatically converted into duty-paid or dual-tax stores that would also retain their exclusivity status. Second, the annual fee on sales by product would be replaced by a fee on the total gross margin, thus reducing the adverse impact of the abolition on Aldeasa’s earnings. Exclusivity was also granted to Aldeasa, unlike other duty paid contractors.

In May 1997 Aldeasa obtained an authorization from the Ministry of Finance to operate its duty free stores as dual tax stores, allowing the company to charge different prices to passengers on national and international flights. This was particularly important as both kinds of passengers tended to coexist in the Schengen areas since 1995, and also served as a test to refine company practices after abolition.

The privatization of Tabacalera, Aldeasa’s shareholder, was completed in April 1998 through a global equity offering. Upon completion of the offering, Aldeasa’s formal ties with the Spanish Government were limited to the revenues from the concessions perceived by AENA, the stateowned airport operator. However, several members of the management team appointed prior to the IPO had very close relationships with senior government officials, including the Minister of Finance. In fact, in November 1998 the former Secretary of State for Tourism, José Manuel Fernández Norniella, was appointed Executive Vice-Chairman and Member of the Board.

Aldeasa’s Market Strategy

As part of its integrated strategy, Aldeasa also implemented a business strategy aimed at minimizing the potential impact of the abolition on earnings. While several elements of this strategy were already present in the company’s operations prior to 1996, they substantially gained 24

The bilateral negotiation was nevertheless admitted under exceptional circumstances. The new concession was challenged in courts by a local retailer for its discriminatory provisions favoring Aldeasa. On March 1999 the Spanish Courts decided not to pursue any action against Aldeasa regarding the duty free concession, while the duty paid concession would be subject to further investigation.

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momentum as a result of the privatization and as the abolition was getting closer in time. The company further increased its diversification efforts, and introduced important innovations in its airport retailing operations. Aldeasa developed a new store concept, “specialized shops”, focusing on well-defined product categories and brands, as opposed to the traditional one-stop, generalist duty free shops selling primarily tobacco and liquors. Aldeasa first opened these new stores in 1992, with retailers such as Bally, Virgin, Tie Rack, Ermenegildo Zegna, Lacoste or The Body Shop. Specialized shops were operated by Aldeasa under semi-franchise agreements.

Among the other elements of its market strategy, Aldeasa opened duty paid shops at airports, fully exploiting the commercial potential of its captive customer base and leveraging its knowhow in airport retailing. The company also moved one step further in the duty paid business by opening its first duty paid stores in urban areas. It developed its own proprietary product brands or obtained exclusive marketing rights from prominent brands such as Ricard, Jameson or Allied Domecq under the label “Exclusive to duty free”. This effort to build the Aldeasa brand as opposed to the generic “duty free” denomination was supplemented by advertising campaigns. At the end of 1998 Aldeasa operated 34 general duty free shops and 63 specialized stores in Spanish airports, as well as 15 stores in non Spanish airports. The outcome of this strategy was a reduction in the relative weight of intra-EU duty free sales and a focus on less tax-sensitive products. The share of duty free sales in Spanish airports in total sales decreased from 85% in 1994 to 66% in 1998, with intra-EU sales estimated to account for approximately 50% of total sales in 1998. The product mix gradually shifted away from traditional duty free products such as tobacco and alcoholic beverages to other items. Although gross margins were higher in traditional duty- free products, perfumes and miscellaneous items were less sensitive to the tax-free effect as they were not subject to special taxes.

The Future

On February 1, 1999, Aldeasa’s stock traded at €35.25, 77% above the IPO price. The company had continued delivering strong financial results, with a 16% growth in revenues and 22% growth in net income in 1998. Financial analysts and investors seemed to believe that a last minute reprieve for duty free abolition, or at least an additional postponement for several years, could not be entirely ruled out. This last card was to be played at the ECOFIN Council meeting to be held in March of 1999. The lobby coalition was still fighting on, encouraged by the fact that several countries (including UK, France and Germany) had showed indications that they wished to review the issue. In addition, most analysts believed that Aldeasa’s market strategy and captive customer base would prevent a major hit in the company’s net income. Therefore, Aldeasa was broadly ranked as a “Buy” or “Strong Buy” stock.

Study Questions 1. What is the position of the European Parliament on this issue? Why? Is the EP likely to have an effect on Council decisions?

2. Why didn’t Aldeasa lobby the Spanish government to obtain a reversal of the EU abolition decision in the Council of Ministers?

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3. Are Aldeasa and the coalition likely to obtain a further postponement of the abolition at the March meeting of the ECOFIN Council? Are they likely to obtain a reversal of the 1991-92 decision to abolish duty free sales for intra-EU travel?

Exhibit 1: Summary of Selected Findings in ETRF’s Reports Project Key Findings The Impact on UK • There would be a small annual reduction in net Government Public Finances of the receipts, estimated at about GBP 18m at 1996 prices Abolition of Intra-EU • Abolition would not lead to a significant increase in overall Duty and Tax-Free receipts by the UK Exchequer (prepared by NERA, • Abolition would lead to consumer substitution from products March 1997) with a high UK manufactured content to goods with a lower UK content The Abolition of • The loss of sales of Scotch and UK-sourced gin and vodka would Intra- EU Shopping. be about GBP 184m Impact on Scotch Whisky and • Scotch producers would be hit harder than any other product Other UK Spirits group (prepared by Pieda, • There would be “trading down” between different Scotch brands July 1997) and between Scotch and other alcoholic beverages There would be about 1,000 job losses • Dramatic fall in passengers traveling Impact of the Abolition of Intra-EU • Likely closure of more marginal ferry routes Allowances upon the • Significant employment losses concentrated in particular areas environmental effects • Adverse European Ferry Increase in costs of in access Falling investment the provision of sea transport services Industry (prepared by • Abolition will reduce airports’ ability to fund necessary • • MDS Transmodal, • June 1997) Impact of the Abolition of Intra-EU infrastructure investment, which may lead to capacity and service Duty Free Allowances problems on the Air Transport • The development of regional airports will be severely affected by Industry in Europe the above problems (prepared by The • There will be significant job losses, extending beyond the air Portland Group, transport sector September 1997) • The price of air travel within Europe will increase, especially for charter and low-cost airlines • Charter traffic will switch to non-EU destinations Source: ETRF, FT Retail & Consumer Publishing

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DUTY FREE ALDEASA AND EU THE ABOLITION (C) 25 “…but in this case, the decision is not going to be changed, even if the budgets were increased to infinity. The time has come for the airlines, airports and ferry operators, as well as suppliers of tobacco and alcohol products, to face up reality and invest their money wisely to get ready for 1999.” Mario Monti, EU Commissioner for the Internal Market, September 1997 At the European Council meeting of Cologne, on June 3rd and 4th 1999, the EU Heads of States confirmed that intra-EU duty free would be abolished at midnight on June 30th 1999. 14 of the 15 Heads voted in favor of an extension of the abolition deadline and only one country, Denmark, voted against it. A unanimous decision was necessary to change the decisions previously taken, so the process finally reached its conclusion: on June 30th, 1999, intra-EU tax and duty free sales were abolished.

The issue had been brought back to the table by the new German Chancellor, Gerhard Schroeder, who had pledged to press for an extension of the abolition deadline during his election campaign.

The French and British Prime ministers supported Schroeder’s plea for an extension. Officials at the European Commission state that, although Denmark was the only country to have voted against the extension, other countries such as the Netherlands, Belgium, Italy, Portugal and Finland opposed the extension but “free rode” on Denmark’s veto.

After the failure of this last minute attempt, EU duty free retailers started to define its strategy for the new operating environment after abolition on July 1, 1999. A joint effort was made to create a new retailing format to replace the duty free for intra-EU flights or ferries. All EU duty free retailers agreed to jointly promote a common brand, “Travel Value”, for their former intra-EU duty free operations, while pricing and marketing strategies would be determined by each retailer.

Aldeasa’s strategy has primarily focused on retaining its customer base. Consequently, it has maintained its pre-abolition prices (with most taxes absorbed by reducing margins) in almost all of its product categories except tobacco, which maintains a dual price system. In addition, Aldeasa launched a massive advertising campaign to support the introduction of the “Travel Value” brand.

On September 27, the company released sales and operating profit figures for July and August, the first two months after the abolition. Results were worse than financial analysts’ expectations.

Operating profit fell by 52% compared with the same two months of 1998, due to higher than expected promotional expenses and the aggressive pricing policy. As a result, the operating profit margin fell from 17.3% to 9.5%.

Aldeasa’s duty free sales for intra-EU passengers (whose tax-free regime was suppressed on July 1, 1999) have declined by 21.8%, less than the financial analysts’ 25% forecast. Furthermore, duty free sales for third country passengers (whose tax-free regime remains in force) have declined by 14.5%. Market analysts suggest that the industry’s media campaign to obtain an extension of the abolition deadline may have backfired, and that consumers may have been under the impression the abolition applied to all sales. Confirming this view, Aldeasa has stated that the impact has been stronger in countries where the media campaign has been most aggressive, such as the UK,

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Copyright © 1999 by the Leland Stanford Jr. University. All rights reserved. Reprinted with permission.

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Germany and Scandinavia. Furthermore, Aldeasa’s sales volume in most product categories fell despite the fact that the company absorbed the abolition by shrinking its margins on almost all of those product categories, without changes in prices.

Exhibit 1: Sales Evolution, July & August 1999 (Euro mn) Total group

July and August July and August % Change 1999 1998 77.03 86.25 -10.7 67.06

77.33

-13.3

36.45

46.63

-21.8

- Spanish Duty Free 3rd countries

13.53

15.82

-14.5

- Spanish duty paid

8.88

7.75

+14.5

- Non-Spanish airports

8.20

7.12

+15.2

Palaces & museums

3.92

3.56

+10.1

Logistics group

6.05

5.36

+12.9

Total airport retailing - Spanish Duty Free intra EU

Source: Aldeasa and BSCH Bolsa

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Chapter 16 China: History, Culture, and Political Economy China has replaced Japan as the principal focus of U.S. attention in Asia. With over 1.3 billion people and a huge economic potential, China has a major economic force. A large number of companies have rushed into China, and some of them have had success. For many it is the promise rather than the actuality of success that has provided the attraction. In addition, Chinese-owned companies have flourished both in the domestic economy and in export markets, particularly as suppliers of goods for developed countries. In contrast, the state-owned enterprises continue to face major challenges. Chinese citizens enjoy substantially higher incomes than a decade ago and greater freedoms in economic activity.

Despite these impressive advances, China continues to be a party-controlled country with only occasional democratic innovations such as the evolving development of a judicial system. Human rights are restricted, and democracy movements and some religious activities are blocked. China continued to protect its economy from competition, welcoming foreign direct investment. Some greater openness of the CCP processes has resulted, but there is no indication that the CCP is preparing to or willing to loosen its grip on the government and the country. The nonmarket environment in China should continue to generate a series of issues that have substantial implications for business.

The intervention of the CCP and the government in the economy will continue to have implications for business in China. Some industries such as the media have been off-limits to foreign firms.

Change could also result from the continuing problems faced by state-owned enterprises. SOEs are currently being restructured, but this also means weakening the social structure that is dependent on those companies. The chapter case Wugang and the Reform of State Owned Enterprises addresses the complexities of reform.

The possibility of social unrest as a result of slower growth and contractions of the activities of SOEs remains a possibility. The government’s sensitivity to social unrest could lead to actions in the economy to avoid unrest. On the other side, the continuing infusions of capital to prop up the SOEs have made many Chinese banks insolvent.

A lecture could also focus on culture, only one aspect of which—Confucianism—is considered in the book. As the book indicates, however, “a degree of modesty is warranted in drawing conclusions about social and economic organization from this highly complex ethical system. On the other hand attempting to understand Chinese groups, organizations, and behavior without sensitivity to the Confucian heritage would be incomplete at best.”

During the rapid growth in the Japanese economy in the 1970s and 1980s, commentators began to refer to Confucian capitalism, built on long-term relationships and government direction, as an alternative to market capitalism. The growth of the Asian tigers through the mid-1990s buttressed the arguments that Confucian capitalism was an effective way of organizing an economy. Skeptics dismissed this perspective, and the Asian crisis of the last part of the 1990s suggested that the

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skeptics may have been right. In some countries, the Asian version has since become known as cronyism capitalism, and is pointed to as a source of problems.

Corruption remains a serious problem in China. Whereas the heads of the CCP may be honest, at lower levels of the party corruption is apparently rampant and in public opinion polls ranks as the country’s worst problem. An instructive article appeared in The New York Times, March 11, 1999.

The article began, “In a typical Chinese town like this one [Hepu], the local Communist Party chief rules with the authority of an old-time mobster.” One common practice is to sell local government positions, which command a high price since they can extract substantial sums as bribes and graft.

The market price of a position is about what can be extracted in a year, and a bureau chief position is said to go for $2,750 and a position to run a small town commands $2,500. The article “In Land Where Bribes Are Common, Mr. Lai Pushed the Envelope,” The Wall Street Journal, November 23, 2001, tells the story of one person’s role in corruption. The government is aggressive in trying to stop corruption both because corruption is harmful and because it is a possible source of social unrest.

In 2001 China was admitted to the WTO. Admission to the WTO carried with it an obligation to reduce the protection of domestic industries, and China has been fulfilling its commitments. A number of the protected industries such as agriculture, automobiles, and financial services were inefficient, and imports were a threat in those and other industries. Unemployment is a very serious problem in China because in spite of its high rate of economic growth the inefficiency of its state owner enterprise sectors mean that millions of people are being laid off so as to increase efficiency.

Since China has little in the way of social security or medical care for the unemployed and the retired, this increases the risk of social unrest. The government fears such unrest.26

Cases Wugang and the Reform of State-Owned Enterprises This case focuses on the plight of state-owned enterprises (SOEs) and the government’s attempts to reform them into profitable business enterprises after the failure of the communist economic system. The transition to a market economy is difficult under any circumstances, but in China it is considerably more difficult because of the role of SOEs in providing social welfare services. In addition to providing many of the services of a medium-sized city, Wugang had absorbed some of China’s unemployed urban youth resulting in a vastly swollen work force. The SOE system and its provision of social services had major implications for not only the SOEs and their dependants but also for the economy as a whole. In particular, the system allowed little labor mobility other than through the government’s assignment of workers to enterprises. With limited labor mobility the

26

See, for example, the article “Leaner Factories, Fewer Workers Bring More Labor Unrest to China,” New York Times, March 19, 2002.

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economy had little flexibility and workers cold not be matched to jobs as they would be in an economy with an active labor market. The changes in CCP’s thinking about the economy resulted in major inflows of FDI and the establishment of many new companies by Chinese nationals. The success of this new sector of the economy contrasted sharply with that of the SOEs which were bloated, inefficient, and loaded with non-economic responsibilities. The CCP, even if it had wanted to, could not allow the SOE sector to fail because it employed such a substantial portion of the work force and because a social welfare system was not in place to handle the unemployed during what would be a long transition and painful transition to a market-based system. The government decided to privatize most of the smaller SOEs, and to preserve many of the largest ones. The latter, however, would have to become more efficient, which would require large amounts of funds and difficult decisions. Subsidies and price controls were being lifted, exposing the inefficiencies in most of these enterprises. As mentioned in the text, state-owned banks made soft loans to these SOEs to keep them afloat. These soft loans, which would likely never be repaid, were causing a crisis in China’s banking system. SOEs like Wugang had operated as largely self-sufficient systems providing not only social services to employees and their families but also vertically integrating to provide most of the inputs needed for its operations. This vertical integration might have made sense in a state-directed economy that operated without markets, but it was an anachronism during the transition to a market economy. In addition to being overstaffed, Wugang had had weak incentives for innovation and efficiency. Instead it had been subsidized by artificially low input prices and artificially high output prices. In addition, the effective taxes it paid were high. China’s relative isolation and its shortage of foreign exchange had also left Wugang with inefficient technology and equipment.

Part of the class discussion could focus on the nature of the communist economic system and its contrast with a market system. China’s decision to reform its economy and restructure its SOE sector had to be implemented in a manner that did not result in social unrest, about which the CCP and government are very sensitive. In addition to structural problems and inefficient technology, managers had little authority to take major steps to improve efficiency.

Privatization was the principal instrument of reform, but China decided to preserve many of its largest SOEs, including Wugang. (This also served to mollify the conservatives in the CCP.) The success of South Korea’s chaebol provided a guiding example of how business could thrive with limited support from but under the guidance of government. (The chaebol bubble subsequently burst.) Liu Benren had little authority to reduce Wugang’s work force, but he did have the authority to follow a strategy similar to that of the central government. He was able to privatize many of the workshops in his efforts to make the steel operations profitable. He had invested in modern technology during the early 1990s and had the advantage of producing steel products that were in high demand in China and in export markets. Beginning in 1997, however, the Russian and Asian economic crises had resulted in a flood of low-priced imports depressing prices and Wugang’s prices. Liu responded in the same way as the U.S. steel industry responded by filing an antidumping petition with the government. (See Chapter 18 for information on antidumping.) Overcapacity remained a problem in China, however. As an example of the commitment problem

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discussed in Chapter 16, the government summarily banned new plant construction in response to falling prices. (See also the chapter case Direct Marketing in China for another example of a decree summarily enacted.)

To become an efficient and competitive company, Liu had to make major changes in structure and management.

With the backing of the government, which sought to ensure that Wugang would be successful, Liu had to make major changes yet make them in a manner that did not harm workers and their families during the transition and did not lead to social unrest. This had to be accomplished in an industry with worldwide excess capacity and falling prices. In exchange for government support Wugang was forced to absorb smaller steel companies. Wugang also sought to increase its size by merging with the largest steel producer in China.

China had grown rapidly during the 1990s and the inflow of FDI and the establishment of new companies

by Chinese nationals had absorbed some of the excess workers from the SOEs and some of the people from rural areas growth slowed as a result of the Asian The following questions can beseeking used tojobs. guideBut theitsdiscussion. economic crisis reducing the rate of absorption of excess workers companies.

1. What were the characteristics of the Chinese SOE system duringinto thenew period of the iron rice Teaching the case bowl?

2. What were the impediments to efficiency in this system?

3. What were the implications of the SOEs’ social services functions for reform of these enterprises?

4. Why are the CCP and the government so sensitive to social unrest? (See also the chapter case Direct Marketing in China.)

5. Is privatization the right answer for reform of the SOEs? If so, why are Wugang and other large SOEs not being privatized?

6. What are the principal challenges facing Liu Benren?

7. What constraints does he face?

8. What strategy should he adopt to attain competitiveness and profitability for Wugang?

9. Should he continue to seek support from the government or should he seek independence for Wugang?

Direct Selling in China PowerPoints are available for this case.

Amway is a family-controlled company, and Amway Asia Pacific is 85% owned by the founding families. In addition to its 70,000 agents Amway Asia Pacific operated a factory in Guangzhou and

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planned a second factory in Shanghai. Amway Asia Pacific operated in 10 provinces in China with a population of 300 million. Amway itself operated in 80 countries and territories.

China represented a substantial opportunity for Amway with a large population, rapidly rising per capita income, and an ample supply of direct marketers. Its nonmarket challenge arose from unscrupulous direct marketing firms operating Ponzi and pyramid schemes. The schemes resulted in financial losses to many people attempting to earn a living in direct marketing. The unscrupulous operators generated social unrest, leading in one case to riots, injuries, and deaths.

The government department responsible for the supervision of direct marketing was the State Administration for Industry and Commerce (SAIC), which had responsibility for the distribution industry. In 1997 “the SAIC had closed 570 direct sales firms that had no license, investigated 2,500 cases of illegal direct sales and seized goods involved in the sales worth 70 million yuan (about HK$ 65 million).”27 To deal with the problem, China issued a broad directive that shut down the scrupulous direct marketers as well as the unscrupulous ones. Amway was told that it could continue to operate in China by selling through retail stores. This was contrary to Amway’s market strategy which was built around direct marketing by independent agents. Amway’s China opportunities were thus directly threatened by foreclosure.

This was not the first problem Amway and other U.S. direct markets had had with the Chinese government. Sales had been suspended three years earlier, and the companies had had to deal with suspicions of the government that the companies were close to running a cult or religious organization. Amway Asia Pacific had attempted to build good relationships with the relevant provincial and central government agencies. Amway reported that it had received several provincial awards.

Amway had two basic and not mutually exclusive nonmarket alternatives. First, it could take action in the United States to enlist the U.S. government to come to its aid. Second, it could attempt to work within the Chinese system with the objective of having the ban lifted or to negotiate an acceptable arrangement with the Chinese government. The first alternative could be conducted as a high-profile activity working through Congress which was frequently dealing with human rights, international trade, and other matters involving China. This issue would add new fire to the China critics in the United States. The first alternative could also be conducted as a lowprofile activity involving lobbying the USTR and the Clinton administration to put pressure on China. This could be supported by behind the scenes lobbying of the congressional committees with jurisdiction over international trade policy.

Teaching the case:

The following questions can be used to guide the discussion.

1. How attractive an opportunity does the market in China represent for Amway?

2. How did the nonmarket problem facing Amway arise?

27

, April 21, 1998.

South China Morning Post

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3. What specific problems is the Chinese government attempting to solve with the directive issued by the State Council?

4. What objectives should Amway pursue on this issue?

5. Should Amway open retail stores in China? (It does not have retail stores in any country.)

6. What strategy should it adopt in China and in the United States? What is the nature of the politics in which that strategy would be implemented?

7. Should its strategy be high-profile or low-profile?

8. If it were able to negotiate with the Chinese government on a revised directive, what should it seek to achieve and what would it accept?

9. What revised directive could Amway propose that would address the serious problem the government sought to solve and still allow Amway and other legitimate direct marketers to continue their business in China?

10. Is Amway likely to be successful in being allowed to resume its operations in China?

Outcome Amway and the other U.S. companies chose a low-profile strategy of working within the Chinese system and behind the scenes lobbying the U.S. government to pressure China to change its rule.

Instead of mounting an effort in Congress to seize advantage of anti-China sentiments, Amway chose to engage in client politics in China. This was wise because if Amway were successful in being allowed to resume operations it would want to be able to maintain good relationships with the Chinese government. Embarrassing the Chinese government when it was attempting to deal with a serious problem would not serve Amway well. Furthermore, as Richard Holwill said, “We have been told that they have no problems with Amway.”28 The first step was a meeting with Wu Yi, the state counselor for trade and foreign investment. The results of that meeting and subsequent lobbying by Amway are not known nor are the subsequent actions. Negotiations such as these are not uncommon in China, where laws are enacted summarily and then exceptions are negotiated.

Two months later the Chinese government issued a new order that allowed Amway to resume operations in China. The new order, however, required a change in Amway’s operations. Instead of having its sales agents purchase merchandise from Amway, they now must act as conventional independent salespersons earning a commission on sales. The agents thus will not have any financial risk themselves, according to the agreement. (It is not clear that they took a financial risk before, since Amway had a complete refund policy.) This provision presumably was directed at those direct marketers that left agents without recourse to disposal of unsold goods, as in the case of the foot massageurs.

The new order also had two provisions intended to drive out the direct marketers operating Ponzi and pyramid schemes. First, it required direct marketers to have invested at least $10 million in China. Second, it required that direct marketers in China also have similar operations in other counties. Amway Asia Pacific chairman Steve Van Andel said, “What’s crucial is that they have allowed us to retain our independent sales force and to continue to make direct sales.”29

28 29

Business Week, May 11, 1999.

San Jose Mercury News , July 21, 1998.

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Without knowing all the details, China’s new order appears to be a reasonable response to the fraud being perpetrated by unscrupulous direct marketers. What is particularly interesting in this case is the process used by the Chinese government to obtain this outcome. It first summarily enacted a rule banning sales and ordered it enforced. Then, it began to work out a new rule that would address the source of the problem while enabling legitimate direct marketers to continue operations in China. In contrast to the U.S. system where the legislative process is open and regulatory processes are subject to due process requirements, an authoritarian government with no due process or openness requirements can act and then sort out the good from the bad later. The absence of due process, openness, and opportunities for public participation weakens the credibility of commitments by the Chinese government.

The following (B) case continues the issues.

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Direct Selling in China (B) To rescue their businesses in China, the U.S. direct marketing companies chose a low-profile strategy of working within the Chinese system and lobbying the U.S. government behind the scenes. In China the companies engaged in client politics. This approach not only had the best chance of success in obtaining changes in the rule, but if the companies were successful in being allowed to resume operations they would want constructive, continuing relationships with the Chinese government.

The first step was a meeting with Wu Yi, the state counselor for trade and foreign investment. The U.S. companies continued to interact with Chinese bureaucrats, seeking a workable resolution of the problem. Two months after the ban the direct marketers met with partial success. The Chinese government issued a new order that allowed the companies to resume operations.

The new order, however, required major changes in the direct marketers’ operations. Direct selling continued to be prohibited, but the companies were allowed to operate in either of two forms. The first allowed door-to-door representatives to promote and demonstrate products and provide preand post-sales service, but they were not allowed to make sales or take orders. The representatives could not buy product from the company but could be compensated through bonuses and commission on orders placed by those they visited. Amway chose this form of operation but was unsure how many of its 75,000 former sales representatives would choose to work under the new arrangement.

The other mode of operation was to sell from the company’s own retail outlets or as a wholesaler through other retailers. Avon chose to sell its products in department stores, beauty boutiques, and kiosks. Chinese law also restricted the companies to sell only products manufactured in China, and Avon opened a manufacturing plant in the city of Conghua in 1999. 30 The new order also had two provisions intended to drive out those who operated Ponzi and pyramid schemes. First, it required direct marketers to have invested at least $10 million in China. Second, it limited direct marketing in China to companies that also had similar operations in other counties.

Although the new order was welcomed by the companies, it prohibited them from implementing their market strategies and exploiting their competitive advantage. Not only did they want to be able to resume door-to-door sales, but they wanted to sell imported products. The door-to-door sales restriction and the manufacturing requirement were not only domestic regulations; they were also barriers to international trade.

Each year, after protracted congressional debate and intense politics, the United States had granted China temporary Most Favored Nation status. This gave China the right to trade with the United States on the same grounds as other countries. The United States and other countries also had blocked China’s entry into the World Trade Organization (WTO) on both economic and human

30

In 2000 Avon began a similar strategy in the United States, selling its products in boutiques in J.C. Penny and Sears stores.

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rights grounds. The economic issues centered on China’s extensive restrictions on imports and other policies that closed domestic markets to imports and in some cases prohibited foreign direct investment. The countries were also concerned about human rights violations in China.

Companies operating in China supported its entry into the WTO on the grounds that continued economic liberalization, growth, and a rising standard of living were the best means of achieving progress on human rights and democratization. Opponents focused on human rights abuses and argued that withholding MFN status and WTO membership would force China to improve its citizen’s human rights. Unions in the United States were major opponents of MFN status and WTO membership for China. To overturn the ban on direct selling, the direct marketers worked through the Clinton administration and the United States Trade Representative. In April 1999 China and the United States reached an agreement to remove all market access restrictions on direct selling by January 1, 2003. The agreement was conditioned on the successful completion of the negotiations between China and the United States on China’s accession to the World Trade Organization. In November 1999 China and the United States signed an agreement withdrawing U.S. opposition to WTO membership. In conjunction with this agreement the proponents of normalized relations with China backed legislation establishing permanent normalized trade relations (PNTR), which would extend permanent MFN status to China and formally end U.S. opposition to China’s accession to the WTO. The Clinton administration backed PNTR, but there was considerable opposition in Congress, which had to enact legislation granting PNTR. The direct marketing companies saw the PNTR campaign as an opportunity to relax the restrictions they continued to face in China. Accession to the WTO required approval by two-thirds of the member countries, and China was believed to already have the needed votes. The companies pointed out that if China joined the WTO and the United States did not establish PNTR, Article 13 of the WTO allowed China to withhold from the United States the tariff reductions that would accompany WTO membership.

Preparation questions: 1. Should the U.S. direct marketing companies operating in China become active in the PNTR issue? 2. If so, what objectives should they have? 3. What strategy should they employ and how should it be implemented? 4. What arguments would you use in supporting PNTR for China?

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Comments on Direct Selling in China (B) At the level of nations the politics of the PNTR issue is that of client politics, with China attempting to become the “client” of a majority of Congress. It is unwise politically for China to actively engage in politics by, for example, directly lobbying in Congress. Instead, China relies on agents—primarily the companies operating there—to work on its behalf. The companies understood that their active support of PNTR would be welcomed by the Chinese government, and most were eager to support PNTR. The direct marketers were no exception.

The two principal objectives of the direct marketers were to be able to resume door-to-door sales before 2003 and to remove the ban on selling imported goods. Joining the WTO would force China to lift many of its trade restrictions and remove domestic barriers to trade. This could take some time, so the direct marketers wanted to be in a position to work with the Chinese government to relax the restrictions on their business operations as quickly as possible. The companies sought to become clients of the Chinese government, and their instrument was active support for PNTR. Note that there need be no formal discussion of this client-agency relationship, since both sides understand the situation and their own objectives.

Given the April 1999 agreement the U.S. direct marketers were in effect obligated to work on China’s behalf on PNTR. Otherwise, their relationships with the Chinese government could be jeopardized.

The U.S. companies lobbied both individually and through coalitions and associations. Some of these were based in China. In many countries including China, U.S. companies belong to the local American Chamber of Commerce (AmCham) organization. In China 2500 U.S. companies belong to AmCham, and non-U.S. companies also belong to the organization. The American Chamber of Commerce in Hong Kong and the American Chamber of Commerce in Shanghai lobbied actively in Washington. (Hong Kong has a special administrative status in China, so there is an AmCham chapter there as well as in Shanghai.)

Avon not only participated in AmCham and lobbied directly in Washington, but Avon’s China division held a seminar in Guangzhou on PNTR for corporate executives. The objective of the seminar presumably was to garner support for PNTR but also to do it in a manner visible to the Chinese government. The headquarters of Avon China was in Guangzhou, and it had branch offices around the country.

Avon believed that if China joined the WTO it would have to allow door-to-door sales and would be forced to lift its import restrictions. WTO membership was thus the instrument for resurrecting its market strategy in China.

Developments As a result of the 1998 crackdown Amway’s sales in China dropped from $170 million to $39 million. The agreement negotiated with the Chinese government allowed the companies to resume

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business. By 2000 sales had rebounded to $288 million, and Amway expected to have sales of $500 million in 2001.31 Amway had 130,000 sales agents in China in 2001.

In December 2001 the Chinese government again announced a crackdown on pyramid schemes and was investigating the practices of U.S. direct marketers. Pyramid schemes and direct marketing were covered under the same Chinese law, so from the perspective of the government the two go together. This is not unreasonable from the government’s perspective, since it was concerned about direct marketers pressuring people to purchase goods they did not need. The direct marketers represented a “potentially destabilizing force,” as indicated by the earlier riots. The deputy director of State Administration for Industry and Commerce stated that pyramid operators “lure customers by promising fat profits, they sell poor-quality goods and they evade taxes. Such activities aren’t allowed in any other country.”32 Amway, Avon, and other U.S. direct marketers met with government officials who reminded them not to let their representatives get mixed up pyramid and other schemes.

Amway adopted a two-pronged strategy for dealing with the ban on direct sales by the State Council. The first was to differentiate itself from the pyramid schemes. (The connection between the two was the compensation system for sales agents, but Amway was quite different in that it provided a full refund for any unsold products.) This proved to be successful, and the government allowed foreign-invested direct selling companies to reopen with sales agents under contract with the company.

Amway was successful in receiving permission to reopen with sales made from stores. Amway opened 58 retail stores. These stores had three roles. First, they were retail outlets, where sales were made to customers, product demonstrations were given, etc. … Second, sales agents were registered with and bought products from the stores and sold them door-to-door. Third, the stores held inventory. The stores proved to be very popular with consumers.

In 2002 the government issued new regulations on direct selling. The regulations banned the payment of commissions on anything other than a seller’s own sales and more broadly prohibited multi-layered commissions.

By late 2002 Amway had 130,000 sales agents in China. Amway had 2,000 full-time employees, 600 of whom worked in the factory in Guangzhou. By early 2004 Amway had 120 stores in 99 cities in China. Amway operated no stores in any other country.

By 2004 China was Amway’s second largest market, representing 20 percent of total sales.

Amway had 160,000 sales agents.

Avon sold though 5,500 stores plus counters in 1,000 department stores. China represented 4.6 percent of Avon’s global sales.

31

The effect of China’s entry into the WTO on Amway’s business is discussed New in York Times , November 17, 2001.

32 Wall Street Journal, December 12, 2001.

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The second prong of Amway’s strategy was, along with other direct sellers, to lobby the U.S. government to require as a condition for entry into the WTO that the ban on direct selling be lifted for responsible and established companies. The companies would also benefit from the lifting of the requirement that only products made in China could be sold. The agreement with China was that it would write a new law on direct selling within three years of joining the WTO. This agreement left a considerable task with the direct sellers to influence the new law. The foreign direct selling companies undertook an extensive lobbying campaign with the objective of obtaining independent contractor status for their sales agents. The companies participating in the lobbying were Amway, Avon, Mary Kay, Nu Skin, and Herbalife. Richard Holwill, vice-president of public policy at Alticor, said, “The key to direct selling is an independent contractor responsible for sales, inventory, financing and marketing. There is no such legal status in China now. We are proposing a substantial change in the law to create such an independent contractor. That is the essence of the decision which China must now make.”33 The new law was drafted by the Ministry of Commerce. The Classification of Modes for Retailing Business divides business modes into 17 categories, one of which was direct selling. The requirements for direct selling were unveiled at the International Fair for Investment and Trade in Xiamen, Fujian province. The direst sellers participated in the event. Pyramid-selling was banned.

The new law required foreign direct sellers to have operated outside China for at least three years and have a minimum investment in China of $10 million. A Chinese direct seller was required to have 500 million yuan in sales for three years before entering into direct selling. This had the advantage of limiting competition for the foreign direct sellers. The direct sellers would be under scrutiny from the government and could be fined. The direct sellers were also required to make deposits into a fund to compensate consumers in the case of a dispute. Commissions were apparently limited to 35 percent of sales.

A Shanghai-based retail analyst commented, “This is not just an issue of sales and preventing fraud and malpractice. The government is nervous of mass organizations outside its control. Direct selling companies can employ tens of thousands of people, with their own national networks.

Beijing is not comfortable with this.”34 Eva Cheng, chairman of Amway (China) commented, “Never take for granted that people will understand your business model. You need to be in aggressive communication mode all the time.”35 At the end of the three-year period, the direct sellers would no longer be required to sell only products made in China. Amway could then close its plant in Guanghzhou if it were more economical to supply China with product made in the United States. South Korea had had a similar requirement as China, and when that requirement was lifted, Amway closed its plant there.

33

South China Morning Post , February 14, 2004. , March 6, 2003.

South China Morning Post 35 New York Times , March 12, 2003.

34

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In July 2004 Amway announced that it would establish a research center in China employing 20 scientists.

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Chapter 17

Emerging Markets This chapter identifies a set of issues associated with operating in emerging markets countries.

This is an extremely broad topic, and the nonmarket issues and the market opportunities can vary dramatically from industry to industry and country to country and region to region. Similarly, the risks can vary greatly across countries and regions both in terms of their nature and their importance. The opportunities considered include both those for for-profit businesses as well as for nonprofit organizations, as in the case of fair trade and microfinance. Greater detail on one emerging markets country, or post-emerging markets country, is provided in Chapter 16 on China.

Chapter 23 addresses a number of nonmarket issues with moral dimensions, many of which pertain to emerging markets countries.

The chapter focuses on the assessment of risks and opportunities in a country. A number of sources of information are identified in the chapter, and many more are available. The indices provide a rough idea of broad features of the nonmarket environment such as freedoms, democracy, stability, corruption, and institutions. These can be supplemented with more specific information on markets as well as institutions. An important feature of the environment of business in a country is the organization of business. In many countries the principal businesses are organized in groups often associated with a family. This often reflects a history of a weak rule of law in which businesses have had to rely on long-term relationships among related entities in the absence of enforceable contracts. The chapter briefly addresses this, and the chapter case Tesco PLC in India? concerns a company whose opportunities for partnering largely focus on business groups.

A useful classroom exercise would be to choose a country and have groups of students research the risks and opportunities in the country. The assignment could be to organize their work along the lines of the four Is and the structured pluralism perspective introduced in Chapter 14. The data sources identified in the chapter can be used to provide a broad perspective on factors such as the rule of law, corruption, and democracy, and Internet searches can be used to provide more specific information. The assignment could be focused on an industry such as wireless telecommunications, as in the chapter case MTN Group Limited. This would also be a basis for a term paper assignment.

Another class session could focus on microfinance using normative principles from Chapters 20 and 21 and the frameworks provided in Chapter 23. The chapter cases Social Enterprise: Banco Compartamos and Social Enterprise: Kiva could be used in a single session or in two sessions. As indicated in the following discussion of those cases the assignment could be on a comparison of the two approaches and an evaluation of the benefits and costs of each.

A number of cases in other chapters involve nonmarket issues in emerging market countries. These cases are identified at the end at the chapter.

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Cases Tesco PLC in India?

International markets were viewed by management as the most profitable opportunities, and Tesco had entered Japan, Turkey, China and the United States recently. India was the last remaining market opportunity for the company. Entry into retailing in India, however, was blocked by restrictions on Foreign Direct Investment (FDI).

India had removed FDI restrictions on most industries, and FDI had increased dramatically, contributing to the rapid economic growth. India had left restrictions in place in retailing, although FDI was recently allowed for single brand retailers and wholesalers. This did not help Tesco.

India continued to protect retailing because of the structure of the industry, and that structure along with rising personal income is what had made retailing attractive to foreign companies. Most retail sales were accounted for by small shops and kirana stores that provided employment for 21 million people. With 41 million people unemployed the government had chosen to protect their interests.

Moreover, the small merchants engaged in public and private politics to retain the restrictions on FDI. Small manufacturers also benefitted for the same reasons. The small merchants and manufacturers were active at both the state and federal levels.

Large companies in India were frequently members of groups, often family controlled. Some of these groups were entering into retailing, and particularly important to Tesco were building supermarket chains. Other groups had chosen to partner with a foreign retailer, as in the case of Bharti and Wal-Mart. The restrictions on FDI, however, meant that Wal-Mart would be restricted to the back-end of the business, including supply chain management, wholesale operations, and distribution. Many other foreign retailers were contemplating entering India, but Carrefour had recently announced that it would not be doing so at this time. Some of the large foreign retailers, such as Metro Cash & Carry, that had opened in India had faced nonmarket harassment by local merchants.

Tesco’s decision was not only whether to enter the India market but when to do it, whether to take a local partner, and which activities to engage in. Tesco could delay entry until FDI restrictions had been listed, but it was unclear when that would be. Also, delaying entry could be costly both because other supermarket chains would be more established and because fewer potential local partners would be available. Having a local partner was important because it could operate at the front end and because of its ability to address nonmarket issues. Moreover, shopping malls were being built at a fast pace and the other retailers would be able to open stores there.

A major problem in large scale retailing in India, and particularly in supermarkets, was that the infrastructure is bad; e.g., the road system. (This is mentioned in Chapter 17.) Supply chain management is thus much more difficult than in a country with a good infrastructure. Some retailers have reported that it is difficult to make a profit in India.

Tesco could try to implement a nonmarket strategy in India to relax the restrictions in FDI, but it had no rent chain on which to base the strategy. It could lobby the UK government to pressure India to relax its restrictions in retailing, but India had already chosen not to do so under pressure

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from the members of the WTO. It seems unlikely that the UK government would have much more impact at this point. If Tesco were to join with a local partner, that partner could take nonmarket action. This seems like a very long shot.

The likelihood that the restrictions on FDI in retailing will be relaxed in the next few years seems very low. Moreover, the inability to use a nonmarket strategy means that Tesco’s decision must be based on the timing considerations. This suggests that if the opportunity to enter is attractive the time to enter is now. The case does not provide sufficient information to make the decision, but what Tesco did is discussed below.

Discussion questions

1. Why has India left in place restrictions on FDI in retailing?

2. What conditions would likely cause India to lift those restrictions? Are those conditions likely to occur soon?

3. Evaluate the timing issue for Tesco.

4. Should Tesco deploy a nonmarket strategy in an attempt to loosen the restrictions on FDI in retailing?

5. Should Tesco take a local partner?

6. Should Tesco enter the Indian market? Should it be satisfied with backend activities?

Developments In October 2008 Tesco signed an agreement with the Tata Group, one of the largest of India’s business groups, to form a venture in which Tesco would build three warehouses to supply Tata stores and also small shopkeepers in a cash and carry format. Tesco will invest £60 million over 2 years. A Tesco spokesperson said, “We would like to open up [Tesco’s own stores] in India. [If that is allowed] we will have had the benefit of working with an experienced partner.”36 Tata operated only 4 superstores, but planned to open 46 more over the next five years.

The Indian communist party quit the ruling government coalition, which increased the prospects that the restrictions on FDI would be relaxed.

Social Entrepreneurship: Banco Compartamos This case can be taught separately or in conjunction with the case Social Entrepreneurship: Kiva .

The discussion here will first contrast the two business models.

Banco Compartamos

Kiva

Compartamos is a for-profit firm, which

Kiva is a non-profit organization, which

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Wall Street Journal, August 12, 2008.

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means that it can raise equity capital. This means it cannot raise equity capital. means that, other things equal, it is able to Instead, it relies on donations to provide it scale up its operations quickly. with funds to cover its operating cost. Kiva Compartamos needs funds not only to has a much lower need for funds since it cover its operations, but also to fund the does not itself make the loans. loans it makes.

Because it is for-profit Compartamos has Kiva has grown rapidly but its scale is been able to grow rapidly with the goal of serving 1 million customers by 2008. It is smaller than that of Compartamos. In the week of October 1, 2008, some 2,117 relatively easy for the bank to find borrowers, given that there are 14 million entrepreneurs were funded for total lending of $700,000. people without a bank account.

To scale up its operation Compartamos has To scale up its operations Kiva must grow to open branches and hire more field personnel to monitor lending. the number of field partners or hope that its field partners can increase their scale independently.

Kiva operates in many countries which Compartamos has the advantage of makes monitoring its field partners more operating in one country. That country is difficult. These countries are low income. middle income.

Kiva lends primarily to individuals, but has Lends primarily to groups of borrowers. expanded its lending to groups. This This requires personnel to help organize the increases the costs to the field partner to groups, but the groups provide internal monitor the loans. monitoring of individual borrowers.

Kiva’s risks are primarily that borrowers Compartamos faces risks of default and may divert their load funds to consumption attempts to control them by monitoring or other uses, leading to defaults. Also, conducted by their own field personnel. field partners may not be effective in identifying qualified borrowers and in collecting payments.

The benefits to borrowers are very large, The benefits to borrowers are measured since interest rates are low. One reason the interest rates are low is that part of the relative to whether the customer can borrow at all and if so what the interest ratefunds are charity; i.e., lenders do not is. The interest rate is high, but with over receive interest on the funds they provide.

800,000 borrowers the interest rates must Also, Kiva receives contributions to cover be lower than otherwise available, if at all, its expenses. to the borrower.

Moral considerations

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Compartamos provides benefits to borrowers in a country that apparently does not have many microfinance lenders. It is a social entrepreneur, but its high profits have generated criticism. It seems clear that it provides a service to borrowers that they are not able to find elsewhere, making them better off.

From a utilitarian perspective Compartamos is clearly morally good. That is, aggregate welfare is greater because of its operations. Whether it is morally “best” is unclear. For example, from a distributive perspective well-being could be increased by transferring wealth from shareholders of Compartamos to borrowers, who largely would be low income people. From a rights perspective, however, Compartamos shareholders have a right to do as the wish with the firm, and if they maximize profits, there can be no rights objection. Moreover, if shareholders are not unanimous in wanting to maximize profits, those who object can take their dividends and donate some of them to low income people.

From a social justice perspective (such as Rawls’ theory) Compartamos might be justified in providing lower interest rates. What we do not know is whether the interest rates it charges maximizes profits or are lower than the profit-maximizing rates. The firm claims to have passed on substantial cost savings to borrowers in the form of lower interest rates.

Carlos Danel and Caros Labarthe issued “A Letter to Our Peers” in response to the criticism of Compartamos’ business by other microfinance participants.

Market co-existence This leaves the question of whether a for-profit microfinance lender could compete in a country with microfinance lenders. The latter undoubtedly would have some cost advantages, particularly if it is able to obtain donations. If it has to fund its lending from retained earnings, its growth will be slow. A for-profit microfinance firm then would have an advantage.

Why do the banks in Mexico not lend to the people to whom Compartamos lends? The reason Social Kiva must be that those banks have high Entrepreneurship: transactions costs. The costs of investigating borrowers’ qualifications and making collections are likely to be high. It should be noted that in the United Kiva ancompanies important rather innovation microfinance. basically facilitates matching of Statesrepresents it is finance than in banks that makeItunsecured, short-termthe loans. individuals with funds and people in developing countries who could put those funds to work in business ventures. In contrast to charities that provide funds for programs in developing countries, the funds are provided in the form of loans, and the business ventures are anticipated to provide sufficient surplus to repay the loan plus interest. The funding does have an element of charity to it, since lenders receive no interest, and some contribute a portion of their funding to support Kiva’s operations. Kiva also receives donations and its operations are support by local firms such as

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PayPal. Kiva’s success has spawned many, many other microfinance organizations that rely on the Internet.

Kiva is a non-profit 501 (C)(3) organization, so it does not raise equity capital. Expanding its lending thus requires bringing on board new lenders and retaining current lenders as their loans are repaid. From the time the case was written to October 2008 when this is being written the number of entrepreneurs listed on kiva.org had increased to nearly 400.

Kiva lends at low interest rates commensurate with those of traditional microfinance lenders. It is able to operate with low interest rates because of low cost, donations, and reliance on field partners for operations such as loan disbursement and repayment.

Kiva has established a ratings system for its field partners and bases the funds it provides to them on their performance. These features indicate that there have been problems with some of the field partners. Kiva personnel also visit the field partners for a first-hand evaluation.

The following table contrasts Kiva and Banco Compartamos.

Banco Compartamos

Kiva

Compartamos is a for-profit firm, which Kiva is a non-profit organization, which means that it can raise equity capital. This means it cannot raise equity capital. means that, other things equal, it is able to Instead, it relies on donations to provide it scale up its operations quickly. with funds to cover its operating costs.

Compartamos needs funds not only to Kiva has a much lower need for funds since cover its operations, but also to fund the it does not itself make the loans. loans it makes.

Because it is for-profit Compartamos has been able to grow rapidly with the goal of serving 1 million customers by 2008. It is relatively easy for the bank to find borrowers, given that there are 14 million people without a bank account.

Kiva has grown rapidly but its scale is smaller than that of Compartamos. In the week of October 1, 2008, some 2,117 entrepreneurs were funded for total lending of $700,000.

To scale up its operation Compartamos has To scale up its operations Kiva must grow to open branches and hire more field the number of field partners or hope that its personnel to monitor lending. field partners can increase their scale independently.

Kiva operates in many countries which Compartamos has the advantage of makes monitoring its field partners more operating in one country. That country is difficult. These countries are low income. middle income.

Kiva lends primarily to individuals, but has expanded its lending to groups. This This requires personnel to help organize the Lends primarily to groups of borrowers.

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groups, but the groups provide internal monitoring of individual borrowers.

Compartamos faces risks of default and attempts to control them by monitoring conducted by their own field personnel.

increases the costs to the field partner to monitor the loans.

Kiva’s risks are primarily that borrowers may divert their load funds to consumption or other uses, leading to defaults. Also, field partners may not be effective in identifying qualified borrowers and in collecting payments.

The benefits to borrowers are measured The benefits to borrowers are very large, relative to whether the customer can since interest rates are low. One reason the borrow at all and if so what the interest rateinterest rates are low is that part of the is. The interest rate is high, but with over funds are charity; i.e., lenders do not 800,000 borrowers the interest rates must receive interest on the funds they provide. be lower than otherwise available, if at all, Also, Kiva receives contributions to cover to the borrower. its expenses.

The following questions can be used to guide the discussion.

Discussion questions 1. Why is Kiva so successful?

2. What are the key elements of its business model? What roles does the Internet serve?

3. What are the principal risks to its continued success?

4. How should it work with and monitor its field partners?

5. Should it continue to lend to individuals or should it emphasize lending to groups?

6. What are the limits to its growth?

7. What qualities should it look for in a field partner?

8. Should it become a for-profit organization as Banco Compartamos did?

Kiva’s website kiva.org provides current information on its organization and financing of entrepreneurs. Casual inspection of kiva.org suggests that a much higher proportion of loans are going to groups than when the case was written.

MTN Group Limited MTN has had remarkable success. It has had the good fortune to be an early entrant into a rapidly growing market in which access to land lines is limited in many places. MTN had primarily grown internally and was experienced in entering new markets. In 2005 it acquired Investcom LLC of

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Lebanon in 2005, giving the company a strong present in North Africa and the Middle East.37 At the time of the case MTN was in merger discussions with Reliance Communications of India.

The opportunities available to MTN fall into three classes. The first is the opportunity to enter new national markets as well as to obtain expanded licenses in the countries in which it operates. The second is growth in its current markets. The third is product and services enhancements.

MTN operates in less than half the countries in Africa and the Middle East, so it may have opportunities to enter new countries. This requires a license, and licenses can become available as governments encourage competition in their countries. Licenses can also become available in new geographic areas within countries. In addition, licenses are from time to time available for sale, and MTN may be able to acquire local companies that hold licenses.

Penetration of wireless telecommunications service is only 29 percent in Africa compared to over 90 percent in Europe, so growth can come from the markets in which it currently operates. Growth will, however, require considerable investment in infrastructure.

The third category of opportunities is service enhancements and extensions. This includes all the services and features that are available, for example, in Europe, North America, and developed countries more generally. In addition, some services, such as payments, may be unique to countries without widely-accessible banking services. Extensions included Internet access and services.

These opportunities depend on both advances in technology and growth in income.

The focus of the chapter is opportunities and risks in the nonmarket environment. The risks that MTN encounters are many and may be thought of in two categories. One is associated with the individual countries in which it operates. The other is associated with operations in the market and nonmarket environments in a country, since wireless telecommunications is a regulated industry.

Country risks center on government turmoil and suppression as in Zimbabwe, civil unrest as in parts of Nigeria, ethnic conflict in a number of countries such as the Sudan, migration, and war.

Risks associated with the economy include the factors found in developed country economies plus things like corruption, hyperinflation, and incomplete markets, such as underdeveloped capital markets. One exercise that could be conducted in conjunction with this case is to assign groups of students to assess the opportunities and risks in individual countries in which it is not currently operating. Entry into these markets requires a license, so the assignment could be that a license was to become available in that country.

The preparation questions mention Zimbabwe, and at the time of this writing the Mugabe government was holding onto power while slowly negotiating a power sharing arrangement with the opposition party. The economy was in a shambles, and millions of Zimbabweans had fled to other countries such as South Africa. Hyperinflation was accelerating and agricultural output was far below the pre-takeover levels. The hope is that by the time this case is taught the situation will be substantially improved.

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Syria accounted for 6 percent of MTN’s revenue and the Sudan and Iran 2 percent each.

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The company operated in many countries and tried to be responsive to local conditions. It faced a number of operating risks in its markets ranging from the challenges of building infrastructure to competition from resellers. The focus here is on risks in the nonmarket environment. Those risks pertain to taxation, regulation, and bureaucracy. Wireless service provides a convenient source of tax revenue, since the companies already have payment systems in effect. These taxes can include value added taxes, which can be specific to wireless telecommunications, as well as special levies.

Regulation can include the control of prices, the conditions of service, and the licensing of territories and service enhancements. Bureaucracy refers to the red tape that can be present in developing as well as developed countries.

MTN can mitigate some of the nonmarket risks through its operating practices and broader nonmarket strategy. MTN attempts to operate much like a domestic company in the countries in which it is present. It hires locally and seeks local (minority) ownership in subsidiaries. This may be thought of as developing a local rent chain upon which it can build when addressing nonmarket issues within a country.

MTN also has a commitment to corporate social responsibility (CSR). The needs are great in the countries in which it operates, and its efforts help address those needs. CSR can also be strategic and both strengthen the company in competition with rivals in a country. (This type of strategic CSR is discussed in more depth in Chapter 19.) It can also be strategic in the sense that it complements the local rent chain in providing access to government and a base on which to build nonmarket strategies to address particular issues. These strategies are the same as those discussed in Chapters 6-8, although many of the countries in which it operates are not democracies.

MTN must interact with regulatory agencies and the bureaucracy. The regulatory strategies are similar to those considered in Chapter 10, although the regulatory decision making is likely to be more opaque. Bureaucratic approval is required for construction permits for base stations and other facilities, and often in developing countries the bureaucracy moves slowly. Bureaucratic approvals also provide an opportunity for extortion and corruption, as considered in Chapter 23.

The taxation of telecommunications services has a long history in both developed and developing countries. Particularly, for low-income countries with many infrastructure and social services needs, sources of tax revenues can be a temptation that is hard to resist. MTN’s strategy has to be tailored to the particular situation of individual countries, but generally its lobbying message should focus on wireless telecommunications as an integral part of the infrastructure of a country and an important facilitator of economic growth. This is particularly the case where access to land lines is limited. The greater is the market penetration of wireless services the greater is the potential tax revenue, but the greater is also the number of customers who can complain about higher taxes.

This characteristic is strengthened as the set of features and services customers use increases.

MTN’s nonmarket strategy for avoiding or limiting tax increases should focus on its role in the infrastructure of the nation and its contributions to economic growth. That strategy should be grounded in its rent chain, which includes its customer base. The principal implementation strategies are informational lobbying and advocacy where that can be helpful.

MTN also faces possible antitrust risks in some cases, and the types of concerns are similar to those considered in Chapter 9.

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Discussion questions 1. What factors have contributed to the growth and success of MTN? 2. What risks and opportunities does it face in its current operations?

3. Why does MTN want local shareholders? Why does it want local employees? In addition to a moral motivation, could there be a strategic role for CSR? 4. What approach should MTN take to dealing with the regulatory agencies and bureaucracy in the countries in which it operates?

5. How should MTN address the threat of sharply higher taxes on wireless services in a country?

6. How should it respond when there are opportunities for corruption in a country?

7. Assess the risks and opportunities in Zimbabwe. If a license were to become available in that country, what should MTN do?

Developments The merger discussions with Reliance Communications collapsed because of the rift between the Ambani brothers. Reliance Industries apparently had the legal right of first refusal to acquire Reliance Communications in the event of a merger, and that killed the deal. MTN became frustrated and withdrew from the discussion on July 18, 2008.

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Chapter 18

The Political Economy of International Trade Policy This chapter provides an introduction to the political economy of international trade, the principal international trade agreements, and U.S. trade policy and law. As indicated in Figure 17-1, trade policy is necessarily intertwined with domestic politics and economic policy and performance. The perspective summarized in this figure is that whereas international trade policy is established by bilateral and multilateral negotiations among countries, the incentives for those negotiations come from the domestic economies of the countries. More specifically, interests in the countries work to influence trade policies. For example, NGOs worked for a larger role in the Doha round of multilateral negotiations. Business organizations also play an important role in influencing negotiations.

The perspective in Figure 17-1 can also be used in conjunction with the chapter case Compulsory Licensing, Thailand, and Abbott Laboratories. In that case Thailand has domestic interests that led it to invoke compulsory licensing.

The forces leading toward trade policy liberalization are strong and stem from the gains from trade that occur when countries can trade based on comparative advantage. This competitive trade theory is illustrated in its simplest form in the chapter, and a lecture could expand on that theory.

The law of comparative advantage is often surprising to students and warrants an explanation and illustration. The PowerPoints for the Sophis Networks and Encryption Export Controls provide additional information on competitive trade theory.

Comparative advantage, however, is only one of the forces shaping international trade policy. A second is strategic trade theory as was practiced by Japan and a number of the NICs. This theory is controversial but it seems clear that there are conditions under which government intervention to affect the strategic relationship between firms in one country and firms in another country can result in gains to the former country at the expense of the latter country. The extent to which those conditions are present is less clear. What is more clear is that strategic trade theory fell a bit out of intellectual favor with the economic crises in the latter half of the 1990s in Asian countries when their governments intervened in industrial policy. What may pass as strategic trade theory is nonmarket action by interests and interest groups that seek trade policy measures that are to their advantage. It is these domestic politics, along with the gains from trade, that play the major roles in shaping international trade policy.

As illustrated in Figure 17-4 the politics of international trade policy are fundamentally majoritarian but pockets of concentrated costs and benefits provide incentives for interest groups to be active. Those incentives arise on both the export and the import-competing sides and lead toward interest group politics. As the chapter indicates, these politics are asymmetric because of the difference between the rents resulting from sunk costs and the future (expected) profits to be earned on as yet unidentified gains from further trade liberalization. Multilateral trade negotiations are one means of moving the politics of international trade back to the majoritarian cell, and the traded agreements reached then constrain some of the nonmarket strategies of interests by foreclosing

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certain policy alternatives. The set of agreements under the WTO umbrella serve as these constraints.

The structure of U.S. trade policy involves a complex and evolving set of relationships between the president and Congress. Trade policy is also complex because actions can be initiated by private parties. Furthermore, the administrative processes that deal with trade complaints are complex and involve several agencies, the International Trade Commission, the International Trade Agency, and the USTR, with the president having final authority under some sections of trade law. Trade policy is of continuing interest to Congress, but in recent years partisan disagreements have blocked new trade legislation.

Trade policy and the economics and politics that underlie it have two primary objectives: protectionism and market opening. Protectionism has its origins in the interests of importcompeting industries whose rents are threatened by imports. Protectionism is costly but those costs are largely borne by consumers who have weak incentives to take political action to oppose it. The references in the chapter provide a number of detailed studies of protectionism measures. The chapter case Cemex and Antidumping addresses a fair trade measure and provides a basis for a discussion of protectionism. The chapter case Sophis Networks and Encryption Export Controls (A) deals with an export issue involving the Congress, the administration, and the FBI/NSA. President Bush was believed to have protected the steel industry for two reasons. One was to shore up electoral support for the 2002 elections. The other was to obtain fast track approval from Congress. Fast track approval gives the president the right to bring a negotiated trade agreement before Congress to be voted up or down without amendments. The House approved fast track 215214.

The Doha Round WTO negotiations have sputtered for many years and in 2008 they collapsed.

Whether any new trade agreement could be reached in the next several years is unclear. Few observers are optimistic that a new agreement can be achieved.

Cases Cemex and Antidumping PowerPoints are available for this case This case is more about Cemex’s strategy in responding to the antidumping decision. This is not a case about an exporter that has a cost advantage solely because of low wages and lax regulatory standards in the exporting country. Cemex is also an efficient, well-managed company with modern facilities and pollution abatement equipment. It also benefits, of course, from low wages.

The United States is an attractive market because prices are high, although not as high as in 339

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Mexico. Cement is produced by two technologies—wet and dry. The wet process is the old process and it is high cost. All new cement capacity uses the dry process, which is low cost. Prices are high in the United States because quite a few cement producers use the wet process. Since the market price of a commodity is set by the high portion of the supply curve; i.e., the wet technology, prices are high.

Administratively, an antidumping case is decided based on the data and on administrative rules.

Prices are compared in the two countries and adjustments are made where appropriate—or inappropriate. In this case there are two controversial issues. The first is whether Cemex has maintained a fictitious market for bulk cement. The second is whether transportation costs should be included in the calculation of the dumping margin.

In this case dumping was found not because Cemex was selling cement in the United States at prices below its costs, but rather because it was selling at a price in the United States, after deducting the transportation and other costs, that was below the price at which it sells in Mexico.

Thus, the dumping is actually price discrimination. That is, Mill Net Prices indicate whether cement is being sent out the mill gate to customers in the United States at a price below that at which cement is sent out to Mexican customers. Note that, even if there were no transportation costs, the price in Mexico could be higher than the price in the United States because of differences in the price elasticity of demand, the number of competitors, and which technologies are used.

Consequently, the administrative process can find dumping when there is only price discrimination that results from demand, competitive, and technology conditions.

In the administrative process for determining the dumping margin, the ITA subtracted the transportation costs between Mexico and the United States. Transportation costs are a substantial portion of the total delivered cost of the cement. Subtracting the transportation costs is consistent with a procedure the ITA follows. (The Court held that the ITA had calculated the dumping margin using one of its accepted procedures.)

The PowerPoint with a map illustrates a sample calculation of the antidumping duty under the procedure used by the ITA. The second map illustrates in the upper right corner what is really happening in this case. Cemex is not selling in the United States at prices below its costs. Instead, it has a very high margin in Mexico. The third map indicates what would happen if the “like product” were bagged cement.

The strategy Cemex adopted to address the antidumping petition had two phases. The first phase involved cooperation with the U.S. agencies with the objective of expediting the process leading to a final determination. Cemex was confident that it would win, and the finding against it as a result of the exclusion of the transportation costs was a surprise. Cemex may have been reasoning by analogy from the earlier case in which the U.S. producers had lost their antidumping case. The second phase involved its response to the imposition of duties.

To address this challenge, Cemex developed a nonmarket strategy integrated with its market strategy both over time and across institutions. The strategy is summarized in the PowerPoints.

The objectives of its integrated strategy were to maintain a presence in the U.S. market, reduce the duty, and eventually overturn the decisions of the U.S. agencies. The market components of its

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strategy included reducing imports by withdrawing from markets such as Florida where cement prices were low, and remaining in markets such as Arizona and California where prices were higher. In addition to the obvious market effects, this strategy had the effect of reducing the dumping margin, based on the difference between the Mexican Mill Net Price and the U.S. Mill Net Price in the markets in which the imports are sold. Restricting sales to markets with high prices thus resulted in a lower difference in mill prices, which provided the basis for a lower duty.

Its margin on sales thus was improved both directly because of the higher price but also indirectly through a lower duty.

The mill prices used in calculating the antidumping duty are for identical or comparable products.

The U.S. cement market is primarily bulk, whereas in Mexico 78 percent of sales are of bagged cement sold through retailers. If bagged cement were the comparable product, the calculated duty would be higher because of the higher price at which bagged versus bulk cement is sold in Mexico.

Cemex continued to sell bulk cement in Mexico, which remained the relevant reference product for the price comparison. Cemex then requested an administrative review of the dumping margin based on its revised market strategy of limiting exports to selected markets. The request was opposed by the U.S. petitioners, which alleged that Cemex maintained a fictitious market for bulk cement in Mexico. The Department of Commerce found for Cemex and reduced the duty to 30.74 percent.

Cemex also sought to overturn the U.S. ruling imposing the duty. Before the U.S. Court of International Trade (CIT) Cemex appealed both the ITC’s determination that the U.S. industry had been injured by cement imports from Mexico and the ITA’s imposition of a duty. The CIT rejected both appeals, and Cemex appealed the ITC ruling to the U.S. Court of Appeals only to lose again.38 Mexico then petitioned the General Agreement on Trade and Tariffs (GATT) requesting that a 3member panel be established to hear Cemex’s complaint. The United States consented to the formation of the panel, and in 1992 the panel found for Mexico on the grounds that the petitioners did not sufficiently represent the U.S. industry. A panel decision, however, is implemented only if all GATT signators concur, and the United States withheld its approval.

Cemex’s market strategy for pursuing its growth objectives had two parts. First, it embarked on a domestic expansion program by acquiring the second and third largest cement producers in Mexico.

Coupled with an aggressive capacity expansion and modernization program, this brought it over 60 percent of the Mexican market. Second, it decided to expand internationally, by exporting first to the United States market. It also acquired the largest cement producer in Spain, giving it a foothold in the European Union.

As discussed above, Cemex had to develop a nonmarket strategy in response to the antidumping petition filed by its U.S. competitors. Its strategy was well integrated, and although it met with only modest success, there was little more that it could have done given U.S. trade law and administrative processes. The decisions to maintain a bulk cement market in Mexico and export only to markets with high prices were effective in reducing the dumping margin. Cemex’s actions

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While the antidumping petition was being decided and appealed, Cemex also conducted limited lobbying activities to make certain that legislators, particularly those in states in which it had operations, understood Cemex’s position on the antidumping issue. More extensive lobbying was not worthwhile because the issue was under the institutional jurisdiction of administrative agencies and the judiciary.

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were also coordinated over time, using the available regulatory and judicial channels and ultimately filing the GATT petition not only for redress but also for leverage in the United States. After Cemex had exhausted all avenues in its nonmarket environment, it altered its market strategy.

Cemex’s strategy was also consistent in the sense that actions taken in the market environment were complementary to the actions taken in the nonmarket environment. Indeed, Cemex found synergy between the two.

Cemex had acquired the Spanish companies to have a threat against the European global companies (e.g., Holcim, Lafarge). That is, if the European countries were to make an additional acquisition in Mexico or were to cut prices in Mexico, Cemex would cut prices in Europe. This has proven to be a successful strategy.

At the end of the case once Cemex has exhausted all alternatives for overturning the antidumping duties, four issues are identified. Cemex can deal with its stranded assets in the United States by importing from Spain and later from Venezuela. Will these imports be met with an antidumping petition? The answer is “no” if prices in Spain are lower that they are in Mexico. They are.

Cemex can perform the calculations illustrated in Figure 17-5. In addition, the petitioners would have to show material injury. Cemex exported to the United States from Spain, and no antidumping petition was filed.

The second problem was excess capacity in Mexico resulting from being forced out of much of the U.S. market. Cemex could export from Mexico to other countries. It was contacted by an importer in Japan and began to export to that country. Cemex also exported to Indonesia and the Philippines. Asian economies were booming at the time.

With respect to the U.S. market, Cemex could purchase capacity in the United States, build capacity de novo, or continue to import from Spain. Since the market in the United States was distressed, it could make sense to purchase capacity, particularly if Cemex could operate the plants more efficiently than could the seller. Cemex has world class engineering and hence could operate plants efficiently. Cemex decided to purchase a plant in Texas from Lafarge and improved the plant’s productivity. The PowerPoints provide a summary.

The petitioners continued to claim that the bulk market in Mexico was fictitious and argued that the duty should be set at 111 percent.

Teaching the case:

The following questions can be used to guide the discussion. What was the motivation of the U.S. cement producers in filing the petition? Are they being injured? Is there anything wrong with their being injured? 1. Had Cemex done anything wrong? Is it selling below its costs? 2. Is the U.S. administrative approach to evaluating an antidumping petition appropriate? 3. Evaluate Cemex’s strategy prior to the imposition of duties? What should it have done differently?

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4. Evaluate Cemex’s strategy for addressing the duties once they were imposed? How well integrated were the market and nonmarket components of its strategy? What should it have done differently?

5. What should Cemex do once it had exhausted all nonmarket avenues to deal with the antidumping duties? What market strategy should it adopt with respect to the U.S. market?

6. Is the antidumping law appropriate for this kind of situation or is its effect to stifle competition and reduce efficiency in the U.S. economy?

7. Is this protectionism?

8. What should Cemex do about its stranded investment in the United States?

9. What should it do about its excess capacity in Mexico?

10. What should it do about the U.S. market?

12. What should it do about the antidumping duties?

Outcome Cemex had exhausted all its nonmarket alternatives after having failed to prevail in U.S. courts and with GATT. It had no base for taking other nonmarket action in the United States; e.g., it had no link between its activities and constituents in the United States that it could use as a basis for lobbying. Its only alternative was to use market strategies. Its two alternatives were to export to the United States from another country and to build production facilities in the United States. It did both. First, it began supplying the United States from its plants in Spain. Second, it built facilities in the United States. It bought from Lafarge Coppee a plant at New Braunfels, Texas. It also purchased the U.S. company Balcones for $105 million in 1994. It has also acquired cement producers in Venezuela and Panama, and an acquisition of a company in Nicaragua was pending in 1995. Its acquisition of the Spanish cement producers was for $1.8 billion.

Cemex was able to weather the 1994 devaluation of the peso and the subsequent currency crisis. Its substantial borrowings were rolled over by J.P. Morgan and Citibank. Its share price fell by almost two-thirds in dollar terms, however. Cemex subsequently recovered and has been quite profitable.

With regard to the continuing antidumping duties, Cemex attempted to influence the U.S. government by forming a coalition with the National Association of Home Builders. This was a long shot but probably worth the effort. This strategy was based on the observation that the party omitted from the antidumping case was consumers, and the consumers of cement are construction companies. The coalition sought a provision that would allow the Department of Commerce to suspend duties in times of shortage in the United States. (The European Union has such a provision.) The coalition lobbied, took out advocacy advertisements, enlisted some allies in the House, and attracted some editorial support from The Wall Street Journal. But, the coalition was countered by the U.S. cement producers, and no negotiations on ending the duties or changing the U.S. antidumping rules resulted. (See below.)

With respect to the antidumping duty, Cemex refused to comply with the U.S. request for data on bagged sales. The ITA then used its Best Available Information procedure in the absence of data.

Subsequently, the ITA began to use bagged cement as the like product, and the duty was set at 109%. Why did Cemex take this route? The answer is that it had decided to take its case to the NAFTA dispute resolution process. A NAFTA panel subsequently ruled that the United States had

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used acceptable procedures, and the duty remained in effect. The PowerPoints summarize the outcome and provide a wrap-up of the case.

Developments In 2005 Cemex was the third-largest cement producer in the world behind Holcim, the new name for Holderbank, and Lafarge, which acquired the remainder of Blue Circle that it did not already own. In 2000 Cemex acquired Southdown, the largest independent U.S. cement producer. Comer, who had been the point person for the petitioners, no longer is with Southdown. Cemex reportedly made the acquisition in the hope that the financial market would no longer treat it as a Mexican company and hence would give it a higher P/E ratio. (Cemex’s P/E ratio was low compared to industry standards. One hypothesis for this is that Mexican companies traditionally received low P/E ratios. Another hypothesis is that Cemex makes much of its profits in Mexico, and those are at political risk.) Cemex is now the largest cement producer in the United States.

Cemex’s strategy in Mexico is discussed in “A Cement Titan in Mexico Thrives by Selling to the Poor,” The Wall Street Journal, April 22, 2002.

The sunset review of the antidumping duty occurred in 2001, and the ITC concluded that there was substantial risk of imminent material injury to the domestic industry if the duties were eliminated.

The duties continued into their second decade. The antidumping duty was set at 74.78 percent in October 2002. As of June 2005 the duties remained in effect and were reviewed annually and the dumping margin recalculated based on updated data. Cemex has had the largest average duty over the longest time period in the history of U.S. antidumping.

In February 2003 Mexico filed a complaint with the WTO on the U.S. antidumping duties on Mexican imports. Opposition within the United States is now 27 companies operating 67 plants in 28 states.

As of mid-2005 the duties remained in effect, but a favorable market development occurred. The United States experienced a construction boom, and demand expanded much more supply could expand. Shortages of cement developed in most areas of the country. The two hardest hit states were Florida and Texas. The Associated General Contractors of America petitioned the Secretary of Commerce Carlos Gutierrez to suspend the antidumping duties on Mexican cement imports.

Domestic producers opposed any suspension, but the Department of Commerce indicated that it was in a “dialogue” with Mexican officials. The Association explained that the shortages of cement were particularly alarming because they were coming at the beginning of the construction season, which according to the Association “meaning more severe problems are almost certain in the near future.”

President Hugo Chavez nationalized Cemex’s operations in Venezuela and offered compensation.

Cemex rejected the compensation. Cemex had apparently acted in support of the president’s socialist policies and had opened a type of microfinance program to help people by cement to build their own homes. Nevertheless, Chavez seized Cemex’s operations. At the time of this writing the financial aspects of this seizure had not been resolved. Chaves had seized many companies.

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Compulsory Licensing, Thailand, and Abbott Laboratories Compulsory licensing had rarely been exercised, although it had been threatened particularly by Brazil. It was important because it posed a threat to patent protection of pharmaceuticals which was the principal basis for appropriating the rents from research and development. With weak patent protection the incentives to innovate would be diminished. The pharmaceutical companies have feared that if one country invoked compulsory licensing others would follow.

As Richard Epstein stated, charity can come from many places. AIDS drugs are provided to poor countries under programs paid for by developed countries. The developed countries contribute to the Global Fund to Fight AIDS, Tuberculosis, and Malaria established under the leadership of United Nations Secretary general Kofi Annan, and the United States provides drugs under the President’s Emergency Plan for AIDS Relief (PEPFAR). These programs have been responsible for substantially expanding access to AIDS drugs in the past few years. (See the Chapter 22 case Gilead Sciences (A): The Gilead Access Program for HIV Drugs for information on these programs.) Thailand, however, is not a poor country, and hence is not eligible for the funds to purchase drugs. Moreover, Thailand is a lower middle income country and hence does not receive the lowest of the tiered pricing used by many pharmaceutical companies. As Tadataka Yamada of the Gates Foundation stated, “Brazil is not Rawanda, which cannot afford to pay.” Thailand can be substituted for Brazil in this statement.

The “legal” basis for compulsory licensing under TRIPS was murky at best, since terms such as “national emergencies” and “other circumstances of extreme urgency” were subject to interpretation. The pharmaceutical companies would like these terms interpreted as an epidemic or an outbreak of a highly contagious disease such as bird flu or SARS. Thailand has interpreted the terms as pertaining to a public health situation in which not everyone has access to a medicine that would help them. Heart disease, for example, is not contagious, and there is no evidence that the incidence of heart disease in Thailand is different from that in other nations. HIV is contagious, and the incidence of AIDS is somewhat higher than in the United States and Brazil, but the incidence is far below that in sub-Saharan Africa, where infection rates can reach 40 percent.

Why has Thailand invoked compulsory licensing? One view is that the military government was looking for something that would appeal to the public, and taking on the pharmaceutical companies was one such thing. While this is hard to verify, when the newly elected government came into office in 2008, the new minister of health announced that the government was reconsidering the decision to invoke compulsory licensing. This was quite unpopular with the public, and the government soon decided to leave the compulsory licenses in place. A second view is that the government invoked compulsory licensing to save money. In the case of Kaletra the savings was estimated to be $24 million a year, which seems like a modest amount. (This savings estimate seems to be in the ballpark. If 20,000 people were given Kaletra at the $2,200 price charged by Abbott for the second tier countries, the cost would be $44 million. Compulsory licensing could easily reduce that amount by $24 million.) A third explanation could be that HIV/AIDS and heart disease could be spreading significantly, but there is no indication that that is so.

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As an ethical evaluation of Thailand invoking compulsory licensing, consider the candidate moral rule: A country can invoke compulsory licensing for a pharmaceutical that will improve public health and is not readily accessible at affordable prices.

The evaluation of such rules is the subject of Chapters 20 and 21 and will not be repeated here.

The conclusion of the developed countries and the institution of patents is that the answer is that the candidate is a moral rule in the case of contagious diseases in a poor country, as in the case of subSaharan Africa. The conclusion in the case of countries such as Thailand, however, is open to disagreement. Both the Global Fund and PEPFAR exclude countries far poorer than Thailand.

The argument against the candidate rule is that if middle income countries violate patents the incentive to conduct research and development will be reduced resulting in fewer new discoveries.

The counterargument is that there is a sufficient return from selling the drugs in developed countries, and the low and middle income countries can free-ride without affecting discoveries.

Abbott The decision to withdraw its registration applications for new drugs in Thailand is extreme and would not likely have been made by other large pharmaceutical companies. Abbott’s explanation that it is “difficult to justify bringing forward new medicines in Thailand” may be true, but from a public relations and perhaps a strategic perspective it does not warrant refusing to bring new drugs into the country. It is possible that this is a shrewd strategy to raise the profile of this issue so that the United States will pressure Thailand to reverse its decision, but it seems that this would be high on the U.S. agenda even without Abbott’s action. Certainly, Abbott and PHRMA will lobby the USTR and other agencies on this issue, but that can be done behind the scenes. It is also possible that Abbott’s refusal was strategic and made in an attempt to improve its bargaining position with the government. If so, that apparently did not work, since Thailand rejected its price cut to $1,000 a year.

Although Abbott’s action was applauded by some pharmaceutical companies and by pharmaceutical associations, no other companied followed Abbott by withdrawing their new drug applications. Most companies prefer quiet discussions and negotiations to confrontation.

What is it that pharmaceutical companies fear about compulsory licensing? It is probably not as much the loss of sales revenue to that country, since their alternative is to lower the price substantially as the companies had done with Brazil in 2000, as it is that another company would be producing the drug. The fear then is that the drug could find its way into other markets, and that other countries could decide to parallel import it. The counterargument is that companies such as Cipla would produce the drug anyway, although they would be less likely to do so without compulsory licensing.

Filing a lawsuit against Act Up Paris is in the same style as withdrawing new drug applications, but this action seems unwise. The organization is an aggressive activist group that welcomes the publicity that comes from confrontation. A lawsuit seems unlikely to deter them.

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What should Abbott do in Brazil? The industry’s answer is that the company should bargain.

Discussion questions 1. Why has Thailand invoked compulsory licensing?

2. Why does the pharmaceutical industry so strongly oppose compulsory licensing? Why does the industry prefer discussions and negotiations that will surely result in major price cuts?

3. Is Abbott’s strategy a wise one? Will it be effective? What would have been a better strategy?

4. Given the answer to 1. above, will the change in strategy with an offer of a price of $1,000 a year be successful?

5. Should Abbott have filed a lawsuit against Act Up Paris?

6. How should Abbott have handled this affair?

7. What should Abbott do about the situation in Brazil?

Developments As of the time of this writing the issues had not been resolved and the situation described in the case continued.

The United States cited Thailand in its annual NTER report as inhibiting trade. Thailand sought to negotiate with the United States, but it was unwilling to do.

In February Merck announced that it was reducing the price of Stocrin (Efavienz) from 1,300 bhat a month to 700 bhat. Merck explained that it was lowering the price because of “efficiencies resulting from improved manufacturing processes.” Thailand had also begun to import a copy of Efavirenz from Cipla in India. Merck’s price for Efavirenz for countries such as Brazil and Thailand was $577 a year per patient, and the new generic price obtained from Indian drug manufacturers Cipla and Matrix was $164.

Cancer was the number one killer in Thailand.

In May the World Health Organization endorsed compulsory licensing against the opposition of the United States.

Michael Weinstein also said, “We congratulate the Thai government for their efforts to step up the availability and use of generic lifesaving drugs for the Thai people. But the government’s commitment to providing universal access to care is facing increasing high drug costs.”39 Tim Wainwright of Oxfam said, “Creating competition among producers is key to reducing drug prices. The most effective way to reduce prices and increase access is to promote generic competition.”40 He also said, “They are…putting two fingers up to the drug companies and saying,

39 40

Associated Press Worldstream, January 31, 2007. Associated Press Worldstream, January 31, 2007.

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‘if you won’t give us a price that we can begin to afford, we are going to get this stuff from a generic company and use it in our public health services.’”41 In 2008 former president Thaskin was convicted of corruption. His wife had been convicted in 2007.

A Wall Street Journal article in March 2008 reported that Thailand had issued compulsory licenses for four additional drugs.

Sophis Networks and Encryption Export Controls (A)42 PowerPoints are available for this case sophisnetworks.ppt.

This case focuses on the formulation and implementation of strategies by high tech companies to relax export controls on encryption software. This case has additional relevance because of September 11. Export controls also apply to powerful computers and other sensitive technologies.

Since the case was written, the export controls on powerful (high MTOPS) computers have been relaxed somewhat. The PowerPoints contain a mini-lecture on international trade economics in addition to material on the case.

The issue of encryption export controls was identified in 1995 by one of the CEOs in CSPP. By the time of the case in 1999 some progress on relaxing the export controls had been made but much remained to be accomplished. The case discussion can focus both on what has already been accomplished as well as what remains. The September 16, 1999 revisions had two major shortcomings from Sophis Networks’ (SN) perspective. First, exporters could sell freely to companies in which governments have ownership. This includes telcoms and many other government-owned companies. Exporters also could sell to foreign governments without permission. The objectives of the exporters should be elimination of the controls, provided security concerns can be satisfied, and if that is not possible to allow sales at least to telcoms and government-owned companies.

Questions for leading the discussion: • What is the nature of the issue? What are key recovery and escrow? Is there anything wrong with the licensing requirements? The purpose of these questions is to reach a common understanding about where the export controls currently stand.

• What effect do the controls have on SN’s business? on sales? on competitive advantage in encryption technology?

41 42

Financial Times, January 30, 2007.

Sophis Networks (SN) is a disguise for a major technology company that prefers anonymity.

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• What is the source of SN’s profit on this line of business? The affected profit derives from sales of hardware and systems in addition to encryption software.

• Does SN have available a substitute? The substitutes are: 1) produce equipment with three flavors of encryption; 2) develop encryption outside the United States; 3) have overseas customers bolt encryption software of other providers to SN’s hardware.

• Do U.S. companies have a comparative advantage in encryption software? Will U.S. companies be able to recover their market position if export controls are not relaxed in the next couple of years?

• Why have the companies had so much difficulty in getting the controls relaxed?

• Which institutions are involved? Who is the decision maker?

• What strategy is the FBI/NSA likely to employ? Will they find allies in the administration and in Congress?

• Is there a way in which SN and its allies can help solve the FBI/NSA’s problem?

• What should be SN’s integrated strategy?

• What should its market strategy be? What should it do in the short run? Should it have encryption software written outside the United States?

• How likely is it that SAFE will be enacted? Is Clinton likely to veto it? Is it a credible threat point in bargaining with the administration?

• What nonmarket strategy should it adopt?

Who is the decision maker on the encryption export issue?

What are the interests affected by this issue?

What is the strategy of the opponents of relaxation? How effective is that strategy?

Can SN’s strategy benefit from the privacy issue? Can it enlist the support of the privacy advocates?

• Which institutions should it target?

• What specifically should SN do? lobbying coalition building grassroots advocacy Which are likely to be the most effective?

• Does SN want to attack the administration on this issue?

• Does SN want its name in the press on this issue?

• Whom should SN lobby and what should its messages be?

• On what would you compromise and on what would you not compromise? escrow and key recovery backdoor list of countries types of companies (e.g., telcoms) the standard—as in SAFE; i.e., software comparable to what is offered by overseas competitors The principal themes that SN should emphasize in its strategy are: • the economic harm to the United States • the many holes already in the dike

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• the privacy issue • the industry may be able to help solve the FBI/NSA’s problem • SAFE is likely to be enacted if the administration does not relax the controls • the most important thing in the long run is to have technology leadership in the United States Comments on analysis of the case and on developments are provided next along with a (B) case that considers the developments and the next stage.

Market analysis: How important is this issue to the companies? It is certainly important, and the companies expended considerable effort on this issue. It affects not only encryption software but more importantly the exports of computer systems, servers, and other hardware. The market for these products is enormous, so the stake is potentially very high. The market for servers, computer systems, and other equipment that incorporate encryption software is much larger, probably by several orders of magnitude, than the market for encryption software. How much the equipment market is really threatened is not clear.

Although the market is huge, the companies have substitutes. Companies can make their equipment so that encryption software produced by Baltimore, Brocat, and others can be plugged in—or “bolted on” in SN’s terminology. The impact may be as great for companies that produce encryption software as well as equipment. These companies also have a substitute, since they can develop encryption technology outside the United States. This is costly, however, so these companies still have large stakes. The other companies that have stakes are the RSA’s and others that specialize in encryption technology and security solutions.

The revisions proposed by the Clinton administration in September 1999 infuriated many high tech companies because they did not allow unrestricted sales to companies owned, even in part, by governments. These companies included telecommunications companies that in many countries were owned by their government. These companies are major purchasers of computer systems, servers, and other equipment.

The relaxation in the export controls took four years to accomplish (from the time the issue was added to the CSPP agenda to January 2000). This is not very long in calendar time as government regulatory issues go, but it is very long in a rapidly changing industry such as computer systems, servers, and software. For the companies involved, it was a long time.

Nonmarket analysis An important factor in this case is whether the industry can help the FBI/NSA meet their legitimate and important responsibility of detecting criminals, terrorists, and spies. The industry showed them how to do an electronic wiretap of encrypted information. There are three points at which a message can be intercepted even if it is perfectly protected through encryption. One is when it resides in plaintext form on the sender’s computer. The second is on the receiver’s computer when the encrypted message is decrypted. The third spot is where the message is stored in plain text format on the receiver’s computer. The question then is how to get into the sender’s and receiver’s

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computers. This is accomplished by either sending a “bot” or a “spider” into the computer or depositing some strong cookie that remains hidden. It is, of course, necessary to identify the sender or receiver. This technological fix was apparently effective in reducing the opposition from the FBI and NSA. One issue is why the Clinton administration required licenses for sales to governments. Was it because it did not trust certain governments such as those for the countries that had been in the former Soviet Union?

What is the nature of the politics of the encryption issue? Note that there is no “interest” that opposes those who seek a relaxation. If the Wilson-Lowi matrix is applicable to this issue, the politics are probably client politics, since there is no organized opposition interest. The organized opposition, however, comes from the FBI and NSA, and the key to their strategy is the provision of information in closed sessions to the cognizant congressional committees. The goal of the FBI and NSA is to block SAFE in the House. This can occur in one of the cognizant authorization committees or the Rules Committee. Until the current Congress the chair of the Rules Committee held up the SAFE bill. (Supporters could have tried to go around the Rules Committee using a discharge procedure.) In 1999 the chair of the Rules Committee retired, and the current chair was sympathetic to SAFE. A political specialist for one of the coalitions said that SAFE probably would not have passed, since committee chairs and the speaker were not in favor of acting. Moreover, the Senate was unlikely to act. The importance of SAFE was as a statement to the Clinton administration that this is an important issue.

The strategy of the FBI and NSA is informational. That is, they provided information about terrorists, spies, and criminals and the role encrypted communications could play in their activities.

The administration and some members of Congress were nervous about instituting a policy that later in retrospect can be criticized as jeopardizing the security of the country or resulting in another Oklahoma City or World Trade Center bombing. The terrorist attacks on September 11 apparently did not involve encrypted communication.

One strategy the companies cannot use is to directly counter the FBI’s and NSA’s information strategy. Not only do the companies not have information to counter it, but challenging the experts would be dangerous.

The FBI and NSA have legitimate and important concerns, and those conerns resonate with politicians and the public. The right perspective for the companies to take is to try to provide an alternative solution to the administration’s problem of obtaining information on the bad guys. The only solution the companies could offer was to demonstrate how the security agencies can use wire taps to intercept messages before they are encrypted or after they are decrypted. Apparently, the technology is available to make this practical. Note that a wire tap solution has the advantage of protecting privacy and civil liberties, since it would require a court order before a wire tap could be implemented.

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The privacy issue was important in the strategy. It showed the government that there were people concerned about the restrictions on the availability of robust encryption. The privacy issue was receiving increasing attention during 1999 and 2000 and that undoubtedly contributed to the importance of the link between encryption and privacy. See the Chapter 13 case DoubleClick and Internet Privacy.

What is the purpose of the ad campaign by ACP? One view is that it is intended to build a grassroots campaign with letter writing directed at Congress to support SAFE. Another view is that it is directed at the Clinton administration to put pressure on it and the Democratic party. The answer is that it is probably some of both, although I think it was intended to put pressure on the Clinton administration. The ads certainly had the effect of raising the profile of the encryption export rules issue.

One effective strategy was the good cop-bad cop strategy. The bad cop was ACP which was a vocal critic of the Clinton administration. The ad campaign was one component of this criticism.

The good cop was CSPP, which worked behind the scenes with the administration. The fact that the Clinton administration was under attack by ACP gave the CSPP an opportunity for influence.

The fact that the CSPP was composed of CEOs probably also helped. It is interesting to note that some of the companies that financed the ACP ad campaign are also in CSPP. This means that a coalition can provide “cover” for a company and allows the company to be simultaneously tough and conciliatory.

Should the CEOs act in public outside of CSPP? Sure, why not? They need to testify and express their concern directly. The CSPP CEOs met twice a year with government officials in Washington to discuss issues including encryption export controls. The CSPP members were concerned about selling products. The CEOs took a reasoned and mild-mannered approach to the issue, which served as an effective complement to ACP’s actions. Although this was not planned as such, this turned out to be an effective good cop-bad cop routine.

Companies were able to get TechNet to make encryption a secondary issue on its agenda. At TechNet events executives were able to discuss this issue just as they could any other issue. I have no idea if campaign contributions were made to the administration or members of Congress as a result of this issue.

Should the companies attempt to mobilize their employees and other stakeholders? Many high tech companies would like to do this but are uncertain how to do this without irritating some employees.

One issue in the case was why restrict exports to government and not to certain industry sectors.

The explanation is that the U.S. government viewed other governments, and not foreign companies, as the ones that were likely to infringe U.S. national security. Moreover, terrorist groups often are supported by governments. The identification of the terrorist seven is a reflection of this view.

More generally, the U.S. government cares about the spread of “bad things” such as nuclear weapons, high speed computers (whose export was also restricted), and encryption technology.

The relaxation was the result of a set of factors and strategies. Those affecting the administration’s final decisions can be summarized as:

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1. Strong encryption products were increasingly available from companies outside the United States, including units of U.S. companies. That is, the dike had too many holes to be plugged.

2. The companies showed the FBI and NSA how they could “wiretap” computer systems; i.e., the companies helped the government solve its problem.

3. The privacy issue grew in importance, and encryption availability was one component of that issue. The emerging popular support for the protection of privacy helped.

4. The government concluded that it would be better to have encryption technology developed in the United States rather than outside the country. This would give the government at least some influence if it needed to intervene for security reasons. Moreover, the Department of Defense relies on a robust commercial sector for superior technology, and the controls were driving encryption technology to other countries.

5. The administration would have to deal with SAFE, which had a good chance of passing the House but probably would not have cleared the Senate. SAFE was a useful prod to the administration.

The people with whom we spoke were not sure whether Carnivore, the technology the FBI developed to scan e-mail traffic to identify communications from specific people, played a role in this. It is reasonable to conclude that Carnivore was developed partly in response to the gradual relaxation of export controls.

An executive of a company other than SN that was involved in the encryption export controls said that he “participated in all the meetings with the government” and has no idea why they decided to relax the controls. He said that the government would tell the companies one thing and two weeks later turn around and do the opposite. He also said that the September proposal by the Clinton administration was incomplete and that the January changes were primarily filling in the details. It is not clear to me that he is correct on the latter point.

The following (B) case summarizes the developments and outcome.

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Sophis Networks and Encryption Export Controls (B) January 12, 2000: First Wave of Changes On January 12, 2000 the Clinton Administration made a surprise proposal to liberalize the rules for export sales of encryption software. Under the new proposal, U.S. companies could export encryption products (after a one-time technical review) to most foreign companies, including those owned by foreign governments.

The Administration changed the late 1999 CESA proposal after it came under sharp criticism from U.S. companies for restricting sales to companies tied to foreign governments.43 The new proposal still required a license for sales directly to foreign governments. Privacy advocates and technology companies were very pleased by the new proposals. “This is a big deal…people all over the world are now going to have access to the strongest encryption built into products they use every day.

That is a real sea change in U.S. encryption policy,” said Alan Davidson of the Center for Democracy and Technology.44 The administration also said it would allow the export, without license, of most types of “source code,” the computer code used to create programs that encrypt data (with exceptions being the seven “terrorist” nations).45 Second Wave of Changes On July 17, 2000 the Clinton Administration further relaxed encryption export policy by eliminating a requirement that U.S. companies acquire a special license to sell encryption products overseas—a process that previously involved a technical review or a 30-day delay before exports were permitted. The new proposal also allowed U.S. companies to sell encryption products not only to businesses and consumers, but also to foreign governments, which previously required a special license.46 According to Scott Schnell, Senior Vice President of RSA Data Security, a top encryption software producer, the new rules were important due to the removal of restrictions to selling to national governments, “…governments are often the biggest buyers of security software, particularly in the recently democratized nations of Eastern Europe.”47 The proposal also called for new legislation to update wiretapping rules so that legal protections currently applied to telephone calls would be extended to electronic communication as well. The wiretapping proposal would require law enforcement officials to obtain high-level approval before

43

Glenn Simpson, “White House Proposes Liberalized Rules for Export Sales of Encryption Software,” Wall Street Journal, January 13, 2000, p. A5. This did not require additional legislation.

44 Ibid., p. A5.

45 David E. Sanger and Jeri Clausing, “U.S. Removes More Limits on Encryption,” New York Times, January 13, 2000, p. C1.

46 Ashley Dunn and Charles Piller, “Restrictions Eased on Encryption Software Exports,” Los Angeles Times, July 18, 2000, p. C1.

47 Ibid., p. C1.

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applying for a court order to intercept confidential electronic communication—similar to the process of applying for a wiretap. Law enforcement officials would need a court order to trace an email or a phone call that may travel through multiple phone carriers or Internet providers.48 Officials could also trace such electronic communications without prior approval in an emergency, such as when a computer is under attack.

Why the Administration Relaxed Encryption Export Policy The main reason the Administration relaxed encryption export policy was that strong encryption products made in other countries were already widely available to terrorists and criminals. U.S. export controls only gave U.S. companies an unfair advantage in the global marketplace.

Joanne Bit, Vice President of Security Products at Sophis Networks, also credited their strategy of helping the government solve its problem by identifying the wiretap alternative for electronic communications. “There were different discussion and reactions coming once we opened up on how to do this [wire] tap…so we knew we made some headway with the government in educating them about this…Louis Freeh [Director of the FBI] was one of strongest proponents on implementing a key recovery system. He needed to understand this [potential to wiretap electronic communications] and what the issues were, so we spent the time through various people to do that education.”49 The Clinton Administration also faced the threat of SAFE. SAFE re-emerged on February 25, 1999 in an improved political environment with 258 co-sponsors. The previous House Rules Committee Chair, Gerald Solomon (R-NY), had pledged not to allow the bill onto the floor unless it contained a provision for key recovery sought by the FBI. In 1999, the new House Rules Committee Chair, David Dreier (R-CA), openly supported SAFE. By September 1999 the Judiciary, Commerce, and International Relations committees had approved SAFE. Although SAFE had gained wide support in the House, its chances for passage in the Senate were only fair.

The administration was in a delicate position because it wanted to avoid public and congressional accusations that it had been lax on national security issues and law enforcement.

Finally, the administration relaxed export policy because it feared that U.S. companies would lose encryption technology leadership. The administration decided that it would make more sense if U.S. companies retained leadership, since it would have more control over the technology if it were developed by U.S. rather than foreign companies.

48

First, the law enforcement officer responsible for the investigation must show probable cause. Second, an attorney for the federal, state, or local government must work with the law enforcement officer to prepare an application for a court order, based on the officer's affidavit. At the federal level the application must be approved by the Attorney General, Deputy Attorney General, Associate Attorney General, any Assistant Attorney General, any acting Assistant Attorney General, or any Deputy Assistant Attorney General in the Criminal Division designated by the Attorney General. At the state and local level the application must be made and approved by the principal prosecuting attorney of the state (State Attorney General) or political subdivision thereof (District Attorney or County Prosecutor). The attorney must be authorized by a statute of that state to make such applications. Third, the attorney must present the approved application ex parte (without an adversary hearing) to a federal or state judge who is authorized to issue a court order for electronic surveillance. A state or local police officer or federal law enforcement agent cannot make an application for a court order directly to a judge. Source: http://www.cpsr.org/cpsr/privacy/wiretap/wiretap.procedure.html.

49 Interview with Sophis Networks, August 18, 2000.

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Preparation questions: 1. What were the principal factors leading to revision in encryption controls in 1999 and 2000?

2. How much influence did the SAFE bill have in the Administration’s decision?

3. What impact did the different interests have in the administration’s decision?

Source: This case was written by Victoria Chang under the supervision of Professor David P. Baron. Copyright by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reproduced with permission.

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Part IV Integrative Case Toys ‘R’ Us and Globalization PowerPoints are available for this case.

Toys ‘R’ Us was one of the great retailing success stories. By the mid-1980s it was the world’s largest toy retailer. It had developed a world-wide supply system and a sophisticated inventory and sales tracking system. It had entered the Canadian and UK markets and had formed joint ventures in Hong Kong and Singapore. Its opportunities for growth clearly were outside the United States.

Toys ‘R’ Us embarked on a globalization strategy of taking worldwide its market strategy of large stores, low prices, advertising, and direct supply. In doing so, it faced a set of nonmarket issues that differed across countries but more fundamentally the interests and their organization and the institutions differ. Moreover, the information that is crucial for nonmarket success is often difficult to obtain.

Companies that are successful in their domestic market typically have an incentive to take their market strategy to other countries. While they have learned the lessons of market competition well, they may not have learned the lessons of nonmarket competition. That is, in many industries the U.S. market is relatively unregulated compared to that in many other countries.

Entry into Canada and the United Kingdom was relatively straightforward for Toys ‘R’ Us, since those countries have relatively transparent regulations. Entry into Singapore and Hong Kong was also relatively easy, since the company had an experienced partner. In many other countries, including Germany and Japan, its opportunities were controlled to some extent by governments and interest groups, as illustrated in Figure 2-2.

Toys ‘R’ Us needs an integrated strategy as it moves into serious international expansion. It must coordinate its market strategy with its nonmarket strategy, and in many cases this involves the employment of a nonmarket strategy to unlock the opportunities in foreign markets. Its market strategy is to identify countries with large populations and high income and then apply its standard market strategy emphasizing price, selection, stock and customer satisfaction. Its market strategy is global with respect to the competitive advantage it gains from its worldwide purchasing power.

Its market strategy is thus global, although because it faces no global competitor, it competes with different local retailers on a market-by-market basis. It thus must tailor its strategy to the particular nuances (e.g., demand structure) in each market. This is evident in its policy of hiring locals to manage its operations in countries.

At the conceptual level its nonmarket strategy is also global, since that strategy is to unlock opportunities so that its market strategy can be implemented. The nonmarket environments in countries differ substantially, however, in terms of their issues, interests, institutions, and information. Its nonmarket strategy thus must be multidomestic in the sense that it deals with the

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nonmarket environment on a county-by-country basis. (This is analogous to what Hout, Porter and Rudden (1982) refer to as a multidomestic market strategy in which a company competes “on a domestic-market-by-domestic-market basis. Typically these businesses have products that differ greatly among country markets ... (p. 99)”50 Toys ‘R’ Us is not purely multidomestic in the sense of full decentralization and autonomy for local units, but country managers have the freedom to respond to local market conditions and demands.) Bartlett and Ghoshal (1989) distinguish among companies that are multinational, global, and international. Their distinctions appropriately focus on the market environments of the firms they studied, but it is useful to consider whether these distinctions are appropriate for the nonmarket environment.

Their notion of a multinational company is closest to what I have referred to as a multidomestic approach. Their concept is that of companies that “manage a portfolio of multiple national entities.” The examples they give emphasize a substantial degree of decentralization and independence of operations, which is suggestive of the notion here that nonmarket strategies must be tailored to the 4 Is of the nonmarket environment of countries. Bartlett and Ghoshal give the following example of a multinational company: “ITT’s commitment to building links to each host country’s political infrastructure has led to the development of operations around the world that were almost always perceived as local countries.” A company need not be or become a multinational company in their terminology to employ a multidomestic nonmarket strategy.

Indeed, a multidomestic nonmarket strategy can, and should, be employed by a company in any of Bartlett and Ghoshal’s categories. In their typology, Toys ‘R’ Us has characteristics of both global and international companies as they pertain to its market strategy. An international company is one that draws on global economies, which Toys ‘R’ Us does in terms of its supply system, rather than the market demand for its products. It is an international company in the sense that it transfers knowledge and expertise from the parent to the countries in which it operates. Toys ‘R’ Us exercises considerable control over its country operations through its standardization and worldwide supply network. The terminology that seems to be most appropriate in the case of Toys ‘R’ Us is that it employs a global market strategy with that strategy tailored to local demand patterns. The company has elements of both a global and an international company in Bartlett and Ghoshal’s terminology. Its nonmarket strategy is multidomestic in that it deals with the barriers to its opportunities on a country (4 Is)-bycountry basis. Its nonmarket strategy is not international, since it is not transferring its domestic knowledge to other countries; i.e., in the United States it faced few nonmarket challenges. In terms of transferring expertise, the company may have a global or international framework that underpins its nonmarket strategy, but the application of that framework is strongly multidomestic. Toys ‘R’ Us’ market and nonmarket strategies are well-integrated. It applies its market strategy everywhere, whereas its nonmarket strategy is tailored to the 4 Is in each country. The strategies are integrated in the sense that the nonmarket strategy is used to unlock opportunities that are blocked by government and interest groups.

50

Thomas Hout, Michael E. Porter, and Eileen Rudden, “How global companies win out,” Harvard Business Review, (Sept.-Oct.) 1982: 98-108.

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Toys ‘R’ Us also adapts and learns in the implementation of its strategy. It learns quickly within a country and acts decisively once its opportunities are unlocked. In Germany it was able to open 18 stores in 18 cities by 1991 and it planned 7 more. It also learns across countries and its internationalization has accelerated with experience. It also adapts in its supply network by incorporating local toy manufacturers into that network. In Germany it incorporated the model train manufacturer Märklin, which had initially refused to supply it. The Single European Act and market integration in the European Union should allow it to develop a distribution system in the EU similar to that in the United States. The nonmarket challenges and issues faced by Toys ‘R’ Us vary with the institutions and interests in each country. The issues range form the LSRSL and the distribution system in Japan to store locations and hours in Germany to taxes in Taiwan, etc. The organization of interests also differs across countries where labor unions are very powerful forces in the nonmarket environment in Germany and in Sweden. In Japan Toys ‘R’ Us faces Protectionism with a capital “P” in the sense that it is blocked by federal laws that empower local merchants and communities to block the opening of large stores. In Germany it faces protectionism with a little “p” in the sense that its opposition is also at the local level but it is not blocked by a federal law. This means that it must deal with protectionism municipality-bymunicipality. In contrast, in Japan it must deal with Protectionism at the national level. This means that the leverage has to be provided by the U.S. government as a powerful local partner.

This analysis leaves two questions. First, what are the implications for the integration of multidomestic nonmarket strategies and multinational, global, and international strategies?

Second, what implications does this have for organizational decisions? For example, when should a firm take a local partner? With respect to the last question, information seems to be an important factor. Toys ‘R’ Us’ entry into the Canadian and United Kingdom markets was straightforward, and it did not take a local partner. This may have been a function of two factors. First, regulations in the two countries are relatively transparent. Second, the language and culture are similar. Because of these two the parent company can manage its entry. (Note that culture and language are likely to be more important for a retailer than for a company selling industrial products, such as semiconductors, where customers are sophisticated and technical language is used.) In contrast, in Asian countries, particularly in Japan, regulations are often nontransparent. Moreover, the culture and language are different. For both of these reasons Toys ‘R’ Us has found it attractive to take local partners in a number of Asian countries. Teaching the case: The following questions are directed at general strategy issues. 1.

What is Toys ‘R’ Us’ globalization strategy? 2. To what extent does its market strategy require a nonmarket strategy? 3. To what extent does that nonmarket strategy have to be tailored to the specific country in

question?

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4. How successful is Toys ‘R’ Us likely to be? Developments With respect to Porter’s five forces, the possible threats come from entry by new competitors and from threatdiscount stores. One new entrant, Child World, recently went bankrupt, so the principal seems to be from discount houses such as Wal-Mart, Kmart, and Target, which have begun to emphasize toys as a means of drawing customers into their stores. (Wal-Mart ultimately became the largest toy retailer in the United States.)

With respect to its global market strategy, Toys ‘R’ Us has opportunities in countries with high income and growth. It also has opportunity in countries that have inefficient distribution systems and small toy retailers. It is exactly in those countries, where the local and nonmarket opposition can be the most severe. Opportunity is also present in countries in which toy retailers do little advertising (Germany), since advertising has been shown to expand demand considerably.

One issue is how to expand in Asia. Note that the company first entered the two countries that are most to open to foreign investment - Singapore and Hong Kong. One natural expansion strategy is have its partners in those two countries carry the business into adjacent countries, such as Malaysia and Taiwan.

Toys ‘R’ Us prefers to purchase the land its stores occupy, and owns 60% of its international properties.

In 1992, Charles Lazarus earned $7.025 million in salary and $57.206 million in long-term compensation, placing him third on Business Week’s executive compensation list.

By 1997 Lazarus had stepped down, and Toys ‘R’ Us began to fall on hard times. It faced increasing competition from discount store chains, and by 1998 Wal-Mart had become the largest toy retailer in the United States. In the United States hard times have continued into 2002.

Japan .

To successfully enter the Japanese market, Toys ‘R’ Us must develop and implement both a nonmarket and a market strategy and those strategies must be well-integrated. The nonmarket strategy must address the delays caused by the LSRSL and the related restrictions on store hours.

The market strategy must address site selection and acquisition, by-passing the distribution system, and a host of other market-related factors in Japan.

The basic politics of Toys ‘R’ Us’ entry is entrepreneurial, since the benefits will accrue to Japanese consumers and the costs will be concentrated on small merchants and wholesalers.

Benefits will also accrue to Toys ‘R’ Us and to toy manufacturers, but since Toys ‘R’ Us has no presence in Japan, it can play no significant 360 role. Toy manufacturers will benefit, but most are not located in Japan but instead are located in Hong Kong and South East Asia.

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The possible entrepreneurs are Toys ‘R’ Us, a Japanese partner, a Japanese retail chain, and the USTR. Toys ‘R’ Us has no presence in Japan, so it can have little direct effect. Both a joint venture partner and a Japanese chain could play the role of an entrepreneur, but working through the policy-making process in Japan will be lengthy. The best way to reduce the nonmarket impediments to entry is to place the issue of the LSRSL, and in particular Toys ‘R’ Us’ entry, on the trade negotiation agenda. At the time of the case, trade negotiations were taking place between the United States and Japan, and this issue could be included on that agenda. The USTR will find this an attractive case to illustrate the barriers to foreign firms. She can also argue that the benefits to consumers certainly outweigh the costs imposed on merchants.

Toys ‘R’ Us should ask the USTR for changes in the LSRSL, which was already on the agenda, and in the local regulations promulgated by the local and prefecture governments. The Japanese government will be able to speed approval of new store applications through bureaucratic revisions in the approval process and/or through revisions or repeal of the law itself. The former is easier than the latter, but the latter should be the objective.

Although it would probably be over the objections of SMEA, MITI is likely to support changes in the process and the law. The MLA may oppose it. If there is a conflict between the ministries, the LDP will have to make the decision. The dilemma faced by Prime Minister Kaifu on this issue is whether to sacrifice some electoral support among store owners so as to build strength with a generalized unorganized constituency—consumers. It appears that the LDP is willing to take the gamble and sacrifice support among small merchants and farmers. (Note that both are declining in number as children do not take over their parents’ shops or farms.)

Toys ‘R’ Us’ nonmarket strategy should be to exert political pressure in the United States to make certain that the USTR takes up its cause. This should include lobbying and the use of the media.

The media is interested in trade issues, particularly when they suggest that Japan is not playing on a level field. If the negotiations were to fail, Toys ‘R’ Us could file a complaint under Section 301 of the trade laws, as considered in Chapter 18. This would be an extreme step that would anger the Japanese government.

Toys ‘R’ Us’ market strategy should be to take on a partner that can do the things that it is unable to do, such as site selection, dealing with local regulations, and by-passing the distribution system.

A Japanese chain would satisfy the first two of these requirements but not the third. Furthermore, Toys ‘R’ Us would compete with certain department store lines so there would have to be a delicate incentive problem addressed in any joint venture arrangement.

A natural partner is McDonald’s, since it has gained a great deal of experience in site selection, dealing with local regulations, and by-passing the distributions system.

Teaching the case

The following sequence of questions can be used to guide the discussion.

1. What does Toys ‘R’ Us have to accomplish to be successful in the Japanese market?

2. What nonmarket impediments are there to entry?

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3. What is the nature of the politics underlying those nonmarket impediments? Which interest groups will oppose entry and what channels and strategy will they use?

4. Where can Toys ‘R’ Us get help in overcoming those impediments? Can the U.S. government be helpful? How? Is it likely to help?

5. Would a market partner be a good idea? What would you want the partner to do? What “assets” should the partner have?

6. Is the LDP likely to become active on this issue?

7. What market strategy should Toys ‘R’ Us adopt? What nonmarket strategy should it adopt? How should those strategies be integrated?

Outcome Toys ‘R’ Us’ basic nonmarket strategy was to complain in the United States about the LSRSL and the difficulty in entering the Japanese market. Although its entry would not increase U.S. exports since almost all toys are made in East Asia, the issue is attractive to a politician because it involves an unfair practice that is harming a U.S. company. Toys ‘R’ Us lobbied, testified before Congress, and took its case to the media. President Bush and the USTR embraced the issue and put pressure on Japan to revise the LSRSL and speed the approval process. The following Toys ‘R’ Us in Japan (B) case and the following discussion describe the outcome.

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Toys ‘R’ Us in Japan (B) To enter the Japanese market, Toys ‘R’ Us decided to form a joint venture with McDonald’s Company (Japan). McDonald’s would own 20 percent of the venture with Toys ‘R’ Us retaining an 80 percent interest. Mr. Fujita was expected to play a major role in the venture. Toys ‘R’ Us chose Mr. Fujita because of his extensive knowledge of local markets and real estate.

On April 5, 1990 the United States and Japan announced a trade agreement, one part of which addressed the large-scale retail store law. Japan pledged to revise the approval process to reduce to one-and-a-half years the length of time for receiving permission to build new, or to expand existing, large stores. Within three years, the government pledged to consider the elimination of the law in the cities of Tokyo, Osaka, and Nagoya.

Because of the attention given to Toys ‘R’ Us by the USTR and by the media, the Japanese government specifically addressed Toys ‘R’ Us’ attempt to open its first store in Niigata. Shortly before the announcement of the trade accord, MITI announced that it had reached an agreement with the municipal and prefecture governments and the chamber of commerce in Niigata to begin the process of store approval for Toys ‘R’ Us. Notice was to be sent to local merchants and to the local governments explaining the plan and the establishment of a local committee to review the application. Thirteen large-scale retailers, including the Toys ‘R’ Us-McDonald’s joint venture, participated in the discussions with local merchants. Toys ‘R’ Us said it was now “very optimistic” about being able to open its first store in Niigata in 1991. A McDonald’s spokesman, however, said that local opposition was still strong.

The reaction in Japan to the announcement of the trade agreement was varied. “The Japan Chamber of Commerce and Industry released a statement saying there could be `problems’ from changing the distribution system and from toughened antitrust penalties. Prime Minister Kaifu, in his news conference, said Japan’s measures ‘have been attained after undergoing a difficult domestic process, and their implementation may, in some cases, be painful.’ But, he said, they are ‘essential in furthering Japan’s own national interest.’”51 “‘It’s not going to be easy for the Government to get agreement from the vested interests,’ one government official said. ‘But the Prime Minister is obviously determined to carry out the terms.

He is putting his leadership on the line.’”52.

The Japanese government faced the problem of attaining support for a weakening of the protection given to small retailers. To obtain support for the revisions and to encourage the stores to carry foreign goods so as to reduce the U.S. trade deficit, the government planned to provide immediate authorization for an expansion of up to 100 square meters for retailers that agree to sell foreign goods.

Opposition was still expected to be strong both at the local level and at the level of national politics.

Mr. Tanaka of the Federation of Specialty Stores Associations said, “‘We feel we were deceived by 51 52

The Wall Street Journal , April 6, 1990.

The New York Times , April 7, 1990

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the LDP because we believed they would protect our livelihoods no matter what. That’s why we voted for them in the last election.’ He added ‘If major urban areas are excluded from the protection of the law, it would be tantamount to abolishment. If the LDP does that, we have to give them a good scare.’”53 the Federation of Specialty Stores Associations said it would do its best ‘to prevent the decisions from being enforced by keeping close ties with other groups and promoting consumer awareness.’ …

Kaifu said effects of the revision would be ‘severe,’ but added, ‘I believe it is important for me and all of you to think of the viewpoint of consumers’ interests.’

The association’s statement said, however, ‘the decision will do nothing but weaken minor retailers, devastate shopping districts and slow economic and cultural development of the community.’

The association claims a membership of 50,000 small retailers nationwide. The trade ministry says Japan has 1.6 million retail shops with fewer than 50 employees, and 800,000 tiny ‘mom-and-pop’ stores.54 In addition to political action at the national level, small-scale merchants are expected to take political action at the local as well as national level. “The retailers say they will also appeal to local authorities, who may have the power to enact their own legislation effectively nullifying any change made at the national level. A recent survey of a dozen major municipal governments showed many would consider enacting some sort of protection if the national changes proved damaging to small retailers. ‘There’s a concern that the regions will respond by tightening laws — they don’t feel the pressure from the U.S.,’ said Weeks Ringle, a retail analyst with W.I. Carr (Overseas) Ltd., a unit of France’s Banque Indosuez, in Tokyo.”55 The principal beneficiaries of relaxation of the Large Scale Retail Store Law would be consumers, but they may not be active on this issue.

Japanese consumers, however, have not formed organizations to press for change, and many Japanese identify their own interests with those of their companies.

Larger is not necessarily better, said Naokazu Takeuchi, head of the Japan Consumer Union, one of the nation’s largest consumer groups.

‘It is not cheap pricing that we consumers want,’ he said. `We have to take many elements -- cultural aspects, community relationships -- into consideration before making decisions.’56

53

Japan Economic Journal, April 1990.

Peninsula Times-Tribune, April 6, 1990.

55 The Wall Street Journal, April 9, 1990.

56 Peninsula Times Tribune, April 6, 1990.

54

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Preparation questions 1. What is the likely nature of the politics in Japan on the revision in the process for the approval of large-scale stores? What forms of interest group politics can be expected? What strategies are likely to be employed?

2. Will the LDP and the government of Prime Minister Kaifu be able to withstand the pressure?

3. What outcome is likely? Will the Japanese market be open to all foreign retailers? Carrefour, a French company, opened a discount store in the United States that is nearly the size of six football fields. In addition to the cost of land, should Carrefour expect any difficulties if it decided to enter Japan?

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Outcome Local resistance delayed the opening of a store in Niigata, but the Japanese government committed to opening a store in 1991. Toys ‘R’ Us pressed forward with a store in Amimachi in Ibaraki Prefecture. The store was scheduled to open on December 20, 1991 and Toys ‘R’ Us hoped to open 7 to 10 new stores each year for the rest of the decade. Secretary of Commerce Robert A. Mosbacher cited this as evidence of the progress made in the Structural Impediments Initiative and said, “We hope Toys ‘R’ Us will be the first in a long line of stores to locate in Japan.”57 Many of the toys Toys ‘R’ Us planned to sell in Japan were made by Japanese toy manufacturers.

In the United States, Toys ‘R’ Us uses a strategy of dealing directly with manufacturers to obtain price discounts and to persuade them to finance a portion of Toys ‘R’ Us’ advertising. In Japan, Toys ‘R’ Us attempted to follow the same strategy, but its success was thwarted by the established relationships between Japanese toy manufacturers and wholesalers. Toys ‘R’ Us was not successful in breaking these links but instead had to enter into Japanese-style arrangements. For example, Bandai Co. supplied Toys ‘R’ Us only through an affiliated wholesaler. “‘We’re not going to set prices especially lower or higher just because it’s Toys ‘R’ Us,’ says a spokeswoman for Bandai.”58 In a breakthrough, Nintendo agreed to supply Toys ‘R’ Us directly but only at a price that was acceptable to other wholesalers.59 Toys ‘R’ Us hoped to sell at a 10% to 15% discount from normal prices.

Toys ‘R’ Us set prices significantly below those of Japanese retailers, but those prices were considerably higher than in the United States. A Barbie doll that Toys ‘R’ Us for $14.99 in the United States and $19.52 in Japan sold for $26.50 at a large Japanese retailer. Play Doh which Toys ‘R’ Us sold for $2.69 in the U.S. and $6.00 in Japan sold at $7.50 in Japanese stores.60 Most Japanese department stores leased the space in their stores, and most of the merchandise was actually on consignment. dae teno (apparently) is the Japanese term for the large store rules.

Toys ‘R’ Us was not without competition in Japan. Small toy stores would be expected to lower their prices and ask wholesalers and distributors for discounts. Japan had one chain, Chiyoda, that sold toys and shoes. It planned to compete on a volume and discount basis with Toys ‘R’ Us, although its strategy was to have a large number of smaller stores of approximately 3,500 square feet. Chiyoda planned to open a store directly across the road from Toys ‘R’ Us in Amimachi on the same day that Toys ‘R’ Us opened its store. Indeed, one of the principal consequences of the regulatory changes instituted as a result of the SII negotiations was that Japanese retailers found it much easier to obtain permission to open a store. New store applications increased by a factor of five.

The Toys ‘R’ Us store in Amimachi opened as scheduled, and 17,000 people visited the store on opening day. The evening news in Japan carried the story, including interviews with customers.

57

Business Week, December 9, 1991. That article also provides a brief description of the local store approval process that new store applicants must go through.

58 The Wall Street Journal, October 8, 1991.

59 The Wall Street Journal, October 8, 1991 60 The New York Times, December 21, 1991.

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U.S. Ambassador to Japan Michael Armacost attended the opening of the store in Ibaraki Prefecture to demonstrate the importance of these issues in Washington. Toys ‘R’ Us opened its second store in Nara in January 1992, and President Bush attended the opening during his state visit to Japan.

In an April 1990 trade agreement the Japanese government agreed to a maximum of 18 months for approval and pledged to eliminate the approval process completely in Nagoya, Osaka, and Tokyo.

MITI also gave stores an automatic approval for expansions of up to 100 square meters if they would sell foreign goods. This not only opened opportunities for Toys ‘R’ Us but for Japanese stores as well. This contributed to the growth of discount stores in Japan.

As an example of the expedited process after the April 1990 accord, Toys ‘R’ Us asked to open a store in Sagamihara, a Tokyo suburb. Talks began in May 1990. The company had to submit plans to SMEA, Kanagawa Prefecture, Sagamihara City, and the Chamber of Commerce. An explanation meeting was held in the local public hall. A presentation was made to the Sagamahara Commercial Activities Council, an 18-member body involved in the SMEA-Chamber of Commerce portion of the approval process. Three subsequent meetings were required with the Council. Approval was granted in June 1991. The store must close 30 days a year and by 8 p.m., so Toys ‘R’ Us was not able to operate as it did in the United States.

One response of the Japanese toy retailers was to form the Specialty Toy Shops whose purpose was to reduce distribution costs.

The inefficiency in the Japanese economy and the wholesale-retail sector in particular remained a concern to MITI. In May 1994 it exempted all stores of less than 1,200 square meters from the application process. Small store applications doubled, and large-scale store applications increased by 41%.61 This has contributed to increased price competition at the consumer level.

Toys ‘R’ Us’ entry into Japan was successful, and within eight years it had 63 stores in Japan. The PowerPoint toysjapan.ppt summarizes the outcome. Japan largely eliminated the LSRSL, resulting in a boom in the construction in large stores. By the end of the decade Toys ‘R’ Us had nearly met its goal of 100 stores. Toys ‘R’ Us then spun off the Japanese company.

The use of the United States government to pressure Japan for marketing opening is now a thing of the past.

Germany In contrast to Japan, Toys ‘R’ Us did not need to use the lever of U.S. pressure in Germany. The German economy is relatively open, and no impenetrable politics prevented entry. It faced opposition by interests, however. The organized interests include local retailers and their organizations, and because of their established market relationships with retailers, the German toy manufacturer. The nonmarket issues are at both the local and the federal level. The issues such as tax rates and labor laws cannot be changed and have to be taken as features of the German nonmarket environment. German labor law and work rules have broad support. Store opening

61

, April 25, 1995.

The Wall Street Journal

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regulations might be changed, but Toys ‘R’ Us will not be able to play much of a role in the changes. Local laws apparently do not prohibit entry, but local merchants and their associations are consulted and can influence the decision-making processes. The centerpiece of Toys ‘R’ Us’ nonmarket strategy should focus on these interests and institutions. Toys ‘R’ Us wants to convince local merchants that its entry will not harm their markets. The two arguments that can be made are 1) that Toys ‘R’ Us will locate on the outskirts of towns rather than in their centers and thus will not be a direct competitor and 2) that its advertising will expand the market for toys. These arguments can be made both to the retailers and manufacturers and to the local governments. The local governments have administrative processes that undoubtedly involve considerable red tape, so some patience and persistence will be required. German nationals are likely to be more effective at this than foreigners. In contrast to its entry into Japan, Toys ‘R’ Us decided not to seek a German partner but to form a wholly-owned subsidiary. It, however, hired an experienced German managing director from Germany’s largest department store chain. The company’s basic market strategy was to have large stores carrying a wide range of products and offering discount prices. It sought to persuade German toy manufacturers that its entry and advertising would expand the market and to argue to toy retailers that its locations outside of the city centers would not be a major impediment to toy retailers. Its basic nonmarket strategy was to try to operate within the German system but to be persistent in seeking permits and avoiding additional restrictions on its operations. Toys ‘R’ Us’ market strategy is to keep its stores open 365 days a year and for long hours. This strategy is blocked in Germany by storeopening regulations that severely limit the times and hours that a store can be open. As one commentator explained, “In the United States retailing is organized for the benefit of the consumer. In Germany retailing is organized for the benefit of the retail employee.” This insight reveals that there is little that Toys ‘R’ Us or the U.S. government can do to change the law.

Other companies must be frustrated by the law as well, so there may be an opportunity at some point in the future to change the law. Indeed, Germany became concerned that its retail sector is underdeveloped and inefficient. Teaching the case One approach to teaching the case is to contrast it with the case of Japan. 1. What market strategy is Toys ‘R’ Us following? 2. What nonmarket issues does it face in Germany and which should it address? 3. Which interests will be concerned about its entry? 4. How do these compare to those Toys ‘R’ Us faces in Japan? 5.

How should Toys ‘R’ Us deal with these nonmarket issues? Develop a nonmarket strategy. 6.

Can it defuse the opposition by local retailers? By toy manufacturers? Outcome Toys ‘R’ Us’ entry into the German market was slow but ultimately successful. By 1998 it had 58 stores in Germany. To deal with the objections of toy manufacturers, Toys ‘R’ Us sought to convince them that its entry and its mass advertising would increase the demand for toys. The

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growth rate of toy sales actually increased substantially because of its entry, and manufacturers such as Märklin agreed to sell to Toys ‘R’ Us. To deal with local permits, Mr. Klöser adopted a strategy that he characterized as, “We stayed polite and friendly.”62 With respect to the retailers, Mr. Klöser said, “What they were really worried about was competition. I had to convince them we would complement business, not kill it.”63 According to Mr. Klöser he would test whether protectionism was being exercised by requesting a location in the city center when objections were raised to a location on the outskirts of town. “If I don’t get one, then I know certain protectionism is at work,” he said. “But times change, politicians change and we keep trying. I think people here realize no one is going to stop us now.”64 In Germany, Toys ‘R’ Us began advertising heavily and in response the German toy retailers began advertising year-round rather thanretail on aexecutive seasonaltobasis had beenitsthe custom.strategy.

From 1987 • Hired an experienced German helpas implement integrated through Familiar withinobstacles, politics,byunions/works councils, ...

1991, toy sales Germanylocal increased 50%. Toys ‘R’ Us estimated that it captured one• Toys played by the local rules quarter –took labor laws, works councils, hours, etc. as given. of the increase and the rest.

Klöser said,cities “In the end, everyone benefited.”

• Objective: Getother a footretailers in the door and Arnt then go to other applications in center of town and meadow The–dual outcome is summarized in toysgermany.ppt and repeated here: –advertise heavily to stimulate demand and lessen opposition from local retailers; demand grew rapidly • Ignored the boycott threats -- model train manufacturer now sells to Toys R Us, not just in Germany but also in U.S. stores.

• First store in 1987 and 58 by 1998; No. 1 toy retailer The number of toy retailers in Great Britain is estimated to have decreased from 6,000 to 1,200 after Toys ‘R’ Us entered the market.

Pressure for change in Germany’s store hours laws grew in 1994 and 1995 as European economic integration put pressure on Germany. More Germans living near the borders were shopping in neighboring countries. Moreover, the inconvenience to German consumers became more apparent.

The labor unions opposed lengthening the store hours. In 1996 a modest increase in store opening hours was enacted.

In 2001 Germany repealed laws banning free gifts and offering rebates. The tide had begun to turn against retail restrictions.

Germany continues to have restrictive retailing laws. The Law Against Unfair Competition allows the Competition Center to take actions against retailers for practices such as offering price discounts. When the euro was introduced, C&A Mode offered a 20 percent discount on credit card 62

The New York Times , August 18, 1991. , August 18, 1991.

The New York Times 64 , August 18, 1991.

The New York Times 63

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purchases for four days. The Competition Center sued C&A and obtained a restraining order prohibiting the company from offering the discounts. The court also fined the company 250,000 euros. The deputy commissioner of the Competition Center said, “If every store had a sale any time it wanted, there would be no price transparency. It would be totally confusing.”65 The Center represents small shops and small companies. German consumers began to question the regulations.

Sweden Sweden is a country with a powerful and encompassing union system. Virtually all employees, including management, are members of a union. Unions are important for the usual reasons but also because certain employee rights are established only through union membership. Health insurance is also much cheaper when purchased through a union rather than purchased independently.

The Swedish labor union system is based on two tiers: the first is the standard nationwide agreement and the second is negotiations on details with local work units regarding work rules and other matters. That is, to get to the point at which it can negotiate work rules, it must first sign the nationwide agreement.

The issue in the case is not unionization but instead is whether to sign the standard nationwide agreement. Toys ‘R’ Us stated that it objected to doing so because as a new company in Sweden it had not been a party to the negotiations. It seems more likely that the company found the work rules in that agreement to be too restrictive and sought more flexibility with respect to firing and work requirements.

Swedish executives have said that the Retail Workers Union is one of the most militant in Sweden, and Kenth Pettersson is said to be “anti-American.” Moreover, this is the first strike in 20 years for this union, so it must have substantial resources to use in support of a strike. This means that the company will have a substantial challenge if it attempts to defeat the union on the issue of signing the standard nationwide collective labor agreement. The company’s Swedish law firm should have known this and made it clear to Toys ‘R’ Us. (Swedish executives have also said the Lagerlof & Leman is an elite corporate law firm and may not have been experienced in dealing with its clients’ labor unions. As the case indicates, signing the nationwide agreement is standard, so this type of confrontation may be rare.)

Moreover, although this is a dispute between the company and the Retail Workers Union, it is really a dispute between the company and the Swedish labor movement. Other unions can be expected to lend their tangible and intangible support for the Retail Workers Union.

In deciding whether to sign the agreement or take a strike, Toys ‘R’ Us must not only think about what it might gain but also what it could lose in terms of its image with the Swedish public. Many Swedes will understand the issues but will be perplexed by why Toys ‘R’ Us cannot act like all other companies and sign the nationwide agreement. That is, will the reputation it obtains with the public damage its sales? The answer seems likely to be “yes.”

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, January 23, 2002.

The Wall Street Journal

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To understand what went wrong here, it is useful to first look at Sweden relative to Japan and Germany, as shown in the following table.

Germany per capita income market size (population millions) organization

management

Japan

Sweden

high

high

high

80

8

subsidiary

120 joint venture

German

Japanese

part of UK company British

Sweden differs from Germany and Japan in terms of Toys ‘R’ Us’ globalization strategy in one important dimension. Its market is small because the population in the country is small. Because Sweden was too small for a subsidiary, the Swedish operation was assigned to Toys ‘R’ Us’ UK company. Moreover, top management was British rather than Swedish. This means that it had to rely on advisors, such as Lagerlof & Leman, to guide it in the nonmarket environment in Sweden. The advice it received was not very good. As suggested in the case, this was an embarrassing episode for the Swedish government, but it was unlikely to intervene on the side of Toys ‘R’ Us. The government attempted to mediate the dispute but failed. Teaching the case The following questions can be used to guide the discussion. 1. How does Sweden compare to Germany and Japan with respect to Toys ‘R’ Us’ globalization criteria? 2. How did the company organize and management its operations in Sweden? 3. What does Toys ‘R’ Us expect to gain from rejecting the nationwide collective labor agreement? 4. What does Toys ‘R’ Us’ rejection look like from the perspective of the Retail Workers Union? Is this issue significant enough to justify a strike? 5. What are the sources of strength of the union? 6. Is a boycott likely to be effective? Are customers likely to cross a picket line? 7. Will the Swedish media cover this issue?

Whose side is it likely to portray more favorably? Where would this issue lie in the audience interest-societal significance framework in Figure 3-2? 8. What went wrong in Sweden for Toys ‘R’ Us? 9. What is the Swedish government’s likely attitude towards Toys ‘R’ Us’s refusal to sign? 10. What should Toys ‘R’ Us do as the strike continues?

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Developments and outcome Once government mediation failed and the union called a strike, the question is why Toys ‘R’ Us did not recognize that the union was unlikely to give in. The strike and the conflict between the union and Toys ‘R’ Us received considerable attention from the news media as would be expected. How successful the boycott was was not clear. Toys ‘R’ Us was able to keep its stores open. The strike lasted three months with the government finally forcing the two sides to arbitration. Both the union and Toys ‘R’ Us claimed they got what they wanted. Whether that is true is not clear, but what is clear is that Toys ‘R’ Us was not viable as a company in Sweden.

Toys ‘R’ Us fired the head of its Scandinavian operations, and in March 1996 it gave up. It entered into a franchise arrangement with Top Toy of Denmark, which is Scandinavia’s largest toy retailer. Under the arrangement Top Toy would take over and operate the Toys ‘R’ Us stores in Sweden and would convert eight of its stores in Denmark to the Toys ‘R’ Us concept.

When the transition took place in Sweden, Top Toy placed advertisements on busses showing the Toys ‘R’ Us animal figures with a caption “Now under Swedish Management.” In the corner of the ad was one of the animal characters with a paint brush painting over the American flag. toyssweden.ppt provides a brief summary of the outcome. The episode in Sweden was clearly a loss for Toys ‘R’ Us, but it gained at least something from its franchise agreement. Toys ‘R’ Us subsequently began using franchising for entry into several smaller markets. After the Toys ‘R’ Us episode, 7-11 stores entered Sweden and had a long drawn out fight with the Retail Workers Union, although not a strike, over whether it could stay open 24 hours a day, which is part of its market strategy. The agreement finally reached with the union allowed the company to operate 24 hours a day, but at night it had to cover most of its merchandise so that it could be sold.

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PART V

ETHICS AND CORPORATE SOCIAL RESPONSIBILITY

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Chapter 19 Corporate Social Responsibility This chapter begins the explicitly normative part of the book. The purpose of the chapter is to raise the issue of the appropriate objectives of a firm and its responsibilities to its various constituencies.

No particular set of objectives is advocated nor is a singular vision of those responsibilities presented. Instead, the chapter concludes that the content of social responsibility is found in ethics, which is the subject of the following two chapters. Chapter 22 then presents a number of policies implemented by companies in accord with their conception of corporate social responsibility.

Chapter 23 focuses on issues of ethics and corporate social responsibility in international business.

Corporate social responsibility is advocated by many firms but their actions vary considerably.

With the pressures facing firms in an era of global competition, costly corporate social responsibility policies can harm competitiveness. For example, Ford Motor Company pledged to increase the fuel economy of its SUV fleet by 25 percent over 5 years. Ford found that achieving that objective would be considerably more difficult and costly than anticipated.

Some policies may improve competitiveness and profitability, and there remains the question of whether that represents social responsibility. The argument that it does not is simply that a firm whose only objective is to maximize profits would adopt the same policy. The adoption of a “socially responsible” policy that is also a profit-maximizing policy thus is not sufficient to conclude that the firm acted in a socially responsible manner. In this sense, CSR is strategic.

Another factor in assessing a firm’s actions is causality. Some firms that are quite successful in their market environment have adopted “socially responsible” policies that may be thought of as philanthropy, since they involve using some of their profits for purposes other than future profitability. The direction of causality issue is whether the “socially responsible” policies are the result or the cause of profitability.

The Tuna and Dolphins example is intended to illustrate another dimension of the issue — whether an action taken as a result of pressure should be labeled as socially responsible or simply as a concession to the pressure from private politics. This raises the issue of motivation for an action or policy.

It should be pointed out to students that Friedman requires firms to act in accord with the law and ethical custom. Thus, even if the value maximization (efficiency) perspective is adopted, there is a need to study ethics. Friedman argues, however, that there is no reason to label policies that increase profits as socially responsible.

The Business Roundtable statement takes the perspective of managerial capitalism, since managers are viewed as principals who have the responsibility for balancing the interests of stakeholders.

The Roundtable intentionally chose not to be specific, since it is managers who are to decide what is an appropriate balancing of interests for any particular firm. Interestingly, management is to consider the interests of constituents without directly involving those constituents in decision

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making. The stakeholder concept is central to this perspective, but the stakeholder relationship is reciprocal. This concept seems to help little in identifying corporate social responsibility other than to identify the importance of creating realistic expectations on both sides of the relationship.

My experience is that students find Friedman’s position clear and relatively unambiguous, whereas they find the Business Roundtable statement to be somewhat vague. Some students, who wish to argue that firms should do good, argue for the rhetoric of social responsibility and for the sacrifice of profits for the direct benefit of others.

The perspective on CSR presented in the chapter in conjunction with the empirical study by Baron, Harjoto, and Jo provides a comprehensive perspective on the possible motivation for CSR activities and the possible rewards for those activities.

One dimension of the responsibility issue involves representation and accountability. Legal accountability and responsibility rest primarily with the officers and the board of directors. Their duties are specified in the law but beyond compliance with the law and answerability to shareholders they may have additional responsibilities. A lecture could expand on the duties of directors, the implications of the court cases, and the requirements of Sarbanes-Oxley. The Enron case raises such issues.

A major feature in the social responsibility debate is the extent to which firms can pursue policies that reduce the value of the firm to pursue social objectives. The market for control disciplines management through the threat and reality of proxy contests and takeovers. The pressure comes primarily from institutional investors and mutual and retirement funds. These pressures are for increased profits, and hence “socially responsible” policies that reduce profits are harder to sustain.

PowerPoints providing an overview of ethics and responsibility are available in ethicsresponsibility.ppt.

In addition to the Citigroup’s problems identified in the chapter, in August 2008 Citigroup agreed to buy back $7 billion of auction-rate securities and paid a $100 million fine for failure to tell buyers that the securities had substantial liquidity risk. The auction-rate market had collapsed in February 2008 when Citigroup and other banks stopped backstopping the auctions.

Cases The Collapse of Enron: Governance and Responsibility PowerPoints are available for this case.

This case was written in February 2002, when much if not most was still unknown about the causes of the collapse of Enron. The Report of the Special Committee of the Board is a very readable account of the events leading up to the bankruptcy filing. (Dean Powers resigned from the Board

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shortly after the Report was released.) It, however, leaves a number of questions unanswered.

Additional information will become available, particularly as lawsuits are prosecuted.

Class action and other civil lawsuits have been filed against Enron, and Bill Lerach of Milberg, Weiss is the lead attorney for the principal class action lawsuit. Lerach is the king of securities fraud litigation. (Lerach was subsequently convicted of fraud for other cases involving him and his firm, as discussed in Chapter 12.) Many of the cases will likely be settled out of court, but some may go to trial. Settlements will be complicated because Enron is under the jurisdiction of the bankruptcy court. Lerach’s case on behalf of shareholders was settled for $2 billion in June 2005.

In addition to the civil cases it is quite possible that criminal charges could be filed against former Enron officials, and several such as Andrew Fastow have pleaded guilty. His wife was convicted and served time in prison. Skilling and Lay had been charged but not yet tried. The directors have been sued for a breach of their duties of care. The Van Gorkom and Hanson Trust cases suggest that the directors may be liable for failing to dig deeper into the establishment of the specialpurpose enterprises and their transactions. The directors have D&O (directors and officers) insurance, but such policies have caps, and hence the directors may be personally liable. They have made restitution from their personal funds. Skilling and Lay were convicted, as were other Enron employees. The other directors were not prosecuted.

Part of the explanation for Enron’s collapse was a series of bad investments which sapped capital from the company and may have provided incentives to structure transactions to give the appearance of strength when the reality was quite different. Whether this was the result of bad management is unclear. The purpose of the case is less to consider the quality of Enron’s management and more to consider the responsibilities of management and directors and governance structures.

One issue likely to be on students’ minds is the type of transactions Enron used and their purpose.

The initial purpose was likely to have been to “manage” Enron’s financial statements to preserve the reported growth that gave Enron its value. This involved taking risks in energy projects and other investments, and Enron sought to insulate its financial statements from those risks. In addition, the special-purpose enterprises and their related transactions allowed Enron to raise more capital than it likely could have raised if all the investments and their financial were on its financial statements. Once some of the investments started to go bad and investors started to have concerns, the bubble burst.

The financial deals could be discussed with the purpose of showing how, for example, the Mahovia-Stonehill transaction was actually a loan and how the put options were risky. The Nigerian barge deal is discussed in the trial.

The Mahovia-Stoneville transaction also drew other attention. In 1996 a copper trader for Sumitomo Corporation lost $2.6 billion in trading, and Sumitomo sued J.P. Morgan and Chase Manhattan charging that they provided loans disguised as trades that the trader used to cover up the trading losses. The same law firm representing Sumitomo filed a lawsuit against the merged J.P. Morgan Chase alleging fraud in disguising the Mahovia transaction as a trade rather than a loan.

The bank stated, “Any prepaid commodity sale contract provides financing. There is nothing

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inappropriate about structuring transactions to satisfy the parties’ financial, tax, regulatory or accounting objectives within the relevant rules and standards.”1 The measures taken by Enron, and particularly by Fastow, were surely pushing the envelope too far and were criminal. The efforts to avoid disclosure by having Kopper manage Chewco and to provide the 3% outside equity were intentional efforts to avoid having to consolidate the transactions. Skilling and Lay presumably were aware of the transactions, although they may have been quite happy to have Fastow doing the work.

The governance of Enron is intended to serve the interests of shareholders and the interests of the public as it pertains to upholding the law. The duties of the officers and directors are discussed briefly in the chapter, and a business law textbook goes into those duties in more detail. In accord with the Van Gorkom and Hanson Trust decisions, Enron obtained valuations and fairness judgments from PricewaterhouseCoopers on some of the transactions, such as the MahoniaStoneville swap.

With respect to governance structures little information is currently available. The Special Report provides some information, and the outside Board members argued that the controls were adequate but that information was withheld from them. Certainly, some information was withheld, such as pertaining to the Barclays’ loan and Kopper’s involvement, but the Board appears not to have probed very deeply into the special-purpose enterprises and their transactions. What they could have accomplished is unclear, but even more questioning might have provided some discipline for management.

Although ethics is the subject of the following chapters, this case provides ample opportunities to assess whether Enron and its officials acted unethically based on standards of aggregate well-being, rights, and justice. The unethical actions include violating the outside equity requirements, conflict of interest and self-dealing, touting Enron’s stock to employees, and misrepresenting information (possibly in violation of SEC requirements). Many actions are in gray areas. For example, assigning Kopper to head Chewco so as to avoid disclosure requirements may have been within the law, but it is questionable from the perspective of justice and possibly utilitarianism. Some of the motivation for some unethical actions is clear. Enron, in particular Lay, may have touted Enron’s stock to employees even though it knew that the Raptors were fragile because if he did not do so, it could have been a signal to Wall Street that Enron’s health was slipping. This would likely have accelerated the collapse.

A particularly troublesome ethics issue is the likely self-dealing in the LJMs. Fastow was on both sides of the negotiations regarding the LJMs; i.e., he represented Enron and he represented the LJMs in negotiating the unwind. More troublesome was his own personal investment and enrichment from the deals. The LJM investment in the Raptors was guaranteed a return, and he and co-investors made large and undue profits. There seems to be little justification for this enrichment.

Another issue is whether Enron made insufficient disclosures or misrepresentations to its lenders and the limited partners in its special-purpose enterprises. At one level, it is the responsibility of

1

, February 25, 2002.

The New York Times

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those lenders and investors to be diligent in discovering information relevant to the transaction and to bargain with Enron over security and collateral. If a lender were concerned about the risk, it could either not lend to Enron, or as Citigroup did it could hedge its exposure. At another level if Enron misrepresented information, such as violating SEC requirements, it acted unethically and perhaps unlawfully. It would be interesting to know what Citigroup told those on the other side of its hedge. Citigroup settled a lawsuit filed by Enron shareholders for $2.5 billion. A number of other lawsuits have also been settled.

An important public policy issue is whether the generally accepted accounting principles (GAAP) are adequate. One observation is that GAAP has never been able to keep up with financial innovation because that innovation takes place too rapidly. That is, as soon as new standards are established to cover a particular trouble area the Wall Street firms go to work to find a way around the new standard. This is a race that accounting may never be able to win. Sarbanes-Oxley places the burden on corporate management.

Arthur Andersen’s reputation was destroyed, and the firm dissolved. A court subsequently ruled that the Department of Justice had been too aggressive in its tactics in reaching a settlement with Arthur Andersen. The firm may have collapsed in any event.

Discussion questions: 1. What was the purpose of the special-purpose enterprises?

2. Why did Enron work so hard to keep assets and liabilities off its financial statements?

3. What was the purpose of the Mahovia and Stoneville transaction?

4. What might have been Fastow’s motives for establishing the LJM partnerships?

5. What was required to keep Chewco, the Raptors, and LJM off the financial statements?

6. Were Lay, Skilling and the Board correct in determining that the partnerships did not adversely affect Enron?

7. Was Enron really doing something wrong? Would it have been wrong if the special-purpose enterprises had been fully disclosed?

8. What should the Board have done?

9. What responsibilities does Enron have with regard to its employees and their retirement funds?

10. What was Arthur Andersen’s role in all of this? Why did it make so many “errors”?

How adequate were the generally accepted accounting principles?

11. What would be required for an auditor to be truly independent?

12. Why was Enron’s outside law firm willing to go along with the special-purpose enterprises?

13. What public policy reforms should be instituted to reduce the likelihood of further cases like Enron?

14. The Enron case is the subject of the 2005 movie Enron: The Smartest Guys in the Room.

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Wal-Mart: Nonmarket Pressure and Reputation Risk (B): A New Nonmarket Strategy This case reports on measures taken by Wal-Mart as a result of the challenges it faced as described in the Part I Integrative Case Wal-Mart: Nonmarket Pressure and Reputation Risk (A).

Wal-Mart faced immediate pressure from its well-organized and well-financed critics, and it needed to repair some of the damage done by their media campaigns as well as its own mistakes. It faced private politics pressure, and it must take the role of the entrepreneur in entrepreneurial politics. The benefits provided by Wal-Mart’s efficiency, low costs, and low prices are widely distributed among its customers, whereas its costs are borne by unionized grocery workers, by the unions that have failed to organize its employees, and by small businesses that are threatened by its expansion. Wal-Mart assumed the role of entrepreneur.

Because the two principal organizations opposing Wal-Mart were run by political operatives, WalMart responded in kind. It hired advisors with political experience, and hired the public relations firm Edelman that frequently works with activists and NGOs. It established a war room and Action Alleys to deal with breaking events, and its established community relations offices to help repair its reputation and deal with local issues. It also attempted to reduce some of the costs borne by small businesses by providing them support as well as establishing jobs and opportunities zones in cities in which it hoped to expand. Similarly, it pledged not to open branch banks if its industrial bank application in Utah was approved.

Wal-Mart also conducted a small media campaign to present the facts as it saw them. Two features of this campaign are noteworthy. First, Wal-Mart emphasized the benefits it provided to consumers and presented estimates of those benefits. Second, Wal-Mart compared itself to the retail industry, whereas its critics compared Wal-Mart to big companies outside that industry; e.g., in the case of health benefits offerings for its employees. Wal-Mart also urged Congress to raise the minimum wage, which would hurt its low-wage competitors but have little effect on itself. Wal-Mart also established a group called Working Families for Wal-Mart that conducted a communications program to counter that of WakeUpWalMart and Wal-Mart Watch. The company also held a conference and invited empirical papers estimating the costs and benefits resulting from WalMart’s operations and market presence. Wal-Mart was undoubtedly confident of what the results would show.

Wal-Mart also addressed the substance of some of the criticism. It embarked on a very ambitious environmental and energy conservation program in which it offset the carbon footprint of its stores and pledged to improve the energy efficiency of its huge fleet of trucks. Wal-Mart also worked with its suppliers to reduce their energy use. A detailed description of these programs is provided in the case Wal-Mart’s Sustainability Strategy, Case No. OIT71, Graduate School of Business, Stanford University.

Wal-Mart expanded its health care offerings and claimed success as 50 percent of its 1.4 million employees elected to participate in the November 2007 open enrollment period compared to 47 percent a year earlier and 45.5 percent five years earlier. Another interpretation of the 50 percent

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participation is that the employees did not want health care benefits because as Wal-Mart had argued many had it through their families, a second wage-earner, or through Medicare or Medicaid.

The company also addressed diversity issues through discussion with employees and a program to support women and minorities backed by a $25 million private equity fund.

Wal-Mart also strengthened its corporate infrastructure by recruiting new staff to interact with stakeholders and address crises.

Discussion questions

1. What motivates Wal-Mart? Is its commitment to the environment and energy conservation likely to be sustained?

2. Is Wal-Mart addressing its critics sufficiently? Should it be more aggressive? Less aggressive?

3. Are its communications responsible?

4. Should it change its aggressive opposition to unionization of its employees?

5. In an election year (2008) will its critics turn their attention to more important issues?

6. In 2008 the economic slowdown swung into a recession as a result of the crisis in the financial markets. Will consumers turn to Wal-Mart in a period of hard times?

Developments In June 2004 Wal-Mart began to implement a new wage policy. Hourly workers would no longer receive percentage increases but instead would receive 40¢ an hour for meeting expectations and 55¢ an hour for exceeding expectations. Executive bonuses would be cut by 7.5 percent and by 15 percent the following year.

In August 2004 Wal-Mart announced that it planned to conduct criminal background checks on all job candidates. The change in policy was due to charges of sexual assault on young girls by two Wal-Mart employees with criminal convictions for sexually related offenses.2 A federal Court of Appeals agreed to review the lower court decision to grant class action status to the sex-discrimination lawsuit. Wal-Mart had appealed the decision to grant class action status, and the Court of Appeals upheld the lower court’s decision. As of the time of this writing the case had not been resolved.

The industrial bank application in Utah was rejected.

In California the state legislature passed a series of bills to put popular Governor Arnold Schwarzenegger on the spot. One such bill was an “anti-Wal-Mart” bill that would have required local governments to require an “economic impact” statement on any store with at least 130,000 square feet, 20,000 types of items, and more than 10 percent of sales from non-taxable goods. The only type of store that would meet these conditions was a Wal-Mart superstore that sold groceries.

The bill had been backed by the California Labor Federation. The governor vetoed the bill.

2

, August 12, 2004.

The Wall Street Journal

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In 1997 the Windsor, Ontario store was unionized under orders of Ontario’s Labor Board, which concluded that Wal-Mart had coerced workers. After three years the union and the company had failed to reach a labor agreement on a contract, and the employees voted to decertify the union in 2000. In 2005 the UFCW attempted to organize the Windsor store. The Canadian branch of the UFCW organized the Wal-Mart store in Jonquiere, Quebec, but WalMart announced that it would close the store in 2005 because it was losing money and the union demands would make it impossible to be profitable. The UFCW then announced that it would attempt to organize the Windsor store. The union also filed a lawsuit challenging the store closing, and the Supreme Court of Canada was reviewing the case. In 2005 the UFCW attempted to organize the workers at a Wal-Mart Tire & Lube Express in Loveland, Colorado, but the workers voted 17-1 against the union. The union claimed that the one worker who had voted for the union had been harassed by other employees. It announced that it would ask the National Labor Relations Board to reject the results. In 2008 an arbitrator imposed a union contract on a store in Gartineau, Quebec. The president of SEIU is chairman of Wal-Mart Watch. Wal-Mart continued to provide health care benefits to the public. It expanded its offerings of prescription drugs at low prices. It sold 300 generic drugs at $10 for a 90-day supply. Wal-Mart pledged to save employers $100 million by processing their prescription drug claims. Wal-Mart also continued to expand its in-store clinics. Wal-Mart also produced results on energy conservation. Wal-Mart had 17 stores and distribution centers in operation with solar panels in operation and testing. In 2006 it began to sell compact fluorescent light bulb, and over the following two years it sold 145 million bulbs. In 2008 Wal- Mart began a partnership with 19 states and Puerto Rico to save on energy and electricity costs for the state governments. In 2008 Wal-Mart warned its managers that the upcoming election could result in a greater likelihood of unionization as a result of a win by the Democrats. The unions reacted angrily. Wal-Mart experienced a protest in India to its joint venture with Bharti Group. See the Chapter 17 case Tesco in India? and the discussion of that case in this Instructors’ Manual for more on this. A study of the impact of Wal-Mart stores on employment is provided in: Emek Basker, “Job Creation or Destruction? Labor Market Effects of Wal-Mart Expansion.” Review of Economics and Statistics, 2005. Vol. 87, 171-183.

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Playing by the Rules?

Congress has tried to provide opportunities to women, minorities, small businesses, rural enterprises, and other designated entities. The Supreme Court has ruled that many of the programs and provisions to implement these opportunities were unconstitutional, particularly those pertaining to race, gender, age, and other characteristics on which discrimination is not allowed. Some of the relevant Supreme Court decisions are discussed in Chapters 20 and 21.

The FCC program providing advantages to women and minorities was inconsistent with the law, but the court decisions did not prohibit providing advantage for small businesses and rural enterprises.

The objective of the FCC program was not to transfer income to designated entities but rather to allow viable enterprises to be established in the telecommunications industry. (The advantage provided can also be viewed as pork intended to benefit constituents of members of Congress.)

The FCC provided advantage through large bidding discounts.

The FCC auctions in which the Gabelli ventures participated had a flaw in that the winner of a license was not required to provide wireless communications services. Designated entities as well as other bidders thus could win a bid, hold it, and resell it—as many did. The Gabelli ventures had no intention of operating a wireless service. Because of the bid discount the license could be resold at a price lower than the bid and still make a substantial profit.

Gabelli set up 10 ventures with friends, business associates, and other acquaintances as the designated principal of the venture. As Gabelli pointed out some of those individuals were women and minorities. Most, and perhaps all, of the Gabelli front ventures were financed by Gabelli enterprises. For example, Beta Communications paid $12.9 million for licenses, but Alfred Angelo invested only $200,000 for 50.1 percent of the enterprise. The rest of the capital required was provided by Gabelli or one of his enterprises. In addition, the ventures paid large fees to Gabelli companies. Gabelli had been warned by an attorney that Ms. Kane’s lack of business experience could be “invite further investigation.” Gabelli had shrugged off the warning.

Gabelli argued that there was full disclosure to the FCC, but that was not clear. For example, was the business experience of the head of the enterprises disclosed, and was the full financial chain of the financing for the enterprises disclosed? He also argued that the participation of the enterprises resulted in higher bids for the FCC. Because of the bid discounts, however, this does not mean that the FCC actually received higher receipts in the auction.

Were Gabelli’s actions responsible? The enterprises may have satisfied the letter of the FCC requirements, but they are also subject to other laws. The False Claims Act certainly seems relevant here. The ventures could well be shams or fronts. The heads of the companies appear not to have experience and may not be competent. Moreover, the full details of the financing of the ventures probably have not been revealed to the FCC. Some or all of the enterprises had no intention of actually using the licenses they won. What is not known is whether somehow the licenses would be used by a Gabelli company.

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The civil lawsuit filed by Taylor under the False Claims Act and the Department of Justice’s participation in the case contend that the ventures were “sham corporations.” The case was settled before a verdict was rendered, but the magnitude of the settlements indicates that there was a high probability that the court would have found for the plaintiffs.

Gabelli argued that the presence of these ventures resulted in higher bids for the spectrum allocations. This is not at all clear, since the entities received large discounts.

Gabelli’s ventures are inconsistent with the objectives of the FCC to help establish viable small businesses and rural enterprises in wireless telecommunications.

In situations in which the rules of a program or agency are open to exploitation that would be contrary to the objectives of that program or agency, the question is whether one should exercise restraint. In this case the answer appears to be yes.

Individuals and companies regularly take advantage of the provisions of the tax codes and seek loopholes that can be used to avoid taxes. The Chapter 20 case Tax Shelters concerns such a situation.

The Chapter 10 case Enron Power Marketing and the California Market is about another instances in which a business exploited the imperfect rules of a regulatory system.

Discussion questions

1. Did Gabelli do anything wrong in setting up ventures to qualify as designated entities to receive bid discounts? Are Gabelli’s arguments for the ventures sufficient justification for them?

2. Were these ventures shams?

3. Even after paying the settlement and the attorney fees Gabelli probably made a substantial profit on the 10 ventures. Given Gabelli’s statement in the last sentence of the case, was he justified in what he did?

4. The FCC did not ban Gabelli from bidding in the upcoming FCC auction? Should Gabelli set up new companies to qualify as designated enterprises and bid in that auction?

5. Suppose you were approached by Gabelli to head an enterprise that would qualify as a designated enterprise for an FCC enterprise. You would be required to provide a very modest investment for a 50.1 percent share with a Gabelli company holding the other 49.9 percent share. Gabelli would loan the enterprise the required capital, and a set of fees would be paid to various Gabelli companies for financial services if a license were won in the auction. The enterprise would not use the license but instead would sell it when it was opportune to do it. If you agree to head the enterprise, you would make a large windfall if a bid was won and your risk would be minimal, since you would be able to withdraw your initial investment. Would you do it?

6. In Gabelli’s position would you do as he did?

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Chapter 20 Ethics Systems: Utilitarianism and Management As indicated in Chapter 19, the content of corporate social responsibility is found in ethics. The purposes of Chapter 20 are first to identify what ethics is and is not and to introduce the perspective taken in the book to the subject. Then the chapter presents the important ethics system— utilitarianism. Moral rights and Rawls’s theory of justice are considered in Chapter 21. A number of the cases in this chapter can be used in conjunction with Chapter 21, and a number of the cases in that chapter can be used in conjunction with this chapter.

Utilitarianism is the system that underlies welfare economics and serves as the justification for social cost-benefit analysis. Rights are also fundamental ethics concepts. Rawls’s framework for justice has been selected less because of how compelling it is and more because it addresses many of the considerations that intuition tells us are important. There are many other ethics systems that could also be considered, and some may be more compelling to some people than those considered here. These three, however, provide a rich enough set of ethics perspectives to permit a comprehensive analysis. One reason for discussing moral philosophy is to show students that ethics is not simply the application of one’s values.

The perspective taken here is that not all ethics systems yield the same evaluations and indeed may yield conflicting evaluations. Moreover, people may not agree on which ethics system is appropriate. For these reasons, it is important to consider issues from each of the perspectives.

Another reason for doing so is that those in the environment of a firm evaluate a firm’s actions and policies using a variety of ethics frameworks. Referring to the framework introduced in Figure 2-5, ethics systems and ethics analysis can be used in positive analysis to examine motivations for nonmarket behavior and to help predict the nature and extent of nonmarket actions.

The first part of the chapter is needed because some students take too casual an approach to ethics.

They too often rely on values and on ex post justification of decisions made on other bases. The chapter argues that ethics is more than values and ex post rationalization. In particular, it argues that the application of ethics frameworks requires reasoning from ethics principles and that a number of difficult issues are often associated with that application.

The chapter discusses two types of reasoning that are not based on ethics reasoning. One is reasoning from one’s self-interest. For example, ethical behavior can make one worse off than less ethical behavior; i.e., good ethics can have a personal cost. Unethical behavior, however, often comes back to harm the person. The second is casuistry which is the art of bending, or making exceptions, to ethics principles in the interests of responsibility to constituents or shareholders.

The discussion of ethics reasoning begins with the distinction between two categories of situations to which utilitarian analysis is applied. The first category includes those situations in which institutions are in place to align private and social well-being. In that case, utilitarian evaluation of alternatives and evaluation based on the self-interest in the firm are the same, so ethics analysis is relatively straightforward. (This is the world that Milton Friedman envisions.) The second category

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is that in which institutions are not present to align private and social well-being. Decision making is more difficult in this situation.

A lecture can begin with the perspective presented in Figures 20-1 through 20-4. Figures 20-2 and 20-3 are particularly important. The former is a useful reminder that the application of ethics is not a search through ethics systems for one that seems to justify an action that one wants to take for other reasons, such as self-interest. The latter is important to emphasize the imaginative generation of alternatives and the importance of reflection and experience in successfully reasoning from the perspective of ethics systems.

A lecture could focus on the basic concepts and the application of utilitarianism. A particularly important distinction is between self-interest and utilitarianism. It is also important to discuss the conditions under which the two are the same. Numerical examples are useful to illustrate the utilitarian standard.

A difficult distinction is that between rule and act utilitarianism. The chapter discusses two conceptions of the difference. One is based on the classical distinction between a choice among actions in a particular situation and choice of a rule to guide behavior in many similar but not identical situations. The other is Harsanyi’s notion of rule utilitarianism corresponding to the simultaneous choice of actions for all parties involved. The best simultaneous choice then becomes the rule for all to follow. Act utilitarianism is then utilitarianism applied to the situation holding the choices of other parties fixed at the actions they are likely to take for whatever reason. In Chapter 23 this approach is applied to the issue of bribery to address whether a company is morally justified in offering a bribe if it is known that a rival will be offering a bribe. Rule utilitarianism addresses the issue of whether any party is justified in offering a bribe and whether all the parties have a mutual duty to stop the practice of bribery. Such a mutual duty has been exercised resulting in an OECD code against bribery.

Another difficult but important aspect of the application of utilitarianism is determining which party has a duty to take an action that would result in maximal aggregate utility. The assignment of duty, particularly when another party does not accept its duty, is one of the most difficult problems in ethics. Another important issue that could be addressed in a lecture is the distinction between intrinsic and instrumental rights.

Cases Pricing the Norplant System This case raises normative issues of two types. The first is normative in the sense of strategy—to achieve improved performance, particularly in the market environment. The second is normative in the sense of ethics. In this second sense the case involves ethics with numbers, which provides an opportunity for students to be specific about tradeoffs.

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One of the complicating features of this issue, and one that is present in most issues involving pharmaceuticals, is the distinction between ex ante and ex post. The cost structure of a pharmaceutical typically involves high ex ante costs for the research, development, and testing of a drug through the lengthy FDA approval process and low ex post costs associated with the actual production and marketing of the drug and the related liability. Thus, when one examines patented drugs that are currently on the market, their ex post contribution to profits is very high. This means that there are frequently nonmarket pressures for lower prices, particularly when there are organized interest groups that recognize an opportunity to gain from reduced prices. In some cases, those interests groups are backed by public sentiment. In the case of Norplant, the clinics and interest groups working for birth control as well as advocacy groups for the poor are critical of the pricing of Norplant. The pricing of pharmaceuticals also attracts political entrepreneurs, and in this case Representative Wyden has assumed that role. Wyeth-Ayerst thus faces a decision about the pricing of Norplant as well as how to deal with the nonmarket pressure from the interest groups and their advocates.

Norplant had proven to be quite successful with sales in the United States exceeding forecasts by a considerable margin. Sales were also extensive outside the United States, where the drug has been in use for a number of years. (Many drugs developed by U.S. companies are approved in other countries before they are approved in the United States.) Norplant will, however, face increased competition from new birth control drugs, including Depo-Provera and at some point RU-486 (now approved).

The market for Norplant is segmented into physicians and clinics. It is customary to price discriminate by offering birth control drugs to clinics at discounted prices. Wyeth-Ayerst is breaking this tradition by refusing to give discounts to clinics. Through the Norplant Foundation, however, it is providing Norplant free to the indigent.

Wyeth-Ayerst’s rationale for not giving discounts is that it wishes to induce doctors to become trained. This produces two types of benefits. First, because the doctors have been trained, there will be fewer complications from the insertion and lower liability costs. Second, it gives the company an “installed base” of physicians who can sell the drug. (Physicians have an incentive to sell the drug because they receive income from the implantation of the capsules.)

Does it matter that a portion of the development costs was paid for by public funds and private contributions through the Population Council? It is easy to construct arguments that it does matter, so I will offer arguments for why it either does not matter or has been adequately taken care of.

First, the development of many drugs has benefited from government funding of research often through universities, and royalties are not paid to the government. There is thus nothing unusual about federal funding in this case. The use of private contributions through the Population Council is somewhat out of the ordinary, but the Population Council is being repaid through the royalties for its involvement. If sales of Norplant in its first three years reach $300 million as projected, the Population Council may have already received $15 million in royalties. Indeed, the Population Council is not only receiving the royalties, but it also has achieved its objective in having a new and effective birth control device brought to market. The Population Council’s involvement and investment certainly has resulted in a substantial return.

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With respect to the pricing of Norplant, information on the demand function is not available nor did Wyeth-Ayerst have a good idea of what it was. In making its initial pricing decision, the company compared the effectiveness of Norplant with other birth control methods, and it compares quite favorably. Even at a price of $600 it is less expensive than other methods, with the exception of tubal ligation and vasectomy which are effectively irreversible. From the perspective of relative benefits a price of $600 certainly seems warranted. That price may be higher than the profitmaximizing price, however, and Wyeth-Ayerst chose a price of $350. One reason for this may have been to increase demand so that physicians would have a greater incentive to become trained in its use.

The other part of the pricing decision is whether it should price discriminate and charge a low price for clinics (presumably those not covered by health insurance) and a high price for other users (presumably those covered by health care insurance).

Ethics principles can be used to gain some insight into the pricing decision. It might be argued that women have a right to the availability of birth control measures so that they can exercise their autonomy. Whether this extends to the availability of birth control drugs without regard to price is debatable. If price is ignored, however, then the argument could be extended to most any good. In the case of Norplant, women have available a wide array of alternatives ranging from abstinence to pills to tubal ligation. Some of these, such as birth control pills, are available for virtually no cost through clinics. It might be argued that Norplant should be provided at a discounted price because it is more effective and has lower risks of side effects than other drugs, but the logic that leads to lower prices the more effective is a product seems curious. There seems to be no necessity to provide Norplant at a discounted price to clinics. The rights analysis presented in Chapter 21 suggests that compelling Wyeth-Ayerst to price at discount would violate a Kantian right.

It might also be argued from a fairness perspective that Norplant should be priced so that it benefits the least advantaged women. Wyeth-Ayerst has in effect done this by providing it free to the indigent. The question then is how extensively it should be made available. In its first two years the Norplant Foundation provided 13,000 kits, so its program for providing Norplant to the indigent was active. In addition, the government could purchase the kits and provide them free to the indigent and to clinics.

The principal ethics framework for pricing decisions is utilitarianism, which economists implement in various forms through the measure of consumers’ plus producers’ surplus. Ex post a price below $350 is probably warranted, since Wyeth-Ayerst is surely emphasizing profits over consumers’ surplus. The difficulty, however, is in determining socially efficient long-run pricing that recovers the development and testing costs of not just those drugs that are successful but those that are unsuccessful either in the marketplace or in testing. The price charged by Wyeth-Ayerst presumably takes into account these costs.

The economics of Norplant can be sketched. At projected sales of $165 million, approximately 450,000 kits would be sold in a year. The Population Council’s royalties could be as much as $8 million. Production and liability costs are approximately $22.5 million, and other annual costs, including the training of doctors, are $20 million. Total ex post costs thus are approximately $50

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million, leaving a contribution of approximately $110 million. Information is not available on the costs of development and testing.

The private politics nonmarket reaction to the pricing of Norplant stems from the burden on clinics and the desire of birth control advocates to make effective treatments as widely available as possible. This focus tends to be ex post, but it is also coupled with the argument that takes into account the ex ante research and development costs of drugs. That argument takes the form that the profits, as measured by return on assets or return on equity, of pharmaceutical companies are high.

This is a claim that received some attention from congressional Democrats and from President Clinton in his failed 1993 attempt to restructure the health care and health care insurance systems.

The pricing of pharmaceuticals in the United States and in other countries is a continuing issue that largely reflects differences in health care delivery systems. Most other developed countries have government controlled health care delivery systems or government-mandated health care insurance systems that regulate the price of pharmaceuticals. Even with these systems, pharmaceutical prices are higher in countries that have a pharmaceutical industry than in those that do not. Unless the United States regulates pharmaceutical prices, comparisons between U.S. prices and prices elsewhere will reveal a substantial difference and will lead to criticism by some interest groups.

Pharmaceutical companies are accustomed to this.

Some of the nonmarket reaction to the pricing of Norplant is morally motivated, based on considerations such as those discussed earlier. The sale of Norplant in Africa at $23 a kit is analogous to giving it to the indigent in the United States.

Teaching the case The discussion can be guided using the following questions.

1. What criteria should Wyeth-Ayerst use in setting the price of Norplant?

2. Were the types of comparisons made to other birth control alternatives appropriate?

3. What ethics issues are involved here?

4. Does it matter that this drug is for use by women? Do women have a right to use Norplant regardless of their willingness to pay?

5. To what extent if any does it matter that the Population Council was involved in the development of Norplant? That some federal funds were used?

6. What price should Wyeth-Ayerst have set initially for Norplant? Should it have offered discounts to clinics?

7. What is motivating the nonmarket reaction to the pricing of Norplant? Is the nonmarket pressure serious?

8. In light of the nonmarket pressure it is encountering, what should Wyeth-Ayerst do about the $350 price? What should it do about Representative Wyden’s hearings?

Outcome The case is set in 1993, which is when the Clinton administration was attempting to restructure the health care system. Part of the pressure Wyeth-Ayerst is receiving derives from this attempt. For a number of years pharmaceutical pricing had been under attack, and a number of companies had

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pledged not to raise prices by more than the rate of inflation. Consequently, pricing a drug low was risky because it could be difficult to increase the price later.

Wyeth-Ayerst came under attack from Surgeon General Joycelyn Elders, who stated in testimony before Representative Wyden’s subcommittee, “If reproductive choice is to be a reality in our country, reproductive choice must include access to the latest, most effective means of contraception.”3 In defending Wyeth-Ayerst’s pricing of Norplant, medical director Dr. Marc W. Deitch testified that Norplant was priced below oral contraceptives. (Depo Provera injections cost $120 per year. In 1994 the price of Norplant was $365.) He also argued that the high price gives doctors an incentive to become trained in the insertion of Norplant. He reaffirmed WyethAyerst’s intention to maintain the price of Norplant for the first five years it is on the market and then to lower the price in December 1995.

All birth control drugs have side effects, and Norplant was no exception. In 1994 Wyeth-Ayerst was the subject of class action lawsuits on behalf of women who complained of headaches, nervousness, dizziness, acne, weight gain, and discomfort from removal of Norplant. (The Norplant brochure given to women warned of the possible side effects, although it states that their “association with the Norplant system has been neither confirmed nor refuted.”) Apparently, removal of Norplant has been in some cases more complicated that had been anticipated.

Moreover, the nonprofit Center for Reproductive Law and Policy reports that 20 percent of women have Norplant removed during the first year because of side effects or their desire to become pregnant. Later, women complained that amounts of silicon were in Norplant, and with Taxsmall Shelters the KPMG a large profitbreast opportunity resulting from the incomes and large capital attentionrecognized being given to silicone implants (see Chapter 12),high sales of Norplant plummeted. gains of some individuals. KPMG decided to market very aggressively tax shelters. The company designed a variety of instruments and arranged for banks to make paper established a telecommunications center to make cold call and assigned 60 veteran salespersons and provided them with strong incentives. KPMG sheltered $11 billion in income.

An instrument had to have economic substance to qualify as a tax shelter. The shelters marketed by KPMG appear not to meet this requirement. The IRS had ruled that BLIPS was a potentially abusive instrument, and KPMG discontinued it. KPMG had sold BLIPS to 186 clients.

Tax shelters had to be registered with the IRS, and clients had to report them on their tax forms.

The IRS rules contained a loophole for instruments that would not provide any tax benefits for 5 years. This apparently allowed KMPG to design instruments that it viewed would not have to be registered. An SC2 instrument illustrates the types of provisions required in an attempt to satisfy 3

, March 19, 1994. President Clinton fired Dr. Elders shortly after she took office.

New York Times

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the conditions for the loophole. Some of the instruments marketed by KPMG, such as FLIP and S- CAPES, were clearly questionable and were withdrawn. Clients relied on the word of KMPG that the instruments qualified as a tax shelter and issued letters of opinion. The letters said the instrument was more likely than not to qualify as a tax shelter and that the instruments had economic substance. KPMG had received advice from an outside law firm. KPMG, however, was apparently concerned about its letters and maintained client-lawyer privilege on communications. KPMG explicitly took into account that the IRS would not qualify its tax shelters or declare them as abusive. Ritchie’s analysis explicitly took into account potential penalties by the IRS. The revenue however was 10 times the expected penalties, and KPMG charged ahead. Analysis KPMG saw a large profit opportunity and was willing to push the envelope of the law in pursuing it. Other companies also provided tax shelters, but KPMG may have been the most aggressive. Its instruments appear to have violated IRS requirements in that at least some appear to have no economic substance. In addition, the failure to register the instruments as tax shelters was also contrary to the law. KPMG and its partners and managers appear to have violated the law, as discussed in the developments section, and those violations could involve criminal charges. Ritchie’s analysis of the OPIS shelters was not consistent with utilitarianism. It took into account only KPMG’s own interests and not the interests of others.

It failed to take into account the interests of clients as well as those of taxpayers. Moreover, the sheltering of income or capital gains provided an increase in income for the client but a corresponding loss to taxpayers. This could net to zero, but it probably amounted to a utilitarian loss. Ritchie’s analysis was also incomplete in the sense that it apparently did not take into account lawsuits by clients who purchased shelters that were subsequently disqualified by the IRS. The analysis also did not take into account the possibility of criminal charges.

Developments The shelters were scrutinized by the IRS. The IRS viewed the tax solutions as “abusive tax- avoidance transactions.” This declaration meant that the deductions could be disallowed and the individual liable for unpaid taxes and interest. Penalties could also be assessed. BLIPS (bond- linked issue premium strategy) was banned by the Internal Revenue Service in 2000. The IRS claimed that BLIPS cost the U.S. Treasury $1.28 billion. KPMG marketed the tax shelters to over 1,800 individuals. A number of the individuals sued KPMG when their tax deductions were disallowed. In 2004 the IRS offered a settlement to the individuals as part of a broader tax amnesty, and 1,200 paid $3.7 billion in taxes. KPMG sold OPIS tax shelters to 111 individuals generating fees of $28 million before the IRS declared the shelter as potentially abusive. The Eachos filed a lawsuit against KPMG.

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CLAS referred to Contested Liability Acceleration Strategy. Twenty-nine corporations bought CLAS shelters resulting in $1.7 billion in tax savings.4 CLAS was used for generating tax deductions on settlements of lawsuits and other claims. “Using the CLAS strategy, a KPMG client would establish a trust with itself as the beneficiary. It then transferred noncash assets—sometimes company stock but usually a kind of IOU called an intercompany note—to the trust. The items represented amounts the client supposedly expected to pay to resolve claims it was still contesting.

The client took corresponding deductions, reducing taxable income.”5 CLAS was declared abusive in 2003 by the IRS, which complained that the shelter used a trust in which the client continued to control the assets in the trust. Joseph Bankman, a law professor at Stanford University, said, “no one purchases a shelter like this without knowing they’re taking significant risks. It’s a classic case of getting something for nothing.”6 The Senate Permanent Subcommittee on Investigations propelled the nonmarket problems KPMG had generated. The Subcommittee examined KPMG tax shelters and concluded that the company had inappropriately avoided $1.4 billion in taxes.7 The Senate also was believed to have put pressure on the Department of Justice to take action against KPMG. Banks The KPMG tax shelters often involved bank loans to the clients to finance the transactions. Three banks in particular, UBS, Deutsche Bank AG, and HVB Group, provided lines of credit to clients.

In August 2005 Domenick DeGiorgio of HVB pleaded guilty to fraud and obstruction of justice in conjunction with BLIPS. In court DeGiorgio stated that the bank loans used in BLIPS were a “sham because, among other things, as designed, no money ever left the bank, and because HVB never set aside any of its own money or procured funds from the banking market in order to fund any of these loans.”8 DeGiorgio had earlier denied the loans were a slam.

In the meeting in which BLIPS was approved, John Ross, CEO of Deutsche Bank’s U.S. unit, “insisted that any customer found to be in litigation be excluded from the product…and that a low profile be kept on these transactions.”9 The Senate Subcommittee reported that Deutsche Bank received fees of $79 million on OPIS and BLIPS shelters.

An anonymous memo from a UBS employee to the bank’s derivative unit stated, “I am concerned that once IRS comes to know about this scheme they will levy huge financial/criminal penalties on UBS.”10 UBS concluded that its participation in the transactions “did not signify the endorsement of he transactions and did not constitute aiding or abetting tax evasion.”11 The banks participated in the shelter.

4

Wall Street Journal, June 16, 2004.

Wall Street Journal, June 16, 2004.

6 Wall Street Journal, June 16, 2004.

7 The Subcommittee report was issued on November 18, 2003.

8 Wall Street Journal, August 19, 2005.

9 Wall Street Journal, August 19, 2005.

10 Wall Street Journal, August 19, 2005.

11 Wall Street Journal, August 19, 2005.

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According to the Senate subcommittee, BLIPS involved a bank loan to a shell corporation followed by a series of transactions including interest rate swaps. The shell corporation had few assets and no ongoing business activities.12 Lawsuits In June 2005 KPMG admitted that its employees had engaged in fraudulent behavior. “Some KPMG tax partners and tax leaders routinely attempted to cloak in the attorney-client privilege communications that revealed the true nature of their conduct even though those communications were not privileged—i.e., they were not conveying confidential information to attorneys for the purpose of receiving legal advice—by routinely copying an associate general counsel on e-mail communications and memoranda in an effort to conceal information contained in those communications and memoranda from the IRS and others.”13 The firm also stated, “KPMG takes full responsibility for the unlawful conduct by former KPMG partners during that period, and we regret that it occurred.” KPMG’s admission was the result of a new chairman and CEO Timothy P. Flynn. Eischeid was fired, and Smith was reassigned.

In August 2005 KPMG and the Department of Justice reached a settlement in which KPMG agreed to one charge of conspiracy to commit tax fraud and paid $456 million. The firm admitted that “a number of KPGM tax partners engaged in conduct that was unlawful and fraudulent.” The settlement avoided criminal prosecution, which could have been the death-knell for the company.

The payment was composed of “$100 million in civil penalties for failure to register the tax shelters with the IRS, $128 million in criminal fines representing disgorgement of fees earned by KPMG on the four shelters, and $228 million in criminal restitution representing lost taxes to the IRS as a result of KPMG’s intransigence in turning over documents and information to the IRS that caused the statute of limitations to run.”14 The payment, which amounted to $300,000 per partner, pertained to four tax shelters that had yielded KPMG $115 million in fees from the $1.2 billion in tax reductions generated by the shields. The settlement was a deferred prosecution agreement under which charges would be dismissed if KPMG fulfills the conditions of the agreement.

The settlement also made KPMG subject to an independent monitor for three years. The monitor was Richard Breeden, former chairman of the SEC. The settlement required the elimination of two KPMG tax practices and imposed higher standards on the firm. The settlement also prohibited the firm from marketing pre-packaged tax products and prohibited billing not based on hours worked.

KPMG was also required to institute a compliance and ethics program.

IRS Commissioner Mark Everson stated, “At some point such conduct passes from clever accounting and lawyering to theft from the people….Accountants and attorneys should be the pillars of our system of taxation, not the architects of its circumvention.”

In conjunction with the settlement the Department of Justice filed criminal charges against 9 former KPMG executives, and in October the DOJ broadened the indictments to 43 counts of tax evasion and 2 counts of obstruction. Seventeen former KPMG executives, an outside attorney, and a tax

12

Wall Street Journal, November 19, 2003.

The New York Times , October 3, 2005.

14 Practical Accountant, October 2005.

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advisor were indicted. All entered pleas of not guilty. The indictments stated that an outside law firm had written a draft opinion letter to KPMG in 2000 warning that the tax shelters had omitted materials facts and misstated other facts. The indictment stated, “As they well knew, the tax positions taken were not more likely than not to prevail against an IRS challenge if the true facts regarding those transactions were known to the IRS, and opinion letters and other documents used to implement FLIP and OPIS were false and fraudulent in a number of ways.”

No clients who purchased the shelters were indicted.

A number of the lawsuits against KPMG and its law firm Sidley Austin Brown & Wood were consolidated into a class-action lawsuit settled for $225 million in October 2005. KPMG paid 80 percent of the settlement with Sidley Austin Brown & Wood paying the other 20 percent. The settlement was on the verge of unraveling in January 2006.

In April 2005 KPMG fired the head of its tax unit and two members of its 15-member board of the partnership.

PricewaterhouseCoopers and Ernst & Young also offered abusive tax shelters reached settlements with the IRS for $1 million and $11 million, respectively.

KPMG appealed the $456 million settlement on the grounds that the settlement violated the rights of the defendants because the settlement negated the company’s long-standing practice of covering the legal fees of employees. A federal judge agreed and dismissed the government’s case against the the 13 defendants. The Department of Justice appealed the decision, and a three-judge panel of Court of Appeals rejected the appeal leaving the decision in place. The panel concluded that the settlement that forced the defendant to pay their own legal fees in contradiction of KPMG’s policy interfered with the defendants’ 6th Amendment right to counsel. Ritchie was one of the 13 employees.

Three other KPMG executives and two other were still under indictment and scheduled Pfizer andpeople Celebrex to Much of the analysis for the Merck and Vioxx case in Chapter 5 is relevant to this case and will not be go repeated. to trial in late 2008.

When Vioxx was withdrawn, for two reasons Pfizer should immediately review all the studies of Celebrex. The first reason is moral; i.e., the company has a moral obligation to assess whether there are unrecognized risks associated with the drug. The second reason is that private and public politics was directed at all Cox-2 inhibitors. This review should include both internal and external studies and uncompleted as well as completed studies. (Pfizer reviewed only completed internal studies.)

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If its review identified no increased risk, Pfizer need not withdraw Celebrex nor stop advertising, although suspending advertising would be a prudent measure. The preponderance of evidence apparently indicated no increased risk. The fact that Onsenal had a more potent dose of celecoxib suggests that Merck should delay introduction of the drug. This should be decided jointly with the EU approval agency.

National Cancer Institute Study The results indicated a serious enough concern that the NCI study was called off. Pfizer thus faced a serious decision. At a minimum it should stop its DTC advertising, and prudence suggests withdrawing Celebrex. Advertising to doctors is less of a concern because most doctors have the expertise to evaluate the study results. At a minimum Pfizer needs to review the data with the FDA. Certainly, the label has to be changed to reflect the additional risk.

If Pfizer does not withdraw Celebrex and Bextra, it must explain clearly to doctors and the public why the drugs should remain on the market. The drugs have benefits for patients, and the utilitarian calculus is improved when individuals make informed decisions. This suggests leaving the drugs on the market if doctors and consumers can be informed of the better-understood risks.

The extensive media coverage given to Celebrex will warn patients and doctors.

The Alzheimer’s Study and Public Citizen Public Citizen’s citizen petition was filed before the Alzheimer’s study data was discovered, and that study added fuel to the fire. Pfizer then faced allegations that it concealed the study because of the evidence of elevated risks. This is the stuff of lawsuits.

Should Pfizer have published the study when it was completed? At the time it certainly was not customary in the industry to do so. It would have been surprising to see a company do more than Pfizer did. Today, those results would have been published. Pfizer made the data available when Dr. Schneider urged the company to do so.

Developments Pfizer decided not to withdraw Celebrex from the market when Vioxx was withdrawn. After the NCI study was reported, Pfizer decided not to withdraw Celebrex. It concluded that the adverse cardiovascular effects of Celebrex were rare, particularly at the dosage most patients take, which was less than used in the NCI study. Pfizer, however, decided to suspend its advertising of Celebrex to consumers.15 It, however, continued its advertising to doctors.

In the European Union Pfizer and the European Medical Agency agreed to delay the marketing of Onsenal. The Agency said its preliminary review of the submitted showed an increased risk of “serious cardiovascular events.” The Agency requested additional data.

Pfizer’s review of studies on Celebrex included only internal studies conducted by the company and restricted attention to completed studies. The 1999 study was not included in its review 15

The previous month the FDA had forced Pfizer to withdraw two ads for Viagra.

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because it had not been completed. Documents subsequently released showed a sharp disagreement between the company and the FDA on labels for Celebrex. Documents released also showed that when Bextra and paracoxib were submitted for approval by the FDA, reviewers were critical of the drugs. The FDA rejected paracoxib, and Bextra was not approved as a treatment for acute pain.

Two weeks after Merck withdrew Vioxx, Pfizer warned doctors that patients who had had coronary bypass surgery and took Bextra were at greater risk of heart attacks. Celebrex and Bextra were chemically different from Vioxx, and Pfizer maintained that its studies had shown no increase in cardiovascular risk, other than for coronary bypass patients.

Shortly after Merck withdrew Vioxx from the market, Pfizer announced a new study to see if Celebrex protected patients with heart disease. A University of Pennsylvania researcher who had conducted a study of mice suggested a mechanism by which combining Celebrex and a drug that operates like aspirin could cause heart attacks and strokes.

In October 2004 a study that was testing whether Celebrex and naproxen reduced the risk of Alzheimer’s disease was halted when it was found that patients taking naproxen had a 50 percent higher incidence of cardiovascular events compared to a placebo.

The congressional investigations focused on the FDA and its procedures for reviewing postmarketing data. An FDA official acknowledged that there were “lapses” in its reviews. The Bush administration had added $5 million to the FDA’s budget to increase its scrutiny of post-marketing data.

Pfizer faced a myriad of lawsuits on Celebrex as the trial lawyers circled the company.

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Chapter 21 Ethics Systems: Rights and Justice This chapter presents two important ethics systems—moral rules and Rawls’s theory of justice.

The chapter also distinguishes between consequentialist systems such as utilitarianism and deontological systems based on considerations independent of or in addition to consequences.

A lecture could focus on each of the types of ethics systems in the chapter with examples to illustrate the concepts. In addition to the examples presented in the chapter, the cases can be used as examples with the reasoning as discussed below in conjunction with each case.

The PowerPoints in rights.ppt provide information on ethics systems and rights. The distinction between consequentialist systems and deontological systems is useful in reminding students that Kant’s system is fundamentally different from utilitarianism and hence can give different prescriptions. The PowerPoints identify types of ethics systems, characteristics of deontological systems, and difficulties in applying them. The distinctions between deontological and consequentialist systems can be made by distinguishing between intrinsic and instrumental rights.

Figures 21-2 and 21-3 can be used to illustrate the difference at an abstract level.

Kant’s system is conceptually difficult and is even harder to apply. It is a system that identifies a relatively small set of intrinsic rights. The example of the price at which a product is to be sold is useful for making this point. The PowerPoints pertain to Kant’s system and also present the pricing example. The PowerPoints address intrinsic rights, present a moral rule, consider whether it is intrinsic or instrumental, and address applied rights analysis.

Conflicts between claimed rights are common in applications, and the rights table illustrated in Figure 21-5 is one approach for addressing those conflicts. A rights table is also presented for the chapter case Genetic Testing in the Workplace.

In two rulings in 2002 the Supreme Court limited the scope of the Americans with Disabilities Act. The Court in a 9-0 decision ruled that an individual must have substantial limitations on abilities that are “central to daily life” and not just to work life. In a 5-4 decision the Court ruled that seniority had precedent over the ADA. The Court held that an employer US Airways was not required to violate seniority to accommodate the need of a disabled employee by transferring him or her to another job.

Justice explicitly requires comparisons among individuals, whereas Kant’s system entertains no such comparisons.

PowerPoints on justice are provided in justice.ppt. Rawls’s theory of justice is a distributive justice theory concerned with the distribution among individuals of the rewards and burdens of social interaction. The theory can be explained in terms of Figures 21-6 and 21-7.

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The PowerPoints address higher order moral standards and how utilitarianism, moral rights, and Rawls’s theory of justice meet those standards. The PowerPoint on higher order standards is useful for reviewing the moral foundations for the three ethical systems considered in Chapters 20 and 21.

The last PowerPoint presents Gert’s principles for reasoning about injustice. These principles are not to be used to provide ad hoc or ex post justification of actions one wants to take based on other grounds. Instead, they are intended to be used in reasoning in the case of fundamental ethical dilemmas.

Cases Genetic Testing in the Workplace PowerPoints are available for this case genetictesting.ppt.

This is an updated version of the case of the same name from the previous edition of the book. The case is related to the integrity testing example considered in Chapters 20 and 21, and the structure of the analysis of that case can be applied here. The case centers on a firm’s response to certain hazards in the workplace. A firm can address those hazards by changing the workplace and/or by changing the workforce. Changing the workforce so that workers are less susceptible to exposure in the workplace can be less costly than changing the workplace. Utilitarian analysis thus indicates that (unless there are external consequences) when it is less costly to change the workforce it is ethical to do so. (This conclusion is based on the supposition that the labor market is “efficient.”)

From a utilitarian perspective, the employer is presumably best-placed to make the assessment of whether the benefits from genetic testing outweigh the costs. Depending on the cost, reassignment of employees who are genetically susceptible may be warranted. Furthermore, genetic testing for the purpose of monitoring whenever there is a potential health problem due to workplace exposure would seem warranted. A PowerPoint summarizes a utilitarian analysis for a screening rule that is intended to provide a more socially efficient matching of applicants to jobs. Another PowerPoint presents a corresponding analysis for a monitoring rule. Another raises two questions about the utilitarian analysis. The answer to the first is “no,” and the answer to the second is “no” if doing so increases aggregate well-being. Safety itself is instrumental to well-being.

The alternative of changing the workforce has at least two dimensions. First, genetic testing may be used to assign existing workers to positions. Second, genetic testing may be used to rule out people at the hiring stage. The use of a genetic test for monitoring is permitted by the Genetic Information Nondiscrimination Act provided that the employee provides authorization. It is not clear whether the use of genetic tests for job assignment where toxic substances are present is permitted if it does not deprive the employee of employment opportunities or affect the employee’s status. This seems to be a gray area. The following analysis proceeds under the assumption that use for job assignments is legal when the employee is informed about the hazard and the possible genetic

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susceptibility and that any employee assigned to such a job will be asked to authorize genetic testing for monitoring purposes.

One unobjectionable policy seems to be using genetic testing to monitor workers to detect genetic damage. The worker could be informed of the test results, and the employee could choose whether to continue to be exposed to the hazard or not. (The employee would presumably take into account the possibility of suing the employer in the event that a disease resulted from the exposure. Any damages awarded would be a transfer and would net to zero in a utilitarian analysis.)

From a rights perspective, the issues are similar to those discussed in Chapter 21 in the context of integrity tests. A PowerPoint identifies a set of rights that might be claimed, and another evaluates a claim to safety from the perspective of Kant’s system. As indicated in the book, a right to safety seems to be instrumental rather than intrinsic; i.e., safety is like many other claimed economic rights.

In a deontological ethics system motive matters, and in this case the motive is to support autonomy by enabling individuals to make their own decisions about avoiding harm given knowledgeable of whether they are genetically susceptible to chemical agents present in the workplace. This supports the use of genetic testing by employers. Employees could prefer not to have a genetic test. In that case, the individual would be free to take a job elsewhere.

Many claims about rights can be made in this case, and those claimed rights can be in conflict. A rights table as introduced in the chapter provides one approach to resolving conflicts. A rights table for this case is presented in the PowerPoints. An important part of any testing program is to keep the results of the test private.

A difficulty in applying this reasoning is that genetic characteristics could be correlated with individual characteristics such as race or sex. To the extent that individuals are disadvantaged because of discrimination based on their sex or race, genetic testing would further disadvantage them if it limited their set of opportunities. The evidence on the correlation between genetic characteristics and characteristics, such as race and sex, on which discrimination is based is surely limited, so the extent of the correlation, if any, remains a matter of speculation.

Another concern is that a genetic deficiency may stigmatize an individual if the results become known. This could extend beyond the workplace and affect the individual’s eligibility for insurance and also affect other employment opportunities. One means of protecting an individual’s privacy is to maintain confidentiality of the information by having only the company physician and those who need to know to have access to the information; this may not include the employee’s immediate supervisor.

The PowerPoints provide one answer to the last preparation question from the perspective of utilitarianism. The probability r of exposure and the social cost C of the harm to someone who is genetically susceptible and becomes ill are not known, but a breakeven analysis can be conducted as illustrated at the bottom of the first figure. Comparing the alternative (1) of doing nothing to the alternative of installing additional equipment indicates that equipment should be installed if and only if rC is at least $33,000. The analysis presented in the second figure indicates that genetic

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testing is better than new equipment or robotics regardless of the value of rC. Moreover, it is better than doing nothing if rC is greater than $1,852. Genetic testing is thus the preferred alternative. If genetic testing were prohibited, robotics would be the preferred alternative if rC were higher than $111,111, new equipment is preferred if rC were between $1,852 and $111,111.

A testing program justified by a high risk r or a high cost C can be designed to capture many of the benefits from testing while still preserving rights. A rights-respecting genetic testing policy is: 1. Respect privacy (a) test results known only to the individual and, if the person accepts a hazardous position, to the relevant doctor (b) information is kept separate from one’s employment record (to prevent possible discrimination) 2. Testing as a right to know (a) for applicants offered a job with exposure, testing is mandatory as is testing for subsequent monitoring purposes. Information is provided only to the individual, unless the applicant accepts the position and is then subject to 1. (b) for job assignments to a job with exposure, testing is required with information made available to individual; i.e., the individual can choose whether to accept the risk (3. (b)) (c) for employees in jobs: require test for monitoring with information subject to 1.

3. Right to free contract (a) employer has right to hire the best qualified person (subject to law) and genetic testing takes place only after the applicant has been offered the job (b) selected applicant/employee can choose whether to accept an offer for a hazardous position with risk of exposure; rejection of the offer is governed by (c) (c) applicant/employee has opportunity to qualify for other positions 4. Safety (a) provide for safety to the point at which benefits equal the costs; i.e. social efficiency.

This policy is intended to provide information to the employee or selected applicant and to place on that person the responsibility for the decision of whether to accept a position with a risk of exposure. Privacy is respected by providing the information only to the individual and if the individual accepts the position, to the doctor as well for use in a subsequent monitoring program.

The employer makes the offer to the best qualified individual without knowledge of genetic susceptibility.

An analysis of the ethics of genetic testing is provided by Joseph Kupfer, “The Ethics of Genetic Screening in the Workplace,” Business Ethics Quarterly, 3 (1993): 17-25.

Teaching the case

The following questions can be used to guide the discussion 1. What ethics concerns are associated with genetic testing?

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2. Isn’t genetic testing for the purposes of reducing the likelihood of damage to health obviously beneficial?

1. Evaluate genetic testing in the workplace from a utilitarian perspective.

2. Which rights might be claimed to be violated by requiring a genetic test?

3. Why is there a right to privacy in this situation?

4. Is such a test objectionable from a deontological perspective if the motive or reason for the test is to provide the individual information on which to make better-informed decisions on job selection?

5. Is there a moral duty to make certain the individual is informed about his or her susceptibility when accepting or holding a position with exposure to particular chemical agents?

6. Is there a possibility that individuals can become stigmatized by their genetic characteristics?

7. Is there a way of dealing with this concern by keeping the results of genetic testing confidential?

8. How should conflicts about claims about rights be resolved?

9. What would be the characteristics of a rights-respecting genetic testing policy?

10. How should the last preparation question be answered? .

Developments The case describes the most recent public policy developments on genetic testing.

Citigroup and Subprime Lending This case has three purposes: (1) to assess the ethics of subprime lending, (2) to identify the moral motivations for nonmarket action, and (3) to consider what actions Citigroup should take once it and the rest of the industry come under fire.

The ethics of subprime lending involve well-being, rights, and justice considerations. From the perspective of utilitarianism, subprime lending fills a gap in the credit markets, allowing many people to obtain loans for which they would not otherwise qualify. Some of these loans are for home improvements, and others are used to restructure debts associated with credit cards and other borrowings. Such lending is important and increases well-being. Well-being is decreased, however, when people are misled and induced into borrowings that are disadvantageous to them.

Since utilitarianism evaluates actions based on the preferences of individuals, there is nothing wrong with people freely choosing to take actions that are contrary to their apparent interests.

Indeed, making judgments about what would be good for people can constitute paternalism.

The appropriate test from a consequentialist perspective seems thus to be whether the individuals would have borrowed the funds if the consequences were fully disclosed to them and they understood those consequences. If disclosures were complete and borrowers understood, there is nothing objectionable to the choice to borrow on the subprime market, according to utilitarianism.

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It seems clear, however, that disclosure was not complete and that some borrowers did not understand the consequences.

The appropriate action from a utilitarianism perspective is to correct the problems while preserving the market for subprime lending. The moral duty then is for lenders to fully disclose the consequences of borrowing and avoid enticing people, e.g., some of the elderly, who may not understand the consequences. This can be accomplished by establishing an instrumental right to information and a corresponding duty of lenders to disclose that information.

From a Kantian rights perspective a violation of rights would be in failing to treat people as autonomous ends but rather treating them solely as a means to a profit. Persuading people to borrow when it is disadvantageous to them treats them as means. People, however, can exercise their autonomy by digging into the structure and terms of the loans offered. Thus, it is not clear that there is a violation of Kantian rights, provided the borrower has the capacity to understand the loans. There may, however, be a violation of instrumental rights as considered in the previous paragraph.

From a justice perspective the concerns focus on those who are already disadvantaged. This may be due to income, health, age, or a variety of other circumstances. Since subprime lending provides access to credit for people who would otherwise not have access to credit, Rawls’ principles would support preserving the market. His principles, however, would call for measures designed to protect those who are disadvantaged and unable to protect themselves. This might involve only the establishment of instrumental rights as identified above, but it might go beyond that to allowing, for example, people to get out of disadvantageous loans.

Nozick, however, would inquire into how the individuals got into their position of disadvantage. If, for example, a person had made bad decisions including not protecting herself against risks, Nozick would not conclude that a moral violation had resulted from subprime lending. Such disadvantageous loans are a matter of choice.

This case also illustrates the moral motivations for private politics, as considered in Chapters 4 and 6. As is frequently the case activist and advocacy groups were already in place and had on their agenda the protection of those who were unable to protect themselves. ACORN had decades of experience dealing with matters involving financial institutions. It had made a practice of pressuring financial institutions and filing lawsuits against them to block mergers with the objective of obtaining lending commitments for local communities. It had extracted many millions of dollars from financial institutions. It thus had experience and expertise to challenge subprime lending practices. This should have been evident to Citigroup prior to the acquisition.

Citigroup can take a variety of actions. One is to correct any abusive practices of the Associates.

A second it to discipline those who have been involved in abusive practices. A third is to develop programs to relieve some borrowers who have been treated unfairly. A fourth is to decide which products it should offer; e.g., should it offer single-premium credit insurance. The actions taken by Citigroup are discussed below.

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Whether Citigroup’s acquisition of the Associates was a bad investment is difficult to say with certainty, but it appears to have had an unanticipated cost. Citibank should have known ex ante that the Associates were engaging in questionable practices. It also should have known that activist groups were concerned with subprime lending practices. The subprime lending bubble apparently burst in 2001 shortly after the acquisition. One company that had exploited subprime lending opportunities was Providian Financial that specialized in providing credit cards to high-risk people who would have been unable to obtain a credit card from the major issuers. Providian’s share price increased from under $15 in 1997 to a peak of $66.72 in October 2000. To maintain growth Providian began to issue cards to increasingly risky individuals. In the summer of 2001 it changed its accounting procedures revealing large credit losses. In was forced to disclose those losses in August, and its share price plummeted to below $5. Management was forced out, and a new CEO was brought in to attempt to rescue the company.16 Discussion questions 1. Is the subprime market beneficial from the point of view of aggregate well-being?

2. Are the alleged abuses serious?

3. What are the objections to the practices from the perspective of utilitarianism?

4. What are the objections to the practices from the perspective of Kantian rights?

5. What are the objections to the practices from the perspective of justice as fairness?

6. What actions if any should Citigroup take to address the objections?

7. What should it do about the activists’ criticisms and actions?

8. Should Citigroup have paid $31 billion for the Associates? What type of due diligence should Citigroup have conducted?

9. Should Citigroup have anticipated actions from ACORN and other activist groups?

Developments On November 7, 2000 Citigroup filed a statement with the regulators condemning abusive practices and announcing a set of measures to avoid abuses. The filing stated:

We condemn predatory practices such as “packing,” “equity-stripping,” and “flipping,” and our track record with our customers and regulators demonstrates that we excel at satisfying customers. We condemn targeting low- and moderate-income and minority customers for high cost credit, and our record demonstrates that we make our credit products available to customers, including low- and moderate-income and minority individuals, through any sales channel for which they qualify.

The filing listed a set of measures the merged CitiFinancial would take.

In March 2001 the FTC took action against Citigroup for the Associates’ predatory lending.

Hughes resigned from Citigroup and announced that he would not stand for reelection to the board.

In June 2001 CitiFinancial announced it would stop selling single-premium credit insurance. In September 2001 Citigroup agreed to pay $20 million to the state of North Carolina to settle its lawsuit. By September 2001 Citigroup had settled over 200 lawsuits against the Associates and over 400 remained.

16

Fortune, March 4, 2002. Providian was purchased by Washington Mutual for $6.45 billion in 2005.

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The Associates had over 6,000 brokers, and Citigroup began to review them in 2001. Initially, Citigroup suspended 1,575 brokers (put them on its “Do Not Buy List”) for a variety of reasons ranging from inactivity (663) to integrity and failure to provide update documentation (487) and compliance issues (102). In a second wave it suspended 2,525 brokers for failure to return Citigroup’s required Code of Conduct.17 Citigroup also suspended a number of the correspondents that had worked with the Associates.

In October 2001 CitiFinancial released its first annual report on its subprime lending performance.

Its “Real Estate Lending Initiatives Progress Report” reported on CitiFinancial’s progress in implementing the reforms identified in its November 7, 2000 filing. In addition to suspending brokers and correspondents, Citigroup initiated a variety of programs to assist buyers. First, it reviewed all proposed foreclosures and suspended 1,484. Second, it began a graduation program that allowed borrowers whose credit rating had improved to move to lower cost conventional loans.

Third, it initiated a similar program for credit applicants. Fourth, it broadened an Associates program to reduce the interest rate on the real estate loans for borrowers who had made payments on time.

In December 2001 the California Reinvestment Committee, an NGO supported by nonprofit organizations and public agencies, issued a report “Stolen Wealth: Inequities in California’s Subprime Mortgage Market.” The report was critical of subprime lending practices and also of the access to the prime lending market for failing to lend more to low-income, minority, and elderly people.

To resolve a Federal Trade Commission complaint, Citigroup paid $215 million to persons the Commission alleged were deceived into high-priced mortgages by the Associates from1995 to 2000.

The Federal Reserve Board investigated Citigroup for abusive loans made by CitiFinancial from 2000 to 2002. CitiFinancial provided restitution for the borrowers and paid a $70 million fine in 2004.

In January 2003 CitiFinancial and in 2004 Citigroup banned all loans that fell under the Homeownership and Equity Protection Act (Hoepa). A study by Inner City Press-Fair Finance Watch, however, reported that Citigroup continued to make the loans in violation of its policy.

Citigroup apparently had acquired some lenders and had not required them immediately to comply with the company’s policy. “A Citigroup spokesman confirmed yesterday that the loans were made, but in a statement said the affiliates in question had ‘migrated to this policy’ over time. ‘We have integrated a number of different businesses,’ the spokesman said. ‘We’ve worked to conform their practices; today, none of these channels originate Hoepa loans.’”18 By 2005 31 states had enacted subprime lending regulations. Those regulations, however, cover only state chartered banks and not federally chartered banks. The state chartered banks claimed that they were disadvantaged because federally chartered banks were not covered, and they backed

17 18

CitiFinancial, “Real Estate Lending Initiatives Progress Report,” October 2001.

New York Times, May 4, 2005.

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federal legislation to establish federal standards that would cover all banks. The draft bill was not as stringent as the regulations in some states. The bill under consideration in the House had bipartisan support.

Consumer Awareness or Disease Mongering? GlaxoSmithKline and the Restless Legs Syndrome Restless legs syndrome is a neurological disorder that manifests itself in a restless sensation in the legs causing the individual to want to get up and move around. In 2005 GlaxoSmithKline (GSK) obtained FDA approval for its Parkinson’s disease drug Requip for treatment of RLS. GSK conducted an extensive market development campaign prior to FDA approval, and upon approval began a direct-to-consumer advertising campaign. (See the Chapter 8 case Responsible Lobbying for a description of Merck’s market development campaign for its vaccine against cervical cancer.)

GSK’s marketing campaign was amplified by media coverage of RLS and Requip. GSK said it was “sharing medical information.”

GSK also was the largest financial supporter of the Restless Legs Syndrome Foundation, which organized support groups and raised awareness of RLS. The RLS Foundation had an incentive to increase the number of people concerned about restless legs so that the “market” would be large.

This would induce drug companies to develop treatment for the disorder. The Ekbom Support Group in Europe served a similar purpose.

The drug companies argued based on a questionable survey that 10 percent of the population in the United States had the disorder. In a highly critical article Schwartz and Woloshin argued based on a better designed survey that only 2.7 percent of the survey respondents had the disorder, and they argued that the actual percent of the population was lower because of selection bias. Moreover, in many respondents the disorder manifested itself only occasionally and in mild form not warranting treatment.

Critics of Requip and the market development and advertising campaign argued that GSK was “disease mongering” by making “healthy people think that they are sick.” They also argued that the campaign made mild cases seem more important than they actually are. Perhaps more importantly according to Schwartz and Woloshin, Requip had side effects for many people, and the side effects could be worse than the disorder itself even for those with RLS. Another concern giving rise to complaints about disease mongering was whether doctors would be an effective screen for people seeking Requip for mild or imagined conditions not warranting treatment. Critics argued that many doctors would follow the path of least resistance by simply prescribing Requip when patients asked for it. Direct-to-consumer advertising was implicated in the claimed disease mongering.

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Analysis Some of the “facts’ are in dispute and are important to the ethics analysis using utilitarianism. The most important is the percent of the population with RLS. Two other factors that are crucial are the proportion of doctors who will prescribe Requip when the patient does not have the disorder or has only mild or occasional symptoms and the frequency of the symptoms. Because of the incentives each has, the following analysis assumes that Schwartz and Woloshin are closer to the truth than is GSK. Utilitarianism requires evaluating the consequences for all those affected by the market development campaign and the advertising. Some of those are people who would benefit from Requip by more that the harm done by the side effects. This might be a small percent, probably 1 percent or less when the severity of the symptoms is taken into account. For many of those people if the side effects are worse than the manifestations of the disorder, they probably will stop taking the drug. Those with RLS who continue to use the drug probably receive net benefits.

Those without the symptoms who are made to feel ill have costs that exceed the benefits if any, although some will probably stop taking the drug. This is more likely the more significant are the side effects. Over prescription of Requip means that the costs exceed the benefits and possibly that the aggregate costs exceed the benefits when the two sets of people are considered together. GSK, however, would argue that doctors would not prescribe the drug for patients who would not benefit from it. The critics of GSK would argue that many doctors will follow the path of least resistance and prescribe Requip when a patient asks for it.

Utilitarianism requires not only that the alternative in question be analyzed but that other alternatives be examined to determine if they yield greater net benefits. In this case the principal alternative is for GSK to market Requip for RLS only to doctors and not to use direct-to-consumer advertising. This would mean that people with sufficiently severe manifestations of the disorder go to a doctor about their symptoms. The doctors then would not face the pressure from patients asking for the drug by name. This would reduce the likelihood of over prescription but risks under prescription. Schwartz and Woloshin would probably argue that this results in greater net benefits than with GSK’s broader marketing campaign.

A complication to this analysis arises from the presence of insurance. Those people with insurance have part of the cost borne by others, and this causes them to consume more drugs than if they paid the full cost. This moral hazard problem results in some costs that also should be taken into account.

Kantian rights do not appear to be violated by GSK’s marketing campaign—with one possible exception. Any imposed restrictions on GSK would, as in the example given in the chapter, result in treating its principals as means rather than ends. Similarly, potential patients are free to make their own decisions on whether to seek treatment, and doctors are free to exercise their professional judgment about whether to prescribe the drug.

The exception is that information is incomplete and people cannot be expected to make fully informed decisions. This, however, pertains to consequences. One argument is that GSK can

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improve the information available to people through its marketing and advertising campaign, allowing them to better exercise their autonomy. The counter argument is that some people will be led to believe that they have the disorder when they do not and others with only mild conditions will be led to believe that they have a sufficiently severe disorder that it should be treated with Requip. These people are not able to exercise their autonomy effectively.

A rights analysis then is required to bring together these two groups and their situations. It seems that the alternative of advertising only to doctors better takes into account the ability of people to exercise their autonomy. The categorical imperative then requires that GSK market only to doctors. Note that this conclusion is based on an aggregation of the ability of people with different conditions to exercise better their autonomy. Moreover, the analysis seems at its foundation is underpinned by consideration of the underlying interests of people. Kant would probably not be happy with this analysis.

Justice as fairness requires that liberties be restricted only to respect liberties, which is consistent with all parties making their own decisions in this situation without restrictions. The equal opportunity principle does not seem to be violated by the alternatives in this case, so the focus here will be on the difference principle. Application of the difference principle requires that the most disadvantaged people be identified. This is difficult in this case because one candidate group is those who would not know of the treatment and hence would suffer in its absence, The other candidate group is those who do not have the disorder or have it only in a mild form who receive treatment that is not in their interests. The alternative of GSK’s current marketing campaign better serves the former group, and the alternative of restricting marketing and advertising to doctors better serves the interests of the latter group. Note that the interests of these two groups are not “closely knit” using Rawls’ terminology.

Discussion questions

1. Characterize the strategy of GSK. 2. In the role of a doctor how do you view direct-to-consumer advertising? Are you likely to follow the path of least resistance when a patient asks for Requip?

3. Is GSK engaged in disease mongering?

4. Analyze the alternatives from the perspective of utilitarianism, moral rights, and justice as fairness.

5. As GSK should you restrict or change your marketing campaign for Requip?

6. Suppose that GSK believes that Boehringer Ingelheim will conduct an aggressive marketing campaign for its RLS drug. What should GSK do?

The moral analysis of the sixth question is similar to that of bribery as presented in Chapter 23 and will not be repeated here.

Developments In July 2007 two separate research teams in Germany and Iceland identified variant sites in the human genome that predispose a person to have restless legs syndrome. The variants are not uncommon in people and only some people with the variant sites have the phenomenon of restless

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legs. Steven Woloshin and Lisa Schwartz of the Dartmouth University Medical School, who had written a critical article on the disorder (as cited in the case), said in response to the publication of the studies that the restless legs disorder is a “case study of how the media helps make people sick.”19 Woloshin argued that the disorder was not very prevalent and prescribing strong drugs was not warranted.

19

New York Times , July 19, 2007.

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Chapter 22 Implementing Ethics Systems Chapter 19 on corporate social responsibility concludes with the argument that the content of corporate social responsibility is to be found in ethics. The step from principles to practice is often a long one, however, and this chapter attempts to address the implementation of ethics principles systems by examining a set of corporate policies intended to guide managers in addressing issues involving responsibility and ethics. The examples of policies were selected to provide a range from those such as Our Credo that express a general perspective to those such as Cummins’ that provide specific guides (see also Chapter 23). The chapter concludes with a brief discussion of some of the factors that can lead to unethical behavior.

This chapter addresses the implementation of ethics systems in the context of the methods developed in the book and through examples of company policies. The chapter begins with a return to the framework introduced in Chapter 2. The analysis stage of the framework calls for the prediction of nonmarket activity that is likely to arise in the context of a nonmarket issue. As indicated in Chapter 6, some nonmarket activity is motivated by moral concerns that individuals have about an issue or a practice of a firm. Ethics systems can be useful in understanding and predicting this activity by increasing the sensitivity of managers to ethics issues and more importantly by predicting the amount of political action.

Paternalism is a particular concern in responding to ethics issues, since it can mean that individuals are denied the opportunity to make decisions for themselves. Paternalism does not treat individuals as autonomous individuals capable of making their own decisions. The complication in many cases is that individuals may not have the requisite information to make the same decision they would make if they were perfectly informed. The difficulty with this perspective is that it allows people to claim that they know best in situations in which they have different preferences from those whom they claim to be protecting. Gert’s test is one means of distinguishing between warranted actions and unwarranted paternalism.

The section on corporate political action and restraint can be tied to the discussion in Chapter 7 of responsibility and the law pertaining to corporate political action.

The British Petroleum example is one that can be followed up with current information obtained from its Internet site and from the news media. In particular, British Petroleum played a leading role in the politics and nonmarket action on the global climate change issue, but it seems to have become more cautious in the past few years.

A lecture can supplement these examples and highlight other policies implemented by companies.

The example of the Body Shop is useful as a reminder that using corporate social responsibility as a promotional tool can come back to haunt a company when its accomplishments fall short of its pronouncements.

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Cases Denny’s and Customer Service (A) This case can be used to address issues of discrimination, diversity, the management of nonmarket issues, and the implementation of managerial policies. One objective of this case is to encourage students to think of these issues from a managerial perspective.

Teaching the case The following questions can be used to lead the discussion.

A. The first set of questions is intended to examine the “problem” and identify who has responsibility for dealing with it.

1. What has happened (gone wrong) here? Are these incidents largely the result of bad service, employee surliness, and miscommunication? This would provide an opportunity to distinguish among the incidents (e.g., the secret service agents incident could have been the result of bad service and the choir incident could have been miscommunication; the prepayment required of blacks but not whites could be an example of “statistical discrimination;” i.e., the problem of people leaving without paying might have been more common among African-Americans than among others (this, of course, does not excuse the discriminatory practices either legally or morally but might “explain” why it happened. The blackout practice, however, is unambiguous and indicates that there is at least a fairly widespread pattern of discrimination at Denny’s.) The hope is that the discussion can identify a variety of ways that discriminatory behavior can occur and that it is not a trivial matter to distinguish it from other inadvertent behaviors.

2. What is the locus of these problems? The hope here is to get an answer such as: “These are problems caused by the behavior and practices of employees and managers at local franchised and owned restaurants.” The follow-up question then is: What responsibility does Flagstar management have? The objective is to have the students discuss the extent of managerial responsibility.

3. Is there a pattern of discrimination or are these a set of isolated incidents? The answer is probably that many are isolated incidents resulting from the actions of individual employees. The incidents are sufficiently numerous, however, that they are in all likelihood the result of organizational culture, insensitivity, and inattention by senior management.

4. Are practices such as the late night policy (prepayment) a good idea or do they invite problems?

Does Denny’s face managerial challenges that McDonald’s does not face? The answer is yes. It has servers and they have degrees of discretion and action that behind the counter employees do not have. Moreover, managers can exercise more direct monitoring behind the counter. In addition, McDonald’s requires prepayment by all customers.

5. How serious an issue is this for Denny’s?

• morally—very serious • commercially—very serious • for Denny’s reputation and image? —crucial (the butt of Letterman jokes) 6. Has Richardson been distracted from the issues at Denny’s? (probably) 409

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B. The next question is intended to address whether there are any positive benefits of diversity to Denny’s.

1. Can diversity within Denny’s be beneficial?

There are a set of “standard” responses, such as “our workforce will be increasingly diverse and we will benefit from that diversity. Responses specific to the case are: • a sensitivity to diversity issues throughout the organization will reduce, but not eliminate, incidents such as those in the case.

• a sensitivity to diversity issues throughout the organization will improve overall customer service.

• diversity in restaurant ownership and among franchisees will result in menus that are more responsive to local differences in tastes. (Denny’s has given restaurant managers more discretion in offering menu items to suit local preferences.)

C. The next set of questions focuses on a strategy for addressing the issues as they stand at the end of the (A) case.

1. What objectives should Denny’s have?

• eliminate discriminatory practices • treat all customers respectfully and efficiently • resolve the lawsuits • improve relations with the African-American community • attempt to redress the public image disaster • attempt to benefit from diversity 2. What specifically should Denny’s do?

• How should it ensure that discriminatory policies are not employed by restaurant managers and Denny’s management? What should it do about the independently-owned restaurants?

• What constituencies should it address?

• How should it deal with the lawsuits—settle soon to get out of the media’s and public’s view • How does it improve customer service?

3. How should it implement those policies?

D. The following two questions can be used to discuss how this all became a public issue.

1. What is the origin of the issues that Denny’s faces?

2. What forces resulted in this issue becoming “public” rather than just a set of local incidents?

The answer is that the issue became public and grew through communities, activists, class action lawyers and their networks, and, perhaps most importantly, the news media.

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Denny’s and Customer Service (B) In March 1993, Flagstar, Inc. entered into a consent decree with the Department of Justice to settle the federal charges of racial discrimination made against the Denny’s chain. Negotiations between the company and the Department had begun after a fifteen-month Department of Justice investigation into several reported incidents at various California Denny’s restaurants substantiated the allegations. In the agreement, which ironically was concluded later on the same day as the Annapolis incident, Denny’s acknowledged that there had been “isolated customer concerns” but that “the company from the beginning has denied any racially discriminatory pattern.” The company added that “any time such behavior is brought to our attention, very strong action, including termination of employees, has been taken.” Denny’s agreed to put an end to all practices in question and undertake a program to insure fair treatment of all customers regardless of their race. The program was to include public advertisements of the company’s non-discrimination policies and video training for all employees on how to avoid discriminatory actions. Flagstar also agreed to hire an administrator to monitor the program.

Five weeks after the filing of the suit by the Secret Service agents, Flagstar reached a far-ranging agreement with the National Association for the Advancement of Colored People (NAACP) to help revise its practices.20 The Fair Share Agreement with a value of $1.01 billion over seven years was applauded by both sides. Flagstar CEO Jerry Richardson stated, “This historic agreement—one that will be a model for other companies—is tangible evidence of Flagstar’s commitment to treating customers and employees fairly regardless of the color of their skin or their racial heritage.

The partnership we began working on 18 months ago and have signed today with the NAACP is a loud and clear signal that Flagstar does not tolerate discrimination, that all people are welcome in our restaurants and that we are building a culturally diverse company.” He added, “We’re trying to make sure that everybody who does business with Denny’s knows that we want to treat everybody fairly. The NAACP will be very helpful in accomplishing our objectives.”

Dr. Benjamin F. Chavis, Jr., executive director of the NAACP, hailed the agreement as a “model for future relations between the civil rights movement and corporate America.” He said, “I am exceedingly pleased that after several months of negotiations, the NAACP and Flagstar, along with Richardson Sports, have today signed a number of historic agreements, unprecedented in scope and magnitude. This $1 billion package will set a standard for future relations between the Civil Rights Movement and Corporate America and will enhance the struggle of African Americans and other racial minorities for economic empowerment and racial justice.”21 The Fair Share Agreement was founded on three principles: “equal opportunity for all; nondiscrimination; and providing a fair share of economic opportunities with Flagstar to minority businesses, individuals and institutions.”22 This was the first such agreement to include a third-party testing program in which Flagstar’s restaurants would be randomly checked to determine compliance with company policies. The third-party firm will report to both Flagstar and the NAACP and will report any “critical situations immediately.” In addition, Flagstar agreed to hire 20

Flagstar News Release, July 1, 1993. Flagstar News Release, July 22 1, 1993. Flagstar News Release, July 1, 1993.

21

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325 African-American managers (at an average salary of $42,000 a year) into all Flagstar operations over the next eight years. Flagstar also agreed to increase the number of minorityowned outlets from the present 54 to 107 by 1997 and place 12% of its $800 million food, paper and supplies purchasing budget with minority enterprises each year through 1997 (compared with 2% currently), 10% of its annual $68 million advertising budget, and 15% of its $12.5 million legal, accounting and consulting budget with minority enterprises.23 A total of 120,000 employees are covered by the agreement. The NAACP also agreed to help Denny’s with sensitivity training for its employees. The agreement also covered Flagstar’s 200 El Polo Loco, 530 Hardee’s, and 215 Quincy’s Family Steakhouse restaurants as well as its Canteen contract food, vending and recreational services company.24 Mr. Richardson admitted that he had not given enough attention to these issues, “I should have invested the time earlier, and I regret it.” Dr. Chavis commented, “I have observed in Richardson over the last two months a level of sincerity unmatched by a corporate executive.”25 In addition to the agreement between Flagstar and the NAACP, Mr. Richardson also reached an agreement with the NAACP regarding his NFL franchise bid. Richardson Sports pledged to "endeavor to achieve a level of 15% to 25% representation of African-Americans in its management ranks and 20% in non-management job categories” if it were successful in obtaining the franchise. After announcing the agreement with the NAACP in a news conference in Baltimore, Mr. Richardson and Dr. Chavis flew to Charlotte, North Carolina, the proposed home of Mr. Richardson’s Charlotte Panthers franchise, where they discussed the plans for the franchise.

Mr. Richardson responded to the criticism by the Jacksons by stating, “Reverend Jackson had made it known to us through the press that he has some concerns about me personally. But I think the key issue is that we are confident that the agreement we will announce [today] will address all of his issues, and I’m confident he’ll be satisfied.”26 In addition to the NAACP agreement, Flagstar decided to run a media campaign to mend its image.

The company leased satellite time so CEO Richardson could be interviewed across the country. In addition, Flagstar released in June a 60-second television commercial to run for at least two weeks in the 41 markets in which the restaurant chain operates. The unusual spot takes the form of a pledge which Denny’s says has been signed by all of its 46,000 employees and will be posted in each of its restaurants. The commercial began with a message from Richardson pledging that “everyone who comes to our restaurants deserves to be treated with respect.” Richardson is followed by a racially diverse succession of Denny’s employees: “I promise you a friendly greeting,” says a white hostess. “Good food, freshly made,” continues a white chef. "If there’s a delay, we’ll let you know,” says a black waitress. “If there’s a mix-up, we’ll apologize,” adds a white waitress. “And we’ll make it right,” promises a black manager. The spot comes closest to addressing the substance of the litigation when a black waiter says, “I am human,” and a white waitress adds, “I will make mistakes,” while an Asian-American waitress concludes, “But please know they will never be intentional.”

23

Flagstar had been purchasing $13 million in supplies from minority firms. Flagstar had one African-American supplier who received orders for about $100,000 a year.

24 Flagstar is the largest franchisee in the Hardee’s system, which is owned by Imasco Limited.

25 Newsweek, July 19, 1993.

26 The Wall Street Journal, July 1, 1993.

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In defending itself, Denny’s was in the delicate position of asserting that the occasional poor service at its restaurants was color-blind, affecting both African-Americans and whites. While conceding that in some instances African-Americans have received poor service at Denny’s, a company spokeswoman added that “unfortunately, others have had lengthy waits, too.” She also said that the company devised the commercial because it felt it had to act quickly to address the concerns of both customers and employees. “We can’t wait until the lawsuits are settled,” she said. However, some public-relations experts warned that the Denny’s commercial could easily backfire. They argued that “when you have a problem like Denny’s has, you have to clean up the problem before talking about it... first you establish a record, then you talk about the record.” However, David Hurwitt, Denny’s senior vice president of marketing, said the commercial was aimed at both customers and employees, “our employees are under a great deal of scrutiny and pressure. We want them to know we believe in them and are concerned with their feelings and morale.” SOURCE: This case was prepared from public sources by Abraham Wu under the supervision of Professor David P. Baron. Copyright © 1994 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reprinted with permission.

Preparation Questions: 1) Was the agreement with the NAACP a good idea? What else, if anything, should Flagstar have done?

2) What risks does Denny’s face from occasional bad service?

3) How should Denny’s address its public image problem? Is the Denny’s advertisement likely to be effective? Might it backfire? How?

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Teaching the (B) case The following questions can be used to guide the discussion of the (B) case: 1. Evaluate the actions Denny’s took to address this issue.

2. What should it have done differently? What in addition should it have done?

3. Was the agreement with the NAACP wise? What if they have difficulty fulfilling their pledges?

More generally, are fair share agreements good ideas? Denny’s was in a weak position morally, commercially, and with the public and found the fair share agreement a good way to resolve part of the problem it faced. What about for a company that does not have such problems?

4. How should Denny’s make sure its employees conduct themselves in a nondiscriminatory and respectful manner? Is the advertisement a good idea?

5. Are these types of issues special to the United States or are they generic managerial issues?

Supplemental information and update The origin of Flagstar was with Spartan Foods, which was founded by Jerome J. Richardson and Charles Bradshaw in 1961, when Mr. Richardson invested in a Hardee’s franchise the $4,500 he had received for the Baltimore Colts’ victory over the New York Giants for the National Football championship game. In 1979 they sold to Trans World Corporation, but continued to run Spartan.

In 1986 Trans World spun off Spartan, which then bought Denny’s, as part of TW Services. In 1989 Coniston Partners headed a leveraged buyout of TW Services, and in 1992 Kohlberg, Kravis, Roberts & Company invested $300 million in Flagstar for a 47% interest. Coniston owned 27% and Mr. Richardson owned 1%.

In January 1994, Flagstar announced that it was taking a $225 million charge to cover the restructuring of its restaurant business. It planned to close 14% of its restaurants and embark on a remodeling and upgrading program. Of the 270 restaurants to be closed, 135 were Denny’s. It also wrote off $1.5 billion in goodwill. Flagstar continued to have financial difficulties.

In November 1994 Flagstar sold 17 Denny’s restaurants to an African-American owned company NDI Inc. with an option to buy 5 more and the right to build 25 restaurants in New York and New Jersey over the next five years. This agreement was one part of Flagstar’s attempt to fulfill its commitment to the NAACP. Discrimination Lawsuits In May 1994, Denny’s reached an agreement with government lawyers and lawyers representing customers who had filed discrimination suits against the company. The agreement settled federal class action suits brought in California and Maryland and a suit in Virginia. (The federal class action suits were filed under Title II of the Civil Rights Act of 1964, known as the Public Accommodation Act.) Under the agreement Denny’s paid $54 million, part of which went to the original plaintiffs and the rest to individuals who allege discrimination. (The $54 million was tax deductible.) (In 1993 Shoney’s, a restaurant chain, paid $105 million to settle discrimination cases involving employees and job applicants.) A toll-free number was established to allow individuals to obtain a claims form. In addition, Denny’s agreed to a program administered by a Los Angeles lawyer to monitor complaints and have African-Americans pose as customers to investigate

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whether Denny’s had discriminatory practices. Denny’s had earlier established training and random checking programs and had hired an African-American to head its human resources department.

In addition to the lawsuits by customers, a former assistant manager of a Denny’s in San Jose, California, filed a discrimination complaint with the Equal Opportunity Commission alleging that Denny’s had a hostile work environment and discriminated against blacks in hiring and promotions.

To illustrate the nature of a financial settlement in a class action suit, the following is the distribution of the $54.4 million.27 California class action plaintiffs $26.975 million; class action plaintiffs in the other 49 states $17.7 million; named plaintiffs in California $9.75 million; attorneys for the class action plaintiffs $8.7 million; contingency fund $0.05 million.

The New York Times Magazine, November 6, 1994 carried a lengthy article on Denny’s entitled “Service with a Sneer.” The story includes details of the incidents in San Jose.

In October 1993 Mr. Richardson’s syndicate was awarded an NFL franchise.

As indicated in the chapter in 2001 the parent of Denny’s was named the best company for minorities to work.

Gilead Sciences (A): The Gilead Access Program for HIV Drugs Gilead had developed the most effective first-line therapy for HIV/AIDS in its drug Viread, and it expected approval in the near future of Truvada which combined Viread and Emtriva to provide a drug that would improve regime compliance. Viread quickly became the best-selling drug in the United States, although at the time of the (A) case it had not yet reached that position. On the basis of Viread and Truvada Gilead’s market capitalization increased to over $30 billion before the collapse in the stock market in 2008. Three exhibits that accompany the (A) case are included here.

Although AIDS had become a treatable disease in the United States and other rich countries, it was devastating poor countries, particularly in Africa. (More information on AIDS and its treatment can be found in Chapter 23, in the Part V Integrative Case GlaxoSmithKline and AIDS Drug Policy), and in the discussion of the GlaxoSmithKline case and the accompanying note in this manual.

The issue for Gilead was how to make Viread available to those in poor countries who could benefit from it. Providing access to Viread required getting the drug to the health care providers who treated patients. Institutions stood between Gilead and the health care providers. Viread was not on WHO’s essential medicines list because Gilead had not yet sold the drug outside the United

27

, June 15, 1994.

The Wall Street Journal

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States. That list was updated only every 2 years. The WHO also had treatment guidelines, and many developing countries relied on both the essential medicines list and the treatment guidelines.

Drugs had to be registered in a country before they could be sold or used, and registration processes varied across the countries. It was also difficult in many cases to identify which offices and which people were in charge of the registration process. The bureaucracy that controlled the registration process was typically understaffed. In some cases corruption was present, and officeholders demanded payments as a requirement for approval. Customs offices could pose a similar problem.

Gilead refused to make any such payments.

It was possible in principle to obtain an import waiver that would allow a product to be brought into a country for use without having to go through the registration process. This provided an opportunity for Gilead. It expected that health officials in a country would support an import waiver because of the importance of Viread for the treatment of the afflicted people in the country.

Gilead had no presence or personnel in any of the countries to which it wanted to make its drug available. The mainline pharmaceutical companies had used a consulting firm Axios in setting up its Accelerated Access Initiative (AAI). Joining AAI was possible, but AAI was mired in conflicts between activist and the drug companies participating in it. (See the Part V Integrative Case on GlaxoSmithKline.) Its critics claimed that AAI did too little and that its prices were far too high.

Moreover, AAI did not have distribution capabilities.

Pricing was a major issue in providing access. Neither individuals nor governments in poor countries could afford Viread (nor other AIDS drugs). Under the leadership of UN Secretary General Kofi Annan the Global Fund had been set up to provide funds to buy drugs and distribute them for free in poor countries in need of them. The Global Fund received contributions from developed countries and made them available to the governments and health ministries of poor countries. This meant that the funds provided by the Global Fund went through the bureaucracy in the recipient countries. In contrast, the U.S. PEPFAR program provided funds directly to healthcare providers in the poor countries to pay for the drugs. Contributions to the Global Fund were initially slow and distribution of the funds was slowed by the bureaucracy and by a lack of acceptable programs for distributing the drugs. (The Global Fund was set up outside the auspices of the United Nations so as to avoid the UN’s bureaucratic inertia.) PEPFAR was well-funded and involved less bureaucracy.

Intellectual property protection was a critical issue for pharmaceutical companies. Under TRIPS (see Chapter 18) countries could in national emergencies issue compulsory licenses for patented drugs, allowing the countries to have the drug produced by a company other than the patent holder.

India had a lenient patent law that enabled companies to copy patented drugs, and not surprisingly India had a large pharmaceutical industry. Under TRIPS a country could also import drugs from such companies. India soon was forced to change its patent law to conform to those in most of the rest of the world, but that change would not happen until 2005.

Pharmaceutical companies had begun to use tiered pricing systems where the poorest countries received low prices, higher income countries received higher prices, and in developed countries

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prices were set based on market conditions. Companies were concerned that products sold to poor countries could be sold back into the markets in Europe and the United States.

Pharmaceutical companies, including Gilead, that produced HIV/AIDS drugs were under strong activist pressure to improve access to their drugs.

Discussion questions 1. What obstacles is Gilead likely to face in trying to provide access to Viread?

2. Should it use Axios or participate in the AAI? 3. How should Gilead price Viread for the poorest countries? Which countries should be included in that group?

4. Design an Access Program for Viread.

Following are two exhibits that can be distributed in advance of the case discussion.

The following (B) describes what Gilead did and why its efforts were largely unsuccessful. This case can be distributed along with the (A) case or can be distributed at the end of the discussion of the (A) case and then summarized in a slide or two. The discussion of the (A) case should be short, since the question posed in the (B) case ask for a creative solution to the problems involved in providing access.

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Exhibit 1 Gilead Sciences: Selected Financial Information (1998 – 2002) Consolidated Statement of Income ($ thousands) Revenues Costs and expenses Income (loss) from operations Gain on sale of oncology assets Income (loss) before accounting change Net income (loss)

2002

2001

$ 466,790 $ 233,769 385,783 354,458 81,007- (120,689) 72,097 $157,771 51,182 $ 72,097 52,271

2000

1999

1998

$ 195,555 247,873 (52,318) (43,106)$ (56,776)

$ 168,979 239,838

$ 151,119 230,631

(70,859)

(79,512)

-

-

(66,486)

(44,758)

$ (66,486)

$ (44,758)

Source: Gilead Sciences, 2002 form 10-K filed March 14, 2003.

Breakdown of Revenue, by Product and Source ($ millions) Viread AmBisome Other product sales Total product sales Royalty revenue Contract revenue Total revenue

2002

2001

2000

$ 225.8 185.7 12.4 $ 423.9 20.4 22.5 $ 466.8

$

$

15.6 164.5 10.9 $ 191.0 23.0 19.8 $ 233.8

Source: Gilead Sciences, 2002 form 10-K filed March 14, 2003.

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141.1 8.6 $ 149.7 24.6 21.3 $ 195.6

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Exhibit 2 Per Capita Gross National Income in US Dollars, by Country (2003) GNI Country 2003 Poland Luxembourg 45,750 43,400 Country

Norway

40,680 Lithuania

Switzerland

37,870 Latvia

United States Japan

34,190 Chile Libya

Denmark

33,580 Lebanon

Iceland High income: OECD Sweden United Kingdom

30,910 Costa Rica 29,360 Mauritius 28,910 Panama

28,320 St. Lucia 28,150 Upper High income middle inc Finland 27,060 Malaysia Ireland Austria Netherlands

27,020 Argentina 26,810 Uruguay 26,240 Belize

GNI 2003 5,280 4,540 4,420 4,400

Country Middle income Ecuador Colombia M.

East,

N. 4,360 Kazakhstan Africa Bosnia 4,320 Herzegovina 4,310 Albania Belarus 4,100 4,040 Samoa Tonga 4,040 4,040 Cape Verde 3,880 3,840

GNI GNI Country 2003 2003 1,880 Sub-Saharan 510 Africa 510 1,830 Yemen, Rep. 1,830 Papua New 490 Guinea 1,830 Mongolia 480 1,810 Vietnam 1,660 Sudan 1,640 Benin 1,590

480

Comoros 1,540 Low income 1,510 1,440 1,390 Guinea 1,370 Timor-Leste Uzbekistan Kenya

440 440

460 440

430 420

Egypt, 420 Arab Rep. Lower 3,770 Swaziland middle inc.

3,740 Morocco Low & 3,690 middle inc.

3,530 Vanuatu Syrian Arab Rep. 3,470 3,380 Paraguay 3,340 China

1,320 Bangladesh 1,310 Haiti Belgium 1,250 25,760 Grenada Mauritania Germany 25,270 Botswana 1,150 Zambia Hong Kong, Venezuela, 1,120 China 25,110 RB Nigeria France 1,110 Kyrgyz 24,750 Dominica Republic Canada 24,470 Gabon 1,100 Lao PDR European L. America, Turkmenistan 1,090 Sao Tome, Union 3,310 3,250 22,810 Carib.

2,850 East Asia & Principe Ghana Australia 1,090 Togo 2,800 Ukraine 21,960 St. Vincent, Pacific Tanzania 1,060 Philippines Italy South 21,570 Africa 970 Singapore 21,410 Turkey

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Spain 17,040 Jamaica Israel 16,240 Brazil New Zealand Russian 15,530 Federation 14,370 High inc: 14,230 Europe & nonOECD Cyprus C. Asia Greece Marshall Korea, Rep. Islands Slovenia 13,230 Maldives Portugal 12,050 Fiji Malta Antigua and 11,870 Romania Barbuda 11,810 Tunisia Saudi Arabia 10,630 El Salvador Trinidad and Tobago Seychelles 9,330 Thailand Czech 9,170 Peru Republic St. Kitts and Nevis Dom. 7,790 Republic Palau Hungary Mexico 7,360 Bulgaria Estonia 7,190 Suriname Croatia World Iran, Slovak 6,860 Islamic Republic Rep. 6,580 Micronesia Macedonia, 6,360 FYR 6,290 Algeria 5,380 Namibia 5,370 Guatemala 5,520 Jordan

Honduras 2,780 2,760 Armenia Djibouti 2,610 2,580 2,490 Indonesia 2,300 Bolivia Sri Lanka

Guyana

2,280 2,260 Kiribati 2,240 Georgia 2,220 Azerbaijan Angola 2,190 2,140 Nicaragua Bhutan 2,130 2,120 Cote d'Ivoire 2,080

Congo Cameroon

2,010 1,990 Lesotho Moldova 1,980 1,930 1,930 Solomon 1,910 India Islands 1,910 Senegal Pakistan 1,900

960 Burkina Faso 950 Mali 950 HIPC* 940 Least developed Cambodi 930 a 920 Madagascar 890 C. African Republic 880 Gambia 840 Uganda 820 Chad 760 Nepal 750 Tajikistan 720 Mozambique 670 Rwanda 650 640 Niger

Sierra Leone 590 Eritrea 590 Malawi Guinea560 Bissau 540 Congo, Dem. Rep. 540 Liberia 520 Ethiopia 520 Burundi

300 300 300 300 300 290 270 270 250 240 240 210 210 210 200

190 160 160 140 100 100 90 90

Serbia, Montenegro South Asia Excludes: Afghanistan, Bahamas, Bahrain, Barbados, Bermuda, Equatorial Guinea, French Polynesia, Iraq, Kuwait, Macao (China), Netherlands Antilles, New Caledonia, Oman, Puerto Rico, Somalia, United Arab Emirates, Virgin Islands (U.S.), West Bank and Gaza, Zimbabwe.

4,970

* HIPC: “Heavily indebted poor countries.”

Source: World Bank, http://www.finfacts.com/biz10/globalworldincomepercapita.htm (October 26, 2006).

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GILEADSCIENCES(B): GILEAD A CCESS ROGRAM IMPLEMENTING THE P FOR HIVD RUGS The commonly held view about treatment in the developing world is that companies simply go there, put down the drugs, and say, ‘Here you are, old chaps!’ It’s completely mistaken. A successful treatment program requires not only funding but infrastructure. That’s the big dilemma. − Robert Webster, Gilead Access Program INTRODUCTION In April 2003 Gilead announced the Gilead Access Program to make available the company’s new drug Viread (tenofovir disoproxil fumarate) at no profit to developing countries. Viread represented a significant advancement in antiretroviral medicines for the treatment of HIV/AIDS with once-a-day dosage, greater effectiveness, and a much improved side-effect profile. Gilead executives expected the Access Program to have an immediate, positive impact on the treatment of HIV/AIDS patients in the world’s poorest countries. At the time of the launch, John Martin, Gilead’s president and CEO, explained, “The Gilead Access Program was created in consultation with experts and advocates, with the objective of making Viread available where the need is greatest and in a way that best addresses the treatment landscape in the developing world.”28 A year after implementation, however, the Access Program had not led to widespread use of Viread in Africa. Having learned from early missteps, Gilead had to make significant changes to improve the program. It also wanted to expand the Access Program to create greater access to therapies in middle-income regions.

THE ACCESS PROGRAM AXIOS AND (2003 – 2004) Pricing The Gilead Access Program promised to deliver Viread to 68 developing nations at no profit. The company recognized the role the drug could play in the broader AIDS pandemic. As Sheryl Meredith of the Gilead Access Program explained: It was very clear to us how the issues in the global epidemic would ultimately become our issues as well…. By driving management of the issues rather than dealing with the historic head-in-the-sand approach, the outcomes would be mutually beneficial to patients and to Gilead.29

28

“Gilead launches Access Program to provide anti-HIV therapy Viread in 68 developing countries at no profit,” April 4, 2003, http://www.gilead.com/wt/sec/pr_1049414990 (October 20, 2006).

29 Interview with Robert Webster and Sheryl Meredith, No-Profit Drug Access Program, Gilead Sciences, August 3, 2006. Subsequent quotes from Webster and Meredith are taken from this interview.

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Gilead priced Viread based on the principle that every patient should have access to the product at a reasonable and affordable price. In the United States, where incomes were high, Gilead priced the product at what it believed was its therapeutic value, taking into account the innovation it brought forward. In Africa, however, because of widespread poverty the drug could not be priced at value.

As Gregg Alton, senior vice president and general counsel at Gilead, explained: That’s a real challenge, particularly when you are dealing with the highest degree of HIV prevalence in the poorest countries of the world and in the poorest populations of the poorest countries of the world. You’re really dealing with people who, no matter where you price the drug, they can’t pay for it. They do not have any disposable income, and many of them can’t even afford to live. So it’s an onerous challenge.30 Gilead decided to make Viread available in the poorest countries at no profit. The company realized that if it could price Viread at a level that was affordable on a global basis, it could generate sufficient volume to bring the price down over time through manufacturing economies of scale. This would ultimately help the program pay for itself, making it beneficial for both Gilead shareholders and patients worldwide.

Gilead priced a 30-day supply of Viread for countries in the Access Program at $39, or $1.30 per day, which represented Gilead’s marginal cost of production for the drug plus the administrative cost of the program. Over time, through manufacturing efficiencies, Gilead was able to lower the cost to $17 for a 30-day supply and reduced the price in the program to that level. This price compared with the price of generic d4T (AZT), an older generation treatment, of $5 for a 30-day supply. A 30-day supply of Viread in the U.S. cost $360. Even at $17 a month, few African HIV/AIDS victims could afford the drug, nor could their governments afford it.

Distribution At the launch of the Access Program, Martin explained that no-profit pricing was just one component of Gilead’s strategy:

In creating this program, we also have included other elements designed to meet the needs of treaters in resource-challenged settings, such as a streamlined and rapid review of requests, and shipment of the drug direct to treatment programs, without expensive or time-consuming intermediaries.31 Direct distribution was recommended by Axios, which had its head office for the developing world in Uganda. Other pharmaceutical companies had used Axios, and Gilead believed the Access Program would benefit from Axios’ physical presence in Africa, as well as its expertise in designing and implementing healthcare systems in developing nations. Gilead planned not to register Viread with each country’s regulatory office but instead rely on import waivers to allow direct shipment of its drugs to local clinics from manufacturing facilities in the United States, Canada, and Europe. The clinics would then be responsible for obtaining the import waivers.

Axios would accept applications from clinics for Viread and forward these applications to Gilead.

30

Interview with Gregg Alton, senior vice president and general counsel, Gilead Sciences, September 27, 2006.

Subsequent quotes from Alton are taken from this interview.

31 “Gilead launches Access Program,” loc. cit.

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Gilead would ensure that the treatment programs were legitimate and sustainable before supplying the drug. The company did not want patients to begin treatment without being able to continue, since discontinued treatment increased drug resistance and the physiological effect could be worse than not starting treatment in the first place.

Gilead soon discovered that simply offering Viread at low prices did not result in orders. The problem was threefold. First, the clinics and government regulators had not heard of Viread or Gilead, so Gilead would have to educate them about the benefits of the drug. Second, the World Health Organization (WHO) managed three important lists that were intended to provide technical support for countries managing treatment programs. These lists included treatment guidelines, prequalification of medicines, and the essential medicines list. Because Gilead did not recognize the WHO as a regulatory authority, it failed to apply to get Viread on the prequalification list.

Also, because the WHO was hesitant to recommend a drug with a single manufacturer, it had not added Viread to its essential medicines list. The WHO listed d4T as the first-line treatment for AIDS and Viread as a second-line treatment even though Viread was more effective. The result was that clinics in Africa did not order the drug because they did not recognize its importance. The Ministry of Health in Ethiopia, for example, was supplied with a shipment of Viread but did not distribute it because the drug was not included in the WHO treatment guidelines. As Meredith explained, “If your drugs are not on those lists, well, they don’t exist essentially.”

The third part of the problem was that even clinicians who knew of Viread did not have experience working with the drug. Robert Webster of the Gilead Access Program elaborated:

Some people in the country may have attended international AIDS events or read scientific journals, but they never got their hands on the drugs or knew how to use them. Those people with clinical training had used d4T. So we needed to find some people in the country who were able to understand the role of the drug and promote its use and perhaps recommend to the national people who formulate or amend the guidelines to consider using the drug.

Direct training of clinicians would require that Gilead employees accompany distribution partners on meetings to clinics and educate key opinion leaders. Both would require a much greater physical presence in Africa than Gilead had obtained while Axios managed the program.

By 2005 Gilead had reached the conclusion that the Access Program as then structured was not delivering Viread to the patients who needed it. Gilead needed to play a significantly more active role and brought the management of the program in-house.

THE ACCESS PROGRAM AFTER AXIOS (2005 – 2006) Managing Infrastructure Development It was clear that offering reduced pricing without pursuing regulatory approval, even while educating clinics and government officials, was not providing access. As Alton explained: The only way for change and impact is for [governments] to say, we see the funding is there, we see the impact of the pharmaceuticals, we’re going to take control, and we’re going to take responsibility, and we’re going to do whatever we can within 423

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our power to put the resources in the regulatory process or waive the regulatory process, to create systems for distribution, to create educational systems, work on awareness campaigns, work on prevention campaigns, work on treatment campaigns.

Gilead believed that it had to play the leading role in moving the program forward.

To build distribution systems, Gilead had to identify and partner with a local distributor in every country. Before selecting a distributor, the company performed comprehensive due diligence on those they were considering, including financial reviews, and analysis of qualities like probity, then began a process of going into the field with prospective distributors to observe operations firsthand. In 2005 Gilead decided to license Viread to Aspen Pharmacare, the largest manufacturer of generic medicines on the African continent, with four manufacturing facilities in South Africa and one in India. Aspen agreed to manufacture Viread according to U.S. standards for Good Manufacturing Practices (GMP) in Aspen’s FDA-approved facilities in South Africa. Gilead would provide the active pharmaceutical ingredient for Viread and do a full technology transfer to Aspen to assist them in creating a finished product.32 Aspen would sell Viread to clinics in the Access Program countries at no-profit pricing plus a 5 percent markup for Aspen. The license fee paid by Aspen was 5 percent.

Gilead leveraged its distributors’ sales forces to improve awareness of Viread. In some instances, distributor sales representatives were brought to Gilead offices in the United States and trained on product usage. In addition, Gilead built awareness in African markets by organizing small meetings of doctors, and by fostering connections between the distributor’s pharmacists and the pharmacists in each country. Demand also came directly from the President’s Emergency Plan for AIDS Relief (PEPFAR). Unlike the Global Fund, which provided funds to African governments and health ministries, PEPFAR provided funds directly to clinical programs. When one AIDS drug manufacturer announced that it had reached production capacity limits, PEPFAR approached Gilead about supplying Viread. Both PEPFAR and the Global Fund would prove to be important sources of funding for the clinics availing themselves of the Gilead Access Program.

Registration of Viread In the transition from Axios to Gilead’s administration of the Access Program, Gilead first assumed responsibility for obtaining import waivers. It also concluded that it had to register the drug with regulatory authorities in each country to advance access. With the list of least developed nations eligible for no-profit pricing expanding from 68 to 97, individual registration was a daunting challenge. Gilead was experienced in dealing with the FDA and the European Union’s EMEA, but it was not experienced in dealing with the ministries of health in developing nations. As a first step, Gilead decided to concentrate first on 15 so-called “focus” countries in the PEPFAR program and then expand gradually to the other nations.33

32

“Gilead Sciences and Aspen Pharmacare sign letter of intent to establish non-exclusive licensing and distribution agreement for antiretrovirals Truvada and Viread in developing world countries,” April 25, 2005, http://www.gilead.com/wt/sec/pr_700521 (October 27, 2006).

33 Botswana, Cote d’Ivoire, Ethiopia, Guyana, Haiti, Kenya, Mozambique, Namibia, Nigeria, Rwanda, South Africa, Tanzania, Uganda, Vietnam, and Zambia.

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Gilead had made the mistake of assuming that because Viread was already approved by the FDA and EMEA, which based their approval on the results of rigorous scientific testing, filing a submission (or “dossier”) for registration was merely a matter of courtesy. As a result, Gilead filed abbreviated applications and expected to obtain fast-track approval. In the case of Gambia, Gilead sent a letter and abbreviated filing for an import waiver, and Gambia responded by giving immediate regulatory approval for the drug. Gilead was not so fortunate with most other nations.

Zambia and Botswana, for example, believed that the application to sell Viread in a white pill versus the blue pill sold in the United States and Europe (to protect against the risk of reimportation) indicated that the countries were being offered an inferior product. Much to Gilead’s surprise and dismay, their applications were rejected. Meanwhile, Nigeria requested original trademark certificates for Viread along with Gilead’s application. After a fire in the Nigerian FDA destroyed the application and certificates, the company had to start the approval process from scratch.

Gilead realized that it would need to embark on a country-by-country effort to confront vastly different, often undocumented approval processes and country-specific concerns. As Alton explained:

You’re dealing with 97 countries, almost all of them having a different dossier requirement. The dossiers have to be presented differently. They’ll ask for different data, which means that each dossier has to be put together separately, and these are not small potatoes. These are very diverse. And sometimes it’s unclear exactly what they want, and it’s unclear where to get what they want. And once you’ve got your dossier and you think you’ve got the dossier done, you don’t even know where to send it, or who to send it to. And once you send it, who do you call to follow up?

South Africa returned Gilead’s initial application because the company had provided too much data. Gilead was instructed to make the application shorter but was not given instructions on what information to remove. In most countries, registration approval was slow, often exceeding 18 months.

Even after approval was granted, the delivery process was complicated. When Gilead delivered a $2-million shipment of drugs to Uganda, for example, the paperwork said the drug was made in Canada but the labels on the crate said it was made in Germany. The first response by the customs office in Uganda was to refuse delivery and instruct Gilead to send the drugs back. Gilead had to obtain a special waiver to prevent a costly and pointless return of the shipment.

Corruption In many developing countries, officials in the health ministries or customs offices expected foreign companies to pay bribes or facilitating payments to accelerate processing of a specific request. As Alton explained:

A lot of these countries look at a regulatory position as a gatekeeper who can charge admission to a process, and that is just the way it is. I don’t think they really look at it as corruption. They look at it as, ‘Of course, I hold a position of power. I have the ability to say whether you can bring your product in or not.’

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The amount of money in question was often small, a few hundred or a thousand dollars. However, Gilead, as corporate policy, refused to pay bribes. As a result, large shipments of drugs were slow to reach clinics because of delays in the registration process.

In many countries Gilead distributors were competing against generic manufacturers who were selling patent-infringing versions of HIV/AIDS drugs. These companies did not have the same restrictions on paying bribes and therefore often obtained approval before Gilead. Kickbacks given by generic manufacturers to local buyers led to increases in the price of generic drugs as they moved through the supply chain to the treatment clinic. In one instance, buyers in Ghana gave an order to a generic manufacturer for tenofovir at $86 for a 30-day supply, not realizing that Gilead’s price for branded Viread was $17.

In some instances, generic manufacturers used their political influence to keep lower-priced Gileadmanufactured drugs out of the market. For example, it took three years for Gilead to get approval to register Viread in Nigeria, and approval came only after a senior politician’s spouse directly intervened.

Nongovernment Organizations Quasi-governmental organizations and nongovernment organizations (NGOs) like the WHO and the Global Fund played an influential role in the global AIDS effort. NGOs included international organizations, and activist or awareness groups like Médecins Sans Frontières (MSF, or Doctors Without Borders), ACT UP!, and the AIDS Healthcare Foundation (AHF). These groups contributed to global relief efforts by influencing international policies, persuading pharmaceutical companies to reduce the cost of medicines, increasing access to funds, assisting in education and prevention campaigns, and generally promoting humanitarian assistance efforts. In addition, groups like MSF and AHF provided direct care of AIDS patients.

Gilead was late to recognize the importance of the WHO. Recognizing that Viread would not achieve widespread clinical use until the drug was added to the WHO’s treatment guidelines, prequalification list, and essential medicines list, Gilead made efforts to have Viread included.

Gilead was eventually able to get Viread added to the prequalification list, which meant that clinics were advised that Viread was safe to administer. Organizational intransigence at the WHO, however, led to delays in adding Viread to the other two lists. Gilead began discussions with the WHO regarding treatment guidelines in the summer of 2005. One year later, the organization was still circulating draft changes with guideline updates, including the replacement of d4T with tenofovir as a first-line treatment. By comparison, d4T had been removed as the first-line treatment by regulatory authorities in the U.S. and Europe in 2002 because of its side effects profile.

Part of the problem was that the WHO and other NGOs had a natural suspicion of the motives of large pharmaceutical companies. As organizations focused on improving patient health worldwide, they were not sympathetic to pharmaceutical companies whose profit motives were seen as inhibiting access to medicines.

By 2006 Gilead was still working to improve its relationships and reputation with international organizations such as the WHO. Part of the effort involved increasing awareness of the specifics of Gilead’s policies and the Gilead Access Program and its commitment to providing access for its drugs, so that its objectives were better understood. The other part of the effort was overcoming a

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natural bias that favored generic manufacturers even when, as in the case of the Gilead Access Program, the cost of a branded pharmaceutical product manufactured in an FDA- approved facility was lower than that of a competing generic product manufactured under less stringent quality standards.

Gilead had relatively more success building relations with AIDS activist and awareness groups.

Part of its success was due to the fact that it had historically made a practice of overcoming adversarial relations to build cooperation. At large international AIDS meetings, activist-oriented NGOs such as ACT UP! continued to challenge Gilead as part of a broader protest against the conduct of pharmaceutical companies. Nevertheless, recent efforts, such as Alton taking a seat on the board of directors of the AIDS Health Foundation, helped Gilead learn and respond to the perspective of these groups. It also helped activists better understand the company’s perspective.

Médecins Sans Frontières (MSF), which was broadly opposed to pharmaceutical patents because they increased the price of medications, was one of the first groups to criticize the Access Program, claiming that the program was a lie because the need for import waivers created a bureaucratic barrier that delayed access to the drug in poor countries. MSF wanted Gilead to increase its efforts to speed the process of registering the drug in each country. Gilead believed this criticism helped put political pressure on some nations to improve the efficiency of their regulatory approval process.

Managing Praise and Criticism Despite the strategic changes Gilead had made to improve the effectiveness of the Access Program, the company’s efforts were largely portrayed negatively by the press. Although some journalists were sympathetic to the challenges Gilead faced, most articles focused on the continued lack of access to Viread in developing countries with the implication that Gilead was responsible for the failure to get it widely distributed.

A June 2006 article in the Associated Press began by stating that “success on Wall Street hasn't insulated Gilead from complaints that it isn't doing enough to combat the disease where it hits hardest.” The article went on to quote an AIDS activist as saying, “For a company that prides itself on their access program, they have been irresponsible in getting the drug out.”34 The article only made passing reference to the difficulties of registering the drug in African nations, no mention of the challenges of working with international organizations or building demand, and no praise for implementing the no-profit program in the first place.

An August 2006 article in the San Francisco Chronicle declared that “one likely target of activist ire this year is Gilead Sciences.” The article focused on criticisms made by groups such as MSF for Gilead’s “slow-footedness in delivering on its promise to make tenofovir available at cost in poor countries.” The article claimed that Gilead’s “drug distribution program has earned the company a black eye.”35 A September 2006 article in the San Jose Mercury News began, “Gilead Sciences, accused of not doing enough to help people infected with HIV in poor countries…”36

34

Paul Elias, “Gilead Faces Criticism Over Drug Access,” Associated Press Newswire, June 4, 2006.

Sabin Russell, “International AIDS Conference, A Look at HIV − Where Are We Now?,” San Francisco Chronicle, August 13, 2006.

36 Steve Johnson, “Gilead Lets 8 More Indian Firms Make Generic HIV Drug,” San Jose Mercury News , September 23, 2006.

35

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For Alton and others at Gilead, the continued critical portrayal of the Access Program by the press was disappointing. The main challenge Gilead faced was that journalists rarely contacted the company for its side of the story before publishing an article, said Alton.

The press really likes to vilify the pharmaceutical industry. We’ve seen articles come out that led us to say, ‘If you just talk to us we could tell you that that’s not the case.’ They seem to print anything that an activist says as the Godgiven truth, […and] everything that we say is a lie …. So it’s been very frustrating.

Alton felt that managing the perception of the program was critical both for its corporate reputation and for the overall integrity and safety of the program. Gilead responded to media criticism by discussing the challenges inherent in operating in developing countries with inadequate infrastructure, including the inadequacy of clinics in diagnosing and treating AIDS, poverty and malnutrition that impeded compliance with AIDS treatment regimens, political and NGO intransigence, corruption, and other barriers. The pharmaceutical industry’s role in the global AIDS relief efforts had expanded over the past few years, and Gilead believed that the press could have a more positive influence by putting pressure on the governments of developing nations to eliminate the structural impediments.

EXPANDING THE ACCESS PROGRAM In 2006 Gilead focused on making the Access Program a truly global initiative. For the top tier of countries by gross national income, the calculation of value included advancements over previous medicines, improved patient effectiveness and side effect profile, as well as the reduction in clinical resources required for monitoring and treating adverse physiological events.

In the second tier, which included countries like Mexico, Brazil, and Russia, Gilead priced the drug at $6 per day, a steep discount reflecting the lower per capita incomes in these nations. Alton explained the pricing: There has been some criticism of this. Individual patients in those countries can’t afford the price because the gross national income is skewed to 3 percent of the population, and 97 percent is at the bottom end. And that’s accurate, but we feel it’s the responsibility of the country or the taxpayers or the governments to come up with systems to make the products available. We can’t do that. If we were to take the position that we had to price the product based on what the patients’ incomes are, even in the United States we wouldn’t be able to sell the product.

Alton pointed to Brazil as an example of a country whose government had a very successful AIDS program: “Brazil [is] a prime example of a country where the individuals aren’t paying for the medications, but the country does have a fairly robust economy, not U.S. standards, but they can afford to have a budget for HIV medications.”

In the third tier, which included countries like Thailand, India, and China, Viread was priced at $1 per day. These nations had low per capita incomes and some had high infection rates. As Alton explained:

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By coming in with a lower price we feel that we will have higher volumes and make up the money on higher volumes as opposed to higher margins in these areas. And we want to make sure that in no case does price come in the way of getting access for patients.

In the 97 low-income nations, Gilead sold Viread at its cost of $17 a month, as of 2006.

Reimportation of Viread to the United States proved not to be a problem, since nearly all patients received the drug through government programs or held private insurance to cover the cost of medication. Intellectual property protection had improved because India changed its patent laws to comply with WTO requirements, bringing them in accord with those in the European Union and the United States. Brazil, however, had threatened to invoke compulsory licensing of AIDS drugs. It used the threat to bargain down the price on one of Abbott’s AIDS drugs, and also to put pressure on Gilead.

As Gilead sought to expand the availability of Viread in the middle income countries, it faced familiar issues of drug registration, building support of NGOs and activists, managing physical distribution, reducing production costs, and protecting intellectual property. Competition would come from Indian generic manufacturers who were following the company as it expanded into new countries, and in some cases entered countries before Gilead with patent-infringing products.

These companies often benefited by the perception that their presence was reducing the cost of therapy, whereas Gilead had seen firsthand that their prices were often significantly higher. As a result of the changes in patent law in India, in 2006 Gilead filed there for a patent for Viread. MSF was critical of these efforts, claiming that it would lead to higher drug prices, when in fact Gilead was planning to sell the drug at $1 per day versus the India generic manufacturers’ then-current market price of $2 per day.

Gilead wanted to extend its Access Program to combination therapy, combining more than one AIDS drug in a single pill. Combination therapy was attractive because it was easier for clinics to administer and resulted in greater regimen compliance by patients. In 2003 the FDA had approved Emtriva, a nucleoside reverse transcriptase inhibitor, and Gilead combined Emtriva with Viread to create a new drug, which was approved by the FDA in 2004 and marketed under the brand name Truvada. Shortly thereafter, Gilead added Truvada to the Access Program and worked to get the drug added to the WHO treatment guidelines and essential medicines list.

Gilead had also been working on a triple drug therapy that would include all three components of an AIDS drug cocktail in one pill. Rather than develop the third drug on its own, it decided to use the drug Sustiva (efavirenz) developed by Bristol-Myers Squibb and marketed in many countries outside the United States and major countries of Europe by Merck. Once approved by the FDA, the drug was to be called Atripla. Gilead expected Atripla to be a significant advancement in AIDS therapy as the first three-in-one combination drug on the market and the only one that included the very effective AIDS drugs Truvada and Sustiva. Adding Atripla to the Access Program would involve new complications. With Merck holding the international distribution rights to Sustiva, Gilead would have to use Merck as its distribution partner for Atripla while still maintaining distribution relationships with Aspen and local distributors for Viread and Truvada.

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By June 2006 Gilead had a market capitalization of $28 billion with 2006 earnings expected to exceed $1 billion. Yet after more than three years of its Access Program, only 35,000 patients in Africa were receiving its drugs. Gilead had to do better.

Brian Tayan, Professor David P. Baron and Professor Keith Krehbiel prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Copyright © 2007 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

Reprinted with permission.

STUDY QUESTIONS 1. As of 2006 what should Gilead do to speed access to Viread and Truvada in the 97 developing nations in the Access Program, keeping in mind the issues of registration of the drug, local corruption, and relations with government and nongovernment organizations?

2. What steps should Gilead take to improve the media portrayal of its efforts with the Access Program?

3. What are the risks to Gilead’s intellectual property in expanding the Access Program to a global scale?

4. What should Gilead do in adding Atripla to its Access Program? How should Atripla be priced?

5. What should Gilead’s manufacturing and distribution strategy be in expanding the Access Program to so-called lower-middle income and upper-middle income countries, given the scale of the effort required? How appropriate is its pricing strategy?

6. Design a bold program to provide greater access to Gilead’s drugs in African countries.

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Use of the (B) case: The (B) case is self explanatory and the preparation questions can be used to lead a discussion.

The principal question however should be the following:

Given the host of problems encountered in trying to provide access to its HIV/AIDS drugs and given its very limited accomplishments (35,000 people receiving Viread), how should it change its Access Program to accomplish its objective of providing access to those in poor countries who need its drugs?

What Gilead did: At the suggestion of one of its board members Gilead devised an innovative solution to its access problem. It decided to license Viread to any company that wanted a license, and those companies were free to sell their copy of the drug in any of the designated low income countries and charge any price they wanted. Gilead would also sell Viread in competition with those companies.

Competition then would force prices down to the level of production costs providing the lowest price at which the drug could be made available.

Gilead expected to make a very modest profit in this market, since the company believed that buyers would favor its product because they could be sure of its quality. Generic manufacturers in India were widely known for skimping on quality once drug approval had been obtained. Several controversies had developed between WHO and Indian drug companies, and two of their AIDS drugs were removed from the approved list until quality problems could be corrected.

To enable the licensing, Gilead registered Viread in India. This enabled Gilead to grant licenses under the Indian patent. Gilead received the standard license fee of 5 percent.

AIDS activists strongly criticized Gilead for registering Viread in India, arguing instead that it should just let anyone produce the drug. A very vocal segment of the AIDS activist community argued that Gilead should give away its patent, and more extreme members sought the elimination of the patent system for drugs.

Gilead did not view as a problem the possibility of the importation of the licensed drugs into the markets in Europe and the United States, since in both markets governments paid for virtually all the AIDS drugs and the governments would buy from Gilead.

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Advanced Technology Laboratories, Inc. PowerPoints are available for this case atl.ppt.

This is a case written about an issue—the use of ultrasound equipment for sex selection—and does not reflect the actual situation of Advanced Technology Laboratories (ATL Ultrasound). The case was written based on public sources of information and may not reflect actual problems faced by ATL. ATL is best thought of in this case as an example of a company that could face the issues identified in the case. ATL produces ultrasound equipment at the high end of the price scale, so its equipment is less likely than others, particularly locally-produced ultrasound equipment, to be used in sex selection. The handheld unit to be introduced by ATL has a greater potential to be used for sex selection. There is also an issue of whether handheld systems are sufficiently accurate for use in sex selection. The answer is “yes.”

This case can be used in conjunction with Chapter 19 with a focus on assessing the extent of ATL’s responsibility with respect to how its product is used. It can also be used in conjunction with Chapter 20 and 21 to apply specific ethical principles.

Ultrasound diagnostic equipment is a highly-valuable product with a wide variety of beneficial uses in a number of medical specialties. Moreover, advances in technology, and particularly digital technology, hold the promise for ultrasound as a primary care diagnostic instrument.

ATL is a small company specializing in digital ultrasound products. Its primary competitors are GE and Siemens, which dwarf ATL in resources. ATL has subsidiaries in the OECD countries and in Argentina, China, and India. The company in India is a joint venture with a local company. The most attractive markets are those with large populations and high growth rates in spending for medical care and services. China and India were particularly attractive markets.

Along with those markets, however, came a serious ethics issue resulting from the use of ultrasound equipment for fetus sex identification and abortion of female fetuses. This practice was culturally-based and stemmed from the importance of sons in caring for elderly parents and in carrying on the family name. In addition, daughters required a large dowry that could impose a substantial hardship on a family, particularly for families with more than one daughter. These cultural factors caused some families to invest more in sons than in daughters and abort female fetuses and in some cases kill female infants.

Sex selection was actively opposed by doctors, women’s groups, and official government commissions. India had passed a law banning abortions after sex identification and prohibiting the use of ultrasound for pregnant women except for those at high risk. There, however, was little enforcement of the law, and ultrasound equipment was not registered so it could not be traced back to the original purchaser. Despite the law, the practice of sex selection using ultrasound was widespread in certain parts of the country, and the practice was believed to have grown with the wider availability of ultrasound equipment. Presumably, the increase in abortions resulted in less female infanticide. Additional information on sex selection in India is provided in: “Amid Poor Villagers, Female Infanticide Still Flourishes in India,” Wall Street Journal, May 9, 2000; “Abortions in India Spurred by Sex Test Skew the Ratio Against Girls,” New York Times, April 22,

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2001; “Means to Pick Baby’s Sex Sets Off Furor in India,” New York Times, November 23, 2001; “Family pressures, unwanted girls,” New York Times, May 13, 2001.

Sex selection is also practiced in developed countries. A San Jose, California doctor operated two ultrasound clinics using technologies that he claimed allowed him to identify the sex of a fetus at 12 weeks. Canadians of Asian decent began traveling to his clinic in San Jose. In response, Dr. Stephens opened a clinic in Blaine, Washington, just across the border from Vancouver, British Columbia. To attract business he advertised in Vancouver newspapers in both English and Punjabi.

The fundamental issues in the case is the extent, if any, of ATL’s responsibility for how its products are used and whether it has a duty to reduce the likelihood of its products being used for sex selection. In assessing responsibility and duty, it is always important to determine what the law requires. In this case the law in India seems to assign duty to those engaged in sex selection and not to the suppliers of ultrasound equipment that may find its way into such use. Consequently, it is necessary to look beyond the law to more fundamental considerations.

Several types of moral concerns can be raised in this case. One is the notion of selection of the sex of a child. A second pertains to the use of abortion as a selection instrument. A third is gender bias, since female fetuses and not male fetuses are aborted. A fourth is the underlying issue of the status of women in Indian society. Other concerns can be identified.

Sex selection may also be argued to have some benefits, given the culture in which it is practiced.

It relieves impoverished families from the economic burden of the dowry system. Given the culture, it also may reduce the level of female infanticide and abandonments. These considerations raise the fundamental issue of whether culture should matter in determining the responsibility of a company. The notion of cultural relativism is considered in Chapter 23.

Responsibility in this case could reside individually or jointly with the woman, the family, doctors, government, society, and equipment manufacturers.

From Friedman’s perspective responsibility seems to rest not with the manufacturers of ultrasound equipment, since it is the use of the equipment and not the equipment itself that is at fault. This perspective is based on the arm’s length nature of the sale, the use of a market, and the transfer of property rights associated with a sale. Moreover, the purchaser of the equipment is best placed to determine how it should be used. This, however, does not necessarily imply that if some other party is likely to violate a duty that the manufacturer does not have a duty to act to reduce the likelihood of that violation.

The Business Roundtable’s notion of a stakeholder seems not to be particularly helpful in this case, since it is difficult to see how a responsibility could arise to take into account the stake of that customer who intends to use an ultrasound unit for sex selection. Moreover, if ultrasound technology advances sufficiently rapidly that a clinic replaces its ultrasound equipment every few years and sells its old units, there is another party between the manufacturer and a purchaser who intends to use the old unit for sex selection.

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The issue of the assignment of duty is complex and difficult and is considered in Chapters 20, 21, and 23. The Calabresi and Melamed principles presented in Chapter 12 and applied in Chapter 20 provide one means of assigning duty. These principles imply that ATL is well placed to reduce the harm associated with the use of its products and hence has a duty.

What specific steps could ATL take to reduce the likelihood that its products will be used in sex selection? There are a number that it can take to lessen the likelihood, recognizing that it is unlikely ever to be able to stop the use of sex selection using its products. First, it should keep records of who purchases each unit. Second, it could ask the purchaser to notify ATL if it sells the unit and identify the buyer. Third, it could ask the purchaser to sign a pledge not to use the equipment in sex selection. Fourth, it could sell only high-end products in India that would likely be too expensive for most of those engaged in sex selection. ATL could also attempt to organize industry-wide action to mitigate the problem and improve the situation of girls. The final question is whether ATL should use its good deeds in the promotion of its products. The discussion of the Body Shop in Chapter 22 suggests that this is risky and probably unwarranted.

The PowerPoint on the positive role of ethics addresses predicting whether interests with be motivated on moral grounds to take nonmarket action against ATL. The above discussion focuses directly on the issue of responsibility. The argument in the book is that responsibility is best identified by examining the implications of ethics systems. Those systems are considered in Chapters 20 and 21. Utilitarianism, moral rules and rights, and justice are briefly identified in the PowerPoints.

Teaching the case The following questions can be used to lead the discussion.

1. Are these ultrasound units good products?

2. What is the concern with them? (their use) 3. Which products have the greatest potential for misuse? (low-priced, portable) 4. What is the specific nature of the moral concern? Is it selecting based on sex, is it the use of abortion, is it gender bias, is it the status of women in Indian society?

5. Does sex selection have any benefits? (relieves an economic burden on the poor, reduces female infanticide, avoids mistreatment of girls) 6. What are the causes of this practice? (culture, poverty) 7. Are the concerns about sex selection due to western paternalism?

8. On whom is the legal duty placed in India to stop this practice? (doctors, women; apparently not on the manufacturers of ultrasound equipment) 9. Does ATL have a responsibility for how its products are used?

10. What do Friedman’s and the Business Roundtable perspectives imply about ATL’s responsibility?

11. Does the contribution to reducing female infanticide outweigh the moral concerns about aborting female fetuses?

12. In reasoning about the responsibilities of ATL should the culture (poverty, the dowry system, sex preferences of parents) be accepted as given or do principles transcend culture?

13. Is there a moral duty on ATL that derives from ethics systems?

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14. What if anything should ATL do? Can it reduce the likelihood that its products will be used in sex selection?

15. Should ATL sell its handheld unit in India and China?

16. Could there be a nonmarket reaction against ATL? 15. Suppose you were a large company such as Philips Electronics of the Netherlands and were considering buying ATL. Would you want to take the issue of responsibility and possible reactions into account?

The following (B) case can be used to continue the discussion.

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Advanced Technology Laboratories, Inc. (B)37 Vaira Mani recounted the death of a neighbor’s newborn baby, “It feels as if you’ve been turned inside out. You’ve just given birth and finally you feel emptied. You’re exhausted. Your breasts are painfully full of milk. And then you look at your baby. And you see that she’s a little girl. And you know you have to kill her.”38 The village of Usilampatti in the state of Tamil Nadu is in the center of the “killing fields of Madurai,” where female infanticide is still practiced.39 The practice is most common among poorer people, who did not have the resources to care for a girl, including her dowry, and cannot afford an ultrasound test to determine the sex of a fetus and the cost of an abortion. The government placed cradles in towns where babies could be deposited, but many women were reluctant to use them. In Dharmapuri 51% of the female infant deaths were estimated to be due to infanticide, and the female infant mortality rate was 131 per 1000 births compared to a male infant mortality rate of 69.40 Female infanticide had been prohibited since the British passed the Infanticide Regulation Act in 1870 and was defined in the Indian penal code as murder. The Indian government had announced that poor families would be eligible for 500 rupees (£8) a year to put a child through school.

Despite measures taken by the government Ms. Sheela Rani Chunkath, Commissioner for Maternal and Child Health and Welfare, said that the practice of female infanticide had not declined but instead had spread to other areas.41

37 Copyright © 1998 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reprinted

with permission.

38 London Times, March 12, 1997.

39 Madurai is a holy city in Tamil Nadu. Female infanticide is also practiced in the north, particularly in Rajasthan, Bihar, and Uttar Pradesh.

40 The Hindu (India), March 30, 1997.

41 FT Asia Intelligence Wire, January 7, 1998.

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Developments ATL decided to spin off its handheld product, creating a company called SonoSite. SonoSite’s first product will sell for $15,000-20,000 and will have a number of high-end features. It will be used for gynecology diagnostics such as abdominal tumors and not for obstetrics. Later products will be designed for cardiology and radiology. SonoSite believes that its products will compete with those “on carts.” In expected that its product would be ready for market in late 1999 or 2000. In China and India SonoSite planned to sell through distributors that are “substantial companies.” High protective tariffs in China tend to keep low-end products out of China.

There is no evidence that any groups have actively undertaken action against ATL or any other manufacturer of ultrasound equipment. However, GE medical equipment was effectively boycotted by INFACT. INFACT targeted GE because of its role in nuclear weapons production and the boycott was directed at all of GE’s products. However, the most effective component of the boycott was the decision by European hospitals to not buy high-end GE medical systems. The boycott cost GE over $60 million in sales of medical devices. GE would seem to be particularly vulnerable to a boycott not only because of the large variety of consumer products it sells but also because it is specifically developing portable ultrasound machines for the Indian market. According to an article in Asiaweek (March 1, 1996) the “General Electric Co. recently unveiled the first ultrasound machine entirely developed and constructed in India. The device is fully portable at under 10 kilos and still provides the clarity of image usually produced by large, immovable machines.”

In August 1998 Philips Electronics NV acquired ATL for $800 million. A student who had worked on the sale of ATL to Philips commented that he had not heard the sex selection issue mentioned during the negotiations, although he believed it was implicit in the bargaining.

The Wall Street Journal, April 18, 2007 carried an article entitled “India’s Skewed Sex Ratio Puts GE Sales in Spotlight.” The GE joint venture with the Indian company Wipro has the largest market share of ultrasound machines. India has banned sex selection and prohibited doctors from providing information on the sex of fetuses. Clinics are required to register, and doctors are required to display their own registration certificates. Nevertheless, the rising income in India has made ultrasound scans more affordable, costing only $8. Sex selection has worsened with 927 girls aged 0-6 for 1,000 boys, down from 945 in 1991. The article reported that only China had a lower ratio of 832. In northern India the ratio of girls to boys has fallen below 900. Because it has the largest market share General Electric has been the target of activists. General Electric has taken measure to assure that its ultrasound machines are registered properly, but it is impossible to track their use. Some doctors routinely violate the law, and ultrasound machines are now available even in small towns and villages.

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Chapter 23 Ethics Issues in International Business This chapter addresses a set of ethics issues encountered in international business. Those issues include (1) international law and conflicts with domestic laws, (2) whether to abide by universal principles, host country custom and practice, or the custom and practice of one’s home country, (3) questionable foreign payments, and (4) operating in developing countries. Ethics principles are intended to be universal and not country specific, yet it is clear that there are differences in what are acceptable practices across countries. Ethics issues are thus often more difficult when they have international dimensions. The chapter provides a set of frameworks for addressing these issues.

International law is an evolving but expanding field that will surely become of increased importance. Its relation to national law remains tenuous, however, and enforcement powers are weak at best. One source of difficulty in international operations is conflicts among the domestic laws in different countries. This can increase compliance costs and in some instances force a firm to violate one set of laws in order to comply with another set.

A major source of difficulty in applying ethics analysis to issues in international business is culture.

The chapter considers cultural relativism, the perspective that one should abide by local laws and customs, and how to reason when it should or should not be relevant. PowerPoints in the file universitygames.ppt provide a summary of aspects of this treatment and can serve as the basis for a lecture. The PowerPoints also identify a set of special issues pertaining to doing business in other countries and cultures.

In a number of countries, facilitating payments to government officials are commonplace. In some cases, these payments are simply grease that cause officials to do what they are supposed to do. In other cases, the payments may cause the official to do something that the official is not supposed to do. The Foreign Corrupt Practices Act (FCPA) distinguishes between these cases and imposes certain reporting requirements. The FCPA, however, does not provide the clarity that some firms require, so many firms have developed company codes that go beyond the FCPA to address specific situations that their employees are likely to encounter. The OECD accord has been implemented fairly widely.

As international trade with and foreign direct investment in a number of developing countries grew during the 1980s and 1990s, corruption and bribery became more widespread and more troublesome. The concern was not just with the countries in which corruption and bribery were widespread but also with the companies in developed countries that were paying the bribes. The publication of Transparency International’s corruption index for countries and its bribe payers index have has highlighted the issue. The concerns of U.S. and other companies that they were losing more business to bribes contributed to the calls for collective action. This resulted in the OECD code which went into effect in 1999. How effective enforcement of the code will be remains to be seen, but some companies appear to be responding to it. Marc Lassus, chairman of

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Gemplus, a French high-tech company said that in France “companies are more and more aware of the problems of bribery and are taking the puritanical approach, the American approach.”42 The FCPA and OECD accord pertain only to foreign government officials, and Germany has gone further to make bribery of private companies illegal. Cummins’ Practices also cover private firms as well. More importantly, Cummins’ Practices are unique in that they provide a framework for reasoning about questionable payments. This framework can be applied in the Complications in Marnera and the Siemens: Anatomy of Bribery chapter cases.

Operating in developing countries is more difficult in a number of dimensions than operating in developed countries because institutions are not in place to guide actions or to enable people to take the same care that people are able to take in developed countries. The Calabresi and Melamed principles introduced in Chapter 12 are one useful guide to reasoning about these situations.

In addition to the FLA and the Workers Rights Consortium discussed in the chapter, many other organizations such as Social Accountability International (SAI) have standards for working conditions in overseas factories. SAI’s standards include a living wage. The FLA, SAI and the Ethical Trading Initiative joined together in 2005 on a project to develop a uniform set of standards and inspections for factories, beginning with a pilot program in Turkey. The wage issue was likely to be the stumbling block to broader cooperation and uniformity.43

Cases Complications in Marnera PowerPoints are available for this case marnera.ppt.

This is a fictional case based on a number of incidents encountered by executives in a number of different countries. The case can be used in conjunction with Chapter 22 with a focus on operating in developing countries with less fully-developed institutions compared to a developed country and with a degree of corruption. The case can also be used in conjunction with a session on utilitarianism in Chapter 20. The analysis presented here is primarily based on utilitarianism considerations.

The case is organized around a set of incidents, as is the discussion here. The first incident is with the customs official. What is undoubtedly going on here is extortion by a low-level government employee, and what is sought is a payment in exchange for the official doing what he is supposed to do. This is undoubtedly illegal in Marnera, but is also likely to be common. Such facilitating payments are allowed by the FCPA and by the OECD agreement. From the perspective of 42 43

The Wall Street Journal , February 16, 1999.

Business Week, May 23, 2005.

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utilitarianism, the customs official is acting immorally. From the perspective of injustice, a greater injustice would likely result if Liu had not made the payment, since the computers could have been held up for a long time. The public disclosure test can be used here in conjunction with the injustice principle. Would the publics in Marnera and the United States understand and approve of Liu’s payment if the situation had been explained to them. The answer may well be yes. The tax system described is found in a number of countries, and it is customary to hire a tax attorney to handle the matter. The fee paid to the attorney is tax deductible, and part of the fee is passed on to NTS officials in exchange for a reasonable tax settlement. These payments are illegal and are unlikely to pass the public disclosure test. From a utilitarian perspective if the payment to the NTS official is a pure transfer then it has no effect in the utilitarian calculus. The payment, however, generates some transactions costs and also could distort economic transactions. This payment is thus immoral from a utilitarian perspective. If the payment is not large and does not result in favoring Bolton, then it may be legal under U.S. law and allowable under the OECD code. With all of these incidents Bolton and others have a moral duty to change the system to eliminate the corruption. To begin the discussion of the safety issue it may be useful to first ask the question of whether Bolton should pay Marnera wages to its construction workers or whether it should pay a higher wage. The answer given by utilitarianism is that the market wage should be paid if there is a functioning labor market, which there probably is. That is, utilitarianism evaluates alternatives in terms of individual’s preferences and if workers are willing to work at those wages, paying the market wage is justified. Some activists have argued based on justice considerations that companies from developed countries should instead pay a “living wage.” This is discussed in this manual in conjunction with the Nike case.

The safety issue is similar to the wage issue, since if workers are willing to work at the wage and safety conditions customary in Marnera, then the customary levels of safety may be moral.

Some further analysis is required, however. The first centers on whether the workers understand the risks associated with the jobs. To choose local safety standards, utilitarianism requires that risks be voluntarily assumed by workers and that requires that they understand the risks. The duty falls on Bolton to inform them. If workers accept risks out of desperation, then the local standards may not be adequate. The next issue is which party should bear the costs of injuries.

Since there is no workers compensation system or liability system in place, the workers, the contractors, or Bolton could bear those costs. As indicated in the PowerPoints, the Calabresi and Melamed principles discussed in Chapters 12, 20, and 23 are applicable here and suggest that Bolton and the contractors should bear the cost. Hiring a relative may not be sufficient.

The analysis to this point suggests that local safety standards are appropriate. The PowerPoints pose a series of questions from the perspective of moral rights and justice. As argued in Chapter 21 safety is an instrumental right, and the voluntary assumption of risk is consistent with a deontological system such as Kant’s. A justice perspective would ask if workers are subsequently denied opportunity because of a disability incurred as a result of an injury on the job. If the answer

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is yes, the Calabresi and Melamed principles imply that the duty to provide compensation falls on Bolton.

Some students may regard safety as an intrinsic right and hence that local safety standards are not acceptable. This leaves the question of at what level standards should be set. Utilitarianism provides a method to determine the level of a safety standard, but it does not acknowledge an intrinsic right to safety. Indeed, the liability and workers compensation systems indicate that safety is protected with a liability rule (in the language of the Coase theorem). As indicated in the section of the manual on the Chapter 4 case, Nike decided to use U.S. health standards for chemicals in the workplace. This may be the beginning of a movement to treat safety in the same manner as many companies already treat the environment. That is, they maintain the same environmental standards everywhere. If this is the right perspective, then Bolton bears the 5 percent additional cost.

The bidding mechanism, the belief that a European company will offer a bribe, and the invitation by the vice-minister all suggest that bribes may be used to influence the award of the contract.

Regardless of whether others are offering bribes, a bribe by Bolton would be illegal under U.S. and Marnera law and would be in violation of the OECD code. Under the pre-existing law of some European companies, such a payment would be legal and tax deductible if it were necessary to secure the contract; e.g., to match a payment by a rival.

The analysis of this type of situation from the perspectives of act and rule utilitarianism is presented in Chapter 23 and can be used at this point in the discussion. The PowerPoints summarize the conclusions from this analysis. Rule utilitarianism as applied to simultaneous choice implies that bribes are morally wrong. The more difficult issue is what to do if it were known that a rival would be offering a bribe. Act utilitarianism, i.e., holding constant that the rival is offering a bribe, implies that a bribe be offered only if doing so would increase aggregate utility, so this is not a decision based on self interest. If Bolton knew that it was better qualified than the company offering the bribe, then from an act utilitarian perspective a matching bribe would be warranted.

The payment of the bribe is still morally wrong but under act utilitarianism is justified by the principle of avoiding a greater injustice. Note, however, that the injustice is to aggregate welfare and not to a bidder.

The reasoning consistent with act utilitarianism is a slippery slope, however, because each bidder is likely as a result of hubris to believe it is the best qualified company and hence that it should make certain that it is not disadvantaged in the bidding by a bribe offered by another company. It is a short step to all bidders offering bribes, resulting in a competition in bribes rather than on the merits. It is this slippery slope, and how far some companies have slid down that slope, that provided the pressure to reach the OECD agreement.

Liu could also reason that a matching bribe should be offered because she has a duty to the Bolton employees who would lose their jobs if Bolton did not win the contract. This does not provide a utilitarian justification of offering a matching bribe, however, since if Bolton were to win, employees of some other company would lose their jobs. Reasoning that she should commit an immoral act because of a responsibility to Bolton’s employees is casuistry, as discussed in Chapter 20.

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Rather than automatically offering a matching bribe when doing so is justified by act utilitarianism, Liu should explore other alternatives. In a standard bidding mechanism, Bolton could raise its bid price to compensate for a bribe offered by a rival. In this case, the first stage of the bid process does not involve bid prices, so this alternative is not available.44 Bolton should explore other alternatives, such as offering to ensure safety standards higher than provided by local practice. A PowerPoint provides the more general perspective on what is required by utilitarianism.

The remaining issue is the temptation for the bidders to collude among themselves to confine their competition to the first stage of the process and then not compete aggressively in the second stage.

The winner of the first stage competition then could get by with a lower bid in the second stage. A PowerPoint summarizes the following analysis. Collusion would be illegal under Marnera law.

Moreover, there is no utilitarian justification for collusion, since at best it simply affects the amount paid by the winner to Marnera. At worst it could result in the choice of a contractor who was not the best for the project. This could easily occur if the contractors competed with each other on many contracts and set up a system to determine who will win which contract. This is like the dango system discussed in Chapter 14.

De Beers and Conflict Diamonds For decades De Beers had maintained an orderly market in rough diamonds. De Beers purchased rough diamonds some of which it produced, maintained an inventory, and graded and distributed the diamonds through its Central Selling Organization that sold to diamond cutters. This cartel was able to maintain high prices for diamonds, which had no intrinsic value.

This cartel began to erode in the 1990s because of increased production in Russia, Western Canada, and elsewhere. In addition, an increasing supply of alluvial diamonds that are easy to mine added to the pressure on the system. More importantly, the alluvial diamonds were used to finance rebels, civil conflict, ethnic conflict, and worse in Africa. Efforts by African countries, the international community, the United Nations, and NGOs to stop the killings were unsuccessful. It became clear that the killings would continue as long as conflict diamonds could be sold to buy weapons.

At the same time De Beers’s situation continued to deteriorate. It had tried to maintain its control but this required buying additional rough diamonds, which increased the inventory it held and jeopardized the health of the company. This was no longer viable, and De Beers was forced to abandon its purchasing system, focusing on distribution. To deal with the excess supply, De Beers tried to increase demand through advertising and branding, but this accomplished little.

NGOs, countries, and international organizations tried to pressure the countries and the diamond companies. One tactic was to try to convince consumers not to buy diamonds, although most people remained ignorant of the situation. The movie Blood Diamond added to the campaign.

These continued to pose a risk to De Beers.

44

This bidding process was used in Indonesia for the sale of some government-owned companies.

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De Beers needed to find a way to deal with its deteriorating situation and deal with the flow of conflict diamonds into the market. (De Beers may also have acted on moral concerns.) Working with producing nation and NGO critics was the solution.

The mechanism devised is referred to as the Kimberly Process that established a system, the Kimberly Process Certification System (KPCS), that certifies that diamonds are conflict free.

The formation of the Kimberly Process began in 2000 with a meeting in Kimberly, South Africa of the diamond-producing African countries. With the support of those governments and the United Nations the certification was established and went into effect in 2003. The Kimberly Process is a joint initiative of countries (now 74), the diamond industry, and civil society. The KPCS involves the certification of diamonds at the production level and the commitment to require a certificate for any diamonds transported across borders and for all purchases. At all the stages a System of Warranties is used, and the diamond companies pledge not to buy unless the diamonds have a warranty declaration. The Kimberly Process also collects data to track the effects. More details can be found at www.kimberlyprocess.com.

Developments The Kimberly Process has been a major success. In the 1990s conflict diamonds were estimated to account for 15 percent of the market, and by 2008 conflict diamonds were estimated to be only 0.2 percent of the market. The Kimberly Process has brought almost all of the world’s production under its auspices. This has also increased the revenue of African countries that have been able to bring production under their control.

Peace had returned to Liberia, Sierra Leone, and other countries.

The Kimberly Process has been criticized by activists and NGOs on a number of grounds. One is that the Kimberly Process relies on self-regulation by companies with no external monitoring.

The potential weaknesses in the KP are cheating by countries and shirking by companies. Three countries have been expelled from the KPCS (but not the KP). The countries are the CongoBrazzaville, Côte d’Ivorie, and Venezuela.

The Kimberly Process also has helped relieve De Beers’ problem, but it continued to face increasing competition from other members of the industry.

De Beers returned to its strategy of building a retail presence and planned to have 50 stores in 2008.

Its the development of retail stores was hampered by antitrust class-action lawsuits in Europe and United States.

443 PLC, 45 percent by the Oppenheimer family, De Beers is owned 40 percent by Anglo American and 15 percent by the government of Botswana.

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Siemens: Anatomy of Bribery Prior to 1999 German law allowed a firm to deduct from its taxes foreign bribes that were necessary to win business. (How this law was administered is unclear, since it must be difficult to determine when a payment was necessary. It is also not clear to which government offices, if any, the bribes were reported.) In 1999 Germany changed its law to make bribery of foreign government officials illegal and a criminal offense. In 2002 bribery of private firms was made illegal. Siemens’ lines of business include those, such as telecommunications, power transmission, and health care, in which governments and government-owned firms were major customers.

Siemens’ internal investigations found €420 million is possibly illegal payments. The outside law firm found €1.3 billion in possibly illegal payments since 1999. Siemens managers took elaborate steps to hide the payments and launder money so that it was available for payments. Siemens also apparently used agents and consultants to arrange and make bribe payments. These payments were made in many countries and apparently in several of Siemens’ business units. An internal amnesty program may generate more disclosures.

Kleinfeld and Von Pierer professed that they were serious about halting the bribery and uncovering those that had been paid. Their measures were not sufficient, and they may have been involved in the bribery themselves or had known about the bribery. Both resigned in 2007, as did seven other management board members.

The legal actions against the company are reported in the case. In addition, Siemens was exposed in supporting a rival union to IG Metall, its principal union.

Why did Siemens engage in such widespread bribery? Kleinfeld gives one explanation—managers were doing anything to “beat the competition.” Another possible explanation is that Siemens’ competitors were paying bribes, but that provides neither a moral nor a legal justification for also offering bribes. This raises the question of why Siemens felt it had to beat or meet the competition regardless of what it took. Perhaps it resulted from how performance was measured and rewarded.

Perhaps it resulted from not wanting to have to lay off employees if a contract were lost.

In the Italian court the Siemens manager provided an explanation: “The alternative would have been to turn down the project, which would have denied Siemens not only the business but also a foot in the door in the Italian market.” At best, this is casuistry.45 This explanation can be compared with the explanation provided by Kotchian in the Lockheed case. He, however, attempted to justify the payments in terms of benefits to constituents, and although he did not say it, he may have had an array of constituents in mind.

How should Siemens’ managers have reasoned about these payments? The chapter provides a detailed analysis of how to reason about these payments from the perspective of utilitarianism.

Beyond that analysis the mangers should have known that the law is not supposed to be violated.

That the managers took elaborate measures to hide the payments means that the managers knew

45

Siemens apparently believed that the payments were not illegal because they were made to a company that their believed was private.

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that the payments were illegal. Moreover, some of the payments were reported to senior executives, and they apparently did not stop the payments or other payments.

What type of management systems should Siemens put in place to prevent bribery? First, top management must be serious about it. Second, those who make the payments should be punished both by firing them and reporting them to law enforcement authorities. Third, managers should receive training in the law and company policy and how to handle situations in which a potential customer asks for a payment or a competitor is believed to be offering a bribe. Fourth, the company should institute a sign-off policy in which a supervisor is required to sign off on contracts with agents and consultants. Fifth, an internal amnesty policy could be implemented under which an employee who reports bribery does not place his or her career in jeopardy. Sixth, audit procedures must be strengthened.

Discussion questions 1. Did the Siemens managers knowingly violate the law?

2. Why was Siemens engaged is such widespread bribery?

3. Evaluate the explanation given in the Italian case.

4. How should Siemens managers reason about a situation in which a competitor is thought to be offering a bribe? First, consider the perspective of utilitarianism. Second, apply Cummins’s principle.

5. What management systems should Siemens put in place to ensure that bribes are not paid in the future?

6. Should Siemens have hired an outside CEO? Developments Richard Siekaczek was convicted of breach of trust and given a two-year suspended sentence and fined €108,000. He was given a lenient sentence because he had cooperated with authorities.

Siemens filed claims for damages against 11 members of its corporate executive committee between 2003 and 2006. Siemens stated, “The company bases its claims on breaches of their organizational and supervisory duties in view of the accusations of illegal business practices and extensive bribery that occurred in the course of international business transactions.”46 Kleinfeld was one of the 11. In addition, Siemens was pursuing civil lawsuits against von Pierer, former CFO Heinz-Joachim Neüburger, and eight other management board members.

The head of Siemens’ medical-equipment division resigned in May 2008 after “new findings of misconduct at the division.”

German prosecutors had 300 suspects in the Siemens case. Three former managers including Neüburger were criminal suspects.

Siemens sold to a U.S. private equity group a 51 percent stake in its telecommunications unit. The sale was expected to result in a charge of €1 billion.

46

Wall Street Journal, July 30, 2008.

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Part V Integrative Case GlaxoSmithKline and AIDS Drug Policy PowerPoints are available for this case.

HIV/AIDS may be the world’s worst pandemic in terms of lives lost and to be lost. Pharmaceutical companies such as GSK have a set of drugs that can turn AIDS from a certain killer to a treatable chronic disease, prolonging the lives of victims. AIDS drugs, however, must be taken in a strict regimen, since if a person interrupts the therapy, resistance to the drugs develops. Moreover, if the drugs are not used properly a more virulent strain or more drug-resistant strain of HIV could develop. AIDS treatment thus requires supervision by medical personnel in addition to discipline by the patient. Simply providing drugs is not sufficient. Moreover, treatment of victims improves their conditions but does little to prevent others from contracting HIV. The Gates Foundation has concluded that prevention should be emphasized. This discussion suggests that a comprehensive program is needed to combat HIV/AIDS, and drugs play an important role among many important roles in any such program.

Below is a teaching note on AIDS and the pharmaceutical industry. Another source of additional information is the UNAIDS report, “AIDS in Africa: Three scenarios to 2025.” Among its conclusions was one that AIDS programs in Africa could produce more harm than good unless they were well coordinated. Similarly, the Global Fund has had difficulty finding enough wellconceived projects to disperse all the funds it has.

The PowerPoints provide information and analysis. Only two issues are discussed here. The first is how one might reason about what responsibility or duty GSK has in an HIV/AIDS program. The second is the development of an integrated strategy based on its responsibility.

The first step is to answer the question: Which parties might be said to have responsibility? A short list is: Individuals in poor countries Poor countries Rich countries Pharmaceutical companies Generic drug companies NGOs; e.g., providing medical care United Nations The next step is to ask: What is each party best positioned to do? This is basically the framework of the Calabresi and Melamed principles.

Individuals—self-restraint, follow treatment regimens Poor countries are best placed to provide prevention programs, since they are most knowledgeable about local culture and what steps would be most effective in getting individuals to exercise self

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restraint. Similarly, poor countries are well placed to provide health care delivery—to the extent of their means—and ensure proper use of the drugs.

Rich countries are best placed to provide the resources for prevention and treatment programs.

Funds could be provided to poor countries for medical care and prevention programs. Funds could be provided to purchase drugs from the pharmaceutical companies and provide them to poor countries for treatment programs. The Global Fund is an appropriate vehicle for a drug purchase program. Funds could also be provided to fund medical care and prevention programs in the poor countries. Funds could also be provided to develop new drugs, and this could be done in government labs, by funding university research, and by subsidizing the R&D of the pharmaceutical companies. Individuals in rich countries could also contribute.

UN/Global Fund is best positioned to coordinate the components of the program, including drug purchases and deliveries. The United Nations also can provide a limited amount of medical care.

Pharmaceutical companies are best positioned to conduct R&D on new drugs to combat HIV/AIDS. They have the scientific expertise and the pipeline to conduct R&D at least as efficiently as any other party. These companies are also best positioned to produce drugs at low cost, although the generic drug companies may also be able to produce efficiently. The pharmaceutical companies are also well positioned to charge low prices for their existing drugs.

The pharmaceutical companies could also license their drugs to lower-cost producers.

The generic pharmaceutical companies are possibly well-positioned to produce drugs at the lowest cost. For example, an Indian company may be able to produce at lower cost than GSK, in which case GSK could license its drugs to a company such as Cipla.

The NGOs are best positioned to participate in the delivery of health care in the poor countries.

Some run clinics, some provide medical personnel, some provide educations, etc.

Note that there is nothing in utilitarianism that justifies how much rich countries are to contribute to support R&D by pharmaceutical companies nor how high the prices of AIDS drugs are.

The assessment of positioning constitutes a social contract in the sense of Rousseau. The following is a summary of a social contract.

• Price drugs at cost (excluding R&D) for poor countries – License where that makes sense – Diseases include those that represent a public health threat • Rich countries fund the Global Fund – Buy drugs (at cost) and give them to low-income countries and victims.

– Initially allocate more to prevention, education and ABC, until infrastructure needed to properly use of drugs is in place.

• Rich countries and NGOs build medical infrastructure • Poor countries focus on prevention and proper use • Pharmas conduct R&D on diseases of the developing world – Governments and foundations fund additional research

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• Price drugs at market in rich countries • TRIPS and compulsory licensing remain as at present and are tightly enforced.

A particularly difficult issue is what is to be done when one or more parties do not fulfill their responsibility. In particular, in this case the funds required to combat HIV/AIDS are much greater than the rich countries will actually provide. This means that other parties should assume some of the unmet burden. The pharmaceutical companies are well positioned to meet this burden. This suggests that the pharmaceutical companies provide their drugs at cost.

The second issue discussed here is an integrated strategy for GSK. The two PowerPoints are summarized here.

Reasoning about GSK’s responsibility for diseases of the developing world: • A conception of responsibility—moral – And of the responsibilities of others • A plan to fulfill that responsibility – Pricing – Scope: country eligibility, drugs and diseases – Licensing • An implementation strategy – To whom do we provide the drugs – How do we ensure proper use • Commitment to R&D for diseases of the developing world – How much to spend – What do we do with the discoveries • Intellectual property – Lobby U.S. and EU to enforce rules on compulsory licensing and parallel importation – Participate in WTO trade discussions • Develop constructive relationships with developing countries • Invest in reputation management Specific implementation components of an integrated strategy: • Addressing the immediate issue of pricing and access to AIDS drugs in low-income countries – Pricing, access, licensing policies – Relieving pressure from governments, public, media, activists • Addressing the prevention issue – GSK has limited competencies in medical care delivery – ARVs reduce the transmission from mother to baby » Work with South African and other governments to make drugs available to pregnant women with HIV • Protecting incentives for R&D – Lobby rich country governments to provide funds » Drug purchases (Global Fund to Fight AIDS, TB, and Malaria) 448

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» R&D support for drugs for pandemics – Should pharmaceutical companies pool their R&D efforts on HIV/AIDS drugs?

One question that arises regarding a pricing policy is the relation between prices and costs.

GSK’s present policy is to not make a profit on its AIDS drugs but not to price below costs.

Which costs? The cost basis for pricing could range from average costs including research and development to short-run production costs. Where in this range GSK should price is debatable, but one answer is that it should use the same cost base as a generic producer would have; e.g., Cipla. This would mean pricing to cover long-run variable costs not including research and development nor marketing. GSK’s specific actions are described in the PowerPoints.

Additional details can be found on its Web site. Discussion questions The following questions can be used to lead the discussion. AIDS in developing countries 1. What is the scope of the AIDS pandemic? 2. Why is AIDS so prevalent in sub-Saharan Africa? 3. What means do subSaharan African countries have to address the pandemic? What is required for effective treatment? What are the consequences of interrupting the use of AIDS drugs? Can improper use of AIDS drugs lead to a mutation of the HIV virus? 4. Given the limited funds available, should the emphasis be on prevention or on treatment of those ill from AIDS? 5. What is the role of the Global Fund? GSK’s situation 6. What pressures are GSK facing on its AIDS drug policy?

7. Can those pressures harm GSK? 8. How should GSK deal with private politics actions of the activists and their criticisms? 9. How should it deal with the pressure from government? Was filing a lawsuit against South Africa a good idea? 10. Is re-exportation a problem? Reasoning toward a policy 11. How should GSK reason about its responsibility and its AIDS drugs policy? 12. What are the components of a comprehensive AIDS program? 13. Who has a duty or responsibility and for what? Who is best placed to do which components of that program?

Formulating a policy 14. Should GSK license its AIDS drugs to companies in Africa and Asia?

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15. What pricing policy should GSK adopt for its AIDS drugs? If GSK is to price at cost, is that long-run average cost (including the cost of research and development), production costs, etc.? Will the drugs be affordable in Africa at those prices?

16. To whom do we supply the drugs? How do we ensure that they reach the patients who can benefit from them? Should GSK monitor the use of its drugs in Africa? Should GSK participate in the delivery of medical care?

17. Should GSK cut AIDS drugs prices in developed countries?

18. What should Garnier announce at the EU conference?

Integrated strategy 19. Should GSK continue to do research on AIDS drugs? A vaccine?

20. Suppose GSK discovers and receives approval to market the drug. What price should it set for the drug?

21. For which other diseases should drugs be made available at preferential prices?

22. Has the pharmaceutical industry’s business model changed?

23. What are the implications for intellectual property protection?

24. What should GSK do about TRIPS, compulsory licensing, and the Doha Round of multilateral trade negotiations in the WTO? Developments The PowerPoints provide information on developments through mid-2004 and more recent information is presented here.

In June 2005 the United Nations reported on the challenges ahead. Dr. Peter Piot, who heads the UN AIDS Program said, “The epidemic has yet to display a natural saturation point. In Swaziland, the country most affected by AIDS in the world, adult prevalence continues to climb; 42.6 percent of the pregnant women there tested positive for HIV in 2004. By 2006, 11 countries in subSaharan Africa will have lost more than one-tenth their labor force to AIDS.”47 The governments of some countries have made progress in containing the disease.

The WHO reported that as of December 2004 700,000 people in less developed countries were receiving anti-retroviral treatment, compared to an estimated 440,000 in June 2004. Approximately 160,000 of the increase was in sub-Saharan Africa. The increase in treatment was due to the large increase in international aid funds. The report also found that in one poor South African township the patients followed the strict regimen of taking the pills and that the success rate was the same as in developed countries.

In 2004 questions raised by the WHO caused Cipla to withdraw three of its generic AIDS drugs and Ranbaxy withdrew all seven of its AIDS drugs from WHO’s recommended list of drugs. The WHO cited discrepancies in the laboratory data and plant inspection date for the two companies.

Pharmaceutical companies have been criticized for failing to discover major new therapies. In an interview in Fortune, March 21, 2005, Garnier stated that research and development expenditures have increased by a factor of 15 over the past 20 years but the number of “novel drugs” discovered

47

, June 3, 2005.

The New York Times

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has not increased. Critics argue that the industry focuses on lifestyle drugs that can be sold in developed countries at high prices.

Garnier reported that to improve the efficiency of the R&D process GSK has organized its scientists into seven organizations of about 600 scientists each. The objective was to remove the research bureaucracy and replace it with a flat organizational structure.

GSK joined with the International Partnership for Microbiotics to test GSK’s AIDS drugs in topical form; i.e., a gel-based treatment.

Bill Gates’ foundation reported that a vaccine for HIV/AIDS may be more than a decade away.

Pharmaceutical companies continue to make progress and at least one vaccine was in Phase II trials.

In 2005 the South African government reported that AIDS deaths had increased by 57 percent from 1997 to 2003. The Mbeki government had played down the scope of the AIDS crisis, and the Prime Minister for years rejected the claim that HIV caused AIDS. Mbeki resigned in 2008, and the new minister of health acknowledges that HIV caused AIDS. One R&D challenge is that the AIDS virus develops resistance to current treatment drugs, which then requires the development of new drugs.

The Bush administration has pledged $2.5 billion a year to fight AIDS in developing countries.

Much less has actually been spent, however, because U.S. expenditures were tied to matching expenditures by other countries. A number of them were lagging in their contributions. The Bush administrations programs were criticized because they emphasized abstinence and required private U.S. NGOs receiving funds to oppose prostitution, which contributes to the spread of HIV. The United States also initially purchased only brand name drugs, but in 2005 began to purchase drugs from generic drug companies as well.

In January 2005 the FDA approved the first generic triple-cocktail of AIDS drugs produced by Aspen Pharmaceuticals of South Africa. Two of pills are GSK’s Combivir and the third is Boehringer Ingelheim’s Viramune. GSK licensed its drugs to Aspen. In 2004 the companies expanded their licensing to more companies in South Africa as a result of the settlement of a lawsuit by TAC. Africa currently receives about $12 billion in foreign aid, and a commission head by UK Prime Minister Tony Blair reported in March 2005 that the amount should be doubled.

Pharmaceutical companies spend more each year on marketing than they do on research and development.

Justine Frain of GlaxoSmithKline commented, “Early on, we realized it was important to work with the activist groups.” She added that GSK believes “that community groups are part of the

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solution.”48 This comment is surprising, since early on GlaxoSmithKline fought hard against the efforts of the activists for lower prices and greater access.

The following is a note on AIDS and the pharmaceutical industry written in 2003. Chapter 23 provides more current information.

48

Wall Street Journal, June 18, 2007.

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NOTE ONAIDS AND THE PHARMACEUTICAL I NDUSTRY49 HISTORY OF A M ODERNEPIDEMIC The crisis began gradually. Early in 1981 eight cases of Kaposi’s sarcoma (KS), a rare cancer, were reported in New York City. In June the Centers for Disease Control (CDC) reported that five Los Angeles men were diagnosed with the uncommon lung infection, Pneumocystis carinii pneumonia (PCP). Doctors in New York, San Francisco, and Los Angeles saw increasing numbers of KS, By 1982PCP, this and rare infections in the homosexual male population. immunosuppression was observed among non-homosexual Haitians, intravenous drug users, and hemophiliacs. Similar ailments appeared in other countries throughout the year. In September 1982 the CDC presented a case definition for this new disease, called Acquired Immune Deficiency Syndrome (AIDS). The age of AIDS had begun.

The Human Immunodeficiency Virus HIV retrovirus was believed to be the sole cause of AIDS. HIV, present in blood and other bodily fluids, was spread through intercourse, drug needles, tainted blood, and embryonic fluids. HIV weakened the immune system by taking over CD4 cells, also known as T-cells. The virus gradually reduced the CD4 counts, and the person became endangered by “opportunistic infections” that a healthy individual would have fought off. A non-infected adult had a CD4 count of 800 to 2,200, but HIV would reduce the count to below 200. In the United States, a person infected with HIV lived an average of 10 years before dying from AIDS-related infections.

TREATMENTS FOR AIDS Traditional medicines helped HIV/AIDS patients with opportunistic infections to live only a few years. Hope was restored with the introduction of anti-retroviral drugs (ARVs), the first of which was AZT, Azidothymidine, approved by the Federal Drug Administration (FDA) in 1987. AZT marked the first treatment for HIV itself, not the infections that accompanied AIDS. ARVs worked by reducing the HIV viral load and increasing the T-cell count. ARVs were typically taken in a combination therapy involving several drugs, known as Highly Active Anti-Retroviral Therapy (HAART). Though not a cure, HAART significantly slowed the spread of HIV and multiplied the CD4 count.

49

Deborah Liu (MBA 2002) and Soon Jin Lim (MBA 2002) prepared this case under the supervision of Professor David P. Baron as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 2003 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. Reprinted with permission.

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THE PHARMACEUTICAL INDUSTRY The pharmaceutical industry, with annual revenues of over $300 billion worldwide in 2002, developed, manufactured, and marketed prescription, generic, and over-the-counter drugs for treatment of diseases and their symptoms. The top 10 pharmaceutical companies were split between the United States and Europe, which with Japan, made up 84 percent of the total global drug market. Global drug sales grew rapidly at 8 to 10 percent a year as economic growth continued.50 The drug industry topped Fortune magazine’s 1999 list in both profit margins, at 18.6 percent, and return on assets, at 16.5 percent. Critics claimed that industry profits were excessive and were derived from inflated drug prices.

Economics of the Drug Industry Drug development was a costly process and was highly regulated globally. The average drug in the United States took 10 to 15 years from initial compound screening to final approval by the FDA, costing an estimated $802 million per drug ultimately marketed. This compared to a cost of $138 million (in year 2000 dollars) in 1970 and $318 million (in year 2000 dollars) in 1980—a six-fold cost increase in 30 years.51 In 2000 U.S. and European drug companies spent $40 billion on new drug research and development, up from $15 billion in 1990. Of 5,000 drug compounds researched, only five went into clinical trials and only one was approved.52 To encourage pharmaceutical companies to bear this risk, governments granted them exclusive patents to produce and manufacture the drugs. In the United States and the European Union this patent protection lasted 20 years, but the patent clock included the time through clinical trials and product launch, so the effective patent period was 11 to 14 years or less.53 European countries guaranteed 5 to 10 years of effective patent life after a drug reached the market. After patent expiration, generic drug makers were allowed to manufacture drugs using the same formulations. Generic drugs had to have the same ingredients, form, and effectiveness as the branded drugs. Because generic drug makers did not bear development risks and costs, generics were often sold for less than 20 to 30 percent of the branded price.54 By 2002 generics made up about half of the U.S. drug market by units sold, though branded drugs held a vast majority of the revenues. The pharmaceutical business model required companies to build a large portfolio of drugs and continuously renew their products to replace older drugs. Pharmaceutical companies maintained that strong patent protection was necessary to provide incentives to innovate. Internationally, however, where many governments spent less per-capita on health care than was needed to purchase even one dose of some blockbuster medicines, there was an outcry.

50

Jan Tudor, “Valuation of the Chemical and Drug Industries,” Weekly Corporate Growth Report, April 9, 2001.

Peg Hewitt and Peter Lowry, “How New Drugs Move though the Development and Approval Process,” Tufts Center for the Study of Drug Development Backgrounder, November 20, 2001, p. 1-2.

52 Pharmaceutical Research and Manufacturers of America, 2002 Industry Profile, PhRMA, Washington, DC, 2002, p.

IX. http://www.phrma.org/publications/publications/profile02/chapter2.pdf , Ibid. p. 16.

53 Ibid. pp. 30-32.

54 Bethany McLean, “Generic Drugs: Don’t Get Hooked,” Fortune, Oct 30, 2000.

51

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Because these firms provided products that improved and saved lives, critics argued that they bore ethical responsibilities. But since they accessed capital markets to fund research and development, they were also bound to shareholders. When ethics and profits were in perceived conflict, pharmaceutical companies were forced to make difficult decisions.

AIDS WORLDWIDE By 2001 nearly 20 million people had died from AIDS and about 40 million worldwide were HIV positive. Eight thousand five hundred people worldwide died from AIDS every day.

While the human toll has been great, the impact on the developed world had been limited by the introduction of ARVs in 1996. Nearly 1 million individuals in North America and over half a million in Western Europe were living with HIV/AIDS by 2001. In the Middle East and North Africa, the spread of HIV had been relatively slow, with fewer than 500,000 HIVpositive cases in 2001. In Eastern Europe and Central Asia, over 1 million people were living with HIV/AIDS, and the virus continued to spread due to intravenous drug use and sexual intercourse. In the Asia/Pacific region, over 7 million people had HIV/AIDS due to the sex trade, intravenous drug use, and tainted blood donations. In Latin America and the Caribbean, 1.4 million people had HIV/AIDS. The Caribbean was particularly hard hit due to tourism and sexual promiscuity among the youth, with 4 percent of some national populations infected. Sub-Saharan Africa had been hit hardest of all by HIV/AIDS with over 28 million people infected, over 8 percent of the adult population. The incidence was as high as 30 to 40 percent in some countries. Primarily spread through unprotected heterosexual contact, the rapid spread of HIV has been aided by the high prevalence of sexually transmitted diseases, which weaken the body’s natural immune system. The inferior status of women, workforce intermigration and mobility, poverty, unemployment, and lack of care exacerbated the situation. Lack of knowledge about how HIV/AIDS was spread, combined with an inadequate health infrastructure for testing and treatment, added to the crisis. Economic Impact of AIDS in Sub-Saharan Africa In countries struggling with poverty, HIV/AIDS was a leading cause of death, destroying decades of economic development and life expectancy gains. The loss of skilled and experienced labor, heightened turnover, and increased health care expenses lowered labor productivity, resulting in a

0.8 percent annual decrease in per-capita income Employers faced mounting direct benefits costs in forsub-Saharan HIV/AIDS.Africa.55 The cost of such benefits was estimated at 7 percent of salary in 1995 and was expected to increase to 18 percent in 2005.56 Sub-Saharan African countries were among those least able to absorb this impact, with a percapita GNP of less than one-ninth the world average and three out of four people living on less than $2 per day in 2001.

55

Dr. Rene Loewenson, “HIV/AIDS Implications for Poverty Reduction,” United Nations Development Programme, June 2001, p. 3.

56 Gavin George, “HIV/AIDS: the fear for business,” Heard all it: The Newsletter of the Health Economics and HIV/AIDS Research Division of the University of Natal, Durban , Issue No. 2, 2001, p. 2, http://www.und.ac.za/und/heard/publications/HEARDNL_Iss2(Final).pdf, (April 6, 2002).

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Because AIDS disproportionately impacted young adults, as the crisis continued, these countries faced a shrinking ratio of working population to the elderly population. This added more pressure on already strapped government budgets and social service sectors. Societal Impact of AIDS in Sub-Saharan Africa Heightened social change in sub-Saharan Africa was inevitable with the continued devastation caused by HIV/AIDS. Life expectancies dropped precipitously. Hardest hit was Botswana, where 35 percent of the adult population was HIV positive, and life expectancy had decreased from 70 years to 31. South Africa, with 20 percent HIV positive, saw its life expectancy drop from 66 to 51. After losing primary wage earners, families on the brink struggled to survive. According to the Botswana Institute of Development Policy Analysis, by 2020 one in four households would be touched by the death of a wager earner. As a result, children, especially girls, were pulled out of school to supplement family wages, and the cycle of poverty continued. Sub-Saharan Africa also struggled to absorb the one-in-ten children who were AIDS orphans. Disintegrating social and community networks left these children with few options, creating social instability, increased crime, and fewer educated workers. With health care and education systems overtaxed and facing their own skilled worker shortages, the social infrastructure dealing with HIV/AIDS was also its victim. The governments of these countries lacked the resources to cope with the economic and social ramifications of the epidemic.

ACCESS TO AIDSTHERAPIESI NTHE THIRD WORLD Many factors contributed to the difficulties of AIDS treatment in the developing world, including poverty, lack of education, inept governments, and cultural pressures. These factors contributed to inadequate health services and limited access to medicines.

Inadequate Health Services AIDS was rampant in societies that were poor and where people were poorly educated. In such societies the health infrastructure was inadequate or non-existent, and the risks of opportunistic infections were magnified. AIDS often was improperly diagnosed, and treatment was not available. Moreover, access to adequate medical care in developing countries declined over the past two decades as populations increased and economic conditions worsened. The already weak and under-financed healthcare systems buckled under the added strain of millions of new AIDS patients.

An annual per-capita healthcare expenditure of $14 was the minimum needed to provide the most basic services.57 Yet the average per-capita spending in sub-Saharan Africa was $6, and in most other African and Asian countries it was under $20. Latin American figures were somewhat higher, ranging from $41 in Guatemala to $792 in Argentina.58 These figures were much lower than the $1,500 or more spent by countries in Western Europe and North America. Sub-Saharan

57 58

GlaxoSmithKline, Facing the Challenge, 2001 World Development Indicators 2000, World Bank and The PANOS Institute, Beyond Our Means?, 2000

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Africa averaged 16 doctors and 75 nurses per 100,000 people, whereas South Asia and Latin America averaged 33 doctors and 24 nurses and 91 doctors and 196 nurses, respectively. This was dwarfed by the industrialized world ratios of 200 to 300 doctors and 500 to 1,000 nurses per 100,000 people.59 Moreover, medical facilities and personnel in developing countries were highly concentrated in urban areas, making them difficult to reach for the mostly rural population of AIDS patients. Diagnostic facilities were inadequate, even for HIV-related conditions that were simple to diagnose and inexpensive to treat. A recent UNAIDS survey of 22 major teaching hospitals in Africa found that only half were equipped to relieve breathing difficulty and only two-fifths had strong painkillers readily available. The standards of healthcare in these countries were depicted as follows:

[Most people] only visit a doctor or hospital when in severe pain or in emergency. Doctors and nurses are usually overworked and underpaid; doctors may ask patients for bribes or spend part of the day running a private practice…. In the poorest countries only the wealthiest, including the political leadership, have access to a full range of drugs and tests, the urban middle class, with limited financial resources, get hold of the pills they can and the impoverished village dwellers agonize on straw beds without clean water or basic painkillers.60 Access to AIDS Drugs As many as 12 million AIDS patients in the developing world could die in the next five years because the disease had advanced to the point that they would succumb to infections such as tuberculosis, pneumonia, or meningitis.61 Many such deaths could be averted with appropriate drugs and medical knowledge. But in the poorest countries, access to even the most basic drugs was severely restricted by poorly-managed distribution systems, funding problems, and widespread corruption. Treating opportunistic infections was inexpensive, particularly in the initial phases of AIDS. The average cost of opportunistic infection and palliative (symptom relieving) treatment in the initial stages was approximately $19 to $33 per patient per year in sub-Saharan Africa. All but the poorest HIV patients and their families could afford these basic drugs. Even the low-cost generic forms of the needed drugs, however, were often unavailable in hospitals and clinics due to deficient medical distribution systems and funding problems. Furthermore, when the drugs were available, doctors and patients often lacked the knowledge to employ them properly. ARVs were in far shorter supply than basic medicines. Less than 10 percent of HIV/AIDS patients in developing countries had access to anti-retroviral therapy; in Africa, only 10,000 to 25,000 patients were being treated with ARVs.62 The causes were many and complex, but the factor most

59

Ibid.

The PANOS Institute, Beyond Our Means?, 2000 61 Ibid.

62 Joint UNICEF-UNAIDS Secretariat-WHO/HTP-MSF Project, Sources and Prices of selected drugs and diagnostics for people living with HIV/AIDS, May 2001 60

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often blamed was high drug prices. Up to 1998 the theoretical costs of HAART were $12,000 per patient per year in Africa.63 HAART costs were estimated to range from $10,000 to $15,000 per year in developed countries. The high drug costs were attributable to patents, limited volumes, limited competition, import duties, and distribution costs. Since HIV was a recent disease, most ARVs were under patent protection and marketed at relatively high prices.

Moreover, few drug assistance programs existed to supply ARVs to impoverished nations at discounted prices. Unlike the developed world, where governments or private insurance plans paid for the drugs, in many developing countries the individual patient had to bear the cost. In the Ivory Coast, Uganda, and Zimbabwe, providing HAART to all their HIV-infected patients would cost from 84 percent to 265 percent of GNP, compared with only 0.06 percent for Switzerland. For HAART to become a realistic option for the poorest countries in Africa, it had to become orders-of-magnitude cheaper.64 While ARVs were only a part of the AIDS treatment, they received the most attention. Patients, caregivers, agencies such as UNAIDS and WHO, non-governmental organizations (NGOs), governments, and others worked for lower ARV prices. Pharmaceutical manufacturers responded by sharply dropping prices, particularly from 1998 to 2001. By May 2000, the annual cost of a standard combination of ARVs was $9,950 in the U.S., $2,365 in Brazil, and $4,201 in Uganda. In 2002 the cost of HAART was less than $500 per person in Africa, a decline of 95 percent from 1998.65 Yet, many activists and governments believed this was not enough, as per-capita incomes in most African countries were less than $300, leaving ARVs still out of reach. Some economists and politicians argued that annual ARV costs had to fall to $250 to make it cost-effective for developing countries to treat their HIV/AIDS populations.

AIDS DRUG PRICING I DN EVELOPING COUNTRIES The patents for most key HIV/AIDS drugs had substantial remaining lives. In the United States the patent for Zidovudine (AZT) would expire in 2005. Bristol-Myers Squibb’s patent on Videx (Didanosine-ddl) would expire in 2007, and the patents on the newer protease inhibitors (the most costly type of ARV) extended until 2014. The issue of patents was central to the debate concerning the pricing of ARVs. The innovation and discovery nucleus of the pharmaceutical industry was in the developed countries, which accounted for the bulk of sales and profits. In 2002 these countries were estimated to account for 95 percent of pharmaceutical industry sales.66 Yet, the industry was global, with all major players operating and marketing drugs worldwide. Despite the prevalence of HIV/AIDS in developing countries, virtually all of the research and development on AIDS drug therapies were As with mostindrugs concentrated the United the multinational States and Europe. pharmaceutical companies, such as GlaxoSmithKline, Bristol-Myers Squibb, Pfizer, and Roche, owned the rights to manufacture and sell ARVs.

63

UNAIDS/WHO, Affordable prices: Annual cost per person for triple therapy in Africa, February 2002 Professor Bernard Hirschel, Roundtable on Comprehensive HIV/AIDS Treatment Access, June 2000 65 UNAIDS/WHO, Affordable prices: Annual cost per person for triple therapy in Africa, February 2002 66 IMS Health Drug Monitor, http://www.ims-global.com/insight/insight.htm 64

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Protecting and enforcing these rights was critical to pharmaceutical companies. Without this protection local companies that did not bear research expenditures would copy the drugs and sell them at significantly lower prices. According to the major drug companies, this would make it impossible to raise funds for the research and development required for new discoveries.

TRIPS and Compulsory Licensing Historically, the standards of patent and intellectual property protection varied widely around the world. As intellectual property became more central to trade activities, these differences resulted in increasing tension. In the 1986-1994 Uruguay Round of multilateral trade negotiations, a set of new trade rules for intellectual property was developed to introduce more predictability and settle disputes more systematically. The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) attempted to narrow the gaps in how these rights were protected and to bring them under common international rules. Under TRIPS, governments had to ensure that intellectual property rights were enforceable under their laws and that infringement penalties were sufficiently stringent to dissuade violations. In general, willful trademark counterfeiting, copyright piracy, and commercial patent infringement were regarded as criminal offenses. Enforcement procedures were required to be fair, equitable, not unreasonably complicated or expensive, and not to involve excessive time limits or delays. Rules for obtaining evidence, provisional measures, injunctions, damages, and other penalties, had to be stipulated, and governments had to ensure that rights owners received the assistance of police and customs authorities to prevent the importation of counterfeit and pirated goods. TRIPS, however, provided for exceptions under Article 31, which allowed a government to

supersede patent protection through compulsory licensing.

The government, however, was required first to seek a voluntary license from the patent holder, except in the case of a “national emergency or other circumstances of extreme urgency.” A patent-owner could also be deemed to be these In abusing cases, its rights TRIPS byallowed declining to supply the product. governments to issue “compulsory licenses,” which granted to another party the right to produce the product or use the process under license domestically. The licensee was required to compensate the patent holder. Article 30 of TRIPS allowed a country to make limited exceptions to a patent to allow exports to a third country, provided that the exceptions do not “unreasonably prejudice the legitimate interests of the patent owner.”

The interpretation of TRIPS was the subject of disagreement between developing and developed countries. countries argued that they should be able to protect the public health Developing particularly in the case of pandemics. The developed countries emphasized the creation of new drugs and the mix of economic, social and health policies required to respond to pandemics.

UNAIDS and AIDS Drugs Pricing Prior to 1996 the World Health Organization (WHO) had assumed the primary responsibility for dealing with the AIDS crisis by assisting member nations in establishing national AIDS programs.

By the mid-1990s, the relentless spread of HIV and the epidemic’s devastating impact on lives and social and economic development required a greatly expanded effort. No single United Nations organization could provide the coordinated level of assistance needed to address the many factors

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driving the HIV epidemic, or help countries deal with the simultaneous impact of HIV/AIDS on households, communities and local economies. The United Nations took an innovative approach in 1996, drawing six organizations together in a joint and cosponsored program— the Joint United Nations Program on HIV/AIDS (UNAIDS). The six original Cosponsors of UNAIDS—UNICEF, UNDP, UNFPA, UNESCO, WHO and the World Bank—were joined in April 1999 by UNDCP.67 The UNAIDS Secretariat operated as a catalyst and coordinator of action on AIDS, rather than as a direct funding or implementing agency. The goal of UNAIDS was to coordinate in a synergistic manner the expertise, resources, and networks of influence that each of the cosponsoring organizations offered. One of the early mandates developed by UNAIDS was to improve access to drugs for HIV/AIDS Various initiatives patients globally. were launched, including programs to improve the affordability of AIDS drugs and ensure availability particularly in developing countries. UNAIDS began collecting information on drug prices in these regions, and initiated negotiations with the major pharmaceutical companies to reduce their prices on both palliative drugs and ARVs, especially in Africa. The agency argued that the prices of ARVs and HAARTs would have to be reduced by a factor of 10 or more before most Africans, or their governments, could realistically afford them.

The first reaction by the pharmaceutical industry was to resist strongly the price reductions requested by UNAIDS. The pharmaceutical companies maintained that the lower prices would be irrelevant in the context of Africa’s ineffective health care systems and distribution infrastructures.

Nonetheless, UNAIDS and national governments pushed hard for preferential prices.

Other Interest and Advocacy Groups

The pharmaceutical companies’ initial refusal to cut prices attracted renewed scrutiny by AIDS activists and other non-governmental organizations (NGOs). The NGOs were extremely diverse in their agendas and priorities but could broadly be classified into three major types of organizations. First, there were the AIDS-related advocacy groups such as ACT UP!, Treatment Access Campaign (TAC) and AIDS Action Now!. Overall, these groups were concerned with the specific plight of AIDS patients both worldwide and in their home countries and sought increased access to funds for treatment of AIDS. The second type of NGO was the humanitarian groups such as Oxfam and Médicins sans Frontières that typically campaigned for humanitarian assistance across a wider spectrum of medical emergencies. The final type of NGO was the consumer rights groups such as the Consumer Project on Technology. These groups varied considerably in their organization and public action strategies, employing a host of tactics and means to achieve their individual objectives, ranging from lobbying governments to organizing protests at rallies and political gatherings. Some of the more aggressive groups such as ACT UP! also resorted to more direct action such as disrupting the Christmas parties of Bristol Myers and invading the investor relations office of GlaxoSmithKline. Emergence of Generics and Compulsory Licensing Actions A key factor in the renewed attention by the NGOs was the production of generic substitutes in Thailand, India and Brazil by local manufacturers at far lower prices than offered by the drug

67

The history and rationale for the founding were based on the UNAIDS website, www.unaids.org

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companies themselves. Between 1996 and 2000 these countries invoked the compulsory licensing rights under TRIPS to allow local manufacturers to produce ARVs based on patented formulas.

Thailand Thailand was the first country to invoke compulsory licensing. After the Asian financial crisis of 1997-1998, it was in no position to afford AIDS drugs at U.S. prices.

Beginning in the fall of 1998, local health groups lobbied the Thai and U.S. governments to license local companies to manufacture ARVs as well as drugs to treat opportunistic AIDS infections. In November 1999, the Government Pharmaceutical Organization (GPO) of Thailand delivered a letter to the Intellectual Property Department requesting the compulsory license for the ARV didanosine (ddI). ddI was developed and patented by the National Institutes of Health (NIH) and licensed to Bristol-Myers Squibb. The GPO estimated that compulsory licensing would cut the cost of a 100-mg ddI tablet to 25 baht or less from 45 baht, a savings of over 40 percent. On January 20, 2000, Thailand announced that compulsory licensing of ddI was unnecessary and that it would produce a cheaper, powdered version of the drug that would not violate international patent laws. Many observers believed that the primary reason for this decision was the threat of trade retaliation by the United States. On January 14, 2000, Sean Murphy, an official of the U.S. Trade Representative’s (USTR) office, had reminded Thailand that it could face U.S. trade sanctions if it issued a compulsory license. The U.S. policy was reversed on January 27, 2000, when USTR’s Joseph Papovich responded with a letter to Thailand’s health minister. “The United States will raise no objection,” said the letter, should the Thailand government decide to issue a compulsory license. This coincided with the shift in American policy on AIDS drugs announced by President Bill Clinton at the Seattle WHO meeting in 1999. He stated that drug-patent rights were secondary and that populations in poor

The Clinton countries should not “have to go without medicine they so desperately need.” administration had previously largely supported pharmaceutical manufacturers in international property and trade disputes.

Brazil Burdened by the steep cost of imported AIDS medications, Brazil began producing generic ARVs in 1998. Brazilian patent law recognized the primacy of compulsory licensing over patents in national emergencies, and AIDS fitted that description.68 As Brazil began producing generic versions of the branded AIDS drugs, the price of these medicines fell by 79 percent between 1998 and 2000, saving the country an estimated $490 million. By 2001 Brazil produced 10 of the 12 key AIDS drugs, using ingredients imported from Asia.

In early 2001 the Brazilian government announced that it would begin manufacturing the remaining two AIDS drugs if import prices did not decrease. The two drugs were the protease inhibitor nelfinavir and efavirenz, whose patents were held by Merck. The government claimed that the two drugs represented 36 percent of the $319 million it spent on AIDS drugs. When the drug

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Under Brazilian law, it was legal to produce drugs whose patents were registered before May 15, 1997. However, to comply with World Trade Organization rules, Brazil passed a patent law that broadly promised to respect international patents granted after that date.

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companies resisted, they drew sharp criticism from governments, NGOs such as Oxfam, Treatment Access Campaign, Médicins sans Frontières, and the general media. After a series of stalled negotiations, Merck backed down in March 2001 and agreed to lower the costs of two drugs. The price of nelfinavir was lowered from $1.30 to $0.47 per capsule and efavirenz from $2 to $0.84. Roche also provided nelfinavir, sold under the Viracept brand, and negotiations with Roche stalled. On August 22, 2001, Brazilian Health Minister Jose Serra announced that his government would issue a compulsory license for Viracept. On August 28 the two parties resumed talks, reaching an agreement three days later. Roche would sell the drug in Brazil at a 40 percent discount initially, with a steeper discount promised in 2002.

South Africa In 1997 the South African parliament granted its minister of health the power to permit parallel importation of drugs produced under license in another country. The Medicines and Related Substances Control Amendment of 1997 bypassed patent protection, allowing the import of generic drugs. In February 1998, 39 major drug companies, represented by the Pharmaceutical Manufacturers Association of South Africa (PMA), sued the government of South Africa to strike down this law, alleging that it breached TRIPS and unconstitutionally allowed the health minister to ignore patent rights. In addition, the industry claimed that the law was unnecessary, since the government enjoyed tiered prices that were far below those offered to the private sector. Drug firms also argued that the law would cut research and development funding, discourage investment in South Africa, and endanger consumers with substandard drugs.

The lawsuit attracted enormous interest from the media and activist groups. Human rights groups and AIDS activists saw it as a landmark battle for securing AIDS medicine for the millions infected in Africa. Countless protests were organized not only in South Africa but also in Europe and the United States, asserting that drug companies were profiting from a public health disaster that threatened to devastate South Africa. In response, many drug companies offered additional price concessions to South Africa and other African nations. Merck agreed in 2001 to cut the annual cost of Crixivan to $600 per patient, compared to $6,016 in the United States, GlaxoSmithKline offered its AVR Combivir for $730, compared to $6,289; Pfizer gave away its antifungal drug Diflucan to selected patients in South Africa.

The price reductions, however, generated additional pressure on the drug companies. Many critics saw the price reductions as a weakening in resolve and proof that there was room for additional price reductions. It also triggered disparagement within home markets. Local advocacy groups fueled public outrage at the high prices being charged domestic HIV/AIDS patients.

These challenges intensified over the six weeks of the trial. Public relations attacks came in a myriad of forms and from many sources, including respected opinion leaders. For instance, Nelson Mandela, the former President of South Africa and a defendant in the case, stated:

The pharmaceuticals are exploiting the situation that exists in countries like South Africa — in the developing world — because they charge exorbitant prices which are beyond the capacity of the ordinary HIV/AIDS person. That is completely wrong and must be condemned. The government is perfectly entitled, in facing that 462

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situation, to resort to generic drugs and it is a gross error for the companies, for the pharmaceuticals, to take the government to court.

In a settlement reached in April the PMA withdrew its lawsuit, and the South African government confirmed that the law would be implemented in a way that complied with TRIPS. The government agreed to consult the industry on the specific applications of the law. Response by the Pharmaceutical Industry In May 2000 GlaxoSmithKline, Bristol-Myers Squibb, Merck, Boehringer Ingelheim, and Roche joined in an initiative with UNAIDS, WHO, UNICEF, the World Bank, and the UN Development Program.

This Accelerating Access program sought to improve HIV/AIDS drug access in developing nations by negotiating preferential prices country-by-country. By September 2001 the program had succeeded in discounting drugs in 13 nations—Burkina Faso, Burundi, Cameroon, Chile, Cote d’Ivoire, Gabon, Mali, Morocco, Romania, Rwanda, Senegal, Trinidad and Tobago, and Uganda. Individual companies reported reaching agreement with four additional countries with their Accelerating Access initiatives—Benin, Chad, Congo (Brazzaville), and the Democratic Republic of Congo.

Drug companies argued that differential pricing was the best means of balancing the fulfillment of their corporate social responsibilities and the need for a return on their research and development investment. The premise behind differential pricing was that drugs would be priced based on different countries’ ability to afford them, resulting in high prices in developed countries and lower prices in developing ones. For differential pricing to work, parallel importation, the shipment of drugs from a low-price country to a high-price country, had to be limited.69 If lucrative home markets could not be protected, pharmaceutical companies might not market products in developing countries.

Differential pricing of AIDS drugs drew severe criticism from some NGOs. They reasoned that if drugs could be marketed in developing countries at a fraction of the price charged in developed countries (typically at a small markup from variable production costs), the higher prices must be unfair and excessive. To stave off such criticism, some drug companies began to give away free drugs to developing nations, but this proved ineffective due to rampant theft and improper allocation of the drugs.

As AIDS in the third world continued to spread, pharmaceutical companies faced growing pressure from their disparate stakeholders. The industry had taken a number of measures, but none stemmed the tide of criticism. Managers were forced to determine how to balance the bottom line with their social responsibility. What was the next step?

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Patricia M. Danzon PhD, “Differential Pricing for Pharmaceuticals: Reconciling Access, R&D and Patents,” Prepared for Working Group 2 of the Commission on Macroeconomics and Health, December 2001.

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Exhibit 1 Adults and Children Living with AIDS70 Region Sub-Saharan Africa North Africa & Middle East South & South East Asia East Asia & Pacific Latin America Caribbean Eastern Europe & Central Asia Western Europe North America Australia & New Zealand

Adults and Children 29.4M 0.55M 6.0M 1.2M 1.5M 0.44M 1.2M 0.57M 0.98MM .015M

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Adult Prevalence Rate (15 to 49) 8.8% 0.3% 0.6% 0.1% 0.6% 2.4% 0.6% 0.3% 0.6% 0.1%

“AIDS Epidemic Update, December 2002,” UNAIDS/WHO, http://www.unaids.org/worldaidsday/2002/press/update/epiupdate2002_en.doc, December 2002.

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